Business Finance: Break-even, Cash Flow and Accounts

Profit is not the same as cash

This topic has five parts: where a business gets money, how much it must sell before it makes any, whether it will have cash when bills fall due, and what its two statements show. **Start with the thing students most often get wrong.** Profit and cash answer different questions. - **Profit** asks whether the business made money over a period. It appears on the income statement. - **Cash** asks whether there is money in the bank on the day a bill has to be paid. It appears on the cash flow forecast. A business can be profitable and still fail, because customers pay late, stock is bought before it is sold, and trade is seasonal. **Running out of cash closes a business whether or not it is profitable**, and that sentence is worth marks on its own.

Where the money comes from

Sources of finance, grouped by where they come from and how long they last.

Match each need to its best source

Which source would you use?

A sole trader needs £30,000 for machinery that will last eight years. She wants to keep full ownership. What do you recommend and why?

• A bank loan, because the repayment period can be matched to the life of the machinery and she keeps full ownership
• An overdraft, because it is quick to arrange
• Share capital, because it never has to be repaid
• Trade credit, because it is free

Break-even, in one formula

Break-even is the output at which a business covers its costs exactly: no profit, no loss. Getting there needs two ideas and one division. **Fixed costs** do not change with how much you make: rent, insurance, salaries. **Variable costs** rise with each unit: materials, packaging. **Contribution per unit = selling price − variable cost per unit.** That is what each unit sold puts towards the fixed costs. **Break-even output = fixed costs ÷ contribution per unit.** Once you know what one unit contributes, you know how many units are needed to cover the fixed costs. **Margin of safety = actual output − break-even output**: how far sales can fall before the business starts losing money. Examiners like this one because it turns a number into a judgement.

Work out the contribution

A workshop sells a chair for **£25**. The materials and packaging for each chair cost **£15**. What is the contribution per unit, in pounds?

Find the break-even output

The same workshop has **fixed costs of £40,000** a year, and each chair contributes **£10**. How many chairs must it sell in a year to break even?

What break-even assumes

Break-even analysis is useful but rests on assumptions. Select the TWO that a strong answer would name.

• That everything produced is actually sold, when in practice stock can go unsold
• That the selling price and the costs per unit stay the same at every level of output
• That the business is already making a profit
• That the business has enough cash in the bank

Two different questions

The income statement and the cash flow forecast are not two versions of the same document.

Forecast the closing balance

A business starts March with **£3,200** in the bank. During March it receives **£18,500** and pays out **£21,000**. What is its closing balance at the end of March, in pounds?

Reading the accounts

Costs that do not change with output, such as rent and insurance, are _____ costs. Selling price minus variable cost per unit gives the _____ per unit, and dividing fixed costs by it gives the _____ output. On an income statement, revenue minus cost of sales gives _____ profit, from which expenses are deducted to give net profit. On a cash flow forecast, the opening balance plus net cash flow gives the _____ balance.

Interpreting the figures

**"A café reports revenue of £180,000 this year against £150,000 last year, and net profit of £9,000 against £14,000. Comment on its performance. (6 marks)"** "Revenue has risen by £30,000, so the café is selling more than it did. On its own that looks like a good year. **But net profit has fallen by £5,000 despite the higher revenue**, which means costs have risen faster than sales. That could be the cost of ingredients, higher wages, or an expense taken on to win the extra trade in the first place. It is also worth noting what these figures do not show. Neither tells us whether the café has cash in the bank, so a business growing like this could still be struggling to pay suppliers on time. To judge the year properly you would want the figures behind the costs, and a comparison against what similar cafés achieved." **The move that earns the marks: a single figure means nothing on its own.** Every judgement here comes from a comparison, either against last year or against what the number does not cover. Quoting a figure without saying what it is being compared to is where most answers stop short.

Build the income statement

Put the lines of an income statement into the order they appear.

• Revenue: the total value of sales made during the period
• Cost of sales: what the goods sold actually cost the business
• Gross profit: revenue minus cost of sales
• Expenses: rent, wages, insurance and other running costs
• Net profit: gross profit minus expenses

Spot the cash flow problem

A supplier of garden furniture describes its year. Tap the TWO details that would cause a cash flow problem.

• The business is profitable and its order book is full.
• Stock for the summer is bought and paid for in February, months before any of it sells
• . Prices are set with a healthy margin and the workshop is efficient.
• Its largest customers are given ninety days to pay, while its own suppliers expect payment in thirty
• . The owner has no plans to expand this year.

Profitable, and out of money

A profitable business tells you it cannot pay next month's suppliers. Work through it.

• The owner says this must be a mistake, because the accounts show a profit. What do you explain?
• Customers are taking ninety days to pay while suppliers want thirty. What is the most direct fix?
• The shortfall is temporary and lasts about six weeks. What finance suits it?

Your turn: advise the business

A small manufacturer sells a product for £40. Its variable costs are £24 per unit and its fixed costs are £64,000 a year. It expects to sell 5,000 units. Advise the owner.

• Calculate the contribution per unit and the break-even output, showing your working
• Calculate the margin of safety at 5,000 units and explain what it tells the owner
• Explain why the business could still run short of cash even at this level of sales
• Recommend one source of finance for a temporary shortfall and one for buying new machinery, justifying each