Where the money comes from

Finance is internal or external, and short or long term:

• Internal: retained profit, sale of assets, owners personal funds.
• External short-term: overdraft, trade credit, debt factoring.
• External long-term: share capital, loan capital (debentures), leasing, grants, crowdfunding, business angels, venture capital.

Choice depends on cost, control (issuing shares dilutes ownership), risk, and whether the need is short or long term.

Internal source of finance

Fixed, variable and total

Fixed costs do not change with output (rent, salaries). Variable costs rise with output (materials). Total cost = fixed + variable. Revenue = price × quantity.

Contribution per unit = selling price − variable cost per unit. It is the amount each unit contributes towards fixed costs and then profit.

Contribution per unit

The break-even point

The break-even output is where total revenue equals total cost — no profit, no loss.

Selling above break-even earns profit; below it makes a loss. A larger margin of safety means more cushion before losses begin.

Break-even output

Margin of safety

Income statement and statement of financial position

The income statement (profit and loss account) works down from sales:

• Revenue − cost of goods sold = gross profit
• Gross profit − expenses = profit before interest and tax (operating profit)
• − interest − tax = profit for the period, then retained or paid as dividends.

The statement of financial position (balance sheet) shows assets = liabilities + equity at a point in time.

GPM, net profit margin and ROCE

Profitability ratios judge how well a firm turns sales and capital into profit:

• Gross profit margin = gross profit ÷ revenue × 100
• Net profit margin = profit before interest and tax ÷ revenue × 100
• ROCE = profit before interest and tax ÷ capital employed × 100

Higher margins are usually better, but compare over time and against competitors.

Gross profit margin

Net profit margin

Current ratio and acid test

Liquidity is the ability to pay short-term debts:

• Current ratio = current assets ÷ current liabilities (a guide of about 1.5–2 is often healthy).
• Acid test (quick ratio) = (current assets − inventory) ÷ current liabilities — a tougher test that strips out stock.

Working capital = current assets − current liabilities, the day-to-day cash to run operations.

Current ratio

Acid test ratio

Classify the ratio

Tap a measure, then the type of analysis it belongs to.

Cash flow is not the same as profit

Cash flow is money actually moving in and out; profit is revenue minus costs over a period. A profitable firm can still fail if it runs out of cash. Improve cash flow by chasing debtors, negotiating supplier credit, leasing rather than buying, and managing stock.

Cash flow vs profit

Payback and ARR

Appraisal compares the returns of an investment:

• Payback period — time to recover the initial cost. Example: 50,000 ÷ 12,500 per year = 4 years.
• Average rate of return (ARR) = (average annual profit ÷ initial investment) × 100.

Match the ratio to its formula

Tap a ratio on the left, then its correct formula on the right.

Payback period

The big ideas to know

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