Chapter 18: Measuring and Increasing Profit

Profit

The difference between the income of a business and its total costs.
Profit= Total Revenue - Total Costs

Profitability

The ability of a business to generate profit or the efficiency of a business in generating profit.

Profitability relates the amount of profit to the size of the company.

Profitability % =   Profit (£)         X 100
                        Revenue (£)

Example:

A business makes £100,000 profit in a year by selling £700,000 worth of goods and services over 12 months. Calculate its profitability.

Answer: 100,000    X 100          = 14.3%
               700,000


There are two measures of the size of the company:
1. Sales Revenue (adding up all the income over a period of time, typically a year)

2. Capital Employed (Share capital is the same thing. Involves adding up all the money that has been invested in the company by the owners)

Net Profit Margin

Net profit margin compares the amount of profit to the total sales revenue of the company.

Net Profit Margin Definition: This measures net profit (although operating profit can be used) as a percentage of sales (turnover). Net and operating profits are considered the best measure of a firm's profit, while sales turnover is an excellent measure of scale.

What is net profit and operating profit?

Net profit is profit made from ALL ACTIVITIES. Sometimes this is misleading as a business may make a lot of money by selling an asset that it owns.

Operating Profit is profit made from TRADING (i.e. the MAIN ACTIVITIES of the business). For example, it does not include money gained from a sale of asset.

 

Example 1:

McDonalds financial year 2006/7. The net profit before tax in this year was £319.2m. The sales revenue was £5698.4m and the capital investment was £2796.3m.  What is the net profit margin for this year?

Answer:  319.2      X 100    
              5,698.4                    = 5.6%


Example 2:
 
Calculate the net profit margin if a business has £53,000 in sales, variable costs of £12,920 and fixed costs of £21,000. 

Answer:  £53,000 - (12,920 + 21,000)      x 100
                           53,000                                                  = 36% Net Profit Margin


Whether a percentage is good or bad, can be determined by:
- Comparisons with previous years' figures
- Other businesses in similar industries or competitors

For example, a lowering of the % net profit margin could indicate that the business is having problems controlling its costs.
But an increase could show the business is becoming more efficient in controlling costs or is able to set a higher price.

Return on Capital (ROC)

ROC compares the amount of net profit to the capital invested in the company.

Return of capital Definition: Ratio showing net profit (operating profit if also used) as a percentage of capital invested.

Capital Invested: All of the money provided to the business by owners.

Example 3:
 
Calculate the return on capital employed if a business invests £6,000 in a new project and receives a return of £480.

Answer:  480      X 100    
              6,000                    = 8%


Whether a return is good or bad may depend upon the opportunity cost. For example, a business may consider a return of 5% as too low, as it could have got 5% from the bank.

Methods of improving profits and profitability

3 basic methods to increase profit:

• Increase the price (to widen the profit margin)
• Decrease the costs (e.g. by sourcing cheaper suppliers, employing fewer people, cutting back on advertising)
• Increasing the sales volume (More advertising or product development)

Increasing the price
An increase in the price will widen the profit margin (difference between the price and the cost) and each product sold will generate more profit.

- Most effective with products that are a necessity or have no close substitutes.
- If this is not true, then there is a danger that demand will move to competitors or rival products.

Decreasing Costs

If there are no changes in demand --> It will increase the total profit.

If changes in costs leads or a decrease in quality or efficiency --> Demand for the product will fall.
Could happen because inferior raw materials are being used or workers accepting a lower wage are less motivated and so less efficient than those being paid a higher wage.

Also by reducing overheads (Such as rent, office expenses and machinery costs) - the costs could damage sales. E.g. a retail outlet may be reluctant to move premises with a lower rent if the new location is less accessible to customers. In this case, the savings in costs may be much lower than the decline in sales revenue caused by the unfavourable location.

Other methods of improving profit/profitability

• Investment in fixed assets - Buying new equipment, buildings or vehicles can allow the business to EXPAND its scale of operation and possibly IMPROVE both the EFFICIENCY of production and the QUALITY of the product. As a result, the business could increases its profits by achieving higher sales volume, charging a higher price and cutting its costs.
• Product development - Introduce new, unique products in order to attract more customers. Could allow a higher price to be charged too.
• Marketing - Encourages customers to buy more of the business' products. (e.g. A clever advertising campaign or a sponsorship). Increases the value of the product to the customer, this enables a higher price to be charged. Although marketing adds to the costs of the business, these extra costs should be offset by the additional revenue generated, so profit should increase.
• Human Resource Strategies - Careful selection, recruitment and training of staff + Motivation Strategies --> Greater efficiency of the workforce --> Greater output --> Higher quality products --> Better customer service --> Higher profits 

Distinction between cash and profit

Profitable firms may be short of cash as:
- Its wealth may lie in assets rather than cash (High stock levels)
- Wealth will be in debtors rather than cash (Gives credit)
- Pay dividends to shareholders
- Repaying a long-term loan

Liquidity: The ability to convert an asset into cash without loss or delay.

A firm may buy an asset and expect to make a profit from it in the future. However, cash payments for this asset may lead to the firm being unable to pay suppliers or workers. This could lead to liquidation, forcing the firm to close and sell its assets in order to make these cash payments.

Chapter 17: Improving Cash Flow

Cash Flow

Cash flow is the amounts of money flowing into and out of a business over a period of time.

Too much cash = Firm will have less machinery and stock than it can afford and so make less profit.
Too little cash= Threaten survival if a bill cannot be paid.
To get the right balance= Plan its cash holdings --> By having a cash-flow forecast --> Firm can identify problems and take appropriate action (e.g. arranging a bank overdraft)

Causes of cash-flow problems

1. Seasonal Demand
Companies typically incur costs in producing in advance of the peak season for sales. However because the problem is predictable, it is easy to persuade suppliers to provide credit or to negotiate a bank overdraft.

2. Overtrading
Firms become too confident and expand rapidly, not organising sufficient long-term funds. Putting a strain on working capital. Businesses often give credit to customers. Rapid expansion = Businesses to buy more materials but lacks money, this is because customers are not paying for the goods as soon as they are sold. This leaves the business short of cash.

3. Over-investment in fixed assets
Firms invest in fixed assets to grow, but leaves them with inadequate cash for day-to-day payments. Could drain the business of finance and lead to cash-flow problems. Equipment and buildings cannot easily be turned back into cash. Extreme situations = Can't pay debts, even though the business has plenty of assets.

4. Credit sales
Marketing dep. would want to give credit to customers --> To encourage them to buy --> lead to lack of cash in the organisation if sales are not leading to immediate receipts of cash.

5. Poor stock management
Hold excessive stock levels, tying up cash that could be used for other purposes.
High level of stock= Danger --> Stock becomes worthless as it is --> out-of-date or unfashionable.
But Low stock levels= Limit sales --> esp. impulse buys
Buying large quantities of stock --> Business benefits from discounts. Can this offset the costs of carrying high stock levels?

6. Poor management of suppliers
A well managed business should be able to negotiate a credit period with suppliers so that payment from customers reaches the business at the same time the business needs to pay suppliers.
Good supply chain management also means negotiations on a reasonably low price so money won't be wasted. It also ensures prompt deliveries of materials so customers will not be lost.

7. Unforeseen changes
Internal changes --> e.g. machinery breakdown
External Factors --> e.g. a change in government legislation
Due to? Management errors? Poor planning? Bad luck?

8. Losses or low profit
Remember that cash flow and profit is different but linked.
Sales revenue less than expenditure --> Usually have less cash than one making a healthy profit.
Also creditors and investors would be less likely to put money into a business that is not expecting to make profit in the future.
Unless a loss-making business can prove it will be profitable in the future, it will be difficult to overcome cash-flow problems.

Methods of improving cash flow

1. Bank overdraft
An agreement whereby the holder of a current account at a bank is allowed to withdraw more money than there is in the account. The agreement specifies the maximum level of the overdraft.

Benefits of an overdraft:

• Administrative convenience - Easy to arrange, once agreed= Confirmation only needed on an annual basis
• Flexibility - Flexible because it can be used to pay for whatever the business requires at the time
• Interest is paid on the amount owed - Only pay interest on the amount of the overdraft that is actually used. Paid on a daily basis.
• No security necessary - Unlike a bank loan, no collateral needed.

Problems of an overdraft:

• Variable interest payments - Based on flexible interest rates. The interest paid will rise and fall with the Bank of England's base rate. Difficult to budget accurately, as the bank may change its rate of interest on a monthly basis.
• Higher interest rate - Higher than a short-term bank loan. Overdraft can prove to be more expensive than a loan.
• Immediate repayment - Agreement to an overdraft means bank can demand immediate repayment. Business with cash flow problems may be forced to pay back the money to the bank at exactly the same time the business is most vulnerable.

2. Short-term Loan
A sum of money provided to a firm or individual for a specific, agreed purpose. Repayment of the loan will take place within two years, and possibly much less.

Benefits of a bank loan:

• Fixed interest repayments - Fixed rate of interest. The interest and repayment schedule is calculated at the time of the loan, so it is easy for a business to know whether it can afford to repay the loan. Easy to budget the loan repayments, can pay the same amount each month over the duration of the loan.
• Lower interest rate - Less than the rate charged on an overdraft. A cheaper solution to a cash-flow problem.

Problems with a bank loan:

• Higher interest repayments - Interest is paid on the whole of the sum borrowed. If the business has a healthy balance in its current account, it will not help reduce the interest repayments on the bank loan. Such payments will be a fixed sum every month. Consequently, bank loans can be more expensive than an overdraft despite the overdrafts high interest rate.
• Security - Must provide ban with security (collateral). Difficulties paying back the loan --> Bank can claim the amount owed by forcing a sale of asset. Major difficulties if asset is a large part of the business' operations.

3. Factoring (Debt factoring)
Factoring is when a factoring company (usually a bank) buys the right to collect the money from the credit sales of an organisation.

- Factoring agent usually pays the firm about 75% of its sales immediately and approximately 15-20% on receipt of the debt.
- Firm therefore loses some revenue (about 5-10% depending on length of time and current interest rate), which is the factoring company's charge for its service.

Benefits of factoring:

• Improved cash flow in the short term - Save expenses like overdraft interest charges and in extreme cases the immediate receipt of cash may keep the business alive by allowing it to pay off debts on time. Businesses who offer long credit periods to their customers in order to boost sales revenue, the immediate receipt of cash may be essential as it would be impossible for the business to wait a year for payment.
• Lower administration costs - Collecting and chasing debts is time-consuming and costly. The factoring agent specialises in this and could possibly collect more than one debt from the same firm.
• Reduced risk of bad debts - Factoring agent takes the risk and not the original company. Factoring agent can refuse to factor a debt which is too risky. Some firms contact the factoring agent before giving credit to a customer. Factoring companies have lists of customers who may be a high risk.
•  Increased efficiency - Encourages companies to be more careful with their provision of credit. If the business has a reputation for having no customers with bad debts attached to them, the factoring company will reduce the cost of factoring to that business. This will give firms an incentive to be more efficient in their provision of credit.

Problems of factoring:

• Loss of revenue - Business using factoring will lose 5-10% of its revenues. Reducing profit. But is possible to increase price charged to customers where credit terms are being offered.
• High Cost - Business pays more for the factoring company's services than it would to pay a bank for a loan (as there are admin expenses involved in chasing up debts). But there are admin savings from the business not having to chase up debts itself....
• Customer relations problems - Customers may prefer to deal directly with the business that sold them the product. An aggressive factoring company could upset certain customers, who will blame their bad experience on the original seller of the product.

4. Sales of Assets:
When a business transfers ownership of an item that it owns to another business or individual, usually in return for cash.

- Sales of assets --> Most likely to be used to overcome cash flow problems --> when a business is changing direction or moving out of a particular market.
- Sales of assets could be used to: ~  Pay a debt or ~ Build up a bank balance.

2 main benefits of sales of assets:

1. Income - It can raise a considerable sum of money particularly in the case of a large asset such as a building.

2. Profitability - A particular asset may not be contributing towards the business's overall success. In this case, the sale of the asset may ease cash-flow problems and enhance its overall profitability (as it is just adding to costs unnecessarily)

Problems of sales of assets:

1. Receiving a low value for the asset - Assets such as buildings or machinery --> Difficult to sell quickly, the business is looking for a quick sale --> Must accept a much lower price than true value.
May not be a good strategy --> damaging effect on long-term profitability.

2. Reduced ability to make a profit - Fixed assets enable a firm to produce the goods and services that create its profit. Exceptions= When assets are no longer required or when the cash-flow situation threatens the survival of the organisation.


5. Sale and leaseback of assets:
When assets that are owned by a firm are sold to raise cash and then rented back so that the company can still use them for an agreed period of time.

 





Other ways of improving cash flow
 
1. Improving working capital control
Working Capital: The day-to-day finance used in a business, consisting of assets (e.g. cash, stock and debtors) minus liabilities (e.g. creditors and overdrafts)
- Must manage working capital to stay solvent (solvent means you are able to pay off your debts)
- Involves careful control of firm's main current assets (cash, stock and debtors) to ensure enough is there to pay creditors and make other immediate payments.
 
2. Cash Management
If a firm is short of cash it has 2 main options:
- Agree to an overdraft with the bank
 
- Set aside a contingency fund so firm can meet unexpected payments or cope with lost income. In industries subject to more rapid change, a higher contingency fund should be kept.
 
3. Debt Management
4. Stock Management
5. Other Methods

(See Below)

Chapter 15: Assessing business start-ups

 

 

Why Start-ups can be risky and why many fail?

 

1/6 of new products succeed in the market place

Failure rate = 80%

 

Reasons for business failure=

• Poor cash flow management
• Lack of effective market research
• Lack of effective planning
• Lack of skills needed to run a business and lack of business training
• Problems in coordinating all the different aspects of the business
• Failure to turn what looks like a good idea into a profitable business
• Lack of finance to fund the business
• The actions of bigger competitors
• Difficulties in developing a solid customer base
• Difficulties in acquiring affordable premises
• Unexpected changes in demand for the product/service
• Unexpected changes in costs
• Delays and unavailability of supplies

Financial Difficulties: Raising Finance

The main issues are:

• It can be difficult to raise sufficient finance to get started. A new business has no 'track record', so lenders see it as much more of a risk than an established business.
• This 'risk' leads to higher interest rates being charged in order to balance the risk to the lender.
• Banks want collateral or security. This means owners putting up personal guarantees for any loans, offering their own assets (such as their homes or business premises). In effect, the owner is taking the risk rather than the lender.

These financial issues can:

- Slow growth of the business

- Threaten the survival of the business

- Affect the productivity of the business

- Affect the ability of the business to invest (e.g. in new machinery or premises)

 

Financial Difficulties: Cash Flow

• Profitable firms --> Impossible to keep trading --> Unable to meet current debts
• Cash tied up in stock that cannot be used immediately to pay bills
• Creditors slow to pay for its debts
• Business start-ups make a cash-flow forecast as part of the business plan --> Shows expected variation in working capital needed over time --> Indicate when overdraft facilities required to cover shortfalls.

Competition and the difficulties of building a customer base

 

The success of a business start-up will be determined by its ability to attract and retain customers. To do this, it will have to offer something more than any of its competitors and to gain customer loyalty.

 

Factors to consider when trying to encourage customer loyalty:

• Providing customers with service that is efficient and meets their expectations
• Providing a good after-sales service and dealing effectively and positively with customer complaints.
• Understanding customers' buying habits and ensuring that stock and staff availability are appropriate
• Ensuring that contact between customers and staff is always friendly and efficient.

 



Chapter 13: Using Cash-flow Forecasting

Cash Flow and Definitions:

1. Cash flow - The amount of money flowing into and out of a business over a period of time.

2. Cash Inflows - RECEIPTS OF CASH, typically arising from sales of items, payments by debtors, loans received, rent charged, sales of assets and interest received.

3. Cash Outflows- PAYMENTS OF CASH, typically arising from the purchase of items, payments to creditors, loans repaid or given, rental payments, purchase of assets and interest payments.

4. Net Cash Flow - The sum of cash inflows to an organisation minus the sum of cash outflows over a period of time.

To understand the concept of cash-flow, check out this website which has animations to demonstrate positive, negative and stable cash flow = http://www.bized.co.uk/learn/business/accounting/cashflow/simulation/positive.htm

The Cash-flow Cycle

Cash-flow cycle - The regular pattern of inflows and outflows of a cash within a business.

- Cash leaves the business between A and B, but then flows back into the business between B and A.
- Usually there is a DELAY between outflows and inflows of cash.
- This can cause cash-flow problems.

The extent to which cash-flow is a problem depends on:
- The amount of cash held at the beginning of the cash-flow cycle
- The length of time required to convert inputs into outputs.
- The level of credit payments by customers.
- The amount of credit offered by suppliers

Cash-flow Forecasting

Cash-flow forecasting is the process of estimating the expected cash inflows and cash outflows over a period of time. Cash flow is often seasonal, so it is advisable to forecast for a period of 1 year.

Cash-flow statement: A description of how cash flowed into and out of a business during a particular period of time.

A cash flow forecast attempts to PREDICT the FUTURE whereas a cash-flow statement DESCRIBES what actually happened in the PAST.

Sources of cash-flow forecasting

To create a cash-flow forecast, a business must use various sources:

1. Previous cash-flow forecasts
An established business can examine forecasts from previous years but still taking into considerations any changes in business activity.

2. Cash-flow Statements
Using last year's cash-flow statement with a description of its financial year. This is an excellent foundation for next year's forecast.

--- Note both of these sources are not available to start-up businesses ---

3. Consumer Research
Research into potential sales and prices that potential customers would deem acceptable. Allowing the business to forecast sales revenue.  Could also identify seasonal variation in sales revenue.

4. Study of similar businesses, such as competitors
Possible to gain information from similar businesses, particularly businesses not competing in the same geographical area.

5. Establishing the level of resources needed
Using the probable sales level of the business to calculate the resources that the business will need. e.g the cost of resources (machinery, rent, wages etc...)

6. Banks
Commercial banks have considerable expertise in supporting and handling the finances of a small business. Local Branches also may have expertise in specific industries. E.g. a bank located in a tourist area will have expertise in the hotel industry. 

7. Consultants
Can gain expert opinion on how to forecast cash flow accurately.

8. The cash-flow forecast itself
Early drafts of the cash-flow forecast are used to build up on the final forecast. E.g. A early draft may indicate a difficulty such as a shortage of cash. A step can be done to rectify this problem, like getting an overdraft from the bank.


Possible Causes of Inaccuracy/ Problems of Cash-flow forecasting

1. Changes in the economy
Changes in economic growth and unemployment levels might mean consumers have less (or more) spending power. Also inflation (increase in prices) means purchasing power decreases.

2. Changes in consumer tastes
Change in consumer opinions. Mostly in fashion and technology markets.

3. Inaccurate market research
e.g. Targeted the wrong group of consumers, small samples, biased questions

4. Competition
New competitors entering the market or a competitor increasing its market share. Will affect the business' level of success.

5. Uncertainty
E.g. Cost over-estimates or under-estimates

Parts of a Cash-flow Forecast

- Cash Inflows
- Cash Outflows
- Net cash flow (Cash inflows - Cash Outflows)
- Opening balance
- Closing Balance - the amount of money left in the bank at the end of the month -
(Opening Cash Balance + Net cash flow)

An example of a cash flow forecast:

Why businesses forecast cash flow

• To identify potential cash-flow problems in advance (e.g. inability to meet payment obligations)
• To guide the firm towards appropriate action (taking a problem and use an action to overcome the difficulty. e.g. change plans like not building the office extension which was causing a predicted cash shortage).
• To make sure that there is sufficient cash available to pay suppliers and creditors and to make other payments. (e.g. planning cash inflow in order to make payments, may require an overdraft for example)
• To provide evidence in support for a request for financial assistance (e.g. asking a bank for an overdraft) - Proving why the firm needs help and how it will be paid back.
• To avoid the possibility of the company being forced out of business (into liquidation) because of a forthcoming shortage of money - Business can still be profitable but have no cash as it is tied up in stock and buildings.
• To identify the possibility of holding too much cash - Too little machinery and stock to be less productive and make less profit.