Business - 3.5

financial objectives

the specific aims and goals of the finance department within an organisation

benefits of financial obejctives

1. focus for decision making

2. yardstick for success or failure

3. improve coordination of teams and departments

4. shareholders can assess whether the business is going to provide a worthwhile investment

5. outside organisations can confirm financial viability

profit

revenue - total costs

revenue

units sold x price per unit

gross profit

sales revenue - cost of sale

gross profit margin

gross profit / revenue x 100

operating profit

gross profit - fixed costs

operating profit margin

operating profit / revenue x 100

profit for the year

operating profit + all other income - total costs (incl. tax, interest etc.)

profit for the year margin

profit for the year / revenue x 100

how to achieve revenue objectives

• reduce price IF product is price elastic

• increase price IF product is price inelastic

• increased advertising and promotion as may increase awareness

cost objectives

• achieve the most cost-effective way of delivering goods and services to the required level of quality

• may allow them to offer lower prices

profit objectives

• may be overall profit, or GPM etc.

• represents clear external validation that the business is successful

• may be demotivating and possibly provide public evidence of underperformance leading to falling share price etc.

cash flow objectives

• without cash, the business will be unable to meet its day to day expenses

• must try improve cash flow

returns on investment

• ensure choosing the option representing the most efficient use of resources

• should also take into non-financial factors etc.

income budget

forward plan of the sales revenue that the business is likely to generate

expenditure budget

the sum of several other budgets involving fixed and variable costs such as purchases budget (cost of raw materials required to meet planned sales), labour budget (the likely cost of the labour required) and capital budget (purchase of any new assets/machinery)

profit budget

the agreed planned profit of a business (or section) over a period of time

stages of calculating a budget

1. set objectives and targets

2. carry out market research to discover the probable level of sales volume and market price for product

3. carry out research into costs based on sales volume

4. complete sales budget so an idea of how much to produce

5. construct expenditure budget to find costs

6. create overall profit budget

7. draw up departmental budgets

8. summarise detailed budgets in master budgets

variance

budgeted value - actual value

favourable budgets

the variance has a positive effect on the business e.g.

1. budgeted profit < actual profit

2. budgeted costs > actual costs

adverse variance

the variance has a negative effect on a business e.g.

1. budgeted profit > actual profit

2. budgeted costs < actual costs

advantages of budgeting

• gain financial support as indicates a good chance of success so can persuade potential investors (low risk)

• ensures business doesn’t overspend

• establish priorities as budget allocated to specific areas

• encourage delegation and responsibility to motivate staff

• assigns responsibility meaning credit is easily recognised and mistakes easily traced

• improves efficiency

disadvantages of budgeting

• managers may not know enough about the division or department so hard to plan accurate budget

• information needed from variety of sources which may prove difficult and have to rely on guesswork

• unforeseen changes may undermine budgeting process

• level of inflation hard to predict

• budget may not be accurate as set by senior managers only

features of a good budget

1. consistent with the needs of the aims of the businesses

2. based on opinion of as many people as possible making it more realistic

3. challenging but realistic targets

4. monitored continually so can act quickly if exceed

5. flexible

contribution

the amount left over from cash sale after variable costs have been deducted

CONTRIBUTION PER UNIT X UNTIS SOLD

TOTAL REVENUE - TOTAL VARIABLE COSTS

contribution per unit

selling price - variable cost per unit

break even formula

fixed cost / contribution per unit

break even definition

the amount the business needs to sell or produce in order to cover all its costs so neither a profit or loss is made

assumptions of break-even analysis

• the selling period remains the same regardless of the number of units sold

• fixed costs remain the same

• variable cost vary in direct proportion to output

• every unit of output that is produced is sold

advantages of break-even

• the business can quickly identify what level of output is required in order to make a profit

• business can use ‘what if’ analysis

• knowledge of margin of safety is useful

• a break-even chart can illustrate the different levels of profit obtainable from different levels of output

• can help with target setting

disadvantages of break-even

• information it is based upon may be unreliable

• not all output produced will be sold straight away (problem if perishable)

• selling price may vary according to amount customers order e.g. bulk purchase discounts etc.

• fixed costs may not stay the same as output increases

profitability

relates the level of profit to the size of the company

factors affecting amount of cash

1. amount of cash held at the beginning of the cash flow cycle

2. length of time required to convert inputs and outputs (large delay is damaging)

3. credit payments (goods delivered but payments takes place after)

receivables

the money owed to the company from customers (debtors)

payables

the amount of money owed by the business to pay suppliers for goods it has bought on credit (creditors)

cash flow forecast

process of estimating the expected cash inflows and cash outflows over a period of time

types of cash inflow

1. sales revenue through sales of goods or services

2. receivables

3. owners capital injection

4. loans from banks

5. other sources of loans or investments e.g. venture capital

6. interest earned on accounts held in banks etc.

types of cash outflow

1. payables

2. gas/electricity and other utility bills

3. repayment of loans and interest charged

4. rent on buildings / lease payments on machinery

5. labour costs

6. raw material costs

7. other costs

net cash flow

cash inflow - cash outflow

opening balance

closing balance from previous month

closing balance

net cash flow + opening balance

benefits of cash flow forecasting

1. liquidity (the ability of the business to turn its assets into cash)

2. identify potential problems in advance

3. provides evidence in support of a request for financial assistance

problems of cash flow forecasting

1. changes in the economy would affect the data

2. changes in consumer tastes would make predicted sales revenue to differ from what is expected

3. inaccurate market research - would make data wildly inaccurate

4. competition - may change sales revenue so may have to change price/aggressive marketing etc. to combat

5. uncertainty - hard to predict especially if unfamiliar with market

factors to consider when choosing a source of finance

1. amount of money required

2. legal structure of business (e.g. PLC = share capital etc.)

3. financial position of the business (some more expensive than others)

4. purpose for the finance (short/long term)

5. levels of risk - high risk = hard to obtain bank loan etc.

6. views of owners

long term sources of finance

requiring for a longer period of time, usually over a year

e.g. long term loans, share capital, retained profits, venture capital, sale of assets etc.

short term sources of finance

needed for a limited period of time, normally than less than one year

e.g. overdrafts, retained profits, debt factoring etc.

internal sources of finance

exist within the business e.g. retained profits, sale of assets etc.

external sources of finance

from outside the business e.g. bank loans, overdrafts, debt factoring, venture capital, share capital etc.

capital expenditure

the spending on items that can be used time and time again and have a long term life in the business e.g.. machinery, land, buildings etc.

revenue expenditure

the spending on current day to day costs such as the purchase of raw materials and the payment of wages

debt factoring

involves a business ‘selling’ its bills to a debt factor for approximately 80% of the value immediately with a further 15% to be paid when the customer pays the invoice to the factor (the factor withholds around 5% of interest)

advantages of debt factoring

• small businesses may be happy to forego the 5% for quick injection of cash

• can avoid cash flow problems caused by late payers

• time can be spent on other things rather than chasing up late payers

• if customer is new or has little credit history then minimises risk of bad debt (customers who don’t pay)

disadvantages of debt factoring

• customers may not appreciate the involvement of a debt factor as may believe the business is experiencing cash flow difficulties and seek other suppliers

• loss of up to 5% can be a substantial amount (may be better to employ staff dedicated to credit control)

• if customer is trustworthy and has good credit history then may be inappropriate

overdrafts

the bank allows the business to go overdrawn (below 0) on its business account up to an agreed figure

advantages of overdrafts

• flexible as available when the business needs it

• relatively easy to arrange

• interest only paid when account is overdrawn (don’t have to pay interest when positive figures)

• prevents cash flow difficulties leading to possible bankruptcy

• particularly useful if seasonal demand

• not usually secured against assets

disadvantages of overdraft

• interest changes an overdrafts are high making it expensive

• if business goes overdrawn above the agreed amount, the bank will charge very high interest rates and may stop the account leading to bankruptcy

• can immediately recall overdraft if bank believes the business is at risk of failure

• require cash flow forecasts and other such financial evidence to secure the overdraft

retained profits

the profit kept back within the business and not distributed to shareholders (by way of dividend if the company is incorporated) in order to finance future activities

advantages of retained profits

• expensive interest payments are not required which has a positive effect on cash flow and future profitability

• no security like land or buildings is required

disadvantages of retained profits

• shareholders may not be happy that the profit was not distributed in dividends to them and so may sell shares as a result

• may not be a sufficient amount to cover all finance required

• business may not make a profit and carry forward a loss

share capital

a company which floats on the stock market can raise substantial amounts of money by issuing shares

advantages of share capital

• substantial amounts of money can be raised

• referred to as permanent capital as once the money has been received on floatation, never has to be repaid

• paying of dividends is not a legal requirement

• banks and other financial providers view incorporated businesses as less risky and so it will be easier to obtain other forms of finance too

disadvantages of share issue

• shareholders have voting rights at the AGM meaning involves some loss of control

• shareholders expect a dividend payable each year

• may have different objectives than the original owners e.g. profits in the short term rather than long term investment

• if over 50% of company floated on stock market, susceptible to takeover

bank loan

sum of money provided to a firm by an individual or by a bank often for an agreed specific purpose

advantages of bank loans

• set interest rates mean easier to plan with regard to budgets and cash flow forecasts

• carry lower interest rates than overdrafts as loan generally secured against assets

• loan is designed to meet the company’s needs with regard to amount borrowed and term of loan

• no loss of ownership and control

disadvantages of bank loans

• size of loan is limited to amount of assets the business has

• can be inflexible as the loan must be paid back with interest on the agreed date each month

• may face additional charges if want to repay earlier than agreed

• interest charges can be high for new or small businesses

• usually require documents to prove bank have

venture capital

sums of between £50,000 and £150,000 which are provided by individuals or merchant banks which often require some say in the running of the company and may involve part ownership through purchase of share capital

advantages of venture capital

• suited to high risk companies who are finding it difficult to obtain finance from other sources

• often allow interest payments or dividends to be delayed as they recognise new companies to become established before generate good profitable return

• can be a good source of advice as they are often knowledgeable about the market with useful contacts which can be used by the business

disadvantages of venture capital

• often demand a significant share of the business in return and if the business is successful further down, they can negotiate better terms

• view investment as ‘high risk’ and therefore require high interest payments or dividends

• could demand too much control and the original owner could lose their independence

crowdfunding

involves the use of the internet to advertise the business opportunity requiring finance and ask for donations (large numbers of investors to invest only small amounts of money to minimise risk)

advantages of crowdfunding

• relatively cheap

• increasingly relevant as UK banks reduce short-term lending

disadvantages of crowdfunding

• unfamiliar source for many managers

• may not raise sufficient funds

sale of assets

the business may sell off unwanted long term assets in the business to generate a quick injection of cash (sale + leaseback involves selling the asset to a leasing company and then lease it back so can still lease it)

advantages of sale of assets

• good if no longer need the asset

• leaseback allows them to still use the asset

disadvantages of sale of assets

• reduces value of company

• must be noted on company accounts

• takes a long time to find people willing to buy it

• monthly leaseback charges

mortgages

used specifically to purchase property or land (same adv + disadv as loans)

debentures

issued by PLCs and are a specific form of long term loan (issued with a set repayment date and a set agreed interest but is repaid at some future agreed date)

advantages of debentures

• ideal for long-term projects

• avoids loss of control

disadvantages of debentures

• managers offer property as collateral

• can pay large amounts of interest

peer to peer lending

enables more mature businesses to offer funds to other businesses on the internet, raise money from large numbers of private investors which then lend to other businesses for specific projects

personal sources

provided by owners or family and friends

how does overtrading cause cash flow problems

occurs when a business expands quickly without organising funds to finance the expansion

rapid growth usually involves paying for labour and raw materials over several months before receiving payment for the final product which can affect cash flow

how does allowing too much trade credit cause cash flow problems

usually between 30 to 90 dats which allows businesses to attract customers but by delaying cash inflows may lead to cash flow difficulties

how does poor credit control cause cash flow problems

reduce delays of cash inflows by chasing up outstanding payments but when not done effectively it can be damaging

must carry out credit checks to ensure customers have a good credit history

how does inaccurate cash flow forecasting cause cash flow problems

could mean the business doesn’t have sufficient cash available due to unforeseen costs increase and inexperience of managers

how does seasonal demand cause cash flow problems

a business may have to build up their inventory during the off season in preparation for their busy period which may drain cash

how do losses or low profits cause cash flow problems

investors and banks less likely to supply funds if the business is unable to demonstrate it is profitable

working capital

the finance necessary to pay for day to day activities of the business

methods of improving cash flow

1. negotiate improved terms for credit to delay payments to suppliers

2. offer less trade credit

3. debt factoring - quick access to cash

4. overdrafts

5. improved credit control

6. short term loans

7. sale of assets (as well as sale + leaseback)

8. inventory management - e.g. must ensure orders of raw materials are carefully managed so not ‘stock out’ but not too much stock to store either

benefits of good cash flow management

1. limits possibility of bankruptcy from liquidity problems

2. may not need to resort to external sources of finance which are expensive

3. more likely to pay suppliers on time resulting in a good working relationship with suppliers

4. no damage to reputation as don’t fear collapse of company

profitability

a measure of the financial performances that compares a business’s profits to some other factor like revenue through rations such as the GPM or OPM

how to improve profits

1. reduced costs of production

2. improving business efficiency (achieving maximum output at minimum cost)

3. use capacity more fully - fixed costs spread across more units of output resulting in lower average costs

4. improve quality of goods and reduced wastage - don’t waste time and resources

5. improved methods of production - e.g. up to date and efficient technology is more productive

6. eliminating unprofitable aspects of the business

7. improving motivation - generally more productive and take less time off work

8. sell more products

9. increased selling price

what does improving business efficiency involve

ensuring all factors of production (land, labour, capital and enterprises) are fully employed in the business including labour (e.g. zero hour contracts ensuring the right amount of staff employed at any one time) BUT may involve replacing labour with technology and lead to more standardized procedure