3.5.2 Analysing financial performance

Process of setting targets, covering all aspects of costs + revenues. Tell individual managers how much can spend to achieve objs.

Budgeting sys shows how much can be spent per time period, gives managers way to check whether on track. Most use sys of budgetary control as means of supervision:
 1) Make judgement of likely sales revenues for coming year
 2) Set cost ceiling that allows for acceptable level of proft
 3) Budget for whole company's cost broken down by division, department or by cost centre
 4) Budget may be broken down further so each manager has budget + therefore some spending power

In business start-up, budget should provide enough spending power to finance vital needs eg building work, decoration, recruiting + paying staff etc. If manager overspends in one area, knows essential to cut back elsewhere. Good manager gets best poss value from budgeted sum.

Most firms treat last year's budget figures as main determinant for this year. Minor adjustments made for inflation + other foreseeable changes. Given past experience, budget setting should be quick + accurate.

Start-ups - setting budgets tougher job. Fundamental to business plan. To succeed, entrepreneur needs to rely on :
 - 'guesstimate' of likely sales in early months of start up
 - entrepreneur's exerpertise + experience, better if entrepreneur worked in industry before
 - entrepreneur's instinct, based on market understanding
 - significant level market research

Best criteria for setting budgets:
 - to relate budget directly to business obj' if company wants to increase sales + market share, best method may be to increase advertising budget - boosts demand
 - to involve as many people as possibly in process; people will be more committe to reaching targets if have say in how budget set

Variance - amount by which actual result differs from budgeted figure. Usually measured each month - compares actual outcome w/ budgeted one. Referred to as adverse or favourable. 

Favourable - leads to higher than expected profit (revenue up or costs down). 

Adverse - refuces profit, eg costs being higher than budgetet level.

Value of regular variance statements is provide early warning. If product's sale slipping below budget, managers can respond by increasing marketing support/by cutting back on production plans. idally, slippage noted in March, new strategy in place by May, recovery in sales achieved by September. Early warning -> early solution.

When signif variances occur, management should first consider whether fault was in budget or in actual achievement. 

When adverse variances occur, senior managers likely to want to hear explanation from responsible 'line manager' - will need to have clear explanation of what's gone wrong. If recession has hit sales throughout market, will be easy to explain adverse income variances. Far tougher is when blame lies w/ falling market share rather than market size.

Uses horizontal axis to represent output per time period for business. Vertical axis represents costs + sales in £.

1st line: fixed costs. Value doesn't change w/ output, horizontal line.
2nd line: total costs (fixed costs + variable costs). Calculate cost at max + min output level, mark on graph, draw line.
3rd line: sales revenue. Calculate max + min sales revenue, mark on chart, draw line (usually starts at 0).

Break-even output - draw line down from where total revenue + total costs meet.

As well as b/e output, also shows level of profits/losses at every poss level of output.

Margin of safety - amount demand can fall before firm starts making losses. Diff b/ween current sales + b/e point. Higher margin of safety, less likely it is that a loss-making situation will develop.

Changes in business circumstances affect b/e chart:
 - Internal factors:
  -> extra launch advertising - fixed costs rise, total costs rise, b/e point rises
  -> planned price increase - revenue rises more steeply; b/e point falls
  -> using more machinery (+ less labour) in production - fixed costs rise, variable costs fall; uncertain effect on b/e point.
 - External factors:
  -> fall in demand - b/e point not affected, margin of safety reduced
  -> competitors' actions force price cut - revenue rises less steeply; b/e point rises
  -> fuel costs rise - variable + total cost lines rise more steeply; b/e point rises

If price increases, revenue line rises more steeply than before. Start at same point, but rise to higher revenue point at max output. Steepening of revenue line increases profit potential at each level output + lower b/e point. If charge more, don't need to sell as many as b/e.

Change in demand no effect on lines of b/e chart. Simply that you have to read the change off chart by drawing line vertically up from new sales quantity.

Increase - variable costs line rises more steeply, but start from same point. If variable costs rise, total costs also rise. If asked to show effect on b/e chart of rise in variable costs, also adjust total costs line.

If sales falling, may be necessary to cut fixed costs to lower b/e point. Fall in fixed costs cuts total costs.

Businesses can use b/e to:
 - estimate future level output will need to produce + sell to meet given profit objs
 - assess impact of planned price changes on profit + level output needed to b/e
 - take decisions about whether to produce own products/components/whether to purchase from external sources

Model is a simplification - assumes variable costs increase constantly, ignores benefits of bulk buying. If firm negotiates lower prices for purchasing larger quanities of raw materials, total cost line will no longer be straight.

Assumes firm sells all output at single price - reality, firms frequently offer discounts for bulk purchases.

Assumes all output is sold. In times of low demand, firm may have difficulty in selling all it produces.

Gross profit is absolute number. To find out if good level profit, helpful to measure profit in relation to sales revenue - gross profit margin. 

Having turned profit figure into %, comparison can be made w/ profitability achieved by other companies.

When media analysts evaluating companies, focus on operating profit, then takes as % of revenue to calculate operating profit margin. 

Having turned profit figure into %, comparison can be made w/ profitability achieved by other companies, or looking at one company over time.

After every poss cost deducted, resulting figure 'profit for year', or 'earnings'. Important as -> huge boardroom decision: directors must decide how much of profit to pay out in dividends to shareholders + how much to leave in business for reinvestment. 

Next plc, 1/3 profit for year - dividends, 2/3 to finance growth of business. 2013, Tesco paid out nearly all profit in dividends. At time when needed capital to invest in repositioning shops, gave nearly all to shareholders. Short-termism in extreme.

Calculations of profit margins undertaken can come under heading 'ratio analysis'. Technique used by accountants to analyse business in comparison w/ close rival, or to investigate performance of business over time. Ratio - comparison of one piece of numerical data w/ another. 

In case of profit margins, comparisons shown in % terms.

Typical net profit margin in an industry varies b/ween sectors. Eg, food retail very competitive, profit margin likely to be quite low. However, provided you sell high volume of items, overall net profits can still be high. May make relatively little profit per product, but provided sell a lot of products, overall profits may still be high.

Luxury items, profit margin likely to be much higher. However, although profit per sale relatively high, doesn't automatically mean profits are high - depends on how many items you sell.

1) Calculate diff b/ween closing balance at end of period + opening balance at start. Gives sense of what happening over time. If overall cash balances building up, cash inflows greater than outflows - situation comfortable. If balance declining, urgent action may be necessary.

2) Use monthly closing balance to assess trends in data.

3) Analyse timings of cash inflows + outflows. Although some firms sell goods for cash, most provide interest-free credit, eg Cadbury selling to Tesco. Longer customers take to pay, longer seller is w/o cash. Any method of speeding up payments can boost cash flow. Sum of money outstanding - 'receivables'. Want this figure to be as low as possible.

When buying goods on credit, longer credit period can negotiate from suppliers, longer cash will be sitting in bank acc - money owed - 'payables'.