What you'll learn
Finance is where every other business decision eventually shows up. A marketing campaign, a new machine or an extra member of staff all become numbers in the same set of accounts, and a business that misreads those numbers can be busy, popular and still fail. For AQA GCSE Business Studies you need to know where businesses get money from, how costs behave, how profit is calculated at two different stages, how much a business must sell before it stops losing money, and why cash and profit are not the same thing. This guide covers internal and external sources of finance, fixed and variable costs, revenue, gross and net profit, break-even and contribution, the margin of safety, cash-flow forecasting, profit margins and the average rate of return. By the end you should be able to calculate break-even output, both profit margins, a closing cash balance and an average rate of return, and explain why a profitable business can still run short of cash.
Key terms and definitions
Revenue — The total value of sales over a period, calculated as price × quantity sold, before any costs are deducted.
Fixed costs — Costs that do not change with the level of output in the short term, such as rent and insurance.
Variable costs — Costs that rise and fall directly with output, such as raw materials.
Total costs — Fixed costs plus variable costs.
Gross profit — Revenue minus the cost of sales.
Net profit — Gross profit minus other operating expenses.
Contribution — Selling price per unit minus variable cost per unit; what each sale puts towards covering fixed costs.
Break-even output — The level of output at which total revenue exactly equals total costs, so the business makes neither profit nor loss.
Margin of safety — Current output minus break-even output: how far sales could fall before a loss begins.
Cash flow — The movement of money into and out of a business over time.
Internal finance — Money raised from within the business, such as retained profit or the sale of assets.
External finance — Money raised from outside, such as a loan, an overdraft, share capital or trade credit.
Core concepts
Internal sources of finance
Retained profit is profit from previous years kept in the business rather than paid out to owners. It charges no interest and gives away no ownership, which is why many businesses treat it as the cheapest money available — though it can only be used once and is unavailable to a new business. Sale of assets raises cash from equipment the business no longer needs, but selling something still in daily use damages the ability to trade. Owner's capital is the owner's own savings put into the business.
External sources of finance
A bank loan provides a fixed sum repaid with interest over an agreed period, which suits buying a long-term asset because the cost is spread over the years the asset is used. An overdraft lets a business spend beyond its bank balance up to a limit; it is short-term, repayable on demand and usually carries a high interest rate, so it suits a temporary shortfall rather than a machine. Share capital is raised by selling shares: there is no repayment date and no interest, because shareholders buy part-ownership rather than lend, but the original owners give up a share of future profits and of control. Trade credit lets a business receive goods now and pay later, typically within 30 to 60 days, and costs nothing at all if payment is made on time. Venture capital, crowdfunding, leasing, hire purchase and government grants are further options.
Choosing a source of finance
Match the finance to the need. A six-week gap between paying a supplier and being paid by a customer is bridged most cheaply by trade credit, because it is interest-free within the agreed period, whereas an overdraft would accrue interest daily. A fifteen-year machine should be financed over years, not days. The questions to ask are how long the money is needed for, how much it costs, and what the business gives up — interest, ownership or flexibility.
Costs, revenue and profit
Every cost is either fixed or variable, and the labels describe how a cost behaves as output changes, not how large it is or who receives it. A salon paying £800 rent whether it serves 50 clients or 500 has a fixed cost — which is precisely why serving more clients lowers the rent carried by each one.
Profit is calculated in two stages, and the distinction carries marks. Revenue − cost of sales = gross profit, which shows the gap between what the business sells for and what the goods cost. Gross profit − other operating expenses = net profit, which takes off rent, salaries, insurance and marketing to show what the business actually earned.
Break-even and contribution
Contribution per unit is selling price minus variable cost per unit. Until fixed costs are fully covered, every pound of contribution is absorbed by them; only after break-even does further contribution become profit.
Break-even output = fixed costs ÷ contribution per unit.
Break-even output therefore rises whenever fixed costs grow or contribution shrinks. A price cut narrows contribution and so raises break-even output — it may still be the right decision if the extra volume is large enough, but it raises the bar rather than lowering it. The common error is dividing fixed costs by the selling price, which ignores the variable cost consumed by every sale.
Margin of safety
The margin of safety is current output minus break-even output. A business selling 2 600 units with a break-even of 2 000 has 600 units of room before it starts making a loss. It converts a vague sense of security into a number the owner can monitor each month.
Cash flow is not profit
A sale made on credit counts as revenue the moment it is made, even though no money has arrived. This is why a profitable business can be unable to pay its bills, and why a fast-growing business is at the greatest risk: stock, staff and premises are paid for now while customers pay later. Actions that improve cash flow without touching profit — such as negotiating a longer payment period with suppliers — change only the timing of payments, and are far better than cutting prices or selling a van still in use.
Cash-flow forecasts
A forecast records money as it actually moves, month by month. Net cash flow = inflows − outflows, and closing balance = opening balance + net cash flow, with each month's closing balance becoming the next month's opening balance. A loan appears as an inflow in the month it arrives and as an outflow in every month it is repaid; showing only the inflow makes later months look healthier than they are.
Measuring financial performance
Gross profit margin = gross profit ÷ revenue × 100. Net profit margin = net profit ÷ revenue × 100. Both are measured against revenue, never against each other, so that businesses of different sizes can be compared. A firm with a 50% gross margin but a 5% net margin buys or makes cheaply yet carries very heavy running costs — the comparison between the two margins is where the diagnosis lies.
Average rate of return
ARR = average annual profit ÷ initial investment × 100, where average annual profit is total profit divided by the number of years. Using total profit instead of the annual average would make every long project look better than a short one regardless of how quickly the money came back.
Worked examples
Example 1: Break-even and margin of safety
A firm has fixed costs of £12 000 a month, sells each unit for £15 and has a variable cost of £9 per unit. Contribution is £15 − £9 = £6, so break-even output is £12 000 ÷ £6 = 2 000 units. If the landlord raises the rent so that fixed costs become £15 000, break-even moves to £15 000 ÷ £6 = 2 500 units, a rise of 500. Selling 2 600 units at the original rent gives a margin of safety of 2 600 − 2 000 = 600 units.
Example 2: Gross and net profit margins
A retailer reports revenue of £400 000, gross profit of £160 000 and other operating expenses of £100 000. Gross profit margin is £160 000 ÷ £400 000 × 100 = 40%. Net profit is £160 000 − £100 000 = £60 000, so net profit margin is £60 000 ÷ £400 000 × 100 = 15%. Note that net profit as a percentage of gross profit would give 37.5% and is not a recognised ratio.
Example 3: A closing cash balance
A business opens June with £4 000 in the bank and expects inflows of £18 000 and outflows of £21 500. Net cash flow is £18 000 − £21 500 = a deficit of £3 500, so the closing balance is £4 000 − £3 500 = £500. The business has a negative month yet still ends in credit, which is exactly why net cash flow and closing balance must not be confused.
Example 4: Average rate of return
A bakery considers a £40 000 oven expected to generate £60 000 of total profit over five years. Average annual profit is £60 000 ÷ 5 = £12 000, so ARR is £12 000 ÷ £40 000 × 100 = 30%. The bakery would compare that with the return on alternative uses of the same £40 000 before deciding.
Common mistakes and how to avoid them
The most frequent error is dividing fixed costs by the selling price when calculating break-even. Use contribution — selling price minus variable cost per unit.
Students regularly confuse gross and net profit. Gross profit deducts only the cost of sales; net profit also deducts operating expenses. Name which one you are calculating.
Margins must be measured against revenue. Dividing gross profit by the cost of sales, or net profit by gross profit, produces a number that looks plausible and means nothing.
Do not treat net cash flow as the closing balance. Add net cash flow to the opening balance, as in Example 3.
Remember that profit and cash are different. "The business is profitable so it can pay its bills" is wrong, and recognising why earns marks on cash-flow questions.
With ARR, divide total profit by the number of years before comparing it with the investment.
Exam technique for "Finance"
Always write the formula before substituting numbers, and show each step — method marks survive an arithmetic slip, but an unexplained wrong answer earns nothing. Include units and the pound sign, and state clearly whether a figure is a percentage, a number of units or a sum of money.
When a question asks you to recommend a source of finance, say how long the money is needed for, name the source, and give the trade-off it carries — interest, lost ownership or repayment on demand. Apply it to the business in the question rather than listing every source you know.
For "analyse" and "evaluate" questions on break-even or cash flow, explain what the number means for the business, not just what it is: how much room it has, how soon trouble arrives, what it could change. Then reach a judgement supported by the figures you calculated.
Quick revision summary
- Revenue = price × quantity. Total costs = fixed + variable.
- Gross profit = revenue − cost of sales. Net profit = gross profit − operating expenses.
- Contribution = selling price − variable cost per unit.
- Break-even output = fixed costs ÷ contribution per unit; margin of safety = current output − break-even output.
- A price cut raises break-even output, because it narrows contribution.
- Net cash flow = inflows − outflows; closing balance = opening balance + net cash flow.
- Profit is not cash: credit sales count as revenue before the money arrives.
- Gross and net profit margins are both measured against revenue.
- ARR = average annual profit ÷ initial investment × 100.
- Internal finance: retained profit, sale of assets, owner's capital. External: loan, overdraft, share capital, trade credit.