Measuring and Increasing Profit

Measuring and Increasing Profits:

Video case study: How does McDonald's make such high profits when most of the food it sells is so cheap? Click on the photograph.

Profit: the difference between the income of a business and its total costs. 

Profit = Total revenue minus Total costs

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

Profit is calculated in 'The Statement of Comprehensive Income' previously known as the 'Income Statement'.

https://www.tutor2u.net/business/reference/income-statement-introduction

Measuring Profitability:

Three ways of measuring profitability will be considered. 

Gross profit: Revenue minus cost of sales.

Gross profit margin:

Formula:

Gross profit      x  100
Sales revenue

Operating profit: Gross profit minus other operating expenses.

Operating profit margin: compares the profit made with the sales income of the business / branch.

Formula:

Operating profit      x  100
Sales revenue

Net profit: Operating profit minus interest.

Net profit margin:

Formula:

Net profit      x  100
Sales revenue

To assess the meaning of a profit margin, two comparisons are usually made:

Comparison over time. Is the net profit margin increasing (suggesting improvements in efficiency) or decreasing (implying a decline in efficiency).

Comparison to other firms or branches/divisions. 

These comparisons are useful because they look at the business’s success (or failure) relative to other businesses.

It is much easier to make high net profit margins in some industries* than in others.

*These industries usually sell fewer items at higher prices, so a high net profit margin is not a guarantee of higher overall profit levels.

Improving Profits/Profitability:

Many methods can be used. 

Three main methods are:

Increasing Prices

Increasing the price will widen the profit margin.

Therefore each product sold will generate more profit.

This strategy will be particularly effective if the product is a necessity or has no close substitutes, as customers will be willing to pay the higher price.

BUT…this strategy will fail if the higher price leads to customers switching to rival products or just giving up on buying the product.

Reducing Costs

Variable costs:

If the firm can cut its variable costs, the profit margin will increase.

This means that each product will generate more profit.

BUT…if the change in costs leads to a decrease in quality (e.g. inferior raw materials) or efficiency, the demand for the product may fall.

Fixed costs:

Profit will also increase if fixed costs, such as rent, are reduced.

BUT…not if the cost cutting leads to lower sales (e.g. locating the shop in a location with low footfall).

Increasing Sales

If costs and price remain the same, it is still possible to increase profits by increasing the volume of products sold.

A business can achieve this by a number of methods, such as:

Increasing marketing

Developing new products

Improving quality

        BUT…all of these methods will cost money.

Cash Flow vs Profits

Why cash flow is not profit….

Profit is total revenue minus total costs (fc + vc).

Revenue comes from customers.

Not all cash comes from customers.

Cash could be received in the form of a bank loan.

Cash (revenue) from customers is recorded as it is received.

So, credit sales are not recorded as cash (revenue) until the money is paid.

But, credit sales can be included in calculating future profit levels.  

Profits are calculated in the ‘Statement of Comprehensive Income’. 

Cash is shown in a cash flow statement. 

What Is a Cash Flow Statement?

The statement of cash flows, or the cash flow statement, is a financial statement that summarises the amount of cash entering and leaving a company.

Cash is only recorded when money changes hands.

It will only be recorded in the statement once the business has 'actually' received money, rather than what it is 'promised' to receive.

For instance, if a business makes sales which are 10% on cash and 90% on credit. 

The cash flow statement will only record the money received for the "10%" of sales and it will record the rest of the "90%" when it has 'actually' received this money.

On the other hand when we calculate profit, we will include the cash as well as credit sales, which means all of the sales made. 

This shows that the business is profitable but it will actually be short of cash.

Some other cases where profitable business can run out of cash are :

a: purchase of an fixed asset (through cash)

b: over-trading

This means to engage in more business than can be supported by the market or by the funds or resources available.

Cash flow is vital in the short run and profit is vital in the long run.

Therefore, cash is important in the short run as it is needed to pay creditors and workers. Without sufficient cash, creditors (in extreme cases) can take you to the court and declare you bankrupt or insolvent in case of companies.

See this video: http://news.bbc.co.uk/1/hi/business/7874984.stm

Workers who will not be paid on time will be demotivated, resulting in poor productivity, high absenteeism and labour turnover.

Profits are essential for the long term survival of the business. 

Nobody would be interested in investing in a business which yields them a very low or negative return.

Business Failure

Why did this business close after 146 years?

Why did this restaurant close down?

Why have half of UK nightclubs closed?

Why did this airline fail?

Click on the picture:

Internal causes of business failure:

1. Poor efficiency. (Financial)

Costs are too high compared to competition.

Productivity (output per worker / machine) is too low.

2. Poor management of working capital. (Financial)

Current assets  (£'s) minus current liabilities (£'s).

3. Poor marketing. (Non Financial)

Click on the picture for other examples of terrible marketing decisions.

4. A failure to innovate. (Non financial)

This business expert points to internal business failure for Mothercare in the UK:

External causes of business failure:

1. Economic recession (Financial)

Demand for some products may fall dramatically causing cash flow issues. 

2. A strengthening pound (appreciation in the value of the pound).

This would be very bad news for any business that relied on export sales.

More on business failure here.

Business rates can be a huge burden on business.

Click on the picture:

Website here.

Managing Finance

Conducting Ratio Analysis

The Statement of Financial Position, previously known as the 'Balance Sheet'.

Statement of Financial position (balance sheet):

https://www.tutor2u.net/business/reference/the-balance-sheet

Liquidity ratios:

1. Current Ratio

The current ratio is a calculation that shows whether a company has enough resources to cover its debts. 

Current assets (£'s)
Current liabilities (£'s)

The result is NOT a %.

It is a ratio expressed to 1 ( x:1)

Typically, textbooks will say a ratio of around 2:1 suggest no immediate signs of running out of cash.

More on the current ratio here.

2. Acid Test Ratio

Less stock means minus stock.

Why is stock (inventory) excluded from current assets?

Typically, textbooks will say a ratio of around 1:1 suggest no immediate signs of running out of cash.

More on the acid test here.

Assessing the value and limitations of ratio analysis. Details here.

You also need to be aware of Working Capital.

A business is solvent if it can meet its short-term debts when they are due for payment. 

To do this it needs adequate working capital. 

There are three main reasons why a business needs adequate working capital. 

It must:

Pay staff wages and salaries.

Settle debts and therefore avoid legal action by creditors.

Benefit from cash discounts offered in return for prompt payment.

The working capital of a business is the amount left over after all current debts have been paid.

Working capital (£s) = Current assets (£s) minus Current liabilities (£s)

Managing working capital:

 

Different businesses have different working capital needs.

Larger businesses are likely to have high levels of working capital.

Retailers are going to require higher working capital compared to businesses that do not have much stock.

The typical business needs around twice the amount of current assets to current liabilities to operate safely.

This means its current ratio is close to 2:1.

Maintaining adequate levels of working capital:

If working capital is too little the business will start to encounter problems.

If a business does not have enough stock then manufacturing or sales will stop.

If there is not enough cash in the business, it might not be able to pay bills on time.

On the other hand, a business does not want too much working capital (i.e. current assets are too high and current liabilities are too low.)

Why?

Stocks are costly to keep.

Too much cash is unlikely to be earning high rates of interest and should be being used for more productive purposes.

Ways to improve liquidity:

Liquidity problems can be prevented by keeping a tight control on financial resources.

The use of budgets and cash flow forecasts will improve the financial management of the business.

If a business runs short of cash:

1. Use of overdraft facilities.

2. Negotiate additional short or long term loans.

3. Encourage cash sales and sell off stocks.

4. Sale and leaseback. An example here.

5. Only make essential payments.

6. Extend credit with selected suppliers.

7. Reduce personal drawings from the business.

8. Introduce fresh capital into the business.

You need to know the consequences of having too little or too much working capital.

More on working capital here.