Topic 18: Managing finance – financial objectives

Key ideas

• Financial objectives (AQA list):

Objective	Meaning
Profit	An absolute target, e.g. operating profit of £2m.
Profitability	Profit relative to revenue or capital, e.g. operating margin of 12%, or ROCE of 15%.
Cash flow	e.g. a positive net cash flow every month.
Liquidity	The ability to pay short-term debts, e.g. keep the current ratio above 1.2.
Levels of borrowing	e.g. reduce gearing below 40%.

• Influences on financial objectives:
  • corporate objectives;
  • shareholders' expectations;
  • the stage of growth (start-ups focus on cash);
  • the economy and interest rates;
  • competitors;
  • the legal form, e.g. plc pressure for dividends.
• Interrelationships with other functions: finance sets budgets for marketing, operations and HR, while those functions' decisions affect costs and revenue.
• Competitiveness: financial decisions affect it. Examples: the ability to fund innovation; borrowing costs; pricing power.

Self-test

Q1: Distinguish profit from profitability. A: Profit is an absolute amount (£). Profitability measures profit relative to something else (revenue or capital employed), e.g. a margin or ROCE, so firms of different sizes can be compared.

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Topic 19: Internal and external sources of finance

Key ideas

Source	Type	✅ Advantages	❌ Disadvantages	Suitable for
Owners' investment	Internal	No interest; no loss of control	Limited by personal wealth; risk to owner	Start-ups
Retained profits	Internal	No interest or dilution; flexible	Only if profitable; less for dividends	Established, profitable firms
Sale of assets	Internal	Raises cash from unused assets	Lost permanently; may be sold cheaply	Firms with surplus assets
Sale and leaseback	Internal	Releases large capital while still using the asset	Ongoing lease payments; lost asset appreciation	Property-rich firms
Working capital	Internal	Squeezing inventories/receivables frees cash	Limited; may damage customer and supplier relations	Short-term needs
Trade credit	External	Effectively a free short-term loan (e.g. 30–60 days)	Lost early-payment discounts; supplier relations	Day-to-day purchases
Share capital	External	Large sums; no repayment or interest	Dilution of control; dividend expectations	Ltd/plc growth
Overdraft	External	Flexible; interest only on the amount used	High interest; can be withdrawn	Short-term cash gaps
Loans	External	Fixed repayments make planning easy; no dilution	Interest; security needed; raises gearing	Asset purchases
Business angels	External	Finance plus expertise and contacts	Give up equity; possible loss of control	High-growth start-ups
Private equity	External	Large funding; management expertise	Big equity stake; pressure for returns and exit	Established firms, buy-outs
Crowdfunding	External	Access to many small investors; builds a customer community and publicity	May fail to hit target; idea exposed publicly; platform fees	Consumer-facing start-ups (e.g. BrewDog's "Equity for Punks")

• Choosing a source depends on:
  • the amount needed;
  • the purpose (long- or short-term);
  • the cost;
  • the legal form;
  • current gearing;
  • owners' attitude to control;
  • the firm's risk and track record.
• Match the source to the use: long-term assets need long-term finance; short-term needs, short-term finance.

Self-test

Q1: Why is an overdraft unsuitable for buying a new factory? A: An overdraft is short-term, expensive and can be withdrawn at short notice. A factory is a long-term asset, so a long-term loan or mortgage, or share capital, is more suitable.

Q2: Give one advantage of sale and leaseback. A: It releases a large sum of cash tied up in property while the business keeps using the building.

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Topic 20: Break-even

Key ideas

• Costs:
  • Fixed costs (FC) do not change with output, e.g. rent and salaries.
  • Variable costs (VC) change directly with output, e.g. raw materials and piece-rate wages.
  • Total costs = FC + VC.
• Contribution per unit = price − VC per unit. Contribution goes first towards covering fixed costs; after break-even, it is profit.
• Break-even output = FC ÷ contribution per unit.
• Margin of safety = actual output − break-even output: how far sales can fall before a loss.

Worked example

A firm makes garden benches: price £25, VC £10 per unit, FC £45,000 a year, and it sells 4,200 units.

• Contribution per unit = 25 − 10 = £15.
• Break-even = 45,000 ÷ 15 = 3,000 benches.
• Margin of safety = 4,200 − 3,000 = 1,200 units, i.e. 28.6% of current sales.
• Total contribution = 15 × 4,200 = £63,000. Profit = 63,000 − 45,000 = £18,000.
• Check: TR = £105,000 and TC = 45,000 + 42,000 = £87,000, so profit = £18,000 ✓.

What-if analysis:

Change	New contribution	New break-even	New margin of safety
Price rises to £28	£18	45,000 ÷ 18 = 2,500	1,700, if sales stay at 4,200 (but sales may fall if demand is elastic!)
VC rises to £13	£12	45,000 ÷ 12 = 3,750	450
FC rises to £54,000	£15	3,600	600

• The break-even chart:
  • Axes: output (horizontal) against costs and revenue in £ (vertical).
  • Lines:
    • FC is horizontal;
    • TC starts at the FC level and slopes up;
    • TR starts at the origin.
  • Break-even is where TR = TC.
  • Profit is the gap between TR and TC to the right of break-even; loss is the gap to the left.
• How changes move the lines:
  • A price rise makes TR steeper, so break-even falls.
  • Higher FC shifts TC up in parallel, so break-even rises.
  • Higher VC makes TC steeper, so break-even rises.
• Purpose and value of break-even analysis:
  • simple;
  • useful for business plans and loan applications;
  • quick "what-if" testing of price and cost changes.
• Limitations:
  • It assumes all output is sold.
  • It assumes constant price and VC (ignoring bulk discounts and price discrimination).
  • Costs are hard to classify (semi-variable costs).
  • It is static.
  • It is only as good as the data.

Self-test

Q1: FC = £60,000; price = £12; VC = £7. Calculate break-even output and the profit at 15,000 units. A: Contribution = £5. Break-even = 60,000 ÷ 5 = 12,000 units. Profit = (15,000 × 5) − 60,000 = £15,000.

Q2: What happens to the break-even chart if the variable cost per unit falls? A: The TC line becomes less steep (it pivots down from the FC intercept), so the break-even point moves to a lower output and the margin of safety widens.

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Topic 21: Profit

Key ideas

• Levels of profit:
  • Gross profit = revenue − cost of sales (the direct costs of making or buying the goods sold).
  • Operating profit = gross profit − operating expenses (overheads such as admin, distribution and marketing).
  • Profit for the year = operating profit + profit from other activities − net finance costs − tax.
• Profit versus cash:
  • Profit is an accounting measure (revenue − costs when earned or incurred). Cash is actual money in the bank.
  • A profitable firm can run out of cash, because of:
    • sales on credit (receivables);
    • buying assets;
    • building inventory;
    • repaying loans.
  • "Profitable but insolvent."
  • Conversely, a firm can have cash but make a loss, e.g. after a loan or a share issue.
• Profit versus profitability: see Topic 18. Profitability compares profit with revenue or capital.
• Ways to increase gross and operating profit:
  • Increase revenue:
    • raise price (depends on PED);
    • sell more through marketing, new markets or new products.
  • Reduce costs:
    • cheaper suppliers (risk to quality);
    • efficiency (lean production);
    • reduce overheads (cheaper premises, delayering).
  • Challenges: quality, reputation and morale effects, and supplier relationships.

Self-test

Q1: Explain how a profitable firm can face a cash-flow crisis. A: If customers pay on long credit terms, revenue is recorded as profit but the cash has not arrived. If at the same time the firm must pay suppliers, wages and loan repayments, it can run out of cash even though it is profitable.

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Topic 22: Budgets

Key ideas

• A budget is a financial plan for a future period. There are:
  • income (revenue) budgets;
  • expenditure budgets;
  • profit budgets.
• Purpose and value:
  • planning;
  • coordination;
  • control (comparing actual with budget);
  • motivation (targets);
  • delegation (budget holders).
• Limitations:
  • They may be inaccurate.
  • They can be rigid.
  • "Spend it or lose it" behaviour.
  • Unrealistic budgets demotivate staff.
• Zero-based budgeting (ZBB): every budget starts at zero and every item of spending must be justified, rather than adding a % to last year's figure.
  • ✅ It removes waste, matches resources to current priorities and questions everything.
  • ❌ It is time-consuming and may be hard for managers to justify every item.
• Budget variance (AQA formula) = budgeted figure − actual figure.
  • Favourable (F): better for profit than planned, i.e. revenue above budget or costs below budget.
  • Adverse (A): worse for profit, i.e. revenue below budget or costs above budget.
  • ⚠️ Always label F or A. With the AQA formula, a positive cost variance is favourable but a positive revenue variance is adverse (because actual revenue was lower than budgeted).

Worked example

Item	Budget (£)	Actual (£)	Budget − Actual (£)	F/A
Revenue	50,000	46,000	4,000	Adverse (revenue below plan)
Materials	18,000	19,500	−1,500	Adverse (costs above plan)
Wages	12,000	10,500	1,500	Favourable
Profit	20,000	16,000	4,000	Adverse

Interpretation: the profit shortfall of £4,000 is mainly due to lower sales. Investigate the causes: pricing, competition or the economy. A favourable wages variance could reflect understaffing, which may explain the lower sales.

Self-test

Q1: A marketing budget was £8,000 and actual spending was £9,200. Calculate the variance and state whether it is favourable or adverse. A: 8,000 − 9,200 = −£1,200. It is adverse, because spending was above budget.

Q2: Give one advantage and one disadvantage of zero-based budgeting. A: Advantage: it removes unnecessary spending because every item must be justified. Disadvantage: it is very time-consuming for managers.

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Topic 23: Cash flow and liquidity

Key ideas

• Payables: money the business owes suppliers (trade creditors).
• Receivables: money customers owe the business (trade debtors).
• A cash flow forecast predicts cash inflows and outflows month by month.
  • Purposes:
    • identify cash shortfalls in advance, so an overdraft can be arranged;
    • support loan applications;
    • planning and control.
  • Limitations: it relies on sales estimates, and unexpected costs or late payers can upset it.
• Ways of improving cash flow:

Method	✅	❌
Debt factoring (sell receivables to a factor for about 80–90% immediately)	Immediate cash	Lose part of the revenue; customers may see it as a sign of weakness
Shorten customer payment terms	Cash arrives sooner	Customers may go to rivals offering credit
Early-payment incentives (discounts)	Faster cash	Lower revenue
Credit checks	Fewer bad debts and late payers	Cost and time; may turn customers away
Extend payment time to suppliers	Cash stays in the business longer	Damages relations; lost discounts; suppliers may refuse
Reduce outgoings	Less cash out	May cut quality, capacity or morale
Better invoice management (prompt, accurate invoicing and chasing)	Speeds up receipts	Admin cost

Worked example: completing a cash flow forecast (£)

	Jan	Feb	Mar
Cash inflows (sales receipts)	12,000	10,000	16,000
Cash outflows (wages, rent, materials)	14,500	13,000	12,000
Net cash flow	−2,500	−3,000	4,000
Opening balance	5,000	2,500	−500
Closing balance	2,500	−500	3,500

The closing balance of one month becomes the opening balance of the next month. The forecast shows that the firm needs an overdraft facility of at least £500 in February (or it should delay a payment).

• Liquidity ratios:
  • Current ratio = current assets ÷ current liabilities. Often around 1.5–2 is described as comfortable. Below 1 is a potential liquidity problem; too high means idle resources.
  • Acid test ratio = (current assets − inventory) ÷ current liabilities. It excludes inventory because inventory may be hard to sell quickly. Around 1 is often described as comfortable. Supermarkets operate with low acid tests because they sell for cash and get credit from suppliers.
• Efficiency ratios:
  • Receivables days = receivables ÷ revenue × 365: how long customers take to pay. Lower is better for cash flow.
  • Payables days = payables ÷ cost of sales × 365: how long the firm takes to pay suppliers. Higher keeps cash longer, but it risks supplier relations.

Worked example (ratios)

Current assets £150k: inventory £60k, receivables £50k, cash £40k. Current liabilities £100k, including payables of £45k. Revenue £600k; cost of sales £360k.

• Current ratio = 150 ÷ 100 = 1.5.
• Acid test = (150 − 60) ÷ 100 = 0.9.
• Receivables days = 50 ÷ 600 × 365 = 30.4 days.
• Payables days = 45 ÷ 360 × 365 = 45.6 days.
• Interpretation: liquidity is adequate. The acid test is slightly below 1, so the firm relies on selling inventory. Customers pay in about a month, while the firm takes about 46 days to pay suppliers, which is good for cash flow if suppliers accept it.

Self-test

Q1: Why does the acid test exclude inventory? A: Inventory is the least liquid current asset. It may take time to sell, or be sold only at a discount, so excluding it gives a stricter test of the ability to pay short-term debts.

Q2: Receivables are £90k and revenue is £540k. Calculate receivables days. A: 90 ÷ 540 × 365 = 60.8 days (about 61).

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Topic 24: Financial reporting

Key ideas

• The income statement (profit and loss account) summarises revenue and costs over a period, usually a year.

Income statement (year ending 31 March)	£000
Revenue	600
Cost of sales	(360)
Gross profit	240
Operating expenses	(150)
Operating profit	90
Profit from other activities	0
Net finance costs	(10)
Tax	(20)
Profit for the year	60

• The statement of financial position (balance sheet) is a snapshot of assets, liabilities and equity on a given date.
  • Non-current assets: long-term assets, e.g. property and machinery.
  • Current assets: inventory, receivables, cash.
  • Current liabilities: due within one year, e.g. payables and overdraft.
  • Non-current liabilities: long-term loans.
  • Net assets = total assets − total liabilities = total equity (share capital + retained earnings).

Statement of financial position	£000
Non-current assets	550
Current assets (inventory 60, receivables 50, cash 40)	150
Current liabilities	(100)
Non-current liabilities	(200)
Net assets	400
Share capital	150
Retained earnings	250
Total equity	400

Check: 550 + 150 − 100 − 200 = 400 ✓. Capital employed = total equity + non-current liabilities = 400 + 200 = £600k.

• "Interpret and amend": you may be asked to update a statement after a change. Example: if the firm takes a further £50k loan and holds it as cash, non-current liabilities rise to £250k and cash rises to £90k, so net assets stay the same.

Profitability ratios (from the data above)

Ratio	Calculation	Result	Meaning
Gross profit margin	240 ÷ 600 × 100	40%	40p of each £1 of sales is left after direct costs
Operating profit margin	90 ÷ 600 × 100	15%	Shows control of overheads
Profit for the year margin	60 ÷ 600 × 100	10%	The final profit per £1 of sales
ROCE	90 ÷ 600 × 100	15%	The return on all long-term capital. Compare with the interest rate, rivals and last year.
Gearing	200 ÷ 600 × 100	33.3%	The proportion of capital from long-term debt. Above 50% is usually called highly geared.
ROI (of a specific project)	£12k ÷ £80k × 100	15%	The return on a particular investment

• Interpreting ratios. Ratios mean little alone; always use:
  • Trends: compare with previous years.
  • Benchmarking: compare with competitors and industry averages.
  • Context: the business environment, objectives and strategy. Example: lower margins may be deliberate in a penetration strategy.
• Gearing:
  • High gearing: more risk if interest rates rise or profits fall, and harder to borrow more. But owners keep control, and returns to shareholders are magnified when profits are strong.
  • Low gearing: safer, but the firm may be missing growth opportunities.
• Limitations of financial reporting:
  • The data are historic.
  • It excludes non-financial factors such as staff morale, brand reputation and environmental impact.
  • Figures can be manipulated ("window dressing").
  • Inflation distorts comparisons.

Self-test

Q1: Operating profit is £45k, total equity is £250k and non-current liabilities are £50k. Calculate ROCE and gearing. A: Capital employed = £300k. ROCE = 45 ÷ 300 × 100 = 15%. Gearing = 50 ÷ 300 × 100 = 16.7%.

Q2: Gross margin is stable but operating margin has fallen. What does this suggest? A: Direct costs relative to sales are under control, but overheads (operating expenses such as rent, admin or marketing) have risen faster than revenue.

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Topic 25: Assessing financial position and performance

Key ideas

• What to assess:
  • profits and margins;
  • ROCE;
  • ROI;
  • cash flow and liquidity;
  • gearing;
  • shareholder rewards (DPS, dividend yield);
  • break-even output and margin of safety;
  • budget variances.
• Always judge relative to:
  • objectives: e.g. is growth the priority over margins?
  • competitors;
  • business planning: e.g. budgets and forecasts;
  • context: e.g. the economy, the industry, the life-cycle stage.
• Exam approach for a quantitative 15-marker:
  1. Calculate two or three relevant ratios for both years or both options.
  2. Interpret the trend.
  3. Link to the case context.
  4. Weigh up any non-financial factors.
  5. Make a judgement.

Worked example (assessing performance)

	2025	2026
Revenue (£m)	20.0	24.0
Operating profit (£m)	2.4	2.4
Capital employed (£m)	16.0	20.0
Non-current liabilities (£m)	4.0	9.0

• Operating margin: 12.0% in 2025, falling to 10.0% in 2026.
• ROCE: 15.0% in 2025, falling to 12.0% in 2026.
• Gearing: 25% in 2025, rising to 45% in 2026.
• Interpretation:
  • Revenue grew 20%, but profit did not grow at all. Costs rose in line with revenue, perhaps because of expansion costs or price cuts.
  • The expansion was largely debt-financed, so the firm is now riskier.
  • Judgement: performance has weakened on these measures. It may improve if the new investment pays off. Check the cash position and interest rates.

Self-test

Q1: Why must ratios be compared with competitors? A: What counts as a "good" ratio varies by industry (e.g. supermarkets have low margins but high volume), so benchmarking shows whether the firm is genuinely performing well.

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Topic 26: Ethics in finance (A-level only)

Key ideas

• Tax avoidance:
  • It is legal: using loopholes and structures to minimise tax, e.g. profit shifting to low-tax countries.
  • Tax evasion is illegal.
  • Avoidance can provoke public backlash. Example: Starbucks' UK tax affairs drew criticism in 2012, and the company then volunteered to pay additional UK corporation tax.
  • Arguments for: a duty to shareholders, and it is within the law. Arguments against: a moral duty to fund public services, reputational risk, and governments closing loopholes.
• Payment terms for customers and suppliers:
  • Large firms delaying payment to small suppliers (late payment) can push those suppliers into cash-flow crises.
  • The UK Prompt Payment Code and payment-practice reporting requirements for large companies encourage fair terms.
  • Unfair credit terms for customers (e.g. high-interest "buy now, pay later" with poor transparency) are another ethical issue.

Self-test

Q1: Distinguish between tax avoidance and tax evasion. A: Tax avoidance is legally minimising tax by using allowances and loopholes. Tax evasion is illegally not paying tax that is owed (e.g. hiding income).

Q2: Why might paying suppliers late be unethical? A: It transfers cash-flow strain to (often smaller) suppliers, risking their survival and jobs, purely to benefit the larger firm's own liquidity.

Assessment checkpoint: 3.1.4 Financial management test.

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QUICK REVISION: SOPHISTICATED CONCEPTS FROM YEAR 12 TO USE IN 15-MARKERS

• Marketing: market mapping, product life cycle, Boston Matrix, PED/YED, return on marketing spend, market share.
• Finance: contribution, break-even, margin of safety, budget variance, cash flow forecasts, GPM/OPM/PFY margin, ROCE, ROI, current and acid test ratios, payables and receivables days, gearing, dividend yield.
• People: Taylor, Maslow, Herzberg, Hackman, employee costs as % of revenue, stakeholder mapping.
• Operations: network analysis (float, critical path), capacity utilisation, inventory turnover, unit costs.