10. Financial analysis

Question 1

What are the key financial factors when assessing the strategy?

Answer 1

Johnson et al (2017) suggest that organisations must consider a number of key financial factors in assessing their strategy.

1. Financial Risk - A company not meeting its critical financial obligations e.g. Debt financing repayments and Liquidity of funds to pay for debts
2. Financial Return - Investors will expect a financial return, so they will analyse the profitability of a project such as return on capital employed, NPV analysis and IRR
3. Capital Funding- Businesses will seek to deliver a return while keeping the risk at an acceptable level.

Question 2

How has technology impacted on the finance function and professionals?

Answer 2

Accountants need to understand and be aware of these developments, they must be willing to embrace these new technologies.

The role now expects accountants to spend less time processing transactions and more time producing reports and interpreting them for non-finance staff. (Advisory services)

• Big Data – Ability to analyse large amounts of data quickly. Financial or non-financial e.g. Company reputation on social media.
• Cloud Computing- In-house software and hardware now maintained offsite and outsourced reducing costs, also allowing for companies to scale in size almost instantly.
• Predictive Analysis Software- Specialist software can assess data for probable future trends.
• FinTech - a general term for secure payment methods and blockchain.

Question 3

Briefly explain the finance function structure and roles?

Answer 3

• Finance Business partner - A finance professional being embedded in the operations of a department .
• Outsourcing - Working with an external provider to manage specific or all finance function roles.
• Shared Services - One service centre to manage finance needs for all locations or multinational subs
• Local finance Service - All SBUs have there own finance department reporting to the H.Q.

Question 4

What are the 3 types of decisions relevant to the financing requirements of the business?

Answer 4

3 key types of interrelated decisions relevant to the financial requirements of the business.

1. Investments Decisions-
   
   • Identifying investment opportunities and decide which ones should be accepted.
2. Financial Decisions –
   
   • How should the organisations be financed in the short and long term?
3. Dividend Decisions –
   
   • How much to pay out as dividends to shareholders and how much kept for reinvestment?

These decisions will then affect the cash of the business:-

Organisations will need to prepare cash flow forecasts and sensitivity analysis which should identify cash flow deficiencies.

Which could be remedied via selling assets or delaying supplier payments and pulling in payments from customers (Leading and Lagging).

Question 5

How are the sources of capital and working funds evaluated?

and

List the types of funds with the advantages and disadvantages?

Answer 5

As with other key strategic decisions, sources of finance can be evaluated using the SAF model:

• Suitability – is the method of finance appropriate for the use we want to make of it? For example, a long-term asset can be financed by long-term debt but it would be inadvisable to finance working capital this way.
• Acceptability – will the method be acceptable to stakeholders, including current providers of finance? For example, risk-averse shareholders might not want a company to take on additional debt.
• Feasibility – can the additional finance be raised? Are the banks prepared to lend, or shareholders to invest more money?

Question 6

Define an initial coin offering?

Answer 6

Initial coin offering (ICO): Involves the creation of virtual ‘tokens’ which are sold to raise funds for business projects.

Question 7

What is an investment appraisal? and what are the 4 Key methods for this exam?

Answer 7

whether a particular investment opportunity should be selected or abandoned.

1. Return on capital employed (ARR): Is also known as accounting rate of return or return on investment. It can be used for projects as well as organisations.
2. Payback: Is a calculation of how long it will take an investment to pay itself back, ignoring the time value of money.
3. Net present value: Is a calculation of all cash flows relating to an investment, allowing for the time value of money.
4. Internal rate of return: Is the discount rate that will bring the net present value to zero for a given set of cash flows.

Question 8

Explain ROCE and the advantages and disadvantages?

Answer 8

Return on capital employed: Is also known as accounting rate of return or return on investment. It can be used to compare projects as well as organisations.

Used to help managers compare a company’s profitability year on year or compare the profitability of different companies. Also, managers can compare different projects, and if they should be accepted or not.

A positive ROCE shows a simple answer for management to approve a project or company to acquire or if management has a choice of different companies or projects they would choose the one with the highest ROCE

Advantages

1. It is a quick and simple calculation.
2. Easy to understand the results of the formula
3. It looks at the entire project life.

Disadvantages

1. It does not consider the timing of profits or the length of the project.
2. It is based on accounting profits; Accounting profits are subject to a number of different accounting treatments.
3. It is a relative measure rather than an absolute measure and therefore takes no account of the size of the investment.
4. it ignores the time value of money.

Question 9

Explain Payback Period? and it’s advantages and disadvantages?

Answer 9

Payback is the time it takes the cash inflows of investment to payback to equal the cash outflows, usually expressed in years.

If a company has a target payback period, they can accept or refuse a project based on this. But projects should not only be based on payback period but should also look at the long term profitability.

Advantages

• It is simple to calculate and simple to understand.
• uses cash flow rather than accounting profits
• useful to screening device to eliminate obvious projects prior to detailed elimination
• Tends to bias in favour of short-term projects, eliminating both financial risk and business risk.
• it can be used when there is a capital rationing situation to identify those projects who generate additional cash for quick investment.

Disadvantages

• • Ignores the timing of cash flow in the payback period
• • ignores the total project return after the payback period
• • ignores the time value of money
• • unable to distinguish projects with each payback periods
• • choice of cut-off payback period is arbitrary
• • excessive investment in short-term projects.
• • it does not take into account the variability of cash flows.

Question 10

Explain NPV and the advantages and disadvantages?

Answer 10

NPV

This includes all relevant costs and benefits of a project and then discounts them to allow for the time value of money.

The discount rate used should reflect the company’s cost of capital, although may also be adjusted to reflect risk. Or the expected rate of return from investors.

If the final net present value of all cash flows is positive, investment projects are subject to non-financial factors, if the project will be beneficial for the organisation and should go ahead or not.

Advantages

• • Takes into consideration of time value of money, risk and cost of capital
• • Considers the future cashflows of the whole project
• • Aims to maximise the shareholder wealth
• • looks at the cash flows and not the accounting profit which can be manipulated
• • variable discounts rates can be incorporated into NPV

Disadvantages

• • Does not indicate the rate of return
• • Does not indicate the number of years of payback
• • Can be difficult to forecast income and
• • the discount rate could be arbitrary (based on opinion and not on facts)
• • Not easily understood
• • Assumes reinvestment

Question 11

Explain IRR and what are the advantages and disadvantages?

Answer 11

IRR Expected Rate of return.

It uses DCF to calculate the exact rate of return, it calculates the exact discount rates that returns an NPV of 0.

This IRR rate can then be used against the discount rate as a comparison.

Ignore the relative size of investments.

Advantages

• After the IRR is calculated It is easily understood by non-financial managers
• It does not need a discount factor to be calculated.

Disadvantages

• Can be mistaken for ROCE.
• Can only be used for conventional cash flows, as non-conventional cash flows create multiple IRR.
• Ignore the relative size of investments.

Question 12

Compare DCF methods of investment appraisal

and

What are the advantages and disadvantages?

Answer 12

DCF methods of investment appraisal

Comparison of NPV and IRR

• In conventional cash flow, both methods give the same accept or reject decision
• NPV is superior to IRR
• In non-conventional cash flows, there will be several IRR’s which could lead to making the wrong decisions
• variable discounts rates can be incorporated into NPV
• With mutually exclusive projects, NPV is always greater

Advantages

• Considers the time value of money, uncertainty/ risk and inflation.
• all relevant cash flows are considered.
• considers the timing of cash flows.
• There are universally accepted methods of calculating the NPV and the IRR.

Problems with DCF methods

Although DCF methods are theoretically the best methods of investment appraisal, you should be aware of their limitations.

• DCF methods use future cash flows that may be difficult to forecast. Although other methods use these as well, arguably the problem is greater with DCF methods that take cash flows into the longer term.
• The basic decision rule, accept all projects with a positive NPV, will not apply when the capital available for investment is rationed.
• The cost of capital used in DCF calculations may be difficult to estimate.
• The cost of capital may change over the life of the investment.

Question 13

How does management deal with the risk and uncertainty of a financial appraisal?

Hint (Expected Values)

Answer 13

• Risk: Involves situations or events which may or may not occur, but whose probability of occurrence can be calculated statistically and the frequency predicted.
• Uncertainty: Involves situations or events whose outcome cannot be predicted with statistical confidence.
• Expected value (or EV): Is a weighted average value, based on probabilities.
• A decision tree: Is a diagram which illustrates choices and the possible outcomes of decisions. It shows both the probability and the value of expected outcomes.

Question 14

What are the limitations of expected values and decision trees?

Answer 14

Expected Values Limitations:

• The probabilities are estimated and possibly unreliable or inaccurate
• Expected values are long-term averages and may not be suitable for use in situations involving one-off decisions on its own. (it’s useful as a guide)
• Expected values does not consider the attitudes to risk in the decision-making process. Therefore does not account for all the factors
• The time value of money may not be taken into account

Decision Tree limitations:

• The time value of money may not be taken into account.
• Decision trees are not suitable for use in complex situations.
• The outcome with the highest EV may have the greatest risks attached to it. Managers may be reluctant to take risks which may lead to losses.
• The probabilities are estimated and possibly unreliable or inaccurate.

Question 15

What are the financial reporting and tax implications of the strategic decision?

Answer 15

When making strategic and investment decisions, it is important to take all relevant information into account, and this includes relevant financial reporting and tax Implications.

They may be required to consider significant differences in tax rates or other types of fiscal burdens in different jurisdictions.

Or if there are any necessary FR impacts required because of a strategic decision

*This will not be examined in detail*

Question 16

How are financial ratios relevant to strategic management?

and

What types of key financial ratios could they use?

Answer 16

Management will analyse data and draw conclusions about an organisation’s performance over a time period and its current position.

This will involve analysing a wide range of data including financial ratios, non-financial key performance indicators and qualitative data.

All these different sources of information will help management, make sense of it all and used to create a coherent message for a non-financial manager.

Types of Key Financial Ratios:-

• Profitability
• Efficiency
• Gearing
• Investment

Question 17

Explain Strategic Cost management and Full Cost?

Answer 17

Any organisation needs to manage its costs in order to achieve its strategic objectives.

• cost leader seek to minimise costs so they can reduce prices and compete effectively
• Differentiator will aim to manage costs so as to improve its margins.
• not-for-profit will aim to manage costs to make the best use of its resources.

Overhead absorption and activity-based costing allow the assessment of the full cost of a product or a service.

Full cost: Is the total amount sacrificed to achieve a particular objective, including all related costs.

• Pricing and output – how many should be made and what price charged to the customer?
• Exercising control – by comparing actual and budgeted performance and addressing discrepancies
• Assessing efficiency – current processes can be compared with different locations, or alternative methods of working, to determine the current efficiency.
• Assessing performance – revenue generated by a product or service can be compared to its full cost

Strategic cost management means not just measuring costs and performance against the budget but focusing on what is driving costs,

whether they can be reduced, and whether resources are being allocated in the best possible way to support the achievement of the organisation’s strategy.

Question 18

Explain forecasting and the various qualitative and quantitative techniques?

Answer 18

Forecasting can help with planning and decision making.

They can be qualitative Methods:

• Delphi technique - a panel of experts, each produces an independent forecast. These forecasts are shared, and each then goes on to produce a revised forecast. The process continues until they are in agreement and a definitive forecast is produced.
• Sales force opinions involve a sales manager gathering input from the sales team and collating their opinions into an aggregate forecast.
• Executive opinions high-level managers during which they develop forecasts based on their knowledge of their own individual areas of responsibility.
• Market research involves the use of customer surveys to evaluate potential demand.

Quantitative Methods:

• - Liner regression
• - Time series analysis

Question 19

Explain linear regression forecasting and time series analysis?

Answer 19

Linear regression measures the relationship between two variables, it uses statistics to find the line of best fit. which will help management develop a formula to predict costs at various volume levels.

The strength of the relationship is measured by correlation coefficient (often shown as ‘r’) which can range from

• +1 (exact positive relationship)
• 0 (no relationship)
• –1 (exact negative relationship).

Number of issues:-

• (a) does not prove there is a link. could be coincidence or other variables.
• (b) It depends on having enough data, and the data is reliable
• (c) When used for forecasting, assumes past data is a reliable guide to the future, which may not be correct.

Time Series analysis

Time series analysis aims to separate seasonal and cyclical fluctuations from long-term underlying trends. It is therefore a form of regression analysis where one variable represents time. eg. summer sales vs winter sales.

Advantages

• • Accounts for seasonal patterns
• • easily understood

Disadvantage

• • ignores other factors that cause a change
• • past data may not be reliable
• • assumes the future show the same trend as the past

Question 20

Explain Budgeting and how it fits in the strategic planning process.

and

What are the benefits and limitations?

Answer 20

A budget: Is a business plan for the short term, usually one year.

It is likely to be expressed in financial terms and its role is to convert the strategic plans into specific targets.

1. The mission sets the overall direction of strategic objectives
2. Strategic objectives illustrate how the mission will be achieved
3. Strategic plans show how the objectives will be pursued
4. Budgets represent short-term plans and targets to meet strategic objectives

Budgets will then be controlled to ensure the planned events actually occur.

Benefits

1. Promotes forward-thinking
2. Helps to coordinate the various aspects of the organisation
3. Potential to Motivate performance
4. Provides a basis for a system of control
5. Provides a system of authorisation for spending limits

Limitations

• Demotivating if unattainable or unachievable
• Slack may be built-in to make the budget more achievable
• Focuses on the short-term results
• Unrealistic budgets may cause managers to make decisions that are detrimental to the company. (High-risk business decisions)

Question 21

What factors lead to successful budgeting?

Answer 21

• Senior management takes the system seriously.
• Accountability. There are clear responsibilities
• Targets are challenging but achievable
• Targeted reporting
• Short reporting periods, usually a month
• Timely reporting
• Provokes action

Question 22

Explain standard costing and variance analysis?

Answer 22

Standard: Is a carefully predetermined quantity target which can be achieved in certain conditions.

Standard cost: Is an estimated unit cost.

Standard costing process:

1. predetermined estimates of costs
2. collection of actual costs
3. comparison of the actual costs with the predetermined estimates.
4. difference between the two variables is known as a variance.
5. the total difference is analysed is known as variance analysis.

Standard costing is most beneficial for repetitive processes. most suited to mass production.

Types and reasons for Variances

• Sales Variances
  
  • Sales Volume - overall turnover variance
  • Sales Price - the average standard price of each sale vs actual
• Materials Variances
  
  • Direct materials
  • Direct materials usage
  • Direct materials price
• Labour Variance
  
  • Total Direct labour
  • Direct labour efficiency - budgeted Volume of output vs actual
  • Direct labour rate
• Fixed Overheads
  
  • Fixed production overhead total

Variances can occur for various reasons and it is important not to make assumptions about them. Potential Reasons:

• The buying department negotiating badly
• Higher quality material being used
• A general increase in prices
• Failure of a supplier, with the only available replacement being more expensive

Question 23

What are the Limitations of control through variances and standards?

Answer 23

• Standard costs can quickly become out of date. Regularly monitoring and updating standards can be costly and time-consuming
• Variances could be impacted by factors out of the control of that manager.
• Lines of responsibility between managers can be difficult to define.
• Once a standard has been met, there is no incentive to improve.
• May encourage undesirable behaviour, high-risk business decisions or decisions not beneficial to the whole business overall.

Question 24

How can marginal and relevant costing help Evaluate strategic options?

Answer 24

Relevant costs Are those costs that are relevant to a particular decision/project. (Future, incremental and cash outflow are relevant costs)

All fixed costs are irrelevant to the decision because they will be the same whatever decision is made. Similarly, any costs which do not represent cash, or have already been incurred, are also irrelevant.

Marginal cost (the cost of producing one additional unit) usually equals the variable cost per unit. Unless there is a step up in the fixed costs, the increment will be included as well as the variable costs.

Marginal analysis is useful for:-

1. (accepting a new product or customer) whether or not a special contract should be accepted
2. (Most beneficial use of resources)limit to the amount that can be produced due to a scarce (limiting) factor
3. (Outsourcing decisions) produce the product or service they sell themselves or whether to buy it from another business
4. Should a department be closed down? - contribution for each department can be determined and negative departments may be used to closed down.