Unit 5

Question 1

What is a financial objective?

Answer 1

A specific goal or target relating to the financial performance, resources and structure of a business.

Question 2

What do financial objectives link closely with?

Answer 2

• Corporate objectives
• Marketing objectives
• Operations objectives
• Budgeting
• Shares and shareholders
• Decision making

Question 3

Key benefits of using financial objectives

Answer 3

• Focus for decision making.
• Specific and measurable way of assessing the success and failure of a business.
• Provides clear targets for managers to achieve.
• Improve coordination - give departments a common purpose.
• Shareholders - can assess if a business is a worthwhile investment.
• Outside organisations - suppliers and customers - can confirm the financial viability of a business.
• Improve efficiency - by examining the reasons for success and failure.

Question 4

Key limitations of using financial objectives

Answer 4

• Difficult to set realistic objectives - eg. for new activities.
• External factors beyond your control - PESTLE e.g. competition.
• Difficult to measure accurately.
• Reasons for success or failure may be impossible to determine.
• Responsibility for achievement - may rest with the financial department, but the actual performance will be dependent on the performance of all departments.
• May conflict with other objectives, both financial and non-financial.

Question 5

What are the key financial objectives?

Answer 5

• Profit objectives (revenue objective and costs objectives)
• Cash flow objective
• Return on investment objective

Question 6

What are profit objectives?

Answer 6

Targets for the surplus of revenue over costs.
- Profit objectives can be satisficing or maximisation.
- Making a profit is the aim of the majority of businesses in private sector.
- Businesses may set specific objective for profit - may be a particular figure/percentage increase, or may be set in terms of a profit margin.
- Profit maximisation sometimes mentioned, but is difficult to judge whether it’s actually been achieved, and a business making unreasonably high profit can be the subject of a great deal of criticism, as is the case with some utility companies.

Question 7

What are revenue objectives?

Answer 7

Targets set for the amount of money coming into a business from sales.
- Revenue objectives look at maximising revenue and creating as many sales as possible (market share).
- A knowledge of the likely revenue of a business is essential - starting point for creating a budget.
- The objective set might depend on the type of market a business is operating in and the state of economy.
- In addition, any objective set would have to be coordinated with other functional areas, e.g. marketing and operations.

Question 8

What are cost objectives?

Answer 8

Limits set on the amount of money leaving the business.
- Cost objectives are about minimising costs either variable or fixed.
- Businesses operate in a highly competitive environment and as a result face increasing pressure on costs. Cost minimisation has therefore become important objective (achieving lowest possible unit costs of production).
- As an alternative to cost minimisation, a business might set an objective of reducing costs by a certain percentage or target a specific area of the business that is seen to be underperforming.

Question 9

What are the different types of profit?

Answer 9

• Gross profit
• Operating profit
• Profit for the year

Question 10

What is gross profit? + how is it calculated

Answer 10

The difference between a business’ sales revenue and the direct costs of production such as materials and direct labour.

Gross profit = revenue - variable costs (VC also called cost of sales)

Question 11

What is operating profit? + how is it calculated

Answer 11

The difference between the gross profit and the indirect costs of production or expenses such as marketing and salaries (revenue minus both the direct and indirect costs of production).

Operating profit = sales revenue - all costs of production

or

Operating profit = gross profit - fixed/indirect costs (also called expenses)

Question 12

What is profit for the year (net profit)? + how is it calculated

Answer 12

The figure for operating profit does not include other expenditure such as interest payments or tax to be paid or other income such as interest received or money received from the sale of assets, which profit for the year does.

Profit for the year = operating profit - other expenses and tax + any other income

• These costs are not linked from the usual activity of the business and this income isn’t coming from the usual activity of the business, e.g. it could have come from the sale of a building or some interest received.

Question 13

What is cash flow?

Answer 13

The difference between the actual amount of money a business receives (inflows) and the actual amount it pays out (outflows) over a period of time.

Question 14

What are cash flow objectives?

Answer 14

Targets set for the amount of and timings of cash inflows and outflows to ensure that the business has enough cash to pay day-to-day expenses.
- Businesses may set cash flow objectives to increase liquidity to avoid insolvency (unable to pay debts).

Question 15

What is the importance of cash flow objectives?

Answer 15

Although it is possible to survive as a business in the short to medium term while making a loss, it is impossible to survive for long without cash to make immediate payments. It is therefore vital that a business manages its cash flow carefully by setting objectives.

Question 16

What is liquidity?

Answer 16

A measure of how much cash a business has to pay for its day-to-day expenses.

Question 17

Examples of cash flow objectives

Answer 17

• Reduce borrowings to target level.
• Minimise interest costs.
• Reduces amounts held in inventories.
• Reduce amounts owed by customers to improve cash flow.
• Reduce seasonal swings in cash flow.
• Increase supplier payment terms.
• Targets for monthly closing balances.

Question 18

What types of businesses may find it more difficult to control their cash flow?

Answer 18

• A business with a fluctuating demand, e.g. some months of the year demand high but in other months may be low, or a business that doesn’t operate all year round (seasonal business).
• A business that supplies a product or service that takes a very long time to produce or sell, e.g. construction.
• A business that invoices its customers (customers do not have to pay when they place an order) or a business that allows its customers trade credit (from 30 to 90 days).
• A start up business.

Question 19

Pros of having a positive cash flow

Answer 19

• Pay suppliers on time
• Pay employees on time
• Ability to handle unforeseen events
• Take advantage of opportunities
• Means to expand business

Question 20

How to calculate net cash flow

Answer 20

Cash inflows minus cash outflows

(This is the money left in the business’ account)

Question 21

Why is cash flow vital in the short term and profit vital in the long term?

Answer 21

CASH is important in the short run as it is needed to pay creditors and workers.
- Without sufficient cash, creditors (in extreme cases) can take you to court and declare you bankrupt or insolvent in the case of companies.
- Workers who will not be paid on time will be demotivated, resulting in poor productivity, high absenteeism (absences) and labour turnover.

PROFITS are essential for the long term survival of the business, otherwise no institution would be interested to invest in a business which gives them low return on their capital investment.

Question 22

What are some of the reasons cash flow and profit differ due to timing?

Answer 22

1) Credit sales is immediate revenue but not inflow. Credit purchases is an immediate cost but not outflow.
2) Buying fixed assets is an outflow but not a cost. Depreciation is a cost but not outflow.
3) Bank loans are long term costs but immediate inflows.

Question 23

What is capital expenditure?

Answer 23

The money spent on fixed assets such as buildings and equipment and represents long-term investment into the business.

Question 24

What are examples of things that businesses invest capital expenditure on?

Answer 24

• Machinery
• New staff
• Existing staff
• New product
• Existing product
• Advertising campaign
• Other businesses
• Stocks and shares
• Bank account

Question 25

When will investment occur in a business?

Answer 25

- When a business first sets up - As a business grows and develops

Question 26

What will objectives for investment depend on?

Answer 26

- The overall corporate objectives, e.g. growth. - The type of business. - The state of the economy. - The market in which the business is operating.

Question 27

What is meant by return on investment?

Answer 27

Measures the profit made as a % of the initial investment.

Question 28

How to calculate return on investment?

Answer 28

ROI = (profit made from investment) / cost of investment) x 100

Question 29

What is a return on investment objective?

Answer 29

A target for the minimum acceptable return on an investment, measured as operating profit as a percentage of the investment, e.g. 10% return. - This formula could also be used when a business is deciding between two different investments. With this type of decision however it is important to remember that any returns (profit) will only be forecasts, and any predictions made may be influenced by a manager's own bias towards a particular investment.

Question 30

Why do we need ROI?

Answer 30

- Measuring tool (predictions) - is the investment worth it? - Measuring tool (actual) - was it worth it?

Question 31

What is the value of setting financial objectives?

Answer 31

Setting financial objectives is key as it enables to: - measure how well a business is doing financially (profit measure) and to compare the performance over time/years (look at the trend) - identify potential areas where the business could improve (gross profit, operating profit or net profit) - control spending (cost targets) - provide sales targets - prevent a business running out of cash (cash flow target) - measure the reward that shareholders receive from their investment or set expectations when making an investment (ROI) - help limit the risk of long-term debts (gearing ratio target) - help support loan application from banks or funding request from investors

Question 32

What is a budget?

Answer 32

A financial plan for the future, anticipating the revenues, costs and profit of a business. - Shows 'forecasted' or 'budgeted' figures.

Question 33

What are the reasons for setting budgets?

Answer 33

- To support bank loan application or share issue. - For financial control - avoid overspending or waste. - For decision making - identifying underperforming areas and decide what to do or change. - To help forward planning. - To provide targets for staff - basis for rewards. - To assign responsibility - budget holders are accountable for performance.

Question 34

How can a budget be analysed?

Answer 34

Analysing a budget means calculating and investigating the discrepancies (differences) between actual results and the budgeted figures. - Variance analysis.

Question 35

Define variance

Answer 35

A variance means a difference. In business it means the difference between a budgeted figure and an actual figure. Variance = budgeted figure - actual figure

Question 36

What is variance analysis?

Answer 36

The process of looking at the variances within a budget and trying to understand the reasons why these differences have occurred.

Question 37

What is a favourable variance?

Answer 37

A positive (or favourable) variance means that the difference between the budgeted and the actual figure has a positive impact on the finances of the business. - When costs are lower than forecasted. - When profit or revenues are higher than forecasted.

Question 38

What is an adverse variance?

Answer 38

A negative (or adverse) variance means that the difference between the budgeted and the actual figure has a negative impact on the finance of the business. - When costs are higher than expected. - When profit or revenues are lower than forecasted.

Question 39

How might an adverse variance occur from something good that has happened in the business?

Answer 39

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) due to sales being significantly higher than budgeted (favourable variance).

Question 40

How can a business respond to adverse sales variances?

Answer 40

- Increase promotions. - Change distribution (instead of selling through retailers only, sell online). - Withdraw the product if it is clear that there is no longer a sufficient demand for it and all improvement have been exhausted. - Reduce the price (only if PED > -1 so price elastic). - Look for new segments or new geographical markets to sell the product. - Improve the product (product life cycle extension). - Train staff to improve customer service.

Question 41

How can a business respond to adverse cost variances?

Answer 41

- Find cheaper suppliers. - Change production method to reduce unit cost. - Invest in automation and replace staff with machines or robotics to reduce staff costs and reduce unit cost (more capital intensive). - Invest in better machinery to reduce unit cost. - Increase size of orders to benefit from purchasing economies of scale (bulk order discount). - Find cheaper premises.

Question 42

How can a business respond to favourable variances?

Answer 42

- Increase production or re-stock to meet higher than expected demand or increase the price as demand is stronger than expected and benefit from higher profit margins. - Reduce price of product/service if costs are below expectations (business can pass on reduction in costs to its customers), which may increase sales. - Reinvest into the business or pay shareholders a higher dividend if profits exceed expectations.

Question 43

How might an favourable variance occur from something bad that has happened in the business?

Answer 43

A favourable production material variance could be generated from using lower-quality raw materials, which in turn could manifest itself a drop in sales.

Question 44

Pros of budgeting

Answer 44

- Gives senior and functional managers spending guidance which encourages spending disciplines. - Helps support a business if they are looking to obtain finance and increases the chances of them obtaining finance. - Targets can be set for each part of a business, allowing managers to identify the extent to which each part contributes to the business' performance. - Inefficiency and waste can be identified, so that appropriate remedial action can be taken. - Budgeting should improve financial control by preventing overspending. - Can help improve internal communication. - Delegated or devolved budgets can be used as a motivator by giving employees authority and the opportunity to fulfil some of their higher-level needs, as identified by Maslow.

Question 45

Cons of budgeting

Answer 45

- If a senior manager sets a budget but doesn't have expertise in a specific area, it could lead to over-ambitious targets and demotivation. - Historical or amended budgets are based on previous years which may encourage the 'use it or lose it' mentality which will lead to waste. - If budgets are not frequently reviewed it could lead to budgetary slack. - Middle management may over-estimate costs. - The operation of budgets can become inflexible. E.g. sales may be lost if the marketing budget does not change when competitors implement major promotional campaigns.

Question 46

What are incomes budgets?

Answer 46

The forecasted earnings from sales and are sometimes called 'sales budgets'. - For a newly established business, they will be based on the results of market research. - Established businesses can also call upon past trading records to provide information for sales forecasts. - Income budgets are normally drawn up for the next financial year on a monthly basis.

Question 47

What are expenditure budgets?

Answer 47

An expenditure budget sets out the expected spending of a business, broken down into a number of categories. The titles given to these categories will depend on the type of business. - A manufacturing business will have sections entitled 'raw materials' or 'components', whereas a service business may not.

Question 48

What are profit (or loss) budgets?

Answer 48

Profit and loss budgets are calculated by subtracting forecast expenditure (or costs) from forecast sales income. - Depending on the balance between expenditure and income, a loss or a profit may be forecast. - It is not unusual for a new business to forecast (and actually make) a loss during its first period of trading.

Question 49

What is the process of setting budgets?

Answer 49

Stage 1: Prepare income budgets - Market research - Trading records (for established businesses) Stage 2: Construct expenditure budgets - Use income budget as a guide - Potential suppliers may offer information on costs Stage 3: Forecast profit or (loss) by comparison of income and expenditure

Question 50

Internal influences on financial objectives and decisions

Answer 50

Corporate objectives: - Any financial targets need to be linked to the overall corporate objectives. - E.g. an objective of growth might lead to improved financial performance in the long term, but in the short term might lead to a decline in performance as more money is used to finance growth. Resources available: - The ability to achieve financial targets may be limited by the resources available, such as the availability of skilled labour and the money available to finance the targets set. Operational factors: - The ability to achieve financial targets will be limited in the short term by the physical capacity of a business.

Question 51

External influences on financial objectives and decisions

Answer 51

Competitor actions: - May be due to competitors launching a new marketing campaign, price cuts or the development of new products or services. Market forces: - Markets and fashion change over time and, unless a business can lead or keep up with changes, financial targets may be missed. - E.g. shopping habits have changed with the growth of online shopping, and these changes have had an impact on high streets, with the closure of many retail outlets. Economic factors: - Changes in economy, such as the 2008 recession, are likely to result in financial targets being missed, whereas increasing growth may lead to better performance. - Changes in interest rates can also impact on performance, illustrating the need for all businesses to review targets in the light of any changes in economy. Political factors: - Change of government and legislation can also have an impact. - E.g. an increase in the minimum wage or the introduction of new health and safety legislation will incur additional costs which, if not passed on to the consumer, will impact financial targets. Technology: - Changes in technology may have various impacts, such as facilitating quicker and easier monitoring of financial data. - Introduction of technology, which may in the long term, lead to greater efficiency and improved performance, is likely to have a significant cost in the short term.

Question 52

What is a cash flow forecast?

Answer 52

A cash flow forecast is a plan or budget for future cash inflows, cash outflows and net cash flows over a period of time.

Question 53

What are the three sections of a cash flow forecast?

Answer 53

- Receipts (revenue) or cash inflow in which the expected total month-by-month receipts are recorded. - Payments (expenses) or cash outflow 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 balances' and 'closing balances'.

Question 54

What are the golden rules of cash flow forecasts?

Answer 54

- Money is only recorded when cash changes hands. - It tells us nothing about profit - a profitable business can have poor cash flow, and still go bankrupt. - The closing balance of one month is the opening balance of another month. - A negative closing balance does not mean that the firm is bankrupt. - Net cash flow + opening balance = closing balance - () signs means negative cash

Question 55

What are the values of a cash flow forecast?

Answer 55

- To highlight when a business will be short of cash, e.g. May, June? - To highlight by how much the business will be short of cash, e.g. £500 or £5m? - To anticipate issues with cash flow and take action, e.g. ask for overdraft or loan? - To see if timings could be changed, e.g. delay a purchase or ask to spread out repayments. - To avoid running out of cash and liquidation. - To manage extra cash, e.g. invest it or expand.

Question 56

Limitations of cash flow forecasts: what types of issues can happen?

Answer 56

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. Costs prove higher than expected: - Perhaps because purchase prices turnout higher. - Maybe also because the business is inefficient. - A common problem for a start-up. - Unexpected costs always arise - often significant.

Question 57

List the potential causes of cash flow (or liquidity) problems

Answer 57

- Too much production capacity. - Excess inventories held. - Allowing customers too much credit. - Overtrading. - Seasonal demand. - Suppliers wanted to be paid quickly.

Question 58

How can too much production capacity cause cash flow or liquidity problems?

Answer 58

- Spending too much on fixed assets. - Made worse if short-term finance is used (e.g. bank overdraft). - Fixed assets are hard to turn back into cash in the short-term.

Question 59

How can excess inventories held cause cash flow or liquidity problems?

Answer 59

- Excess stocks tie up cash. - Increased risk that stocks become obsolete, BUT... - There needs to be enough stock to meet demand. - Bulk buying may mean lower purchase prices.

Question 60

How can allowing customers too much credit cause cash flow or liquidity problems?

Answer 60

- Customers who buy on credit are called "trade debtors" - Offer credit = good way of building sales, BUT... - Late payment is a common problem. - Worse still, the debt may go 'bad'.

Question 61

How can overtrading cause cash flow or liquidity problems?

Answer 61

- Where a business expands too quickly, putting pressure on short-term finance. - Classic example: retail chains - keen to open new outlets; have to pay rent in advance, pay for shop-fitting, pay for stocks; large outlay before sales begin in new store. - Businesses that rely on long-term contracts also at high risk of overtrading.

Question 62

How can seasonal demand cause cash flow or liquidity problems?

Answer 62

- Where there are predictable changes in demand and cash flow. - Production or purchasing usually in advance of seasonal peak in demand = cash outflows before inflows. - This can be managed - cash flow forecast should allow for seasonal changes.

Question 63

What can cash flow or liquidity problems lead to?

Answer 63

- Increase in financial costs: fees and interest are charged for using an overdraft facility. - Poor credit score making it difficult to obtain trade credit with suppliers or finance from banks in the future. - Suppliers asking for cash payments up front before delivering, or even refusing to supply the business altogether. If a business can't pay for or buy new stock it may not be able to function. - Unpaid suppliers taking legal action against the business (taking the business to court non-payment) which could lead to insolvency or bankruptcy (or liquidation).

Question 64

What are receivables (as an amount of money £)?

Answer 64

Represent the money owed to a business by customers for goods and services purchased on credit (haven't paid their invoice yet). - Future cash inflows.

Question 65

What are receivables (as an amount of days)?

Answer 65

Represent the average length of time it takes for a business' customers to pay for the goods and services purchased on credit. - The average for receivables is 30 days (this is the usual trade credit period).

Question 66

What are payables (as an amount of money £)?

Answer 66

Represent the amount of money owed by a business to pay its suppliers for goods and services purchased on credit. - Future cash outflows.

Question 67

What are payables (as an amount of days)?

Answer 67

Represent the average length of time it takes for a business to pay its suppliers for goods and services purchased on credit.

Question 68

Define asset

Answer 68

Something the business owns that could be sold.