2.3 Managing finance Flashcards
What is cost of sales?
The cost of inventory bought or produced
How is gross profit calculated?
Gross profit = Revenue - Cost of sales
How is operating profit calculated?
Operating profit = Gross profit - Operating expenses
How do you calculate profit for the year?
Profit for the year = Operating profit - Interest
What does a statement of comprehensive income show?
The income and expenses of a business during the financial year
What is a statement of comprehensive income used for?
It is used to calculate gross profit, operating profit and profit for the year
How do you measure profitability?
By calculating profit margins, which measure the size of profit in relation to revenue
What is gross profit margin?
It shows the gross profit made on sales revenue
How is the gross profit margin calculated?
Gross profit margin = (gross profit / revenue) x 100
What does a higher gross profit margin show?
It means that more gross profit is being made per £1 of sales
How can the gross profit margin be increased?
- By raising the revenue relative to the cost of sales, by increasing price
- By cutting the cost of sales, by finding cheaper suppliers
What is operating profit margin?
It shows the operating profit made on sales revenue
What is the operating profit margin used for?
To measure a company’s pricing strategy and operating efficiency
How is the operating profit margin calculated?
Operating profit margin = (Operating profit / Revenue) x 100
What is net profit margin?
It takes into account all business costs, including interest, other non operating costs and exceptional items
How is the net profit margin calculated?
Net profit margin = (Net profit before tax / Revenue) x 100
Are high or low profit margins preferred?
Higher margins are usually better than lower ones because more money is made on each £1 of sales
What will increasing profit margins do?
It will improve business performance. If margins can be raised, the business will make more profit at the existing level of sales.
How can profit margins be raised?
• Raising prices
• Lowering costs
How will raising prices improve profitability?
If a business raises its price it will get more revenue for every unit sold. If costs remain the same then profitability should improve.
How is raising prices a risky thing to do?
It might have an impact on the level of sales as demand will fall. Also it is never certain how competitors will react.
How will lowering costs improve profitability?
It might be possible to buy resources from new suppliers that offer better prices. Or make better use of current resources to improve efficiency. However, if doing this businesses should be cautious and understand pitfalls.
What is a statement of financial position?
It is like a photograph of the financial position of a business at a particular point in time, usually produced at the end of a financial year
What is an asset?
The resources owned by a business. Examples include buildings, machinery, equipment etc.
What is a liability?
The debts of the business, a source of funds for a business. Examples include an overdraft or mortgage.
What is capital?
The money put into a business by the owners, it is used to buy assets
What do the value of assets and liabilities equal in such statements?
The value of assets will equal the value of liabilities and capital. This is because all resources purchased by a business have to be financed from either.
What are non current assets?
Long term resources that will be used repeatedly by the business over a period of time
What are examples of non current assets?
• Land
• Property
• Equipment
What are current assets?
Assets that will be changed into cash within 12 months, they are liquid assets
What is liquidity?
How easily it can be converted into cash
What are examples of current assets?
• Inventories
• Trade and other receivables
• Cash/cash equivalents
What are current liabilities?
Any money owed by a business that must be repaid within one year
What are examples of current liabilities?
• Loans
• Trade and other payables
• Current tax liabilities
What are non current liabilities?
Long term loans and any other money owed by the business that does not have to be repaid for atleast a year
What are examples of non current liabilities?
• Long term bank loans
• Mortgages
• Company pension funds
What are net assets?
They’re calculated by subtracting the value of total liabilities from total assets. This will be equal to shareholders equity.
What is shareholders equity?
A summary of what is owed to the owners of the business
What are examples of shareholders equity?
• Shared capital
• Retained profit
How can you measure liquidity?
• Current ratio
• Acid test ratio
What is current ratio?
A liquidity ratio and focuses on the current assets and current liabilities of a business
How is current ratio calculated?
Current ratio = Current assets / Current liabilities
What does a current ratio of 1.5 - 2.0 suggest?
Having sufficient liquid resources
What does a current ratio of below 1.5 suggest?
The business does not have enough working capital, meaning a business may be over-borrowing or overtrading
What does a current ratio of above 2.0 suggest?
Too much money is tied up unproductively. Money tied up in stocks, for example, does not earn any return.
What is acid test ratio?
A more severe test of liquidity. This is because inventories are not treated as liquid resources, there is no guarantee that stocks can be sold.
How is acid test ratio calculated?
Acid test ratio = Current assets-Inventories / Current liabilities
What does an acid test ratio of less than 1.0 suggest?
Its current assets minus stocks do not cover its current liabilities. This could indicate a potential problem.
What is working capital?
The amount of money needed to pay for the day-to-day trading of a business
What does a business need working capital for?
To pay expenses such as wages, electricity and gas charges, and to buy components to make products
What is the calculation of working capital?
Working capital = Current assets - Current liabilities
What factors affect working capital?
- Size of business
- Stock levels
- Debtors and creditors
How does size of business affect working capital?
Sales typically generate a need for stocks, trade credit and cash. Hence the larger businesses, the larger the amount of working capital there is. Equally, expanding businesses need growing amount of it.
How does stock levels affect working capital?
Businesses in different industries have different needs for stock. The more stocks a business needs, the higher will be its working capital.
How does debtors and creditors affect working capital?
The time between buying stock financed by trade credit and selling finished products can influence levels of working capital. For example, builders need high levels of working capital.
What is the rule for working with negative working capital?
The typical business needs around twice the amount of current assets as current liabilities to operate safely. This means current ratio between 1.5 and 2.
Why should businesses avoid having too little working capital?
- If a business does not carry enough finished stock, it might be unable to fulfil orders on time
- If there is not enough cash in the business, it might not be able to pay its bills on time
Why should businesses avoid having too much working capital?
- Stocks are costly to keep. The more stock, the higher the cost of physically storing it.
- Too much cash is also a problem because the cash is unlikely to be earning very high rates of interest. It could be used, perhaps, to pay back debts or to invest in higher interest investments.
What is cash?
The most liquid of all business aspects. It is the notes and coins it keeps on the premises and any money it has in the bank.
Why is cash very important?
Cash is vital. Without it, the business would cease to exist. A lot of businesses fail due to poor cash flow or a lack of working capital.
What are ways to improve liquidity?
- Use of finance options
- Encourage cash sales, discounts, sell-off stock
- Control your purchases
- Reduce personal drawings from business
- Introduce fresh capital
What are the internal factors of business failure?
Poor planning
Lack of leadership
Ineffective marketing
Cash flow problems
Lack of funds
What are examples of poor planning?
- Ineffective business plan
- Poor budgeting
- Lack of research and development so little innovation
What are examples of lack of leadership?
- Poor decision making
- Lack or urgency
- Failure to delegate
- Lack of skills to run a business
What are example of ineffective marketing?
- Not enough or inappropriate market research
- Poor understanding of customer needs
- Flawed product and pricing decisions
- Promotional mistakes
What are examples of cash flow problems?
- Poor liquidity
- Too little or too much working capital
- Bad acid test/current ratio results
What are examples of lack of funds?
- Failure to attract investment
- Difficulties in borrowing
- Limited owner capital
What are the external factors of business failure?
Economic challenges
Changes in consumer tastes
Legal factors
Market challenges
Technological change
What are examples of economic challenges?
- Business failures increase during periods of recession due to reduced demand
- Rising interest rates increase business costs
- Exchange rate fluctuations affect planning
What are examples of changes in consumer tastes?
- The need for frequent market research increases costs
- Dated stock may be unsellable
What are examples of legal factors?
- Products or assets may need to be redesigned or replaced to meet legal standards
- Legal rulings can affect operations
- Legislation can increase staffing and transport costs
What are examples of market challenges?
- Competitors undercut prices to gain market share
- Market selling prices may be too low to achieve break even
How can you remember external factors of business failure?
PESTLE
Political
Economic
Social
Technological
Legal
Environmental
What are financial factors of business failure?
Businesses either become bankrupt or they become insolvent. The most common reason for failure is the shortage of cash.
What are non financial factors of business failure?
Factors such as lack of planning, lack of business skills, inability to compete effectively. These are not directly linked to money issues but they can eventually lead to financial issues if not addressed.
