Scientific decision-making is the use of formal procedure to ensure that decisions are arrived at in an objective manner. It attempts to eliminate hunch or bias by ensuring that decisions are based on factual, numerical evidence.
Hunch the intuition that can lead a decision-maker to go against the obvious or statistically proven route.
Niche marketing: a corporate strategy based on identifying and filling relatively small market segments. This can enable small firms to operate profitably in markets dominated by large corporations. Pros:
- the first company to identify a niche market can often secure a solid market position as consumers see the original product as superior (e.g. Findus French Bread Pizza)
- Consumers are willing to pay a price premium for a more exclusive product.
- In overlooked or ignored segments of the market competition can be avoided.
- The company can focus on the needs of consumers in their specific market segment.
Cons:
- Lack of economies of scale may make costs high to achieve satisfactory profit margins
- The firms production system must be flexible enough to cope with relatively small quantities of several products.
- Firms who are successful in Niche markets often attract competition. Large businesses joining the market may benefit from economies of scale which small firms are unable to achieve.
- Many small firms involved in Niche marketing have just one product aimed at one small market. This does not allow a business to spread its risks as a firm producing many products might.
- Because niche markets contain small numbers of consumers, they tend to be faced by bigger and more frequent swings in consumer spending than larger markets. This may mean a rapid decline in sales following an equally rapid growth.
*Mass market: market with a large volume or value of sales, e.g. soap powders.
*Product portfolio analysis: used to examine the existing position of the organisations products in their markets to enable better decisions to be made.
- Define corporate objectives
- Gather information
- Undertake marketing audit
- Set marketing objectives
- Decide marketing strategy
- Implement
- Review
Boston Matrix: This matrix places products into four categories:
- ‘stars’ – products with a large share of a high growth market.
- ‘problem children’- might have a future potential as they are in growth markets, but their sales are not particularly good.
- ‘cash cows’ – are those which are able to generate funds, possibly to support other products. They are mature products with stable market share.
- ‘dogs’ are products that may be in decline
Market share: Star-high, Cash cows-low, Problem child-low, dogs-low.
Firms must ensure that their product mix does not contain too many items within each category. Firms do not want lots of ‘Dogs’, but they should also avoid having too many ‘stars’ and ‘problem children’.
‘Stars’ and problem children are in the early stages of the product life cycle and are in the growing markets, but the cost of developing and promoting them will not yet have been recovered. This will drain resources. Balancing these with ‘cash cows’ will mean the revenue from the ‘cash cows’ can be used to support products in a growing market. The development cost of ‘cash cows’ is likely to have already been recovered and promotional costs should be low relative to sales. Many of the ‘stars’ may become the ‘cash cows’ of the future.
Product life cycle: The product life cycle shows the different stages that a product passes through and the sales that can be expected at each stage. Most products pass through six stages-
Development: the product is designed and ideas are investigated, and a prototype might be made.
Introduction: at this stage the product is new on the market and sales are often slow. Costs are incurred when the product is launched (production & distribution). Therefore it is likely the product will not be profitable.
Growth: once the product is established, sales begin to grow rapidly. The product becomes profitable. If there is rapid growth competitors may launch their own versions of the product; this may slow-down the rise of the product.
- Maturity: the growth sales level off. The product has become established with a stable market point.
- Saturation: as more firms enter the market it will become saturated, some businesses will be forced out the market.
- Decline: eventually sales of products will decline. This is usually due to consumer tastes, new technology or the introduction of new products.
Factors affecting the length of a products’ life cycle:
- Durability: the item need be bought only once (such as a sandwich toaster) then market saturation can hit demand, as all those who want the item, have it.
- Fashion: if the item’s sales grew because of fashion, it is likely that they will die quickly, for the same reason.
- Technological change can be very significant in turning the customer away from a product, which seems obsolete.
Extension strategy: a medium to long-term plan for lengthening the life cycle of a product or brand. It is likely to be implemented during the maturity or earlier decline stage within the life cycle. Extension strategies can be divided into two categories, defensive and offensive.
- Defensive: a plan designed to postpone the obsolescence of a product by a year or two, perhaps to keep sales going until a replacement can be launched. Examples include car manufactures ‘special editions’.
- Offensive: a plan to revitalise or reposition a product to give it a wholly new long-term market. Johnson and Johnson’s repositioning of its baby powder and baby oil to appeal to women instead of just the baby care market.
Types of extension strategies include:
- Redesigning or reformulating the product (‘New improved’)
- Adding an extra feature (‘Now with…!)
- Repositioning its price and image (usually down market)
- Changing the packaging and advertising imagery to appeal to a new or additional market sector
Note sales promotion or extra advertising spending alone would not be regarded as extension strategies. They can be used to boost sales at any stage of the life cycle.
Capacity utilisation
Asset-led marketing bases the firms marketing strategy on its strengths (instead of purely on what the customer wants). The planning starts with examining the firms’ assets (e.g. its staff, its location or its distribution network) as well as consumer wants.
*Market-led marketing
Adding value: the process by which firms add value to a product. This may take a very simple form: for example cleaning your car before you sell it will make it seem worth more to the purchaser. Therefore you have added value. Identifying the right mix of design functions, image and service can also do this.
Unique selling point (USP): the feature of a product that can be focused on in order to differentiate it from all competition. The USP should be based on real product characteristic, such as the advertising slogan ‘bounty the taste of paradise’. USPs can be based on a patented technical advantage. Many firms attempt to create USPs that are simply advertising imagery.
Marketing budget: a marketing budget will be set to control and monitor expenditure in this area. The marketing budget may depend on
- Present resources/ as a percentage of anticipated sales revenue. ADV- resources are allocated according to their effect on sales. DISADV- the firm assuming that the level of advertising has a direct effect on sales. This may not be the case. Some products sell well no matter how much is spent on advertising, also, anticipated figures for sales revenue can be estimated and may be. inaccurate
- As percentage of past sales. ADV - Finance allocated to advertising budget has already been earned. DISADV- it does not take into account market changes. A fall or increase in sale will not result in the changing of the budget
- By comparing spending with competitors. ADV- may help maintain market share. DISADV – May lead to a continually rising amount of money spent on advertising. It assumes competitors are spending a sensible amount on advertising.
- As a fixed cost, based on advertising needs. For example being higher if launching a new product.
Typically firms set the budget as a percentage of the years projected sales, as a percentage of last years sales, or try to match competitors budgets. If sales are declining, a firm might reduce its budget due to lack of finance, even though this may be the time to increase the budget to boost sales.
Sales ratio, effectiveness of market spending
Sales forecasting: estimating future outcomes such as next year’s sales figures. There are three main ways of doing this:
- Projecting an established trend forward. Extrapolation – trend values have been established, they can be plotted on a graph and extrapolation by eye or by mathematical means can be undertaken.
- Market research into consumers buying intentions
- Consulting experts with proven ability at anticipating trends
Test marketing: the launch of a new or improved product within a tightly defined area, in order to measure actual sales potential.
Pros: provides more accurate sales forecasts, therefore the right-sized factory can be set up.
Enables lessons to be learnt before the national launch.
Cons: gives competitors a chance to evaluate your product and decide how to respond.
Management and sales force focus on a small area, which may cause higher sales than are realistic nationally.
Marketing mix refers to those elements of a firms marketing strategy which is designed to meet the needs of consumers. There are four parts to the marketing mix – product, price, promotion and place. The four ‘Ps’. To meet consumers needs, firms must produce the right product, at the right price, make it available at the right place, and let consumers know about it through promotion.
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Product: Businesses must make sure their product is meeting the needs of their consumers. This means paying close attention to a number of features of the product. Such as: #How consumers will use the product. Products designed for the home will be different than that designed for the office. #The appearance of the product. This may involve a consideration of things such as colour, shape, taste and size or even smell. #Financial factors. There is little point in a firm producing a product which meets consumer needs if it cannot be produced at the right cost.
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Price: The pricing policy is often a reflection of the market, which a business is aiming at. Products may be set at a high price so consumers regard it as exclusive rather than because production costs are high, although production costs do influence pricing to some extent.
Skim pricing pricing a new product at such a high level that it is only purchased by trend-setters, enthusiasts or the very rich. The firm may choose to hold this high price for the long term, or cut prices when competition arrives.
Pros: # The price tag placed on a product affects consumer perception of its quality and desirability; pricing high can be an important element in establishing an up-market image.
# Skimming can be used as a form of price discrimination, ensuring that trend-setters pay the high price they are willing to pay, then lowering the price to attract the mass market later.
Cons: #A high price may make it easy for a competitor to launch a successful, low price imitation
# By failing to maximise sales at the start, the firm may not be able to hold on to a viable market share when competitors arrive.
Penetrate pricing: a pricing strategy for a new product based on a desire to achieve high sales volume or high market share. Penetration pricing means setting the price relatively low, thereby accepting low gross profit margins with the expectation that the high turnover will allow overheads to be covered.
Pros: #very useful if the market is one in which customers build up brand loyalty (price can be pushed up later)
#sensible if you have only a small technological edge, because competitors will be arriving soon.
Cons: #loses the opportunity to change higher prices to those willing to pay them for being first innovators
#once a low-price image has been established in the customers’ mind, it is hard to shift, and may be associated with low quality.
Predatory pricing: a firm undercuts competitors to remove competition; once competitors leave, the price is increased again. This policy can lead to a price war in which all firms try to undercut each other. Loss leader: a product sold at or below cost in the hope of generating other, profitable sales. E.g. retailers put well known brand in shop windows and sell at loss to attract people into the store.
Physiological pricing: focuses on consumers perceptions on price, e.g. charging high prices to convey quality charging £2.99 rather than £3.00 because people regard it as ‘over £2’ rather than in the £3 band, and stressing a reduction in price (e.g. was £20, now £12).
Price leader/maker: a brand that is in such a powerful position within the market place that it can largely dictate the widespread price level. The prices set by rivals are usually in relation to the leader.
*Price taker: a firm that is unable to influence the price at which it sells its products.
Cost-plus pricing adding a set profit percentage to the estimated total cost per unit.
Worked example: a firm with fixed costs of £40 000 per month and variable cost of £1 per unit wants to price its product on the basis of 25 per cent coat plus. Monthly sales are estimated at 100 000.
Total cost per unit = fixed cost per unit + variable costs per unit
= £40 000 ÷ 100 000 + £1 = £0.40 + 1
Total cost p.u. + 25% = £1.40 × 125/100 =£1.75 so the price is £1.75
Pros: #cost plus ensures that any cost increases will be passed onto the customer in the form of higher prices, thereby protecting the firm’s profit margins.
#It may be the only way of pricing a job for which the amount of work cannot be predicted. Such as R&D.
Cons: #cost plus pricing can only be applied in a situation where no effective competition exists; this is because it means setting prices with no reference to the market situation.
#By ignoring market conditions, the firm may be missing out on the further profit opportunities offered by price discrimination.
Mark-up is the amount of gross profit added on to the direct cost per unit, usually expressed as a Percentage.
FORMULA: gross profit/cost of sales × 100 = profit mark-up
*Contribution pricing: the setting of prices so that as long as an item is sold for more than the variable cost, it is making a contribution towards overheads in the business. The main consequence of contribution pricing is its effect on the acceptance of additional customer orders at cut prices.
Worked example contribution pricing:
The BG has sales of 2000 units at £5. Its fixed costs are £3000, variable costs are £3 and average costs are £4.50. BG’s sales director has just phoned through with an extra order for 500 units at £4 each. Should it be accepted?
Answer: the immediate thought is that average costs are £4.50, it must be unprofitable to accept an order at £4. That is wrong, however, because if fixed costs have already been covered and variable costs are £3, any price above £3 is profitable. The order will in fact generate an extra 500 × £1 = £500 profit (assuming BG has the capacity to produce the extra units).
Price discrimination means charging different price to different people for what is essentially the same product. This is done in order to maximise revenue by charging more to those who can afford, and are willing to, more. Price discrimination is a response to the recognition by a firm that different types of people may have different price elasticities of demand for a product. For examples under 16s get half-price entrance in most cinemas, because the owners know that higher prices will cut demand for a product.
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Promotion: There are a number of promotional methods a business can use including *above the line promotions, such as TV advertising, and *below the line promotions such as personal selling. Firms choose a promotion method it feels is likely to be most effective in the market in which it operates. National television advertising will only be used for products with a high sales turnover and wide appeal.
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Place: This refers to distribution to consumers. The product must get to the right place at the right time. This means making decisions on how the product will be physically distributed, i.e. by air, sea, rail or road. It also means taking into account how the product is sold. This may be by direct mail from the manufacturer or through retail outlets such as supermarkets.
Distribution channels: Traditional; producer - wholesaler - retailer - consumer
Modern; producer - retailer - consumer
Direct; producer - consumer
*Marketing plan: To help make marketing decisions a business must plan effectively. A marketing audit analyses the external and internal factors, which affect a company’s performance. A SWOT ANALYSIS can be used.
Internal; strengths (the strong points of the business)
Weaknesses (the problems it has at present)
External; opportunities (that may arise in the future)
Threats; (that may arise and should be avoided)
Elasticity of demand is the measurement of how customer demand is effected by a change in price, advertising spending or income. It measures how much demand changes (in %) compared to the variable.
Factors affecting price elasticity of demand:
- The number of substitutes for a product. A product with a wide range of substitutes is likely to be highly sensitive to price changes and relatively price elastic. This is because consumers can easily purchase another product when price changes occur.
- Time. The longer the period of time, the more price elastic the demand for a product is likely to be. The more time consumers are given, the more able and willing they are to adjust their buying habits. For example you may have a gas cooker and gas central heating, but over a longer period of time it is possible to switch to electric.
Price elasticity: sensitivity to changes in price. Formula:
PED= percentage change in quantity demanded or change in quantity demanded ÷ change in price
Percentage change in price original quantity demanded original price
Businesses are also concerned about how price changes affect revenue they earn. Total revenue = quantity sold × price
A price change is likely to lead to a change in revenue. Whether it is an increase or decrease depends on the elasticity of demand of the product.
Elastic and inelastic: if demand changes more than the variable (in %), it is sensitive or elastic. ELASTIC; % change in demand is greater than % change in variable. E.g. if demand increases 30% following a 10% price cut, the price elasticity of demand is 3. It is elastic because demand has changed 3 times price. If demand changes less than the variable, it is insensitive or inelastic. INELASTIC: % change in demand is less than % change in variable. E.g. if demand changes 5% following a 10% price cut, the price ealsticity of demand is 0.5. It is inelastic because demand changes is half as much as the change in price.
If demand is price inelastic the firm is more likely to increase price to increase revenue, because the increase in price leads to smaller decrease in quantity demanded (in %).
If demand is price elastic the firm will lower the price to increase revenue because a lower price will lead to a larger increase in quantity demanded (in %). Whether an increase in revenue will also increase profit depends on what happens to costs as output changes.
Income elasticity: shows sensitivity of demand to income.
Income elasticity = % change in demand income elastic- overseas holidays, sports cars and houses.
% change in income income inelastic- potatoes, pencils, milk, and newspapers.
A positive sign shows that when income increases, demand increases as well (or vice versa), i.e. both demand and income move together. NORMAL GOODS.
A negative sign occurs if demand falls when income increases (i.e. demand and income move in opposite directions). INFERIROR GOODS- as consumers get more income they wish to switch to more luxurious options.
Advertising elasticity: shows how responsive demand is to changes in advertising.
Advertising elasticity = % change in demand
% change in advertising expenditure
the larger the value of the advertising elasticity, the greater relationship between advertising and demand. A value of 3 means that demand changes 3 times more than the change in advertising expenditure (elastic). If the answer has a positive value this means that demand increases with advertising; if it is negative, demand decreases with advertising (e.g. ‘Don’t drink and drive’ campaign).
*Cross elasticity: shows how responsive demand for one good (A) is to changes in the price of another good (B).
Cross elasticity = % change of demand for A
% change in price of B
ACCOUNTING AND FINANCE
*Problems of setting budgets.
Budgeting: A budget is a plan, which is agreed in advance. It will show the money needed for spending and how this will be financed; they are based on the objectives if the business. They force managers to think ahead and improve co-ordination.
Benefits of budgets:
- Budgets provide a means of controlling income and expenditure. They draw attention to losses, waste and inefficiency.
- They act as a ‘review’ for the business, allowing time for corrective action.
- Budgets emphasise and clarify the responsibilities of executives.
- They enable management to delegate responsibility without losing control.
- Budgets help ensure that capital is usefully employed.
- They help improve the co-ordination of the business and improve communication between departments.
- They provide clear targets and help focus on costs.
Drawbacks:
- Budgets might lead to resentment from some of the firms’ personnel. This could result in poor motivation and targets being missed.
- If budgets are too inflexible it is possible that the business could suffer.
- If the actual business results are very different from the budgeted ones then the budget can lose its importance as a means of control.
Zero budgeting: the attempt to prevent budgets creeping upwards each year by setting the coming years budget at zero and demanding that managers should give full justification for every pound of budget they request.
Pros: 1) should identify departments that no longer need high budgets, therefore releasing funds for growth areas.
2) a way of reducing the cost base of the whole organisation, especially important when facing a period of weak demand.
Cons: 1) effective zero budgeting requires considerable management time spent in identifying and justifying the appropriate budget level. 2) no budget system is free from the problem that some managers are more cunning about justifying high budgets than others, so the system may not ensure extra funds for those in the most need.
Variance analysis involves investigating and giving reasons for the differences in the actual results and the budgeted figures. Variances can be favourable (F) or adverse (A). Favourable variances could occur because sales revenue is higher than expected or costs are lower. Adverse variances are when sales revenue is lower or costs are higher than expected. Variances may be shown in terms of money, but can also be written as quantities. For example, the production budget in a month may be 100, 000 units. If the actual budget level of production was 115,000 units the production variance will be 15,000F. If the actual level was 90,000, the
Variance would be 10, 000A. The profit variance will be influenced by other variances. For example if the overheads variance is favourable.
Cost centres: a department or section of an organisation to which specific costs can be allocated. If a large company splits itself up into cost centres, various benefits can result:
- Team spirit is easier to generate among 20 people rather than among 2 000
- Each individual knows that personal effort to cut costs can have an impact within a small budget, but not within 2 000 strong workforce.
- By identifying costs generated by each department, the firm is better able to make decisions.
Profit centres: a division or department of a company that has been given the authority to run itself as a business within a business, with its own profit and loss account.
Pros: 1) enables power to be delegated to the local level, which should speed up decision-making.
2) the local profit and loss account can form the basis of financial incentives for the entire workforce at the centre.
Cons: 1) hard to co-ordinate the activity of several different ‘small firms’, all wishing to grow rapidly, but with the possibility that they could end up competing with each other.
2) the performance of a profit centre may bear no relation to the effort and skill of its management: a blazing summer would make high profits in the ice-cream market.
Overheads are costs that are not generated directly by the production process. The term is used interchangeably with indirect costs or even fixed costs. Examples of fixed overheads: salaries, rent, heating and lighting. Examples of variable overheads: salesforce commission, postage (for a mail order company), advertising (for a direct marketing company).
Overhead allocation: the overheads or fixed costs of an organisation are difficult to allocate to cost centres, as they do not vary with activity in the short run. Most methods of allocation are arbitrary (changeable) and run the risk of being influenced by those who want their department to look efficient. The best method in theory is *activity-based costing, which attempts to measure the overheads attributable to each cost centre.
Decision-making based on “profits” after overhead costs have been allocated.
Balance sheet: shows the financial position of an organisation at a particular moment in time. It shows what the business owns and how it gas been financed. The balance sheet contains two sections – a list of the company’s assets and a summary of its liabilities and capital. Balance sheets will balance assets employed with capital employed.
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Assets are resources that a company owns and which have value for the company. They are resources that can be used in production. Current assets- those that are used up in production, such as stock and raw materials. Fixed assets- such as machinery, which can be used over and over again for a period of time.
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Liabilities are the debts of the company, i.e. what the company owes to other companies, individuals and institutions. Liabilities are a source of funds for a company.
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Capital is the money introduced by the owners of the business, for example when they buy shares. It is another source of funds and can be used to purchase assets.
In all balance sheets the value of assets will equal the value of liabilities and capital. Any increase in assets must be funded by an increase in capital or liabilities. A firm wanting to buy machinery (an asset) may need to obtain a bank loan (a liability). Also, a reduction in capital or liabilities will mean a reduction in the value of assets. So, Assets = capital + liabilities
A disadvantage of the balance sheet is that it fails to show that businesses are dynamic (active). The balance sheet only shows transactions that have taken place up until the time it is produced, and not those that are actually taking place at the time. It is a static statement.
Profit and loss statement: shows the profit or loss generated over a given period. It involves:
Revenue or turnover – this measures the value of the sales; it may not be in cash since the firm is often owed money (debtors).
Cots – this is the value of items used up in the process; this is not necessarily the same as the cash paid out; e.g. if a firm pays for £300 of materials in cash but only uses up one third, the costs are £100 since the other £200 of materials remain assets to the firm.
Sources of finance/funds: where an organisation might obtain funds for expansion or replacement of plant and equipment.
INTERNAL: 1) Profit. A firms profit after tax, is important and an inexpensive source of funds.
2) Sale of assets. Sometimes businesses sale off assets to rise money.
EXTERNAL LONG TERM: 1) Share capital (limited company). The sale of shares can raise very large amounts of money.
2) Loan capital. Debentures- holders are entitled to a fixed rate return. Mortgage- a long term loan from a bank or other financial institutions. The lender must use land or property as security to the loan.
EXTERNAL SHORT TERM: 1) Bank overdraft. (large company) Very flexible, the amount a business goes overdraft depends on there needs at the time. Interest is slightly lower than a bank loan. Bank loan. A rigid agreement between the borrower and the bank. The amount borrowed must be repaid over a clearly stated time period, in regular instalments. *Trade credit & *Leasing.
Depreciation: the value of an asset falls over time. A machine brought in one year will be worth less the next. This depreciation. Accountants must make allowances for this when showing the value of assets. They estimate the amount by which asset values depreciate, and then deduct the depreciation from the value of assets before placing the value in the balance sheet.
A firm should allow for depreciation each year in its accounts because:
- If it does not, the accounts will be inaccurate. If the original value of the assets were placed on the balance sheet this would overstate the value. The value of assets falls each year as they depreciate.
- Fixed assets generate profit for many years; writing off the value of the asset over this whole period matches the benefit from the asset more closely with its cost.
- Assets must be replaced in the future, depreciation provides for this.
*Role
Cash flow is the sum of cash inflows to the organisation minus the sum of cash outflows, over a specific period of time. A cash flow forecast statement helps the business to identify times when cash will be short, so borrowing can be arranged. It will also highlight points where there are cash surpluses, which could be used for investment. Improving cash flow:
- Debt factoring – a firm raises finance using debtors as an asset. A debt factor lends cash to the firm and takes over its sales ledger, sends invoices and chases debtors
- Stimulate sales for cash, offering large discounts if necessary
- Arrange overdrafts.
- Mount a rigorous drive on overdue accounts
- Use trade credit
- Use sale and leaseback – sell assets and lease them back; this raises finance whilst allowing firms to keep use of the assets.
- Reduce personal drawings from the business.
Profit is not the same as cash: e.g. if goods are sold on credit this creates revenue but not cash. If materials or equipment are brought in cash, this leads to a cash outflow, but no cost is involved until they are used up.
Capital expenditure is spending on new fixed assets such as machinery or new buildings. This affects the balance sheet, as cash a purchase would cause cash to fall while fixed asset total rises.
Revenue expenditure/spending is expenditure on all costs other than fixed asset purchases. Examples include materials, expenses and salaries.
Working capital is the day-to-day finance available for running a business.
FORMULA: current assets – current liabilities = working capital.
Working capital is used to pay for raw materials and running costs, and also funds the credit offered to customers (debtors) when making a sale. If a firm has too little working capital available, it may struggle to finance increased production without straining its liquidity position. If a firm has too much capital tied up in the short term, it may not be able to afford the new machinery that could boost efficiency.
Window dressing: presenting the company accounts in a favourable manner. Not illegal. Methods include:
- Depreciating an asset over a longer period of time to reduce the depreciation cost per annum.
- Including a valuation for brands ass a fixed asset (boosting intangible assets).
- Deciding when to recognise revenue, e.g. if a company delivers a machine to a client, installs it and gives a trial period during which the client can return the machine, the revenue might be declared on delivery, after installation or after the trial period.
- Sale and leaseback shortly before the balance sheet date to boost liquidity.
Window dressing:
- Produces impressive results to attract investors
- Helps maintain share prices
- Gains favourable press
Liquidity: the ability of a firm to meet its short-term debts. As bills can only be paid with cash, liquidity can also the availability of cash or near cash resources.
FORMULA: current assets = liquidity ratio
Current liabilities
Accounts recommend a figure of around 1.5; a value at or below 1.0 indicates concern and values greater than 2.0 may mean that too much finance is tied up in the short-term assets. The way the current assets are valued are crucial, so is the date. If these are untypical, then the ratio may be distorted.
Acid/quick test ratio: measures the ability of the firm to meet its current liabilities if it could not sell its stock.
FORMULA: current assets – stock
Current liabilities
Accountants recommend that this figure should be about 1, i.e. that there should be about £1 of liquid assets for every £1 of short-term debt.
Worked example:
Acid test ratio = 300 – 160 = 0.5
280
This means that the firm has only 50p of highly liquid assets for each £1 of short-term. Debt: very low liquidity.
Liquidity crisis: a loss of confidence in a firm’s ability to meet its short-term debts. This may encourage bankers or creditors to demand payment before others get at the firm’s money. Inability to meet those payments might lead to liquidation.
To improve liquidity: See improving cash flow.
Gearing/leverage measures the proportion of capital employed that is provided by long-term lenders. The gearing ratio is:
FORMULA: *Long-term liabilities × 100
*Capital employed
If loans represent more than 50% of capital employed, the company is highly geared. Such a company has to pay interests on its borrowing before it can pay dividends to shareholders or reinvest profits in new equipment. The higher the gearing the higher the risk.
*Aged debtors and *aged stock
Profitability is the measure of an organisations ability to earn revenues above its expenditures.
Profit margin: profit as a proportion of sales revenue. It can be expressed as a total (the percentage of sales revenue, which is profit). Or it can be calculated on a unit basis (profit as a percentage of the selling price). Margin is a % of the price while the mark-up is a profit as a % of cost.
Worked example: a sofa is brought for £550 and sold for £625,
Profit margin Mark-up
Profit £125 × 100 =20% Profit £125 × 100 = 25%
Selling price £625 cost £500
Return on capital (ROC) is the % return that the firm is able to generate on the long-term capital employed in the business. It is sometimes referred to as the primary efficiency ratio. A firms ROC enables judgements to be made on the financial effectiveness of all its policies. The average firm generates around 20% on its capital employed.
FORMULA: operating profit/net profit× 100 = return on capital
Capital employed
Worked example: If a firm has a operating profit of £252 000 and capital employed of £2m., its ROC equals:
252 000 × 100 = 12.6%
£2 000 000
This shows you how much of your investment has come back, and how long it would take to get all your money back. I.e. 20% a year takes 5 years.
Gross profit margin = GP × 100 Mark up + Gross profit Cost price £10 so, GP = £3
Sales Selling price £13
Mark up = GP so, mark up = 30%
COGS
Net profit margin = NP (b4 tax) × 100
Sales
The difference gross profit margin and net profit margin tells you how much sales income has to be spent on expenses.
How a price cut could cut gross yet boost net.
Price/earnings ratio: measures how highly a firms shares are valued. The earnings are the profits of the company, which could be paid out to shareholders. The price is the share price. The ratio measures how much investors are willing to pay for a share compared to the profits of the company per share. If it is high investors are willing to pay more to buy the share; this suggests confidence in the future performance of the business.
FORMULA: Market share
Earnings per share
Dividends per share (pence): dividends ÷ number of shares.
Dividend yield (%): (dividend per share ÷ market price) × 100. Shows the dividends as a rate of return compared to the price of buying a share; this should be compared with rates available elsewhere.
Dividend cover (number of times): (Profit attributable to ordinary shares ÷ dividends. This is the number of times the dividend declared could have been paid out of net profit available after tax and interest. A figure of around 3 is usually felt desirable. Much below it and the firm is paying out such high dividends as to leave too little for reinvestment.
Limitations to ratio analysis:
- Ratios are only as reliable as the underlying data. Firms can window dress their final accounts to show they are in a better position.
- They only use quantitative data. Also need to consider qualitative factors, such as the skill of staff, location and industrial relations record, which also affect the business.
- Need to consider the type of firm, stage in development, and the objectives of the owner. E.g. a low profitability ratio may be acceptable in the early stages of growth when the owners are investing heavily in equipment & training.
- It does not take into account factors such as in inflation, changes in accounting procedures, activities of the firm and business conditions.
- Some information is estimated, i.e. provision for bad debts.
Fixed costs are the expenses that do not alter in relation to changes in demand or output (in the short term). They have to be paid whether the business trades or not. I.e. rent, depreciation and interest charges.
Variable costs: one which varies in direct proportion to changes on output, such as raw materials, components, piece rate labour and energy used in production. These are costs that double if output doubles. In practise it is unlikely that any costs will be totally variable. For instance, raw materials are likely to cost less when buying in bulk. So the materials cost might not quite double when output doubles.
Direct and indirect overheads: see overheads
Contribution per unit is the amount each unit sold contributes towards covering the fixed overheads of the business. Once the fixed costs are covered all extra contribution is profit.
Calculating break even output Number of units which must be sold to break even = Fixed costs ÷ contribution per unit
Find the contribution peer unit. This is the selling price – variable cost per unit. This gives the contribution towards fixed costs. Find how many units must be sold for these contributions to cover fixed costs.
Example: Price per unit £10; Variable cost per unit £4; fixed costs £12000; maximum output 5000 units.
Contribution per unit = £10 - £4 = £6
Fixed costs/contribution = 12000 ÷ £6 = 2000 units, i.e. 2000 units must be sold to get a large enough contribution to meet the fixed costs
*Plotting the break even graph
Payback period: a method of investment appraisal that estimates the length of time it will take to recoup the cash outlay on an investment. Most set criterion levels such as two years.
FORMULA: investment outlay = payback period
Contribution per month
*Criterion level
*Average rate of return (ARR): a calculation of the average annual profit on an investment as a percentage of the sum invested.
FORMULA: total profit over project life ÷ number of years × 100
Capital outlay on project
*Net present value (NPV): the present value of future income from an investment project, less the cost.
NPV = Present value of return – cost
