U5: Setting Financial Objectives Flashcards
`What are financial objectives?
Financial objective are the targets set by to be achieved by the finance department in a specific time period.
What are the benefits of Setting/ Using Financial Objectives?
- focus and direction for staff
- keep departments in line with corporate objectives
- maximise efficient use of resources
- potentially motivate staff
What do all businesses face?
All businesses face constraints. Constraints are the internal and external factors that affect the firms’ ability to achieve the objectives.
What is the bottom line in business?
‘Money is the bottom line’ in business; this means it needs to be carefully managed to make best use of the financial resources available to maximise the financial prosperity of the business - i.e. make good financial decisions
What are key financial objectives?
- revenue costs and profits
- cash flow
- return on investment
- capital structure
What is profit calculation?
selling price - cost of making product or providing a service = profit
What is the total revenue calculation?
selling price (p) X quantity sold (q) = total revenue (TR)
What are fixed costs (FC)?
costs that don’t vary directly with output in the short run (e.g. rent)
What are variable costs (VC)?
costs that vary directly with output in the short run (e.g. raw materials)
What are total costs (TC)?
costs that are the sum of fixed and variable costs
What are different types of profit?
Sales revenue - cost of sales (direct/ variable costs) = gross profit
Gross profit - expenses/ overheads (indirect/ fixed costs) = operating profit
Operating profit - interest (in/ out) and tax = profit for the year
Percentage change calculation
(Change/ original amount) X 100
Why set financial objectives?
- focus for decision making
- provide a measure for success
- improve co-ordination (a common product)
- improve efficiency
- inform potential investors
What are the difficulties of setting objectives?
- difficulties to set realistic objectives
- external changes (e.g. competition/ economic downturn)
- difficult to measure accurately
- reasons for success/ failure may be difficult to identify
- responsibility for achieving financial objectives rests with finance but the performance is dependent on all departments
- finance objectives may conflict with other objectives in different functional areas
What is cash flow?
Cash flow is the money flowing into and out of a business over a period of time
Info about cash flow objectives
Objectives need to be set for all amounts and timings of these inflows and outflows to avoid potentially running out of cash.
Businesses can fail due to a lack of cash rather than a lack of profit.
What is a return on investment?
A target for the minimum acceptable return on an investment, measured as operating profit as a percentage on the investment.
Return on investment (ROCE) calculation?
(profit from investment/ capital invested) X 100
What is capital structure objectives a target for?
Capital structure objective is the target for the debt to equity ratio
What is debt to equity ratio?
The percentage of total capital tied up in the business that comes from debt (loans) as opposed to shareholder funds.
What are the Advantages of Equity as a source of finance?
Less risk: you don’t have any fixed monthly loan payments to make
Credit problems: equity financing may be the only choice for funds to finance growth. Even if debt financing is offered, the interest rate may be too high.
Cash flow: equity financing does not take funds out of the business
Long- term planning: equity investors do not expect to receive an immediate return on their investment. They have a long-term view and also face the possibility of losing their money if the business fails.
What are the Disadvantages of Equity as a source of finance?
Cost: Equity investors expect to receive a return on their money. The business owner must be willing to share some of the company’s profit with his equity partners.
Loss of Control: The owner has to give up some control of his company when he takes on additional investors. Equity partners want to have a voice in making the decisions of the business, especially the big decisions.
Potential for Conflict: All the partners will not always agree when making decisions. These conflicts can erupt from different visions for the company and disagreements on management styles.
What are the Advantages of Debt/ Loans as a source of finance?
Control: Taking out a loan is temporary. The relationship ends when the debt is repaid.
Taxes: Loan interest is tax deductible, whereas dividends paid to shareholders are not.
Predictability: Original loan and interest payments are stated in advance, so it is easier to work these into the company’s cash flow. Loans can be short, medium or long term.
What are the Disadvantages of Debt/ Loans as a source of finance?
Qualification: The company and the owner must have acceptable credit ratings to qualify.
Fixed payments: Original loan and interest payments must be made on specified dates without fail.
Cash flow: Taking on too much debt makes the business more likely to have problems meeting loan payments if cash flow declines.
Potentially higher risk
Collateral: Company assets may be held as collateral, often with personal guarantees.
Factors that might influence a businesses choice of capital structure
• The cost of borrowing (interest rates)
• The rate of inflation
• The state of the economy
Influences on a business’ choice of capital structure
• Match a business’ capital structure to the timings of outflows and inflows of cash brought about by investment plans
• Balance the cost of their financing with the level of risk involved
How are financial objectives set?
They will be decided by taking into account the internal position of the business and the external business environment.
What does the Internal Position mean?
Internal Position: This means considering what the business is currently doing and what resources it has available; these issues will determine what the business can achieve.
What does the External Environment mean?
External environment: This means consideration of the business in relation to factors outside the business; for example the economy.
What are Internal Influences on Financial Objectives and Decisions?
Business ownership: The nature of business ownership has a significant impact on financial objectives. A venture capital investor would have quite a different approach to a long-standing family ownership.
Size and status of the business: E.g. start-ups and smaller businesses tend to focus on survival, breakeven and cash flow objectives. Quoted multinational businesses are much more focused on growing shareholder value.
Other functional objectives: Almost every other functional objective in a business has a financial dimension - which often brings the finance department into conflict with other functions.
What are External Influences on Financial Objectives and Decisions?
Economic conditions: The economic downturn forced many businesses to reappraise their financial objectives in favour of cost minimisation and maximising cash inflows and balances. Significant changes in interest rates and exchange rates also have the potential to threaten the achievement of financial targets like
return on investment.
Competitors: Competitive environment directly affects the achievability of financial objectives. E.g. cost minimisation may become essential if a competitor is able to grow market share because it is more efficient.
Social and political change: Often an indirect impact. E.g. legislation on environmental emissions or waste disposal may force a business to increase investment in some areas, and cut costs in others.
What does the current ratio assess?
The current ratio assesses a company’s ability to meet short- term liabilities with short-term assets
What is the Current Ratio formula?
Current Assets/ Current Liabilities
What ratio is typically healhty?
A ratio of 2:1 is typically healthy.
What is Quick Ratio (Acid Test Ratio)?
A stricter measure than the current ratio as it excludes inventory from current assests
What is the Quick Ratio formula?
(Current Assets - Inventory)/ Current Liabilities
