3.5 DECISION MAKING TO IMPROVE FINANCIAL PERFORMANCE Flashcards
Define ‘net profit’ / ‘operating profit’
Amount of money your business earns after deducting all operating, interest, and tax expenses over a given period of time.
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Define ‘gross profit’
Profit after deducting costs associated with making and selling the products
- HIGH cost of sales = LOW gross profit
Define ‘profit’
The reward/return for taking risks and making investments
What are the two ways of measuring profit/return?
- Absolute: the £ value of profits earned
- Relative: difference between the absolute return and the performance of the market (or other similar investments) - COMPARE TO RELATIVE FIGURES
What is ratio analysis?
Analysing relationships between financial data to assess the performance of a business
What are the main profitability ratios?
- Gross profit margin
- Operating profit margin
- Return on capital employed
What is net profit margin / operating profit margin ?
- What is left after all costs have been taken from its sales revenue
- Percentage return made on sales
- Measure of firm’s profitability by looking at the relationship between net profit and sales revenue
What does operating profit tell us?
- How effective a business turns sales into profit
- To see if the business needs to be more profitable
What is a concern around cash flow?
It is dynamic and unpredictable, can change at any moment
Why create a cash flow forecast?
- Advanced warning for cash flow issues
- Makes sure the business have enough money to pay suppliers and employees
- Reassures investors that there is full control over finance
Equation for net cash flow
Inflows - outflows
When is breakeven output reached?
When…
Total revenues = total costs
Equation for breakeven output
Fixed costs / contribution per unit
Equation for contribution per unit
Revenue - Variable Costs
Define ‘margin of safety’
The amount sales can fall before the break-even point is reached and the business makes no profit
Equation for margin of safety
Difference between…
Actual Output and Breakeven Output
What does a positive margin of safety mean for a business?
Profitability
What does a negative margin of safety mean for a business?
Loss being made
BELOW THE BREAKEVEN POINT LINE, looking at how much more £££ needs to be made to reach the breakeven point
Ways to improve margin of safety
- Increase contribution per unit, by:
- Rising selling prices
- Reducing variable costs per unit
- Lowering the breakeven output
- Lowering fixed costs
- Turning fixed costs into variable costs
- Increase actual output
Define ‘contribution per unit’
Coverage of fixed costs
All sales revenue not consumed by variable costs
Define ‘breakeven output’
How many products need to be sold to reach breakeven point
Define ‘budget’
A financial plan for the future concerning revenues and costs of a business
How much you are allowed to spend on something
How do managers use budgeting?
- Set targets
- Provide direction
- Assign responsibilities
- Motivate staff
- Prevents overspending, keep within budget
Explain a good budgetary control
- Responsibilities clearly defined
- Make sure don’t go over the budget
- Corrective action taken if results differ from budget
Define ‘historic budgeting’
Use last year’s figures as basis of budget
Advantage of ‘historic budgeting’
- Realistic, based on actual results
Disadvantage of ‘historic budgeting’
- Circumstances may have changed
- Does not encourage efficiency
Define ‘zero budgeting’
- Budgeting costs set to zero
- Budget based on new proposals
AS YOU GO ALONG
Advantage of ‘zero budgeting’
- More realistic and up-to-date
Disadvantages of ‘zero budgeting’
- Time consuming
- More complicated
Define ‘management by exception’
Process of focusing on activities that require attention and ignoring those that appear to be running smoothly
How do variances make “Management by exception” easier?
Highlights areas of a business which don’t meet standards of the budgeting
Adverse = pay attention to these
Define ‘variances’
Difference between actual and budget figures
Define ‘variances’
Difference between actual and budget figures
Define ‘adverse variance’
NEGATIVE
Worse than expected
If actual is lower than budget
Define ‘favourable variance’
POSITIVE
Better than expected
If actual is higher than budget
What do variances depend on?
- What is foreseen
- Size of budget
- If temporary problem or result of long-term trend
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How should a business act on variances?
- Act only if variance is outside of agreed margin, don’t waste time
- Investigate the cause
- Was it avoidable?
- Act to save the problem
In what way could an adverse variance be positive for a business?
- May be a result of something good that has happened to the business
(e. g.) higher production costs than budget occur because sales are higher than budget
Problems with budgeting
MAY BE BIAS?
- Can lead to inflexibility in decision making, as the business must remain within the budget
- Needs to be changed as the circumstances change
- Takes time to complete and manage
- Costs are subject to change
- Competitor actions unknown
- Managers may lack experience
- Takes time and effort: associated with opportunity costs
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Behavioural Affects of Budgeting
- May create a ‘use it or lose it’ approach amongst businesses, costing the business
- De-motivating if not negotiated, stakeholders may not agree with it
- Department rivalry, battles over budget allocation
Suggest some internal sources of finance
- Retained profit
- Rationalisation - through selling assets
- Owner investment
Suggest some external sources of finance
- Debt factoring
- Overdrafts
- Share capital
- Loans
- Venture capital
- Crowdfunding
Advantages of ‘retained profit’
- Avoids interest repayments
- Doesn’t dilute business ownership
- Increase share price
- Improve financial safety net
Disadvantages of ‘retained profit’
- Only an option if sufficient retained profit exists within the business
- May cause shareholder dissatisfaction if this is at the expense of dividend payments
- Reduces security blanket of keeping retained profit for unforeseen situations or to take advantage of new opportunities
Define ‘rationalisation’
INTERNAL
Selling assets
Reorganise the business to make it more efficient
Advantages of ‘rationalisation’
- Less risky (as its internal)
- No cost involved, if privately sold
- Quick and easy source of finance
Disadvantages of ‘rationalisation’
- Cost to replace these assets later
- Can decrease productivity if machinery is sold
- No guarantee of improved return
Define ‘debt factoring’
EXTERNAL
Selling debts to another organisation
Sells its accounts receivables to a third party
Advantages of ‘debt factoring’
- Improves cash flow: can pay threatening debt / cash-flow problems off immediately (short-term)
- Debts dealt with by experts, saving managers time
- Debt protection: reduces risk of a debt getting out of hand
- Improves cash flow
- Reduces stress in the short-term: improving productivity
- Less admin work to organise the debt: taken care of elsewhere
Disadvantages of ‘debt factoring’
- Reduces profitability in the long term as fee must be paid to debt factorer when it is sorted
- Less control
- Creates more debt in long term
Define ‘overdrafts’
EXTERNAL
- Facility to overspend on a current account up to agreed sum
- Short term
- USED IN EMERGENCIES!
Advantages of ‘overdrafts’
- Small/no interest
- Quick / easy - available whenever
- Only borrowed when essential
- No charges
- You’re in control: only pay for what you use - FLEXIBLE
Disadvantages of ‘overdrafts’
- Needs to be paid back asap (short term)
- Interest payment vary, hard to budget
- If go over, may damage connection with bank, meaning borrowing will be harder in the future
- Bank can call in at any time, unreliable
- Limitation: only available from current bank account
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Define ‘share capital’
Finance raised from shares
Advantages of ‘share capital’
- Happy shareholders: shareholders get dividends and benefit from increase in share price
- Dividends are flexible, business can maximise profit by decreasing
- No interest repayments
- If successful. business can raise large amounts of finance
- LOW RISK: source of permanent capital: source of permanent capital
Disadvantages of ‘share capital’
Must become a PLC…
- Loss of ownership
- Risk of loss of control: PLC with a threat of hostile takeover. More than 50% = owner
- Complex and costly
- Reliant on people actually wanting to invest
Define a ‘loan’
- EXTERNAL - LONG TERM (but depends on situation of a business)
- Money provided for a specific purpose (apply)
- Interest rate is based on risk placed on the loan
Advantages of a ‘loan’
- Quick and easy to secure
- Build connection with bank for better future interest
- Fixed interest rates allow budgeting
- Improves cash flow in short term
- Ability to borrow large amounts of money
Disadvantages of a ‘loan’
- Interest must be paid at some point, regardless of financial performance
- No flexibility, no more than given amount
- May require collateral security: ASSETS pledged by a BORROWER as security for a LOAN (which a business may not be able to provide)
- Creates debt, making cash flow a problem
Define ‘venture capital’
- Investment from an established business into another business in return for % equity
- Form of investment for early-stage, innovative businesses with strong growth potential
Advantages of ‘venture capital’
- Large sum of money quickly, to get started with
- Gain expertise from the venture capitalist
- Easier to attract other sources of finance
- Allows for easy expansion
- No personal assets pledged
Disadvantages of ‘venture capital’
- Ownership reduced
- Control reduced: loss of full decision making
- Long/complex process
- Time consuming: may be hard to find people willing to invest
- Expert financial projections likely to be required to present to VC’s
- Proportion of profit lost to venture capitalists
Define ‘crowdfunding’
Raising finance from a large number of people, voluntarily contributing
e.g. GoFundMe
Possible incentives
Advantages of ‘crowdfunding’
- Cheap
- Can be fast if publicised well: MEDIA ATTENTION
- Alternative to loan which is more risky
- No debt!
- Support: gain feedback and expert guidance
Disadvantages of ‘crowdfunding’
- Patience: takes longer
- Takes time and resources to publish the crowdfunding page
- Ineffective: possibility of no engagement
- Risk of accusations of fraud
- If full amount not raised, business will have to return all £ to contributors
Define ‘financial objectives’
Monetary targets a business wants to achieve within a set period of time
Examples of financial objectives
- Return on investment
- Capital structure
- Revenue
- Costs
- Profit
- Cash flow
Define ‘return on investment’
MEASURED IN %
Measure of a business’ profitability of an investment
Compares how much paid for an investment to how much you earned, evaluating the efficiency.
Method of benchmarking / comparison
Define ‘capital structure’
Proportion of long term funding that is debt
How long is ‘long-term funding’?
Over a year
How long is ‘long-term’ in business?
Over a year
Define ‘cash flow’
Movement of money into and out of a business
Required to meet the short term objective of survival
Give examples of ‘economic conditions’`
- Stable vs unstable
- Economic growth or decline
- Optimistic or pessimistic
External influences on financial objectives
- Competitor actions
- Consumers
- Economic conditions
What are the 3 types of budgeting?
- Income
- Expenditure
- Profit
What are the 3 types of budgeting?
- Income
- Expenditure
- Profit
Define ‘income budgeting’
- Target set for amount of revenue to be achieved in a set time period
- Can be split by products, services or departments
- Informed by market research and sales forecasts
- Informs predicted cash inflows in the cash flow forecast
Define ‘expenditure budgeting’
- Limit placed on the amount to be spent in a given period of time
- Informs predicted cash outflows
- Possible separate expenditure budget per department
Define ‘profit budgeting’
Target set for the surplus between income and expenditure in a given time period
Target for how much profit a business wants to make
What could an ‘adverse variance’ suggest about the expenditure budget?
Expenditure higher than budget
What could an ‘adverse variance’ suggest about the income budget?
Income lower than budget
What could an ‘adverse variance’ suggest about the profit budget?
Profit lower than budget
What could an ‘favourable variance’ suggest about the expenditure budget?
Expenditure lower than budget
What could an ‘favourable variance’ suggest about the income budget?
Income higher than budget
What could an ‘favourable variance’ suggest about the profit budget?
Profit higher than budget
External influences on ‘variances’ of a business’ budget
- Actions of competition
- Action of suppliers
- Changes in economy
Internal influences on ‘variances’ of a business’ budget
- Internal efficiency / labour productivity
- Internal decision making / leadership
What decisions could variance analysis help to inform?
- Change in budget?
- Staff training?
- Reward staff, to improve motivation?
- Change suppliers?
- Reallocate budgets?
- New marketing tactics?
- Review product portfolio?
Strengths of break-even analysis
- Calculate minimum sales needed before starting to make a profit and therefore see if a venture is viable
- Calculate level of profit/loss
- Provides targets
- Aids decision making
Weakness of break-even
- Based on predicted costs and revenue
- Even fixed costs can vary in reality, especially in long run
- Ignores change in variable costs or selling price if items are bought or sold in large quantities, BULK BUYING
- Only indicates the number of sales needed, does not ensure actual sales will materialise
Name all parts of a breakeven chart (not including axis)
- Revenue
- Total costs (Variable + Fixed)
- Fixed costs
- The Breakeven point
Where is the breakeven point located on a breakeven chart?
Where the…
REVENUE and TOTAL COSTS meet.
Where is the breakeven point located on a breakeven chart?
Where the…
REVENUE and TOTAL COSTS meet.
Define ‘profitability’
Measures the financial performance of a business by comparing profits achieved to a second variable e.g. revenue
What does a falling Gross Profit Margin suggest?
- Not managing costs of sales effectively
What does a falling Operating Profit Margin suggest?
- Sales declining
- Not managing its expenses effectively
Define ‘gross profit margin’
Measure of firm’s profitability by looking at the relationship between gross profit and sales revenue
Define ‘operating profit margin’
Measure of firm’s profitability by looking at the relationship between operating profit and sales revenue
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What does a falling Net Profit Margin suggest?
- Gross profit / operating profit in decline
- Interest rates have changed (as after interest and taxation costs)
How to increase profitability
The ‘Sell’ strategy
- Sell same quantity but at a higher price
- Sell more at a current price
- Sell the same at the same price but reduce costs
Define ‘receivables’
OPPOSITE TO PAYABLES
Payment from debtors
Amount owed to a business
Examples of ‘cash inflows’
- Cash sales
- Payment from debtors (receivables)
- Owner’s capital invested
- Sales of assets
- Bank loan
Examples of ‘cash outflows’
- Purchasing stock
- Paying wages
- Paying debts - bank loans, creditors
- Purchasing assets
Ways to improve cash flow
- Increasing the volume of the inflow of cash
- Speeding up the timing of the inflow of cash
- Reducing the volume of the outflow of cash
- Slowing down the timing of the outflow of cash
- Taking out a source of finance (eg overdraft) to mend it in the short term
- Selling assets
- Delay payments to suppliers
- Reduce fixed costs spending
Factors affecting cash flow
- Transaction types - cash vs credit
- Timings of cash flow: trade credit?
- Nature of the business
Define the term ‘liquid cash’
Cash readily available, can be quickly used
What may insufficient liquid cash cause?
Inability to meet short term debts
Limited cash = limited opportunity
Causes of cash flow problems
- Offering trade credit
- Overtrading
- Internal management
- Seasonality
- Unexpected events (COVID)
Suggest the ‘cash conversion cycle’
- Cash
- Material / services
- Accounts payable
- Pay AP
- Sales
- Accounts receivable
Define ‘payables’
OPPOSITE TO RECEIVABLES
Debts owed by a business; liabilities.
Define ‘payables’
OPPOSITE TO RECEIVABLES
Debts a business needs to pay; liabilities.
Define “overheads”
Costs that do not alter when production changes
