Money decides whether a business survives. This chapter covers where finance comes from, how to plan cash, and how to read a business's accounts.
5.1 Business finance: needs and sources
Why businesses need finance
- Start-up capital: money to set up (premises, equipment, stock).
- Capital for expansion: new premises, machines, products.
- Working capital: money to pay day-to-day costs (wages, suppliers, bills) until customers pay.
Short-term finance is needed for less than a year (to fund stock or cover a gap in cash). Long-term finance is for more than a year (buying property or machinery).
Sources of finance
| Internal | External | |
|---|---|---|
| Meaning | from within the business | from outside the business |
| Examples | retained profit, sale of assets, owner's savings, reducing stock | bank loans, overdraft, share issue, trade credit, leasing, debentures, grants |
| Source | Notes | |
|---|---|---|
| Short-term | Overdraft | the bank lets the account go below zero up to a limit; flexible, but a high interest rate and can be withdrawn |
| Trade credit | delaying payment to suppliers (e.g. 30 days); free, but can lose discounts | |
| Factoring (selling debts) | immediate cash for unpaid invoices | |
| Long-term | Debt: bank loan or debentures | must be repaid with interest, keeps ownership, but interest is a cost whatever the profit |
| Equity: selling shares | no repayment or interest, but owners' control is diluted and dividends are paid; only limited companies | |
| Retained profit | cheap, no interest, but only available if the business has made profit | |
| Leasing | use an asset for a fee instead of buying; no big outlay, but no ownership and total cost may be higher |
Alternative sources of capital: micro-finance (very small loans to people, often in developing countries, who cannot get bank loans) and crowd-funding (many people each give a small amount, usually through a website, in exchange for a reward or a share).
Factors considered when choosing: size and legal form (a sole trader cannot sell shares), the amount needed, the length of time (a long-term asset needs long-term finance), cost (interest), existing loans, risk and control.
5.2 Cash-flow forecasting and working capital
Why cash matters
Cash is the money a business has available to spend. A business can be profitable and still fail if it runs out of cash to pay bills. Profit and cash are different: profit is revenue minus costs over a period (and may include sales not yet paid), while cash is the actual money in hand.
The cash-flow forecast
A cash-flow forecast is an estimate of the cash coming in (receipts) and going out (payments) each month, and the resulting balance.
| Jan | Feb | Mar | |
|---|---|---|---|
| Opening balance | 2,000 | 1,500 | 600 |
| Cash inflows (sales, loans) | 8,000 | 9,000 | 12,000 |
| Cash outflows (wages, stock, rent) | 8,500 | 9,900 | 10,500 |
| Net cash flow (inflows – outflows) | –500 | –900 | +1,500 |
| Closing balance (opening + net) | 1,500 | 600 | 2,100 |
Importance: shows when cash shortages are likely so action can be taken, helps persuade banks to lend, helps plan spending and spot problems early.
Amending a forecast: if a figure changes (sales fall by $500 in March), recalculate that month's inflows, net cash flow and closing balance, and every month after (because each opening balance depends on the previous closing balance).
Interpreting: look for negative balances (cash shortage), the months with high outflows, and whether the closing balance is increasing or decreasing. Limitations: it is only an estimate (sales may be wrong; unexpected costs appear).
Overcoming a short-term cash problem: arrange an overdraft, delay paying suppliers (use trade credit), ask debtors to pay more quickly, cut spending or delay purchases, sell unused assets, or sell stock at a discount.
Working capital
Working capital is the money available for day-to-day running costs.
It is important because without enough, a business cannot pay suppliers and wages on time and may fail. Too much working capital is wasteful (cash sitting idle or too much stock).
5.3 Income statements
Profit
Profit = revenue – total costs. A business makes profit by selling at more than it costs to produce.
Importance of profit to private-sector businesses: reward for risk-taking and enterprise (owners), a source of finance (retained profit for growth), a sign of success and a measure of performance, and the way to pay dividends to shareholders.
Profit and cash differ: profit includes sales on credit that have not yet been paid, and costs like depreciation that do not involve cash leaving the business.
The income statement
An income statement (profit and loss account) shows revenue, costs and profit over a period (usually a year).
| $ | |
|---|---|
| Revenue (sales) | 200,000 |
| Cost of sales (cost of goods sold) | (120,000) |
| Gross profit | 80,000 |
| Expenses (wages, rent, advertising, interest) | (50,000) |
| Profit (before tax) | 30,000 |
| Tax | (6,000) |
| Profit after tax | 24,000 |
| Dividends paid | (10,000) |
| Retained profit | 14,000 |
Decision-making: compare profit with the previous year or with competitors, identify costs that are rising, or decide whether to raise prices or cut expenses. (You will not be asked to construct an income statement, but you must read and use one.)
5.4 Statement of financial position
The statement of financial position (balance sheet) shows what a business owns (assets) and owes (liabilities) at one date, and how it is financed.
| Classification | Meaning | Examples |
|---|---|---|
| Non-current assets | assets kept for more than a year | buildings, machinery, vehicles |
| Current assets | assets that become cash within a year | inventories, receivables (debtors), cash |
| Current liabilities | debts to repay within a year | payables (creditors), overdraft, tax owed |
| Non-current liabilities | debts to repay after more than a year | long-term bank loans, debentures |
| Equity (capital) | the owners' stake: share capital and retained profit |
Interpreting: see how the business is financed (mostly by loans, which is risky, or by the owners' funds), what assets it owns, whether current assets cover current liabilities (liquidity) and how much is tied up in inventories. Selling inventories is a way to raise cash quickly. (You will not be asked to construct a statement of financial position.)
5.5 Analysis of accounts
Profitability is how much profit a business makes compared with its sales or capital. Liquidity is its ability to pay short-term debts when they are due. A business can be profitable but not liquid.
Ratios
| Ratio | Formula | What it shows |
|---|---|---|
| Gross profit margin | gross profit ÷ revenue × 100 | profit left from each $100 of sales after direct costs |
| Profit margin | profit ÷ revenue × 100 | profit from each $100 of sales after all costs |
| Return on capital employed (ROCE) | profit ÷ capital employed × 100 | profit relative to money invested; compare it with the interest rate on savings |
| Current ratio | current assets ÷ current liabilities | ability to pay short-term debts; about 1.5 to 2 is often seen as healthy |
| Acid test ratio | (current assets – inventories) ÷ current liabilities | stricter measure that excludes inventories; about 1 or more is often seen as safe |
To improve ratios: raise profit margin by increasing prices or cutting costs; improve liquidity by reducing inventories, collecting debts faster, or borrowing long-term instead of short-term.
Always compare ratios with the previous year or with competitors, and say what has changed and why it matters.
Users of accounts
| User | What they want to know |
|---|---|
| Owners / shareholders | profit, ROCE, return on their investment |
| Banks / lenders | liquidity and ability to repay a loan |
| Managers | performance, to plan and compare |
| Employees and trade unions | profit and job security, scope for pay rises |
| Suppliers | whether they will be paid (liquidity) |
| Government (tax) | profit, for tax |
| Potential investors | whether it is worth investing |
Users use ratio results to make decisions, such as whether to lend to or invest in the business, or whether to grant credit. Limitations of ratio analysis: based on past data, may be manipulated, differences between industries, and ignores non-financial factors such as quality and staff morale.
Practise this chapter
Every past-paper question on these topics, with the mark scheme.