3.5 Decision making to improve financial performance Flashcards
Financial Objectives - RETURN ON INVESTMENT
Tells you how much profit you’ve made (or lost) on an investment after accounting for its cost
Return on investment = (operating profit x 100) / capital invested
Profit
Profit = sales - total costs
When revenue is greater than expenditure
Revenue Objectives
Revenue growth (% or value)
Sales maximisation
Market share
Cost Objectives
Cost minimisation aims to achieve the most cost-effective way of delivering goods and services to the required level of quality
Cost minimisation leads too lower unit costs –> higher gross profit margin and operating profits –> improved cash flow & higher return on investment
Profit Objectives
Specific level of profit
Rate of profitability
Profit maximisation
Exceed industry or market profit margins
Cash flow objectives
Minimise interest costs
Reduce amounts held in inventories or owed by customers
Objectives for investment - CAPITAL EXPENDITURE
Capital expenditure - spending on non-current assets such as vehicles and property
Objectives may include:
Lowering capital expenditure to reduce amount it has borrowed if the debts are too high
Reasons for why its easy to raise capital for a business
The business hasn’t borrowed excessive amounts already –> reassuring lenders that they will be able to repay the money
The business is purchasing non-current assets e.g. property that will retain its value and could be sold if necessary to repay a loan
The business is a company and can sell additional shares to raise funds
Capital Structure and gearing ratio
Capital structure - refers to the way in which a business has raised the capital it requires to purchase its assets
Gearing ratio = non current liabilities / total equity + non current liabilities x 100
Capital structure - LOAN CAPITAL & SHARE CAPITAL
LOAN - Have to pay interest on these loans until they are repaid
SHARES - have to pay dividends to shareholders BUT, company may lose control if they sell to many shares to existing owners
Budgets and the different types
Budgets are financial plans that predict revenue from sales and expected costs
3 types of budgets include:
Revenue budgets
Expenditure budgets
Profit budgets
Difficulties in constructing budgets
Sales forecasting –> depends on market research, changes in tastes & fashions, changes in consumer income, new technology, rivals
Costs –> unexpected costs can arise e.g. through external environment (taxes, exchange rates)
Analysing budgets
2) Analysing revenue data –> effective managers will use the info from analysing budgets to improve sales performance e.g. considering pricing, quality, and advertising of the product
3) Analysing profit budgets –> Allows managers to take action if profit falls e.g. by cutting expenditure & boosting revenue from sales
Analysing budgets - VARIANCE ANALYSIS
Variance analysis is the process of investigating any different between predicted data and actual figures
Two types of variance analysis include adverse and favourable
Favourable variances and examples
Difference between actual and budgeted figures will result in the business enjoying higher profits than shown in the budget –> so its positive
Examples include - budgeted sales revenue is lower than actual sales revenue or actual expenditure on fuel is less than budgeted figure
Adverse variances and examples
Occurs when the difference between the figures in the budget and the actual figures will lead to the firm’s profits being lower than planned –> so its negative
Examples include - actual overheads turn out to be higher than in the budget or actual sales revenue is below the budgeted figure
Value of budgeting - ADVANTAGES
Allow managers to control finances effectively –> by making informed and focused decisions
Can help motivate staff –> employees gain satisfaction when being given responsibility for a budget
Value of budgeting - DISADVANTAGES
Budgets can lead to short term decisions to keep within the budget rather than the right long term decision which exceeds the budget
Managers can become too preoccupied with setting & reviewing budgets and forgetting to focus on the real issues of winning customers
If budget decisions are delegated to employees then this leads to higher costs as more money will be spent on training employees
Cashflow Forecasts - Reasons why a manager might forecast cashflow
1) To support application for loans –> banks are more likely to lend money to businesses that evidence of financial planning as they will have carefully planned out to avoid cashflow crises
2) To help avoid unexpected cashflow crises –> cashflow forecasts help a business to ensure they don’t suffer when they are short of cash & unable to pay debts
Constructing cashflow forecasts
1) Cash in = cash inflows into the business e.g. cash sales, loans
2) Cash out = cash outflows from the business e.g. expenditure on raw materials, wages, rent, fuel etc.
3) Net monthly cash flow - consists of opening and closing balance
- Net cash flow = total outflows - total inflows
Analysing cashflow - PAYABLES
Relates to the amount of time taken by a business to pay its suppliers and other creditors –> normally expressed in terms days
Analysing cashflow - RECIEVABLES
Relates to the time taken by a businesses customers to pay a business for the products that it has supplied –> normally expressed in terms of days
If receivable days are higher than payable days –> incurs cashflow problems because business is incurring cash outflow before they have received an inflow –> may lead to a cash shortage
Analysing cash flow - TRADE CREDIT
Trade credit - period of time given by suppliers before customers have to pay for goods or services
Trade credit can help win customers over as it reduced pressure on customers cashflow as they have additional time to pay
Links to the time period given for receivables
What is break-even?
Level of output where TC exactly equal TR
Break-even output formula
Break-even = fixed costs / (selling price - variable costs)
Contribution per unit & total contribution
Contribution per unit = selling price - variable cost
Total contribution = contribution per unit x units sold
Margin of safety
Where the current level of output exceeds break-even output
Margin of safety = actual level of output − Break-even level of output
Value of break-even analysis - ADVANTAGES
Can be completed quickly providing immediate results
Can be of value when applying for a bank loan as break-even analysis provides credibility of financial planning
Allows most managers to use it without need for expensive training —> so more suitable for newly established & small businesses
Value of break-even analysis - DISADVANTAGES
Most businesses sell more than one product, so break-even for the business becomes harder to calculate
Sales are unlikely to be the same as output – there may be some build up of stocks or wasted output too
Analysing Profitability - GROSS PROFIT and GROSS PROFIT MARGIN
Gross profit = revenue - cost of sales
Gross profit margin = gross profit / revenue x 100
Analysing profitability - OPERATING PROFIT
Operating profit = gross profit - operating expenses
Operating profit margin = operating profit / revenue x 100
Analysing profitability - PROFIT FOR THE YEAR MARGIN
Profit for the year margin = profit for the year / revenue x 100
Sources of Finance - DEBT FACTORING
External and short term source of finance
Debt factoring is when a business sells their invoices / receivables to a factoring company at a discount (90%) for cash now –> factoring company then collects the receivable from customers and sends the remaining 10% of the money however they take a 3% fee of it so business technically gets 97% of the money
Debt factoring - ADVANTAGES
Receivables (amounts owed by customers) are turned into cash quickly!
Business can focus on selling rather than collecting debts
There is no security required – unlike a loan or overdraft.
Debt factoring - DISADVANTAGES
Quite a high cost – 3% fee –> reduces business profits
Customers may feel their relationship with the business has changed
Sources of Finance - BANK OVERDRAFTS
External and short term source of finance
An overdraft is a facility offered by banks allowing businesses to borrow up to an agreed limit of money for however long
Bank Overdrafts - ADVANTAGES
Flexible way of funding day-to-day financial requirements
Bank Overdrafts - DISADVANTAGES
Interest rates are high –> on the long-term it is very expensive
Bank may demand for a repayment at any time
Sources of Finance - RETAINED PROFITS
Internal and short term source of finance
Through previous profits, the owners either extract it from the business by way of dividend, or use it for reinvestment
Retained Profits - ADVANTAGES
Flexible – management have complete control over how they are reinvested and what proportion is kept rather than paid as dividends
Cheap - don’t have to pay interest
They don’t dilute the ownership of the company
Retained Profits - DISADVANTAGES
Shareholders may prefer to receive dividends
Danger of hoarding cash
Sources of Finance - SHARE CAPITAL
External and long term source of finance
Money invested in the company by shareholders –> so shareholders receive part-ownership of a business (share) –> companies raise capital by selling shares
Share capital - ADVANTAGES
Company doesn’t have to pay any interest
Share capital - DISADVANTAGES
Existing owners may risk losing control of their business
Profit is divided up as dividends to all shareholders
Sources of Finance - BANK LOANS
External and long term source of finance
Loan provided to a business by a bank for a fixed period of time
Two types of bank loan include: mortgages and debentures
Bank Loans - ADVANTAGES
Flexibility with a bank loan –> can spend it on whatever, while other sources of finances are restricting
You have full control –> no risk of losing control
Bank Loans - DISADVANTAGES
Have to pay interest on them
Business needs to have evidence of financial planning before bank gives a loan –> if business doesn’t have much collateral (security) the bank may implement a higher interest rate
Sources of Finance - VENTURE CAPITAL
External and long-term source of finance
Almost a mix between share capital and a bank loan
Organisations and individuals providing venture capital which to have some control over the business for which they are providing finance
Financing provided to small start up businesses that are high risk but have high growth potential
Venture Capital - ADVANTAGES
Brings expertise advice into the business
Great source of finance for start-up businesses
No obligation for repayment
Venture Capital - DISADVANTAGES
Risk of losing control
Usually on able to raise small amounts of finance
Methods of improving cash flow
1) Improved control of working capital
3) Offer less trade credit –> get customers to pay in a short period of time
4) Debt factoring –> get cash straight up which leads to lower overdraft and pay less interest
5) Arrange short-term borrowing –> e.g. loans or overdraft which allows businesses to borrow an agreed amount of cash for a short period of time
Difficulties of improving cash flow
Customer loyalty may reduce if they are offered less trade credit & will move to other businesses offering better trade credit terms
Using debt factoring may reduces profit margins due to the small fee required by factoring companies
Interest rates on loans and overdrafts are high and banks needs collateral / security of financial planning before giving a loan
Methods of improving profits and profitability
1) Reduce costs of production
2) Increase prices
3) Use capacity fully –> if capacity is fully used then fixed costs will be spread across more units of output, –> reducing average cost
4) Advertise more –> increase brand awareness and sales
5) Improve efficiency e.g. from capital intensive production
Difficulties of improving profit
Reducing costs may result in poor quality products –> reduces customer satisfaction and loyalty & will be harder to attract high-quality customers in the future
