Business finance

Business AS · Finance and accounting. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

Every business needs finance: to start up (premises, equipment, first inventory), to grow, and to survive when cash is short. Short-term needs, up to about one year, cover day-to-day spending. Long-term needs cover assets used for many years.

Cash and profit are different. Profit is revenue minus costs, counted when the sale is made. Cash is the money that has actually come in and gone out. A profitable firm that sells on credit can still run out of cash and fail.

Working capital is the finance for daily operations. Too little and bills cannot be paid; too much and money sits idle. Firms manage it by collecting from trade receivables quickly and using the credit that trade payables allow.

Rules to remember

Working capital = current assets − current liabilities.
Current assets = inventory + trade receivables + cash. Current liabilities = trade payables + overdraft and other debts due within one year.
Capital expenditure = spending on non-current assets that last more than one year (e.g. machinery, buildings). Revenue expenditure = day-to-day spending (e.g. wages, rent, materials, repairs).
Profit = revenue − costs. Net cash flow = cash inflows − cash outflows.
Bankruptcy: a legal process for an individual (such as a sole trader) who cannot pay debts.
Liquidation: the company stops trading and its assets are sold to pay creditors.
Administration: an appointed administrator runs an insolvent company and tries to rescue it or get a better result for creditors.

Common mistake

Students treat a credit sale as cash received. It counts as revenue, and so as profit, at once, but the cash arrives only when the customer pays.

Worked example

A firm has inventory $18,000, trade receivables $12,000, cash $5,000, trade payables $14,000 and an overdraft of $6,000. It then uses $4,000 of cash to pay suppliers. What is its working capital before and after?

Current assets = 18,000 + 12,000 + 5,000 = $35,000. Current liabilities = 14,000 + 6,000 = $20,000.
Working capital before = 35,000 − 20,000 = $15,000.
After the payment: current assets = 35,000 − 4,000 = $31,000; current liabilities = 20,000 − 4,000 = $16,000.
Working capital after = 31,000 − 16,000 = $15,000.

Answer: $15,000 both before and after: paying a supplier in cash lowers assets and liabilities by the same amount.

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