Business (9625) | Finance

Study Notes: Finance (Syllabus Section 3.2.3)

Hello future Business leaders! Welcome to the Finance chapter. Don't worry if numbers aren't your favourite thing—finance isn't just about maths; it's about making smart decisions that keep the business healthy and competitive. Think of finance as the fuel gauge and the engine management system for your business car. Without checking the fuel (cash) and the engine performance (profit), you won't get far!

This section focuses on the goals businesses set, where they get their money from, and how they use tools like budgeting and break-even analysis to survive and thrive. Let's dive in!

3.2.3.1 Financial Objectives

The Importance of Managing Finances

Finance is crucial because it dictates if a business can achieve its goals (like growth or market expansion). Effective financial management directly improves the competitiveness of a business by ensuring:
1. The business has enough cash to pay bills (survival).
2. Funds are available for investment in new technology or products.
3. Costs are kept low, allowing for competitive pricing.

Did you know? Financial decisions are deeply interrelated with other functions. If Marketing wants a big advertising campaign, Finance must approve the budget. If Operations wants a new machine, Finance must find the source of capital.

Key Financial Objectives

These are the measurable targets the finance department aims for:

• Revenue (Sales or Turnover): The total value of sales made over a period. Objective might be to increase revenue by 10%.
• Cost of Sales (COS): Direct costs linked to producing the goods or services sold (e.g., raw materials, direct labour). Objective: Reduce COS per unit.
• Expenses: Indirect costs not directly related to production (e.g., rent, salaries, marketing). Objective: Control or reduce overhead expenses.
• Gross Profit: What's left after paying for the direct cost of production. It shows how efficiently the business converts materials into products.
  Formula: \(Gross\ Profit = Revenue - Cost\ of\ Sales\)
• Operating Profit (PBIT): What's left after deducting all operating expenses (Costs of Sales plus overhead expenses) from revenue. This shows the true profit from core business activities.
• Gross and Operating Profit Margin: These measure profitability as a percentage of revenue. Margins are better for comparison than absolute profit figures.
  Formula: \(Gross\ Profit\ Margin = \frac{Gross\ Profit}{Revenue} \times 100\)
• Cash Flow: The movement of cash in and out of the business. Objective: Maintain positive cash flow to ensure liquidity.
• Return on Investment (ROI): Measures the efficiency of capital usage. It shows what percentage profit the business makes relative to the capital invested. Objective: Achieve an ROI higher than the cost of borrowing capital.
  Formula: \(Return\ on\ Investment (ROI) = \frac{Operating\ Profit}{Capital\ Invested} \times 100\)

Influences on Financial Objectives

Objectives don't exist in a vacuum. They are shaped by factors both inside and outside the business:

• Resources: Limited capital or human resources may restrict objectives (e.g., you can't aim for 50% growth if you can only afford small R&D spend).
• Developments in Technology: New technologies, like the rise of crowd funding (raising small amounts of money from many people online), influence how finance can be raised and managed.
• Ethical and Environmental Influences: A business might set an objective to reduce costs by sourcing materials locally, which also meets an environmental objective to reduce carbon footprint.
• Market Conditions: In a recession, the primary objective might shift from maximizing profit to survival and cash flow maintenance.

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3.2.3.2 Financial Data

We use financial data to calculate important metrics and track performance against our objectives.

Profit Calculations and Interpretation

We already introduced these, but remember to be able to calculate and interpret them:

• Gross Profit: (See formula above). A high Gross Profit suggests good control over direct production costs (e.g., getting raw materials cheaply).
• Operating Profit: (See formula above). This is often the most important profit figure, showing true core performance before interest and tax.
• Margins: High profit margins are essential for long-term health. A 2% Operating Profit Margin means that for every $100 in revenue, the business keeps only $2 as profit after paying all its operating costs.
• Return on Investment (ROI): A business must aim for a ROI higher than the interest rate it could get by simply putting the money in a bank, otherwise, the investment isn't worthwhile.

Budgeting and Variance Analysis

A budget is a financial plan for the future, usually covering a year. It sets targets for revenue and expenditure.

The value of budgeting is immense:

• It provides a clear target for departments (e.g., "Operations must keep unit costs below $5").
• It allows management to monitor performance and identify problems early.
• It helps with resource allocation (planning where money needs to go).

Understanding Variance

A variance is the difference between the budgeted figure and the actual result.

• Favourable Variance: Good news! This happens when actual revenue is higher than budgeted, or actual costs are lower than budgeted. Example: We budgeted to sell 100 units, but we sold 120.
• Adverse Variance: Bad news! This happens when actual revenue is lower than budgeted, or actual costs are higher than budgeted. Example: Raw material costs rose unexpectedly, leading to higher Cost of Sales.

Don't worry if the variance is adverse—the key is analyzing why it happened so you can adjust future plans or take corrective action.

3.2.3.3 Sources of Finance

Every business needs money to start, grow, or just keep the lights on. Sources of finance are typically grouped by whether they come from Internal (from inside the business) or External (from outside) sources, and whether they are Short-term (needed for immediate liquidity, paid back quickly) or Long-term (funding major assets, paid back over many years).

Internal Sources of Finance

These are often the cheapest and quickest sources, as they don't involve external lenders.

• Retained Profits (Long-term): Profit kept back in the business rather than paid out to owners/shareholders. Advantage: No interest cost, full control. Disadvantage: Reduces dividends paid to shareholders, only possible if profit is made.

External, Short-Term Sources (Under 1 Year)

Used for managing day-to-day cash flow problems (liquidity).

• Overdrafts: Allows a business bank account to go into negative balance up to an agreed limit. Advantage: Flexible and immediate. Disadvantage: High interest rates, often called in by the bank unexpectedly.
• Debt Factoring: Selling your receivables (money owed to you by customers) to a specialist company (a factor) for immediate cash, usually at a discount. Advantage: Quick cash inflow. Disadvantage: Business loses a percentage of the debt, and the factoring company takes over collection.

External, Long-Term Sources (Over 1 Year)

Used to fund large, expensive assets (e.g., factories, land, R&D).

• Loans: Fixed amounts borrowed from a bank, paid back with interest over a set period. Advantage: Predictable repayments. Disadvantage: Assets often need to be offered as security (collateral).
• Share Capital (Equity): Money raised by selling shares in the company (only available for limited companies). Advantage: No repayment required, no interest. Disadvantage: Dilutes ownership and control, requires paying dividends.
• Debentures: Long-term loan certificates issued by large companies, often secured against the assets of the company.
• Leasing: Renting an asset (like a delivery van or equipment) rather than buying it. Advantage: Avoids large upfront cost, maintenance often included. Disadvantage: Expensive in the long run, business never owns the asset.
• Venture Capital: Investment made by firms (Venture Capitalists) into high-growth, high-risk start-ups, in return for a large stake in equity. Advantage: Provides large funding and expertise. Disadvantage: Loss of significant ownership stake.
• Micro-finance: Small loans offered to poor entrepreneurs or start-ups in developing countries who cannot access traditional banking services.
• Government Grants: Money provided by the government, usually to encourage specific activities (e.g., job creation, R&D). Advantage: Does not need to be repaid. Disadvantage: Often comes with strict conditions and can be hard to obtain.
• Crowd Funding: Raising capital through small contributions from a large number of people, typically via the internet. Advantage: Great for start-ups and testing market demand. Disadvantage: Requires a compelling pitch, public exposure if it fails.

Choosing the right source depends entirely on the situation. A start-up might rely on Venture Capital, while an established, profitable firm might prefer Retained Profits or Debentures to finance a new factory.

3.2.3.4 Breakeven Analysis

Breakeven analysis is a powerful tool used to determine the exact point where a business makes neither a profit nor a loss. This figure is called the Break-even Output.

Key Concepts and Terminology

• Fixed Costs (FC): Costs that do not change with output level (e.g., rent, manager salaries, insurance). Even if you produce zero units, you still pay fixed costs.
• Variable Costs (VC): Costs that change directly with output (e.g., raw materials, packaging, piece-rate wages).
• Total Costs (TC): Fixed Costs plus Total Variable Costs.
  Formula: \(Total\ Costs = Fixed\ Costs + Variable\ Costs\)
• Revenue (Turnover): Total money received from sales.

The Concept of Contribution

The most crucial concept in break-even analysis is Contribution. This is the amount of money each unit sold contributes towards covering the Fixed Costs. Once all Fixed Costs are covered, this money becomes profit.

• Contribution Per Unit: The selling price minus the variable cost per unit.
  Formula: \(Contribution\ per\ Unit = Selling\ Price - Variable\ Cost\ per\ Unit\)
• Total Contribution: Contribution per unit multiplied by the number of units sold.

Calculating Break-even Output

The Break-even Output (BE Output) is achieved when Total Revenue equals Total Costs.

Formula: \(Break-even\ Output = \frac{Fixed\ Costs}{Contribution\ per\ Unit}\)

Margin of Safety (MOS)

The Margin of Safety is the difference between the actual or budgeted output and the break-even output. It shows how much sales can fall before the business starts losing money. A large MOS means the business is much safer.

Formula: \(Margin\ of\ Safety = Actual\ Output - Break-even\ Output\)

Break-even Charts

A chart visually represents the break-even point.

How to construct one (imagine the axes):
1. The X-axis is Output (units); the Y-axis is Costs/Revenue ($).
2. Draw the Fixed Cost line (a horizontal line, as FC doesn't change with output).
3. Draw the Total Cost line, starting where the Fixed Cost line is (since TC = FC at zero output). It slopes upwards.
4. Draw the Total Revenue line, starting at the origin (0,0). It slopes upwards.
5. The point where the Total Revenue line crosses the Total Cost line is the Break-even Output.
6. The area between the Total Revenue line and the Total Cost line after the break-even point is the Profit area.

3.2.3.5 Profit and Cash

It is vital to understand that Profit is not the same as Cash, and Profit is not the same as Profitability. This distinction is crucial for business survival.

Profit vs Cash

Profit: Recorded on the income statement. It is the excess of revenue over costs in a given period. It includes sales that may have been made on credit (receivables).

Cash: The actual physical money the business has available right now. If a customer buys $1000 of goods on a 60-day credit term, that $1000 counts as profit immediately, but the business doesn't receive the cash for 60 days.

Analogy: You win a $100,000 lottery (Profit), but they pay you in monthly instalments over 10 years (Cash Flow). You are profitable, but you don't have enough cash in hand today to buy a house!

A business can be profitable (making good sales and margins) but fail due to poor cash flow (can't pay immediate bills).

Profit vs Profitability

• Profit: An absolute figure ($100,000).
• Profitability: A relative measure (margins, ROI). A $100,000 profit is fantastic for a small coffee shop, but terrible for a multinational car manufacturer. Profitability ratios (like Gross Profit Margin) allow us to compare performance regardless of business size.

Cash Flow Statements and Working Capital

The Statement of Cash Flows tracks all the money moving in (inflows) and out (outflows) over a period. Management often uses a Cash Flow Forecast to predict future movements.

Working Capital is the money available to cover the day-to-day running costs of the business. It is defined as:

Formula: \(Working\ Capital = Current\ Assets - Current\ Liabilities\)

• Current Assets: What the business expects to turn into cash within one year (inventory, cash, receivables – money owed to the business).
• Current Liabilities: What the business must pay within one year (overdrafts, payables – money the business owes to suppliers).

A healthy positive working capital is crucial for short-term survival.

Ways of Improving Working Capital and Cash Flow

Managing the timing of inflows and outflows is key:

• Speed up Inflows: Offer discounts for immediate payment; chase up slow paying receivables; use debt factoring.
• Delay Outflows: Negotiate longer credit terms with suppliers (increasing payables); manage inventory carefully to avoid tying up cash.
• Increase immediate cash: Use an overdraft (short term solution) or sell unused fixed assets.

Ways of Improving Profits and Profitability

• Increase Revenue: Raise prices (if PED allows), increase marketing, or boost sales volume.
• Reduce Costs: Negotiate better deals with suppliers (reducing COS); improve efficiency to reduce waste; cut unnecessary expenses.
• Improve Profitability: Focus on selling products with the highest contribution or margin; invest in technology that lowers unit cost (increasing ROI).

Common Mistake to Avoid: Don't confuse increasing sales revenue with increasing profitability. You could sell millions of items, but if your costs are too high, you might generate massive revenue but zero profit!

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