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3.5 Financial Decisions
A financial objective is a specific goal or target relating to the financial performance, resources and structure of a
business. (forms decision making of other areas)
The key financial objectives
Revenue- revenue growth (% or value), sales maximisation, market share
Costs – cost minimisation, unit costs, achieve economies of scale
Profit- specific level of profit (in absolute terms), rate of profitability (% of revenues), profit maximisation to maximise
shares
Cash flow- maximise cash balances, limited how much is tied up in working capital, cash flow to profit %
Capital- wealth in the form of money or assets owned by the business
Capital structure- % of capital provided by debt (gearing), debt/ equity ratio
Capital expenditure- money spent to buy fixed assets e.g factories, vehicles.
Return on investment- level of investment (£), return on investment (%), return on capital employed % (ROCE)
The value of setting Financial Objectives:
§ A focus for the entire business, helps motivate employees
§ Important measures of success or failure for the business
§ Helps reduce the risk of business failure
§ Provides transparency for shareholders about their investment
§ Helps coordinate the different business functions
§ Keep context for making investment decisions (investment)
Cash flow objective aim to improve cash flow:
Cash flow is all the money flowing into and out of the business, calculated at the exact time it enters or leaves the bank
account or till. On the other hand profit includes all transactions that will lead to cash in or out, now or in the future.
Cash flow calculations most important in S/T, need cash to survive. L/T profit is the main objective
If a business allows payments to be made on credit- may damage cash flow. If they need to spend lots of money on a
new system- outflow of cash = could lead to a potential crisis. If a business produces too much, have to pay suppliers
and staff so much they’ll become insolvent (this is called OVERTRADING)
Return on investment objectives
§ Businesses may set objectives for Return on investment
§ Measures how efficient an investment is- compares the returns to the amount of money invested. Higher the
ROI, the better. Firms may set a target value for the ROI or use it to compare the profitability of 2 potential
investments
,Businesses set objectives for Long term Investment and funding
§ Capital is simply wealth in the form of money or other assets owned by the business
§ Capital expenditure (or investment) is the money spent to buy fixed assets
§ Businesses may set an investment objective to help achieve a set amount of capital expenditure during a year
e.g. ‘capital expenditure of £150,000 to fund purchase of new equipment’.
§ Capital structure refers to the way a business raises capital to purchase assets. A businesses capital structure is
a combination of its debt capital (borrowed fund) and its equity capital- the capital raised by selling shares, also
share capital
§ Capital structure objective is to set a debt to equity ratio e.g. 1:5:1 after 4 years. Sometimes businesses set
targets to reduce the proportion of debt in their long term funding.
Internal and external factors influence financial objectives:
Internal factors
The overall objectives of the business- financial objectives need to be consistent with the corporate objectives e.g. a
company with a strong environmental standpoint might be more interested in minimising its carbon footprint than in
maximising profits.
The status- new businesses might set ambitious targets for revenue – to establish them in the marketplace. Start ups-
survival, breakeven and cash flow. Established companies might be satisfied with smaller increases in revenue if they’re
not actively trying to grow. Multinational- growing sales, profit
Other areas of business- financial obj may be limited by what’s happening in other departments which can bring finance
depart into conflict with other functions. E.g. if they have a high turnover of sales staff an objective to increase rev may
be unrealistic – experienced staff necessary to encourage customers to spend more.
Business ownership- nature of business ownership has a significant impact on F Obj. Venture capitalist has a different
approach to a long standing family ownership
Other Functional objectives- every other functional obj in a business has a financial dimension- brings the finance depart
into conflict with other function
External factors influencing financial objectives
Availability of finance- cash flow targets may depend on how easy it’s to get credit
Competitors- new competitors enter the market, or demand for competitors product increases (due to a special offer to
price reduction) business may set an objective to cut costs- more competitive
The economy- In a period of economic boom, businesses can set ambitious profit targets. Downturn- restrained targets,
targets to minimise costs
Shareholders- want the best possible return on their investment- may put pressure on businesses to set objectives to
increase profits and dividends
Profit- the difference between total revenues and total costs over a period
Cash flow- the difference between total cash inflows and total cash outflows over a period
Profit is the difference between revenue and costs, profitability measures the ability of a business to
generate profit by comparing profit to the size of the business
Profits are the main source of funds. Revenues eventually turn into cash inflows. Costs eventually
turn into cash outflows.
Businesses Aim is to MAXMISE PROFIT:
§ Improve profit by increasing price. If demand is price inelastic increase prices, if its price
elastic reduce costs. However doesn’t guarantee profit
§ Lowering cost of production – this may lead to lower quality- damage sales
§ Advertising can increase demand for a product- higher profits but £££ and no guarantee
profits will increase
§ Improving quality can reduce costs from returns, lead to an increase in profits as long as
costs of improving quality don’t outweigh sales.
Different ways of reporting:
Gross profit is the amount left over when the cost of sales is subtracted from sales revenue. Cost of sales includes the
costs directly related to making the product e.g. the cost of materials
Operating profit takes into account all revenues and costs from regular trading but not any costs from one off events. It
considers both the cost of sales and operating expenses. = sales revenue- cost of sales- overheads or Gross profit-
overheads
, Profit margins show how profitable a business or product is:
How to measure profitability:
§ Gross profit margin
§ Operating profit margin
Profit margins measure the relationship between the profit made and the sales revenue. They tell you
what percentage of the selling price of a product is actually profit
Profit margins can be used to make comparisons over a period of time, or compare profitability of
different companies.
What internal factors affect the operating profit margin?
§ Labour turnover – high turnover of labour will disrupt production. It may lower labour productivity and increase the
costs of recruiting staff. May also be low morale which increases unit costs,
§ Capacity utilisation – high capacity utilisation will lead to fixed costs being spread over more units of output and so
this will lead to lower fixed costs per unit. This should improve operating profit.
§ High added value – effective use of the marketing mix can improve the brand image and enable a business to
charge a higher price, even when the costs are the same. This leads to a higher profit margin and improve the
operating profit margin.
§ Effective use of the marketing mix- improves brand image, improves operating profit margin
,Ways to improve and increase profit:
Different internal approaches to increase profits?
p
§ Changing the price
§ Decreasing costs
§ Increasing sales volume
§ Reduce variable costs per unit
§ Increase output
§ Reduce fixed costs
§ Advertising- increase demand. However no guarantee profits will increase and £££
§ Improving the quality of a product can reduce costs from returns or from items that aren’t acceptable. This
should lead to an increase in sales, profits as long as costs of improving quality don’t outweigh the savings
Difficulties of changing the price when trying to increase profit (When talking about price change linked to profit –
make reference to elasticity of demand)
§ Impact of a price change can be difficult to predict because its effects depends on the elasticity of demand and the
profit margin. These can both be unknown when making a decision about a price change
§ If increasing the price with lots of competitors and close substitutes or price elastic demand then unlikely to increase
revenue.
§ To increase your revenue through increasing the price you need an inelastic demand – consumers are unresponsive to
a price change
§ If a business decides to increase the price and demand is price elastic this will result in a bigger % change in reducing
demand and revenue will decrease thus reducing profit. It all depends upon the PED and changing the price could also
result in consumers switching to competitors.
Price inelastic: increase in price = increase revenue
Reduce variable costs per unit:
Price elastic: increase in price= decreases revenue Problems:
§ Increase the value added per unit sold
§ Higher profit margin on each item produced and sold § Lower input costs might mean lower quality
§ Customers do not notice a change in price inputs – which can lead to greater wastage
§ Customers may notice a decrease in product
Depends on: quality
§ Yes, if suppliers can be persuaded to offer better prices
§ Yes, if quality can be improved through lower wastage
§ Yes, if operations can be organised more efficiently
Increase output
Problems:
§ Provides greater quantity of product to be sold
§ Enables business to maximise share of market demand § A dangerous option – what if the demand is not
there?
§ Spreads fixed costs over a greater number of units
§ Fixed costs might actually rise (e.g. stepped
fixed costs)
Depends on:
§ Production quality might be compromised
§ Yes, if the extra output can be sold (e.g. finding a new (lowered) in the rush to produce more
market, offering a lower price for a more basic product)
§ Yes, if the business has spare capacity
,Reduce fixed costs Depends upon/ will it work:
§ A drop in fixed costs translates directly into higher profits § Yes, provided costs cut don’t
§ Reduces the break-even output affect quality, customer service
§ Often substantial savings to be made by cutting unnecessary overheads or output
§ A business can nearly always
Reduce product range
find savings in overheads
§ Business often has too many products = complex operations & Problems:
inefficiency
§ Some products may be very low-margin or even loss-making § Might reduce ability of
business to increase sales
Outsource non-essential functions
§ Intangible costs – e.g.
§ A way of reducing fixed costs lower morale after making
§ Focus the business on what it is good at redundancies
§ Areas to outsource: e.g. IT, call handling, finance
Problems that might arise if a business attempted to improve its profits by cutting costs:
§ If costs are cut because inferior raw materials are being used, the quality of the product may suffer, leading to a
decline in sales. It is possible that there will be waste, increasing costs
§ If workers are paid low wages they may become demotivated. The firm may attract less efficient workers,
reducing production levels, as better employees move to other firms.
§ Reducing overheads, such as rent, office expenses and machinery may damage sales. For example moving
premises to lower rent may not be accessible for customers leading to a decline in sales revenue.
Changes to external factors that might help a business to increase its profits.
§ Demographic changes – for example a growth in immigration has led to an increase in demand for many products. It
has led to new businesses and also led to lower labour costs for businesses. Ageing population – impact on demand
for certain goods.
§ Consumer incomes – if incomes fall like in a recession in 2008/09 then difficult for business to increase the sales
revenue.
§ Competition – a reduction in competition can boost a business profit as they can set higher prices and sell a higher
volume of goods. Price wars have an adverse effect on business profits.
§ Interest rate – higher interest rates make it more expensive to borrow and increase business costs and reduces profit
levels. Higher interest rates will hit profits in 2 ways – increase cost of credit and dissuade customers buying on credit.
This will be damaging for retailers of household durables, such as furniture, which are often sold on credit.
§ Environmental issues – this has led to greater costs with businesses modifying their products and environmentally
aware customers may be less inclined to buy products.
Q1) Analyse two changes to external factors that might lead to a business experiencing a fall in profits.
§ Market conditions – if CMA prevents a merger between two businesses this may lead to lower profits because
smaller businesses are less able to benefit from economies of scale, such as bulk buying.
§ Environmental issues – stricter laws and regulations to limit pollution and environmental damage can increase costs
if a firm has to adapt its methods in order to comply with new regulations. The firm could incur fines if it does not
comply with the legislation.
Problem of trying to increase the sales volume when trying to increase profit levels.
• Good customer service is required and effective communication between all levels of departments in the
business. All these aspects are hard to come by and may not increase profit levels.
,Measures of improving cash flow
Bank overdraft- ease cash flow problems as interest is only paid on the amount borrowed
Debt factoring- connects receivables into an immediate receipt of cash
Sale and leaseback-
Leasing of non-current assets
Improved working capital control- Working capital is the day to day finance used in a business consisting of current assets
(e.g. cash, inventories, and receivables) minus current liabilities (payables and overdrafts). Indication of a firm’s scope to
pay its short term debts. Money available to a business for its day to day running costs.
To stay solvent a business must manage its working capital. Working capital management involves careful management of
a firms main current assets to ensure that there is enough cash to pay payables and other payments.
Cash flow and improving working capital management:
§ Effective inventory control- generally minimising levels of inventory by employing methods such as JIT with a
reliance on efficient suppliers will lower storage costs and improve cash flow. (The traditional approach was to
have inventory to guarantee continuation)
§ Receivables- should be kept to a minimum as they mean a delay in receiving cash. This makes it harder to pay
debts. Prompt invoices and regular reminders of the need for payment towards the end of the credit period can
help ensure that customers pay promptly.
§ Payables- use a credit period to its maximum in order to improve holding of cash. You must ensure that a
payment is on time in order to avoid legal action and a bad reputation
It’s vital a firm’s working capital isn’t too high as it may lead to current assets being tied up in unproductive resources. If
working capital is too high- missed opportunity to invest
Balance between working capital and non -current assets.
Reasons why it may be difficult to improve a business’s cash flow.
§ Seasonal demand – companies typically incur costs in producing in advance of the peak season for sales. This causes a
significant, but predictable, cash flow problem for any seasonal business, especially for businesses in industries such as
farming, where there is heavy expenditure just prior to the sale of the crop.
§ Overtrading – firms become too confident and expand rapidly without organising long term funds and out a strain on
working capital. During rapid expansion this means a firm needs to buy more and more materials, but lacks the money
because its customers have not yet bought the goods.
§ Over investment in long term assets – firms may invest more in order to grow, but leave themselves with inadequate
cash for day to day expenditure payments. The more successful a small firm, the more eager the owners will be to
purchase new shops or equipment.
§ Unforeseen changes – cash flow may be difficult due to internal changes e.g. machinery breakdown leading to lower
receipts of cash for a period
§ Losses or lower profits – business whose sales revenue is less than its expenditure will usually have less cash than one
who is making a healthy profit.
§ Poor stock and inventory management – organisations may hold excessive stock levels, using up cash that could have
been used for other purposes. There is an added danger that high levels of stock may mean that stock becomes
worthless.
, Budgets and Budget variances:
Budgets- a financial plan for the future, looking at revenue and costs of the business.
Income budgets- forecast the amount of money that will come into the company as revenue. To do this predict how
much it will see and at what price. Managers estimate this using sales figures from previous years as well as market
research
Expenditure budgets- predict what the business’s total costs will be for the year, fixed and variable costs accounted for.
Variable costs increase with output so managers must predict output based on sales estimates
The profit budget- uses the income budget minus the expenditure budget to calculate what the expected profit or loss
will be for the year
Value of Budgeting:
§ Financial support= reassurance for investment. More detailed= more reassurance
§ Budgeting is important as it provides direction and coordination
§ Encourages to not overspend
§ Motivate staff
§ Establishes priorities and sets targets
§ Assigns responsibilities, recognises who gets the credit
§ Forecasts outcomes
§ Looks to increase efficiency
§ Allocates resources accordingly
Advantages: Drawbacks:
§ Budgets help to achieve targets like keeping § Budgeting can cause resentment and rivalry if
costs low or revenue high departments have to compete for money
§ Budgets help control income and expenditure § Budgets can be restrictive. Fixed budgets stop firms
§ Helps managers to review activities and make responding to changing market conditions
decisions § Budgeting is time consuming. Managers can get too
§ Help focus on the priorities preoccupied with setting and reviewing budgets and
§ Budgets let heads of departments delegate forget to focus on the real issues of winning
authority to budget holders. Getting authority business and understanding the customer
is motivating
§ Budgets allow departments to coordinate § Inflation is difficult to predict- some prices can
spending change by levels much greater than average
§ Budgets help persuade investors that the § Start-up businesses may struggle to gather data
business will be successful from other firms so the budget may be inaccurate
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