the impact of business growth on ratio results

Finance and Accounting Strategy – Business Growth & Ratio Analysis (Cambridge 9609)

1. Why Businesses Need Finance

• Start‑up & expansion – finance is required to buy land, plant & equipment, develop new products, enter new markets or increase production capacity.
• Working‑capital needs (short‑term) – cash to bridge the gap between cash outflows (payables, wages, overheads) and cash inflows (sales receipts).
• Long‑term investment – funding for assets that will generate returns over several years (e.g., a new factory, research & development).
• Cash‑flow vs. profit – a profit‑making business can still run out of cash if receipts are delayed or outflows are front‑loaded.

  Profit (income‑statement) ≠ Cash (cash‑flow statement)
  
  +-------------------+-------------------+
  |   Income          |   Cash            |
  +-------------------+-------------------+
  | Sales on credit   | Cash received     |
  | Depreciation      | No cash outflow   |
  | Accrued expenses  | Cash paid later   |
  | ...               | ...               |
  +-------------------+-------------------+
  

• Business failure – insufficient finance (especially working‑capital) is a common cause of failure; even profitable firms may collapse if they cannot meet short‑term obligations.
• Capital vs. revenue expenditure
  • Capital expenditure (CapEx) – purchase of long‑term assets; recorded on the balance sheet and depreciated over useful life.
  • Revenue expenditure (RevEx) – day‑to‑day operating costs; charged to the profit & loss account in the period incurred.

2. Sources of Finance

3. Forecasting & Managing Cash Flows

A cash‑flow forecast shows the expected movement of cash over a chosen period (usually monthly). It highlights potential deficits and informs financing decisions.

Ways to improve cash flow

• Accelerate receivables – offer early‑payment discounts or use factoring.
• Delay payables – negotiate longer credit terms with suppliers.
• Maintain optimal inventory – adopt just‑in‑time (JIT) or reorder‑point systems.
• Control discretionary spending – regular review of overheads and non‑essential costs.

4. Costs, Costing Methods & Break‑Even Analysis

• Cost classifications
  • Fixed vs. variable
  • Direct (e.g., raw material) vs. indirect (e.g., factory overhead)
  • Product (attached to a specific product) vs. period costs (charged to the period)
• Costing methods
  • Full (absorption) costing – all production costs (fixed + variable) allocated to each unit.
  • Contribution (marginal) costing – only variable costs allocated to units; fixed costs treated as period expenses.
• Break‑Even Point (BEP)

  Using contribution costing:

  $$\text{BEP (units)} = \frac{\text{Fixed Costs}}{\text{Selling Price per unit} - \text{Variable Cost per unit}}$$

  Graphically, the BEP is where the total revenue line meets the total cost line.

  Limitations: assumes constant selling price, constant variable cost per unit and that all output produced is sold.

5. Budgets & Variance Analysis

• Types of budgets
  • Incremental – based on the previous period plus a set increase.
  • Flexible – adjusts for the actual level of activity (e.g., sales volume).
  • Zero‑based – every expense must be justified from scratch.
• Example: Sales Budget vs. Actual

Variance analysis pinpoints where performance diverged from the plan and helps managers take corrective action.

6. Core Financial Statements (Cambridge Requirement)

• Profit & Loss Account (Income Statement) – summarises revenue, cost of sales, gross profit, operating expenses, operating profit, interest, tax and net profit for a period.
• Balance Sheet – a snapshot of assets, liabilities and equity at a specific date.
  • Current assets (cash, receivables, inventory)
  • Non‑current assets (property, plant, equipment – shown net of depreciation)
  • Current liabilities (payables, short‑term loans)
  • Non‑current liabilities (long‑term loans, debentures)
  • Equity (share capital, retained earnings)
• Inventory valuation – lower of cost or net realisable value; methods include FIFO, LIFO and weighted‑average.
• Depreciation – systematic allocation of the cost of a non‑current asset over its useful life. Common methods: straight‑line, reducing balance, units of production.

7. Core Ratio Analysis – Formulas & Interpretation

8. How Business Growth Affects Ratio Results

1. Scale of operations – Higher sales spread fixed costs, usually improving GPM and NPM (economies of scale).
2. Asset‑base expansion – New plant, equipment or acquisitions increase total assets. If operating profit does not rise proportionally, ROCE may fall.
3. Working‑capital requirements – Faster sales often raise trade receivables and inventory, putting downward pressure on the Current Ratio and Quick Ratio unless funded by additional current liabilities or cash.
4. Financing mix – Debt‑financed growth raises the D/E ratio, increases interest expense and can compress NPM and ROE.
5. Economies vs. diseconomies of scale – Realised economies boost margins; managerial or coordination diseconomies can erode them, leading to lower profitability ratios.

9. Illustrative Example – Impact of Growth on Ratios

Company Alpha expands production capacity. Figures are shown in £ thousands.

10. Quick Checklist for Exam Answers (Cambridge 9609)

• Define the purpose of finance and distinguish short‑term vs. long‑term needs.
• State that profit ≠ cash and illustrate with a simple diagram.
• List at least three internal and three external sources of finance, noting cost, control and choice factors.
• Show a basic cash‑flow forecast and name two ways to improve cash flow.
• Explain the difference between full (absorption) and contribution (marginal) costing.
• Write the BEP formula and comment on its limitations.
• Identify the three main types of budget and the purpose of variance analysis.
• Recall the key components of the profit & loss account and balance sheet.
• Provide formulas for the eight core ratios and briefly interpret each.
• Explain how growth can affect at least three ratios, using examples of economies of scale, asset expansion and financing mix.