2. 5.1.1 S ETTING FINANCIAL OBJECTIVES AQA Business 5 D ECISION MAKING TO IMPROVE FINANCIAL PERFORMANCE Recap. Unit 1 What is business? You were introduced to business objectives including:  Profit  Cash flow You were also introduced to the measurement of profit including:  Revenue  Fixed costs  Variable costs  Total costs Write down everything you can remember about these topics.

3. 5.1.1 S ETTING FINANCIAL OBJECTIVES  In this topic you will learn about  The value of setting financial objectives  The distinction between cash flow and profit  The distinction between gross profit, operating profit and profit for the year  Revenue, costs and profit objectives  Cash flow objectives  Objectives for investment (capital expenditure) levels  Capital structure objectives  External and internal influences on financial objectives and decisions

4. F INANCIAL OBJECTIVES  Financial objectives are the monetary targets a business wants to achieve within a set period of time  These include:  Return on investment  Capital structure  Revenue  Costs  Profit  Cash flow What might the financial objectives be for Airbus?

5. F INANCIAL OBJECTIVES  Return on investment (ROI)  Return = how much money is the business getting back  Investment= how much capital is being used within the business  ROI is a measure of a firm’s profitability and performance  How effectively is it using the money tied up in the business to generate profit  ROI targets will be set as a %  Benchmark to industry standard  Internal benchmarking  External factors e.g. Interest rate  ROI allows for comparisons between alternative investment opportunities

6. T HE CALCULATION AND U OF RETURN ON INVESTMENT  Return on investment is calculated as:  Operating profit x 100 Capital invested  Example:  Capital invested = £100 000  Operating profit = £8 000  £8 000/£100 000 x 100 = 8%  This means that for every £1.00 invested in the business £0.08 was generated in profit in that year  Practise calculation:  Operating profit = £68 000  Capital invested = £400 000  What is the ROI? How much profit is made each year for each £10000 invested? We will define different types of profit later on in this unit.

7. F INANCIAL OBJECTIVES  The proportion of long term funding that is debt  Long term funding is the amount of capital that has been invested in a business and will stay in the business for over a year. This is normally for the purchase of assets  Long term funding can come from 2 sources:  Equity i.e. capital invested by the shareholders of a company  Debt i.e. money borrowed from financial institutions  Capital structure refers to the relative ways in which the capital has been raised i.e. the ratio of equity to debt

8. F INANCIAL OBJECTIVES  The proportion of long term funding that is debt  Long term funding that is debt is compulsory interest bearing  This means that regardless of profits interest and repayments have to be made to the financial institutions  This increases the degree of risk undertaken by the business especially if interest rates start to rise  Interest represents a cost to the business  A business may set a capital structure objective to keep the proportion of long term funding that is debt below a certain percentage Interest rates explained.

9. F INANCIAL OBJECTIVES  The proportion of long term funding that is debt  This relationship is referred to as gearing  A business can be described as highly geared if the % is thought to be high as this increases the element of risk  Calculated as:  Debt x 100 Total long term funding Example: Long term funding = £3.2m Debt = £1.2m £1.2m/£3.2m x 100 = 37.5% Gearing is a concept you will look at in more detail in year 2.

10. F INANCIAL OBJECTIVES  Revenue, cost and profit objectives  Revenue objectives are targets set for the amount of money coming into a business from sales in a set period of time  Cost objectives are limits set for the amount of money to be spent on expenditure in a set period of time  Profit = Revenue – total costs  Profit objectives are targets set for the amount of surplus to be achieved in a set period of time  Revenue, cost and profit objectives can be set in relation to previous years or each other e.g. profit as a percentage of revenue Can you identify a business that is likely to set an objective of cost minimisation?

11. T YPES OF PROFIT Income statementExplanation Sales revenueMoney coming in from sales Quantity sold x selling price Cost of salesCosts directly linked to the production of the goods or services sold e.g. raw materials Gross profitSales revenue – cost of sales ExpensesAll other costs associated with the trading of the business e.g. salaries and marketing expenditure Operating profitGross profit – expenses Interest and taxationInterest paid on debt or received plus tax payable of profit Profit for the yearOperating profit - interest and taxation

12. F INANCIAL O BJECTIVES Cash flow objectives Cash flow is the movement of money into and out of a business If the net effect is negative i.e. more money is flowing out quicker that it is flowing in then a business may face cash flow (liquidity) problems Required to meet the short term objective of survival A healthy cash flow is necessary to meet day to day expenses May be a specific cash flow target To ensure all debts are received within 30 days To maintain a cash balance of £25,000 A cash flow target may be to keep a surplus in order to take advantage of unforeseen opportunities

13. T HE DISTINCTION BETWEEN CASH FLOW AND PROFIT  Profit exists in financial records when total revenue is greater than total costs  Cash is the physical existence of money within the business  Cash flow is the timings of cash flowing in and out of the business  Profitable businesses can fail because of lack of cash  Why might cash and profit be different?  Credit Sales  Bad debts  Heavy stock holdings  Investment in fixed assets  Seasonality  Repayment of loans

14. C AN YOU DEFINE EACH OF THESE KEY TERMS ?  Financial objectives  Return on investment  long term funding  Debt  Cash flow  Profit  Gross profit  Operating profit  Profit for the year  Revenue  Costs  Capital structure

15. I NTERNAL AND E XTERNAL I NFLUENCES  Internal  Factors from within the business  Corporate and other functional objectives  Characteristics of the firm  Relationship between owners and directors  Public or private sector  External  Factors from outside the business  Competitors  Consumers  Economic conditions  External environment

16. I NTERNAL I NFLUENCES Financial objectives Will have to contribute towards achieving corporate objectives Will be influenced by other functional objectives The characteristics of the firm Capital vs labour intensive Innovative Established Low cost or highly differentiated Relationship between owners and directors Within a PLC these can be the same or different What is the power of individual shareholders? Public or private sector A key influence on the overall objective of a business

17. E XTERNAL I NFLUENCES 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, ethical and technological change

18. I N PAIRS - COMPLETE THE TABLE TO EXPLAIN THE POSSIBLE LINKS BETWEEN EACH FINANCIAL OBJECTIVE AND OTHER FUNCTIONAL OBJECTIVES Financial Objectives Cash flowProfitReturn on investment Capital structure HR Objectives Marketing Objectives Operational Objectives

19. T EST YOURSELF - 15 MINUTES End 1.Briefly explain the significance of the proportion of long term funding that is debt. 2.What is the formula for return on investment? 3.Distinguish between cash flow and profit. 4.Distinguish between gross profit, operating profit and profit for the year. 5.State 2 internal influences on financial objectives. 6.State 2 external influences on financial objectives.

20. 5.1.1 S ETTING FINANCIAL OBJECTIVES  In this topic you have learnt about  The value of setting financial objectives  The distinction between cash flow and profit  The distinction between gross profit, operating profit and profit for the year  Revenue, costs and profit objectives  Cash flow objectives  Objectives for investment (capital expenditure) levels  Capital structure objectives  External and internal influences on financial objectives and decisions