Edexcel A-level Business (9BS0) · 2.3 Managing finance
Mini-Lesson
Managing finance
This mini-lesson covers Edexcel 2.3 Managing finance: 2.3.1 profit (gross, operating and profit for the year, profit margins and ways to improve profitability), 2.3.2 liquidity (the current and acid test ratios and working capital) and 2.3.3 business failure — with every figure calculated.
Work through each screen, answer the questions as you go (multiple choice, calculations and sorting tasks) and collect ⭐ stars. Press Start when you are ready.
2.3.1 · Profit
Three levels of profit
The statement of comprehensive income (profit and loss account) works down from revenue to profit in three stages:
gross profit = revenue − cost of sales operating profit = gross profit − operating expenses profit for the year = operating profit − interest − taxCost of sales = the direct cost of the goods sold. Operating expenses = indirect costs such as salaries, rent, marketing and depreciation.
Ways to improve profitability — and the danger in each:
Raise price — works only if demand is price inelastic; otherwise volume and revenue fall.
Cut cost of sales (cheaper suppliers, better purchasing) — improves the gross margin, but may damage quality and the brand.
Cut operating expenses (overheads, marketing, training) — improves the operating margin, but cutting marketing or training can weaken future revenue.
Raise volume — spreads fixed costs over more units, but requires demand.
Diagnostic tip: compare the two margins. If the gross margin holds but the operating margin falls, the problem is overheads, not the product. If the gross margin falls, the problem is pricing or the cost of inputs.
Quick check
Diagnosing the margins
?A firm's gross margin is steady at 40% but its operating margin has fallen from 15% to 9%. What is the most likely explanation?
2.3.1 · Profit
Profit is not cash
The single most examined distinction in Theme 2:
Profit is an accounting measure over a period: revenue earned minus costs incurred, regardless of when the money moves.
Cash is the money actually in the bank right now.
A firm can be profitable and insolvent at the same time. A sale made on 60-day credit is recognised as revenue immediately, but no cash arrives for two months. Meanwhile wages, rent and suppliers must be paid. If the firm cannot pay its bills as they fall due, it fails — however good the profit figure looks.
Overtrading is the classic version of this: a firm wins so many orders that it must buy stock and hire staff faster than its customers pay it. Sales and profit rise while the cash balance collapses.
2.3.2 · Liquidity
The statement of financial position and liquidity ratios
The statement of financial position (balance sheet) is a snapshot of what the business owns and owes on one day. Liquidity is the ability to meet short-term debts as they fall due.
current ratio = current assets ÷ current liabilities acid test ratio = (current assets − inventory) ÷ current liabilitiesThe acid test strips out inventory because stock is the hardest current asset to turn into cash quickly.
Worked example — Hartley Ltd
Current assets £180,000 (inventory £60,000 · receivables £70,000 · cash £50,000) · current liabilities £120,000
Current ratio = 180,000 ÷ 120,000 = 1.5 (often written 1.5:1)
As a rough guide, a current ratio of about 1.5–2.0 and an acid test near 1.0 are considered healthy — but the right level is industry dependent. A supermarket runs safely on a much lower ratio because it sells stock for cash long before it pays its suppliers.
Calculate
Your turn — current ratio
3Hartley Ltd has current assets of £180,000 and current liabilities of £120,000. Calculate the current ratio, to 1 decimal place.
: 1
Hint: Current assets ÷ current liabilities = 180,000 ÷ 120,000.
Calculate
Your turn — acid test ratio
4Of Hartley's £180,000 current assets, £60,000 is inventory. Calculate the acid test ratio, to 1 decimal place.
: 1
Hint: (180,000 − 60,000) ÷ 120,000.
Quick check
Interpreting liquidity
?A firm's current ratio is 2.4 but its acid test is 0.6. What does this tell you?
2.3.2 · Liquidity
Working capital and how to improve liquidity
working capital = current assets − current liabilitiesIt is the day-to-day money that funds stock, credit to customers and the wage bill. Too little and the firm cannot trade; too much and cash is sitting idle in stock and receivables, earning nothing.
Ways to improve liquidity:
Reduce inventory (just-in-time) — releases cash, but risks stock-outs.
Collect receivables faster (tighter credit terms, prompt-payment discounts, debt factoring) — but discounts cost margin and tough terms can lose customers.
Extend payables — negotiate longer credit from suppliers, but relationships suffer and discounts are lost.
Sale and leaseback of assets — an immediate cash injection at the cost of a permanent rental.
Arrange an overdraft or short-term loan — fast, but costly in interest.
Non-financial: weak leadership, no strategy, poor marketing, poor-quality products, failure to innovate, over-reliance on one customer or one supplier.
External causes
Financial: a rise in interest rates, a recession cutting demand, currency movements raising the cost of imported inputs, the withdrawal of credit by a bank.
Non-financial: new competitors or disruptive technology, changes in tastes, new legislation, the loss of a major customer, supply-chain shocks.
The examiner's point: most failures have an internal and an external element. A recession is external, but the firm that fails in it is usually the one that was already over-borrowed, illiquid or undifferentiated. Strong answers weigh which cause was decisive.
Quick check
Profitable but failing
?A firm reports a record annual profit of £400,000 yet enters administration three months later. Which explanation is most consistent with both facts?
Match it
Match the ratio to what it measures
Tap a formula on the left, then the ratio it defines on the right.
Formula
Ratio
Quick check
Improving liquidity has a cost
?To improve liquidity a firm offers customers a 2% discount for payment within 10 days. What is the key trade-off?
Quick check
Too much liquidity?
?A firm has a current ratio of 4.0 and holds a very large cash balance. Why might shareholders criticise this?
Recap
The big ideas to know
Profit levels: gross = revenue − cost of sales · operating = gross − expenses · profit for the year = operating − interest − tax
Margins: each profit ÷ revenue × 100; compare gross and operating margins to locate the problem
Profit ≠ cash: profit is earned; cash is received. Overtrading kills profitable firms
Liquidity: current ratio = CA ÷ CL · acid test = (CA − inventory) ÷ CL · working capital = CA − CL
Improving liquidity: cut stock, collect receivables faster, extend payables, sale and leaseback, overdraft — each has a cost