2.4 - Making Financial Decisions

Question 1

What do businesses have to keep an eye on?

Answer 1

+Businesses have to keep an eye on their finances.

+They can find out how risky an investment is likely to be working out the ARR.

+They can find out how much the business is making by working out its gross or net profit.

Question 2

What can you find on an investment?

Answer 2

+You can find the average rate of return on an investment

Question 3

What is the return on an investment?

Answer 3

+The return on an investment is how much a business makes or loses as a proportion of the original investment.

+You need to be able to work out the average rate of return [ARR].

Question 4

What is an investment’s lifespan?

Answer 4

+An investment’s lifespan is the length of time over which it earns money for the firm.

Question 5

What is the average rate of return?

Answer 5

The average rate of return is a calculation of the average return on an investment each year over its lifespan.

Question 6

How do you calculate the average annual profit?

Answer 6

average annual profit = total profit number of years

Question 7

How can you calculate the average rate of return?

Answer 7

+To calculate it you first have to work out the average annual profit.

+Then you can put your value for average annual profit into this formula, to find the ARR:

ARR[%] = average annual profit cost of investment x100

Question 8

What will it mean for the firm the bigger the ARR?

Answer 8

+The bigger the ARR for an investment, the more successful the investment for the business.

Question 9

What will a good ARR depend on?

Answer 9

+But a good ARR will depend on the firm involved, as well as the amount of money invested - an ARR of 6% would be significant for a £1m investment, but probably not for a £100 one.

Question 10

What do you need to be able to do to gross profit and net profit?

Answer 10

You need to be able tl calculate gross profit and net profit.

Question 11

What can a business calculate from its financial data?

Answer 11

+A business can calculate its net profit and gross profit from its financial data.

Question 12

What is gross profit?

Answer 12

+Gross profit is the profit a firm makes after the cost of making products [the cost of sales] is taken into account.

Question 13

What is net profit?

Answer 13

Net profit is the profit a firm makes when all expenses [that includes operating expenses, eg. salaries and rent, the interest paid on loans and the cost of sales] are taken into account.

Question 14

What is it important to know before calculating any kind of profit?

Answer 14

+Before calculating any kind of profit, it’s important to know what the revenue is.

Question 15

What is revenue?

Answer 15

+Revenue is the total amount of money earned by the business through sales of products in the given time period.

Question 16

What is the equation for revenue?

Answer 16

Revenue = sales price x quantity sold [or sales volume]

Question 17

How can you calculate the gross profit?

Answer 17

+To calculate the gross profit, take away the cost of sales from the revenue:

gross profit = revenue - cost of sales

Question 18

How can you calculate the net profit?

Answer 18

+To calculate the net profit, you can use the following formula:

Net profit = gross profit - [operating expenses + interest]

[The total profit is really the net profit for the business]

Question 19

What are profitability ratios?

Answer 19

These show what happens to each pound spent by a customer.

Question 20

What does Gross profit margin ignore?

Answer 20

Gross profit margin ignores indirect costs

Question 21

What is the gross profit margin?

Answer 21

+Gross profit margin is the fraction of every pound spent by customers that doesn’t go directly towards making a product.

Question 22

What is the equation for gross profit?

Answer 22

Gross profit margin = gross profit ÷ sales [revenue] x 100

Question 23

What counts as a good gross profit margin?

Answer 23

+What counts as a good gross profit margin depends on the type of business, but the higher the percentage the better.

+The margin can be improved by increasing prices or reducing the direct cost of sales.

+Some businesses [eg. a supermarket loan] can have a low gross profit margin because they sell in high volumes and they need to keep their prices competitive to survive.

Question 24

What does the net profit margin take into account?

Answer 24

Net profit margin takes all costs into account

Question 25

What is the net profit margin?

Answer 25

+Net profit margin is the fraction of every pound spent by customers that the company gets to keep [after all its costs have been paid].

Question 26

What is the equation for net profit margin?

Answer 26

Net profit margin = net profit ÷ sales [revenue] x 100

Question 27

What counts as a good net profit margin?

Answer 27

+Just like for gross profit margins, what counts as a good net profit margin depends on the business, but the higher it is, the better.

+Net profit margin is often larger for new companies which are still small and don’t have many indirect costs.

+As the businesses grow, these costs go up and the net profit margin decreases.

Question 28

How can data help a business?

Answer 28

Data can help a business to make decisions

Question 29

What do businesses have to keep track of?

Answer 29

+Businesses have to keep track of how well they are doing.

+They also need to be able to predict the effect of making certain decisions.

Question 30

What can different types of data inform a business on?

Answer 30

+Different types of data can help inform a business on the impact of a decision, and so help to support or justify it, or prevent the business from making a mistake.

Question 31

What types of data may be used by businesses when making decisons?

Answer 31

• Financial data
• Marketing data
• Market data

Question 32

How can financial data help a business make decisions?

Answer 32

+Financial data - [eg. cash flow forecasts] can show whether or not a business decision [eg. investing cash in new equipment] would lead to cash flow problems.

+Calculations of profit and loss and profitability ratios can help a business to see if it should reduce costs or try to increase revenue.

+And predicting the average rate of return of an investment can help a business to determine if an investment would be worthwhile.

Question 33

How can marketing data help a business make decisions?

Answer 33

+Both primary and secondary market research data can give an indication of how customer preferences are changing over time.

+So a business can use this data to see if a business decision is likely to lead to increased sales.

Question 34

How can market data help a business make decisions?

Answer 34

+Market data [eg. knowing the market share of different business, the costs of supplies and prices of competitor products] may help a business to see if it should eg. lower its prices, or reduce the cost of its supplies.

Question 35

What are there limitations to?

Answer 35

There are limitations to financial data

Question 36

What should a business put in place in order to use some types of financial data?

Answer 36

+In order to use some types of financial data, it’s important that there is another source of appropriate data to allow a comparison.

+For example, a firm could compare how their financial data has changed over time, or they could compare it against a competitor who produces similar products.

Question 37

What are the downsides of using financial data to understand business performance?

Answer 37

+However, using financial data to understand business performance isn’t perfect.

+In some cases it may not be possible to directly compare two different sources of data.

+For example, one firm in the comparison may be much larger or operate in a different country.

Question 38

What are the downsides even if the firm’s financial performance for different years is compared?

Answer 38

+Even if the same firm’s financial performance for different years is compared, it can still be hard to tell exactly what may have caused any changes.

+That’s because there are often lots of different variables which may affect a company’s financial performance - such as how well the economy is doing.

Question 39

How is using only quantitative data a limitation to using financial data?

Answer 39

+Another limitation to using financial data to assess business performance is that it only includes quantitative data and not qualitative data.

+Qualitative data can include things like customers’ opinions, which can be useful for determining what changes a business should make.

Question 40

What isn’t foolproof?

Answer 40

+Using financial data isn’t foolproof, but without it businesses wouldn’t be able to get much of an idea of their performance.

+Businesses can use their financial data alongside other forms of data such as market research, to get a more well-rounded idea of how their business is performing compared to their competitors.