AQA Business Studies/Printable version

AQA Business Studies

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Elasticity of Demand

Elasticity of Demand is the term used to describe the difference between the price of a product and the demand. Generally the higher the price of the product the more the demand will fall and vice versa, although there are exceptions to this where a high price is used to make a product appear more "exclusive". Businesses use the elasticity of demand to determine what price to set in order to maximise profitability. Some businesses operate within markets where the products are considered inelastic. For example, petrol is generally considered to be inelastic as if the price rises the demand is not affected greatly. This is because vehicle owners need petrol so the increase in sales would be greater than the loss in demand. Over the long term it is elastic as vehicle buyers will be encouraged to buy vehicles using alternative fuels, find different means of transport (e.g., train, bus) or better fuel consumption. Individual petrol stations are elastic as consumers will go where the prices are cheapest. Commodity products are also generally inelastic (e.g., bread). An example of elastic demand might be McDonalds in the fast food market. They are in a highly competitive market and raising their prices too high would lead to a loss in demand greater than the increase in sales. Businesses will raise prices as high as possible if it demand is inelastic until it is so high it becomes elastic, whereas elastic products should be lowered to gain better profits caused by increase in demand.

Uses and Limitations of Accounts

There are two types of business accounts:

• Financial Accounts
  • Balance Sheet
  • Trading, Profit and Loss account
• Management Accounts
  • Cash flow statement

Financial accounts are open to be window dressed (manipulated) to make them look better before they are published. Company Act 1985 made it compulsory for Ltd and Plc companies to publish these accounts. Unlimited firms don't actually have to.

Management Accounts are for internal use in decision making. It isn't beneficial to window dress these accounts because they are usually used to make decisions by the management. They could also be drawn up for each profit/loss centre in order to make better decisions

Ratio Analysis

Ratios in a business, are important in order to compare the efficiency with either another company in the same or a similar market or previous years.

There are 5 types of Ratios we will look at:

• Shareholders Ratios
• Profitability Ratios
• Liquidity Ratios
• Activity Ratios
• Financial Ratios

Shareholders Ratios

Dividend Per Share

The amount of the overall dividend that each share will get - what essentially shareholders are investing for.. The Dividend is announced each year and can be found in the Trading, Profit and Loss Account after Tax has been taken off.

$Dividend\ Per\ Share={\frac {Overall\ Dividend}{Number\ of\ Shares}}$

Dividend Yield

The percentage of the Market Price that the Shareholders will get in dividend. This shows potential investors how much a company values it's shareholders investment.

$Dividend\ Yield={\frac {Dividend\ Per\ Share}{Market\ Price\ Per\ Share}}$

Profitability Ratios

Gross Profit Margin

Gross Profit is the Revenue minus the cost of making the products.

Gross Profit Margin is the measure of how efficiently a company is making the products to sell and turn into revenue (remember - Sales revenue and sales turnover are the same things). The higher the percentage, the better for the business because it means that the Profit Margin on each product is high - for a 'company', a higher dividend could be given.

To increase the Gross Profit Margin:

• Supplier costs could be decreased if a cheaper one is available
• Price per unit can be increased
• Sales turnover can be increased (marketing or price decrease - but has an adverse effect on overall profit)

$Gross\ Profit\ Margin={\frac {Gross\ Profit}{Sales\ Turnover}}\times 100$

Net Profit Margin

Net Profit is Revenue minus all the costs of the day to day running of the business - Costs of making the products, Overheads, Vehicles, Machinery, etc.

Net Profit Margin is the measure of how efficiently a company is turning Revenue into Net Profit. The higher the Net Profit Margin, is again the better. It shows what percentage of the revenue is available to cover taxes to be paid to inland revenue and how healthy the dividend will be.

To increase the Net Profit Margin:

• (Everything used to increase Gross Profit Margin)
• Carefully monitor Overhead usage (turning lights off, turning heating off)
• Budget on expenditure carefully

${\mbox{Net Profit Margin}}={\frac {\mbox{Net Profit}}{\mbox{Sales Turnover}}}\times 100$

Return on Capital Employed (ROCE)

ROCE is also known as the primary accounting ratio. It measures how efficiently a business is investing capital in a business in order to make profit. Sales revenue can again be found on the Trading, Profit and Loss account and the Capital Employed on the balance sheet. Capital Employed can be worked out by adding the Shareholders capital and Long-term liabilities.

The higher the figure, the more attractive investment the business would be to investors (More returns on their capital!).It can be compared to previous years (show levels of previous investment and expected returns and whether it is satisfactory or not) or other businesses ROCE. It should also be compared to bank interest rates - what's the point in the risk of investing it in a business if you could invest it in a risk-free bank and earn more in interest rates than you would on ROCE?

ROCE can be adjusted by:

• Earning more revenue with the same amount of capital employed
• Earning the same amount of revenue but decreasing the Capital used to generate the revenue.

$ROCE={\frac {Sales\ Turnover}{Capital\ Employed}}\times 100$

Liquidity Ratios

Liquidity ratios measure how effectively a business can sell it's assets to cover it's liabilities.

Acid Test Ratio

Acid test is the measure of how effectively a business can liquidate (pay off creditors) without considering the stock. Stock is taken off because it is the most illiquid asset that a business owns. In order to sell it immediately the stock becomes very cheap and so loses its value.

It is recommended a business keeps this at about 0.8 as the stock will always be worth something even if a very small proportion to what it's actual value is. If the number becomes lower, the business may experience difficulties covering it's short term debts. If the number increases, the business is probably using the cash in an unprofitable or unproductive form.

$Acid\ Test={\frac {Current\ Assets\ -\ Stock}{Current\ Liabilities}}$

Current Ratio

Not actually needed (it's not in the syllabus) but useful to know as the theory for acid test links in.

$Current\ Ratio={\frac {Current\ Assets}{Current\ Liabilities}}$

Gearing Ratio

Shows how reliant a business is on External sources of finance. It is used by banks and lenders to see how risky a business is before they give them the loan. Highly geared companies are known as the riskiest type of business because they are reliant on loans for the day to day running of assets, which they haven't yet paid off.

$Gearing={\frac {Long\ term\ Liabilities}{Capital\ Employed}}$

Financial Ratios

Asset Turnover

$Asset\ Turnover={\frac {Sales\ Turnover}{Net\ Assets}}$

Stock Turnover

$Stock\ Turnover={\frac {Overall\ Cost\ of\ Goods\ Sold}{Average\ Number\ of\ Stock}}$

Debtor Days

$Debtor\ Days={\frac {Debtors}{Sales\ Turnover}}$

Changes in Ownership

A change in ownership can be because of many different factors. When ownership changes (for example from a Private Limited Company to a Public Limited Company) there may be a change in focus. For example, a private company typically has few, if any, institutional investors and a stable shareholder register. This allows the company to focus on very long term goals, to retain profit for future investment, etc. A public company, in contrast, will have a more diverse and changeable shareholder base. This can lead to the company needing to maintain or increase income distributions year-on-year which could be against the best long term interests of the company.

Takeovers and mergers

These are the main ways change in ownership can occur.

Takeovers

This is where one company takes control of another. It can be an agreed takeover which happens when a current owner and an external person agrees a price which the share of the company is sold for. It can also occur in hostile conditions where a potential owner goes about collecting shares, buying off the market when they are made available and trying to get a large enough share to control the company. In the United Kingdom, public company take overs are governed by the Take Over Panel and company law. These set rules around how a stake is accumulated, the timetable for making an offer, etc. They also ensure all shareholders are treated equally.

Many advantages can be taken for the new owner. These include:

• Brand name retained
• Reputation retained
• Customer base retained
• Staff/expertise retained
• Patents and designs retained

Even if the failing companies get taken over, the best parts of the companies can be retained, or the market share can still mean a larger market share (e.g., Volkswagen take-over of Skoda - Skoda before the takeover was known as a bad quality car but Volkswagen then put its engines and reliability into Skoda and before long Skoda became a good quality car at a lower price point).

Disadvantages can also be experienced:

• Not only the good parts of companies are taken over, but also the bad parts
• The cost of completely taking it over can be huge

Mergers

Two companies may decide to join together to gain synergies. This could be where the companies have complimentary products (allowing a wider range to be offered or to cover a greater geographic area), have significant overlap (allowing duplication and hence cost to be eliminated) or other reasons. This is called a merger. An example is the now HBOS where Halifax and the Bank of Scotland merged and also Lloyds TSB when Lloyds merged with Trustee Savings Bank. Lastly when two gaming companies merged called Activision and Blizzard to form Activision Blizzard.