2.3.

3 Managing finance

34 Profit
● Profit is the money left over after all costs have been met and belongs to the owners of
the business.

a) Calculation of :

• gross profit
● Gross profit: The difference between revenue/turnover and the cost of sales.
● Turnover can be calculated as price x quantity of sales.
● The cost of sales is the cost of buying in stock to resale for retailers.
● However, for manufacturers, the cost of sales is any costs associated directly with
production such as raw materials or factory wages.
● For suppliers of services, it is any direct cost ex: direct labour
● GROSS PROFIT = REVENUE - COST OF SALES

• operating profit
● Operating profit: The difference between gross profit and business overheads, such as
selling and administrative expenses.
● Operating profit margin: Operating profit expressed as a percentage of
revenue/turnover
● OPERATING PROFIT = GROSS PROFIT - OPERATING EXPENSES

• profit for the year (net profit).

● Profit for the year/net profit: The profit made by the business for the financial year
where the difference between operating profit and finance costs and any other
exceptional costs are shown.
● Exceptional costs: a one off cost, such as a large bad debt.
● Amortisation: The writing off of an intangible asset
● PROFIT FOR THE YEAR = OPERATING PROFIT - FINANCE COSTS (AND
EXCEPTIONAL COSTS)
● Sometimes, net finance costs are shown in the SOCI.
● This is the difference between any interest paid by a business and any interest received
by the business.
b) Ways to increase profits.
Increase profitability
● This involves raising prices or lowering costs per unit.

Adjust the marketing strategy

● They could use a bunch of new marketing strategies to increase their revenues ⇒
increasing profits.
● Examples:
- Invest more in advertising
- Invest in a new promotional campaign such as introducing a loyalty card
- Exploit new distribution channels such as selling goods online
- Increase commissions to sales staff (so that they would be motivated to sell
more)
- Improve customer targeting
- Accept a wider range of payment methods
- Encourage people to bulk buy or repeat purchase

Find new markets

● Sell to international markets or online

Diversify
● Extend product lines
● Produce completely new products

Mergers and takeovers

● Some businesses try to grow their profits by joining together with others.
● They could merge together or take over rivals.
● They do this to lower costs by exploiting economies of scale.
● A business could also diversify by taking over a firm that sells a completely different
product

Disposal of non-profitable activities

● They could increase profits by getting rid of poorer performing products that they are
currently selling

c) Statement of comprehensive income (profit and loss account):

● The statement of comprehensive income shows the income and expenses of a
business during the financial year and is used to calculate the gross profit and the
operating profit.
● The SOCI of a business is usually presented by showing this years statement and last
years to make comparisons.
• measuring profitability: calculation of gross profit margin, operating profit
margin, and profit for the year (net profit) margin
● It is possible to measure the profitability of a business in a more meaningful way.
● This can be done by calculating profit margins which measure the size of the profit in
relation to revenue/turnover.
● There are 3 profit margins that can be calculated.

Gross profit margin

● Gross profit margin: Gross profit expressed as a percentage of revenue/turnover

● The GPM:
- May be increased by raising revenue relative to the cost of sales, by
increasing unit price.
- May be increased by cutting the cost of sales relative to the revenue
- Will vary between different industries. This is because it is a rule that quicker
turnover of inventory means the lower gross margin that's needed. (ex:
supermarkets with a fast stock turnover is likely to have a lower GPM than the
car manufacturers who has a slower stock turnover, but both of them are still
successful.)
Operating profit margin
● Operating profit margin: Operating profit expressed as a percentage of
revenue/turnover
● It is used to measure a company’s pricing strategy and operating efficiency
● It gives an idea of how much a company makes before deducting the finance costs and
taxes.

● A high or increasing operating profit margin is preferred as it means that there is more
money made on each $1 of sales.

Profit for the year (net profit) margin

● Net profit margin: net profit before tax, expressed as a percentage of revenue/turnover
● This takes into account all business costs including finance costs, non-operating costs
and exceptional items. But it is calculated before tax is subtracted.
• ways to improve profitability
● All businesses will want to improve performance. This can be done through increasing
profit margins.
● There are 2 ways to increase profit margins:

Raising prices
● If a business raises its price, it will get more revenue for every unit sold.
● This can only be achieved if costs remain the same.
● However, raising prices may lead to a fall in demand.
● Therefore, the elasticity of the product should be considered before doing so.

Lowering costs
● Lowering cost would increase profits if the price remains the same.
● This can be done by:
- Buying cheaper resources (buy from new suppliers with cheaper prices)
- However, this can be negative if the quality of the product decreases due to the
cheap prices.

- Using existing resources more efficiently. (by introducing new working

practices or training staff, reduce waste by recycling or reusing)
- However, it can be negative if workers resist new working practices or
technological breakdowns take place.
35 Liquidity

a) Distinction between profit and cash.

● At the end of the year, the amount of cash in the business was different from the amount
of profit earned by the business.
● This is because of a number of reasons listed below:
- If there are credit sales or purchases, it would mean that the profit value would be
different from the actual value of cash in the business, as the SOCi will record all
values to be recorded for the year, whether or not the cash has actually been
settled.

- Trading costs will not be the same as cash paid out as if the business is paying
back on credit, then there wil be an accrued expense which would mean the cash
is still not gone out of the business, but the costs to calculate profits would
increase.

- If the owner adds more cash in the business, it would increase cash but not profit
as capital is not treated as business revenue.

- Purchase of fixed asets would reduce the cash in the business but not profits as
purchases of assets are not treated as a business cost in the SOCI.

- Same for sale of fixed assets. It increases cash but not profit.

- The amount of cash at the beginning compared to profit at the beginning would
be different as if a business has ¥23,000 at the end, the amount of cash will
exceed profit by that value.

b) Statement of financial position (balance sheet):

● SOFP: a summary at a particular point in time of the value of a firm's assets, liability and
capital (financial position)
●

• measuring liquidity: calculating current ratio and acid test ratio

● Liquidity: the ease with which assets can be converted into cash.
● Inventories are the least liquid of the assets as you cannot guarantee when it would be
sold to be turned into cash.
● Information contained in the balance sheet can be used to measure liquidity.
● It is important for the business to meet short term debts and 2 financial ratios can be
used to measure liquidity:
Current ratio
● Current ratio: assesses whether or not a business has enough resources to meet any
debts that arise in the next 12 months. It is found by dividing current assets by current
liabilities.
● The ideal value of the current ratio is 1.5:1 - 2:1,
● Anything below this range could mean that the business does not have enough working
capital.
● Anything above that may mean they have idle cash.

Acid-test ratio
● Acid test ratio: Similar to the current ratio, but excludes stocks from current assets. A
more severe test of liquidity.
● In this ratio, inventory is not treated as liquid resources.
● The ideal value for this ratio is 1:1

• ways to improve liquidity, including assets, supplier credit terms, factoring,

inventory JIT.
● Liquidity problems can be prevented by monitoring financial resources through the use
of budgets and cash flow forecasts. But, firms may run out at some point.
● The following measures may be used to generate cash or save it:

Sale of assets or leaseback

● Businesses can sell unwanted physical assets such as vehicles or property.
● Businesses can also sell unwanted intangible assets such as shares or bonds.
● They could also sell off part of its operation
● Businesses can also sell such assets and lease back so that they can still use the assets
even if they sold it.
● However, such agreements can be expensive

Supplier credit terms

● Businesses can save cash by delaying paying suppliers by a couple of days or months.
● However, this can create a negative relationship with the supplier and may lead to them
refusing to deliver the goods in the future.
Factoring
● Debt factoring: when a financial institution called a factor takes over the administration
of a company’s recievables (= money owed by customers). The factor pays the business
the money that customers owe to it immediately, in return for a percentage.

Inventory JIT
● Operating in just in time production would help reduce the inventory stored, therefore
make the business more liquid.

c) Working capital and its management: the importance of cash.

● Working capital: the funds left over to meet day-to-day expenses after current debts
have been paid. It is calculated as follows:
● Current Assets - Current Liability
● A business needs working capital to pay expenses such as wages, electricity and gas.
● The amount of working capital a business has can reflect how well a business is
performing.

Managing working capital

● Different businesses have different working capital needs:

Size of the business

● Sales generate a need for inventory, trade credit and cash. Hence, the larger the
business, the more need for working capital.

Inventory levels
● Businesses in industries that require more inventory would have a higher working capital
compared to businesses in the car industry for instance with JIT techniques of
production.
● Therefore, depending on business inventory levels, working capital can change.

Debtors and creditors

● If the business does not have much debtors, it would mean that it would have a low
working capital.
● For instance, the supermarket purchases inventory on credit (current liability) and sells
the inventory to customers who pay in cash. This would mean that inventory will flow out
immediately, reducing current assets. Hence, they can result in negative working capital
but still operate successfully.

Maintaining adequate levels of working capital

● Businesses need to maintain a good working capital value in order to stop encountering
trading problems:
 - Lack of inventory such as raw materials may lead to businesses not being able to
continue production if the items run out
- If there is not enough cash in the business it might not be able to pay its bills on
time
- If it has borrowed too much through trade credit, it might not be able to pay
invoices when they are due.

● However, too much of working capital may not be likable for businesses in certain
instances:
- Inventories are costly to keep as higher the inventory, the higher the cost of
physically storing and handling it. It could be at risk of shrinkage (a business
term for theft by employees)
- Too much idel cash is also a problem as it is not being used efficiently to pay
back debts or invest in long-term investments.

Problems caused by insufficient working capital

With suppliers
● Damages relationship with suppliers since they might not have cash to pay

With banks
● Interest has to be paid to banks. So if they notice that you have less working capital,
they might not give you loans and they also might cease certain properties. They might
also charge higher interest % if they are uncertain about your financial situation.

Opportunities may be missed

● Cannot buy raw materials in bulk and hence miss out on bulk discount.

How businesses should manage its working capital

● Control the cash used
● Minimise spending on fixed assets
● Plan ahead by estimating cash needed
● Seeking long term solutions to short term issues
● Contingency finance planning - accounts that are used when it is only necessary

The importance of cash

● Cash is part of the working capital but it is not the same as working capital as it includes
other current assets.
● Cash is important unlike the rest of the CA as it can be used to pay bills to operate on a
daily basis.
● 21% of business failures are due to poor cash flow or lack of working capital according to
the CBI
36 Business failure

a) Internal causes of business failure:

● Internal causes of business failure roots from within the business.
● These are through ineffective coordination of internal factors
● Internal factors: factors that businesses are able to control which can cause collapse.

• poor management of cash flow

● Many businesses fail because they run out of cash
● This is because entrepreneurs focus too much on profit and neglect the importance of
cash.
● The reasons below are why businesses runs short of cash:

Investing in too much of fixed assets:

● Businesses tend to overspend on getting start up assets such as equipment during the
beginning of their business. This leads to less cash being left in the business.
● They should try to lease some of their resources to avoid this problem. Instead of paying
in full.

Allowing too much credit

● When businesses allow customers a long credit period, they run out of cash in the short
run.
● Businesses should be cautious of their credit periods to avoid bad debts.

Overborrowing
● When businesses borrow to finance growth, interest costs can keep rising
● Overborrowing may threaten the overall control of the business.
● It is important to fund growth in a balanced way by raising some capital through shares
for instance.

Seasonal factors
● Agricultural businesses tend to have high cash inflows for only a certain period of the
year, leading to poor cash flow for when the produce is not available.

Unforseen expenditure
● If businesses do not prepare for unexpected expenditure such as equipment
breakdowns, there may be a poor cash flow

External factors
● Cash flow problems can occur due to events outside the control of the business.
● For instance, changes in legislation or poor economic state or change in customer wants
Poor financial management
● Inexperience in managing cash may lead to poor cash flow.
● For instance, if a business plans to spend heavily before they get the cash from trade
customers, it is not guaranteed they will actually receive the money back from trade
customers.

• overestimation of sales
● This is when businesses estimate that they will earn a large amount of sales in the
future, (using the sales forecast)
● This can be a problem because customer wants and tastes can change in a short period
of time.
● Overestimating sales due to optimistic entrepreneurs may lead to unsold stock and lack
of cash inflow.
● This means that businesses may have used too much of cash to create the stock they
thought would sell out, leading to high cash outflow and low cash inflow, leading to
business failure.

• overtrading
● Overtrading: a situation where a business does not have enough cash to support its
production and sales, usually because it is growing too fast.
● This is when a business is attempting to fund a large volume of production with
inadequate cash.
● This happens to established companies trying to expand too quickly
● One way you can find out if a business is overtrading is if they are borrowing money to
meet day-to-day expenses.

• poor inventory control

● Poor inventory control means that the business is either holding too much stock, too little
stock or the wrong stort of stock.
● If a business carries a large quantity of inventory, it means that money is tied up in
productive assets. Inventories do not generate any cash for this instance as the stock
keeps increasing, costs will be incurred to store them.　
● If the wrong sort of stock is bought by a business, it would cause serious problems for
the business as not only did they lose their cash for buying the wrong inventory but they
would no longer make money from the stock.
● If a business has too little stock, customers are left waiting and will end up going to
rivals and never return.
• poor marketing
● A range of marketing problems could lead to business failure.
● Businesses that launch new products that do not meet the needs of customers may lead
to failure.
● Wrong pricing strategies (too low or too high)
● Investing and wasteful or inappropriate promotional campaigns
● Failing to position themselves correctly in the market.
● Inappropriate or offensive marketing messages or materials can lead to bad PR

• poor quality.
● Supplying products which fail to meet customer quality expectations is likely to lead to
business failure.
● Social media can worsen the reputation of a business, even if it's one poor quality, very
quickly.
● Therefore, quality assurance is important in this day and era.

b) External causes of business failure:

● Business owners tend to blame external factors for their failure
● However, only 20% of the businesses fail due to external forces.

• market conditions
● Markets are dynamic, which means they change over time.
● This means that if the business cannot meet the changing patterns of the market, it can
lead to failure.
● Ex: struggling to set up online businesses as online retailing is in high demand now.
● Society is increasing its demand for renewable energy, therefore, businesses who use
non-environmentally friendly energy may lead to poor reputation
● Sometimes, prices can change drastically in markets. This can be bad for businesses if
the general price of their product falls, as it may not be able to cover costs.

• competition
● Competitors with better prices, products, marketing strategies or distribution channels
may outrun a business.
● Especially if the competitor adapts to new trends such as onine retiailing, many physical
clothing stores may be threatened
• economic
● The general state of the economy (both domestic and global) can have an impact on the
success of the business.
● The financial crisis in 2008 shows that many business failures arose as their economies
went into recession.
● The government's economic policies can also lead to business failure.
● Ex: not investing in expenditure to help out industries or increasing certain taxes which
leads to a reduction in disposable incomes.
● This can lead to less demand for businesses, leading to failure.

• exchange rates
● Businesses that trade internationally may be affected by changes in exchange rates.
● If a business relies on export incomes, if their exchange rate rises, prices of their goods
will be expensive for foreigners, leading to low income.

• interest rates
● A sharp increase in interest rates could cause difficulties for businesses with large debts
or businesses that depend on consumers using credit to fund their purchasing.

• government regulations
● When government legislation interferes with the business, it can lead to problems.
● Examples being reducing subsidies for the business or cutting government expenditure.

• supplier problems
● The interconnection between the supplier and the business is vital.
● If a key supplier fails to make deliveries, businesses may not be able to meet customer
orders.
● As a result, customers may go to rivals and never return.
● Especially if it is in an industry that uses just-in-time production such as the car industry

• natural phenomena
● Some businesses fail due to natural factors such as the weather conditions
● Farmers are extremely vulnerable to weather patterns
● Another problem caused by natural phenomena is disease.
● Agricultural businesses can suffer from this problem as if there is a disease infecting
produce, it would mean that the business will run short on supply