2.4 Making Financial Decisions

• Business investment is when money is used to purchase an asset that is expected to generate a return of income or profit.
• Types of business investment: Land and buildings

  • usually required when business first starts up or when its expanding
  • 25% of costs of business start up is spent on a property
• Types of business investment: Machinery

  • Business start ups will need to acquire machinery to produce their goods or supply services
  • could include purchasing comoyter systems
  • established business will need to replace existing machinery as technology advances
• Types of business investment: Vehicles

  • having cost effective, modern and reliable transport can reduce costs and improve profitability as well as customer service
• Concept links: flexibility (e.g. planning process), customer needs (e.g. delivery), reputation (e.g. competition), competitive advantage (e.g. could increase sales and market share)
• ARR (average rate of return) is a quantitive method of deciding whether an investment is likely to be worthwhile.
• ARR (average rate of return) formula =

  
  

  (average annual profit)/(cost of investment)*100

  
  

  expressed as a %
• (from ARR) :

  average annual profit = (total profit/no. of years)
• The higher the rate of ARR the better, as it means that the investment will generate a higher return on the money spent on the investment.
• It is up to the business owner/manager to decide whether to invest or not. The decision will be based on many factors such as the type and reasons for the investment. Also is based on current rate of interest and how reliable the figures are. REMEMBER THE FIGURES ARE PREDICTIONS!
• how to - ARR method:

  1. select information that details the total or lifetime profit.
  2. calculate average annual profit.
  3. calculate average rate of return (%)
• Gross profit is the amount of money the business makes after the direct costs of making/selling its products or providing its services, otherwise known as its costs of sales, are deducted from its sales revenue.
• Net profit is the profit the business generates after all other operating expenses and interest, not included in the calculation of gross profit, have been paid.
• Gross profit formula =

  sales revenue - costs of sales
• net profit formula:

  gross profit - other operating expenses and interest
• The gross and net profit figures will tell business owners/managers how much profit a business has made in a specific time period.
• Gross Profit Margin (%) formula =

  (gross profit)/(sales revenue)*100

  this is the percentage of sales revenue that is gross profit
• Increasing sales revenue: lowering the selling price (may increase demand), increasing the price (may generate more revenue), increasing awareness of the product.
• lowering cost of sales: can renegotiate price with existing suppliers, could change suppliers if other suppliers offer cheaper prices, could review their existing products and see if it could be made cheaply.
• net profit margin (%) formula =

  (net profit)/(sales revenue) * 100
• Increase sales revenue: lower selling price, increase selling price, increase awarness
• Lower expenses (e.g.): delayer organisational structure

  review salary structure/bonuses, freeze recruitment, move to cheaper location.
• The specific business situation must be looked at carefully before deciding the best way to improve either the GPM (%) or the NPM (%).
• Net Profit Margin (%) is a better indication of a business's financial performance, as the ratio takes into account all the other operating expenses/interest.
• GPM (%) only takes into account the cost of sales while NPM (%) also involves expenses/interest.
• Ratio provides information that can help business managers make decisions. They have to decide their circumstances and the needs of different stakeholders.
• The best way to assess financial is by comparing either actual profit figures or ratios with: targets, previous figures, competitors, stakeholder objectives.
• Businesses will regularly use quantitive data to understand the performance of the business and the market it operates within.
• Quantitive data is the data that can be measured numerically and can be easily transformed into graphs and charts.
• Quantative data is used by businesses everyday in order to provide information that will allow successful decision-making to take place.
• types of financial data: gross/net profit, gross/net profit margin (%), ARR, profit and loss, break even point, cash flow forecast.
• profit and loss: a business will want to make the highest profit possible, it's an important internal source of finance that is used for business growth.
• break even: determine how many units it has to sell to break even and to determine whether the business idea is actually viable.
• cash flow forecast: predict if a business is likely to have shortfalls of cash, decisions can be made to ensure that the business can continue to trade and pay its day-to-day bills.
• Marketing data included a business's internal data such as on sale figures, marketing spending, and market research.
• market data involves secondary data and includes population information such as age distribution, income levels, employments.
• market share is the percentage share of the total market that is owned by a particular business, product or brand.
• Businesses will be interested to know: value/volume of market share and who are the competitors andwhat market share they have.
• Market share formula: Total sales of a product / Total market sales x 100 = %
• Market data shows potential growth that may attract new entrants (e.g. investors, etc.) to the market, keen to take advantage of the potential sales and opportunities.