Topic 5 - Decision-Making to Improve Financial Performance Flashcards
Internal influences likely to affect the financial objectives:
- Business ownership
- Size and status of business
- Other functional objectives
External influences likely to affect the financial objectives:
- Economic conditions
- Competitors
- Social and political change
What are 2 main ways in which net cash flow differs from net profit during any accounting period:
1) Timing differences
- Arise because business may not received cash straightaway from customer and may also delay payments for its costs.
2) Way fixed assets accounted for
- Assets that business means to keep. Treated as capital expenditure in financial statements - meaning cost of assets not treated as operating cost. So:
- Payment for fixed asset = cash outflow
- Cost of fixed asset = treated as asset not cost
- Depreciation charged as cost when value of fixed assets reduced.
What is profit?
- Return on investment
- Reward for taking risks
- Key source of finance
- Measure of business success
- Motivating factor & incentive
Define profit:
Reward or return for taking risks & making investments.
What would profit in absolute terms measure?
£ value of profits earned in specific period.
What is profit in relative terms?
Looks at profit earned as proportion of revenues achieved or investment made.
Why is profit important?
Business will struggle to survive if suffers sustained losses.
What could happen if a business runs out of cash?
Likely to become insolvent and will without further injection of finance.
What happens if a business generates strong profits?
Turns into positive cash flow and in much stronger position to achieve all of its objectives.
What could be examples of possible cash flow objectives?
- Minimise time taken by customers who pay on credit to settle outstanding invoices
- Reduce bank borrowings to target level
- Minimising amounts paid out in interest charges.
A cash flow problem can be defined as:
When business doesn’t have enough cash to be able to pay its liabilities.
Main causes of cash flow problems are:
- Low profits or (worse) losses
- Over-investment in capacity
- Too much stock
- Allowing customers too much credit
- Overtrading
- Unexpected changes
- Seasonal demand
The keys to the ability of a business to handle cash flow problems are:
- Have reliable cash flow forecasting system
- Actively manage working capital
- Choose right sources of finance for business needs.
A good cash flow forecast:
- Updated regularly
- Makes sensible assumptions
- Allows for unexpected changes
- Reviewed regularly by senior management
Working capital management focuses on:
- Striking right balance between offering customers credit and ensuring pay on time
- Holding appropriate level of stock
- Managing relationships with suppliers so that maximum amount of trade credit obtained without damaging supplies to business.
Credit control covers areas such as:
- Policies on how much credit to give and repayment terms and conditions
- Measures to control doubtful debtors (chasing, threatening legal action)
- Credit checking
- Selling off debts to debt factors
- Cash discounts and other incentives for prompt payment
- Improved record keeping
What is factoring?
Selling of debtors (money owned to business) to third party.
What is a good thing about factoring?
Generates cash and guarantees firm percentage of money owed to it.
What is the downside to factoring?
Reduces income and profit margin made on sales. Costs involved in factoring can be high.
What is trade credit?
Amount owed to suppliers for goods supplied on credit and not yet paid for.
Why do businesses have to be careful about delaying payment to suppliers?
Can damage its credit reputation and rating. Trade creditors seen (wrongly) as “free” source of capital. Some firms habitually delay payment to creditors to enhance cash flow - a short sighted policy which also raises ethical issues.
What does stock refer to?
Goods purchased and awaiting use or produced and awaiting sale. Stocks take form of raw materials, work-in-progress and finished goods.
Stockholding is costly and therefore it is sound business to:
- Keep smaller balances (just in time stocks)
- Computerise ordering to improve efficiency
- Improve stock control
What is one of the key issues in cash flow management?
Ensuring that business has right kind of finance. Essential choice between bank overdraft and bank loan.
2 essential main types of financial reports (or ‘accounts’):
- Financial accounting: formally records, summarises and reports transactions of business.
- Management accounting: presents and analyses financial data to help management take decisions and monitor performance.
3 main elements of financial accounts are:
1) Income statement
2) Balance sheet
3) Cash flow statement
Income statement:
Measures business’ performance over given period of time, usually one year. Compares income of business against cost of goods/services and expenses incurred in earning that revenue.
Balance sheet:
Snapshot of business’ assets and liabilities on particular day - usually last day of financial year.
Cash flow statement:
Shows how business has generated and disposed of cash and liquid funds during period under review.
Some useful analytical tasks would include:
- Comparing performance over time
- Comparing performance against competitors or industry as whole
- Benchmarking against best-in-class businesses
- Potential weaknesses in using published financial information to assess performance
Income statement:
Historical record of trading of business over specific period. Shows profit/loss made by business - which is difference between firm’s total income and total costs.
The income statement serves several important purposes:
- Allows shareholders/owners to see hoe business has performed and whether made acceptable profit
- Helps return whether profit earned by business is sustainable
- Enables comparison with other similar businesses and industry as whole.
What is the main strength of ratio analysis?
Encourages systematic approach to analysing performance.
Drawbacks of ratio analysis:
- Ratio deal mainly in numbers
- Ratios largely look at past
- Most useful when used to compare performance over long period of time or against comparable businesses and industry
What does the balance sheet provide?
Summary of assets and liabilities of business. is a snapshot of those assets at particular moment in time.
Why does the balance sheet always balance?
Because of us of ‘double-entry’ bookkeeping to record business transactions.
Why was the Kaplan & Norton’s Balanced Scoreboard devloped in the early 1990’s?
As attempt to help firms measure business performance using both financial and non-financial data.
What is the aim if the Balanced Scoreboard?
To align business activities to vision and strategy of business, improve internal and external communications, and monitor business performance against strategic goals.
What does the Balanced Scoreboard provide?
Relevant range of financial and non-financial information that supports effective business management.
Background to the Balanced Scoreboard:
- No single measures can give broad picture of organisation’s health
- Organisation should select critical measures for each of these perspectives
- Framework based on 4 perspectives: financial, customer, internal and learning and growth.
Scoreboard produces a balance between:
- Four key business perspectives: financial, customer, internal processes and innovation
- How organisation sees itself and how others see it
- Short run and long run
- Situation at moment in time and change over time.
Main benefits of using the balanced scoreboard:
- Acts as integrating device for variety of corporate programmes
- Makes strategy operational by translating it into performance measures and targets
- Helps break down corporate level measures so local managers/employees can see what need to do well if want to improve organisational effectiveness.
Some drawbacks of the balance scoreboard model:
- Danger that business will have too many performances indicators
- Need to have balance between four perspectives
- Senior management may still be too concerned with financial performance
- Needs to be updated regularly to be used.
What do current liabilities represent?
Amounts that are owed by business and which are due to be paid within next 12 months.
Main elements of current liabilities:
- Trade and other payables
- Short-term borrowings
- Current tax liabilities
- Provisions
What are current assets?
Assets business owns which either cash, cash equivalents, or expected to be turned into cash during next 12 months.
Why are current assets important to cash flow management and forecasting?
They’re assets business uses to pay its bills, repay borrowings, pay dividends.
What are current assets listed in order of?
Their liquidity - how easy is to turn each category of current asset into cash.
Main elements of current assets are:
- Inventories
- Trade and other receivables
- Short-term investments
- Cash and cash equivalents
The current ratio is one of 2 main liquidity ratios. What are they used to assess?
Whether business has sufficient cash or equivalent current assets to be able to pay for its debts as they fall due.
What does liquidity ratios focus on?
- Solvency of business. Business that finds it doesn’t have cash to settle debts becomes insolvent.
- Short-term and make use of current assets and current liabilities shown in balance sheet.
What does the current ratio estimate?
Whether business can pay debts due within one year of current assets. Ratio of less than one often cause for concern if persists for length of time.
What current ratio is encouraging for a business and what does it suggest?
1-3, suggests business has enough cash to be able to pay debts, but not too much finance tied up in current assets.
What is a low current ratio and what would it suggest?
Less than 1, suggests business not placed well to pay its debts. Might be required to raise extra finance or extend time takes to pay creditors.
What is return on capital employed (ROCE)?
Sometimes referred as ‘primary ratio’. tells us what returns (profits) business has made on resources available.
The capital employed figure normally comprises:
Share capital + Retained earnings + long-term borrowings
With ROCE, the ____ the figure, the better
Higher figure, the better. Figure needs to be compared with ROCE from previous years to see if there’s trend of ROCE rising/falling.
Why is it important to ensure that the operating profit used for the top half of the calculation doesn’t include any exceptional terms?
Might distort ROCE percentage and comparisons over time.
To improve its ROCE a business can try to do 2 things:
1) Improve top line without corresponsing increase in capital employed, or
2) Maintain operating profit but reduce value of capital employed
Working capital =
Current assets less current liabilities
If there was an increase in the length of the working capital cycle, what would it suggest?
Takes longer to turn stocks and debtors into cash, or that payment period for settling creditors has shortened.
Factors affecting the level of working capital:
- Businesses with lot of cash sales and few credit sales should have minimal trade debtors. Supermarkets good example.
- Businesses that exist to trade in completed products will only have finished goods in stock.
- Some finished goods, notable foodstuffs, have to be sold within limited period.
The amount of working capital held by a business depends on a variety of factors:
- Need to hold investors
- Production lead time
- Lean production
- Expected credit period by customers
- Effectiveness of credit control function
- Credit period offered by suppliers
- Main causes of working capital problems.
What do payables estimate?
Average time takes to settle debts with trade suppliers.
How could a business maximise its cash flow?
Take as long as possible to pay its bills.
What are the risks associated with taking more time than is permitted to pay suppliers?
Loss of supplier goodwill; another is potential threat of legal action or late-payment charges.
When does overtrading happen?
When business expands too quickly without having financial resources to support such quick expansion.
What is an important point to remember about overtrading?
Can occur even if business is profitable. Is an issue of working capital and cash flow.
Overtrading is most likely to occur if:
- Growth achieved by making significant capital investment in production or operations capacity before revenues generated.
- Sales made on credit and customers take too long to settle amounts owed.
- Significant growth in inventories required in order to trade from expanding capacity.
Classic symptoms of overtrading:
- High revenue growth but low gross and operating profit margins
- Persistent use of bank overdraft facility
- Very low inventory turnover ratio
- Low levels of capacity utilisation.
Most effective steps to avoid overtrading are those that would be taken as part of a sensible cash flow and working capital management. For example:
- Reducing inventory levels
- Leasing rather than buying
- Obtaining better payment terms from suppliers
- Enforcing better payment terms with customers.
What does gearing measure?
Proportion of assets invested in business that are financed by long-term borrowing.
How can the gearing ratio be evaluated?
- Gearing ratio more than 50% traditionally said to be ‘highly geared’
- Gearing ratio less than 25% traditionally said as having ‘low gearing’.
- 25%-50% considered normal for well-established business happy to finance activities using debt.
Why can long-term debt be good?
Normally cheap, reduces amount shareholders have to invest in business.
Long-term capital structure of the business is in the control of who?
Shareholders and management.
What may a higher figure of receivables suggest?
General problems with debt collection or financial position of major customers.
Among the factors to consider when interpreting debtor days are:
- Industry average debt days needs to be taken into account.
- Can determine through terms and conditions of sale how long customers officially allowed to take
- Several actions business can take to reduce debtor days, including offering early-payment incentives or using invoice factoring.
