Decision making to improve Financial Performance (3.5) Flashcards
Financial Objectives are the…
Are the monetary targets a business wants to achieve within a set period of time.
Financial Objectives Example (6) :
~ Return on investment.
~ Capital structure.
~ Revenue.
~ Costs.
~ Profit.
~ Cash flow.
(Financial Objectives) Return on Investment (ROI) :
- A measure of a…
- Allows for…
- How effective it is to…
A measure of a business’ profitability and performance.
~ Allows for comparison between alternative investment opportunities.
~ How effective it is to use the money tied up in the business to generate profit.
‘Return’ meaning…
‘Investment’ meaning…
‘Return’ is how much money a business gets back.
‘Investment’ is how much capital is being used within the business.
(Financial Objectives) ROI targets will be set as a % :
~ Benchmark to industry standards.
~ Internal benchmarking.
~ External environment e.g. Interest rate.
(Financial Objectives) Return on Investment Formula :
Operating profit
———————— x 100
Capital invested
Things on an Income Statement (7) :
Sales revenue, Cost of sales, Gross profit, Expenses, Operating profit, Interest and taxation, Profit for the year.
(Income Statement) Sales Revenue :
Money coming in from sales.
Quantity Sold x Selling Price.
(Income Statement) Cost of Sales :
(variable costs)
Costs directly linked to the production of the goods or services sold e.g. Raw materials.
(Income Statement) Gross Profit Formula :
Sales Revenue - Cost of Sales.
(Income Statement) Expenses :
(fixed costs)
All other costs associated with the trading of the business e.g. Salaries and Marketing Expenditure.
(Income Statement) Operating Profit Formula :
Gross Profit - Expenses.
(Income Statement) Interest and Taxation :
Interest paid on debt or received on positive balances.
- Less tax payable on profit.
(Income Statement) Profit for the Year Formula :
(end profit)
Operating Profit - Interest and Taxation.
(Financial Objectives) Cash Flow :
The movement of money into and out of a business.
- It’s important for survival.
(Financial Objectives) A business may have a specific Cash Flow Target, e,g, :
- To ensure all debts are received (paid) within 30 days.
- To maintain a cash balance of £25,000.
Capital Structure :
Refers to the relative ways in which the capital has been raised i.e. the ratio of equity to debt.
Long-term Funding :
Amount of capital that has been invested in a business and will stay in the business for over a year.
- Normally for the purchase of assets.
Long-term Funding can come from two sources :
- Equity, i.e. capital invested by shareholders of a company.
- Debt, i.e. money borrowed from financial institutions.
Gearing : The relationship, or ratio, of a…
- A business can be described as highly geared if the…
The relationship, or ratio, of a company’s debt-to-equity (D/E).
- A business can be described as highly geared if the % is thought to be high as this increases the element of risk.
Gearing Formula :
non-current liabilities (debt)
—————————- x 100
Total Long-Term Funding
(equity + non-current liabilities)
(Influences on financial objectives) INTERNAL, can control (4) :
- Corporate and other functional adjectives.
- Characteristics of the firm.
- Relationship between owners and directors.
- Public or private sectors.
(Influences on financial objectives) EXTERNAL, can’t control (4) :
- Competition.
- Economic climate/conditions (interest rates, etc).
- External environment.
- Consumers.
Budgets are…
Forecasts or plans for the future finances of a business.
- These can be for the business as a whole or set for specific functions e.g. Marketing Budget.
Budgets can be on : (3)
- Income.
- Expenditure.
- Profit.
Budgets Flow Chart (8) :
1) Set clear…
2) Carry out…
3) Produce a…
4) Set…
5) Set…
6) Set…
7) Set…
8) Review…
1) Set clear objectives.
2) Carry out market research.
3) Produce a sales forecast.
4) Set income budget.
5) Set expenditure budget.
6) Set profit budget.
7) Set divisional targets.
8) Review against objective.
Variance analysis is the process…
Of calculating and interpreting these variances (between budget and actual income).
Variance :
The difference between the actual income, expenditure or profit and the figure that has been budgeted.
- (may not always be a variance)
Adverse Variance :
Is one that is bad for the business.
- Expenditure higher than budget.
- Income&profit lower than budget.
Favourable Variance :
Is one that is good for the business.
- Expenditure (costs) lower than budget.
- Income&profit higher than budget.
Once a variance has been identified, it is important to (3) :
1) Identify the cause of the variance.
2) Consider the effect of the variance.
3) If appropriate, look for a solution.
Possible causes of variances (5) :
- Actions of competitors (new products/lower prices).
- Actions of suppliers (change prices, offer a discount).
- Changes in economy (change in interest rates, increase to minimum wage).
- Internal inefficiency (demotivated sales team).
- Internal decision making (change suppliers, special promotion).
Benefits of Budgeting (3) :
+ Provides a quantifiable target, against which ‘actual outcomes’ can be measured e.g. ‘Are sale targets being achieved?’.
+ Informs decision making e.g. ‘Where can cuts be made?’.
+ Motivates budget holders due to increased responsibility.
Drawbacks of Budgeting (3) :
- Potential for conflict e.g. short-term saving may be detrimental to long-term objectives.
- May be restrictive e.g. opportunities may be missed.
- Time consuming to set and monitor.
Break-Even is the point at which…
A business is not making a profit or loss i.e it is just breaking even.
~ At this point total costs must be the same as total revenue. TC = TR.
Break-Even Output is the…
Number of items that a business must sell to reach this point.
~ Before reaching Break-Even a business is operating at a…
~ After reaching Break-Even each additional…
~ Before reaching BE, a business is operating at a loss.
~ After reaching BE, each additional unit sold will contribute towards profit.
Charity/Public sector businesses may just be looking to break-even.
Contribution per unit is the…
Difference between selling price per unit and variable cost per unit i.e. how much is left to contribute.
~ firstly to fixed costs and secondly to profit.
Contribution per Unit formula :
Selling price - Variable cost per unit.
Total Contribution formula (2) :
Total Revenue - Total Variable Costs
Contribution per unit x Units sold
Break-Even Output Formula :
Fixed Costs
—————————
Contribution per unit
(sp-vc)
Calculating Break-Even, Strengths (5) :
+ Allows business to calculate minimum no. of sales needed before making profit (see if venture is viable).
+ Can calculate the level of profit or loss at different levels.
+ Provides a target.
+ An integral part of business plan when seeking finance.
+ Aids decision making.
Calculating Break-Even, Weaknesses (4) :
- Is based on predicted costs + revenue.
- Even fixed costs can vary in reality, especially in the long run.
- Ignores changes in VC or SP as items are brought or sold in larger quantities.
- Only indicates the number of sales needed, does not ensure actual sales will materialise.
Margin of Safety is…
How much actual output is above the Break-Even level of output.
Margin of Safety Formula :
Actual output level - Break-even level of output
Profitability :
Measures the financial performance of a business by comparing profits achieved to a second variable e.g. revenue & ROI.
Profitability Ratio :
Gross-Profit Margin, Operating Profit Margin, Profit for the Year Margin and Return on Investment.
Gross Profit Margin :
- If its low/falling it may mean…
Is a measure of a firm’s profitability by looking at the relationship between Gross Profit and Sales Revenue.
- If it’s low/falling may means sales are in decline/not managing its cost of sales effectively.
Gross-Profit Margin, FORMULA :
Gross Profit
—————— x 100
Sales Revenue
Operating Profit Margin :
- If low/falling may mean…
Is a measure of a firm’s profitability by looking at the relationship between Net Profit and Sales Revenue.
- If low/falling may mean its not managing expenses properly/sales are in decline.
Operating Profit Margin, FORMULA :
Operating Profit
———————– x 100
Sales Revenue
Profit for the Year Margin :
- If low/falling may mean…
Is a measure of a firm’s profitability by looking at the relationship between profit for the year and sales revenue.
- If low/falling may mean GP/OP are in decline/interest rates have changed.
PFTY Margin, FORMULA :
Profit for the Year
————————– x 100
Sales Revenue
Increasing Profitability is often a major aim for growing businesses, Some ways it can be achieved are (3) :
- Sell the same quantity at a higher price (BUT customers may go to cheaper alternative).
- Sell more at the current price (BUT have to inc production&wages&advertising).
- Sell the same, at the same price but reduce costs (BUT may have to reduce quality which can have knock on implications).
Sources of finance are the options…
The options available to a business when seeking to raise funds to support future business actions.
- For Start-up, might be raising sufficient capital to establish the business.
- For an Established Business, might be to fund growth or implement a new strategy e.g. relocation.
(Source of Finance)
Short-Term : … (3)
Long-Term : … (5)
ST : Overdraft, Factoring, Crowd funding
LT : Share issue, Retained profits, Loan, Mortgage, Venture capital.
(Source of Finance) Overdraft, + (3) AND - (2):
A sum of money which has been borrowed. The amount may vary on a daily basis.
(EXTERNAL, SHORT-TERM, EMERGENCY)
+ Flexible&quick&easy can borrow what you need, Can be used regularly, Only pay for money borrowed.
- Expensive if used for LT due to interest, Higher interest rates than a bank loan.
(Source of Finance) Share Issue, + (3) AND - (3):
The sale of part of the business in return for an amount of money.
(EXTERNAL, LONG-TERM)
+ New finance, No interest, Only pay dividends when profit’s made.
- Loose a % of the business to others (diluted), Don’t get all the profits since you have to pay dividends, Complex&Costly process (especially for PLC).
(Source of Finance) Retained Profits, + (4) AND - (3) :
Finance obtained from within the business following successful trading.
(INTERNAL, LONG-TERM)
+ Flexibility, Business owners in control, Low cost, No interest (don’t owe anyone).
- A drain on finance if loss-making, Only an option if sufficient profits, Shareholders may become unhappy (if its at expense of dividends).
(Source of Finance) Trade Credit, + (3) AND - (2) :
Goods obtained from a supplier which does not have to be paid for immediately.
(EXTERNAL)
+ Flexible (business decides when to pay), Commonly available, Improve cash flow.
- Risk of late payment fees, May affect creditworthiness.
(Source of Finance) Hire Purchase, + (3) AND - (3) :
A method of obtaining an asset in return for a series of monthly payments. Ownership of the asset doesn’t transfer until the final payment has been made.
(EXTERNAL)
+ Flexible, Immediate access of thing, Spreads costs over a fixed term.
- No ownership until contract ends, More expensive than buying, Late payments damage credit score.
(Source of Finance) Grants, + (3) AND - (5):
Finance obtained for a specific purpose usually at no cost to the business. Doesn’t have to be paid back.
(EXTERNAL)
+ Don’t have to be repaid, Allow for growth, No impact on business ownership.
- Competitive , Not widely available for most, Time-consuming to apply, No guarantee of success, One-off.
(Source of Finance) Loan, + (2) AND - (3):
Finance obtained, usually for a fixed period of time which has to be paid back.
(EXTERNAL, LONG-TERM)
+ Lower interest rate than a bank overdraft, Greater certainty of funding.
- Interest has to be paid, Harder to arrange, Not very flexible.
(Source of Finance), Mortgage, + (2) and - (2) :
Finance obtained to help with the purchase of property.
(EXTERNAL)
+ Lower interest rates than other unsecured borrowing, Fixed monthly payment (structure finance plans etc).
- Long-Term financial commitment, Higher down payment.
(Source of Finance) Lease, + (3) AND - (4):
The right to use goods, in return for a monthly payment. The goods are not owned by the business.
(EXTERNAL)
+ Predictable cash flows, Widely available, Lower interest than a bank loan.
- More expensive (in total) than buying assets outright, Don’t own the asset, May need up-front deposit, Some long-term contracts are difficult to cancel.
(Source of Finance) Debenture, + (3) AND - (2) :
A long-term secured loan. Process of selling the debts owed to a business to a financial institution.
(EXTERNAL)
+ Fixed interest rate, Secured investment, Business will receive funds immediately (but at a reduced rate).
- Not backed by any form of collateral, Risky.
(Source of Finance) Factoring, + (2) AND - (2) :
The sale of debt to a specialist firm who secures payment and charges commission for the service.
(EXTERNAL, SHORT-TERM)
+ Receivable (amounts owed by customers) are turned into cash quickly, Business can focus on selling rather than collecting debts.
- Quite as high cost, Customers may feel their relationship with their business has changed.
(Source of Finance) Sale of Assets, + (3) AND - (3) :
Selling something that the business already owns.
(INTERNAL)
+ A significant amount of money can be raised, Doesn’t need to be paid back, No effect on the ownership of the business.
- Limited to businesses with spare assets (not all have them), May take some time to sell asset, Businesses lose future use of assets.
(Source of Finance) Business Angels, + (4) AND - (4):
A small sum of capital invested from an individual.
(EXTERNAL)
+ A significant amount of money can be raised, Relatively quick to organise, Provide skills, expertise, contacts etc. Can lead to further investment.
- Usually involves selling a significant stake (therefore loss of control), Will usually want to have large involvement in decision-making, Will want dividends, Not easy to find right angels.
(Source of Finance) Venture Capital, + (4) AND - (3) :
Finances obtained from limited companies willing to invest in fast-growing companies.
(EXTERNAL, LONG-TERM)
+ Get investors expertise & resources & technical existence, A significant amount of money can be raised, Opportunity to make business connections, Easier to attract other sources of finance.
- Demand a significant return against the investment, May lose ownership and autonomy (∴ risk of conflict/perceived interference), Don’t fund start-ups from the onset.
(Source of Finance) Crowd Funding, + (4) AND - (3) :
Raising finance through a large number of people of people, who each contribute a small amount usually via the internet.
(EXTERNAL, SHORT-TERM)
+ Relatively low-risk, Form of free marketing & generate publicity, Relatively fast & easy way to raise capital, Can do it online.
- Potential failure to meet goals and not received money, Fees can be expensive, Your business idea can be swiped.
Cash INFLOWS examples (5) :
- Cash sales.
- Payments from debtors (owe money, e.g. electricity).
- Owners’ capital invested.
- Sale of assets.
- Bank loan.
Cash OUTFLOWS examples (4) :
- Purchasing stock.
- Paying wages.
- Paying debts (bank loans, creditors, they take money).
- Purchasing assets.
Cash flow is interested in the balance between…
The cash inflows and cash outflows in terms of their relative size and timings.
What’s the difference between Cash Flow Forecasts and Cash Flow Statement :
- CF Forecast is PREDICTED, usually new businesses.
- CF Statement ACTUALLY HAPPENED, you can analyse financial performance).
Net Cash Flow & Formula :
The net result of cash inflows and cash outflows each month.
NCF = Cash Inflow - Cash Outflow.
Closing Balance & Formula :
How much the business has at the end of each month.
CB = Opening Balance + Net Cash Flow
Cash sales VS Credit sales :
Cash sales, customers pay immediately, Credit sales aren’t paid immediately e.g. Laptop or electricity bill.
The opening balance is the…
Closing balance of the previous month.
