5.2 - Analysing financial performance

• Businesses want to


  Maximise their Profits
• Most businesses exist to make a profit - if a business makes large profits then it is successful. Even successful businesses want to increase profits and become more successful.
• Businesses measure their profits

  1. On a regular basis

  2. Compare current period profits to previous periods

  3. To measure progress
• If profits go down

  This is bad news, even if the business is still making large profits
• Businesses work out the percentage increase or decrease in their profits from year to year - it makes it easy to see how well they're performing in comparison with other years.
• If profits are decreasing, the business needs to investigate why this is happening and take action to fix it.
• Methods to Increase Profits

  • Increase prices (if demand is price inelastic)
  • Reduce prices to increase demand (if demand is price elastic)
  • Reduce costs of production
  • Use advertising to increase demand
  • Improve product quality
• Reducing production costs


  May lead to a lower quality product, which could damage the number of sales
• Improving the quality of a product

  Should lead to an increase in profits, as long as the costs of improving the quality don't outweigh the savings
• Measures of Profit


  • Gross profit
  • Operating profit
  • Profit for the year
• Gross profit


  Amount left over when the cost of sales is subtracted from sales revenue
• Operating profit


  Takes into account all revenues and costs from regular trading, but not any revenues or costs from one-off events
• If a company's gross profit is increasing but its operating profit is decreasing


  It usually means the company is not controlling its costs
• Profit for the year


  Also takes into consideration profit or loss from one-off events and financial costs, e.g. interest payments and tax. It's the measure of profit that dividend payments are based on.
• Profit Margins


  Show how Profitable a business or product is
• Profitability


  The amount of profit relative to revenue or investment
• Profit margins


  Measure the relationship between the profit made and the sales revenue. They tell you what percentage of the selling price of a product is actually profit.
• Profit margins


  • Can be used to make comparisons over a period of time
  • Can compare the profitability of different companies
• Gross Profit Margin


  Measures gross profit as a percentage of sales revenue
• Gross Profit Margin


  • What counts as a good gross profit margin depends on the type of business
  • The higher the percentage the better
  • A business with a high sales volume (e.g. a bakery) can afford to have a low gross profit margin
• Improving Gross Profit Margin

  1. Increasing prices

  2. Reducing the direct cost of sales
• Operating Profit Margin


  Takes into account all the costs of regular trading
• Operating Profit Margin


  • It's best to have a high operating profit margin, although it does depend on the type of business
  • Operating profits can be improved by increasing prices or reducing the cost of sales or operating expenses
• Comparing Operating Profit Margin and Gross Profit Margin

  A business with a decreasing operating profit margin compared to gross profit margin is struggling with operating expenses
• Profit for the Year Margin


  Measures the profit for the year as a percentage of sales revenue
• Profit for the Year Margin

  • A high profit for the year margin is attractive to shareholders, because it can indicate that they may receive high dividends
  • A high profit for the year margin can attract potential shareholders
• Cash Flow Cycle


  The Gap between Money Going Out and Coming In
• Cash inflows


  Sums of money received by a business, e.g. from product sales or loans
• Cash outflows


  Sums of money paid out by a business, eg. to buy raw materials, or pay wages
• Cash flow cycle


  1. Businesses need to pay out money for the costs of producing an order, or for assets like machinery, before they get paid for that order

  2. Delay between money going out and money coming in
• Importance of cash flow

  • Make sure there's always enough money available to make payments
  • Not paying suppliers and employees can be a disaster
  • For new businesses the cash flow cycle can be a big problem because they need money for start-up costs before they've made any sales at all
• Working capital


  The money available to a business for its day-to-day running costs
• Factors affecting length of cash flow cycle

  • The type of product - this determines the length of time it takes to produce and how long it's held in stock
  • Credit payments - Buying on credit means that the goods are received, but the buyer has an agreed period of time (credit period) before payment is due
• Creditors


  People who are owed money by the business
• Payable


  Money that the business owes
• Debtors


  People who owe the business money
• Receivable


  Money that is owed to the business
• Ideal cash flow situation


  • Short period of time from the start of production to the sale of goods
  • Business is given a longer credit period by its creditors (e.g. suppliers) than it gives its debtors (e.g. customers)
• Methods to improve cash flow

  • Overdrafts
  • Holding less stock
  • Reducing time between paying suppliers and getting money from customers
  • Credit controllers keeping debtors in control
  • Debt factoring
  • Sale and leaseback
• Overdrafts


  • Allows a business to borrow money according to its needs, up to a preset amount
  • Can be very expensive as the business will need to pay interest on the borrowed money