Financial Planning & Analysis

Cash Flow Forecasting

Types of Cash Flow Cash Flow Forecasts show the expected flows of cash into and out of a business over a trading period in the immediate future, e.g. next 6 months or year. Actual Cash Flow Statements, these show an historic view, showing the actual flows of cash into and out of a business that have occurred over a previous trading period, e.g. 6 months, or 1 year.

Purpose To identify periods in time when cash might have to be borrowed To identify when cash could be invested

3 parts to a cash flow statement Cash Inflows (Revenues) Cash Outflows (Expenses) Money Left Over (Balance)

Jan Feb Mar Total Receipts 4000 12000 Total Payments 8050 12450 9450 Net Cash Flow (4050) (8450) 2550 Opening Balance 7950 (500) Closing Balance 2050

Sources of finance LONG TERM Issue shares Debentures Mortgage Government Loan Industrial Specialist INTERNAL Sell assets Profit SHORT TERM Bank Overdraft Bank loan Hire purchase Trade Credit Credit Cards Leasing Debt Factoring Trade Bills

Which one to use? The source of finance that a business may use is dependant upon:- Cost Motive Size & status Financial position

Budgeting

Budgeting Budgeting is the process of setting targets covering all aspects of costs and revenues It is to ensure that no department overspends How do you decide on the amount of money to be allocated to each department?

Methods of Budgeting Method 1: Take last years and add a bit (Flexible budgeting) Method 2: Zero based budgeting Method 2: Each company starts at £0 and has to fill in requisition forms in order to spend money

Advantages of budgeting A way to control and monitor costs A company wide profile can be gained of how much money is needed Senior staff can find out who is responsible for overspending Budgets can be used as targets Budgets are motivational

Disadvantages of budgeting Not an exact tool, it is based on predictions Flexible budgeting is dodgy Senior managers may be ‘conned’ into allocating more money than is necessary Spread of risk Imbalance- some have too much money to spend, others not enough Short termism, may lead to further cash flow problems in the future

Flexible budgeting Variances are used to show the amount of overspend and underspend Favourable Example; sales/ turnover is greater than the amount in the budget; actual expenditure is less than the amount in the budget Adverse Example; sales/ turnover is less than the amount in the budget; Actual expenditure is greater than the amount in the budget

Budgetting Budget Actual Variance Adv/Fav Sales 5270 6375 1105 Fav Rent received 145 180 35 Wages 5125 6195 1070 Adv Expenses 6416 6441 25 Profit 1291 246 1045 Example: 5270- 6375 = 1105 is this good or bad?

Variance analysis Variances are the key to analysing budgets. Once a variance has been recognised either adv or fav, analysis can take place Variance analysis is a means of identifying symptoms- is there too much spending, is there not enough money being allocated? Quality of management can be assessed with variance analysis- production costs will only be kept down is wastage is low and quality is high. Sales budgets will only be achieved if commitment is high and staff are enthusiastic Budgets can tell you a lot about the culture of a business

Break Even

Starter Activity 1) What are the two methods that exist to calculate break even? 2) Using the formula, calculate the break-even point for a firm making toy daleks using the following details: Fixed costs are: £1000 per month Selling price per dalek: £15 Variable costs per dalek: £5 3) Why might a business prefer to use the formula method? 4) On a graph, the break even point occurs when which two lines cross? 5) What is contribution?

Contribution = Total Revenue – Variable Costs Mars Bars cost 30p from the wholesaler, they are sold for 40p in the shop. The 10p leftover is not pure profit, because we have to pay the shops overheads too. Once the overheads have been paid, the money left over is profit. So the 10p is called Contribution. Overheads for the shop £1.00, how may Mars Bars would we need to sell to cover costs? What happens once we have sold 11?

Profit & Loss

What is a profit & loss account? The Trading Profit & Loss account shows the income that a business has earned over a period of time (usually one year) Profit (or loss) is calculated by subtracting costs and expenses from revenue. The P&L can tell us whether the company is trading successfully

Balance Sheets

Definition The balance sheet is an accounting statement which shows what a company owes and owns (Assets and Liabilities). It also shows how the company is financed (Capital)

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Ratios

Objectives of Ratio Analysis Standardize financial information for comparisons Evaluate current operations Compare performance with past performance Compare performance against other firms or industry standards Study the efficiency of operations Study the risk of operations Uses 1.      Managers – to help analyze, control, improve a firm’s operations 2.      Credit analysts – to help ascertain a company’s ability to pay its debts 3.      Stock analysts – to determine a company’s efficiency, risk and growth potential

Acid Test 1:1 seen as ideal A ratio of 3:1 therefore would suggest the firm has 3 times as much cash as it owes – very healthy! A ratio of 0.5:1 would suggest the firm has twice as many liabilities as it has cash to pay for those liabilities. This might put the firm under pressure but is not in itself the end of the world

Current Ratio Looks at the ratio between Current Assets and Current Liabilities Ideal level – 2 : 1 A ratio of 5 : 1 would imply the firm has £5 of assets to cover every £1 in liabilities A ratio of 0.75 : 1 would suggest the firm has only 75p in assets available to cover every £1 it owes Too high – Might suggest that too much of its assets are tied up in unproductive activities – too much stock, for example? Too low - risk of not being able to pay your way

Gearing The higher the ratio the more the business is exposed to interest rate fluctuations and to having to pay back interest and loans before being able to re-invest earnings

GPM 80% Enables the firm to assess the impact of its sales and how much it cost to generate (produce) those sales A gross profit margin of 45% means that for every £1 of sales, the firm makes 45p in gross profit

NPM 20% Net profit takes into account the fixed costs involved in production – the overheads Keeping control over fixed costs is important – could be easy to overlook for example the amount of waste - paper, stationery, lighting, heating, water, etc. e.g. – leaving a photocopier on overnight uses enough electricity to make 5,300 A4 copies. (1,934,500 per year) 1 ream = 500 copies. 1 ream = £5.00 (on average) Total cost therefore = £19,345 per year – or 1 person’s salary

ROCE Return on Capital Employed (ROCE) = Profit / capital employed x 100 The higher the better Shows how effective the firm is in using its capital to generate profit A ROCE of 25% means that it uses every £1 of capital to generate 25p in profit Partly a measure of efficiency in organisation and use of capital

Asset Turnover Asset Turnover = Sales turnover / assets employed Using assets to generate profit Asset turnover x net profit margin = ROCE

Stock Turnover Stock turnover = Cost of goods sold / stock expressed as times per year The rate at which a company’s stock is turned over A high stock turnover might mean increased efficiency? But: dependent on the type of business – supermarkets might have high stock turnover ratios whereas a shop selling high value musical instruments might have low stock turnover ratio Low stock turnover could mean poor customer satisfaction if people are not buying the goods (Marks and Spencer?)

Debtor Days Debtor Days = Debtors / sales turnover x 365 Shorter the better Gives a measure of how long it takes the business to recover debts Can be skewed by the degree of credit facility a firm offers

Limitations of Ratio Analysis A firm’s industry category is often difficult to identify Published industry averages are only guidelines Accounting practices differ across firms Sometimes difficult to interpret deviations in ratios Industry ratios may not be desirable targets Seasonality affects ratios Limitations 1.      Large firms operate different divisions in different industries a. Difficult to develop meaningful industry averages b. More useful for small, narrowly focused firms 2.      Firms want to be better than average a. Attaining average performance not necessarily good b. Best to focus on industry leaders’ ratios 3.      Inflation may have distorted balance sheets a. Must consider effects when comparing over time 4.      Seasonal factors distort ratio analysis a. Use monthly averages for season items such as inventory 5.      Window dressing can make financial statements look better 6.      Different accounting practices can distort comparisons a. Inventory valuation, depreciation methods 7.      Difficult to generalize whether a ratio is “good” or “bad” a. High current ratio – strong liquidity or too much cash (nonearning) 8.      Ratios can give “mixed” view of company a. Analyze net effects of a set of ratios