Business | Managing finance

👋 Welcome to Managing Finance!

Hello everyone! This chapter, Managing Finance, is one of the most practical and crucial parts of running a successful business. Don't worry if numbers aren't your favourite thing—we are going to break down these concepts so clearly that you'll feel confident tackling any financial scenario.

Understanding finance isn't just about crunching numbers; it's about making smart decisions: where to get money, how to spend it wisely, and how to measure if you're actually successful. Let’s dive in!

Section 1: The Essential Role of Finance

Finance is the lifeblood of any business. Without adequate funds, a business cannot pay staff, buy supplies, or invest for the future.

Financial Objectives

Businesses set financial goals to guide their operations. These typically include:

• Profit Maximisation: The classic objective—making the highest possible profit.
• Revenue Maximisation: Focusing on achieving the highest level of sales income possible (sometimes at the expense of short-term profit).
• Survival: Particularly important for new businesses or those facing economic downturns. The goal is simply to stay afloat.
• Return on Investment (ROI): Ensuring that the money invested yields a satisfactory return.
• Cash Flow Management: Maintaining enough cash on hand to meet immediate debts.

💡 Quick Tip: Financial objectives are often in conflict. For example, focusing too heavily on survival might mean delaying investments that could lead to profit maximisation later.

Section 2: Sources of Finance (Where Does the Money Come From?)

Every business needs money to start and grow. The source chosen depends heavily on how much money is needed and for how long.

Internal Sources of Finance

These are funds generated from within the business itself. They are usually cheap and readily available.

• Retained Profit: Profit earned by the business that is kept back for reinvestment rather than paid out to owners/shareholders. (Analogy: Saving money in your piggy bank instead of spending it immediately.)
• Sale of Assets: Selling off unused or outdated equipment or property (e.g., selling an old delivery van).
• Working Capital Management: Improving the way the business manages its day-to-day operations (e.g., reducing inventory levels or chasing debtors faster).

External Sources of Finance

These funds come from outside the business. They usually involve interest payments or giving up a share of ownership.

Short-Term External Finance (Must be repaid within one year)

• Overdrafts: Allows a business to withdraw more money than it currently holds in the bank account, up to an agreed limit. This is flexible but often has high-interest rates.
• Trade Credit: The period of time allowed by suppliers before they must be paid (e.g., 30 days). This is essentially an interest-free loan from the supplier.

Long-Term External Finance (Repayment over many years)

• Loans: Money borrowed from banks, repaid with interest over a fixed term (e.g., 5-10 years).
• Share Capital (Equity Finance): Selling ownership stakes (shares) in the company to investors. The business does not have to repay this, but it must share future profits (dividends). (Only available to limited companies.)
• Debentures/Bonds: Large loans usually taken by very large companies from multiple investors, often traded on financial markets.
• Venture Capital: Investment made by firms or individuals in high-growth, high-risk start-ups, usually in exchange for equity.

Factors Affecting the Choice of Finance

Management must consider:

1. Cost: Is the interest rate affordable?
2. Purpose: Is it for daily expenses (short-term) or buying a factory (long-term)?
3. Time Scale: How quickly is the money needed and when can it be repaid?
4. Risk/Security: Does the business have to offer collateral (security) for a loan? Will the chosen source dilute ownership?

🔑 Key Takeaway: Internal finance is usually cheaper and less risky than external finance, but it might not provide enough capital for major expansion.

Section 3: Understanding and Managing Cash Flow

This is one of the most critical areas for business survival.

Cash Flow vs. Profit

It is vital to understand the difference between these two concepts. A business can be profitable but still fail due to poor cash flow!

• Profit: When Revenue (Sales Income) is greater than Costs (Expenses). Profit is calculated when sales are made, regardless of whether the money has been received yet.
• Cash Flow: The movement of actual cash into (inflows) and out of (outflows) a business during a specific period.

Example: A business sells £50,000 worth of goods in March (making a profit). If the customer doesn't pay until May, the business has a cash flow problem in April, even though it is technically profitable.

The Cash Flow Forecast

A cash flow forecast estimates future cash inflows and outflows over a period (e.g., the next 6 or 12 months).

Step-by-Step Structure:

1. Inflows (Receipts): Money expected to come in (e.g., sales, loans received).
2. Outflows (Payments): Money expected to go out (e.g., wages, rent, stock purchases).
3. Net Cash Flow: Inflows minus Outflows.
4. Opening Balance: Cash held at the start of the month.
5. Closing Balance: Opening Balance + Net Cash Flow. (This closing balance becomes the next month’s opening balance.)

Net Cash Flow Formula: \( \text{Inflows} - \text{Outflows} = \text{Net Cash Flow} \)

Closing Balance Formula: \( \text{Opening Balance} + \text{Net Cash Flow} = \text{Closing Balance} \)

Addressing Cash Flow Problems

If a forecast shows a business running out of cash (a negative closing balance), management must act quickly:

To Increase Inflows:

• Offer discounts for prompt payment from customers.
• Immediately reduce credit terms (make customers pay faster).
• Sell off unused stock or assets quickly.

To Decrease Outflows:

• Negotiate longer credit terms with suppliers (pay later).
• Reduce inventory levels (buy less stock).
• Delay non-essential spending (e.g., postpone marketing campaigns).

Section 4: Measuring Financial Performance (Profitability)

Financial ratios help managers, investors, and creditors judge how well a business is performing by comparing different figures from the financial statements.

Types of Profit

• Gross Profit: Revenue minus Cost of Goods Sold (COGS). This shows how efficiently the business makes or buys its products.
• Operating Profit (Profit Before Interest and Tax): Gross Profit minus Operating Expenses (like rent, salaries, utilities). This shows the profit generated purely from core business operations.
• Profit for the Year (Net Profit): Operating Profit minus Interest and Tax. This is the final profit figure available to shareholders or retained in the business.

Key Profitability Ratios

These ratios measure how effective the firm is at generating profit from its sales or investment.

1. Gross Profit Margin (GPM)

Measures the proportion of revenue left after paying for the direct costs of the goods sold (COGS). A higher margin is better.

\( \text{Gross Profit Margin (\%)} = \frac{\text{Gross Profit}}{\text{Revenue}} \times 100 \)

2. Return on Capital Employed (ROCE)

This is perhaps the single most important measure of business performance. It assesses how effectively a business uses the total capital (money) invested in it.

Capital Employed is the total value of long-term funds invested in the business (e.g., share capital + reserves + long-term loans).

\( \text{ROCE (\%)} = \frac{\text{Operating Profit}}{\text{Capital Employed}} \times 100 \)

Analogy: If you invest £100 in a savings account, and get £5 back, your return is 5%. ROCE does the same for a business—it tells you how much profit they got for every £100 invested.

Section 5: Basic Investment Appraisal

When a business considers a major project (like buying new machinery or building a new warehouse), it needs to decide if the investment is financially worthwhile. This process is called Investment Appraisal.

1. Payback Period (PBP)

The Payback Period calculates the time it takes for a project to generate enough cash flow to recover its initial cost.

The Decision Rule: Managers usually choose projects with the shortest payback period, as this means less risk and quicker access to the funds for other uses.

Step-by-Step Calculation (Simple Case: Even Cash Flows)

If the cash flow is the same every year:

\( \text{Payback Period (Years)} = \frac{\text{Initial Investment}}{\text{Annual Net Cash Flow}} \)

Step-by-Step Calculation (Complex Case: Uneven Cash Flows)

When cash flows change yearly, you use cumulative cash flow:

Example: Project costs £100,000. Year 1 returns £40,000. Year 2 returns £50,000. Year 3 returns £30,000.

1. Year 1 Cumulative: £40,000 (Remaining needed: £60,000)
2. Year 2 Cumulative: £90,000 (Remaining needed: £10,000)
3. Year 3 Cash Flow: £30,000. Only £10,000 is needed from this year.
4. Calculation for the final months: \(\frac{\text{Cash needed}}{\text{Cash flow in final year}} \times 12 \text{ months}\)
5. \( \frac{£10,000}{£30,000} \times 12 = 4 \text{ months} \)
6. Payback Period = 2 years and 4 months.

2. Average Rate of Return (ARR)

The Average Rate of Return (ARR) measures the total profitability of an investment over its entire lifespan. It is expressed as a percentage of the initial investment.

The Decision Rule: Choose projects that yield an ARR higher than the company’s target percentage.

ARR Calculation

The key is to calculate the Net Return first (Total cash inflows minus Initial Investment).

\( \text{ARR (\%)} = \frac{\text{Average Annual Profit}}{\text{Initial Cost of Investment}} \times 100 \)

Where: \( \text{Average Annual Profit} = \frac{\text{Total Net Return (Total Profit)}}{\text{Number of Years of Project}} \)

Advantages and Disadvantages of Appraisal Methods

• PBP Advantage: Simple to calculate and focuses on risk (how fast you get your money back).
• PBP Disadvantage: Ignores cash flows that occur after the payback period.
• ARR Advantage: Looks at profitability over the whole life of the project.
• ARR Disadvantage: Ignores the timing of cash flows (a pound received in year 1 is treated the same as a pound received in year 10).

🌟 Don't Worry! Investment appraisal can feel intimidating, but remember the purpose: Payback is about speed and risk; ARR is about overall profit percentage. Practice these formulas, and you will master them!

Summary Key Takeaway for Managing Finance

Effective financial management means ensuring liquidity (having enough cash) while also ensuring profitability (making money) and making wise investment decisions for future growth.