current liabilities, e.g. trade payables, overdraft

5.1 Why Businesses Need Finance

• Start‑up finance (short‑term & long‑term) – purchase of land, plant, equipment and initial working‑capital before the business generates cash.
• Growth & expansion finance (long‑term) – funding for new premises, additional machinery, research & development, market entry.
• Working‑capital finance (short‑term) – cash needed for day‑to‑day operations such as stock, wages, utilities and debt repayments.
• Contingency finance (short‑term) – reserves for unexpected events (equipment breakdown, sudden drop in sales, emergency repairs).

5.1 Sources of Finance

Source	Type	Typical Use	Key Advantage	Key Disadvantage
Retained earnings / profit reinvested	Internal – short‑term & long‑term	Working capital, equipment upgrades	No interest, no dilution of control	Limited to profit generated
Owner’s capital (share capital)	Internal – long‑term	Start‑up, major asset purchase	Simple to obtain, no repayment	Owner bears all risk; may limit growth
Bank overdraft	External – short‑term	Temporary cash shortages	Flexible; interest only on amount used	Payable on demand; relatively high interest
Bank loan / debenture	External – long‑term	Purchase of plant, buildings, vehicles	Fixed repayments aid budgeting	Requires security; interest payable
Trade credit (payables)	External – short‑term	Purchase of stock or services	No cash outflow until due date; may obtain discounts for early payment	May affect supplier relationships; interest‑free period limited
Leasing / hire‑purchase	External – long‑term (leasing) / short‑term (hire‑purchase)	Use of equipment without immediate ownership	Spreads cost; preserves cash	Overall cost higher than outright purchase
Factoring	External – short‑term	Conversion of trade receivables into cash	Immediate cash; reduces credit risk	Fees reduce profit margin

5.2 Cash‑Flow Forecasting & Working Capital

Simple 12‑Month Cash‑Flow Forecast (illustrative)

Month	Cash Inflows (£)	Cash Outflows (£)	Net Cash Flow (£)	Cumulative Cash (£)
Jan	12,000	10,000	2,000	2,000
Feb	13,000	11,500	1,500	3,500
Mar	14,000	12,000	2,000	5,500
Apr	13,500	13,200	300	5,800
May	15,000	14,000	1,000	6,800
Jun	16,000	15,500	500	7,300
…	…	…	…	…

A positive cumulative cash balance indicates the business can meet its short‑term obligations; a negative balance signals a liquidity problem that may require overdraft or short‑term borrowing.

Working Capital

Working capital measures the short‑term financial health of a business:

\[ \text{Working Capital} = \text{Current Assets} - \text{Current Liabilities} \]

It represents the amount of resources available to fund day‑to‑day operations.

Cash‑Conversion Cycle (optional for A‑Level)

\[ \text{CCC} = \text{Days Stock Held} + \text{Days Debtors Outstanding} - \text{Days Creditors Outstanding} \]

Shortening the CCC improves cash flow and reduces the need for external short‑term finance.

5.3 The Income Statement (Profit & Loss Account)

The income statement records performance over a period (usually one year). The profit (or loss) for the year is transferred to retained earnings in the Statement of Financial Position.

Item	Explanation
Revenue (Sales)	Income from the core business activity.
Cost of Sales (COGS)	Cost of goods sold or services delivered.
Gross Profit	Revenue – Cost of Sales.
Operating Expenses	Wages, rent, depreciation, utilities, advertising, etc.
Operating Profit	Gross Profit – Operating Expenses.
Finance Costs	Interest on loans, overdraft charges, factoring fees.
Profit Before Tax (PBT)	Operating Profit – Finance Costs.
Tax Expense	Corporation tax (and any other taxes payable on profit).
Net Profit	PBT – Tax Expense; transferred to retained earnings.

5.4 Statement of Financial Position (Balance Sheet)

Classification of Items

Class	Definition	Typical Examples (IGCSE/A‑Level)
Non‑current assets	Resources expected to provide economic benefit for more than one year.	Plant & equipment, motor vehicles, patents, goodwill.
Current assets	Resources expected to be realised or used within 12 months.	Cash & bank, stock, trade receivables, prepaid expenses.
Non‑current liabilities	Obligations repayable after more than one year.	Long‑term loan, debentures, lease liabilities.
Current liabilities	Obligations that must be settled within 12 months.	Trade payables, bank overdraft, accrued expenses, tax payable, current portion of long‑term borrowings, dividends payable.
Owners’ equity	Residual interest of the owners after all liabilities are deducted.	Share capital, retained earnings (cumulative net profit).

Extract – Example Statement of Financial Position (1 Jan 2025)

£	Non‑current assets	Current assets	Current liabilities	Non‑current liabilities	Owners’ equity
1 Jan 2025	150,000 – Plant & equipment	80,000 – Cash & bank	30,000 – Trade payables	40,000 – Long‑term loan	160,000 – Share capital + retained earnings
	20,000 – Goodwill	25,000 – Stock	10,000 – Bank overdraft
		15,000 – Trade receivables	5,000 – Accrued wages
		5,000 – Prepaid insurance	2,000 – Tax payable

Current Liabilities – In Detail

• Trade payables – Amounts owed to suppliers for goods or services bought on credit; usually payable within 30–90 days.
• Bank overdraft – Facility allowing withdrawals beyond the cash balance up to an agreed limit; interest charged only on the overdrawn amount.
• Accrued expenses – Costs incurred but not yet paid (e.g., wages, interest, utilities).
• Tax payable – VAT, corporation tax, PAYE etc. due within the next 12 months.
• Current portion of long‑term borrowings – Part of a loan or debenture that must be repaid within the next year.
• Dividends payable – Declared dividends that have not yet been paid to shareholders.

Management of Trade Payables

Effective credit management balances cash flow benefits against supplier relationships.

• Payables turnover ratio: \(\displaystyle \frac{\text{Purchases on credit}}{\text{Average trade payables}}\)
• Cash discount – Suppliers may offer a % discount for early payment (e.g., 2 % discount if paid within 10 days, “2/10, net 30”).
• Negotiating longer credit periods improves liquidity but may reduce the discount earned.

Management of Bank Overdrafts

• Interest is calculated daily on the overdrawn balance; rates are usually higher than for standard loans.
• Facilities are reviewed annually; limits can be increased or reduced based on the company’s credit rating.
• Because repayment is on demand, overdrafts are always classified as a current liability.

5.5 Analysis of Accounts – Profitability & Liquidity Ratios

Key Ratio Formulae

Ratio	Formula	Interpretation (higher is …)
Current Ratio	\(\displaystyle \frac{\text{Current Assets}}{\text{Current Liabilities}}\)	More liquid – ability to meet short‑term debts.
Acid‑Test (Quick) Ratio	\(\displaystyle \frac{\text{Cash} + \text{Trade receivables}}{\text{Current Liabilities}}\)	More stringent test of liquidity (excludes stock).
Gross Profit Margin	\(\displaystyle \frac{\text{Gross Profit}}{\text{Revenue}} \times 100\%\)	Higher = more efficient production or pricing.
Net Profit Margin	\(\displaystyle \frac{\text{Net Profit}}{\text{Revenue}} \times 100\%\)	Higher = better overall profitability.
Return on Capital Employed (ROCE)	\(\displaystyle \frac{\text{Operating Profit}}{\text{Capital Employed}} \times 100\%\) Capital Employed = Non‑current assets + Working capital	Higher = more efficient use of capital.
Payables Turnover Ratio	\(\displaystyle \frac{\text{Purchases on credit}}{\text{Average trade payables}}\)	Higher = payables settled quickly (good supplier relations).
Days Creditors Outstanding (DCO)	\(\displaystyle \frac{365}{\text{Payables Turnover Ratio}}\)	Higher = longer credit period, improves cash flow.

Worked Example Using the Sample Balance Sheet

Assumptions (income statement)

• Revenue = £120,000
• Cost of Sales = £70,000
• Operating expenses = £30,000
• Finance costs (interest on overdraft) = £2,000
• Tax expense = £4,000

Profit calculations

\[ \begin{aligned} \text{Gross Profit} &= 120,000 - 70,000 = 50,000\\ \text{Operating Profit} &= 50,000 - 30,000 = 20,000\\ \text{Profit Before Tax} &= 20,000 - 2,000 = 18,000\\ \text{Net Profit} &= 18,000 - 4,000 = 14,000 \end{aligned} \]

Ratio calculations

• Current Ratio = \(\dfrac{80,000 + 25,000 + 15,000 + 5,000}{30,000 + 10,000 + 5,000 + 2,000}\) = \(\dfrac{125,000}{47,000}\) ≈ **2.66**
• Acid‑Test Ratio = \(\dfrac{80,000 + 15,000 + 5,000}{47,000}\) = \(\dfrac{100,000}{47,000}\) ≈ **2.13**
• Gross Profit Margin = \(\dfrac{50,000}{120,000} \times 100\% = 41.7\%\)
• Net Profit Margin = \(\dfrac{14,000}{120,000} \times 100\% = 11.7\%\)
• ROCE = \(\dfrac{20,000}{150,000 + (125,000 - 47,000)} \times 100\% = \dfrac{20,000}{228,000} \times 100\% \approx 8.8\%\)
• Payables Turnover Ratio (assume credit purchases £60,000) = \(\dfrac{60,000}{30,000}\) = **2.0** times per year
• DCO = \(\dfrac{365}{2.0}\) ≈ **182 days**

Interpretation (AO3 / AO4)

• The **current ratio of 2.66** shows ample liquidity – the firm can cover its current liabilities more than twice over.
• The **acid‑test ratio of 2.13** remains comfortably above 1, indicating the business could meet obligations even if stock could not be sold quickly.
• A **gross profit margin of 41.7 %** suggests efficient production or strong pricing power, but the fall to an **11.7 % net profit margin** highlights the impact of operating and finance costs.
• The **payables turnover of 2.0** (≈182 days credit) improves cash flow but may be considered a long credit period by some suppliers, potentially affecting future terms.

5.6 External Influences on Financial Decisions

• Economic factors – Inflation raises input costs, increasing trade payables and squeezing profit margins.
• Tax legislation – Changes in corporation‑tax rates directly affect the tax‑payable line and retained earnings.
• Exchange‑rate movements – For importers, a weaker domestic currency raises the sterling value of foreign invoices, increasing current liabilities and reducing profit.
• Regulatory changes – New health‑and‑safety or environmental rules may create additional accrued liabilities and require capital investment.
• Ethical considerations – Choosing fair‑trade or sustainable suppliers can increase purchase costs, affecting cost of sales and the level of trade payables.
• Interest‑rate fluctuations – Affect the cost of borrowing (overdrafts, loans) and therefore finance costs on the income statement.

Understanding how these external forces impact both the income statement and the statement of financial position enables managers to make informed financing, investment, and risk‑management decisions.