Finance: 3.5 - 3.9 Flashcards
What is the gross profit margin?
the % of the sales revenue that turns into gross profit
Why are percentages useful when calculation margins?
The company’s size becomes irrelevant, allowing for easier comparisons
Gross profit margin =
gross profit/sales revenue x 100
What are some strategies to improve the gross profit margin?
- decrease COGS - technology/efficiency/cheaper materials or labor
- increase sales revenue and keep COGS the same
- decrease COGS and increase sales revenue - economies of scale
What is the net profit margin?
the % of how much of the sales revenue is net profit
Net profit margin =
net profit/sales revenue x 100
What is net profit used for?
- paying banks and the government
- dividends
How could one improve their net profit margin?
- decrease expenses and indirect costs through marketing/administration etc
- decrease COGS - technology/efficiency/cheaper materials or labor
- increase sales revenue and keep COGS the same
- decrease COGS and increase sales revenue - economies of scale
What is capital employed and operating profit?
What is return on capital employed?
Capital employed: all the finance that has been invested into the company so that it could perform
Operating profit: net profit
ROCE: how efficient the company is in being profitable from investments, how efficient in their trading activities
ROCE =
operating profit/capital employed x 100
How can one improve ROCE?
- increase operating profit - increase sales revenue or decrease COGS/expenses
- reduce capital employed - difficult, NCL may turn into retained earnings/equity, or company would need to sell NCA which would affect sales revenue
- an increase in capital employed may lead to an increase in operating profit
What is working capital?
the amount of cash the company has for daily opertions, necessary so that it can continue its activities until their debtors pay for the sale
Working capital =
Current assets - current liabilities (= net current assets)
Whatis the current ration?
the amount of $ you have to pay for each $ in liabilities
measures if the working capital is sufficient
current ratio =
current assets/current liabilities
What would be the optimum current ratio?
1 - all of the cash would be used to pay up
less than 1 - not enough to pay
more than 1 - more than enough to pay
close to 2 - most desirable
too high would be undesirable because it means cash is not being used for reinvestment and growth
Acid test and what does it measure?
measures healthy liquidity, does not include less liquid stocks, good to be around 1.2-1.5
current assets - inventory/current liabilities
How can a business improve its current ratio?
Increase current assets
* Increase sales - some strategies can increase liabilities, so the benefits may be cancelled out
* Reduce debtors - may cause the business to lose customers
* Sell unused fixed assets
* Reduce drawings
Reduce current liabilities
* Extend credit period - can threaten relationships with suppliers.
* Decrease overheads
* Reduce current liabilities - business may not have enough working capital to pay down debts, limits the funds available for daily working
Limitations of ratio analyses
- Incomplete picture of current and future finances
- External influences can influence the ratios unexpectedly
- Qualitative factors ignored like customer satisfaction, quality of goods, staff motivation
- Different interpretation by social enterprises
Efficiency ratios measure…
how well a business is managing its operations in the working capital cycle
Stock turnover ratio measures…
the number of times, on average, that a company sells and therefore replenishes its stock within a period of time
an average because sales vary over the course of a year
stock turnover in days
average stock/cost of sales x 365
stock turnover in number of times
cost of sales/average stock
debtor days measures…
the average number of days it takes the business to collect its debts
debtor days ratio =
debtors/sales revenue x 365
creditor days means…
an indicator of the average number of days it takes a business to pay its debts
creditor days ratio =
creditors/COGS x 365
gearing ratio measures…
how much of the business’s capital employed is financed by long-term debt (NCL)
prime gearing ratio numbers
25% - low
25% to 50% - normal for many businesses
above 50% - high
Why is a high gearing ratio bad?
- more of operations are funded by long-term debt
- risky: if interest rates increase, then loan payments could rise, undermining profits and dividends to shareholders
Gearing ratio =
non current liabilities/capital employed x 100
Capital employed =
non current liabilities + equity
Strategies to improve the stock turnover ratio
Supplying a narrower range of goods
- Simplifies the stock
- increases the control over stock
- may negatively affect sales revenues
Selling obsolete stock, stocking goods in high demand
- reduces stocks
- increase sales of stocks, can save storage costs
Just-in-time stock control
- Stock ordered only when needed for the production
- no excess stock
- this increases risk
Strategies to improve debtor days
Cash only policy
- discounts for cash payments/charge interest on credit payments/cash-only policy
- may lead to decline in sales revenue
Shortening the credit period
Improving credit control
- trade credit only to customers with a record of paying on time
- stricter criteria for buying on credit
Refusing to do business with customers who pay late
Threatening legal action or imposing a penalty or interest on overdue amounts
Strategies to improve creditor days
Negotiating longer credit periods
- can threaten relationships with suppliers
Good stock control system (just-in-time)
- Stock ordered only when needed, no excess stock.
- increases risk due to delays
Looking for different suppliers
- new relationships, less trust
What is insolvency
a situation where an individual or a business is not able to pay its debts
Causes for insolvency
when the working capital cycle does not function effectively
Debtor days are too long
Loss of sales revenue
Increased costs
Legal action
What is bankruptcy
a legal process that gives an insolvent business a chance to restructure its operations and debt, so that it may become profitable again
What happens when a business files for bankruptcy
especially a smaller business - liquidate current and non-current assets immediately to pay creditors fully/partially
Larger companies - develop a plan to become solvent, being temporarily protected from creditors. This plan will be monitored by an authority.
If the plan fails - business’s assets liquidated to pay debts. Liquidation is usually the last resort - damage to many stakeholders.
What is the difference between profit and cash flow?
Profit does not take into account the timings of your costs and revenues, cash flow takes inflows and outflows into account, which may not align with its profitability timewise
Why is the cash flow important?
allows company to plan for when they receive/pay in order to have enough cash on hand for daily operations
How often/and how are P&Ls released vs cash flows?
P&L - each year or quarter, public
cash flow - monthly or even daily, not public
What does a better cash flow mean?
a better working capital cycle, the business is better at withstanding market fluctuations
Structure of a cash flow forecast
- Opening balance
- Cash inflows
A
B
C - Total inflows
- Cash outflows
D
E
F - Total outflows
- Net cash flow
- Closing balance
What is debt restructuring?
under a judge’s guidance, a forced renegotiation of debts between a business and its creditors
company may survive, last chance
What happens after debt restructuring?
liquidation under supervision of a judge
creditors paid in the legal order
then shareholders (preferential first)
last paid: ordinary shareholders
Insolvency vs bankruptcy
insolvency: company unable to pay debts
bankruptcy: legal situation when a company wants a last attempt at surviving
What are some reasons for poor cash flow?
- Poor stock management - too much stock, having spent much purchasing the inventory
- Poor pricing strategy or low sales - trying to penetrate the market or increase sales, the business may have priced the product too low
- Expanding too fast - heavy investments in expansion can result in large debts that can cause cash flow problems
- High expenses
- Seasonal demand
How can one increase cash flow?
8 ways
- Effective debt collection system - ensures that the company is paid in time. Eg: frequent phone calls/emails, credit checks on customers to reduce slow payment or bad debts
- Cash transactions only
- Increased promotion
- Expanding the product portfolio - diversifies risk, increases the revenue or cash inflow streams
- Going public - IPO
- Overdrafts
- Loans
- Government assistance - grants/subsidies to companies that produce essential goods/ services/employment
How can one decrease cash outflows?
5 ways
- Better stock management
- Renegotiate credit terms
- Switch to cheaper suppliers
- Reduce expenses
- Lease rather than purchase equipment
What is investment appraisal?
A process of quantitative and qualitative evaluation of an investment decision
What is an opportunity cost?
The potential cost of missing an opportunity by choosing one option and foregoing another
What is the payback period?
the number of years and months it will take for the investment to pay for itself
What is the average rate of return (ARR)?
expresses the annual forecast returns as a percentage of the initial capital cost
What is the net present value (NPV)?
method of making investment appraisals more accurate by using a discount rate to adjust the value of future returns
Why is money worth more now than in the future?
- inflation
- bank’s interest rate on deposits is lower than the inflation rate
What is a discount rate?
the rate a business could earn on another comparable investment, applied to the expected future cash flows from an investment to reflect today’s value
ARR =
((total returns - capital cost)/years of use)/capital cost x 100
Limitations of payback period?
- ignores the long-term profitability of an investment
- assumes that future cash flows have the same value as those of today
- different businesses will weigh up the payback period differently - eg Social enterprises may not prioritise the length of the payback period, and instead qualitative data
- simplistic view and only relies on cash flow forecasts, which are estimates
Why is payback period good?
its simplicity
What are cost and profit centres?
profit centres - areas of the business that generate both revenue and costs
cost centres - areas of the business that generate costs but no revenue
What are the responsibilities of a profit vs cost centre?
profit centres - meeting profit goals and controlling costs
cost centres - controlling costs
What is a centre?
departments of the business that will get its budget
What is the difference between revenue streams and profit centres?
revenue streams - different ways that a business earns money and gains resilience
profit centres - different areas of business that might bring in cash
What are the advantages of multiple profit centres?
- easier to identify opportunities in different departments due to easy separation
- more organised and specific
- each centre can set and track their own targets
Why are budgets necessary?
- controlling
- setting more specific and meaningful targets, measuring performance
- gives managers more information about how they are expected to spend money
- more organised
What are 2 characteristics of budgets?
- Short-term
- Coordinated - departmental budgets are set after the business’s corporate objectives have been agreed, feeding into a centralised budget for the whole business.
What are some factors to consider when constructing a budget?
hanges to marketing decisions on product, price, promotion and other marketing factors that may affect the revenues and costs
labour turnover issues that may affect recruitment and training costs, as well as salaries
operations changes that affect efficiency and waste
External factors can also have an impact on budgets
Examples of how steeple can affect budgets
sociocultural changes - change a product or market, incurring costs
technological - new capital investments
economic - inflation
environmental - damage business infrastructure, resources harder/expensive
political - disrupt supply chains, transport more expensive
legal - environmental protection laws, operations more expensive
ethical - require changes to the product portfolio, or operations
Requirements of a budget for profit centres
- title
- multiple income (revenue) streams should be grouped together and summed
- multiple costs should be grouped together and summed
- net income: total income - total costs
Format of a budget for profit centres
Columns: budgeted figures, actual figures, variance
Rows:
Income
A
B
Total income
Costs
A
B
C
D
Total costs
Net income
Format of a budget for cost centres
like a profit centre, but only shows costs
What is variance analysis?
tool used to compare a business’s budgeted sales revenue and costs with the actual figures
Define adverse variance.
actual budget situation is worse than the forecast
could be because costs are higher than expected, incomes are lower than expected or profits are lower than expected
Define favourable variance.
actual budget situation is better than the forecast
could be because actual costs are lower than expected or the actual income is higher than expected
