Summary
Highlights
This section introduces Unit 5: Finance, for Cambridge IGCSE and OLevel Business Studies. It covers key topics like cash flow forecasts, statements of financial position, and liquidity ratios. Businesses need finance for various reasons, including startup capital, expansion, replacing assets, investing in technology, and working capital to cover day-to-day expenses.
Finance is categorized into short-term (less than 12 months) and long-term (more than 12 months), and also internal (from within the business) or external (from outside sources). The story of 'Cautious Carla' illustrates internal finance. Carla, who dislikes borrowing, uses her owner's savings to open a cafe, manages working capital by reducing stock and limiting credit, sells an unwanted asset (an old oven) for renovations, and uses retained profit to expand. These internal sources offer advantages like no interest payments and control, but are limited by available funds and can take time to build up.
'Risky Ryan' illustrates external finance. To start his construction firm, he obtains a government grant (free money, but competitive and with conditions). For materials, he uses trade credit (buying now, paying later, typically interest-free, but risks losing discounts and supplier relationships). He acquires a van through hire purchase (paying in installments, but with interest and risk of repossession). For a large digger, he opts for leasing (renting, no upfront cost, includes maintenance, but no ownership and long-term commitment).
When Ryan's van breaks down, he uses an overdraft to cover a short-term cash deficit (fast and flexible for small amounts, but high interest). For larger projects, he takes a bank loan (provides large sums with fixed repayments, but requires collateral and incurs interest). For an eco-pilot project, he uses crowdfunding (raises funds from many people, creates marketing buzz, but is competitive and makes ideas public). For a high-growth eco-estate, he seeks venture capital (large investment, expertise, shared risk, but loss of independence and pressure for high returns). Finally, as a public limited company, he issues shares (raises massive funds with no direct repayments, but involves loss of control and high legal requirements).
Working capital is defined as the capital available in the short term to cover day-to-day expenses. It's calculated as current assets minus current liabilities. A silly story about 'Cavitt' illustrates this: Cavitt has €1 cash and a €2 chocolate bar (current assets), but owes €3 to 'Big Scary John' (current liability). His working capital is €0, meaning he cannot cover his immediate debt. Working capital is crucial for covering daily expenses, managing unexpected costs, and maintaining a good reputation for future borrowing.
A cash flow forecast is an estimate of future cash inflows and outflows, usually monthly, showing the expected cash balance. The story of 'Kehani' and his gym illustrates setting up a cash flow forecast. He estimates membership fees and personal classes as inflows, and treadmill purchases, electricity, water, and Sara's salary as outflows. The forecast helps him predict potential cash shortages (liquidity problems) and decide whether he can afford to employ staff, buy a van, or needs a bank loan. It allows him to adjust plans and secure necessary financing in advance.
Income statements, also known as profit and loss statements, detail a business's revenue, costs, and profits over a period (e.g., a year). The story of 'Big Al' emphasizes that high revenue doesn't automatically mean high profit. An income statement calculates gross profit (revenue minus cost of sales) and then overall profit (gross profit minus expenses). After deducting corporation tax, the remaining amount is retained profit. Stakeholders like government, investors, lenders, and competitors use these statements to assess a company's financial health, tax obligations, and performance.
A statement of financial position (balance sheet) summarizes a business's assets and liabilities at a specific point in time, indicating its overall wealth. A 'gold digger' game illustrates how to assess wealth beyond just cash. Assets are good things owned (non-current assets like buildings, current assets like cash), while liabilities are bad things owed (current liabilities due within a year, non-current liabilities due after a year). The statement shows where the money came from (e.g., share capital, retained profit) to balance the total assets with total liabilities plus equity. It helps stakeholders understand 'quality' of wealth and financial structure.
Profitability ratios simplify complex financial figures into percentages for easier comparison and analysis. Gross profit margin (gross profit / revenue x 100) measures profitability from core operations, while profit margin (profit / revenue x 100, also called operating profit margin) reveals overall profitability after all expenses. A story comparing 'Antonio' and 'Lisa' for investment illustrates that percentages remove currency and scale issues, making cross-company comparisons straightforward. A higher percentage indicates greater efficiency in turning revenue into profit. However, it's crucial to understand the difference between gross and operating profit, as expenses significantly impact the final profit margin.
Return on capital employed (ROCE) (profit / capital employed x 100) measures how efficiently a business uses its capital to generate profit. The story of 'Jack' (small website, €10,000 profit from €20,000 capital) and 'Tim' (Nike International, €300,000 profit from €10 billion capital) demonstrates that absolute profit figures can be misleading without considering the capital invested. Jack's 50% ROCE signifies high efficiency, while Tim's 0.03% indicates poor performance relative to the massive capital. ROCE is vital for comparing performance across different-sized companies or within the same company over time. Comparisons with industry benchmarks (e.g., Adidas's ROCE) provide further context.
Liquidity ratios assess a business's ability to pay its short-term debts. The current ratio (current assets / current liabilities) indicates how much current assets are available for every unit of current liabilities. A story of 'James' (2:1 ratio) shows strong liquidity, while 'Raj' (0.5:1) faces a liquidity crisis. An 'Al' (25:1) with a very high current ratio, while seemingly safe, is often considered inefficient in business, as too much capital is tied up in easily convertible assets. The optimum is typically 2:1. The acid test ratio (current assets - inventory / current liabilities) provides a more stringent measure by excluding inventory, recognizing that some stock (like 'Nervous Nick's' Christmas trees in February) might not be easily or quickly converted to cash, revealing a more realistic picture of immediate liquidity.