[FINANCIAL STRATEGIES AND ACCOUNTS] BUSS3 - AQA
[FINANCIAL STRATEGIES AND ACCOUNTS] BUSS3 - AQA
Understanding Financial Objectives
Financial Aims: the broad, general goals of the finance and accounting function or
department within an organisation.
Financial Objectives: the specific, focused targets of the finance and accounting
department within an organisation.
Financial Strategies: long-term or medium term plans, devised at senior
management level, and designed to achieve the firm’s financial objectives.
Financial Tactics: short-term financial measures adopted to meet the needs of a
short-term threat or opportunity.
Financial Objectives
The examples set out below illustrate the types of financial objective that a business
might pursue;
Cash Flow
Many businesses get into financial difficulties because of lack of cash flow rather
than lack of overall profitability. Consequently, it is vital that businesses set
themselves cash-flow targets to ensure they are able to keep operating. E.g.
 Maintaining a minimum closing monthly cash balance, for example a minimum
cash balance of £10,000 would be a sensible target for a small newsagents
 Reducing the bank overdraft by a certain sum by the end of the year
 For new start-up companies, it is likely an overdraft will be needed to
support everyday expenses
 Interest means it is not advisable to sustain an overdraft, therefore
businesses may set objectives with this in mind
 Creating a more even spread of sales revenue
 Spreading costs more evenly
 Achieving a certain level of liquid, non-cash items
 Raising certain levels of cash at a particular point in time
 Setting contingency funds
Cost Minimisation
A business that reduces its costs can benefit in two ways; keeping prices the same
therefore having a higher profit margin, or reducing the selling price to attract more
customers. E.g.
 Achieving a certain cost reduction in the purchase of raw materials
 Reducing wage costs per unit
 Lowering levels of wastage
 Relocating the business to the least cost site
 Reducing the cost per thousand customers of the business’ promotion and
advertising
 Improving the efficiency of production by reducing variable costs per unit
[FINANCIAL STRATEGIES AND ACCOUNTS] BUSS3 - AQA
ROCE Targets
The success of a business is invariably demonstrated by its profit levels. Clearly, large
firms will achieve higher profit levels than smaller businesses, so the profit needs to
be compared to the size of a business. E.g.
 Achieve an ROCE that exceeds the level recorded for the previous year by a
certain percentage
 Achieve an ROCE that compares favourably to the average ROCE achieved in the
UK
 Achieve an ROCE that exceeds the level of a particular competition
Shareholders’ Returns
A business must satisfy the needs of its shareholders/owners. Many shareholders
assess a business in terms of dividends received because a high dividend is likely to be
linked to high profit levels and sound financial performance. E.g.
 High dividend per share which will indicate a well performing business and will
benefit shareholders with increased dividends
 High dividend yield - shows the dividend paid as an percentage of the market
value of the share. This can be compared to interest rates in banks or alternative
investments
 Increasing the share price as this tends to reflect the value of the business,
therefore if a business retains its profits and grows successfully, the share price
should increase
 High earnings per share. Show profit made by each individual share in a
business, and is a good indicator of efficiency
[FINANCIAL STRATEGIES AND ACCOUNTS] BUSS3 - AQA
Internal Influences on Financial Objectives
Internal factors that affect financial objectives are those within a business, such as
its workforce, resources and financial position.
Corporate Objectives:
The overall aims of an organisation are a key influence on the objectives of a
functional area, such as the finance department. The finance department must
ensure that its objectives are consistent with the corporate objectives of the
business.
Human Resources (HR):
Achieving financial objectives depends on the efforts and skills of the workforce.
Effective planning of the workforce and a good recruitment and training policy can
enable a business to increase its profitability, by increasing the efficiency of the
workforce. However, there can be a conflict between the needs of the workforce
and the business’ financial objectives.
Finance:
A business in a healthy financial situation is in a much better position to achieve
high levels of profits and cash-flow. It can fund investment into items such as
research and development, new technology and marketing campaigns that may
help improve its overall financial performance. Consequently a such a business can
set more challenging objectives.
Operational Factors:
The finance department relies on each of the functional areas in order to reach its
objectives. If the operations management function of a business is operating
efficiently, the firm will be able to produce goods of high quality and low cost. This
will lead to good sales revenue and high profit margins, and enable the business to
achieve quite challenging financial objectives.
Resources Available:
A business, which over time has built up a strong resource base, will be able to
target and achieve a strong financial performance. These resources might be in the
form of premises, well-known brand names, or the quality of the workforce.
The Nature of the Product:
The success of a business is heavily influenced by its product and services it offers.
In many cases, successful businesses have happened to be in the right place at the
right time.
[FINANCIAL STRATEGIES AND ACCOUNTS] BUSS3 - AQA
External Influences on Financial Objectives
External factors are those outside the business, such as the state of the economy
and the actions of competitors. PESTLE describes external factors that can affect a
business.
Political Factors:
Financial objectives are often guided towards the wishes of the shareholders.
However, the great openness has also led to expectations on businesses to serve the
needs of other groups, such as the workforce, customers, the local community and
the environment.
Economic Factors:
The state of the economy is a major influence on the financial performance of
businesses. For example, if an economy is in recession, customers will purchase
fewer products and so lower sales and profit targets will be set. For businesses
dealing with luxury products, it is likely that these targets will be significantly lower.
For some businesses, such as those selling staple foods, there will only be a limited.
Social Factors:
Society is constantly changing and businesses must adjust to suit society. People now
expect access to businesses 24/7 if possible. This change in expectations can make it
difficult for businesses to set targets that involve lower costs, but at the same time it
opens up opportunities for targeting greater revenue and creating new ways of
generating income.
Technological Factors:
Technological change can lead to improvements in communication. A particular
benefit is that financial targets can be monitored more regularly and more closely,
and objectives or strategies modified in the light of changing circumstances.
Legal Factors:
In some industries, legal requirements have a big impact on the objectives of a
business, and changes in these requirements will lead to modified financial
objectives.
Environmental Factors:
Growing environmental awareness among consumers and actions by pressure
groups have had financial implications for businesses. Acquiring supplies and raw
materials from environmentally friendly sources is now an aim for many businesses
as they try to minimise their carbon footprint.
Other external factors that can influence financial objectives include market factors
(as products go through the product life cycle, objectives will have to be modified),
competitor’s actions and performance (competing may lead to lower profit margins
or limited competition may increase them), and suppliers (as they can have a major
impact on costs).
[FINANCIAL STRATEGIES AND ACCOUNTS] BUSS3 - AQA
Using Financial Data to Measure and
Assess Performance
Two key financial documents kept by a firm are:

Balance Sheet
 A document describing the financial position of a company at a
particular point in time, by comparing items owned by the company
(assets) with the amounts it owes (liabilities)

Income Statement
 An account showing the income and expenditure (and thus profit or
loss) of a firm over a period of time (usually a year)
Revenue/Capital Expenditure
Business expenditure can be classed as either revenue expenditure or capital
expenditure.
 Capital expenditure is when cash is spent on an item that will be used over
and over again that will help the business in future years – a non-current
(fixed) asset
 Revenue expenditure covers spending on day to day items such as wages,
office consumables, operating expenses, rental payments and marketing
expenditure.
The significance of the distinction between capital and revenue expenditure lies in
accountancy practice. A basic rule of accounting is matching or accruals concept.
When calculating a firm’s profit any income should be matched to the expenditure
involved in creating that income. Revenue expenditure offers little problems,
however capital expenditure needs to be allocated over several years (the lifetime of
the asset). For example, if a machine cost £50,00 and would be used for 5 years, the
expenditure would be £10,000 per year for 5 years rather than a lump sum.
Prudence is another accounting convention. Accounts should ensure that the worth
of the business in not exaggerated, therefore firms are slightly pessimistic in
estimating the value of its assets
Depreciation is a fall in value of an asset over time, reflecting the wear and tear of
the asset as it becomes older. The three causes of depreciation are time, use and
obsolescence.
[FINANCIAL STRATEGIES AND ACCOUNTS] BUSS3 - AQA
Balance Sheets
The balance sheet looks at the accumulated wealth of the business and can be used
to assess its overall worth. It lists the resources that a business owns and the items it
owes.
In addition, it shows the capital provided by the owners. Capital is provided through
either the purchase of shares or the agreement to allow the company to retain or
‘plough-back’ profit into the business, known as reserves, rather than using it to pay
further dividends to the shareholders.
 Assets: Items that are owned by an organisation. Assets are generally grouped into
two categories: non-current and current.
o In general, non-current assets are purchased to allow the business to operate
continuously. Land and buildings, machinery and vehicles are acquired so that
firm has the equipment from which to operate. These are examples of tangible
assets. Intangible assets include goodwill (brand names and patents).
o Current assets are short term items that circulate in a business on a daily basis
and can be expected to turn into cash within a year. Examples of current assets
are inventories (stocks), debtors, the bank balance and cash. Inventories are
valued at cost paid, rather than expected sale price.
 Liabilities: Debts owed by an organisation to suppliers, shareholders, investors or
customers who have paid in advance.
o Examples of non-current liabilities include debentures and long-term or
medium-term loans. Debentures are fixed interest loans with a repayment date
set a long-time into the future
o Examples of current liabilities are creditors, bank overdrafts, corporation tax
owing and shareholder’s dividends due for repayment.
 Capital: Funds provided by shareholders to set up the business, fund expansion and
purchase fixed assets. It generally takes two forms:
o Share Capital: Funds provided by shareholders through the purchase of shares.
o Reserves: Those items that arise from increases in the value of the company,
which are not distributed to shareholders as dividends, but are retained by the
business for future use.
It is important to know the purpose of the balance sheet;
 Recognising the value of the business
 Gaining an understanding of the nature of the firm.
 Identifying the company’s liquidity position.
 Showing sources of capital.
 Recognising the significance of changes over time.
[FINANCIAL STRATEGIES AND ACCOUNTS] BUSS3 - AQA
Income Statements
An income statement describes the income and expenditure of a business over a
given period of time.
Purpose of the profit and loss account –
o Regular calculations of profit throughout the year help managers to review
progress before the final end-of-year accounts are completed.
o To satisfy legal requirements to do so.
o Publication allows stakeholders to see if a firm is meeting their needs.
o Comparisons can be made between two different firms.
o Potential investors can see if the firm is able to provide a good return.
o Helps identify whether the profit earned by the business is sustainable
(“profit quality”)
The profit and loss account is divided into three sections, these are; the trading
account, the profit and loss account and the appropriation account:
 The trading account records the turnover of the company and the ‘cost of
sales’. Therefore this account calculates the gross profit. Gross profit
indicates how efficient a business is at converting its raw materials or stock
into a finished product.
 The profit and loss account, on the other hand, looks at the turnover minus
the fixed costs; thus calculating the operating profit. This is the revenue
earned from everyday trading activities minus the costs of carrying out these
activities.
 The appropriation account is a statement which shows what happens to
profit; how it is used or distributed. Typically, it will show how much profit is
retained by the business and how much is given to the shareholders.
The profit and loss account is structured in a specific way for three main reasons.
1. The first reason is that the trading account enables a business to see how
efficiently it is at turning materials into sales revenue.
2. The profit and loss account shows the efficiency of a firm in controlling its
overheads and expenses.
3. The appropriation account is of particular interest to share holders. A
business that is using most of its profits to pay high dividends will please
shareholders looking for a quick return. However, shareholders with a longterm interest in the business may prefer to see high retained profits, as these
will be reinvested into the business to boost profits in the future.
[FINANCIAL STRATEGIES AND ACCOUNTS] BUSS3 - AQA
Working Capital
Liquidity – the ability to convert an asset into cash without loss or delay
The working capital shows the net current assets of a firm. It is the day-to-day
finance used in a business, consisting of current assets minus current liabilities. It is a
measure of liquidity, and firms generally want to have between 1.5 and 2 times as
many assets than liabilities. Less than this, the firm is becoming illiquid, more than
this it is too cautious and should invest more.
𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
Of course the balance sheet is just a snapshot of the working capital position at a
point in time (the balance sheet date). In reality, a business is constantly settling
liabilities, taking money from customers, buying inventories and so on. This is known
as the working capital cycle, as illustrated below:
In the diagram above:

The business uses cash to acquire inventories (stocks)

The stocks are put to work and goods and services produced. These are then
sold to customers

Some customers pay in cash but others buy on credit. Eventually they pay and
these funds are used to settle any liabilities of the business (e.g. pay suppliers)

And so the working cycle repeats
Influences on working capital levels:



Time taken to sell stock
Time taken by customers to pay for goods
Credit period offered by suppliers
[FINANCIAL STRATEGIES AND ACCOUNTS] BUSS3 - AQA
Causes of difficulties:






Failure to control inventory levels
Poor controls of receivables
Poor controls of payables
Cash flow problems
Poor internal planning and coordination
External factors
Solving problems:
 Inventory control - Low inventory levels mean no storages costs, however
you miss out in purchasing economies of scale. Just In time system is effective
 Receivables control – receivables should be kept to a minimum, however the
offer of credit may increase sales though
 If credit is offered, credit control must be strict

Invoices and reminders

Chasing up people

Taking people to court

Credit rating
Profit Quality/Utilization
Profit Quality:
One of the issues to consider when looking at the income statement is to look at
whether the reported profit is high quality or low quality. A high quality profit is one
which can be repeated or sustained. A low quality profit is one which it is difficult to
repeat. The profit is likely to benefit from one or more “exceptional items” which will
not repeat.
Profit Utilisation:
This shows the ways in which a business uses it’s profit of surplus cash, and there
are mainly two ways in which does this. Firstly, it can decide to pay dividends to
shareholders. This means other shareholders may have interest in the firm, boosting
the share price and the level of investment, however it means they may have cash
flow problems in the short term. The other option is to retain the profits and put
them straight back into the business. This will not satisfy shareholders as much, but
depending on the firm’s financial position, may be necessary. It can also be used to
buy back shares, meaning in future it pays fewer dividends.
[FINANCIAL STRATEGIES AND ACCOUNTS] BUSS3 - AQA
Using Financial Accounts to Assess Business Performance
The balance sheet and income statement provide much useful information for a user
of accounts to better understand how the business is doing. Some useful analytical
tasks would include:
Comparing performance over time:
A danger with just looking at one year’s results is that the numbers can hide a longer
term issue in the business. By looking at data over several years, it is possible to see
whether a trend is emerging.
Comparing performance against competitors or the industry as a whole:
A comparison against competitors provides a useful way for management and
shareholders to assess relative performance. Has the business’ revenues grown as
fast as close competitors? How has the business performed compared with the
market as a whole?
Benchmarking against best‐in‐class businesses:
Comparison against other businesses who are not direct competitors can also be
useful – particularly if they help set the standard that the business aims to achieve.
Care has to be taken with this, though. The benchmark business might operate in a
very different industry, with significantly different profit margins and balance sheet
norms.
Strengths and Weaknesses of Financial Data
There are strengths and weaknesses involved in using a firm’s financial data to judge
performance. They are based on the accuracy of the data as a measure of current
performance and potential performance.




Balance Sheet has been designed to help
people judge a company’s performance –
can assess size, net assets, liquidity position
and sources of capital of a firm.
Income Statement can help calculate a
firm’s profit level, assess whether or not to
buy shares, look at profit quality and how
profit is being used.
Stakeholder’s can expect regular and
accurate data
Published accounts are checked by
independent auditors
 Some valuations are partially subjective
 Different accounting methods can be
employed
 Accounts show what has happened rather
than why
 Published accounts focus on
profitability/liquidity and ignore other
objectives that may be important to a
business
 A firm’s financial situation changes daily,
and can be manipulated to provide a
favourable view on the day they were
prepared – window dressing
[FINANCIAL STRATEGIES AND ACCOUNTS] BUSS3 - AQA
Interpreting Published Accounts
Financial information is always prepared to satisfy in some way the needs of various
interested parties (the "users of accounts"). Stakeholders in the business (whether
they are internal or external to the business) seek information to find out three
fundamental questions:
1. How is the business trading?
2. How strong is the financial position?
3. What are the future prospects for the business?
For outsiders, published financial accounts are an important source of information to
enable them to answer the above questions. To some degree or other, all interested
parties will want to ask questions about financial information which is likely to fall
into one or other of the following categories, and be about:
Performance Area
Profitability






Financial Efficiency



Liquidity and Gearing




Shareholder Return




Key Issues
Is the business making a profit?
How efficient is the business at turning
revenues into profit?
Is it enough to finance reinvestment?
Is it growing?
Is it sustainable (high quality)?
How does it compare with the rest of
the industry?
Is the business making best use of its
resources?
Is it generating adequate returns from
its investments?
Is it managing its working capital
properly?
Is the business able to meet its
short‐term debts as they fall due?
Is the business generating enough
cash?
Does the business need to raise further
finance?
How risky is the finance structure of
the business?
What returns are owners gaining from
their investment in the
business?
How does this compare with similar,
alternative investments in
other businesses?
[FINANCIAL STRATEGIES AND ACCOUNTS] BUSS3 - AQA
Profitability Ratios
Return On Capital Employed (ROCE):
This ratio shows the operating profit as a percentage of the capital employed.
Operating profit is considered to be the best measure of performance, as it focuses
only on the businesses main trading activities. It also can be used to compare
between firms overseas, as it is profit before tax, meaning various tax rates in
different countries are not considered.
𝑅𝑂𝐶𝐸(%) =
𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡 𝑜𝑟 𝑝𝑟𝑜𝑓𝑖𝑡 𝑏𝑒𝑓𝑜𝑟𝑒 𝑡𝑎𝑥
× 100
𝑡𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝑛𝑜𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
With ROCE, the higher the percentage figure, the better. The figure needs to be
compared with the ROCE from previous years to see if there is a trend of ROCE rising
or falling. Generally, ROCE tend to be 10-15%, however anything above interest rates
is usually deemed acceptable.
It is also important to ensure that the operating profit figure used for the top half of
the calculation does not include any exceptional items which might distort the ROCE
percentage and comparisons over time.
To improve its ROCE a business can try to do two things:


Improve the top line (i.e. increase operating profit) without a corresponding
increase in capital employed, or
Maintain operating profit but reduce the value of capital employed
Gearing
Gearing focuses on the capital structure of the business – that means the proportion
of finance that is provided by debt relative to the finance provided by equity (or
shareholders). It measures the proportion of assets invested in a business that are
financed by long‐term borrowing.
In theory, the higher the level of borrowing (gearing), the higher the risks to a
business, since the payment of interest and repayment of debts are not "optional" in
the same way as dividends. However, gearing can be a financially sound part of a
business's capital structure, particularly if the business has strong, predictable cash
flows.
𝐺𝑒𝑎𝑟𝑖𝑛𝑔(%) =
𝑛𝑜𝑛 − 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
× 100
𝑡𝑜𝑡𝑎𝑙 𝑒𝑞𝑢𝑖𝑡𝑦 + 𝑛𝑜𝑛 − 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
 A business with a gearing ratio of more than 50% is traditionally said to be
“highly geared”.
 A business with gearing of less than 25% is traditionally described as having
“low gearing”
 Something between 25% ‐ 50% would be considered normal for a
well‐established business which is happy to finance its activities using debt.
[FINANCIAL STRATEGIES AND ACCOUNTS] BUSS3 - AQA
Liquidity Ratios
Two liquidity ratios – the current ratio and the acid test ratio – are used in order to
assess the ability of a firm to meet its short-term liabilities.
Although profit is the main measure of company success, firms can be vulnerable to
cash-flow problems, so the ability of a firm to meet its immediate payments is a key
test.
Solvency – the ability of a firm to pay its debts on time.
Current Ratio:
This is a simple measure that estimates whether the business can pay debts due
within one year out of the current assets. A ratio of less than one is often a cause for
concern, particularly if it persists for any length of time.
The formula for the current ratio is:
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
A current ratio of around 1.7‐2.0 is pretty encouraging for a business. It suggests that
the business has enough cash to be able to pay its debts, but not too much finance
tied up in current assets which could be reinvested or distributed to shareholders.
A low current ratio (say less than 1.0‐1.5) might suggest that the business is not well
placed to pay its debts. It might be required to raise extra finance or extend the time
it takes to pay creditors.
Acid Test:
Not all assets can be turned into cash quickly or easily. Some ‐ notably raw materials
and other stocks ‐ must first be turned into final product first. This ratio therefore
adjusts the Current Ratio to eliminate certain current assets that are not already in
liquid form. Since inventories are assumed to be the most illiquid part of current
assets, they are removed from the current assets total.
The formula for the acid test ratio is:
𝐴𝑐𝑖𝑑 𝑇𝑒𝑠𝑡 =
𝐶𝑢𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑡𝑜𝑟𝑖𝑒𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
Some care has to be taken interpreting the acid test ratio. Around 1:1 ratio is
standard, however the value of inventories a business needs to hold will vary
considerably from industry to industry (e.g. selling fresh cakes or selling cars).
A good discipline is to find an industry average and then compare the current and
acid test ratios against for the business concerned against that average.
[FINANCIAL STRATEGIES AND ACCOUNTS] BUSS3 - AQA
Financial Efficiency Ratios
Financial Efficiency ratios measure the efficiency with which a business manages
specific assets and liabilities. They allow the business to scrutinise the effectiveness
of certain areas of its operation.
Receivables Days
The debtor days ratio focuses on the time it takes for trade debtors to settle their
bills. The ratio indicates whether debtors are being allowed excessive credit. A high
figure (more than the industry average) may suggest general problems with debt
collection or the financial position of major customers.
The formula to calculate debtor days is:
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝐷𝑎𝑦𝑠 =
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
× 365
𝑅𝑒𝑣𝑒𝑛𝑢𝑒
The average time taken by customers to pay their bills varies from industry to
industry, although it is beneficial for all firms to have a minimum debtor day’s ratio.
It is often compared against the firm’s Payables Days ratio.
Among the factors to consider when interpreting debtor days are:
 The industry average debtor days needs to be taken into account
 A business can determine through its terms and conditions of sale how long
customers are officially allowed to take
 There are several actions a business can take to reduce debtor days, including
offering early‐payment incentives, aged-debtor analysis or by using invoice
factoring
Payables Days
Payables Days is a similar ratio to debtor days and it gives an insight into whether a
business is taking full advantage of trade credit available to it. It estimates the
average time it takes a business to settle its debts with trade suppliers. As an
approximation of the amount spent with trade creditors, the convention is to use
cost of sales in the formula which is as follows:
𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠 𝐷𝑎𝑦𝑠 =
𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠
× 365
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑆𝑎𝑙𝑒𝑠
In general a business that wants to maximise its cash flow should take as long as
possible to pay its bills. However, there are risks associated with taking more time
than is permitted by the terms of trade with the supplier. One is the loss of supplier
goodwill; another is the potential threat of legal action or late‐payment charges. As
an average, 28 days is normally acceptable for receivables/payables days, however
varies significantly between industries.
[FINANCIAL STRATEGIES AND ACCOUNTS] BUSS3 - AQA
Asset Turnover
This ratio considers the relationship between revenues and the total assets
employed in a business. A business invests in assets (machinery, inventories etc) in
order to make sales. A good way to think about the asset turnover ratio is
considering how effectively the business is using its assets to generate revenue.
The formula for asset turnover is:
𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝑅𝑒𝑣𝑒𝑛𝑢𝑒
𝑁𝑒𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
A high figure shows that the business is using its assets efficiently in order to achieve
sales revenue. A low figure shows its assets are not being used efficiently.
Care needs to be taken with the asset turnover ratio. For example:
 The number will vary enormously from industry to industry. A capital‐intensive
business may have a lower asset turnover than a labour intensive one
 The asset turnover figure for a specific business can also vary significantly from
year to year. For example, a business may invest in new production capacity in
one year but the extra revenues might not arise until the following year
 The asset turnover ratio takes no direct account of the profitability of the
revenues generated
Inventory Turnover
Stock turnover helps answer questions such as "have we got too much money tied
up in inventory"? An increasing stock turnover figure or one which is much larger
than the average for an industry may indicate poor inventory management.
The stock turnover formula is:
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠 𝐻𝑒𝑙𝑑
Interpreting the stock turnover ratio needs to be done with some care. For example:
 Some industries necessarily have very high levels of stock turnover.
 Some businesses have to hold large quantities of stock to meet customer needs.
They may have to stock a wide range of product types, brands, sizes etc
 Stock levels can vary during the year, often caused by seasonal demand. Care
needs to be taken in working out what the “average stock held” is
A business can take a range of actions to improve its stock turnover, such as selling
off slow-moving stock, using lean production/just-in-time or rationalise product
ranges. This ratio is irrelevant in some industries such as many in the service sector.
[FINANCIAL STRATEGIES AND ACCOUNTS] BUSS3 - AQA
Shareholder Ratios
A prime concern of shareholders is their return on investment. The returns from
investing in shares of a company come in two main forms:
1. The payment of dividends out of profits
2. The increase in the value of the shares (share price) compared with the price
that the shareholder originally paid for the shares
Dividend per Share
One very straightforward shareholder ratio is dividend per share. This shows the
value of the total dividend per issued share for the financial year.
The formula for dividend per share is:
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 =
𝑡𝑜𝑡𝑎𝑙 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑎𝑖𝑑
𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑖𝑠𝑠𝑢𝑒𝑑
An ordinary shareholder would probably be pleased with a higher dividend per share
as possible, however some with a large interest in the firm may wish for it to retain
profits for future growth and therefore more dividends in the future.
The problem with this ratio is that it lacks context. We don’t know:
a) How much the shareholder paid for the shares – i.e. what the dividend means
in terms of a return on investment
b) How much profit per share was earned which might have been distributed as
a dividend
Dividend Yield
The dividend yield builds on the dividend per share by expressing it as a percentage
of the current market price of the shares. This way, you can see the return and
compare it to other investments, bank interest rates and other firms.
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑌𝑖𝑒𝑙𝑑 (%) =
𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑡 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
× 100
𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
Value and limitation of ratio analysis
The main strength of ratio analysis is that it encourages a systematic approach to
analysing performance. However, it is also important to remember some of the
drawbacks of ratio analysis:
 Ratios deal mainly in numbers – they don’t address issues like product quality,
customer service, employee morale – which may ignore corporate objectives
 Ratios largely look at the past, not the future.
 Ratios are most useful when they are used to compare performance over a long
period of time or against comp - this information is not always available
 Financial information can be subject to ‘window dressing’
 External factors need to be considered when drawing any conclusions from
these ratios
 They show what happened rather than why
[FINANCIAL STRATEGIES AND ACCOUNTS] BUSS3 - AQA
Selecting Financial Strategies
Raising Finance
Cash is vital to any business and once a business is established it often faces the
challenge of raising finance to support expansion. A good way to look at the
finance‐raising options for a business is to categorise them into sources which are
from within the business (internal) and from outside providers (external).
Internal Sources of Finance
The main internal sources of finance for an established business are:
 Retained profits
 Reductions in working capital
 Disposal of assets / sale & leaseback
Retained Profits:
Retained profit is by some way the most important and significant source of finance
for an established profitable business. When a business makes a net profit, the
owners have a choice: either extract it from the business by way of dividend, or
reinvest it by leaving profits in the business. Some of the retained profit might be in
the bank; some might be spent on additional plant & machinery; perhaps some are
reinvested in more inventories or used to reduce overdrafts or loans. The total value
of retained profits in a company can be seen in the “equity” section of the balance
sheet.
 No interest charges, so they are cheap (though not free) – opportunity cost
 They are very flexible – management have complete control over how they
are reinvested and what proportion is kept rather than paid as dividends
 They do not dilute the ownership of the company
 They restrict the value of dividends
 Opportunity Cost
 Can be said to ‘hoard too much cash in the business’
 If retained profits don't result in higher profits, there is the argument that
shareholders could make better returns by having the cash for themselves
Reduction in Working Capital:
Some businesses undoubtedly operate with excess inventories and trade debtors.
More efficient management of these current assets can release cash. However, a
reduction in working capital has to be sustainable for it to become a long‐term
source of finance.
In most cases, a business that is growing will find that it has to finance an increase in
working capital over the longer‐term (i.e. net current assets will have to grow).
[FINANCIAL STRATEGIES AND ACCOUNTS] BUSS3 - AQA
Sale / Sale & Leaseback of Assets:
Selling non‐current assets such as spare land and buildings or redundant plant &
equipment can result in a one‐off cash inflow. However it is unlikely to be a
long‐term solution for a business that needs to raise significant finance.
Asset disposals often occur when management grow the business through
acquisitions. The business they buy may have excess assets which can be sold, or
fixed assets become redundant when the acquired businesses are merged into fewer
locations.
 The sale will give an immediate injection of cash into the company
 Can help when retrenching or when you have excess capacity
 A one-off source of finance
 If leasing back, you may end up paying more than you would have if you had
have kept the asset
External Sources of Finance
There are many ways for a larger business to raise finance from external providers.
The main methods are outlined below.
Selling Shares:
Both private and public companies can raise finance by selling new shares in the
company. Ordinary Share Capital is money given to a company by shareholders in
return for a share certificate that gives them part ownership of the company and
entitles them to a share of the profits.
 Scope for lots of investment – no limit on the amount
 Can add value to the company if share prices increase
 Need to pay more dividends
 Lose control of part of the company
Loan Capital:
The three main methods of raising loan capital are:
 Bank overdrafts
 Bank loans
 Debentures
Bank Overdrafts are when a bank allows an individual or organisation to overspend
its current account in the bank up to an agreed (overdraft) limit for a stated period of
time. Interest is paid per day you are overdrawn.
Bank Loans are sums of money provided by a bank for a specific, agreed purpose.
Interest rates can fluctuate and banks will need proof of ability to repay the loan.
Debentures are a long‐term source of finance. A debenture is a form of bond or
long‐term loan which is issued by the company. The debenture typically carries a
fixed rate of interest over the course of the loan.
[FINANCIAL STRATEGIES AND ACCOUNTS] BUSS3 - AQA
Cost Minimisation
Cost minimisation aims to achieve the most cost‐effective way of delivering goods
and services to the required level of quality. For this reason, it is vital to have
communication with all departments when undertaking cost minimisation to ensure
they are not adversely affected.
Popular sources of cost reductions in a well‐established business include:
 Eliminating waste & avoiding duplication (lean production)
 Simplifying processes and procedures
 Outsourcing non‐core activities (e.g. payroll administration, call handling)
 Negotiating better pricing with suppliers
 Using the most effective methods of training and recruitment
 Introducing flexible working practices to better match production and demand
Actions aimed at minimising costs need to be taken with care. The danger is that
overaggressive pruning of overheads, using cheaper raw materials or cutting pay
rates might have a adverse effect on quality and customer service.
Also, the business can be left with insufficient capacity to handle unexpected or
short‐term increases in demand and cost reductions by one department may
surprise and/or annoy other functions if they are not properly communicated and
coordinated.
Profit Centres
A popular approach to managing financial performance in a multi‐site or
multi‐location business is to use profit centres. A profit centre is a
separately‐identifiable part of a business for which it is possible to identify revenues
and costs (i.e. calculate profit).
Examples of profit centres would include individual shops in a retail chain, local
branches in a regional or nationwide distribution business, a geographical region or a
team or individual (e.g. a sales team)
 Provides insights into exactly
where profit is earned
 Supports budgetary control
 Can improve motivation of those
responsible
 Comparisons can be made
between similar profit centres
 Improves decision‐making at a
local level (likely to be closer to
customer needs)
 Finance can be allocated more
efficiently – where it makes the
best return
 Can be time‐consuming to both




set‐up and monitor
Difficulties in allocating costs
May lead to conflict and
competition
Potentially de‐motivating if
targets are too tough or if cost
allocations are unfair
Profit centres may pursue their
own objectives rather than those
of the broader business
[FINANCIAL STRATEGIES AND ACCOUNTS] BUSS3 - AQA
Making Investment Decisions
If a business wishes to grow, it needs to invest. The cash spent on investment in a
business is normally referred to as capital expenditure. This can be contrasted with
spending on day‐to‐day operations (e.g. paying for materials, staff costs) which is
known as “revenue expenditure”.
The distinction between capital and revenue expenditure is that capital expenditure
is on non‐current assets which have an ‘economic life’ in the business – they are
intended to be kept, rather than sold or turned into products.
There are several reasons why a business needs to invest in capital expenditure:
• To add extra production capacity
• To replace worn‐out, broken or obsolete machinery and equipment
• To support the introduction of new products and production processes
• To implement improved IT systems
• To comply with changing legislation & regulations
Investment Appraisal is a quantitative, scientific approach to investment decision
making, which investigates the expected financial consequences of an investment, in
order to assist the company in its choices.
There are several methods available which help management make the decisions
about which projects to invest in, which are described and illustrated further below:
 Payback
 Net Present Value (NPV)
 Average Rate of Return (ARR)
Payback
The payback period is the time it takes for a project to repay itself from the net
return provided by the investment, and is usually measured in terms of years and
months.
To work out the payback period, the cash flow and cumulative cash flow needs to be
looked at. Using the cash flow column, you can work out which year the cumulative
cash flow goes from a positive value to a negative one. In this year, the project has
paid for itself. In payback calculations, it is assumed that costs and income occur at
regular intervals throughout the year. Therefore in the year that an investment pays
for itself, the net return over the year is split up into the 52 weeks over which it is
earned. You then work out how many weeks it takes to pay off the remained of the
outstanding loss caused by the investment.
 Simple and easy to calculate + easy to
understand the results/ compare projects
 Focuses on cash flows – good for use by
businesses where cash is a scarce
resource
 Emphasises speed of return; may be
appropriate for businesses subject to
significant market change
 Ignores cash flows which arise after the
payback has been reached Doesn’t
consider the time value of money
 May encourage short‐term thinking
 Ignores qualitative aspects of a decision
 Does not actually create a decision for the
investment
[FINANCIAL STRATEGIES AND ACCOUNTS] BUSS3 - AQA
Net Present Value (NPV)
-
the net return on an investment when all revenues and costs have been
converted to their current worth
Offered the choice of £100 now or £100 in one year’s time, most rationale people
would opt to receive the £100 now. This is because you could invest the £100 in a
savings account and get interest on the investment – the opportunity cost of money
(time value of money).
NPV recognises that there is a difference in the value of money over time.
In effect, cash flows received earlier in an investment project are considered to be
worth more than those received in the future. You could use the interest rate which
could be obtained on saving or compare it to profit that could be made off an
alternative investment when deciding what discount factors to use.
When you have discounted the projected cash flow, you can calculate the
cumulative cash flow. After ‘x’ amount of years, if the NPV is positive, the project is
financially worthwhile, whilst if it is negative, it is not. NPV gives a definite
recommendation.
 Takes account of time value of
money, placing emphasis on earlier
cash flows
 Looks at all the cash flows involved
through the life of the project
 Has a decision‐making mechanism –
reject projects with negative NPV
 More complicated method – users
may find it hard to understand
 Difficult to select the most
appropriate discount rate – may lead
to good projects being rejected
 The NPV calculation is very sensitive
to the initial investment cost
Average Rate of Return (ARR)
-
total net returns divided by the expected lifetime of the investment,
expressed as a percentage of the initial cost
Firms want to achieve as high a percentage return as possible. A benchmark that is
often used to see if the ARR is satisfactory is the interest rate that the firm must pay
on any money borrowed to finance the investment. If the percentage return on the
project exceeds the interest rate that the business is paying, the project is financially
worthwhile.
𝑡𝑜𝑡𝑎𝑙 𝑛𝑒𝑡 𝑟𝑒𝑡𝑢𝑟𝑛⁄
𝑛𝑜. 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠
𝐴𝑅𝑅(%) =
× 100
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐶𝑜𝑠𝑡
 ARR provides a percentage return which can
be compared with a target return
 ARR looks at the whole profitability of the
project
 Focuses on profitability – a key issue for
shareholders
 Does not take into account cash flows – only
profits (they may not be the same thing)
 Takes no account of the time value of money
 Treats profits arising late in the project in the
same way as those which might arise early
[FINANCIAL STRATEGIES AND ACCOUNTS] BUSS3 - AQA
Evaluating Investment Appraisal
Given the range of investment appraisal methods and the need for a business to
allocate resources to capital expenditure in an appropriate way, what key factors do
management need to consider when making their investments?
The key issues to consider are:
Risks and uncertainties
All business investments involve some level of risk. An investment needs to earn a
return that compensates for the risk.
The risk of a capital investment will vary according to factors such as:
Risk
Length of the project
Issue
The longer the project, the greater the risk that
estimated revenues, costs and cash flows prove
unrealistic
Source of the data
Is the data used reliable and accurate?
The size of the
investment
The more capital invested, the higher the risk of a
project
The economic and
market environment
Most projects will make assumptions about demand,
costs, pricing etc which can become inaccurate through
changing market and economic conditions
The experience of the
management team
A project in a market in which the management team
has strong experience is a lower‐risk proposition than
one in which the business is taking a step into the
unknown!
Qualitative influences
An investment decision is not just about the numbers. A spreadsheet calculation for
NPV or ARR might suggest a particular decision, but management also need to take
account of qualitative issues such as:
 The impact on employees
 Product quality and customer service
 Consistency of the investment decision with corporate objectives
 The business’ brand and image, including reputation
 Implications for production and operations, or disruption to the existing set‐up
 A business’ responsibilities to society and other external stakeholders
Quantitative influences
The investment appraisal comes up with a result, but how is a decision made?
Many firms set “investment criteria” against which they judge investment projects.
The use of investment criteria is intended to help guide management through these
decisions and address the potential conflicts, however because there is so much risk
involved with the accuracy of forecasts, it is difficult to be very certain with any
quantitative method used.