3.5 Finance Flashcards
why are financial objectives often the most important in a business
because without sufficient financial security the business will cease to trade
financial objectives such as profit maximisation are also the incentive for which many businesses are run
importance of financial objectives
poor financial management is a key reason why a business might fail
financial objectives are easier to manage than other functional pbjectives often with a numerical element and timescale
financial measures determine the success of all other functional areas such as marketing operations and human resources
financial measures such as profitability and shareholder value are two key reasons why people invest in businesses
the level of long term debt in a business increases risk
a business may set objectives to reduce the proportion of long term funding that is debt
what is cash balance
cash inflows - cash outflows
what is profit
revenues earned - expenses incurred
profit hierarchy
revenue
gross profit
operation profit
profit of the year
how do u get to gross profit from revenue
direct costs such as materials are taken away from revenue
how do u get operation profit from gross profit
indirect costs such as salaries and overheads are taken away from profit
how do u get profit of the year from operation profit
other incomes such as interest are taken into account and taxation to be applied to the business profit also called net profit
costs
lowering costs may be important where a business is trying to improve efficiency
cost is also an important factor in a recession or where a business competes on price
profit
profit objectives are clear to understand and one of the key performance indicators of a business
profits are often shared with all stakeholders and as such are the indicator that most businesses will be judged against
eve though the business may be performing well, shareholders and the public may judge a business as underperforming if profits have fallen
revenue
this is earnings generated by a business from its trading activity
setting revenue objectives helps drive a businesses ambition to grow
increased revenue indicates the popularity of a particular product
also suitable where profit is less important eg a charity
cash flow objectuves
a business will fail if it cant meet its financial obligations and pay bills which is why some businesses will set specific objectives to help manage cash flow
businesses with long cash cycles will find it more challenging to manage cash flow
specific cash flow objectives
maintaining a specific level of cash reserves
extending payment periods to suppliers
shortening payment periods from customers
return on investment
a business may set a target for capital investment over thee year
this will support a strategy of growth
similarly a business may set an objective to reduce capital over the year in order to reduce debt
investment objectives may also refer to the returns recieved on the investment
this may be calculated as the operating profit as a percentage of investment
return on investment formula
operating profit divided by capital invested x 100
what is capital structure
the balance between capital from borrowing (loan capital) and the capital from selling shares (share capital) in the company
some businesses will want to balance these two sources ( low and high gearing)
low gearing
danger of losing control of the business
high dividend payments to shareholders
high gearing
may be at risk of increasing interest payments
difficult to find further lending
financial objectives
corporate objectives
nature of the product
other functions
the competative environment
economic environment
technological
corporate objectives
all functional objectives will flow from these
nature of the product
a product with a short life cycle may dictate that sales revenue is an important financial objective to set
other functions
if the business sets operational objectives to improve efficiency, financial objectives around reducing costs may be appropriate
the competitive environment
businesses will naturally set objectives that will allow them to compete
eg aggressive investment targets
economic environment
a business may set lower profit objectives if indicators suggest the market is shrinking
technological
new technology may determine how a business invests
it may also create opportunities to cut costs and increase revenues
what is a budget
a financial plan for the future
an effective budget should drive many of the decisions taken across the functional areas of a business
eg the number of products to make, how to promote the product and the number of workers to employ
budgets can also be used to motivate the workforce when used in target setting
types of budgets
setting budgets helps a business achieve its financial and wider objectives
a business looking to grow will increase its revenue budgets
this will inform the expenditure budgets which will determine the business’s budgeted profits
the budgeting process
analyse the market such as trends and average prices
set financial objectives
set revenue objectives
forecast expenditure such as labour costs
set expenditure budgets
set profit budgets
review and monitor budgets- adjusting as appropriate
what will managers rely on when setting budgets
market research
past sales trends and internal forecasts such as quotes from suppliers
problems with budgets
a budget is only accurate as the data on which it is based
past trends can be a poor indicator of what is likely to happen in the future therefore it can be very difficult to forecast sales
new decisions taken by governments and public bodies- such as interest rate changed (interest to be paid on business loans might increase) and employment legislation (leading to more costs for employers)
unexpected changes such as a rise in comodity prices
an unrealistic budget loses all value as a motivational tool
variance analysis
compares the forecast data to the actual figures
can be used to analyse the accuracy of the budgeting process and help make decisions about budget adjustments
a favourable variance is one that is better than budgeted and an adverse variance is one that is worse
key questions when analysing budgets
which adverse variances are due to unexpected factors
how effectively has the business budgeted revenue
what are the key areas that have led to the budget being innaccurate
how effectively has the business budgeted expenditure
which adverse variances are due to poor forecasting
cash flow forecast
a cash flow forecast will predict the cash inflows (reciepts) for a business and the cash outflows (expenditure)
a cash flow forecast should determine the cash funds a business has at any one time
if a business knows what cash funds it needs it can take measures to ensure finance is available
what are the three sections a cash flow forecast is made up of
cash in
cash out
net cash flow
net cash flow
difference between monthly inflows and monthly outflows
closing balance
net cash flow + opening balance
closing balance is the available cash a business is forecast to have during that trading period
opening balance
cash carried foreward from previous trading period for example Februarys opening balance will be Januarys closing balance
cash flow calculation
(inflows- outflows= net cash flow) + opening balance = closing balance
what questions should managers consider when analysing cash flow forecasts
are monthly inflows greater than monthly outflows
what are the forecast periods of high expenditure
is a posotive cash flow sustainable
are inflows increasing over time
is there a seasonal trend
do we have enough cash reserves to cover unexpected costs
why should business construct a cash flow forecast
used to support an application for lending (perhaps as part of a business plan)
supports the budgeting process
identifies any potential cash flow crisis
what must a business analyse the timings of in order to manage cash flow effectively
payables
recievables
payables
amount of time (days) taken for the business to pay creditors
recievables
amount of time taken for debtors to pay the business
what is the break even output
the point at which a business’s revenue generated through the sales of its products will cover the total costs
the uses of break even analysis
decide whether a business idea is profitable and viable
identify the level of output and sales necessary to generate a profit (and therefore the scale of the business)
assess changes in the level of production
assess the effects of costing and pricing decisions
break even output formula
contribution per unit divided by fixed costs
contribution
the difference between the variable costs of one unit and its selling price
total contribution formula
total output x contribution per unit
what are the three lines shown on a break even graph
total revenue
total costs
fixed costs
what can analysing and manipulating break even charts help a business to do
make decisions on whether to accept prices on orders different from those normally charged or the impact on profitability of a change in costs and output levels
what is the margin of safety
the difference between the breakeven point and the current level of output
the size of the margin of safety will determine the risk of the business- the margin of safety should be as high as possible
margin of safety formula
current level of output - break even output
benefits of break even analysis
can be used to analyse the impact of varying customers, prices and costs on a businesses profit
it is simple and easy to use
the break even point is a useful guideline to help businesses make decisions
limitations of break even analysis
break even analysis simplifies what can be a very complex process- most business sell multiple products which makes break even more difficult
costs are rarely constant- break even analysis presumes that costs stay the same over various levels of output
break even focuses on output- it pressumes that the business will sell all of its output at the same price
what do we need to compare profit to for it to be useful
compare to level of sales and level of investment required to generate that profit
gross profit margin
a useful indicator to analyse how a business has performed in terms of its direct trading activity
it helps a business answer the queston ‘have our products been successful’
however gross profit doesnt take into account inidrect costs
gross profit margin calculation
gross profit divided by sales revenue x100
operating profit
takes into account the performance of a business more fully as the calculation takes into account direct and indirect costs
useful when working alongside the gross profit margin
operating profit margin calculation
operating profit divided by sales revenue x100
profit of the year margin
ratio takes into account all revenues and costs incurred by the business
a good measure of how effectively the business performed over the financial year
may be used to identify the potential to pay a dividend to shareholders
profit for the year margin
profit for the year divided by sales revenue x100
how can financial data be used to make business decisions
break even analysis can be used to answer ‘what if’ scenarios
profitability ratios can be used to analyse which aspects of a business are being run effectively and where improvements are needed
why is financial information very important in business decision making
because all business decisions must be financially viable
however managers must also take into account the issues behind the numbers eg financial informatio wont take into account human or ethical factors
retained profit (long term)
net profit reinvested back into the business instead of being returned to the ornwers
internal sources of finance
retained profit
sale of assets
owners capital
advantages of retained profit
a free source of finance that doesnt incur interest
disadvantages of retained profit
shareholders may wish to recieve back in the form of a dividend
sale of assets (long term)
selling off items of value to free up capital
advantages of sale of assets
frees up value in unwanted assets to be invested in other areas of the business
disadvantages of sale of assets
the business loses the benefit of the asset such as no longer owning a delivery vehicle
owners capital (long term)
personal savings used to start or expand a business
advantage of owners capital
a free source of finance gthat does not incur interest
disadvantage of owners capital
owners could lose their personal investment
overdraft (short term)
where a bank allows a firm to take out more money than in its bank account
advantages of overdrafts
flexible way to fund working capital- acts as a buffer for day to day expenses
disadvantages of overdrafts
bank may ask for repayment at any time and interest rates are high
debt factoring (short term)
where a firm sells on its debt to a third party factor
advantages of debt factoring
allows a business to recieve cash immediately
disadvantages of debt factoring
customers could be aware if debts are factored and lose faith in the company
bank loans (long term)
borrowing from a bank
advantages of bank loans
can be negotiated to meet busines requirements
disadvantages of bank loans
business has to pay interest and may have to offer collateral to secure it
mortgage and debentures
(long term)
mortgage is a special type of loan made for purchasing property
a debenture is a loan made to a business secured against its assets
advantage of mortgages and debentures
ideal for long term investments
disadvantages of mortgages and debentures
large amounts of interest can be charged over its lifetime
venture capital (long term)
capital invested at an early stage (‘seed funding’) by an individual or company in return for equity in the business
advantage of venture capital
can bring expertise into the business
disadvantage of venture capital
owner may not want input from elsewhere into the running of the business
share capital (long term)
an owners investment into a limited company to become a shareholder
advantage of share capital
can access very large amounts of capital and interest
disadvantage of share capital
only available to Ltd (people you know) and Plc (public)
crowdfunding
raising monetary contributions from a large number of people, today often performed via crowdfunding websites (LT)
advantages of crowdfunding
cheap and easy to set up
disadvantages of crowdfunding
not suitable for raising amounts of money
improving cash flow
the key to managing cash flow is to speed up the process of cash coming into the business (recievables) and slow down the process of money leaving the business (payables)
speed up inflows
incentives early repayment- gives customers a discount for paying early
reduce trade credit given to customers
sell off stock at a discounted price to free up cash
inject fresh capital into the business
slow down outflows
delay payments to suppliers
increase trade credit agreements with suppliers
cut costs- find cheaper alternatives or postpone spending in areas such as training and advertising
causes of cash flow problems
overtrading
allowing too much trade credit to customers
unforeseen costs
poor credit control
innaccurate cash flow management
what is the best way to ensure a business has a posotive cash flow
to invest time and effort in researching and planning effective cash flow forecasts
how can profitability be improved
through measures taken by each functional area of the business
ways to increase revenue
increase price
reduce process (dependent on price elasticity of demand)
create awareness and desire through marketing
add value to the product- increase benefits and features
why are businesses unprofitable
no demand for the product
selling at the wrong price
low contribution per unit
poor management of costs
expansion of the business-profit retained and not available for return to shareholders
improving profit
profit is the difference between total revenue and total ncosts
therefore there are two general ways that a business can improve its profits
increase revenue/ decrease costs
ways to reduce costs
reduce production costs
improve efficiency
use capacity more fully
eliminate unprofitable processes-such as unprofitable product lines
reduce variable costs- negotiate better deals with suppliers
lower overheads- move to a cheaper location
problems with managing finance
impact on stakeholders
spend money to make money
short term solutions
impact on stakeholders
some actions can damage relationships with stakeholders eg delayed payment could upset suppliers and high prices could deter customers
spend money to make money
measures to improve profits and cash flow often costs the business eg an advertising campaign to boost sales or lower prices to incentive early payment from customers
short term solutions
sometimes efforts may boost profits and improve cash flow in the short term but hinder long term sucess eg lowering reinvestment to return profits for shareholders
