3.5.2 Analysing financial performance

Question 1

What is a budget and what is budgeting?

Answer 1

• Budget: A financial plan for the future concerning the revenues and costs of a business
• Budgeting: The process involved in setting a budget

Question 2

What are the three types of budget?

Answer 2

• Income budget
• Expenditure budget
• Profit budget

Question 3

What is profit budget, income budget and expenditure budget?

Answer 3

• Profit budget: Shows the agreed, planned profit of a business (or division of a business) over a period of time
• Income budget: Shows the agreed, planned income of a business (or division of a business) over a period of time. it may be also be described as a revenue budget or sales budget.
• Expenditure budget: Shows the agreed, planned expenditure of a business over a period of time

Question 4

What is contribution ?

Answer 4

• Contribution looks at the profit made on individual products
• It is used in calculating how many items need to be sold to cover all the business’ total costs (variable and fixed)
• Contribution is the difference between sales and variable costs of production

Question 5

How do you construct a budget? (1)

Answer 5

1. Set objectives
2. Carry out market research
3. Carry out research into costs
4. Complete the sales (income budget)

Question 6

How do you construct a budget? (2)

Answer 6

5. Construct expenditure budget
6. Construct overall profit
7. Draw up divisional or departmental budgets
8. Summarise the detailed budgets in the master budget

Question 7

What is variance analysis?

Answer 7

Calculating and investigating the differences between actual results and the budget

Question 8

What is a favourable variance and adverse variance?

Answer 8

• Favourable variance: When costs are lower than expected or revenue is higher than expected
• Adverse variance:When costs are higher than expected or revenue is lower than expected

Question 9

What are some possible Causes of Favourable Variances?

Answer 9

• Competitor weakness leading to higher sales
• Better than expected productivity or efficiency
• Selling prices increased higher than budget

Question 10

What are Possible Causes of Adverse Variances?

Answer 10

• Unexpected events lead to un-budgeted costs
• Over-spends by budget holders
• Sales forecasts prove over-optimistic

Question 11

What is a point to remember about adverse variances?

Answer 11

• An adverse variance might result from something that is good that has happened in the business…
• E.g. higher production costs than budget (adverse variance) that occur because sales are significantly higher than budget (favourable budget)

Question 12

What are reasons for budgeting?

Answer 12

• To gain financial support
• To improve efficiency
• To encourage delegation and responsibility and to motivate staff

Question 13

What are some of limitations of budgets?

Answer 13

• Are only as good as the data being used
• Need to be changed as circumstances change
• Can lead to inflexibility in decision-making

Question 14

What are the strengths of break-even analysis?

Answer 14

• Calculations are quick and easy
• Focuses on what output is required before a business reaches profitability
• Illustrates the importance of keeping fixed costs down to a minimum

Question 15

What are the limitations of break-even analysis?

Answer 15

• Unrealistic assumptions - products are not sold at the same price at different levels of output; fixed costs do vary when output changes
• Most businesses sell more than one product
• A planning aid rather than a decision-making tool

Question 16

What is profitability?

Answer 16

The ability of a business to generate profit or the efficiency of a business in generating profit

Question 17

What is the gross profit margin?

Answer 17

• This measures gross profit as a percentage of sales (turnover)
• This ratio measures how efficiently the business is transforming raw materials into products

Question 18

What is operating profit margin?

Answer 18

This measures operating profit as a percentage of sales (turnover). This ratio measures how efficiently the business is making a profit from the resources that it’s using for its trading activities

Question 19

What is profit for the year margin or profit of the year as a percentage of sales?

Answer 19

• This measures the profit that is available for shareholders, as a percentage of sales (turnover)
• This ratio measures how much the shareholders may benefit directly from the financial performance of the business

Question 20

What are the types of cash inflows and outflows?

Answer 20

Inflows:

• Cash sales
• Interest on bank balances
• Loans from bank
• Grants

Outflows:

• Payments to suppliers
• Dividends paid to shareholders
• Wages and salaries

Question 21

What are the main benefits of cash flow forecasting?

Answer 21

• Identifying potential cash flow problems in advance
• Guiding the firm towards appropriate action
• Identifying the possibility of holding too much cash

Question 22

What are the problems with cash flow forecasting?

Answer 22

Sales prove lower than expected:

• Easy to be over-optimistic about sales potential
• Market research may have gaps

Customers do not pay up on time:
- A notorious problem for businesses, particularly small ones

Imprudent cost assumptions:

• A common problem for a start-up
• Unexpected costs always arise - often significant

Question 23

What is cash flow management?

Answer 23

Cash flow management is a crucial day-to-day activity for every business

Question 24

How to manage cash flow problems?

Answer 24

• Make and action reliable cash flow forecasting
• Manage working capital effectively; credit control from trade debtors
• Choose the right sources of finance