3.5 Decision making to improve Financial performance Flashcards
Financial Objective
A specific goal or target relating to financial performance
What financial objectives can be based on:
Revenue
Costs
Profit
Cash flow
Investment levels
Capital structure
Return on investment
Debt as a proportion of long-term funding
Return on Investment (ROI)
This is the measure of the efficiency of an investment in financial terms, used to compare the financial returns of alternative investments
= return on investment/cost of investment x 100
(ROI=financial gains from the investment – the cost of investments)
Profit
revenue – total costs
Profitability
The firm’s ability to make a profit through selling goods and services
more sold=more profitable
Ways of calculating and measuring profitability:
Gross profit margin
Operating profit margin
Profit for the year margin
Internal influences on financial objectives
Business ownership – the nature of business ownership has a significant impact on financial objectives. A venture capital investor would have quite a different approach to long-standing family ownership.
Size and status of the business – (e.g. start-ups and smaller businesses tend to focus on survival, breakeven, and cash flow objectives. Quoted multinational businesses are much more focused on growing shareholder value)
Other functional objectives – almost every other functional objective in a business has a financial dimension
External influences on financial objectives
Economic conditions – economic downturns can force many firms to reappraise their financial objectives in favour of cost minimisation so they can maximise their cash inflows and balances. Significant changes in interest rates and exchange rates also have the potential to threaten the achievement of financial targets like ROCE.
Competitors – competitive environment directly affects the achievability of financial objectives (e.g. cost minimisation may become essential if a competitor is able to grow market share because it is more efficient)
Social and political change – this is often an indirect impact (e.g. legislation on environmental emissions or waste disposal may force a business to increase investment in some areas and cut costs in others)
Cash Flow
The money flowing in and out of the business on a day-to-day basis
Net Cash Flow
This is the money left over when a business takes its outflows from its inflows
Main cash inflows:
Money invested by business owners
Loan from the bank
Income from sales
Main cash outflows:
Wages and training
Raw materials
Advertising
Rent, mortgage, and bills
Taxes
Interest on loans
Maintenance and repair
Why cash flow is important:
It can be used to support an application for sources of finance
If a business does not have enough cash available to pay its bills it could fail
A business that is not able to pay its suppliers will probably not receive any more supplies
It may be unable to pay its workers, which will at the very least cause demotivation, and encourage them to leave, at worst
It is the main cause of failure of small businesses
The principle of timing, managing when money flows in and when it flows out is vital
Advantages of cash flow forecasts:
identify problems in advance
Guide to appropriate action
Make sure there is sufficient cash to make payments
Evidence for financial support
Avoids failure
Identifies if they are holding too much cash
Causes of cash flow problems:
Poor management (spending too much)
If the business isn’t performing well – the outflows are greater than inflows
Offering customers too long to pay – slow cash inflow compared to outflow
Problems with cash flow forecasting:
Changes in the economy
Changes in consumer taste
Inaccurate market research
Competition
Uncertainty
Capital Structure
Finance in terms of how much is equity (or share capital) and how much there is in the form of debt
Capital structure objectives:
Gearing ratio (the percentage of total business finance that is provided by debt)
Debt/equity ratio (the proportion of business finance provided by debt and equity)
Budgets
These are set by businesses so that they have a future financial target/plan
Types of budgeting:
Income (or revenue)
Expected revenues
Broken down into more detail
Expenditure (or cost)
Expected variable costs based on sales budget
Expected fixed costs
Profit
Based on the combined sales and cost budgets
May form the basis for performance bonuses
Why a business uses budgeting:
Control income and expenditure (the traditional use)
Establish priorities and set targets in numerical terms
Provide direction and coordination, so that business objectives can be turned into practical reality
Assign responsibilities to budget holders (managers) and allocate resources
Communicate targets from management to employees
Motivate staff
Improve efficiency
Monitor performance
Advantages of budgeting:
Helps firms to get financial support through investors
Ensures a business doesn’t overspend
Establishes priorities and sets targets in numerical terms
Motivates staff
Assigns responsibility to departments
Improves efficiency
Disadvantages of budgeting:
Budgets are only as good as the data being used to create them - inaccurate and unrealistic assumptions can quickly make a budget unrealistic
They need to be changed as circumstances change
It is a time-consuming process
Unexpected costs may arise
May have difficulties in collecting information needed to create a forecast
Managers may not have enough experience to budget
Inflation (external change that the business has no control over)
Variance analysis
This compares the expected budget to the actual figures (the difference found)
This can be positive (favorable – meaning costs are lower than expected or revenue is higher) or negative (adverse – meaning costs are higher than expected or revenue is lower)
Evaluative points of variance:
Whether is it positive or negative
Was it foreseen and foreseeable
How big was the variance
The cause
Whether it is a temporary problem or the result of a long-term trend
Break-Even
A business will break-even when its total revenue equals its total costs
= fixed costs/contribution per unit
Advantages of break-even analysis:
Shows how many items need to be sold to make a profit for the business
Useful tools to set targets
Identifies the fixed and variable cost
Calculate the profit or loss at different levels of output
Disadvantages of break-even analysis:
Information can be reliable (less knowledge)
Assumes that the costs and revenue don’t change with output
Target set may be too high, creating stress
Methods of improving cash flow
Cut costs
Use an overdraft
New source of cash inflows
Reschedule payments
Causes of poor cash flow
Poor management
The business is making a loss
Offering customers too long to pay
Over-optimistic forecasting
Methods of improving profitability
Increase the quantity sold (higher sales volume)
Increase the selling price (higher price per unit sold)
Reduce variable costs per unit
Increase output
Reduce fixed costs
Debt factoring
An external, short-term source of finance for a business.
With debt factoring, a business can raise cash by selling its outstanding sales invoices (receivables) to a third party (a factoring company) at a discount.
Bank overdrafts
A common external and short-term source of finance for a business.
Bank Loans
A bank loan is a long-term source of finance.
It is a fixed amount of money that is given to a business by the bank that has to be repaid over time with interest, usually in monthly installments.
Retained Profits
These are profits that the owners put back into the business. There is no interest to be repaid and no loss of control.
Share capital
The money invested in a company by the shareholders. Share capital is a long-term source of finance. In return for their investment, shareholders gain a share of the ownership of the company.
Venture capital
Money invested in a business, usually a start-up, that is seen as having strong growth potential.
Payables
People or organisations that a business owes.
Receivables
The money a company’s customers owe for goods or services they have received but not yet paid for.
Gross Profit
This shows how efficiently a business converts raw materials into finished goods and how much value they add
= revenue – cost of sales
Operating profit
gross profit – expenses
