Financial information
Using financial Information to measure and understand business performance and decision making
The financial position of a business is crucial to all decisions that it makes. Using financial information, a business should be able to identify what options it can afford when making decisions. This financial data can be used to forecast how decisions might affect the business’ cash flowThe movement of money in and out of the business. and assess any impact on future profitsThe amount of money made after all expenses have been paid..
The financial information that can help to inform business decisions includes:
- Costs and revenues - A business should be aware of what is happening to its total costsTotal costs are calculated by adding total fixed costs and total variable costs together and represent all the costs of the business when producing a certain level of output. and revenueThe income earned by a business over a period of time from selling its goods or services., and how well it is able to control them. This makes it easier to forecast what might happen in the future.
- Gross and net profit - Identifying what is happening to costs and revenues enables a business to calculate how this might affect both gross profitThe difference between sales revenue and the cost of making the product sold. and net profitThis profit is calculated by deducting all expenses away from gross profit., using historical profit information.
- Profit margins - profit marginThe difference between sales revenue and total costs expressed as a percentage. can be calculated and compared either to the business’ previous figures or to competitors’ figures. They can help a business to understand what is causing any change in its profit levels.
- Cash flow - Businesses need access to cash in order to survive. Accurately forecasting the cash flow in and out of a business is crucial when deciding what a business can and cannot afford to do.
- Break-even - Knowing the break-evenThe point where the business is not making a profit or a loss. point in the business’ output is important when making decisions about which products to make. It can help a business to avoid making unprofitable products.
- Average rate of return - Whenever investment decisions are required, a business will want to compare the expected returns from the options available. Calculating the average rate of returnA method of comparing the profitability of different choices over the expected life of an investment. for each project enables a business to do this. This helps the business to identify the most profitableAble to make a profit. options.
Understanding business performance
There are a number of ways to measure the performance of a business, including:
- changes in costs
- changes in revenueThe income earned by a business over a period of time from selling its goods or services.
- gross profitThe difference between sales revenue and the cost of making the product sold.
- net profitThis profit is calculated by deducting all expenses away from gross profit.
- gross profit marginThe percentage of sales revenue that is left once the cost of sales has been paid.
- net profit marginThe proportion of sales revenue that is left once all costs have been paid.
Most of the information required to analyse the performance of a business is contained within its accountsThe financial records of a business.. Particular care is required if this information is used to compare the performance of one business against another business. This is because different businesses might have different accounting periods, and they may also have different accounting policiesA system of principles used to guide decisions.. It is important that comparable data is used.
Even when analysing multiple sources of information from the same business, it is possible to interpret the performance of the business in different ways, depending on how the information is used.
Question
The bosses at a large supermarket chain are pleased with the performance of the business this year, pointing out that sales have increased by 20%. They claim that this is because of their decision to open ten new stores over the past year. Complete the table below and explain whether you think the bosses of this supermarket chain are right to be pleased with the performance of the business.
| Information from a large supermarket chain | Last year | This year |
| Sales revenue | £1,000,000 | £1,200,000 |
| Gross profit | £380,000 | £600,000 |
| Net profit | £150,000 | £150,000 |
| Gross profit margin | ||
| Net profit margin |
| Information from a large supermarket chain | Sales revenue |
|---|---|
| Last year | £1,000,000 |
| This year | £1,200,000 |
| Information from a large supermarket chain | Gross profit |
|---|---|
| Last year | £380,000 |
| This year | £600,000 |
| Information from a large supermarket chain | Net profit |
|---|---|
| Last year | £150,000 |
| This year | £150,000 |
| Information from a large supermarket chain | Gross profit margin |
|---|---|
| Last year | |
| This year |
| Information from a large supermarket chain | Net profit margin |
|---|---|
| Last year | |
| This year |
| Information from a large supermarket chain | Last year | This year |
| Sales revenue | £1,000,000 | £1,200,000 |
| Gross profit | £380,000 | £600,000 |
| Net profit | £150,000 | £150,000 |
| Gross profit margin | 38% | 50% |
| Net profit margin | 15% | 12.5% |
| Information from a large supermarket chain | Sales revenue |
|---|---|
| Last year | £1,000,000 |
| This year | £1,200,000 |
| Information from a large supermarket chain | Gross profit |
|---|---|
| Last year | £380,000 |
| This year | £600,000 |
| Information from a large supermarket chain | Net profit |
|---|---|
| Last year | £150,000 |
| This year | £150,000 |
| Information from a large supermarket chain | Gross profit margin |
|---|---|
| Last year | 38% |
| This year | 50% |
| Information from a large supermarket chain | Net profit margin |
|---|---|
| Last year | 15% |
| This year | 12.5% |
The information shows that although the supermarket chain’s sales revenue did increase by 20%, its net profit remained the same. This means that the net profit margin fell from 15% to 12.5%. The fact that the gross profit margin increased from 38% to 50% would indicate that the fall in the net profit margin was caused by an increase in overheads related to the costs associated with opening the new stores. The performance of the business overall is worse this year than last year as the net profit margin is lower.
Making business decisions
Businesses make decisions using the information that they have available. It is important to ensure that any information used is:
- accurate
- sufficient
- up to date
Accurate
Information used to make decisions needs to be accurate and complete. Inaccurate or incomplete information is likely to lead to incorrect business decisions being made. The consequences of this could be serious, potentially leading to a business failing.
Sufficient
One set of data, particularly financial data, can be meaningless unless put into context. This might mean comparing it with historical data or data from similar businesses. This is particularly true for seasonal goodsCommodities that are sold to make a profit. and servicesA number of activities that serve the general public for different purposes e.g. restaurants and cinemas., such as ice cream, where comparing sales in the summer months against sales in the winter months would not give a realistic growth figure for the business.
Up to date
Information needs to be kept up to date to ensure that it remains relevant. It is not just the passing of time that makes information go out of date. Any significant changes in the market can make data less useful. For example, the emergence of a new competitor would make historical market share data less useful.
Other limitations
Even when the information used to make decisions is accurate, sufficient and up to date, the way that such information is used may have limitations. For example, the average rate of returnA method of comparing the profitability of different choices over the expected life of an investment. is often used to help a business make decisions by comparing the profitability of different investment options. However, this technique does not consider the effects of inflation on the value of cash. For example:
| Project A | Project B | |
| Cost of project | £10,000 | £10,000 |
| Additional profit in year 1 | £8,000 | £4,000 |
| Additional profit in year 2 | £4,000 | £8,000 |
| Total additional profit | £12,000 | £12,000 |
| Cost of project | |
| Project A | £10,000 |
| Project B | £10,000 |
| Additional profit in year 1 | |
| Project A | £8,000 |
| Project B | £4,000 |
| Additional profit in year 2 | |
| Project A | £4,000 |
| Project B | £8,000 |
| Total additional profit | |
| Project A | £12,000 |
| Project B | £12,000 |
The average rate of return for each option would be calculated as:
| Project A | Project B | |
| Average annual profit = | £12,000 ÷ 2 = £6,000 | £12,000 ÷ 2 = £6,000 |
| Average rate of return = | (£6,000 ÷ £10,000) × 100 = 60% | (£6,000 ÷ £10,000) × 100 = 60% |
| Average annual profit = | |
| Project A | £12,000 ÷ 2 = £6,000 |
| Project B | £12,000 ÷ 2 = £6,000 |
| Average rate of return = | |
| Project A | (£6,000 ÷ £10,000) × 100 = 60% |
| Project B | (£6,000 ÷ £10,000) × 100 = 60% |
In this example, the average rate of return is the same, so the technique shows no difference between these two investment projects. However, in project A, £8,000 additional profit is made in year 1 compared to £4,000 in project B. This is an important difference because of the effect of inflation. If inflation between year 1 and year 2 were 10%, then supplies that cost £8,000 in year 1 would cost 10% more in year 2. For example, in order to buy £8,000 worth of products in year 2, the business would need £8,800. As such, receiving larger amounts of returns sooner is better for a business, yet average rate of return does not take this into account.
More guides on this topic
- Production processes - OCR
- Quality of goods and services - OCR
- The sales process and customer service - OCR
- Business location - OCR
- Working with suppliers - OCR
- The role of the finance function - OCR
- Sources of finance - OCR
- Sources of finance - OCR
- Break-even - OCR
- Cash and cash flow - OCR
- Ethical and environmental considerations - OCR
