Unit 5 - Financial Management Flashcards
Why is it important to set financial objectives?
- without financial security a business will cease to trade
- poor financial management is a key reason for failure
- financial measures determine success of all other functions
- easier to manage as quantitative
- high levels of long term debt increases risk in business
- financial objectives may reduce risk
What are the three financial objectives?
- revenue
- for growth
- costs
- reducing costs to improve efficiency
- especially products with low profit margins
- reducing costs to improve efficiency
- profit
- key incentive
What is revenue?
the money made from sales
What is the formula for revenue?
revenue = no. of sales x selling price
What are fixed costs?
costs that don’t change with output
What are variable costs?
costs that change with output
What is the formula for variable costs?
variable costs = variable cost per unit x no. of sales
What are total costs?
all costs added
What is the formula for total costs?
total costs = fixed costs + total variable costs
What is the difference between cash and profit?
- cash considers the timing of payments in and out of the business
- profit is measured over a period of time
a business can be very profitable but still run out of cash
What is the formula for profit?
profit = revenue - expenditure
Why may profitable firms be short of cash?
- high inventory costs
- sales are on credit (trade credit)
- buy now, pay later
- used profits to pay dividends or repay long term loans
- purchased fixed assets (non-current)
- e.g. factory or new IT system
What are the three types of profit? / What is the process from revenue to net?
- revenue
- take away direct costs
- gross
- take away indirect costs (salaries, rent, etc)
- operating
- take away tax and dividends
- net
- profit for the year
What is the formula for gross profit?
gross profit = revenue - cost of sales
What does gross profit show?
- how efficiently a business is converting raw materials into finished goods
- indicates how well a business is adding value
What is cost of sales?
- items of expenditure that are directly related to production
- wages, raw materials, inventory
What is the formula for operating profit?
operating profit = gross profit - expenses
What is operating profit?
- profit made from trading
- best measure of a company’s performance
What is the net profit?
- profit available to owners
- includes all revenue
- including non-trading revenue such as sale of assets
- includes all expenditure
- finance costs such as interest payments on loans
- taxation
- useful measure for shareholders as it shows how much they benefit from their ownership
- help existing and potential shareholders to judge whether the company is a good investment
Income Statement:
1. revenue = £17,680
2. cost of sales = £16,606
3. gross profit
4. expenses = £1,169
5. operating profit
6. taxation = £62
7. net profit
Calculate the gross profit, operating profit and net profit. State whether the business has made a profit or loss.
gross profit = 17,680 - 16,606 = £1,074
operating profit = 1,074 - 1,169 = £ - 95
net profit = -95 - 62 = £-157
Made a loss
What are cash flow objectives?
- maintaining specific amounts of cash in reserve
- shortening payment period for customers
- extending cash outflows to suppliers
- e.g. pay supplier in 2 months (with supplier agreement)
What are inflows?
sums of money entering the business
What are examples of inflows?
- sales
- capital investment
- bank loans
- government grants
- receipts from trade customers
- sale of spare assets
- payments from debtors (receivables)
What are outflows?
sums of money leaving the busniess
What are examples of outflows?
- payments to suppliers
- rent and rates
- wages and salaries
- utility bills
- advertising
- repayment on loans
- payment of dividends
- interest on loans
What is the formula for net cash flow?
net cash flow = total inflows - total outflows
What are investment and return objectives?
- target for capital investment over the year
- aligned with growth targets
- reducing capital over the year to reduce debt
What is the formula for return on investment (ROI)?
ROI = ( profit of investment / cost of investment ) x100
What is the definition of investment?
capital goods which include machinery, delivery vehicles, factories and offices
What is return on investment?
financial gains from investment - cost of investment
What are the advantages of setting financial objectives?
- acts as a focus
- measures success or failure
- gives a common purpose
- improves efficiency as learn from past mistakes
- shareholders can assess whether business is worthwhile investment
- outside organisations can confirm financial viability of business
What are the disadvantages of setting financial objectives?
- difficult to set realistic objectives
- external changes may be unforeseen
- certain objectives difficult to measure
- potential conflict of objectives
- responsibility for achievement of objectives may rest with finance department, but the actual performance depends on performance of all departments
What is a budget?
- a financial plan for the future
- not a forecast
- sets out financial targets
What is the purpose of a budget?
- control and monitoring
- motivation
What are the three types of budget?
- income budget
- expenditure budget
- profit budget
What is the income budget?
- shows agreed planned income of a business over a period of time
- also known as revenue budget or sales budget
- includes revenue and any rent received
What is the expenditure budget?
- shows the agreed planned expenditure of a business over a period of time
- includes raw materials, labour costs, marketing expenditure, admin costs, rent, capital costs, etc
What is the profit budget?
- shows the agreed planned profit of a business over a period of time
Using the data below, complete the budgets.
Budgeted sales for June 2017
- Product A: 7,500 units at price of £3.50 each
- Product B: 8,000 units at price of £2.50 each
Budgeted costs for June 2017
- Raw material costs: 36% of sales income
- Wages: 30p per unit for both Products A and B
- Rent: £3,500
Income Budget
- Source of income = income (£)
- Product A = 7,500 x 3.50 = 26,250
- Product B = 8,000 x 2.50 = 20,000
- Total = 26,250 + 20,000 = 46,250
( sales revenue = units sold x selling price)
Expenditure Budget
- Expenditure item = expenditure (£)
- Raw materials = 46,250 x 0.36 = 16,650
- Wages = (7,500 + 8,000) x 0.30 = 4,650
- Rent = 3,500
- Total = 16,650 + 4,650 + 3,500 = 24,800
Profit Budget
- Income / Expenditure item = £
- Total income = 46,250
- Total expenditure = 24,800
- Budgeted Profit = 46,250 - 24,800 = 21,450
What is variance?
a comparison between the budget and the actual finance figures achieved
What is the formula for variance?
variance = budget - actual figure
What are the two types of variance?
- favourable
- adverse
What is favourable variance?
- occurs when a cost is less than expected or a revenue is more than expected
- more profit than expected = favourable variance
What is adverse variance?
- occurs when a cost is more than expected or a revenue is less than expected
- less profit than expected = adverse variance
What is the variance for the figures below?
Budget
- Revenue
- 2019 Budget = 100 million
- 2019 Actual = 110 million
- Expenses
- 2019 Budget = 50 million
- 2019 Actual = 80 million
Revenue Variance
- 110 million - 100 million = 10 million
- more revenue than expected
- favourable variance
Expenditure Variance
- 80 million - 50 million = 30 million
- more expenditure than expected
- adverse variance
Calculate and fill in the ?
Income Budget
Source of income
- Product A
- Budget (£) = 26,250
- Actual (£) = 28,000
- Variance (£) = 1,750 (favourable)
- Product B
- Budget (£) = 20,000
- Actual (£) = 16,500
- Variance (£) = ?
- Total Income
- Budget (£) = 46,250
- Actual (£) = ?
- Variance (£) = ?
- Product B
- Variance (£) = 20,000 - 16,500 = 3,500 (favourable)
- Total income
- Actual (£) = 28,000 + 16,500 = 44,500
- Variance (£) = 46,250 - 44,500 = 1,750 (favourable)
Variance = Budget - Actual
Variance is favourable as there is more revenue than expected
Expenditure Budget
Expenditure item
- Raw materials
- Budget (£) = 16,650
- Actual (£) = 15,200
- Variance (£) = ?
- Wages
- Budget (£) = 4,650
- Actual (£) = 5,620
- Variance (£) = ?
- Rent
- Budget (£) = 3,500
- Actual (£) = 3,500
- Variance (£) = ?
- Total Expenditure
- Budget (£) = ?
- Actual (£) = ?
- Variance (£) = ?
- Raw materials
- Variance (£) = 16,650 - 15,200 = 1,450 (favourable)
- Wages
- Variance (£) = 4,650 - 5,620 = -970 (adverse)
- Rent
- Variance (£) = 3,500 - 3,500 = 0 (no variance)
- Total Expenditure
- Budget (£) = 16,650 + 4,650 + 3,500 = 24,800
- Actual (£) = 15,200 + 5,620 + 3,500 = 24,320
- Variance (£) = 24,800 - 24,320 = 480 (favourable)
Profit Budget
Income / Expenditure item
- Total income
- Budget (£) = 46,250
- Actual (£) = ?
- Variance (£) = ?
- Total expenditure
- Budget (£) = ?
- Actual (£) = ?
- Variance (£) = ?
- Budgeted Profit
- Budget (£) = ?
- Actual (£) = ?
- Variance (£) = ?
Look at previous cards for information
- Total income
- Actual (£) = 44,500
- Variance (£) = 1,750 (favourable)
- Total Expenditure
- Budget (£) = 24,800
- Actual (£) = 24,320
- Variance (£) = 480 (favourable)
- Budgeted Profit
- Budget (£) = 46,250 - 24,800 = 21,450
- Actual (£) = 44,500 - 24,320 = 20,180
- Variance (£) = 21,450 - 20,180 = 1,270 (favourable)
Variance = Budget - Actual
Profit = Revenue - Expenditure
POSSIBLY CHECK WITH DARRIE
Why is cash important?
- pays for overheads
- if cash runs out, business is in financial difficulty
- businesses don’t have access to unlimited finance, so cash needs to be managed carefully
What is a cash flow forecast?
a prediction of the cash coming in and going out of a business
Why is a cash flow forecast important?
- negative cash flow (cash flow deficit) is the main reason for failure
- helps prevent insolvency
What is the definition of insolvent?
- when a business can no longer pay its debts or staff wages
- as they have no cash
- would need to sell assets to repay debts
What is another term for inflows?
receipts
What is another term for outflows?
payments
What is the formula for the opening balance?
opening balance = closing balance of previous period
What is the formula for the closing balance?
closing balance = opening balance + net cash flow
When calculating closing balance, what must you do if net cash flow is negative?
put it in brackets
What are the advantages of having a cash flow forecast?
- identify potential cash flow problems in advance
- a guide towards actions to avoid problems
- ensure there is sufficient cash to pay suppliers and customers and make payments
- evidence to support bank loans
- avoid possibility of liquidation
- identify possibility of holding too much cash and not utilising it effectively
- e.g. for further investment
What are the disadvantages of having a cash flow forecast?
- there may be changes in demand
- economic changes can impact customer spending
- may be based on inaccurate market research
- doesn’t take into account the actions of rivals
- e.g. new entrants or increased marketing actions
- unexpected cost changes
- e.g. supplier costs increase
- customers or suppliers failing
What is liquidity?
- refers to a business’ ability to maintain cash within the business to pay its operating costs
- how quickly it can turn assets into cash
How can liquidity be improved?
- better use of assets
- empty warehouse/office could be hired to other businesses
- make sure as little interest as possible is being paid on borrowing
- pay debts early and consolidate debts
- negotiate payment dates with suppliers
- avoid offering discounts for early payments
How can a business improve cash flow?
- speed up inflows
- discount early payments
- reduce trade credit lengths
- de-stock
- get a loan or overdraft
- slow down outflows
- delay paying creditors
- reduce costs
What is break even?
- when the total revenue is equal to the total costs
- at this point the business is making neither a profit or loss
What is contribution?
how much money a product contributes towards fixed costs
What is the formula for contribution?
contribution = selling price - variable costs
What is the formula for break even?
break even = fixed costs / contribution
What does break even tell a business?
how many products need to be sold to break even (make neither profit nor loss)
A cake shop has fixed costs of £21,000.
The selling price of a cake is £5 and the variable cost of a cake is £2.
Calculate the break even point.
break even = 21,000 / (5 - 2) = 7,000 cakes
What is the margin of safety?
the difference between the actual level of sales and the break even point
What is the formula for margin of safety?
margin of safety = actual sales - break even point
The following monthly data is available for a business:
Selling price per unit = £42
Variable costs = £14
Total fixed costs = £42,000
Actual sales for month of June = 4,000 units
How much is the margin of safety for the business for the month of June?
break even = fixed costs / contribution
contribution = selling price - variable costs
break even = 42,000 / (42 - 14) = 1,500
margin of safety = actual sales - break even point
margin of safety = 4,000 - 1,500 = 2,500
Draw a break even chart.
See notes or powerpoint.
Draw a break even chart with:
1) an increase in price
2) a decrease in price
See powerpoint.
How can you change the break even point?
- increase/decrease fixed costs
- increase/decrease variable costs
What happens to break even with an increase/decrease in fixed costs?
more/less units need to be sold in order to generate enough total contribution to cover the higher/lower fixed costs and therefore break even
What happens to break even with an increase/decrease in variable costs?
more/less contribution per unit will be generated compared with the selling price, so more/less units will need to be sold in order to cover the fixed costs and therefore break even
What are the advantages of break even?
- allows business to plan how many products need to be sold in order to start making profit
- break even info can be used to make judgements about costs and prices
- supports applications for bank loans
What are the disadvantages of break even?
- break even assumes the business sells all products at a single price
- doesn’t take into account offers etc
- not as accurate because it is either the break even for all products or for the average of all products
- assumes costs increase constantly
- doesn’t take into account economies of scale
What is profitability?
a measure of an organisation’s profit relative to its expenses
What does the gross profit margin show?
shows the gross profit as a percentage of revenue
- e.g. GPM of 20% means that for every £1 of revenue, 20p is the gross profit
What is the formula for gross profit margin?
gross profit margin = ( gross profit / revenue ) x 100
What does the net profit margin show?
shows the net profit as a percentage of revenue
- e.g. NPM of 5% means for every £1 of revenue, 5p is the net profit
What is the formula for net profit margin?
net profit margin = ( net profit / revenue ) x 100
Out of gross profit margin and net profit margin, which is a greater indicator of a business’ profitability?
Why?
net profit margin
- because it includes the sames costs as GPM, and fixed costs
- therefore is a better indicator
How can a business improve profit?
- increase prices
- use cheaper raw materials
- increase marketing
- increase capacity utilisation
- relocate to cheaper premises
- negotiate deals with suppliers
What are the difficulties in improving profit?
- spend money to make money
- lower quality products if use cheaper raw materials
- there are always consequences, so context is important to assess difficulty
Why do businesses need finance?
- expand business
- but new equipment
- buy premises
- fund research and development
- pay bills
- buy stock
- develop marketing activities
- pay workers
- start new business
Why are some sources of finance not available to every business?
- sole traders and partnerships
- cannot sell shares to raise finance
- limited companies (LTD or PLC)
- cannot take extra partners to raise finance
- businesses with poor financial record
- unlikely to get bank loan
What are the 3 time frames of finance?
- short term
- medium term
- long term
What is short term finance?
- usually money required up to a year
- day to day expenses
- revenue expenditure
What is medium term finance?
- usually money needed for 1 to 3 years
- for new machinery etc
- capital expenditure
What is long term finance?
- money needed for over 3 years
- usually for major business investments
What are the 2 types of sources of finance?
- internal
- external
What are internal sources of finance?
finance found inside the business
What are external sources of finance?
finance found outside the business
What are internal sources of finance usually used for?
short or medium term finance
- except retained profits, which is medium to long term
What are examples of internal sources of finance?
- sale of assets
- owners’ capital
- sale and leaseback
- retained profits
What is sale of assets?
where a business sells off part of the business or equipment which they no longer want to run or which is unprofitable or outdated
Is sale of assets short, medium or long term?
short/medium term
What are the advantages of sale of assets?
- may be able to sell land or equipment to release the money, and then lease it back off new owner
- saves money
What are the disadvantages of sale of assets?
- can no longer use what was sold
- may have to buy more expensive equipment to replace what was sold
- may take a long time to find buyer and sell asset
What is sale and leaseback?
immediate cash can be acquired by selling off a property the business owns and then renting/leasing it back from the new owner
Is sale and leaseback short, medium or long term?
short/medium term
What are the advantages of sale and leaseback?
- immediate cash
What are the disadvantages of sale and leaseback?
- business no longer has that asset
- the rent may be more than the mortgage of the building
What is owners’ capital?
existing owners of business may invest more money in it from their savings
Is owners’ capital short, medium or long term?
short/medium term
What are the advantages of owners’ capital?
- no need to repay money
- no interest to be paid
What are the disadvantages of owners’ capital?
- owners may not have enough savings
- will need to look at other sources of finance
What are retained profits?
the part of the business’ profit that is reinvested in the business rather than distributed to shareholders
(also known as ploughed-back profit)
Is retained profits short, medium or long term?
medium/long term
What are the advantages of retained profits?
- don’t have to pay interest or dividends on the money = cheaper
- don’t have to look at other sources of finance
What are the disadvantages of retained profits?
- shareholders will expect a certain amount of profit as reward for buying shares, so dividends will have to be paid
- only available to businesses that have made a profit
What are examples of external sources of finance?
- overdraft
- ordinary share capital
- bank loan
- venture capital
- taking on new partner
- crowd funding
- trade credit
- debt factoring
What is an overdraft?
when a bank allows the business to overspend its current account with the bank up to an agreed limit and for a stated period of time
Is an overdraft short, medium or long term?
short term
What are the advantages of an overdraft?
- can meet short term cash flow problems
- used to pay day-to-day expenses
- flexible and so useful for seasonal businesses
What are the disadvantages of an overdraft?
- interest is charged on the daily amount of money that the business owes the bank
- can be expensive
What is ordinary share capital?
- new shares are sold, raising money for the business
- buyers of the shares become shareholders
- the investor can earn a dividend
Is ordinary share capital short, medium or long term?
long term
What are the advantages of ordinary share capital?
- finance raised may be used to fund major business development such as take over, extension
- money doesn’t have to be paid back
- no interest
What are the disadvantages of ordinary share capital?
- dividends may have to be paid on the shares
- shareholders entitled to have a say in the running of the business
- business may be taken over and existing shareholders no longer own the business
What is a bank loan?
- business borrows fixed amount of money from the bank
- pays it back over a period in regular installments
- interest paid on it
- bank may want to take a security (asset it can sell to recover its money)
Is a bank loan short, medium or long term?
medium/long term
What are the advantages of a bank loan?
- repayment is spread over time
- know how much will pay back each month
- helps budgeting
What are the disadvantages of a bank loan?
- interest can be expensive
- bank needs security/collateral, and if fail to pay, can take this in return (car, premises, etc)
What is venture capital (Business Angels)?
- finance provided to small or medium firms that seek growth, but may be considered risky by other lenders or share buyers
Is venture capital short, medium or long term?
medium/long term
What are the advantages of venture capital?
- source of advice and contacts
What are the disadvantages of venture capital?
- give up some ownership of the business
What is trade credit?
- when a business receives goods from a supplier now and can pay up to 30 days later for no extra charge
- gives business time to sell them on before making a payment
- only given to reliable businesses
Is trade credit short, medium or long term?
short term
What are the advantages of trade credit?
- effectively free loan with no interest charges
- increases amount of cash in business which can be used for other things
What are the disadvantages of trade credit?
- still have to pay even if the goods haven’t sold
- interest is charged if credit not paid within the time limit
What is crowd funding?
- money raised from ‘sponsors’
- usually by advertising business idea on crowd fund raising website
Is crowd funding short, medium or long term?
medium/long term
What are the advantages of crowd funding?
- sponsors can donate money, lend money or become part owner of the business
What are the disadvantages of crowd funding?
- profits may need to be shared if equities are sold
What is taking a new partner to raise finance?
- partnerships can obtain additional finance by selling off part of the business to a new partner
- sole traders and partnerships only
Is taking on a new partner short, medium or long term?
long term
What are the advantages of taking a new partner?
- new skills and ideas
- finance the partner beings may be used to buy new equipment or premises or buy another business
What are the disadvantages of taking a new partner?
- new partner will have a say in running of business
- new partner entitles to share of profits
What is debt factoring?
- when a factoring company (usually bank) buys the right to collect the money from credit sales of a business
- selling off debt to a third party
Is debt factoring short, medium or long term?
short term
What are the advantages of debt factoring?
- collecting and chasing up debts can be costly and time consuming
- factoring company specialises in this
- potential for factoring company to get more than one debt from same firm
What are the disadvantages of debt factoring?
- business using the factoring company may lose between 5% and 10% of what it is owed
- debt factoring company needs to be paid
What is an example of how debt factoring works?
- sell debt for £80 instead of £100 to a third party
- the third party gets the money (£100) from the person that owed money
- the third party gains £20, and you lose £20 but don’t have the hassle of chasing the money
