5.1 Business finance
Finance is needed to start up, operate day to day (working capital), grow and replace assets.
| Meaning | Example | |
|---|---|---|
| Capital expenditure | spending on non-current (fixed) assets that last more than a year | machinery, buildings, vehicles |
| Revenue expenditure | spending on day-to-day running costs | wages, materials, rent, electricity |
Working capital is the finance for day-to-day operations (current assets minus current liabilities). Too little means the business cannot pay bills even if profitable (liquidity problems).
Business failure from lack of finance: a business that cannot pay its debts may face bankruptcy (an individual or partner declared unable to pay), liquidation (the business is closed and its assets sold to repay creditors) or administration (an outside administrator runs the business to try to save it or sell it). Managing working capital means collecting trade receivables (money owed by customers) promptly and managing trade payables (money owed to suppliers) so cash is available.
Short-term and long-term finance
Short-term finance (under a year: overdrafts, trade credit, factoring) pays for working capital and day-to-day costs; long-term finance (loans, shares, retained profit) pays for capital expenditure and growth. Matching them matters: using a short-term overdraft to buy a building risks a cash crisis when it is recalled.
5.2 Sources of finance
Internal sources
- Retained profit: profit kept in the business: no cost or interest, but limited and slow.
- Owner's investment: the owner puts in personal funds, with no interest but at personal risk.
- Sale of unwanted assets and sale and leaseback (selling an asset such as a building and renting it back): raises cash quickly but may reduce capacity or add rent.
- Working capital management: reduce inventory or collect debts faster.
External sources
| Source | Time scale | Features |
|---|---|---|
| Overdraft | short | flexible, interest only on what is used; can be recalled |
| Trade credit | short | delay paying suppliers; free unless discounts are lost |
| Bank loan | medium/long | fixed repayments, interest and sometimes security |
| Debentures / bonds | long | long-term loans with fixed interest |
| Mortgage | long | long-term loan to buy property, secured on it |
| Leasing | medium | rent an asset instead of buying; no big outlay, but total cost higher |
| Hire purchase | medium | buy an asset by instalments, owning it after the last payment; spreads cost but carries interest |
| Debt factoring | short | sell unpaid invoices to a factor for immediate cash (less a fee) |
| New partners | permanent | extra capital and skills from partners, but profits and control are shared |
| Micro-finance | short/medium | very small loans to people and tiny businesses who cannot use banks, mostly in developing countries |
| Share issue | permanent | new capital with no repayment; dilutes control and brings dividends |
| Venture capital | long | investors take a stake; can bring expertise but give up ownership |
| Crowdfunding | varied | many small investors via a website |
| Government grants | varied | no repayment; conditions |
Choosing finance depends on cost (interest and charges), amount needed, how long, legal form (only a plc can sell shares to the public), risk and control the owners want to keep. Match the source to the purpose: short-term finance for working capital, long-term for fixed assets.
5.3 Forecasting and managing cash flows
Cash flow is the movement of cash into and out of a business. A cash-flow forecast estimates cash receipts and payments over time.
| Row | Meaning |
|---|---|
| Cash inflows | sales receipts, loans, investment, asset sales |
| Cash outflows | purchases, wages, rent, loan repayments |
| Net cash flow | inflows − outflows in the month |
| Opening balance | cash at the start (the previous closing balance) |
| Closing balance | opening balance + net cash flow |
A profitable business can still run out of cash (it may wait for customers to pay while still paying suppliers and wages). Cash flow forecasts help plan borrowing, show lenders, spot shortages and control spending. Their limits: they are estimates that can be wrong (sales are hard to predict) and external changes upset them.
Improving cash flow: chase debtors, negotiate longer credit from suppliers, reduce inventory, sell assets, use an overdraft or factor invoices, cut costs or delay spending, offer discounts for quick payment.
5.4 Costs
| Type | Meaning | Examples |
|---|---|---|
| Fixed | do not change with output in the short run | rent, insurance, salaries |
| Variable | change with output | raw materials, piece-rate pay |
| Total costs | fixed + variable | |
| Direct | traced to a product | materials, direct labour |
| Indirect (overhead) | not traced to one product | rent, admin |
Break-even analysis
Break-even is the level of output at which total revenue equals total cost (no profit, no loss).
Example: price $20, variable cost $12, fixed costs $24,000. Contribution = $8. Break-even = 24,000 ÷ 8 = 3,000 units. If sales are 4,000, margin of safety = 1,000 units. Profit = 1,000 × $8 = $8,000.
Break-even chart: the revenue line and total cost line cross at break-even; below it there is a loss, above it a profit. Uses: help set prices and targets, assess whether a loan is needed, show the effect of changes in costs or price. Limitations: assumes all output is sold, a constant selling price, straight-line cost and revenue and one product; costs and prices actually change.
Full and contribution costing
Full (absorption) costing gives each product a share of all costs, including overheads, so the full cost of each unit is known; it is useful for pricing and the accounts, but the allocation of overheads is arbitrary. Contribution costing looks only at selling price − variable cost (the contribution) and does not share out fixed costs; total contribution − fixed costs = profit. It helps with decisions such as whether to accept a special order at a lower price: accept if price exceeds variable cost and there is spare capacity. Limits: it ignores fixed costs, so a firm that only covers variable costs will not make a profit in the long run.
Using cost information
Accurate cost information is needed to set prices, decide whether to accept an order, find where costs can be cut and judge profit. Average cost = total cost ÷ output; marginal cost = the extra cost of one more unit. Costs are used to monitor performance (actual versus budgeted cost, profit = revenue − costs) and to improve it, for example by cutting waste or renegotiating supplier prices.
5.5 Budgets
A budget is a financial plan for the future (sales, costs, profit, cash). Uses: plan and set targets, control and monitor performance, allocate resources, motivate and co-ordinate departments.
| Type | Description |
|---|---|
| Income budget | forecast sales |
| Expenditure budget | planned spending |
| Profit budget | forecast profit |
| Incremental | last year's budget adjusted by a % for inflation or expected change: simple, but may repeat past waste |
| Flexible | changes with the actual level of output or activity, so variances are fairer |
| Zero-based (zero budgeting) | each year starts at zero and every item must be justified: removes waste, but takes time |
Variance analysis
Variance = actual − budget. Favourable (F): profit is higher than planned (higher revenue or lower costs). Adverse (A): profit is lower (lower revenue or higher costs). Investigate the cause: poor forecasting, price changes, wage rises, changes in demand. Managers then adjust.
Advantages of budgeting: control, direction, motivation, early warning. Disadvantages: the time to set, inaccurate forecasts, inflexible budgets, conflict between departments over limits.
Practise this chapter
Every past-paper question on these topics, with the mark scheme.
These notes are AI generated and may contain mistakes. Check them against your syllabus.