3.5 Financial Decisions Flashcards

Question

Changes to external factors that might help a business to increase its profits.

Answer 1

§ Demographic changes – for example a growth in immigration has led to an increase in demand for many products. It has led to new businesses and also led to lower labour costs for businesses. Ageing population – impact on demand for certain goods. § Consumer incomes – if incomes fall like in a recession in 2008/09 then difficult for business to increase the sales revenue. § Competition – a reduction in competition can boost a business profit as they can set higher prices and sell a higher volume of goods. Price wars have an adverse effect on business profits. § Interest rate – higher interest rates make it more expensive to borrow and increase business costs and reduces profit levels. Higher interest rates will hit profits in 2 ways – increase cost of credit and dissuade customers buying on credit. This will be damaging for retailers of household durables, such as furniture, which are often sold on credit. § Environmental issues – this has led to greater costs with businesses modifying their products and environmentally aware customers may be less inclined to buy products.

Answer 2

§ Market conditions – if CMA prevents a merger between two businesses this may lead to lower profits because smaller businesses are less able to benefit from economies of scale, such as bulk buying. § Environmental issues – stricter laws and regulations to limit pollution and environmental damage can increase costs if a firm has to adapt its methods

Answer 3

* Good customer service is required and effective communication between all levels of departments in the business. All these aspects are hard to come by and may not increase profit levels.

Answer 4

Bank overdraft- ease cash flow problems as interest is only paid on the amount borrowed Debt factoring- connects receivables into an immediate receipt of cash Sale and leaseback- Leasing of non-current assets Improved working capital control- Working capital is the day to day finance used in a business consisting of current assets (e.g. cash, inventories, and receivables) minus current liabilities (payables and overdrafts). Indication of a firm’s scope to pay its short term debts. Money available to a business for its day to day running costs. To stay solvent a business must manage its working capital. Working capital management involves careful management of a firms main current assets to ensure that there is enough cash to pay payables and other payments.

Answer 5

§ Effective inventory control- generally minimising levels of inventory by employing methods such as JIT with a reliance on efficient suppliers will lower storage costs and improve cash flow. (The traditional approach was to have inventory to guarantee continuation) § Receivables- should be kept to a minimum as they mean a delay in receiving cash. This makes it harder to pay debts. Prompt invoices and regular reminders of the need for payment towards the end of the credit period can help ensure that customers pay promptly. § Payables- use a credit period to its maximum in order to improve holding of cash. You must ensure that a payment is on time in order to avoid legal action and a bad reputation It’s vital a firm’s working capital isn’t too high as it may lead to current assets being tied up in unproductive resources. If working capital is too high- missed opportunity to invest Balance between working capital and non -current assets.

Answer 6

- Seasonal demand – companies typically incur costs in producing in advance of the peak season for sales. This causes a significant, but predictable, cash flow problem for any seasonal business, especially for businesses in industries such as farming, where there is heavy expenditure just prior to the sale of the crop. § Overtrading – firms become too confident and expand rapidly without organising long term funds and out a strain on working capital. During rapid expansion this means a firm needs to buy more and more materials, but lacks the money because its customers have not yet bought the goods. § Over investment in long term assets – firms may invest more in order to grow, but leave themselves with inadequate cash for day to day expenditure payments. The more successful a small firm, the more eager the owners will be to purchase new shops or equipment. § Unforeseen changes – cash flow may be difficult due to internal changes e.g. machinery breakdown leading to lower receipts of cash for a period § Losses or lower profits – business whose sales revenue is less than its expenditure will usually have less cash than one who is making a healthy profit. § Poor stock and inventory management – organisations may hold excessive stock levels, using up cash that could have been used for other purposes. There is an added danger that high levels of stock may mean that stock becomes worthless.

Answer 7

Budgets- a financial plan for the future, looking at revenue and costs of the business. Income budgets- forecast the amount of money that will come into the company as revenue. To do this predict how much it will see and at what price. Managers estimate this using sales figures from previous years as well as market research Expenditure budgets- predict what the business’s total costs will be for the year, fixed and variable costs accounted for. Variable costs increase with output so managers must predict output based on sales estimates The profit budget- uses the income budget minus the expenditure budget to calculate what the expected profit or loss will be for the year

Answer 8

§ Financial support= reassurance for investment. More detailed= more reassurance § Budgeting is important as it provides direction and coordination § Encourages to not overspend § Motivate staff § Assigns responsibilities, recognises who gets the credit § Forecasts outcomes § Looks to increase efficiency § Allocates resources accordingly

Answer 9

§ Budgets help to achieve targets like keeping costs low or revenue high § Budgets help control income and expenditure § Helps managers to review activities and make decisions § Help focus on the priorities § Budgets let heads of departments delegate authority to budget holders. Getting authority is motivating § Budgets allow departments to coordinate spending § Budgets help persuade investors that the business will be successful

Answer 10

§ Budgeting can cause resentment and rivalry if departments have to compete for money § Budgets can be restrictive. Fixed budgets stop firms responding to changing market conditions § Budgeting is time consuming. Managers can get too preoccupied with setting and reviewing budgets and forget to focus on the real issues of winning business and understanding the customer § Inflation is difficult to predict- some prices can change by levels much greater than average § Start-up businesses may struggle to gather data from other firms so the budget may be inaccurate

Answer 11

where outcomes of budgets are examined and compared with the actual result

Answer 12

§ Profits= higher § Costs= lower Causes: § Stronger demand than expected = higher actual revenue § Selling prices increased higher than budget § Cautious sales and cost assumptions (cost contingencies) § Better than expected productivity or efficiency Favourable variances may mean budget targets aren’t stretching far enough- need to set more difficult targets

Answer 13

§ Profits lower than expected § Costs higher than expected Causes: § Unexpected events lead to unbudgeted costs § Over spends by budget holders § Sales forecasts prove to be over optimistic § Market conditions mean demand is lower than budget May not be a sign of poor management as start-up firms may find it difficult to anticipate sales, revenues and costs § Budgets may be imposed- set by senior managers who don’t have knowledge § Changes in the external environment, inflation rates, interest rates § Difficulty gathering information

Answer 14

Internal: § Improving efficiency causes favourable variances § Business might overestimate the amount of money it can save by streamlining its production methods § A business may underestimate the cost of making a change to its organisation § Changing selling price changes revenue § Internal causes of variance are a big concern – suggest communication needs improving External § Competitor behaviour and changing fashions may increase or reduce demand § Changes in the economy can change workers’ wages § Cost of raw material can go up

Answer 15

§ Cash flow is dynamic and unpredictable for businesses especially for start ups § Cash flow problems are a key reason for business failure- when businesses do not have enough cash to pay its liabilities

Answer 16

§ Advanced warning of cash shortages § **Make sure that the business can pay suppliers and employees** § Important part of financial control § Support applications for a loan § Plan corrective action for possible cash flow problems § **Provide reassurance to investors and lenders that the business is being managed properly**

Answer 17

§ Can be based on false assumptions § Economic changes § Changes in consumption § Inadequate market research § False forecast= disastrous results= run out of cash = insolvent

Answer 18

§ Payables refers to the money a company owes to its creditors § Receivables are those people or businesses who owe the business money Cash flow refers to the daily movement in and out of a business whereas profit refers to revenue-costs, money after all expenses have been covered.

Answer 19

Too much spending on capacity: Allowing customers too much credit Seasonal demand: Too much stock: Overtrading:

Answer 20

§ Spending too much on fixed assets § Introducing a new production line § Made worse if s/t finance is used (e.g. bank overdraft) § Fixed assets are hard to turn back into cash in the s/t § Adding production capacity

Answer 21

§ Customers who buy on credit ‘’trade debtors’’ ‘’trade receivables’’ § Offer credit= good way of building sales § However late payment is a common problem, debt may go on

Answer 22

§ When there are predictable changes in demand and cash flow § Production or purchasing usually in advance of seasonal peak in demand= cash outflow s before inflows § This can be managed- cash flow forecast should allow for seasonal changes

Answer 23

§ Excess stocks tie up cash § Increased risk that stocks become obsolete § But there needs to be enough stock to meet demand § Bulk buying could mean lower prices, purchasing economies of scale

Answer 24

§ Where a business expands too quickly, putting pressure on s/t finance and working capital Retail chains: § Keen to open new outlets § Have to pay rent in advance, pay shop fitters, pay for stock § Large outlay before sales § Businesses rely on l/t contracts also at high risk of overtrading

Answer 25

indication of a firm’s scope to pay its short term debts. Money available to a business for its day to day running costs Length of time goods held at inventory + time taken for receivables- period of time to creditors (payables)

Answer 26

§ Type of product- determines the length of time it takes to produce and how long its left in stock e.g. a butcher wouldn’t hold supply for long, thus a short delay between paying suppliers and selling to customers § Credit payments- buying on credit means good are received but the buyer has an agreed period of time before payment is due. Businesses also buy on credit from their suppliers People who owe money to the business- debtors People who are owed money by the business- creditors The ideal cash flow situation is where there’s a short period of time from the start of the production to the sale of goods and where the business is given a longer credit period by its creditors (suppliers) than it gives its debtors

Answer 27

Debt factoring Credit control establishes credit limits for new customers Overdrafts Hold less stock, Sales and leaseback Businesses try to reduce the time between paying suppliers and getting money from customers.

Answer 28

§ Credit checking new and existing customers § Setting realistic credit limits § Monitoring the age of debt and chasing bad debts § Determine appropriate terms and conditions for credit § Chasing up debtors will get payment in sooner but may upset customers

Answer 29

gives instant cash to businesses whose customers haven’t paid their invoices § Banks and other financial institutions act as debt factoring agents § The selling of debtors (money owed to the businesses) to a third part § This generate cash and guarantees the firm a percentage of the money owed to it but reduces income and profit margin made on sales § Cost involved In factoring can be high Benefits: receivables can be turned into cash quickly, helps liquidity. Business can focus on selling rather that collecting debts. Drawbacks: customers may feel their relationship has changed.

Answer 30

can be arranged with banks to allow borrowing up to a pre-set amount. Useful in times of needs but in the l/t can be expensive, as need to pay interest on the borrowed money. Flexibility, can vary the amount borrowed within limits

Answer 31

so less cash is tied up. Could cause problems if there’s a sudden increase in demand for a product, may run out

Answer 32

when businesses sell equipment to raise capital and then lease the equipment back § They get a lump sum form the sale, pay a little bit of money each month for the lease.

Answer 33

Get their suppliers to give them a longer credit period- and customers shorter credit period. Important to balance the need to manage the cash flow with the need to keep suppliers happy- don’t want customers to go elsewhere

Answer 34

trade credit managing inventories

Answer 35

– amount owed to suppliers for goods supplied on credit and not yet paid for § Delayed payments means that the firm retains cash longer § Need to be careful not to damage the firms credit reputation and rating § Trade creditors and seen (wrongly) as a ‘free’ source of capital § Some firms habitually delay payment to creditors in order to enhance their cash flow- short sighted policy and raises ethical issues

Answer 36

§ Stockholding is costly as so businesses should keep smaller balances, computerise ordering to improve efficiency, improve stock control § This cut down the spending on stock however may leave them vulnerable to stock out

Answer 37

Short term: § Reduce current assets (stocks and debtors) § Increase current liabilities (delaying payments) § Sell surplus fixed assets Long term: § Increase equity finance § Increase long term liabilities h § Reduce net outflow on fixed assets

Answer 38

Break even means covering your costs The break- even output is the point at which revenue and total costs are the same so the business is neither making a profit or loss. § When sales are below the break even output, costs are more than revenue= loss § When sales are above the break even output , revenue exceeds costs- profit New businesses should always do break even analysis to find the break even output. It tells them how much they will need to see to break even. Banks and venture capitalists thinking of loaning money to the business will need to see a break even analysis as part of the business plan- helps to decide whether to lend money Established businesses preparing to launch new products use break even analysis to work out how much profit they are likely to make, predict activity on cash flow

Answer 39

Selling price per unit stays the same, regardless of output produced Variable costs vary in direct proportion to output § i.e variable costs per unit is the same § All output is old § Fixed costs do not vary with output- stay the same These assumptions aren’t realistic and is a key limitation

Answer 40

§ Focuses entrepreneur on how long it will take before a start-up reaches profitability – i.e. what output or total sales is required § Breakeven analysis can be used to calculate how long it will take to reach the level of output needed to make a profit. You can assess if a project is viable § Allows a firm to use a what ‘if’ and the changes in profit levels that might arise from changes in the price. Ascertain the most profitable price. § Help predict profit levels arising from the various levels of output and the sales that might be achieved. § Helps entrepreneur understand the viability of a business proposition, and also those who will lend money to, or invest in the business § Margin of safety calculation shows how much a sales forecast can prove over-optimistic before losses are incurred § Helps entrepreneur understand the level of risk involved in a start-up § Illustrates the importance of a start-up keeping fixed costs down to a minimum (higher fixed costs = higher break- even output) § Calculations are quick and easy – great for giving quick estimates

Answer 41

- Unrealistic assumptions – products are not sold at the same price at different levels of output; fixed costs do vary when output changes § Sales are unlikely to be the same as output – there may be some build-up of stocks or wasted output too § Variable costs do not always stay the same. For example, as output rises, the business may benefit from being able to buy inputs at lower prices (buying power), which would reduce variable cost per unit. § Most businesses sell more than one product, so break-even for the business becomes harder to calculate § Break-even analysis should be seen as a planning aid rather than a decision-making tool

Answer 42

profit (L/T, established : Profit can be retained and built up over the years for later investment, S/T and L/T § The main benefit of using profit for investment is that the business doesn’t have to pay interest on the money. § No control/ share given up- no external influence § Safe low risk approach HOWEVER § Not all businesses can use this method though- might not be making enough profit § Shareholders may object as they wish to receive the profits as dividends (conflict). Also retaining profits may cause the business to miss out on investment opportunities § Usually finite retained profits therefore slow growth. No expertise added

Answer 43

§ Rationalisation reorganise the business to make it more efficient- selling some of their assets (e.g. factories, machinery etc) to generate capital then leasing them back when required § Don’t need to pay interest on finance they raise by selling their assets § Drawback- business no longer owns the asset, leasing the asset back introduces another cost to the business. Also assets like cars and computers lose value over time so the business won’t get back as much as it paid for them

Answer 44

can be arranged with banks to allow borrowing up to a pre-set amount. Useful in times of needs but in the l/t can be expensive, as need to pay interest on the borrowed money § S/T finance- widely used by all businesses. Bank lets the business ‘owe it money’ when bank balance goes below zero. A flexible source of finance. Excellent for handling seasonal fluctuations when it runs into s/t cash flow problems (e.g. major customer fails to pay on time)

Answer 45

Benefits: § Easy to arrange, immediate availability once agreed § Flexibility – can change the amount borrowed within limits § Bespoke to businesses need. No control given up § S/T debt no debt involved in gearing ration § Interest only paid on amount borrowed under the facility Drawbacks: § Can be withdrawn at short notice, Banks could cancel overdraft at any time, in reality only happens if you have severe financial problems § Interest charge varies with changes in I/R § Higher I/r than on a bank loan, increases costs § Persistent use of overdraft will decrease credit rating- less likely to get loan. Increase i/r offered

Answer 46

are usually provided over a fixed period of time. The rate of interest is determined on a fixed or variable basis § Timing and repayment is set § Security is required

Answer 47

Benefits: § Greater certainty of funding, provided terms of loan complied with § Lower I/r than a bank overdraft § Appropriate method of financing fixed assets § No shares in business needs to be given up – keep control § Able to bespoke to business needs, repayment terms § Frequent repayments may improve credit score- can get further sources of finance l/t § Increase net assets- increase net worth of business Drawbacks: § Requires security (collateral) – size of loan can be limited by the amount of collateral that can be provided § Interest paid on full amount outstanding § No flexibility § Fail to pay will worsen credit score- limits sources of finance in future § Increases gearing of a business as long term debt finance § Harder to arrange. keeping up with repayments can be difficult if there isn’t cash coming in may lose collateral § Start-ups and small businesses often excluded

Answer 48

Debt Factoring: Gives instant cash to businesses whose customers haven’t paid their invoices. It’s a way in which they can raise cash my selling sales to a third party factoring company § Banks and other financial institutions act as debt factoring agents § The selling of debtors (money owed to the businesses) to a third part § This generates cash § Guarantees the firm a percentage of the money owed to it § But reduces income and profit margin made on sales § Cost involved In factoring can be high

Answer 49

Benefits: receivables can be turned into cash quickly, helps liquidity. Business can focus on selling rather that collecting debts. Factoring can increase efficiency- encourages businesses to be more careful with provision of credit Drawbacks: customers may feel their relationship has changed. RTN

Answer 50

Private and limited companies can be financed in the long term using ordinary share capital – money raised by selling shares. When a limited company issues shares in exchange for a payment- equity finance Advantages: § Money doesn’t need to be repaid and new shareholders can bring additional expertise into a business § Increased opportunity to raise huge amount of finance. Employee incentive- profit sharing motivated aligned § No interest Drawback: § The original owner no longer owns all of the business- may have to pay shareholders a dividend and given them a say in how the business is running. Loss of decision making § Expected you pay shareholders dividends thus retained profits decrease § If public limited company ‘flotation’ is £ as increase as £100k rules

Answer 51

method of financing a business or project using contributions made by a large number of people, usually done via the internet through organisations such as Kickstarted and Crowdcube. Contributors can give donation, loans or buy shares depending on the business. Businesses invite people to provide funding online and invite people to provide funding. The finance provided in return of share capital. Rewards are sometimes offered for donations such as early access to a product, or the product as a discounted price upon release. These can reduce profits if not controlled carefully. The crowd funding organisation often take a small portion of the finance raised too, meaning not all of it reaches the crowdfunded business

Answer 52

Venture capitalist- commonly involves sum of £50k to £150k- finance provided to small, medium sized firms that seek growth but are considered risky by typical share buyers or other lenders. They are often known as ‘business angels’ . Venture capitalists a good way of trying to fund an expansion Advantages: § Suited to high risk companies- it is often provided to companies who cannot get finance from other sources due to risk involved § Venture capitalists allow interest or dividends to be delayed § Source of advice and contacts as they establish links with other businesses (networking) such as suppliers, customers or people Disadvantages: § Giving up ownership, loss of control – demand a large share of business e.g. Levi Roots had to settle giving up 40% of the business as opposed to only wanting to give up 20% § Excessive influence – venture capitalists may exert too much influence and so original owner could lose independence § High cost associated § Want a huge return on investment

Answer 53

A hire purchase is a method of buying goods through making instalment payments over time § Flexible (including option to purchase at end) § Cash flows can be weighted towards the end of the term § Wide range of assets that can be financed using HP § Overall cost in higher than buying outright up front

Answer 54

A form or renting an asset, given beneficial use of the asset without owning it Advantages: § Predictable cash flows § Asset owner (lessor) carries risk § Lower interest than a bank loan § Less security required § Widely available Drawbacks: § More expensive in total than buying asset out right § Don’t own the asset § Some long term leasing contracts difficult to cancel § Maybe need for up front deposit

Answer 55

Advantages: § Not a form of debt thus no interest paid § Not equity- no control given up § Providing you can find a buyer it’s a quick form of cash Disadvantages: § Only a finite amount of times you can do It as likely you have few surplus assets- most fixed assets needed for the business § Risk you do not receive fair value for their fixed asset § Very likely it depreciates.

Answer 56

§ Cash flow forecast- to inform decision § Amount of finance- internally – cash, working capital § Timeframe- s/t = overdraft. L/T= fixed assets sales, retained profits § Type of business- sole trader/ partnership *debt, bank loan § Cost externally- debt or equity It depends upon: § Interest rate § Existing debt (gearing ratio) § Risk of business § Existing shares