2.3 Flashcards
Gross Profit formula
GP = Revenue - cost of sales
Operating Profit formula
OP = Gross Profit - operating expenses
Net Profit formula
Gross Profit - operating expenses - interest and taxes
what is the Statement of Comprehensive Income
an end of year financial statement that shows all of a businesses income and expenses over the previous twelve months
what is a profit margin
the amount by which the sales revenue exceeds the costs
how can a business use profit margins
(helps businesses understand business performance by …)
Profit margins can be compared to previous years to better understand business performance
gross profit margin formula
(gross profit/revenue) x 100
operating profit margin formula
(operating profit/revenue) x 100
Ways to improve profitability
Raising prices
Raising prices is likely to have an impact on demand so businesses must understand the price elasticity of demand for its products
Ways to improve profitability
pros of Raising prices
- Increased Revenue: When you raise prices, you can earn more money from each sale, which can lead to higher overall revenue.
- Perceived Value: Higher prices can sometimes make customers perceive your product or service as more valuable or exclusive.
- Better Profit Margins: Higher prices can improve your profit margins, meaning you keep more of the money you earn after covering costs.
- Resource Allocation: You may attract more serious customers willing to pay a premium, allowing you to focus on quality rather than quantity.
Ways to improve profitability
cons of raising prices
- Customer Resistance: Some customers may be hesitant to pay higher prices, potentially leading to a drop in sales volume.
- Competitive Disadvantage: If your competitors offer similar products or services at lower prices, you might lose customers to them.
- Perception of Greed: Customers might view price increases as greedy or unfair, damaging your reputation.
- Market Sensitivity: In markets where customers are particularly price-sensitive, raising prices can lead to significant backlash or loss of market share
Ways to improve profitability
Reducing variable costs
This may involve purchasing cheaper/alternative resources, negotiating with suppliers or purchasing in bulk
Ways to improve profitability
Pros to Reducing variable costs
- Competitive Pricing: Lower costs can allow you to price your products more competitively, potentially attracting more customers.
- Flexibility: Lower variable costs can make your business more flexible and adaptable to changes in the market, allowing you to adjust prices or respond to competitive pressures more easily.
Ways to improve profitability
cons to Reducing variable costs
- Quality Compromises: Cutting variable costs may lead to compromises in product quality or service levels, which could harm your reputation and customer satisfaction.
- Supplier Relationships: Negotiating lower prices with suppliers or switching to cheaper alternatives could strain relationships or result in lower-quality inputs.
- Innovation Constraints: Cost-cutting measures may limit investments in research, development, or innovation, potentially hindering your ability to stay competitive in the long term.
- Employee Morale: Cutting variable costs could involve reducing workforce hours, layoffs, or other measures that may negatively impact employee morale and productivity.
what is the Statement of Financial Position (Balance Sheet)
- shows the financial structure of a business at a specific point in time
what is liquidity?
Liquidity is the ability of a business to meet its short term commitments with its available assets
what is current ratio?
- A high ratio (above 1) = good liquidity, meaning the company can meet its obligations easily.
- However, too high a ratio might indicate inefficient use of assets.
- low ratio (below 1) = liquidity problems, potentially affecting the company’s ability to pay debt
current ratio formula
current assets / current liabilities
what is acid test ratio?
assesses a company’s ability to pay its short-term liabilities using only its most liquid assets, such as cash, marketable securities, and accounts receivable.
It excludes inventory from current assets, as it may not be readily convertible to cash.
A higher acid-test ratio indicates better short-term liquidity, as the company has more immediate resources to cover its obligations.
Conversely, a lower ratio may suggest potential liquidity issues, especially if it falls below 1.
acid test ratio formula
( current assets - inventory ) / current liabilities
Ways to Improve Liquidity
Reduce the credit period offered to customers
Collecting money owed from customers more quickly will increase the level of current assets in the business
Customers may move to competing businesses that offer better credit terms
what is working capital and what is the formula?
- he money that a business has to fund its day to day activities
- It is often described as net current assets on the Statement of Financial Position
- Current Assets - Current Liabilities
Ways to Improve Liquidity
Ask suppliers for an extended repayment period e.g an extension from 60 to 90 days
Current liabilities will not be reduced
The business can use cash it would have paid to suppliers for other purposes
Suppliers may be unwilling to extend credit terms
Ways to Improve Liquidity
Make use of Overdraft facilities or short-term loans
Current liabilities will increase
The business can spend more money than it has in its bank account
Banks may be reluctant to lend to businesses with cash-flow problems
Ways to Improve Liquidity
Sell off excess stock
Less liquid current assets will be reduced and converted into more liquid forms of current asset (e.g. cash)
Storage and security costs may also be reduced
Stock may need to be sold at a low price to attract sales
Ways to Improve Liquidity
Sell assets and lease fixed assets instead (e.g. Sale and Leaseback)
Both current assets and current liabilities will increase
The business will continue to have the use of assets but must make regular payments to the leasing company
Ways to Improve Liquidity
Introduce new capital and reduce drawings from the business
Current assets will be increased
New capital may be introduced by the owner or from additional investors
This may result in the dilution of control of the business
what is a result of a business having too much working capital
- If a business is holding large amounts of cash it is likely to be missing out on the benefits of investing it in fixed assets or investments
- This may represent a significant opportunity cost especially when interest rates are high
- If a business is holding large amounts of inventory it may incur extra storage costs (e.g. security and handling costs) and could use the cash ‘tied up’ in this stock for other purposes
