Financial information and decisions

• Three questions, three toolkits: Obtain → sources of finance. Pay → cash flow, working capital, current and acid test ratios. Earn → statement of profit or loss, margins and ROCE.
• Three questions, three toolkits. Obtain → sources of finance (5.1). Pay → cash flow, working capital, current and acid test ratios (5.2, 5.5.2). Earn → statement of profit or loss, margins and ROCE (5.3, 5.5.1). Almost every wrong answer in this topic is an answer to one of the other two questions.
• If you have only ten minutes before the examination, revise these five: net cash flow and closing balance; working capital; gross profit and profit; the five ratio formulas with their notation; and the fact that profit, cash, profitability and liquidity are four different things.

• 5.1.1 — Explain the five official reasons a business needs finance: start-up capital, capital for expansion or growth, replacing existing non-current assets, investing in new technology, and working capital.
• 5.1.1 — Distinguish a short-term finance need from a long-term one, and justify matching the term of the finance to the life of the purpose it funds.
• 5.1.1 — Define working capital, calculate it, explain why it matters, and explain why an unusually high figure is not automatically good news.
• 5.1.2 — Name the four internal sources and the nine external sources of finance, and classify any source correctly as internal or external.
• 5.1.2 — State the advantages and disadvantages of internal finance as a class, and of external finance as a class.
• 5.1.2 — Apply the seven official selection factors — size of business, legal form, amount required, length of time, existing loans, cost and purpose.
• 5.1.2 — Recommend and justify an appropriate source of finance for a stated business, using its own figures.
• 5.2.1 — Explain why cash is important to a business, and what a cash flow forecast is for.
• 5.2.1 — Name the five main features of a forecast: cash inflow, cash outflow, net cash flow, opening balance and closing balance.
• 5.2.1 — Complete or amend a simple cash flow forecast, carrying each closing balance into the next period.
• 5.2.1 — Interpret a forecast: say when a shortage begins, how large it becomes, and what caused it.
• 5.2.1 — Explain the four official responses to a short-term cash flow problem — overdraft, delaying supplier payments, asking customers to pay more quickly, and delaying the purchase of non-current assets — and name the disadvantage of each.
• 5.3.1 — Explain what profit is, and why it matters to a private sector business as a reward for risk-taking, a source of finance, a measure of success and a way to attract investors.
• 5.3.2 — Name the five features of a statement of profit or loss: revenue, cost of sales, gross profit, expenses and profit.
• 5.3.2 — Calculate any missing figure in a simple statement of profit or loss, using both official profit formulas.
• 5.3.2 — Distinguish a change caused by cost of sales from one caused by expenses, and use that evidence in a decision.
• 5.4.1 — Classify an item as a non-current asset, a current asset, a non-current liability or a current liability, with a suitable example of each.
• 5.4.1 — Explain the concept of capital employed and calculate it.
• 5.4.1 — Calculate total assets, total liabilities and working capital from a statement of financial position, and make a decision from what they show.
• 5.5.1 — Explain the concept of profitability, and calculate and interpret the gross profit margin, the profit margin and the return on capital employed.
• 5.5.2 — Explain the concept of liquidity, and calculate and interpret the current ratio and the acid test ratio.
• 5.5.3 — Explain how internal users — owners, managers and employees — and external users — suppliers, government and lenders or banks — use accounts to make decisions.
• 5.5.3 — State the limitations of using accounts and ratio analysis as evidence.

Fictional learning case — Northwind Furniture Ltd, the expansion decision. All figures are invented for teaching purposes and no real business is described. Northwind Furniture Ltd is a private limited company owned by four shareholders, all of whom work in the business. It opened a second workshop during year 2. The directors now propose a third workshop costing $120 000, with an expected useful life of fifteen years, and have asked you which source of finance to use.

• “The business made a profit, so it has the cash.” Fix Profit is measured over a period against revenue and costs; cash is a balance on a date. Credit sales, credit purchases, loan repayments and purchases of non-current assets all move cash on a different timetable from profit.
• “Negative net cash flow means the business has run out of money.” Fix Negative net cash flow only means more cash left than came in that period. If the opening balance was large enough, the closing balance is still positive. Always read the closing balance, not the net figure alone.
• “An overdraft solves any shortage.” Fix An overdraft is flexible short-term finance for a temporary gap. Using it to buy a building creates refinancing risk, because the bank can reduce or withdraw the facility on demand while the building still has twenty years of life left.
• “Retained profit is free finance.” Fix It charges no interest, but it has an opportunity cost: the owners forgo the distribution, and the money cannot be used for anything else. “No interest” is not the same as “no cost”.
• “Revenue is the money received this month.” Fix Revenue is the value of goods and services sold, whether the customer has paid yet or not. Money received also includes loans and asset sales, which are not revenue at all.
• “Inventory is a non-current asset because the business keeps it.” Fix Inventory is a current asset: it is held in order to be sold and converted into cash within the operating cycle. The shelving it sits on is the non-current asset.
• “A higher current ratio is always better.” Fix A very high ratio can mean unsold inventory piling up, customers not paying, or cash sitting idle instead of earning a return. Look at what the current assets are made of before you judge the number.
• “Profit went up, so profitability went up.” Fix Only if revenue and capital employed did not rise faster. A business that doubles its profit while tripling its capital employed has become less profitable on the ROCE measure.
• “The ideal current ratio is 2 : 1, so anything below that is a failure.” Fix No universal ideal exists. A supermarket selling for cash and paying suppliers on credit operates safely well below 2 : 1; a business with slow-moving specialist inventory may need more. Compare with the same business last year and with similar businesses.
• “One ratio proves the business is doing well.” Fix Ratios are historical, based on accounting judgements, and silent about brand, staff skill and the state of the market. One ratio from one year is the weakest evidence in the chapter.
• Accounts are historical Why it matters They report what has already happened. A business that was profitable last year may have lost its largest customer last month, and the accounts will not show it for another year.
• One year's figures are not a trend Why it matters A single ratio has nothing to be compared against. Northwind's 16% ROCE means one thing after a year of heavy investment and quite another after five flat years, and one year of figures cannot tell the two apart.
• Accounting judgements are involved Why it matters Figures such as the value placed on inventory or on non-current assets involve judgement. Two businesses in identical circumstances can report different figures without either being wrong.
• Inflation distorts comparison over time Why it matters Revenue that rises 6% while prices generally rise 6% has not grown at all in real terms, but the accounts will show growth.
• Qualitative strengths are omitted Why it matters The skill and motivation of the workforce, the reputation of the brand, the quality of the management and the loyalty of customers determine future performance, and none of them appears anywhere in the accounts.
• One ratio cannot prove overall performance Why it matters Ratios interact. A strong current ratio built on unsold inventory, or a strong profit margin achieved by cutting the marketing that generates future sales, each looks like strength in isolation and is not.
• Industry comparisons are imperfect Why it matters No two businesses are truly alike. Different sizes, product mixes, ages of assets and business models all make a like-for-like comparison approximate rather than exact.

• One habit worth fixing before you start. Section 5 is the part of this syllabus where you both calculate and judge. A number written down with no business meaning attached to it is an unfinished answer, and a judgement offered with no figure behind it is an unsupported one. Every worked example in this chapter therefore ends in a decision about the named business, and you should write yours the same way.
• AO2 is 30% of the qualification and 30% of each paper. Application means connecting the concept to this business. A sentence that would still be true if you swapped the company name for any other company has applied nothing. “An overdraft is flexible” is knowledge; “an overdraft suits Harbourline because its shortage is $2 700 for two months and reverses in April” is application.
• FIND — an Academiq habit for every calculation, not a Cambridge rule. Formula written out first → Insert the figures → Numerical answer with its unit, percentage sign or ratio notation → Decision or interpretation in the business's own context. Skipping F leaves you nothing to show for your method when the arithmetic slips; skipping D leaves the answer unfinished.
• The one row candidates get wrong most often. Retained profit produces no new inflow of cash. It is an accumulated figure — profit the owners chose not to take out — and it is not a pile of cash sitting in the bank: it may already have been spent on inventory, on receivables or on a machine. That matters twice over. A business can hold $80 000 of retained profit and $3 000 of cash, so retained profit cannot be assumed to be available. And it cannot solve a cash shortage, because whatever cash the business does hold was already counted in the closing balance.
• The row after that. Leasing and hire purchase look identical in the cash flow column and are opposite in the ownership column. If the case says the business wants to own the asset at the end, hire purchase is the answer and leasing is not, whatever the two cost.
• Choosing between remedies. Ask three questions of the case. How large is the shortage? A $2 000 gap does not justify a loan. How long does it last? A gap that corrects itself in two months needs flexible finance, not fixed instalments. What caused it? A one-off asset purchase is treated quite differently from customers who have simply stopped paying, because the second cause will still be there next quarter.
• Notice what the current ratio hides. It is 1.5 : 1 in both years and reports no change at all, while the acid test falls from 1.0 : 1 to 0.84 : 1. Inventory rose from a third of current assets to 44% of them, so the extra current assets were exactly the kind least able to pay a bill. A candidate who calculates only the current ratio concludes that liquidity is stable, which is the wrong answer. Always calculate both.
• Match the ratio to the user. A question that asks how a supplier would use the accounts is asking about the current and acid test ratios and about trade payables — not about ROCE, which tells a supplier almost nothing. A question about an owner is asking about ROCE and margins over several years, not about next month's overdraft. Answering with the wrong ratio for the named user answers a question that was not asked, however well you understand the ratio itself.
• How to practise the evaluation questions. Set a timer for the marks — roughly one minute per mark — and force yourself to write the decision sentence first, before the supporting argument. It feels backwards, but it guarantees you never run out of time with a well-argued answer that has not actually answered the question.

• Every candidate takes both papers. There is no choice of tier and no choice of paper, and both papers may assess content drawn from anywhere in the syllabus — including this topic.
• The assessment objectives were reweighted for this syllabus, and the direction of the change matters more than the numbers themselves: application carries far more weight than it used to, and pure recall carries less. Answering a financial question in general terms, without touching the figures you have been given, now costs more than it once did.
• AO2 is 30% of the qualification and 30% of each paper. Application means connecting the concept to this business. A sentence that would still be true if you swapped the company name for any other company has applied nothing. “An overdraft is flexible” is knowledge; “an overdraft suits Harbourline because its shortage is $2 700 for two months and reverses in April” is application.
• Paper 1 introduces every question with stimulus material, and for financial content that may be a partial cash flow forecast, a few lines of a statement of profit or loss, or a small table of ratios over two years. Some questions require you to refer to that material in your answer, so read the figures before you read the question. In the specimen paper each 20-mark question is built from parts worth 2, 4, 6 and 8 marks, sometimes with subparts inside a part. Treat that progression as verified preparation evidence, not as a promise that every live question will use identical wording.
• On Paper 2, the same content is embedded in the case-study insert, whose appendices present data as tables, graphs, newspaper extracts and advertisements. In the specimen paper each question is an 8-mark applied part (a) and a 12-mark part (b), and part (b) is typically a Consider task answered from the evidence supplied. The whole purpose of a case study is that it is answered from the given figures. A general statement about overdrafts that could have been written before you opened the insert describes no business in particular; one that quotes this business's own closing balance and its own existing loan describes this one.
• FIND — an Academiq habit for every calculation, not a Cambridge rule. Formula written out first → Insert the figures → Numerical answer with its unit, percentage sign or ratio notation → Decision or interpretation in the business's own context. Skipping F leaves you nothing to show for your method when the arithmetic slips; skipping D leaves the answer unfinished.