5. Decision Making to Improve Financial Performance
Financial Objectives of Businesses
A financial objective is a specific goal or target relating to the financial performance, resources, and structure of a business.
SMART objectives:
Specific
Measurable
Attainable
Relevant
Time-bound
Value of setting financial objectives:
Provides a focus for the entire business.
Serves as an important measure of success or failure.
Helps reduce the risk of business failure.
Provides transparency for stakeholders about their investment.
Helps coordinate different business functions.
Provides the key context for making investment decisions (investment appraisal).
Key Financial Objectives:
Revenue:
Revenue growth (% or value)
Sales maximisation
Market share
Costs:
Cost minimisation
Unit costs
Profit:
Specific level of profit (in absolute terms)
Rate of profitability (% of revenues)
Profit maximisation
Cash flow:
Maximise cash balances
Limit how much is tied up in working capital
Cash flow to profit %
Capital structure:
% of capital provided by debt (gearing)
Debt/equity ratio
Return on investment:
Level of investment (£)
Return on investment (%)
Return on capital employed % (ROCE)
Influences on Financial Objectives:
Main types of financial objectives:
Revenue Objectives
Cost Objectives
Profit Objectives
Cash Flow Objectives
Investment Objectives
Capital Structure Objectives
Internal Influences:
Business ownership: Different approaches based on ownership type (e.g., venture capital vs. family ownership).
Size and status of the business: Start-ups focus on survival, breakeven, and cash flow, while larger companies focus on growth.
Other functional objectives: Almost every other functional objective in a business has a financial dimension.
External Influences:
Economic conditions: Economic downturns lead to cost minimization and maximizing cash flow. Changes in interest rates and exchange rates affect ROCE.
Competitors: Competitive environment affects the achievability of financial objectives; cost minimization may become essential.
Social and political change: Indirect impact; legislation may force increased investment in some areas and cost cuts in others.
Profit:
Operating profit: The difference between sales revenues, cost of goods sold, and other operating costs.
Operating profit margin equation: Operating\ profit\ margin\ % = \frac{Operating\ profit\ £}{Sales\ revenue\ £}
Interpreting the operating profit margin:
Changes from year to year should be analyzed and compared with similar businesses.
A fall in operating profit margin may indicate higher operating costs or a lower gross profit margin.
An increase in operating profit margin may reflect a higher gross profit margin or better control of operating costs.
Gross Profit: The difference between sales revenues and cost of goods sold.
Gross profit equation: Gross\ Profit\ Margin\ % = \frac{Gross\ Profit\ £}{Sales\ Revenue\ £}
Interpreting the gross profit margin:
Changes from year to year should be analyzed and compared with other similar businesses.
A fall in gross profit margin may indicate higher costs from suppliers or a decision to sell at lower prices.
An increase in gross profit margin may reflect better buying from suppliers or selling price rises.
Cash Flow Objectives:
Cash is crucial for achieving other financial objectives.
Example cash flow objectives:
Reduce borrowings to a target level.
Stay below the limit for gearing %.
Minimize interest costs.
Reduce amounts held in inventories or owed by customers.
Reduce seasonal swings in cash flows.
Cash Flow Management:
Main causes of cash flow problems:
Low profits or losses
Too much production capacity
Excess inventories held
Allowing customers too much credit and too long to pay
Overtrading (growing business too fast)
Seasonal demand
How to manage cash flow problems:
Use reliable cash flow forecasting.
Keep costs under control.
Manage working capital effectively.
Choose the right sources of finance.
Managing Working Capital:
Effective working capital management focuses on:
Stocks
Debtors
Creditors
Managing stocks:
Stocks take the form of raw materials, work-in-progress, and finished goods.
Stockholding is costly; therefore:
Keep smaller balances (just-in-time stocks)
Computerize ordering to improve efficiency
Improve stock control (e.g., stock control chart)
This cuts spending on stocks but may leave the business vulnerable to stock-outs.
Managing amounts owed by customers:
Credit control:
Policies on how much credit to give and repayment terms and conditions
Measures to control doubtful debtors
Credit checking
Selling off debts to debt factors
Cash discounts for prompt payment
Improved record keeping (e.g., accurate and timely invoicing)
Debt Factoring:
Selling debtors (money owed to the business) to a third party.
Generates cash.
Guarantees the firm a percentage of money owed to it.
Reduces income and profit margin made on sales.
The cost involved in factoring can be high.
Managing Cash Paid to Suppliers:
Trade credit: Amounts owed to suppliers for goods supplied on credit and not yet paid for.
Delayed payment means that the firm retains cash longer.
Must be careful not to damage the firm’s credit reputation and rating.
Trade creditors are (wrongly) seen as a ‘free’ source of capital.
Some firms habitually delay payment to creditors to enhance their cash flow—a short-sighted policy that raises ethical issues.
Evaluation: Improving a Poor Cash Position:
Short term:
Cut costs
Reduce current assets (stock and debtors)
Increase current liabilities (delaying payment)
Sell surplus fixed assets
Long term:
Increase equity finance
Increase long-term liabilities
Reduce net outflow on fixed assets
Capital Structure (Finance):
Capital of a business represents the finance provided to it to enable it to operate over the long term.
Two parts to the capital structure:
Debt: Finance provided to the business by external parties (bank loans, other long-term debt)
Equity: Amount invested by the owners of the business (share capital, retained profits)
Reasons for a business to have higher:
Debt:
Where interest rates are very low (debt is cheap to finance)
Where profits and cash flows are strong (debt can be repaid easily)
Equity:
Where there is a greater business risk (e.g., a startup)
Where more flexibility is required (e.g., don’t have to pay dividends)
Budgeting:
A budget is a financial plan for the future concerning the revenues and costs of a business.
Budgeting: A process by which financial control is exercised in a business.
Budgets for revenues and costs are prepared in advance and then compared with actual performance to establish any variances.
Managers are responsible for controllable costs within their budgets.
Variances:
A variance arises when there is a difference between actual and budget figures.
Variances can be:
Positive/Favorable (better than expected)
Adverse/Unfavorable (worse than expected)
Favorable variances:
Actual figures are better than the budgeted figure (e.g., costs lower, revenue/profits higher)
Adverse variances:
The actual figure is worse than the budget figure (e.g., costs higher, revenue/profits lower)
Possible causes of favorable variances:
Stronger demand than expected (higher actual revenue)
Selling prices increased higher than the budget
Cautious sales and cost assumptions (e.g., cost contingencies)
Better than expected productivity or efficiency
Possible causes of adverse variances:
Unexpected events lead to unbudgeted costs
Over-spends by budget holders
Sales forecasts prove over-optimistic
Market conditions (e.g., competitor actions) mean demand is lower than budget
Breakeven Analysis:
Breakeven output: Reached when total revenues = total costs.
Revenues and costs:
Revenues: Value of sales made by a business (Selling\ price \times units\ sold)
Costs:
Variable costs: Vary in relation to output
Fixed costs: Do not vary in relation to output
Total costs: Variable costs + Fixed costs
Margin of Safety:
The difference between actual output (units) and breakeven output (units).
Profit of a business equation: Profit = Margin\ of\ safety\ (units) \times Contribution\ per\ unit\ (£)
How to improve the margin of safety:
Increasing contribution per unit:
Raise selling prices
Reduce variable costs per unit
Lower the breakeven output:
Lower fixed costs
Turn fixed costs into variable costs
Increase actual output:
Sell more
Receivable and Payables
Key terms:
Trade receivables (Debtors): Amounts owed to a business by customers
Trade payables (Creditors): Amounts owed by a business to suppliers and others
Receivables days: The average length of time taken by customers to pay amounts owed
Payables days: The average length of time taken by a business to pay amounts it owes
Evaluating receivable days:
Interpreting the results:
Shows the average time customers take to pay
Each industry will have a ‘norm’
Look out for significant changes
Look out for:
Comparisons (good or bad) vs. competitors
Balance sheet window-dressing
Evaluating payable days:
Interpreting the results:
In general, a higher figure is better for cash flow
Ideally, payable days are higher than receivable days
Be careful: a high figure may suggest liquidity problems (stretching supplier goodwill)
Look out for:
Evidence from the current ratio or acid test ratio that business has problems paying creditors
Window-dressing: this is the easiest figure to manipulate
Sources of Finance:
Factoring is one of many potential sources of finance:
Long-term:
Finances the whole business over many years
Share capital
Retained profits
Venture capital
Mortgages
Long-term bank loans
Medium-term:
Finances major projects or assets with a long life:
Bank loans
Leasing
Hire purchase
Government grants
Short-term:
Finances day-to-day trading of the business
Bank Overdraft
Trade creditors
Factoring
Factoring
What is Factoring:
Factoring is a way a business can raise cash by selling its sales invoices to a third party (a factoring company) at a discount
An example of factoring:
A business makes sales of £100,000 per month. Its customers are given 60 days to pay their invoices. On average, the business has around £200,000 owed to it by customers at any one time. The business needs to raise cash to improve its liquidity
What can the business do about these invoices?
Two options:
Wait for customers to pay their invoices (e.g 60 days)
Sell these invoices to a factoring company for cash (at a discount)
E.g invoices worth £200,000 are sold to the factoring company
The business gets 90% in cash £180,000
The factoring company collects and keeps the £200,000
Benefits and Drawbacks of Factoring:
Benefits:
Receivables (amounts owed by customers) are turned into cash quickly
Businesses can focus on selling rather than collecting debts
Drawbacks:
Quite a high cost (discount offered to the factoring company)
Customers may feel their relationship with the business has changed
Bank Loans and Overdraft
Long-term:
Finances the whole business over many years
Share capital
Retained profits
Venture capital
Mortgages
Long-term bank loans
Medium-term:
Finances major projects or assets with a long life:
Bank loans
Leasing
Hire purchase
Government grants
Short-term:
Finances day-to-day trading of the business
Bank Overdraft
Trade creditors
Factoring
Internal Sources:
Retained profits
Working capital
Asset disposals
External Sources:
Share capital
Bank loan/overdraft
Debentures
Venture capital
Suppliers
Bank loans:
Key Features:
The loan is provided over a fixed period (e.g. 5 years)
The rate of interest either fixed or variable
Timing and amount of repayments are set
Usually, some security is required for the loan
Bank Loan benefits:
Greater certainty of funding provided terms of the loan complied with
Lower interest rate than a bank overdraft
Appropriate method of financing fixed assets
Bank Loan drawbacks:
Requires security (collateral)
Interest paid on the full amount outstanding
Harder to arrange
Startups and small businesses are often excluded
Bank Overdrafts- key features:
Short-term finance, widely used by businesses of all sizes
An overdraft is really a short-term facility- the bank lets the business ‘owe it money’ when the bank balance goes below zero
A flexible source of finance: only used when needed
Excellent for helping a business handle seasonal fluctuations in cash flow or when the business runs into short-term cash flow problems (e.g. a major customer fails to pay on time)
Bank Overdraft benefit:
Relatively easy to arrange
Flexible- use as cash flow requires
Interest- only paid on the amount borrowed under the facility
Bank Overdraft drawbacks:
Can be withdrawn at short notice
Interest charge varies with changes in interest rate
Higher interest rate than a bank loan
Retained Profits:
Long-term:
Finances the whole business over many years
Share capital
Retained profits
Venture capital
Mortgages
Long-term bank loans
Medium-term:
Finances major projects or assets with a long life:
Bank loans
Leasing
Hire purchase
Government grants
Short-term:
Finances day-to-day trading of the business
Bank Overdraft
Trade creditors
Factoring
Internal Sources:
Retained profits
Working capital
Asset disposals
External Sources:
Share capital
Bank loan/overdraft
Debentures
Venture capital
Suppliers
Retained Profits as a Source of Finance:
How are profits a source of finance?
A retailer buys a stock of vinyl records for £100
During the next month, it sells this stock for £300 cash, making a profit of £200
The cash profit of £200 is then reinvested in £100 of new stock and the balance of £100 is used to pay shop wages
Retained Profits: key features:
Earned from profitable trading
Can either be kept in business or paid out as dividends
Highly flexible- shareholders in control
Not zero-cost because of opportunity costs
Retained Profits: benefits:
Flexibility
Business owners in control
Low cost
Can be substantial
Retained Profits: drawbacks:
A drain on finance if loss-making
The danger of hoarding profits
The opportunity cost for shareholders