Unit 3 PDF

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Personal and Business

Finance 3
UNIT 3
Getting to know your unit
The ability to manage money is crucial to keep both yourself, as an

Assessm ent individual, out of future difficulties and also to keep businesses out of
This unit is extern ally difficulties. If you are not able to manage your money effectively, then
all sorts of problems may lie ahead. Managing your money will help you
assesse d using an unseen
achieve future objectives and dreams. Similarly, if a business cannot
paper-based examin ation.
manage its money it is not likely to survive.
and marke d by Pearson .
How you will be assessed

This unit is externally assessed by an unseen paper-based examination. The
examination is set and marked by Pearson. Throughout this unit you will find practice
activities that will help you prepare for the examination. At the end of the unit, you will
also find help and advice on how to prepare for and approach the examination. The
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examination must be taken under examination conditions so it is important that you
are fully prepared and confident with key terminology and accounting techniques. You
will also need to learn key formulas and be confident with carrying out calculations
accurately. A calculator will be essential.
The examination is 2 hours and the paper is made up of questions that require
short answers, calculations and extended writing. You will need a calculator in the
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examination and throughout your study of this unit.
Assessment criteria
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This table outlines the content that you must cover as part of this unit.
Content area A Understand the importance of managing personal finance

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Content area B Explore the personal finance sector
Content area C Understand the purpose of accounting
Content area D Select and evaluate different sources of business finance
Content area E Break-even and cash flow forecasts
Content area F
Complete statements of comprehensive income and financial position
and evaluate a business’s performance
Getting started
60 Personal and Business Finance

UNIT 3
Personal finance involves understanding why money is important and how

managing your money can help prevent future financial difficulties. Write
Personal and Business Finance

down a list of future medium- and long-term wants. Discuss why you will
need to be able to manage your money to achieve these goals.
Understand the importance of managing
personal finance
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You will make important financial decisions throughout your
life. The choices you make will not be without some risk
and need to be taken very carefully. This unit will help you
understand how to manage your personal finances and make
informed decisions to help prevent future financial difficulties.
Functions and role of money
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Money flows in two directions, into your ownership and out.
Money comes in from various sources including wages, gifts
and savings. Money goes out to pay for necessities and wants.
The same is true in business – money comes in from sources,
including sales and bank loans, and goes out to pay day-to-day
expenses and fund expansion. Therefore the ability to handle
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money received, and to control money paid, is a fundamental
▸▸ What do you think are the three biggest financial decisions you
requirement for personal and business success. The starting
will ever make in your life?
point is to understand what ‘money’ is.
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Discussion
What is money? Can you write a definition? What forms can money take? In
small groups, discuss what you think money is. Write a definition of money and
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produce a spider diagram showing the different forms that money can take. Feed
back to the rest of the class and discuss your results. Can you all agree on the best
definition of money?
The functions of money

The functions of money are the jobs that it performs. These are outlined below.
▸▸ Unit of account
• It allows us to place a monetary value on goods and services.
• The price of goods and services show the unit of account, for example a
chocolate bar is 60p or a new car is £30,000.
▸▸ Means of exchange
• It allows us to trade.
• Businesses and customers can buy and sell goods and services using money, for
example when you purchased your lunch yesterday or paid to go to the cinema.
▸▸ Store of value
• It allows us to use it in the future as it keeps its value.
• You might have money saved in a bank account or ‘piggy bank’ which you can
then use to buy goods and services in the future.
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▸▸ Legal tender:
• It is a legaly recognised form of payment.
• Money is widely recognised and used for all sorts of transactions from buying an ice
cream or getting a haircut to paying a deposit on a house and receiving your wages.
Research
Did you know that the Royal Mint sets rules on what is legal tender? If you owed
£100 and wanted to pay off your debt in 2p pieces would this be legal tender?
Take a look at the guidelines on the Royal Mint website. Why do you think these
guidelines exist.
Role of money
Different people will have different attitudes to money. An individual may also change
their attitude to money based on the situation they find themselves in. The role of
money is affected by a wide number of factors, including those outlined below.
▸▸ Personal attitudes
Individuals will vary in their attitude to risk and reward as well as saving and
borrowing. You may be risk averse so you will try to avoid risk, or you may be
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willing to take more risks and may even enjoy risk taking as you are incentivised by
the potential rewards. Equally, you may be more or less likely than others to save
your money rather than spend it. This can, in part, depend on your family’s attitude
to money, for example whether you were brought up being told savings were good
and encouraged to save for a rainy day. You will also be influenced by your attitude
to borrowing. You might like to live within your own means and only buy what you
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can afford. Alternatively, you might be happy to buy goods and services on credit
or to borrow money in order to get what you want sooner rather than later.
▸▸ Life stages
As you grow up from childhood to adulthood, your financial needs change. Each
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stage of your life has different implications that will affect not just your needs but
also your attitude to money, as discussed above. Table 3.1 shows the common
financial needs and implications of each stage.
▸▸ Culture
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Different cultures, affected by tradition, religion and ethical beliefs, will have
different attitudes to money. The older generation of Chinese people, for example,
have a culture of saving. However, as the country becomes wealthier young people
are more willing to spend and even buy on credit.
▸▸ Life events
Events throughout your life will impact on your attitude to money. These events
may be within your control, for example going to university, travelling abroad,
getting married or starting a family, or may be outside your control, for example
illness, financial gains or losses.
▸▸ External influences
Factors outside your control, including the state of the economy, will have an
impact. For example, the state of the economy will impact on wages, availability of
jobs and the prices of goods and services. Decisions by the government will affect
Key term the amount of tax you pay or the amount you receive in benefits. These all directly
affect your ability to spend and save.
Interest rate – the cost of
▸▸ Interest rates
borrowing money or the
When interest rates are low you may be more willing to borrow money or spend on
reward for saving money.
credit. When interest rates are high there is more of an incentive to save.

Content area A UNIT 3
Table 3.1: Financial needs and implications at different life stages

Life stage Financial needs Implications
Childhood •• Limited needs Money received from presents may be spent as attitude will
•• Mainly reliant on parents be that this is to buy things you want
•• May want to buy sweets or toys May be encouraged to save or parents or grandparents
may set up a savings account for you into which they make
regular payments
May rely on pocket money
Adolescence •• Want to be more independent May look for a part-time job
•• Slightly less reliant on parents as want to Still partially reliant on pocket money
socialise away from family More likely to receive cash as gifts and may be willing to
save up smaller amounts in order to make bigger purchases
Young adult •• University or starting a career May take a student loan if going to university
(This is a very big stage •• Looking to be more independent Borrow money to pay for a car or purchase one on a
which can encompass a •• Buying a car and buying or renting a flat or finance deal
wide range of different house May be looking at taking out a mortgage
scenarios depending •• Looking to settle down and maybe get Need to earn money to support self and others
upon life choices) married or start a family Eligible for credit and debit cards
Middle age •• Support family Savings accounts for specific purposes
university, weddings, etc.
move house
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•• Start saving for children’s futures, e.g.
•• Look to improve own lifestyle, e.g. new car or
•• Enjoy having access to additional money to

spend on luxuries such as foreign holidays
Paying a mortgage
Planning for own future through pensions and retirement
plans
Likely to be the stage of life when income peaks but
matched with high expenditure
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Old age •• Fewer dependents Mortgage payments stop or become lower
•• May downsize, e.g. move from family home Less income as reliant on a pension rather than a salary
to a smaller retirement home
•• Fewer financial needs for assets but may be
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higher for services such as health care
Planning expenditure Key terms

When planning expenditure, that is, money paid out, it is important to consider a
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number of common principles. These are important to ensure that you avoid over Debt – money owed.
spending which will put you at risk of financial difficulties both now and in the future. Credit rating – a score given
You should look to control costs in order to avoid getting into debt in the future. If to individuals on how likely
your spending is too high, this may mean more money is going out than coming in they are to repay debts based
which will lead to the build-up of debt. Debt is expensive as interest will be charged upon their previous actions.
on money owed. If debts are not paid or not paid on time, this will affect your credit Bankrupt – when an
rating. A poor credit rating will affect your ability to borrow in the future. In extreme individual or organisation
cases, an individual may be declared bankrupt if their debts have spiralled out of legally states its inability to
control. repay debts.
To remain solvent, you should set financial targets and goals. These should consider Solvent – the ability to meet
how much money you want to earn and place limits on how much you will spend. If day-to-day expenditure and
you save some of your income, this can help generate future income as money saved repay debts.
will earn interest. Savings will also help provide a safety net for the future, for example
to provide insurance against loss or injury. What would happen if you could not work
in the future? Sometimes you will also want to save to fund future purchases, for
example to buy a car or pay a deposit on a house.
Inflation is a general rise in prices. This leads to the value of money falling, that is, £10
today is worth less than £10 ten years ago. Expenditure now can help counter the effects
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of inflation. For example if you spent £150,000 buying a house today the value of the
Reflect
house would increase. If you left £150,000 in a savings account the amount would go up
In pairs discuss: because of inflation but the spending power of your savings would go down.
•• How would you rate your
The common principles to be considered in planning personal finance are summarised
own attitude to money?
•• Do you take risks? in Figure 3.1.
•• Can you think of a time
when your attitude to Avoid getting
money was irresponsible? into debt
Counter the
•• How could you have
effects of inflation Control
behaved differently?
•• What factors influence costs
Provide insurance
your attitude to risk?
against loss or illness Avoid legal action
As a group draw a spider
and/or repossession
diagram of factors
influencing people’s Set financial Common Principles
attitudes to risk. targets and goals Remain
solvent
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Generate income Maintain a good
and savings credit rating
Manage money Avoid

to fund purchases bankruptcy
▸▸ Figure 3.1: How important are each of these principles in planning your own personal
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finances?
P a us e p o int Can you explain the functions and role of money?

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Hint Close the book and draw a concept map about the factors affecting the role of
money. Think about both personal factors and external factors.
Extend What do you think are the short- and long-term consequences of bankruptcy?
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Different ways to pay

One of the functions of money is as a means of exchange. This means you can use it
to pay for things. There are, however, a number of ways of paying for things – not just
with notes and coins. Therefore any method of payment is classed as money. Table 3.2
shows methods of payments.
▸▸ If you wanted to buy a car what are the different ways you could pay for it?

▸▸ Table 3.2: Methods of payment

Method of payment Explanation/features Advantages Disadvantages
Cash Notes and coins in a wide range Most widely accepted form of Can be lost or stolen
of denominations exchange Threat of counterfeit
Physical not virtual Only really appropriate on purchases up
Consumers feel confident when to a certain amount
using Cannot be used online
Makes budgeting easier
Debit card Issued by banks with payments No need to carry cash Short time lapse between making
for goods and services being Secure method of payment with the transaction and the money being
deducted directly from a current low risk of theft withdrawn from the customer’s account
account Widely accepted may result in overspending
Offers a degree of protection on Not accepted or appropriate for small
purchases transactions
Suitable for online transactions
Credit card Issued by financial institutions Allows a period of credit that is Interest is charged on balances not paid
allowing customers to delay interest free, e.g. one month off within a month
payments for goods and Most cards are widely accepted Can encourage a customer to overspend
services Loyalty schemes are often and get into debt
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offered, e.g. collect points or Interest is charged on cash withdrawals
cash back A limit will be set on the amount of
Offers a degree of protection on credit allowed
purchases
Suitable for online transactions
Cheque A written order to a bank to Low risk form of payment as the Expensive for the consumer if the
make a payment for a specific cheque can only be cashed by bank refuses to clear the cheque, i.e. it
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amount of money from one the named payee ‘bounces’
person’s account to another Widely accepted for face-to- The time delay between writing the
account face and postal transactions cheque and it being cashed could cause
No need to provide change a consumer to go overdrawn
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as can be written for an exact Viewed as old fashioned
amount Easy for the consumer to make errors
when writing the cheque which will
create problems for both the consumer
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and the recipient

Electronic transfer Payment is transferred directly Almost instantaneous Risk of loss if the transfer is incorrectly
from one bank account to Provides a record of payment set up
another No additional costs incurred Not appropriate for face-to-face
Easy to use for one-off and transactions
more frequent transactions
Direct debit An agreement made with a An easy way to make regular If the payer makes a mistake and takes
bank allowing a third party payments, e.g. utility bills too much it is the payee’s responsibility
to withdraw money from an Amount paid can vary to ensure to claim back the money
account on a set day to pay for the payment matches the The payer determines the amount paid
goods or services received, e.g. amount required by the vendor each time making it difficult for the
pay a gas bill Quick and easy to set up payee to plan and budget
Standing order An agreement made with a The same amount is paid each Payments are taken regardless of the
bank to transfer a fixed sum of time making it easier for the customer’s balance which could lead
money to a third party account payee to plan and budget to the unplanned use of an overdraft
on a set date on a regular Easy both to set up and to facility
basis, e.g. pay £30 for a phone cancel Payments will continue to be made
contract each month No need to remember to make unless cancelled
regular, standard payments
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▸▸ Table 3.2: – continued
Method of payment Explanation/features Advantages Disadvantages
Pre-paid card Money is uploaded onto a Can set a budget in advance to No protection if lost
card with transactions then avoid overspending Sometimes requires an initial fee to
being withdrawn to reduce the If lost or stolen the loss is purchase or set up the card, e.g. Oyster
balance limited to the remaining travelcards
balance
An effective way of controlling
the amount spent by children
and where money is spent,
e.g. upload money for school
lunches or transport
Contactless card Cards containing antennae Gaining in popularity Often only accepted for relatively small
allow money to be transferred Secure method of making transactions
when the card touches a payments Still not widely accepted as seen as new
contactless terminal technology
Charge card Issued by financial institutions Reduces risk of running up Must be paid in full each month
allowing customers to delay debts Often an annual fixed fee is applied
payments for goods and services Allows a short period of credit
for a short period of time; the Avoids the need to carry cash
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balance must be paid off in full
Often offers additional perks
when a statement is issued
Store card Issued by a retail outlet so that Allows a short period of credit Only accepted in issuing store or linked
customers can delay payments that is interest free, e.g. one associations
for goods and services (similar month Interest is paid on outstanding balances
to a credit card but only Often offer loyalty schemes, Can encourage overspending and
accepted by stores specified) discounts and special result in a consumer getting into debt –
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promotions or privileges particularly if they hold multiple cards
Mobile banking The ability to carry out financial Convenient as can be used at Features are still limited and hence
transactions using mobile any time and place mobile banking does not offer all of the
devices such as phones or Secure functionality of Internet banking
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tablets
Banker’s Automated A system that allows the transfer Faster payment allows almost Faster payment is not offered by all
Clearing Service (BACS) of payments directly from one instant transfers that are banks or branches and the customer
Faster Payment bank account to another guaranteed within 2 hours may therefore have to default to BACs
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Can be accessed in a number of which can take three days to transfer

ways including in a branch, over payments
the telephone and online A limit is set on the amount that can be
No additional costs transferred in any single transaction
Clearing House A system that allows the transfer Transfers can be made the same Normally, there is a fixed charge per
Automated Payment of payments directly from one day assuming instructions are transaction regardless of the amount
Systems (CHAPS) bank account to another received prior to a set time, e.g. transferred
2 pm at Barclays
There is no limit on the amount
that can be transferred in a
single transaction
Discussion
In pairs discuss:
•• Which of the payment methods in Table 3.2 do you use regularly or semi-regularly?
•• Which of these methods do your parents use regularly or semi-regularly?
•• Does your payment method depend upon the product you are buying?
As a class, draw a mind map to show when each method of payment is suitable.
Justify your decisions.

Current accounts

A current account is an account with a bank or building society that is designed for
frequent use. Money can be paid in and withdrawn on a daily basis without the need Key terms
to give notice. Most people will use a current account to get wages paid into, to pay
cheques into and out of, pay bills and other frequent expenses, and to withdraw cash. Current account – an
account with a bank or
In the same way as a business changes the features of its products to try and be
building society designed
competitive and attract customers, banks will try to attract customers by changing the
for frequent use, e.g. regular
features of their accounts. The features of a current account will include:
deposits and withdrawals.
▸▸ rate of interest paid on any positive balance
Overdraft – the ability to
▸▸ rate of interest charged on a negative balance
withdraw money that you
▸▸ overdraft limit
do not have from a current
▸▸ charges on unauthorised overdrafts
account.
▸▸ additional incentives.
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▸▸ What would you look for when choosing a bank to open a current account with?
Types of current account are outlined below.

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▸▸ Standard
This is the normal account offered to customers with a reasonable credit rating.
It includes standard features such as the ability to pay and withdraw money,
cheque book, debit card, interest payments on positive balances and a pre-agreed
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overdraft limit.
▸▸ Packaged, premium
This account offers additional features to a standard account, for example car and
house insurance, credit card protection, breakdown cover and cash back on certain
transactions. The bank may have additional charges for these accounts so it is
important that you check whether you are being offered a good deal or not.
▸▸ Basic
This account offers only limited features designed for those customers who may
otherwise find it difficult to open a bank account due to poor credit ratings. A basic
account will not offer an overdraft and will not pay interest on positive balances.
▸▸ Student
This account is designed specifically to meet the needs of learners. Common
features include an agreed overdraft limit and incentives to join the bank, for
example free rail cards or cash. Banks are keen to attract learners because once a
young person has joined a bank they tend to stay with that bank for life. However,
this is less often the case now due to the availability of information on the Internet
and the ease with which banks can be changed.
The advantages and drawbacks of different account types are summarised in Table 3.3.
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▸▸ Table 3.3: Advantages and disadvantages of different types of current account
Type of current Advantages Disadvantages

account
Standard No charges on credit balances Potentially high charges on the
Offers the holder a wide range of use of an overdraft facility
facilities including a cheque book, Standard features only, i.e. no
debit/cash card and possibly an additional perks
overdraft facility
Convenient for receiving regular
payments, e.g. wages and making
regular withdrawals
Packaged, No charges on credit balances Additional monthly charge is
premium Offers the holder a wide range of frequently applied
facilities including a cheque book, The package offered may not
debit/cash card and possibly an offer value for money or meet the
overdraft facility needs of the individual account
Convenient for receiving regular holder
payments, e.g. wages and making
regular withdrawals
Offers the holder additional perks
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at a packaged price cheaper
than acquiring them individually
(standard additional features
include things such as holiday/travel
insurance, break down cover and
phone protection)
Basic Available to customers with a low Limited facilities, e.g. no debit card
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Research credit rating or overdraft facility
Offers an easy first step for
Look at the student accounts individuals to gain access to basic
currently being offered by banking facilities, i.e. the ability to
banks. As well as visiting pay in and withdraw cash
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individual bank websites, you Student Course fees and student loans can Overdraft facilities could
could also look at comparison be easily handled encourage overspending
websites. Which bank do you Bonuses offered are designed to Charges for overspending are high
think is currently offering the meet the needs of learners, e.g. Limited facilities
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discounts on travel or small lump

best deal to learners?
sum cash payment
Case study
Which account?
Gabriella has just finished sixth form and is looking forward to starting at
Birmingham University in October. During the summer, she starts to look at
which student accounts are available. She is surprised to see that they vary so
much between different high street banks. To help her decide which account
is best, she summarises her findings in a table


Account Interest paid on Interest free Charges for Conditions Other
name credit (positive overdraft and unauthorised
balances) additional overdraft
overdraft
Student 3% on balances Up to £500 £25 None £100 Waterstones
first between £500 in first year administration voucher
and £3000 increasing to £5 daily charge Ability to apply
up to £1500 for a student
in subsequent credit card
years (terms and
conditions apply)
No additional
overdraft
Varsity None Up to £1000 in £10 a month Must pay Four year student
account first 3 years penalty plus 8% £250 a rail card plus
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Up to £3000 if on outstanding month into 10% discount on
studying for a balance account national coach
fourth and fifth travel
year
Student 1% up to £200 Up to £1500 per £35 Must register Three year
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sense 1.5% up to £1000 year administration for online student rail card
£5 daily charge banking Debit card
2% up to £3000
10% discount on
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student insurance
with same
provider
Student 0.5% no upper Up to £1000 in Must register £60 cash deposit
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ABC limit year 1 and £3000 for online

in year 2 and banking
beyond Must pay
£100 per
month into
account
Check your knowledge

1 Outline why you think Gabriella should open a student current
account.
2 Can you identify which student account is best for Gabriella? Justify
your answer.
3 What would be your priorities when choosing a student account?
4 What do you think are the benefits to the banks of offering student
accounts?
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Managing personal finance
Few businesses have just one product. They have a range of products to meet the
needs of different customers. A car manufacturer, such as Ford, will have cars to match
different incomes, lifestyles, family size and preferences. This is also true of banks,
building societies and other providers of financial services. They will all offer a range
of products to match the needs of different individuals. Financial services will include
borrowing.
Different types of borrowing

These are outlined below.
▸▸ Overdraft
• This allows you to withdraw money that you do not have from a current account.
• It may be suitable to meet short term needs, for example a shortage of cash just
before payday.
▸▸ Personal loan
• This gives you the ability to borrow a set amount of money, normally for a
specific purpose, to be repaid in regular instalments with interest.
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• It may be suitable to fund the purchase of a high price item such as a car or to
make home improvements.
▸▸ Hire purchase
• This allows you to have use of an item immediately but pay for it in regular
instalments. The item remains the property of the seller until all instalments have
been made.
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• It may be suitable for one-off or infrequent purchases, for example a TV or fridge
freezer.
▸▸ Mortgage
• This is a long-term loan to fund the purchase of assets, normally paid back over
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a long time, for example 25 years. It is secured against an item, for example a
house.
• It is suitable for assets that will maintain value for a long time and cannot
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normally be paid for outright.

▸▸ Credit card
• Goods are paid for by card and can be paid for either at the end of a set period,
normally a month, when a statement is issued or over time with the card provider
stating a minimum payment each month. The minimum payment will be a
percentage of the balance on the credit card.
• It may be suitable when buying high price goods or services, for example a
holiday, or at times when expenses are higher than usual, for example Christmas,
to spread the costs of spending.
• It may also just be used for convenience and safety as an alternative to using cash.
▸▸ Payday loan
• This is a short term source of finance used to bridge the gap between now and
next receiving a wage. It will normally only available for relatively small amounts
at very high rates.
• It may be suitable in an emergency to meet cash shortages.
The advantages and drawbacks of the various types of borrowing are summarised in
Table 3.4.

▸▸ Table 3.4: Advantages and disadvantages of different types of borrowing

Type of borrowing Advantages Disadvantages
Overdraft Interest is charged only on the amount outstanding When used, interest charges are often high
Can be paid off without penalties Additional penalty charges for going over a pre-
An overdraft facility can be prearranged and only arranged limit are often very high
used if needed Not the cheapest form of borrowing
Provides a short term solution to cash flow problems The ease with which these can be obtained could
encourage overspending
Personal loans Regular, pre-agreed payments make planning and May have to be secured against an asset which means
budgeting easy if payments are missed the asset may be taken to
As a general rule these would only be issued to cover the outstanding debt
individuals who can prove their ability to make the Not really suitable for short term loans
repayments
Useful when looking to purchase a specific item
of medium to high value, e.g. a car or home
improvement
Hire purchase Spreads the cost of an expensive item over a period Interest charges may be higher than other traditional
of time loans
Credit is secured against a specific item Ownership of the asset may legally be kept by the
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Often allows a customer to afford something now seller until the final payment is made
that they could not otherwise afford, e.g. four years’ Agreements can be manipulated to make a purchase
interest free on furniture seem deceptively appealing
Mortgages Allows the customer to spread the cost of expensive Interest payments, although sometimes fixed for
items over a long period of time, e.g. the purchase of a short period of time, can vary – this seriously
a house is often spread over 25 years affects the borrower’s ability to repay or meet other
Interest rates, depending upon the mortgage deal, expenses
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can sometimes be fixed or tracked against a standard Failure to meet repayments may lead to a loss of a
rate of interest reducing the risk of fluctuations home and seriously affect an individual’s future credit
rating
Penalties may be applied to early repayment
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Credit cards The credit card holder can pay above the minimum Can encourage overspending, sometimes on
rate if they wish and hence speed up the rate of unnecessary purchases, and can lead to debt
repayment and reduce interest incurred problems
Can be used for items of multiple sizes and value, to a Interest rates are often higher than on a personal loan
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limit, without the need to secure against an asset

Provides some protection on purchases
Payday loans Help solve immediate short term cash flow problems Interest rates are very high and the cumulative
Relatively easy to secure amount to be repaid can quickly spiral out of control
Different types of saving and investment

Managing personal finance can also include saving and investment.
These options are open to you when you are earning or receiving more
money than you need to cover your expenditure. Even when income and
expenditure are the same or similar, it can be wise to take advantage of
opportunities to save and invest to increase future wealth. Different types of
expenditure are outlined below.
▸▸ Individual savings accounts (ISA)
This is a type of saving account where the holder is not charged income
tax on the interest received.
▸▸ Deposit and savings accounts
These are accounts where interest is paid on the balance and normally ▸▸ In what ways might a new business pay for its
the holder needs to give notice before withdrawing funds. office equipment?
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Key terms
▸▸ Premium bonds:
Expenditure – the amount of A government sheme that allows individuals to save up to a set amount by buying
money you need to cover all bonds. The bond holder does not receive interest on their savings but each bond is
your expenses/outgoings, e.g. placed into a regular draw for cash prizes.
your mortgage and bills. ▸▸ Bonds and gilts
Shareholder – someone who These are fixed term securities where the lender (the individual) lends money to
has invested in a company in companies and governments in return for interest payments. The money is invested
return for equity, i.e. a share for a specified period of time.
of the business. ▸▸ Shares
Shares involve investment in a business in return for equity, i.e. the shareholder
becomes a part owner of the business. The shareholder will receive dividends from
the company’s profits and will also want the value of the shares to increase.
▸▸ Pensions
These are long-term savings plans where individuals make regular contributions,
called premium payments, throughout their working life. This is then repaid as
either a lump sum, regular payments or a combination of the two upon retirement.
Pensions can be state, company or private.
The advantages and drawbacks of the different types of savings and investment are
summarised in Table 3.5.
Type of saving
and investment
Individual savings
accounts (ISAs)
Advantages
FT
▸▸ Table 3.5: Advantages and disadvantages of different types of saving and investment
Tax is not charged on interest earned allowing the saver to keep

all of the rewards for saving
Disadvantages
Notice is often required to make withdrawals and

according to the agreement there may be a limit
A
Interest rates are sometimes slightly higher than in alternative set on the number of withdrawals made
savings accounts If the saver makes more withdrawals than set out
in the agreement then the penalty may cancel
out the tax savings
R
There is a limit set on the annual amount that can
be placed in an ISA
Deposit and Interest is earned on positive balances Interest earned is taxed
savings accounts Accounts sometimes require regular deposits of a set amount The percentage rate of interest paid on savings
D
forcing the saver to follow a savings plan is likely to be lower than interest to be paid on
borrowing, therefore the benefits of savings are
lost if the customer is borrowing at the same time
Premium bonds Chance of winning substantially more than could be earned in No guaranteed return on investment
interest Maximum amount reviewed annually by the
Can be easily withdrawn with no loss or penalty government
The amount invested, assuming zero or low
returns, loses value due to inflation
Bonds and gilts Regular fixed returns Risk of losing some or all of the value of the
Spreads risk across a range of markets investment if the bond or guilt value falls
Interest payments may not be received if the
issuer is unable to make payments
Shares Share prices fluctuate offering a potential high reward Share prices fluctuate offering a potential high
Shareholders’ returns can include dividend payments and an risk
increase in share value There is no guarantee of any reward or return as
As part owners in a business there may be additional benefits all of an investment can be lost
including discounts and special offers
For some investors share ownership is more than just a way of
saving – it is a pastime and creates interest

▸▸ Table 3.5: – continued

Pensions Encourages individuals to save throughout their working life for Movement between jobs may mean that one
retirement policy stops and another starts, thus reducing the
Depending upon the policy, an individual’s savings may be overall cumulative value of the savings
boosted by an employer’s contributions increasing the final Final outcome is difficult to predict
value of the saving If compulsory payments are deducted this may
Regular payments are deducted, sometimes at source, meaning affect short-term living standards
the individual is tied into making the regular contributions
P a us e p o int Can you explain the difference between saving and investment?
Hint Draw a concept map about different methods of saving and investment. For each
method, weigh up the risk versus the reward and award the method a mark out of
with 10, 10 being highest risk and 1 lowest risk.
Extend Which method of saving or investment do you think offers the lowest risk at the
highest reward? Justify your answer.
Risks and rewards of saving versus investment Key terms

Saving and investment both involve forfeiting current spending in the hope of gaining
FT
Saving – placing money in a
greater wealth in the future. Saving involves placing any extra money in a secure secure place so that it grows
place where it will hopefully grow as it gains interest. If you are saving your money, it is in value and can be used in
often with a view to buying a specific good in the future or to support a planned future the future.
lifestyle. Many parents will start to save when a child is born to pay future college fees
or to support the child as he or she grows up. Investment involves making a Investment – speculative
commitment to a project in the hope that it is successful and a healthy return is made commitment to a business
A
on the investment. This could involve investing in the shares of a business. venture in the hope that it
generates a financial reward
The risks and rewards of saving versus investment are summarised in Table 3.6.
in the future.
▸▸ Table 3.6: Risks and rewards of saving versus investment
R
Risks Rewards
Saving •• Low or zero risk as money saved is •• Interest payments
guaranteed to be available in the future •• Financial security/peace of mind
•• Inflation can reduce the spending power of
D
money saved
Investment •• Investments can go wrong and all or some of •• If successful, there is potential for a high financial return
the value may be lost (significantly higher than could be earned in interest)
•• No guarantee of a return •• Can be exciting! Some people will invest in shares, antiques, art
or foreign currencies, for example, in the hope of high returns
Research
Work in pairs. You have £2500 and must invest or save it for at least five years.
•• Mind map all the options – showing risk versus potential rewards.
•• Identify your preferred saving method. Find an account that offers the highest return.
How much would your savings be worth in five years?
You read about a new form of investment called crowd funding. Visit one of these
websites as part of your research.
•• Choose one or more businesses to invest in. Calculate your expected return on your
£2500 in five years’ time.
•• Present your saving and investment options to the rest of the class.
•• As a class, try to reach an agreement on what would be the best use of the money.
73
Key terms Different types of insurance products: their features, advantages
and disadvantages
Insurance – an agreement
with a third party to provide Insurance is a form of protection. Specific items as well as individuals and pets can be
compensation against insured. Insurance policies cover the cost of loss, damage or illness up to prearranged
financial loss in line with the levels in return for regular payments called premiums. Figure 3.2 illustrates some of
conditions laid down in the the different types of insurance that are available.
policy agreement.
Premiums – regular Car
payments made by an
individual or company to an
Home and
insurance provider in return Health
contents
for protection.
Types of insurance
Life assurance
Pet
and insurance
FT Travel
▸▸ Figure 3.2: What items of worth do you have insured? Is your mobile phone insured?
A
Insurance can be taken out against anything deemed to have a worth or where there
is a risk of financial loss. A common type of insurance now is against mobile devices
such as your mobile phone. The premium paid will vary depending upon the amount
of cover provided and the amount of risk as assessed by the insurance provider. Types
R
of insurance are outlined below.
▸▸ Car
• It is a legal requirement to insure any car that is on the road – this covers theft as
well as accidents.
D
• The degree of cover will vary depending upon whether the policy is third party or
fully comprehensive.
• It protects the driver, passengers and other road users.
▸▸ Home and contents
• Home insurance covers the physical building, for example against fire.
• Contents insurance covers the physical items in the house including electrical
equipment, furniture and personal items. If there are individual items of high
value, for example a diamond ring, then they may need to be specified on the
policy.
• Items can be insured when a person is using them away from home as well as
when inside the house.
▸▸ Life assurance and insurance
• Life assurance is an ongoing policy to pay a lump sum upon death.
• Life insurance is a policy for a set period of time to pay a lump sum if you die
within that time period.
• Mortgage lenders often insist upon life insurance for the same period as the
mortgage to secure repayment of the mortgage if the holder dies while monies
are still owed.

▸▸ Travel

• This protects individuals or groups while abroad. Policies can be purchased to
cover a specific trip, multiple trips or for all trips within a year.
• Cover will generally include loss or theft of property, illness, cancellation and
emergencies up to predetermined limits.
• Specific types of holiday or activities, for example skiing or extreme sports, will
require additional cover due to the high level of risk associated.
▸▸ Pet
• This protects the owners of pets against some or all of the expenses associated
with treating ill or injured pets, i.e. vets’ fees.
▸▸ Health
• This covers individuals, families or employees against medical expenses including
assessments, treatments and loss of earnings.
• In the UK the National Health Service provides free medical care but individuals
may wish to take out insurance to receive payments if, for example, time is spent
in hospital, or to receive private treatment.
• Health insurance can include payment plans to cover routine visits such as to the
dentist or optician with a percentage of expenses paid.
FT
The pros and cons of different types of insurance are summarised in Table 3.7.
▸▸ Table 3.7: Advantages and disadvantages of different types of insurance
Type of insurance Advantages Disadvantages

Car Meets legal requirements Premiums can be high depending upon assessed
Protects self against theft or damage level of risk, e.g. expensive for young drivers
A
Protects against damage caused to a third party Normally there is an excess that must be
paid, e.g. first £500 of all damages is still the
responsibility of the car owner
Home and contents Protects against damage which may otherwise Premiums are an additional expense to home
R
be too expensive to repair resulting in the loss of ownership
a home Some items cannot be replaced due to a value
Contents are protected both when inside the beyond the financial worth, e.g. a painting or
house and outside inherited piece of jewellery
D
Life assurance and insurance Provides peace of mind to family following the If the policy holder does not die within the
bereavement of a homeowner period of life insurance no payment is made
(could be seen as an advantage!)
Travel Provides protection for personal belongings The person suffering the loss is likely to have to
when away from home pay upfront to replace items or cover medical
Covers medical costs when on holiday costs and then reclaim later
Protects against cancellation and sometimes An additional cost when travelling abroad
delays
Pet Avoids expensive vet fees An additional monthly expense to protect

If vet fees are too high, there may be no against the unexpected
alternative to having the pet put down –
insurance can avoid this
Health Some compensation is provided when ill which Paying for something that you hope you will not
can reduce the financial burden and stress use
allowing the patient to concentrate on recovery Premiums can be expensive depending upon the
rather than financial worries degree of cover required
If used to fund private care, this often results in Will not cover pre-known conditions
quicker treatment and better facilities
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Case study
Insurance is big business Real Madrid the club obviously felt his legs were an
asset worth protecting and insured his legs for £90
million in 2013.
The music business also sees professionals insuring their
voice, hands or other body parts. Jennifer Lopez, for
example, insured her bottom to the sum of £180 million
while Mariah Carey insured her legs for £1 billion.
Following his role as James Bond, Daniel Craig insured
his body for £6 million; not to be outdone, Joey Essex
insured his hair for £1 million.
Check your knowledge
1 Outline why the general public are likely to insure
their homes and content.
2 Outline why celebrities are willing to take out
Members of the general public are likely to protect
insurance policies worth such high amounts.
FT
their home, their home’s contents, their car and maybe
their health or pet. For celebrities, it seems they protect 3 What would be the benefit to Real Madrid of
a whole lot more. Sporting stars can insure against Christian Ronaldo being insured?
damage to limbs which would ultimately lead to a huge 4 Explain why insurance companies would be willing
loss of earnings. When Christiano Ronaldo played for to issue these types of insurance policies.
A
Assessment practice 3.1
R
1 Identify two disadvantages of using a credit cards. (2 marks)
2 Describe two examples of a type of borrowing. (4 marks)
3 Describe the likely financial needs and implications of a person in the
D
young adult stage of the life cycle. (6 marks)

Bethany and Mark have inherited some money from their grandfather. Bethany
wants to save the money for future use so that she has something to rely on while
Mark thinks that he will make the best use of his money if he invests it.
4 Assess the risks and rewards of saving versus investment. (12 marks)
B Explore the personal finance sector

Features of financial institutions
Financial institutions are organisations that offer financial services to individuals and/
or businesses. These services include the ability to deposit or withdraw money, obtain
credit and make investments, as well as offering advice on matters of personal and
business finance.

Content area B UNIT 3
Types of organisations and their advantages and disadvantages are outlined below.

▸▸ Bank of England:
• This is the UK’s central bank with responsibility for maintaining a healthy level of
financial stability for the UK as a whole.
• Responsibilities include issuing legal tender, setting interest rates and controlling
the national debt.
▸▸ Banks
• A bank is an organisation that handles financial transactions and stores money on
behalf of its customers.
• Services offered will include holding deposits, making payments when instructed
to do so and supplying credit.
▸▸ Building societies
• These are organisations that handle financial transactions and store money on
behalf of their members.
• The members, or account holders, are part owners of the building society and
have a right to vote and receive information on the running of the society.
• Unlike banks they do not have shareholders on a stock exchange which allows
costs to be kept down.
▸▸ Credit unions
•
•
FT
• These are not-for-profit organisations that handle financial transactions and store
money on behalf of their members.
Often there is a responsibility or desire to support a community made up of its
members.
A
Members are the owners and have a voting right.
▸▸ National Savings and Investments
• This is a government-backed organisation that offers a secure saving option.
• It offers a range of options including ISAs, premium bonds and gilts and bonds.
R
▸▸ Insurance companies
• These are businesses that protect against the risk of loss in return for a premium.
• They are profit-making organisations.
D
▸▸ Pension companies
• These are businesses that sell policies to individuals, either privately or through
employers, to allow them to save now to fund retirement in the future.
• Pension companies normally invest the money paid to them in contributions in
order to increase its value. However this is not risk free.
▸▸ Pawnbrokers
• These are businesses or individuals who loan money against the security of a
personal asset, for example an item of jewellery or piece of electronic equipment.
• If the item is not bought back from the pawnbroker within a specified period of
time then it will be sold on.
▸▸ Payday loans
• These are organisations that offer a short-term source of finance used to bridge
the gap between now and next receiving a wage; they are normally only available
for relatively small amounts at very high rates.
• They may be suitable in an emergency to meet cash shortages.
The pros and cons of different financial institutions are summarised in Table 3.8.
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▸▸ Table 3.8: Advantages and disadvantages of types of financial institution
Type of organisation Advantages Disadvantages

Bank of England Responsible for protecting the financial stability of Not a bank for members of the general public
the economy as a whole Can raise interest rates making borrowing more
Sets interest rates at a level designed to help expensive
achieve a stable economy
Lends to banks
Banks Offer a range of services and account types Savings are only protected up to the value of
Provide a secure place to store money £85,000, so if a bank goes bankrupt savings above
Pay interest on credit balances on most types of this would be lost
accounts Profit-making organisations owned by
shareholders, therefore costs to individuals may be
higher than necessary in order to fulfil shareholder
objectives
Building societies Offer a range of services and account types Savings are only protected up to the value of
Provide a secure place to store money £85,000, so if a building society goes bankrupt
Pay interest on credit balances on most types of savings above this would be lost
accounts May lack the business drive of a commercial bank
Owned by members and therefore costs can be
FT
kept down allowing for higher interest payments
Credit unions Offer a range of services and account types Savings are only protected up to the value of
Provide a secure place to store money £85,000, so if a credit union goes bankrupt savings
Owned by members and therefore costs can be above this would be lost
kept down allowing for higher interest payments May lack the business drive of a commercial bank
Often offer additional benefits to the community
A
or a good cause
National Savings and Government-backed, therefore offering security on Rates are variable
Investment 100% of savings with no upper limit Not as easy to access due to lack of a high street
Offers additional services/methods of savings, e.g. presence
R
premium bonds Often required to give notice on withdrawals
Insurance companies Protect against unexpected losses or financial Premiums are assessed on the estimated degree of
expenses risk which may be seen to penalise some members
Easy and regular monthly payments make planning or groups of society too harshly
D
easy Profit-making organisations, therefore premiums

Wide range of services and levels of cover to suit will be charged to ensure shareholder needs are
the needs of individuals met
Pension companies Provides a structure to help plan for financial Poor investment decisions by the pension company
security after retirement may result in a disappointing return
Deductions can be taken directly from pay and Money already invested in a pension cannot be
be fully or partially matched by an employer’s released prior to the dates agreed in the policy
contribution
Experts are employed to make investment
decisions
Pawnbrokers A quick way of acquiring cash needed for a short The amount given for the asset is often
period of time substantially lower than its actual worth
The asset can be brought back within a set period If the money is not repaid within the agreed period,
of time the asset will be sold on
Interest is not charged
Payday loans A quick way of acquiring cash needed for a short Interest charges are likely to be very high
period of time Often results in paying back a final sum
substantially higher than the initial amount
borrowed


▸▸ A pawnbroker’s business can thrive during times of financial hardship. How do you feel about
this?
Communicating with customers
FT
Traditionally, banking was carried out face to face where there was a personal
relationship between the bank manager and clerk and the customer. The bank
manager was seen as a figure of authority in the community. Over time, this
relationship has become less common and, as banking organisations have grown, the
service has become less personal.
A
Changes in technology have also changed the way in which the banking industry
operates.
Discussion
R
In small groups, discuss how technology changes have affected how banking
operates. As a whole group, discuss whether these changes have had a positive or
negative impact on banking? Consider this from the point of view of employees,
D
banks, customers (of different ages) and other businesses. Think about whether
this has affected other industries or just banking. Think of examples.
Methods of interacting with customers include:

▸▸ branch:
• physical places where the customer will visit to carry out transactions which can
be face to face, for example over the counter transactions or using computerised
facilities, such as1 automatic teller machines (ATM)
• offer additional facilities and services such as advice.
▸▸ online banking:
• the use of the internet to carry out banking transactions.
▸▸ telephone banking:
• when transactions are carried out over the telephone.
▸▸ mobile banking:
• the use of mobile devices such as mobile phones and tablets to conduct financial
transactions.
▸▸ postal banking:
• the use of the postal service to carry out paper-based financial transactions.
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The pros and cons of different ways of interacting with customers are summarised in
Table 3.9.
▸▸ Table 3.9: The advantages and disadvantages of different methods of interacting with
customers
Method Advantages Disadvantages

Branch Opportunity to build a relationship developing trust Need to travel to a branch which is likely to incur travel
and brand loyalty costs, e.g. parking or fares for public transport
Transactions can be conducted there and then Restricted to bank opening hours
Additional services such as advice can be offered May be long queues plus travel time, making the
Gives the customer a high level of confidence process time consuming
Online banking Available 24/7 Takes time at the beginning to set up or apply for
High degree of privacy Not suitable for cash withdrawals
Convenient Increased risk due to cyber crime
If just an online account, the facilities may be limited
Telephone banking Convenient, especially to access basic functions such as Full access may be limited to set hours
checking a balance Call centres and automated telephone systems can
No additional charges frustrate customers
FT
Higher risk of fraud and identity theft
Mobile banking Convenient May need to download specific apps to access mobile
Available 24/7 banking for a particular bank
No additional charges Higher security risk due to increased risk of loss or theft
of mobile devices
Can be prone to hackers sending texts asking for bank
details
A
Postal banking Traditional method that many customers will feel Can be slow due to the postal system
comfortable with Post can get lost
Does not require any additional technology or devices
R
Consumer protection in relation to personal finance
There are laws and organisations responsible for protecting the rights of consumers.
In relation to personal finance, they are there to help ensure that the consumer is not
D
treated unfairly or exploited. The following organisations and laws are concerned with
protecting consumer rights.
▸▸ Financial Conduct Authority (FCA)
• The FCA is an independent organisation with a remit to regulate the actions of
providers of financial services.
• It is funded by membership fees charged to financial service providers.
• The organisation’s work focuses on three key areas:
•
authorisation – permitting financial service providers to trade
•
supervision – ensuring procedures and practices are in the interest of the
consumer
•
enforcement – using powers to ensure standards are maintained.
▸▸ Financial Ombudsmen Service (FOS)
• The FOS is an organisation appointed by the government to represent the
interests of the consumer in disputes with financial service providers.
• It is funded by compulsory fees charged to all regulated financial institutions plus
additional fees when actions are taken against an institution.
• The FOS becomes involved in disputes only if they cannot be satisfactorily sorted
between the consumer and the financial institution prior to involving the FOS.

▸▸ Financial Services Compensation Scheme (FSCS)

• The FSCS is the organisation in the UK that will pay compensation to a consumer
of financial services if the service provider is unable to.
• The FSCS, for example, protects all savers in banks and building societies up to
£85,000, i.e. if the financial institution goes bankrupt the savings will be refunded
by the FSCS.
▸▸ Office of Fair Trading (OFT)
• The OFT is a government organisation that was established to regulate all
markets, including financial markets.
• The OFT’s aim was to encourage fair practices and healthy competition between
financial institutions.
• Since 2014 responsibility for financial institutions has been passed to the FCA.
▸▸ Legislation: consumer credit
• These are laws passed by the UK government to enforce the regulation of any
firm offering credit to consumers.
• Any firm offering credit, for example leasing, hire purchase agreements or credit
cards, must be registered with the FCA.
Research
FT Visit the websites below to

carry out research on the
roles and responsibilities
of these organisations and
consumer credit laws.
A
www.fca.org.uk/
www.financial-ombudsman.
org.uk/
www.fscs.org.uk/
R
www.gov.uk/offering-credit-
consumers-law
Do you think that it is
D
necessary for the government

and other organisations to
regulate financial institutions?
Or should they be trusted to
self-regulate?
▸▸ How confident are you that your savings are safe in the bank?
Information guidance and advice

Personal finance is a complicated matter and it is important to all individuals. There
are a number of government-funded and independent organisations which offer
guidance and advice to individuals on personal finance. These are outlined below.
▸▸ Citizens Advice
• This is an organisation, run by charities, that offers advice on a wide range of
issues both financial and non-financial.
• Advice is offered at physical centres as well as online and via email and
telephones.
• Financial advice covers areas including, debt, benefits, banking, pensions and
insurance.
81
▸▸ Independent financial advisor (IFA)
• IFAs are professionals who offer independent advice to their clients on financial
matters including savings, investments, mortgages and pensions.
▸▸ Price comparison websites
• These websites collate prices for similar goods and services within an industry
allowing consumers to make comparisons easily and find the best deals.
▸▸ Money advice service
• This is a government organisation set up to offer free and impartial financial
advice in the UK.
▸▸ Debt counsellors
• This is a professional who offers independent advice on how best to manage
debt.
▸▸ Individual Voluntary Arrangements (IVAs) bankruptcy:
• This is a government organisation that allows an inividual to declare themselves
bankrupt while agreeing to pay all or part of the money they owe to creditors
through an insolvency practitioner.
• Regular payments are made to the insolvency practitioner who then spreads this
across the creditors deciding how much to pay each one.
FT
The pros and cons of different providers of financial information and guidance are
summarised in Table 3.10.
▸▸ Table 3.10: Advantages and disadvantages of different providers of financial information and
guidance
Provider Advantages Disadvantages

A
Citizens Advice Free service Trained volunteers are not necessarily
Offers face to face as well as online and professionals in financial issues and therefore
telephone advice knowledge may be limited
Wide range of areas covered
R
Independent financial advisor (IFA) Advice is offered by professionals in the field Services will be charged for
Services offered are regulated by the FCA and Advice offered is not guaranteed to be 100%
FOS up to date or unbiased
Advisers will take time to understand an
D
individual’s full financial situation

Price comparison websites Easy to access 24/7 Not guaranteed to be 100% up to date,
Free service accurate or unbiased
Do not always cover all of the available options
Potential for bias
Money advice service Government-funded therefore advice is free Advice is only available online or over the
and impartial telephone – no physical presence
Covers a wide range of financial matters Can take time to find and understand the exact
advice that is being searched for
Advice can be generic rather than personal
Debt counsellors Advice is offered by a professional who Services will be charged for
specialises in debt management Advice will focus just on debt management
Services offered are regulated by the FCA rather than the whole package of financial
and FOS concerns
Individual Voluntary Arrangements Helps manage debt repayment with regular Set up and handling fees are charged for the
(IVAs) bankruptcy payments making budgeting easier service
Independent advice, without bias Will affect future credit ratings

Content area C UNIT 3

1 Describe the role of the Financial Conduct Authority. (2 marks)
2 Identify two disadvantages of online banking. (2 marks)
3 Explain two advantages of building societies. (4 marks)
Bethany is still not sure what to do with her inheritance money. She has tried
researching online but is overwhelmed by the amount of information available.
4 Discuss the different sources of financial information and guidance that
Bethany could use. (12 marks)
C Understand the purpose of accounting

It is impossible to truly understand how a business operates without some knowledge
of the accounting process. You may be familiar with the expression ‘a picture paints a
thousand words’ – in business you can adapt this to ‘numbers paint a thousand words’.
FT
Anyone who wants to understand how well a business is performing – such as the
owner, an employee or a potential investor – is likely to turn straight to its accounts.
However good a business idea might be, if the owner does not keep a careful eye on
the business’s accounts, it is almost certain to be doomed to failure. Key terms
Financial transactions –
Purpose of accounting actions by a business that
A
involve money either going
Accounting involves the recording of financial transactions, planned or actual, and
into or out of a business – for
the use of these figures to produce financial information. In this first section, you will
example, making a sale or
look at a number of reasons why accounting is important to business success.
paying a bill.
R
Record transactions HM Revenue & Customs
Keeping business records accurate and up to date is important for the smooth running (HMRC) – HM is an
of a business. The business owner or a bookkeeper must record all of the money abbreviation for Her (or His)
D
coming into the business (from sales) and all of the money going out, such as expenses. Majesty’s, and the HMRC
If a business fails to do this it may find itself not chasing payments, forgetting to pay is a British government
bills or, even more seriously, in trouble with HM Revenue & Customs (HMRC). If department responsible for
the business does not record its transactions correctly, it cannot report its financial the collection of all types of
performance accurately and therefore tax payments may be wrong. taxes.
Management of the business

A manager is responsible for the planning, monitoring and controlling of the resources
for which they are responsible. A manager who clearly understands the business’s
accounts will be better able to make informed decisions and plan for the future.
Management of a business involves careful coordination of resources including staff,
materials, stock and money. The manager must ensure there are sufficient funds to
pay wages, order new stock, pay bills and meet other demands for cash outflows by
balancing this with the money coming in from sales.
Compliance
Financial reporting is governed by laws and regulations. This is to ensure that any
financial records give a fair and accurate picture of the business. It is important that
businesses comply with these laws and regulations in order to ensure that investors
83
and other stakeholders are not misinformed. Compliance will also help protect against
Key term
fraud. Fraud is when company monies are used inappropriately or acquired by the
Fraud – when an individual wrong person for personal gain.
acquires company money for ▸▸ What are the main purposes of these laws and regulations?
personal gain, through illegal
▸▸ How do the reporting requirements vary between organisations?
actions.
▸▸ Why do you think it is important for financial reporting to be regulated?
Research
In pairs research the laws and regulations that govern financial reporting in the
UK. Some useful websites to get you started are:
www.gov.uk/guidance/audit-accounting-and-reporting-guidance-for-uk-
Key terms companies
www.frc.org.uk/
Profit – surplus achieved
when total revenue (income) www.icaew.com/en/technical/financial-reporting/other-reporting-issues/other-
from sales is higher than the uk-regulation.
total costs of a business.
Loss – shortfall suffered when
Measuring performance
FT
total revenue from sales is
lower than the total costs of a Without financial records it would be impossible to know if the business was making
business. a profit or a loss, or whether or not the business was owed money or was in debt to
others.
Gross profit – sales revenue
minus cost of goods sold (the Throughout this unit, you will consider how a business can measure its financial
cost of the actual materials performance and what actions it can take to improve its performance. Key indicators
of financial performance include:
A
used to produce the quantity
of goods sold). ▸▸ gross profit – this is the amount of profit left after the cost of producing the good
or service is deducted from the amount of sales revenue
Sales revenue – quantity
▸▸ net profit – this is the smaller amount of profit made after all other expenses are
sold multiplied by the selling
R
deducted from the gross profit
price.
▸▸ value owed to the business – this is the amount of money owed to the business
Net profit – gross profit from sales that have not yet been paid for
minus other expenses, for
▸▸ value owed by the business – this is the amount of money the business owes to
D
example, rent and advertising.

others for goods or services purchased but not yet paid for.
▸▸ Why is it important to keep a close eye on a business’s financial affairs?

Control

Key term
Accounting will control the flow of money into and out of the business by maintaining
Trade receivables – money
accurate records and monitoring performance. This should mean that any unusual
owed to the business from
activity is spotted, helping to prevent fraud. It will also, therefore, track the amount of
sales made but not yet paid for.
money the business is owed, trade receivables, from the sale of goods and the amount
the business owes, trade payables. This will help ensure that the business can meet Trade payable – money the
its day-to-day expenses. If trade receivables and payables are not carefully controlled, business owes from supplies
there is a danger that the business may not be able to survive. This will also involve credit purchased but not yet paid for.
control which aims to ensure that all money owed to the business is paid on time.
Types of income
Income is money coming into the business. There are two categories of income:
▸▸ capital income
▸▸ revenue income.
Capital income
Key term
Capital income is the money invested by the owners or other investors that is used to
set up a business or buy additional equipment. It tends to be used to buy things that Fixed assets – items of value
owned by a business that are
FT
will stay in the business for a medium-to-long period of time – for example, premises,
vehicles or equipment. These are called fixed assets. When setting up a business, likely to stay in the business
capital income might also be used to buy opening stock, but, as the business develops, for more than one year – for
stock should be paid for by sales income. The sources of capital income available to example, machinery. Also
business owners are influenced by the type of business. known as non-current assets.
Loans
A
A loan is an amount of money lent to the business or business owner(s) from a bank
or other financial institution. It is a lump sum that then has to be paid back at a set
amount per month over the period of the loan, often five years, although longer-term
loans can be agreed. As well as the repayment of the loan, there will be a monthly
R
interest repayment. This is the amount of money the bank is charging for the loan as a
percentage of the amount borrowed. The interest rate can be fixed or it may vary with
changes in the economy. It is the interest payable on top of the loan that makes a loan
a relatively expensive source of capital income. Monthly payments have to be made
D
even if the business is not making a profit.

Banks are not guaranteed to lend money to a business, so the business would have to
justify how the money borrowed would be spent and, more importantly, how they can Key term
afford to repay it. Often bank loans have to be secured against an asset (for example,
Asset – any item of value
the entrepreneur’s home or the company’s vehicles) to convince the bank that the risk
owned by an individual or
being taken is not too great. This means that if the business fails to meet payments, the
firm.
bank can claim the asset.
Mortgages
A mortgage is similar to a bank loan, but it tends to be for a larger sum of money and
over a longer period of time (typically 25 years). Mortgages are always secured on
an asset, normally a property. Individuals will take out a mortgage to buy a house.
Businesses might take out a mortgage to buy their premises – for example, a factory,
retail store or warehouse.
Shares
A company is when a business is registered with Companies House and issues shares
to its shareholders. The shareholders are the owners of the business and all contribute
towards the capital income. Shareholders normally receive a voting right and the more
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shares they own, the greater their ability to influence decision making. Shareholders
are rewarded for their investment by the payment of a dividend; this is a share of the
profits.
Owner’s capital
Owner’s capital is money invested in a business from the owner’s personal savings. A
sole trader is a person who owns a business on their own; they therefore have to find
all of the capital income from their own sources or personal loans. Sole traders often
invest their personal savings into the business or borrow from the bank using their
personal assets, such as their house, to secure the loan. This investment is a big risk for
a sole trader, as they are ultimately responsible for the debts of the business. Being a
sole trader can also limit the amount of money available and can therefore restrict the
size of the business. However, if successful, the sole trader can keep all of the profits
for themselves.
A partnership is when two or more people join together to set up a business as
partners. Each partner would be expected to contribute towards the capital income,
so increasing the potential amount of money available. Partners also share decision
making and the profit. In most partnerships, any loans taken out are still secured by
the partners’ own assets, so this is still quite a high-risk option.
FT
Debentures
Debentures are medium- to long-term sources of capital income. Large companies
often use them to secure income. Interest is payable, normally at a fixed rate, and the
debenture is repaid as a lump sum, normally on a pre-agreed date. Debentures can be
secured against an asset.
A
Revenue income
As you have already seen, capital income is the money invested in the business to set
it up or later buy additional assets; it is a long-term investment. Revenue income is
the money that comes into the business from performing its day-to-day function –
R
selling goods or providing a service. The nature of the revenue income depends on the
activities that the business does to bring in money.
Sales
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Sales, or sales turnover, is money coming in from the sales of goods or services. For
example, a jeans shop has money coming in each time a customer buys a pair of jeans,
or a hairdresser receives money each time a customer has a haircut. Sales turnover is
therefore determined by the prices charged and the number of customers.
Sales can be either: cash sales (the customer pays there and then) or credit sales (the
Key term
customer buys then but pays at a later date).
Commission – A commission
The significance of the difference between cash and credit sales will become clear later
is a fee paid to a salesperson
on when you learn about cash flow.
in exchange for services in
facilitating or completing a Rent received
sales transaction. Commission A business that owns property and charges others for use of all or part of that property
could be a flat fee or a will receive rent as their main source of income. If a business owns a house and
percentage of the revenue, rents out three rooms, then it will receive rent from each of these renters. Similarly, a
gross margin or profit business may own land or offices which it rents out to other businesses.
generated by the sale. It could
Commission received
also be charged by brokers to
assist in the sale of security, A business may sell products or services as an agent of another business. They sell
properties etc. another business’s products on their behalf and, for each sale they make, they get paid
a percentage on that sale. This percentage is called commission.

If, for example, you were to buy tickets for a concert from www.ticketmaster.co.uk,

then Ticketmaster would receive a percentage payment for that ticket from whichever
company was hosting the concert.
Interest received
Interest received is money earned on savings or lending. If, for example, a business
has a positive bank balance it will receive interest on this. This acts as revenue coming
into the business. Equally a business may lend money to another person or business.
Interest will be charged to the lender and the business lending the money will receive
interest as a form of revenue.
Discount received
Discount received is when a business is given a percentage off a sale, normally in
return for quick payment or a bulk order. This reduces the costs to the business.
Can you explain, with the use of examples, the difference between capital income
P a us e p o int
and revenue income?
Hint Close the book and draw a concept map about the classifications of income. Think about
how often income is coming into the business and what it is likely to be used for.
FT
Extend Can you explain how capital income can lead to revenue income in a number of
scenarios?
Types of expenditure Key terms

Expenditure is money spent by a business and can be split into two categories: capital Capital items – assets
A
expenditure and revenue expenditure. You are going to start by looking at capital bought from capital
expenditure. This is used to buy capital items, which are assets that will stay in the expenditure such as
business for a long period of time. Capital items are non-current assets and intangible machinery and vehicles that
assets, as explained below. will stay in the business for
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Capital expenditure more than a year.
Non-current assets Statement of financial

situation – a financial
Non-current assets are items owned by a business that will remain in the business for
document that shows the
D
a reasonable period of time. These are shown on a business’s statement of financial

net worth of a business by
position (or balance sheet) and include land and premises, machinery and equipment,
balancing its assets against its
vehicles, and fixtures and fittings. These are sometimes referred to as ‘tangible assets’
liabilities. It is often called a
because they can be touched.
balance sheet.
Most fixed assets lose value over time and for this reason they are depreciated. This
means that each year their value on the balance sheet is reduced in order to give a fair
value of the asset.
Intangibles
An intangible asset is something owned by the business that cannot be touched
but adds value to the business. Here are four common intangibles that exist within
businesses.
▸▸ Goodwill – when you buy an existing business, its name and reputation will already
be known, and it may already have an established customer base or set of clients.
This increases the value of the business and therefore increases the selling price of
the business. A sum of money is added to the value of the business to reflect the
value of this goodwill. However, goodwill is difficult to place a figure on – how much
would you pay for a recognised brand business name?
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▸▸ Patents – a patent is the legal protection of an invention, such as a unique feature
of a product or a new process. An entrepreneur or business may patent their
idea to stop others from copying the idea. Having a patent allows the business to
exploit this in the future by launching an innovative product at a premium (more
expensive) selling price. The patent itself must, therefore, be worth something, but
again it is difficult to know exactly how much value to place on it.
▸▸ Trademarks – a trademark is a symbol, logo, brand name, words or even colour that
sets apart one business’s goods or services from those of its competitors. Trademarks
can be a key influence on consumer choice and build a strong brand loyalty. A
trademark, therefore, is of value to a business and consequently recorded as an
intangible asset.
▸▸ Brand name – a feature of a business that is recognised by customers and
distinguishes the business from competitors. Customers will link the brand name
to expectations based on previous experiences with the brand. It is sometimes said
that a brand name is a promise of what to expect.
Case study
Colour wars customers’ best interests. Orange had trademarked
FT
a specific shade of orange, but Haji-Ioannou felt that
Orange had no case and that easyMobile had the right
to use any colour they wished.
The case eventually went to court, but easyMobile
ended mobile phone service in 2006 and so it was never
v126203_ph_036
brought to a resolution.
A
The European Court of Justice confirmed in 2003
that colours could be trademarked but that they had
to be identified by a colour code (such as Pantone),
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not just a sample of colour. Other colour trademarks
include Heinz’s distinctive turquoise cans and Cadbury
When Stelios Haji-Ioannou, founder of easyJet, Schweppes plc’s famous shade of purple.
launched easyMobile in 2004 he planned to launch the
D
brand with their signature colour of orange. However, Check your knowledge
Orange, a competitor in the mobile phone market, had 1 Should Orange be able to stop a competitor from
already trademarked the colour orange in relation to using a specific colour? Justify your answer.
‘telecommunications products and services’. 2 Why might it be important to show a value for
Orange, the company, felt that two mobile phone these trademarks in a business’s accounts?
companies using the same colour would cause 3 How would you go about attaching a monetary
confusion to customers and wanted to protect their value to these trademarks?
Revenue expenditure
Revenue expenditure is spending on items on a day-to-day or regular basis. These are
the expenses incurred by a business that are shown on the profit and loss account (also
known as a statement of comprehensive income). The types of costs incurred vary
from business to business.
Inventory
Most businesses providing a good or service will require some sort of inventory,
whether it is raw materials, finished goods to sell on or supplies to provide the service

– for example, shampoo and conditioner for a hairdresser. When a business is first set

up, it is likely to have to buy inventory with cash as it will not have built a reputation
as being trustworthy and able to pay. As a business becomes more established, it may
be able to buy inventory on credit (such as receiving the inventory and paying 30 days
later). Bigger and more established businesses may also be able to drive the cost of
inventory down as they will buy in larger quantities. There are other costs related to
inventory, such as insurance and storage costs.
Rent
This is the cost of using premises not owned by the business. These are regular
payments, usually monthly, for the use of premises.
Rates
In the same way as private residents pay council tax to the local authority, businesses
pay non-domestic rates. This is a sum of money paid to the local council to go towards
services such as street lights and refuse collection. This is not a set amount, but is
calculated by the council based on the size and location of the premises and the
nature of the business.
Heating and lighting
services.
Water FT
This covers payments for services such as gas and electricity. The business will receive
regular bills, often quarterly (every three months) for the provision and use of these
This involves payment for the supply of water to premises and use of water. This can be
A
a fixed rate or based upon usage if a water meter is fitted.
Insurance
A business is legally required to take out a number of types of insurance to protect
R
itself from the possibility of serious losses. These include:
▸▸ buildings insurance – to protect the physical building from damage that may be
caused by events such as fire
D
▸▸ contents insurance – to protect what is inside the building in terms of machinery,

fixtures and fittings and stock from damage that may be caused by events such as
flooding
▸▸ public liability insurance – to protect people within the building who may be
harmed or injured from an event such as an accident
▸▸ employers’ liability insurance – this means that if the employee is injured at work,
the business is protected against any claims for compensation or any legal costs
incurred.
Administration
Administration refers to the paperwork that goes on within a business either internally
between employees or externally with suppliers and customers. Administrative costs
include items such as postage, printing and stationery, which might include items such
as business cards, headed paper and order books.
Telephone charges are also classed as an administrative cost and are slightly unusual
from an accounting point of view. For a landline, these costs are split into two: there is
the line rental cost, which is paid quarterly in advance and then the call charges, which
are paid quarterly after use.
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Salaries
A salary is an annual figure paid to an employee divided into equal monthly payments.
For example, a trainee accountant may have a salary of £18,000 per year, meaning
their gross pay is £1500 per month. The employee will then have to pay National
Insurance, tax and maybe pension contributions on this figure, so the amount they
actually take home will be quite a bit less. For the business, however, the actual
amount they have to pay (the real cost to the business) is higher. On a salary of £18,000
the business also has to pay employers’ National Insurance of 12.8 per cent, (an
additional £2304) plus any pension and other benefits.
Wages
A wage is an hourly rate paid to an employee, meaning there is a direct link between
the number of hours worked and the amount of money paid. Paying a wage rather
than a salary allows greater flexibility for both the employer and the employee, but
also creates greater uncertainty.
Research
Employers in the UK, by law, have to pay a minimum wage to all employees over
16. From April 2016 a National Living Wage will be introduced for workers over 25.
Link
FT
What is the current minimum wage in the UK?
Should business pay a National living wage? Debate the arguments for and against
introducing the living wage.
Marketing
A
This covers a whole range of costs associated with attracting the customer and
The minimum wage is convincing them to make a purchase. Possible marketing costs might include
covered in more detail in advertisements, promotional literature, promotional events, point of sale materials
Unit 8: Recruitment and and so on.
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Selection Process.
Bank charges
Unlike personal banking, which is generally free, banks charge businesses for each
transaction that takes place, for example, every time a cheque is paid in or written,
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whenever cash is deposited, and so on. Banks might offer free banking to businesses
for the first year as a marketing technique, but, once the first year is over, bank charges
can soon start to add up to quite a large amount of money.
Interest paid
If the business has a bank loan or a mortgage, then interest will be charged on
this. Banks may offer big businesses preferential rates if they are confident that
the money will be paid back and if they want to keep that particular business as
a loyal customer. Big businesses will carry out a lot of transactions and pay high
bank charges, so, for the bank, it may be worth offering lower interest rates to
Key term
keep them happy.
Depreciation – an
Depreciation
accounting technique used
to spread the cost of an asset Assets lose value over time. Accountants use depreciation to spread out the cost of an
over its useful life. asset over its useful life. Depreciation is a paper exercise to match the cost of an asset
against the time it is used within a business. For example, if a machine is purchased at a
cost of £50,000 this would not be shown as a one-off expense at the time of purchase

Content area D UNIT 3
but in the accounts shown as an expense of £10,000 per year. You will learn about two

types of depreciation in more detail later in this unit:
▸▸ straight-line depreciation: an asset is depreciated by a set amount each year
▸▸ reducing balance depreciation: an asset is depreciated by a set percentage of its
remaining value each year.
Discount allowed ▸▸ When a business offers a discount
Reductions offered to customers are an expense to a business as it reduces the on its products, are you encourage
amount of cash flowing into the business. Discounts may be allowed to attract to buy?
customers, for bulk purchases or to gain a competitive advantage.
Can you explain, with the use of examples, the difference between capital
P a us e p o int
expenditure and revenue expenditure? Close the book and draw a concept map
about the classifications of expenditure.
Hint Think about the frequency with which the expenditure is going out of the business
and what it is being used for.
Extend Can you think of any examples where short-term capital expenditure may reduce
long-term revenue expenditure?

1 Identify one intangible asset.
2 Identify two sources of revenue income.
3 Outline what is meant by ‘depreciation’. FT (1 mark)
(2 marks)
(2 marks)

A
Select and evaluate different sources of
D business finance
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Sources of finance
As discussed earlier, businesses need finance for a wide number of reasons, both to
fund capital and revenue expenditure. The source of finance is where this money
D
comes from. What the money will be used for will determine which source is the most
suitable. For example, you might look for a long-term bank loan or mortgage to fund
capital expenditure such as buying a factory, but this would not be appropriate for
replenishing stock. Sources of finance can be short term which means they have to be
paid back within one year or long term which means they are paid back in a period of
time greater than one year.
Internal sources of finance are those available from within a business. These include:
▸▸ retained profit
• profit (sales revenue minus total costs) kept in the business to fund future expenditure.
▸▸ net current assets Key term
• current assets minus current liabilities shows the money available in the business Internal sources of finance
to fund day-to-day expenditure. – money available to fund
▸▸ sale of assets expenditure from within the
• selling an item of worth owned by a business in order to achieve an immediate business.
cash injection.
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The pros and cons of internal sources of finance are summarised in Table 3.11.
▸▸ Table 3.11: Advantages and disadvantages of internal sources of finance
Internal source Advantages Disadvantages

of finance
Retained profit No interest charges Amount available may be limited
Available immediately Reduces payments to shareholders
Only available up to the amount which may cause dissatisfaction
already accumulated by the Once used it is not available for
business and therefore avoids debt alternative purposes
No loss of ownership (control)
Net current Encourages the business to manage Can put pressure on customers as
assets cash flow effectively shorter credit terms are offered and
this negatively affects relationships
with suppliers if longer credit terms
are negotiated
Lower stock holdings can affect
the firm’s ability to meet customer
needs
FT
Sale of assets No interest charges It is likely that the amount received
Reduces capital tied up in assets, is not a true reflection of the value
releasing it for other purposes of the asset
Can mean disposing of an asset no Can increase costs in the long run if
longer of use to the business an asset needs to be leased back
External sources of finance are those available from outside the business. They are
A
outlined below.
External sources of finance – the places where finance can be raised from outside the
business.
▸▸ Owner’s capital
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• This is money invested in the business from the owner’s personal savings.
▸▸ Loans
• Loans are money borrowed from a financial institution normally for a set period
of time and for a specific purpose.
D
• Interest will be payable on the loan.

▸▸ Crowd-funding
• This involves attracting investment from a large number of speculative investors
many of whom may invest relatively small amounts. If cumulatively this matches
the required amount then the investments are collected together.
• Normally makes use of the internet to attract investors.
▸▸ Mortgages
• These are long-term loans, normally around 25 years, that are secured against a
specific asset, for example a building.
• Interest will be payable on the mortgage.
▸▸ Venture capital
• This is investment from an experienced entrepreneur in return for a stake (equity)
in the business.
▸▸ Debt factoring
• This involves the selling on of a business’s debts to a third party in order to
receive the cash quickly.
• The factor company pays the business a percentage of the money owed and
takes on the responsibility to chase the debts which need to be repaid.

Content area D UNIT 3
▸▸ Hire purchase

• This involves paying to use an asset in instalments to spread the cost over its
useful life and hence provide a source of finance.
• The asset will remain the property of the seller until the final instalment has been
paid.
▸▸ Leasing
• This involves paying to use an asset in instalments to spread the cost over its
useful life and hence providing a source of finance.
• Ownership of the asset stays with the supplier throughout the length of the lease
agreement.
▸▸ Trade credit
• This is a period of time offered by suppliers to allow the customer to purchase a
good or service now and pay at a later date, for example 30 days after purchase.
▸▸ Grants
• This is a lump sum provided to a business by the government or another
organisation to be used for a specific purpose. For example, it could be used
to provide employment in a deprived area or invest in the research and
development of an environmentally friendly alternative to fossil fuels.
▸▸ Donations
FT
• These are sums of money given voluntarily to a charity or social enterprise.
▸▸ Peer-to-peer lending
• This involves one business person lending money to another business person in
return for interest payments.
▸▸ Invoice discounting
• These are reductions offered to customers making a product or service cheaper, ▸▸ If you had enough money, what
often applied as a percentage.
A
would encourage you to invest in
someone else’s business?
The pros and cons of external sources of finance are summarised in Table 3.12.
▸▸ Table 3.12: Advantages and disadvantages of external sources of finance

R
Advantages Disadvantages
Owner’s capital No interest payments or need to repay Amount available is likely to be limited
High level of commitment from the owner If there is more than one owner this could cause
friction if everyone is not able to contribute the
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same amount
Loans Regular pre-agreed repayments make planning and Interest is charged on the amount borrowed
budgeting relatively easy Interest rates can fluctuate
Ownership or control is not lost Often secured against an asset which can be seized if
repayments are missed
Interest has to be paid regardless of whether a profit
is being made
Crowd-funding Offers the ability to raise finance from a large Partial loss of ownership
number of investors No guarantee that the crowd fund will attract
No interest is paid as investors will only be rewarded sufficient investment to meet the proposal
if the business is successfully sold on at a later date
Mortgages Large amounts of finance can be raised and repaid Interest is charged on the amount borrowed
over a prolonged period of time Interest rates can fluctuate
Ownership or control is not lost Often secured against an asset which can be seized if
repayments are missed
Interest has to be paid regardless of whether a profit
is being made
Not suitable for small amounts or as a short-term
source of finance
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Venture capital Finance is provided by a business professional who Partial loss of ownership and control
will often offer advice and mentoring alongside the Conflict can arise between the entrepreneur and
investment venture capitalist regarding the direction and
Venture capitalists are often risk takers and may see the day‑to-day running of the business
potential in a high risk investment that other investors
including banks may not be willing to invest in
Debt factoring Speeds up the flow of cash into the business from Only receive a percentage of the amount owed,
debts therefore reducing profits
The factor company takes on the risk of bad debt Can give the wrong impression or alienate
customers
Hire purchase Avoids the need to pay a lump sum for the use of an Overall amount paid for the use of an asset is likely
asset to be higher than if purchased outright
Regular instalments make planning and budgeting Only really suitable for relatively low cost assets, e.g.
easier vehicles and not premises
Spreads the cost of an asset over its useful life
Leasing Responsibility for maintaining and repairing the Overall amount paid for the use of an asset is likely
asset stays with the supplier to be higher than if purchased outright
FT
Spreads the cost of an asset over its life to avoid Never actually own the asset and therefore
paying a lump sum up front payments are ongoing
Trade credit Delays the need to pay for goods and services Potential loss of discounts offered for cash payments
purchased, therefore aiding cash flow Only suitable as a short-term source of finance
No loss of ownership or control
Grants No need to repay and no interest charges Often require a lengthy application process
A
No loss of ownership or control Might only be awarded if certain conditions are
met affecting the way the business operates on a
day‑to‑day basis
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Donations No need to repay and no interest charges Likely to be small amounts only
No loss of ownership or control Unpredictable
Peer to peer lending Interest rates can be lower than lending from more Amounts available may be limited and provided for
traditional financial institutions a short period of time only
D
Fixed rate of interest can be agreed making it easier

to plan and budget
Invoice discounting No need to repay and no interest charges Often only available if purchases are paid in cash
No loss of ownership or control which affects cash flow
Reduces costs to the business so increases profit

1 Give two examples of external finance. (2 marks)
2 Outline two advantages of net current assets as an internal source of
finance. (4 marks)
Ahmed wants to open a small business selling custom bikes, and is looking at ways
of raising money. He owns his own house and is considering acquiring a second
mortgage. He is also speaking to his bank about a loan and is looking at crowd-
funding sites, as he thinks his product is innovative and could attract investors.
3 Assess a mortgage, a loan and crowd-funding as sources of finance for
Ahmed. (8 marks)

Content area E UNIT 3

E Break-even and cash flow forecasts
Cash flow forecasts

Cash flows into and out of a business on a regular basis. A cash flow forecast tries
Key term
to predict in advance what and when these cash flows will be. Having a healthy cash
flow is crucial to the survival of a business. A healthy cash flow means that a business Cash flow forecast – a
will have enough cash at any one point in time to be able to meet demand for short- document that shows the
term cash outflows. Imagine what would happen if at the end of the week a manager predicted flow of cash into
turned to the business’s employees and said, ‘Sorry, I haven’t got enough cash to pay and out of a business over
your wages this week.’ a given period of time,
normally 12 months.
By forecasting cash flow in advance, a business can identify where there might be
shortages and either try to prevent this from happening or put plans in place to deal
with it. Tip
Inflows/receipts Formulas used in this topic
Cash inflows or receipts are the money coming into the business from various sources, will not be given to you in the
examination. It is therefore
FT
which include:
▸▸ cash sales – the customer pays at the time of purchase important that you learn
▸▸ credit sales – the customer pays in a pre-agreed period after the sale, for example
them.
30 days
▸▸ loans – bank loans to fund the purchase of assets such as machinery and vehicles
▸▸ capital introduced – money invested from entrepreneurs or shareholders when a
A
business is first set up or looks to expand
▸▸ sale of assets – the sale of items owned by the business which are no longer needed
in order to bring a short-term cash injection into the business
▸▸ bank interest received – interest paid by the bank on credit balances.
R
Outflows/payments
Cash outflows or payments are the money going out of the business for various
purposes, which include:
D
▸▸ cash purchase – items purchased by a business and paid for at the time of purchase
▸▸ credit purchases – items purchased by a business and paid for at a later point in
time
▸▸ purchase of assets – non-current assets that a business is likely to keep for more
than one year such as machinery and vehicles
▸▸ Value Added Tax (VAT) – businesses that are VAT registered must pay VAT to HM
Revenue & Customs (HMRC), and this should be shown in the cash flow forecast
▸▸ bank interest paid
▸▸ rent
▸▸ rates
▸▸ salaries
▸▸ wages
▸▸ utilities.
A business with sales in excess of the VAT threshold, £82,000 in 2015, must register
itself with HMRC and then record VAT received on sales and paid on purchases. A
business must then work out whether it has paid or received more money in VAT, then
claim a refund or make a payment as appropriate.
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Worked Example
Paddington Games sells £10,000, excluding VAT, of games per month and purchases supplies of £6000, excluding
VAT. The tables below show the cash in and the cash out for Paddington Games.
Cash in January February March
Sales £10,000 £10,000 £10,000
VAT on sales £2000 £2000 £2000
Refund from HMRC
Total cash in £12,000 £12,000 £12,000
Cash out January February March

Purchases £6000 £6000 £6000
VAT paid £1200 £1200 £1200
Payment to HMRC
Total cash out £7200 £7200 £7200
Over the three months of January to March:
•• the total VAT received was £2000 × 3 = £6000
•• the total VAT paid was £1200 × 3 = £3600.
The net VAT is therefore £6000 − £3600 = £2400
FT
This means that the business has received more in VAT than it has paid and therefore must make a payment of £2400 to
HMRC.
A
Key terms
Opening balance – amount Prepare, complete, analyse, revise and evaluate cash flow
of cash available in a business A cash flow forecast is a simple statement showing opening balance, cash in, cash
at the start of a set time out and closing balance. It is normally shown on a monthly basis and drawn up for a
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period, for example a month. 12-month period. The opening balance is how much money the business has at the
start of the month and the closing balance shows how much money it has at the end
Closing balance – amount of of the month. For example, the closing balance at the end of January becomes the
cash available in a business at opening balance at the start of February.
D
the end of a set time period,

for example a month.
Case study
Carla’s Cycles
Carla owns a small bicycle store in Sheffield, called
Carla’s Cycles. She opened the business three years ago
with a friend who had a finance degree, but has recently
had to start completing the finances for the business
herself. The illustration below shows the cash flow
forecast for Carla’s Cycles.


January February March
Opening (£) (£) (£)
February’s
balance; Opening 1,000 (280) 240 closing balance
how much balance
becomes March’s
is available (b/f)
opening balance
at the start Income
of the year Sales 1,000 2,800 2,000
Total
inflows 1,000 2,800 2,000
Total cash 2,000 2,520 2,240
available Cash available =
Expenses Opening balance
+ Total inflows
Puchases 980 980 500
£1,000 + £1,000 =
Wages 1,000 1,000 1,000 £2,000
Heat & light 300 300 300
Closing
balance =
total cash
available −
total
outflows =
Total
outflows
Closing
balance
(c/f)
FT
2,280
(280)
2,280
240
1,800
440
Brackets are
used to show
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£2,000 − that a figure
£2,280 = is negative
(£280)
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▸▸ Figure 3.3: Cash flow forecast for bicycle shop, Carla’s Cycles
Carla’s Cycles has £1000 available at the start of the year; The timing of the cash inflows and outflows is
D
Carla then predicts the following sales: important. At the end of three months Carla has a
•• £1000 in January positive balance of £440, but in January she had a
•• £2800 in February negative balance of £280. This means that, although her
•• £2000 in March. cash flow was healthy at the end of three months, she
had problems earlier and would have had an overdraft
In this case, total inflows and sales are the same,
of £280 in her bank or been unable to pay one of
showing that Carla only makes cash sales and not credit
her expenses, which could stop her from operating
sales. The total cash available is opening balance plus
successfully in the following months.
total inflows. Carla predicts the following:
•• her purchases will be £980 in both January and Check your knowledge
February, and £500 in March 1 What problems might Carla experience as a result
•• wages will be £1000 per month of cash flow in January and February?
•• heating and lighting will be £300 per month.
2 Outline three reasons why cash flow forecasts are
Total outflows are all of Carla’s expenses added so important to businesses.
together. The closing balance is calculated by deducting
the total outflows from the cash available. Remember 3 Can you think of any actions Carla should take in
that one month’s closing balance becomes the next light of her cash flow forecast?
month’s opening balance.
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You will need to learn the formula to calculate the closing balance:
Key term
Credit period – the length opening balance + cash inflows – cash outflows = closing balance
of time given to customers Credit periods have two major influences on a business’s cash flow.
to pay for goods or services
The business must consider how long it gives its customers to pay. If it accepts cash
received.
sales only, then this will not be a concern, but it may have to offer credit in order to
ensure a sale. The longer the credit period, the slower will be the money coming in. If a
greengrocer gives one month’s credit for a sale made in January, they will not see cash
flowing into the business until February. Yet the greengrocer may have had to pay for
their stock up front.
▸▸ Credit periods affect the ability of the business to gain credit from its suppliers. If
a business can secure supplies on credit, then this will slow down the flow of cash
out of a business. The longer the credit period, the later the cash flows out. Some
businesses can secure credit periods of 30, 60 or even 90 days.
If a business both sells on credit to its customers and buys on credit from its suppliers,
it needs the first to have a shorter credit period than the second.
Opening and closing cash/bank balances
FT
The opening balance at the start of the year will be a true reflection of the business’s
bank balance, whereas the closing balance will be based upon the predicted incomes
and expenditures over the period of the cash flow forecast, normally a year. One of the
key purposes of the cash flow forecast is to highlight, in advance any months where
there is a risk of a negative cash flow, as this allows the business to make arrangements
Key terms – for example, a prearranged overdraft with the bank – or to try to take actions to
avoid this.
A
Liq idity – measures a firm’s
ability to meet short-term A business with a negative closing balance is often said to have liquidity problems
cash payments. and is in danger of becoming insolvent. In the next section on cash flow
management, you will look in more detail at methods available to try to avoid these
Insolvent – when a firm is
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negative closing balances.
unable to meet short-term
cash payments. Figure 3.4 illustrates a sample cash flow forecast for the first four months of a sole
trader.
D
Possible pic to
fill????


January £ February £ March £ April £ Total £
Opening balance (b/f) 0 (3,500) (1,520) 2,500
Income owner’s capital 10,000 10,000

Bank loan 15,000 15,000
Cash sales 5,000 7,000 8,000 7,000 27,000
Credit sales 0 9,000 11,000 12,000 32,000
Commission received 0 800 950 950 2,700
Total inflows 30,000 16,800 19,950 19,950 86,700
Total cash available 30,000 13,300 18,430 22,450
Expenses
Cash purchases
Credit purchases
Heat and light

8,000
0
FT 9,500
0
9,500
0
3,500
7,000
200
30,500
7,000
200
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Fixtures and fittings 5,000 600 0 0 5,600
Equipment 5,000 0 0 0 5,000

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Drawings 0 2,000 2,000 2,000 6,000
Marketing 3,000 0 1,200 0 4,200

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Premises costs 10,000 0 0 0 10,000
Insurance 500 0 0 0 500
Wages 1,000 1,500 2,000 2,000 6,500
Administrative costs 1,000 750 800 1,250 3,800
Overdraft interest 0 70 30 0 100
Loan repayments 0 400 400 400 1,200
Total outflows 33,500 14,820 15,930 16,350 80,600
Closing balance (c/f) (3,500) (1,520) 2,500 6,100
▸▸ Figure 3.4: Why might a new business experience cash flow problems in the first few months of trading?
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Case study
Lily’s cleaning services At the beginning of January, Lily will buy two small cars,
to drive herself and staff to the offices, each costing
£10,000. She will invest £15,000 of her own money
and has agreed a bank loan of £7000. Lily will receive
the loan in January and start repayments the following
month at a fixed rate of £250 per month. When meeting
with her bank manager, she also agreed a business
overdraft that will be charged at a rate of 1 per cent on
any negative closing balances.
In order to start trading in January, she buys £4000 worth
of cleaning equipment, including vacuum cleaners and
floor buffers. In addition, she spends £150 on less durable
Lily is setting up a small business providing cleaning (not as long-lasting) products such as dusters and mops,
services to offices on a trading estate in Scarborough. which she plans to replace every second month.
She has asked you to help her prepare a cash flow Lily plans to offer 30 days’ credit terms to two of her
FT
forecast for her first 12 months of trading. bigger cleaning contracts. These two combined will
You should produce a forecast from January to account for £2200 of her monthly sales.
December based on the information provided below. Lily has rented a small lock-up to store her equipment and
Sales and purchases for the 12 months are expected to materials at a cost of £600 per month. She will employ four
be as follows. cleaners, each earning £400 per month, and a cleaning
supervisor earning an annual salary of £7200. She will
Month Sales Purchases withdraw £1000 a month for herself, and hopes to be able
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January £5000 £600 to increase this to £1200 per month after six months.
February £5000 £600 Additional monthly costs include:
March £5000 £600 •• £300 car insurance
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April £5000 £600 •• £20 advertising
May £5000 £600 •• £100 fuel.
June £5000 £600 Check your knowledge
July £4000 £500
D
1 Use a spreadsheet to produce a 12-month cash

August £4000 £500 flow forecast for Lily.
September £5000 £600 2 Identify and explain any potential cash flow
October £6000 £650 problems she may face.
November £6000 £650 3 Do you think Lily was right to offer her two biggest
December £6000 £650 customers 30 days’ credit? Justify your answer.
Use of cash flow forecasts for planning, monitoring, control and

target setting
A cash flow forecast can help to identify where there are potential shortfalls but might also
indicate where there are large amounts of cash left at the end of a month or year. Although
you may think this is a good thing, if the cash balance at the end of each month is high,
it might be an indication that the business is not taking advantage of opportunities. For
example, could it use this cash surplus to improve or expand the business?
Cash flow forecasts are just that, a forecast, and therefore the actual cash flow of the
business should be monitored alongside the forecast to see if inflows and outflows are
as expected, better or worse.

Problems within the cash flow forecast

Problems occur with cash flows when the business’s outflows are greater than the
opening balance plus the inflows, as this will result in a negative closing balance. This
means that the business will not have enough cash to meet payments that are due.
Very few businesses have consistent cash flows throughout the year; they are likely to
experience busy times and quiet times. These fluctuations are known as the cash flow
cycle. For some businesses, particularly those in a seasonal industry, these fluctuations
can be quite severe. Someone who owns a small bed and breakfast in a seaside town
will have to pay costs like rent, heat and light, insurance and bank charges throughout
the year. In season, they will also have additional costs like wages and stock, but it
might only be in the summer months where there are any cash inflows.
Solutions to cash flow problems

If a business has predicted cash flow problems in advance, then there are a number of
possible solutions. These are outlined below.
▸▸ Overdraft arrangements – a business with a fluctuating cash flow cycle should
be able to show the forecast to the bank and make arrangements for periods
of negative cash flows. Banks sometimes offer free overdraft facilities to help
FT
businesses through these periods, but only if pre-agreed. Going overdrawn on a
bank account without an agreement with the bank can be a very expensive option.
▸▸ Negotiating terms with creditors – creditors are people or businesses that a
business owes money to, normally because goods or services have been bought
on credit as opposed to cash purchases. A business with cash flow problems could
try to negotiate a longer payment term with its suppliers – for example, an increase
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from 30 days to 60 days. This would slow down the flow of cash out of the business.
A negative effect of this, however, may be the loss of any discounts offered for
prompt or early payment.
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▸▸ Reviewing and rescheduling capital expenditure – having identified cash flow
problems, the owner or manager could review what cash outflows were being spent
on. Such a review might identify areas of expenditure that could be cut or postponed.
It is difficult to do this if the expenditure is on revenue items – for example,
D
replacement stock – but more achievable if it is capital expenditure. A business could,

for example, postpone plans to replace machinery or buy a new van.
An alternative action here could be to consider leasing an item of capital equipment
rather than buying it outright. This can prove expensive in the long run, but means that
rather than paying one lump sum, the business can pay to use it on a monthly basis.
Theory into practice
Draw a cash flow table to show your personal finances for the next month.
Think about what money will be coming in from wages, presents, parents, as
appropriate, and what expenses you will have. These might include food and
drink, presents, trips, travel etc.
1 What is your opening balance at the start of the month?
2 What is your closing balance at the end of the month?
3 Are there any points during the month where you may have a cash flow
problem?
4 What actions can you take to ensure that any cash flow problems are solved?
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Benefits and limitations of cash flow forecasts
Cash flow forecasts are a very useful tool for many businesses. Table 3.13 outlines the
benefits and limitations of using them.
▸▸ Table 3.13: Benefits and limitations of cash flow forecasts
Benefits Limitations
•• Encourages planning for cash inflows and •• Based on forecasts and therefore may be
outflows inaccurate
•• Enables cash flow to be monitored and •• Cannot plan for unexpected events such as
corrective action taken if necessary a rise in the cost of raw materials
•• Can be used as part of a business plan to •• Time taken to produce a cash flow forecast
help raise finance could have been spent on other tasks
•• Identifies in advance times of negative
closing balances allowing the business to
plan for these
Draw a flow diagram showing how cash can flow into and out of a business. Identify
P a us e p o int
whether each cash flow is a regular or one-off (less frequent) occurrence.
Hint
Extend
FT
Think about your own cash flow table. Are there any similarities between your cash
flow and a business’?
‘It is possible for a successful business to go out of business because it has cash flow
problems.’ Can you explain this statement?
A
Break-even analysis
Discussion
Break-even is the point at which a business is not making a profit or a loss, i.e. it is just
Work in small groups. Each breaking even. This means that the money being received from sales is the same as the
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group takes a different local money being spent on costs.
business – a retailer, leisure
Costs to a business can be categorised as follows:
provider, manufacturer,
service provider etc. ▸▸ variable costs – vary with the level of output, for example raw materials
D
Produce a diagram to show ▸▸ semi-variable – part of the cost stays the same and part varies in relation to the
fixed, semi-variable and degree of business activity, for example a worker may be paid a fixed rate of pay but
variable costs for each at busy times earn additional payments for working overtime
business. ▸▸ fixed costs – do not vary with output, for example rent
How easy was it to classify ▸▸ total costs – fixed costs + variable costs.
each cost? What are the
Sales by a business generate revenue; this is cash coming into the business. Important
similarities and differences
terms are:
between different types of
business? Why might there ▸▸ total revenue – the total amount of money coming in from sales, calculated as
be similarities between quantity sold multiplied by selling price
businesses that are different? ▸▸ total sales – the amount of sales made in a set time period, for example a year; this
can be expressed as value or volume
▸▸ selling price per unit – the amount a customer pays for each unit bought
▸▸ sales in value – sales expressed in monetary value, for example £s, calculated as
quantity sold multiplied by selling price per unit
▸▸ sales in volume – sales expressed as a quantity, for example tons or units.
Break-even is the point where total revenue (TR) = total costs (TC).

This can be calculated using the formula below:

fixed costs
break-even point =  ______________________
   
  
contribution per unit
Contribution per unit is calculated as:
selling price − variable costs per unit
Total contribution is calculated as:
sales revenue − total variable costs
Total variable cost is calculated as:
variable cost per unit × quantity
or
contribution per unit × number of units sold
Worked Example
Fay makes celebration cakes from a rented kitchen. She has fixed costs of
£20,000. Her variable cost per cake is £10 and her selling price is £26.
contribution per unit = selling price − variable cost
contribution per unit = £26 − £10 = £16
FT
fixed costs
break-even point =  ______________________
   
  
contribution per unit
£20,000
break-even point =  _________ = 1250 cakes
   
 
£16
Fay must sell 1250 cakes to achieve break-even. If she sells less than this she will
make a loss. If she sells more she will make a profit.
If Fay sells 1251 cakes she will make £16 profit, because after, break-even has been reached, the contribution per unit
A
no longer has to contribute towards fixed costs and therefore becomes profit.
How much profit would Fay make if she sold 1500 cakes?
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Margin of safety is the actual number of units sold over and above the break-even
point. This is calculated as:
actual sales in units – break-even level of output
D
To work out the break even level you need to calculate:

break-even point = fixed costs / contribution per unit
contribution per unit = selling price − variable costs
then
margin of safety = actual sales − break-even level of output
Worked Example
Assume Fay sold 1500 cakes.
margin of safety = actual sales in units − break-even level of output 
margin of safety = 1500 cakes − 1250 cakes = 250 cakes
Drawing a break-even chart

Break-even can also be shown on a break-even chart. This plots the costs and
revenues at each unit of output. The break-even point is where the total cost line
crosses the total revenue line. A break-even chart can also be used to calculate margin
of safety and profit or loss at different levels of output.
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Step by step: drawing a break even chart 6 Steps
1 Draw your axes, adding labels ‘Cost/sales’ on the 2 Draw your fixed cost line.
vertical axis and ‘Output’ on the horizontal axis. •• Remember this stays the same regardless of
Cost/sales output and is therefore a horizontal straight line.
Cost/sales
Fixed costs
Output
Output
3 Draw your variable cost line. 4 Draw your total cost line.
•• At 0 output variable costs will be £0. •• Remember total costs are fixed costs plus variable
•• As output increases variable costs will increase. costs.
•• The variable cost line therefore slopes upwards
from 0.
FT •• The total cost line therefore starts at the fixed cost

point and slopes upwards.
•• Notice the total cost line is parallel to the variable
Cost/sales
cost line.
Cost/sales
Variable costs
Total costs
A
Fixed costs
Variable costs
Output Fixed costs

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Output
D
5 Draw your total revenue line. 6 Identify the break-even point.

•• If no units are sold, total revenue will be £0. •• Identify where the total cost line crosses the total
•• As sales increase, total revenue will increase. revenue line.
•• The total revenue line therefore slopes upwards •• Draw a line downwards to the × axis.
from 0. •• Read off the break-even level of output.
Total revenue Total revenue
Cost/sales
Cost/sales
Total costs Total costs
Variable costs
Break-even
Fixed costs point
Output Break-even Output

output
▸▸ Figure 3.5: Completing a break-even chart


Theory into practice
You are the finance assistant at Deluxe Car Washing Services. Produce a break-
even chart and check your workings against the break-even formula for the
following:
•• car wash price = £12.50 per car
•• overhead costs = £175 per week
•• labour costs per wash = £4.50 per car
•• materials and water cost = £1 per car.
1 Label your graph in full and include the break-even formula to show you are
right.
2 The business averaged 30 cars per week during July – work out the margin for
safety.
3 How much profit would they make if they washed 20 cars during one week,
and what recommendations would you make to them about this?
Identification of area of profit and area of loss
FT
Break-even level of output is the level of output where the business is making neither a
profit nor a loss. If the business sells less than the break-even level of output, then it is
making a loss. For every item sold above the break-even level it is making a profit.
Worked Example
A
Suki imports silk dresses from Vietnam which she then sells through her online shop.
She has imported 100 dresses at a cost of £1000. In addition to the cost of the dresses,
it costs her £3 per dress postage and packaging. Her fixed costs are £1105. She sells
her dresses for £35 with free postage and packaging offered to the customer.
R
First calculate Suki’s break-even level of output.
contribution = selling price − variable cost
Her variable cost per dress is (£1000/100) + £3 postage and packaging = £13
D
contribution = £35 − £13 = £17

break-even = fixed costs/contribution
£1105
break-even = _______
     
= 65 dresses
 
£17
Suki must sell 65 dresses to reach her break-even point.
If she sells 50 dresses she makes a loss.
sales revenue = 50 × £35 = £1750
total costs = £1105 + £1000 = £2105
loss of £2105 − £1750 = £355
If she sells 66 dresses she will make a profit of £17 as the contribution from the one dress over her break-even now
becomes profit.
If she sells all 100 dresses she will make a profit of £595.
Carry out a calculation to show how she will make a profit of £595.
105
Profit and loss can also be shown on a break-even chart, as demonstrated by Figure 3.6.
LOSS is shown by the space between costs PROFIT is shown by the space
and revenue BELOW the break-even point between costs and revenue
ABOVE the break-even point
Costs and
revenue (£)
Units
The BREAK-EVEN POINT is where the total
cost and revenue lines cross. This is shown MARGIN OF SAFETY is the amount
as an X on the chart. by which the sales would have to fall
before the break even
FT
▸▸ Figure 3.6: What are the benefits of showing profit and loss on a break-even chart?
Contribution per unit benefits and limitations

Contribution per unit is used by businesses to help inform decision making. There are
benefits and limitations to it as a decision‑making tool, as shown in Table 3.14.
A
▸▸ Table 3.14: Benefits and limitations of contribution per unit
Benefits Limitations
•• Straightforward to calculate •• Does not take into account fixed costs
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•• Allows for the calculation of break-even •• Assumes that prices remain constant
level of output •• Does not take into account any unexpected
•• Can be used to inform decisions, e.g. what changes to variables, e.g. selling price and
price to charge variable costs can fluctuate
D
•• Can be used to carry out what-if analysis
Use of break-even for planning, monitoring, control and target

setting
Break-even can be used as a management tool for planning, monitoring, control and
target setting.
▸▸ Planning
• Set budgets for the amount of sales necessary and costs.
• Forms part of a business plan to show at what point the business will start to
make a profit.
• Informs pricing decisions.
▸▸ Monitoring
• Monitor progress towards achieving break-even point.
• Identify changes to selling price of costs.
• Take corrective action if targets look unlikely to be met.
▸▸ Control
• Keep costs within budget.
• Motivate employees.
• Manage sales accounts.

▸▸ Target setting

• Set sales targets for individual employees, teams or products.
• Set expenditure budgets.
• Set profit budgets based upon sales targets and cost targets.
Prepare, complete, analyse, revise and evaluate break‑even
You should now be able to prepare a break-even chart, calculate the break-even level
of output and analyse the effect on break-even and margin of safety if any of the
variables, i.e. costs or selling prices, vary.
Case study
Cheltenham Coffee to trade 250 days a year and estimates he can sell 120
cups of coffee each day.
1 Calculate Faizal’s break-even level of output.
2 What is Faizal’s margin of safety?
3 Draw a break-even chart to show:
•• break-even point
FT
•• margin of safety
•• loss if he sells just 60 cups per day
•• profit if he sells 120 cups per day.
Unfortunately, Faizal had forgotten about some of
the cheaper competitors in the local area including
Faizal is looking to set up a mobile coffee van in the Wetherspoons who charge just £1.20 per cup of coffee
A
centre of Cheltenham. He has calculated that his fixed with unlimited refills.
costs will be £24,000 per year. Each cup of coffee will
cost him 40p to make. He has decided on a selling price 4 Draw a new total revenue line to show what would
of £1.60 per cup to undercut major competitors such as happen if Faizal lowered his selling price to match
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Costa and Starbucks who have stores nearby. He plans Wetherspoons.
Break-even is a useful management tool. Table 3.15 shows the advantages and
disadvantages of break-even.
D
▸▸ Table 3.15: The advantages and disadvantages of break-even
•• The business knows how many items it must sell in order to break-even •• Does not take account of variations in costs or selling
•• Informs decisions on what price to charge price
•• Can set targets •• Forecast sales may not be achieved and hence, even
•• Identifies fixed and variable costs though the break-even point is known, it may not be
•• Can identify if costs are too high allowing the business to look for ways of achieved
lowering costs •• Targets set may be too high, creating stress
•• Can set targets which will motivate employees
•• Easy way to calculate profit or loss at different levels of output
P a us e p o int Do you know how and why a business should use break-even analysis?
Hint Think back over the case studies and identify what they needed to know from the
analysis.
Extend What actions do you think businesses might take from the results of their break-even
analysis?
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1 Give two examples of inflows or receipts that might come into a
business. (2 marks)
2 State three uses of break-even. (3 marks)
3 Outline two benefits to a business of using contribution per unit. (4 marks)
Dominic has started his own bread-making business. So far, he has been just
checking his finances month-to-month. A friend recommends he complete a cash
flow forecast for his business. Dominic isn’t sure that completing a forecast will be
worth his time.
4 Assess the benefits and limitations of cash flow forecasts for
Dominic. (8 marks)
Complete statements of comprehensive income and

F financial position and evaluate business performance
FT
Until now, you have focused on whether or not a business has enough cash to survive
on a day‑to‑day basis and whether it can achieve break-even. As part of this you have
already learned a number of formulas including costs, revenues, contribution and
break-even. Beyond survival, a business is also likely to have an objective of profit.
Here you will look at the financial documents that a business produces at the end of a
A
financial year (or mid-year, called interim accounts). There are two key documents that
a firm will produce, and these are:
▸▸ a statement of comprehensive income, which calculates whether the firm has
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made a profit or a loss by deducting all expenses from sales revenue
▸▸ a statement of financial position, which calculates the net worth of a business by
balancing what the business owns against what it owes.
Key term
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Statement of
comprehensive income –
Statement of comprehensive income
shows the trading position of Purpose and use
the business which is used to A statement of comprehensive income, if produced correctly, will give an accurate
calculate gross profit. It then calculation showing how much profit or loss the business has made. It records sales,
takes into account all other costs and profit over a period of time (normally a year).
expenses to calculate the
profit or loss for the year. Calculation of gross profit
Statement of financial The first part of the statement of comprehensive income is made up of three
position – a snapshot of components.
a business’s net worth at ▸▸ Sales revenue is the money coming into the business from providing a trade – for
a particular moment in example, selling goods, manufacturing goods, or providing a service. The calculation
time, normally the end of a for sales turnover is quantity sold × selling price.
financial year. ▸▸ Cost of goods sold includes the costs directly linked to providing that trade, for
example, the cost of buying in the goods or the raw materials used to produce the
Cost of goods sold – the goods. To work out the cost of goods sold, a simple calculation is done to ensure
actual value of inventory used that the figure recorded for cost of goods sold can be directly linked to the goods
to generate sales. actually sold and not just all the materials purchased.

Content area F UNIT 3
If, for example, you bought 12 balls of wool and knitted a jumper, is the cost of wool

Key term
for that jumper 12 balls? What if you had three spare balls to start with or two balls
left at the end? Opening inventory – the
The calculation for cost of goods sold is: value of inventory in a
business at the start of a
opening inventories + purchases − closing inventories
financial year.
▸▸ Gross profit is the amount of money left or the surplus after the cost of goods sold
has been deducted from the sales turnover. This is not, however, the business’s final Closing inventory – the
profit as there are still other expenses to deduct in the next part of the account. The value of inventory at the end
calculation for gross profit is: of a financial year.
sales turnover − cost of goods sold.
hensive income for the

Section 1 of a statement of compre
year ended 30 April 2015
£000s £000s
411,529
Sales
FT
Less cost of goods sold
34,993
Opening inventory
Purchases 128,129
21,445
Closing inventory
141,677
269,852
Gross profit
A
▸▸ Figure 3.7: Why is it important to calculate the actual cost of goods sold rather than just use
R
the purchases for the year?
Calculation of profit or loss for the year

D
Profit is the money after all other expenses have been deducted from gross profit and
any other revenue income has been added. Revenue income is non-capital income
that is received by the business from sources other than sales, for example, discounts
received and interest on positive bank balances.
Depreciation appears as an expense in the statement of comprehensive income, as
this is a way that accountants can spread the cost of a fixed asset over its lifetime.
Depreciation will be explained in more detail under the fixed asset heading when you
look at a balance sheet.
The calculation for profit for the year is:
gross profit − expenses + other revenue income
gross profit = sales revenue – cost of goods sold
cost of goods sold = opening inventory + purchases – closing inventory
profit or loss for the year = gross profit – expenses + other income
Figure 3.8 shows a statement of comprehensive income for the year ended 30 April
2015. What expenses do you think a business might include under the heading
‘miscellaneous’?
109
me for the
Statement of comprehensive inco
year ended 30 April 2015
£000s £000s
411,529
Sales
Less cost of goods sold
34,993
Opening inventory
128,129
Purchases
21,445
Closing inventory
141,672
269,852
Gross profit
Less expenses
37,554
Rent and rates
96,221
Wages and salaries
FT
1,359
Telephone and postage
31,593
Distribution
15,579
Advertising
28,452
Miscellaneous expenses
17,848
Depreciation
228,696
A
Total expenses
0
Revenue income
41,246
Net profit before tax
R
▸▸ Figure 3.8: Statement of comprehensive income for year ended 30 April 2015
D
Reflect Transfer of profit to a statement of comprehensive income

Assume that Lily’s cash Tax is to be deducted from the profit: this is a percentage of the profit that is to be paid
flow forecast for year 1 was to HM Revenue & Customs (HMRC). This then gives profit after tax.
accurate and at the end The business then has to decide how to use this profit. In the case of a company, a
of the year she holds one proportion of it may be issued to shareholders in the form of dividends. For a sole
month’s worth of purchases. trader or partnership, it could be taken out of the business as drawings. Either some or
Produce a statement of all of it is likely, however, to be ploughed back into the business – this is called retained
comprehensive income profit. Retained profits are transferred from the statement of comprehensive income
for Lily’s cleaning business. to the statement of financial position.
Swap your work with
another learner and check Adjustments for depreciation (straight-line and reducing balance)
each other’s work. Did
Depreciation is an accountancy concept used to spread the cost of an asset over its
you remember all the
useful life. It is important that when fixed assets are shown in the statement of financial
information you needed?
position, they are given a realistic value. For this reason, they are depreciated on an
Is there anything you need
annual basis. The annual amount by which the assets are depreciated is therefore
to remember for future
included as an expense in the statement of comprehensive income. If, for example, a
activities?
business bought a delivery van for £30,000 and three years later still showed its value

as £30,000, this would be unrealistic and inaccurate accounting. The statement of

financial position should therefore show the historic cost of an asset, the amount by
which it has depreciated over its life and then a current value for the asset. This final
figure is called the net book value and this represents what the asset is thought to be
worth at that moment in time. Key terms
There are two ways in which depreciation can be calculated. These are: Historic cost – the cost of
▸▸ straight-line depreciation: an asset is depreciated by a set amount each year an asset when it was first
▸▸ reducing balance depreciation: an asset is depreciated by a set percentage of its purchased.
remaining value each year. Expected life – how long an
The straight line method involves reducing the value of an asset, from the price asset is expected to be used
paid, i.e. its historic cost, by a fixed amount each year. To calculate the amount, the within a business.
accountant must, first of all, make two decisions: Residual value – the value of
▸▸ how long the asset is expected to be useful to the business, i.e. its expected life an asset when it is disposed of
▸▸ at the end of its useful life, how much it might be worth if sold on or sold for scrap,
by the business, for example,
i.e. its residual value. resale value.
Once these decisions have been made, the following formula can be applied.
 historic value − residual value

_______________________________
FT
        
expected life
If, therefore, a Ford transit van cost £16,000 and it was expected to be used by the
business for four years with a resale value of £4000, the calculation of depreciation
would be shown as follows.
£16,000 − £4, 000 _________
___________________ £12,000
 
      =       = £3,000 depreciation per year
 
4years 4
A
The £3000 would be shown as an expense on the statement of comprehensive
income.
The reducing balance method involves reducing the value of the asset by a set
R
percentage each year. The percentage is decided by a senior accountant and stated in
the financial reports. This method depreciates an asset by a lower amount as the asset
ages.
D
If, therefore, a Ford transit cost £16,000 and a decision was made to depreciate it by
20 per cent per year the depreciation would be calculated as:
Historic cost = £16,000
Year 1 depreciation = £16,000 × 0.20 = £3200
Net book value = £16,000 – £3200 = £12,800
Net book value = £12,800 – £2560 = £10,240
Net book value = £10,240 – £2480 = £7760
▸▸ Why do new cars depreciate as

Adjustments for prepayments, accruals soon as they are driven out of a
It is important that the financial records are a true and fair record of the business’s car showroom? Can you list five
activities. For this reason, adjustments will be made to a statement of comprehensive possible factors that might
income so that the expenditure shown matches the period in which the good or explain it?
service is used. For example, if rent is paid quarterly in advance, the expense may be
incurred in one financial year but the premises are actually used in the next financial
year. To take account of such timing differences, two types of adjustment are made.
111
These are outlined below.
▸▸ Prepayments
• A prepayment is when an expense is made in advance of the periods to which it
relates.
• The expense is therefore taken out of expenses in the statement of
comprehensive income and shown as a current asset in the statement of financial
position.
• An example would be rental on a phone line paid quarterly in advance.
▸▸ Accruals
• An accrual is when an expense is paid after the periods to which it relates.
• The expense is therefore added as an expense in the statement of comprehensive
income and shown as a current liability in the statement of financial position.
• An example would be electricity paid quarterly in arrears.
Interpretation, analysis and evaluation of statements

Once produced, the statement of comprehensive income can be used internally by
management to help measure the performance of the business and inform future
decision making. It can also be used externally by potential investors and creditors. A
FT
creditor, for example, might look at the business’s statement of comprehensive income
when deciding whether or not to offer trade credit.
The statement of comprehensive income may be analysed in a number of ways
including making:
▸▸ comparisons between figures within the statement of comprehensive income, e.g.
profit as a percentage of sales revenue
A
▸▸ comparisons between years, i.e. gross profit this year as compared with gross profit
for last year
▸▸ intrafirm comparisons to see how different aspects of the business are performing,
R
e.g. revenue for one product or branch compared with another profit or branch
▸▸ interfirm comparisons to see how the business is performing in relation to its
competitors.
D
When interpreting and analysing a statement of comprehensive income, it is also

useful to consider profit quality. Profit quality is how sustainable the profit is. If profits
have increased, but this is because of a one-off event, such as selling an asset, then
this cannot be repeated the following year and profit quality may therefore be seen as
poor. However, if the increase in profit is as a result of increased sales or lower costs,
then this may be seen as achievable in future years and therefore profit quality is seen
as good.
Profit quality can be used to evaluate the statement of comprehensive income.
Anyone looking at the accounts may also want to consider the accuracy of the
information. Accounts must be accurate to meet legal requirements but it is possible
to manipulate data to make it look more favourable. This is called window dressing.
Write out a list of all the headings shown on a statement of comprehensive income.
P a us e p o int
Write a short explanation or formula next to each heading.
Hint Remember to include the adjustments you have just read about.
Extend What are the benefits of comparing a statement of comprehensive income between
different years for the same business?

Statement of financial position

Purpose and use
A statement of financial position is a snapshot of a business’s net worth at a particular
moment in time, normally the end of a financial year. It is a summary of everything
that the business owns (its assets) and owes (its liabilities). A statement of financial
position therefore states the value of a business.
Statement of financial position

Statements of financial position can be shown in a vertical or horizontal format,
vertical being the most common, and therefore the style of presentation you will use
in this unit. A vertically presented balance sheet is presented as:
non-current assets
• intangible assets
• tangible assets
+ current assets
− current liabilities
FT
= non-current assets/liabilities
− non-current liabilities
= net assets.
This is the first half of the balance sheet that calculates the net assets – that is, the
worth of the business. Imagine if the business were to close today and you sold
A
all of its assets, then paid off all of its liabilities. This is the amount you would be
left with.
Non-current assets
R
Non-current assets are those items of value that are owned by the business and likely
to stay within the business for more than one year. These can be:
▸▸ tangible assets
D
• i.e. they can be touched, for example a machine or premises.

▸▸ intangible assets
• i.e. they cannot be touched, for example a trademark or recognised name.
Tangible assets include premises, fixtures and fittings, equipment and vehicles. It is
important that when these are shown in the statement of financial position, they are
given a realistic value. For this reason, they are depreciated on an annual basis. As you
have already learned, if a business buys a delivery van for £30,000 and three years
later still shows its value as £30,000, this is unrealistic and inaccurate accounting. The
statement of financial position should therefore show the historic cost of an asset,
the amount by which it has depreciated over its life and then a current value for the
asset. This final figure is called the net book value and this represents what the asset is
thought to be worth at that moment in time.
You have already looked at how to calculate depreciation using the straight-line
method. The Ford transit van that cost £16,000, with a residual value of £4000, was to
be depreciated by £3000 per year.
In the balance sheet, the net book value (the cost of an asset minus depreciation)
would therefore be shown as in Table 3.6.
113
▸▸ Table 3.16: Example net book value for a Ford transit van
Year Cost Accumulated depreciation Net book value

1 £16,000 £3000 £13,000 (1)
2 £16,000 £6000 £10,000
3 £16,000 £9000 £7000
4 £16,000 £12,000 £4000 (2)
(1) The value of the van at the end of 1 year: £16,000 − £3000 = £13,000.
The value of the van at the end of 4 years matches the residual value used in the calculation
(2)
above.
An intangible asset is something that adds value to the business but does not have
a physical presence. One example of this that you might see on a balance sheet is
‘goodwill’. This means when someone buys an already-established business, they are
also buying the goodwill that the business has built up, such as brand recognition or a
loyal customer base.
The value of an intangible asset can change over time. If a decision is made to decrease
the value of an intangible asset, a principle similar to depreciation is applied. This is
called ‘amortisation’ where a one-off change is made to the value of the intangible
FT
asset. This will be shown in the statement of financial position to record the cost,
amortisation and net book value of the intangible asset.
A
R
D
▸▸ Why is it important for this business to put a realistic value on its office equipment?
Current assets
Current assets are those items of value owned by a business whose value is likely to
fluctuate on a regular basis. Every time a business makes a transaction, the value of its
Key term current assets will fluctuate. Current assets include:
▸▸ inventories
Current assets – items
▸▸ trade receivables
owned by the business that
▸▸ prepayments
change in value on a regular
▸▸ cash in the bank
basis, such as stock.
▸▸ cash in hand.
Inventory is the value of stock held at that moment in time. Depending upon the
nature of the business, it can take three different forms: raw materials, work in progress
and finished goods. A business must be careful to give stock a realistic value and not
overvalue stock – for example, inventory which they are unlikely to sell because it has
gone out of fashion or is damaged.

Trade receivables are people who owe the business money. Although the business does

not yet physically have the money, it is, in effect, owned by the business. Trade receivables
are customers who have not yet paid for the good or service provided by the business
and must be monitored to ensure that they do make the payment by the due date.
Prepayments are when an expense is made in advance of the period to which it
relates. Therefore it is classed as an asset and transferred from the statement of
comprehensive income.
Current assets are listed in order of how easy it is to turn them into cash quickly. For
example, if a business has liquidity problems, it may find it difficult to turn inventory
into cash quickly. In addition, in trying to do so, it may not receive its true value. In
contrast, cash in hand is just that – cash!
Current liabilities
A current liability is something owed by the business that should be paid back in under
one year. Examples of current liabilities are outlined below.
▸▸ Overdrafts
• The ability to withdraw money from a current account that you do not have.
▸▸ Accruals
• This is when an expense is paid after the period to which it relates.
FT
▸▸ Trade payables
• These are people or businesses the business owes money to because it has
received a good or service but has not yet paid for it.
Net current assets/liabilities
Net current assets/liabilities is a very important figure for a business; it represents the
business’s ability to meet short-term debts. A business with insufficient net current
A
assets, also called working capital, does not have enough current assets to meet its
current liabilities. This is potentially disastrous because, if the liabilities have to be paid
for now, and the business cannot meet these demands from its current assets, then it
R
will have to find the cash elsewhere. This could mean being forced to sell a fixed asset
without which the business cannot operate. Net current assets/liabilities is calculated
as current assets minus current liabilities.
▸▸ Current assets are greater than current liabilities = net current assets.
D
▸▸ Current assets are less than current liabilities = net current liabilities.
Non-current liabilities
A liability is something that the business owes. If it is classed as non-current, this
means the business will pay it back in more than one year. Examples of non-current
liabilities include bank loans and mortgages. These are likely to be used to buy fixed
assets or to set up the business initially.
Net assets
Net assets are the figure that represents the total value of all the assets minus the value
of the liabilities. Net assets are calculated as follows.
Non-current assets + current assets – (current liabilities + long term liabilities) Key term
Capital Capital employed – the total
The second half of the statement of financial position then asks how this has been amount of capital tied up in
financed. This shows the capital employed and is presented as: a business at a point in time.
owners’ or shareholders’ capital It is calculated as owners’
+ retained profit or shareholders’ capital +
– drawings retained profit – drawings.
= capital employed.
115
Opening capital is the capital in the business at the start of trading. This is the money
invested in the business from the owners. Owners may be a sole trader, partners or
shareholders.
Retained profit is the profits kept from previous years plus the net profit from the
current year. This will be transferred from the statement of financial position.
Drawings are withdrawals made by owners from the business. For a statement of
financial position to balance, net assets must be equal to capital employed.
Cost Accumulated Net book value

depreciation
£ £ £
Non-current assets
Premises 218,000 28,880 189,120
Fixtures and fittings 38,500 15,800 22,700
FT
Vehicles 19,500 19,500 0
Current assets
Stock
34,294
Debtors
21,455
Cash at bank
0
A
Cash in hand
381
56,130
Less current liabilities
R
Creditors
17,881
Overdraft
12,389
D
30,270
Working capital
25,860
Non-current liabilities
Bank loans
50,998
Net assets
186,682
Financed by
Capital
60,000
Retained profit
126,682
Capital employed
186,682
▸▸ Figure 3.9: Example of a statement of financial position

Adjustments

Adjustments will be made between the statement of comprehensive income and the
statement of financial position to ensure that both records are showing a true and fair
picture of the business’s activity. These adjustments are outlined below.
▸▸ Depreciation, straight line or reducing balance
• Annual depreciation is shown as an expense on the statement of comprehensive
income.
• Each year depreciation is deducted from the net book value of an asset to show
the value of the asset at the end of the year; this is the value of the asset recorded
in the statement of financial position.
▸▸ Prepayments
• A prepayment is when an expense is made in advance of the periods to which it
relates.
• The expense is therefore taken out of expenses in the statement of
comprehensive income and shown as a current asset in the statement of financial
position.
• If, for example, broadband is paid for 12 months in advance, and the accounts are
produced half way through this 12 month period, half of the total payment would
be recorded as a prepayment under the current asset heading on the statement
FT
of financial position.
▸▸ Accruals
• An accrual is when an expense is paid after the periods to which it relates.
• The expense is therefore added as an expense in the statement of comprehensive
income and shown as a current liability in the statement of financial position.
• An example would be electricity paid quarterly in arrears; a figure would be
A
shown in the statement of financial position to account for the value of electricity
already consumed.
▸▸ Interpretation, analysis and evaluation of statements.
Once produced, the statement of financial position can be used internally by

R
management to help measure the financial health of the business and inform future
decision making. It can also be used externally by potential investors and creditors. An
investor, for example, might look at the business’s statement of financial position when
deciding whether or not to offer capital to the business.
D
The statement of financial position may be analysed in a number of ways. These

include making:
▸▸ comparisons between figures within the statement of financial position, e.g. current
assets in relation to current liabilities
▸▸ comparisons between years, i.e. value of fixed assets or current liabilities in one year
compared with previous years
▸▸ intrafirm comparisons to see how different aspects of the business are performing,
e.g. debtors for one branch compared with another branch to identify any potential
concerns regardinf bad debts
▸▸ interfirm comparisons to see how the business is performing in relation to its
competitors.
When interpreting and analysing a statement of financial position, it is also useful
to consider working capital because this is a measure of the firm’s ability to meet
day‑to‑day expenses. The statement of financial position is a useful indicator of how
effectively management are running the business.
Both statements of financial position and statements of comprehensive income are
interpreted with the use of ratios.
117
Write out a list of all the headings shown on a statement of financial position. Write a
P a us e p o int
short explanation or formula next to each heading.
Hint Remember to include the adjustments you have just read about.
Extend Explain the relationship between a statement of financial position and a statement
of comprehensive income.
Measuring profitability
You should now be familiar with the basic language of accounts and the key financial
accounts produced by businesses. You will now look at what these accounts actually
tell us and how an accountant can use or interpret them. Ratio analysis allows for a
more meaningful interpretation of published accounts by comparing one figure with
another. Ratio analysis also allows for both interfirm and intrafirm comparisons.
Ratios will be used by internal stakeholders such as managers and employees, as well
as external stakeholders such as investors and creditors.
Profitability is a measure of the profit of a firm in relation to another factor. It allows
FT
for a more comprehensive assessment of the performance of a firm by comparing
one figure to another. Imagine that there are two firms, A and B, both with a profit of
£750,000 per year – how would you be able to tell which one was performing better?
If, however, you were told that Firm A has sales revenue of £1.5 million and Firm B has
sales revenue of £3 million, then it is clear that Firm A has greater profitability as it is
generating the same amount of profit from a lower level of sales. This indicates it is
more efficient and better at controlling its costs.
A
There are four profitability ratios you will look at here:
▸▸ gross profit margin
▸▸ mark-up
R
▸▸ net profit margin
▸▸ return on capital employed (ROCE).
D
Key terms
Interfirm – between
different firms, for example,
comparing the performance
of two different house
builders.
Intrafirm – within the firm,
for example, comparing
this year’s results with last
year’s, or the performance
of the York branch with the
Leicester branch of a retail
store.
Stakeholder – anyone with
an interest in the activities of
a business, whether directly
or indirectly involved. ▸▸ What sort of information will the investors in this business need to be given about
the company’s finances?

Gross profit margin

gross profit
This is calculated using the following formula:  ____________
revenue    × 100
 
This ratio looks at gross profit as a percentage of sales turnover. It shows us, for every
£1 made in sales, how much is left as gross profit after the cost of goods sold has been
deducted. A gross profit of 88 per cent therefore means that, for every £1 of sales
made, 88p is left as gross profit.
If gross profit margin falls from one year to the next or is thought to be too low, a firm may
try to reduce the cost of its purchases. This may involve looking for a cheaper supplier,
but the firm must try to ensure that this does not affect the quality of the product.
Alternatively, it may try to increase sales without increasing the cost of goods sold.
Mark-up
gross profit
This is calculated using the following formula:  _____________  × 100
 
cost of sales
This ratio looks at profit as a percentage of cost of sales. It shows what percentage
of cost of sales is added to reach selling price. For example, a mark-up of 25 per cent
would mean that if the cost of raw materials used to produce a good were £1, it has
been sold for £1.25.
Net profit margin
FT
net profit
This is calculated using the following formula:  __________
revenue  × 100
This ratio looks at net profit as a percentage of sales turnover. It shows, for every
£1 made in sales, how much of it is left as net profit after all expenses have been
deducted. A net profit of 31 per cent therefore means that, for every £1 of sales made,
A
31p is left as net profit.
If net profit margin falls from one year to the next or is thought to be too low, a firm
may look to reduce its expenses, for example, by moving to cheaper premises or
cutting staffing costs. Before taking any action, however, the accountant must try to
R
identify the cause of a falling figure – whether it is related to sales, cost of goods sold
or expenses – as all of these factors will impact upon the net profit margin.
D
Worked Example – Freedom Fashion Ltd

Sales turnover = £411,529
Gross profit = £269,792
Net profit = £41,246
Gross profit percentage of sales = £269,852 / £411,529 × 100 = 65.5 per cent
For every £1 Freedom Fashion Ltd makes in sales, 65p is left as gross profit.
A fashion retailer is likely to have reasonably high costs of sales due to the
nature of their product. If it was a service industry then you might expect
this percentage to be higher.
£41,246
Net profit percentage of sales = __________
    × 100 = 10 per cent
  
£411,529
For every £1 Freedom Fashion Ltd makes in sales, just 10p is left as net profit. A fashion retailer is likely to have
reasonably high expenses due to the nature of their business. A retail business with a physical location (as opposed
to e‑commerce) may have high overhead costs such as premises and heat and light.
119
Return on capital employed (ROCE)
This is calculated using the following formula:
net profit before interest and tax

__________________________________
   
        × 100
capital employed
This ratio shows the percentage return a business is achieving from the capital (or
money) being used to generate that return. It shows, for every £1 invested in the
business in owners’ capital or retained profits, what per cent is being generated in
profit. A ROCE of 5 per cent means that, for every £1 tied up in the business, 5p is
being generated in net profit.
Investors will often compare ROCE to the interest rate being offered in a bank or
building society to see if their investment is working effectively for them in generating
a return.
FT
Net profit before interest and tax = £41,246
Capital employed = £186,682
£41,246
ROCE = _________
    
× 100 = 22 per cent
186,682
This means that, for every £1 being used within the business, there is a return of 22p. This is certainly higher than you
A
could expect from a bank.
R
Measuring liquidity
Liquidity ratios measure how solvent a business is – that is, how able it is to meet
D
short-term debts. There are two liquidity ratios you will look at here:
▸▸ current ratio
▸▸ acid test ratio/liquidity ratio (liquid capital ratio).
Current ratio
current assets
__________________
   
   
current liabilities
This ratio shows the amount of current assets in relation to current liabilities and is
expressed as x:1. If a firm had a current ratio of 2:1, this would mean that, for every £2
it owned in current assets, it owed £1 in current liabilities, and this would generally
be considered acceptable. If, however, a firm had a current ratio of 0.5:1, this would
mean that, for every 50p it owned in current assets, it owed £1 in current liabilities.
This means if the firm’s bank demanded that it repaid its overdraft immediately and
creditors demanded payment, the firm would not be able to cover these demands
from current assets. This is therefore a dangerous position to be in.


Current assets = £56,130
Current liabilities = £30,270
£56,130
Current ratio = _________
   = £1.85
 
£30,270
This means that, for every £1 the business owes in short-term debt (that is, its current liabilities), it owns £1.85 in
current assets. The business therefore has sufficient liquidity to meet short-term debts.
Liquid capital ratio

Current assets − inventory

 ____________________________
        
current liabilities
The liquid capital ratio is thought to be a tougher measure of a firm’s liquidity. Like the
FT
current ratio, it shows the amount of current assets in relation to current liabilities, but
it does not include inventory. This is because inventory is considered to be the hardest
current asset to turn into cash quickly. The result is expressed as x:1.

A
Current assets = £56,130
Stock = £34,294
Current liabilities = £30,270
R
£56,130 – £34,294
Acid test = ____________________
  
      
£30,270
D
£21,826
=  _________ 
 = 0.72
£30,270
This means that, for every £1 the business owes in short-term debts, it only has 72p in liquid assets (current assets
excluding stock). This figure shows the firm to be illiquid, as it could not meet its short-term debts if immediate
repayment was demanded. A fashion retailer is likely to have a large amount of its current assets in the form of stock,
due to the nature of the firm.
Research
Select a business that you are interested in (or you could use the one you studied
in Unit 1: Exploring Business). Compare the profitability and liquidity of your Key term
chosen business to that of Freedom Fashion Ltd. Illiquid – not easily converted
Which one do you think is performing best? Justify your answer.. into cash.
121
Measuring efficiency
Efficiency ratios tend to be used to assess how well management is controlling key
aspects of the business, primarily stock and finances. There are three efficiency ratios
you will look at here:
▸▸ trade receivable days
▸▸ trade payable days
▸▸ inventory turnover.
Trade receivable days

( ___________________
credit sales )
trade receivables
        × 365
If you do not know what percentage of sales were made on credit, then it is acceptable
to use the sales figure as given in the statement of comprehensive income. The ratio
measures, on average, how long it takes for debtors to pay; it is expressed as a number of
days. For example, if a business has a debtors’ payment period of 60 days, this means, on
average, it takes debtors two months to pay for goods or services purchased on credit. A
FT
business with cash flow problems will try to reduce its debtors’ payment period.

Debtors’ trade receivables = £21,455
Sales = £411,529
A
£21,445
Trade receivables days = __________
    
  × 365 = 19 days
£411,529
This means that, on average, it takes a customer 19 days to pay for their purchases. A fashion retailer is unlikely to
R
offer long payment terms.
D
Trade receivable days will vary from firm to firm, depending upon the nature and price
of items sold and whether the business deals in business-to-business or business-
Key terms to-consumer sales. If it is business-to-business, longer payment terms may be given.
Business-to-business – B2B One business may also give different payment terms to different customers depending
refers to when one business upon the size and importance of a customer’s business, reliability of payment and
sells to another business – discounts offered.
for example, a stationery
business selling to a firm of
Trade payable days
accountants. This is calculated using the following formula:
( credit purchases )
Business-to-consumer trade payables
 __________________
    × 365
  
– B2C refers to when one
business sells to an individual If you do not know what percentage of purchases were made on credit, then it is
– for example, a stationery acceptable to use the purchases figure as given in the statement of comprehensive
business selling wedding income. The ratio measures, on average, how long it takes a firm to pay for goods
stationery to a bride and and services bought on credit; it is expressed as a number of days. For example, if
groom. a business has trade payable days of 30 days, this means that, on average, there is a
one month gap between the business buying the good or service and paying for it. A
business with cash flow problems will try to lengthen its trade payables days.


Trade payables = £17,881
Purchases = £128,129
£17,881
Trade payables days = __________
    
  × 365 = 51 days
£128,129
This means that, on average, the firm pays its suppliers in 51 days. This may mean that some suppliers offer one
month’s credit and others two months.
Inventory turnover
( ____________________
cost of sales )
average inventory
        × 365
Average inventory is calculated as follows:
opening inventory + closing inventory

 ________________________________________
      
2
 
FT
This ratio measures the average amount of time an item of stock is held by a business,
and is expressed as a number of days. If a business has an inventory turnover of 7,
A
this means that, on average, it holds each item of stock for one week. The rate of
inventory turnover is very much dependent upon the nature of the firm. For example,
you could expect a florist or fishmonger to have a much lower inventory turnover than
a fashion store or car showroom. However, if the rate of inventory turnover appears
R
high for the nature of the product, this might result in stock going out of date or out of
fashion.
D

Opening inventory = £34,993
Closing inventory = £21,445
Cost of goods sold = £141,737
£34,993 + £21,445
Average inventory = ____________________
  
   
 
2
£56,438
= _________
      = £28,219
 
2
£28,219
Inventory turnover = __________
    
  × 365 = 73 days
£141,737
This means that, on average, the business turns its stock over, or sells its stock, every 73 days. This is just over every
two months, which is what you might expect from a fashion retailer with approximately six new lines per year.
123
Limitations of ratios
Although ratios are very useful there are also a few limitations. These are described
below.
▸▸ They are calculated on past data and therefore may not be a true reflection of the
business’s current performance.
▸▸ Financial records may have been manipulated and therefore the ratios will be based
on potentially misleading data.
▸▸ Ratios do not consider qualitative factors.
▸▸ A ratio can indicate that there is a problem in a business but does not directly
identify the cause of the problem or the solution.
▸▸ Interfirm comparisons can be difficult as not all firms report their performance in
the same way or generate their accounts in the same way.
Ratios only report on the financial performance at a set point in time; the statement of
financial position is a snapshot of the business at a point in time. At other times of year
the picture may be different.
FT
1 Identify two components that make up the first part of the statement of
comprehensive income. (2 marks)
2 A business purchases 20 new laptops for £11,500. They expect each laptop to
last around 3 years and hope to resell nine of the laptops at the end of this
time.
Calculate the straight line depreciation value of the laptops. (2 marks)
A
3 It costs Dominic 85p to make a loaf of sourdough bread. He sells the bread for
£1.25. He is thinking of increasing the price to £1.50.
Calculate the following.
R
(a) The mark up on the bread when sold for £1.25. (2 marks)
(b) The mark up on the bread when sold for £1.50. (2 marks)
Think future
D

UNIT 3

Think
Future
I’ve been working in accounts for four years since finishing in the sixth
form at school. I started as an apprentice which meant I was being
Charlotte Donaldson paid to work at the same time as gaining professional qualifications. I
Assistant Management am now AAT qualified and studying for CIMA. At the end of this I will
be a fully qualified accountant. When I first started, I was responsible
FT
Accountant for everything from raising invoices for customers and processing
invoices from suppliers, to keeping a register of fixed assets, including
controlling company cars. Since I started, the company has grown
and I now manage two junior clerks who have taken responsibility
for raising and processing invoices. Managing and training other
members of staff has given me a real sense of responsibility. I have
A
even been sent on two management courses to help me develop my
management skills. This has been a great experience.
R
Focusing your skills

It is important to take care and ensure that everything I do Looking ahead
D
is accurate. I have to check everything I do because it has a After four years, I have learned so much and was lucky to
knock‑on effect on the final management accounts. be in a company that was growing. This meant my job role
•• Company records have to be up to date and correct in was constantly growing and evolving with the company,
preparation for any VAT inspections. allowing me to take on more responsibility. I have now
•• Employees’ benefits need to be recorded otherwise they been successful in gaining a new job in a different company,
may be taxed incorrectly. which is a promotion. I am looking forward to learning
•• The information I pass on to the management new skills and continuing with my studies to become fully
accountant has to be correct in order for her to produce qualified as a management accountant in my new job.
accurate reports to HMRC and the company directors. •• Once Charlotte had decided she was ready for a new
•• The accounts we produce have to meet legal challenge, what do you think she had to do to get ready
requirements. for a promotion?
•• Do you think she was right to look for a new job with a
new company?
•• What might the advantages be of moving to a new
company?
125
UNIT 3
Getting ready for assessment

This section has been written to help you to do your best when you take the external examination.
Read through it carefully and ask your tutor if there is anything you are not sure about.
About the test Sitting the test

This unit is externally assessed using an unseen paper-based Listen to, and read carefully, any
examination. Pearson sets and marks the examination. The instructions you are given. Lots of marks
assessment must be taken under examination conditions. are often lost through not reading
The external assessment will last two hours and there are questions properly and misunderstanding
100 marks available. The test is in two sections: what the question is asking.
•• Part A: personal finance Most questions contain command words.
•• Part B: business finance. Understanding what these words mean
There are three types of questions: will help you understand what the
FT
•• short answer questions question is asking you to do.
•• calculation questions
•• longer answer questions.
Command word Definition – what it is asking you to do

Give You can provide:
A
•• examples
•• justifications.
Outline Your work, performance or practice provides a summary or overview or a brief description of something.
R
Identify Indicate the main features or purpose of something by recognising it and/or being able to discern and
understand facts or qualities.
Illustrate Include examples, images or diagrams to show what is meant within a specific context.
Calculate Work out an answer, usually by adding, multiplying, subtracting or dividing. Can involve the use of formulas.
D
Explain Your work shows clear details and gives reasons and/or evidence to support an opinion, view or argument.
It could show how conclusions are drawn (arrived at). You are able to show that you understand the origins,
functions and objectives of a subject, and its suitability for purpose.
Discuss Consider different aspects of:
•• a theme or topic
•• how they interrelate
•• the extent to which they are important.
•• A conclusion is not required.
Analyse Present the outcome of methodical and detailed examination either by breaking down:
a theme, topic or situation in order to interpret and study the relationships between the parts and/or
information or data to interpret and study key trends and interrelationships.
Assess Present a careful consideration of varied factors or events that apply to a specific situation or identify those
which are the most important or relevant and arrive at a conclusion.
Evaluate Your work draws on varied information, themes or concepts to consider aspects such as:
strengths or weaknesses
•• advantages or disadvantages
•• alternative actions
•• relevance or significance.
Your inquiries should lead to a supported judgement showing relationship to its context. This will often be in a
conclusion.

Sample answers

For some of the questions you will be given some background information on which the
questions are based.
Look at the sample questions which follow and the tips on how to answer them well.
Answering short answer questions – give, state and identify

Read the question carefully.
Highlight or underline key words.
Note the number of marks available which will match the number of points
asked for in the question, e.g. ‘state one’ = 1 mark or ’give two’ = 2 marks.
Make sure that you make the same number of statements as there are marks
available. Take care that if you are making two or more points that these are
sufficiently different points (not the same one made in a slightly different way).
Worked example
State two functions of money. [2]

Answer: Unit of account. Store of value. FT Two accurate and
different points are
made gaining full marks.
Command words ‘give’,
A
Answering short answer questions – describe ‘state’ or ‘identify’ can
be answered in single
Note the number of marks available. If 2 marks are available you will be
words or statements.
required to describe one concept. ‘Describe’ requires two linked sentences
R
There is no need to
where the second sentence adds a development to the first. If the question write in full sentences
is worth 4 marks, you would repeat this process of making a point and then as the examiner is only
adding a development a second time. testing your knowledge,
D
i.e. your ability to recall

information.
Worked example
Describe one benefit of producing a cash flow forecast. [2]

Answer: One benefit of producing a cash flow forecast is it will identify
months where there is a potential cash shortage. It can also be shown to a
bank manager as part of a business plan.
The first point is correct, as is the second. However, the candidate

would only be awarded 1 mark as these are two separate points rather
than one point which has been described or developed. A better
response would have made the first point: ‘One benefit of producing
a cash flow forecast is it will identify months were there is a potential
cash shortage’. This statement would then have been developed,
gaining a second mark: ‘This would allow the business to make plans for
these months, maybe by arranging an overdraft’.
127
UNIT 3
Answering calculation questions

Write down the formula.
Identify the numbers provided in the additional information given within the
question.
Put numbers into the formula.
Show all your working.
Express the answer in the correct way, e.g. £, units.
Check your working.
Worked example
Jack has provided you with the following information from his statement of
financial position.
Revenue
Cost of goods sold
Expenses
£250,000
£130,000
£80,000 FT
A
Calculate Jack’s net profit margin. [5]
net profit
Net profit margin = ____________
       × 100
sales revenue
R
Net profit = revenue – cost of goods sold – expenses
Net profit = £250 000 − £130 000 − £80 000 = £40 000
£40 000
Net profit margin = ________
     
= 0.16
D
£250 000
The candidate has written down all of the information, including

the formulas, correctly. Working is well laid out, making it easy for
the examiner to see what they have done. Unfortunately, they have
forgotten to multiply by 100 at the end to gain the correct answer of
16%. However, because everything else is correct, only 1 mark would be
lost for this error.
Answering extended answer questions – explain

You are required to develop a line of argument using linking words such as
therefore, so that, because. Start your answer by making a relevant point and
expand on this using two or three steps in a line of argument.
Avoid moving on to new points until the point you have made has been fully
developed.

Example:

Explain the benefits of an individual taking out travel insurance before
It is a good idea to
travelling abroad. [6]
start by identifying the
key term in the question.
Travel insurance protects the holder from financial losses incurred while away Here the answer starts
from home. by showing the examiner
One benefit of this is that if personal belongings are lost or stolen they will be that the candidate
covered by the insurance policy. Therefore, the holder will be able to make a understands what
claim so that they can get back the cost of replacing the lost items, e.g. money travel insurance is. It
is important here that
or a camera. This means that the person travelling has not lost a lot of money
the candidate has said
because they had taken out protection in advance.
‘while away from home’,
A second benefit is that the traveller may be protected if the holiday is so they are not just
cancelled or other changes are made, such as flight delays. This means that, talking about insurance in
although the inconvenience will still exist, the traveller could be compensated general but the answer
for this. This would allow them to cover additional expenses incurred while is specific to travel
waiting for flights, etc. insurance.
FT
A third benefit is the traveller would be insured if they fell sick. This would
mean that they could receive treatment without having to worry about big
medical bills. These would be paid for by the insurance company or paid for
and then reclaimed. This means that the traveller will feel more confident while
away and be happy that if they need medical care that they can seek this.
A
A number of steps have then been given in a logical line of argument,
e.g. covered – claim – get back the cost – not lost money. Three
different aspects of travel insurance have been identified and explained
R
in context.
Answering extended answer questions – discuss, analyse,

D
assess, evaluate
Read the question carefully.
Highlight or underline key words.
Look at the number of marks available as an indication of how many
arguments are required and the depth of arguments.
You are required to develop a line of argument using linking words such as
therefore, so that, because.
Start your answer by making a relevant point and expand on this using two or
three steps in a line of argument.
Avoid moving on to new points until the point you have made has been fully
developed.
You will need to present two arguments from different viewpoints, e.g. one
advantage and one disadvantage or one argument for and one argument
against.
You do not need to make judgements and write a conclusion.
129
UNIT 3
Example:
Karren runs a road haulage business. She is looking to expand the

business and wants to purchase two more lorries.
Assess the use of external sources of finance to Karren. [10] This answer shows a
good understanding of
the topic, i.e. external
External sources of finance are from outside the business, e.g. bank loans and sources of finance, and
leasing. uses technical language
Karren could use a bank loan. This would involve receiving a lump sum from the throughout the answer.
bank. She could use this to buy the lorries. However, it is expensive. The first paragraph
makes a relevant point
Karren could lease the lorries rather than buy them. The advantage of this is and some judgement
that she would be able to expand the business as she would have the lorries but lacks development.
now. However, she would not be paying a lump sum for them but paying in It is rather descriptive.
smaller amounts on a regular basis to the lease company. This helps spread The second paragraph is
out the payment for the lorries and could help Karren’s cash flow. She would much better, discussing
also avoid potentially high interest payments. However, although this is a the issues related
FT
good source of finance in the short run, in the long run it is likely to be more to leasing in a more
developed way. It also
expensive as Karren will have to keep paying to lease the lorries for as long as
provides a balanced
she wants to use them. She will never actually own them. Therefore, this may
argument.
have a negative effect on her profit margins in the long run.
Overall, a bank loan may be the better option as Karren wants to expand the
business and she will therefore benefit from owning the lorries rather than
A
leasing them. Or she could look at asking friends and family or a venture
capitalist to invest money into the business to help her expand.
R
The conclusion tries to weigh up the two options but then moves on to
bring in new points/ideas. It is not a good idea to bring in new points
in the conclusion. This should be a judgement made based on the
D
arguments that have already been presented. The candidate would have
gained more marks if they had brought in additional sources of finance
earlier and discussed the advantages and disadvantages of these to
help present a more balanced argument.

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FT

Personal and Business

Getting to know your unit

The ability to manage money is crucial to keep both yourself, as an

How you will be assessed

Content area A Understand the importance of managing personal finance

Content area B Explore the personal finance sector

Content area C Understand the purpose of accounting

Content area D Select and evaluate different sources of business finance

Content area E Break-even and cash flow forecasts

60 Personal and Business Finance

Personal finance involves understanding why money is important and how

Personal and Business Finance

Understand the importance of managing

Functions and role of money

The functions of money

62 Personal and Business Finance

Table 3.1: Financial needs and implications at different life stages

Personal and Business Finance

university, weddings, etc.

•• Look to improve own lifestyle, e.g. new car or

•• Enjoy having access to additional money to

Planning expenditure Key terms

Manage money Avoid

P a us e p o int Can you explain the functions and role of money?

Different ways to pay

64 Personal and Business Finance

▸▸ Table 3.2: Methods of payment

Personal and Business Finance

and the recipient

Can be accessed in a number of which can take three days to transfer

66 Personal and Business Finance

Personal and Business Finance

Types of current account are outlined below.

Type of current Advantages Disadvantages

discounts on travel or small lump

68 Personal and Business Finance

Personal and Business Finance

ABC limit year 1 and £3000 for online

Check your knowledge

Different types of borrowing

normally be paid for outright.

70 Personal and Business Finance

▸▸ Table 3.4: Advantages and disadvantages of different types of borrowing

Personal and Business Finance

limit, without the need to secure against an asset

Different types of saving and investment

Tax is not charged on interest earned allowing the saver to keep

Notice is often required to make withdrawals and

72 Personal and Business Finance

▸▸ Table 3.5: – continued

Personal and Business Finance

Risks and rewards of saving versus investment Key terms

74 Personal and Business Finance

Personal and Business Finance

▸▸ Table 3.7: Advantages and disadvantages of different types of insurance

Type of insurance Advantages Disadvantages

Pet Avoids expensive vet fees An additional monthly expense to protect

young adult stage of the life cycle. (6 marks)