2.3.3 - Managing finance

Profit is the surplus left after relevant costs are deducted from revenue. A statement of comprehensive income separates three stages so the source of a change in profit can be identified.

If revenue is £420,000, cost of sales is £250,000, other operating expenses are £95,000 and interest is £8,000, gross profit is £170,000, operating profit is £75,000 and profit for the year is £67,000. Keep every figure in the same period and currency.

Because profit equals revenue minus costs, a business can seek higher revenue, lower costs, or both. Trace each proposal through demand, quality and relevant cost.

Build the chain in context: a restaurant might raise its fixed-price menu, increasing revenue per diner; but if demand is price elastic, the fall in diners could reduce total revenue. Restricting portions may lower food cost but damage the offer that attracts customers.

Compare the likely size and durability of each effect. A short-term cost cut can lower future revenue, while investment can reduce current profit before improving profitability.

A profit margin expresses a profit stage as a percentage of sales revenue. This relates profit to business scale, allowing comparisons across years or businesses when accounting bases and contexts are reasonably comparable.

Using revenue of £420,000, gross profit of £170,000, operating profit of £75,000 and profit for the year of £67,000 gives 40.48%, 17.86% and 15.95% respectively. Show the formula, substitute the correct profit stage and include the percentage sign.

Profit records revenue earned minus costs incurred for a period; cash records the timing of money entering and leaving. Credit periods and financing therefore make the two figures diverge.

Suppose a service worth £12,000 is completed on 28 June with 60-day credit. June can report the revenue and related profit, but the cash may arrive in August. Wages and rent due in July still require cash, creating a survival risk despite reported profit.

Debtor periods delay receipts; creditor periods delay supplier payments. Managers must coordinate both because employees, lenders and suppliers are paid with cash, not accounting profit.

Liquidity is the ability to meet short-term liabilities as they fall due. A statement of financial position supplies current assets, inventory and current liabilities for two related ratios.

If current assets are £180,000, inventory is £60,000 and current liabilities are £100,000, the current ratio is 1.8:1, the acid test ratio is 1.2:1 and working capital is £80,000. The acid test removes inventory because it may take time to sell and convert into cash.

Working capital is current assets minus current liabilities. It supports commitments while cash moves from purchasing inputs to collecting customer payments.

Rapid growth can create overtrading: orders and reported profit rise, but inventory, wages and receivables must be funded before customers pay. A service business with prompt customer payment may need less working capital than a manufacturer with long production and credit periods.

Manage the whole cycle. Factoring accelerates receivables but costs a fee; longer supplier terms delay outflow but may weaken relationships; JIT releases inventory cash but depends on reliable supply.

Internal causes arise within the business and are open to management action. They often reinforce one another, so explain causal chains rather than listing labels.

One weakness can amplify another: overestimated sales may create excess inventory; tied-up cash then makes supplier payment harder; supply disruption lowers quality or availability and reduces future revenue.

Importance depends on context. Quality may be critical to a marketplace with many sellers, while cash timing may dominate a fast-growing firm offering long credit. Controls reduce risk but cannot remove external shocks.

External causes originate outside the business's direct control. Failure usually occurs through their effects on demand, revenue, cost, cash or access to essential resources—not from the label alone.

Managers can diversify suppliers or markets, hold suitable liquidity reserves, insure selected risks, reduce debt exposure, monitor regulation and prepare continuity plans. These actions change vulnerability and recovery speed without controlling the original event.

Compare the shock's scale and duration with the business's exposure and response. Strong competitors are external, but failure to update a product or marketing offer is internal. The most defensible judgement often considers how both categories interacted.