Financial Information & Decisions

Business finance: needs and sources

Finance is needed at three moments: at start-up, at expansion, and whenever money goes out before it comes in. The skill examined is choosing a source and defending the choice.

Why finance is needed

Start-up capital pays for premises, equipment and inventory before the first sale. Capital for expansion funds growth. Working capital covers day-to-day costs — wages, materials, bills falling due before customers pay. A need is short-term where the money is wanted for under a year and repaid out of trading, and long-term where it buys an asset used for years. Match the two: short need to short source, long need to long source.

Internal and external sources

Internal finance comes from within — retained profit, sale of unwanted assets, tighter working capital. It carries no interest, no repayment date and no loss of control, and is available at once, but it is limited to what has been earned or owned, and spending it denies owners a payout. External finance comes from outside — bank loan, overdraft, trade credit, share capital, leasing, grants, crowd-funding, micro-finance. It provides far larger sums and reaches firms with no retained profit, but interest cuts profit, new shares dilute control, and lenders demand security and may refuse.

Choosing between them

Four factors decide the choice. Size and legal form: only a limited company can issue shares; a sole trader is limited to loans, savings and retained profit. Amount required: an overdraft suits a small shortfall; a factory needs a loan or a share issue. Length of time: short need, short source. Existing loans: a heavily indebted business struggles to borrow more, and pays more in interest if it does.

Cash flow and working capital

Cash is the money a business can spend today. A forecast sets out what it expects to receive and pay each month, so a shortage is seen coming — while there is time to act.

Forecasting cash

A forecast lists cash inflows (sales receipts, loans, owners’ capital) and cash outflows (wages, materials, rent, repayments), month by month. Net cash flow = cash inflows − cash outflows. Closing balance = opening balance + net cash flow, and a negative closing balance is a cash shortage.

Solving a shortage

A negative closing balance is a warning, not a verdict. The business can arrange an overdraft, delay paying suppliers, press debtors to pay sooner, cut outflows, or sell an unused asset. Each carries a cost: an overdraft charges interest, and delaying suppliers risks trade credit.

Working capital

Working capital is what is left to trade with once short-term debts are met: current assets − current liabilities. Too little and wages cannot be paid; too much and cash sits idle in inventory and unpaid invoices.

Income statements

An income statement shows how a business performed over a period — usually a year. It moves in one direction: from revenue at the top, through two deductions, to profit at the bottom.

How profit is made

Profit is what remains of revenue once the costs of earning it are deducted. Cost of sales is the direct cost of the goods actually sold; gross profit = revenue − cost of sales. Expenses are the indirect costs of running the business — rent, salaries, marketing, insurance; profit = gross profit − expenses. Only the second figure can be retained.

Worked example — reading an income statement

Kito Furniture reports revenue of $480,000, cost of sales of $300,000, and expenses of $90,000 for the year. Gross profit = $480,000 − $300,000 = $180,000. Profit = $180,000 − $90,000 = $90,000. Expenses absorb half of the gross profit, so a fall in gross profit would wipe out profit far faster than it appears.

Statement of financial position

Where the income statement covers a period, the statement of financial position is a photograph of a single day. It shows everything the business owns, everything it owes, and — necessarily — that the two sides balance.

Assets and liabilities

Non-current assets are kept for more than a year: property, vehicles, machinery, equipment. Current assets are turned into cash within a year: inventory, trade receivables (debtors), and cash itself. Current liabilities fall due within a year: an overdraft, trade payables (creditors), unpaid tax. Non-current liabilities are repaid over more than a year — chiefly long-term bank loans. What is left belongs to the owners: equity, made up of share capital and retained profit.

Making deductions from it

The statement is set for interpretation, not construction. Three deductions recur: how the business is financed (large non-current liabilities against small equity means it is funded mainly by debt, and carrying the interest to match); what it owns and how liquid it is (current assets set against current liabilities show whether short-term debts can be met); and where finance could be found (a large inventory figure is cash tied up, and selling inventory raises finance without borrowing).

Profitability, liquidity and the five ratios

Profit is a number; profitability is a judgement. A $1m profit is impressive on $5m of revenue and disappointing on $50m. Ratios turn raw figures into comparable ones.

Profitability

Three ratios do the work. Gross profit margin = (gross profit ÷ revenue) × 100, which falls if cost of sales rises. Profit margin = (profit ÷ revenue) × 100, which falls if expenses rise. Return on capital employed = (profit ÷ capital employed) × 100. Read the margins together: if the gross margin holds while the profit margin falls, the problem is expenses.

Liquidity

Liquidity asks a blunter question: can short-term debts be paid? The current ratio = current assets : current liabilities. The acid test ratio = (current assets − inventory) : current liabilities, stripping out inventory, the slowest current asset to turn into cash. Both are stated as X : 1 to two decimal places.

Worked example: Anaya’s store holds current assets of $84,000 (including $36,000 of inventory) and current liabilities of $60,000. Current ratio = 84,000 ÷ 60,000 = 1.40 : 1. Acid test = (84,000 − 36,000) ÷ 60,000 = 0.80 : 1. The store looks solvent until inventory is stripped out — without selling stock, short-term debts cannot be met.

Using the accounts

Accounts are read by people with different questions. The same set of ratios can support a loan, block a supply contract, or end a shareholding — depending entirely on who is reading, and what they need to decide.

Who reads the accounts

Owners and shareholders ask whether their investment earns a good return (ROCE, profit margin). Managers ask whether targets are met and where performance is slipping (all five ratios, year on year). Employees ask whether the business is secure and can afford a pay rise (profit, liquidity). Banks and lenders ask whether the business can repay a loan and how indebted it already is (current ratio, acid test). Suppliers ask whether they will be paid if they grant trade credit (acid test, working capital). Government checks the correct tax is paid on declared profit (income statement).

Turning a ratio into a decision

A single ratio in isolation means little. It becomes evidence when it is compared — against last year, against a competitor, or against what the user actually needs. Ratios are drawn from past accounts, cover only what the figures capture, and can be presented flatteringly. They start the argument — they do not end it.

Worked example: a manufacturer’s gross profit margin rises from 52% to 57% while its profit margin falls from 18% to 14%. The gross margin has risen, so the cost of producing each item has fallen relative to its selling price; the profit margin has fallen, so expenses must have risen sharply. The trading side is improving; the cost of running the business is not — a shareholder should question the expenses, not the product.