5.2 Analysing financial performance

Question 1

What is a budget?

What is its purpose?

Answer 1

• Its a financial plan - forecasts revenue from sales and expected costs over a period of time.
• Purpose- provide target for entrepreneurs & managers as well as basis for a later assessment of the performance of a business.

Question 2

What are the different types of budgets?

Answer 2

• Income budgets
• Expenditure budgets
• Profit (or loss) budgets

Question 3

What are income budgets & what are they sometimes called?

What will they be based on for newly established businesses?

How do already established businesses provide info for sales forecasts?

Answer 3

• The forecasted earnings from sales and are sometimes called “Sales budgets”
• Results from market research.
• Call upon past trading records to provide information.

Question 4

What are Expenditure budgets?

Answer 4

Set out expected spending of a business (costs or production budget) - broken down into a number of categories, the title given to the category will depend on the type of business.

• Can include: labour, fuel costs, raw materials and any other items essential for the production process.

Question 5

What are profit (or loss) budgets and what do they include?

Answer 5

• They are calculated by subtracting forcast expenditure (costs) from forecast sales income (revenue).
• Depending on the balance between expenditure and income, a loss or a profit may be forecast.

(It is extremely important information for stakeholders!)

Question 6

Why do businesses set budgets?

Answer 6

• Essential - business plan. Bank -unlikely to grant loan without evidence of this form of financial planning.
• Help decide whether to go ahead with a business idea. (If budget shows significant loss in first year of trading, with little improvement, business idea may be abandoned.)
• Help-pricing decisions. If large loss forecast, business may decide to adjust price to improve the business’s financial prospects.

Question 7

What are the advantages of budgeting?

(6)

Answer 7

• Targets can be set out for each part of business- allows managers to identify the extent to which each part contributes to business performance.
• Inefficiency & waste can be identified so appropriate remedial action can be taken.
• Make managers think about financial implications of their actions & focus decision-making on the achievement of objectives.
• Improve financial control by preventing overspending.
• Help improve internal communication.
• Delegated/ devolved budgets- used as a motivator by giving employees authority/ opportunity to fulfil some of their higher-level needs (Maslows hierachy). At same time- senior managers can retain control of business by monitoring budgets!

Question 8

What are the disadvantages of budgets?

Answer 8

• Can lead to inflexibility in decision making.
• Need to be accurate to have meaning. Setting unrealistic targets adds to demotivation of staff and wastes resources used to prepare budgets.
• Need to be changed as circumstances change.
• Time consuming process.
• Demotivating if they are imposed rather than negotiated.
• If employees are delegated responsibility then they will need to be trained, which could be costly.

Question 9

What are payables? (trade creditors)

Answer 9

Money owed for goods and services that have been purchased on credit.

Question 10

What are recievables?

Answer 10

Money owed by a businesses customers for goods or services purchased on credit. (they need to pay the business)

Question 11

What is contribution and how is it calculated?

Answer 11

• Contribution- the difference between sales revenue and variable costs.

C= sales revenue- variable costs

OR per unit

C= sales price per unit- variable cost per unit

Question 12

What is the calculation for total contribution?

Answer 12

Total contribution = unit contribution x output

Question 13

What is the calculation for break even?

What does this tell us?

Answer 13

BE= Fixed costs/ contribution per unit.

It tells us the number of units that need to be sold to break even.

Question 14

How can profit be calculated?

Answer 14

profit = contribution total- fixed costs.

Question 15

What is a profit margin?

Answer 15

It compares a businesses profit to its sales revenue expressed as a percentage.

Question 16

How do you work out Gross profit margin?

Answer 16

GPM= (Gross profit/ sales revenue) x 100

Question 17

How do you calculate operating profit margin?

Answer 17

OPM= (operating profit/ sales revenue) x 100

Question 18

How do you calculate profit for the year margin?

Answer 18

PFTY= (profit for the year/ sales revenue) x 100

Question 19

What will the analysis of the relationship between payables and receivables enable a business to do?

(5)

Answer 19

• Forecast periods of time when cash outflows might exceed cash inflows and take action (e.g. arrange a loan) to avoid business being unable to pay bills on time.
• Plan when & how to finance major items of expenditure (e.g. vehicles/machinery) which may lead to large outflows of cash.
• Highlight any periods when cash surpluses, that could be used elswhere, may exist.
• Assess whether an idea will generate enough cash to be worthwhile putting into action.
• Give evidence to lenders, e.g. banks that any loans given can and will be paid.

Question 20

What are the benefits of break even analysis?

(4)

Answer 20

Starting a new business- Can estimate level of sales required before would start to make profit. From this- can see whether or not the business proposal is viable.

Supporting loan applications: Business- unlikely to succeed in negotiating a loan with a bank unless it has carried out a range of financial planning- including BEA.

Measuring profit and losses: In diagrammatic form, BEA enables businesses to tell at a glance what their estimated level of profit or loss would be at any level of output and sales.

Modelling what if scenarios: BEA enables businesses to model what will happen to their level of profit if they change prices or are faced by changes in costs.

Question 21

How do you calculate the return on an investment?

Answer 21

(Return on investment(or profit) / capital invested) x 100

Question 22

What is variance analysis?

Answer 22

The study by managers of the differences between planned activities in the form of budgets and the actual results that were achieved.

Question 23

What is a positive (or favourable) variance?

Answer 23

It occurs when costs are lower than forecast or profit or revenues higher, as in the case of sales revenue and profits.

Question 24

What is a negative (or adverse) variance?

Answer 24

It arises when costs are higher than expected or revenues are less than anticipated.

Question 25

Why may positive variances occur?

Answer 25

Due to good budgetary control or by accident e.g. due to rising market prices.

Question 26

What are the difficulties of setting up budgets?

Answer 26

• No historical evidence available to business- particularly new business/ existing business entering new market. Will be no trading records- showing the level of sales income/ costs/ how the figures fluctuated throughout the year.
• Forecasting costs can be problematic- business may lack experience to estimate costs such as raw materials/ wages.
• Competitors may respond to the actions of a business by cutting prices/ promoting products heavily. This can affect sales income and a business may receive less income than forecast. As a result, expenditure on promotion may have to increase- so increasing costs.

Question 27

What are possible responses to positive variances?

Answer 27

• To increase production if prices are rising, giving increased profit margins.
• To reduce prices if costs are below expectations and the business aims to increase its sales.
• To reinvest into the business or pay shareholders higher dividends if profits exceed expectations.

Question 28

Why may negative variances occur?

Answer 28

Inadequate control or factors outside the firms control- such as rising raw material costs.

Question 29

What are possible responses to negative variances?

Answer 29

• To reduce costs (e.g. buying less expensive materials)
• To increase advertising in order to increase sales of the product and revenues.
• To reduce prices to increase sales. (Relies on demand being price elastic)

Question 30

When does a variance arise?

Answer 30

When there is a difference between actual and budget figures.

Question 31

What are the two types of variances?

Answer 31

Favourable ( positive- better than expected)

Adverse (Negative- worse than expected)

Question 32

Why may you get a favourable variance?

Answer 32

Costs were lower than expected in the budget.

Revenue/ profits were higher than expected.

Question 33

Why may an adverse variance arise?

Answer 33

• Costs were higher than expected.
• Revenue/ profits were lower than expected.

Question 34

Are all adverse variances always bad? Explain your answer using an example!

Answer 34

No!
An adverse variance might result from something that is good that has happened in the business.

E.g. A budget statement might show higher production costs than budget (adverse variance). However, these may have occured because sales are significantly higher than budget ( favourable budget).

Question 35

What three sections does a cash flow forecast comprise of? What do they include?

Answer 35

• Receipts: In which the expected total month-by- month receipts are recorded.
• Payments: In which the expected monthly expenditure by 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. These are termed “opening” and “closing” balances. The closing balance at the end of the month becomes the opening balance of the next month.

Question 36

What happens to the closing balance at the end of one month?

Answer 36

It becomes the opening balance at the start of the next month.

Question 37

What are the drawbacks of BE analysis?

Answer 37

• No Costs are truly fixed! (A stepped fixed cost line would be a better representation, fixed costs are likely to increase in the long term & at higher levels of output if more production capacity is required.
• The total cost line shouldn’t be represented by a straight line as it doesn’t take into account the discounts available for bulk buying.
• Sales revenue assumes that all output produced is sold and at a uniform price- which is unrealistic.
• The analysis is only as good as the information provided. Collecting accurate information is expensive and in many cases the cost of collection would outweigh any benefit that the BEA could provide.