Setting financial objectives

• Revenue, cost and profit objectives — e.g. "raise operating profit margin from 6% to 9%".
• Cash flow objectives — e.g. "cut receivables days from 60 to 40".
• Return on investment — is the capital tied up in this business earning more than it would elsewhere? Measured by ROCE: operating profit ÷ capital employed × 100.
• Capital structure objectives — what proportion of long-term funding is debt (gearing). Debt is cheaper and does not dilute ownership, but the interest must be paid whatever happens.
• Investment (capital expenditure) objectives — how much to commit to new productive assets.

A firm that sells £1m of goods on 90-day credit has made the profit but has no cash. It must still pay wages on Friday. This is overtrading, and it is the single most common way a growing, profitable business goes bust.

Cash flow forecasting

A cash flow forecast lists, month by month: cash inflows − cash outflows = net cash flow; then opening balance + net cash flow = closing balance (which becomes next month's opening balance).

The forecast has done its job: it has shown the board, in advance, that October needs a £25,000 overdraft facility. Arranging it in September is routine; discovering it on 31 October is a crisis.

Value and limits: forecasts allow finance to be arranged early, support a loan application, and set a benchmark. But they rest on estimated sales and on customers actually paying when they said they would. A forecast built on optimistic sales is worse than none, because it breeds false confidence.

Profitable but broke

Budgets and variance analysis

A budget is a financial plan: a target for revenue or a ceiling for expenditure over a set period. Variance analysis compares budget with actual.

Now be careful, because this is where marks are lost every year:

• Revenue above budget → favourable. Revenue below budget → adverse.
• Costs above budget → ADVERSE. Costs below budget → favourable.

"Higher" does not mean favourable. It depends entirely on whether the line adds to profit or subtracts from it.

Interpret, don't just label. A favourable labour-cost variance may mean the firm ran understaffed — and the adverse quality and delivery consequences will land next quarter. An adverse marketing variance may be an over-spend that generated the favourable revenue variance beside it. Variances are the start of the investigation, not the end.

Favourable or adverse?

Contribution and break-even

Contribution is what each unit contributes towards paying off the fixed costs — and, once they are paid, towards profit.

Your turn — contribution per unit

Your turn — break-even output

Your turn — margin of safety

Your turn — profit from contribution

The break-even chart

What moves the break-even point?

• Price ↑ → contribution ↑ → break-even falls (revenue line steeper). But volume may fall — check the PED.
• Variable cost ↓ → contribution ↑ → break-even falls.
• Fixed costs ↑ (e.g. buying automation) → break-even rises, though variable cost per unit usually falls at the same time.

Limits of break-even analysis: it assumes everything is linear — that price is constant at all volumes (it is not: discounts) and that variable cost per unit is constant (it is not: bulk discounts, overtime premiums). It assumes everything produced is sold, and it is only as good as the cost data behind it. It is a planning tool, not a prophecy.

Automation and break-even

The three levels of profit — and their margins

Read down an income statement:

Each has a margin: margin (%) = (that profit ÷ revenue) × 100.

Why three? They diagnose where the problem is. A healthy gross margin with a weak operating margin means the product is fine but the overheads are bloated. A weak gross margin means the problem is in pricing or direct costs — and no amount of overhead-cutting will fix it.

Your turn — gross profit margin

Match each profit measure to its calculation

Tap an item on the left, then its partner on the right.

Your turn — ROCE

Sources of finance

Internal: retained profit (free, no interest, no dilution — but limited, and it belongs to shareholders who may want it as a dividend) · sale of assets · tighter working-capital management.

External — short term:

• Overdraft — flexible, interest only on what is used, ideal for a temporary cash dip. But expensive, and repayable on demand.
• Trade credit — pay suppliers in 30–90 days. Free, but stretching it damages supplier relationships.
• Debt factoring — sell your invoices to a factor for perhaps 80–90% of face value, now. Instant cash and no chasing, but you give up a slice of the profit and the factor's collection style may upset your customers.

External — long term: bank loans (predictable repayments, no ownership lost, tax-deductible interest — but interest must be paid in bad years too, and security is required) · share capital (no repayment obligation and no interest — but ownership and control are diluted, and dividends are expected) · venture capital (money plus expertise for high-risk ventures — at the price of a big equity stake and real influence).

The golden rule — match the term to the use. Finance a long-term asset with long-term finance. Funding a £2m factory on an overdraft is reckless: the bank can withdraw it on demand and the interest is punitive. Equally, taking a 10-year loan to cover a one-month cash dip means paying interest for a decade.

Which source of finance?

Tap a source, then tap the category it belongs to.

Financing a long-term asset

Improving cash flow and profits

To improve cash flow: chase receivables harder or offer prompt-payment discounts · negotiate longer credit from suppliers · use debt factoring · cut or delay stock purchases · sell and lease back assets · delay capital expenditure · arrange an overdraft.

To improve profitability: raise price (only wise if demand is inelastic) · cut variable costs (renegotiate supply, reduce waste — but watch quality) · cut fixed costs / overheads · raise volume and spread fixed costs · improve the sales mix towards higher-contribution products.

Every one of these has a sting. Chasing customers harder can drive them to a rival. Stretching suppliers invites them to raise prices or deprioritise you. Delaying capital expenditure fixes this year's cash and damages next decade's competitiveness. Discounting to shift stock generates cash and destroys profit. Cutting a marketing budget flatters this quarter and starves the pipeline.

So say which problem you are solving. A cash crisis needs cash actions, even if they cost profit — because insolvency is fatal and low profit is not. A profitability problem needs margin actions, and taking cash-flow measures instead will simply make it worse.

Thinking like an examiner

• Diagnose before you prescribe. Is this a cash problem or a profit problem? They demand opposite medicine.
• Contribution is the workhorse. Price − variable cost. Break-even, margin of safety, profit, special-order decisions and product-mix decisions all fall out of it.
• Read the three margins together. Where the margin collapses tells you where the business is broken.
• Match the finance to the use, and watch gearing. Debt is cheap until the year the sales fall — then the interest is still due.
• Break-even assumes linearity. Say so, and say what changes if price or unit variable costs move with volume.

The big ideas to know

Press Finish to see your score.