Managing Finance
Unit 2: Managing Business Activities
Managing Finance
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A business does not have one profit figure. It has three, and each one is what is left after a different set of costs has been taken off.
Sub-topic 1 of 2.3.3 opens by asking for the calculation of three things: gross profit, operating profit and profit for the year (net profit). They are not three ways of saying the same thing. They are three points on one ladder, and each step down takes off a different kind of cost.
Appendix 9 prints the ladder: Gross profit = revenue − cost of sales; Operating profit = gross profit − other operating expenses; Profit for the year = operating profit − interest. Nothing else comes off. There is no tax line in the specification's own statement.
At Lantana Tiles, a wholesaler that imports floor tiles and sells them to builders on thirty days' credit, a year of trading produces $700,000, then $200,000, then $160,000. Three numbers, one business, one year — and a question that says "profit" without saying which is a question that cannot be answered.
Why three? Each one answers a different question. Gross profit asks whether the goods are bought and sold well; operating profit asks whether the whole trading operation works; profit for the year asks what is left for the owners once the lenders have been paid.
Real Example: Two tile wholesalers can report the same $160,000 while one buys far better and the other borrows far less. The ladder is what tells them apart.
Exam Matters: Appendix 6 defines Calculate as requiring students to perform a calculation based on given data, with workings given. Setting the three lines out in the specification's order is the workings, and it shows which of the three the question asked for.
Gross profit is revenue less the cost of the goods themselves. It measures buying and pricing, and nothing else.
Gross profit = revenue − cost of sales. Cost of sales is what the goods that were actually sold cost the business to obtain. Everything else a business spends belongs on the line below, however necessary it is.
Lantana Tiles sold $2,000,000 of tiles that had cost $1,300,000 to buy in. Gross profit is $700,000. That is the money available to pay for everything else the business does, and it is the ceiling on every figure below it.
Because only two figures go into it, gross profit can move for only two reasons: what the business charges, or what the goods cost. A gross profit that has fallen while revenue held up means the goods got dearer; a gross profit that has fallen with revenue means fewer were sold.
That is what makes it a diagnostic line rather than a headline. It is the first place to look when a business is earning less, because it separates a buying problem from a spending problem before any of the other costs are considered.
Real Example: An importer whose supplier raises prices by a tenth sees gross profit fall even though it sells exactly as many tiles at exactly the same price. Nothing about the way it runs its office changed.
Exam Matters: A data table gives revenue and cost of sales as separate lines precisely so that this subtraction can be made. Appendix 6 defines Calculate as requiring a calculation based on given data, so the two figures it hands you are the two it expects to see used.
Operating profit is gross profit less the other operating expenses. It is what the trading operation earns before the cost of borrowing.
Operating profit = gross profit − other operating expenses. The other operating expenses are the costs of running the business rather than of buying the goods: salaries, rent, insurance, marketing, the electricity in the warehouse.
Lantana Tiles has $700,000 of gross profit and $500,000 of other operating expenses, so operating profit is $200,000. More than two thirds of the gross profit is consumed before the line is reached.
This is the line that says whether the business works. It takes in everything the firm decides — what it charges, what it pays for goods, how many people it employs, what it spends on getting customers — and it stops short of how the business was financed. Two firms doing exactly the same trade have the same operating profit whether one borrowed heavily and the other did not.
That is why it is the line to compare across businesses. The figure below it mixes the quality of the trade with the size of the loan, and a firm can look worse than a rival purely for having borrowed.
Real Example: Two wholesalers buying and selling identically report the same operating profit. One then pays $40,000 of interest and the other pays none, and their final lines differ by exactly that.
Exam Matters: Where a data table gives no interest figure, the last profit it can support is operating profit. Appendix 6 defines Calculate as a calculation based on given data: a profit for the year cannot be produced from data that contains no interest.
Profit for the year is operating profit less interest. It is the specification's name for what most textbooks call net profit.
Profit for the year = operating profit − interest. The specification writes it as "profit for the year (net profit)" at 2.3.3 · 1a, and Appendix 9 uses the same pair of names. Both appear on data tables, and they are the same line.
Lantana Tiles has $200,000 of operating profit and pays $40,000 of interest on a loan of $500,000, which is 8%. Profit for the year is $160,000.
Interest is the only thing that comes off at this step, and it is fixed by decisions made in the past: how much was borrowed, on what terms. Nothing the business does this week changes it. That is exactly why it sits below operating profit rather than inside the expenses — it measures the financing, not the trading.
The line matters because it is what is actually left for the owners: to reinvest, or to take out. A business can trade well and keep very little of it, which is what a large interest line means and what the failure chapter returns to.
Real Example: A firm that borrowed $500,000 to buy its warehouse hands $40,000 a year to its lender before its owners see anything. Over five years that is $200,000.
Exam Matters: The label a data table uses is the specification's, so a question may say "profit for the year" where a textbook says net profit. Appendix 6 defines Calculate as working from given data: match the label on the table to the rung, not to the word you revised from.
The statement of comprehensive income is the ladder written out as a document. It covers a period of trading, not a moment in time.
2.3.3 · 1c names the document: the statement of comprehensive income (profit and loss account). It is the ladder set out in order, and every figure a profit question needs is on it. Appendix 8 of the specification says the assessments use International Accounting Standards terminology, so this is the name that appears on the paper.
The order is fixed and it is the order of the calculation: revenue, then cost of sales, then gross profit, then other operating expenses, then operating profit, then interest, then profit for the year. Reading down it is doing the arithmetic.
The most important thing about it is the word missing from its name: it covers a period. Lantana Tiles's statement says what happened across a whole year of trading. It is a record of flows — money earned and costs incurred between one date and another — not a photograph of what the business owns.
That distinction decides which document a question is about. Anything with the word "during" in it is this statement. Anything asking what the business holds or owes is the other one, which the next chapter reaches.
Real Example: A data table headed "for the year ended 31 March" is this statement. One headed "as at 31 March" is not, and the two are never interchangeable however similar the figures look.
Exam Matters: Appendix 6 defines Explain as requiring a brief explanation of cause or effect supported by details or examples. A question about a movement in one line wants the cause and its effect on the line below, which is what reading the statement in order gives you.
A margin turns a profit into a rate: how much of every dollar of revenue survives to that line. It is what lets two different-sized firms be compared.
2.3.3 · 1c asks for measuring profitability, and profitability is not profit. Profit is an amount; profitability is a rate. The specification wants the calculation of three of them — the gross profit margin, the operating profit margin, and the profit for the year (net profit) margin. Gross profit margin = (gross profit ÷ revenue) × 100.
Lantana Tiles has $700,000 of gross profit on $2,000,000 of revenue, so its gross profit margin is 35%. Of every dollar a builder pays, 35% is left once the tiles have been paid for.
The point of the rate is comparison. A firm ten times the size has ten times the gross profit, and that says nothing about whether it trades better. The margin strips the size out, so it can be set against last year, against a rival, or against the trade.
Because only revenue and cost of sales go into it, a moving gross profit margin has a short list of causes: prices charged, prices paid, or a change in what is being sold. Appendix 9 prints the formula, and Unit 2's own description says these ratios are not supplied in the examination.
Real Example: A wholesaler moving from plain tiles to patterned ones can hold revenue flat and still see its gross profit margin rise, because the patterned tiles carry more margin each.
Exam Matters: Appendix 6 defines Calculate as a calculation based on given data with workings given, and Unit 2's description says the ratios are not supplied. Write the formula, substitute, then give the percentage: the substitution is the working that shows which figures were used.
Operating profit margin measures the whole trading operation as a rate. It is the one margin that is not affected by how the business was financed.
Operating profit margin = (operating profit ÷ revenue) × 100. It is named in the specification alongside the other two, at 2.3.3 · 1c, and printed in Appendix 9 with them.
Lantana Tiles keeps $200,000 of its $2,000,000 of revenue as operating profit, so the margin is 10%. Against a gross profit margin of 35%, the gap of 25% is exactly what running the business costs, expressed as a rate.
That gap is the reason this margin is worth having separately. A business can have an excellent gross profit margin and a poor operating profit margin, and the diagnosis is completely different: the first says the buying and pricing work, the second says the overheads have eaten the result.
It is also the fairest of the three for comparing firms, because interest has not been taken off yet. A heavily borrowed business and a debt-free one doing identical trade report the same operating profit margin and different profit for the year margins.
The sensitivity is worth seeing. A 5% cut in price with the same tiles sold takes revenue to $1,900,000, leaves cost of sales untouched, and drops operating profit to $100,000 — half of it, from a five per cent move.
Real Example: A wholesaler that discounts by a twentieth to hold a customer has given away half of its operating profit, because nothing it pays out fell with the price.
Exam Matters: Appendix 6 defines Analyse as requiring a brief chain of reasoning applied to given data. A chain that moves from a change in price to the operating profit margin, and then to what the firm can still afford, is the shape this command word asks for.
The profit for the year margin is what survives everything, including the lenders. It is the only margin that reflects how the business was financed.
Profit for the year (net profit) margin = (profit for the year ÷ revenue) × 100. Appendix 9 gives both names for it, because both appear on data tables.
Lantana Tiles keeps $160,000 of $2,000,000, so the margin is 8%. Every dollar a builder spends leaves 8% with the owners once the tiles, the running costs and the lender have all been paid.
The distance from the operating margin to this one is the financing. Here it is 2% of revenue, and it is entirely the $40,000 of interest. A firm with no borrowing has no gap at all.
So the three margins read as a diagnosis from the top down. The first gap is what the goods cost; the second is what running the business costs; the third is what borrowing costs. A student who can say which gap widened has said something a single profit figure cannot.
Real Example: Two firms both report a 8% final margin. One has a 35% gross margin and heavy overheads; the other buys badly and spends almost nothing. They need opposite remedies.
Exam Matters: Appendix 6 defines Analyse as a brief chain of reasoning, explanation or justification applied to given data. Quoting all three margins is not a chain; naming which gap moved, and why that cause produces that effect, is.
There are only three levers on a profit figure: charge more, sell more, or spend less. Everything a business does is one of them.
2.3.3 · 1b is a leaf of one line — ways to increase profits — and the reason it is short is that the list is short. Profit is revenue minus costs, so there are three places to push.
The levers are not equally safe. Raising a price is the only one whose effect on profit is the whole amount, and the only one that can lose the customer entirely. Selling more is the slowest, because most of the extra revenue leaves again as the cost of the extra goods.
At Lantana Tiles, a 5% price rise with the same tiles sold would add $100,000 of operating profit — a rise of half. Selling 5% more at the same price adds $35,000, because the extra tiles must be bought first.
Real Example: A wholesaler choosing between a small price rise and a large sales push is choosing between the fastest lever and the safest one, and the arithmetic says how much that safety costs.
Exam Matters: Appendix 6 defines Explain as requiring a brief explanation of cause or effect supported by details or examples. One lever, its effect on one line of the statement, and the condition it depends on is a complete answer; three levers listed is not.
Improving profitability means raising the rate, not the amount. An action can raise profit and lower profitability at the same time.
The specification asks for ways to increase profits at 1b and ways to improve profitability at 1c, as two separate things. They are separate because one is an amount and the other is a rate, and an action can move them in opposite directions.
Take Lantana Tiles cutting its price by a tenth and finding that half as many tiles again go out of the door. Revenue rises to $2,700,000, cost of sales rises to $1,950,000, and with operating expenses unchanged the operating profit becomes $250,000 — up from $200,000. The operating profit margin, meanwhile, falls from 10% to 9.3%.
More profit, less profitability. The business is working harder for each dollar it earns, and it now has more money tied up in tiles and in what builders owe it. Whether that is an improvement depends on something the profit figure does not contain.
The ways that raise the rate are the ones that change the shape of the business rather than its size: buying better, dropping the lines that carry the least margin, cutting an overhead that does not shrink the trade. Each of them widens a gap on the statement rather than lengthening it.
Real Example: Dropping the cheapest tile line can cut revenue and raise every margin at once, because the line that left was the one carrying the least on each sale.
Exam Matters: Appendix 6 defines Assess as requiring a balanced and wide-ranging chain of reasoning about competing factors, leading to a supported judgement. A question that offers growth as the remedy is asking you to weigh the amount against the rate and then say which matters here.
Profit is what a year of trading earned. Cash is what is in the bank. A business can earn a large profit and end the year with less money.
2.3.3 · 2a is one line — the distinction between profit and cash — and it is the idea the rest of the topic rests on. Profit is recorded when a sale is made and a cost is incurred. Cash moves when money actually changes hands, and the two happen on different days.
Lantana Tiles made $160,000 of profit for the year. Its bank balance went from $110,000 to $10,000: down $100,000. Nothing is wrong with either figure.
Add them to the profit and the bank balance comes out exactly: $160,000 less $90,000 less $60,000 plus $70,000 less $100,000 less $80,000 is −$100,000.
Real Example: A wholesaler whose builders all pay a month late is lending them a month of its own revenue, every month, for as long as it trades.
Exam Matters: Appendix 6 defines Explain as requiring a brief explanation of cause or effect supported by details or examples. "Profit is not cash" is the claim, not the explanation; naming one mechanism and following it to the bank balance is what the command word asks for.
The statement of financial position lists what a business owns and owes on one date. It is a photograph, not a film.
2.3.3 · 2b names the second document: the statement of financial position (balance sheet). Where the statement of comprehensive income covers a period, this one is taken on a single date, and it lists what the business holds and what it owes on that date.
Appendix 9 sets out the order: non-current assets plus current assets, less current liabilities, less non-current liabilities, gives net assets. The split that matters for this topic is the word "current", which means within twelve months.
Every liquidity question in this topic is answered from those two totals, so the skill being tested is extraction: find the current assets, find the current liabilities, and ignore everything with "non-current" in front of it. Appendix 8 also settles the vocabulary — inventory rather than stock, trade receivables rather than debtors, trade payables rather than creditors.
Real Example: A warehouse full of tiles on the last day of the year is a current asset worth $240,000. The same warehouse building is a non-current asset, and no liquidity question touches it.
Exam Matters: Unit 2's description says students must apply the ratios in Appendix 9 and that those ratios will not be supplied in the examination. So the statement is given and the formula is not: the extraction and the formula both have to come from the student.
Working capital is current assets less current liabilities: the money a business has to run on, after what it owes this year is set aside.
2.3.3 · 2c asks for working capital and its management. Working capital = current assets − current liabilities. At Lantana Tiles that is $400,000 less $250,000, which is $150,000.
It is a cushion measured in dollars: the amount by which what comes in this year exceeds what goes out. A business with negative working capital owes more within the year than it can expect to receive, and has to find the difference somewhere.
Managing it means moving money around the cycle faster. Cash buys inventory; inventory is sold and becomes trade receivables; trade receivables are collected and become cash again. The longer a stage takes, the more money is tied up in it.
That last figure is the one to act on. Lantana Tiles pays its own suppliers in about 51 days, so it funds the gap between that and the 94 days out of its own pocket, every cycle, for as long as it trades.
Real Example: A wholesaler that holds tiles for two months and waits another month to be paid has three months of trading money locked in the cycle at all times.
Exam Matters: Appendix 6 defines Analyse as requiring a brief chain of reasoning. A chain about working capital runs through the cycle — a stage lengthens, money is tied up in it, less cash is available — rather than stopping at the subtraction.
A business closes when it cannot pay what is due, not when it stops being profitable. Cash is the only thing that settles a bill.
The specification ends 2c with four words — the importance of cash — and they are the reason the whole of sub-topic 2 exists. A supplier, a landlord and a lender can all be paid in exactly one thing, and it is not profit.
Lantana Tiles has $10,000 in the bank, an overdraft of $50,000 the bank may call in, and $250,000 falling due within the year. Its profit for the year was $160,000. If the invoices arrive before the builders pay, none of that profit is available to meet them.
This is why the two documents are read together and never separately. The statement of comprehensive income says whether the trade is worth doing; the statement of financial position says whether the business can still be trading next month. A business needs both answers to be yes, and only one of them is optional in the short run.
The practical consequence is that a growing business needs more cash, not less. Every extra sale puts money into tiles and into what builders owe before it comes back, so growth consumes the cushion it is supposed to build.
Real Example: A firm with a full order book can still be closed by a single supplier who wants paying this week and will not wait for the builders to settle next month.
Exam Matters: Appendix 6 defines Assess as requiring a balanced chain of reasoning about competing factors that leads to a supported judgement. A judgement about whether a firm is in trouble needs both documents, and the supporting evidence for it is a figure from each.
The current ratio compares what will arrive within the year with what falls due within it. Below one, the arithmetic does not work.
2.3.3 · 2b asks for measuring liquidity, and the first of the two measures is the current ratio = current assets ÷ current liabilities. It expresses working capital as a ratio instead of an amount, so businesses of different sizes can be compared.
Lantana Tiles has $400,000 of current assets against $250,000 of current liabilities, so its current ratio is 1.60:1. For every dollar falling due within the year, $1.60 is expected to arrive.
Above one means the year's obligations are covered on paper. Below one means they are not, and the business is relying on something that is not on the statement — new borrowing, an owner's injection, or a sale it has not made yet.
What counts as comfortable depends entirely on how fast the current assets actually move. A wholesaler holding tiles for 67 days needs a higher ratio than a shop that sells for cash the same afternoon, because most of its current assets are a long way from being money.
Real Example: A ratio of 1.60:1 at a firm holding two months of tiles is a different proposition from 1.60:1 at a firm holding two days of them.
Exam Matters: Unit 2's description says the Appendix 9 ratios will not be supplied in the examination, so the formula has to be reproduced. Appendix 6 defines Calculate as a calculation from given data with workings shown, and the substitution is the working.
The acid test takes inventory out of the current assets, because inventory has to be sold before it can pay anybody.
The second measure at 2b is the acid test ratio = (current assets − inventory) ÷ current liabilities. Appendix 9 also calls it the liquid capital ratio, and the single change from the current ratio is the one that matters: the inventory comes out.
It comes out because it is the only current asset that still has to be sold to somebody before it is money. Trade receivables are already sales; cash is already money; inventory is a hope.
Lantana Tiles has $400,000 of current assets, of which $240,000 is tiles. Take them out and $160,000 is left against $250,000 of current liabilities: an acid test of 0.64:1.
Set the two ratios side by side and they say opposite things. 1.60:1 looks safe; 0.64:1 says that without selling the tiles the firm can cover only 64% of what falls due this year. The gap between them is a measure of how much of the comfort depends on selling inventory, and for a wholesaler it is most of it.
Real Example: A wholesaler asked to settle $250,000 tomorrow can reach $160,000 of it. The remaining $240,000 is on the racks and needs a buyer first.
Exam Matters: Appendix 6 defines Analyse as requiring a brief chain of reasoning applied to given data. Two ratios and the gap between them is data; the chain is what the gap is made of, which here is 67 days of tiles.
The first two ways of improving liquidity do very different things: one adds money to the business, the other only delays money leaving it.
2.3.3 · 2b names four ways to improve liquidity, including assets, supplier credit terms, factoring, inventory JIT. The first two are here and the other two are next. Each has to be judged on what it does to the bank balance, to working capital and to both ratios, because the four answers are not the same.
Selling an underused asset. Lantana Tiles sells a delivery yard it barely uses for $120,000. Cash rises to $130,000, working capital to $270,000, the current ratio to 2.08:1 and the acid test to 1.12:1: everything improves, because something that was not a current asset became one.
The cost is capacity. An asset sold is gone, and if it turns out to have been needed it must be rented back or replaced at a worse price. That is a real argument against it, and not an argument that it never works.
Extending supplier credit terms. Taking 30 more days to pay holds $106,849 in the bank — and adds the same $106,849 to trade payables. Working capital is unchanged at $150,000. The current ratio falls to 1.42:1 and the acid test rises to 0.75:1: adding the same amount to both sides drags every ratio towards one to one.
Real Example: A supplier who agrees to 30 more days has lent the wholesaler $106,849 without calling it a loan — and can withdraw the offer at any time.
Exam Matters: Appendix 6 defines Discuss as requiring logical chains of reasoning in context showing causes and effects, with a brief assessment. Each of these four ways has a cost as well as an effect, and the assessment is which cost this particular firm can bear.
Factoring sells what customers owe for cash today. Inventory JIT stops money sitting on the racks. Both raise cash; only one raises the acid test.
Factoring. A factor buys the trade receivables and pays now, keeping a fee. Lantana Tiles sells its $150,000 of receivables for a 3% fee of $4,500, so $145,500 arrives and the bank balance goes from $10,000 to $155,500.
Look at what it does to the ratios, though. One quick asset has become another, minus the fee, so working capital falls by exactly the $4,500 and the acid test edges down from 0.64:1 to 0.62:1. Factoring is the move that rescues the bank balance while very slightly worsening the measure of liquidity — which is the clearest proof in the topic that a ratio is not the same thing as being able to pay.
Inventory JIT. Ordering tiles so they arrive as they are needed cuts inventory from 67 days of cover to 30 days, releasing $133,151 of cash. Current assets do not change — tiles became cash — so working capital and the current ratio stay exactly where they were, while the acid test jumps from 0.64:1 to 1.17:1.
Its cost is fragility. A business holding 30 days of tiles has no buffer against a supplier who is late, which is one of the external causes of failure the next chapter reaches.
Real Example: Two wholesalers both raise about $133,151 of cash. The one that factored still holds its tiles; the one on JIT has nothing on the racks if a ship is delayed.
Exam Matters: Appendix 6 defines Evaluate as requiring fully developed chains of reasoning and a full awareness of competing factors, leading to a perceptive conclusion proposing a recommendation. Four options with four different costs is what that command word is built for.
Most failures are not caused by losses. They are caused by running out of money while still trading profitably.
2.3.3 · 3a lists six internal causes of business failure, and the specification puts poor management of cash flow first. It is first because it is the mechanism most of the others end in: whatever goes wrong, the business closes on the day it cannot pay.
Poor management of cash flow is not the same as making a loss. It is letting money go out faster than it comes in — paying suppliers before customers pay, buying assets outright that could have been paid for over time, holding tiles for 67 days when builders pay in 27 days.
Overtrading is the version of this that happens to successful businesses, and the specification names it separately. A firm grows faster than its working capital can support: every extra sale buys inventory and creates a receivable before any money comes back.
If Lantana Tiles grew by 50%, inventory would rise by $120,000 and trade receivables by $75,000, while trade payables would only rise by $90,000. That is $105,000 of extra money needed, from a business with $10,000 in the bank whose trading produced no spare cash at all this year.
Real Example: A wholesaler that wins a large contract and cannot fund the tiles for it has been destroyed by good news, which is precisely what makes overtrading hard to see coming.
Exam Matters: Appendix 6 defines Assess as a balanced and wide-ranging chain of reasoning about competing factors leading to a supported judgement. A case with rising revenue and falling cash is asking which of the two is the more reliable signal, and the judgement has to say why.
Buying for sales that never happen turns cash into tiles. Both of these causes are the same mistake at different points in the cycle.
Overestimation of sales is the second internal cause at 3a. A business forecasts more than it will sell and commits to it: it buys the goods, takes the space, hires the people. The cash goes out on the strength of the forecast and the revenue does not arrive.
If Lantana Tiles bought in for 25% more trade than it achieved, $325,000 of extra tiles would be sitting on the racks — more than twice its entire working capital of $150,000. Tiles go out of fashion, so if a quarter of that never sells, $81,250 is written off, which is 40.6% of the year's operating profit.
Poor inventory control is the fourth cause, and the same damage without a bad forecast. Holding too much means cash in tiles rather than the bank, storage to pay for and breakages to absorb. Holding too little means turning builders away to a rival who had the tiles.
Lantana Tiles holds 67 days of cover; getting that to 30 days would release $133,151. That is inventory JIT from the liquidity chapter seen from the other end: good inventory control and improving liquidity are one action with two names.
Real Example: A pattern that stops selling is worth what somebody will pay for it, which is usually a fraction of what it cost. Until it is sold, it is counted as an asset at full value.
Exam Matters: Appendix 6 defines Explain as requiring a brief explanation of cause or effect supported by details or examples. One cause, its route through the working capital cycle, and its effect on the bank balance is the chain the marks are for.
Poor marketing costs a business customers it never hears about. Poor quality costs it the ones it already has, and costs it twice.
The last two internal causes at 3a are poor marketing and poor quality. Both act on the top of the statement, and they act differently enough to be worth separating.
Poor marketing means customers who would have bought do not know the business exists, or no longer think of it. Revenue falls while the costs of running the business do not. If Lantana Tiles lost 15% of its volume this way, operating profit would fall from $200,000 to $95,000, because the $500,000 of operating expenses carries on regardless.
Poor quality costs twice over. The immediate cost is replacing what was wrong: if 3% of tiles arrive broken and are replaced free, cost of sales rises by $39,000 and operating profit falls to $161,000 — a fall of 19.5% from a 3% breakage rate.
The second cost is the one that closes businesses. A builder who has had a bad delivery does not order again and tells other builders, so the quality problem becomes a marketing problem a year later — and by then no amount of advertising fixes it, because what customers heard was true.
Real Example: A wholesaler with a 3% breakage rate loses $39,000 in replacements, and loses the builders who now specify a different supplier in every quotation.
Exam Matters: Appendix 6 defines Analyse as requiring a brief chain of reasoning applied to given data. A chain that runs from a breakage rate through cost of sales to operating profit uses the data; naming the cause and asserting the business suffers does not.
External causes are not the firm's fault and are still its problem. The first three all arrive as a fall in what it can sell or charge.
3b lists eight external causes of business failure, beginning with market conditions, competition and economic conditions. None of them is inside the firm's control, and each of them reaches the statement through the top line.
Market conditions. Demand for the product itself changes: builders stop building, or tastes move. A 10% fall in volume takes Lantana Tiles's operating profit from $200,000 to $130,000, because the $500,000 of operating expenses does not fall with the trade.
Competition. A rival takes customers, or forces the price down. This one is the sharpest: a 5% price cut with exactly the same tiles sold leaves cost of sales untouched and takes operating profit to $100,000 — half of it. Price cuts fall straight through to the profit line, which is why a price war closes businesses faster than a downturn.
Economic conditions are the general background: incomes, employment and confidence across the whole economy rather than in one trade. They matter here because they move several things at once, and because a business cannot wait them out without cash.
Real Example: A wholesaler can survive builders ordering a tenth less. Matching a rival's price cut of a twentieth on every tile costs it the same amount again, and it has not lost a single customer.
Exam Matters: Appendix 6 defines Assess as requiring a balanced and wide-ranging chain of reasoning about competing factors, leading to a supported judgement. Assessing a failure means weighing an external cause against the internal position it landed on.
A currency movement hits an importer at the cost of sales. An interest rate rise is the one cause that leaves operating profit untouched.
The next two external causes at 3b are exchange rates and interest rates. They are grouped here because they arrive from the same direction and land on completely different lines.
Exchange rates. Lantana Tiles buys its tiles abroad. If the home currency falls 10% against the currency the tiles are priced in, they cost 10% more: cost of sales rises to $1,430,000 and operating profit falls from $200,000 to $70,000, which is 65% of it gone.
The same movement helps an exporter, which is why the effect has to be worked out for the firm in front of you rather than recalled.
Interest rates. Lantana Tiles owes $500,000 at 8%. A rise of 4 percentage points takes the interest to $60,000 and the profit for the year from $160,000 to $140,000 — while the operating profit does not move at all, because interest comes off below it.
That is the whole reason the ladder has three rungs. A business hit by rates trades exactly as well as it did the week before, and only one of its three profit figures says so.
Real Example: An importer and an exporter in the same street read the same currency news and one of them is in trouble. Which one depends on which side of the statement the foreign currency sits on.
Exam Matters: Appendix 6 defines Calculate as a calculation based on given data with workings given. A currency question is a percentage on one line of the statement, so the working is the line it lands on as much as the arithmetic.
The last three external causes arrive without warning, and a business survives them out of its cash rather than out of its profit.
3b ends with government regulations, supplier problems and natural phenomena. None can be forecast from the trade itself, and what decides the outcome is the same in all three: how long the business can keep paying while it is disrupted.
Government regulations. A new rule can close a product line overnight. If a building standard changed and a quarter of Lantana Tiles's inventory no longer met it, $60,000 would be scrapped — against a bank balance of $10,000.
Supplier problems. A factory that stops delivering stops the wholesaler too. Lantana Tiles sells about $8,000 on each of 250 trading days, so 20 days without tiles costs $160,000 of revenue and takes operating profit to $144,000, every expense carrying on.
Natural phenomena. A flood, a storm or an earthquake closes premises and destroys what is in them. The $240,000 on the racks is at risk in a single night, and insurance pays later rather than now.
So the last three make the same argument as the first: what a business needs against an external shock is liquidity. Profit is what it earns when things go normally, and none of these three is normal.
Real Example: Two identical wholesalers are flooded on the same night. The one that had cut its inventory and held cash reopens; the one with $240,000 of tiles on the floor and $10,000 in the bank does not.
Exam Matters: Appendix 6 defines Evaluate as requiring fully developed chains of reasoning and a full awareness of competing factors leading to a perceptive conclusion that proposes a recommendation. A failure case usually has an external trigger and an internal reason it was fatal, and a conclusion has to say which was decisive.
A business does not have one profit figure. It has three, and each one is what is left after a different set of costs has been taken off.
Gross profit is revenue less the cost of the goods themselves. It measures buying and pricing, and nothing else.