Welcome to Financial Terms and Calculations!
Hello Business student! Don’t worry if the word “finance” sounds scary. This chapter is all about understanding the language of money in business, and it’s actually one of the most important things you’ll learn!
Why? Because money is the lifeblood of any business. If you can’t manage your money, even a brilliant idea will fail. We are going to break down terms like revenue, profit, and cash flow into simple, manageable steps.
You don't need to be a math genius, just a careful organizer! Let’s get started.
Section 1: The Basics – Income and Costs
1.1 Revenue (Sales)
Revenue is the total amount of money a business earns from selling its goods or services over a specific period. It’s the money that comes into the business before any costs are subtracted.
Sometimes revenue is called Sales Turnover.
Calculation Tip:
Revenue is calculated by multiplying the price of the product by the quantity sold.
\[ \text{Revenue} = \text{Selling Price} \times \text{Quantity Sold} \]Example: If a coffee shop sells 100 coffees at \$3 each, the Revenue is \$300.
1.2 Understanding Business Costs
To make money (revenue), a business always has to spend money (costs). Costs are generally divided into two types:
Fixed Costs (FC)
- These costs DO NOT change with the level of output or sales.
- They must be paid regardless of whether the business makes one product or a thousand.
- Example: Rent for the office, manager’s salary, insurance payments.
Variable Costs (VC)
- These costs CHANGE directly with the level of output or sales.
- If you produce more, variable costs go up. If you produce less, they go down.
- Example: Raw materials (flour for a baker), wages for temporary staff, packaging costs.
Memory Aid: F-ixed costs are F-or always (the same). V-ariable costs V-ary (they change).
Total Costs (TC):
Total Costs are simply the addition of fixed and variable costs.
\[ \text{Total Costs} = \text{Fixed Costs} + \text{Variable Costs} \]Quick Review - Key Takeaway: Revenue is the money earned from sales. Costs are the money spent, categorized as Fixed (doesn't change) or Variable (changes with output).
Section 2: Calculating Profit
2.1 What is Profit?
Profit is the main goal of most businesses! It is the money left over after all the costs of running the business have been subtracted from the revenue.
Profit is NOT the same as Revenue. Revenue is the income; Profit is the income minus the spending.
2.2 Step-by-Step Profit Calculation
Step 1: Calculate Gross Profit
The first step is to calculate Gross Profit. This tells you how much money you made just from selling your products, after deducting the direct cost of making or buying those products.
The costs directly linked to the products sold are called the Cost of Sales (or Cost of Goods Sold, COGS). These are usually variable costs.
\[ \text{Gross Profit} = \text{Revenue} - \text{Cost of Sales} \]Example: A bookstore buys a book for \$5 and sells it for \$12. The Gross Profit on that book is \$7.
Step 2: Calculate Profit for the Year (Net Profit)
After calculating Gross Profit, we must subtract all the other costs—the Expenses (or Overheads). These are usually the fixed costs that keep the entire business running, such as rent, salaries, utilities, and marketing.
The result is often called Profit for the Year (or Net Profit). This is the true profit the business has made.
\[ \text{Profit for the Year} = \text{Gross Profit} - \text{Expenses (Overheads)} \]Common Mistake to Avoid: Don't confuse Gross Profit (before expenses) with Profit for the Year (after all expenses).
2.3 Loss
If the total costs (Cost of Sales + Expenses) are higher than the Revenue, the result is a Loss. The business is spending more money than it is earning.
Quick Review - Key Takeaway: Profit measures the financial success of a business over a period. It is calculated in two stages: Gross Profit (Revenue - direct costs) and Profit for the Year (Gross Profit - all other expenses).
Section 3: Understanding Cash Flow
3.1 Profit vs. Cash Flow: The Crucial Difference
This is often the trickiest part, so read carefully!
Profit tells you if your business is financially successful in the long term (Are your sales prices higher than your total costs?).
Cash Flow tells you if you have enough actual money in the bank right now to pay your bills.
Analogy: A business can be very PROFITABLE (it sold \$10,000 worth of goods) but have bad CASH FLOW if all its customers bought on credit and haven’t paid yet!
3.2 Cash Inflows and Outflows
Cash flow is a movement of money into and out of the business bank account.
Cash Inflows (Money In)
- Money coming into the business.
- Examples: Cash sales, payments from debtors (customers who bought on credit), bank loans received.
Cash Outflows (Money Out)
- Money leaving the business.
- Examples: Paying suppliers, paying rent, paying wages, paying back a loan.
3.3 Calculating Net Cash Flow and Closing Balance
We calculate the cash flow for a specific time period (e.g., one month).
Net Cash Flow (NCF)
This tells us whether more cash came in or went out during the period.
\[ \text{Net Cash Flow} = \text{Total Cash Inflows} - \text{Total Cash Outflows} \]If NCF is positive, you have a Cash Surplus. If NCF is negative, you have a Cash Shortage (Deficit).
The Balances
We use the NCF to determine how much cash the business ends up with.
1. Opening Balance: The amount of cash the business has at the start of the period (this is the same as the previous period’s Closing Balance).
2. Closing Balance: The amount of cash the business has at the end of the period.
Did You Know? A business with strong sales might go bankrupt simply because it has poor cash flow—it can't pay its workers or rent because it's waiting for customers to pay!
Quick Review - Key Takeaway: Cash Flow tracks the actual movement of physical money in and out. Net Cash Flow determines if there is a surplus or deficit, which is added to the Opening Balance to find the Closing Balance.
Section 4: Managing Cash Flow
4.1 Cash Flow Forecasts
A Cash Flow Forecast is a plan that predicts the expected cash inflows and outflows over a future period (e.g., the next 6 or 12 months).
They are essential planning tools because they allow a business to:
- Spot potential cash shortages well in advance.
- Plan how to use cash surpluses effectively.
- Use the forecast to support applications for bank loans.
4.2 Dealing with Cash Flow Shortages (Deficits)
If a forecast shows that the business will run out of cash, managers must take action immediately.
Actions to Increase Inflows:
- Speed up Payments from Debtors: Offer discounts for early payment, or chase late payers more aggressively.
- Raise Prices: Generate more revenue per sale.
- Secure External Finance: Arrange a bank loan or an Overdraft (the ability to withdraw more money than is currently in the account, up to an agreed limit).
Actions to Reduce Outflows:
- Delay Payments to Creditors/Suppliers: Negotiate longer payment terms (e.g., pay in 60 days instead of 30 days).
- Reduce Expenses: Cut down on non-essential spending (e.g., marketing).
- Reduce Stock Levels: Hold less inventory, reducing the amount paid to suppliers upfront.
4.3 Dealing with Cash Flow Surpluses
If the forecast shows a large surplus, this cash should be put to good use:
- Repay Loans: Reduces future interest payments.
- Invest: Use the money to buy new machinery or expand the business (capital expenditure).
- Keep a Reserve: Hold cash aside for unexpected problems or future opportunities.
Final Word of Encouragement: Don’t panic about the formulas! Focus on the concepts: Revenue is sales, Profit is success, and Cash Flow is survival. Master these terms, and you’ll master the financial section! You’ve got this!