Unit 5 -- finance
Setting financial objectives
Financial objective -- this is a specific goal ot target focused on financial performance, resources and structure of the business.
Benefits of using financial objectives
Provides a focus for the entire business.
Provides an important measure of success or failure.
Helps reduce the risk of business failure.
Provide transparency for shareholders on their investment.
Helps cordinate different business functions.
Important for making business investment decisions.
Profit -- this is the differences between total revenues and total costs over a period.
Cash flow -- this is the differences between total cash inflows and total cash outflows over a period.
Measurements of profits
Gross profit
gross profit = revenue - cost of sales
Cost of sales -- these are the costs that are directly linked to the selling of products and includes the cost of raw materials and direct labour costs.
Operating profit
operating profit = revenue - (cost of sales + administrative expensives)
Administrative expensives -- these are costs that are not directly to the goods or services and includes costs such as distribution costs and overheads.
Profit for the year
operating profit = revenue - total costs
This includes finance expensives and taxtion.
Objectives
Revenue objectives
Sales maximisation - aims to maximise total sales regardless of profitability.
Market share -- grow market share.
Revenue growth -- this means increasing the amount of renevnue a business generates.
Cost minimistation objectives
Cost minimistation -- this aims to achieve the most cost effective way of delevering goods and services to the required level of quality.
Benefits
Lower unit costs.
Higher gross profit.
Higher operating profit.
Potentially improve cash flow.
Higher return on investment.
Profit objectives
Specific profit objective -- achieve an operating profit of a certian amount.
Rate of profitability -- this is an objective of obtiaining an operating profit margin of a certian amount.
Profit maximistation -- maximise total profit for the year.
Exceed industry or market profit margins -- achieve a higher gross profit or operating profit margin than key competitors.
Cash flow objectives
A strong cash flow makes it easier to achieve other financial objectives by providing more day to day cash.
Examples
Reduce borrowing
Minimise interest costs
Reduce seasonal swings in cashflow
Return on investment objectives
Level of capital expenditure (i.e control how much money is beign invested).
Return on investment
This aims to improve a businesses return on investment as a business wants a high return on investment.
Capital structure
Capital structure -- this is how a business raises its funds either through loans or internal sources.
Equity -- this is the amount of money a business owns.
Debt -- this is the money that busineses owe to other organistions such as banks.
gearing = (non-current liabilities/total equity+non-current liabilities)100*
Used to show how much of the business is debt.
Influences on financial objectives
Internal
Business ownership.
Size and status of the business.
Size and financial demand of other functional areas.
External
Economic conditions
Actions of competitors
Social and political change
Analysing financial performance
Budgets
Budgets -- these are a financial plan for the future concerning the revenue and costs of a business.
Variances
Use of budgets
Can help set targets (e.g cut unit costs by 10%).
Helps provide direction and coordination.
Helps management delaget without loosing control (they still control the budget).
Principles of good budgeting
Managerial responsibility is clearly defiend in the budgets (who/which department has/controls what).
Managers must adhere to the budgets (as best they can).
Managers and departmental performance is based off budgets.
Corrective action is taken if thee is a large varience.
Variences that are unacounted for must be investigated (helps prevent embezolement).
There are two ways that a business can decide how its budgets are given out:
Historical budgeting
Last years figures are the basis of this method.
This is a realistic estimate to what the future will be like as it is based off past events.
Con: it fails to take into account possible changes to the external and internal enviroments.
Zero budgeting
Each year, each departments argues its case for a set amount of budget and budgets are based on the predications of each department.
Cons:
-- This makes budgeting choatic and complicated.
-- A charismatic manager may be able to get a larger budget they their department deserves.
Types of budgets
Revenue/income budgets -- based off each departments (either functional, product or regional) predicated revenues.
Cost/expenditure budgets -- based of the exected costs of a business.
Forces management to justify every expense they make and this should help cut waste from the business.
Profit budgets -- these are based on both the revenue and cost budgets and are used to predict the profit of a business. These are of great interest to stakeholders and may be the basis of performance based ratings.
Difficulties in constructing budgets
Sales forcast
Can be hard to forcast sales in rapidly changing markets (such as tech).
It can be hard for startup businesses to predict sales as they have little to no prioir data.
Can be hard to predict competitor actions.
Costs
There will always be unexpected costs.
Can be impacted by the external enviroment (e.g inflation).
Varriences -- these are the differences between the actaul budget and the predicated budget.
Adverse -- this is where a business's performance has been worse then expected (although they can still be profitable).
Favourable -- this is where a business's performance has been better then expected (although they can still be unprofitable).
Interpreting variances
Once a varience has been indentified a business should:
Identify the cause of the variance.
Consider the effect of the variance (for example will they need a loan?).
If approaite, look for a solution.
Causes of variances
Actions of competitors.
Actions of suppliers.
Changes in the economy.
Changes in internal effiency.
Internal decision making (e.g supplier change or you close a store).
Disadvantages with setting budgets
Potenial conflict.
A lack of transparency may lead to managers feeling short changed.
Budgets may be to hard to achieve, putting to much pressure on managers.
Maybe restrictrive.
Managers may pass up opportunities over fears it will damage their budget.
May force ineproatiate cost cutting.
Can waste time setting and monitoring them.
Budgets are only as good as the data that is inputed to them meaning that poor data collection will make budgets effectivly worthless.
The study and analysis of variences enables businesses to identify weaknesses in the business and focus on improving those areas.
Breakeven
Breakeven is used to anlyse how much a business needs to produce to ensure that it is covering its costs.
Contribution
Contribution -- this is a measure how much profit comes from a product or product line.
Contribution = total sales - total variable costs
Contribution per unit = selling price per unit - variable costs per unit
Profit = contribution - fixed costs
Total contribution = contribution per unit X fixed cost
Breakeven output = fixed costs / contribution per unit
Margin of safety = units produced - breakeven output
Strenths of break even analysis
Shows the business how much it needs to produce to be profitable.
Helps show the importance of keeping fixed costs down.
Quick and easy.
Helps show how long it should take for a startup to become profitable.
Limitations of break even analysis
Unrealistic as fixed costs can change as output increases (e.g needing to expand to a bigger premise).
Output deos not equal sales and therefore just because you are producing enough products deos not mean you are profitable.
Variable costs do not increase at the same rate constantly, there growth can slow due to economies of scale.
Most businesses sell more then one product, but a break even chart is only for one product.
It is a planning aid not a decision making tool.
Profitability
Gross profit margin
Gross profit margin = (GP/revenue)X100
A bad GPM indicates the business is:
The business is not managing the cost of sales effectivily.
Sales in decline.
Operating profit margin
Operating profit margin = (OP/revenue)X100
A bad OPM indicates the business is:
Poor at managing its expenses.
Sales in decline.
Profit for the year margin
PFYM = (PFY/revenue)X100
A bad PFYM indicares the business is:
Gross profit or operating profits are in decline.
Interest rates have changed.
How to improve profitability
Sell the same number of products for more.
Sell more at the same price.
Sell the same amount, at the same value, but reduce costs.
Sources of finance
Long term
Share capital
Pros
Only costs money is the business is profitable (that is the only time dividends are paid).
Enables some businesses to raise large sums of money.
No interest to pay.
Cons
Business and founders loose control/ownership as shareholders gain some of the business.
There is a threat of hostile takeover.
Can be complex and costly to issue shares.
Retained profits
Retained profits -- these are the profits a business keeps from the last financial year.
Pros
Avoids interest payments.
Deosn't dilute ownership.
Cons
Only an option if the business retains profits.
Can upset shareholders if it reduces dividends.
Uses up retained profits that can act as a security blanket for the business.
Venture capital
Venture capital -- this is where a business or person will invest money into a business commonly a start-up which caries a substianl level of risk (e.g Dragons Den).
Pros
Potential for large sums of money.
Can provide expertise to help the business.
Makes it safer for other sources of finance.
Provides the required capital for expansion.
Cons
A long term and complex process.
A business needs a concrete business plan to justify the risk to the venture capitalists.
Can be expensive early on due to legal and accounting fees.
Risk of conflict (due to different ambitions of the venture capitalist and management (e.g rapid or steady growth)).
Mortgage
Long term bank loan
Long term bank loan -- These are bank loans with a fixed interest rate and which are usually secured against business assets.
Crowdfunding
Crowdfunding -- this is the process of raising large sums of money from a wide range of people all of whom usually provide a small amount. This is commonly done over the interet and those that invest will commonly gain small rewards.
Meduim term
Leasing
Leasing is commonly used by a business to rent long term equipment such as IT systems, company cars and printers.
Higher purchase agreements
Higher purchase agreements -- these are deals with the consumer where the consumer buys an expensive product, but pays it off in installments. Once the last installment is paid they own the products.
Government grant
Government grant -- this is a financial reward given by the governemnt to business for beneficial products, the grantee is not expected to rapay the grant, but is expected to use it well (commonly used to stimulate the economy in deprived areas and in emerging industries such as tech).
Short term (finances used for everyday trading)
Overdraft
Trade credit
Trade credit -- this enables a business to delay when it pays a business (i.e buy now, pay later).
Bank loan
Debt factoring
Debt factoring -- this is where a business sells its debt to a third party who will collect the debt in exchange for a share of the debt (i.e a business buys debt off another business, but keeps some as profit).
Pros
The business that orginally has the debt deos not have to wait for the debt to be repaid.
Debts are chased by experts and this saves managers time.
Cons
A business deos not get all its debt back.
May damage the businesses reputation as it may be seen as in need of short term finace (may impact share prices).
How deos a business decide which source of finance to go with?
A business will assess how much they will get from the source of finance and whether this provides safety in the budget.
Business will assess the speed in which they get the money (this will be more important to some businesses then others).
Improving cash flow and profits
Cash flow -- this is the money going in and out of a business, but deos not equal profit (you can be profitable, but have cashflow issues).
Net cash flow = money in - money out
Opening budget -- this is how much money a business has at the start of the month.
Closing budget -- this is how much money a business has at the end of the month.
Cash flow statement -- this is a backwards looking assesement of the cashflow of a business over a period of time.
Cash flow forcasting
Cashflow forecasting -- this is the process of predicting the cashflow of a business.
Problems with forecasting cashflow:
Sales are hard to predict.
Customers may not pay on time.
Costs may prove higher then expected (inflation).
Working capital -- this is the money used by a business on a day to day basis.
Reasons for cashflow problems
Customers don't pay on time.
Lower then expected sales.
To much capacity meaning money is wasted on fixed assests.
Excess inventories are held.
Overtrading (where the business expands to fast and its current sources of finance are not suffiecent to keep it running).
Seasonal demand (especially businesses connected to tourism).
External enviroment changes.
How to manage cashflow problems
Improve the quality of cashflow forecasts.
Manage working capital effectivly.
Choose the right sources of finance for the situation for example if interest rates are high using an overdraft is less desireable.