💷 Finance

Sources of finance

A business can raise money from internal sources or from external sources. Internal finance comes from within the business itself, for example retained profit or the owner's personal savings, while external finance comes from outside the business, for example a bank loan.

Cash flow

Cash and profit are not the same thing. Cash is the money a business has available to pay its bills right now, while profit is its revenue minus its costs over a trading period. A business can be profitable on paper and still run out of cash.

Cash flow matters because a business that runs out of cash cannot pay its suppliers or its staff, which can force it to close down even if it is otherwise profitable. This is why even a profitable business needs to plan and monitor its cash flow carefully.

A cash flow forecast predicts the cash moving into and out of a business, usually set out month by month. It shows the cash inflows, the cash outflows, the net cash flow, and the opening and closing balance for each month.

Each month's closing balance becomes the following month's opening balance, so a single poor month carries its effect forward into the rest of the forecast. This is why a cash flow forecast is normally read across several months rather than just one.

For example, suppose a business starts a month with an opening balance of £2,000. Over the month it receives cash inflows of £8,000 and pays out cash outflows of £6,500, so its net cash flow is £8,000 - £6,500 = £1,500. Adding this to the opening balance gives a closing balance of £2,000 + £1,500 = £3,500, which then becomes the opening balance for the following month.

• Delaying payments to suppliers, so cash stays in the business for longer.
• Offering customers a discount for paying early, to bring cash in sooner.
• Arranging an overdraft, to cover a short-term gap between outflows and inflows.

Financial calculations

Revenue is the total income a business receives from its sales, before any costs are taken away. The more units a business sells, and the higher its selling price, the greater its revenue will be.

A business's costs are either fixed or variable. Fixed costs, such as rent, stay the same regardless of how much the business produces. Variable costs, such as raw materials, change directly with the level of output.

Profit is what remains once total costs are taken away from total revenue. If costs are higher than revenue, the business makes a loss instead.

Profit is often split into two more detailed figures. Gross profit takes away only the direct cost of the goods sold, while net profit also takes away the business's other running expenses, such as rent and wages.

For example, a bakery sells 500 cakes at £20 each, giving revenue of 500 × £20 = £10,000. The ingredients and other direct costs of making the cakes come to £4,000, so its gross profit is £10,000 - £4,000 = £6,000. Its other expenses, such as rent and wages, come to £3,500, so its net profit is £6,000 - £3,500 = £2,500.

Break-even

The break-even point is the level of output at which total revenue exactly equals total costs, so the business is making neither a profit nor a loss. Finding it starts with the contribution per unit, which is what each unit sold contributes towards paying off the fixed costs once its variable cost has been covered.

For example, a business has fixed costs of £4,000. It sells its product for £25, and the variable cost of making each one is £15, so the contribution per unit is £25 - £15 = £10. Dividing the fixed costs by this contribution gives a break-even output of £4,000 ÷ £10 = 400 units, so the business must sell 400 units before it starts making a profit.

The margin of safety shows how far output can fall below its current level before the business drops back to break-even and stops making a profit.

Continuing the example above, if the business actually sells 550 units, its margin of safety is 550 - 400 = 150 units, so output could fall by 150 units before the business stopped making a profit.

Analysing financial performance

Profit margins turn profit into a percentage of revenue, which makes it possible to compare businesses of different sizes, or to compare the same business from one year to the next. A higher margin generally shows that a business is converting more of its revenue into profit.

For example, the bakery above had a gross profit of £6,000 from revenue of £10,000, giving a gross profit margin of (£6,000 ÷ £10,000) × 100 = 60%. Its net profit of £2,500 gives a net profit margin of (£2,500 ÷ £10,000) × 100 = 25%.

The average rate of return (ARR) is used to judge whether a longer-term investment, such as buying new machinery, is worthwhile, by expressing the profit it generates as a percentage of what it cost. A higher ARR generally makes a project more attractive, since it shows the investment is expected to generate more profit relative to what it cost.

For example, a business invests £20,000 in a new machine, and expects it to generate total profit of £8,000 over the following four years. Its average annual profit is £8,000 ÷ 4 = £2,000, so its average rate of return is (£2,000 ÷ £20,000) × 100 = 10%.

Businesses judge their financial performance by comparing their profit margins over time, or against competitors, to see whether they are becoming more or less efficient at controlling their costs. A falling margin from one year to the next can be an early warning sign that costs are rising faster than revenue.

Financial data alone has a limitation: it ignores non-financial factors, such as staff morale, customer satisfaction or environmental impact, which also affect a business's long-term success. A business that looks healthy on paper can still be storing up problems if these wider factors are ignored.