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Business101

Setting Financial Objectives

Financial management is like navigating a ship through turbulent waters. To reach your destination successfully, you need a clear plan and objectives. Here, we'll uncover the significance of setting financial objectives, the types of financial objectives, and the crucial distinction between cash flow and profit, as well as various types of profit.

 

The Value of Setting Financial Objectives:

Setting financial objectives is akin to charting your course on a map. It provides direction, purpose, and a target to aim for in your financial journey. Let's break down the key financial objectives:

 

Return on Investment (ROI):

​ROI is like measuring the profit you make on an investment. Imagine you invested £1,000 in a business venture, and after a year, your investment has grown to £1,200. Your ROI would be (£1,200 - £1,000) / £1,000 = 20%. This indicates that you earned a 20% return on your investment.

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Revenue, Costs, and Profit Objectives:

  • Revenue objectives are like setting goals for your total income. For instance, if you're running a retail store, your revenue objective might be to achieve £500,000 in sales for the year.

  • Costs objectives involve controlling and managing expenses. For example, you might aim to reduce operational costs by 10% to improve profitability.

  • Profit objectives are the financial goals for your net income. If your revenue is £500,000, and your total costs are £400,000, your profit objective could be to achieve a profit of £100,000.
     

Cash Flow Objectives:

  • Cash flow objectives are about managing the money flowing in and out of your business. They ensure you have enough cash to cover expenses when they arise. For instance, you might set a cash flow objective of maintaining a minimum cash balance of £20,000 to handle unexpected expenses.
     

The Distinction Between Cash Flow and Profit:

  • Cash flow and profit are like two different lenses through which you view your financial health.

  • Cash Flow: Imagine your friend owes you £100, but they haven't paid you yet. In your cash flow statement, this £100 isn't considered income until it's in your pocket. Cash flow focuses on when money physically comes in and goes out of your business.

  • Profit: Profit, on the other hand, is about measuring your financial performance over a specific period, usually a year. It considers all revenues and expenses, including non-cash items like depreciation. Profit provides a comprehensive view of your financial success.
     

The Distinction Between Gross Profit, Operating Profit, and Profit for the Year:

These are like different layers of a financial cake, each revealing a different aspect of your business's performance.

  • Gross Profit: This is the first slice of the cake. It's the profit left after deducting the cost of goods sold (COGS) from your total revenue. If your bakery earned £10,000 from selling cakes and the ingredients and labour cost £4,000, your gross profit would be £6,000.

  • Operating Profit: Moving a layer deeper, operating profit considers all operating expenses, such as rent, salaries, and utilities. If your operating expenses were £2,000, your operating profit would be £4,000.

  • Profit for the Year (Net Profit): This is the whole cake. It includes all revenues and expenses, both operating and non-operating. It's what's left after accounting for taxes and interest payments. If your net profit is £3,000, this is the final slice, indicating your overall financial performance.

Analysing Financial Performance

Constructing and Analysing Budgets and Cash Flow Forecasts:

​Budgeting Benefits: Imagine you're the owner of a small seaside ice cream shop. Budgets act as your financial lighthouse, guiding you through stormy waters. They are your blueprint for success. Budgets allow you to plan for the future, allocating resources wisely. For instance, you can use a budget to predict how many ice creams you need to sell during the summer season to cover your costs and generate a profit.

 

Variance Analysis: Now, let's talk about variance analysis. This involves comparing your actual financial results with what you budgeted. If your budget projected lower expenses than you actually incurred, it's like realizing you spent more on ice cream ingredients than you planned. On the flip side, if your ice cream sales exceed your budgeted numbers, that's cause for celebration. Variance analysis helps you identify where things are going according to plan and where they need adjustment.

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The Value of Budgeting:

​Financial Health: Budgeting is your financial health check-up. It ensures you're financially fit and prepared for any financial curveballs that may come your way. Just like planning a family holiday, a budget helps you stay within your financial limits, making sure you have enough money for accommodation, fun activities, and, of course, ice cream on the trip!

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Constructing and Interpreting Break-Even Charts:

​Break-Even Point: Picture your ice cream shop again. The break-even point is like finding out how many ice creams you need to sell to cover all your costs but not make any profit yet. It's a critical milestone because once you surpass this point, every ice cream sale adds to your profit. Break-even analysis helps you set pricing strategies and sales targets.

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The break-even point is the level of sales at which a business covers all its costs and neither makes a profit nor incurs a loss. To calculate the break-even point, you can use the following formula:

Break-Even Point (in units) = Fixed Costs / (Selling Price per Unit - Variable Cost per Unit)

Let's say you own an ice cream shop. Here's how you can apply the break-even formula:
 

Example:

Fixed Costs:

  • Rent and utilities: £1,000 per month

  • Employee salaries: £2,000 per month

  • Equipment lease: £500 per month

  • Total Fixed Costs: £3,500 per month

Variable Costs per Unit:

  • Cost of ice cream ingredients: £1 per ice cream cone

  • Cost of cones and napkins: £0.25 per ice cream cone

  • Total Variable Cost per Unit: £1.25 per ice cream cone

Selling Price per Unit:

  • The price you charge for each ice cream cone: £3
     

Now, plug these values into the formula:

Break-Even Point (in units) = £3,500 / (£3 - £1.25)

Break-Even Point (in units) = £3,500 / £1.75

Break-Even Point (in units) ≈ 2,000 ice cream cones


In this example, your ice cream shop needs to sell approximately 2,000 ice cream cones each month to cover all your costs and break even. Any sales beyond 2,000 cones would contribute to your profit.

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Margin of Safety: Think of the margin of safety as your financial cushion. It tells you how many ice creams you can afford not to sell before losing money. Just like having extra ice cream cones in case of unexpected sunny days, the margin of safety helps you prepare for unpredictable changes in sales or costs.

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Analysing Profitability:

​Peeling the Onion: Profitability analysis is like exploring the layers of your ice cream sundae. It involves examining different profit margins within your business. For instance, gross profit shows how much money you're making after deducting the cost of ingredients like ice cream and toppings. Profitability analysis helps you identify which parts of your menu are the most lucrative.

 

Product Line Insights: If your ice cream shop sells sundaes, cones, and milkshakes, profitability analysis might reveal that sundaes have the highest profit margins. This insight can help you tailor your menu or marketing efforts to focus on the most profitable items.

 

Analysing Timings of Cash Flows:

Cash Flow is Vital: Cash is to your business what ice cream is to your shop—a lifeline. Understanding when money flows in and out is like knowing when your customers will visit your shop. It ensures you have enough cash on hand to pay bills and buy ingredients when needed.

 

Payables and Receivables: Consider payables as the money you owe to your ice cream suppliers, like when you order fresh cream and toppings. Receivables are the payments your customers owe you when they purchase ice creams on credit. Managing the timing of these cash flows is crucial to prevent any financial crunches, just as you wouldn't want to run out of your best-selling ice cream on a hot summer day.

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The Use of Data for Financial Decision Making and Planning:

​Data-Driven Insights: In today's digital era, data is your secret ingredient for success. It's like having a magic scoop that uncovers valuable insights. Data can reveal customer preferences, market trends, and operational efficiencies. For example, data analysis might show that your customers prefer strawberry ice cream over chocolate on warm summer evenings. Armed with this insight, you can adjust your offerings accordingly and boost sales.

Internal and External Sources of Finance

Imagine you're running a small bakery, and you want to expand your business by opening a second location. To do this, you need to find the dough (pun intended) to finance your growth. Here are some sources of finance you can tap into:

Internal Sources:

​Retained Profits: Think of retained profits as the money you've saved from previous successful sales of your delicious pastries. It's like having a savings account for your bakery. The advantage? You don't owe anyone, and you have full control over your finances. The disadvantage? It might take a while to accumulate enough dough (pun intended) for significant expansion.

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External Sources:

​Loans: Loans are like borrowing flour from a friend to bake more cakes. You get a lump sum of money upfront, and you repay it with interest over time. The advantage? Quick access to funds. The disadvantage? You'll have to repay with interest, which can increase the cost of your expansion.

 

Share Capital: Imagine your bakery is so famous that people want to buy a piece of the pie (again, pun intended). You can sell shares in your bakery to investors. They become partial owners and provide funds in exchange for a share of your profits. The advantage? You get an injection of capital without taking on debt. The disadvantage? You'll have to share your profits and decision-making with shareholders.

 

Overdrafts: Overdrafts are like using a credit card when you run out of cash. Your bank allows you to withdraw more money than you have in your account, up to a set limit. The advantage? It's flexible and convenient for managing short-term cash flow gaps. The disadvantage? High-interest rates can make it an expensive option.

 

Venture Capital: Venture capitalists are like fairy godmothers for businesses with potential. They provide significant funding in exchange for equity (a share of ownership). The advantage? They bring not just money but also expertise and connections. The disadvantage? You might have to give up a substantial portion of your business.

 

Crowdfunding: Crowdfunding is like hosting a bake sale where people from all over contribute money to your bakery. It's usually done online through platforms like Kickstarter. The advantage? You can raise money from a large number of people who believe in your business. The disadvantage? It requires a compelling pitch and marketing effort to attract backers.
 

Advantages and Disadvantages:

Now, let's talk about the pros and cons of these financing sources, considering both short-term and long-term needs:

  • Debt Factoring: This involves selling your accounts receivable to a third party at a discount in exchange for immediate cash. It's like getting paid early but at a lower amount. The advantage is improved cash flow, but the disadvantage is the cost.

  • Retained Profits: Advantages include no interest or ownership dilution. The disadvantage is it may not provide enough funds for significant expansion.

  • Loans: Quick access to funds and flexibility in repayment are advantages, but interest payments can be a drawback.

  • Share Capital: The advantage is access to substantial funds, but you'll share profits and decision-making with shareholders.

  • Overdrafts: Great for short-term needs, but high-interest rates can eat into your profits.

  • Venture Capital: Offers significant capital and expertise but means giving up a portion of your business and control.

  • Crowdfunding: Access to a diverse group of backers, but success depends on your marketing skills and the appeal of your project.

Improving Cash Flow & Profit

Imagine you run a small online clothing store, and sometimes you find your cash flow resembling a rollercoaster ride. Here's how you can smooth out those financial ups and downs:

 

Faster Invoicing: Send out your invoices pronto when you make a sale. The quicker you bill, the faster you'll get paid.

 

Offer Discounts: Consider giving customers a small discount for early payment. It's like a little reward for helping your cash flow.

 

Manage Expenses: Keep a close eye on your outgoings. Can you cut any unnecessary costs or negotiate better deals with suppliers?

 

Inventory Management: Don't overstock your virtual shelves. Having too much unsold inventory ties up your cash. Find the right balance.

 

Flexible Payment Terms: Negotiate with suppliers for extended payment terms. This can buy you some breathing space.

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Improving Profits and Profitability:

Now, let's talk about boosting those profits because every successful business wants a bigger slice of the pie (or in your case, fashion sales).
 

Pricing Strategy: Review your pricing. Can you increase your prices without scaring off customers? Sometimes, a small price hike can significantly boost profits.

 

Cost Control: Scrutinize your costs regularly. Are there areas where you can trim expenses without compromising quality?

 

Product Mix: Focus on the products that bring in the most profit. Sometimes, it's better to let go of underperforming items.

 

Marketing and Sales: Invest in marketing strategies that bring a good return on investment. Analyze what works and what doesn't.

 

Customer Retention: Repeat business is often more profitable than acquiring new customers. Keep your existing customers happy.

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Difficulties Improving Cash Flow and Profit:

Now, let's address the challenges. Even though these strategies can be highly effective, they're not without their hurdles:

Market Conditions: Sometimes, economic conditions or shifts in consumer behavior can affect your cash flow and profits, and these factors are beyond your control.

 

Competition: Fierce competition can make it challenging to increase prices or maintain profit margins.

 

Rapid Growth: Oddly enough, rapid growth can strain your cash flow because you need to invest in more inventory, staff, and marketing to sustain it.

 

Economic Downturns: Economic recessions or unexpected crises can hit your cash flow hard, as consumers cut back on spending.

 

Market Saturation: If you're in a saturated market, it can be tough to stand out and maintain profitability.

Financial Statements (Income statement, Balance sheets & Cash flow statements
 

Income Statement (Profit and Loss Statement):

Purpose: The Income Statement, often referred to as the Profit and Loss Statement (P&L), serves the purpose of providing a concise summary of a business's financial performance over a specific period, usually a fiscal year or a quarter. It answers the fundamental question: "Did the company make a profit or incur a loss during this period?"

 

Components:

  • Revenue (Sales): This represents the total income generated by the business from selling its goods or services. Revenue is at the top of the income statement.
     

  • Cost of Goods Sold (COGS): COGS includes all the direct costs directly associated with producing the goods or services that were sold during the specified period. It encompasses expenses such as raw materials, labor, and manufacturing costs.
     

  • Gross Profit: This figure is derived by subtracting the COGS from the total revenue. Gross profit shows the profit generated from the core operations of the business before considering other expenses.
     

  • Operating Expenses: Operating expenses include various costs incurred in running the day-to-day operations of the business, such as salaries, rent, utilities, marketing expenses, and administrative costs.
     

  • Operating Profit (Operating Income): Also known as Earnings Before Interest and Taxes (EBIT), it is calculated by subtracting operating expenses from the gross profit. Operating profit reflects the profitability of the business's primary activities.
     

  • Interest and Taxes: This section accounts for any interest payments on loans and income taxes incurred during the reporting period.
     

  • Net Profit (Net Income or Profit After Tax): The final figure on the income statement, net profit, is obtained by subtracting interest and taxes from the operating profit. It represents the actual profit or loss after all expenses.

 

Importance: The Income Statement is a vital tool for assessing a company's profitability and financial performance. It helps investors, creditors, and management analyze the business's ability to generate profit from its operations.

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Balance Sheet (Statement of Financial Position):

Purpose: The Balance Sheet provides a snapshot of a company's financial position at a specific date, typically the end of a fiscal year. It offers a comprehensive view of what the business owns (assets), what it owes (liabilities), and the owners' equity.
 

Components:

  • Assets: Assets are resources owned by the business. The Balance Sheet lists them in two categories: current assets (those expected to be converted into cash within one year) and non-current assets (assets held for the long term). Examples include cash, inventory, buildings, and machinery.
     

  • Liabilities: Liabilities represent the financial obligations and debts owed by the business. Like assets, they are classified into current liabilities (short-term obligations) and non-current liabilities (long-term obligations). Examples include accounts payable, long-term loans, and bonds.
     

  • Owners' Equity (Shareholder's Equity): This section represents the residual interest in the assets of the business after deducting liabilities. It reflects the owners' claim on the company's assets. Owners' equity consists of common shares, retained earnings, and additional paid-in capital.

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Importance: The Balance Sheet provides essential insights into a company's financial health and stability. It helps stakeholders evaluate the company's liquidity, solvency, and overall financial strength. It's a valuable tool for understanding the firm's ability to meet its obligations and invest in growth.

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Cash Flow Statement:

Purpose: The Cash Flow Statement tracks the movement of cash in and out of a business over a specific period. It ensures that a company's operations generate enough cash to meet its financial obligations.


Components:

  • Operating Activities: This section details the cash flows generated or used by the company's core operations. It includes revenue, expenses, and working capital changes, such as accounts receivable and accounts payable.
     

  • Investing Activities: Investing activities represent cash flows related to the acquisition or sale of long-term assets. Examples include purchasing or selling equipment, property, or investments.
     

  • Financing Activities: Financing activities encompass cash flow from borrowing or repaying loans, issuing or repurchasing shares, and paying dividends to shareholders.
     

  • Net Cash Flow: The Cash Flow Statement calculates the net change in cash by summing up the cash flows from operating, investing, and financing activities. It reflects the overall increase or decrease in cash for the period.
     

Importance: The Cash Flow Statement is critical for assessing a company's liquidity and its ability to generate cash to support its operations and growth. It helps stakeholders understand how a business finances its activities and whether it can meet its financial obligations.

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These three financial statements collectively provide a comprehensive view of a company's financial performance, position, and cash flow. They are essential tools for decision-making, financial analysis, and evaluation by both internal management and external stakeholders.

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