2.4 - Making Financial Decisions Flashcards
What do businesses have to keep an eye on?
+Businesses have to keep an eye on their finances.
+They can find out how risky an investment is likely to be working out the ARR.
+They can find out how much the business is making by working out its gross or net profit.
What can you find on an investment?
+You can find the average rate of return on an investment
What is the return on an investment?
+The return on an investment is how much a business makes or loses as a proportion of the original investment.
+You need to be able to work out the average rate of return [ARR].
What is an investment’s lifespan?
+An investment’s lifespan is the length of time over which it earns money for the firm.
What is the average rate of return?
The average rate of return is a calculation of the average return on an investment each year over its lifespan.
How do you calculate the average annual profit?
average annual profit = total profit number of years
How can you calculate the average rate of return?
+To calculate it you first have to work out the average annual profit.
+Then you can put your value for average annual profit into this formula, to find the ARR:
ARR[%] = average annual profit cost of investment x100
What will it mean for the firm the bigger the ARR?
+The bigger the ARR for an investment, the more successful the investment for the business.
What will a good ARR depend on?
+But a good ARR will depend on the firm involved, as well as the amount of money invested - an ARR of 6% would be significant for a £1m investment, but probably not for a £100 one.
What do you need to be able to do to gross profit and net profit?
You need to be able tl calculate gross profit and net profit.
What can a business calculate from its financial data?
+A business can calculate its net profit and gross profit from its financial data.
What is gross profit?
+Gross profit is the profit a firm makes after the cost of making products [the cost of sales] is taken into account.
What is net profit?
Net profit is the profit a firm makes when all expenses [that includes operating expenses, eg. salaries and rent, the interest paid on loans and the cost of sales] are taken into account.
What is it important to know before calculating any kind of profit?
+Before calculating any kind of profit, it’s important to know what the revenue is.
What is revenue?
+Revenue is the total amount of money earned by the business through sales of products in the given time period.
What is the equation for revenue?
Revenue = sales price x quantity sold [or sales volume]
How can you calculate the gross profit?
+To calculate the gross profit, take away the cost of sales from the revenue:
gross profit = revenue - cost of sales
How can you calculate the net profit?
+To calculate the net profit, you can use the following formula:
Net profit = gross profit - [operating expenses + interest]
[The total profit is really the net profit for the business]
What are profitability ratios?
These show what happens to each pound spent by a customer.
What does Gross profit margin ignore?
Gross profit margin ignores indirect costs
What is the gross profit margin?
+Gross profit margin is the fraction of every pound spent by customers that doesn’t go directly towards making a product.
What is the equation for gross profit?
Gross profit margin = gross profit ÷ sales [revenue] x 100
What counts as a good gross profit margin?
+What counts as a good gross profit margin depends on the type of business, but the higher the percentage the better.
+The margin can be improved by increasing prices or reducing the direct cost of sales.
+Some businesses [eg. a supermarket loan] can have a low gross profit margin because they sell in high volumes and they need to keep their prices competitive to survive.
What does the net profit margin take into account?
Net profit margin takes all costs into account
What is the net profit margin?
+Net profit margin is the fraction of every pound spent by customers that the company gets to keep [after all its costs have been paid].
What is the equation for net profit margin?
Net profit margin = net profit ÷ sales [revenue] x 100
What counts as a good net profit margin?
+Just like for gross profit margins, what counts as a good net profit margin depends on the business, but the higher it is, the better.
+Net profit margin is often larger for new companies which are still small and don’t have many indirect costs.
+As the businesses grow, these costs go up and the net profit margin decreases.
How can data help a business?
Data can help a business to make decisions
What do businesses have to keep track of?
+Businesses have to keep track of how well they are doing.
+They also need to be able to predict the effect of making certain decisions.
What can different types of data inform a business on?
+Different types of data can help inform a business on the impact of a decision, and so help to support or justify it, or prevent the business from making a mistake.
What types of data may be used by businesses when making decisons?
- Financial data
- Marketing data
- Market data
How can financial data help a business make decisions?
+Financial data - [eg. cash flow forecasts] can show whether or not a business decision [eg. investing cash in new equipment] would lead to cash flow problems.
+Calculations of profit and loss and profitability ratios can help a business to see if it should reduce costs or try to increase revenue.
+And predicting the average rate of return of an investment can help a business to determine if an investment would be worthwhile.
How can marketing data help a business make decisions?
+Both primary and secondary market research data can give an indication of how customer preferences are changing over time.
+So a business can use this data to see if a business decision is likely to lead to increased sales.
How can market data help a business make decisions?
+Market data [eg. knowing the market share of different business, the costs of supplies and prices of competitor products] may help a business to see if it should eg. lower its prices, or reduce the cost of its supplies.
What are there limitations to?
There are limitations to financial data
What should a business put in place in order to use some types of financial data?
+In order to use some types of financial data, it’s important that there is another source of appropriate data to allow a comparison.
+For example, a firm could compare how their financial data has changed over time, or they could compare it against a competitor who produces similar products.
What are the downsides of using financial data to understand business performance?
+However, using financial data to understand business performance isn’t perfect.
+In some cases it may not be possible to directly compare two different sources of data.
+For example, one firm in the comparison may be much larger or operate in a different country.
What are the downsides even if the firm’s financial performance for different years is compared?
+Even if the same firm’s financial performance for different years is compared, it can still be hard to tell exactly what may have caused any changes.
+That’s because there are often lots of different variables which may affect a company’s financial performance - such as how well the economy is doing.
How is using only quantitative data a limitation to using financial data?
+Another limitation to using financial data to assess business performance is that it only includes quantitative data and not qualitative data.
+Qualitative data can include things like customers’ opinions, which can be useful for determining what changes a business should make.
What isn’t foolproof?
+Using financial data isn’t foolproof, but without it businesses wouldn’t be able to get much of an idea of their performance.
+Businesses can use their financial data alongside other forms of data such as market research, to get a more well-rounded idea of how their business is performing compared to their competitors.
