Finance and Financial Decision-Making
What you must understand
Candidates must read and interpret the three core statements: the income statement (profit and loss over a period), the statement of financial position (balance sheet - assets, liabilities, equity at a point in time) and the cash flow statement. Distinguish profit from cash: profit is an accounting measure; cash is liquidity. A profitable firm can still fail through poor cash flow.
Know sources of finance: internal (retained profit, sale of assets) versus external (loans, overdrafts, share issue, debentures, leasing, trade credit), and short versus long term. Understand break-even analysis: break-even quantity = fixed costs ÷ (selling price − variable cost per unit), and the margin of safety. Apply investment appraisal: payback period, average rate of return (ARR) and net present value (NPV), recognising that NPV accounts for the time value of money while payback ignores cash flows after the payback point. Use ratios: gross profit margin, net profit margin, current ratio, gearing.
Traps examiners set
- Saying a firm is profitable therefore liquid - the two are independent.
- Forgetting that break-even ignores the fact that costs may not be linear.
- Mixing fixed and variable costs: rent is fixed, raw materials variable.
- Choosing the shortest payback without considering total returns.
- Confusing gross profit (revenue − cost of sales) with net profit (after all expenses).
Worked example / rule of thumb
Fixed costs £30,000; selling price £25; variable cost £10. Contribution per unit = £15. Break-even = 30,000 ÷ 15 = 2,000 units. If the firm sells 2,500 units, margin of safety = 500 units (20%). Rule of thumb: always compute contribution first - it drives break-even and profitability.
Key terms to use precisely
Contribution, break-even, margin of safety, liquidity, gearing, payback, ARR, NPV, working capital.