The Student Network

Transcription

1 The Student Network Profitability By Lucy Ralph Definitions Profitability: The ability of the business to earn profit, measured by comparing its profit against a base, such as sales, assets or owner s equity Liquidity: The ability of the business to meet its short-term debts as they fall due Efficiency: The ability of the business to manage its assets and liabilities Stability: The ability of the business to meet its debts and continue its operations in the long term Trend: The pattern formed by changes in an item over a number of periods Benchmark: An acceptable standard against which the firm s actual performance can be assessed Variance: The difference between an actual figure, and a budgeted figure, usually expressed as favourable or unfavourable Profitability Indicator: Measures that express an element of profit in relation to some other aspect of business performance What does P.I.G. stand for? P Past performance, how well the business has done in previous Reporting Periods I industry performance, how well the business has done compared to other businesses of the same type G Goals/Budgeting, how well did the business go against the budgeted reports and the goals that were intended for the period. Return on Investment State what is measured by Return on Investment/Capital ROI measures for each $1 of capital invested by the owner into the business, how much profit the business is making. Indicating, how effectively the business has used the owner s funds to earn profit. Debt Ratio What is the Debt Ratio? The Debt Ratio is a stability indicator that measures the percentage of a firm s assets that are financed by liabilities, indicating the extent to which the business is reliant on liabilities/debt (rather than the owner s capital) to purchase its assets. TOTAL LIABILITIES / TOTAL EQUITIES

2 What is meant by a high Debt Ratio and what impact can this have on the business? A high Debt Ratio means that there has been a greater reliance on borrowed funds (liabilities) to purchase assets and, consequently a lower reliance on funds contributed by the owner. This can be more risky to the business as it jeopardises the business s stability as there is a higher risk that the business will be unable to repay its debts and meet the interest payments. However this is one way to increase the ROI, without actually increasing profit. With a higher debt ratio, the business is using someone else s funds to buy the assets to earn profit, but the business still receives all that profit. What will the impact on increased gearing be? Increased gearing means increased risk due to increased interest payments and loan repayments, causing increased pressure on cash flow and possible bankruptcy. High gearing is not always bad, and can be profitable when return on assets exceeds the interest rate. What are the causes for a HIGH Debt Ratio? Total liabilities increase Increase in non-current liabilities Decrease in Owner s Equity Drawings are higher than profit There are drawings and a loss What are the positive and negative impacts from an increased Debt Ratio? Positive: Loans can allow for the business to afford Non-Current Assets ROI could increase if borrowed funds are put to profitable use Compare ratio of interest on loan to ROA Negative: Increase in an interest expense which leads to a decrease in Net Profit. Hence, a decrease in NPR, thus profit is falling Return on Assets State what is measured by Return on Assets ROA measures for every $1 of assets put into the business, how much profit has been earned. It is a profitability indicator that measures how effectively a business has used its assets to earn profit. State reasons for change for the Return on Assets If Assets increase and Net Profit increases by a smaller proportion than ROA will fall -->

3 deteriorating profitability If Net Profit increases more than Assets increase than ROA will rise --> improved profitability Net Profit changes is reliant on two factors: earning revenue and controlling expenses What is the connection b/w ROA and ROI ROI will always be higher than ROA, this is because owner s equity will always be lower than total assets, which in turn is due its liabilities. Only if the firm has no liabilities (very unlikely) will the ROA be the same as ROI Assets Turnover State what is measured by Assets Turnover The ATO measures for each $1 of assets put into the business, how many cents the business is making. It is an efficiency indicator that measures how productively a business has used its assets to earn revenue. The higher the ATO, the more capable the business is of using its assets to earn revenue. What decisions need to be made about Assets Turnover Decisions include: If the business need to buy new assets Expanding Improving efficiency of use of current assets If the business needs to sell unproductive assets to increase this ratio What is the connection b/w ATO and ROA The ROA relates to profit, whereas ATO relates only to revenue. Normally an increase in ATO should mean an increase to ROA and increased Net Profit. However, if the ATO and ROA both move in different directions, it indicates a change in expense control. E.g. ATO increases and ROA decreases, indicating worse expense control Net Profit Margin/Return on Sales What is the Net Profit Margin/Ratio/Return on Sales/Return on Revenue? The net profit margin is a profitability indicator that measures expense control by calculating the percentage of Sales revenue that is retained as Net Profit. It measures how much of each $1 earned from sales revenue remains as Net Profit after expenses are deducted. What does deducting the NPM% from 100 reveal? It reveals the percentage of each Sales dollar that is consumed by expenses.

4 Explain the relationship b/w NPM, ATO & ROA. As ROA highlighted that the ability of a firm to use its assets to earn profit relies on its ability both to earn revenue and to control its expenses. Thus, NPM & ATO are both indicators to do just that. Thus, ROA depends on ATO and NPM. ROA = ATO x NPM Expense Control What is expense control? Expense control is the firm s ability to manage its expenses so that they either decrease, or in the case of variable expenses, increase no faster than sales revenue. What are the two analysis indicators used to evaluate expense control. Net Profit Margin (NPM) Gross Profit Margin (GPM) State what is measured by Other Expense Ratio The other expense ratio measures for every $1 of sales, how much is being used up as another expense. This indicates whether the business its expense control is being used to the best of its ability. State reasons for change to the Other Expense Ratio Stock discrepancies Changes in mark-up Better inventory control Better expense control Gross Profit Margin GROSS PROFIT / TOTAL SALES What is the Gross Profit Margin/Ratio (GPM)? It is a profitability indicator that measures the average mark-up by calculating the percentage of Sales revenue that is retained as Gross Profit. Gross Profit is able to assess expense control specifically related to Stock and Costs of Goods Sold. The Gross Profit is the difference between Sales Revenue and Costs of Goods Sold used to assess the adequacy of the firm s mark-up: the difference b/w the selling price and cost price of stock. If the Gross Profit Margin increases from one Reporting Period to the next, poor Costs of Goods

5 Sold will not be responsible for a decrease in the Net Profit Ratio What does a higher Gross Profit Margin indicate? This indicates a higher average mark-up; on average, a bigger gap between the selling and cost prices. Occur due to: Selling prices increased and cost prices remained constant Cost prices decreased, and selling prices remained constant Both increased, but selling prices increased by more Both decreased, but cost prices decreased by more Explain how increasing selling prices could lead to an increase in the Gross Profit Margin but a decrease in Gross Profit. A higher-selling price would increase the average mark-up and the gross profit margin. However, customers may be unwilling to pay for the higher prices, leading to a decrease in the volume/quantity of sales. Thus, may decrease the total Gross Profit for the Reporting Period. Non-Financial Information What is defined as Non-Financial Information? It is any information that cannot be found in the financial statements, and is not expressed in dollars and cents, or reliant on dollars and cents for its calculation. What are the limitations of relying solely on the Income Statement and profitability indicators to evaluate profitability? The reports historical data they do not guarantee what will happen in the future Many indicators rely on averages, and this may conceal details about individual items. Firms use different accounting methods, which can undermine the Comparability of the reports, and profitability indicators the reports contain limited information: there are many items of information simply not reported on the income statement. What are these Non-Financial indicators the business uses to help assess: The firm s relationship with its customers Number of repeat sales Number of sales returns Number of customer complaints Number of sales enquiries/catalogue requests Degree of brand recognition, based on market research The suitability of stock Number of Sales Returns will provide a useful guide to the suitability of stock Number of Purchase Returns Number of customer complaints

6 The firm s relationship with its employees Performance appraisals Assessed by the number of days lost due to sick leave/industrial action Assessed by turnover average/average length of employment The State of the Economy Needs to consider: Interest Rates Unemployment Rates Number of competitors Level of inflation will also be relevant when assessing the firm s ability to control expenses What are strategies implemented in order to improve a firm s ability to earn revenue? Selling Price Selling prices could be decreased to generate more Sales Volume, or increased to generated greater revenue per sale. Advertising Advertising could be increased, or targeted more accurately at prospective customers Stock Mix Stock held for sale could be changed so that only those products that are in demand are kept on hand; slow moving lines of stock should be removed, and replaced with those that sell. Non-Current Assets Non-current assets could be increased, or replaced by more efficient versions, to enable the firm to increase Sales. This may be better equipment, display fittings, delivery vehicles or a new location Customer Service Internal procedures could be made more friendly; staff training could improve employee s service/product knowledge, extra services could be offered e.g. deliveries, wrapping, internet/phone access/product advice What are strategies implemented in order to improve a firm s ability to control expenses? Management of Stock Cheaper supplier may be able to provide cheaper and/or better quality stock Different ordering procedures could reduce storage costs and stock losses or generate price discounts Management of Staff Different rostering systems, Appropriate incentives and extra training could improve staff productivity and performance Management of Non-current Assets Assets that are Inefficient, Underutilised or Unreliable are ultimately expensive, and should be replaced or removed.