The Importance of Finance

• Entrepreneurs need finance to cover initial setup costs when starting a new business 

  • These initial costs may include acquiring equipment, renting or purchasing premises, conducting market research, hiring staff and developing a marketing strategy
     

• Businesses often require finance to fuel their expansion and growth plans

  • These plans could involve opening new locations, entering new markets, launching new products or services, and increasing production capacity 
     

Diagram Explaining Different Reasons why Businesses Require Finance

Businesses need finance for capital and revenue expenditure, for marketing and for growth
 

Capital expenditure

• Businesses require finance for capital expenditure such as purchasing machinery, technology, vehicles, and infrastructure

  • These investments enable businesses to enhance productivity, expand operations and improve efficiency
    

Working capital

• Working Capital is necessary to manage the day-to-day operations of a business

• It helps cover expenses such as purchasing inventory, paying suppliers, meeting payroll obligations and funding overhead costs like rent and utilities

  • Sufficient working capital ensures that a business can operate smoothly without facing cash flow issues
    

Research & development

• Businesses require finance for research and development (R&D)

  • Money is needed to invest in technical research and product development

  • This investment helps them to stay ahead of the competition and create new revenue streams
    

Marketing

• Effective marketing and advertising requires finance to develop and execute marketing campaigns, create advertising materials, conduct market research and build brand awareness

  • Investing in marketing helps attract customers, increase sales, and generate revenue
    

Risk management

• Businesses need finance to manage risks and protect against unforeseen events

  • This includes paying for insurance coverage, contingency funds and implementing risk management strategies 
    

Debt servicing

• Many businesses need to service debts such as loans or credit facilities

  • These debts, including interest, must be repaid over the agreed-upon period
     

Business performance

• Finance provides a metric to measure business performance

• Business success is often judged by the level of profits it makes and the stability of a business can be determined by the level of working capital or liquid assets available

Exam Tip

The role of finance is different for every business and changes over time

For small businesses having enough working capital to cover costs is often its most important role - but as businesses grow obtaining finance to purchase capital equipment such as machinery or larger premises is likely to be more important

Capital Expenditure

• Capital expenditure is business spending on non-current assets

  • These are assets which will be used many times and for more than one year

  • Examples of non current assets for which capital expenditure is required include

Examples of current assets for which capital expenditure is required

Revenue Expenditure

• Revenue expenditure is spending on goods and services that a business uses in the short-term as part of its normal trading activities
  
  

• Common examples of current assets for which revenue expenditure is required include

An Introduction to Sources of Finance

• Businesses have different sources of finance available to them
  

• When the finance comes from inside the business it is called an internal source of finance
   

• When the finance comes from outside the business it is called an external source of finance
   

The different types of internal and external sources of finance available to help businesses grow

Sources of Internal Finance

• Internal finance comes from the owner’s capital, retained profit, or the sale of assets
   

Owner’s capital: personal savings

• Personal savings are a key source of funds when a business starts up

  • Owners may introduce their savings or another lump sum e.g. money received from a redundancy payment
     

• Owners may invest more as the business grows or if there is a specific need e.g. a short-term cash flow problem

Retained profit

• The profit that has been generated in previous years and not distributed to owners is reinvested back into the business
   

• This is a cheap source of finance, as it does not involve borrowing and associated interest and arrangement fees
   

• The opportunity cost of investing the money back into the business is that shareholders do not receive extra profit for their investment

Sale of assets

• Selling business assets which are  no longer required (e.g. machinery, land, buildings) generates a source of finance
   

• A sale and leaseback arrangement may be made if a business wants to continue to use an asset but needs cash

  • The business sells an asset (most likely a building) for which it receives cash

  • The business then rents the premises from the new owners

  • E.g. In early 2023 Sainsbury’s announced that it is in talks to sell the prime retail property for £500m which will then be leased back to them by the new owners, LXi Reit

The Advantages & Disadvantages of Using Internal Finance

External Sources of Finance

• New business startups may be seek external finance from family and friends

  • This is usually a very cheap source of funds with ‘no strings attached (e.g. a share of the business)
     

• As the business grows, a more sources of finance are available
   
  

The external sources of finance available to businesses
 

• Businesses often make use of a range of sources of finance that meet different needs

  • For example, long-term loans or share capital are likely to be most suitable sources of finance to fund capital expenditure including the purchase of land, buildings or machinery whilst overdrafts may be used to solve short-term cash flow problems
     

  An Explanation of the main External Sources of Finance

Choosing the most Appropriate Source of Finance

• Businesses must investigate and select a combination of sources of finance that are most suitable for their particular needs
    

A range of factors will affect the most suitable sources of finance for a business
 

Timescale

• Short-term sources of finance will be needed to meet unexpected costs or to pay bills and suppliers

  • These are likely to be relatively small amounts and are rarely needed beyond a year

• Longer-term sources of finance will be needed to fund the purchase of non-current assets such as buildings and other types of capital equipment

  • These are likely to be large sums that may be required for a significant period of time
    

Long-term and short-term sources of finance

Legal structure

• Sole traders, partnerships and small private limited companies usually have a more limited range of sources of finance as they are seen as a greater lending risk

  • Interest rates on loans are likely to be higher as these businesses tend to lend smaller amounts than public limited companies and are not in a position to approach specialist lenders
     

• Public limited companies are able to access a wide selection of sources of finance and are able to provide collatoral as security for lenders

 
Cost

• Interest payable on loans can add a significant cost to the use of some sources of finance
  

  • Variable interest rates change during the borrowing term which may make financial planning difficult

  • Fixed interest rates remain constant for the period of the loan and for this reason they are usually higher than variable rates
     

• Selling shares in public limited companies is an expensive process

  • Flotation is usually carried out by merchant banks which charge a premium price  for their specialist services

  • Selling shares through a rights issue may reduce the amount of share capital raised as they are usually sold at a discount to existing shareholders

 
Control

• Selling shares or raising venture capital can result in some loss of control for business owners
  

  • Smaller businesses may have to accept the terms of more powerful suppliers or business angels as they have little power to negotiate  

 
Purpose of the finance

• Certain sources of finance have narrowly focussed uses

  • A mortgage is the most appropriate type of lending to purchase land or property

  • Overdrafts are flexible and are best used for short-term working capital requirements

 
The level of existing debt

• Highly geared businesses already make use of significant amounts of debt

  • Lenders and investors may be reluctant to provide further funds due to the level of risk the business presents

  • Businesses with a poor or no borrowing history may not meet credit score requirements and would be excluded from most types of credit

An Introduction to Costs

• In preparing goods/services for sale, businesses incur a range of costs

  • Some examples of these these costs include purchasing raw materials, paying staff salaries and wages, and paying utility bills such as electricity  
     

• These costs can be broken into different categories

  • Fixed costs (FC) are costs that do not change as the level of output changes

    • These have to be paid whether the output is zero or 5000 

    • E.g. building rent, management salaries, insurance, bank loan repayments etc.
      

  • Variable costs (VC) are costs that vary directly with the output

    • These increase as output increases & vice versa

    • E.g. raw material costs, wages of workers directly involved in the production
      

  • Total costs (TC) are the sum of the fixed + variable costs 
    

Sketches Which Represent the Different Types of Cost

Direct & Indirect Costs

• Direct costs are related to the production of a particular product and vary directly with output

  • They are often the same as variable costs 

  • Examples include raw materials, components and packaging
    

• Indirect costs cannot be allocated easily to the production of a particular product

  • They are often the same as fixed costs

  • They relate to the business as a whole and are often called overheads

  • Examples include administration costs, salaries and rental fees
    

Revenue & Revenue Streams

• Sales Revenue is the value of the units sold by a business over a period of time

• E.g the revenue earned by Apple Music from sales of music downloads 

  • Sales revenue is a key business performance measure and must be calculated to identify profit

  • Sales revenue is calculated using the formula

Sales revenue = quantity sold x selling price{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="Sales space revenue space equals space quantity space sold space straight x space selling space price" style="box-sizing: border-box; vertical-align: -4px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 18px; width: 283px;">
 

• Sales revenue usually increases as the sales volume increases
  
  

• When a firm sells one product it is easy to calculate the sales revenue

  • The more products a firm sells, the harder it is to calculate the sales revenue

  • Computer systems make it easier to track sales revenue when multiple products are sold by the business

Revenue Streams

Some examples of revenue streams for businesses

• Revenue may also be generated from sources other than sales

• These sources are called revenue streams
   

An Explanation of Different Revenue Streams Businesses can Generate

An Introduction to Financial Accounts

• Financial accounts detail the financial performance of a business over a trading period
  

• The two main financial accounts are

  • The Statement of Profit or Loss

  • The Statement of Financial Position
    
    

• Public Limited Companies (PLCs) have to produce financial reports annually

  • Annual reports must comply with International Financial Reporting Standards (IFRS) allowing straightforward comparisons of performance over time and between companies

Exam Tip

The two main financial accounts sometimes go by different titles

• The Statement of Profit or Loss is also widely known as the Profit and Loss Account or an Income Statement

• The Statement of Financial Position is often referred to as the Balance Sheet.

The Statement of Profit or Loss

• The Statement of Profit or Loss shows the income and expenditure of a business over a period of time - usually a year - and calculates the amount of profit made 
   

• It is divided into three parts

  • The trading account

  • The profit and loss account

  • The appropriation account
     

Diagram Showing the Statement of Profit or Loss Layout

Head to Toe Wellbeing Ltd made a profit of £44.63m in 2022
 

The Trading Account

• The trading account is where the cost of sales is deducted from sales revenue to calculate the gross profit

• In 2022 Head to Toe Wellbeing Limited's sales revenue was $124.65m and its cost of sales were $18.92m

  • The gross profit for the period was therefore 

$124.65m - $18.92m = $105.73m{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="$ 124.65 straight m space minus space $ 18.92 straight m space equals space $ 105.73 straight m" loading="lazy" style="box-sizing: border-box; vertical-align: -4px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 18px; width: 246px;">

The Profit & Loss Account

• The profit and loss account deducts a series of expenses to determine the profit for the period 

• In 2022 gross profit was $105.73m and expenses were $39.87m

  • The profit before interest and tax was therefore 

$105.73m - $39.87m = $65.86m{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="$ 105.73 straight m space minus space $ 39.87 straight m space equals space $ 65.86 straight m" loading="lazy" style="box-sizing: border-box; vertical-align: -4px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 18px; width: 238px;">

• The business also paid $2.01m interest

  • The profit before tax was therefore

$65.86m - $2.01m = $63.85m{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="$ 65.86 straight m space minus space $ 2.01 straight m space equals space $ 63.85 straight m" loading="lazy" style="box-sizing: border-box; vertical-align: -4px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 18px; width: 222px;">

• The business also paid $5.47m tax

  • The profit for the period was therefore

         $63.85m - $5.47m = $58.38m{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="$ 63.85 straight m space minus space $ 5.47 straight m space equals space $ 58.38 straight m" loading="lazy" style="box-sizing: border-box; vertical-align: -4px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 18px; width: 222px;">

The Appropriations Account

• The appropriations account shows how profits are distributed for the period

• In 2022 Head to Toe Wellbeing Limited distributed $13.75m to shareholders as dividends

  • $44.63m was therefore retained as profit

Exam Tip

For non-profit organisations some amendments are made to the standard layout of the Statement of Profit or Loss

1. The word 'profit' is replaced by 'surplus'

2. Non-profit organisations are usually exempted from the payment of corporation tax so this is not normally recorded or is recorded as a 0 value

How Stakeholders use the Profit & Loss Account

• The Statement of Profit or Loss is a very useful source of information for stakeholders to evaluate the performance of a business
   

How Stakeholders use The Statement of Profit or Loss

The Statement of Financial Position

• The Statement of Financial Position shows the financial structure of a business at a specific point in time
   

• It records the business assets and liabilities and specifies the capital (equity) used to fund the business
  
  

• The Statement of Financial Position is also known as the Balance Sheet

  • It is called the balance sheet as the net assets should equal the total equity
     

Diagram: Statement of Financial Position

The Statement of Financial Position for Packer Sports Ltd balances on $14,735

Calculating the total assets

• On the stated date Packer Sports Ltd owned non-current assets worth $24,250

  • Property, plant and machinery is valued at $22,700

  • These assets have been depreciated by $1,550
    

• The value of its current assets (cash, debtors and stock) was $15,545
  

• Total assets were therefore

         $24,250+$15,545 = $39,795{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" height="18" width="207" alt="begin mathsize 14px style $ 24 comma 250 plus $ 15 comma 545 space equals space $ 39 comma 795 end style" style="box-sizing: border-box; vertical-align: -4px; max-inline-size: 100%; block-size: auto; object-fit: contain;">

Calculating total liabilities

• On the stated date Packer Sports Ltd had current liabilities worth $5,060, comprised of a bank overdraft, trade creditors and other short-term loans
  

• The value of its long-term liabilities were $20,000
  

• Total liabilities were therefore 

$5,060 + $20,000 = $25,060{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" height="18" width="207" alt="$ 5 comma 060 space plus space $ 20 comma 000 space equals space $ 25 comma 060" style="box-sizing: border-box; vertical-align: -4px; max-inline-size: 100%; block-size: auto; object-fit: contain;">
 

Calculating the net assets

• Packer Sports Limited's net assets were therefore

$39,795 - $25,060 = $14,735{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" height="18" width="215" alt="$ 39 comma 795 space minus space $ 25 comma 060 space equals space $ 14 comma 735" style="box-sizing: border-box; vertical-align: -4px; max-inline-size: 100%; block-size: auto; object-fit: contain;">
 

Calculating total equity

• Net assets of $14,735 were funded through share capital of $1,500 and retained earnings of $13,235

Exam Tip

In Paper 2 you may be asked to construct a balance sheet from given data.

To achieve full marks you must follow the format illustrated above and you should check that you have

1. Included all of the relevant headings in the correct order

   • Non-current assets

   • Current assets

   • Total assets

   • Current liabilities

   • Non-current liabilities

   • Total liabilities

   • Net assets

   • Equity
     

2. Correctly classified items under each heading

   • For example, you need to ensure that you have correctly allocated cash, stock and debtors as current assets, and creditors and bank overdrafts as current liabilities
     

3. Omitted irrelevant figures that belong to the profit and loss account

   • For example, costs and revenues are not included in the balance sheet

How Stakeholders use the Statement of Financial Position

• Stakeholders will use the Statement of Financial Position alongside the Statement of Profit or Loss to perform ratio analysis and compare performance over time or with other businesses
   

 How Stakeholders use the Statement of Financial Position

Exam Tip

If you are answering a question about sources of finance you might be able to use the capital structure of the business to recommend whether a business should borrow or look at an alternative source. If a business already relies heavily on borrowing, it may be more sensible to recommend seeking to raise more share capital.

Different types of Intangible Assets

• Intangible assets are non-physical and cannot be held
   

• Businesses need to account for intangible assets in their annual reports as it adds to the value of the business

Diagram Showing Different Types of Non-physical Assets

Intangible assets include assets such as intellectual property and domain names
  

Intellectual property

• This includes patents, trademarks, patents and copyrights which protect unique ideas, inventions, artistic works, and brand names
   

Brand value

• The reputation and recognition associated with a brand has a value

  • It includes the brand name, logo, slogans, and customer loyalty to the brand
     

Customer relationships

• Long-term relationships with customers including customer lists, contracts, and customer loyalty programs

  • These relationships can provide recurring revenue and a competitive advantage
     

Software and technology

• Proprietary software, computer programs and technology systems that are crucial to a business's operations or provide a competitive advantage
   

Contracts and agreements

• Long-term contracts, lease agreements, licensing agreements and franchise agreements that have value and contribute to future cash flows

• Agreements with employees or business partners that restrict them from competing with the company for a specific period which protect the company's interests and market position (non compete contract)
    

Goodwill

• The value of a company's reputation, customer base and brand

• Goodwill often represents the premium paid when one business takes over or merges with another business
   

Domain names and other online assets

• Valuable domain names, websites, social media accounts and online platforms that drive customer engagement, traffic, and online presence
   

Licenses and permits

• Licenses, permits, and regulatory approvals that grant exclusive rights or access to certain markets or resources, often issued by governments

Understanding Depreciation

• Depreciation is an accounting technique which recognises that the value of fixed (non-current) assets falls over time
  

  • It reflects wear and tear, the reduction in an asset's value as it ages or obsolescence
    
    

• Two common methods of calculating depreciation include

  • Straight line depreciation

  • Units of production depreciation
    

• Whichever method a business selects, the goal is to allocate the historic cost of the asset in a way that reflects its reduction in value over time
   

Reasons for Calculating Depreciation

Straight Line Method

• The straight line method reduces the value of an asset by the same value each year of its useful life
  
  

• Three key variables are required to calculate the annual rate of depreciation of an asset

  • Life expectancy

    • The number of years it is expected to be used before it will need to be replaced

  • Residual value

    • The scrap value of the asset at the end of its useful life

  • Historic cost

    • The initial cost of purchasing the asset
      

• The annual rate of depreciation is calculated using the following formula

Annual depreciation = Historic cost - Residual ValueLife Expectancy{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="Annual space depreciation space equals space fraction numerator Historic space cost space minus space Residual space Value over denominator Life space Expectancy end fraction" loading="lazy" style="box-sizing: border-box; vertical-align: -16px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 43px; width: 391px;">

Worked example

Luftig Tours sells hot air balloon flights in the Salzburg area of Austria. The company recently paid €280,000 for a new balloon. Its life expectancy is anticipated to be 7 years. Its residual value is forecast to be €52,500

Calculate the annual rate of depreciation of the new hot air balloon 

(2 marks)

Step 1: Deduct the residual value from the historic cost

 €280,000  -  €52,500 =  €227,500{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="space € 280 comma 000 space space minus space space € 52 comma 500 space equals space space € 227 comma 500" loading="lazy" style="box-sizing: border-box; vertical-align: -4px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 20px; width: 272px;">      (1)

Step 2: Divide the result by the life expectancy

€227,5007 years = €32,500{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="fraction numerator € 227 comma 500 over denominator 7 space years end fraction space equals space € 32 comma 500" loading="lazy" style="box-sizing: border-box; vertical-align: -16px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 43px; width: 169px;">    (1)

• Once the annual rate of depreciation has been calculated, until the end of its life expectancy

  • It is recorded each year as an expense in the income statement

  • The value of the asset is reduced each year by this amount in the balance sheet and is recorded as its book value 

Worked example

Luftig Tours sells hot air balloon flights in the Salzburg area of Austria. The company recently paid €280,000 for a new balloon. Its life expectancy is anticipated to be 7 years. Its residual value is forecast to be €52,500

(a) Calculate the book value to be recorded in the balance sheet for each of the hot air balloon's years of useful life

(4 marks)

(b) Calculate the accumulated depreciation for each year of the the hot air balloon's useful life

(2 marks)

Step 1: Create a table with the following headers

Step 2: Complete Year 0 with the historic cost

Step 3: Calculate Year 1 by deducting the annual rate of depreciation

Year 1 = €280,000 - €32,500 = €247,500{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="Year space 1 space equals space € 280 comma 000 space minus space € 32 comma 500 space equals space € 247 comma 500" loading="lazy" style="box-sizing: border-box; vertical-align: -4px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 20px; width: 328px;">    (2)

Step 4: Record these values in the table

Step 5: Calculate Years 2 to 7 in the same way

(2)
 

Step 6: Calculate accumulated depreciation by adding the annual rate of depreciation each year

(2)

Strengths and Weaknesses of the Straight Line Method

• The main benefit of the straight line depreciation over other methods is that it is simple to calculate 

• In many countries it is preferred for tax purposes as it allows for a consistent deduction of depreciation expenses over the asset's useful life
   

The Main Strengths and Weaknesses of Using Straight Line Depreciation 

Units of Production Method

• The units of production method depreciates an asset based on its usage or production output during an accounting period (usually a year)

  • It is commonly used for assets that wear out based on the number of units produced or hours of operation rather than the passage of time

  • Vehicles commonly lose value as their mileage increases

  • Machinery wears out as it is used in production 
    

• The units of production calculation involves two steps

• Step 1: Calculate the depreciation per unit

Depreciation per unit = Historic cost - Residual valueExpected units over asset's lifetime{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="Depreciation space per space unit space equals space fraction numerator Historic space cost space minus space Residual space value over denominator Expected space units space over space asset apostrophe straight s space lifetime end fraction" loading="lazy" style="box-sizing: border-box; vertical-align: -16px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 43px; width: 431px;">

• Step 2: Calculate the depreciation per time period (year)

Depreciation per time period = Depreciation per unit × Number of units produced{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="Depreciation space per space time space period space equals space Depreciation space per space unit space cross times space Number space of space units space produced" loading="lazy" style="box-sizing: border-box; vertical-align: -4px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 20px; width: 578px;">

Worked example

Emilio's Pizzeria purchased a new pizza oven for $22,600

It expects the pizza oven to last for 12,000 hours before it needs to be replaced

It will be sold for scrap for $4,000 after 4 years

(a) Calculate the depreciation expense if Emilio's Pizzeria uses the pizza oven for 2,900 hours in the first year

(3 marks)

Step 1: Calculate the depreciation per unit

Historic cost - Residual valueExpected units over pizza oven's lifetime= $22,600 - $4,00012,000 hours= $1.55{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="fraction numerator Historic space cost space minus space Residual space value over denominator Expected space units space over space pizza space oven apostrophe straight s space lifetime end fraction equals space fraction numerator $ 22 comma 600 space minus space $ 4 comma 000 over denominator 12 comma 000 space hours end fraction equals space $ 1.55" style="box-sizing: border-box; vertical-align: -77px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 152px; width: 297px;">    (2)

Step 2: Calculate the depreciation for the time period

Depreciation per unit × Number of units= $1.55 × 2,900 hours= $4,495{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="Depreciation space per space unit space cross times space Number space of space units equals space $ 1.55 space cross times space 2 comma 900 space hours equals space $ 4 comma 495" style="box-sizing: border-box; vertical-align: -54px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 106px; width: 283px;">    (1)

• Once the depreciation total has been calculated

  • It is recorded as an expense in the income statement

  • The value of the asset is reduced by this amount in the balance sheet and is recorded as its book value 

Strengths and Weaknesses of the Units of Production Method

• This method is more complicated to calculate than the straight line method

• It is more likely to reflect the true running costs of non-current assets such as machinery
   

The Main Strengths and Weaknesses of Units of Production Depreciation

When to use each Depreciation Method

• The method chosen to depreciate a fixed asset depends on a range of factors, such as

  • Whether the asset is likely to become obsolete

  • Whether the asset is directly used in production

  • Whether its value is closely linked to the amount it is used
     

Appropriate Situations for each Depreciation Method

An Introduction to Ratio Analysis

• Ratio analysis involves extracting information from financial accounts to assess business performance and answer key questions including 

• Why is one business more profitable than another one in the same industry?

  • Is a business growing?

  • How effectively is a business using assets and capital invested?

  • What returns on investment are expected?

  • How risky is the financial structure of the business?
    

 Information Extracted from the Profit & Loss Account and Balance Sheet for Ratio Analysis

• Ratio analysis supports evidence-based decision making, as it provides measurable data that can be used to support judgements and compare performance against objectives
  

The Ratio Analysis Process
 

• The three main profitability ratios are

  • The Gross Profit Margin

  • The Profit Margin

  • Return on Capital Employed (RoCE)
    

• The two main liquidity ratios are

  • The Current Ratio

  • The Acid Test Ratio

Profit Margins

• A profit margin is the amount by which the sales revenue exceeds the costs
  
  

• Profit margins can be compared to previous years to better understand business performance

  • Higher and increasing profit margins are preferable as it means that more revenue is being converted to profit

Gross Profit Margin 

• This shows the proportion of revenue that is turned into gross profit and is expressed as a percentage

  • It is calculated using the formula below 

 Gross ProfitSales Revenue× 100      {"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="fraction numerator Gross space Profit over denominator Sales space Revenue end fraction cross times space 100 space space space space space space" loading="lazy" style="box-sizing: border-box; vertical-align: -15px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 39px; width: 168px;">

Worked example

Head to Toe Wellbeing’s revenue in 2022 was £124,653. Its gross profit was £105,731.

Calculate Head to Toe Wellbeing Ltd’s Gross Profit Margin in 2022. [2]

 
Step 1: Substitute the values into the formula

      Gross Profit Sales Revenue × 100   = £105,731 £124,653 =  0.8482  {"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="fraction numerator Gross space Profit space over denominator Sales space Revenue end fraction space cross times space 100 space space space equals space fraction numerator £ 105 comma 731 over denominator space £ 124 comma 653 space end fraction equals space space 0.8482 space space" style="box-sizing: border-box; vertical-align: -68px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 134px; width: 160px;">            [1 mark]

Step 2: Multiply the outcome by 100 to find the percentage

   0.8482 x 100

    = 84.82%                   [1 mark]

84.82% of Head to Toe Wellbeing’s revenue was converted into gross profit during 2022

Profit Margin

• The Profit Margin shows the proportion of revenue that is turned into profit before interest and tax

• It is calculated using the formula below and is expressed as a percentage
   

Profit before Interest & TaxSales Revenue×100{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="fraction numerator Profit space before space Interest space & space Tax over denominator Sales space Revenue end fraction cross times 100" loading="lazy" style="box-sizing: border-box; vertical-align: -15px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 39px; width: 213px;">

Worked example

Head to Toe Wellbeing’s revenue in 2022 was £124,653. Its profit before interest and tax was £65,864.

Calculate Head to Toe Wellbeing Ltd’s Profit Margin in 2022. [2]

Step 1: Substitute the values into the formula

Profit before Interest & TaxRevenue×100= £65,864£124,653= 0.5284{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="fraction numerator Profit space before space Interest space & space Tax over denominator Revenue end fraction cross times 100 equals space fraction numerator £ 65 comma 864 over denominator £ 124 comma 653 end fraction equals space 0.5284" style="box-sizing: border-box; vertical-align: -67px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 133px; width: 213px;">        [1 mark]

Step 2: Multiply the outcome by 100 to find the percentage

 
0.5284 x 100

=  52.84%                [1 mark]

In 2022 52.84% of Head to Toe Wellbeing’s revenue was converted into profit before interest and tax.

Return on Capital Employed

• The Return on Capital Employed is also known as the Primary Ratio
  

  • It compares the profit made by a business to the amount of capital invested in the business

  • It is a measure how how effectively a business uses the capital invested in the business to generate profit
      

• Return on Capital Employed is a key performance indicator that can be compared over time and also with competitors and other potential capital investments
  

• Return on Capital Employed is expressed as a percentage and can be calculated using the formula
   

Return on Capital Employed = Profit before interest & taxCapital Employed  × 100{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="Return space on space Capital space Employed space equals space fraction numerator Profit space before space interest space & space tax over denominator Capital space Employed end fraction space space cross times space 100" loading="lazy" style="box-sizing: border-box; vertical-align: -15px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 39px; width: 420px;">

• Capital employed is usually provided for you, however it can be calculated using the formula
   

Capital Employed = Non-current Liabilities + Equity{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="Capital space Employed space equals space Non minus current space Liabilities space plus space Equity" loading="lazy" style="box-sizing: border-box; vertical-align: -4px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 18px; width: 342px;">

Worked example

The table shows an extract from the company accounts of Keals Cosmetics.

Calculate Keals Cosmetics' Return on Capital Employed.         [3 marks]

 
Step 1: Calculate the capital employed

Capital employed = Non-current Liabilities + Equity Capital employed = £1.5m + £15.4m Capital employed = £16.9m{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="Capital space employed space equals space N o n minus c u r r e n t space L i a b i l i t i e s space plus space E q u i t y space Capital space employed space equals space £ 1.5 straight m space plus space £ 15.4 straight m space Capital space employed space equals space £ 16.9 straight m" style="box-sizing: border-box; vertical-align: -51px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 100px; width: 346px;">      [1 mark]
  

Step 2: Divide Operating Profit by Capital Employed

Return on Capital Employed = Profit before interest & taxCapital Employed  × 100Return on Capital Employed = £2.2m£16.9mReturn on Capital Employed = 0.13{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="Return space on space Capital space Employed space equals space fraction numerator Profit space before space interest space & space tax over denominator Capital space Employed end fraction space space cross times space 100 Return space on space Capital space Employed space equals space fraction numerator £ 2.2 straight m over denominator £ 16.9 straight m end fraction Return space on space Capital space Employed space equals space 0.13 " style="box-sizing: border-box; vertical-align: -88px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 174px; width: 422px;">   [1 mark]

Step 3: Multiply the result by 100 and express the outcome as a percentage

0.13x   100       = 13%            [1 mark]

The capital employed in Keals Cosmetics has generated a return of 13%         

Understanding Return on Capital Employed (RoCE)

• RoCE differs between industries so comparison across sectors is not recommended

• RoCE can be compared with other forms of return such as interest rates on savings in a bank account, and with other businesses within the same industry
  
  

• RoCE can be used to support strategic decisions (e.g. investment or divestment decisions) to determine the most profitable option given the level of capital employed
  

• With RoCE the higher the rate the better as it indicates that the business is profitable and using its capital efficiently

  • Investors prefer businesses with stable and rising levels of RoCE as this indicates low-risk growth is being achieved

  • A ROCE of at least 20 per cent is usually a good sign that the company is in a good financial position
     

• To increase the RoCE level a business can

  • Increase the level of profit generated without introducing new capital into the business

  • Maintain the level of profit generated whilst reducing the amount of capital in the business

Worked example

Faced with increasing costs Kent & Medway Properties Ltd is looking to close one of its three high street estate agency branches.

The table below shows some key data for each of the branches.

Calculate the Return on Capital Employed (RoCE) for each branch and recommend which branch, on profitability terms, should close.  [5 marks]

Step 1: Apply the formula to calculate the RoCE for each branch

      Return on Capital Employed = Profit before Interest & taxCapital Employed  × 100Return on Capital Employed Sevenoaks = £0.37m£2.4m  × 100 = 15.42%  (1mark)Return on Capital Employed Whitstable = £0.57m£3.1m  × 100 = 18.39%  (1 mark)Return on Capital Employed Rochester = £0.51m£2.9m  × 100 = 17.59%  (1 mark){"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" loading="lazy" style="box-sizing: border-box; vertical-align: -117px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 233px; width: 520px;">

Step 2: Identify the least profitable branch for closure

Sevenoaks is the least profitable branch with a RoCE of 15.42% and should be the branch selected for closure.  (2 marks)

Improving Profitability Ratios

• Businesses aim to improve their profit margins over time

• Whilst profit margins may fall as a result of external factors (for example, the cost of raw materials may rise as a result of poor weather damaging raw materials) there are a number of internal steps a business can take to improve its profit margins
   

Improving the gross profit margin

• The gross profit margin can be improved in two ways

  • The business can increase their sales revenue

  • The business can reduce their direct costs

How to Increase the Gross Profit Margin

Improving the profit margin

• The profit margin can be improved in two ways

  • Increasing the gross profit margin (see above)

  • Reducing overhead costs
    

Reduce the Overhead Costs

• Reducing staffing levels, relocating to cheaper premises or changing utility companies can reduce expenses
  

  • Reducing staffing levels may affect staff morale and negatively affect productivity

  • Relocation costs can outweigh some benefits of moving to a cheaper location

  • Replacing inefficient or outdated equipment may require staff training
     

• Ways to Measure Liquidity

  • Liquidity refers to the cash and other current assets businesses have available to quickly pay bills and meet short-term business/financial obligations
     

  • The liquidity of a business can be measured using two ratios, the current ratio and the acid test ratio
    
    

  1. The Current Ratio

  • The Current Ratio is a quick way to measure liquidity and the outcome is expressed as a ratio

  • All of the current asset are included in calculating this ratio

  • The current ratio is an effective liquidity measure for businesses that hold little stock

  • The result indicates how many £s of current assets it has available to cover each £1 of short term debt

  • It is calculated using the formula

  Current assetsCurrent liabilities  = ? :1{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="fraction numerator Current space assets over denominator Current space liabilities end fraction space space equals space ? space colon 1" style="box-sizing: border-box; vertical-align: -39px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 76px; width: 119px;">

  Worked example

  Packer Sports Ltd has current assets of £15,545, current liabilities of £5,060 and an inventory figure of £8,250.

  Calculate Packer Sports Ltd’s current ratio. [2]

   

  Step 1: Substitute the values into the equation

     £15,545 ÷ £5,060    =    3.07       [1 mark]

   

  Step 2: Express the outcome as a ratio

     =    3.07: 1                [1 mark]

   
  In this example, Packer Sports Ltd has £3.07 of current assets to cover each £1 of short-term debt

   
  2. The Acid Test Ratio

  • The acid test ratio is a precise way to measure liquidity and is expressed as a ratio

  • The acid test ratio is also known as the liquid capital ratio

  • The least liquid form of current assets (stock) is deducted so the acid test ratio provides a more realistic measure of the businesses ability to meet short-term debts quickly

    • It may take some time to sell stock, so it is excluded
       

  • The acid test ratio is a particularly important measure of liquidity for businesses that hold a large amount of stock

  • It is calculated using the formula
    
    

   Current assets - stockCurrent liabilities=     ?      :     1{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="fraction numerator space Current space assets space minus space stock over denominator Current space liabilities end fraction equals space space space space space ? space space space space space space colon space space space space space 1" style="box-sizing: border-box; vertical-align: -39px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 76px; width: 157px;">

  Worked example

  Packer Sports Ltd has current assets of £15,545, current liabilities of £5,060 and a stock figure of £8,250.

  Calculate Packer Sports Ltd’s acid test ratio. [3]

   

  Step 1: Subtract stock from current assets 

  £15,545 - £8,250     =    £7,295              [1 mark]
   

  Step 1: Substitute the values into the equation

  £7,295 ÷ £5,060    =    1.44                  [1 mark]

   
  Step 2: Express the outcome as a ratio

  =    1.44: 1          [1 mark]
    

  In this example, Packer Sports Ltd has £1.44 of the most liquid current assets to cover each £1 of short-term debt

  Ways to Improve Liquidity

  • The best way to improve liquidity is to manage the business better

    • Use cash flow forecasts to identify potential cash flow issues before they arise - and take appropriate action

    • Budget effectively and consider adopting zero budgeting to carefully control spending

    • Set clear financial objectives and look for ways to reduce costs and increase income wherever possible
       

  Methods to Improve Liquidity

  Method	Explanation
  Reduce the credit period offered to customers	Collecting money owed from customers more quickly will increase the level of current assets in the business Customers may move to competing businesses that offer better credit terms
  Ask suppliers for an extended repayment period e.g an extension from 60 to 90 days	Current liabilities will not be reduced The business can use cash it would have paid to suppliers for other purposes Suppliers may be unwilling to extend credit terms
  Make use of Overdraft facilities or short-term loans	Current liabilities will increase The business can spend more money than it has in its bank account Banks may be reluctant to lend to businesses with cash-flow problems
  Sell off excess stock	Less liquid current assets will be reduced and converted into more liquid forms of current asset (e.g. cash) Storage and security costs may also be reduced Stock may need to be sold at a low price to attract sales
  Sell assets and lease fixed assets instead (e.g. sale and leaseback)	Both current assets and current liabilities will increase The business will continue to have the use of assets but must make regular payments to the leasing company
  Introduce new capital and reduce drawings out of the business	Current assets will be increased New capital may be introduced by the owner or from additional investors This may result in the dilution of control of the business

An Introduction to Efficiency Ratios

• Efficiency ratios show how well a business utilises its assets and liabilities to generate sales and maximise profits 

• They can provide insights into the operational efficiency of a business, including

  • How well stocks are being managed

  • The time taken for a business to settle debts with its creditors

  • How well credit offered to customers is being controlled

  • The balance of business funding between loans and equity capital
     

• Stakeholders, such as investors, can use the ratios to assess how well a company manages its resources

• Management can use ratios to set targets for key staff
   

Diagram: The four main Efficiency Ratios

Efficiency ratios provide insights into the operational efficiency of a business

Stock Turnover

• The stock turnover ratio shows how well a business converts its stock into sales
  

• Before calculating stock turnover it is first necessary to calculate the average value of stock held by a business in a given period

  • It is calculated using the formula

Average stock = Opening stock + Closing stock2{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="Average space stock space equals space fraction numerator Opening space stock space plus space Closing space stock over denominator 2 end fraction" loading="lazy" style="box-sizing: border-box; vertical-align: -15px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 42px; width: 353px;">
  

Calculating the Stock Turnover Ratio

• Stock turnover can then be calculated in two ways

1. Number of times a business sells all of its stock during a period (usually a year)

Cost of salesAverage Value of Stock{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="fraction numerator Cost space of space sales over denominator Average space Value space of space Stock end fraction" loading="lazy" style="box-sizing: border-box; vertical-align: -16px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 43px; width: 175px;">

• Businesses aim for a high or increasing ratio

• More stock sold means that it is generating profit more efficiently

  • Perishable goods are less likely to be wasted
    
    

2. Number of days taken to sell all of its stock
 
Average Value of StockCost of Sales × 365{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="fraction numerator Average space Value space of space Stock over denominator Cost space of space Sales end fraction space cross times space 365" loading="lazy" style="box-sizing: border-box; vertical-align: -15px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 43px; width: 225px;">

• Businesses aim for a low or falling ratio

  • Selling stock quickly means profit is achieved swiftly

  • Less likely to hold obsolete stock that may need to be sold at a loss

Worked example

YakPur Fashions is a manufacturer and exporter of high quality fashion outerwear

A selection of YakPur Fashions' financial performance indicators are shown in the table

(a) Calculate YakPur Fashions' stock turnover ratio for 2022

(i) in terms of the number of times stock was sold during the year

(ii) in terms of the number of days taken to sell all stock

(4 marks)

Step 1: Calculate the average value of stock

Opening stock + Closing stock2= €47,600 + €26,0002= €36,800{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="fraction numerator Opening space stock space plus space Closing space stock over denominator 2 end fraction equals space fraction numerator € 47 comma 600 space plus space € 26 comma 000 over denominator 2 end fraction equals space € 36 comma 800" style="box-sizing: border-box; vertical-align: -76px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 150px; width: 227px;">    (1)

Step 2: Calculate the number of times stock sold during the year

Cost of salesAverage stock= €112,400€36,800= 3.05 times{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="fraction numerator Cost space of space sales over denominator Average space stock end fraction equals space fraction numerator € 112 comma 400 over denominator € 36 comma 800 end fraction equals space 3.05 space times" style="box-sizing: border-box; vertical-align: -77px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 152px; width: 110px;">     (1)

Step 3: Calculate the number of days taken to sell stock

Average stockCost of sales × 365= €36,800€112,400 × 365= 119.50 days{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="fraction numerator Average space stock over denominator Cost space of space sales end fraction space cross times space 365 equals space fraction numerator € 36 comma 800 over denominator € 112 comma 400 end fraction space cross times space 365 equals space 119.50 space days" style="box-sizing: border-box; vertical-align: -77px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 152px; width: 160px;">     (2)

Ways to Improve the Stock Turnover Ratio

• The stock turnover ratio can be improved by holding less stock or reducing cost of sales
   

Improving the Stock Turnover Ratio

Stock Turnover Variations

• There is no ideal ratio for stock turnover

  • Some businesses will have a very low stock turnover ratio as they sell few products - usually at a high price

    • Examples include 

      • Jewellers

      • Luxury vehicles

      • Specialist equipment or services
        

  • Other businesses have a very high stock turnover ratio

    • Their business model often requires this - for example, they may sell perishable goods

      • Examples include

        • Supermarkets

        • Florists

        • Takeaway food businesses

Gearing Ratio

• The gearing ratio illustrates the long-term financial structure of the business

  • It shows the balance of non-current liabilities (e.g. long-term loans) to shareholder capital used to fund a business

  • The outcome is expressed as a percentage and is calculated with the following formula
    
    

Gearing Ratio = Non Current LiabilitiesCapital Employed x 100{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="Gearing space Ratio space equals fraction numerator space Non space Current space Liabilities over denominator Capital space Employed end fraction space straight x space 100" loading="lazy" style="box-sizing: border-box; vertical-align: -16px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 43px; width: 331px;">

• Capital employed can be calculated by adding non-current (long term) liabilities to the equity
   

Interpreting the results 

• If the outcome is less than 50% the business is low-geared

  • The business is largely funded by shareholder capital
    
    

• If the outcome is more than 50% the business is highly-geared

  • The business is largely funded by loan capital

Worked example

The table shows an extract from the company accounts of Keals Cosmetics.

Calculate Keals Cosmetics' gearing ratio       

(2 marks)

 
Step 1: Identify the data required to calculate the gearing ratio

Non-current liabilities      =      $9.6 million

Capital employed            =      $43.3 million

Step 2: Divide non-current liabilities by capital employed

$43.3 million    ÷         $9.6 million         =      0.22      (1)

Step 3: Multiple the outcome by 100 and express the result as a percentage

0.22      x      100               =      22%       (1)

22% of Keals Cosmetics capital structure is made up of long-term loans

It is a low-geared business

Problems Associated with High Gearing

• The higher the gearing ratio the more dependent a business is on long-term borrowing

• High gearing can be problematic for several reasons
   

Risks Associated with High Gearing 

Situations Where High Gearing is Less Problematic

• When interest rates are low - and expected to remain low 

  • Interest rates in Europe have been historically low for more than a decade

  • Many businesses have taken advantage of borrowing cheaply to fund investment
    

•  Large and profitable businesses are capable of meeting debt obligations

  • Multinational car manufacturers such as Toyota and Volkswagen are highly geared

  • High levels of borrowing have funded research into new generations of electric vehicles
     

Ways to Improve Gearing

• Improving gearing usually means lowering it

• This can be achieved by reducing long-term borrowing or raising more equity capital
   

Ways to Improve Gearing

Debtor Days

• Debtor days measures the average number of days it takes for a business to collect money from its debtors
  

• Businesses often provide a period of trade credit to customers

  • In the UK 30 to 60 days is typical

  • The growth of promotional 'buy now, pay later' deals has increased the level of debtors for some businesses
    

• It is calculated using the formula

Debtor days = DebtorsTotal credit sales revenue × 365{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="Debtor space days space equals space fraction numerator Debtors over denominator Total space credit space sales space revenue end fraction space cross times space 365" style="box-sizing: border-box; vertical-align: -16px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 42px; width: 352px;">
 

• Businesses aim for a low or reducing ratio

  • This indicates efficiency in collecting outstanding debts from credit customers

  • Collecting debts promptly can improve cash flow

Worked example

YakPur Fashions is a manufacturer and exporter of high quality fashion outerwear

A selection of YakPur Fashions' financial performance indicators are shown in the table

(a) Calculate YakPur Fashion's Debtor Days ratio for 2022

(2 marks)

Step 1: Divide debtors by credit sales revenue

€31,200€241,200= 0.1294{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="fraction numerator € 31 comma 200 over denominator € 241 comma 200 end fraction equals space 0.1294" style="box-sizing: border-box; vertical-align: -44px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 86px; width: 81px;">      (1)

Step 2: Multiply the outcome by 365

0.1294 × 365= 47.23 days{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="0.1294 space cross times space 365 equals space 47.23 space days" style="box-sizing: border-box; vertical-align: -32px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 63px; width: 101px;">      (1)

• It takes YakPur Fashions an average of 47.23 days to collect money owing from debtors

Ways to Reduce the Debtor Days Ratio

• Maintaining open communication with customers helps to address any issues promptly
   

Ways to Reduce the Debtor Days Ratio

• If these methods fail to persuade customers to pay their invoices on time a business has a range of further options. These methods should be pursued with caution as relationships with customers may be damaged
   

Further Ways to Reduce the Debtor Days Ratio

Creditor Days

• Creditor days measures the average number of days a business takes to pay its creditors
  

• It is calculated using the formula

Creditor days = CreditorsCost of sales × 365{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="Creditor space days space equals space fraction numerator Creditors over denominator Cost space of space sales end fraction space cross times space 365" loading="lazy" style="box-sizing: border-box; vertical-align: -16px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 42px; width: 270px;">
 

• Businesses generally aim for a high or increasing ratio

  • This indicates skills of negotiation in arranging extended credit terms with suppliers

  • Delaying payments to suppliers can improve cash flow
    
    

• However, taking longer than agreed to pay outstanding invoices may have negative consequences

  • Relationships with important suppliers may worsen

    • They are less likely to extend further trade credit 

    • Penalties may be issued for late payment 

    • Orders may be delayed until payment is received

  • Creditworthiness may worsen

    • A business may fail credit checks

    • Unable to place orders with other suppliers

    • Less chance of obtaining trade credit elsewhere

    • Could impact applications for borrowing e.g. loans

Worked example

YakPur Fashions is a manufacturer and exporter of high quality fashion outerwear

A selection of YakPur Fashions' financial performance indicators are shown in the table

(a) Calculate YakPur Fashion's Creditor Days ratio for 2022

(2 marks)

Step 1: Divide creditors by cost of sales

€28,500€112,400= 0.2536{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="fraction numerator € 28 comma 500 over denominator € 112 comma 400 end fraction equals space 0.2536" style="box-sizing: border-box; vertical-align: -44px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 86px; width: 81px;">      (1)

Step 2: Multiply the outcome by 365

0.2536 × 365= 92.56 days{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="0.2536 space cross times space 365 equals space 92.56 space days" style="box-sizing: border-box; vertical-align: -32px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 63px; width: 101px;">      (1)

Yakpur takes an average of 92.56 days to settle supplier invoices

Ways to Improve the Creditor Days Ratio

• Larger businesses often employ a credit controller to manage negotiations about payments with their suppliers. This person has a range of methods which they can use to improve the creditor days ratio
   

Improving the Creditor Days Ratio

Exam Tip

Improving debtor and creditor days should have a positive impact on business liquidity - and improve the working capital situation too

As a result making efforts to take the steps outlined above can improve the stability of a business and increase its chances of survival

Insolvency Versus Bankruptcy

• Insolvency refers to the inability of a business to pay debts and continue trading

• Bankruptcy occurs when a business ceases to trade and the value of its possessions are distributed to its creditors

• The outcome of insolvency depends on the ownership type of the business

A Diagram Comparing Bankruptcy and Liquidation

Insolvency can lead to bankruptcy for unincorporated businesses and to administration or liquidation for companies
 

• Insolvency for a sole trader or partnership can lead to a legal declaration of bankruptcy by a court of law
  

  • The assets of the business and its owners may be sold to settle outstanding debts
    

• Companies may liquidate or enter into administration

  • Liquidation involves the selling of business assets to settle outstanding debts and dissolve a company

  • Administration protects businesses from administration whilst it attempts to settle debts and continue trading

    • If administration fails a company faces liquidation

The Difference Between Profit & Cash Flow

• Profit and cash are different financial terminologies

  • Profit is calculated at a specific point in time

  • While a company may be in profit, they may lack cash as some customers may not actually have paid them yet
    
    

• Profit is the difference between revenue generated and total business costs during a specific period of time
  

  • Profit can be an important indicator of a company's financial health and long-term sustainability as it helps to assess the effectiveness of a company's operations
     

• Cash is measured by taking into account the full range of money flowing in and out of a business

  • This includes revenue from sales, operating expenses, investments, loans, and any other cash-related transactions
     

• A profitable business is likely to fail if it does not have sufficient cash

  • Cash-poor businesses will struggle to pay suppliers

    • E.g. Lifestyle retailer Joules announced plans to liquidate in December 2022 as a result of cash flow difficulties despite making a profit of £2.6 million during the previous year
      

Working Capital

• Working capital is the money that a business has available to fund its day to day activities

• It is sometime reffered to as net current assets on the Statement of Financial Position

• Working capital is calculated using the formula
   

Working capital = Current assets - Current liabilities{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="Working space capital space equals space Current space assets space minus space Current space liabilities" loading="lazy" style="box-sizing: border-box; vertical-align: -4px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 20px; width: 378px;">

Worked example

Rondat Components is a heating components business based in Malmö. It has been struggling to control its level of stock. Its customers are Scandinavia’s leading gas boiler manufacturers,. They require Rondat Components to supply products ‘just in time’ and as a result they must hold large amounts of varied stock to ensure that their customer’s needs can be met. Rondat Components offers its customers 90-days credit terms.

Financial Information for Rondat Components

 
Calculate Rondat Components’ working capital in 2021 and 2022    [3]

Step 1: Identify and calculate current assets and current liabilities for 2022 and 2021

Current assets    2022 = £8.1m + £2.2m + £0.9m = £11.2m           2021 = £7.2m + £3.1m + £1.2m = £11.5m{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="table row cell 2022 space end cell equals cell space £ 8.1 straight m space plus space £ 2.2 straight m space plus space £ 0.9 straight m space equals space £ 11.2 straight m space space space space space space space space space space space end cell row cell 2021 space end cell equals cell space £ 7.2 straight m space plus space £ 3.1 straight m space plus space £ 1.2 straight m space equals space £ 11.5 straight m end cell end table" loading="lazy" style="box-sizing: border-box; vertical-align: -20px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 39px; width: 357px;"> [1 mark]

Current liabilities       2022 = £6.4m + £5.1m = £11.5m  2021 = £4.4m + £5.9m = £10.3m{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="table row cell 2022 space end cell equals cell space £ 6.4 straight m space plus space £ 5.1 straight m space equals space £ 11.5 straight m space space end cell row cell 2021 space end cell equals cell space £ 4.4 straight m space plus space £ 5.9 straight m space equals space £ 10.3 straight m end cell end table" loading="lazy" style="box-sizing: border-box; vertical-align: -20px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 39px; width: 254px;">        [1 mark]

Step 2: Subtract current liabilities from current assets for 2022 and 2021

2022    =     £11.2m - £11.5m     =    (£0.3m)  2021    =     £11.5m - £10.3m     =    £1.2m{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="table row cell 2022 space space space space end cell equals cell space space space space space £ 11.2 straight m space minus space £ 11.5 straight m space space space space space equals space space space space left parenthesis £ 0.3 straight m right parenthesis space space end cell row cell 2021 space space space space end cell equals cell space space space space space £ 11.5 straight m space minus space £ 10.3 straight m space space space space space equals space space space space £ 1.2 straight m end cell end table" loading="lazy" style="box-sizing: border-box; vertical-align: -20px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 39px; width: 328px;">             [1 mark]

Managing Working Capital

• Working capital is described as the lifeblood of a business because a lack of working capital often leads to business failure if the business cannot meet its immediate financial obligations

  • Cash is the most liquid of a business's current assets and can be used to settle debts immediately
     

• Effective management of working capital involves careful cash management
  

  • Businesses that are struggling with a lack of working capital may look to convert debtors and stock into cash as quickly as possible (e.g. by selling the stock at lower prices or by more purposefully chasing payment from customers)

  • Requesting an extension of payment terms from suppliers can increase working capital in the short term as cash remains in the business for longer

  • Making use of short-term borrowing options such as overdrafts can improve a businesses working capital situation as it can access more cash than it has in its current account
      

• A business can have too much working capital

  • If a business is holding large amounts of cash it is likely to be missing out on the benefits of investing it in fixed assets or investments

  • This may represent a significant opportunity cost especially when interest rates are high

  • If a business is holding large amounts of stock it may incur extra storage costs (e.g. security and handling costs) and could use the cash ‘tied up’ in this stock for other purposes
    

Exam Tip

A common exam error is the confusion between working capital and cash. Whilst working capital includes cash, it also includes less liquid current assets (e.g. debtors and stock). These less liquid assets cannot be used to pay bills and so, whilst a business may have a positive working capital figure, it may still fail because it cannot meet its immediate financial commitments.

Liquidity Position

• The Statement of Financial Position contains the financial information required to draw conclusions about the liquidity of the business

  • Liquidity is the ability of a business to meet its short term commitments (e.g. payments to creditors) with its available assets

  • A business that cannot pay its bills will usually fail very quickly, even if they are profitable

  • Managing liquidity is a key way to manage risk in a business - and helps a business to prepare for the unexpected

Cash Flow Forecasts

• A cash flow forecast is a prediction of the anticipated cash inflows and  cash outflows, usually for a six to twelve month period

• A detailed business plan should include a cash flow forecast that allows the business owners to identify its financial needs
  
  

Key terminology and an example

• The net cash flow is calculated by subtracting total cash outflows from total cash inflows

• The opening balance is the previous month’s closing balance carried forward

• The closing balance is calculated by adding the net cash flow to the opening balance
   

An Example of a Start-up Six-month Cash Flow Forecast (£s)

Analysis of the cash flow forecast example

Executive Summary

• Overall, this cash flow forecast supports an application for the business to borrow £6,000 in January to cover the initial low inflows, significant outflows and negative net cash flow

• As sales increase from June, inflows are greater than outflows and the business has a positive cash flow

• Should a loan be approved, the business will require any short-term sources of finance such as overdraft facilities

January

• The cash flow forecast assumes that the bank approves a £6,000 loan in January (capital introduced)

• The opening balance of £500 has been introduced by the owner

• The business is expected to achieve sales of £2,600

• Total inflows are therefore expected to be £8,600 (£2,600 + £6,000)

• Total outflows are expected to be £4,770

• The Net Cash Flow is expected to be £3,830 (£8,600 - £4,770)

• January’s closing balance is expected to be £4,330 (£3,830 + £500)

February

• The closing balance from January becomes the opening balance for February

• Sales of £2,800 as expected to be the business total inflows 

• Total outflows are expected to be £4,414 

• The Net Cash Flow is expected to be -£1,614 (£2,800 - £4,414) 

• The closing balance is expected to be £2,716 (-£1,614 + £4,430) 

June

• The closing balance from May becomes the opening balance for June

• Sales of £5,200 are the business total inflows 

• Total outflows are expected to be £5,026

• The Net Cash Flow turns positive and is expected to be £174 (£5,200-£5,026) 

• The closing balance is expected to be £814 (£174 + £640) 

Worked example

Here is a simple three-month cash flow forecast for a small seaside café

The café owner thinks that good weather will increase the volume of customers and decides to appoint another full-time assistant in March. As a result, wages increase to an expected £31,000 per month

Calculate the closing balances in the cash flow forecast resulting from the changes above. [4]

Step 1: Insert the value of the new wages into the relevant space for each month

Step 2: Calculate the new total outflows for each month and insert them into the relevant space for each month

• March: £13,000 + £31,000 + £3,500 = 47,500

  • April: £13,000 + £31,000 + £4,000 = 48,000      [1 mark]

  • May: £13,000 + £31,000 + £4,000 = 48,000 
     

Step 3: Calculate the new net cash flow for each month and insert it into the relevant space for each month

• March: £46,000 - £47,500 = -£1,500

  • April: £54,000 - £48,000 = £6,000                        [1 mark]

  • May: £61,000 - £48,000 = £13,000
    
    

Step 4: Calculate and insert the new closing balance for March and carry it forward as the opening balance for April

• £4,000 + - £1,500 = £2,500                                  [1 mark]
  
  

Step 5: Calculate and insert the new closing balance for April and carry it forward as the opening balance for May

• £2,500 + £6,000 = £8,500                                    [1 mark]
   

Step 6: Calculate and insert the new closing balance for May

• £8,500 + £13,000 = £21,500                                 [4 marks for the correct answer]
  
  

Note that this one change in the anticipated cost of wages impacts four other variables 1.Total outflows 2. Net cash flow 3. Opening balance (except March) 4. Closing balance

Exam Tip

When calculating opening and closing balances, work through each month in turn. 

Always double-check your calculations in cash flow forecasts as one mistake will have a knock-on effect elsewhere and, in some cases, lead you to make inaccurate judgements.

Evaluating Cash Flow Forecasts

• Cash flow forecasts provide insights into the expected inflows and outflows of cash over a specific period
  

• By analysing these forecasts over time, businesses can better plan and allocate their financial resources
  

• It is also important to recognise that cash flow forecasts have limitations
    

The Uses & Limitations of Cash Flow Forecasts

The Relationship Between Investment, Profit & Cash Flow

• Business investment involves the purchase of assets that are expected to create value over time

  • E.g the purchase of new machinery will improve productivity or quality which may allow the business to sell more items at a higher price and this increases sales revenue
     

• Financial investment may include the purchase of shares, bonds or property with the expectation that they will gain value over time

  • For some businesses this is an important source of income alongside their core business activities

    • E.g. US supermarket giant Walmart owns and leases over 10 thousand residential and commercial properties worldwide which act as as important added revenue stream for the brand
      
      

Changes to Investment, Profit and Cash Flow as a Business Grows

Investment, profit and cash flow over the lifetime of a business
 

• The challenges for business start ups are evident from the image above

  • They require significant investment from owners, receive little profit - and often have negative cash flow
     

• Established businesses find themselves ina more sustainable position

  • They still require investment from owners (but less), receive some profit - and usually have positive cash flow
     

• Large business require little or no investment from the owners, generate high profits - and have positive cash flow

Strategies to Improve Cash Flow

• The best way to improve cash flow is to manage the business better

  • Use cash flow forecasts to identify potential cash flow issues before they arise - and take appropriate action

  • Budget effectively and consider adopting zero budgeting to carefully control spending
     

• A business can also have too much cash

  • If a business is holding large amounts of cash it is likely to be missing out on the benefits of investing it in fixed assets or investments

  • This may represent a significant opportunity cost especially when interest rates are high
     

Methods to Improve Cash Flow

Introduction to Investment Appraisal

• Investment appraisal involves comparing the expected future cash flows of an investment with the initial expenditure on that investment
   

• A business may want to analyse 

  • How soon the investment will recoup the initial outlay

  • How profitable the investment will be
     

• Before an investment can be appraised key data will need to be collected, including

  • Sales forecasts

  • Fixed and variable costs data

  • Pricing information

  • Borrowing costs
      

• The collection and analysis of this data is likely to take some time

  • It requires significant experience to interpret the data appropriately before the investment appraisal can take place
      

• Three methods used to appraise the value of an investment, include:

  • The simple payback period

  • The average rate of return (ARR)

  • The net present value (NPR)

Simple Payback Period

• The simple payback period is a calculation of the amount of time it is expected an investment will take to pay for itself
   

• Where net cash flows are expected to be constant over time the payback period can be calculated using the formula

Initial OutlayNet Cash Flow per Period          =              Years/Months{"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="fraction numerator Initial space Outlay over denominator Net space Cash space Flow space per space Period end fraction space space space space space space space space space space equals space space space space space space space space space space space space space space Years divided by Months" loading="lazy" style="box-sizing: border-box; vertical-align: -16px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 43px; width: 408px;">

Worked example

1. Simple Payback Calculation

Gomez Carpets is considering an investment in a new storage facility at a cost of $200,000. It expects additional net cash flow of $30,000 per year as a result of the investment.

Calculate the Payback period for the investment. [3]

Step 1 - Substitute the values into the formula

   $200,000$30,000  =   6.67 years  {"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="fraction numerator $ 200 comma 000 over denominator $ 30 comma 000 end fraction space space equals space space space 6.67 space years space space" loading="lazy" style="box-sizing: border-box; vertical-align: -15px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 39px; width: 182px;"> [1 mark]

Step 2 - Convert the outcome to years and months

   6 years

   0.67 years     =    8.04 months  [1 mark]

   Payback period    =    6 years and 8 months  [3 marks for the correct answer]

Worked example

2. Payback calculation for varying cash flow over time

Hammer and Son provides a household repairs service that has recently employed a new handywoman who requires her own van. The new van will be purchased for $32,000

The net cash flows are expected to vary over the five years following its purchase and are shown in the table below.

Calculate the payback period for the van. [4]
 

Step 1 - Identify the final year where the cumulative cash flow is negative

   In this case the cumulative cash flow figure is  -$2,000 at the end of Year 3

   This is the remaining amount (outlay) outstanding. [1 mark]
 

Step 2 - Calculate the monthly net cash flow for the next year (year 4)

    $3,000 ÷ 12 (months)       =    $250  [1 mark]
 

Step 3 - Divide the remaining amount outstanding by the monthly net cash flow

    $2000 ÷ $250     =     8 months  [1 mark]
 

Step 4 - Identify the payback period

   In this case the Payback period is 3 years and 8 months  [1 mark]

 
Advantages & Disadvantages of Using the Payback Method

Average Rate of Return (ARR)

• The Average Rate of Return compares the average  profit per year generated by an investment with the value of the initial capital cost
   

• The average rate of return is calculated using the formula and is expressed as a percentage which makes it easy to compare different investment options
   

Worked example

Creative Frames, a small artwork framing business based in Bermuda, is considering an investment of $40,000 in new machinery. Megan, the business owner, believes that total returns over a 6-year period will be $76,000

Calculate the Average Rate of Return of the proposed investment.   [4 marks]

Step 1 - Deduct the capital cost from the total returns

$76,000 - $40,000   =   $36,000    [1 mark]

Step 2 - Divide the outcome by the number of years of use

$36,000 ÷ 6 years      =      $6,000     [1 mark]
 

Step 3 - Substitute the values into the formula

The Advantages & Disadvantages of Using the Average Rate of Return (ARR)

Using the Net Present Value (NPV)

• The Net Present Value (NPV) takes into account the effects of interest rates and time
  

• It recognises

  • The fact that that money received in the future is often worth less than money received today (inflation)

  • The opportunity cost of not having the money available for other uses
     

• To calculate the Net Present Value of an investment, the value of all future net cash flows in today’s terms need to be calculated first and then discounted using a table
  

• The cost of the initial investment is deducted from the total of the discounted net cash flows

  • If future net cash flows minus the initial investment are positive, then the investment is likely to be worthwhile

  • If the sum of future net cash flows minus the initial investment is negative, then the investment is unlikely to be worthwhile
    
    

• Discounted cash flows are calculated using discount tables, which allow future cash flows to be expressed in today’s terms
   

Table: Discount factors at Different Rates of Interest

Worked example

Brownsea Sightseeing Tours Ltd is considering purchasing a new pleasure craft at a cost of £325,000.  It expects the investment to achieve the following net cash flows over five years of operation

Using the 10% discount factor calculate the NPV of the leisure craft investment. (4 marks)

Step 1 - Calculate the discounted cash flow for each year by multiplying the net cash flow by the discount factor

(2)

Step 2: Add together the discounted cash flow values for each year, including Year 0   

£325,000 + £100,100 + £74,400 £56,250 + £44,200 + £37,200= (£12,550){"language":"en","fontFamily":"Times New Roman","fontSize":"18","autoformat":true}" class="Wirisformula" role="math" alt="open parentheses £ 325 comma 000 close parentheses space plus space £ 100 comma 100 space plus space £ 74 comma 400 space £ 56 comma 250 space plus space £ 44 comma 200 space plus space £ 37 comma 200 equals space left parenthesis £ 12 comma 550 right parenthesis" style="box-sizing: border-box; vertical-align: -33px; max-inline-size: 100%; block-size: auto; object-fit: contain; height: 64px; width: 503px;">       

(1)

The Net present Value of the investment is -£12,550

This negative outcome suggests that the investment in the new pleasure craft is not financially worthwhile         

(1)

 
Advantages and Disadvantages of the Net Present Value Method

Exam Tip

Being able to calculate the payback period, ARR or NPV of an investment is a key quantitative skill

More important, though, is interpreting the outcome of your calculation and using it to make a judgement

• Is an investment worthwhile?

• Which investment is the most profitable?

• The costs of which investment will be recouped first?

Qualitative factors should be considered alongside calculations - review case study material carefully to select relevant information

Limitations of using Investment Appraisal

• Each techniques relies upon forecasted future cash flows which may lack accuracy

  • Managers may lack experience or may be biased towards a particular investment

  • Incomplete past data may make forecasting imprecise or mean that confidence in the data is limited
     

• Longer-term forecasts used to predict returns on investments may be inaccurate for a variety of reasons

  • Unexpected increases in costs

  • The arrival of new competitors

  • Changes in consumer tastes

  • Uncertainties arising as a result of economic growth or recession
    
    

• Non-financial factors are ignored

  • Business finances and availability of external finance to fund the investment

  • Overall corporate objectives 

  • Potential for positive public relations or meeting social responsibilities

An Introduction to Cost & Profit Centres

• Tracking costs and revenues becomes more complex as a business grows

• Cost and profit centres classify different parts of a business based on their financial performance
   

Cost Centres & Profit Centres

Advantages & Disadvantages of Cost & Profit Centres

• The advantages and disadvantages of cost and profit centres can vary according to the size and type of business

• Multi-unit businesses, those with numerous product lines and complex businesses may benefit extensively from using cost and/or profit centres
   

Advantages & Disadvantages of Cost and Profit Centres

An Introduction to Budgets

• A budget is a financial plan showing the business costs and revenue for a given time period

  • Budgets are set for the whole business and for individual cost centres or profit centres

  • Budgets are set in advance (monthly, quarterly or annua) and monitored regularly

  • The budget is usually closely aligned with the business objectives
     

Why Businesses use Budgets

 
Types of Budgets

• Budgets are generally prepared using one of two methods

  • Historical figure budgets

  • Zero based budgeting

A Comparison of Historical and Zero Budgeting Methods

Constructing a Budget

• The master budget consolidates all of the budgets delegated to cost centres or profit centres into one budget

• It is managed by the Finance Director
   

A Diagram that shows Common Types of Delegated Budgets

The Master Budget is a consolidation of delegated budgets such as Sales, Marketing, Production and Staffing
 

• Sales budgets forecast the volume of sales and expected sales revenue

• Marketing budgets plan finances allocated for marketing activities including market research, promotion and pricing tactics

• Production budgets plan the level of output, stock and overhead costs as well as aspects such as waste

• Staffing budgets plan the costs involved in employing workers including recruitment and training
    

Factors Affecting the Construction of Budgets 

• A range of factors are considered when determining budgets
   

Factors Affecting the Construction of Budgets

Understanding Budget Variances

• A budget variance is a difference between a figure budgeted and the actual figure achieved by the end of the budgetary period (e.g. twelve months)

• Variance analysis seeks to determine the reasons for the differences in the actual figures and budgeted figures
  
  

A Diagram to Illustrate Favourable and Adverse Budget Variances

Variance analysis identifies adverse and favourable budget outcomes
  

• A favourable variance (F) is where the actual figure achieved is better than the budgeted figure
  

  • A favourable variance in a revenue or profit budget is where the actual figure is higher than the budgeted figure
    

  • A favourable variance in a costs budget is where the actual figure is lower than the budgeted figure
    

  • Examples of favourable variances include

    • Actual wages less than budgeted wages

    • Actual sales volumes higher than budgeted sales volumes

    • Expenditure on raw materials less than the budgeted figure
       

• An adverse variance (A) is where the actual figure achieved is worse than the budgeted figure
  

  • An adverse variance in a revenue or profit budget is where the actual figure is lower than the budgeted figure
    

  • An adverse variance in a costs budget is where the actual figure is higher than the budgeted figure
    

  • Examples of adverse variances include

    • Expenditure on fuel higher than the budgeted figure

    • Profit lower than budgeted

    • Actual marketing costs higher than budgeted marketing costs

Worked example

Selected financial information for Bunsens PLC 2022

Using the data, calculate the total profit variance for Bunsen PLC in 2022. You are advised to show your working (4)

Step 1 - Calculate the budgeted profit for 2022

￡12,460 - ￡8,420

= £ 4,040                       (1)

Step 2 - Calculate the actual profit for 2022

￡13,718 - ￡10,627

= ￡3,091                             (1)

Step 3 - Subtract the budgeted profit from the actual profit for 2022

￡3,091 - ￡4,040

= ￡949                                (1)

Step 4 - Identify the nature of the variance

In this case, the variance is adverse because the actual profit for 2022 is lower than the budgeted profit for 2022

The correct answer is ￡949 A                           (1)

Responses to Budget Variances

• Once variances have been identified a business should carefully investigate the reasons why they have occurred and take appropriate action such as
  
  

  • Where adverse cost variances are identified a business may seek alternative suppliers or investigate ways to improve efficiency
    
    

  • Where adverse sales variances are identified a business may review its marketing activities to improve their effectiveness
    
    

  • Where favourable cost variances are identified a business may review key quality indicators such as the volume of returns or wastage levels to ensure that output standards are being met
    
    

  • Where favourable sales variances occur a business may reward customer-facing staff with performance based incentives