TOPIC 5 - Decision Making on Financial Performance (3.5.1 - 3.5.2)✅

• 3.5.1 Setting financial objectives ..
• financial objectives?


  The monetary targets a business wants to achieve in a given time period
• what are included within financial objectives?

  1. return on investment

  2. capital structure

  3. revenue

  4. costs

  5. profit

  6. cash flow
• benefits of financial objectives?

  - provide direction and measure financial performance (measure for success/failure)

  - support decision making

  - motivate employees
• return on investment (ROI)?

  a measure of a firm's profitability + performance, shows how efficient an investment was, used to compare the financial opportunity costs
• profitability?


  a measure of a firms financial performance against factors such as revenue
• formula for ROI?


  operating profit/capital investment x 100
• long term funding?


  the amount of capital that has been invested in a business + will stay in the business for over a year —> normally a purchase of assets
• two sources of long term funding?

  1. Equity - money invested by shareholders of a company

  2. Debt - money borrowed from financial institutions
• capital structure?


  ways in which capital has been raised i.e. the ratio of debt to equity
• risks of using long term funding?

  repayments have to be made to the financial institutions

  increases the degree of risk especially if interest rates rise

  insolvency - if business cannot pay back loans
• gearing?


  debt/long term funding x 100

  
  

  ratio of a company's debt to equity
• high gearing ratio shows?

  the company is using more debt to fund its operation which may increase financial risk
• revenue objectives?


  targets set for the amount of money coming from sales in a set period of time
• cost objective?


  limits set for the amount of money to be spent on expenditure (cost minimisation)
• profit?


  profit = revenue - total costs

  
  

  total revenue is greater than total costs
• profit objectives?


  amount of surplus to be achieved in a set period of time
• cash flow?


  the movement of money into and out of a business
• what is a 'negative net effect'?

  when more money is flowing out quicker than it is flowing in
• 3.5.2 Analysing financial performance
• budget?


  a financial plan for the future concerning the revenue + costs of a business
• key uses of budgets?

  - establish priorities + set targets

  - allocate resources

  - monitor performance

  - provide direction + co-ordination
• what are the two main approaches to budgeting?

  1. historical budgeting - use of last year's figures as the basis for the budget

  2. zero budgeting - setting all future budgets at £0, force managers to justify their spending levels
• advantages & disadvantages of historical budgeting?

  advantages

  - realistic

  - more likely to be accurate as it is based on previous actual results

  
  

  disadvantages

  - circumstances may have changed e.g. new products, loss of customers, change in market

  - does not encourage efficiency
• advantages & disadvantages of zero budgeting?

  advantages

  - the budget is based on new proposals for sales + costs i.e. built from bottom up

  - budgeting is potentially more realistic

  
  

  disadvantages

  - makes budgeting more time consuming

  - lack of flexibility
• the three main types of budget?

  1. revenue (income) budget

  2. cost (expenditure) budget

  3. profit budget
• profit budget?


  based on the combined sales + cost budgets, they are of great interest to stakeholders + form the basis for performance bonuses
• what are the main difficulties of budgeting accurately?

  1. forecasting sales

  2. costs
• why is forecasting sales difficult to deal with when budgeting?

  - it is hard to budget when the market is continually changing (e.g. new technology)

  - start up firms will find it hard to estimate likely sales + revenues

  - competitor actions difficult to predict
• why are costs difficult to deal with when budgeting?

  - there will always be unexpected costs

  - the costs will VARY depending on sales budget

  - changes in external environment will impact costs (e.g. taxes, exchange rate)
• variance analysis?


  differences between actual results + the budgets
• variances can be either:

  positive/favourable (better than expected)

  adverse/unfavourable (worse than expected)
• a favourable variance might mean that:

  - costs were lower than expected in the budget

  - revenue/profit were higher than expected
• causes of favourable variances?

  - stronger demand than expected = higher actual revenue

  - selling price increased higher than budget

  - cautious sales + cost of assumptions (e.g. cost contingencies)

  - better than expected productivity/efficiency
• an adverse variance might mean that:

  - costs were higher than expected

  - revenue/profits were lower than expected
• causes of adverse variance?

  - unexpected events

  - overspending by budget holders

  - sales forecast were too optimistic

  - market conditions may mean that demand is lower
• advantages of variance anaylysis

  planning —> helps managers to budget smarter and more accurately

  responsibility —> helps with the assignment of trust within an organisation

  monitoring —> helps to monitor success and failure
• disadvantages of variance analysis

  - can be misleading or inaccurate if budget is unrealistic, outdated or based on faulty assumptions

  - it does not tell us the causes of the problems + the reasons why which may lead to poor decision making from managers
• total contribution?


  total sales - total variable costs or contribution per unit x number of units sold
• contribution per unit?


  the amount of revenue which contributes to FC once VC have been taken away

  
  

  selling price per unit - variable costs per unit