3.5.2 Analysing financial performance

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    How to construct and analyse budgets and cash flow forecasts

    Budgets = these are set by businesses so that they have a future financial target/plan

     

    Types of budgeting:

    • Income (or revenue)
      • Expected revenues
      • Broken down into more detail
    • Expenditure (or cost)
      • Expected variable costs based on sales budget
      • Expected fixed costs
    • Profit
      • Based on the combined sales and cost budgets
      • May form basis for performance bonuses

     

    Cash flow forecasting involves:

    • The opening balance – this is cash balance at the start of the month
    • The net cash flow – this is added to the opening balance to get the closing balance
    • The closing balance – this will become the opening balance for the next month

     

    The value of budgeting

    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 = this compares the expected budget to the actual figures (the difference found)

    • This can be positive (favourable – meaning costs are lower than expected or revenue is higher) or negative (adverse – meaning costs are higher than expected or revenue is lower)

     

    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

     

    How to construct and interpret break-even charts

    Break-Even = a business will break-even when it’s total revenue equals its total costs

    • = fixed costs / contribution per unit

    Contribution = this 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

    • = selling price per unit – variable cost per unit

     

    Margin of Safety = this is the difference between the actual output and the break-even output

     

    The value of break-even analysis

    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

     

    Disadvantages of breakeven analysis:

    • Unrealistic assumptions – products are not sold at the same price at different levels of output; fixed costs do vary when output changes
    • Sales are unlikely to be the same as output – there may be some build up of stocks or wasted output too
    • Variable costs do not always stay the same (e.g. as output rises, the business may benefit from being able to buy inputs at lower prices (buying power), which would reduce variable cost per unit)
    • Most businesses sell more than one product, so break-even becomes harder to calculate
    • Break-even analysis should be seen as a planning aid rather than a decision-making tool

     

    How to analyse profitability

    Profitability = the firms ability to make a profit through selling goods and services

     

    Ways of calculating and measuring profitability:

    • Gross profit margin
    • Operating profit margin
    • Profit for the year margin

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