Profit as a beacon attracting market entry (dependent on barriers to entry and exit – ease of setting up in a market and exiting a market) which in turn increase supply and lowers market price.
Accounts are for keeping track of the finances is an essential part of assessing business performance, planning for the future and for tax purposes. An important part of any company’s accounts is the ‘statement of comprehensive income’, aka the ‘profit and loss account’ – a video of a business’s performance.
Economists and accountants use different terms for the same thing! E.g. Cost of Sales = Total variable costs! There is potential for confusion here, which the examiner will exploit! Please bare in mind that all ‘statements of comprehensive income’ contain the same data, let the examiner name it anyway he wants!
Learn the below template for a P/L account as you’ll be likely asked to fill in blanks to come to these calculations in your exam. Be wary of the (000s) info, it catches a lot of people out in referencing questions!
Remember, in accounting, negative figures are written in brackets so they stand out from the page more! e.g. -4,000 is written as (4,000).
Remember – these ratios are only useful if we compare them to previous years and to competitors. A NP margin of 8.9% sounds impressive…but if the previous year it was 16% and your closest competitor has a margin of 19% then it isn’t so impressive after all!
GROSS PROFIT MARGIN is gross profit as a percentage of sales revenue. It shows us how well the business is using its inputs. GP Margin Formula: GP / (TR x 100)
OPERATING PROFIT MARGIN is operating profit as a percentage of sales revenue. It gives information about how efficiently the business is using ALL of its resources (i.e. it considers the FC of the business as well as the VC!). OP Margin Formula: OP / (TR x 100)
NET PROFIT MARGIN is net profit as a percentage of sales revenue (see a pattern here!?). It is a measure of financial performance and indicates how shareholders may be rewarded. As a potential investor – this is the margin you would judge a business on as the other two (especially GP margin) might mislead you! NP Margin Formula: NP/ (TR x 100)
It’s important to compare like with like – a jeweler’s NP figure will be much higher than a supermarket’s. Also, it is important to put things in perspective of previous year’s. We might look at profit margins for a number of car manufacturers or several different travel agents. Comparing the profits of a travel agent with those of a car manufacturer would not be meaningful at all!
SHAREHOLDERS – clearly have an interest in knowing how big a profit or loss was made. Will want to know if the business is worth more at the end of the year than at the beginning (reconsider their investment) – judging success in meeting objectives.
CREDITORS – Before a creditor agrees to give a business goods on credit, it might want to study the accounts to see if the company can afford to pay them back. Same for banks who want to give loans – they will study the accounts carefully to assess RISK.
GOVERNMENT – profits tax they are paying. Also if the business is in trouble the government might help it out to avoid job losses and damage to the economy (e.g. British banks).
OTHER COMPANIES – maybe considering a bid to take over the company (e.g. BP) or they may wish to compare the performance of the business with that of their own.
There are a number of ways of improving profits:
Reduce cost of sales (i.e. variable costs) e.g. find a cheaper supplier
Reduce overheads (i.e. fixed costs) e.g. cut salaries, move offices
Increase total revenue e.g. raise/cut prices [depends on price elasticity!], scale market, boost marketing
Business survival and cash flow
Cash flow management
Cash flow is the flow of cash in and out of a business over a period of time.
Cash flow is important to a business because it means there’s:
Never suffer from a shortage of ready money (e.g. bills are regular but income is irregular)
Steady money supply to pay its essential debts (e.g. creditors and wages)
Suppliers wouldn’t trade with a business which couldn’t pay for its purchases
Employees wouldn’t work if wages weren’t met
Save business from borrowing money (interest rates)
Take advantage of stock offers
Remember there’s a difference between __profitability__ and __cash flow__.
Cash flow problems
How? More money going out of the business (cash outflows) than coming in (cash inflows).
Consequences? Ultimate consequence is business failure and bankruptcy. E.g. JAL – Japanese Airlines.
Cash flow forecasting
Cash flow forecasting is a bit like a weather forecast, it’s all about the future! A CFF is a prediction of the cash flow in and out of a business over a future period of time (normally 6 months to a year).
Cash inflows are money received by the business for a variety of reasons.
Some examples can include:
Sales of goods for cash
Payments made by debtors (customers who have purchased goods but not paid for them yet)
Borrowing money from an external source (though will have to be repaid eventually)
Sale of assets & from investors (e.g. shareholders in a company)
Cash outflows are money spent by the business for a variety of reasons, depending on the main purpose of the business.
Some examples can include:
Purchases – Raw materials, Fixed Assets.
Consumable items = office stationery and cleaning materials.
Capital items = Computers, vehicles and equipment. Expensive but last longer.
Wages and salaries. Bonuses.
Paying creditors – suppliers who were not paid immediately.
Loan repayments – a key outflow!
Key definitions to remember
Net cash flow = cash inflow - cash outflow
Opening balance – amount of money in a business’s bank account at the START of a period of time, usually a month.
Closing balance - amount of money in a business’s bank account at the END of a period of time, usually a month.
Income per period – all the cash INFLOWS during that period
Expenditure per period – all the cash OUTFLOWS during that period.
__Positive cash flow – __Whenever a business’s income is more than its expenditure – i.e. a positive net cash flow, it makes money.
Negative cash flow – Whenever a business’s expenditure is more than its income – i.e. a negative net cash flow, it loses money.
CFS are normally produced in a little more detail than the summary statements that we have been looking at.
Uses and consequences
A cash flow forecast predicts the likely income (cash inflow) and expenditure (cash outflow) __over a __future period of time. The business will try to predict what their bank balance will be at the end of each month. Thus all entries are estimated because they haven’t occurred yet.
For a business, it can be used for:
- Planning ahead - see which months might be problematic, take appropriate action (e.g. apply for an overdraft/loan in advance). In other words, used to identify credit requirements and minimise risk! Many businesses may continue to trade in the short term even if they are making a loss via delaying paying creditors – therefore good cash flow forecasting is essential to business survival! CASH IS TRULY KING!
- Monitor planned against actual - see what lies behind the differences (variance analysis)
- Startup analysis - used when starting up a business, do you have enough money? (bank manager MUST see a cash flow forecast – planning means less risk__,__ more likely to give a loan)
- Manage cash flow - E.g. if have a very healthy opening balance, this capital can be used in other areas – use some money to pay off a loan or pay the creditors immediately or repaint the factory etc.
- Planning for major payments - e.g. when to buy new machinery
There’s a forecast is done incorrectly, there’s a number of issues that will arise. Largely this depends on the dependence the business has put upon the forecast to drive business decisions. They may have to sell assets to raise cash when they don’t meet their revenue/profit targets.
Identify credit requirements and minimise risk
Edexcel advises the following…‘Students are required to use a forecast to recognise when a problem might occur and know what to do about it. The emphasis here is on simple cash flow forecasts; complex spreadsheets are not required.’ Therefore if you identify a negative cash flow statement from a CFF, what should be done about it…
If cash flow is predicted to be really negative in an important month, it can be improved by:
Arrange with the bank for an extra loan or over an overdraft that month
Reduce some expenses by cutting down.
Delay paying some suppliers (creditors) for that month. I.e. ask for credit on purchases.
Increase the forecasted income in some way – e.g. extra sales at a fair