Finance and accounts
Finance and accounts tests whether you can turn financial data into decisions: choosing a source of finance, calculating break-even, forecasting cash, reading final accounts and judging performance with ratios. HL candidates also handle investment appraisal. Calculations carry few marks; most marks sit in interpreting the number for the business in the case.
Core rules
- Sources: internal (retained profit, sale of assets) versus external; short-term (overdraft, trade credit, debt factoring) versus long-term (bank loan, debenture, share issue). Debt raises gearing and fixed interest obligations; equity dilutes control.
- Break-even: contribution per unit = price − variable cost per unit; break-even quantity = fixed costs ÷ contribution; margin of safety = actual output − break-even output.
- Cash is not profit: a profitable firm can run out of cash through poor credit control, overstocking or heavy capital spending.
- Final accounts: income statement (gross profit → operating profit → profit for the year) and balance sheet (assets = liabilities + equity). Depreciation is straight-line (cost ÷ life) or reducing balance (fixed % of carrying value).
- Ratios: gross and net profit margins, ROCE (operating profit ÷ capital employed × 100), current and acid test, gearing, inventory turnover, debtor and creditor days.
- HL appraisal: payback, ARR (average annual profit ÷ average investment) and NPV (accept if positive).
Worked example: break-even
Price $40, variable cost $24, fixed costs $96,000. Contribution = $16. Break-even = 96,000 ÷ 16 = 6,000 units. At current output of 7,500 units the margin of safety is 1,500 units, or 20% of output ($60,000 of revenue). To reach a target profit of $32,000: (96,000 + 32,000) ÷ 16 = 8,000 units - 500 more units, so check the case shows capacity to deliver.
Traps
- Equating profit with cash, or contribution with profit.
- Including inventory in the acid test (it must be excluded).
- Applying reducing-balance depreciation to original cost rather than carrying value.
- Using profit instead of cash flow in payback, and forgetting payback ignores cash after the payback date.