Making financial decisions Flashcards
Profit
Pro fit is the reward for the risk that entrepreneurs take in proving a product/service.
Gross profi t takes into account the expenses directly incurred in the cost of production and is calculated as follows:
Gross profit = sales revenue - cost of sales
Net profit takes into account all of the business expenses and is calculated as follows: net profit = gross profit - (operating costs + interest)
Profit margins
A profit margin is the amount by which sales revenue exceeds the costs.
Pro fit margins can be calculated for each type of pro t (gross, operating and net profit ).
Profi t margins can be compared to previous years to better understand
business performance.
Higher and increasing profit margins are preferable as it means that more revenue is being converted into profit.
Gross profit margins
This shows the proportion of revenue that is turned into gross pro t and is expressed as a percentage.
Gross profit margin = (gross profit / sales revenue) x 100
Gross profit margin shows the proportion of revenue left over after the
business has paid for its costs of sales.
A business that adds a lot of value would be expected to have a high gross pro fit margin.
Net profit margin
The net profit margin shows the proportion of revenue that is turned into net profit before tax and is expressed as a percentage.
Net profit margin = (profit for the year / sales revenue) x 100
Net pro t margin is the proportion of revenue left over after the business has paid all of its costs.
A business with high net profi t margins may have low total pro fits if sales are low.
Average rate of return (ARR)
The average rate of return (ARR) measures the pro t from a proposed capital project.
ARR is used when a decision is required about which of two projects should be pursued in order to generate the most profit.
ARR = (average annual profit / initial outlay) x 100
Average annual profit = total profit / number of years
Advantages and disadvantages of ARR
Advantages - It considers all of the net cash flows generated by an investment over time.
It is easy to understand and compare the percentage returns with each other.
Disadvantages - As it depends on an average of cash flows, it ignores the timing of those cash flows.
The opportunity cost of the investment is ignored.
Market share
The market share that a business enjoys is the proportion of the total sales revenue of a product/service compared to the market as a whole.
Market share = (sales revenue of a business / total sales revenue in the market) x 100
If a business sells multiple items, the percentage that each item contributes to its overall sales revenue can be calculated using the following formula:
(Sales revenue of product x / total sales revenue of all products) x 100
Quantitative data to make businesses
Quantitative data is statistical numeric data that can be used to support decision making.
Quantitative data needs to be accurate and interpreted correctly if it is to be useful.
Quantitative data may be collected from primary or secondary sources.
Primary data is collected first hand for a specific purpose.
Secondary data has been collected by someone else.
Sources of quantitative data include: graphs and charts, fi nancial data, marketing data and tables or infographics.
Information form graphs and charts
Information presented in graphs and charts is often easy to understand because it is presented visually.
Financial data
Businesses can use a selection of internal and external financial data to support decision making including: Sales revenue, Profi t, Costs, Tax, Interest and exchange rates, Valuations of assets and Bank balances.
Companies need to send key financial data to Companies House each year whereas sole traders and partnerships may keep this information private.
Marketing data
Marketing data is collected through primary and secondary market research, such as: Surveys, Focus groups, Observation, Customer feedback, Retail or online footfall, Government or trade publications and The media.
Marketing data can help business managers forecast sales and to make decisions about product development and promotional plans.
Market data
Market data refers to the characteristics and performance of the market in which a business operates such as:
Demographic data relates to the market’s population structure such as age, gender and income statistics.
Market dimensions includes factors such as the size of the market, the market shares of key competitors, the rate of market growth and average prices across the market.
Investment data relates to the prices of commodities (e.g. oil) as well as exchange rate data and stock market performance.
Market data can help a business identify and plan for new opportunities and spot external threats such as the increased power of a competitor.
It can also be used alongside other types of quantitative data to make investment decisions.
limitations of financial information to a business
Different interpretations of data - Statistical information can be interpreted in diff erent ways.
Financial data can be window dressed to present a positive impression of performance.
Data becomes out of date quickly - By its very nature fi nancial data relating to sales, costs and pro t is out of date as soon as it is generated.
Using financial data to make decisions relies on future performance to be
at least broadly similar to past performance.
Qualitative factors are ignored - Businesses measure their performance against a range of financial and non- financial criteria.
Use of financial information to a business
To identify trends and make calculations for comparison over time and with other businesses.
To support an application for external nance such as a loan.
To attract potential investors.
To support spending decisions.
