3.5 Decision making to improve Financial performance

Question 1

Financial Objective

Answer 1

A specific goal or target relating to financial performance

Question 2

What financial objectives can be based on:

Answer 2

Revenue
Costs
Profit
Cash flow
Investment levels
Capital structure
Return on investment
Debt as a proportion of long-term funding

Question 3

Return on Investment (ROI)

Answer 3

This is the measure of the efficiency of an investment in financial terms, used to compare the financial returns of alternative investments

= return on investment/cost of investment x 100

(ROI=financial gains from the investment – the cost of investments)

Question 4

Profit

Answer 4

revenue – total costs

Question 5

Profitability

Answer 5

The firm’s ability to make a profit through selling goods and services

more sold=more profitable

Question 6

Ways of calculating and measuring profitability:

Answer 6

Gross profit margin

Operating profit margin

Profit for the year margin

Question 7

Internal influences on financial objectives

Answer 7

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 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

Question 8

External influences on financial objectives

Answer 8

Economic conditions – economic downturns can force many firms to reappraise their financial objectives in favour of cost minimisation so they can maximise their cash inflows and balances. Significant changes in interest rates and exchange rates also have the potential to threaten the achievement of financial targets like ROCE.

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 – this is 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)

Question 9

Cash Flow

Answer 9

The money flowing in and out of the business on a day-to-day basis

Question 10

Net Cash Flow

Answer 10

This is the money left over when a business takes its outflows from its inflows

Question 11

Main cash inflows:

Answer 11

Money invested by business owners

Loan from the bank

Income from sales

Question 12

Main cash outflows:

Answer 12

Wages and training

Raw materials

Advertising

Rent, mortgage, and bills

Taxes

Interest on loans

Maintenance and repair

Question 13

Why cash flow is important:

Answer 13

It can be used to support an application for sources of finance

If a business does not have enough cash available to pay its bills it could fail

A business that is not able to pay its suppliers will probably not receive any more supplies

It may be unable to pay its workers, which will at the very least cause demotivation, and encourage them to leave, at worst

It is the main cause of failure of small businesses

The principle of timing, managing when money flows in and when it flows out is vital

Question 14

Advantages of cash flow forecasts:

Answer 14

identify problems in advance

Guide to appropriate action

Make sure there is sufficient cash to make payments

Evidence for financial support

Avoids failure

Identifies if they are holding too much cash

Question 15

Causes of cash flow problems:

Answer 15

Poor management (spending too much)

If the business isn’t performing well – the outflows are greater than inflows

Offering customers too long to pay – slow cash inflow compared to outflow

Question 16

Problems with cash flow forecasting:

Answer 16

Changes in the economy

Changes in consumer taste

Inaccurate market research

Competition

Uncertainty

Question 17

Capital Structure

Answer 17

Finance in terms of how much is equity (or share capital) and how much there is in the form of debt

Question 18

Capital structure objectives:

Answer 18

Gearing ratio (the percentage of total business finance that is provided by debt)

Debt/equity ratio (the proportion of business finance provided by debt and equity)

Question 19

Budgets

Answer 19

These are set by businesses so that they have a future financial target/plan

Question 20

Types of budgeting:

Answer 20

Income (or revenue)

Expected revenues
Broken down into more detail

Expenditure (or cost)

Expected variable costs based on sales budget
Expected fixed costs

Profit

Based on the combined sales and cost budgets
May form the basis for performance bonuses

Question 21

Why a business uses budgeting:

Answer 21

Control income and expenditure (the traditional use)
Establish priorities and set targets in numerical terms
Provide direction and coordination, so that business objectives can be turned into practical reality
Assign responsibilities to budget holders (managers) and allocate resources
Communicate targets from management to employees
Motivate staff
Improve efficiency
Monitor performance

Question 22

Advantages of budgeting:

Answer 22

Helps firms to get financial support through investors
Ensures a business doesn’t overspend
Establishes priorities and sets targets in numerical terms
Motivates staff
Assigns responsibility to departments
Improves efficiency

Question 23

Disadvantages of budgeting:

Answer 23

Budgets are only as good as the data being used to create them - inaccurate and unrealistic assumptions can quickly make a budget unrealistic
They need to be changed as circumstances change
It is a time-consuming process
Unexpected costs may arise
May have difficulties in collecting information needed to create a forecast
Managers may not have enough experience to budget
Inflation (external change that the business has no control over)

Question 24

Variance analysis

Answer 24

This compares the expected budget to the actual figures (the difference found)

This can be positive (favorable – meaning costs are lower than expected or revenue is higher) or negative (adverse – meaning costs are higher than expected or revenue is lower)

Question 25

Evaluative points of variance:

Answer 25

Whether is it positive or negative

Was it foreseen and foreseeable

How big was the variance

The cause

Whether it is a temporary problem or the result of a long-term trend

Question 26

Break-Even

Answer 26

A business will break-even when its total revenue equals its total costs

= fixed costs/contribution per unit

Question 27

Advantages of break-even analysis:

Answer 27

Shows how many items need to be sold to make a profit for the business
Useful tools to set targets
Identifies the fixed and variable cost
Calculate the profit or loss at different levels of output

Question 28

Disadvantages of break-even analysis:

Answer 28

Information can be reliable (less knowledge)
Assumes that the costs and revenue don’t change with output
Target set may be too high, creating stress

Question 29

Methods of improving cash flow

Answer 29

Cut costs

Use an overdraft

New source of cash inflows

Reschedule payments

Question 30

Causes of poor cash flow

Answer 30

Poor management
The business is making a loss
Offering customers too long to pay
Over-optimistic forecasting

Question 31

Methods of improving profitability

Answer 31

Increase the quantity sold (higher sales volume)

Increase the selling price (higher price per unit sold)

Reduce variable costs per unit

Increase output

Reduce fixed costs

Question 32

Debt factoring

Answer 32

An external, short-term source of finance for a business.

With debt factoring, a business can raise cash by selling its outstanding sales invoices (receivables) to a third party (a factoring company) at a discount.

Question 33

Bank overdrafts

Answer 33

A common external and short-term source of finance for a business.

Question 34

Bank Loans

Answer 34

A bank loan is a long-term source of finance.

It is a fixed amount of money that is given to a business by the bank that has to be repaid over time with interest, usually in monthly installments.

Question 35

Retained Profits

Answer 35

These are profits that the owners put back into the business. There is no interest to be repaid and no loss of control.

Question 36

Share capital

Answer 36

The money invested in a company by the shareholders. Share capital is a long-term source of finance. In return for their investment, shareholders gain a share of the ownership of the company.

Question 37

Venture capital

Answer 37

Money invested in a business, usually a start-up, that is seen as having strong growth potential.

Question 38

Payables

Answer 38

People or organisations that a business owes.

Question 39

Receivables

Answer 39

The money a company’s customers owe for goods or services they have received but not yet paid for.

Question 40

Gross Profit

Answer 40

This shows how efficiently a business converts raw materials into finished goods and how much value they add

= revenue – cost of sales

Question 41

Operating profit

Answer 41

gross profit – expenses