2.3 Managing Finance

• profit is the financial gain of a business through trading and can be found by deducting expenditure from income

  P = TR - TC where TR is total revenue and TC is total costs
• gross profit


  the difference between revenue and cost of sales
• operating profit


  gross profit - other operating expenses
• net profit


  operating profit - interest, taxes (and exceptional costs)
• statement of comprehensive income


  the profit and loss account

  a historical record of the trading of a business over a specific period (normally one year)

  shows the profit or loss made by the business

  PLCs and limited companies need to publish their accounts every year - UK law
• profitability

  measures the size of the profit in relation to revenue/turnover

  often more useful than simply looking at the profit figure as it measures the relationship between profit and sales revenue

  profitability - the ability of the business to turn sales revenue into profit
• how the statement of comprehensive income helps to measure profitability

  a business that is profitable will be able to reward its investors with a return on their investment - dividends

  a business that is not profitable will not last long unless drastic changes are made

  statement of comprehensive income helps managers, owners and investors to know how the business is doing by measuring the profitability
• profit margin

  profit margin calculations compare profits to sales and show how well the business is handling its finances
• gross profit margin


  shows profit remaining after deducting the goods brought to sell

  $\frac{\\\mathit{gross profit}_{}}{\\\mathit{sales revenue}_{}} X 100$
• operating profit margin


  shows the earnings from operating activities

  $\frac{\\\mathit{operating profit}_{}}{\\\mathit{sales revenue}_{}} X 100$
• net profit margin


  shows the total profit that can be gained from sales and allows the business to compare itself to its competitors

  $\frac{\\\mathit{profit for the year}_{}}{\\\mathit{sales revenue}_{}} X 100$
• stakeholder interest in the statement of comprehensive income of a business - shareholders


  an increase in profit - better performance - larger business - higher dividends
• stakeholder interest in the statement of comprehensive income of a business - managers/directors


  P&L Account will be used alongside other financial documents to monitor progress

  assess whether targets are met
• stakeholder interest in the statement of comprehensive income of a business - employees


  see if the business is doing well or not - in case of chances of promotion or risk of dismissal (job security/bonuses/pay rises)

  motivating to contribute to business's profits
• stakeholder interest in the statement of comprehensive income of a business - suppliers

  see if the business is able to pay for supplies/plan if the business may buy less suppies

  prove credit worthiness
• stakeholder interest in the statement of comprehensive income of a business - government

  helps HMRC calculate how much tax needs to be paid
• ways to improve profitability

  • increase revenue
  • change prices - sales affected by decrease/increase in price
  • dependent on PED
  • increase in advertisement
  • promote the product more
  • decrease costs
  • restructuring, delayering and redundancies
  • automating production or processes (self-service counters)
  • buying cheaper resources - new suppliers may offer more competitive pricing
  • using existing resources more efficiently (decrease wastage, consider maintaining quality)
• distinction between profit and cash

  • profit
  • recorded straight away
  • a business can trade for many years without profit
  • to improve profitability a business must either increase revenue or reduce costs
  • cash
  • will not be recorded until it is paid out or received which could be in a different trading year
  • a profitable business may go bust if it runs out of cash to pay a supplier or wages of staff
  • if owner introduces cash via savings or a loan this will not affect the profit figure
• liquidity


  the ability of a business to turn its assets into cash to pay its current liabilities
• the least liquid assets are listed at the top of the statement of financial position (balance sheet) - premises and specialist machinery for example may take a while to sell, while stock is easy to sell
• most liquid asset of all

  cash
• assets


  items of value owned by a business
• non-current assets


  long term resources that will be used by the business repeatedly and are likely to be kept for more than one year e.g.

  • vehicles
  • premises
  • machinery
  • IT equipment
• current assets


  liquid assets, i.e. those assets that will be turned into cash within one year e.g.

  • inventories (stock)
  • receivables
  • cash and cash equivalents
  • money owed to them
• liabilities


  money a business owes i.e. debts
• non-current liabilities


  money owed by a business for more than one year, sometimes called long-term liabilities e.g.

  • bank loans
  • mortgages
• current liabilities


  money owed by the business that must be repaid within one year e.g.

  • overdrafts
  • payables
  • money owed to suppliers or utility companies
• less than 1 year = current

  more than 1 yea = non-current
• liquidity

  the ease with which assets can be converted into cash

  a business owner and their investors can use liquidity as a measure of how healthy the business is, that it doesn't have too many debts and that it can easily pay its bills

  tools to measure liquidity is the statement of financial position and two key ratios

  • current ratio
  • acid test ratio
• current ratio formula

  $\frac{\mathit{current assets}_{}}{\mathit{current liabilities}_{}}:1$
• acid test ratio formula

  $\frac{\mathit{current assets-inventory}_{}}{\mathit{current liabilities}_{}}:1$
• acid test ratio

  also known as the quick ratio and is a harsher test of liquidity as you cannot guarantee to sell all of the stock - stock can also spoil, become obsolete or just go out of fashion

  if an acid test ratio of less than 1:1 then its current assets (minus stock) do not cover its current liabilities - could mean a problem for the business

  some retailers with a strong cash flow and fast-moving stocks may have an acid test of 0.4:1 and be fine, it depends on the industry
• how can liquidity be improved

  a business could reduce the amount of stocks that it holds, so finished goods need to be dispatched faster to customers

  a business could reduce the credit period offered to customers; for example insist that customers pay in 30 days not 90

  a business could also pay suppliers later on agreed credit terms

  increase borrowing long term and clear the short-term debts
• working capital

  CA - CL where CA is current assets and CL is current liabilities

  funds left over to meet day-to-day expenses after current debt has been paid
• importance of cash

  cash is the most liquid of all business assets

  includes money it has on the business's premises and cash in the bank

  without cash, business has to stop trading

  Confederation of Business Industry (CBI), 21% of business failures are due to poor cash flow or lack of working capital

  businesses with potential for profitability can still run out of cash