3.5 Decision making to improve financial performance

• Financial Objective


  A specific goal or target relating to financial performance
• What objectives can be based on

  • Revenue
  • Costs
  • Profit
  • Cash flow
  • Investment levels
  • Capital structure
  • Return on investment
  • Debt as a proportion of long term funding
• Benefits of setting financial objectives

  • Provides a focus for the business as a whole
  • Focus for decision making and effort
  • Can measure success and failure
  • Reduces the risk of business failure (particularly prudent cash flow objectives)
  • Improved coordination (of the different business functions) and efficiency
  • Information for shareholders – priorities of management
  • Allows external stakeholders to confirm financial viability
  • Provides a target to help make investment decisions
• Difficulties of setting financial objectives

  • Not always realistic
  • External changes
  • Difficulty in measuring
  • May conflict with other objectives
  • Responsibility may lie with finance department, when it is a whole business priority
• Return on Investment (ROI)


  The measure of efficiency of an investment in financial terms, used to compare the financial returns of alternative investments
• Profit


  Revenue – total costs

  
• Cash Flow


  The money flowing in and out of the business on a day to day basis
• Net Cash Flow


  The money left over when a business takes its outflows from its inflows
• Main cash inflows


  • Money invested by business owners
  • Loan from the bank
  • Income from sales
• Main cash outflows


  • Wages and training
  • Raw materials
  • Advertising
  • Rent, mortgage, and bills
  • Taxes
  • Interest on loans
  • Maintenance and repair
• Gross Profit


  Shows how efficiently a business converts raw materials into finished goods and how much value they add
• Operating Profit (Net Profit)

  Gross profit – expenses
• Profit for the Year


  The profit available to shareholders and it includes the sale of assets, interest payments, and tax
• Revenue objectives


  • Sales maximisation – volume/value
  • Targeting a specific increase in sales revenue
  • Exceeding the sales of a competitor
  • Revenue growth (% or value)
  • Market share
• Cost objectives


  • Cost minimisation – this could be in terms of unit cost which are then further linked to efficiency, labour productivity, and capacity utilisation
  • Productivity – in terms of unit per worker and capacity utilisation
• Profit objectives


  • Specific level of profit (in absolute terms)
  • Rate of profitability (as a % of revenues)
  • Profit maximisation
  • Exceed industry or market profit margins

  
• Cash flow objectives


  Ensure the firms can keep trading
• Cash flow objectives


  • Maintain a minimum closing monthly balance
  • Reduce bank overdraft by a certain amount by the end of the year
  • Create a more even spread of sales revenue
  • Spread costs more evenly
  • Setting contingency fund levels
• Cash flow objectives


  • Maximum level of debt (the absolute amount, rather than the gearing ratio)
  • Amount of cash tied up in working capital (inventories, receivables)
  • Cash flow to profit %

  
• Advantages of cash flow forecasts

  • Identify problems in advance
  • Guide to appropriate action
  • Make sure there is sufficient cash to make payments
  • Evidence for financial support
  • Avoids failure
  • Identifies if they are holding too much cash
• Causes of cash flow problems

  • Poor management (spending too much)
  • If the business isn't performing well – the outflows are greater than inflows
  • Offering customers too long to pay – slow cash inflow compared to outflow
• Problems to forecasting


  • Changes in the economy
  • Changes in consumer taste
  • Inaccurate market research
  • Competition
  • Uncertainty
• Investment objectives


  • Replacement capital/investment – to replace assets that have depreciated (this does not add to the stock of capital goods)
  • New investment – money spent on new capital goods which enables a business to increase its capacity to produce
  • Level of capital expenditure – at either an absolute amount (e.g. invest £5m per year) or as a percentage of revenues (e.g. 5% of revenues)
  • Return on investment – usually set as a target % return, calculated by dividing operating profit by the amount of capital invested
• Capital Structure


  The balance of its finance in terms of how much is equity (or share capital) and how much is is in the form of debt
• Capital structure objectives


  • Gearing ratio (the percentage of total business finance that is provided by debt)
  • Debt/equity ratio (the proportion of business finance provided by debt and equity)
• Internal influences on financial objectives


  • Business ownership
  • Size and status of the business
  • Other functional objectives
• External influences on financial objectives


  • Economic conditions
  • Competitors
  • Social and political change
• Budgets


  These are set by businesses so that they have a future financial target/plan
• Types of budgeting

  • Income (or revenue)
  • Expenditure (or cost)
  • Profit
• Cash flow forecasting


  Involves the opening balance, the net cash flow, and the closing balance
• The process of setting budgets


  • Setting objectives
  • Market research
  • Complete income budget
  • Complete expenditure budget
  • Complete profit budget
  • Complete departmental budget
  • Summarise in master budget
• Why a business uses budgeting


  • Control income and expenditure (the traditional use)
  • Establish priorities and set targets in numerical terms
  • Provide direction and co-ordination, so that business objectives can be turned into practical reality
  • Assign responsibilities to budget holders (managers) and allocate resources
  • Communicate targets from management to employees
  • Motivate staff
  • Improve efficiency
  • Monitor performance
• Advantages of budgeting


  • Helps firms to get financial support through investors
  • Ensures a business doesn't overspend
  • Establishes priorities and sets targets in numerical terms
  • Motivates staff
  • Assigns responsibility to departments
  • Improves efficiency
• Disadvantages of budgeting


  • Budgets are only as good as the data being used to create them - in accurate and unrealistic assumptions can quickly make a budget unrealistic
  • They need to be changed as circumstances change
  • It is a time consuming process
  • Unexpected costs may arise
  • May have difficulties in collecting information needed to create a forecast
  • Managers may not have enough experience to budget
  • Inflation (external change that the business has no control over)
• Variance Analysis


  Compares the expected budget to the actual figures (the difference found)
• Evaluative points of variance


  • Whether is it positive or negative
  • Was is foreseen and foreseeable
  • How big was the variance
  • The cause
  • Whether it is a temporary problem or the result of a long term trend
• Break-Even


  A business will break-even when it's total revenue equals its total costs
• Contribution


  Looks at whether an individual product is making a profit and only accounts for variable costs – if sales revenue is higher than costs, it shows that the product is contributing to overall profits

  
• Margin of Safety

  The difference between the actual output and the break-even output
• Advantages of break-even analysis


  • Focuses entrepreneur on how long it will take before a start-up reaches profitability – i.e. what output or total sales is required
  • Helps entrepreneur understand the viability of a business proposition, and also those who will lend money to, or invest in the business
  • Margin of safety calculation shows how much a sales forecast can prove over-optimistic before losses are incurred
  • Helps entrepreneur understand the level of risk involved in a start-up
  • Illustrates the importance of a start-up keeping fixed costs down to a minimum (higher fixed costs = higher break-even output)
  • Calculations are quick and easy – great for giving quick estimates