Analysing Business Performance Using Financial And Non-financial Measures Flashcards
What is a budget
A budget is a financial plan for the future; without such a plan, businesses and individuals often get into financial trouble.
Variances
Favourable and adverse
Favourable sales revenue, expenses and cost of sales
A favourable sales revenue variance will mean that if cost of sales does not change from the budgeted figures, then the business will make more gross profit.
A favourable cost of sales variance will mean that the cost of producing goods and services will be lower than expected. This will lead to an increase in gross profit if the sales revenue does not change from the budgeted figures.
A favourable expenses variance will mean that the business is spending less than expected on the day-to-day running costs such as wages, salaries of management, advertising and utility bills etc. This will lead to higher levels of net profit if the gross profit remains unchanged from the budgeted figures.
Reasons for budget variances (sales)
Favourable sales variances might be caused by a number of factors including an effective bonus scheme for a sales team, a successful advertising campaign, favourable weather (depending on the products), the demise of a competitor etc.
Adverse sales variances might be caused by several factors including the successful activities of competitors, ineffective advertising, logistical problems that meant that stock did not arrive with the customer on time, bad weather etc.
Reasons for budget variances (cost)
Favourable cost variances may be caused by such factors as improved labour productivity, reduced costs of imported components due to a strengthening of the pound, finding a cheaper supplier etc.
Adverse cost variances might have been caused by several factors including increased waste in production, a strike by dockers, bad weather in the growing region for crops such as sugar or coffee, a devaluation of the pound, unexpected price rises from suppliers etc.
Advantages of a budget
Improved financial control. Part of the budgeting process is the monitoring of expenditure and revenues. Any variances need to be explained and reacted to. If adverse variances are prevented, the business will increase profits which will not only provide more capital for the business but will also satisfy owners/shareholders who may receive higher returns on their investment.
Budgeting ensures – or should ensure – that limited resources are used effectively. The budgeting process allocates resources to where they are most likely to help achieve the firm’s objectives. This will help a business to save money and reduce costs, both of which can improve profits for the benefit of the business and its owners/shareholders.
Budgeting can motivate managers and employees. When managers at all levels are involved in the budgeting process they will have a commitment to ensuring that budgets are met. If communicated with employees, this will also motivate them to achieve targets if they feel involved in the setting of budgets. Financial rewards may also be used to motivate employees to meet targets.
Budgeting can improve communication systems within the organisation. The budgeting process itself will involve communication both up and down the hierarchy. This will help to establish formal methods of communication, which can be used for purposes other than setting and administering budgets.
Disadvantages of a budget
If managers and employees are excluded from the budgeting process then they may not be committed to the budgets and may feel demotivated. This could be the reason for adverse variances in sales revenue and/or costs. If this is the case, profits may fall which may reduce dividend payments to owners/shareholders.
The budget may be inflexible; therefore, the business may not be able to react to changes in the market or other conditions may not be met by appropriate changes in the budget. For example, new competitors may have entered the market and the marketing budget may not allow for a response to this. Therefore, sales are likely to be lost. This will lead to an adverse variance and may lead to lower profits. This will negatively affect owners/shareholders.
An effective budget can only be based on good-quality information. If information use is unreliable, budgeted figures will be inaccurate. Therefore, budget variances may be inaccurate.
What is an income statement
The trading, profit and loss account (income statement) is a historical record of the trading of a business over a specific period (usually one year). It shows the profit or loss made by the business
Why is an income statement important
it allows shareholders/owners to see how the business has performed and whether it has made an acceptable profit (return)
it enables comparison with other similar businesses (e.g. competitors) and the industry as a whole
it allows providers of finance to see whether the business is able to generate sufficient profits to remain viable
it allows limited companies to satisfy their legal requirements to report on the financial record of the business.
Layout of profit and loss account
SALES REVENUE
Cost of Sales
GROSS PROFIT
Expenses
NET PROFIT
Corporation Tax
PROFITS AFTER TAX
Dividends
RETAINED PROFIT
Corporation tax and profit after tax
Limited companies will be required to pay tax on the net profit the business makes. This tax is paid to the government.
Profit after tax is simply net profit minus corporation tax.
When analysing the trading, profit and loss account (income statement), the following should be considered:
Comparing performance over time
Comparing performance against competitors or the industry in which the business operates
Benchmarking – A comparison against other businesses who are not direct competitors can also be useful, particularly if they help set the standard that the business aims to achieve. However, if the benchmark business operates in a very different industry, with significantly different profit margins, then this kind of comparison would not be worthwhile.
To analyse the trading, profit and loss account (income statement). The main components should be:
Sales revenue – If this is increasing or falling then it could be a sign that the business is attracting or losing customers. This can then be analysed in relation to the impact it may have on market share and/or profit. Reasons for the changes could also be addressed, such as effective/poor product range or advertising campaigns, competitor’s actions or external factors, e.g. a recession.
Cost of sales – If this is increasing or falling it would impact on gross profit. Therefore, the reasons for the changes need to be discussed, such as increasing costs of raw materials/stock or labour.
Gross profit – This is an indicator of how efficient the business is at making and selling goods and/or services. Therefore, if this is increasing, it is positive; if it is falling, it is negative. It would be possible to assess the reasons for this, which would involve issues with sales revenue and/or cost of sales.
Net profit – This is a true indicator of profit and the efficiency of a business. If this is increasing or decreasing, then the reasons need to be addressed and the importance discussed. For example, if net profit is falling then it could be due to sales revenue falling, cost of sales increasing, gross profit falling, expenses rising or a combination of all these.
What is on a balance sheet
Fixed (non-current) assets
Current Assets
Stock
Debtors
Cash and Bank
Total current assets
Current liabilities
Bank Overdrafts and Loans
Creditors
Other
Total Current Liabilities
Net Current Assets (Working Capital)
Total Long-Term Liabilities
Net Assets
Shareholder Funds
Capital employed
This is the area of the balance sheet that shows where all the money has come from to fund investment into assets and to pay liabilities.
