Finance and accounting
Domain 5 covers sources of finance, cash-flow forecasting, costs and break-even, financial statements and ratios, and investment appraisal. Calculations support interpretation: explain what a ratio suggests about liquidity, risk or return under the supplied assumptions.
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 stated classroom 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 firm has separately specified an ARR hurdle of10% on the same initial-investment convention,7.5% fails that hurdle, although the project meets a three-year payback target. An accounting return should not automatically be compared with a discounted cash-flow cost of capital. Reasoning: the methods disagree because payback ignores the return after the cutoff and ignores the time value of money.
Traps
An overdraft is usually short-term or repayable on demand; funding a long-lived asset with it can create refinancing and liquidity risk, even when such a purchase is possible. 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.
Recording transactions and checking financial evidence
Elementary accounting separates the business from its owners for recording purposes and uses a stated measurement model. The accounting equation is assets equal liabilities plus equity. An asset is not the same as a receipt, and a liability is not the same as an expense. Double entry records equal debit and credit amounts, but the economic meaning of those entries depends on the account type. Under a conventional teaching model, asset increases are debits, liability and equity increases are credits, expenses are debits and revenue is credited. A debit is not universally a loss and a credit is not universally income.
Consider an owner contributing five thousand in cash. Bank increases and owner capital increases. Buying equipment for three thousand cash then exchanges one asset for another under a capitalization assumption. It does not make three thousand of sales revenue or automatically reduce equity by the equipment price. A service completed on credit may create revenue and a receivable before cash is collected. Later collection increases bank and reduces the receivable without recording the same sale twice. Loan proceeds create cash and a liability rather than operating revenue. Repayment of principal reduces cash and the loan; interest is analyzed separately.
Accrual adjustments assign items to the relevant reporting period under the supplied model. Wages earned by employees but unpaid at the reporting date can produce an expense and a liability. A prepayment represents a benefit not yet consumed rather than an immediate expense for every payment. Depreciation allocates a depreciable amount over an estimated useful life; it is not a cash reserve automatically set aside for replacement. With cost twelve thousand, residual value two thousand and a five-year straight-line life, the annual allocation is two thousand. Estimates and applicable reporting requirements must be checked for real accounts.
An inventory exercise must state its valuation and transaction assumptions. In a simple periodic model, opening stock plus purchases less closing stock gives cost of goods sold. Opening one hundred, purchases four hundred and closing one hundred twenty produce three hundred eighty. Do not subtract purchases from sales and also charge the same goods a second time elsewhere.
Controls improve the quality of evidence. A balanced trial balance does not detect a transaction omitted completely from both sides or an equal entry posted to the wrong accounts. Bank reconciliation explains differences between the cash book and bank statement; it is not permission to force the totals to agree with an unexplained adjustment. Distinguish timing differences from genuine unrecorded receipts or charges. Record corrections with their explanation and retain the supporting evidence. The examples here are supplied classroom models, not a claim that one country's detailed tax, filing, inventory or lease rules apply everywhere.