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A financial hierarchy

In order to achieve a businesses corporate aims and objectives, its functional aims and objectives need to be consistent with these. Financial strategies are used to achieve these objectives.

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Company accounts

  • The balance sheet
  • The income statement

These documents are required by law to show people the financial strengths and weaknesses of an organisation's recent performance and current situation

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Purposes and users of company acounts

Internal users:

  • Managers (to plan, control and analyse the business)
  • Employees (to asses the security of their employment)
  • Owners and investors (to compare with alternatives)

External users:

  • Government (meeting legal requirements such as tax paying)
  • Competitiors (comparing their performance)
  • Suppliers (to see whether it's worth supplying to a business)
  • Customers (to know if the company is financially ok)
  • The local commuity (needs to know if it is closing down/successful)
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Analysing balance sheets

Balance sheets list the resources that a business owns (assets) and the amounts it owes to others (liabilities), it also shows the capital (equity) provided by the shareholders, equity is provided through shares or the agreement to allow the company to retain profit into the business (reserves)

What's in a balance sheet?

  • Assets: non-current assets (things owned for over a year) and current assets (things owned for less than a year)
  • Liabilities: non-current liabilities (debts due for longer than one year) and current liabilities (debts due for under one year)
  • Capital: share capital (funds provided by shareholders) and reserves and retained earnings (cash that isn't distributed to shareholders, but is kept for the business)

Balance sheets allow businesses to recognise the scale of the business, to calculate the net assets of a business, to gain an understanding of the nature of the firm, to identify the company's liquidity position, to show sources of capital and to recognise changes over time

Net assets = total assets - total liabilities
Capital employed = total equity + non-current liabilities
Assets = liabilities + equity

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Capital expenditure, revenue expenditure and depre

Business expenditure can be classified as etiher: revenue expenditure (spending on day-to-day items such as raw materials, stock, wages and power) or capital expenditure (spending on non-current assets, those used repeatedly in the production process such as buildings, vehicles and machinary)

Depreciation is the fall in value of an asset over time, reflecting the wear and tear of the asset as it becomes older, the reduction in its economic use or its unusefulness

Annual depreciation = initial cost - residual value/expected lifetime (in years)

Depreciation is used to ensure that the income statement is not overaggerated and that the balance sheet is true and fair

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Working capital (net current assets)

Working capital (net current assets) = current assets - current liabilities

The working capital of a business provides an indication of the firm's scope to pay its short-term debts. The working capital cycle is the inflow and outflow of liquid assets and liabilities within a business, length of working capital cycle = length of time that goods are held + time taken for recievables to be paid - period of credit recieved from suppliers

Factors that influence the level of working capital include: the nature of the product, the durability, the efficiency of suppliers, lead time, customer expectations, competition, the nature of the market, the type of product and bargaining power

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Analysing income statements

An income statement describes the income and expenditure of a business over a given period of time. It is divided into sections: revenue and cost of sales, expenses, finance income and expenses and tax paid on the profits made. 

gross profit = revenue - cost of sales 

This gross profit shows hw efficiently a business is converting its raw materials or stock into finished products

operating profit = gross profit - expensives +/- exceptional items

This is the revenue earned from everyday trading activities minus the costs involved in carrying out those activities

when there are no exceptional items:
profit before tax = operation profit + finance income - finance costs
profit for the year = profit before tax - taxation
earnings per share = profit for the year / number of shares issued

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Analysing income statements

An income statement describes the income and expenditure of a business over a given period of time. It is divided into sections: revenue and cost of sales, expenses, finance income and expenses and tax paid on the profits made. 

gross profit = revenue - cost of sales 

This gross profit shows hw efficiently a business is converting its raw materials or stock into finished products

operating profit = gross profit - expensives +/- exceptional items

This is the revenue earned from everyday trading activities minus the costs involved in carrying out those activities

when there are no exceptional items:
profit before tax = operation profit + finance income - finance costs
profit for the year = profit before tax - taxation
earnings per share = profit for the year / number of shares issued

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Using financial data for comparisons, trend analys

  • Intro-firm comparisons - comparisons within the company, e.g. different areas
  • Inter-firm comparisions - comparisons between companies, e.g. rival companies
  • Comparisons to a standard
  • Comparisons over time: trend analysis
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Assessing strengths and weaknesses of financial da


  • A balance sheet can help people to assess the size of a business, calculate the net assets, discover their liquidity position and understand the sources of capital
  • An income statement can help people to calculate the profit levels of the firm, assess whether it is worth buying shares in the business, note if profit is of high quality and see if profit is being utilised sensibly


  • Accounts show what has happened, rather than why
  • Financial performance is greatly influenced by external factors such as: fashion and the economic environment
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The concept of ratio analysis

Ratio analysis - a method of assessing a firm's financial sitaution by comparing two sets of linked data. It is usually based on the balance sheet and income statement of a business. Ratio analysis allows a business to compare itself with other firms and also allows people to judge a firm's situation.

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Stages in using ratio analysis

1. Identify the reason for the investigation
2. Decide on the relevant ratio(s) that will help to achieve the purpose of the user(s)
3. Gather the information required and then calculate the ratios
4. Interpret the ratios
5. Make the appropriate comparisons to understand the significance of the ratios
6. Take action in accordance with the results
7. Apply the above processes again to measure the success of the actions taken place in stage 6

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Types of ratio

Profitability ratios - These compare profits with the size of the firm, as profit is often the primary aim of a company, these ratios are often decribed as performance ratios

Liquidity ratios - These show whether a firm is likely to be able to meet its short-term liabilities. Although profit shows long-term success, it is vital that firms hold sufficient liquidity to avoid difficulties in paying debts

Gearing - This focuses on long-term liquidity and shows whether a firm's capital structure is likely to be able to continue to meet interest payments on, and to repay, long-term borrowing

Financial efficiency ratios - These concentrate on the firm's management of its working capital. They are used to assess the efficiency of the firm in its management of its assets and short-term liabilities

Shareholders' ratios - These focus on drawing conclusions about whether shareholders are likely to benefit financially from their shareholding in a company

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Users of ratios

Managers - They can identify the efficiency of the firm and its different areas, to plan ahead, to control operations and to assess the effectiveness of policies

Employees - They can find out whether the firm can afford wage rises and to see if profits are being allocated fairly

Government - Can review the success of its economic policies and can find ways of improving businesss efficiency overall

Competitiors - They can compare their performance against rival firms and discover their relative strengths and weaknesses

Suppliers - They can know the sort of payment terms that are being offered to other suppliers, and whether a firm can afford to pay

Customers - They can find out the future of the firm, and therefore any guarantees

Shareholders - They can compare the financial benefits of their investment with other alternatives

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Profitability and performance ratios

Two ratios: 

The return on capital employed:

  • Shows the operating profit as a percentage of capital that a business has at its disposal
  • Return on capital employed (%) = operating profit or profit before tax/total equity + non-current liabilities x 100

Net profit margin

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Liquidity ratios

Two types:

Current ratio:

  • In order to meet its liabilities, a firm can draw on its current assets (e.g. cash and bank balances)
  • Current ratio = current assets:current liabilities
  • The 'ideal' current ratio is between 1.5:1 and 2:1

Acid test (quick) ratio:

  • Acid test ratio = (current assets - inventories):current liabilities
  • 'Ideal' acid test ratio is between 0.75:1 and 1:1
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Gearing (%) = non-current liabilities/total equity + non-current liabilities x 100

If the gearing ratio is higher than 50%, it is considered to be high capital gearing (showing that a business has borrowed a lot of money in relation to its total capital) , if the gearing ratio is below 25% is is said to be low capital gearing (showing that a firm has raised most of its capital from shareholders).

Benefits of high capital gearing:

  • Relatively few shareholders
  • The company can benefit from a very cheap source of finance when interest rates are low
  • In times of high orofit, interest payments are usually lower than shareholders' dividend requirements

Benefits of low capital gearing:

  • Most capital is permanent share capital, meaning it is at less risk of payables forcing it into liquidation
  • avoids the problem of having to pay high levels of interest
  • The company avoids the pressure of repaying the borrowing at one time 
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Financial efficiency ratios

Asset turnover:

  • This measures how well a company uses its assets in order to achieve sales revenue
  • Asset turnover = revenue (annual sales turnover)/net assets
  • A high figure shows that a business is using its assets efficiently to achieve sales

Inventory turnover/stock turnover:

  • Inventory (stock) turnover = cost of goods sold/average inventories held
  • This indicates how quickly stock is converted into sales - high figure quick sold stock

Receivables (debtors) days:

  • Recievables (debtors) days = recievables (debtors)/revenue (annual sales) x 365
  • This shows the number of days that it takes to convert recievables into cash, the lower - better

Payables (creditors) days:

  • Payables (creditors) days = payables (creditors)/cost of sales x 365
  • Shows the number of days that it takes to pay back payables, higher value the better
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Shareholders' ratios

Dividend per share:

  • Dividend per share = total dividends paid/number of ordinary shares issued
  • Dividends are given to shareholders as their reward for holding shares

Dividend yield:

  • Dividend yield (%) = dividend per share/market price per share x 100
  • This shows the annual percentage return on the money needed to purchase the share
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Limitations of ratio analysis

  • The data may be unreliable
  • Some figures are subjective to some extent
  • Different accounting methods may be employed
  • A firm's financial situation changes daily
  • Accounts show what happened rather than why
  • No two busineses face identical circumstances
  • It ignores: reputation, human relations, relationship with suppliers, product quality and future profit
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Ratio analysis: choosing the right ratio(s)

Return on capital employed (%) - To assess whether the business is making a satisfactor level of profit from the capital that it has available to it

Current ratio - To see if the business is likely to run short of liquid assets in the short term and to ascertain whether a cash-flow problem might occur in the short term

Acid test ratio - To see if the business has sufficient liquid assets in the short term, even if it has difficulties in selling stock and to ascertain whether a cash-flow problem might occur in the short-term

Gearing (%) - To measure how reliant a business is on borrowed money, to study the likley impact on the costs of a business if there are changes in interest rates and to gauge whether a business may be vulnerable from having to repay loans in the next few years

Asset turnover - To measure the efficiency of a business - how well it uses its assets for sales

Inventory turnover - To calculate how many times a year a business is able to sell its stock and to measure the speed a business is able to conver its stock into sales

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Ratio analysis: choosing the right ratio(s) (conti

Recievables days - To discover the time taken for its receivables to pay their debts to the business and to assess whether individual receivables are possibly going to become bad debts

Payables days - To discover the time taken for the business to pay its debts to its payables and to assess whether the business is in danger of defaulting on the debts it owes

Dividends per share - To calculate the direct financial reward that a shareholder will recieve from the company every 6 months, in return for owning its shares

Dividend yield (%) - To assess the percentage return that a shareholder recieves from a share, based on the assumption that the shareholder is considering purchasing shares at the current parket place - this can be compared to current interest rates for savings in a bank

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Introducing and implementing profit centres

Profit centeres are an indetifiable part of an organisation (e.g. a department, product or branch) for which costs and revenue (profit) can be calculated

Reasons for profit centres: they allow a more focused study of a firm's finances, benchmarking can take place, responsibility for a profit centre may help to motivate the indivudal responsible and finances may be run more efficiently

Disadvantages of profit centres: allocating costs, demotivation, setting targets, diseconomies and external changes

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Allocating capital expenditure

Decisions on allocating capital expenditure fit into two categories:

  • Decisions on whether to introduce capital equipment to replace labour
  • Investment decisions on whether it is financially visable to put money into a capital project

It is vital that the finance department liases with the other functional areas to ensure that they have an input into these decisions

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Investment appraisal

A scientific approach to investment decision making, which investigates the expected financial consequences of an investment, in order to assist the company in its choices

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Methods of investment appraisal

Three main methods:

  • Payback period
  • Average rate of return, or annual rate of return, or average annual rate of return (ARR)
  • Net present value (NPV)

Payback period (the length of time that it takes for an investment to pay for itself from the net returns provided by that particular investment):

  • Calculated by adding the annual returns from an investment until the cumulative total equals the initial cost of the investment

Average rate of return (total net returns divded by the expected lifetime of the investment, expressed as a percentage of the intial cost of the investment):

  • Firms want to achieve as high a percentage return as possible

Net present value (the net return on an investment when all revenues and costs have been converted to their current worth):

  • Payments in the future are considered to be worth less than the amount paid today
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Strengths and weaknesses of investment appraisal m


  • Easy to calculate and easy to understand
  • Ignores any revenues or costs that occur after the point at which [ayback has been reached and it is difficult to establish a target payback time

Average rate of return:

  • The result can easily be compared with the next best alternative and can be understood by non-accountants
  • Harder and more time consuming to calculate

Net present value:

  • Only method that considers the time value of money and it gives a precise answer
  • Time consuming and difficult to calculate and more difficult to understand than other approaches
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Assessing the risks and uncertainties of investmen

For most projects it is difficult to estimate the anticipated costs and revenue. Firms usually take the following actions to allow for risks and uncertainties in their investment appraisals:

  • Build in allowances or contingencies in case problems occur
  • Calculate alternative results (the expected, best case and worst case scenarios)
  • Set more demanding targets
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Evaluating quantitative and qualitative influences

Qualitiatve factors affecting decisions:

  • The aims of the organisation
  • Reliability of the data
  • Risk
  • Personnel
  • The economy
  • Image
  • Subjective criteria
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Porter's generic strategies: low cost versus diffe

Every busdiness strategy needs to find a basis for competitive advantage that can be defended against the forces of competition. This means that business strategy must involve the anlysis of Porter's five competitive forces. Five forces analysis considers the following factors:

  • New entrants
  • Substitute products
  • The power of buyers
  • The power of sellers
  • The level of competition between firms

If customers see acceptable alternatives from new/existing competitors or if suppliers can find alternative markets, the firm's competitive advantage will be weak, but if the firm is a major buyer of its materials the firm's advantage will be strong.

Cost leadership - a firm sets out to be the lowest-cost producer in its industry
Differentiation - a firm needs to make sure that its product is different from its competitors'
Focus - applied in niche markets

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Ansoff's matrix

A decision making tool which provide a company with a range of options/strategic choices

Existing products, existing markets:

  • Market penetration - increasing brand loyalty, etc.
  • Consolidation - concentrating on competitive advantages
  • Withdrawal 
  • Doing nothing

Existing products, new markets:

  • Market development - to extend a product's market into new areas

New products, existing markets:

  • Product development - modifications/additions to a product range

New products, new markets:

  • Diversification
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Assessing the effectiveness of marketing strategie

Porter's generic strategies:

  • Whether the strategy provides a significant advantage to the business
  • Whether the strategy can be maintained over a long period of time
  • Whether the strategy appeals to sufficient numbers of customers to allow the business to meet its targets

Ansoff's matrix:

  • Useful for deciding on strategic direction
  • However doesn't take into account competitiors' actions
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Components of a marketing plan

A marketing plan is a statement of the organisation's current marketing position and future strategies, and a detailed examination of the tactics that it will use to achieve its objectives

  • SWOT analysis
  • Forecasting sales and market analysis
  • Setting SMART marketing objectives
  • Agreeing marketing strategies
  • Allocating a marketing budget
  • Implementing marketing tactics through the marketing mix
  • Control and review
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Choosing the right scale of production

Economies of scale:

  • The advantages that an organisation gains due to an increase in size
  • Fixed costs must be paid, regardless of the number of units that the organisation produces and sells
  • Variable costs can be combined more effectively in a large firm to save unit cost
  • Technical economies, specialisation economies, purchasing economies, marketing economies, financial economies, research and development economies, social and welfare economies and managerial and administrative economies

Diseconomies of scale:

  • The disadvantages that an organisation experiences due to an increase in size
  • Coordination diseconomies, communication diseconomies, motivation diseconomies and other diseconomies
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Choosing the optimal mix of resources: capital and

Capital-intesive production - methods of production that use a high level of capital equipment in comparison to other inputs, such as labour

Labour-intensive production - methods of production that use high levels of labour in comparison to capital equipment

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Industrial inertia

The tendency for firms to remain where they are, even though the original reasons for location no longer apply

Main external economies of scale:

  • A labour supply with the skills needed by firms in that industry
  • Specialist training facilities in the region
  • An infrastructure that is geared towards the needs of that industry
  • Suppliers and customers based locally
  • The reputation of the area, which may help to sell the product/allow the firm to charge a premium price

Main external diseconomies of scale:

  • Congestion
  • Pollution
  • Shortages of resources
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Methods of making location decisions

Location decisions using investment appraisal:

  • To see if a location provides a quick payback, yields a high average rate of return percentage or gives a positive net present value

Location decisions using qualitative factors:

  • Accessibility to leisure facilities
  • Types of leisure facility
  • Quality of life
  • Accessibility to good transport links for personal use
  • Geographical attractiveness
  • Convenience of access to other places
  • Availibility of housing
  • Opportunity to make a difference to a local community
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Multi-site locations

Where a business chooses to operate from a number of different sites, as opposed to a single-site location. These sites may be within one country or located in many different countries


  • Lower costs
  • Improved market focus
  • Avoidance of trade barriers
  • Increase flexibility
  • Overcoming cultural barriers
  • Regional specialisation


  • Globalisation
  • Increased unit costs
  • Increased risk
  • Loss of control
  • Cultural differences
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The effective management of time

Time-based management - an approach that recognises the importance of time and seeks to reduce the level of 'unproductive' time wihtin an organisation, this leads to quicker response times, faster new product development and reductions in waste, culminating in greater efficiency

Time-based management:

  • Can be used as a selling point
  • E.g. the AA 

Reduced lead times:

  • The time taken between an order being recieved and the final product/service being delivered to or provided for the customer

Shorter product development times:

  • Constant changes in customer demands mean that companies which can produce new products quickly are able to stay competitive
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Critical path analysis

The process of planning the sequence of activities in a project in order to discover the most efficient and quickest way of completing it

Features of critical path analysis:

  • Nodes (circles representing a point in time)
  • Activities (events/tasks that consume time are shown as lines that link the nodes)
  • Duration (the length of time that it takes to complete an activity)
  • Prerequisite (the activity that must be completed before our selected activity can commence)
  • Dummies (these are activites that do not consume time, but are incorporated into a network to show the true sequence of events)
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Factors determining the choice of organisation str

  • The size of organisation
  • The nature of the organisation
  • The culture and attitudes of senior management
  • The skill and experience of its workforce
  • The dynamic, or ever-changing, external environment
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Functional vs. matrix organisational structures

Functional organisation structure - The traditional management structure consisting of a different department for each of the main functions of the business

Matrix organisational structure - A flecible organisational structure in which tasks are managed in a way that cuts across traditional departmental boundaries

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