Key Financial Objectives (AQA A Level Business): Revision Note

What are financial objectives?

• Financial objectives are the specific financial targets a business sets for itself

• They give direction to financial planning and decision-making and are shaped by the business's overall goals and the environment in which it operates

Common financial objectives

Profit

• Profit is the financial surplus left over after costs have been deducted from revenue

• There are two types of profit

  • Gross profit

    • Revenue minus the direct cost of producing or buying the goods sold

  • Operating profit

    • Gross profit minus all other operating expenses, such as rent, wages and marketing

Significance

• Profit is the primary reward for the risk taken by business owners and entrepreneurs

• It provides funds for reinvestment in the business

  • Buying new equipment, expanding into new markets or developing new products

• It enables businesses to pay dividends to shareholders, which is important for attracting and retaining investors

• In the long run, a business that consistently fails to make a profit cannot survive

Profitability

• Profitability measures how efficiently a business generates profit relative to its revenue

• The gross profit margin shows the proportion of revenue converted to gross profit

$\mathrm{Gross}\mathrm{profit}\mathrm{margin}=\frac{\mathrm{Gross}\mathrm{profit}}{\mathrm{Revenue}}\times 100$

• The net profit margin shows the proportion of revenue converted to net profit

$\mathrm{Net}\mathrm{profit}\mathrm{margin}=\frac{\mathrm{Net}\mathrm{profit}}{\mathrm{Revenue}}\times 100$

Significance

• A business can make a large profit in absolute terms but have low profitability if its revenues are also very high

  • Profitability shows how well the business is actually managing its costs

• Investors and shareholders use profitability margins to compare businesses of different sizes and to judge how well a business is being run

• Improving profitability - by either increasing revenue or reducing costs - is a common strategic objective

Cash flow

• Cash flow refers to the movement of money into and out of a business over a given period

  • Positive cash flow means more money is flowing in than going out

  • Negative cash flow means more money is flowing out than coming in

Significance

• Cash flow is essential for the day-to-day running of the business—paying wages, suppliers, rent and utility bills all require cash

• A business can be profitable on paper but still fail if it runs out of cash

  • For example, a business that sells goods on credit may show a profit in its accounts but struggle to pay its bills while waiting for customers to pay

• Many businesses set cash flow objectives, such as maintaining a minimum cash balance or improving the timing at which money is received from customers

Liquidity

• Liquidity refers to how easily a business can meet its short-term financial obligations

  • Simply, how quickly can it get hold of enough cash to pay what it owes in the near future?

• A business is described as liquid if it holds enough short-term assets (cash, stock it can sell, money owed by customers) to comfortably cover its short-term debts and bills

• A simple measure of liquidity is the current ratio

  • It compares the amount of short-term assets with short-term liabilities

$\mathrm{Current}\mathrm{ratio}=\frac{\mathrm{Current}\mathrm{assets}}{\mathrm{Current}\mathrm{liabilities}}$

• A current ratio above 1 indicates the business can meet its short-term obligations; a ratio below 1 suggests it may struggle

Significance

• Even profitable businesses can become insolvent if they have poor liquidity

• Strong liquidity provides financial flexibility and resilience, particularly during periods of uncertainty or unexpected costs

• Businesses may set liquidity objectives, such as maintaining a current ratio above a certain level

Levels of borrowing

• Levels of borrowing refer to the total amount of debt a business has taken on through loans, bank overdrafts or other forms of credit

  • This is often described in terms of gearing

    • This is the proportion of a business's funding that comes from debt rather than from shareholders' equity

Significance

• High borrowing increases financial risk

  • Interest payments must be made regardless of how well the business is performing, and if the business struggles, lenders may demand early repayment

• Low borrowing provides greater financial security and flexibility

  • However, it may limit the business's ability to invest and grow

• Businesses often set objectives around keeping borrowing below a specific level, paying down existing debt, or maintaining a target gearing ratio, particularly when interest rates are high

Influences on financial objectives

• The financial objectives a business sets are shaped by a range of internal and external factors