Unit 3: Finance

Using Budgets

A budget is an agreed plan establishing, in numerical or financial terms,

the policy to be pursued and the anticipated outcomes of that policy.
In Unit 1 the setting of budgets was discussed. The focus was on planning
a budget.
In Unit 2 the actual using of budgeting is studied. How can budgeting help
the business to improve its performance?

Benefits:
They provide direction and coordination.
They can motivate staff.
They improve efficiency.
They encourage careful planning.

Drawbacks
They are difficult to monitor fairly.
Allocations may be incorrect and unfair.
Savings may be sought that are not in the interests of the
firm.
They may be inflexible.
Encourages budgetary slack

A good budget should:

be consistent with the aims of the business

be based on the opinions of as many people as possible

set challenging but realistic targets (be SMART)

be monitored at regular intervals

be flexible

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Variance Analysis:
Variance analysis: the process by which the outcomes of budgets are
examined and then compared to the budgeted figures. The reasons for
any differences (variances) are then found.
Favourable variance: when costs are lower than expected or revenue is
higher than expected.
Adverse (unfavourable) variance: when costs are higher than
expected or revenue is lower than expected.

A variance is calculated by the following formula:

Variance = budget figure actual figure
For variance analysis, use F for favourable variances and A for adverse
variances, rather than positive or negative numbers.

A favourable variance would happen when:

actual income is greater than budgeted income

actual costs are below budgeted costs

An adverse (or unfavourable) variance would be shown when:

actual income is less than budgeted income

actual costs are above budgeted costs

The golden rule: knowing the effect a variance has on profit tells you
whether it is favourable or adverse.
A favourable variance will mean more profit than expected.
An adverse variance will mean less profit than expected.

The type of variance will depend on whether it is a profit, expenditure or

income budget being looked at.

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Improving Cash-Flow

Cash Flow: the amounts of money flowing into and out of a business over
a period of time.

Causes of Cash-Flow Problems:

Firms may have shortages of cash for a variety of reasons:

seasonal demand

overtrading, arising from over-expansion

over-investment in fixed assets

credit sales

poor stock management

poor management of suppliers

unforeseen change, e.g. a strike

losses or low profits

Improving Cash-Flow:
There are many ways of improving cash flow. The method(s) chosen may
vary according to the cause of the cash-flow problem. The AQA
specification identifies five main ways of improving cash-flow problems:

Bank overdraft. An agreement whereby the holder of a current

account in a bank is allowed to withdraw more money than there is
in the account.
It is easy to arrange and, once agreed, tends only to need
confirming on an annual basis.
It is very flexible, as the overdraft can be used to pay for
whatever the business requires at the time.
Interest is only paid on the level of the overdraft that is
actually used. Furthermore, interest is only paid on a daily
basis.

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Unlike with a bank loan, a firm that uses a bank overdraft does
not need to provide security (collateral).

Bank overdrafts are based on flexible interest rates, so it is

difficult to budget accurately the bank may change its rate
of interest.
The rate of interest charged on an overdraft is usually higher
than that charged on a short-term bank loan.
Agreements to provide an overdraft normally allow the bank
to demand immediate repayment.

Short-term loan. This is a sum of money provided to a firm or an

individual for a specific, agreed purpose. Repayment of the loan will
usually take place within 2 years.
Bank loans are usually at a fixed rate of interest. The interest
and repayment schedule is calculated at the time of the loan,
so it easy for the business to know whether it can afford to
repay the loan and budget for repayment.
The rate of interest charged on a bank loan is usually less than
that charged on an overdraft, so it can be a cheaper solution
to a cash-flow problem.
A bank loan may be set up for a long period of time, to help
the firm.
Interest is paid on the whole of the sum borrowed.
The business will need to provide the bank with security
(collateral).
Short-term loans can often only be used for a specific, agreed
purpose.

Factoring. When a factoring company (usually a bank) buys the

right to collect the money from the credit sales of an organization.
Improved cash flow in the short term.
Lower administration costs.
Reduced risk of bad debts.
Can encourage businesses to be cautious and careful with
their provision of credit, to ensure that all debts are factored.

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The main problem is the cost to the business, which will lose
between 5% and 10% of its revenue.
The factoring company will charge more for factoring than it
would for a loan, as there are administrative expenses
involved in chasing up the debts.
Customers may prefer to deal directly with the business that
sold them the product. An aggressive factoring company may
upset certain customers, who will blame the original seller of
the product.

Sale of assets. This process can improve cash flow by converting

an asset
(e.g. property or machinery) into cash, which can then be used to
ease the problem.
Selling assets can raise a considerable sum of money,
particularly in the case of a large asset such as a building.
If a particular asset is no longer helping towards the
businesss overall success, sale of the asset will not only ease
the cash-flow problem, but also enhance the overall
profitability of the business.
Assets such as buildings and machinery may be very difficult
to sell quickly. A business trying to make a quick sale usually
has to accept a much lower price than its true value.
It is a fundamental principle of business that a firm should not
sell fixed assets to improve liquidity, as the fixed assets
enable it to produce the goods and services that create its
profit.

Sale and leaseback of assets. Assets that are owned by the firm
are sold to raise cash and then rented back so that the company can
still use them for an agreed period of time.
This will overcome a cash-flow problem by providing an
immediate inflow of cash, usually of quite a significant level.

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A firm can be more flexible, as new and more efficient assets

can be leased.
The ownership of fixed assets can lead to a number of costs,
such as maintenance. Sale and leaseback eliminates these
costs.
Owning an asset can distract a business from its core activity
because it has to get involved with activities such as property
management or organizing a transport fleet.
In the long term, the firm will usually pay more in rent than it
receives from its sale.
As a result, sale and leaseback will also reduce the value of
the firms assets that can be used as security against future
loans.
The business may eventually lose the use of the asset when
the lease ends, as a competitor may be prepared to pay a
higher rental for the lease.

Some other ways of improving cash flow (not specified in the AQA
specification) are listed below:

Careful cash management (e.g. setting aside a contingency

fund for emergencies).

Effective debt management chasing up customers who

have not paid on time.

Stock management making sure that money is not tied

up in excessively high stock levels.

Diversifying to create a range of products that sell

throughout the year.

Careful budgeting.

Unit 3: Finance

Measuring and Increasing Profits:

Profit: the difference between the income of a business and its total costs.
Profit = revenue total costs
Profitability: the ability of a business to generate profit or the efficiency of
a business in generating profit.

Measuring Profitability:
Two ways of measuring profitability will be considered. Both measures
investigate how efficient a business is in terms of achieving a profit:

Net profit margin: compares the profit made with the sales income of
the business/branch.
Return on capital: compares the profit made with the amount of capital
invested by the entrepreneur or financial backer.

Net Profit -

net profit before tax

net profit margin( )=
100
sales revenue (turnover)

Unit 3: Finance

To assess the meaning of a net profit margin, two comparisons are usually
made:

Comparison over time. Is the net profit margin increasing

(suggesting improvements in efficiency) or decreasing
(implying a decline in efficiency)?

Comparison to other firms or branches/divisions. These

comparisons are useful because they look at the businesss
success (or failure) relative to other businesses. It is much
easier to make high net profit margins in some industries*
than in others; this calculation avoids judgments that may be
affected by this factor.

*These industries usually sell fewer items at higher prices, so a high net
profit margin is not a guarantee of higher overall profit levels.

Return on Capital Employed -

ROCE=

Net Profit
100
Capital Employed

To assess the meaning of the return on capital (%), three comparisons are
usually made:

Comparison over time. Is the return on capital increasing or

decreasing?

Comparison with other firms or branches/divisions. Is

the money invested in this business providing a better return
than the money invested in other businesses?

Comparison with bank interest rates. The opportunity

cost for many investments is the interest that could have been
gained from placing the money in a bank account. As there is
no real risk in this investment, the return on capital invested

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in a business needs to be higher than the interest rate offered

by a bank.

Improving Profits/Profitability:
Many methods can be used. Three main methods are:

Increasing Prices
Increasing the price will widen the profit margin. Therefore
each product sold will generate more profit.
This strategy will be particularly effective if the product is a
necessity or has no close substitutes, as customers will be
willing to pay the higher price.
BUTthis strategy will fail if the higher price leads to
customers switching to rival products or just giving up on
buying the product.
The business must analyse the likely effect of any price
increase in situations where there are many close competitors.
It is possible that the price rise may cause such a large fall in
demand that the higher profit margin will be offset by a
dramatic fall in quantity, so the overall profit may fall.
To assess the impact of price changes on profit, an
understanding of price elasticity of demand is needed.

Reducing Costs
Variable costs
If the firm can cut its variable costs, the profit margin
will increase.
This means that each product will yield more profit.
BUTif the change in costs leads to a decrease in
quality (e.g. inferior raw materials) or efficiency, the
demand for the product may fall.
Fixed costs
Profit will also increase if fixed costs, such as rent, are
reduced.
BUTnot if the cost cutting leads to lower sales (e.g.
locating the shop in a place that is less accessible to
customers).

Increasing Sales

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If costs and price remain the same, it is still possible to

increase profits by increasing the volume of products sold.
A business can achieve this by a number of methods, such as:
increasing marketing
developing new products
improving quality
BUTall of these methods will cost money.

Some other methods of improving profits are noted below, but this is
not an exhaustive list:

investment in fixed assets

product development
marketing
staff training

Profit and Cash-Flow:

Profit is calculated by subtracting expenditure from revenue. It is easy to
assume that a profitable firm will be cash rich, but this is not necessarily
true.
Liquidity is the ability to convert an asset into cash without loss or delay.
The most liquid asset that a business can possess is cash.
Many firms will not have their profit in the form of cash, so a high profit
may not guarantee a high level of cash.
It is also possible for a firm to have low profits but high cash levels. For
example, a business that has just borrowed a large sum of money will
have high cash levels, regardless of its profit levels.