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Finance
Neil.elrick@tes.tp.edu.tw
IGCSE
FINANCE
REVISION
NOTES
Table of contents
Table of contents ................................................................................................................. 2
SOURCES OF FINANCE........................................................................................................ 3
CASH FLOW......................................................................................................................... 5
HOW TO CALCULATE THE CASH BALANCE ............................................................... 5
HOW TO WORK OUT THE CASH AVAILABLE TO THE BUSINESS ................................ 8
THE PURPOSE OF ACCOUNTING....................................................................................... 9
THE ACCOUNTANT.......................................................................................................... 11
TRADING ACCOUNTS AND PROFIT AND LOSS ACCOUNTS.................................. 12
BALANCE SHEETS .............................................................................................................. 14
RATIO ANALYSIS ............................................................................................................... 18
Profitability Ratios .............................................................................................................. 18
Liquidity Ratios ................................................................................................................... 18
Break Even Analysis ............................................................................................................ 24
SOURCES OF FINANCE
Companies1 need short-term finance to start up, or to cover day-to-day running costs.
This has to be repaid over a short period. It provides a business with working capital.
Long-term finance is used to grow or expand and is paid back over a number of years.
Sources of finance can be:
Internal
External
Internal sources of finance are a cheaper way to raise working capital. Obtaining finance externally is
usually the last option as interest has to be paid.
Try to remember three ways of raising finance from each source, internal and external:
Firms often lease equipment or machinery to avoid a large outlay of cash. This is useful if a firm needs
to upgrade within the medium term as technology advances. Why would it want to do this?
Check your understanding of which internal and external sources of finance are available to
businesses, and when they are used.
CASH FLOW
A business needs to know how much cash is coming in and going out. Cash is like a river flowing
through a business. Cash is like the liquid flowing through the diagram above. Cash is often called a
liquid asset.
Drawing up a cash flow forecast shows whether there is enough cash (liquidity) available to pay
salaries and settle (ie pay) debts on time.
It calculates the firm's reserves, which could be invested in expansion projects or new equipment.
Accountants can identify when shortfalls are likely to happen, and when surplus funds are likely to
become available.
This helps them plan for when the firm might need an overdraft, or be able to reinvest its retained
profits into the business.
Remember
Questions on cash flows are fairly common in Business Studies examinations, so you must to be able to:
Apart from the manager, there are two full-time members of staff.
This is its cash flow for the past three months in other words, they are looking back in time:
You can see that the total flow of cash into the business (income) for January was 15,500, and that
the total outflow from the business (expenditure) was 15,000.
You can find the cash balance by subtracting the expenditure from the income, shown as a net surplus
(profit) or a net deficit (loss).
Income - Expenditure = Balance
15,500 - 15,000 = 500 (a surplus)
Compare this with February's results:
Income - Expenditure = Balance
16,100 - 17,200 = -1,100 (a deficit)
Februarys deficit could also be written like this: (1,100) with a bracket, or in red: 1,100
You will also (probably) need to work out WHEN the CASH comes in to the business. You will need to
work out a cash part of the sales. This money will come into the business when the goods are sold
IGCSE Business Studies revision notes
Finance
Neil.elrick@tes.tp.edu.tw
There will always (?) be a CREDIT part of sales. The CASH from this will arrive in one or two months
time, so that is where you enter it into the cashflow forecast.
So, stuff sold in January on two months credit will not appear in the cash flow forecast until March.
This is often one of the main reasons for cash flow problems.
Now look at the layout below. Its different! This is a cash flow projection. In other
words, they are looking a year ahead. Its a guessing game!
Remember
In an examination you can never be 100% sure if the layout for cash flow, Trading, Profit and Loss
accounts or Balance Sheets are going to be exactly the same as you have studied in class. But dont
panic! The basic principles are exactly the same. Just read it carefully, and it will all fall into place!
ASHLEYS SHOES
Cash Flow Projection for 2006
JAN
FEB
MAR
APR
MAY
JUN
JUL
AUG
SEP
OCT
NOV
DEC
450
1150
2300
3150
3050
5100
8200
9050
11850
12500
16300
Customer Sales
11000
12000
13000
13500
12000
14000
14200
12000
13000
12000
14500
15000
11000
12000
13000
13500
12000
14000
14200
12000
13000
12000
14500
15000
5500
5500
6500
6000
6000
5000
5000
4500
5400
4900
6000
Wages
1900
1900
1950
1950
2000
2000
2000
2000
2000
2000
2000
2000
Electricity
1150
1200
1400
1100
1100
1000
1100
1000
900
1100
1200
1150
OPENING BALANCE
Cash Inflows
Cash Outflow
Rent
1000
1000
1000
1000
1000
1000
1000
1000
1000
1000
1000
1000
Other Expenses
1500
1700
2000
2100
2000
1950
2000
2150
1800
1850
1600
1900
10550
11300
11850
12650
12100
11950
11100
11150
10200
11350
10700
12050
450
700
1150
850
-100
2050
3100
850
2800
650
3800
2950
CLOSING BALANCE
450
1150
2300
3150
3050
5100
8200
9050
11850
12500
16300
19250
Limited companies also have to publish an annual report and final accounts because they have a
separate legal identity.
These accounts have to be checked by an independent person - an auditor - to ensure that they give
a 'true and fair view' of what has happened to the business during the previous year.
Potential investors or shareholders, for example, will want to know if a business is worth investing
in.
Potential creditors will also want to know whether the company will be able to repay any credit they
give them.
These assessments are based on two key accounting ideaS, which you need to be able to explain:
1. liquidity
2. profitability
THE ACCOUNTANT
An accountant has three main responsibilities. These are to:
1. Collect a firm's financial records e.g. receipts, invoices, cheques and statements
2. Maintain the book-keeping and construct accounts
3. Analyse and interpret the information.
Once all the individual departments' financial records have been collected, the accountant can construct
the company's accounts. These accounts are often known as a ledger and includes a sales ledger,
bought ledger and cash book amongst others. Usually they are computerised. You dont have to know
exactly how they work.
The accountant then analyses the information using various accounting ratios and formulae. The
purpose of this is to identify any trends by comparing the results with previous results. Any
trend, whether positive or negative, could affect the planning for the next year.
Accountancy is a specialist area with its own technical language. As a result, the accountant will have to
interpret his/her findings into a meaningful format.
Other managers can then understand the information and will then be able to work together to plan and
set budgets for the next year.
Check your understanding of accounting principles. Try answering these questions, T(rue) or F(alse).
1. An auditor must be an independent person.
2. Business Studies teachers are amazingly cool.
3. Profitability is a measure of a firm's gross profits.
4. One function of accounting is to compare results and identify trends.
5. Only limited companies have to keep financial records.
6. A firm's liquidity is its ability to meet short-term debts as they arise.
(Make sure you understand how to work out the Cost of Sales! If you cant do this, then you
have to just stop there, and cant get any further marks).
This amount, the cost of sales total, is then subtracted from the turnover of 200,000 to give a
gross profit of 100 000.
The accounts then continue with the profit and loss account.
They show the rest of the annual expenditure, which is the normal cost of running a business, plus
depreciation and bad debts.
These are deducted from the gross profit to give the true profit: the net profit.
you really must understand how to do this! In the end youll find its very easy! But it takes everybody a few times to go
through it. If you cant understand it in class, which is not at all unusual, then you must tell me so until you do. If you cant
work out the Gross Profit your marks stop there!
IGCSE Business Studies revision notes
Finance
Neil.elrick@tes.tp.edu.tw
Depreciation is an estimate of the loss in value of major assets like vehicles, furniture and
machinery through wear and tear. This is useful to know for resale purposes.
Bad debts represent the amount of money written off through goods already sold on credit which will
never be paid for. So it is always wise to do a credit check on a business before you give them
credit.
BALANCE SHEETS
A balance sheet shows the value of a business. It shows what the business is worth. It shows what it
owns and what it owes, in other words, its assets and its liabilities on a particular date.
It is a snapshot of the business, and you can draw up a balance sheet at any time. (But the Trading
and Profit and Loss account tells you how profitable the business has been over the past year).
CURRENT ASSETS
A current asset is also something the company owns, but it will probably be disposed of within 12
months.
There are five types of current assets:
1. Cash in the bank.
2. Cash on the premises ("petty cash").
3. Debtors (customers who have bought goods from the business on credit, and have not yet
paid). They are called debtors because they owe you a debt.
4. Stock (raw materials, work-in-progress and unsold finished goods).
5. Prepayments (where the business has paid in advance for the use of something - rent for an
office, for example).
LABILITIES
A liability is money that the business owes to someone else or another business, and it has to be
paid back.
IGCSE Business Studies revision notes
Finance
Neil.elrick@tes.tp.edu.tw
Make sure you thoroughly understand these (underlined) important business terms:
Fixed assets shows the current value of major purchases that help in the running of the business, like
delivery vans or PCs. In this case it is 40,000. This amount should be subtracted on the balance
sheet.
Current assets shows the cash or near-cash available to the firm. This includes stock ready to sell,
money owed to them by debtors, and cash in the bank. Here the amount comes to 30,000.
Current liabilities shows the short-term amounts that the firm owes. In this case they may have a
short-term loan for 5,000.
To calculate the net current assets, the current liabilities are subtracted from the current
assets:
RATIO ANALYSIS
Liquidity Ratios
4
5
When an exam question asks you to analyse the performance of a business over the last
year, then this is what they want: RATIOS! They do not want a simple The profit has gone up so
that must be good.
Ratio analysis is used to measure a companys
profitability and
It does this by analysing its financial accounts (the balance sheet and the profit and loss account).
Ratios are very easy to calculate!
They enable a business to see which areas of its finances are weak and therefore require immediate
attention.
There are TWO main types of accounting ratio you need to know about:
1) PROFITABILITY (or PERFORMANCE) ratios. These analyse the profit made over the
last year.
2) SOLVENCY ( or LIQUIDITY) ratios. These measure the solvency of the business in other
words, its ability to meet short-term debts with cash it can find quickly.
PROFITABILITY RATIOS
We said before that he aim of businesses in the private sector is to make a profit. Profit is important
in three ways:
1. It rewards the business people who have taken risks to run it
2. It provides the funds to develop the business further
3. It is a source of cash, which allows the business to meet its debts
The purposes of a firm's Trading account and Profit and Loss account are to calculate and
show the gross and net profits.
IGCSE Business Studies revision notes
Finance
Neil.elrick@tes.tp.edu.tw
Ratios make it easier to compare one set of results with those of a previous year, or those of a
competitor.
You may have to answer questions in an exam about information given in a Trading account and Profit
and Loss account, like Go Faster Sports below, and you may have to calculate
The next section tells you exactly how to do it. Its easy!
GROSS PROFIT MARGIN
Question
Calculate Go Faster Sports' gross profit margin.
To calculate the gross profit margin, use the following equation:
Gross Profit Margin = gross profit/turnover x 100
Answer
Go Faster's Gross Profit Margin would therefore be:
100,000
If you were asked in the exam to comment on Go Faster's profitability, you could say their gross profit
margin of 50% is fairly healthy, but the net profit margin of only 10% is not very good.
It suggests that Go-Faster's expenditure relative to income is higher than they might want. The
management might look for ways to cut costs, for example by reducing their wage bill, which is quite
high.
This represents a good investment. The amount being earned per pound (0.31 rounded up) is much
higher than most alternative investments would offer, such as a building society savings account.
Remember
The results in themselves, however, mean little, unless they are compared with previous company
results or those of their competitors.
SOLVENCY RATIOS
All businesses need to know how well or how badly they are performing. This next section uses simple
calculations to assess solvency. It covers:
Working capital
Current ratio
Acid test / liquid assets ratio
Remember
There are many groups of people who are interested in the published accounts of a company. The
information these accounts provide may influence future decisions.
For example, lenders will always be looking at the solvency of a business. Why?
A business is solvent if it can meet its short-term debts when they are due for payment. To
do this it needs adequate working capital.
There are 3 main reasons why a business needs adequate working capital. It must:
1. pay staff wages and salaries
2. settle debts and therefore avoid legal action by creditors
3. benefit from cash discounts offered in return for prompt payment
You can calculate a firm's working capital by using the following equation:
Working capital = current assets - current liabilities
Question
Go-Faster Sports is a high street retailer dealing in sports equipment. Look at its balance sheet below
and calculate its working capital.
This ratio shows us that it could afford to pay its liabilities six times from its current assets.
ACID TEST / LIQUID ASSETS RATIO
Another measure of liquidity is the acid test/liquid assets ratio.
This deducts the value of currently held stock to find the company's ability to meet (pay) its liabilities
immediately.
Stock is the least liquid current asset so it is deducted to give a more realistic view of the
company's liquidity.
Learn this equation. You may be asked to calculate the acid test ratio in an exam.
acid test = current assets - closing stock/current liabilities
Now look at Go Faster Sport's balance sheet and calculate the acid test / liquid assets ratio.
You will see it is:
30,000 - 15,000
This shows us that Go Faster can afford to pay their short-term debts three times over immediately
without selling any stock.
Draw and label axis, x is output, y is money. If you are unsure what to go up to, look in the
question for How much profit & loss is made when x are made?, and use that for the x axis, for
the y axis, multiply this by the price. Do not be afraid to redraw your graph if you need to,
it will take seconds.
2. Add up all the fixed costs and draw a HORIZONTAL line from this point on the y axis. And label it
fixed costs
3. Add up all the variable costs to give us the variable cost per unit. Find a handy number on the x
axis (like 100 or 1000 or something), and multiply this number by the variable cost per unit. Plot
this point, join it up to the origin, and extend it rightwards too. And label it variable costs
4. Draw a line parallel to the variable cost line, but starting where the fixed cost line cuts the y axis.
Label this one total costs.
IGCSE Business Studies revision notes
Finance
Neil.elrick@tes.tp.edu.tw
5. Next add in the revenue. Repeat step 3, but this time use price rather than variable cost. Label
this line revenue.
6. The break even point is where the total cost and revenue lines cross. MEASURE DOWN TO FIND
THE BREAK EVEN QUANTITY.
7. Check this is correct by using the formula.
8. Take a deep breath, and now think! Usually, an exam question will ask you to find how much
profit (or loss) (they always put (loss) in brackets) the firm will make if they sell so many. This is
easy! Profit is, as we all know, the difference between what we spend (total cost), and what we
get in (revenue). Find the right amount on the x axis, and draw a dotted line straight up to where
it crosses the highest line on graph (Hopefully the revenue line). Measure across from this point.
Now, follow the dotted line down until it crosses the total cost line, again measure across
horizontally. The VERTICAL difference between these two points is the profit (or loss).
9. Double check you have done step 8 right by using the formula.
10. To complete your graph, draw on the margin of safety. The question will tell you how much they
are making. It is the distance along the x axis from this amount to the break even point. Easy
peasy.
So dont slip up!
We need to remember that increasing the price will lower the break even point (and increase profits.
But only if we can sell at this higher price. (It will depend upon price elasticity of demand, and the rest
of the marketing mix for loads of bonus points).
Break even assumes:
1. No economies of scale
2. We sell all that we make.
3. Dont have to lower the price to sell more.