Finance and accounting
Domain 5 covers sources of finance, cash-flow forecasting, costs and break-even, financial statements and ratios, and investment appraisal. Questions test both calculation and interpretation: a correct ratio with no comment on liquidity, risk or return earns limited credit.
Core rules
- Internal finance includes retained profit, sale of assets and tighter working capital. External finance includes bank loans, overdrafts, debentures, share issues, leasing, hire purchase, trade credit and grants. Match short-term assets with short-term finance and long-term assets with long-term finance.
- Cash flow is not profit. A profitable firm can fail if debtors are slow or stock is excessive. Working capital = current assets − current liabilities.
- Break-even output = fixed costs ÷ contribution per unit; contribution = price − variable cost per unit. Margin of safety = current output − break-even output.
- The income statement shows profit; the statement of financial position shows assets, liabilities and equity at a date. Depreciation spreads the cost of non-current assets.
- Ratios include current ratio, acid test, ROCE, gross and net margin, gearing and receivable days. Gearing = debt ÷ (debt + equity) × 100 using the common IAL convention.
- Appraisal methods: payback, ARR and NPV. Payback ignores cash flows after the cutoff; ARR ignores timing; NPV discounts and is theoretically preferred.
Worked example
A project costs $200,000 and yields net cash inflows of $80,000, $70,000, $60,000 and $50,000. Cumulative inflows are $150,000 after two years, so $50,000 of year three is needed: payback = 2 + (50 ÷ 60) = 2.83 years, about 2 years 10 months. Total profit = $260,000 − $200,000 = $60,000; average annual profit = $15,000. Using initial capital cost, ARR = 15,000 ÷ 200,000 × 100 = 7.5%. If the cost of capital is 10%, the project fails the ARR test, although it may pass a three-year payback target. Reasoning: the methods disagree because payback ignores the return after the cutoff and ignores the time value of money.
Traps
Do not call an overdraft long-term finance or use it to buy machinery. Profit is not cash. Gearing formulas differ - state the one you use. A high current ratio can hide obsolete inventory or slow receivables. Payback is not a measure of profitability. ARR using average investment can double the result, so show your assumption. Break-even assumes constant variable cost per unit and fixed costs.