Financial Information and Decisions

• Three questions, three toolkits: Obtain → sources of finance. Pay → cash flow, working capital, current and acid-test ratios. Earn → income statement, margins and ROCE.
• 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 why a business needs finance for start-up, for expansion and for working capital, and distinguish a short-term need from a long-term one.
• 5.1.1 — Justify matching the term of a source of finance to the life and cash pattern of the purpose it funds.
• 5.1.2 — Classify any of the eleven syllabus sources as internal or external, short-term or long-term, and debt or equity.
• 5.1.2 — State the benefits, limitations, cost, repayment obligation and effect on ownership of each source.
• 5.1.2 — Recommend a source of finance for a stated business, using case evidence about amount, purpose, term, legal form, existing borrowing, security and control.
• 5.2.1 — Calculate net cash flow and closing balance, and carry a closing balance into the next period.
• 5.2.1 — Complete missing entries in a cash-flow forecast and amend a forecast when a payment is rescheduled.
• 5.2.1 — Identify when a cash shortage begins and how large it is, and recommend a remedy while naming its disadvantage.
• 5.2.2 — Calculate working capital and explain why an unusually high figure is not automatically good news.
• 5.3.1 — Explain the difference between profit and cash, and how a profitable business becomes illiquid.
• 5.3.2 — Calculate gross profit, profit and any missing figure in a simple income statement.
• 5.3.2 — Distinguish a change caused by cost of sales from a change caused by expenses, and use that evidence in a decision.
• 5.4.1 — Classify an item as a non-current asset, current asset, current liability, non-current liability or owners' equity, with correct examples.
• 5.4.2 — Interpret a statement of financial position: what is owned, how it is financed, and how strong the short-term position is.
• 5.5.1 — Distinguish profit from profitability and explain why a larger profit can mean weaker profitability.
• 5.5.2 — Explain liquidity, its causes of weakness, and why it is not the same as profitability.
• 5.5.3 — Calculate gross profit margin, profit margin, ROCE, current ratio and acid-test ratio, using correct percentage or ratio notation.
• 5.5.3 — Diagnose the likely cause of a change in any of those five ratios and state the limitation of your conclusion.
• 5.5.4 — Explain how owners, managers, employees, lenders, suppliers, government and potential investors each use accounts, and the limitations of accounts as evidence.

Fictional data-response stimulus — Tamar Ceramics. Tamar Ceramics is a private limited company making decorative tableware. All figures are invented for teaching purposes. Tamar Ceramics — extracts from the accounts (fictional) Item$Item$ Revenue320 000Capital employed220 000 Cost of sales208 000Current assets72 000 Gross profit112 000  of which inventories34 000 Expenses76 800Current liabilities48 000 Profit35 200Opening cash, next quarter6 000 For the coming quarter Tamar forecasts cash inflows of $78 000 and cash outflows of $84 500, the latter including $19 000 for a new kiln with an expected life of ten years.

Working Capital

The finance available to a business for its day-to-day operations, calculated as current assets minus current liabilities. Current assets are cash and the resources expected to become cash within the operating cycle, such as inventory and trade receivables; current liabilities are the obligations due within the short term, such as trade payables and an overdraft. Adequate working capital allows a business to pay wages, suppliers and other short-term obligations as they fall due.

Statement of Financial Position

A financial statement showing what a business owns and what it owes at one particular date, together with the owners' claim on the business. It sets out non-current assets, current assets, current liabilities, non-current liabilities and owners' equity, and always satisfies the relationship that total assets equal total liabilities plus owners' equity. Unlike an income statement, which covers a period of trading, it is a snapshot of a single moment.

Net Cash Flow

The difference between the total cash a business receives in a period and the total cash it pays out in that same period. A positive net cash flow means more cash came in than went out; a negative net cash flow means the reverse. Net cash flow added to the opening balance gives the closing balance, so a negative net cash flow still leaves a positive closing balance whenever the opening balance was larger than the deficit.

Business Finance

Money raised by a business to fund its activity, obtained either from inside the business or from outside it, and used to pay for start-up costs, expansion or day-to-day operations. Finance is distinct from revenue, which is the value of sales, and from profit, which is what remains after all costs have been deducted from revenue over a period.

External Finance

Finance obtained from a party outside the business, such as a bank, a supplier, a leasing company, a shareholder, a bondholder, a microfinance institution or the public through a crowdfunding platform. External finance can raise far larger amounts than internal sources, but it imposes obligations: interest, repayment, security, or a share of ownership and control.

Gross Profit

The amount remaining when the cost of sales is deducted from revenue, before any other expenses of running the business are taken into account. Gross profit measures how much a business earns on the goods it actually sells, so a change in it points to a change in selling prices or in direct costs, and not to a change in overheads such as rent, salaries or marketing.

Cash-Flow Forecast

A financial plan setting out the cash a business expects to receive and to pay in each future period, together with the opening balance, the net cash flow and the closing balance for each period. It is used to identify the timing and size of any expected shortage in advance, to arrange finance before the shortage arrives, to test the cash consequences of a proposed decision, and to monitor actual performance against what was planned.

Return on Capital Employed

A profitability ratio expressing profit as a percentage of the capital employed in a business, where capital employed is owners' equity plus non-current liabilities. It measures how much profit each unit of long-term finance generates in a year, and it is therefore the ratio that answers whether the business is a worthwhile use of the money invested in it, independently of how large that business happens to be.

Users of Accounts

The groups that read a business's financial statements in order to make decisions about it: owners and shareholders, managers, employees and trade unions, lenders, suppliers, government, and potential investors. Each group examines different information within the same accounts, because each faces a different decision, so the same set of figures can support opposite conclusions depending on who is reading them and why.

Internal Finance

Finance raised from within a business itself, without borrowing from or issuing shares to any outside party. The three internal sources are the owner's own savings invested in the business, profit retained rather than distributed to owners, and the proceeds of selling assets the business already owns. Internal finance carries no interest and no repayment obligation, but it is limited in amount and has an opportunity cost.

Profitability

A measure of profit expressed in relation to another financial quantity, most often revenue or capital employed, rather than as an absolute amount. Profitability answers whether the profit earned is adequate for the size of the business and for the capital invested in it, so a business can increase its profit and become less profitable at the same time if revenue or capital employed grows faster than profit does.

Equity Finance

Finance raised by selling a share in the ownership of a business, most commonly by issuing share capital in a limited company. Equity carries no obligation to repay and no compulsory interest, so it does not add to the fixed cash burden of the business, but it dilutes the existing owners' share of both control and future profits, and shareholders expect dividends in return.

• “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.
• Forecasts may differ from what follows Why it matters Any forward-looking statement in the accounts rests on assumptions about demand, prices and costs, and every one of those may turn out to be wrong.
• 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.

• The FIND protocol for every calculation. 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 commits money the business already has. That matters when a question asks whether retained profit solves a cash shortage — it cannot, because the cash was already counted in the closing balance.
• 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 a potential investor 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.

• Paper 1 introduces every question with stimulus material, and for financial content that may be a partial cash-flow forecast, a few lines of an income statement, 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.
• On Paper 2, the same content is embedded in the case-study insert, whose appendices present data as tables, graphs, newspaper extracts and advertisements. 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.
• The FIND protocol for every calculation. 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 BLADE structure for every evaluation. Balanced consideration of the realistic alternatives → Linked to evidence taken from the case → Analysis developed through the chain of consequences → Decision stated clearly and unambiguously → Evaluation of the strongest limitation and the condition that would change your judgement. An answer that ends “it depends on the situation” without saying on what has not evaluated anything.