Unit 5 (3.5) – Finance | AQA A-Level Business (Revision)

If you're an AQA A-level business student looking for a video to revise all of unit 5 finance, well, this video is for you. Because we're going to go through all the key concepts that you need to know for your exams and all the calculations, including looking at income statements and balance sheets. We'll also look at how to do our calculations for break-even. We'll also take a look at budgeting and cash flow forecasts. Then we'll look at the different sources of finance, both internal and external methods, and much more. Let's get into it.

The first topic that we're going to take a look at in this revision video will be the different financial objectives that a business may set. Now, there's a couple of different ones that we'll take a closer look into. That will include objectives about revenue, our costs, and profit. We'll also look at different objectives around cash flow and return on investment.

We're going to take a closer look now at our revenue objectives. Now, by this point in the course, you should know what revenue is, but essentially revenue is just the money that a business makes from selling their products and services. The way we calculate revenue is that we take our selling price multiplied by the quantity of products that we've sold. Now, when we look at setting revenue objectives, this could be around revenue growth or sales maximization. Now, with revenue growth, this can either be a value of growth or a percentage of growth. But whereas when we look at sales maximization as a business objective, this is when we have the primary focus on achieving the highest possible level of sales revenue or volume rather than just prioritizing profit. So, for example, we could have a revenue objective growth of increasing annual revenue by 10% within the next 12 months, or we could have another one: achieve £1 million in total revenue by the end of the next financial year.

The next type of financial objective that we have is our cost objectives. Now, think with cost: it's just the total expenses that a business will spend in order to keep the business operating and to obviously make and sell their products. Now, with our formula for total cost, all we do is we plus our fixed cost and our variable costs. Remember your fixed costs are costs that stay the same regardless of the level of output. Whereas your variable cost, they will change with the level of output. And when we look at setting these cost objectives, typically it will be around cost minimization. It will be trying to focus on reducing our expenses to the lowest possible level, hopefully without compromising the quality of our products. So, for example, our objective could be around to reduce the total operating costs by 10% within the next 12 months by streamlining our operations. Or it could be decreasing our manufacturing cost per unit by £2 by the end of the year through process improvement. And the reason why we would want to look at reducing and minimizing our costs is because this can help improve our profit margin. As we said, if we reduce the unit cost, profitability tends to increase. Or if we reduce our unit cost, we may be able to become more competitive in the market with our pricing strategies and setting a lower one compared to our rivals. Now, of course, the biggest issue when you focus on cost minimization, it's about how you reduce your costs: is it seen as being ethical and is it going to hinder the quality of your service?

Another really important financial objective will be around our profits. Now, remember the way we calculate profits is that we take our total revenue and we minus total costs. So, when we look at our profit objectives, it's typically around maximizing those profits, which can be done in either one of two ways. You can either look at increasing your revenue or reducing your costs. So, for example, a business could have a profit objective of increasing overall profit by £50,000 within the next 12 months by launching a brand new product line. Now, similar to our cost minimization, we have to ask, well, how are we making more profit? Are we doing so in an ethical manner? Because typically there's a trade-off. The more ethical you'll be, the less profitable the company will be. Because we're typically increasing costs, we're trying to source more ethically, and we're focusing more on our environmental impact.

Another really important financial objective will be around cash flow. Now, you may have heard the phrase "cash is king," and they're not lying. Essentially, what we mean by cash flow is that this is the movement of money both in and out of the business. Now, if the business doesn't have a healthy cash flow, they're not able to pay their expenses such as suppliers, employees, and their rent. And if this is the case, well, the business becomes insolvent. They may go bankrupt and have to close their doors. So, cash flow is essential for a business to survive. The reasons why businesses tend to fail is because they run out of cash. And especially with our startup businesses, we know that these startup companies, they're not exactly blessed with cash. They don't have lots of money just lying around. And the way we calculate our net cash flow, real simple calculation, or you do your cash inflows minus your cash outflows. So a cash flow objective could be around increasing our total cash inflows by 10% over the next 12 months by looking at different sources of finance.

And the final type of financial objective that a business may want to set could be around return on investment. Now, setting return on investment objectives can help a business, first of all, measure their profitability by comparing returns against different investments that they've made. It can also help them allocate resources more effectively by identifying which projects have the best returns. And finally, it will help them evaluate the success of a project by, once again, assessing whether investments meet the set objectives that they originally set. It also helps to let a business know whether they go ahead with a decision or not based on whether the return on investment is going to be high enough. So the way we calculate the return on investment is that we look at the profit made from the investment divided by the cost of investment, times that by 100. So, for example, a return on investment objective could be that the business wants to make a 15% return on investment for all of their projects that they make over the next 12 months.

The next topic that we're going to take a look at in this revision video will be the difference between cash flow and profit. Now, you would be surprised, but students tend to get these two terms mixed up quite often. Well, when we look at cash flow, this is the money flowing in and out of the business. Whereas profit is just the amount of money that we make when we take our total revenue minus our total costs. Now, they are not the same thing, but they do have some similarities. What I want to do, I want to show you the four main reasons why cash and profit are very different.

And the first example of the difference between cash flow and profit is revenue made on credit. Now, how this works. Let's say we are a business and we sell our TVs at £1,000 each and I've sold a TV to a customer. However, they've told me that they can only pay £200 in cash today. So, they've got that £1,000 TV, but I've only received £200. And they've told me that the other £800 they're paying about 30 to 60 days' time. Now, how is that different then? How is our cash recorded different and how is our revenue and profit recorded different? Well, in terms of revenue, we have to record the entire transaction. So, for my revenue, I would record that I've made a £1,000 sale. But in cash, I could only record the amount that I received. Now, we've also got this concept called trade receivables. All that means is the amount of money that we're waiting to receive from our customers who have bought products and services on credit. So, as you can see here, it would be £800 because that's how much they owe me. So, a key difference between revenue and cash is how we record it and the timing of it.

The second example is delayed payment expenses. And this follows the same concept as us making revenue on credit, but now we're looking at buying supplies from our supplier. So, let's say, for example, our supplier is selling us £100,000 of raw materials. Brilliant. We get them today, but we tell our supplier, how about I give you £25,000 today and I'll give you the rest of the money about 60 days' time. So, how is that different then with our profit and with our cash? Well, in terms of our costs, we've recorded £100,000 because that's how much we received, and that will impact our profit. But in terms of our cash, well, we've only seen £25,000 going out of the business today. So, we would only record -£25,000 in cash. Now, in terms of our trade payables, similar concept to trade receivables, but instead of receiving the money, I'm now paying it. I owe that money to my creditors and suppliers. So what you can see here, £75,000 in trade payables because that's how much I owe them. So, once again, we can only record cash as it's leaving the business or entering the business. But with revenue, cost, and profit, we record the transactions of the products that we sell or the raw materials or expenses that we receive.

The third example of how cash and profit are very different is to do with loans and how we go about repaying them. So, in this example, let's say I go to my trusted bank and I ask them for a £10 million loan. They say, "Cool, no worries. We're just going to charge you a 6% interest rate." Now, interest rates are the cost of borrowing and the reward for saving. In this case, it will be the cost of borrowing. So what that basically means for my business, I receive £10 million today and in about a few years' time I pay them back £10,600,000. The reason why I owe them £600,000 more than I borrowed is because that is the interest rate. That's the cost of borrowing. Keep that in mind. So, how is this going to impact the business's financial statements? How does it impact our revenue? Cost, cash in, cash out. Well, in terms of revenue, I've not made any at all. Of course, I haven't because I haven't sold any products or services. In terms of cost, well, that would be the interest rate because it's the cost of borrowing. So the cost recorded would be £600,000. Now, when looking at the cash into the business, well, we've received £10 million. And in terms of the cash out the business, that will be £10,600,000, of course, once we've actually made that payment.

And the final example of how cash and profit is recorded differently is through depreciation. Now, all depreciation is is that a non-current asset loses its value over time. So you may have heard it when you brought a car and you said, "Oh, by the way, in a few years' time that's probably going to be worth half the amount that it is today." So that's because it's depreciating. It's losing its value for wear and tear. It's going out of date. So now let's say, for example, the business pays for a van £10,000 and we've paid all the cash upfront. Now, another assumption that we're going to make is we're going to say, "Well, this van is going to last me five years, and after those five years we're scrapping it, so it's going to be worth 0." So, how does this impact my costs and how does it impact my cash flow? Well, my cash outflow in that first year would be £10,000 because I've paid for it upfront. But the way we record the cost is that well, we can't just say it's £10,000 in cost in year 1 because it's going to last us 5 years. So, what I do is I look at the cost of the actual non-current asset, divide that by how many years I think it's going to last for, and then spread that expense over that year period. Now, we would have to potentially factor in whether we scrap the non-current asset afterwards or whether we could sell it.

The next topic that we're going to take a look at in this revision video, which is quite a nice follow-up now we know the difference between cash and profit, because we're going to take a look at our income statements. Now, what we mean by an income statement is that these are the profit and loss statements. So you can see on the screen here, it's a financial document that shows all of the business's revenues, expenses, profit or loss if we make one over a specific period of time. Now, we've got three types of profit. Remember the acronym GAN, go n gone, which stands for gross profit, operating profit, and net profit, because that's how it shows up in our income statement. So, first of all, let's break down each of these sections. We've got revenue. We know what revenue is; it's the money that we make from selling products and services, calculated by taking the selling price times by how many units we sell. Now, we've got cost of sales. Well, essentially these are the direct costs that go into making a product or service. So, you can factor in costs such as the direct labor, the raw materials that we use, the packaging of the product itself. They're kind of like the variable costs of the business. And then we've got our operating expenses. Now, these are the indirect costs. So they're not directly used to make the product or service. Instead, what these costs are used for is to do the day-to-day operations of the business. So, once again, fairly similar to our fixed costs, we've got salaries and wages of non-direct labor staff. We've got the marketing expenses, the rent that we pay in our buildings, research and development, utilities, and so much more. And then we've got our finance costs. Now, remember what interest rates are. They are the cost of borrowing or the reward for saving. Well, if they're the costs of borrowing, it has to show up in our profit and loss statement. And this is where we would have it here. So, they are the expenses incurred by a business for borrowing money, maybe on a bank loan, maybe on an overdraft. More on those later on in the session when we look at our sources of finance. And it also could be rewards for saving as well. So, we may have put money into our savings account. So, the money we make from that goes into here. So, we do the interest that we've paid minus the interest that we've made, and that is our finance costs. And then finally, we have our taxation. This is what we have to pay to the government. So, for a business, if you're an LTD or public limited company, you pay corporation tax, which at the time of this recording, 25%, or if you're self-employed, you would pay income tax levels.

How do we do our calculations? Well, always remember, gone: gross operating net. The way we calculate gross profit first of all is that we do your revenue minus your cost of sales; those direct expenses that have been used to make the product or service. So, in 2023, we made £10 million in revenue and our cost of sales were equal to £6 million. So, revenue £10 million minus our cost of sales £6 million gives me a gross profit of £4 million. Then we do our operating profit. The way we calculate our operating profit is that we take our gross profit minus our operating expenses. So, for 2023, gross profit is equal to £4 million. Operating profit, we want to minus that of £2 million to give our operating profit of £2 million in total. Then you can do your net profit. So if you have the net profit before tax, so they've given you the finance costs, you do your operating profit minus your finance costs. So, operating profit £2 million minus finance cost £500,000 gives me a net profit before tax of £1.5 million. And then we do the net profit after tax. So we just figure out what the taxation is. If we are just doing simply, we've done the corporation tax which is 25%. 25% of £1.5 million is £375,000. So the net profit £1.5 million minus £375,000, which gives me a net profit after tax of £1,125,000. Now, the net profit after tax is what you can pay your shareholders in the form of dividends or you can reinvest that back into the business as an internal source of finance.

The next topic that we're going to take a look at in this revision video is a nice follow-up now we've just understood what our income statements are because we're going to take a look at profitability. Now, as a hint, do not write about profit and profitability the same way because they are two different concepts. Yes, there are overlaps, but they are two very different concepts. So, if your exam question says, "How can this help the business improve their profitability?" Don't just say, "Well, it can increase revenue, decrease cost, therefore profit improves." Because you're not answering the question. You're not directly answering about profitability. Now, I think profitability is like an efficiency ratio. It basically looks at how efficient is a business at taking one thing and turning that into profit. So that one thing could be revenue. So how efficient is a business taking their revenue and generating profit from it? It could be about the cost that they're spending. So how efficiently is a business taking their cost and turning that into profit? Or it could be capital employed and other investments, which we will take a look at the return on capital employed in unit 7. So just to recap, profitability, it's a measure of how efficiently a business generates profits from its revenue or other operations.

Now, one of the main ways for a business to look at their profitability is to calculate their profit margins. Now, as I said earlier, don't write about profit and profitability in the exact same way because there is a chance for a business to make really good profit but have poor profitability because they may be operating at a lower profit margin. Now, the way we calculate our profit margin, I'm going to show you this in just a moment, is that you divide the specific type of profit by the business's revenue. And remember, we've just done income statements, so we know we've got three types of profit: gross, operating, and net, go n gone. So, how do we do these calculations? Well, to calculate the generic profit margin, all you want to do is you want to take the profit, divide it by the revenue, and times 100. So, as you can see, our profit margins are going to be measured as a percentage. And to do the different type of profit margins that we've learned from our income statement, first of all, we've got our gross profit. To calculate the gross profit margin, take gross profit, divide by revenue, and times by 100. To do your operating profit margin, it's more or less the exact same formula, but now we do the operating profit, divide by revenue, and then times by 100. And as you could imagine, to do the net profit margin, we take the net profit, divide that by the revenue, and times by 100. Now, when we look at measuring the success of a business's profit margin, we want to look at a higher figure, but industry-specific; different industries will have different profitabilities. So, for example, one business in one industry could have a gross profit margin of 60%. And that could be considered really good. But another business in a completely different industry, they could have a gross profit margin of 20%. But that also could be considered really good in that specific industry. So, when you are looking at whether a business's profitability is good, two things: one, look at their direct competitors; two, look at how it changes over time.

The next topic that we're going to take a look at in this revision video will be having a look at budgeting. First of all, what on earth are budgets? Well, a budget is a financial plan. That is the key element of this definition. And the idea with a budget is that we want to outline the expected income and expenditure. Now, the problem is most students think budgets are just for our spending, but it's not. It's also made for our incomes. Now, it's important to know budgets, it's not a forecast. It is a plan. The budget is more so a target to achieve. Whereas when we look at what a forecast is, this is just a prediction of the future. And as I've said earlier, a budget is not just for your expenditure. It's also for your income; so the revenue you're making. So if it's for your revenue and it's for your costs, then we can also do the budget for our profit. And the idea with a budget is that you want to use these to plan and control your financial resources. And you also want to use it to help monitor your spending. So, you don't want to overspend within your budget. Now, of course, how accurate these plans and these budgets are, it depends on who is making them because if you've got the intern making them who probably doesn't have a lot of experience, then the budget may not be that good. Or if you've got a chief financial officer making the budget, 30, 40 years of experience, you can have a better expectation that it's going to be accurate and that it's going to be good for the business. And as part of our budgeting, we also want to conduct variance analysis because there's no point making a plan and then just not really using it ever again. We want to measure the business's performance. Have we stuck to the plan? Have we gone over? Have we done better than we thought or have we done worse than we thought? And the variance analysis will tell us this. The way we calculate the variance is that we want to take your actual value minus your budgeted value. Now, when we look at categorizing your variance results, it can either be classed as favorable or adverse. Now, as you can imagine, if we've got a favorable variance, then the actual results are better than the original budgeted one. Well, how would a better situation look like? Well, of course, you would make more revenue than you actually originally budgeted for than you actually expected in the first place. But what about our costs? Well, realistically you want to spend less money than more money. So, in terms of your cost, a favorable situation is that your costs are lower than expected. And as you can imagine for your profit, a favorable profit is when the actual is higher than your budgeted. But when we look at adverse variance, this is when the situation swaps around. So your actual value is worse than your budgeted value. So it's not necessarily all of them being lower, but some of them will be. So, for example, with revenue, of course, if we make less revenue than we originally expected for, that would be an adverse situation. But in terms of costs, this is now when they are higher than they're expected. So, we've spent more money than we originally budgeted for. And of course, when it comes to profit, we've made lower levels of profit than we originally expected. And to show you guys how we would do the variance calculations, I've got some data on the screen. So, it's separated into revenue, costs, and profit. So revenue based on product A, product B and the total revenue, cost separated down into salaries, raw materials, machinery, of course, total cost and our profit. Now, on the right-hand column we have the actual value and on the left-hand column we've got the budgeted value. So, for product A, to do the variance analysis we do your actual value minus the budgeted. So £75,000 minus £40,000 gives me a variance of £35,000. For product B, £130,000 - £150,000 gives me a variance of -£20,000. Same thing with total revenue, £205,000 minus £190,000 gives me a variance of £15,000. I'm just going to do the salaries for the costs because you can see all the information here. So for our cost, we do £60,000 minus £55,000 to give me a variance of £5,000. Straight now down to the profit. Actual value £60,000, budgeted value £50,000 gives me a variance of £10,000. Now, all we need to do for each individual line is say whether it's favorable or whether it's adverse. Well, for product A, it's favorable because we've made £35,000 more than we originally budgeted for. But for product B, we've made £20,000 less than we originally budgeted for. Henceforth, it's adverse. Total revenue overall, we've made £15,000 more. Therefore, it's favorable. But now when it comes to the cost, the rules switch around because we've spent £5,000 more than we originally budgeted for. Therefore, this is adverse. Same with the raw materials. We spent £10,000 more than we originally budgeted for. Once again, also being adverse. But if you look at machinery, we actually spent £10,000 less than we budgeted for. Henceforth, it is favorable. Overall, £5,000 more in total cost. Therefore, adverse situation. But when we look at the profit overall, we've made £10,000 more than the original budgeted value. Therefore, that's favorable. Now, we are business students; we love a little bit of evaluation because...

Let's say, for example, we look at the raw materials. So, we've said it's an adverse situation. You spend £10,000 more in raw materials than you originally budgeted for. Is that bad though? Because if you look at total revenue overall, we made £15,000 more. So what you want to do is you really want to go into the values and actually evaluate them. You know, is it necessarily a bad thing or has that adverse variance caused something positive or has that favorable variance caused something negative?

So once again, spending £10,000 less on machinery, but is our unit cost higher because our efficiency is a lot lower? And you want to obviously measure the size. So a small adverse variance isn't necessarily a bad thing, but of course, a larger one will be. And the final thing that we need to do now for budgeting is to look at the advantages. Well, budgeting is a brilliant tool. It helps monitor your spending and your income levels.

Now, the reason why you want to specially monitor your spending is so you don't overspend because if the business has a habit of overspending, that could begin to really reduce our profit margin. It can also act as a good motivational target for our employees. Because if we set these revenue budgets in mind, we communicate that across the business; that becomes then a target for them to try and achieve, to make as many products or make as many sales depending on where they are in the business. And finally, it just helps us with decision-making. So, for example, if I'm looking at investing into a certain project, well, what is my expenditure budget? Have I got enough money to look at investing in this specific project?

The next topic that we're going to take a look at in this revision video, and it's one of my personal favorites from the entire finance section, we are going to look at break even. Now, first of all, what on earth is break even analysis all about? Well, essentially, all break even is it wants to identify how many units does a business need to sell in order for their total revenue to equal their total cost. Because at this point, when total revenue equals total costs, our profits are exactly equal to zero. So by specifically knowing how many units I need to sell for my revenue to equal total cost for profit to equal zero, well, after the break even point, that's when the business starts making profit. So every product I sell over my break even point, the business is becoming more and more profitable.

However, for break even to work, we have to make some unrealistic assumptions. Keep these in mind for when we look at the disadvantages of break even a little bit later on. But the first one is that we assume that the variable cost per unit will remain the same. Now, we know this isn't true in the real business world. We've got factors such as inflation. We may get purchasing economies of scale and start to negotiate different price points for my raw materials. We also assume that we only ever sell at a single price point. But when we look at cans of Coke, for example, you want to buy one of them by yourself, probably about 90p. You want to buy a pack of four; that could be two pounds, so they're 50p each. And what happens if the business sells different products? It's going to be quite difficult to spread those fixed costs for those specific products. Exactly. We also assume that we are the best business owners in the world and we've sold every single unit. So every unit in my inventory, there is zero waste, and I sell every single one of them. Once again, not realistic in the real business world. And finally, we assume that fixed costs will always remain the same. Now, fixed costs, they stay the same in the short term regardless of output, but over time they will naturally increase, maybe because of inflation; we may need to move to larger facilities as well.

And onto the main event of break even, we need to know how we do the calculation, but before I show you the formula for break even, I need to introduce another concept called contribution. Now, what contribution is, or the total contribution, is essentially when we take our total revenue minus the total variable costs. And we also want to know the contribution per unit. Now, the way we calculate the contribution per unit is that we take the selling price of the product minus the variable cost per unit. Keep those formulas in mind. And with HUA, they have examined on these two formulas before. So make sure you know them for your exams. But now let's take a look at how we calculate the break even point. There's a couple of different variations of this formula. The first one is that it's equal to your fixed cost divided by your contribution per unit. But remember, I've just shown you the formula for contribution per unit. That is equal to the selling price minus your variable cost per unit. So the second way of calculating this is that it's equal to your fixed cost divided by your selling price minus your variable cost per unit. And yes, for your exams, you need to know both.

Now, I know that can be quite a confusing formula for you to remember. So let me give you an easier way of how to remember this. Try and remember the phrase, "Father Christmas, he sends presents via chimneys." Father Christmas, FC, for your fixed costs, sends presents, SP, for your selling price, via chimneys, variable cost per unit. Always make sure to add per unit at the end. And in terms of an example of this formula in action, well, let's say I've got this data here. So, we've been able to identify my total revenue I've made is £1.5 million. Fixed costs are equal to £500,000. Total variable cost equal to £600,000, and I've sold 300,000 units. Well, remember there's three key elements of that formula: fixed costs, selling price, variable cost per unit. How nice of them. They've already given us the fixed cost. So, we don't need to do anything with there. The second thing we need to do is to calculate the selling price. Well, remember that formula for revenue. Revenue is equal to your selling price times by the unit sold. But we've not got exactly the selling price here, but I've got the total revenue and I've got the units sold. So I just need to rearrange that formula to get price is equal to revenue divided by quantity sold. So simply 1.5 million divided by 300,000 gives me a selling price of £5.

Next up, we've got to find out our variable cost per unit. Looking at the data, how mean of them? But they haven't actually given us that information. But remember to calculate our total variable costs, we do the variable cost per unit multiplied by the unit sold. Well, they've given me your total variable cost and they've given me the unit sold. So total variable cost £600,000 divided by £300,000 units gives me a variable cost per unit of £2. And all we need to do now is to put all of that information into our formula. So the fixed cost equal to £500,000. Divide that by the selling price £5 minus the two pound of variable cost per unit gives me a break even point of 166,667 units. The correct units we need for your exam is either units or whatever product they're selling.

Now, a couple of the key things. You always want to round up to the nearest whole number. I know you might be asking, well, why not round it down? Well, the problem is if you was to round it down, our profit would be still seen as a negative. And you can't sell 0.2 of a product; you can't sell 6 of a product. Therefore, always round up to the nearest whole number. And I shouldn't need to tell you by now, write down every single line of working.

And the next thing that we need to do now with our break even analysis is to construct our break even chart. I'm going to give you a step-by-step process starting from scratch. First of all, draw your axes. On your x-axis, you have the number of units. On your y-axis, you have your sales or cost, or you can just measure that in pound sign or dollars, whatever the currency is. Then you want to draw your total revenue line. As you can see, it's a constant gradient because our selling price always remains the same. Then we have our fixed cost. Now, remember, fixed cost will be a horizontal line because they don't vary with the level of products that you produce. They will remain the exact same. We can also draw our variable cost line fairly similar to your total revenue, but it'll be a lot more shallower because hopefully, the variable cost per unit is a lot smaller than your selling price. Then you want to draw your total costs. Now, your total cost should be parallel to the variable cost line because the distance should always be the same because that distance will be your fixed costs. So all you've done is you've added those two lines together. So you can see the total cost line; it intersects the y-axis at the very same point as fixed cost does. And all we need to do now is that we just need to draw our break even point. Well, of course, break even is when your total revenue equals your total costs. So you just identify that point, track it down to figure out how many units we need to sell to break even. And of course, the more products you sell past that break even point, the more profit you make. But if you sell less products than the break even point, you are going to be making a loss.

Another important concept as part of break even we need to look into is the margin of safety. Now, the way we calculate the margin of safety is that we take the actual output. So how many products that you've actually sold or how much you forecast to sell minus the break even point. So the margin of safety, this is the difference between a business's actual output or projected sales and the break even sales, which indicates how much sales can drop before the business incurs a loss. So if we go back to that break even chart, I've added on one more line which is the actual sales. Well, all the margin of safety is is the difference between your actual sales and the break even point. So, as you can imagine, we want a higher margin of safety because the higher the margin of safety, the further we are away from that break even point, the more profit we're making, but the smaller the margin of safety, well, we're only over that break even point by a smaller amount, i.e., we're making a smaller profit. So, the higher the better when we have a margin of safety. And in terms of an example of how we calculate this, really simple. Let's say they've been so nice. They've given us the predicted sales and they've given the break even point. Just use the formula: actual output 750,000 minus your break even point of 500,000 gives me a margin of safety of 250,000 units. The measurement unit is still the exact same.

And the final thing that we need to do now with break even is to look at the value of it, the advantages of using the break even analysis. Well, it's a brilliant tool. It helps evaluate the financial feasibility of different products. Because, for example, we've conducted our break even analysis of a new product that we're thinking of selling, and we've identified as a new start to business that the break even point is 500,000 units. So I need to sell 500,000 products in order to start becoming profitable. We may look at that and think actually it's not really that worth it. We're not really going to be making a profit for a very long time, or the break even point could be a lot more reasonable, which would give us the go-ahead for the product development. It also helps us with decision-making, especially around our pricing strategies. Because if you think about it, if you was to increase your selling price, well, that total revenue line, it gets a little bit more steeper. And what that would mean is that your break even point becomes lower versus if we was to reduce the price, that total revenue line becomes a bit more flatter. And what you find now with your break even point is that it begins to increase. But we know with the law of demand that if you increase your price, well, the level of demand typically reduces. And we can bring in that concept of price elasticity of demand to help us further with this pricing decision. But as a side note, one of the biggest problems with the break even analysis is that it just tells me how many products that I need to sell in order to break even. It doesn't actually tell me whether I will or not because it doesn't predict demand. And typically, you would use your break even analysis when trying to secure funding. And we'll talk about that in a little bit more detail for our different sources of finance.

Now, as I said, break even, brilliant tool. We've got lots of amazing advantages there. The big issue is those unrealistic assumptions. And realistically, break even analysis only really works if you're selling one product because it's quite hard to distribute those fixed costs to the different products of the business. Just a quick one. If you need a bit of support with how to improve your exam technique, such as how you improve your chains of analysis, how you improve your application with your answers, and also how you improve your evaluation, well, I've created a free exam technique course that goes through all of this, including the different answer structures for your 9 markers, 12 markers, 16, 20, 24, and those dreaded 25 markers. And you can access this by clicking the link in the description.

Back to the video. The next topic that we're going to take a look at in this revision video will be our cash flow forecast. Now, we've had a look at cash flow a bit earlier on in the session, but essentially, just remember cash flow is the movement of money into the business and out of a business over a specific period of time. Like we said earlier on in our financial objectives, cash flow, it's crucial for a business's survival because it makes sure that the business is still able to pay their expenses and operate effectively. But when we think of why cash flow problems begin to occur, well, quite simply, it's when your cash outflows start to be a lot higher than your cash inflows. And what a cash flow forecast is is that we're trying to predict what our future cash flow could look like. Now, on the screen now, you can see an example of the cash flow forecast. So, for example, we were in December and we wanted to plan our future cash flow over the next four months of January, February, March, and April. Well, the reason why we want to do this is that it will help us identify potential cash flow issues in advance. So, for example, if we saw in April that we were in a bit of a poor cash flow position, at least we could start to action on it sooner. It can also help us as well with actually planning the business and helping us with making decisions.

Now, there's a few important calculations that you need to know for your exam. But first of all, let's go over some key concepts. The first section is our cash inflows, which is just any cash, any money flowing into the business. This could be from revenue that you make. This can be from your different sources of finance. So, for example, a bank loan, investment, share capital. Then we've got our cash outflows. This is the money flowing out of the business. So, this is typically the business's costs and their expenses such as the wages of their staff, the rent, the utility bills, paying for the raw materials to your suppliers, and any other costs that the business might have. Then, we've got our first calculation, which is our net cash flow. Now, the way you calculate your net cash flow is that you take your cash inflows minus your cash outflows. So, as you can see here, in January, we had £1 million flowing into the business and we only had £200,000 flowing out of the business. So, in January, our net cash flow is £800,000. Then, we want to calculate the opening balance. Well, with the opening balance, all it's going to be is the exact same value as the closing balance of the previous month. So to do the opening balance for February, I just look at the closing balance for January, which would be £800,000. To look at the opening balance in March, I just need to look at the closing balance in February, which would be £650,000. And finally, to find out the opening balance in April, I look at the closing balance in March, which would be £600,000. And then finally, the last calculation that we need to do is the closing balance. And the way we calculate this, we do the net cash flow plus your opening balance. So here we can see that the net cash flow is £800,000. The opening balance is zero. £800,000 plus 0 equals the closing balance of £800,000.

The next topic that we're going to take a look at in this revision video will be identifying the differences between payables and receivables. These terms should look familiar when we looked at the difference between profit and cash earlier on in this revision video. Well, just to be really clear that we know the difference between your receivables and your payables. Both of this piece of information will come up on our balance sheet, and we'll learn about a balance sheet in a lot more detail in unit 7. But to give you guys an understanding, all a receivable is it's a current asset. What that means is is any items that the business intends to turn into cash within the next 12 months. So all a trade receivable is is any money that the business is waiting to receive from their debtors. Also could be their customers for products that they bought on credit. Now, trade receivables also is known as account receivables; it just means the exact same thing. So, using that same example from earlier of me selling a TV for £1,000. So, let's say I've sold this TV for £1,000 to our end customers, but the cheeky customers come back to me and said, I can only pay you £200 today. I'm going to give you that £800 at a later date. So, what we need to think now is, well, what is our trade receivables equal to? Well, essentially, how much money are we waiting to receive from our customers, which would just be £800.

And now we'll take a look at trade payables. It's a fairly similar concept, but instead of receiving the money, we're now paying it. Now, a trade payable would come under our current liabilities. Now, a current liability, it's the money that the business owes within the next 12 months. So when we look at trade payables, it's just when a business has brought goods or services on credit from creditors and now they need to owe them the money. When we think about creditors, just think for example of suppliers. Now, once again, trade payables, also known as account payables, just means the exact same thing. So now let's look at the example that my supplier is selling to my business £100,000 of raw materials. So they've delivered that £100,000 of raw materials, but I'm the one being cheeky. Now, I've said to them, I tell you what, let me give you £25,000 today. I'll give you the rest of the money in 60 days time. Now, when we look at what my trade payables is, it's just how much do I have to pay them? What's the remaining amount to my creditors? Well, if they've given me £100,000 worth of raw materials, I've only paid them £25,000 so far. The rest I owe them is £75,000, which therefore would be £75,000 of trade payables.

The next section of this revision video, we'll be taking a look at the different sources of finance. Starting off with our internal methods. Now, internal sources of finance is essentially money coming already from within the business. And the first method of internal finance is through retained profits or retained earnings; they both mean the exact same thing. Now, after a company decides to pay off whatever dividends they want to pay from their shareholders, so we've made a profit at the end of the year, we've paid our tax, and we've got some money left over. So we can decide how much we want to pay to our shareholders. Let's say we've given them 50% of that net profit after tax, where we will be still left with some money, and the money that we still have left over, we can now reinvest that back into the business, and that is our retained profit. Now, it is important to note that a business doesn't actually have to pay any dividends to their shareholders at all. So what a business might do is that they might say to their shareholders, we are just looking at retaining all of these profits back into the business to keep fueling the business's growth. So, remember those income statements that we looked at earlier on in the session and how we had our net profit after tax? Well, the net profit after tax, this is the amount of money that can be paid to your shareholders as dividends, or we can just keep it back into the business as retained profit. Now, retained profit, it's a brilliant source of finance because we're not taking on any loans. I don't have to pay an interest rate, so I'm not incurring any costs. And it's also a great source of finance for these highly profitable businesses. So think of your Apples of the world. Think of your Amazons of the world. But it depends. It depends how much profit that you're actually making. Because if you're a small starter business who's barely making a profit, then that retained profit isn't going to be able to keep fueling the business's growth. You may need to look at additional sources of finance. And as well, the more profit that you decide to retain into the business, the less profit the shareholders would get as a dividend. And once again, they may not be too happy with this.

And the other internal source of finance that we have is the sale of assets. More specifically, the sale of non-current assets. Now, all a non-current asset is is an item that the business intends to keep and to use for longer than 12 months to help it generate some economic benefits from. Now, when we look at selling these non-current assets, and just some great examples, we've got is property, we've got equipment, we've got machinery. The reason why a business may decide to sell some of these non-current assets is because they're not being used anymore. We may not want them. They may be really inefficient. So, the business may make that decision to go and sell that non-current asset. Now, with the sale of assets, you only want to sell the assets that you're not really using. There's no point having a piece of machinery that is critical for the business's operations. And we look at that and go, "Huh, we can make a bit of money from that. Let's go and sell it." That's not what the sale of assets is all about. It's selling unused or unnecessary resources, and it can be quite good because not only does it provide the business with a bit of cash, but it can also help reduce the business's expenses. So, let's say for example, I'm a national supermarket retailer and I've identified one of my shops isn't really performing that well. In fact, it's actually making a loss. So, not only now do I make money from selling that asset, from selling that shop, I don't have to keep investing costs into it. So, what you'll find is that the sale of the asset actually helps reduce the business's costs because I don't need to pay for the people in there anymore. I'm not paying their wages and I'm not paying their salaries. I don't have to pay for the utility bills. The problem is though that non-current asset that you're potentially selling could be quite useful for the business in the future to help produce their products to help make more revenue. So, for example, if I sell a non-current asset such as a delivery vehicle, well, I now have to think of alternative methods to deliver my products and services.

Now, we've just gone through the internal sources of finance. It's time for us to have a look at those external methods of finance. And there's a few more of the externals than there are of the internals. First of all, we have debt factoring. Now, for some reason, students hate debt factoring. They just can't seem to understand it. But that's because they don't understand what trade receivables are. But by now, all of you lot should really understand what a trade receivable is because let's say, for example, the business has £100,000 of unpaid invoices. We have £100,000 of trade receivables, which we know is the money that we're waiting to receive from customers who have brought products and services on credit. Now, the problem is I might need that £100,000 today. I may have different expenses. I may owe the money to my

Suppliers. But the problem that I have is that I have to wait until I receive that from my customers because I've given them this credit period. I've said to them, "Don't pay until 60 days' time," but I need that money now. And this is where debt factoring can be quite useful because what the debt factoring would do, they would buy our unpaid invoices and give us some upfront cash today.

So what the factor in business might do, they may say to the business, "Here's £80,000 of cash today, and how about you give me those £100,000 worth of unpaid invoices, and I will collect the cash myself at a later date." So as a business, I'm getting £80,000 today in cash, but I'm selling £100,000 worth of unpaid invoices. So essentially, I'm not having £20,000 of those invoices. And debt factoring is typically used by businesses who have a lot of trade receivables, but they need the money today. Maybe they owe it in terms of their trade payables. And it's great because it provides the business with instant cash. So any short-term cash flow problems they have, brilliant. It can solve them really well. And we don't have to now invest time and resources chasing those unpaid invoices.

But as you've probably figured out, the biggest issue with debt factoring is that I'm not receiving all the money from that trade receivables anymore. So, from that example, I'm just missing out on £20,000 cash. Yes, it solves my short-term cash flow problems, but that £20,000 cash may now have reduced my profitability, has reduced my overall profit margins. And it's not only that, because your customers now have to deal with this factoring company. They may not be as nice as you. And the problem with this is that the customer may have a negative reputation over your brand because they're constantly being chased up now by this factoring company.

Another external finance that we have, and this is more so a short-term source of finance, is our bank overdraft. Now, a bank overdraft essentially lets you spend more money than is actually in your bank account. But you have to pre-agree this before with the actual bank. So, if I have a product that I'm wanting to buy worth £10,000, but I've only got £5,000 in my bank account, but I've already agreed on an overdraft up to £10,000. Well, it's good because I can buy that £10,000 product, and I would be in my overdraft by £5,000. So, when I log into my bank account, I would see negative £5,000. So, as we said, we're withdrawing more money than is actually set in that bank account.

Now, the big, big problem of overdrafts is the interest rates. Now remember, an interest rate, when we are borrowing money, it's the cost of borrowing. Now when we look at a bank overdraft, the interest rates tend to be quite high. I'm talking around 20 to 30% every single year. And this is the biggest reason why it's a short-term source of finance because you don't want to be in your overdraft for a very long time because of the amount of interest that you'll end up having to pay, and the bank can demand that money back at any point in time.

The next source of finance that we have, and we're now looking at more of a long-term source of finance, is share capital. Now this is not a form of debt. This is a form of an equity source of financing, and it's only present for private and public limited companies. The reason why these are incorporated businesses, meaning they're made up of shares. Now all share capital is, it's the exchange for shares for money into the business. So as a company, I may sell 100,000 shares, issue 100,000 shares—the fancy way of selling it—for a million pounds worth of cash. That £1 million in cash that the business is getting, that is what we call share capital. Now this is not a debt source of finance. So I don't owe them the money, but of course, they buy shares into the company. So they now have voting rights, like control, and they are also within their rights to have dividends if we are paying it out.

Now share capital, it's a brilliant source of finance, especially for public limited companies because think a public limited company sells their shares on the public stock exchange. So typically the amount of share capital they have access to is quite a lot. And as I said, share capital, brilliant. We do not need to repay that money back. However, we do have problems. The biggest issue is because it's an equity source of finance, we are giving ownership away. So of course, that might dilute the ownership. If we're a private limited company, they may want to get involved a lot more with the decision-making. And they're also entitled to dividends if we are paying it out. So let's say, for example, I've sold 25% of my private limited company, and I've decided to pay £100,000 of dividends because we've done really well in our profits. The issue is that shareholder now gets access to £25,000 of that overall dividend.

Another really popular external source of finance that we have are loans. Typically these are from banks. Now, a loan is a debt source of finance, which essentially means I'll borrow the money off you, and I have to pay you that money back, typically with a little bit of interest. Now, as we said, loans is when we borrow money and we have a certain time period to pay it back. Now, when we get a loan, we would have to sign a loan agreement, and this will outline factors such as the repayment schedules, the interest rates, i.e., the cost of borrowing, that percentage amount, uh how much we are borrowing, any penalties for late fines as well, and also collateral.

Now, you may wonder what on earth is collateral? Well, with a bank, for example, they don't necessarily like taking lots of risk. They want to make sure that they're going to be making money, that they can guarantee it. So, for example, a private limited company goes to a bank and asks for a £100,000 loan. And what the bank may decide to do, they may look at the business's balance sheet and identify that the business owns a building worth £100,000. Now what the bank may ask for is that for the business to have that loan, they sign that building up as collateral. So if the business is not able to pay a single penny back off that loan, the bank has the right to seize the asset, seize the building in form of collateral to get their money's worth.

It's also important to note that smaller businesses, they are often perceived as higher risk, and this is because the smaller business, they may have less financial data. A smaller business is more likely to go out of business. So what a bank might do is that they may charge a higher interest rate for a smaller business. But for a larger business, these are perceived as lower risk, and the larger businesses have more negotiation power now with whoever is providing the loan. So with larger businesses with a larger loan, typically they would get a smaller interest rate.

Now loans are a popular source of finance for a very good reason. It's because they are very good. They provide lots of finance for the business that obviously they can use to help fund different projects, which of course supports their cash flow, and it supports their cash flow as well because they get the money today and may not have to pay that until 3 to 5 years' time. So the money that they've got today, they've used it to make products and services to help make them further cash to help them pay off that loan in the future. But the problem is is that you are now in debt. You now owe that money back to the bank. So it doesn't matter how well the business is performing. We could be doing extremely well, or we could be doing extremely poorly. The bank will still demand those repayments on time. And it's not only that, it's the interest rates. Remember, interest rates are the cost of borrowing. So, if the cost of borrowing is increased, therefore, our overall cost increase, meaning that we could make lower profits.

Another popular external source of finance that we also have is crowdfunding. Now, crowdfunding is a way to raise funds by gathering small contributions from many people, from many people, from a crowd of people to finance a business's project, business ideas, or just the business in general. Now, crowdfunding projects typically set a funding target and aim to attract investment from, as we said, a large group of people. Now, in return, the investors may get ownership of the business. They may get rewards or exclusive perks related to the project. They may just get a return on their investment through debt interest, or they may get recognition. So most crowdfunding could be just through donations.

And what's really good about crowdfunding is that you start to gather a bit of public interest. So for example, let's say I'm setting up a bakery in a small town. And the way we're funding this is through crowdfunding. Now the type of people who would want to see a bakery in the town may be the local residents. So, not only are we getting money from them, but we're gathering a bit of public interest, which can be quite useful for when we launch the business. And what's great about crowdfunding is that it funds certain projects where you may not be able to get that finance in different methods. So, for example, the projects that you would get money from crowdfunding, you know, a bank loan may not be willing to give you that money. But the problem is you are relying mostly on people's goodwill. So the issue that you have with crowdfunding is that there's no guarantee that you will actually hit that target. You know, with a bank loan, you want to go for £30,000. So you secure £30,000. But with crowdfunding, I've just set a £30,000 target. I may get only £5,000, £2,000. And another problem is, well, what if it's a really innovative idea that we're looking to get crowdfunding for? Well, I need to make that project public. And who else is going to see that? Your competitors. And competitors who already may have the cash and they may just steal your idea.

And the very final method of external finance that we have is venture capital. Now, if you've ever watched the show Dragons' Den, then you should know what venture capital is all about. Essentially, venture capital is an equity source of finance, is private equity funding. So, similar to share capital, we're selling shares of the business in return for a bit of funding. But we are not just selling these shares to absolutely anybody. We are selling it to venture capitalists. And what we mean by a venture capitalist is that these are very successful entrepreneurs. They built up their own personal wealth by starting different businesses. But so why venture capital is a good source of finance? Well, it's not just because of the money. It's because of the venture capitalists that will hopefully help you because venture capital is a popular source of finance for starter businesses that show high growth potential. Because now I'm not just getting money. I'm getting mentorship. I'm getting expert guidance. Potentially the venture capitalist who's working with me has started multiple marketing agencies. So, they should be able to give me very good advice on marketing. I also have access to their network. They may provide me with more opportunities, and the amount of finance that they're funding into the business. It doesn't need to be repaid because I'm given ownership. But remember, with venture capital, it's an equity source of finance. We're giving ownership away. So if we're giving ownership away, they start to have a level of control in my business. They get to influence me on my decision-making. They may slow down the decision-making. And realistically, venture capitalists, they want to see a return on investment. So they may be pushing the business to be making lots and lots of profit.

The next topic that we're going to take a look at in this revision video will be the different methods of how we go about improving our cash flow. Because as we said earlier, cash is king. It's essential for a business's survival. So what are some different ways? Well, realistically, you either want to boost your cash inflows or look at reducing your cash outflows. So a key way to increase your cash inflows, start making more revenue, start investing in promotional activities. Of course, you want to evaluate that because if you promote more, then surely your cash outflows increase. So how else can we increase revenue? Well, we can increase our selling price. Well, that depends on the price elasticity of demand because if you're price elastic, you actually may see less revenue. But of course, if your price inelastic then you may see more revenue, so more cash flowing into the business. We could also look for different sources of finance. This just depends on the type of business and the issue that is present because if we have a short-term cash flow problem then we want to use a short-term source of finance. If we've got a long-term cash flow problem then we need to look for more of the long-term cash flow finances such as loans, such as share capital. We also want to look at managing our receivables and our payables. Now, we'll take a look at this in a bit more detail in unit 7 with our receivable days and our payable days. Essentially, you want to be receiving money quicker than money's going out of the business. So, you want to try and reduce your receivables as much as possible and increase your payables as much as possible. But of course, the evaluation: if you are offering your customers less credit, then they may be a little bit less satisfied. And if you try to push for a longer credit period with your suppliers, then they may be less satisfied and they may become less reliable. You can also look at inventory management. So looking at different ways to minimize waste, such as just in time, reduce the amount of inventory space. So we can look at downsizing potentially. And finally, just reducing any unnecessary expenses. So maybe we may find that we've got a lot of waste within our workforce. So we could also look at redundancies. Now, of course, that comes with problems such as motivational issues and potentially being seen as unethical.

And the very last thing that we need to do now in this revision session is to look at the different ways that a business can use to improve their profits and their profitabilities. First of all, we can look at increasing our prices. Now, increasing prices, it can lead to more revenue, and that could of course increase our profits. But the problem is if we are price elastic, then that typically leads to a lower amount of revenue. So increasing your prices can lead to an increase in profits, but it tends to lead to an increase in your profitability because your profit margins get higher. We could also look at improving our labor productivity. So focusing on more motivational methods, look at training our staff for them to develop new skills. Now once again, profitability could increase, but profits could go down because if I'm looking at staff training, well the issue I've got there is that my costs begin to rise. We could also look at going from a labor-intensive approach to a capital-intensive approach. So introducing more automation and technology because we know that has more benefits with our efficiency levels. But that could actually worsen our profits because if we're introducing more technology, well that might have an upfront investment into it. And of course, that could increase our costs. Another key method as well is looking at reducing costs by finding cheaper suppliers. Well, the problem is we may find cheaper supplies, cheaper raw materials, but the quality of our products may go down. So, we may have to charge lower prices otherwise customers may not be as loyal to us. We're going to look at reducing waste. So, implementing methods such as Kaizen, just in time. And the very last way is improving our capacity utilization. So, maybe going from 50% to 85%. So, our fixed costs are spread over more units, improving the business's efficiency. And that is a great way to improve our profitability.

If you found this video useful and want to continue your revision for your A-level business exams, I highly recommend you check out our video here on unit 6 HR because we're going to go through some of the key concepts that you need to know for your exam, such as the difference between soft and hard HRM. We'll look at different HR data such as labor productivity, labor turnover. We'll also go through the different theories of motivation, the different financial and non-financial methods of motivation, and much more. I really do hope these videos have been helping you guys out for your revision.