Financial Strategies and Accounts

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Financial Objectives

"The monetary targets a business wants to achieve in a given time period"

These could include:

  • Cash-flow targets - Objectives designed to achieve a specific net cash balance at the end of the month, year, or specific trading period
  • Cost-minimisation targets - Objectives focused on actions that can be taken to minimise fixed and/or variable costs
  • ROCE targets - A minimum acceptable percentage for the money the business gets back compared to how much money is being used in the business
  • Shareholders' return targets - A minimum acceptable level of financial rewards in return for shareholders' investment
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Influences on Financial Objectives

Internal

  • Corporate and Functional Objectives - Will have to contribute towards achieving corporate objectives. Will be influenced by functional objectives
  • The characteristics of the firm - Capital of labour intensive? Low cost or highly differentiated
  • Relationship between owners and directors - Within a plc these can be the same or different. The power of individual shareholders

External 

  • Competitors - Leader or follower? Degree and relative power of competition? Actions and reactions
  • Consumers - Degree of loyalty, changing tastes
  • Economic conditions - Stable or unstable? Economic growth or decline? Optimistic or pessimistic?
  • External environment - Political, social and technological change
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Balance Sheets

"A formal financial document that summarises the net worth of a business at a given point in time"

It is important to understand: 

  • Depreciation - The accounting process of spreading the cost of non-current assets. Ensures the value is a fair reflection of the actual value. Annual depreciation appears as an expense in the income statement
  • Working capital - Measures a firm's liquidity. Current assets - current liabilities
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Balance Sheet Headings

  • Non-current assets - long term or fixed assets owned
  • Inventories - value of stock held
  • Receivables - cash owed from credit sales
  • Cash & cash equivalents - cash in hand or in the bank
  • Total current assets - current assets added together
  • Current liabilities - money owed to be repaid in the short term
  • Net current liabilities - total current assets - current liabilities 
  • Non-current liabilities - long term debts
  • Net assets - net worth of a business' assets and liabilities 
  • Share capital - money raised from the sale of shares
  • Reserves & retained earnings - cumulative profits kept in the business
  • Total equity - value of shareholders' funds
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Income Statements

"A formal financial document that summarises a business' trading activities and expenses to show whether the business has made a profit or a loss"

It is important to understand: 

  • Profit utilisation - How the profit after tax is used - will break down the profit to show:
    - % paid in dividends to shareholders
    - % reinvested in the business
    Will depend on both long term and short term financial objectives
  • Profit quality - The substantiability in the profit figure - will break down the profit to show:
    - % from normal trading activities
    - % from non-standard trading activities
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Income Statement Headings

  • Revenue - selling price x quantity sold
  • Cost of sales - direct costs relating to a quantity sold
  • Gross profit - profit after cost of sales has been deducted
  • Expenses - other costs incurred
  • Operating profit - profit after all other expenses have been deducted
  • Finance income - money from investments 
  • Finance costs - costs incurred through debts
  • Profit before tax - profit after adjustments for profits from joint ventures or investments
  • Taxation - tax deducted as a % of profit before tax 
  • Profit for the year - profit after tax has been deducted
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Comparisons

Inter-firm

  • Looking at the performance of one firm against another
  • May be comparing performance against competitors or similar sized businesses
  • Can help inform ROCE targets
  • May lead to benchmarking of performance against a market leader

Intra-firm

  • Looking at the performance of different operations within the same firm
  • May be comparing branches, product lines, profit centres or geographical areas
  • Can help inform ROCE targets
  • Can help identify best practice within a business
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Using Financial Data Pros & Cons

Pros 

  • Plc accounts are audited and should therefore be accurate
  • Provides detailed qualitative data
  • Ease of comparison between firms and within the firm
  • Facilitates ratio analysis for meaningful interpretation

Cons

  • Does not consider qualitative factors
  • Potential for some manipulation
  • Need to be considered in the context of corporate and functional objectives
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Ratio Analysis

"A comparison of two or more pieces of data taken from the financial records of a business"

Used to measure the following financial indicators:

  • Profitability
  • Liquidity
  • Financial Efficiency
  • Gearing
  • Shareholders' Returns
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Profitability Ratios

ROCE

  • Measures how efficiently a business is using capital employed to generate profits
  • (Operating profit/[total equity + non-current liabilities]) x 100 

Gross Profit Margin 

  • (Gross profit/sales revenue) x 100 

Net Profit Margin 

  • (Net profit/sales revenue) x 100
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Financial Efficiency Ratios

Asset Turnover

  • Considers the relationship between assets and revenue 
  • Revenue / net assets

Stock Turnover

  • Cost of sales / average stock held

Debtor Days

  • (Trade debtors / revenue) x 365

Creditor Days

  • (Trade payables / cost of sales) x 365
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Liquidity Ratios

Current Ratio

  • Current assets / current liabilities

Acid Test Ratio

  • (Current assets-stocks) / current liabilities
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Gearing

This focuses on the long-term stability of the business.

(Long term liabilities / capital employed) x 100 

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Shareholder Ratios

Dividend per share

  • Total dividends paid / number of ordinary shares in issue

Dividend yeild 

  • (Dividend per share [p] / share price [p]) x 100
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Disadvantages of Ratio Analysis

  • Ratios deal mainly in numbers so ignore qualitative factors
  • Ratios look mainly at the past and not the future
  • Ratios are most useful when looked at over a long period of time or against comparable businesses
  • Financial information can be made to look more attractive, and therefore may not be representative of the truth
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Internal Sources of Finance

  • Retained earnings - This is when a business keeps some of their net profit. These can be spent in the business or kept in a bank account.
    - They are a cheap source of finance
    - They are flexible
    - They do not dilute the ownership of the company.
    If too much of the earnings are retained, shareholders may become upset
  • Reduction in working capital - This is where companies collect money from their debtors, but this has to be sustainable to become a long-term source of finance
  • Disposal of assets / sale & leaseback - This is where a business sells their assets in order to create a one-off cash inflow. It is unlikely to be a long-term solution to a lack of finance. 
    Sale and leaseback is a specialist method of selling fixed assets and then leasing them back from the new owner. This is a one-off way of raising cash as it can only be done once
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External Sources of Finance

  • Selling shares - Two options are available when selling shares: 
    - Flotation (issue of new shares) - this is a costly way of raising finance which involves a percentage of a company being on the stock market for the first time.This is only usually an option with a business worth £25-50 million. This means that the shareholder base of the business becomes much wider, and management therefore liquidates
    - Rights issue or open offer - This is fairly common, and involves a company offering new shares to existing customers. These shares will often be offered at a discount price.
  • Loan capital - There are 3 main ways of raising loan capital:
    - Bank overdrafts
    - Bank loans
    - Debentures - These are a long-term soure of finance  which is issued by the company. Interest payments must be made by the company
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Cost Minimisation

"Aims to achieve the most cost-effective way of delivering goods and services to the required level of quality"

Popular sources of cost-minimisation include:

  • Eliminating waste and avoiding duplication
  • Simplifying processes and procedures
  • Outsourcnig non-core activities
  • Negotiating better pricing with suppliers
  • Improving communication
  • Pruning product ranges and customer accounts to eliminate unprofitable business 
  • Using the most effective methods of training and recruitment
  • Introducing flexible working that benefits both employer and employee
  • Aggressive control over non-essential overheads

Being too aggressive with cost-minimisation can have disadvantages: 

  • Can be left with insufficient capacity to handle increase in demand
  • Cost reductions could annoy departments if not properly communicated
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Profit Centres

"A separately identifiable part of a business for which it is possible to identify revenues and costs"

E.g.

  • Individual shops in a retail chain 
  • Local branches in a regional or nationwide distribution business
  • A geographical region
  • A team or individual 
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Profit Centres Pros & Cons

Advantages

  • Provides insight into where profit is earned in a complex business
  • Supports budgetary control at a detailed level
  • Can improve motivation of those responsible for the profit centre
  • Comparisons can be made between profit centres 
  • Improves decision making at a local level
  • Finance can be allocated more efficiently

Disadvantages

  • Can be time consuming to set up & monitor
  • Difficulties allocating costs & revenues
  • May lead to conflict & competition rather than cooperation
  • Potentially de-motivating if targets are too tough
  • Profit centres may persue their own objectives rather than those of the broader business
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