Finance and Accounts
Finance tests whether you can calculate, interpret and recommend. SL questions commonly combine break-even, cash flow, sources of finance and ratio analysis in one case.
Core rules and concepts
- Sources of finance: internal sources include retained profit and sale of assets; external sources include bank loans, share capital, leasing, trade credit and grants. Match short-term needs with short-term finance.
- Costs and contribution: contribution per unit = selling price − variable cost per unit. Break-even output = fixed costs ÷ contribution per unit. Margin of safety = forecast sales − break-even sales.
- Cash flow versus profit: profit is revenue minus costs over a period; cash flow is money moving in and out. A profitable business can still fail from poor liquidity.
- Working capital = current assets − current liabilities.
- Investment appraisal: payback measures time to recover the outlay; ARR uses average annual profit; NPV discounts future cash flows.
- Final accounts: the income statement shows profit; the balance sheet shows assets, liabilities and equity at a date.
- Ratios: gross and net profit margins, ROCE, current ratio, acid-test ratio, gearing and stock turnover.
Worked example
A product sells for $20, variable cost is $12 and fixed costs are $30,000. Contribution is $8, so break-even is 30,000 ÷ 8 = 3,750 units. Forecast sales are 5,000 units, giving a margin of safety of 1,250 units, or 25% of forecast sales. If fixed costs rise to $36,000, break-even becomes 4,500 units and the margin falls to 500 units. The business is still forecast to profit, but it has much less room for error, so cost control or a higher contribution becomes important.
Traps that cost marks
Break-even uses contribution, not profit. The acid-test ratio excludes stock; the current ratio includes it. Payback ignores cash flows after the payback date and the time value of money. High gearing is not automatically bad, but it raises financial risk. Always interpret a ratio, not just calculate it.