LO2 - Using financial data to inform business decisions
2.1 - How to use profitability data
2.2 - How to use break-even analysis
2.3 - How to use contribution data
2.4 - How to use cash flow data
2.5 - How to use investment appraisal
Costs: the amount of money business spends on goods and services
Fixed: don't change according to sales
Variable: change depending on output level
Total costs= fixed costs+ variable costs
Revenues: money earned through sold goods, coming into the business, revenues should show an upwards trend.
Revenue= selling price x units sold
Gross profit/ loss: money left after taking costs off the revenue, shows how profitable the product is.
Gross profit= revenue - total variable cost
total variable costs= variable cost per unit x units sold
Net profit/ loss: money left over after taking away expenses from gross profit (salaries, rent, insurance) expenses not linked to production of goods. shows business profitability over all
Net profit= gross profit - expenses
Profitability ratios: measure business ability to make profits, indicator of business performance, used by management to show how to keep costs down, shareholders base investment decisions on these.
net profit ratio: comparison of business net profit with sales revenue, in %, measures ability to make profit and efficiency, compared over period of time or with competitors.
Net profit ratio= net profit/revenue x 100
gross profit ratio: profitability of goods and services, compares gross profit from selling goods with total sales revenue received, in %.
Usually higher than net profit margin as is proportion of profit made before taking expenses into account, comparisons made over time.
gross profit ratio: gross profit/ revenue x 100
Performance data: key indicators of business performance
customer satisfaction: including with quality and price of goods, can predict long term performance and used to compare across the industry to assess competitivity
Employee satisfaction: they work harder and better improving productivity, rates of absenteeism and staff turn over will be low, costs kept low, wastage level low, better motivation
when business revenue = total costs, neither profit nor loss is made. the min number of units that have to be sold.
info used to plan production, control stock and used as a modeling tool to find effect of different selling prices on break even level. also indicates viability of business idea.
Pros:
used to work out min amount of sales needed to not make a loss
a modelling tool to work out pricing strategies
effects of changes in variable and fixed costs worked out, contingency can be put in place.
break even analysis supports application for a loan
Cons:
model assumes all output is sold, doesn't account for waste, this makes it unrealistic
assumes costs increase at a constant rate, ie business may negotiate discount price making total cost line not straight
assumes selling price is constant, no special offers or discounts observed, its unrealistic to assume sales revenue increases at constant rate
Break even graphs
has three lines: fixed costs, total costs, sales revenue
Y axis shows amount of costs/ revenue, X axis shows units sold/ produced. fixed cost shown as horizontal line as doesn't change, sales revenue starts at 0 and increases at constant rate.
third line= total costs= fixed cost + variable cost, starts at the fixed cost line.
breakeven: intersection between sales revenue and total costs, read on the X axis then Y axis shows the cost from selling the breakeven quantity.
Calculations
break even point= fixed costs/ selling price- variable cost
profit= sales revenue - total costs
Sales revenue= selling price x quantity sold
total variable costs= variable cost per unit x amnt of units sold
total costs= fixed cost + total variable cost
Margin of safety: difference between quantity at certain output level and the breakeven level.
profit= margin of safety x unit contribution
unit contribution- selling price - variable cost per unit.
factors effecting breakeven level of output:
costs could rise ie rent, pay rises, spending on marketing campaign, investing in technology, more expensive raw materials.
increase in cost increases break even level, decrease cost lowers it
increase in revenue decreases break even and vise versa
How to lower breakeven level of output, this will increase profit level, includes weighing up effects of lower fixed costs and higher selling price or lower variable costs.
Lowering fixed costs:
negotiating cheaper rent
moving to smaller premisies
shopping around for cheaper insurance premiums and utility costs
increasing selling price:
product or service has to have unique selling point, so high end customers are still attracted
prices can increase when there are shortages in supply
Lowering variable costs
switching to cheaper supplier
buying stock in bulk at discount price
using less or poorer quality material
paying lower wages on direct labour
Unit contribution= selling price - variable cost per unit
This calculates how much gross profit each unit sold makes, therefore how many need to be sold to cover fixed costs.
Special order decision: selling good at lower price, closer to the unit contribution to an important customer ordering bulk.
Cash flow: movement of money into and out of business. Net cash flow: difference between cash in and cash out, needs to be positive. Doesn't indicate profit, just how healthy the business is.
Interpreting cash- flow position:
Net cash flow= total inflow- total outflow
Opening balance: same as the closing balance for the previous month
Closing balance= total inflow - total outflow + opening balance
good cash flow position:
net cash flow +ve : total spend is less than income
closing balance +ve so business has money for next month
opening balance +ve so cash is available for bills.
How to improve cash flow
increasing cash inflow ie sales revenue or use loan
decreasing cash outflow ie reduce spending
This is the process of evaluating how attractive a business project or idea is, uses three main techniques:
Payback
The time it takes to recoup initial investment, estimated net cash flow shows the payback period, where the entire net cash flow= initial investment. payback periods used to compare projects, shorter the payback the better.
Pros:
Cons:
Easy to understand clearly
Focuses on liquidity, important for business with limited funds
Risk of project with short payback lower, so more preferred by careful businesses.
Cash flow is not discounted so time value of money not accounted for.
Payback emphasizes liquidity and ignores profitability
Calculation ends as soon as payback is reached
Projects with longer payback may be more profitable
Short term approach
Average rate of return (ARR)
Calculates average profit made over lifetime of project, expresses it as a % of initial investment. ARR= average profit/ initial investment x 100
Pros:
Cons:
Accounts for profitability, so is performance indicator
takes into account cash flow throughout project lifetime
Ignores time value of money
Average profit doesn't account for timing of cash flow, which can be a priority for business with limited funds.
Net present value (NPV)
Recognizes the time value of money by calculating net cash flow over lifetime of a project, allows for comparisons to be made for various projects
Pros:
accounts for time value of money
considers all cash flow in whole lifetime of a project
can be easily compared with a target
Cons:
Choice of a discount factor might not reflect accuracy of rate of depreciation over lifetime
Cash flow is estimated, so accuracy requires skill and experience.