Three numbers, three questions

Finance arrives as a pile of formulae. Revenue minus costs. Fixed plus variable. Break-even. Net cash flow. Closing balance. And the revision problem seems to be remembering which formula goes with which word. ⚠️⚠️ IT IS NOT, AND TREATING IT THAT WAY IS WHY CANDIDATES CALCULATE SOMETHING CORRECTLY AND STILL ANSWER THE WRONG QUESTION. ⭐⭐ THERE ARE THREE KINDS OF NUMBER IN THIS TOPIC AND THEY ANSWER THREE DIFFERENT QUESTIONS. ⭐ REVENUE, COSTS AND PROFIT LOOK BACKWARDS. They add up what already happened over a month or a year. They are a report. ⚠️ WHICH MEANS THEY CANNOT TELL YOU ANYTHING BEFORE YOU START TRADING, BECAUSE THERE IS NOTHING TO ADD UP YET. ⭐⭐ BREAK-EVEN LOOKS FORWARDS, AND IT IS THE ONLY ONE OF THE THREE THAT DOES. It answers how much has to happen before the losing stops. You can work it out before a single sale, from figures you already know: what each unit sells for, what each one costs to make, and what you have to pay whether you sell anything or not. That is why it sits at the centre of this topic, and why somebody lending money asks for it rather than for last year's profit. Last year's profit is somebody else's history. ⭐⭐ AND CASH FLOW IS NEITHER OF THOSE. IT IS ABOUT TIMING. Not whether money has been earned, but whether it has actually arrived by the day a bill has to be paid. ⚠️⚠️ WHICH IS WHY A BUSINESS CAN BE PROFITABLE AND STILL FAIL, A SENTENCE EVERY BUSINESS COURSE SAYS AND FEW EXPLAIN. Profit answers a question about a period. Being able to pay answers a question about a day. Those are different questions, so the answers can disagree, and when they disagree it is the day that closes the business. ⭐ SO THE THREE ARE NOT THREE VIEWS OF THE SAME THING. THEY ARE ANSWERS TO WHAT HAPPENED, TO WHAT MUST HAPPEN, AND TO WHEN THE MONEY MOVES. Carry one question through everything that follows: is this number telling me what happened, what has to happen, or whether I can pay on Friday?

What happened, what must, and when

The same three groups of figures, set out by the question each answers and by what each one cannot tell you.

Tap the two that look forward

Tap the TWO figures that can be worked out BEFORE a business has traded at all.

How many units must be sold before the fixed costs are covered
A forecast of what money will come in and go out in each of the next few months
The profit made over the last twelve months
The revenue taken during the last quarter

Profitable, and out of money

A business reports a healthy profit for the year and closes three months later because it cannot pay its suppliers. How is that possible?

Because profit answers a question about a whole period while paying a bill answers a question about one day, so money earned but not yet received cannot settle an invoice that is due now
Because the profit figure must have been calculated incorrectly
Because the business forgot to include its fixed costs
Because profit is reduced by tax after it is reported

Five figures, said precisely

Five terms, each defined by what it is. The last one is the one that trips people up, because it sounds like profit and is not.

Match each figure to the question it answers

Last year's profit
The break-even point, worked out before opening
The forecast closing balance for next month
What one unit contributes after its own variable cost
The monthly fixed costs

Did the period that has already finished go well, which is a report rather than a plan
How much has to happen before the losing stops, which is the one figure available before any trading
Whether there will be enough in the bank on the day the bills fall due
How much of the unavoidable bill each sale chips away at, which is what makes the forward calculation possible
How big the bill is that has to be covered before anything counts as profit at all

Two that follow from the split

Select the TWO statements that follow from the three kinds of number answering different questions.

A lender asks a new business for a break-even figure and a forecast rather than for a profit figure, because only those two exist before trading
A profit figure and a bank balance can disagree without either being wrong, because they answer questions about different things
If a business is profitable its cash flow must also be healthy
Because break-even looks forward, past profit figures are of no use to anybody

Deciding which figure is wanted

You may already have worked on reading a break-even chart: finding the crossing point, reading off the margin of safety, seeing which region is loss and which is profit. This card is about the step before that, which is knowing which of the three kinds of figure a question is asking for at all. ⭐⭐ READ THE QUESTION FOR ITS TENSE. Did, made and was are asking about a finished period. Needs to, must and would are asking about break-even. Can, when and by then are asking about cash. ⭐ THEN CHECK WHAT YOU HAVE BEEN GIVEN, BECAUSE THE FIGURES SUPPLIED USUALLY NAME THE METHOD. A selling price and a cost per unit alongside a fixed cost is a break-even question whatever the wording. A list of months is a cash-flow question. THEN DO THE ARITHMETIC AND LABEL THE ANSWER WITH ITS UNITS. ⚠️ UNITS SOLD, POUNDS, OR POUNDS PER MONTH ARE DIFFERENT ANSWERS, AND AN UNLABELLED NUMBER CANNOT BE MARKED AS THE RIGHT ONE. ⭐ AND IF THE QUESTION ASKS YOU TO INTERPRET RATHER THAN CALCULATE, SAY WHAT THE FIGURE MEANS FOR THE DECISION IN FRONT OF THE BUSINESS. A break-even figure on its own is a number; saying whether it looks achievable given what the business can produce is an answer. ⚠️ THREE HABITS THAT COST MARKS HERE. ⚠️ THE FIRST IS TREATING PROFIT AND CASH AS THE SAME WORD. ⭐ THEY ARE ANSWERS TO DIFFERENT QUESTIONS, AND AN ANSWER THAT USES ONE WHERE THE OTHER BELONGS HAS MISREAD THE QUESTION RATHER THAN MISCALCULATED. ⚠️ THE SECOND IS FORGETTING THAT BREAK-EVEN ASSUMES THINGS STAY PUT. It takes the selling price and the unit cost as fixed, and if either moves the answer moves with it. Saying so is an evaluation mark rather than a quibble. ⚠️ AND THE THIRD IS GIVING A BARE NUMBER WHERE A JUDGEMENT WAS ASKED FOR. Calculate means produce the figure; explain, analyse and evaluate all want the figure plus what it implies. One last thing. If you are unsure which figure is wanted, ask which day the question is standing on. A finished year, a business that has not opened, or a Friday when the rent is due. The tense of the question usually tells you.

The business that did everything right

A small workshop makes furniture to order for shops. It is not a real business and no amounts of money appear here, because the point does not need them. It has a good year. It sells more than it ever has, every piece sells for comfortably more than it costs to make, and at the end of the year the books show that the year went well. By every measure of the year as a whole, the business is doing fine. ⚠️⚠️ AND IN MARCH IT CLOSES. Follow what actually happened, day by day rather than year by year. The shops that buy from it pay on terms: they take delivery and settle up sixty days later. That is normal and nobody is behaving badly. The workshop, meanwhile, buys its timber when it starts a piece and pays for it then. Its rent goes out on the first of the month. Its two employees are paid weekly, and they are paid whether the shops have settled up or not. ⭐⭐ SO EVERY ORDER IT ACCEPTS COSTS IT MONEY IMMEDIATELY AND BRINGS IN MONEY TWO MONTHS LATER. ⚠️ WHICH MEANS THAT THE BETTER THE YEAR GOES, THE WORSE THAT GAP GETS, BECAUSE MORE ORDERS MEANS MORE TIMBER BOUGHT NOW AGAINST MORE MONEY DUE LATER. Growth, here, is the thing that empties the account. In February it takes its largest order yet. It buys the timber. It pays its people for four weeks of work on it. It delivers in early March, and it is owed a great deal of money, all of which will arrive in May. ⭐ AND ON THE FIRST OF MARCH THE RENT IS DUE, AND THERE IS NOT ENOUGH IN THE ACCOUNT TO PAY IT. ⚠️⚠️ NOTHING WENT WRONG WITH THE BUSINESS. IT SOLD WELL, IT PRICED WELL, AND ITS CUSTOMERS INTENDED TO PAY AND LATER DID. ⭐⭐ WHAT CLOSED IT WAS A QUESTION ABOUT A SINGLE DAY, ASKED OF A BUSINESS WHOSE ANSWERS WERE ALL ABOUT A YEAR. ⭐ THE GENERAL LESSON IS WORTH MORE THAN THE WORKSHOP: WHEN MONEY LEAVES BEFORE IT ARRIVES, DOING MORE BUSINESS MAKES THE PROBLEM BIGGER RATHER THAN SMALLER.

Order the way to pick the method

Put these six steps into the order that takes you from a finance question to a labelled answer.

Read the question for its tense: a finished period, a business not yet trading, or a day when a bill falls due
Check which figures you have been given, since they usually name the method
Choose the calculation that answers that question rather than the one you know best
Do the arithmetic
Label the answer with its units, whether that is units sold, pounds, or pounds per month
If asked to interpret, say what the figure means for the decision in front of the business

Build the sentence that explains failure

This is the sentence that explains how a profitable business runs out of money. Assemble it.

Work out the break-even point

A small workshop has fixed costs of 4500 pounds a month. Each item it makes sells for 23 pounds and costs 14 pounds in materials and direct labour. Using only those figures, how many items must it sell in a month to break even?

The finance run

Five questions on which figure answers which question. Three lives.

Complete the finance facts

The total value of sales made over a period, whether or not the money has arrived, is _____. Costs that have to be paid whether or not anything is sold are _____. The point at which what each unit contributes has covered those costs exactly is _____. Money actually moving in and out, arranged by when it happens, is _____.

revenue fixed costs break-even cash flow variable costs profit closing balance margin of safety

Three answers to aim properly

Three students answer finance questions. Their arithmetic is correct in each case, and the figure they produced is not the one that was wanted.

Asked whether a business starting next month will be able to pay its rent in its third month, a student calculates the break-even point correctly. What went wrong?
A student writes that a business with a large profit will obviously have plenty of cash available. How would you correct it?
A student calculates a break-even figure and concludes the business will definitely succeed once it passes that number of sales. Is that the strongest version?

Explain the three questions

A friend is starting a small business making and selling candles. They have worked out that they will make a profit on every candle, and they think that settles the matter. Explain what else they need to work out and why, using the three kinds of figure in this topic.

Explain what a profit on each candle does and does not tell them
Explain what break-even would tell them, and why it can be worked out before they sell anything
Say which figures they would need to calculate it
Explain what a cash-flow forecast answers that neither of the others does
Use one example of money leaving before it arrives to show why that matters
Name one assumption the break-even figure depends on
Finish with a judgement about what they should work out first, and use only figures they would actually have

Business Finance: Costs, Profit and Break-even

Use it, the way the marks are given

What you'll cover