2.3 managing finance Flashcards
how to calculate profit:
total revenue - total costs
what are the three types of profit?
-gross profit
-operating profit
-profit for the year/net profit
define gross profit
(+ limitations)
the money made from selling products after the costs of producing have been deducted
(only tells us a little bit about profit as it only includes direct costs)
how to calculate gross profit:
revenue - cost of sales/production
define operating profit:
the money left after all the costs of a
business have been taken from its profits
what are operating expenses / administration expenses
(+ examples)
day to day costs that aren’t directly attributed to the product
(rent, equipment)
how to calculate operating profit
gross profit - other operating expenses
what is profit for the year/net profit?
(+ value)
the actual profit the business has made (taking into account interest and all costs)
(tells us much more, because we have taken away EVERY cost)
how to calculate profit of the year/net profit:
operating profit +/- interest
what are profit margins?
the proportion of sales revenue that has been converted into profit
what is a gross profit margin useful for?
a useful indicator for analysing how a business has performed in terms of its direct trading activity
how to calculate a gross profit margin:
gross profit/revenue x 100
why is an operating profit margin useful?
-it takes into account the performance of a business more fully, as the calculation takes into account direct and indirect costs
-tells us how effectively a business turns its sales into profit
how to calculate an operating profit margin:
operating profit/revenue x 100
how is a net profit margin useful?
-it takes into account all revenues and costs incurred by the business
-it is a good measure of how effectively the business performed over the financial year
how to calculate the net profit margin
net profit/revenue x 100
what is interest?
a percentage of the amount of money borrowed that must be repaid in addition to the original amount borrowed
how to calculate interest
total repayment - borrowed amount/borrowed amount
x100
what is ratio analysis?
the different ratios that are used to analyse how a business is performing
(eg: gross profit margin)
what can a profit and loss account be called?
a statement of comprehensive income
what is the purpose of the statement of comprehensive income?
to list all of the business’s actual income and expenditure for a year
why are statements of comprehensive income done?
-if a profit is made, tax must be paid to the government
-management may want to compare statement to past years
-to compare to rivals
-shareholders/investors may be interested in the profitability
what order are the headings in a profit & loss account?
1) sales revenue
2) cost of sales
3) gross profit
4) operating expenses
5) operating profit
6) interest
7) net profit/profit of the year
what are costs of sales?
the direct costs associated with the production and sale of the product or service
what can a profit and loss account be used to calculate?
profitability ratios/ratio analysis
what we can find out from a statement of comprehensive income:
-changes in sales revenue
-changes in the direct costs of sales
-how well a business is managing its operating costs
-the profitability of a business
is an increase in cost of sales always bad? (analysing a statement of comprehensive income)
no, if sales revenue has increased, cost of sales will also increase
how can cost of sales be decreased & what is the impact of this?
a supplier can be changed, however this could worsen quality and then lower sales revenue
what effect would increasing marketing have on a statement of comprehensive income?
operating expenses would increase but there could be a greater gain in sales revenue
what does operating profit exclude that profit for the year includes?
debts/interest
4 reasons why businesses are unprofitable
-no demand
-selling at the wrong price
-low contribution per unit
-poor management of costs
what are two main ways to improve profitability?
-increase revenue
-decrease costs
how can revenue be increased?
-increase quantity sold
-increase selling price
-create awareness and desire through marketing
-add value to the product (increase benefits and features)
increasing quantity sold to improve profitability (why?, will it work?, why it might not work)
why?
higher sales volumes = higher revenue
will it work?
-depends on elasticity of demand
-sales value may fall if price has to be reduced to achieve higher sales volumes
-does business have capacity to sell more?
why it might not work
-competitors are likely to respond
-marketing efforts may be unsuccessful
-fixed costs might rise
increasing selling price to improve profitability (why?, will it work?, why it might not work)
why?
-higher selling price = higher revenue
-no need for extra production capacity
-maximises value extracted from customers
will it work?
-depends on price elasticity of demand
-it will work if customers remain loyal and still perceive product to be good value
why it might not work
competitors are likely to respond (lower prices)
-customers may decide to switch to competitors
how can costs be decreased?
-reduce variable costs per unit
-reduce fixed costs
-improve efficiency
decreasing variable costs to improve profitability (why?, will it work?, why it might not work)
why?
-higher profit margin on each item produced and sold
-customers do not notice a change in price
will it work?
-if suppliers can be persuaded to offer better prices
-if quality can be improved through lower wastage
why it might not work
-customers may notice a decrease in product quality
decreasing fixed costs to mprove profitability (why?, will it work?, why it might not work)
why?
-drop in fixed costs causes higher profits
-substantial savings can be made by cutting unnecessary overheads
will it work?
-yes, if quality, customer service & output are unaffected
-a business can nearly always find savings in overheads
why it might not work
-might reduce ability of business to increase sales
are cash flow and profit the same?
no
profit is an absolute position when all costs have been deducted from revenue.
however, cash flow is an ongoing concern
what is profit?
the reward for taking risks and making investments
what is cash flow?
inflow - outflow
2 examples of cash flow being different to profit
1) if a customer is given credit (get item now, pay later) then you have revenue as the sales are recognised but you don’t have the cash until the payment is made
2) if you take out a loan, you have an inflow, however that is a cost in terms of revenue
how are cash and profit linked?
-to make a profit, a business must manage cash flow so that it can pay expenses and running costs
benefits of a good cash flow
-can pay suppliers & employees on time
-can handle unforeseen events
-can expand
drawbacks of poor cash flow
-can’t pay suppliers & employees on time (relationships ruined)
-could become bankrupt due to unexpected events
what is a balance sheet?
-financial document that records the assets and liabilities of a business
-snapshot of the business’s equity
(statement of financial position)
which three items does a balance sheet show?
-assets
-liabilities
-capital
why is a statement of financial position also called a balance sheet?
businesses aim to have their total net assets equal to their equity
what are assets?
-all the items that the business owns
-the money it has in the bank
-the money it is owed by other people
what are fixed assets/non current assets?
-used to operate the business
-will be held for more than a year
what are current assets?
(+ examples)
assets that the business expects to use or sell within the year (stock, debtors)
what are liabilities? (+ examples)
all the money the business owes to others
(suppliers, bank)
what are current liabilities? (+ examples)
money that must be paid back within a year (suppliers, bank overdraft)
what are long term/non-current liabilities? (+ example)
money being paid back over a longer period (loans)
what are examples of tangible & intangible non-current assets)
tangible → land
intangible → patents
what are debtors?
people who owe the business money
what are creditors?
people who the business owes money
how to calculate net assets:
non current assets + current assets
- (subtract)
non current liabilities + current liabilities
what is equity?
the shareholders’ stake in the company
what will equity always equal?
net assets
what is working capital?
the amount of money available to run the business
why are balance sheets important?
-the government uses them to work out how much tax should be collected
-banks use them to decide whether to give a business a loan or not
-investors use them to decide if they should invest or not
what is liquidity?
the ability of a business to pay its debts and liabilities in cash when they fall due
how do cash and liquidity link?
-cash is the most liquid asset (cash is a current asset) that a business has and any business would quickly fail if it ran out of cash
what do liquidity ratios do?
assess whether a business has sufficient cash/ enough current assets to be able to pay its debts
how to calculate current ratio:
(+ meaning of different values)
current assets/current liabilities
(expressed as a ratio, eg: 2.1)
1.5 - 2.5:1 - fabourable
below 1 - unfavourable
10 or more - unfavourable
what does a current ratio of 1.5 - 2.5 suggest?
-efficient management of working capital
-good liquidity
what does a current ratio below 1 suggest?
-cash problems
-can’t cover short term liabilities
-poor liquidity
-poor working capital management
what does a current ratio around 10 suggest?
current assets are high:
-cash could be invested
-stock may be wasted
-good liquidity
-poor working capital management
how to calculate acid test ratio
current assets - stock/current liabilities
why is an acid test ratio more useful than a current ratio?
it does not take into account the inventories (stock) of a business, for many businesses there is no guarantee that inventories can be quickly turned into cash
what is the target for an acid test ratio?
1.5:1 - 1:1
what is a bad result from an acid test ratio?
under 1
issue with acid test ratio
-doesn’t show how long it will take for debtors to pay, if debtors will take long then liquidity is actually poor
when should an acid test ratio be higher?
-when a business has a low stock turnover (you’re not selling your products quickly enough)
-if a business has no negotiation over creditors (eg: can’t negotiate reduced payments)
how to calculate working capital
current assets - current liabilities
ways to improve liquidity
-use an overdraft facility
-delay payments
-take out credit agreements with suppliers
-sell off current assets
how cash flow links to working capital
cash flow management is a crucial day-to-day activity for every business
main causes of cash flow problems
-low profits
-excess inventories held
-allowing customers too much credit & too long to pay
-seasonal demand
issues with excess stock
-excess stocks tie up cash
-increased risk that stocks become obsolete
issues with allowing customers too much credit
-customers who buy on credit are called trade debtors
-offeing credit is a good way of building sales
-but late payment is a common problem
debt factoring
-the selling of debtors (money owned to the business) to a third party
-this generates cash
why it’s difficult to start a business
-high rate of business failure for start-ups
-difficult to test a model without trading
-easy to be over-optimistic in the business plan
-competitor response is often aggressive
internal factors of business failure
-poor planning
-cash flow
-marketing
-lack of skills
how poor planning causes business failure
-can lead to important factors not being addressed
-may be the root cause of other issues, such as cash-flow problems or poor marketing through a lack of understanding of customer needs
how lack of skills causes business failure
may include technical skills, such as financial management, or leadership capacity
external factors for failure
-competition
-legislation
-market conditions
-economic conditions
how competition causes business failure
a new competitor or an overcrowded market can lead to a shortage of demand and falling sales
how legislation causes business failure
new legislation can often mean increased costs as a business adjusts its products and processes to comply
how market conditions cause business failure
changes in consumer tastes can cause demand to fall
financial reasons for failure
-poor management of cash flow
-inadequate financing
non-financial reasons for failure
-lack of management control
-significant external shock
