The PPT About The Financial Decision Making----4

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MN7029 – Financial Decision Making

Welcome to Week 1.3!

Lecture recordings

This session is being recorded

You can access the weekly recording from Weblearn

This Photo by Unknown Author is licensed under CC BY-SA

What are the three main financial statements?

Ask the class to see if they remember

Financial Statements

Statement of Financial Position

A summary at a fixed point in time;

Assets, liabilities and equity.

Statement of Profit or Loss

Data for a period of time (accounting period);

Shows income and expenditure for that period.

Cash Flow

Data for a period of time (accounting period);

Shows cash in and outflows for that period.

Not profit

Learning Outcomes

Consider how management make business decisions

Look at the role of financial statements in decision making

Prepare projected financial statements

Consider how they can be adapted for uncertainty

Start to investigate how gearing impacts risks and return.

Natalie’s Restaurant

I set up a restaurant club.

On Thursday I spend £60 on ingredients.

I also spend £20 on new tablecloths which I can use for the foreseeable future.

On Friday I cook a meal with ¾ of the ingredients and charge 10 people £15 each for dinner.

An example of putting together a simple set of financial statements

What are my cash flows?

My initial funding	£80
Money from the customers (£15x10)	£150
Cash inflow		£230
Money spent on ingredients	£60
Money spent on tablecloths	£20
Cash outflow		£(80)
Net Cash		£150

Cash balance at start		£0
Net cash inflow		£150
Cash balance at end		£150

What is my profit?

Sales revenue (£15 x 10)	£150
Cost of goods sold (3/4 of ingredients)	£(45)
Profit		£105

What is my financial position?

Tablecloths	£20
Cash	£150
Stock (unused food)	£15
Assets		£185
Equity (initial funding of £80 + profit £105)		£185

The Finance Function Contd.

To carry out the aforementioned functions requires managers to undertake a number of tasks namely:

This session we are focussed on the first of the main finance functions - planning

Financial Planning

Investment Project Appraisal

Financing Decisions

Capital Market Operations

Financial Control

Why does a business need to plan?

Ask the class – why does a business need to plan? Some ideas

So that it knows where it should be going

To decide what prices to charge so it can make a profit

So it doesn’t run out of money

To make sure all the different bits of the business are aligned

The Decision Making Process

5. Develop short term plans

4. Select option and consider long term plans

6. Implement the decisions

7. Review and monitor outcomes of decision

8. Act on differences from plan

2. Determine options available

1. Set aims and objective

3. Gather data and information on options

Examples of how a businesses mission (or overarching aim and objective) needs to be taken account of when financial planning

For example, compare easyjet strategy (low cost affordable) with Virgin (most loved travel company) in the context of a management team deciding whether to invest in more luxurious seats on the plane, or whether to charge travellers for inflight meals. They are both airlines, but their different strategy means that they would have different answers to these questions.

Can also link in theories or competitive advantage – Virgin would not be competing with easyjet on price

Walt Disney company strategy is around creative minds and innovative technologies, so it’s financial decisions on how much to pay staff, who to recruit and spending money on R&D will also be influenced by this

Today…

In the discussion today we are focussed on these two steps

4. Develop short term plans

3. Select option and consider long term plans

Projected financial statements

Projected income statement

Projected statement of financial position (balance sheet)

Projected cash flow statement

The projected financial statements normally comprise:

Projected financial statements look into the future and help a business to plan

Preparing projected financial statements

External variables:

Rate of taxation

Interest rates for borrowings

Rate of inflation

Look at external info to identify rates;

Consider inflation rates for different items.

To prepare projections we need to start by looking at different variables, external and internal (next slide)

Preparing projected financial statements (Continued)

Capital expenditure commitments

Financing agreements

Inventories holding policies

Payment policies for trade payables

Credit period allowed to customers

Dividend policy

Accounting policies

Internal variables:

Steps in preparing projected financial statements

Step 1

Step 2

Step 3

Step 4

Identify the key variables affecting performance

Prepare sales forecasts

Prepare forecasts for remaining elements of financial statements

Prepare projected financial statements

Specific steps to prepare projections – after variables we start with sales and then go on from there

Why do we look at sales first?

Question for class

Answer – because sales drives most of the other elements of the statements – in determines how much we need to spend on stock, staff, how much tax we eill pay etc

Preparing sales forecasts

Two main approaches:

Qualitative

Quantitative

Sales forecasts approaches

A qualitative approach uses subjective judgement to estimate forecasts, using for example:

Information and predictions from the sales teams

Managers opinions

Consumer surveys

A quantitative approach uses a numerical analysis based on past performance, for example:

Trend analysis

Regression analysis

Econometric models

Preparing projected financial statements

Short-term

Usually involves detailed forecasts of income, cash flows and financial position

Long-term

Usually involves making simplifying assumptions

Projected financial statements may cover a short-term or long-term horizon:

Projected Cash Flow Statement

What would we use a projected cash flow for?

Monitor changes in liquidity;

Help management to manage the impact of events on cash;

Indicate when business may need to raise more funds;

Indicate when funds will be available for projects;

Make sure it doesn't run out of cash!

Figure 2.2 Sources of cash inflows and outflows

Remember this statements is about cash not profit – these are some of the main sources of cash in and out flows

	Jan £000	Feb £000	Mar £000	Apr £000	May £000	June £000
Cash inflows
Issue of shares
Credit sales	____	____	____	____	____	____
	____	____	____	____	____	____
Cash outflows
Credit purchases
Other costs
Rent and rates	____	____	____	____	____	____
	____	____	____	____	____	____
Net cash flow
Opening balance	____	____	____	____	____	____
Closing balance	____	____	____	____	____	____

Projected cash flow statement for the six months to 30 June

Example proforma of a cash flow statement – note that this is on a monthly basis. Some businesses might even do this on a weekly or daily basis as cash management is so important. Cannot just do it on an annual basis

Cash flow items

Example of how cash might not necessarily occur in the same month as the sale or the purchase

January

Buy raw materials on 30 days credit

February

Pay supplier for raw materials

CASH OUTLOW

March

Sell product on 30 days credit

April

Recive cash for product

CASH INFLOW

	£000	£000
Credit sales revenue
Less Cost of sales
Opening inventories
Add Purchases	____
Less Closing inventories	____	____
Gross profit
Less
Credit card discounts
Rent and rates
Other costs
Depreciation of fittings		____
Profit for the period		____

Projected income statement for the six months to 30 June

Example of projected income statement

	£000
ASSETS
Non-current assets
Fittings
Less Accumulated depreciation	_____
	_____
Current assets
Inventories
Trade receivables	_____
	_____
Total assets	_____
EQUITY AND LIABILITIES
Equity
Share capital
Retained earnings	_____
	_____
Current liabilities
Trade payables
Bank overdraft	_____
	_____
Total equity and liabilities	_____

Projected statement of financial position as at 30 June

Figure 2.4 Variance between actual performance and forecast performance

Source: KPMG (2016) Forecasting with confidence, KPMG, p. 41 Reprinted with permission from Parker Scott.

Just to illustrate that very few companies get projections spot on – all kinds of things could happen that means there is a divergence from projections.

Forecast financial statements and decision making

What underlying assumptions have been made and are they valid?

Have all relevant items been included?

How were the projections developed?

As a manager if we are presented with a set of projections, what questions should we ask our team to determine the reliability of the statements and what questions do we ask to see what kind of decisions would flow from these?

Forecast financial statements and decision making (Continued)

Is there a need for additional financing? Is it feasible to obtain the amount required?

Can any surplus funds be profitably reinvested?

Are the cash flows satisfactory? Can they be improved by changing policies or plans?

Is the level of projected profit satisfactory in relation to the risks involved? If not, what could be done to improve matters?

Forecast financial statements and decision making (Continued)

Are the sales and individual expense items at a satisfactory level?

Is the financial position at the end of the period acceptable?

Is the level of borrowing acceptable? Is the business too dependent on borrowing?

Projected financial statements and risk

Scenario analysis

Sensitivity analysis

Risk assessment may be undertaken using

As financial projections are forward looking we might want to test out how much it would affect the business if they are wrong – this can be done with these methods

Sensitivity Analysis

Take a single variable and examine the effect of changes in that variable on overall performance

Shows how sensitive changes are for the projected outcome.

What happens if sales are 5% lower/higher?

What if sales price could be increased by 20%?

BUT – does not assign probability or consider changes to more than one variable at a time.

Scenario Analysis

Prepare projected statements according to different states of the world:

Optimistic view

Pessimistic view

"Most likely" view

Can change more than one variable

Does not identify likelihood of each occurring.

Practice Question

If we have time this is an example that can be done in class or students can practice and home and the answer will be posted on weblearn

What’s Next…

Today

7.30pm 8.30pm – Business Simulation Round 1

8.30pm – Finish!

For next week:

Review Weblearn for additional reading and exercises

Read Atrill Ch 3

Consider: One advantage of using financial ratios is that the eliminate problems in comparing businesses of different sizes. Why might this be helpful to an investor?

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