Section 5 Flashcards
Cost centre
A section/department of a business, to which costs can be allocated
Profit centre
A section of a business to which both costs and revenues can be allocated
Full costing
All fixed + variable costs are allocated to products/services or divisions of a business
Contribution/marginal costing
Allocates direct costs to cost/profit centres only - overheads are not included
Budget
A detailed financial plan for the future
~ Can be used for sales and costs
~ Must account for financial needs = consequences
~ Financial targets facilitate measurement performance of each part of the budget
~ Usually set for 12 months
Purpose:
• Planning - realistic future target
• Effective resource allocation - ensures access to to/afford resources according to priorities
• Set targets - realistic targets to be achieved creates motivation
• Coordination - coordination between departments
• Monitoring + control- check if plans are in place regardless of change in conditions
• Modifying - determine plan change using budget
• Measure/assess performance - Variance analysis can be used to compare
Features:
• Not a forecast - it’s a plan
• Created by budget holder
• Delegated budgets are completed by junior managers
Stages of preparations:
1. Establish objective
2. Identify key factors/considerations
3. Sales budget prepared - sales managers in all branches + divisions in business
4. Subsidiary budgets prepared - budget holder
5. Budgets are coordinated - commitee
6. Prepare master budget + budgeted IS + SFP
7. Present master budget for approval
Budget holder
Individual responsible for the initial setting and achievement of a budget
Variance analysis
Calculating differences between budgets and actual performance, analysing reasons for such differences
Delegated budgets
Giving some delegated authority over the setting and achievement of budgets to junior managers
Incremental budgeting
Uses last years budget as a basis and an adjustment is made for the coming year
Zero budgeting
Setting budgets to zero each year and budget holders have to argue their case to receive any finance
Flexible budgeting
Cost budgets for each each expense allowed to vary if sales or production vary from budgeted levels
Adverse variance
Exists when the difference between the budgeted and actual figure leads to a lower than expected profit
Favourable variance
Exists when the difference between the budgeted and actual figure leads to a higher than expected profit
Intellectual property
The amount by which the market value of a firm exceeds its tangible assets less liabilities (intangible asset)
Market value
The estimated total value of a company if it were taken over
Capital expenditure
Any item bought by a business and retained for more than one year that is a NCA
Revenue expenditure
Any expenditure on costs other than NCA expenditure
Depreciation
The decline in the estimated value of an NCA over time
~Normal wear and tear through use
~ technological change making it obsolete
Net book value - NBV
NBV = original cost of asset - accumulated depreciation
Straight line depreciation
A constant amount of depreciation is subtracted from the value of the asset each year (amount doesn’t change)
Cost of asset - expected residual value
expected useful life of an asset
Net realisable value
The amount for which an asset (usually inventory) can be sold minus the cost of selling it
~ Inventory should be valued in the SFP at the lower of NRV or cost
Return on capital employed - ROCE
Operating profit x100
Capital employed
Improve ROCE:
~> Increase operating profit
• Raise prices
• Reduce variable costs
• Reduce overheads
~> Reduce capital employed
• Sell assets
• Reduce debts
Other:
- ⬆️ amount = ⬆️ invested capital
- Compare with other companies and previous years
- Compare with return with interest + cost of borrowing
- Not used to assess risk
Capital employed
Total value of all long term finance invested in the business
= Total assets - total liabilities + shareholders equity
Inventory turnover ratio
Cost of good sold (COS)
Value of inventories
• In no. Of days
• ⬆️ no. = more efficient sales management
• N/A to service industries
Day’s sales in receivable ratio / Trade receivables ratio
Trade receivables x 365
Revenue
• Cash only business - lower results
• ⬆️ ratio could be strategy to get more customers by offering ⬆️ credit
• value can be reduced by ⬇️ credit terms
Share price
Quoted exchange price of one share on the stock exchange
Dividend
Share of the company profit paid to shareholders
Dividend yield ratio
Dividend per share x100
Current share price
Notes:
• Want ⬆️ ratio to retain shareholders
• Share price ⬆️, yield ⬇️
• Compared with investments + companies
Dividend per share
Total annual yield
Total no. Issued shares
Dividend cover ratio
Profit for the year
Annual dividends
Notes:
• Want ⬆️ ratio - ⬇️ directors retain low profits for future investments
• ⬆️ dividends without ⬆️ profits, ratio ⬇️
Price/earnings ratio
Current share price
Earnings per share
• Compared only with companies in industry
Earnings per share
Amount of profit after tax and interest earned per share
Profit for the year
Number of shares issued
Gearing ratio
Measures then degree to which capital of the business is financed from long term loans
NCL x100
Shareholders equity + NCL
Or alternatively
Long term loans x100
Capital employed
Note:
• Extent to which assets are financed from long term borrowing (50% = ⬆️ geared)
• ⬆️ ratio = ⬆️ risk for shareholders
• Results in ⬇️ liquidity
• ⬇️ ratio indicates safe business
Investment appraisal
Evaluating the profitability /desirability of an investment project
• Using quantitative techniques to assess financial feasibility of projects
• Assess likely future returns on project
• Never use one method alone
• Assumption that results are certain
• Only important guides for final decision making
• Conflicting results from different appraisals (depends on managers attitude)
Quantitative methods:
1. Payback period
2. Average rate of return
3. Discounted payback
4. Net present value
5. Internal rate of return
Qualitative factors:
• Impact on environment + community
• Planning permissions/continuation
• Business aims/objectives
• Different managers and their degrees of risks
Annual forecasted net cash flow
Forecast cash inflows - forecast cash outflows
Payback period
Length of time it takes for the net cash inflows to pay back the original capital cost of the investment
Additional net cash inflow needed. x 12 (months)
Annual cash flow in year
Notes:
• Compare with other projects
• Compared with cut-off time
Accounting rate of return - ARR
Measures the annual profitability of ann investment as a percentage of the initial investment
Notes:
• Comparison between 2 projects - ⬆️ returns projects is chosen
• Compare ARR on other projects
• Minimum expected return can be set
• ARR ⬇️ than interest rate on loan - not worth in using a loan for project
• Good to use with payback results
Annual profit ( = net cash flow) x 100
Initial capital cost
Or
Annual profit
Average capital cost
~ Average capital cost :
= initial capital cost - residual capital value
2
Net present value - NPV
Today’s value of the estimated cash flow resulting from an investment
Notes:
• Uses discounted cash flow
• Business will choose rate of discount that reflects the interest cost of borrowing the capital to finance the investment
Internal rate of return
Rate of discount that yields a net present value of zero
~ Higher the IRR = more profitable the investment project
~ Used with NPV
~ Compare with IRR of other projects
Criterion rates/levels
Minimum levels set by management for investment appraisal results for a project to be accepted
Overheads
Costs that stay fixed regardless of changes in production units
Unit costs
Average cost of producing each unit of output
Total costs of producing product
No. Units produced
Marginal cost
Cost of producing 1 extra unit
Contribution
Revenue gained from selling after deducting variable + direct costs
Goodwill
Value of reputation of a business
Financial efficiency ratios
Indicate effectiveness of business management and ability to use resources and collect debts
• Inventory turnover ratio
• Day’s sales in receivable ratio
Liquidity ratios
Measure the business’ ability to meet short term debt
Shareholder ratio
Used by existing/potential customers to assess rate of return on shares and their prospects
• Dividend yield
• Dividend per share
• Dividend cover ratio
• Price/ earnings ratio
Discounted payback
Used to combat problem of comparing projects with different returns and payback periods. Calculates present value of future cash flows so that investment projects can e compared
Notes:
• Considers size of cash flow and timing of them
Payment today rather than later is preferred:
• Benefits of expenditure is experienced immediately
• Can be saved at current rate of interest
• Future cash is always uncertain
Present value of future sum of money depends on:
• ⬆️ interest rate - ⬇️ value future cash has in today’s money
• ⬆️ into future cash is received, ⬇️ value it has today
