How finance works

What finance is for

The three decisions finance makes, why profit is not cash, and why time and risk change what money is worth.

15 minfoundationFree lesson

Learning objectives

Explain the investing, financing and payout decisions and what it means to create value
Calculate profit and cash flow for the same period and explain why they differ
Explain why money today is worth more than money later, and why risk must be paid for

Every business decision eventually becomes a finance question. Should we open a second branch? How do we pay for it? How much should we give back to the owners? Finance answers these questions with numbers: where money should go, where it comes from, and whether the result is worth more than it cost.

Three ideas run through every lesson on this platform, from a café's monthly budget to the valuation of a large company: profit is not cash, money has a time value, and risk has a price. Get them clear now and everything later is easier.

The three decisions

Investing: which assets or projects to put money into, such as a new oven, a store or a whole company.
Financing: where that money comes from: the owners' money (equity) or borrowed money (debt).
Payout: what to do with the cash the business generates: reinvest it, or return it to the owners as dividends.

A business creates value when its investments earn more than investors could earn elsewhere on something equally risky. That alternative return is the opportunity cost of capital. Making a profit is not enough; the profit has to beat the alternative.

Profit versus cash

Accountants record profit when revenue is earned and costs are incurred, whenever the money actually changes hands. This is the accrual principle. Cash flow records money only when it moves. The two differ for three everyday reasons:

Timing: customers who pay later, and suppliers you pay later.
Long-lived assets: a machine is paid for up front, but its cost is spread over its useful life as depreciation.
Financing: a loan brings in cash but isn't profit; repaying it uses cash but isn't an expense.

Two different measures of the same period

Profit = Revenue earned − Expenses incurred | Cash flow = Cash received − Cash paid

Revenue earned: sales delivered in the period, whether or not the customer has paid yet
Expenses incurred: costs used up in the period, including this period's share of equipment cost (depreciation)
Cash received / paid: money that actually came in or went out of the bank account

Worked example

A furniture workshop's first month: profitable, but short of cash

The workshop sells 40 tables at SAR 1,500. Half the customers pay now; the rest pay in 60 days. Materials cost 600 a table and are paid for now. Rent is 5,000. It also buys a saw for 36,000 cash, expected to last 60 months.

	Profit	Cash flow
Sales / cash from customers	60,000	30,000
Materials	−24,000	−24,000
Rent	−5,000	−5,000
Saw: depreciation vs purchase	−600	−36,000
Total	30,400	−35,000

The workshop made a profit of 30,400, yet its bank balance fell by 35,000. Nothing is wrong with the accounts. Profit spreads the saw's cost over 60 months (36,000 ÷ 60 = 600 a month) and counts sales that haven't been collected yet. Cash shows what actually moved.

Time and risk

A riyal today is worth more than a riyal next year, because today's riyal can be invested. At 5% a year, 1,000 today grows to 1,050 in a year. So a promise of 1,000 next year is worth less than 1,000 today.

A risky promise is also worth less than a safe one. Investors accept risk only if they expect to be paid for it with a higher return. The next lesson measures that trade-off; the Time Value of Money track turns it into the discounting tools behind every valuation.

Calculation

Exercise 1

Calculate

A small trading business has this month:

Sales of 80,000, of which customers have paid 55,000 so far
The goods it sold had cost 48,000
It bought and paid for 60,000 of stock this month (some is still on the shelf)
Rent paid: 6,000

What is the business's cash flow for the month? Enter a negative number if cash fell.

Your answer

Concept check

Exercise 2

Check your understanding

A company can invest SAR 100,000 in a project that will earn 6% a year. Its investors could earn 9% a year on other investments of similar risk. Does the project create value?

No. It earns 6,000 a year where investors could earn 9,000 for the same risk, so it destroys value even though it is profitable.Yes. It makes a profit every year, so it adds value.Yes, as long as 6% is higher than a bank deposit rate.It can't be judged without the project's accounting profit.

Worksheet

Exercise 3

Challenge: profit vs cash in a start-up's first month

A catering start-up's first month. Complete both columns: Profit (what was earned and used up) and Cash flow (what moved through the bank). Enter costs and outflows as negative numbers, then total each column in row 15. The van is bought for cash this month; for profit, only one month of depreciation (van cost ÷ useful life) counts. Link every cell to the assumptions.

0/10 cells entered · Ctrl+. jumps to the next empty cell

B11

	A	B	C
1	Assumptions
2	Events catered	25
3	Price per event	4,000
4	Share collected in cash this month	40%
5	Food & staff cost per event (paid now)	1,700
6	Kitchen rent (paid now)	9,000
7	Van bought for cash	72,000
8	Van useful life (months)	48
9
10	Month 1 (SAR)	Profit	Cash flow
11	Sales / cash from customers
12	Food & staff
13	Rent
14	Van: depreciation / purchase
15	Total

InputYou build (dashed while empty)Given, lockedProfit · Sales / cash from customers

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