2.1 - Raising finance
2.1.1 Internal finance
Internal finance comes from within the business itself. It does not involve taking on debt or giving up ownership.
Internal finance is often preferred because it avoids interest payments and does not dilute ownership. However, it is limited by the size of the business's reserves and assets. In an exam, match the source to the business context.
2.1.2 External finance
Sources of external finance (who provides the money):
Methods of external finance (how the money is structured):
Exam questions on sources of finance often ask you to justify a choice. Key factors: the size and maturity of the business (start-up vs established), whether the owner wants to retain control, the cost of finance, and the timescale of the need (short-term gap vs long-term investment).
2.1.3 Liability
Finance appropriate to each:
- Unlimited liability businesses (sole traders, partnerships): personal savings, family loans, bank loans (secured on personal assets), overdrafts. Cannot issue shares.
- Limited liability businesses (Ltd, PLC): all of the above plus share capital, venture capital, and (for PLCs) stock market flotation. Ability to issue shares makes raising large amounts of capital much easier.
Liability is a key factor when choosing a business structure. A sole trader bears unlimited risk but has total control; a private limited company offers protection but involves more administration and shared ownership.
2.1.4 Planning
Business plan: a written document that sets out the business's aims, strategy, and financial projections. Typically includes:
- Business aims and objectives
- Description of product or service and target market
- Marketing strategy
- Operational plan (how the business will function)
- Financial forecasts: sales forecast, cash flow forecast, projected profit and loss
- Funding requirements
Relevance for obtaining finance: lenders and investors require a business plan to assess the viability of the business and the risk of lending. It also forces the entrepreneur to think systematically about the business.
Cash flow forecast: a prediction of all cash inflows and outflows over a future period (typically monthly). Used to:
- Identify months when the business will have a cash deficit (negative net cash flow)
- Plan in advance for additional finance (e.g. arranging an overdraft before it is needed)
- Monitor actual cash flow against forecast
Key calculations:
Interpreting a cash flow forecast (£):
| Jan | Feb | Mar | |
|---|---|---|---|
| Cash inflows (sales) | 20,000 | 18,000 | 24,000 |
| Wages | 8,000 | 8,000 | 8,000 |
| Materials | 9,000 | 9,000 | 9,000 |
| Rent | 4,000 | 4,000 | 4,000 |
| Total outflows | 21,000 | 21,000 | 21,000 |
| Net cash flow | (1,000) | (3,000) | 3,000 |
| Opening balance | 2,000 | 1,000 | (2,000) |
| Closing balance | 1,000 | (2,000) | 1,000 |
Figures in brackets are negative. The closing balance is negative in February, so the business needs at least £2,000 of extra finance that month, such as an overdraft arranged in advance.
Calculations based on changes in the cash-flow variables: when one figure changes, recalculate net cash flow for each month affected, then carry the change through every later opening and closing balance. If materials cost 10% more (£9,900 a month instead of £9,000), outflows rise by £900 a month:
The effect builds up: by March the balance is £2,700 lower than forecast. The business now needs £3,800 of extra finance in February and is still overdrawn in March. A change in timing works the same way: giving customers a month's credit moves each month's sales inflow into the following month.
Use and limitations of a cash flow forecast:
Cash flow forecast questions often ask you to complete a table (fill in net cash flow or closing balance) or to interpret a negative closing balance. A negative closing balance means the business needs additional finance that month.
2.2 - Financial planning
2.2.1 Sales forecasting
Sales forecast: a prediction of future sales volumes and/or revenue over a given time period.
Purpose of sales forecasts: to plan production levels, staffing, and stock requirements; to set revenue and profit targets; to underpin cash flow forecasts; to support applications for finance; to identify seasonal patterns.
Factors affecting sales forecasts:
Difficulties of sales forecasting: markets are inherently unpredictable; past trends do not always predict future performance; unexpected events (economic shocks, pandemics, technological disruption) invalidate assumptions; competitors' actions are unknown; consumer tastes can shift rapidly.
Forecasting questions often ask you to evaluate the reliability of a forecast. Use context clues: is the market stable or volatile? Is the business established (more past data) or a start-up? Are there economic uncertainties? The quantitative techniques used to project forecasts (moving averages and extrapolation) are covered in Theme 3 (3.3.1).
2.2.2 Sales, revenue and costs
In calculations, always check whether the question gives costs per unit or total costs. Variable cost per unit multiplied by output gives total variable costs. Fixed costs do not change with output.
2.2.3 Break-even
Contribution is the amount each unit sold contributes towards covering fixed costs, and then to profit once fixed costs are covered.
Break-even point: the level of output (or sales) at which total revenue exactly equals total costs. The business makes neither a profit nor a loss.
Margin of safety: the difference between actual output (or sales) and the break-even output. Shows how much output can fall before a loss is made.
Worked example: price £20, variable cost £12 per unit, fixed costs £4,000, sales of 700 units.
If break-even output is not a whole number, round up. An answer of 512.5 means 513 units, because selling 512 would still leave a small loss.
Break-even chart: a graph with output on the x-axis and costs/revenue (£) on the y-axis.
- Fixed cost line: horizontal; starts on the y-axis at the fixed cost value
- Total cost line: starts on the y-axis at the fixed cost value; rises with a gradient equal to variable cost per unit
- Total revenue line: starts at the origin (zero output = zero revenue); rises with a gradient equal to the selling price
- Break-even point: the intersection of the total revenue line and the total cost line
- Profit/loss area: above break-even, TR > TC (profit); below break-even, TC > TR (loss)
Reading the chart: the break-even point gives break-even output on the x-axis and break-even revenue (£10,000 here) on the y-axis. At any output, the vertical gap between the total revenue and total cost lines is the profit or loss: at 700 units it is £14,000 - £12,400 = £1,600.
How changes show on the chart (starting from the worked example):
| Change | Effect on the chart | Break-even output |
|---|---|---|
| Price rises to £22 | Total revenue line becomes steeper | Falls: 4,000 / 10 = 400 units |
| Fixed costs rise to £4,800 | Fixed cost and total cost lines shift up in parallel | Rises: 4,800 / 8 = 600 units |
| Variable cost rises to £14 per unit | Total cost line becomes steeper | Rises: 4,000 / 6 = 666.7, so 667 units |
The opposite change has the opposite effect. A price rise lowers break-even output, but if demand is price elastic, sales volume may fall too, so the margin of safety may not improve.
When drawing a break-even chart, always label both axes, mark the break-even output on the x-axis, and shade or annotate the profit and loss areas. The margin of safety is shown as a horizontal distance on the x-axis between break-even output and actual output.
Limitations of break-even analysis:
- Assumes all output is sold at a single price; ignores the effect of discounting or price changes on demand
- Assumes linear cost and revenue relationships; ignores economies of scale and bulk discounts
- Only useful for a single product or service; unsuitable for multi-product businesses without modification
- Based on estimates; inaccurate assumptions produce misleading results
- A static tool; does not respond to changing market conditions
2.2.4 Budgets
Budget: a financial plan that sets targets for revenue and expenditure over a specific period, typically a year broken into monthly periods.
Purpose of budgets: to allocate financial resources across departments; to set performance targets that motivate managers; to monitor actual performance against plan; to identify areas of overspending or underperformance; to support decision-making and coordination.
Types of budget:
Variance analysis: comparing actual financial performance against budgeted figures to identify differences (variances).
| £ | Budget | Actual | Variance |
|---|---|---|---|
| Revenue | 50,000 | 46,000 | 4,000 A |
| Costs | 30,000 | 28,000 | 2,000 F |
| Profit | 20,000 | 18,000 | 2,000 A |
F = favourable, A = adverse. Judge each variance by its effect on profit, not by whether the difference is positive or negative: revenue below budget is adverse, but costs below budget are favourable.
Difficulties of budgeting: forecasts are estimates and may be wrong; external conditions (inflation, competitor actions) can make budgets rapidly out of date; setting unrealistic targets can demotivate staff; the process is time-consuming, particularly for zero-based budgets.
Variance questions ask you to calculate and interpret a variance. Always state whether it is favourable or adverse and explain what may have caused it. Link adverse variances to corrective actions the business could take.
2.3 - Managing finance
2.3.1 Profit
The statement of comprehensive income (also called the income statement, or the profit and loss account) records a business's revenue and costs over a period of time, usually one year. It shows profit at three levels.
| Statement of comprehensive income | £000 |
|---|---|
| Revenue | 800 |
| Cost of sales | (480) |
| Gross profit | 320 |
| Other operating expenses | (200) |
| Operating profit | 120 |
| Interest | (20) |
| Profit for the year (net profit) | 100 |
Figures in brackets are subtracted. This is the layout the specification uses in its list of accounting ratios.
The specification's layout subtracts only interest between operating profit and profit for the year. Published company accounts also subtract tax. If a question gives a tax figure, subtract it; if it does not, subtract interest only.
Measuring profitability: the three margins show what percentage of revenue is left as profit at each level.
Worked example (figures from the statement above):
Profit and profitability are different. Profit is an amount in pounds. Profitability is profit relative to revenue (a margin), so businesses of different sizes can be compared. Profit can rise while profitability falls: if revenue grows by 20% but profit grows by only 5%, the margin has fallen.
Reading the margins together:
Profitability ratio questions often ask you to calculate and then evaluate. Always compare against a benchmark (last year's figure or a competitor). A falling margin despite rising revenue means costs are growing faster than sales.
Ways to improve profitability:
| Method | How it helps | Drawback |
|---|---|---|
| Raise prices | More revenue and profit per unit sold | Only works if demand is price inelastic (1.2.4). If demand is price elastic, sales volume falls and revenue may fall; customers may switch to rivals |
| Increase sales volume (marketing, new markets, new products) | Overheads are spread over more units, so the operating margin rises | Marketing and development cost money up front and may not work |
| Cut cost of sales | Cheaper or renegotiated supplies and less waste raise the gross margin | Cheaper materials can lower quality and damage the brand; a new supplier may be less reliable |
| Cut other operating expenses | Fewer staff, cheaper premises or lower energy use raise the operating margin | Redundancies can hurt morale and customer service; cutting marketing may reduce future sales |
| Improve efficiency and productivity (2.4) | Lower cost per unit without cutting prices | Usually needs investment first, in machinery or training |
| Focus on higher-margin products | Changing the product mix raises the average margin | Customers who wanted the lower-margin lines may go elsewhere |
| Reduce interest costs | Repaying debt raises profit for the year | Uses cash that could fund investment or protect liquidity |
An "assess" question on improving profitability needs a drawback as well as a benefit. The strongest answers say which method suits the business in the case study, and why.
Distinction between profit and cash: profit is revenue minus costs for a period, and a sale counts as revenue when it is made, not when the customer pays. Cash is the money the business actually holds in the bank and on the premises. The two differ for several reasons:
Example: a furniture maker makes and sells £40,000 of tables in March, giving customers 60 days' credit. The materials and wages cost £30,000, paid in March. March shows a profit of £10,000 on these tables, but £30,000 of cash has gone out and the £40,000 does not arrive until May. Unless it has cash in reserve or an overdraft, it may not be able to pay April's bills.
A business needs profit to survive in the long run, but cash to survive in the short run. A profitable business can fail through lack of cash; an unprofitable one can keep going for a while if it has cash, for example from a loan or from selling assets.
2.3.2 Liquidity
Liquidity is the ability of a business to meet its short-term financial obligations as they fall due. It is measured using figures from the statement of financial position (balance sheet).
Statement of financial position: a snapshot of what a business owns (assets), what it owes (liabilities) and the owners' investment (equity) on a single date, usually the last day of the financial year. The statement of comprehensive income covers a period; the statement of financial position shows one moment.
| Statement of financial position | £000 |
|---|---|
| Non-current assets | 600 |
| Current assets (inventory 110, receivables 50, cash 20) | 180 |
| Current liabilities (payables 80, overdraft 40) | (120) |
| Non-current liabilities (bank loan) | (200) |
| Net assets | 460 |
| Share capital | 300 |
| Retained profit | 160 |
| Total equity | 460 |
Net assets always equal total equity. The two totals always match, which is why the statement is called a balance sheet.
Tangible and intangible assets:
Intangible assets are harder to value than tangible ones. A brand or reputation that a business has built up itself is not normally shown on its statement of financial position; it appears only when it has been bought. When one business takes over another and pays more than the value of its net assets, the extra is recorded as goodwill (see mergers and takeovers, 3.2.2). As a result, the statement of financial position can understate the value of a business with a strong brand.
Measuring liquidity:
Worked example (figures from the statement above):
The current ratio looks acceptable, but the acid test shows that without its inventory the business has only 58p of liquid assets for every £1 it owes in the short term. It depends on selling its stock to pay its debts.
| Ratio | Usually taken as comfortable | Interpretation |
|---|---|---|
| Current ratio | About 1.5:1 to 2:1 | Below 1:1, current liabilities are larger than current assets, so the business may struggle to pay its debts as they fall due. A very high ratio (say 3:1 or more) is also a weakness: too much money is tied up in stock, receivables or idle cash that could be earning a return elsewhere. |
| Acid test ratio (liquid capital ratio) | About 1:1 | Leaves out inventory, because stock may take time to sell, may have to be sold at a discount, and can become obsolete or perish. Below 1:1, the business relies on selling stock to pay its short-term debts. |
What is normal depends on the sector. Supermarkets often have current and acid test ratios well below 1:1 without being in difficulty: customers pay at the till, stock sells within days, and suppliers are paid weeks later. A manufacturer holding months of stock would be expected to have a higher current ratio.
Limitations: the ratios describe one date. A seasonal business, such as a toy retailer before Christmas, can look very different a month later. They also say nothing about how quickly receivables will actually be paid.
Give liquidity ratios as a ratio to 1 (for example 1.5:1 or 0.58:1), not as a percentage. Then say what the figure means for this business and compare it with a benchmark: last year, a competitor or the sector norm.
Working capital is the money available for day-to-day running: paying suppliers, wages and bills.
The working capital cycle:
- Cash is spent on materials and wages.
- These become inventory: raw materials, then finished goods.
- The goods are sold, often on credit, creating receivables.
- Customers pay, and the cash is used again.
The longer the cycle (slow-selling stock, long credit given to customers), the more working capital the business needs. Taking longer to pay suppliers shortens the time the business's own cash is tied up.
Managing working capital means holding enough of each current asset, but no more than is needed:
- Inventory: enough to meet demand without tying up cash in stock that sits on shelves (see stock control and JIT, 2.4.3)
- Receivables: credit control: set credit limits, invoice promptly and chase late payers. Giving credit can win customers, but every day of credit delays cash.
- Payables: use the full trade credit period offered, without paying late and damaging supplier relationships
- Cash: keep a buffer for unexpected bills, but idle cash earns little
Too little working capital and the business cannot pay its bills; too much and money is tied up that could be invested. Working capital is usually positive, but businesses such as supermarkets (above) can run safely with negative working capital.
The importance of cash: cash pays wages, suppliers, rent, interest and tax on the day they are due. A business that cannot pay its debts as they fall due is insolvent. Its creditors can take legal action to recover what they are owed, which can force it to close even if it is profitable. Cash also gives flexibility: a business with cash can take early-payment discounts from suppliers, buy stock cheaply when the chance arises, and survive a bad month without emergency borrowing.
Ways to improve liquidity:
| Method | How it helps | Drawback |
|---|---|---|
| Collect receivables faster | Shorter credit terms, discounts for early payment and chasing late payers bring cash in sooner | Discounts reduce revenue; customers may move to rivals that give more credit |
| Negotiate longer credit from suppliers | Cash stays in the business for longer | Suppliers may refuse or raise prices; paying late damages relationships |
| Reduce inventory | Selling off surplus stock turns it into cash; ordering less (or JIT) ties up less cash in future | Stock may have to be sold at a discount; low stock risks running out |
| Sell surplus non-current assets | Unused machinery or property is turned into cash | A one-off source; may reduce capacity |
| Sale and leaseback | Sell an asset such as a building and lease it back, so the business keeps using it | Lease payments continue for years; the business loses any future rise in the asset's value |
| Long-term loan or new share capital | Raises cash without adding a current liability | Interest must be paid on a loan; new shares dilute ownership and control |
| Overdraft | Gives quick access to cash when needed | High interest and repayable on demand. It counts as a current liability, so it adds to the short-term debts the ratios measure |
Not every method changes the ratios. Collecting receivables turns one current asset into another, so the current ratio and acid test stay the same even though the business now has cash to spend. Methods that bring in cash from outside current assets (selling non-current assets, a long-term loan, a share issue) raise both ratios. Do not confuse liquidity with profitability: a business can be profitable but illiquid, or liquid but unprofitable.
2.3.3 Business failure
Most businesses that fail run out of cash. A business that cannot pay its debts as they fall due is insolvent, and its creditors can force it to close.
The specification groups the causes two ways: internal (inside the business and within its control) or external (outside its control), and financial or non-financial.
| Financial factors | Non-financial factors | |
|---|---|---|
| Internal | Poor cash flow management; overtrading; too much debt and a heavy interest burden; poor credit control, leading to bad debts; weak cost control and falling margins; underestimating start-up costs | Poor management and leadership; weak planning and market research; wrong product, price or location; failure to innovate or adapt; poor quality or customer service; high staff turnover |
| External | The bank withdraws or cuts an overdraft, or refuses a loan; interest rates rise; suppliers cut trade credit or demand payment on delivery; a major customer fails and does not pay; costs of materials or energy rise; the exchange rate moves against the business | New competitors or a price war; changing consumer tastes; new technology makes the product obsolete; new legislation raises costs or restricts the product; a recession cuts demand; loss of a key supplier; natural disasters or pandemics |
Overtrading means growing faster than the business's working capital can support. A business takes on large new orders, so it must buy more materials and pay more wages before its customers pay. Sales and profit rise, but cash runs out. It is common in fast-growing young businesses.
Warning signs (see 2.3.2): a falling current or acid test ratio, an overdraft that is always in use, paying suppliers later and later, falling profit margins and rising bad debts.
A question may ask for one type of cause, such as an external financial factor, so learn all four boxes. The categories can overlap: a recession cuts demand, which then cuts cash inflows. Internal causes are within the business's control; external causes are not, though a well-run business can reduce their effect, for example by keeping a cash buffer. Explain the chain from the cause to the business running out of cash.
2.4 - Resource management
2.4.1 Production, productivity and efficiency
Methods of production:
Productivity: output per unit of input per time period.
Higher productivity reduces unit labour costs, making the business more competitive. Factors influencing productivity include: motivation and skills of the workforce, quality of machinery and technology, effectiveness of management, and the production method used.
Link to competitiveness: higher productivity lowers unit costs, allowing the business to either reduce prices to compete on cost, or maintain prices and improve profit margins.
Efficiency: producing output at the minimum average (unit) cost. A business is efficient when it minimises waste of resources relative to output.
A question may ask whether a business should switch from labour-intensive to capital-intensive production. Consider: the cost and availability of capital equipment, the volume of output, whether the product requires customisation, and the impact on the workforce (redundancies, retraining).
2.4.2 Capacity utilisation
Ideal capacity utilisation is around 90%: high enough to spread fixed costs efficiently, but leaving a small reserve for maintenance and unexpected demand increases. Operating at exactly 100% is risky.
Ways of improving capacity utilisation:
- Increase output: more aggressive marketing, price reductions, targeting new markets or customers, taking on subcontracted work
- Reduce capacity: sell surplus machinery or premises, make employees redundant (rationalisation), outsource production
- Flexible working: use part-time or temporary staff to match labour supply more closely to actual demand
Capacity utilisation questions may ask you to calculate it or to evaluate the implications of a given percentage. A very low figure (e.g. 40%) suggests serious problems; a figure above 95% suggests the business may need to invest in additional capacity.
2.4.3 Stock control
Stock control diagram: a graph showing stock levels over time (time on x-axis; stock level on y-axis). Key features:
- Maximum stock level: the upper limit the business is willing to hold (storage constraints, cost)
- Reorder level: the stock level at which a new order is placed; set high enough so stock does not fall below buffer before delivery arrives
- Buffer stock: the minimum stock level held as a safety margin against unexpected increases in demand or delivery delays
- Reorder quantity: the amount ordered each time; takes stock back up to maximum level on delivery
- Lead time: the time between placing an order and receiving delivery; determines where to set the reorder level
Reading the diagram: the slope of the line is the usage rate. The dots show when orders are placed (stock reaches the reorder level), and the vertical jumps show deliveries arriving.
The reorder quantity formula assumes each delivery arrives just as stock reaches the buffer level, as in the diagram. If usage rises or a delivery is late, the business starts using its buffer stock; if that runs out, it has a stockout.
Implications of poor stock control:
Just-in-time (JIT) stock management: stock is ordered and delivered only when it is needed for production or sale. Key features:
- Eliminates the need for large buffer stocks; greatly reduces storage costs and cash tied up in stock
- Requires highly reliable suppliers with short, consistent lead times
- Any disruption to supply (strike, natural disaster, transport delay) immediately halts production
- Associated with lean production: eliminating waste across all aspects of the operation
Waste minimisation and lean production: lean production aims to eliminate all forms of waste (over-production, waiting time, excess inventory, defects, unnecessary movement). Businesses gain a competitive advantage through lower costs and faster response times.
JIT is high-risk, high-reward. In an exam question asking whether a business should adopt JIT, consider: how reliable are its suppliers? How predictable is demand? Does the business have strong supplier relationships? A business with unpredictable demand or unreliable suppliers should retain buffer stocks.
2.4.4 Quality management
Kaizen (continuous improvement): a Japanese management philosophy based on making small, incremental improvements to processes continuously, involving all employees. Improvements are cumulative over time and can deliver significant gains in quality and efficiency without large capital investment.
Competitive advantage from quality management: consistent quality builds brand reputation and customer loyalty; enables premium pricing; reduces costs of defects, returns, and reworking; lowers the risk of reputational damage; can be a sustainable differentiator that is hard for competitors to replicate quickly.
Questions on quality often ask you to compare quality control and quality assurance. The key distinction: control is reactive (finding defects); assurance is proactive (preventing them). TQM extends this to a whole-organisation culture.
2.5 - External influences
2.5.1 Economic influences
Effect of economic uncertainty on the business environment: when the future economic outlook is unclear, businesses tend to: reduce capital investment; hold larger cash reserves; use flexible (short-term, temporary) contracts rather than permanent hires; delay major strategic decisions; cut costs to maintain liquidity. Uncertainty reduces innovation and long-term planning.
Exchange rate questions are commonly tested. Remember: a stronger pound is bad for exporters and good for importers. A weaker pound is good for exporters and bad for businesses that rely on imported inputs. Always consider both sides.
2.5.2 Legislation
Legislation questions often ask you to evaluate the impact on a specific business. Always consider: the direct compliance cost, the potential cost of non-compliance (fines, legal action, reputational damage), and whether the regulation could lead to long-term efficiency gains or competitive advantage.
2.5.3 The competitive environment
Competition and market size: the degree of competition in a market is determined by the number and size of competitors, the ease of entry, the availability of substitutes, and the rate of market growth.
Market size is the total sales of all businesses in a market, measured by value (£) or volume (units) (see 1.1.1). It affects how much competition there is:
Changes in the competitive environment: competition increases when new entrants join the market (lower barriers to entry, e-commerce reducing geographic barriers), when close substitutes emerge, or when the market matures and slows. Businesses must continuously monitor the competitive environment and adapt their strategy accordingly.
The competitive environment links closely to 1.1.1 (dynamic markets) and 1.1.3 (competitive advantage). In an exam, use Michael Porter's idea of competitive advantage implicitly: businesses respond to greater competition by competing on either cost or differentiation.