The document discusses key finance concepts related to managing a business, including: - Profit is revenue minus total costs, while profitability is a business's ability to generate profit efficiently. - Net profit margin and return on capital are two common measures of profitability, calculated by comparing profit to sales or capital invested. - Businesses can improve profitability by increasing prices, decreasing costs, or boosting sales volumes - though these strategies also carry risks if not implemented carefully. - While profit and cash flow are related, a profitable business may still face short-term cash shortages due to investing profits back into the business or tying up capital in inventory, assets, or by extending credit to customers.

1. Unit 2: Managing a business
Finance
Profit and profitability
Profit: the difference between the income of a business and its total
costs.
profit = revenue – total costs
Profitability: the ability of a business to generate profit or the
efficiency of a business in generating profit.

2. Unit 2: Managing a business
Finance
Measure of profitability
Two ways of measuring profitability will be considered. Both measures investigate
how efficient a business is in terms of achieving a profit.
net profit margin: compares the profit made with the sales income of the
business/branch.
return on capital: compares the profit made with the amount of capital invested by
the entrepreneur or financial backer.

3. Unit 2: Managing a business
Finance
Net profit margin
This ratio is calculated as follows:
net profit margin (%) = net profit before tax × 100
sales income (turnover)
For example:
net profit = £20,000
sales income = £80,000
net profit margin (%) = £20,000 × 100 = 25%
£80,000

4. Unit 2: Managing a business
Finance
Interpreting the net profit margin (1)
To assess the meaning of a net profit margin, two comparisons are usually made:
• Comparison over time. Is the net profit margin increasing (suggesting
improvements in efficiency) or decreasing (implying a decline in efficiency)?
• Comparison to other firms or branches/divisions. These comparisons are
useful because they look at the business’s success (or failure) relative to other
businesses. It is much easier to make high net profit margins in some industries*
than in others; this calculation avoids judgments that may be affected by this
factor.
*These industries usually sell fewer items at higher prices, so a high net profit
margin is not a guarantee of higher overall profit levels.

5. Unit 2: Managing a business
Finance
Interpreting the net profit margin (2)
What conclusions can be drawn about the net profit margins of the three
companies in the table above?
Company Net profit
margin (%)
2005
Net profit
margin (%)
2006
Net profit
margin (%)
2007
Net profit
margin (%)
2008
Company A 10.3 10.9 12.0 14.0
Company B 15.2 13.8 12.4 12.1
Company C 5.6 5.5 5.8 5.6

6. Unit 2: Managing a business
Finance
Interpreting the net profit margin:
conclusions
With all three companies, comparisons should be made with competitors in the same
industry. This analysis assumes that the three companies are in direct competition.
Company A earns a consistent net profit that has increased steadily over the 4
years. In 2008, it recorded the highest net profit margin, so it is the company that
appears most likely to be successful in the future.
Company B has been the most successful business for 3 of the 4 years, so its
overall performance has been the best of the three companies. However, its net
profit margin has fallen each year and the trend suggests that it is unlikely to be as
successful as Company A in the future (unless there are specific, temporary reasons
for 2007 and 2008 not being such good years).
Company C has made a consistent profit each year but it has been less profitable
than the other two companies and its owners may be concerned at the relatively low
levels of profit being made. However, in some competitive industries (such as
supermarkets) Company C’s net profit margins are only slightly below the average.

7. Unit 2: Managing a business
Finance
Return on capital
This ratio is calculated as follows:
return on capital (%) = net profit × 100
capital invested
For example:
net profit = £20,000
capital invested = £100,000
return on capital (%) = £20,000 × 100 = 20%
£100,000

8. Unit 2: Managing a business
Finance
Interpreting the return on capital (1)
To assess the meaning of the return on capital (%), three comparisons are usually
made:
• Comparison over time. Is the return on capital increasing or decreasing?
• Comparison with other firms or branches/divisions. Is the money invested
in this business providing a better return than the money invested in other
businesses?
• Comparison with bank interest rates. The opportunity cost for many
investments is the interest that could have been gained from placing the money
in a bank account. As there is no real risk in this investment, the return on
capital invested in a business needs to be higher than the interest rate offered by
a bank.

9. Unit 2: Managing a business
Finance
Interpreting the return on capital (2)
What conclusions can be drawn about the return on capital of the three
companies in the table above?
Company Return on
capital (%)
2005
Return on
capital (%)
2006
Return on
capital (%)
2007
Return on
capital (%)
2008
Company A 20.2 23.6 25.8 30.0
Company B 15.0 14.2 3.3 2.8
Company C 2.5 2.5 4.1 7.3
Bank interest
rate (%)
4.5 4.75 5.75 5.5

10. Unit 2: Managing a business
Finance
Interpreting the return on capital:
conclusions
Company A has steadily improved and made excellent returns on capital. It is
clearly the best company in which to invest.
Company B performed well in 2005 and 2006, but its performance became
unsatisfactory in 2007 and has worsened again in 2008. Its overall return is below
the bank interest rate and it is not a good investment unless the reason for its
sudden decline can be discovered and put right.
Company C has only performed satisfactorily in one year (2008). However, it has
been improving its profitability and would seem to be a better investment for the
future than Company B.

11. Unit 2: Managing a business
Finance
Methods of improving
profits/profitability
Many methods can be used. Three main methods are:
• increasing the price
• decreasing costs
• increasing sales volume

12. Unit 2: Managing a business
Finance
Increasing the price
• Increasing the price will widen the profit margin. Therefore each product sold will
generate more profit.
• This strategy will be particularly effective if the product is a necessity or has no
close substitutes, as customers will be willing to pay the higher price.
BUT…this strategy will fail if the higher price leads to customers switching to rival
products or just giving up on buying the product.
• The business must analyse the likely effect of any price increase in situations
where there are many close competitors.
• It is possible that the price rise may cause such a large fall in demand that the
higher profit margin will be offset by a dramatic fall in quantity, so the overall
profit may fall.
In situations where there are many competitors, it may actually be more
profitable to cut the price.

13. Unit 2: Managing a business
Finance
Price elasticity of demand
To assess the impact of price changes on profit, an understanding of price elasticity
of demand is needed.
•Price elasticity of demand will enable you to provide more sophisticated responses
to questions about price changes.
•Obviously this is highly inelastic in a B2B situation where the customer company is
dominant. Try charging more to Tesco!

14. Unit 2: Managing a business
Finance
Decreasing variable and fixed costs
Variable costs
If the firm can cut its variable costs, the profit margin will increase but how much
power has it over its suppliers?
This means that each product will yield more profit.
BUT…if the change in costs leads to a decrease in quality (e.g. inferior raw materials)
or efficiency, the demand for the product may fall.
Fixed costs
Profit will also increase if fixed costs, such as rent, are reduced.
BUT…not if the cost cutting leads to lower sales (e.g. locating the shop in a place
that is less accessible to customers).

15. Unit 2: Managing a business
Finance
Increasing sales volume
If costs and price remain the same, it is still possible to increase profits by increasing
the volume of products sold.
A business can achieve this by a number of methods, such as:
• increasing marketing
• developing new products
• improving quality
BUT…all of these methods will cost money.

16. Unit 2: Managing a business
Finance
Numerical example:
background information
A business sells 500 units of a product at £10 each. Its fixed costs are £2,000 and its
variable costs are £3 per unit.
Calculate the profit made on this product.
Answer
TR – TC = £5,000 – (£2,000 + £1,500) = £5,000 – £3,500 = £1,500
Research reveals the following:
1 An increase in price to £12 will lead to a fall in sales to 450 units.
2 Cheaper raw materials will reduce variable costs to £2.50 per unit.
3 A poster campaign costing £800 will increase sales by 10%.

17. Unit 2: Managing a business
Finance
Numerical example: exercise
Will the changes on the previous slide increase or decrease the profit?
Taking each change in isolation, calculate the profit made from:
1 An increase in price to £12, which leads to a fall in sales to 450 units.
2 Cheaper raw materials, which reduce variable costs to £2.50 per unit.
3 A poster campaign costing £800, which increases sales by 10%.
Should the business make these three changes?

18. Unit 2: Managing a business
Finance
Numerical example: answers 1 and 2
1 TR = £12 × 450 TR = £5,400
FC = £2,000 TVC = £3 × 450 = £1,350 TC = £3,350
Profit = £2,050
Profit increases by £2,050 – £1,500 = £550.
Note how some of the increase in profit has come from lower variable costs because
fewer products are made.
2 TR = £5,000 FC = £2,000 TVC falls to 500 × £2.50 = £1,250
profit = TR – TC = £5,000 – (£2,000 + £1,250) = £5,000 – £3,250 = £1,750
Profit increases by £1,750 – £1,500 = £250.

19. Unit 2: Managing a business
Finance
Numerical example: answer 3
and conclusion
3 Sales volume increases by 10% from 500 to 550 units. FC increases by £800.
TR = 550 × £10 = £5,500 VC = 550 × £3 = £1,650
FC = £2,000 + £800 = £2,800
profit = £5,500 – £1,650 – £2,800 = £1,050
Profit increases by £1,050 – £1,500 = –£450 (the business’s profits fall by £450).
Conclusion
The business should carry out actions 1 and 2 but not implement action 3.

20. Unit 2: Managing a business
Finance
Extension work
Calculate the final profit if actions 1 and 2 only are implemented.
How much profit would be made if all three options were implemented?

21. Unit 2: Managing a business
Finance
Other methods of improving
profit/profitability
Some other methods of improving profits are noted below, but this is not an
exhaustive list:
• investment in fixed assets
• product development
• marketing
• staff training
Note how each of the functional areas can contribute to improved profitability.
Can you add to this list?

22. Unit 2: Managing a business
Finance
Distinction between cash and profit
Profit is calculated by subtracting expenditure from revenue. It is easy to assume
that a profitable firm will be cash rich, but this is not necessarily true.
Liquidity is the ability to convert an asset into cash without loss or delay.
The most liquid asset that a business can possess is cash.
Many firms will not have their profit in the form of cash, so a high profit may not
guarantee a high level of cash.
It is also possible for a firm to have low profits but high cash levels. For example, a
business that has just borrowed a large sum of money will have high cash levels,
regardless of its profit levels.

23. Unit 2: Managing a business
Finance
Why a profitable firm might
be short of cash
• The firm has built up its stock levels. Its wealth will lie in stocks on shelves
rather than cash.
• The firm has given credit to its customers. Its wealth will be in debtors
(people who owe money to the firm).
• The firm has used its profit to pay dividends to shareholders or repay long-term
loans; it may be short of cash.
• The firm has purchased fixed assets, such as new machinery or vehicles.