QuizGecko Finance Business Full PDF

Why Businesses need Finance All businesses need finance to get started, allow them to grow and fund their continuing activity Businesses often call the money needed to start and operate \'capital\' Diagram: explaining why a business needs finance The finance department manages the finances and e...

Why Businesses need Finance All businesses need finance to get started, allow them to grow and fund their continuing activity Businesses often call the money needed to start and operate \'capital\' Diagram: explaining why a business needs finance The finance department manages the finances and ensures that the business is able to remain liquid The finance department manages the finances and ensures that the business is able to remain liquid Starting a business Start-up capital is the finance needed by a new business to pay for fixed assets and current assets before it can begin trading A business usually estimates the amount of start-up capital they need in the business plan Many small new businesses will get a start-up loan to cover these initial costs E... \[9:43 pm, 22/01/2025\] Ruskni: The Importance of Cash to a Business Cash is the \'blood\' of a business, as without it, a business will die It is a liquid asset in the form of notes, coins and money in the bank A profitable business is likely to fail if it does not have sufficient cash Cash-poor businesses will struggle to pay suppliers, employees and operating expenses This is called insolvency E.g. Lifestyle retailer Joules announced plans to liquidate in December 2022 as a result of cash-flow difficulties despite making a profit of £2.6 million during the previous year A new business may have to pay cash on purchase for all of its supplies until its suppliers trust them enough to provide credit terms (buy now, pay later) A supplier may then give the business trade credit of 30 or 60 days This means that the business can receive their stock now and only pay for it in 30 or 60 days; the cash outflow is delayed As the business sells its products, they receive money generated from the business revenue and this represents a cash inflow At the end of 60 days they will pay their supplier (cash outflow), but the firm may still have half of its stock available for sale A cash flow cycle shows the stages between paying out cash for labour, materials, and so on, and receiving cash from the sale of goods cash-flow-cycle-cie-igcse-business-rn The cash flow cycle shows the process of cash entering the business, being used to generate products, before leaving the business to pay suppliers Explanation of the cash-flow cycle The diagram shows that cash is needed to pay for materials used to produce the product Time is needed to produce the products before they can be sold to customers If customers purchase the goods using a credit facility provided by the business, then they will not have to pay immediately, which will delay cash inflows When they do pay for the goods immediately, this money will be used to pay business expenses Due to the time between each stage, the business needs to make sure it has enough working capital to keep running and pay bills Businesses, particularly start-ups, need to ensure that they manage cash-flow to ensure that it does not run out of money Cash-flow issues may put the business in a situation where it is Unable to pay key stakeholders, such as workers and suppliers Production is likely to cease as workers will not work without pay and suppliers will not supply goods if they are not paid Unable to pay utility bills and rent The business could be forced into liquidation and, ultimately, is likely to fail Constructing a Cash-flow Forecast A cash-flow forecast is a prediction of the anticipated cash inflows and cash outflows typically for a three, six or twelve month period Typical outflows include payments for raw materials, paying staff wages and salaries, paying bills such as electricity and repaying loans Typical inflows include receipts from sales, money received from a new bank loan, money from the sale of an asset and money from investors 3-month-cash-flow-forecast-example-cie-igcse-business-rn The six month cash-flow forecast clearly shows how inflows and outflows of cash into a business are accounted for Steps in constructing a cash-flow forecast The business starts with an opening balance of £500 in January Total inflows for January are £8,600 Total outflows are expected to be £4,770 The Net Cash-flow is expected to be £3,830 (£8,600 - £4,770) January's closing balance is expected to be £4,330 (£500 + £3,830) Each closing balance becomes the opening balance for the next month As the closing balance for January is £4,330, the opening balance for February is therefore £4,330 The calculation process starts again in February, and every month onwards Net cash flow + opening balance = closing balance Overall, despite negative net cash flow between February and May, this businesses closing balance is expected to remain positive during the period, suggesting it does not expect to suffer cash flow problems The importance of cash-flow forecasts By analysing cash flow over time, businesses can better plan and allocate financial resources E.g. Problematic months can be identified early and sources of additional finance put in place to ease the cash-flow Cash flow forecasts are useful in the following situations Starting up a business: identifying how much cash is needed in the first few months Running an existing business: recognising where a fall in sales may require use of an overdraft facility Supporting applications for borrowing: determining the size of loan or overdraft needed, when and for how long it is needed and by when it is likely to be fully repaid Managing transactions: identifying how much or how little cash is deposited at the bank can determine when bills should be paid Calculating & Interpreting Cash-flow Forecasts It is important for a business to know how to calculate and interpret a cash-flow forecast An Example of a Start-up 3 Month Cash Flow Forecast (£s) Jan Feb Mar Inflows Cash received from sales 4,600 5,100 3,100 Total inflows 4,600 5,100 3,100 Outflows Inventory/stock 1,500 850 900 Wages 2,200 2,200 2,200 Utilities 840 840 840 Total outflows 4,540 3,890 3940 Net cash flow 60 1,210 (840) Opening balance 500 560 1770 Closing balance 560 1,770 930 Cash-flow forecast analysis Executive summary Overall, this cash flow forecast supports a decision for the business to arrange an overdraft facility with their bank As sales increase in January and February, inflows are greater than outflows, and the business has a positive cash flow This changes in March as the level of sales falls and the net cash flow turns negative An overdraft facility will help them survive if their closing balance drops below zero in the next month or two January The opening balance of £500 has been introduced by the owner The business is expected to achieve sales of £4,600 Total outflows are expected to be £4,540 The Net Cash Flow is expected to be £60 (£4,600 - £4,540) January's closing balance is expected to be £560 (£60 + £500) February The closing balance from January becomes the opening balance for February Sales of £5,100 are expected to be the business total inflows Total outflows are expected to be £3,890 The net cash flow is expected to be £1,210 (£5,100 - £3,890) The closing balance is expected to be £1,770 (£1,210 + £560) March The closing balance from February becomes the opening balance for March The business expects to achieve sales of £3,100 as its total inflows Total outflows are expected to be £3,940 The net cash flow is expected to be -£840 (£3,100 - £3,940) The closing balance is expected to be £930 (-£840 + £1,770) Worked Example The following is an extract from a cash flow forecast April May June 000s 000s 000s Cash inflow 23 24 30 Cash outflow 28 81 Net cash flow 10 (51) Opening bank balance 30 40 36 Closing bank balance 40 36 Fill in the three blanks to complete the cash flow forecast. (3) Step 1: Calculate the cash outflow for April Net space cash space flow space equals space Cash space inflow space minus space Cash space outflow £ 10 comma 000 space equals space £ 23 comma 000 space minus space £ 13 comma 000 (1 mark) Step 2: Calculate the net cash-flow for May Net space cash space flow space equals space Cash space inflow space minus space Cash space o utflow Net space cash space flow space equals space £ 24 comma 000 space minus space £ 28 comma 000 Net space cash space flow space equals space minus £ 4 comma 000 (1 mark) Step 3: Calculate the closing balance for June Closing space balance space equals space Opening space balance space plus space n et space cash space flow Closing space balance space equals space £ 36 comma 000 space plus space minus £ 51 comma 000 Closing space balance space equals space minus £ 15 comma 000 (1 mark) Examiner Tips and Tricks When calculating opening and closing balances, work through each month in turn. Always double-check your calculations in cash-flow forecasts, as one mistake will have a knock-on effect elsewhere and may lead you to make inaccurate judgements Overcoming Short-Term Cash-Flow Problems Liquidity is the ability of a business to meet its short-term commitments (e.g. payments to creditors) with its available assets A business that cannot pay its bills will usually fail very quickly, even if they are profitable Managing liquidity is a key way to manage risk in a business and helps a business prepare for the unexpected Many businesses experience short-term cash-flow problems Start-ups initially have high costs and low sales revenue Existing firms may unexpectedly receive a large order that requires them to buy and pay for a large amount of raw materials There are several ways in which a short-term cash-flow problem can be resolved Diagram: solving short-term cash-flow problems Asking a supplier to increase the amount of trade credit they offer is one popular solution to ensure raw materials keep flowing into the business Asking a supplier to increase the amount of trade credit they offer is one popular solution to ensure raw materials keep flowing into the business A business often uses more than one method to ensure cash-flow remains positive, e.g. combining an overdraft and reducing the time period available for their customers to pay them The Methods used to Overcome Short-term Cash-flow Problems Method Explanation Seek to increase the trade credit period The business may approach some of its most trusted suppliers and ask them for more generous repayment terms E.g. They may request their suppliers to extend the repayment period from 30 days to 90 days Shorten debtor repayment periods If the business offers customers the ability to \'buy now, pay later\', this delays the cash inflow. Removing the option to pay later will improve cash-flow However, the business may lose some customers to competitors who are able to keep offering credit terms Apply for a bank loan Businesses can often arrange short-term bank loans in a very short time frame, often a couple of days Interest will have to be paid Delay plans to purchase new equipment Postponing the purchase of new equipment, such as vehicles, may significantly reduce cash outflows Only sell in cash, not credit Businesses can choose to only accept cash as payment, meaning it receives money immediately Customers may buy from competitors that sell on credit instead Overdraft facility Temporary cash-flow problems can be solved by arranging to spend more than the businesses current account balance Interest rates may be relatively high, increasing business costs An Introduction to Working Capital Working capital is the money that a business has available to fund its day-to-day activities It is calculated using the formula Working Capital = Current Assets - Current Liabilities Current assets include cash, cash equivalents or assets which can be converted to cash within a one year period Cash Debtors Inventories (stock) Current liabilities are short-term financial obligations that are usually repayable within one year, or as demanded by creditors Creditors Short-term loans Overdrafts The Importance of Working Capital Working capital is vital to the day-to-day operation of a business A lack of working capital often leads to business failure if the business cannot meet its immediate financial obligations Cash is the most liquid of a business\'s current assets and can be used to settle debts immediately Stock takes time to be sold and converted to cash to pay debts so is the least liquid current asset Effective management of working capital involves careful cash management If the finance manager is able to balance the flow of money in and out of the business, then the business is more likely to grow and be successful A business can hold too little or too much cash, both of which cause different issues The Problems of a Shortage or Excess of Working Capital Shortage of Working Capital Excess of Working Capital Businesses may look to convert debtors and stock into cash as quickly as possible. This may mean they have to sell stock at low prices, reducing revenue Suppliers may not allow an extension of trade credit terms as the business is seen as too much of a risk Making use of short-term borrowing options such as overdrafts can improve a businesses working capital situation but relatively high level of interest must be paid Holding large amounts of cash may mean missing out on benefits of investing it in fixed assets or investments This may represent a significant opportunity cost not being put to work for the business If a business is holding large amounts of stock, it may incur extra storage costs, and the cash value of the stock could be used for other purposes An Introduction to Profit Most businesses have the main objective of making a profit Profits help new businesses survive and break-even It is a reward for risks taken by entrepreneurs and investors For more established businesses, profits can enable long-term growth The most simple formula for calculating profit is: Profit space equals space Sales space Revenue space -- space Total space Costs Profit can be categorised into net profit and gross profit Gross profit is the difference between the money received from selling goods or services and the cost of making or providing them It is calculated using the formula Gross space Profit space equals space Sales space Revenue space -- space Cost space of space Sales Net profit is the difference between the gross profit and all of the other business expenses It is calculated using the formula Net space Profit space equals space Gross space Profit space -- space Expenses Profit is the surplus that remains after business costs have been subtracted from the total sales revenue If costs exceed revenue, the business makes a loss Diagram: the process of making a Profit Diagram to show how a profit is made Profit can be increased using the following strategies Increasing sales revenues Reducing costs A combination of increasing revenue and reducing costs The Importance of Profit to Private Sector Businesses Profit is the financial reward that entrepreneurs receive in return for the risks they take Business owners invest long hours, creativity, their own money, and effort to make a successful business Profit is a useful source of finance E.g. Retained profit can be used to fund the purchase of assets, pay bills and invest in research and development Profit is an indicator of success Increasing profitability suggests that a business is being run effectively and could be an attractive investment Profit levels can be compared over time and with similar businesses to determine how well a business is performing Some public sector organisations, such as public corporations, can have the objective of making a profit Although social objectives may be more important, such as serving the local community, profits can be reinvested back into services such as education and healthcare These profits, known as surpluses, could also be used to improve quality and service efficiency Social enterprises also need to make a profit to survive, as they often have similar objectives to grow so that they can fund their social objectives The Difference Between Profit & Cash Profit and cash are different financial terminologies Profit is calculated at a specific point in time While a company may be in profit, they may lack cash as some customers may not actually have paid them yet Profit is the difference between revenue generated and total business costs during a specific period of time Profit can be an important indicator of a company\'s financial health and long-term success, as it helps to assess the effectiveness of a company\'s operations Cash is measured by taking into account the full range of money flowing in and out of a business This includes revenue from sales, operating expenses, investments, loans, and any other cash-related transactions Diagram: profit vs cash flow Profit and Cash are different concepts in business. A business may make a profit yet lack cash. A profitable business is likely to fail quickly if it does not have sufficient cash Cash-poor businesses will struggle to pay suppliers, employees and operating expenses This is called insolvency Lifestyle retailer Joules announced plans to liquidate in December 2022 as a result of cash-flow difficulties, despite making a profit of £2.6 million during the previous year An Introduction to Income Statements An income statement records the income and costs of a business incurred over a period of time (usually one year) The statement is also known as a profit-and-loss account Four types of profit are calculated in the income statement Gross profit, net profit, profit after tax, and retained profit The extract from the income statement for Toys and Trikes PLC shows figures for both 2022 and 2023, which enables year-on-year comparisons to be made Diagram: income statement for toys and trikes Ltd Four different types of profit are calculated in an income statement Four different types of profit are calculated in an income statement The main features of an income statement Sales revenue Money generated through selling goods and services Calculated by Price x Quantity In 2023, Toys and Trikes Ltd earned Sales Revenue of \$274,000 Cost of sales The cost of producing or buying in the goods actually sold by the business during a time period Includes the costs of raw materials and labour used to produce the goods In 2023, Toys and Trikes Ltd had Cost of Sales of \$169,000, which included materials and labour Gross profit Gross profit is made when revenue is greater than the cost of sales Calculated by Sales Revenue - Cost of Sales The Gross Profit for Toys and Trikes Ltd was therefore \$274,000 - \$169,000 = \$105,000 Net profit Profit made by a business after all costs have been deducted from revenue Calculated by Gross Profit - Expenses In 2023, Toys and Trikes Ltd made a gross profit of \$105,000 It had expenses of \$48,000, which included advertising and equipment The Net Profit was therefore \$105,000 - \$48,000 = \$57,000 Profit after tax The income statement for limited companies needs to account for corporation tax paid on net profits In 2023, Toys and Trikes Ltd made a Net Profit of \$57,000 The tax payable was \$11,000 The Profit after Taxes was therefore \$57,000 - \$11,000 = \$46,000 Retained profit Profit remaining for reinvestment into the business after any dividends have been distributed to shareholders In 2023, Toys and Trikes Ltd made a Profit after Tax of \$46,000 The dividends payable were \$22,000 The Retained Profit was therefore \$46,000 - \$22,000 = \$24,000 Using Income Statements in Decision-Making Income statements inform managers whether the business is making a profit or loss They allow the comparison of performance to previous years, aid with future forecasts and can be used to make comparisons with competitors Finance managers are able to interrogate the data in order to make beneficial changes or set new strategic objectives Example: Chillie\'s cafe Chillie\'s cafe sells cold drinks during the summer season in central Berlin Its two best-selling products are bubble tea and smoothies Diagram: bubble tea versus smoothies Chillie\'s Cafe\'s two best-selling products are bubble tea and smoothies Although Chillie\'s sells bubble tea drinks at a higher price, smoothies are more profitable for the business Fewer bubble tea drinks than smoothies are sold, so revenue is lower The cost of sales of bubble tea are higher than those for smoothies Questions to Consider when Analysing the Income Statement Business is Making a Profit Business is Making a Loss Is the profit higher or lower than last year? If higher, what has the business done that could have led to this? E.g. Finding a cheaper supplier of raw materials or increasing sales due to a new promotional campaign If lower, why is profit falling? Have costs increased, such as higher energy bills for the premises, or have sales fallen due to a new competitor entering the market? Is this a short-term or long-term problem? Lower profits may be a result of an external shock affecting all businesses, such as the 2020 Covid pandemic, in which many businesses had to close or reduce working hours Some losses may be more long-term E.g. E-commerce growth has led to many high-street stores closing down as the number of customers has dwindled Is the profit higher or lower than that of competitors? If lower, what can be done to become as profitable as other businesses? E.g. Does the business need to improve the quality of the products or increase the product portfolio? Are competitors making losses? If they are, the business needs to consider whether the industry is changing to the point that it may become extinct Alternatively, it needs to ask tough questions about what can be done to evolve with changing market conditions An Introduction to the Statement of Financial Position The Statement of Financial Position shows the financial structure of a business at a specific point in time It identifies a businesses assets and liabilities and specifies the capital (equity) used to fund the business operations The Statement of Financial Position is also known as the Balance Sheet It is called the balance sheet as the net assets are equal to the total equity Different Types of Assets Assets are items owned by a business Non-Current Assets are owned by a business in the long-term Examples include tangible assets such as buildings, land, machinery and vehicles Non-current assets may be intangible, such as patents, goodwill or brand value Current Assets include cash and items that can be turned into cash relatively quickly, usually within 12 months The four types of current assets are cash in hand, cash in bank, debtors (trade receivables) and inventory (stock) Different Types of Liabilities Liabilities are amounts of money owed by a business (debts) Non-current liabilities are amounts owed that do not need to be paid back for at least 12 months E.g. Long-term loans such as mortgages Current liabilities are amounts owed that must be repaid within 12 months E.g.Creditors (trade payables) and bank overdrafts Interpreting a Statement of Financial Position The statement of financial position is a key document that is part of a businesses annual accounts It generally follows the structure shown below Diagram: statement of financial position The statement of financial position shows assets and liabilities of a business and how the business is funded The statement of financial position is sometimes called the balance sheet Interpreting the statement of financial position Several deductions can be made from the Statement about how a business finances its activities, what it owns, and what it owes This information is useful as it can inform the decision-making process Financing its activities Packer Sports Limited is funded through share capital of \$1,500 and retained earnings of \$13,235 The business has long-term liabilities of \$20,000 This is likely to be a long-term loan This is significantly greater than share capital so its gearing is high Future applications for loans may be declined as the business is likely to be seen as a lending risk What the business owns On the stated date, Packer Sports Ltd owned assets worth \$39,795 in total Non-current assets of \$24,250 consisting of property, machinery (plant) and other equipment Current assets worth \$15,545, comprised of cash, debtors and stock Stock will be sold and converted to cash or debtors When debtors pay their invoices they will become cash What the business owes On the stated date, the business had total liabilities of \$25,060 Its current liabilities were \$5,060, comprised of a bank overdraft, trade creditors and other short-term loans Its long-term liabilities were valued at \$20,000 Examiner Tips and Tricks In your exam, you will not be required to construct a Statement of Financial Position. You do need to understand how they work and more importantly, how the information contained in them can be used to make decisions. The Importance of Profitability Profit is what a firm earns once the total costs have been deducted from the total sales revenue Profitability is a measure of how successful a business is Profitability can be defined in two ways A measure of how effectively a business converts sales revenue into profit - effectively, what percentage of sales revenue is profit A measure of how well capital resources invested in the business generates profit Profitability is expressed in percentage form, which allows comparison of business performance over time and also comparisons with other businesses Several stakeholders are interested in profitability Investors look carefully at profitability when deciding which business to invest in The higher the level of profitability, the higher their rewards are likely to be Directors and managers consider profitability when assessing business success and determining future objectives and strategy Employees may consider profitability as justification for requesting higher wages or better working conditions The Importance of Liquidity Liquidity is defined as the ability of a business to pay back its short-term debts, e.g. its suppliers A businesses that cannot pay its debts is considered illiquid If a business cannot pay its suppliers, raw materials or components may not be delivered and production will be delayed If it cannot repay an overdraft, banking facilities may be withdrawn, and its credit rating will suffer Creditors may force it to stop trading and sell its assets so that the debts owed to them are repaid Stakeholders interested in liquidity include Suppliers want to be reassured that a business is likely to be able to pay for them Financial providers such as banks want evidence that a business is likely to be able to repay loans or overdrafts Customers want to be sure that a supplier will be able to produce and deliver goods it orders The Gross Profit Margin This calculation shows the proportion of revenue that is turned into gross profit It is calculated using the following formula and is expressed as a percentage Gross space Profit space Margin space equals space fraction numerator Gross space Profit over denominator Sales space Revenue end fraction cross times space 100 space space space space space space Improving the gross profit margin The gross profit margin can be improved in two ways The business can increase its sales revenue The business can reduce its direct costs How to Increase the Gross Profit Margin Method Explanation Increase the sales revenue 1\. Increase the value of sales Raise prices If costs remain the same, this will improve profitability as the difference between the selling price and costs is now greater Sell premium products If customers are willing to spend money on these goods, the business could earn more profit per item sold 2\. Increase the volume of sales Price tactics Use price tactics to encourage higher quantity or more frequent purchases E.g. \'Buy one get one half price\' doubles the number of items a customer purchases, increasing revenue Increase marketing activities Engage in more marketing activities to increase sales volume Reduce the direct costs Reduce variable costs This may involve purchasing cheaper/alternative resources, negotiating with suppliers or purchasing in bulk Businesses must ensure that reducing variable costs will not have an adverse effect on the quality or desirability of products Buying stock in greater quantities may require investment in increased storage space which will reduce the impact of the cost savings made Businesses may also be able to reduce wastage of raw materials and components Worked Example Head to Toe Wellbeing's revenue in 2022 was \$124,653. Its gross profit was \$105,731 Calculate Head to Toe Wellbeing Ltd's Gross Profit Margin in 2022 \[2 marks\] Step 1: Substitute the values into the formula Gross space profit space equals space fraction numerator Gross space profit space over denominator Sales space revenue end fraction space cross times space 100 space space space equals space fraction numerator \$ 105 comma 731 over denominator space \$ 124 comma 653 space end fraction equals space space 0.8482 space \[1 mark\] Step 2: Multiply the outcome by 100 to find the percentage equals space 0.8482 space cross times space 100 equals space 84.82 percent sign \[1 mark\] 84.82% of Head to Toe Wellbeing's revenue was converted into gross profit during 2022 The Net Profit Margin The Net Profit Margin shows the proportion of revenue that is turned into profit before interest and tax It is calculated using the formula below and the outcome is expressed as a percentage text Net Profit Margin = end text fraction numerator Profit space Before space Interest space and space Tax over denominator Sales space Revenue end fraction cross times 100 Improving the net profit margin The profit margin can be improved in two ways Increasing the gross profit margin (see above) Reducing overhead costs by reducing staffing levels, relocating to cheaper premises or changing utility companies Reducing staffing levels may affect staff morale and negatively affect productivity Relocation costs can outweigh some of the benefits of moving to a cheaper location Replacing inefficient or outdated equipment may require staff training Worked Example Head to Toe Wellbeing's revenue in 2022 was \$124,653. Its profit before interest and tax was \$65,864 Calculate Head to Toe Wellbeing Ltd's Profit Margin in 2022 \[2 marks\] Step 1: Substitute the values into the formula text Net Profit Margin = end text fraction numerator Profit space Before space Interest space and space Tax over denominator Sales space Revenue end fraction cross times 100 equals space fraction numerator \$ 65 comma 864 over denominator \$ 124 comma 653 end fraction equals space 0.5284 \[1 mark\] Step 2: Multiply the outcome by 100 to find the percentage equals space 0.5284 space cross times space 100 equals space 52.84 percent sign \[1 mark\] In 2022, 52.84% of Head to Toe Wellbeing's revenue was converted into profit before interest and tax Return on Capital Employed The Return on Capital Employed (RoCE) measures how how effectively a business uses the capital invested in the business to generate profit It is calculated using the formula below and is expressed as a percentage Return space on space Capital space Employed space equals space fraction numerator Profit space Before space Interest space and space Tax over denominator Capital space Employed end fraction space space cross times space 100 RoCE be compared over time and with competitors It can also be compared with other potential capital investments, such as savings rates The Capital Employed figure is usually provided for you If required, it is calculated using the formula Capital space Employed space equals space Non minus current space Liabilities space plus space Equity Improving RoCE When analysing the RoCE, the higher the rate the better, as it indicates that the business is profitable and using its capital efficiently Investors prefer businesses with stable and rising levels of RoCE, as this indicates low-risk growth is being achieved A ROCE of at least 20 per cent is usually a good sign that the company is in a good financial position To increase the RoCE, a business can Increase the level of profit generated without introducing new capital into the business Maintain the level of profit generated whilst reducing the amount of capital in the business Worked Example The table shows an extract from the company accounts of Keals Cosmetics. Non-current Liabilities €1.5 million Revenue €7 million Equity €15.4 million Profit before Interest & Tax €2.2 million Calculate Keals Cosmetics\' Return on Capital Employed. \[3 marks\] Step 1: Calculate the capital employed begin mathsize 16px style Capital space employed space equals space Non minus current space liabilities space plus space Equity Capital space employed space equals space € 1.5 space straight m space plus space € 15.4 space straight m Capital space employed space equals space € 16.9 space straight m end style \[1 mark\] Step 2: Divide Operating Profit by Capital Employed RoCE space equals fraction numerator space Profit space Before space Interest space and space Tax over denominator Capital space Employed end fraction space cross times space 100 equals space fraction numerator € 2.2 space straight m over denominator € 16.9 space straight m end fraction space cross times space 100 equals space 0.13 \[1 mark\] Step 3: Multiply the result by 100 and express the outcome as a percentage equals space 0.13 space cross times space 100 equals space 13 percent sign \[1 mark\] The capital employed in Keals Cosmetics has generated a return of 13% Using RoCE to make decisions RoCE can be used to support strategic decisions (e.g. investment or divestment decisions) to determine the most profitable option given the level of capital employed Worked Example Faced with increasing costs, Kent & Medway Properties Ltd is looking to close one of its three high street estate agency branches. The table below shows some key data for each of the branches. Branch Capital Employed Profit Before Interest & Tax Sevenoaks £2.4m £0.37m Whitstable £3.1m £0.57m Rochester £2.9m £0.51m Calculate the Return on Capital Employed (RoCE) for each branch and recommend which branch, on profitability terms, should close \[5 marks\] Step 1: Apply the formula to calculate the RoCE for each branch RoCE equals space fraction numerator Profit space Before space Interest space and space Tax over denominator Capital space Employed end fraction space space cross times space 100 RoCE space Sevenoaks space equals space fraction numerator £ 0.37 straight m over denominator £ 2.4 straight m end fraction space space cross times space 100 space equals space 15.42 percent sign space space (1 mark) RoCE space Whitstable space equals space fraction numerator £ 0.57 straight m over denominator £ 3.1 straight m end fraction space space cross times space 100 space equals space 18.39 percent sign (1 mark) RoCE space Rochester space equals space fraction numerator £ 0.51 straight m over denominator £ 2.9 straight m end fraction space space cross times space 100 space equals space 17.59 percent sign (1 mark) Step 2: Identify the least profitable branch for closure Sevenoaks is the least profitable branch with a RoCE of 15.42% and should be the branch selected for closure \[2 marks\] Examiner Tips and Tricks When calculating financial ratios check that you are using the correct units. In some cases financial data is presented as raw figures (e.g. £14,520) but in most cases, you will be working in thousands (£000) or millions (£m). Ensure that you convert correctly, e.g. £0.39 million is equal to £390,000 and £34.9 (000) is equal to £34,900 Make sure the decimal place is in the correct place Calculate to two decimal places unless stated otherwise The Current Ratio Liquidity refers to the cash and other current assets businesses have available to quickly pay bills and meet short-term financial obligations The liquidity of a business can be measured using two ratios Current ratio Acid test ratio The current ratio The Current Ratio is a quick way to measure liquidity The outcome is expressed as a ratio All types of current asset are included in calculating this ratio The result indicates how many £s (or other currency units) of current assets are available to cover each £1 (or other currency unit) of short-term debt It is calculated using the formula Current space ratio space equals space fraction numerator Current space Assets over denominator Current space Liabilities end fraction space space equals space ? space colon 1 Worked Example Packer Sports Ltd has current assets of \$15,545, current liabilities of \$5,060 and an inventory (stock) figure of \$8,250. Calculate Packer Sports Ltd.'s current ratio. \[2\] Step 1: Substitute the values into the equation \$ 15 comma 545 space divided by space \$ 5 comma 060 equals space 3.07 \[1 mark\] Step 2: Express the outcome as a ratio equals space 3.07 space colon space 1 \[1 mark\] In this example, Packer Sports Ltd has \$3.07 of current assets to cover each \$1 of short-term debt The acid test ratio The acid test ratio is a precise and realistic way to measure liquidity, especially for businesses that hold large amounts of stock It is expressed as a ratio It is also known as the liquid capital ratio The least liquid form of current assets (stock) is deducted so the acid test ratio provides a more realistic measure of the businesses ability to meet short-term debts quickly It often takes time to sell stock so it is excluded The Acid Test is calculated using the formula Acid space Test space Ratio space equals space fraction numerator space Current space Assets space minus space Stock over denominator Current space Liabilities end fraction equals space space space space space ? space space space space space space colon space space space space space 1 Worked Example Packer Sports Ltd has current assets of \$15,545, current liabilities of \$5,060 and a stock figure of \$8,250. Calculate Packer Sports Ltd's acid test ratio. \[3\] Step 1: Subtract stock from current assets \$ 15 comma 545 space minus space \$ 8 comma 250 equals space \$ 7 comma 295 \[1 mark\] Step 1: Substitute the values into the equation Acid space Test space Ratio space equals space fraction numerator space Current space Assets space minus space Stock over denominator Current space Liabilities end fraction equals space fraction numerator space \$ 7 comma 295 over denominator \$ 5 comma 060 end fraction equals space 1.44 \[1 mark\] Step 2: Express the outcome as a ratio begin mathsize 16px style equals space 1.44 space colon space 1 end style \[1 mark\] In this example, Packer Sports Ltd has \$1.44 of the most liquid current assets to cover each \$1 of short-term debt Improving Liquidity Ratios The best way to improve liquidity is to manage the business better Use cash flow forecasts to identify potential cash flow issues before they arise and take appropriate action Budget effectively and consider adopting zero budgeting to carefully control spending Set clear financial objectives and look for ways to reduce costs and increase income wherever possible Methods to Improve Liquidity Method Explanation Reduce the credit period offered to customers Collecting money owed from customers more quickly will increase the level of current assets in the business Customers may move to competing businesses that offer better credit terms Ask suppliers for an extended repayment period, e.g an extension from 60 to 90 days Current liabilities will not be reduced The business can use cash it would have paid to suppliers for other purposes Suppliers may be unwilling to extend credit terms Make use of Overdraft facilities or short-term loans Current liabilities will increase The business can spend more money than it has in its bank account Banks may be reluctant to lend to businesses with cash-flow problems Sell off excess stock Less liquid current assets will be reduced and converted into more liquid forms of current asset (e.g. cash) Storage and security costs may also be reduced Stock may need to be sold at a low price to attract sales Sell assets and lease fixed assets instead (e.g. sale and leaseback) Both current assets and current liabilities will increase The business will continue to have the use of assets but must make regular payments to the leasing company Introduce new capital and reduce drawings out of the business Current assets will be increased New capital may be introduced by the owner or from additional investors This may result in the dilution of control of the business Using Financial Accounts To Make Decisions The financial accounts of a limited liability business need to be submitted to Companies House each year Public Limited Companies need to have their accounts audited before they publish them Different stakeholders use the business accounts for different purposes Stakeholder Interactions with the Financial Accounts Stakeholder How they use the Balance Sheet How they use the Income Statement Investors/Shareholders Used to identify the asset structure of the business and how their investment has been put to use Used to calculate the working capital of the business and determine its solvency Used to determine the rough value of a business, which helps make a judgement on whether their investment is growing Interested in revenues, costs and profits earned, business growth and dividend payments Shareholders may use ratio analysis tools to identify profit margins and returns on investment Management Used to identify the financial position of the business at a given point in time It is useful to assess the working capital position of the business and determine if there are enough liquid assets to pay its bills Provides information on the capital structure of the business which helps guide decisions on whether to raise further funds through borrowing or via other means (e.g. share issue) Interested in key performance data such as an improvement in sales revenue and net profit This data can aid in business decision-making Financial data can provide evidence to support the payment of bonuses Lenders/Creditors Look at the balance sheet to evaluate the company\'s solvency They are interested in the company\'s ability to pay back its debts Consider profit generated, as this could indicate the stability of the business and level of risk it presents Suppliers Businesses with low levels of working capital may find it difficult to pay short-term debts and so suppliers may offer trade credit, but with stricter terms Interested in the continued success of the company This information is also used by suppliers to determine the level of trade credit offered to businesses Employees Used to answer questions such as: Is the business financially stable or are jobs at risk? Has the businesses performance improved or worsened? What is the business spending its money on? How much are senior executives paid? How much tax is the business paying? Interested in profits earned, the potential for wage increases, and job stability Employees may look at notes to the accounts that detail levels of executive pay Regulatory bodies/Tax authorities Regulatory bodies use financial statements to ensure a business is complying with accounting standards and regulations Tax authorities use financial statements to check the accuracy of tax returns and assess how much tax a business is liable to pay The Income Statement can provide an insight into whether the business will continue to provide employment, place orders with other businesses and supply goods and services to the public sector Local community Interested in the stability of the business and what this may mean for jobs in the community Another interest is to see if the firm is generating enough profit to perhaps approach them for local sponsorship