Profitability: - Isn’t managing its costs of sales

Profit is the surplus of revenue over costs. effectively e.g. costs of materials
- Gross profit. increasing
- Operating profit. - Sales are in decline.
- Profit for the year. Gross profit
GPM = x 100.
These are shown on a statement of Sales revenue
comprehensive income.
A formal financial document that Operating Profit Margin (OPM) is a
summarises a business’ trading activities & measure of firm’s profitability by looking
expenses to show whether it has made a at the relationship between net profit &
profit or loss. sales revenue.
 Sales revenue: money coming in
from sales. If OPM is low or failing, this may indicate:
o Quantity sold x selling - Is not managing its expenses
price. effectively e.g., wages are
 Costs of sales: costs directly linked increasing, or overheads are going
to production of goods or services up.
sold e.g., raw materials. - Sales are in decline.
 Gross profit: sales revenue – cost Operating profit
OPM = x 100
of sales. Sales revenue
 Other operating expenses:
 All other costs associated with Profit for the year (NPM) margin is a
trading of business e.g., salaries & measure of a firm’s profitability by
marketing expenditure. looking at relationship between profit for
 Operating profit: Gross profit – the year & sales revenue.
operating expenses.
 Interest & taxation: interest paid on If net profit margin is low of failing, this
debt or received plus tax payable of may indicate that a firm:
profit. - Gross profit or operating profit are
in decline.
 Exceptional items: any unusually
- Interest rates have changed.
large or infrequent transaction.
Net profit
 Profit of the year (net profit): GPM= x 100
Sales revenue
Operating profit – interest.
Profitability measures financial
performance of a business by comparing
profits achieved to a second variable
e.g., revenue.
- Gross profit margin
- Operating profit margin
- Profit for the year (net profit)
margin.
How to improve Profit & Profitability:
Gross profit margin (GPM) is a measure of
Sell the same quantity but at a higher
a firm’s profitability by looking at
price:
relationship between gross profit & sales
Costs remain the same, and difference
revenue.
between selling price & costs is now
greater.
If GPM is low or failing, this may indicate
- Raising prices is likely to have an
that a firm:
impact on demand.
Sell more at current price. Cash is measured by taking into account
Sell at the same price but reduce variable full range of money flowing in & out of
costs: business.
May involve purchasing
cheaper/alternative resources, negotiating A new business may have to pay cash on
with suppliers, or purchasing in bulk. purchase for all its supplies until a good
- Ensure reducing variable costs will business relationship has built up a level of
not have an adverse effect on trust with suppliers.
quality or desirability of products. - May then begiven trade credit.
- Buying bulk in greater quantities
may require investment in
increased storage space which
will reduce impact of cost savings
made.
Reducing other expenses:
Reducing staffing levels, relocating to
cheaper premises or changing utility
companies can reduce expenses.
- Reducing staffing levels may affect
staff morale & negatively affect
productivity.
- Relocation costs can outweigh
some benefits of moving to a
cheaper location.
- Replacing inefficient or outdated
equipment may require staff
training.
Reducing one-off costs & interest charges:
Delaying purchase of fixed assets, entering
leasing arrangements, or restructuring
borrowing can reduce costs.
- Delaying purchases of new fixed
assets may negatively impact
capacity utilisation as a result of
increased breakdowns &
maintenance of old equipment.
- Leading equipment can reduce one- Liquidity:
off purchase costs, but business
never owns these assets which Statement of Financial Position
weakens balance sheet. (Balance Sheet):
- Restricting borrowing can result in Contains financial information required to
lower monthly payments but draw conclusions about liquidity of
requires lenders to agree to new business, by summarising net worth of
terms, which they may not be business at given point in time.
willing to do.  Liquidity is the ability of a
business to meet its short-term
Distinction between profit & cash: commitment.
Profit is difference between revenue  Business that cannot pay its bills
generated & business costs. will usually fail very quickly, even
if they’re profitable.
  Managing liquidity is a key way to A business with low liquidity is in danger
manage risk in a business - & if short-term creditors demand payment
helps business to prepare for the quickly e.g., bank recalls & overdrafts.
unexpected.
Ways to Improve Liquidity:
Non-current assets are items that are The best way to improve liquidity is to
owned by business for the long-term. manage business better:
e.g., Machinery & Buildings. - Use cash flow forecasts to identify
potential cash flow issues before they arise
Current assets are items that are converted - & take appropriate action.
to cash quickly – usually within 12 - Budget effectively & consider adopting
months. xero budgeting to carefully control
Current assets are comprised of cash, trade spending.
receivables & inventory. - set clear financial objectives & look for
ways to reduce costs & increase income
Current liabilities is money a business wherever possible.
owes & is due to be settled soon – usually
within 12 months. Reduce credit period offered to
These include trade payables & short-term customers:
borrowing such as a bank overdraft. - Collecting money owed from customers
more quickly will increase level of
Non-current liabilities is money a current assets in business.
business owes & that does not need to be - customers may move to competing
paid back for at least 12 months. businesses that offer better credit terms.
Include bank loans & mortgages.

Net assets = assets – liabilities.

statement of financial position shows how

net assets of a business are business are
funded. Ask suppliers for an extended repayment
Total funding is known as capital period e.g., an extension from 60 to 90
employed. days:
Net assets = Capital employed. - current liabilities will not be reduced.
- business can use cash that would have
Share capital + retained profit = total been paid to suppliers for other purposes.
equity. - suppliers may be unwilling to extend
credit terms.
Measuring liquidity:
Current ratio: Make use of overdraft facilities or short-
current assets term loans:
current liabilities - Current liabilities will increase.
- Business can spend more money than it
?:1 has in its bank account.
- Banks may be reluctant to lend to
Acid Test ratio: businesses with cash-flow problems.
Current assets−Inventory
Current liabilities Sell off excess stock:
?:1
- Less liquid current assets will be reduced business cannot meet its immediate
& converted into more liquid forms of failure obligations.
current assets (e.g. cash). - Cash is the most liquid of
- storage & security costs may be business’s current assets & can be
reduced. used to settle debts immediately.
- stock may need to be sold at a low price
to attract sales. - Debtors & inventory are less
liquid.
Sell assets & lease fixed assets instead: - Businesses struggling with lack of
- Both current assets & current working capital may look to
liabilities will increase. convert those current assets into
- business will continue will continue to cash as quickly as possible.
have use of assets but must make regular - Requesting extension of payment
payments to leasing company. terms from suppliers can increase
capital in short term as cash
Introduce new capital & reduce drawings remains in business for longer.
from business: - Making use of short-term
- current assets will be increased. borrowing options such as
- new capital may be introduced by overdrafts can improve businesses
owner or from additional investors. working capital situation as it can
- may result in dilution of control of access more cash than it has in its
business. current accounts.
Business can have too much working
capital:
- If business is holding large
amounts of cash, it is likely to be
missing out on benefits of
investing it in fixed assets or
Increase current assets and/or reduce investments.
current liabilities: - Represents significant opportunity
- sell assets no longer being used. costs especially when interest rates
- move cash balances from current are high.
accounts to high interest-bearing accounts - If business is holding large
so its value increase more rapidly. amounts of inventory it may incur
- switch to long term sources of finance. extra storage costs & could use
- monitor debtors to avoid bad debts. cash tied up in stock for other
purposes.
Working capital:
Money that a business has to fund its day-
to-day activities.
- often described as net current assets on
Statement of Financial Position.

Working capital: Current assets-current

liabilities.

Working capital is described as lifeblood

of business because a lack of working
capital often leads to business failure as a
 36 Business Failure

The highest rate of business failure is

amongst new businesses (start-ups).
It is obvious why this is the case:
- difficult to test a business model without
trading.
- Easy to be over-optimistic in business
plan.
- Competitor response is often aggressive.
- Management may lack experience.

INTERNAL CAUSES OF BUSINESS

FAILURE:
POOR PLANNING:
- ineffective business plan.
- poor budgeting.
- lack of research & development so little
innovation.
- inaccurate cash flow forecasts.
- Inadequate resources.

Lack of leadership:
- poor decision making.
- lack of urgency.
- Failure to delegate.
- lack of skills to run a business.

Failure to understand the market:

- lack of market research.
- wrong segment.
- underestimated degree of competition.

Badly organised:
- poor stock control.
- inefficient labour.
- Bad customer service.
- cash-flow/ liquidity problems.

Ineffective management is a key cause of

business failures.
- Leaders may lack experience or
skills to run a business effectively,
especially during periods of crisis.