Finance For Non Finance Managers

FINANCE
FOR NON-FINANCIAL MANAGERS
Manjit Biant
PLEASE
TURN ME OFF
OR
SET TO SILENT
• Over to you
– What is your name and job title
– What are your main areas of job responsibility?
– How much involvement do you presently have with
finance?
– What kind of financial reports do you see in your
work?
– How will a greater knowledge of finance help you in
your work?
– Which topics would you particularly like to cover?
– Do you have any specific concerns about the course?
Introduction
Financial crisis Credit crunch
We live in turbulent times
Recession Survival?
Recovery?
Business failure?
Introduction
• Key course topics

– Understanding Financial Statements
– Managing Working Capital for strong
cashflow
– Gross margin and pricing for profit
– Measuring performance
– Investment appraisal
– Budgeting
Understanding Financial Statements
Understanding Financial
Statements
Sells kitchens imported from Scandinavia
Floated on the Alternative Investment Market 2001
Sales of £34m and 120 UK employees
Who might be interested in Skanda’s performance?
Why might they be interested?
Skanda Kitchens PLC

• Who might be interested?
– Shareholders and prospective shareholders
– Company’s directors and managers
– Banks
– Suppliers and prospective suppliers
– Customers and prospective customers
– Employees and prospective employees
• Why might they be interested?
– Check investment is safe and performing well
– Check company performance and their own
– Check company is good credit risk
– Check company can and will pay on time
– Check company can deliver
– Check long term career prospects
Statements
• Development of financial statements
– Joint stock companies proliferated after
industrial revolution
– Financial statements became more widely
used
– 19th century saw accounting scandals and
investor frauds
– Companies Acts set out first reporting rules
– Fundamental concepts much the same
today
• Fundamental requirement
– Show “true and fair view”
– Prepared in accordance with:
• Generally Accepted Accounting Principles
• Financial Reporting Standards
• Standard Statement of Accounting Practice
• Four basic accounting concepts

– Going concern concept
– Accruals concept
– Consistency concept
– Prudence concept
• Various accounting policies

– Sales income recognition
– Depreciation of fixed assets
– Stocks and work in progress
– Research and development
Statements
‘under the bonnet’ they all use a well established approach to accounting
• Double entry bookkeeping

– Each transaction shown by two entries
– Two simple rules apply:
– DEBIT the account of the RECEIVER of value
– CREDIT the account of the GIVER of value
Double entry bookkeeping:

the finest invention of the human mind
• Types of accounting entry

– Capital and revenue
– Cash and non-cash
Accounting entries to 31-3-07 Balance Transaction 1 New Balance
Racking & equipment

Bank account £400,000 £400,000
Stock
Debtors
Prepayments
Creditors
Accruals
Share capital (£400,000) (£400,000)
Sales
Cost of sales
Distribution costs
Salaries
Rent
Marketing costs
Other overhead
Depreciation
Check total £0 £0 £0
Racking & equipment

Bank account £400,000 (£30,000) £370,000
Stock
Debtors
Prepayments £15,000 £15,000
Creditors
Accruals
Share capital (£400,000) (£400,000)
Sales
Cost of sales
Distribution costs
Salaries
Rent £15,000 £15,000
Marketing costs
Other overhead
Depreciation
Racking & equipment £40,000 £40,000

Bank account £370,000 (£40,000) £330,000
Stock
Debtors
Creditors
Accruals
Share capital (£400,000) (£400,000)
Sales
Cost of sales
Distribution costs
Salaries
Rent £15,000 £15,000
Marketing costs
Other overhead
Depreciation

Bank account £330,000 (£20,000) £310,000
Stock
Debtors
Creditors
Accruals
Share capital (£400,000) (£400,000)
Sales
Cost of sales
Distribution costs
Salaries £20,000 £20,000
Rent £15,000 £15,000
Marketing costs
Other overhead
Depreciation

Bank account £310,000 (£18,000) £292,000
Stock
Debtors
Creditors
Accruals
Share capital (£400,000) (£400,000)
Sales
Cost of sales
Distribution costs
Salaries £20,000 £20,000
Rent £15,000 £15,000
Marketing costs
Other overhead £18,000 £18,000
Depreciation

Bank account £292,000 (£200,000) £92,000
Stock £200,000 £200,000
Debtors
Creditors
Accruals
Share capital (£400,000) (£400,000)
Sales
Cost of sales
Distribution costs
Salaries £20,000 £20,000
Rent £15,000 £15,000
Marketing costs
Depreciation

Bank account £92,000 £92,000
Stock £200,000 £75,000 £275,000
Debtors
Creditors (£75,000) (£75,000)
Accruals
Share capital (£400,000) (£400,000)
Sales
Cost of sales
Distribution costs
Salaries £20,000 £20,000
Rent £15,000 £15,000
Marketing costs
Depreciation

Bank account £92,000 £92,000
Stock £275,000 (£147,000) £128,000
Debtors
Creditors (£75,000) (£75,000)
Accruals
Share capital (£400,000) (£400,000)
Sales
Cost of sales £147,000 £147,000
Distribution costs
Salaries £20,000 £20,000
Rent £15,000 £15,000
Marketing costs
Depreciation

Bank account £92,000 (£14,000) £78,000
Stock £128,000 £128,000
Debtors
Creditors (£75,000) (£75,000)
Accruals
Share capital (£400,000) (£400,000)
Sales
Cost of sales £147,000 £147,000
Distribution costs £14,000 £14,000
Salaries £20,000 £20,000
Rent £15,000 £15,000
Marketing costs
Depreciation

Bank account £78,000 £78,000
Stock £128,000 £128,000
Debtors £245,000 £245,000
Creditors (£75,000) (£75,000)
Accruals
Share capital (£400,000) (£400,000)
Sales (£245,000) (£245,000)
Cost of sales £147,000 £147,000
Salaries £20,000 £20,000
Rent £15,000 £15,000
Marketing costs
Depreciation

Bank account £78,000 £78,000
Stock £128,000 £128,000
Debtors £245,000 £245,000
Creditors (£75,000) (£75,000)
Accruals (£17,000) (£17,000)
Share capital (£400,000) (£400,000)
Sales (£245,000) (£245,000)
Cost of sales £147,000 £147,000
Salaries £20,000 £20,000
Rent £15,000 £15,000
Marketing costs £17,000 £17,000
Depreciation
Racking & equipment £40,000 (£2,000) £38,000

Bank account £78,000 £78,000
Stock £128,000 £128,000
Debtors £245,000 £245,000
Creditors (£75,000) (£75,000)
Accruals (£17,000) (£17,000)
Share capital (£400,000) (£400,000)
Sales (£245,000) (£245,000)
Cost of sales £147,000 £147,000
Salaries £20,000 £20,000
Rent £15,000 £15,000
Marketing costs £17,000 £17,000
Depreciation £2,000 £2,000
The Mega Toy Company Limited Trial Balance at 31-3-07
Racking & equipment £38,000

Bank account £78,000
Stock £128,000
Debtors £245,000
Prepayments £15,000
Creditors (£75,000)
Accruals (£17,000)
Share capital (£400,000)
Sales (£245,000)
Cost of sales £147,000
Distribution costs £14,000
Salaries £20,000
Rent £15,000
Marketing costs £17,000
Other overhead £18,000
Depreciation £2,000
Check total £0
Balance sheet
Statements
UK versus US financial
terms
There are some differences in terms used
The course manual shows some examples
We will be using UK terminology
• Balance sheet
– A snapshot of the company’s financial
position
– As at the balance sheet date
• What does the balance sheet show?
– What the company owns = assets
– What the company owes = liabilities
– How these are financed = capital
employed
• The accounting equation
Assets minus liabilities = capital

• The Mega Toy Company Limited
Balance sheet at 31st March 2007
• Racking & equipment at cost £ 40,000

• Less depreciation £ 2,000
• Fixed assets at net book value £
38,000
• Cash £ 78,000
• Stock £128,000
• Debtors £245,000
Statements
Business funds flow
External Internal External

Share capital Cash
Stock
Loans
Debtors
= “Trade cycle”
• The Mega Toy Company Limited Balance sheet at
31st March 2007

• Fixed assets at net book value £ 38,000
• Cash £ 78,000
• Stock £128,000
• Debtors £245,000
• Prepayments £ 15,000
• Current assets £466,000
• Creditors £ 75,000
• Accruals £ 17,000
• Current liabilities £ 92,000
Statements
Business funds flow

Share capital Cash
Stock
Loans
Debtors
Creditors
= Working capital
= Trade cycle
• The Mega Toy Company Limited Balance sheet at 31st March 2007

• Cash £ 78,000
• Stock £128,000
• Debtors £245,000
• Net current assets £374,000
• NET ASSETS £412,000
• Represented by
• Share capital £400,000

Stock £128,000
Debtors £245,000
Accruals (£17,000)
Sales (£245,000)
Salaries £20,000
Rent £15,000
Check total £0

• Cash £ 78,000
• Stock £128,000
• Debtors £245,000
• Represented by
• Profit for the period £ 12,000
• £412,000
• Balance sheet shows

– What the company owns = assets
– What the company owes = liabilities
– How these are financed = capital
employed
• But does it tell us what the company is
worth?
SAPPHIRE
SOFTWARE
SAPPHIRE SOFTWARE LIMITED
BALANCE SHEET AS AT 31ST DECEMBER 2009
Fixed assets at cost £120,000

Accumulated depreciation £(75,000)
Fixed assets at net book value £45,000
Current assets
Cash £2,000
Debtors £8,000
£10,000
Current liabilities
Creditors £7,000
Net current assets £3,000
NET ASSETS £48,000
Represented by
Share capital £40,000
Retained profits £8,000
CAPITAL EMPLOYED £48,000
• Valuable items not usually in the balance

sheet
– Customer lists and goodwill in the business
– Future earning capability of the business
– Management talent and workforce skills
– Good industrial relations
– Real economic value of fixed assets
– Brands, logos and trademarks built up in the
business
– Copyrights and patents built up in the
business
• Accounting policies give a subjective view

– Stock
– Long term contracts
– Research and development costs
– Valuation of intangible assets
– Depreciation
Profit and loss account
• What is the profit and loss account?

– Technically part of the capital section of
balance sheet
– A statement of trading performance for the
period
• What does the profit and loss account

show?
– Sales
– Cost of goods and services sold
– Gross profit
– Other costs of running the business
– Profit

Stock £128,000
Debtors £245,000
BALANCE SHEET
Accruals (£17,000)
Sales (£245,000)
Salaries £20,000
PROFIT & LOSS ACCOUNT
Rent £15,000
Check total £0
• The Mega Toy Company Limited Profit & loss account to 31st March
2007
• Sales £245,000
• Cost of sales £147,000
• Gross profit £ 98,000
• Distribution costs £ 14,000

• Salaries £ 20,000
• Rent £ 15,000
• Marketing costs £ 17,000
• Other overhead costs £ 18,000
• Depreciation £ 2,000
• Administrative expenses £ 86,000
• Profit before tax £ 12,000

Cashflow statement
• In the good old days before the recession

– Around 18,000 UK businesses failed every
year
– Research shows that many were profitable
– So why do profitable businesses fail?
• Why do profitable businesses fail?

– Many businesses focus on sales and profit
– Profit is not the same thing as cashflow
– Many businesses have poor cashflow
information
– No easy access to additional funds
– Lack of cash causes profitable businesses to
fail
• The golden rule

Cashflow is the lifeblood of the business
• Vital difference between profit and

cashflow
• What is profit?
– Profit (or loss) arises from trading activity
– Calculated in accordance with accounting
rules

cashflow
• What is profit?
– Profit (or loss) arises from trading activity
– Calculated in accordance with accounting
rules
– Profit = net sales income earned
minus
trading costs incurred
– Profit is a matter of opinion

cashflow
• What is cashflow?
– Cash actually flowing in and out of the
business
– Cashflow is a matter of FACT
– The biggest mistake any business can make is
to assume that profit is an indicator of
strength & health
– Lose control of cashflow and you lose control
of the business

cashflow
– Profit for the period is £12,000
– Cashflow for the period is £78,000
– But why are they different?

THE MEGA TOY COMPANY
JANUARY - MARCH 2007 TRANSACTIONS : EFFECT ON PROFIT AND CASHFLOW
Effect on cash Effect on profit

+ - + -
1. Shares issued for £400,000 cash to the business partners £400,000

2. The company paid £30,000 for six months rent
3. Racking and equipment bought for £40,000
4. Salaries of £20,000 paid
4. Other overheads of £18,000 paid
5. Cash paid for stock worth £200,000
6. Stock worth £75,000 bought on credit with 30 days to pay
7. Sale of toys from stock costing £147,000
7. Freight costs paid by cheque
7. Toys sold and invoiced for £245,000 on 60 day terms
8. Company incurred £17,000 for the toy fair but has not been invoiced
9. Racking and equipment depreciation charge of £2,000 for first three months
TOTALS
NET CASHFLOW / NET PROFIT

• Profit includes
– Non cash items like depreciation
– Sales invoiced but not paid for by customer
– Costs incurred but not paid for
• Profit includes
– Non cash items like depreciation
– Sales invoiced but not paid for by customer
– Costs incurred but not paid for
• Profit does not include
– Stock bought but not sold
– Prepaid costs
– Funds received from share issues or loans
– Fixed assets purchased
• Cashflow statement
– Is a bridge between profit and loss account
and balance sheet
• What does the cashflow statement show?
– Where funds have come from
– How funds have been applied in the business
– Cashflow in the period
• The Mega Toy Company Limited Profit & loss account to 31st March
2007
• Sales £245,000
• Cost of sales £147,000
• Gross profit £ 98,000
• Distribution costs £ 14,000

• Salaries £ 20,000
• Rent £ 15,000
• Marketing costs £ 17,000
• Other overhead costs £ 18,000
• Depreciation £ 2,000
• Administrative expenses £ 86,000
• Profit before tax £ 12,000

• The Mega Toy Company Limited Cashflow
statement to 31st March 2007
• Profit £ 12,000
• Add back non-cash items: depreciation £
2,000
• Funds generated from operations £
14,000
• Proceeds from share issue £400,000
• Source of funds £414,000
• Increase in stock

• Cash £ 78,000
• Stock £128,000
• Debtors £245,000
• Represented by
• Profit for the period £ 12,000
• £412,000
• The Mega Toy Company Limited Cashflow
• Profit £ 12,000
• Add back non-cash items: depreciation £ 2,000
14,000
• Increase in stock £(128,000)
• Increase in debtors £(245,000)
Statements
Business funds flow

Share capital Cash
Stock
Loans
Debtors
= “Trade cycle”
• The Mega Toy Company Limited Cashflow statement to
31st March 2007
• Profit £ 12,000
• Funds generated from operations £ 14,000

• Increase in prepayments £( 15,000)
• Increase in creditors £ 75,000
• Increase in accruals £ 17,000
• Increase in net working capital £(296,000)
Statements
Business funds flow

Share capital Cash
Stock
Loans
Debtors
Creditors
= Working capital
• The Mega Toy Company Limited Cashflow statement to 31st March 2007
• Profit £ 12,000
• Increase in prepayments £( 15,000)
• Increase in creditors £ 75,000
• Increase in accruals £ 17,000
• Fixed assets purchased £( 40,000)

• Application of funds £(336,000)
• CASHFLOW £ 78,000
Statements
Business funds flow

Share capital Cash
Stock
Loans
Debtors
Creditors
Tax
Fixed assets Dividends
Profits / losses Loans repaid
Acquisitions
• Cashflow is the lifeblood of the business

– Weak cashflow causes many business
failures
– Cashflow drives business growth
– Without strong cashflow business slows and
dies
• Two ways to improve cashflow

1.Inject additional funds
• Debt
• Equity
2.Unlock the funds tied up in the business

• Inject additional funds

– Debt
• Loans and overdrafts from banks and others
• No dilution of ownership or control of the company
• Overdrafts provide flexible funding
• Not easy to get in current climate
• Can be expensive
• Must be repaid regardless of conditions
• Loan covenants may restrict business activities
• Overdrafts repayable on demand
Statements
• Inject additional funds
– Debt
– Equity
• Share capital from existing or new investors
• Usually less expensive than debt
• Dividends only paid when profit and cash allows
• Not always easy to find investors
• Can mean significant dilution of ownership
• Significant loss of control of business
• Unlock the funds tied up in the business

– Fixed assets
• Operating leases
• Asset backed loans
– Working capital
Managing Working Capital
• What is working capital?

– The “circulating capital” of the business
Business funds flow

Share capital Cash
Stock
Loans
Debtors
Creditors
= Working capital
• What is working capital?

– The “circulating capital” of the business
– Shown in balance sheet as “net current
assets”
– Net current assets = current assets
minus
current liabilities
The Kosi-Knit Sweater Company

KOSI-KNIT SWEATERS BALANCE SHEET AS AT 31st DECEMBER
2007 2006
Fixed assets £86,000 £121,000
Cash £25,000 £153,000
Stock £680,000 £544,000
Debtors £1,001,000 £833,000
Current assets £1,706,000 £1,530,000
Creditors £341,000 £398,000
VAT & tax creditor £75,000 £62,000
Current liabilities £416,000 £460,000
Net current assets £1,290,000 £1,070,000
NET ASSETS £1,376,000 £1,191,000
Represented by:
Share capital £750,000 £750,000
Retained profits £441,000 £410,000
Current year profit £185,000 £31,000
£1,376,000 £1,191,000
• Kosi-Knit Sweaters Limited Cashflow
• Profit £ 185,000
• Add back non-cash items: depreciation
£ 35,000
• Funds generated from operations
£ 220,000
• Source of funds £ 220,000
• Increase in stock £544,000 to £ 680,000

£(136,000)
• Why hold stock?

– Holding stock is expensive
– But “stock-outs” also incur costs
– Holding stock is a trade off
• Kosi-Knit Sweaters Limited Cashflow statement to 31st
March 2007
• Profit £ 185,000
• Add back non-cash items: depreciation £
35,000
220,000
• Increase in stock £544,000 to £ 680,000

£(136,000)
• Increase in debtors £833,000 to £1,001,000
£(168,000)
• Why give free loans to customers?

– Providing credit is expensive
– But the alternative also incurs cost
– Giving credit to customers is a trade off
• Kosi-Knit Sweaters Limited Cashflow statement to 31st March 2007
• Profit £ 185,000
• Increase in stock £544,000 to £ 680,000 £(136,000)

• Increase in debtors £833,000 to £1,001,000 £(168,000)
• Decrease in creditors £398,000 to £ 341,000 £( 57,000)
• Increase in VAT due £ 62,000 to £ 75,000 £ 13,000
• Application of funds £(348,000)
• CASHFLOW £(128,000)
• Kosi-Knit Sweaters Limited Working capital requirement
• 2007 2006
• Sales £3,650,000 100.0% £3,400,000 100.0%
• Stock £ 680,000 18.6% £ 544,000 16.0%

• Debtors £1,001,000 27.4% £ 833,000 24.5%
• Current assets £1,681,000 46.1% £1,377,000 40.5%
• Creditors £ 341,000 9.3% £ 398,000 11.7%

• VAT creditor £ 75,000 2.1% £ 62,000 1.8%
• Current liabilities £ 416,000 11.4% £ 460,000 13.5%
• Working capital £1,265,000 34.7% £ 917,000 27.0%

• (excluding cash)
• Working capital required to finance sales of £1,000,000 =

• £1,000,000 x 34.7% £1,000,000 x 27.0%
• = £ 347,000 = £ 270,000
• Why is working capital so important?

– Working capital must be funded
– Sales growth requires additional working capital
– So additional funding will be required to finance
growth
– Beware of overtrading
• Overtrading results in an acute cashflow crisis
• Caused by a rapid expansion in sales
• Resulting in an increased working capital requirement
• Beyond the level that can be funded by the business
• Always consider working capital impact
– Decisions to improve sales and profit affect
working capital
– Kosi-Knit made smart decisions to improve
sales and profit
– But did not consider impact on working
capital
• Supply from China increased stockholding
requirement
• And reduced a source of funds from creditors
• New customers’ terms increased level of debtors
• Significant increase in funding required
• Two drivers of strong business

– Cashflow is the lifeblood of the business
– Strong cashflow drives business growth
– Profit is a vital internal source of additional
cashflow
Masters in Finance
Gross Margin and Profit

• Generating strong profits

– Profit concept seems straightforward
– Profit = revenue minus costs
– But not all costs behave in the same way
The barrow boy’s guide to profit

• The fruit market:
• Selling price of one box of fruit £15.00
• Cost of one box of fruit £10.00
• Gross margin £ 5.00
• Daily cost of renting market stall £40.00
• So stall rent is paid for after selling £40.00 boxes of fruit

• £5.00
• Stall rent is paid for after selling 8 boxes of fruit

• Break-even point
– The most important dividing line in business
– Sales level at which the business just covers
its costs
– Below this sales level the business will make
a loss
– Above this sales level the business will make
a profit
• Two types of business cost

– Fixed costs
• not related to activity level - time related
• e.g. salaries, rent and insurance
– Variable costs
• related to activity level
• e.g. product costs, freight and delivery costs
• Gross margin
– What is left after deducting variable cost
from sales
– Gross margin is the real income of the
business
Break-even point = Fixed costs

Gross margin per unit
• Cost of one box of fruit £10.00
• Daily cost of renting market stall £40.00
• So stall rent is paid for after selling £40.00 boxes of fruit

• £5.00
• Stall rent is paid for after selling 8 boxes of fruit

• Variable cost £10.00
• Fixed costs £40.00
• Break-even point = £40.00 boxes of fruit

• £5.00
• Break-even point = 8 boxes of fruit

• Gross margin percentage Gross margin x 100

• Selling price
•
• Gross margin percentage £ 5.00 x 100
• £15.00
• Gross margin percentage = 33.3%

Break-even point = Fixed costs

Gross margin per unit
Break-even sales = Fixed costs

Gross margin percentage
• Fixed costs £40.00
• Break-even sales = £40.00

• 33.3%
• Break-even sales = £120 ( sales value of 8 boxes of fruit )
•
• A business cannot make a profit
– Until sales exceed break-even point
or in other words
– Until fixed costs are covered by gross margin
business
– Seems obvious?
– But the concept is not widely understood
• Sales Gross margin % Gross margin
• £2,000,000 5% ?
• £1,000,000 10% ?
• £ 500,000 20% ?
• £ 333,333 30% ?
• £ 200,000 50% ?
• These five businesses have one thing in common

• Sales Gross margin % Gross margin
• £2,000,000 5% £100,000
• £1,000,000 10% £100,000
• £ 500,000 20% £100,000
• £ 333,333 30% £100,000
• £ 200,000 50% £100,000
• These five businesses have one thing in common
• They all produce a gross margin of £100,000

• Fixed costs Gross margin % Break-even sales
• £ 100,000 5% £2,000,000
• £ 100,000 10% £1,000,000
• £ 100,000 20% £500,000
• £ 100,000 30% £333,333
• £ 100,000 50% £200,000
•
Bright Spark Electronics

• The Bright Spark Electronics Company
• Profit and loss account to 31st December 2008 2007
• Sales £2,200,000 £2,300,000

• Gross margin £ 568,000 £ 600,000
• Gross margin percentage 25.8% 26.1%
• Overhead costs £ 510,000 £ 475,000

• Operating profit £ 58,000 £ 125,000
What is the break-even sales point in each of the two years?

•
• Sales £2,200,000 £2,300,000

• Gross margin £ 568,000 £ 600,000
• Overhead costs £ 510,000 £ 475,000

Fixed costs
• Break-even sales = £ 510,000 £ 475,000
Gross margin percentage
• 25.8% 26.1%
•
• Sales £2,200,000 £2,300,000

• Gross margin £ 568,000 £ 600,000
• Overhead costs £ 510,000 £ 475,000

• Break-even sales £ 510,000 £ 475,000

• 25.8% 26.1%
• Break-even sales £1,975,352 £1,820,833
Why has the break-even point increased?

• Sales £2,200,000 £2,300,000

• Gross margin £ 568,000 £ 600,000
• Overhead costs £ 510,000 £ 475,000

Why is profit lower in 2008?

•
Because of the combined effect of:
Higher break-even sales point
Lower sales volume
• Sales £2,200,000 £2,300,000

• Gross margin £ 568,000 £ 600,000
• Overhead costs £ 510,000 £ 475,000

•How can profit be increased?

• 2Gb special memory chip Before After
• Selling price per unit £10.00

£ 9.00 - 10%
• Variable cost per unit £ 7.50
£ 7.50
• Gross margin per unit £ 2.50
£ 1.50 - 40%
• Annual sales units 10,000

11,600 + 16%
• Gross margin from sales £25,000
£17,400 - 30%
• Increase in sales volume required to achieve same gross margin =

67%
•
Increase in sales volume to offset effect of price reductions on gross margin
Existing gross margin percentage

20% 25% 30% 35%
% increase in sales volume to produce same gross margin
% price
reduction
5 33 25 20 17
7 54 39 30 25
10 100 67 50 40
12 150 92 67 52
15 300 150 100 75

• How can profit be increased?
– Increase price and sell the same volume
– Action on price is the most effective way to
improve profit
– Increase sales volume at the same price
– Reduce the break-even point
• Reduce variable costs : “value analysis”
techniques
• Improve sales mix
• Reduce fixed costs
• A business cannot make a profit

– Until sales exceed break-even point
or in other words
– Until fixed costs are covered by gross margin
business
• How does this work with service

businesses?
– Some service businesses use third party
consultants
– But many retain full time partners and staff
– These businesses tend to have no variable
costs
– All costs tend to be fixed
• How does this work with service

businesses?
– So in these businesses sales = gross margin
– Break-even is achieved when sales = fixed
costs
– To ensure that the business achieves target
profit check that
• Required sales are achievable at realistic
utilisation levels
• And at a realistic average fee rate
Morgan Brown Gillespie Limited

• Morgan Brown Gillespie Limited
• Salary and pension costs £2,000,000

• Administration costs £1,350,000
• Fixed costs for 2009 £3,350,000
• Break-even sales = £3,350,000
• Hours to be billed to achieve break-even = Break-even sales

• Average hourly rate
• Hours to be billed in 2009 to achieve break-even = £3,350,000 = 11,965

hours
• £280
• Percentage of available chargeable hours 11,965 = 73%

• 16,500
•
• Morgan Brown Gillespie Limited
• Sales to achieve target profit of 20% on sales = fixed costs x 100

• (100 – 20)
• So sales to achieve target profit of 20% on sales = £4,187,500
• Hours to be billed in 2009 to achieve target profit = £4,187,500

= 14,955 hours
• £280
• Percentage of available chargeable hours = 14,955 = 91%

• 16,500
• It is unlikely that the firm will achieve the level of utilisation required to achieve
target profit
FINANCE
FINANCE
Masters in Finance
Please check your mobile
is switched off
Measuring Performance
• Financial measures
• Non-financial measures
– Performance measures: how well the business is
run
– Financial strength measures: ability to meet
liabilities
– Stock market measures: from the investors point
of view
Skanda Kitchens PLC

Morgan Brown Gillespie Limited
• Performance measures
– How well the business is being run
– Profit and cashflow are good indications
– Return on investment (ROI) is a key measure
• Return on investment
– Fundamental business concept
– Investors’ funds are attracted by best rate of
return
– But different investments carry different risks
– So rate of return must reflect level of risk taken
Return
High
Low
Risk
Low High
But why does a zero risk investment still require a financial return?
Return on Equity
Profit after tax
Ordinary shareholders funds (Equity)

Return on Net Assets
Profit before interest payable and tax (PBIT)
Net Assets
• Return on Net Assets
– Determined by two key measures:
• Profit Margin
• Net Asset Turnover
• Profit Margin
Profit before interest payable and tax x 100
Sales
Skanda Kitchens PLC
Profit and loss account for year ended 31st December 2007
£000's omitted
Sales 34,000
Cost of sales 22,780
Gross profit 11,220
Distribution and administrative expenses 8,800

Operating profit ( PBIT ) 2,420
Loan interest payable 250

Profit before tax 2,170
Tax 650
Profit after tax 1,520
• Profit Margin
£ 2.42m x 100 = 7.1%
£ 34m
Comparison of Profit Margin
£ millions omitted
Company Year ended Sales Operating Profit
Profit Margin
Skanda Kitchens Dec 07 34 2.4 7%
Walmart Jan 09 $405,607 $22,798 6%
South East Water Mar 09 170 61 36%
Marks & Spencer Mar 09 9,062 871 10%
British Airways Mar 08 8,753 875 10%
• Why do some have better profits than others?
– More profitable industry sectors
– More profitable products
– More profitable companies
• Why are some industries more profitable?
Porter’s Five Forces: determinants of industry sector profitability

Porter’s Five Forces: determinants of industry sector profitability

• Why are some products more profitable?
– Stage in product lifecycle
– Complexity and cost
– Perceived customer value and price
– Availability of substitutes
– Elasticity of demand
– Brand premium
• Why are some companies more profitable?
– Industry sector
– Product type and mix
– Gross margin / volume
– Cost management
– Competitive advantage
• Competitive advantage
Is what enables the enterprise to create superior
value for its customers and superior profits for
itself
Michael Porter
• Two types of competitive advantage
– Cost advantage
The enterprise creates the same benefits as
competitors but at a lower cost
– Differentiation advantage
The enterprise delivers benefits that exceed those of
competitors at the same cost
Here is a real example of a business with a cost advantage

• Competitive advantage
– Real competitive advantage has two key attributes
• It is hard to copy and
• It is sustainable
• Why do some have better profits than others?
– More profitable industry sectors
– More profitable products
– More profitable companies
So how do the companies with low profit margins keep their shareholders
happy?
• Profit Margin
– Measures capital intensity of the business
• Capital intensity
£ millons
March 09 Forecast Dec 09
Fixed assets £5,868 £3,295
Net current assets (£917) £10
Net assets £4,951 3,305
Sales £9,062 £422
Capital intensity £4,951 = 55% £3,305 = 783%
£9,062 £422
Capital intensity of different industry sectors
High Medium Low
National Grid
Supermarkets
Hotel chain
Tour operator
Advertising agency
Water company
Motor manufacturer
Law firm
Electricity generator – nuclear
Electricity generator – gas
Airline operator – British Airways
– Measures the level of asset utilisation in the
business
– Measures the level of asset utilisation in the
business
– Calculated as:
Sales
Net Assets 1
Skanda Kitchens PLC

Balance Sheet as at 31st December 2007
£000's omitted
Fixed assets at net book value 3,700
Cash 1,184
Stock 13,288
Debtors 4,658
Current assets 19,130
Creditors due within one year 2,060
Net current assets 17,070
NET ASSETS 20,770

Comparison of Net Asset Turnover
£ millions omitted
Company Year ended Sales
Net Assets Net Asset Turnover
Skanda Kitchens Dec 07 34

21 1.6
Walmart Jan 09 $405,607
$108,039 3.8
• Profit Margin
– Return on Net Assets =

Profit Margin x Net Asset Turnover
Comparison of Return on Net Assets
Company Year ended Profit Margin Net Asset Turnover

Return on Net
Assets
Skanda Kitchens Dec 07 7% 1.6 12%
Which is the same as:

Return on Net Assets = Operating Profit = £ 2.4m =
12%
Net Assets £20.8m
Comparison of Return on Net Assets
Company Year ended Profit Margin Net Asset Turnover

Return on Net
Assets
Skanda Kitchens Dec 07 7% 1.6 12%
Walmart Jan 09 6% 3.8 26%
South East Water Mar 09 36% 0.2 6%
Marks & Spencer Mar 09 10% 1.8 18%
British Airways Mar 08 10% 1.1 11%
= Profit Margin x Net Asset Turnover
– Provides the basis of ‘pyramid of ratios’
– Pyramid of ratios is a powerful management
control tool
Pyramid of financial performance ratios
Operating Profit
Net Assets
Profit Margin Net Asset Turnover

Operating Profit Sales
Sales Net Assets
Gross Profit Overhead Sales Sales

Sales Sales Fixed Assets Working Capital
Pyramid of financial performance ratios
Net Asset Turnover
Sales
Net Assets
Sales Sales
Fixed Assets Working Capital
Sales Sales Sales Sales

Creditors Cash Stocks Debtors
Debtors Sales / debtors
Debtors Sales Turnover
Skanda Kitchens 4.66m £34m 7.3
Walmart $3,905m $405,607m 103.9
Debtors is vital component of working capital for most businesses

Days’ sales outstanding (DSO) Debtors / sales x 365
Debtors Sales DSO
Skanda Kitchens 4.66m £34m 50
Walmart $3,905m $405,607m 4

• Working capital management

• Working capital management
– Not only critical for strong cashflow
– Also affects Net Asset Turnover
– Can significantly affect Return on Net Assets
– Working Capital Cycle Days measures ‘speed of
circulation’
Working Capital Cycle Days
Skanda Walmart
Stock 213 41
Debtors 50 4
Creditors (34) (34)
Net Working Capital Cycle Days 229 11

Management action to improve performance
Operating Profit
Net Assets
Increase Reduce
Profit Net Assets
Increase Reduce Reduce Reduce

Sales Costs and expenses Fixed Assets Working Capital
Reduce
Stocks – Debtors – Cash
Increase
Creditors
run
liabilities
of view
• Financial strength measures
– Measure a company’s ability to meet its liabilities
– Solvency ratios deal with long term liabilities
– Liquidity ratios deal with short term liabilities
• Solvency ratios
– Debt ratio measures “gearing” or “leverage”
Debt ratio = Debt

Capital employed
Skanda Kitchens PLC
£000's omitted

Cash 1,184
Stock 13,288
Debtors 4,658
NET ASSETS 20,770
Creditors due after more than one year

Long term loan 2,900
Capital and reserves
Share capital 14,000
Retained profits 3,350
Current year profit 520
CAPITAL EMPLOYED 20,770
• Debt ratio
Skanda Kitchens Debt ratio = £ 2.9m
£20.8m
Debt ratio = 14%
So equity = 86% of capital
employed
Low “gearing” represents a lower risk
This gives prospective lenders a higher level of
safety
• Solvency ratios
– Debt ratio measures “gearing” or “leverage”
– Interest cover measures safety of loan interest
Interest cover = Profit before interest payable and

tax
Interest payable
• Financial strength measures
– Measure a company’s ability to meet its liabilities
• Liquidity ratios
– Current ratio
– Measures to what extent short term assets cover
short term liabilities
Current ratio = Current assets
Current liabilities
• Liquidity ratios
– Current ratio measures to what extent short term
assets will cover short term liabilities
– “Acid test” ratio is a stricter test
Acid test ratio = Liquid assets (cash + debtors)

Current liabilities
Skanda Kitchens PLC
£000's omitted

Cash 1,184
Stock 13,288
Debtors 4,658
NET ASSETS 20,770
Creditors due after more than one year

Long term loan 2,900
Capital and reserves
Share capital 14,000
Retained profits 3,350
Current year profit 520
CAPITAL EMPLOYED 20,770
• Acid test ratio
Skanda Kitchens Acid test ratio = £ 5.8m
£ 2.1m
Acid test ratio = 2.8 times
Ratio of less than one indicates possible problems
But high ratios should also be carefully examined
run
liabilities
of view
• Standards for financial analysis
– Ratios are useful tools but one year’s results do
not give full picture
– Earlier years’ results for same business
– Business segment analysis for same business
– Internal budgets
– Other businesses in same industry
• Non-financial measures
“Imagine entering the cockpit of a modern jet airplane and seeing
only a single instrument there.”
• Kaplan & Norton’s Balanced Scorecard
– Supplements traditional financial performance
indicators
– BSC adds a variety of non-financial indicators
– Aims to address all areas of performance
objectively
– BSC focuses on four different perspectives
• Developing a Balanced Scorecard
– Three stages to development of BSC
• Answer the question in each perspective to set goals
• Identify key competencies required to achieve
objectives
BALANCED SCORECARD
Perspective Question Explanation
Customer What do existing and new Gives rise to targets that matter to
customers value from us? customers: cost, quality delivery, inspection
etc.
Internal At what processes must we excel Aims to improve internal processes and
to achieve our financial and decision making
customer objectives?
Innovation and Can we continue to improve and Considers the capacity of the business to
learning create future value? maintain its competitive position through the
acquisition of new skills and the development
of new products
Financial How do we create value for our Covers traditional measures such as growth,
shareholders? profitability and shareholder value but set
through talking directly to shareholders
• Developing a Balanced Scorecard
– Three stages to development of BSC
• Answer the question in each perspective to set goals
• Identify key competencies required to achieve
objectives
• Set appropriate measures for key improvement areas
BALANCED SCORECARD
Perspective Measures
Customer  New customers acquired  On time deliveries

 Customer complaints  Returns
Internal  Quality control rejects  Speed of producing management data

 Average set-up time
Innovation and  Labour turnover rate

learning
 Percentage of revenue generated by new products and services
 Average time taken to develop new products and services
Financial  Return on Net Assets  Return on Capital Employed

 Cashflow  Revenue growth
 Earnings per share
• Using Balanced Scorecard
– BSC becomes main monthly report
– Balanced means equal focus is on all four
perspectives
– Related to key elements of organisation’s strategy
• Using Balanced Scorecard
– BSC becomes main monthly report
– Balanced means equal focus is on all four
perspectives
– Related to key elements of organisation’s strategy
– Encourages “goal congruence”
– Financial and non-financial measures linked
– Useful where profit is not key performance
indicator
• The “Tesco Steering Wheel”
– Tesco was early adopter of BSC approach
– Tesco wanted a measurement system to motivate
all staff
– Tesco developed a “Steering Wheel”
– “Community” added as fifth perspective to BSC
Measuring company performance
• The “Tesco Steering Wheel”
– Tesco was early adopter of BSC approach
– Tesco wanted a measurement system to motivate
all staff
– Tesco developed a “Steering Wheel”
– “Community” added as fifth perspective to BSC
– Every store receives monthly update on its
performance
– Kept Tesco focused during period of rapid growth?
• Criticisms of Balanced Scorecard
– No financial theoretical basis and entirely
subjective
– Cannot be used to calculate impact on profit
– Time consuming and can be overly bureaucratic
– Care needed to avoid conflicting measures
– Can result in too many measures
– Expertise needed to analyse “big picture”
• Key Performance Indicators – KPI’s
– Care must be taken in selecting KPI’s
– Must be relevant and linked to critical success
factors
– Act to initiate action
– Not just add to “sea of information”
• What is a critical success factor
– “ an issue or aspect of organisational performance
that determines the ongoing health, vitality and
well being of that enterprise”
– Characteristics of critical success factors
• Usually fairly obvious
• Influence cuts across several aspects of performance
• Examples of critical success factors
– Delivery in full on time, all the time, to key
customers
– Completion of projects on time and to budget
– Getting the right product in the right place at the
right time
– Increasing the gross margin
– Customers being active advocates for our business
– Positive brand recognition
Critical success factor:
Timely arrival and departure of aircraft

British Airways
Financial KPI: Operating profit margin of 10%
British Airways
Operations KPI: punctuality target of 48% “ready to go”
British Airways
Customer KPI: 63% of customers likely to recommend BA
British Airways
Employees KPI: involvement measure of 74%
• Key Performance Indicators
– Care must be taken in selecting KPI’s
– Must be relevant and linked to critical success
factors
– Act to initiate action
– Not just add to “sea of information”
– No more than 20 – ideally 10 or less
– Work well where profit is not organisational
priority
– But must be regularly monitored to be effective
Investment Appraisal
• Why do we need investment appraisal tools?
– Capital is scarce in both public and private sectors
– That’s never been more true than today
– We need to know if the investment is worth
making
– We need to know if the risk is justified by the
financial return
– We need to know if the project meets our
investment criteria
– How it compares to other projects competing for
same funds
• Various methods available
• Accounting rate of return (ARR)
• Payback period
• Net Present Value (NPV) using discounted cashflow (DCF)
Annual profit x 100

Investment
Skanda Kitchens PLC

SKANDA KITCHENS
INVESTMENT APPRAISAL: ACCOUNTING RATE OF RETURN
£000's omitted OWN RENTED
Investment £2,000 £1,000
Profit before tax £300 £200
Rate of return 15.0% 20.0%

• Calculates annual profit as percentage of investment
cost
• Advantages
– Easy to understand
– Similar concept to ROI calculation
• Calculates annual profit as percentage of investment
cost
• Advantages
• Disadvantages
– Based on profit and ignores cashflows
– Percentage approach ignores size of project
– Ignores time value of money
• Payback period
• Payback period
• How many years project cashflow to payback initial
investment
Investment
Annual cashflow
Skanda Kitchens PLC

SKANDA KITCHENS
INVESTMENT APPRAISAL: PAYBACK PERIOD
£000's omitted OWN RENTED
Investment £2,000 £1,000
Cashflow £400 £300
Payback period 5.0 3.3

• Payback period
investment
• Advantages
– Easiest to understand
– Easy to compare different projects
• Payback period
investment
• Advantages
• Disadvantages
– Ignores cashflows after payback point
– Takes no account of the risk in the project
– Ignores time value of money
• Payback period
Would you like it now or in one year’s time?
• Reasons for time preference
• Cash received now can be spent now
• Risk disappears when cash is received
• Cash received now can be invested
• Net Present Value using DCF analysis
• Recognises time value of money
• Based on projected cashflows
• Reflects risk in investment and capital projects
• Good basis for comparing competing projects
• Based on principle of compound interest
• Future value of £100 invested at 10% interest
per year
Initial investment
£100
Interest at 10% £
10
Balance at end of year 1
£110
• Future value of £100 invested at 10% interest
per year
Initial investment
£100
Interest at 10% £
10
Balance at endweofcanyear
Using this approach 1 the value to us today of
calculate
cashflows that we will receive at some point in the future
£110
Interest on balance at 10%

• Present value of £121 received in two years’
time after investing at 10% per year
Value in two years time
£121
Present value = value of investment in two
years’ time = £100
1.21
Present value = value of investment in two
years’ time
( 1 + 0.10)2
Skanda Kitchens PLC

SKANDA KITCHENS
INVESTMENT APPRAISAL: NET PRESENT VALUE RENTED RETAIL STORE
£000's omitted 0 1 2 3 4 5
Investment (£1,000)
Operating cashflow £300 £300 £300 £300 £300
Terminal value:
Freehold
Fixtures and fittings £600
Trade £1,500
NET CASHFLOW (£1,000) £300 £300 £300 £300 £2,400
Discount factor 0.9091 0.8264 0.7513 0.6830 0.6209
NPV £1,441 (£1,000) £273 £248 £225 £205 £1,490

SKANDA KITCHENS
INVESTMENT APPRAISAL: NET PRESENT VALUE OWN RETAIL STORE
£000's omitted 0 1 2 3 4 5
Investment (£2,000)
Operating cashflow £400 £400 £400 £400 £400
Terminal value:
Freehold £1,300
Fixtures and fittings £600
Trade £1,500
NET CASHFLOW (£2,000) £400 £400 £400 £400 £3,800
Discount factor 0.9091 0.8264 0.7513 0.6830 0.6209
NPV £1,627 (£2,000) £364 £331 £301 £273 £2,360

• Which discount rate?
– Frequently used discount measures
• Borrowing cost
• Weighted average cost of capital
• Company’s own ‘hurdle’ return on investment
– Sometimes adjusted to reflect level of risk
involved
– Good idea to use sensitivity testing at range of
rates
– But should we use the same rate for both options?
• Why cashflow and not profit?
• Cashflow is what ultimately counts
• Profit measurement is subjective
• Cash is used to finance growth and pay dividends
• Incremental cashflow approach
• Important to use only relevant incremental cashflows
• Careful consideration of
– Sunk costs
– Opportunity costs
– Interest and dividends
– Taxation
– Scrap and terminal proceeds
• Using a cashflow approach to business
valuation
• Estimate NPV of future incremental cashflows
generated
– Identify main drivers of sales and costs
– Produce high / low forecasts of incremental cashflows
– Remember timing of cashflows is significant
– Use spreadsheet models to test sensitivity to variables
– Use spreadsheet models to test sensitivity to discount factor
valuation
generated
• Estimate current cash position using “zero balance
sheet”
– Assign “realistic” figures for current assets and liabilities
– Use DD results to include all potential liabilities
– Estimate true position for surplus cash on acquisition
valuation
generated
• Estimate current cash position using “zero balance
sheet”
• Business valuation is the sum of the above
• Double check against other valuation methods
– Normal industry EBITDA or P/E multiples
– Bank’s valuation for loan purposes
– What the competition is prepared to pay!
Budgeting
Budgeting
• What is a budget?
– A plan expressed in money
– Prepared and agreed prior to the budget
period
– The budget may show
• Income
• Expenditure
• Capital to be employed
Chartered Institute of Management Accountants
Budgeting
• What is a budget?
– The budget is part of the strategic planning
process
– Organisation gains from the budget process
itself
– And gains from the budget once it is
prepared
What is Budgeting About?
PEOPLE
PLANNING
CONTROLLING
MEASURING
PEOPLE
PLANNING
CONTROLLING
MEASURING
Planning
“With careful and detailed planning

one can win;
with careless less detailed planning
one cannot win.
How much more certain is defeat
if one does not plan at all”
Sun Tzu:
“The Art of War” written in 400BC
In other words:
Failing to plan is planning to fail
Planning
• What is planning about?
– Looking at where we are now
– Deciding what we want to achieve
– Taking stock of resources available or needed
– Anticipating problems
– Deciding what will need to be done
Planning
• Types of business planning
– Operational planning
• Detailed planning
• Day to day
Planning
– Tactical planning
• Short term annual planning
Planning
– Tactical planning
– Strategic planning
• Long term planning
• Three to five years
Planning
THE PLANNING PROCESS
STRATEGIC / CORPORATE / LONG RANGE PLANNING

Covers periods of longer than one year
Involves setting long term objectives of the organisation
Formulation, evaluation and selection of strategies designed to achieve the objectives
Strategies are the basis of long-term plan of action
BUDGETARY / SHORT TERM TACTICAL PLANNING

Covers period of one year
Involves preparing detailed plans for an organisation's functions
Works within framework set by strategic plans
Converts strategic plans in to actions
OPERATIONAL PLANNING
Covers very short term day-to-day activities
Concerned with how the organisation's resources will be used
Work within the framework set by the budget
Converts budgetary plans in to detailed plan of action
Planning
– Tactical planning = Budgeting
– Strategic planning
Planning
• Budgeting
– Uses the strategic plan
– To identify short term goals and objectives
– To produce an annual operating plan
PEOPLE
PLANNING
CONTROLLING
MEASURING
People
• Budgeting and People
– Responsibility
• Objectives should be set at departmental level
• Department manager is made responsible for delivery
People
– Responsibility
– Integration
• Individual efforts focussed on common goals
• Managers and staff “pull in the same direction”
• Avoids managers following their ‘own agenda’
People
– Responsibility
– Integration
– Motivation
• Budgeting can be a good way of motivating people
People
• Motivation
– Budgetary systems can provide good motivation
– But it's also easy to produce negative reactions
– Style of budgeting is a major factor
• Top down – imposed budget
• Bottom up – participatory budget
• Negotiated – between budget holders and managers
Style of budgeting is a major factor
People
• Motivation
– Budgetary systems can provide good motivation
– But it's also easy to produce negative reactions
– Style of budgeting is a major factor
– Style affects attitude and can cause demotivation
– Attitudes to setting; implementing; controlling
budgets
People
• Motivation
– Most successful budgetary control systems:
• Set realistic and achievable budgets
• Are prepared in consultation with the whole team
• This approach provides the best basis for motivation
People
– Responsibility
– Integration
– Motivation
– Evaluation
• Performance of budget holders can be measured
• Both by attitude and results
PEOPLE
PLANNING
CONTROLLING
MEASURING
Measuring
• Actual performance must be measured
– Income and spending must be recorded and
monitored
– Accounted for in sufficient detail
– Monthly and year to date report at department
level
– Other non-financial KPI’s also calculated monthly
PEOPLE
PLANNING
CONTROLLING
MEASURING
Controlling
• One of the main purposes of budgeting
– Actual monthly performance must be measured
– And compared to monthly phased budget
– Feedback reporting to budget holder is key
Controlling
• The key to good feedback reporting
– Clear and comprehensive
– Timely to allow prompt action to be taken
– Accurate but without superfluous detail
– Directed to the responsible manager with
authority to act
Controlling
• One of the main purposes of budgeting
– Actual monthly performance must be measured
– And compared to monthly phased budget
– Feedback reporting to budget holder is key
– Actual results should be compared to budget
– Variances shown for investigation
– Appropriate action taken promptly to deal with
variance
Controlling
Morgan Brown Gillespie Limited BUDGET REPORT : JUNE 2009
June June year to date
Actual Budget Variance Actual Budget Variance
£000's % £000's % £000's £000's % £000's % £000's
Sales 420 100.0 400 100.0 20 2,000 100.0 2200 100.0 (200)
Direct costs 215 51.2 200 50.0 (15) 1,050 52.5 1100 50.0 50
Gross profit 205 48.8 200 50.0 5 950 47.5 1100 50.0 (150)
Administration costs 136 32.4 130 32.5 (6) 730 36.5 700 31.8 (30)
Operating profit 69 16.4 70 17.5 (1) 220 11.0 400 18.2 (180)
Comments
Action
Controlling
• Appropriate action taken promptly
– No action if results in line with budget
– Remedial action if results indicate problem
PEOPLE
PLANNING
CONTROLLING
MEASURING
Budgeting
• Alternative approaches to budgeting
– Incremental budgeting is traditional approach
• Current period budget is base for next period
• Sales and costs subject to incremental increase
• Inappropriate for some kinds of costs
• Inefficient form of budgeting which encourages waste
Budgeting
– Zero based budgeting
Budgeting
• Zero based budgeting
– Each cost element specifically justified
• In principle budgeted from zero base
• In practice works back from current cost level
• Every aspect of budget subject to cost benefit review
• Encourages managers to develop questioning attitude
Budgeting
– Advantages of ZBB
• Identifies inefficient operations and processes
• Avoids wasteful expenditure
• Can improve motivation
Budgeting
– Advantages of ZBB
– Disadvantages of ZBB
• Requires a great deal of management time
• Depends on large amounts of paperwork
Budgeting
– Zero based budgeting
– Activity based budgeting
Budgeting
• Activity based budgeting
– Traditional approach
• Assumes resources consumed evenly
• Makes managers responsible for activities beyond their
control
Budgeting
• Activity based budgeting
– Traditional approach
– Activity based approach
• Identifies specific cost drivers
• Assigns responsibility for costs on this basis
• Allows activity related increases in budgeted
• Allows more efficient allocation of resources
Criticisms of Budgeting
Is Budgeting the Corporate Curse?

In a recent survey by the CBI senior
executives reported that up to 30% of
their time was spent in preparing for and
carrying out the budget process
Lord Browne : ex-CEO of BP
“The process of management is not about administering fixed

budgets, it is about the dynamic allocation of resources’
Peter Drucker
“Uncertainty…has become so great as to render futile, if not

counterproductive, the kind of planning most companies still
practice; forecasting based on probabilities’
Jack Welch : ex-CEO of General Electric
“Budgeting is the bane of corporate America”

– Time consuming and expensive
– Encourages short term thinking
– Discourages risk taking
– Focus on sales rather than customer
satisfaction
– Budgets divorced from long term strategy
Budgeting
• To Summarise
– The budget is part of the strategic planning process
– Organisation gains from the budget process itself
– Used correctly they can be a good management tool
– The most successful budgetary control systems
• Set realistic and achievable budgets
• Are prepared in consultation with the whole team
• Provide the best basis for motivation
FINANCE

Finance For Non Finance Managers

Uploaded by

Copyright:

Available Formats

Finance For Non Finance Managers

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Finance For Non Finance Managers

Uploaded by

Copyright:

Available Formats

What are the main topics covered in the document?

What are the main topics covered in the document?

What are some criticisms of traditional budgeting approaches?

What are some criticisms of traditional budgeting approaches?

FINANCE

FOR NON-FINANCIAL MANAGERS

Financial crisis Credit crunch

We live in turbulent times

• Key course topics

Skanda Kitchens PLC

• Four basic accounting concepts

• Various accounting policies

• Double entry bookkeeping

Double entry bookkeeping:

• Types of accounting entry

Racking & equipment

Racking & equipment

Racking & equipment £40,000 £40,000

Racking & equipment £40,000 £40,000

Racking & equipment £40,000 £40,000

Racking & equipment £40,000 £40,000

Racking & equipment £40,000 £40,000

Racking & equipment £40,000 £40,000

Racking & equipment £40,000 £40,000

Racking & equipment £40,000 £40,000

Racking & equipment £40,000 £40,000

Racking & equipment £40,000 (£2,000) £38,000

Racking & equipment £38,000

• The accounting equation

Assets minus liabilities = capital

• Racking & equipment at cost £ 40,000

External Internal External

• Racking & equipment at cost £ 40,000

External Internal External

• Racking & equipment at cost £ 40,000

Racking & equipment £38,000

• Racking & equipment at cost £ 40,000

• Balance sheet shows

Fixed assets at cost £120,000

Net current assets £3,000

NET ASSETS £48,000

• Valuable items not usually in the balance

• Accounting policies give a subjective view

• What is the profit and loss account?

• What does the profit and loss account

Racking & equipment £38,000

• Distribution costs £ 14,000

• Profit before tax £ 12,000

• In the good old days before the recession

• Why do profitable businesses fail?

• The golden rule

• Vital difference between profit and

• Vital difference between profit and

• Vital difference between profit and

• Vital difference between profit and

– But why are they different?

JANUARY - MARCH 2007 TRANSACTIONS : EFFECT ON PROFIT AND CASHFLOW

Effect on cash Effect on profit