3.5.2 Analysing financial performance

Question 1

What are budgets?

Answer 1

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

Question 2

What are types of budgeting?

Answer 2

• Income (or revenue)
• Expenditure (or cost)
• Profit

Question 3

Explain income budgeting

Answer 3

Expected revenues
Broken down into more detail

Question 4

Explain expenditure budgeting

Answer 4

Expected variable costs based on sales budget
Expected fixed costs

Question 5

Explain profit budgeting

Answer 5

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

Question 6

What does cash flow forecasting involve?

Answer 6

• The opening balance – this is cash balance at the start of the month
• The net cash flow – this is added to the opening balance to get the closing balance
• The closing balance – this will become the opening balance for the next month

Question 7

What is the process of setting budgets?

Answer 7

• Setting objectives
• Market research
• Complete income budget
• Complete expenditure budget
• Complete profit budget
• Complete departmental budget
• Summarise in master budget

Question 8

Give reasons as to why a business uses budgeting.

Answer 8

• Control income and expenditure (the traditional use)
• Establish priorities and set targets in numerical terms
• Provide direction and co-ordination, 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 9

What are advantages of budgeting?

Answer 9

• 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 10

What are disadvantages of budgeting?

Answer 10

• Budgets are only as good as the data being used to create them - in accurate 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 11

What is variance analysis?

Answer 11

this compares the expected budget to the actual figures (the difference found)
This can be positive (favourable – meaning costs are lower than expected or revenue is higher) or negative (adverse – meaning costs are higher than expected or revenue is lower)

Question 12

What are evaluative points of variance that a business should consider?

Answer 12

• Whether is it positive or negative
• Was is 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 13

What is break-even?

Answer 13

a business will break-even when it’s total revenue equals its total costs
= fixed costs / contribution per unit

Question 14

What does a break even chart look like?

Answer 14

Question 15

What is contribution?

Answer 15

this looks at whether an individual product is making a profit and only accounts for variable costs – if sales revenue is higher than costs, it shows that the product is contributing to overall profits
= selling price per unit – variable cost per unit

Question 16

What is margin of safety?

Answer 16

this is the difference between the actual output and the break-even output

Question 17

What are advantages of breakeven analysis?

Answer 17

• Focuses entrepreneur on how long it will take before a start-up reaches profitability – i.e. what output or total sales is required
• Helps entrepreneur understand the viability of a business proposition, and also those who will lend money to, or invest in the business
• Margin of safety calculation shows how much a sales forecast can prove over-optimistic before losses are incurred
• Helps entrepreneur understand the level of risk involved in a start-up
• Illustrates the importance of a start-up keeping fixed costs down to a minimum (higher fixed costs = higher break-even output)
• Calculations are quick and easy – great for giving quick estimates

Question 18

What are disadvantages of breakeven analysis?

Answer 18

• Unrealistic assumptions – products are not sold at the same price at different levels of output; fixed costs do vary when output changes
• Sales are unlikely to be the same as output – there may be some build up of stocks or wasted output too
• Variable costs do not always stay the same (e.g. as output rises, the business may benefit from being able to buy inputs at lower prices (buying power), which would reduce variable cost per unit)
• Most businesses sell more than one product, so break-even becomes harder to calculate
• Break-even analysis should be seen as a planning aid rather than a decision-making tool

Question 19

What is profitability?

Answer 19

the firms ability to make a profit through selling goods and services

Question 20

What are ways of calculating and measuring profitability?

Answer 20

Gross profit margin
Operating profit margin
Profit for the year margin