5.2 analysing financial performance Flashcards
define: budgets
- Financial plans for future periods of time
- Businesses forecast their revenue and expenditure (or costs) using a budget
- Budgets are usually drawn up on a monthly basis, over the period of a financial year
types of budget:
- Revenue or earnings budgets- businesses expected revenue from selling its product. (the expected level of sales and the likely selling price of the product)
- Expenditure budgets- costs for labour, raw materials, fuel and other items.
- Profit budgets- combining sales revenue and expenditure budgets
Construction of budgets needs research which may involve:
- Analysing the market to predict likely trends in sales/ prices
- Researching costs for labour, fuel and raw materials by contacting suppliers (negotiating cheaper if buying in bulk)
- Considering government estimates for wage rises and inflation -> then incorporating into future sales rev + expenditure budgets
Sources of information for budgets:
- Previous trading records
- Market research - predict likely sales
- Suppliers
- Government agencies
Difficulties in constructing budgets:
- Difficult to accurately forecast sales - tastes and preferences
- The risk of unexpected changes - external environment
- Decisions by governments and other public bodies - publishing of the budget
define: Adverse variance
difference between the figures in the budget and actual figures will lead to the firm’s profits being lower than planned.
define: Favourable variance
difference between the figures in the budget and actual figures will lead to the firms profits being higher than planned.
causes of adverse variances:
- Competitors introduce new products + win extra sales
- Government increases business tax rates by an unexpected amount
- Fuel prices increase as price of oil rises
causes of favourable variances:
- Wage rises were lower than expected
- Economic boom leads to higher than expected sales
- Rising value of the pound makes imported raw materials cheaper
Overcoming an adverse budget: Due to low revenue
- Cut prices - this will work if customers are sensitive to price.
- Improve brand image /reputation.
- Seek new markets.
- Expand product range.
- Increase advertising / promotions.
Overcoming an adverse budget: Due to high costs
- Seek cheaper raw materials.
- Reduce waste.
- Cut wages.
- Increase labour productivity.
benefits to budgeting:
- Control finance effectively
- Enable managers to make informed and focused decisions
- Production budgets ensures that a business doesn’t overspend
- Can allocate finances where needed
- ## Used to motivate staff
drawbacks to budgeting:
- Revenue budget used as a target (not accurate)
- If employees are delegated responsibility then they will need to be trained, which could be costly
- Teething problems, errors or delays as employees adjust to the position
- Allocating budgets fairly and in the best interest of the business can be difficult
- Budgets are normally within the current financial year - so may try and stay within budget which may not be in the longer term interest of the business
define: cash flow
relates to the timing of payments and receipts (money flowing in and out a business)
Reasons for a cash flow forecast:
- Support applications for loans - banks and other financial lenders more likely to lend to a business that has done some financial planning which gives them more confidence the repayments will be met
- Avoid unexpected cash flow issues - forecasting to see when additional cash will be needed so that solutions can be found to keep a business functioning
define: payables
the amount of time taken by a business to pay its suppliers and other creditors
define: receivables
the amount of time taken by debtors (businesses customers) to pay for the products that has been supplied
possible cash flow issues:
- Overtrading - business expands quickly without organising funds to finance the expansion
- Allowing too much trade credit
- Poor credit control - getting customers to pay on time
- Inaccurate cash flow forecasting
Fixing cash flow issues:
- Offer less trade credit
- Arrange short term borrowing
- Negotiate improved terms for trade credit
- Debt factoring
- Sale and leaseback
define: break even analysis
a level of output which the sales of products generate just enough revenue to cover all costs of production.
Break even output: total revenue = total costs
-> Therefore, the business makes neither a loss nor a profit
Always given in units
Always round up
Why do managers use break even analysis?
- Help to decide whether a business idea is profitable or not
- Help to decide the necessary level of output to generate a profit
- The results can be used to support an application for a loan
- Used to assess the impact of changes in the level of production on profits
- Used to assess the effects of prices / costs on potential profits
define: Contribution (formula)
difference between sales revenue and variable costs of production
Contribution = revenue - variable costs
Calculating break even analysis - Method:
Step 1: Find the contribution
Selling price - Variable costs = Contribution
Step 2: Find the break even point
Fixed costs/Contribution = BEP
Q: Business B sells 500 units for £10 each. Their variable costs per unit are £4 and their fixed costs are £1,200.
- £5000 - £3,200 = £1,800
- £1,800 / 500 = £3.60
- £1,200 / £10 - £4 = 200 units
how do you calculate: Total Contribution?- (contribution= n.o of units sold)
use the contribution from the break even and multiply it by the amount of units.
what is: margin of safety?
is the difference between the number of units sold and the break even point.
e.g. If the break even was 250 and the number of units sold was 300, the margin of safety would be 50 units
300 - 250 = 50 units
Revenue formula:
Selling Price x Quantity Sold
define: Fixed Costs
Costs that do not change with output.
define: Variable costs
Costs that do change with output
Total Costs formula:
Fixed costs + variable costs
see graph with total/fixed/variable/revenue lines on
made copy in class
Break even analysis advantages:
- Forecast the effect of varying numbers of customers on revenue, costs and profit
- Implications of changes in price or costs on profitability
- Simple technique - particularly suitable for start up businesses and businesses that produce a single product
- Quick
- Used to gain additional finance - financial planning
Break even analysis disadvantages:
- A prediction - information may be inaccurate
- Simplification of what happens - businesses don’t usually stick to a single price
- More difficult if a business sells numerous products
- Costs do not rise as steadily as suggested - economies of scale
When VC rise, the total cost line would…
pivot upwards and therefore a greater output is necessary to break even.
When FC fall, the total cost line would…
parallel shift down and therefore a lesser output is necessary to break even.
When selling price falls, the revenue line would…
pivots downwards and therefore a greater output is necessary to break even.
When selling price rises, the revenue line…
pivots upwards and therefore a lesser output is necessary to break even.
Which costs do the following consider?
Net profit
Operating profit
Gross profit
Net profit - direct, indirect, remaining
Operating profit - direct + indirect
Gross profit - indirect
gross profit margin formula:
Gross profit / revenue x 100
