Unit 5 Flashcards
Decision making to improve financial performance
The value of setting financial objectives
-they may act as a measure of performance
-they provide targets which can be a focus for decision making
-potential investors or creditors may be able to assess the viability of the business
Cash flow
the difference between the actual amount of money a business receives and the actual amount it pays out (outflows)
Profit
the difference between all sales revenue (even if payment has not yet been received) and expenditure
Gross profit
gross profit = sales revenue - direct cost of production
Operating profit
operating profit = gross profit - expenses
Profit for the year
profit for the year = operating profit - other expenditure
Cash flow objectives
-targets for monthly closing balances
-reduction of bank borrowings to a target level
-reduction of seasonality in sales
-targets for achieving payment from customers
-extension of the business’s credit period to pay suppliers
Capital expenditure
The money spent on fixed assets such as buildings and equipment and represents long term investment into the business
Return on investment
return on investment = profit from investment / capital invested x 100
Capital structure of the business
The long term capital (finance) of a business
Total capital formula
Total capital = loan capital + equity
External influences on financial objectives and decisions
-competitor actions
-market forces
-economic factors
-political factors
-technology
Internal influences on financial objectives and decisions
-corporate objectives
-resources available
-operational factors
Budget
A financial plan
Income budget
Forecasted earnings from sales, sometimes called a sales budget
Expenditure budget
Sets out the expected spending of a business, broken down into a number of categories.
Why do businesses set budgets?
-they are an essential element of a business plan, a bank is unlikely to grant a loan without evidence of this in a particular form of financial planning
-help businesses decide whether or not to go ahead with a business idea
-can help with pricing decisions
Difficulties of setting budgets
-there may be no historical evidence available to a business
-forecasting costs can be problematic
-competitors may respond to the actions of a business by cutting prices or promoting their products heavily
Variance analysis
The study by managers of the differences between planned activities in the form of budgets and the actual results that were achieved
Positive variance
Costs are lower than forecast or profit or revenues higher
Negative variance
Costs are higher than expected or revenues are lower than anticipated
Responses to positive variance
-to increase production
-to reduce prices if costs are below expectations to increase sales
-to reinvest into the business or pat shareholders higher dividends
Negative variance responses
-reduce costs
-increase advertising
-reduce prices to increase sales
Benefits of budgeting
-targets can be set for each part of the business
-inefficiency waste can be identified
-can make managers think about financial implications
Drawbacks of budgeting
-the operation of budgets can become inflexible
-budgets have to be accurate to have any meaning
Structure of cash flow forecast
-receipts- in which the expected total month by month receipts are recorded
-payments- in which the expected monthly expenditure item is recorded
-running balance in which a running total of the expected bank balance at the beginning and end of each month is recorded
Contribution formulas
Contribution = sales revenue - variable costs
Contribution = sales price per unit - variable cost per unit
Total contribution formula
Total contribution = unit contribution x output
Break even formula
Break even = fixed costs / contribution per unit
Profit formula using contribution
Profit = total contribution - fixed costs
Benefits of break even analysis
-starting a new business
-supporting loan applications
-measuring profit and losses
Drawbacks of break even analysis
-no costs are truly fixed
-total cost line should not be represented by a straight line because this takes no account of the discounts available for bulk buying
-sales revenue assumes that all output produced is sold and at a uniform price which is unrealistic
Profit margins
Type of profit / sales revenue x 100
Profits- gross profit, operating profit, profit for the year
Payables
The money owed for goods and services that have been purchased on credit
Receivables
Money owed by a business’ customers for goods and services purchased on credit
The two main sources of external finance
Equity- money provided by shareholders or owners. It does not need to be paid pack so their is no interest on it. Shareholders can sell their shares if they want their money back. Dividends will need to be paid to shareholders
Loans- money raised from a creditor but have to be paid back including interest
Other sources of external finance
Venture capital- mostly with small or medium sized businesses that may struggle to raise money from traditional sources may have a venture capitalist that provides funds a loan or in return for a share of the business
Mortgages- loan granted for buying land or buildings
Crowdfunding- a large number of people contribute a small amount of money
Sources of internal finance
Retained profit- profit that is not paid to shareholders and is kept within the business for future investment
Sale of assets- a business sells assets it no longer requires such as machinery, a warehouse and factory space or land. Although this can raise large amounts the business needs to be sure they won’t be needed in the future
Short term sources of finance
Overdraft- a bank allows a business to overspend on its bank account up to an agreed limit
Debt factoring- a business sells its bills (invoices) that have not been paid to a third party factoring company for a discounted amount to receive an immediate cash advance
Trade credit- a business receives materials but pays for them at a later date. Trade credit periods can vary from a week to several months
Retained profit advantages and disadvantages
Advantages
-no interest to pay
-does not have to be paid back
-no dilution of shares
Disadvantages
-shareholders may have reduced dividends
Sales of assets advantages and disadvantages
Advantages
-no interest to pay
-does not have to be paid back
-no dilution of shares
Disadvantages
-once sold the assets are gone forever
Equity advantages and disadvantages
Advantages
-no interest to pay
-does not have to be paid back
Disadvantages
-might upset existing shareholders
Loans advantages and disadvantages
Advantages
-no dilution of shares
Disadvantages
-interest payments
-set maturity date
Overdraft advantages and disadvantages
Advantages
-quick and easy to follow
-interest paid only on an amount overdrawn
Disadvantages
-interest payments higher than for a loan
Debt factoring advantages and disadvantages
Advantages
-immediate cash
-improves cash flow
-protection from bad debts
-reduced administration costs
Disadvantages
-expensive
-customer relations may be affected
Trade credit advantages and disadvantages
Advantages
-eases cash flow
Disadvantages
-if late paying, can damage credit history
Reasons opportunity cash flow problems
Poor management- if managers don’t forecast and manage cash flow problems may arise
Giving too much trade credit- giving customers lots of time to settle accounts, slows business’ cash inflows reducing its cash balance
Overtrading- a business expands rapidly without planning how to finance expansion
Unexpected expenditure- a business may incur unexpected costs such as break down of a machine leading to significant outflows of cash
Methods of improving cash flow
Factoring- a business sells its outstanding debtors to a specialist debt collector.
Sales and leaseback- the owner of an asset sales it and leases it back
Improves working capital control- selling stocks of finished good quickly and making customers pay on time or offering less trade credit
Persuading suppliers to offer longer periods of trade credit
Methods of increasing profits
-increasing prices
-cutting costs
-using capacity as fully as possible
-increasing efficiency
Problems improving cash flow
Factoring- profit margin is reduced to the cost of factoring
Sales and leaseback- asset is removed forever and rent has to be paid
Working capital control- customers may be put off by reduced credit periods
Difficulties of improving profit
Increasing prices- may reduce sales and revenue
Cutting costs- likely to result in a reduction in quality
Use capacity fully- may cause problems in matching supply with demand
Increasing efficiency- may result in redundancies if technology is introduced
