Welcome to Profit and Cash: Mastering Unit 2 Finance
Welcome! In this chapter, we explore one of the most critical areas in business finance: Profit and Cash. Many people think that profit and cash are the exact same thing, but in business, confusing them can lead to disaster! A firm can report massive profits and still collapse because it has run out of physical cash to pay its bills.
In this chapter, aligned directly with the OxfordAQA International AS Business (9725) syllabus, you will master:
• Profit: Calculating gross, operating, and net profit, along with their profit margins.
• Budgeting: Setting financial targets, understanding why budgets are amended, and conducting variance analysis.
• Cash Flow Forecasts: Predicting cash inflows, outflows, and balances over time, and understanding the vital distinction between cash and profit.
Note: For external funding methods, see the chapter on "Sources of finance". For calculating output targets to cover all costs, refer to "Break-even analysis".
1. Understanding and Calculating Profit
Don't worry if financial accounts seem daunting at first. Think of profit like a staircase: you start at the very top with all the money your customers hand over, and as you walk down, you pay off different types of business expenses until you reach what is left at the bottom.
Key Financial Terminology
In OxfordAQA Business, we use standard UK financial reporting terms:
• Revenue (Turnover): The total value of sales made during a trading period.
• Cost of sales: The direct costs directly involved in producing goods or services (e.g., raw materials, direct factory labour).
• Operating expenses: The day-to-day indirect overheads required to run the enterprise (e.g., office rent, marketing, administrative salaries).
• Interest and taxes: Finance costs paid on borrowed money and taxes owed to the government.
The Three Levels of Profit
Here are the official syllabus formulas for each level of profit:
1. Gross Profit:
\(\text{Gross profit} = \text{Revenue} - \text{Cost of sales}\)
2. Operating Profit:
\(\text{Operating profit} = \text{Gross profit} - \text{Operating expenses}\)
3. Net Profit:
\(\text{Net profit} = \text{Operating profit} - \text{Interest} - \text{Taxes}\)
Profit Margins
A business might make \$50,000 in profit, but is that actually good? If sales were \$100,000, that is fantastic. But if sales were \$10,000,000, that profit is tiny! Profit margins convert profits into percentages of revenue, allowing comparison over time or between businesses of different sizes.
• Gross profit margin (%):
\(\text{Gross profit margin (\%)} = \left(\frac{\text{Gross profit}}{\text{Revenue}}\right) \times 100\)
• Operating profit margin (%):
\(\text{Operating profit margin (\%)} = \left(\frac{\text{Operating profit}}{\text{Revenue}}\right) \times 100\)
• Net profit margin (%):
\(\text{Net profit margin (\%)} = \left(\frac{\text{Net profit}}{\text{Revenue}}\right) \times 100\)
Worked Example: Step-by-Step
Imagine a manufacturing company with the following annual results:
• Revenue: \$200,000
• Cost of sales: \$80,000
• Operating expenses: \$50,000
• Interest: \$6,000
• Taxes: \$14,000
Step 1: Calculate Gross Profit and Gross Profit Margin
\(\text{Gross profit} = \$200,000 - \$80,000 = \$120,000\)
\(\text{Gross profit margin} = \left(\frac{\$120,000}{\$200,000}\right) \times 100 = 60\%\)
Step 2: Calculate Operating Profit and Operating Profit Margin
\(\text{Operating profit} = \$120,000 - \$50,000 = \$70,000\)
\(\text{Operating profit margin} = \left(\frac{\$70,000}{\$200,000}\right) \times 100 = 35\%\)
Step 3: Calculate Net Profit and Net Profit Margin
\(\text{Net profit} = \$70,000 - \$6,000 - \$14,000 = \$50,000\)
\(\text{Net profit margin} = \left(\frac{\$50,000}{\$200,000}\right) \times 100 = 25\%\)
Key Takeaway for Section 1: Profit is the surplus remaining after costs are deducted from revenue. Gross profit only deducts direct production costs, operating profit removes overheads, and net profit removes all remaining financial costs (interest and taxes).
2. Budgeting and Variance Analysis
A budget is an agreed financial plan setting out future targets for revenue, expenditure, or profit over a given period.
Why Businesses Use Budgets
• Control and monitoring: They prevent managers from overspending.
• Coordination: They ensure production, marketing, and human resource departments work toward common operational targets.
• Delegation and motivation: Giving department managers control over their own budgets can empower and motivate them.
• Planning: They force managers to anticipate future challenges and allocate limited resources effectively.
Amending Budgets
Budgets are drawn up based on estimates of the future. However, reality often changes! If raw material costs suddenly spike, or if a global competitor enters the market, original budgets become unrealistic. Businesses must amend budgets when internal or external circumstances change substantially so that managers are not held to impossible or demotivating targets.
Variance Analysis
At the end of a budgeting period, managers compare what actually happened with what was planned. This process is called variance analysis.
The syllabus formula is:
\(\text{Variance} = \text{Actual figure} - \text{Budgeted figures}\)
Variances fall into two categories:
• Favourable variance (F): The difference is financially beneficial for the business. This occurs when actual revenue is higher than budgeted OR when actual costs are lower than budgeted.
• Adverse variance (A): The difference is bad for the business. This occurs when actual revenue is lower than budgeted OR when actual costs are higher than budgeted.
Variance Calculation Example
Let us look at three items for a department:
1. Sales Revenue: Budgeted = \$50,000; Actual = \$54,000.
\(\text{Variance} = \$54,000 - \$50,000 = +\$4,000\)
Since revenue is higher than planned, this is a \$4,000 Favourable (F) variance.
2. Direct Material Costs: Budgeted = \$20,000; Actual = \$23,000.
\(\text{Variance} = \$23,000 - \$20,000 = +\$3,000\)
Even though the math produces a positive number, costs were higher than planned! This hurts profits, so it is a \$3,000 Adverse (A) variance.
3. Administrative Costs: Budgeted = \$10,000; Actual = \$8,500.
\(\text{Variance} = \$8,500 - \$10,000 = -\$1,500\)
Costs were lower than expected, which improves profits! This is a \$1,500 Favourable (F) variance.
Top Exam Tip: Do not just rely on plus and minus signs. Always label your final answer with (F) for Favourable or (A) for Adverse, and explain the business impact!
Key Takeaway for Section 2: Budgets establish targets; variances show whether the business performed better (favourable) or worse (adverse) than expected against those targets.
3. Cash Flow Forecasts
A cash flow forecast is a forward-looking financial statement that estimates the cash expected to flow into and out of a business over a future period of time (usually month by month).
Core Components of a Cash Flow Forecast
• Cash Inflows: Money coming into the business bank account (e.g., cash sales, payments from trade receivables, bank loans).
• Cash Outflows: Money leaving the business bank account (e.g., buying inventory, paying wages, rent, paying trade payables).
• Net Cash Flow: The difference between total cash inflows and total cash outflows in a single period.
\(\text{Net cash flow} = \text{Total cash inflows} - \text{Total cash outflows}\)
• Opening Balance: The amount of physical cash the business holds at the very start of the period.
\(\text{Opening balance} = \text{Closing balance from previous period}\)
• Closing Balance: The amount of physical cash held at the end of the period, which is carried forward to become the next month's opening balance.
\(\text{Closing balance} = \text{Opening balance} + \text{Net cash flow}\)
Worked Example: Completing a Cash Flow Table
Below is a forecast for two consecutive months. Let us fill in the missing items step by step.
Month 1:
• Total Inflows: \$15,000
• Total Outflows: \$12,000
• \(\text{Net cash flow} = \$15,000 - \$12,000 = \$3,000\)
• Opening Balance: \$2,000
• \(\text{Closing balance} = \$2,000 + \$3,000 = \$5,000\)
Month 2:
• Opening Balance: This must be the closing balance of Month 1, so it is \$5,000.
• Total Inflows: \$10,000
• Total Outflows: \$14,000
• \(\text{Net cash flow} = \$10,000 - \$14,000 = -\$4,000\)
• \(\text{Closing balance} = \$5,000 + (-\$4,000) = \$1,000\)
Notice how easy this becomes once you follow the two core rules: closing balance links to next month's opening balance, and net cash flow simply adjusts the opening balance.
4. The Crucial Difference: Profit versus Cash
One of the most heavily tested themes in AS Business Finance is understanding why a profitable firm can still fail due to a lack of cash (insolvency).
Why Profit Does Not Equal Cash
• Credit transactions: If a business sells \$100,000 worth of goods on trade credit terms (e.g., pay in 60 days), that \$100,000 is recorded as revenue and counted toward profit immediately. However, the business receives zero cash today.
• Purchases of Non-Current Assets: Buying a new delivery van for \$30,000 in cash causes an immediate \$30,000 cash outflow. However, it does not reduce profit by \$30,000 immediately in that period.
• Holding Inventory: Using cash to purchase large stocks of inventory reduces bank balances immediately, but inventory does not become an expense on the income statement until it is actually sold.
Summary Comparison
• Profit is an accounting measure of revenue minus costs over a period of time.
• Cash is the physical money currently held in the bank account or register available to settle debts immediately.
• "Profit is a promise, but cash is a fact." Suppliers, landlords, and workers will not accept promises of future profit; they demand physical cash!
Key Takeaway for Sections 3 & 4: Cash flow forecasts map the timing of money moving in and out of the bank. Businesses can survive periods without profit, but they cannot survive a single day if they run out of cash to meet pressing liabilities.
5. Chapter Quick Review
Before moving on, verify you can answer these check questions:
1. What is the formula for Operating profit margin (%)?
Answer: \(\left(\frac{\text{Operating profit}}{\text{Revenue}}\right) \times 100\)
2. If actual costs turn out to be lower than budgeted costs, is the variance favourable or adverse?
Answer: Favourable (F), because spending less than planned increases profitability.
3. How is the Closing balance calculated in a cash flow forecast?
Answer: \(\text{Closing balance} = \text{Opening balance} + \text{Net cash flow}\)
4. Can a business be highly profitable yet run out of cash?
Answer: Yes. For example, if it makes large sales on credit, the revenue is recorded as profit, but cash will not arrive until the credit period expires.