2.3 managing Finance Flashcards
What is profit?
The money left over after all costs have been accounted for
What are the 3 different types of profit?
Gross profit: the difference between revenue and costs directly related to production (GP = revenue - cost of sales)
Operating profit: the difference between between the gross profit and the indirect expenses (business overheads that are non directly related to output such as salaries, rent and selling costs) involved in operating the business
(OP = gross profit - operating expenses)
Net profit: the difference between the operating profit and any interest and received as well as any one-off costs
(an exceptional cost), e.g.the purchase of a significant asset.
(NP = operating profit - net interest + exceptional costs)
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 12 months
Each type of profit is calculated within the statement of comprehensive income
The previous year’s figures are also shown for comparison purposes
What is a profit margin?
The amount by which the sales revenue exceeds the costs
Profit margins can be calculated for each type of profit (gross, operating and net profit)
What is gross profit margin?
The proportion of revenue that is turned into gross profit and is expressed as a %
How is the gross profit margin calculated?
(Gross profit/revenue) x 100
What is the operating profit margin?
Shows the proportion of revenue that is turned into operating profit and is expressed as a %
How is the operating profit margin calculated?
(Operating profit/revenue) x 100
What is net profit margin?
Shows the proportion of revenue that is turned into net profit before tax and is expressed as a %
How is net profit margin calculated?
(Profit for the year/revenue) x 100
How can profitability be improved?
- reducing one-off costs and interest, this could be done by implementing zero budgeting or leasing fixed assets
- reduce variable costs, this can be done by changing packaging, purchasing in bulk to gain economies of scale, or buying cheaper stock
- reduce expenses, this could be done by seeking new suppliers, reducing staff levels or relocating the business
- increase prices
What is the difference between profit and cash?
Profit is the difference between revenue and business costs, whereas cash is the full range of money flowing in and out of a business
What does the statement of financial position contain?
The financial information required to draw conclusions about the liquidity of the business.
It also shows the financial structure of a business at a specific point in time
It identifies a businesses assets and liabilities and specifies the capital (money) used to fund the business
The Statement of Financial Position is also known as the Balance Sheet
What is liquidity?
The ability of a business to meet its short term commitments (e.g. payments to creditors) with its available assets
Managing liquidity is a key way to manage risk in a business - and helps a business to prepare for the unexpected
What are non-current assets?
Items that are owned by a business for the long-term
E.g. machinery and buildings
What are current assets?
Items that are converted to cash quickly
E.g. inventory
What are current liabilities?
The money a business owes and is due to be settled soon - usually within 12 months
E.g. short term borrowing such as a bank overdraft
What are non-current liabilities?
The money a business owes and that does not need to be payed back for at least 12 months
E.g. bank loans or mortgages
How is net assets calculated?
Assets - liabilities
What does the statement of financial position show?
How the net assets of a business are funded
What is the total funding of a business known as?
The capital employed
Net assets = capital employed
What are the 2 ways of measured liquidity?
The current ratio:
Quick way to measure liquidity
Effective liquidity measure for businesses that hold little stock.
The result indicates how many pounds of current assets it has available to cover each 1 pound of short term debt
The acid test ratio:
The least liquid form of current assets (inventory/stock) is deducted so the acid test ratio provides a more realistic measure of the businesses ability to meet short-term debts quickly. Effective liquidity measure for businesses that hold large amounts of stock
How is the current ratio calculated?
Current assets/current liabilities
How is the acid test ratio calculated?
(Current assets - inventory)/current liabilities
What are the methods 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
Ask suppliers for an extended repayment period e.g. from 60 to 90 days: The business can use cash it would have paid to suppliers for other purposes
Make use of overdraft facilities or short-term loans
Sell off excess stock
Sell assets and lease fixed assets instead
Introduce new capital and reducing the amount of money taken out the business:
New capital could be gained from additional investors
What is working capital?
The money that a business has to fund its day to day activities
How is working capital calculated?
Current assets - current liabilities
What happens if a business has a lack of working capital?
It usually leads to business failure as a business cannot meet its immediate financial obligations
What is the most liquid form of assets?
Cash
What may businesses that are struggling with a lack of working capital do?
Convert their current assets into cash as quickly as possible
E.g. by selling stock at lower prices or by purposefully chasing payments from customers
What are the implications 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 into fixed assets and investments
This may represent a significant opportunity cost especially when interest rates are high
What are the internal reasons for business failure?
Poor planning: lack of research and development, so little innovation. Poor budgeting. Ineffective business plan
Lack of leadership: poor decision making, failure to delegate
Ineffective marketing: not enough or inappropriate market research, poor understanding of customer needs.
Cash flow problems
Lack of funds: difficulties in borrowing, limited owner capital, failure to attract investment
What are the external reasons for business failure?
Economic challenges: business failures increase during periods of recession due to reduced demand. Rising interest rates increase business costs
Changes in consumer tastes: dated stock may be unsellable
Legal factors: products or assets may need to be replaced or redesigned to meet changed legal standards. Laws can increase staffing and transport costs e.g. minimum wage.
Market challenges: competitors undercut prices to gain market share. Market selling prices may be too low to achieve break even
Technological change: significant capital spending is needed to replace obsolete non-current assets. Product innovation leads to the disappearance of a businesses market
