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A2(1) Making Business DecisionsStudent Notes

GCE Business Studies

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MAKING BUSINESS DECISIONS The theme of this unit is about making business decisions. A wide range of business decisions are taken every day by managers, employees, customers and other stakeholders of a business. The following sections consider issues related to the important decisions likely to be made in a business context. BUSINESS OBJECTIVES Chapter Aims:

· Evaluate the purpose of a Mission Statement; · Evaluate differing Business Objectives; · Evaluate the nature of short-term and long-term objectives; · Evaluate the meaning of goals in business, including Survival, Profit

Maximisation and Growth; · Evaluate the term Market Share within a business context; · Evaluate the nature and consequences of conflict within the context of

business objectives.

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Introduction: This chapter discusses key definitions related to the mission statement of a business, including an introduction to various short and long-term objectives that a business might have. Related to this is a discussion of various goals which might be pursued in the course of business. The nature of conflict is discussed too. Mission Statement

“To enable the full potential of all learners to be achieved and recognised” A mission statement is a description of the key objectives of a business. The Purpose of a Mission Statement: Within the context of decision making, a business should draw up a mission statement for a number of reasons, enabling it to:

· Set out the purpose of the business

· Document the main aim(s) of the business

· Provide an insight to the long-term objective(s) of the business

· Communicate to stakeholders the focus of short-term business activities

· Motivate employees within the business

· Attract customers to the business

· Publicise in qualitative terms, the aspirations of the management team within the business

The mission statement should be a clear and succinct representation of the enterprise's purpose for existence. It should incorporate socially meaningful and measurable criteria addressing concepts such as the moral/ethical position of the

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enterprise, public image, the target market, products/services, the geographic domain and expectations of growth and profitability. Usefulness of Mission Statements In terms of decision making, the extent to which a mission statement is useful will depend on the reason why it was prepared in the first place. Benefits: A mission statement might be useful in the following circumstances:

· It can assist the management team to focus on the main purpose of the business

· It summarises the aim(s) of the business, which in turn should support the

main purpose of the business

· It enables the management team to develop long-term plans for the business

· It allows the management team to communicate to relevant stakeholders

the goals of the business

· It can motivate staff within the business

· It can act as a useful device in order to attract publicity for the business in a positive manner

Drawbacks: Alternatively, the publication of a mission statement might have some negative implications:

· It may result in an inability of the management team to relate the mission statement to the actual decision making process or purpose of the business – either unintentionally or deliberately

· Staff may not be motivated to read the mission statement, instead focusing on their individual roles within the business, letting the management team take responsibility for all key decisions

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· Negative publicity may be attracted if a business fails to achieve the goals stated within the mission statement as stakeholders are likely to have expectations about the extent to which a business will act in this manner

· There may exist an alternative motive on the part of the management

team – i.e. a variation might exist between the stated aim of the management team and actual aims pursued

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Business Objectives: A business objective can be defined as a goal which a business is seeking to achieve. A business is likely to have a number of objectives – typically one overall key objective supplemented by a number of related or subsidiary objectives. Objectives will change depending on economic conditions and the decisions which have to be made by the management team at a given point in time, however the most common objectives are:

1. Survival

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In terms of decision making, the key objective is to ensure that a business continues to operate for the foreseeable future, as a going concern. This can be seen in a number contexts:

· New starts – in this situation a business is faced with various decisions

regarding the success of the initial start-up and survive the early stages of trading;

· Existing businesses – in this situation a business might encounter a

downturn in economic performance due to internal (poor management/inappropriate product portfolio) and/or external factors (recession), hence the decisions taken in this situation will be aimed at ensuring survival on an ongoing basis;

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· Takeover – in this situation a business might be the subject of a takeover bid by another business, which will ensure the survival of the existing business.

Survival may be the only option open to an organisation. Although this may not be in the interests of shareholders who are seeking a return from their investment, it may be the only viable option, ensuring that shareholders do not lose their initial capital commitments.

2. Profit Maximisation


In terms of decision making, this objective can be taken to mean operating a business at that level of output (measured in terms of sales revenues and/or sales quantities) whereby a business achieves the maximum available profit. In reality, very few businesses achieve profit maximisation (due to pressure from stakeholders, industry regulators and other parties), instead, aiming to achieve a position whereby a satisfactory level of profit can be achieved. However, profit maximisation may mean that other objectives are sacrificed as the organisation seeks to make as much profit as possible.

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3. Growth


In terms of decision making, this is likely to be the most common objective and is likely to be considered within the context of an existing business. Growth can be measured in various ways, including measurement of sales quantities, revenues, profit levels or market share for example. Indeed, achievement of growth of revenues or market share might secure the future prospects of a business, enhance the competitive position within the industry or minimise the chance of business failure. Various growth strategies are available in order to achieve this objective. However, the objective of growth can mean that profits need to be reinvested into the organisation, meaning that shareholders may not receive dividends as high as they were expecting.

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4. Social Responsibility


Social responsibility typically refers to the practices of a company or organization. A company with strong levels of social responsibility will prove to be an asset to the community and society where it is based. Social responsibility requires a balance of responsible business practices, sound business decisions and strong ethics and morals. However, acting in a socially responsible manner may mean that the objective of profit maximization is not achieved. These two objectives can conflict with one another in cases where business practices that seek to maximize profits can only be achieved by not being socially responsible.

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5. Employee Welfare

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The provision of employee welfare is an important objective; this relates to issues such as wages & salaries; comfortable and safe working conditions, training and development; pensions etc. The value of many businesses is critically-dependent on attracting and retaining high quality employees which makes managing the welfare of such people even more important. However, ensuring that employee welfare is achieved can be costly and in some cases when employees receive training they can use this to apply for other jobs with competitors.

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6. Corporate image


The corporate image or reputation of an organization is an important objective. A good corporate image can generate interest from potential customers and also help to keep existing customers. Bad publicity can have a detrimental impact on an organization. Customers can become very suspicious of an organization which has a poor corporate image and look for alternative organizations to meet their needs.

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7. Concern for the environment

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Some customers have a genuine desire to ensure that business practices take into account environmental issues. In some cases this will help them to decide which organization they will buy their product or services from. This can therefore be used by organizations to achieve a competitive advantage. However, some organizations use this objective as a means of saving money rather than having a genuine concern for the environment.

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Factors determining business objectives: There are a variety of factors which can determine the objectives of a business. These include:

· Owners – the ownership of a business will influence key business objectives. Small Business – the ultimate responsibility for decision making rests with

the owner in a sole trader business (or partners in a partnership), thus it is likely that they exert personal control over the decisions taken in order to support the primary objective of making a profit.

Large Business – in most cases, the responsibility for decision making will

rest with the board of directors, thus it is likely that the board will consider a variety of related issues in relation to the primary profit objective.

· Stakeholder Power – the power of specific stakeholder groups relative to

the business is likely to influence key business objectives, as it is likely that different stakeholder groups will have different objectives.

· Shareholders – in the context of a limited company, shareholders will be motivated by profits and are thus likely to be the most dominant group of stakeholders.

· Size – the size of a business will influence key business objectives, as it is

likely that businesses of different sizes will have different objectives. Small Business – such businesses are likely to be concerned with

achieving a satisfactory level of profit or breakeven position, in order to ensure survival.

Large Business – such businesses are likely to be concerned with

maintaining market share/revenues and securing growth of the business in the long-term.

· Pressure Groups – a business may be forced to reconsider key business

objectives if, for example, a pressure group yielded sufficient power to influence a particular course of action, e.g. a drugs manufacturer who tests products using animals, might be subject to negative publicity brought about by the actions of pressure groups concerned with the safety/welfare of animals.

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· Timescale – the timescale within which business decisions are taken is likely to influence key business objectives. It is likely that the objectives of a business will change in the short-term (i.e. up to 1 year) and long-term (i.e. 2+years) – very often the primary objective will be the same. Most businesses will aim for survival or building market share in the short-term (measured in terms of revenues or profits), with a long-term focus on profitability/growth in terms of revenues and market share within the context of a competitive market.

· Internal/External pressure – the combination of pressure exerted by

sources internal or external to a business is likely to influence key business objectives – examples of such pressure can usually be traced to stakeholder groups yielding influence over key business decisions. Internal – changes in personnel within the management team are likely to

give rise to internal pressure in respect of the decisions to be taken in relation to the key business objectives – for example, the appointment of a managing director with a marketing background might lead to a business pursuing ‘marketing’ type goals in order to achieve success (e.g. increase customer numbers or sales revenues or increased promotional activity aimed at increasing the profile of the business amongst customers), compared to a managing director with an accounting background who might decide that costs need to be reduced within a business, in order to improve profitability.

External – changes in the external environment brought about by the

government as a result of legislation might force a business to re-evaluate the decision making process in order to achieve key objectives – for example, the law requires that business owners make reasonable adjustments to their premises in order to facilitate physically disabled customers access to their premises. This might mean that decisions are taken to ensure that all entrances/exits have automatic opening/closing facilities to accommodate the needs of disabled staff/customers, which in turn means that additional funds are required to pay for modifications to premises thus increasing cost and decreasing profits. Such a decision might be a positive one, in that, not only does a business attract able-bodied customers but also physically disabled customers, thus increasing revenue streams in the long-term. · Risk – the conduct of business involves a degree of risk and this will

influence key business objectives. This will be dependent in part, upon the attitude to risk adopted by the management team in relation to the decision making process in a business. Risk Taking – in this case, the management team could decide that in order for the business to succeed, it must take a risk (or gamble) that revenues/profits can be gained from sales of existing products in new

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markets (e.g. overseas). The risk taken is that a market exists for such products and that by entering the overseas market; increased revenues/profits will accrue, at least covering expenses and secure market share. On the other hand, there is that chance that no demand for the products of the business exists and therefore the business will fail. Businesses that take such a gamble against huge odds in the context of many unknown factors are referred to as ‘risk takers’. Risk Avoiding – in this case, the management team could decide that in order to survive, it must avoid taking risks, and that by continuing to serve the needs of existing customers in existing markets it will secure a satisfactory revenue/profit stream for the business – at least this will maintain current market share. Businesses that do not take such risks and ‘play safe’, preferring relative certainty in the decision making process are referred to as ‘risk averse’.

· Culture – culture refers to ‘the way things are done’ in a business, hence

is likely to play a large part in the decision making process and likely to influence key business objectives. The way things are done will depend to a large extent on the processes and procedures followed and the behaviour of people within a business entity as it attempts to meet objectives. Cultures vary from ‘people centred’ (i.e. a business might focus on meeting the needs of customers and staff as a priority) to ‘competition orientated’ (i.e. a business might focus on meeting profit or market share objectives in the first instance.

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Market Share


This refers to the proportion of customers or sales that a business has successfully conducted business with in relation to the total number of customers or sales that exist within the overall market. Market share can be measured in various ways including sales revenues, quantities or customer numbers. In a decision making context, it is important that a business can build market share in the short term (in order to survive) with a long term focus on maintaining growth in market share (in order to grow the business). Short-term Objectives: These are objectives which are designed to be achieved in the short-term. The short term is generally defined as a period of up to 1 year. Most businesses would prepare plans focussing on key objectives which might be achieved in this timeframe – such plans are referred to as ‘Operating Plans’. Short term objectives should be drawn up in line with the long term objectives of the organisation. However in some cases changes in the internal or external environment may mean that short term objectives need to be changed. This may have an impact on the long term objectives of the firm. Long-term Objectives: These are objectives which are designed to be achieved in the long-term. The long term is generally defined as a period beyond 1 year. Many larger businesses would prepare plans summarising key objectives which might be achieved going forward into the future over a longer time span – such plans are referred to as ‘Strategic Plans’. These objectives should be achieved through the implementation of short term plans, however as already noted, changes in the operating environment can have an impact on this.

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Conflict:

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Conflict can be defined as the contradiction of ideas or objectives, which generally mean that one objective, cannot be achieved or that it might be achievable at the expense of another related/subsidiary objective. Many business objectives complement each other and are acceptable to a broad range of stakeholders. For example, an objective for a business start-up of achieving survival would be supported by nearly all the stakeholders. It is in no-one’s interest for a business to fail! However, once a business becomes better established and larger, then potential conflicts begin to arise.

Business expansion versus higher short-term profit:

An objective of increasing the size and scale of a business might be supported by managers, employees, suppliers and the local community – largely for the extra jobs and sales that expansion would bring.

However, an expansion is often associated with increased costs in the short-term (e.g. extra marketing spending, new locations opened, more production capacity added). This might result in lower overall profits in the short-term, which may cause conflict with the business shareholders or owners. In the longer-term, however, most business owners would be pleased to support an expansion if it increases the overall value of the business.

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Job losses versus keeping jobs

This has been a big issue for many businesses during a period of economic downturn. In order to reduce costs and save cash, business managers have often made redundancies amongst the workforce or introduced other measures such as short-time working to reduce wage costs. This will have been supported by business owners and managers.

However, it creates a potential conflict with stakeholders such as employees (who are directly affected), the local community (affected by local job losses) and suppliers (who suffer from a reduction in business).

Below are some other potential causes of conflicts between stakeholders:

• “Short-term” thinking by managers may discourage important long-term investment in the business

• New developments in the business such as a major product launch or a new factory may require extra finance to be raised, which reduces the control of existing investors

• Investing in new machinery to achieve better efficiency may result in job losses

• Extending products into mass markets may result in lower quality standards

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Generally speaking, a business will need to continuously achieve it’s key objective in order to succeed in the market. Conflict tends to arise when one or more business objectives are unclear. It has been suggested that business objectives should be ‘SMART’


Specific – objectives must be stated precisely Measurable – objectives must be capable of measurement in order to determine achievement of them Agreed – objectives must be understood and approved by key stakeholders Realistic – objectives must be capable of attainment, grounded in reality relative to the business resources Time Bound– objectives must be achievable with a particular timeframe If an objective does not fit into any of the above criteria, then it is likely that this will give rise to conflict and thus have negative consequences on the business entity. Key Terms: Mission Statement; Business objective; Short-term; Long-term; Goals; Survival; Profit maximisation; growth; market share; conflict.

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Test Your Knowledge: · Explain what is meant by the term ‘mission statement’. · Explain what is meant by the term ‘conflict’. · Evaluate three possible objectives that a business might have. · State two reasons why a business would use a mission statement

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Mission Statement: Case Study: Read the following information and answer the questions that follow. Walk-it Limited builds and maintains various city centre infrastructure projects under tender from the UK government. Such projects include provision of temporary car parks on derelict city centre sites and building bridges across natural barriers, e.g. rivers. The headquarters of the company are located in Larne. Walk-it Limited entered into a contract to build a footbridge across the River Foyle in Derry City Centre, which would link the two parts of the City separated by the river. Construction work on the new footbridge will finish in December this year, and users (including disabled persons) will be able to use the footbridge as from the start of January. The footbridge will have a series of ‘moving walkways’ built into it to assist user mobility. It is proposed to charge all users a ‘toll’ for use of the footbridge, whereby each person using the bridge would pay a 50 pence ‘toll charge’. The footbridge will be conveniently located such that, it links the main shopping district with bus, rail, taxi and car-parking facilities enabling commuters to enjoy the benefits of similar ‘park and ride’ schemes operating in other major UK cities. This would reduce congestion at peak times in addition to providing a new landmark for the city of Londonderry, in which approximately 100,000 people live. The nearest bridge (Craigavon Bridge) which pedestrians could use is located some distance away and necessitates a time-consuming detour away from the main shopping district, thus the footbridge is convenient, particularly for those with restricted access to transport facilities. Walk-it Limited would operate and maintain the footbridge for a period of 25 years after construction. The footbridge will face competition with existing bus and taxi services. The management team at Walk-it Limited have indicated that they must attract a minimum of 200,000 users each year in order for the footbridge to be commercially viable. Management estimate that 250,000 users will use the footbridge per year for the first two years, growing to an estimated 400,000 users each year thereafter following extensive promotion of the facility using various media networks. The mission statement of Walk-it Limited states: ‘Walk-it Limited is a private company operating key infrastructure projects. It aims to increase market share and profitability, promoting confidence in the use of transport projects, doing so in an efficient, profitable, safe and innovative manner. Walk-it Limited will co-operate with relevant stakeholders as appropriate in order to achieve objectives’.

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Questions: Q1: Explain the purpose of a mission statement. Illustrate your answer with reference to the case study. Q2: Walk-it Limited is likely to have short term and long term objectives.

Outline two examples of each with reference to the case study. Q3: With reference to Walk-it Limited, discuss the extent to which the

following objectives might be successfully achieved: (a) survival; (b) growth; (c) profit maximisation.

Q4: Referring to Walk-it Limited, evaluate the use of a mission statement in relation to the possible achievement of business objectives.

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Suggested Solutions Q1: Mission Statement: The purpose of this statement is to indicate the reason for the existence of a business entity. It is a useful mechanism through which the management team can communicate the objectives and values of the organisation, influence employee behaviour and attitudes and assist achievement of common business objectives. With reference to Walk-it Limited, the mission statement states that: ‘Walk-it Limited is a private company operating key infrastructure projects. It aims to increase market share and profitability, promoting confidence in the use of transport projects, doing so in an efficient, profitable, safe and innovative manner. Walk-it Limited will co-operate with relevant stakeholders as appropriate in order to achieve objectives’. This will guide the management team and others toward achieving business objectives. Q2: Long Term Objectives Walk-it Limited could aim to: (i) build and maintain a city centre infrastructure project, operating and maintaining a footbridge for a period of 25 years after construction; (ii) maintain footbridge viability - management estimate that 400,000 users each year are required after the first two years to ensure growth. Short Term Objectives Walk-it Limited could aim to: (i) initially build and maintain a footbridge across Lough Foyle, establishing market share in the transport market; and (ii) build market share, by attracting a minimum of 200,000 users each year in order for the footbridge to be commercially viable. Q3: Achievement of Business Objectives: The extent to which Walk-it Limited might successfully achieve the key objectives is as follows: Survival: it is likely that Walk-it Limited will survive as a business – during the first two years of operation, it requires 200,000 users per year for the footbridge to breakeven. It is expected to carry 250,000 passengers in each of the first two years. This is 50,000 more than breakeven thus assumed to yield some profit each year to enable the company to survive. It will also focus on building market share during this period, carrying 200,000 users per year compared to bus, rail and taxi services.

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Growth: it is likely that Walk-it Limited will focus on achieving growth in sales revenues and market share as from year three, since it is estimated the footbridge will have 400,000 users each year. This represents a substantial increase relative to the breakeven point, yielding profits and is likely to be as a result of the heavy advertising undertaken by the company. This objective is likely to be achieved over the long term, within the context of a city where 100,000 live and as users become more familiar with it’s existence and market share increases. Profit Maximisation: it is likely that this objective will not be achieved in the short term, as there will be substantial costs related to construction and maintenance, operating the footbridge and increasing market share. Walk-it Limited is assumed to operate in a competitive market (compared to bus, rail and taxi services) and with the influence of the public, it is not likely to set ‘toll charges’ that yield profit maximisation. Q4: Evaluation of Mission Statement: the extent to which the achievement of business objectives will be achieved in accordance with the stated mission statement of Walk-it Limited will have an impact in terms of both positive and negative aspects. Positive aspects include: (i) achievement of increased levels of efficiency and profitability, subject to increased levels of public confidence in the use of the footbridge; (ii) achievement of safety in the provision of the footbridge, since this is specifically mentioned, this will benefit employees too, and arises from increased public confidence; (iii) the element of competition noted in the mission statement would imply that Walk-it Ltd will provide users with a service that they can afford to pay, thus increasing user numbers; (iv) the provision of efficient, safe and innovative services is dependent upon the extent to which the needs of employees can be met, through training, working conditions and other issues; (v) increased user numbers could lead to increased market share, thus increasing public confidence, which in turn would meet the objectives of the management team and government; (vi) co-ordinated bus and rail services linking to the footbridge will make the company more efficient and profitable – the mission statement implies that the company with work with other stakeholders. Alternatively, a number of negative aspects include: (i) Walk-it Ltd has a vision of efficient, safe and innovative operations/services, implying modern facilities, which would require investment, which in turn will be expensive;

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(ii) costs must be managed in order to compete effectively with other public service transport providers; (iii) Walk-it Ltd may be required to operate the footbridge in a way that is not profitable due to the terms of the contract granted by the government; (iv) safe and innovative facilities require funding which will increase the cost base of Walk-it Ltd and in turn reduce profitability; (v) Walk-it Ltd may encounter resistance to change from key stakeholders which would reduce its ability to meet the mission statement contents. It is possible to conclude that the mission statement is of value to an organisation such as Walk-it Ltd and should ensure that it is successful. Evaluation will be expected throughout this answer.

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STAKEHOLDER OBJECTIVES Chapter Aims:

· Evaluate different stakeholder groups in business; · Evaluate the nature of different stakeholder objectives; · Evaluate the nature of conflict between business and stakeholder

objectives; · Evaluate various strategies available to deal with conflict within the context

of stakeholder and business objectives.

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Introduction: This chapter discusses key definitions related to the objectives of various stakeholder groups within a business. Stakeholder: A stakeholder is a person or group who has a direct influence on the business entity. Stakeholder Groups: There are a number of stakeholder groups related to a business entity. These include: Owners Managers Employees Suppliers Customers Creditors Society Government Stakeholder Objectives: Each stakeholder group is likely to have their own set of objectives in relation to a business, and will therefore usually adopt a different perspective regarding the activities of the business, which in turn, is likely to influence the business in different ways. Depending on where the balance of power lies, it could be that the business is more powerful and can manipulate stakeholder behaviour in a way that would be consistent with the achievement of business objectives. However, there are situations in which the power of stakeholders would appear to be more influential. Either way, the relationship between the business and various stakeholder groups is likely to feature in the context of making business decisions.

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Influence of Stakeholder groups: Stakeholder groups which are likely to influence the decision making process in a business include: Owners

© Creatas/Jupiterimages/Thinkstock

This stakeholder group are traditionally seen as the most powerful, since ultimately the responsibility for decisions taken in the business rests with them, however, this is also dependent upon the type of business entity. Consider the following: Sole Trader – responsibility for decision making in a sole trader business will rest with the sole trader, including providing finance, setting up the business, trading and operating the business on a daily business. In this type of business, the most powerful stakeholder is likely to be the sole trader, unless the decisions have been delegated to staff (examples of such businesses include small businesses providing a retail service, professional service or something similar). Partnership – responsibility for decision making in a partnership business will rest with the partners, including provision of finance, establishing the business, trading and operating the business on a daily basis. In this type of business, the most powerful stakeholder group is likely to be the partners, unless the decisions have been delegated to a managing partner or manager (examples of such businesses include limited partnerships such as firms of professionals (e.g. accountants, lawyers, architects).

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Limited Companies – responsibility for strategic and operational decision making in such organisations is likely to be delegated to the board of directors, however shareholders are likely to be consulted and provided with opportunities to approve the key decisions in a business at various annual general meetings of the company. It is possible that in some companies (particularly private limited companies), the major shareholders are also members of the board of directors. Nationalised Industries (and government agencies) – responsibility for strategic and operational decision making in such business entities/agencies is likely to be delegated to the board of directors (or panel of government representatives), however, the government (on behalf of taxpayers) is likely to be consulted and provided with opportunities to approve the key decisions at various meetings of the business entity/agency. Managers

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Members of the management team are typically responsible for making key decisions in a business entity in relation to the daily operation of the business, in addition to decision making within a longer term strategic context. The extent to which managers are the most powerful stakeholder group in a business will depend on the control that can be exercised over the use of resources – thus the greater the control that the management team exercise over use of resources, the more powerful this stakeholder group is likely to be. In a profit-orientated business, it is likely that managers will be motivated to achieve success since their terms/conditions of employment will be linked to business performance.

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Employees


Employees will typically make decisions on behalf of their employer in order to fulfil the key objectives of the business and ensure the smooth running of the business on a daily basis. Such decisions are likely to be of a routine nature and might provide some motivation to staff. Many larger businesses have mechanisms in place that enable communication between employees (staff) and management to occur on a regular basis. Employees, as a stakeholder group, can exercise power to the extent that they are heavily involved in daily operations and interfacing with customers, or where the output of an employee’s workload contributes significantly to the employer’s objectives.

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Suppliers


Suppliers can be seen as the initial link in the supply chain, supplying other business entities with resources and/or component parts for onward sale to final customers further along the supply chain. Power in terms of this stakeholder group can be seen to the extent that suppliers can exert control over initial supplies to their immediate customers, although they will be dependent upon such customers to return payment and contribute to their profitability. In terms of decision making, a business will be reliant upon suppliers to participate fully in all aspects of the supply chain in order to contribute effectively to the achievement of business objectives.

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Customers

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Customers are typically thought of as being the end-consumer of the products or services of a business, that is, the final link in the supply chain. The ultimate decision a customer will make is to proceed with the acquisition of a product/service from the vendor, and to that extent can be seen to be a powerful stakeholder group outside of a business entity. The level of competition within the industry might provide leverage to customers enabling them to ‘shop around’ to secure the most appropriate product/service. Customer focused businesses are likely to engage customers fully and put in place substantial customer care arrangements in order to maximise the buying experience for customers.

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Creditors

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In relation to a business entity, creditors as a stakeholder group are most likely to be related to the business through a financial link. A business could potentially have different types of creditors. Consider the following: Short term – short term creditors are typically trade creditors or suppliers from whom the business has acquired resources (e.g. goods for sale, expenses such as electric, rates and payments for tax) Long term – long term creditors could be represented by financial institutions who provide funding for business in the form of loans, debentures and other financial instruments In terms of decision making within a business, the ultimate power of this stakeholder group can be seen initially through the provision of financial resources to the business from which it has benefited in order to achieve its key objectives, but also in terms of default – a creditor can take legal action which might affect the future ability of a business entity to continue trading – e.g. instigation of bankruptcy proceedings in the event of non-payment thus restricting the ability of a business to operate.

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Society – the relationship between a business entity and society in general will take many forms, given the diversity of business activities and the multi-cultural society evident in the modern age. The power that society might exert in relation to a business entity will largely depend on moral and social issues impacting business decisions and ultimately business activities. In relation to making business decisions, various ways in which business interacts positively with society in a local sense can include the employment of staff from local communities where businesses are located, contribution of the multiplier effect within local economies due to staff spending their wages locally, and perhaps various promotional activities undertaken locally aimed at increasing product awareness in return for sponsorship of community activities. On the other hand, local communities are likely to exert influence if a business entity undertakes controversial or business activities which do not find favour to society in general, e.g. testing beauty products using animals or noise and/or air pollution. Pressure groups typically ensure that such issues are addressed by business. Government


The relationship between a business entity and government in general will take many forms, given the diversity of business activities and the complexity of modern business practice and politics. The power that government might exert in relation to a business entity will depend on the legislative regime in place. In recent times, there has been an increase in government intervention in relation to

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business activity for example, nationalisation of sectors of the UK banking industry, increasing regulation of utility industries, increasing scope of taxation in relation to business activity, legislating for health and safety, disability discrimination and smoking, and deregulation of international trade. Government is likely to be the most powerful stakeholder external to a business entity, since it has the backing of parliament to regulate entire industries, levy taxes and manage the economy of the nation. Business entities however, can usually lobby the government in order to influence government opinion. Conflict and Stakeholder Groups:


Conflict can be defined as the potential contradiction of ideas or objectives between various groups of stakeholders, which will usually mean that a particular objective of one specific group of stakeholders can be achieved at the expense of another. The following are examples of:

· the potential for conflict between stakeholder groups · the potential for conflict between business objectives

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Investors such as shareholders in limited companies want to gain regular income, security of investment and some input to the decisions of the business – this would bring investors into conflict with customers, who want to acquire products/services at a reasonable cost without leading to ‘super-profits’ for example; Individual managers want to retain responsibility for their decisions, control over resources and compensated appropriately for their contribution towards meeting business objectives – this might lead to conflict with shareholders as the latter stakeholder group may want to maintain a constant focus on profitability, when an alternative objective might be securing an increase in market share in the short-term; Employees want to aim for high levels of compensation and prospects of secure employment – fierce competition within an industry might mean that management have decided that cost savings are required in order for a business to remain competitive, hence salaries are frozen at current rates with no bonuses payable in order to save money and thus lead to conflict between managers and employees; Customers of the business want to procure goods/services of high quality at the lowest possible cost – managers within a business might decide to use lower quality materials which are cheaper and hence increase profitability, but the end product might not be as durable as the customer expects, hence this might cause conflict between customers and managers; Suppliers want to take advantage of secure and profitable orders from their counterparts in the supply chain – the management team of a business might decide to change suppliers in order to source quality materials at a cheaper price thus reducing unit cost and increasing profits for a business, but might result in a supplier going out of business hence this leads to conflict between managers and suppliers; Government want to secure low levels of inflation and unemployment, yet maximise tax receipts to fund government policies – in times of recession, unemployment tends to rise, fewer people pay tax and greater numbers of people claim benefits, thus increasing government expenditure which can lead to inflationary pressures. This can lead to conflict between business and government; Society want to see thriving business entities in order to secure harmonious relationships within local communities aimed at securing employment for local employees, yet minimising pollution generated from business activities – a business might argue that some pollution is necessary in order to keep costs to a minimum and secure employment hence leading to conflict between managers and society.

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Strategies to deal with Conflicting Objectives


There are a range of strategies that an organisation can use to deal with conflicting objectives that may arise amongst stakeholders. Improving Communication If stakeholders are fully aware of what the aims and implications of the objectives that have been set are, they may be more willing to accept them. An effective communication system will ensure that all stakeholders are fully aware of the objectives that have been set and how they may have an impact on individuals. The benefits of the objectives to each stakeholder should be clearly highlighted and areas where long term gains may arise at the expense of short term gains should be explained. This process can however be time consuming and costly and communication can be misinterpreted. Arbitration / Satisfying In some cases it may be necessary to liaise with stakeholders and try to find a solution that is acceptable to all interested parties. This will involve negotiation with all stakeholders and trying to find a compromise which is in the best interests of all concerned. However this can be time consuming and costly, and may even lead to a situation where the initial objectives are completely lost in the process.

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Ignoring the Problem / Enforcing a Solution Sometimes organisations will decide to simply ignore the issue of conflicting objectives and proceed with the initial plan. Although this approach is speedy and will allow decision makers to progress with their initial objectives, it can result in more conflict than initially envisaged if stakeholders feel that their voices are not being heard. The Stakeholder Concept The Stakeholder Concept means that businesses give due recognition to various stakeholder groups throughout the decision making process of a business. This could take various forms including negotiation, face-to-face meetings, inclusion of stakeholders in key decisions and other arrangements. The aim is to ensure early resolution of any potential conflict. Advantages of adopting a stakeholder approach include:

· A more positive attitude from employees and easier recruitment of specialised staff.

· A positive public relations experiences from society in general towards the

business.

· It is easier access to resources if suppliers are treated fairly.

· It can result in increased levels of customer satisfaction.

· It can lead to increased levels of profitability and market share brought about by the early resolution of conflict between stakeholder groups.

Disadvantages of adopting a stakeholder approach:

· It is a time-consuming process trying to to resolve disputes and incorporate stakeholder opinions into the decision making processes of the business.

· The disclosure of confidential information to stakeholder groups might

result in loss of competitive advantage.

· More costly as additional arrangements are required to be made to incorporate stakeholder opinions into the decision making processes of a business.

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Key Terms: Stakeholder; objectives; owners; managers; employees; suppliers; customers; creditors; society; government; conflict; strategy. Test Your Knowledge: · Explain what is meant by the term ‘stakeholder’. · Analyse six stakeholder groups commonly found in a business context. · Evaluate three ways in which stakeholder objectives could differ from

business objectives.

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Case Study: Read the following information and answer the questions that follow. The Magilligan-Greencastle Ferry is a short ferry service operated using a roll-on-roll-off ferry for the benefit of foot passengers, cars and small freight vehicles (e.g. vans). The ferry operates from a terminal, located in Magilligan, on the outskirts of Limavady, and is operated by a private company. The location of the ferry service within the North West of Northern Ireland means that it is a key transport service provided for the benefit of the travelling public to various destinations, including Donegal, Londonderry, Coleraine and other towns located throughout the North West and County Donegal, through the provision of scheduled services. In addition, the ferry service facilitates inbound tourism. The location of the ferry terminal is convenient to the border with the Republic of Ireland, thus includes a catchment area as far north as Falcarragh, in competition to other forms of public transport such as taxi and bus services. Management have decided to review the operation of the ferry service and have indicated that the future of the service is in doubt, due to deteriorating economic conditions, high maintenance costs and declining passenger numbers. The proposed closure, which was reported in the national media, could cause major disruption to the business operations and travel arrangements of many stakeholders, including tourists, commuters, business customers, small businesses in the North West and neighbouring communities. Should the service be withdrawn, it would mean that commuters, tourists and other users would face on average, a time-consuming 30-mile trip in order to travel from Limavady (and surrounding area) to the Republic of Ireland/Donegal, along with traffic congestion and poor road networks. Fares levied on passengers have risen in recent years from a price of €5 about 10 years ago, to their current level of €20 per passenger. Questions: Q1: Define the term ‘stakeholder’. Q2: Define the term ‘conflict’. Q3: With reference to the Magilligan-Greencastle Ferry Service, identify any four stakeholder groups, analysing one way in which each group would have a legitimate interest in the ferry service. Q4: Evaluate the potential for conflict between four different stakeholder groups, particularly in light of the proposed closure of the ferry service.

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Suggested Solutions (to include the following salient points): A1: Stakeholder: someone who has a real or psychological interest in a business entity. In the context of the Magilligan-Greencastle ferry service, it is likely that there will be a range of stakeholders both internal and external to the business. Each stakeholder group might well be affected by the operation of the ferry service or in the event of closure, the withdrawal of the ferry service. One example of a stakeholder group will be passengers. A2: Conflict: this can be described as a contradiction in terms of trying to achieve different business objectives, whereby one objective will be achieved at the expense of another, or as a difference between stakeholder groups in relation to attitude, goals, experience and other matters related to achievement of the primary objective of the business. An example of conflict will be the withdrawal of ferry services for passengers forcing them to make alternative transport arrangements. A3: Stakeholder Groups – Magilligan-Greencastle Ferry Service: Typically includes anyone who has significant dealings with the business or operation of the ferry service, including (answers referring to any four groups will suffice): Employees - staff who operate the Magilligan-Greencastle Ferry Service for the benefit of passengers would want to ensure provision of safe and efficient ferry services. Customers - these include ferry passengers (commuters and tourists) and motorists who use the Magilligan-Greencastle Ferry Service, who rely on the ferry service to go about their daily business; Suppliers - these include taxi services, bus services or those who contribute to the transport systems in operation to/from the ferry terminal for the benefit of passengers or those suppliers who supply the Magilligan-Greencastle Ferry Service with goods and services to enable it to function effectively and efficiently; Society - these include those residents/businesses located close to the ferry terminals in either Magilligan or Greencastle, and who may be subject to the operations of the ferry service; Management - the management team are responsible for the operation of the Magilligan-Greencastle Ferry Service on a daily basis, who are anxious to run the business on a profitable basis.

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A4: Stakeholder Group Conflict – Magilligan-Greencastle Ferry Service: Conflicting objectives will arise between various stakeholder groups as follows (analysis using any four groups will suffice): Employees - staff who operate the Magilligan-Greencastle Ferry Service for the benefit of passengers would want to ensure provision of safe and efficient ferry services, in addition to securing employment, thus they would be interested to ensure continuation of the ferry service but unlikely to be concerned that the management team are required to cut costs or make a profit for investors in the long term, hence giving rise to conflicting objectives. Customers - these include ferry passengers (commuters and tourists) and motorists who use the service, thus saving extensive and frustrating road trips, and therefore rely on the Magilligan-Greencastle Ferry Service to go about their daily business – the withdrawal of the service would create uncertainty for such passengers as they are not likely to be concerned with ensuring profitability of the service for the benefit of the owners thus giving rise to conflicting objectives; Suppliers - these include taxi services, bus services or those who contribute to the transport systems in operation to/from the ferry terminals in Magilligan or Greencastle for the benefit of passengers or those suppliers who supply the ferry operators with goods and services to enable it to function effectively and efficiently – the proposed withdrawal of the ferry service will mean that the suppliers will lose a key customer and suffer a drop in revenues/profitability, which would lead to conflicting objectives between the two stakeholder groups. Society - these include those residents/businesses located close to the ferry terminal and who may be subject to the operations of the ferry service, e.g. noise and/or air pollution – with the proposed withdrawal of the service, it might be that such pollution will cease. This will benefit the local community as they will likely appreciate the reduction in pollution however, management would be interested in the continued viability of the Magilligan-Greencastle Ferry Service for their benefit (secure employment), giving rise to conflicting objectives; Management - the management team are responsible for the operation of the ferry service on a daily basis, who are anxious to run the business on a profitable basis, hence the steady increases in prices/fares in order to raise sufficient funds to pay operating and fixed costs of providing the service. This stakeholder group would also wish to secure employment and thus interested in the continued viability of the business. The decision to withdraw the Magilligan-Greencastle Ferry Service would lead to conflicting objectives with stakeholder groups including passengers, suppliers, local community and employees.

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BUSINESS STRATEGY AND PLANNING Chapter Aims:

· Explain the meaning of the term business plan; · Identify business objectives; · Understand concepts available to analyse current business position,

including SWOT analysis and PESTEL analysis; · Understand various approaches to decision making in business, including

concepts available to develop business strategies, including Ansoff and Boston matrixes;

· Identify and explain various issues related to dealing with implementation of business strategies.

© iStockphoto/Thinkstock Introduction: This chapter discusses key concepts related to the analysis of the current business position, and suggests some concepts available to facilitate such an analysis and develop strategies for business decision making.

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Business Plan: A business plan is a plan of action prepared by the business entity for a future time period. This document will summarise the key assumptions and decisions that are likely to be made by the management team going forward into the future. A business plan summarises the key objectives of a business and the main plans which are likely to be followed in order to achieve the stated objectives. Contents of a Business Plan: A business plan is likely to contain the following elements: The Business – this section will summarise the name/address of the business; the aims of the business; type of business entity established. Product/Service – this section will describe in summary format, the product/service being provided to the market; the quantities to be provided; the proposed sales price(s). Market – this section will summarise the results of market research or pilots; estimates of market size; likely growth estimates of the market; identification of likely customers; identification of likely competitors and their strengths/weaknesses and challenges posed by them; alternative methods of promotion/advertising. Resources: Staff – this section will summarise the key personnel required to operate the business; the experience and skills likely to be possessed by workforce; details of working arrangements and compensation packages. Operational – this section will summarise the key decisions/issues to be taken in relation to functional areas of the business; types of premises required; likely location of the business; likely types, specifications and age of equipment required (fixed assets); policies to manage growth in business operations/market demand. Financial – this section will summarise the key financial projections related to the business; likely profit based on sales quantities/revenues; anticipated breakeven point in terms of quantities/revenues; cashflow forecast summarising cashflows in/out and respective timing; banking arrangements; capital required; investment in non current assets required; likely levels of debt.

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Benefits and Drawbacks of Preparing a Business Plan: Potential benefits of preparing a Business Plan:

· They enable the management team to make business decisions effectively

· They provides the management team with an insight to the key

strategic decisions to be made regarding achievement of business objectives

· They enables the management team to budget and plan for resources

in order to achieve key objectives

· They enable the management team to secure debt finance in order to fund the business if required

· They facilitate the management team in making comparisons with

actual performance and deciding areas for improvement Potential drawbacks of preparing a Business Plan:

· They are time consuming to prepare

· They may not always be accurate, particularly regarding the assumptions made about markets, customer behaviour and financial impacts of key decisions

· A business plan might reveal too much information about the

business, which might be useful to a competitor The use of a business plan will assist a business in making business decisions, related to financial, marketing, production and other support activities in relation to competing within the market.

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Business Objectives:


As stated earlier, the key business objectives are: Survival Profit Maximisation Growth Social Considerations Employee Welfare Corporate Image Concern for the Environment In order to achieve these objectives an organisation should carry out strategic planning.

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The Strategic Planning Process

Analysing the current position: In order to put a strategic plan in place an organisation needs to analyse its current position in the market. Two common techniques that can be used to facilitate an analysis of the current position facing a business include: (i) a SWOT analysis; and (ii) a PESTEL Analysis.

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SWOT analysis:

A SWOT analysis involves the examination of the strengths and weaknesses of a business and a review of the opportunities and threats facing a business. The strengths and weaknesses tend to be issues ‘internal’ to a business, whilst opportunities and threats tend to focus on issues ‘external’ to a business entity. A SWOT analysis is meant to provide an in-depth identification, explanation and analysis of the various issues facing a business, in order to provide a reference point for decision making in pursuit of key business objectives. The preparation of a SWOT analysis requires careful consideration of each of the following elements:

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Strengths: These are considered to be things which are of benefit to a business and which enable it to achieve key objectives. Examples of strengths which a business might possess include:

· Things that they do effectively or efficiently · Things that they have an excellent reputation for · An ability to enhance profitability · Creativity/innovation in business · Excellent reputation · High levels of repeat business · A unique characteristic related to their field of expertise

Weaknesses: These are considered to be things which pose a challenge to a business and which must be addressed in order to ensure success in a competitive environment. Examples of weaknesses which a business entity might possess include: Poor standards of quality in product/service delivery Bad reputation Disruptions to daily operating activities Exposure to financial difficulties/lack of investment Personality clashes between members of the senior management team Opportunities: These are considered to be issues which enable a business to potentially succeed in the context of the competitive environment and achieve key objectives. Examples of opportunities which a business might aim for include: Securing access to natural or raw materials/specific resources Successful completion of a takeover of another business in order secure market share Investment in capital projects Taking advantage of technological developments Threats: These are considered to be issues which might prevent a business from succeeding within the context of the competitive environment and thus achieving key objectives. Examples of threats which a business should address include: Legislative developments Competitor actions Political developments Lack of control regarding access to natural or raw materials/specific resources

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A SWOT analysis is a useful way of collecting relevant information about the business entity and summarising the key external issues facing the business. It also provides the basis for further planning and development of strategies aimed at achieving key business objectives. SWOT Analysis – worked example: Case Study: Belfast International Airport Limited (BIAL) During 2006, Belfast International Airport published a 25-year business plan in response to a request from the UK government. The plan summarised the views of the management team in relation to how they might address the issue of providing sustainable airport capacity for the period up to 2030. The plan considered the key assets at the Airport’s disposal, its key strengths and the challenges faced in the coming years and its role in sustaining regional economic development. The Airport has reported increased growth in passenger numbers using the facilities, rising from 1.5m in 1984 to 4.8m in 2005, and this is forecasted to grow to approximately 7m by the year 2015. This currently accounts for approximately 67% of passenger numbers using airports within Northern Ireland. In addition to long-established airlines operating from the Airport, the Airport has reported an increase in new business, such that additional airlines are flying to/from the Airport, including Aer Lingus plc, easyJet plc and Continental Airlines (USA). It is estimated that 2m people live within a 2-hour drive of the Airport, and that 80% of Northern Ireland’s industrial base is located within one hour of the Airport. Challenges facing the Airport are numerous, including its out-of-town location, the fact that there is only one access road to/from the Airport (A57), a poor transport infrastructure (no rail-link operates directly into the terminal), the loss of passengers to other regional airports (estimated at over 1m per year), and emergence of Dublin Airport, City of Belfast Airport and City of Derry Airport as credible alternatives to passengers and airlines operating therein. Belfast International Airport Limited has recently received unfavourable press, in that, the car parking charges levied are amongst the highest in the UK for a public car park. In addition, the Airport has lost a number of key airline customers who have opted to operate their services from other regional airports. Strengths: (i) BIAL appears to have approximately 67% of NI aviation market; (ii) BIAL has increasing throughput of passenger numbers (4.8m, 2005); (iii) good reputation, attracting new airlines (Aer Lingus plc). Weaknesses: (i) BIAL loss of airline customers to rivals; (ii) unfavourable press – high parking charges. Opportunities: (i) increased growth of passenger numbers to 7m by 2015; (ii) active role in regional economic development; (iii) increased market opportunities

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- 2m people live within a 2-hour drive of airport, and 80% of NI industry located within 1 hour drive; (iv) BIAL provides air services to new destinations. Threats: (i) lack of good road network – only one access road (A57); (ii) out-of-town location, no rail links; (iii) emergence of Dublin Airport, Belfast City Airport and City of Derry Airport as credible alternatives to passengers. PESTEL Analysis: A PESTEL analysis involves the examination of the main features of the external environment in which the business operates. A PESTEL analysis is meant to provide, in summary form an identification, explanation and analysis of the various external or environmental issues facing a business, in order to provide a reference point for decision making in pursuit of key business objectives – such issues which should receive consideration in the analysis include political, economic, social, technological, environmental and legal matters. PESTEL analysis may be used to identify the Opportunities and Threats part of the SWOT analysis. Political: This considers the key political issues facing a business entity, which exist both in a domestic and international context. Common issues include the introduction of new legislation affecting business, e.g. smoking bans in public places, such as places of work, pubs, clubs and restaurants; consumer protection legislation, health and safety regulations, distance selling directive; trade barriers including administrative restrictions, war and other matters which present a risk in the context of international trade. Economic: This considers a wide range of economic issues facing a business entity, which exist both in a domestic and international context. Common issues include challenges presented by recessionary conditions which exist within the national and global economy, issues related to the ‘credit crunch’, the extent to which government objectives are being achieved (e.g. low inflation, low unemployment and increasing levels of trade and economic growth), consumer confidence, cost structures within a business (e.g. impact of minimum wage settlements) and impact of government fiscal policy, monetary policy, supply side policy and foreign exchange policy. On a more positive side, a business might consider how to take advantage of the conditions presented in the context of economic growth. Social: This considers the key social issues prevalent within society at a given point in time, which might have an impact on the performance of a business entity. Common issues include challenges presented by changes in the opinion of society about specific business issues. Examples include issues such as

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management of nuclear waste products, use of live animals to test drugs or beauty products, the termination of unwanted pregnancies by private medical clinics upon payment of medical fees, and managing the impact of a smoking ban on business premises where such premises are deemed to be accessible to the public. The important strategic issue in terms of a business will likely be how best to ensure that such challenges contribute to profitability of the business and hence, survival. Technological: This considers the key issues facing a business entity, which exist in a fast-changing technological world. The availability of information technology and other updated technologies rapidly changes working practices, and if used properly can enhance business performance. Examples might include the conduct of transactions using mobile broadband facilities, use of the internet to complete deals and updated models of production equipment. An important issue in terms of business is to ensure that technological changes are embraced in a way that makes an effective contribution to the key objectives of the business, e.g. profitability or increased market share. Environmental: This considers the key environmental issues facing a business, which have gained increasing levels of importance in the modern business world. Typically, this includes reference to ‘green’ issues, i.e. ensuring a degree of protection for the environment, greater use of recycling and minimisation of waste. The scope of environmental issues could be interpreted much more widely, to include issues such as use of ‘cloning’ technologies in biological research and eradication of disease, genetically modified crops and their entry into the food chain, the minimisation of disease amongst farm animals across international borders, the reduction of carbon emissions and adoption of alternative energy sources over the next 20 – 30 years are all topical issues which create opportunities for business, but carry a degree of risk in relation to public opinion which might influence the success or otherwise of such businesses to meet their key objectives. Legal: This considers the key legal issues within the external environment which typically face a business. Examples of legislative changes in recent times include the requirement by a business to pay all relevant taxes to the government by certain deadlines, the introduction of smoking bans in workplaces, the payment of a minimum wage to staff in the UK, the requirement to have vehicles tested every year after 4 years (MOT tests), the requirement to undertake risk management in relation to all activities related to health and safety in the workplace – such issues tend to lead to increases in costs for a business, however, significant opportunities do exist to conduct a successful business (measured in terms of meeting key objectives), brought about by changes in legislation – some businesses specialise in assisting other businesses meet the

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requirements of various forms of legislation e.g. tax specialists, health/safety advisors and risk management specialists. PESTEL Analysis – worked example: Case Study: Belfast International Airport Limited During 2006, Belfast International Airport published a 25-year business plan in response to a request from the UK government. The plan summarised the views of the management team in relation to how they might address the issue of providing sustainable airport capacity for the period up to 2030. The plan considered the key assets at the Airport’s disposal, its key strengths and the challenges faced in the coming years and its role in sustaining regional economic development. The Airport has reported increased growth in passenger numbers using the facilities, rising from 1.5m in 1984 to 4.8m in 2005, and this is forecasted to grow to approximately 7m by the year 2015. This currently accounts for approximately 67% of passenger numbers using airports within Northern Ireland. In addition to long-established airlines operating from the Airport, the Airport has reported an increase in new business, such that additional airlines are flying to/from the Airport, including Aer Lingus plc, easyJet plc and Continental Airlines (USA). It is estimated that 2m people live within a 2-hour drive of the Airport, and that 80% of Northern Ireland’s industrial base is located within one hour of the Airport. Challenges facing the Airport are numerous, including its out-of-town location, the fact that there is only one access road to/from the Airport (A57), a poor transport infrastructure (no rail-link operates directly into the terminal), the loss of passengers to other regional airports (estimated at over 1m per year), and emergence of Dublin Airport, City of Belfast Airport and City of Derry Airport as credible alternatives to passengers and airlines operating therein. Belfast International Airport Limited has recently received unfavourable press, in that, the car parking charges levied are amongst the highest in the UK for a public car park. In addition, the Airport has lost a number of key airline customers who have opted to operate their services from other regional airports. Political (BIAL required to prepare 25-year plan by government, addressing sustainable airport capacity); Economic (role of BIAL in regional economic development is favourable at present; decision of airlines to operate at BIAL promotes environmental opportunities for greater economic development); Social (BIAL provides links to new destinations, presenting opportunities for passenger travel; enable passengers to fly more frequently);

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Technological (key assets at BIAL’s disposal will sustain its competitive position into the future); Environmental (out-of-town location does not appear to present any issues in terms of noise or other types of pollution); Legal (it is assumed that BIAL operates to the highest safety standards, consistent with CAA, hence the increased numbers of passengers and airlines using the facilities). In addition to the above tools, organisations might also use the following to help with decision making: The Ansoff Matrix: In terms of making key marketing decisions within the business, the Ansoff Matrix is a useful tool. The product-market framework can assist management analyse the strategic position of the firm, and enable formulation of strategies to meet key objectives. The Ansoff Matrix is shown below:

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Four strategic options are open to a business in terms of the decision making process. In summary, the matrix subdivides the options into four quadrants (representing the specific strategy to be followed, and thus the strategic decision to be taken by the management team), depending on (i) whether or not the product is existing or new; and (ii) whether or not the risk level attached to each product type is high or low. Each option is considered below: Market Penetration – the aim of this strategy is to increase market share, achievable using the existing product range of the business. In terms of the decision making process, a low level of risk is associated with this strategic option. Markets which are maturing or in decline will be much harder for a firm to penetrate, than a market in which growth is possible to achieve. Market Development – the aim of this strategy is to increase market share or profitability of the existing product range for the business. In terms of the decision making process, higher levels of risk are associated with this strategic option. It might be considered a feasible strategy since the products are already established in existing markets, but the management team consider that further development of the market might lead to achievement of key objectives. By entering new global markets for example, the existing product range can be used to gain leverage and increase market share; alternatively segmenting an existing market might target customers more effectively. Product Development – the aim of this strategy is to increase market share, but take advantage of existing customer base. This is done by undertaking a range of product development activities. Product Life Cycles tend be much shorter, forcing manufacturers to constantly re-evaluate their product ranges and ensuring that, through this process, product developments occur which meet the needs of customers. In terms of key decisions to be taken it is recognised that existing products can be modified or new products introduced which is thought to represent a low risk approach towards achieving key objectives since existing branding policies can be successfully deployed. Diversification – the aim of this strategy is to increase market share but will require a business to attract a new customer base for its new product range. Two possible interpretations are possible depending on the decision taken by the management team – (i) related diversification strategy means that the business is entering new markets with existing products modified slightly; or (ii) unrelated diversification means that the business is targeting new markets with completely new products. Either way, the decision to be taken will involve a high degree of risk for the business if it is to succeed in achieving key business objectives.

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Benefits and Drawbacks of The Ansoff Matrix: Potential benefits of use of the Ansoff Matrix are as follows:

· It facilitates an analysis of the relevant strategic decisions to be taken

· It provides a simplistic analysis of the likely strategic plans for a business

· It indicates the likely outcome of product marketing strategies within

context business plan Potential drawbacks of use of the Ansoff Matrix are as follows:

· Critics suggest that the analysis provided by the Ansoff Matrix is too simplistic and does not reflect economic reality

· It focuses on product portfolio or market potential rather than resources

required to support each strategy

· It does not guarantee success even if a particular strategy is followed by the business

Use of the Ansoff Matrix will assist a business entity in making business decisions, related to strategic options facing the business as it competes in the market. Case Study: Ansoff Matrix (Belfast International Airport): Products

M Existing Market Penetration Product Development Low

A Domestic Flights: UK New UK destinations, R R Int'l: Continental; e.g. easyJet current airlines, I K Parking; Duty Free; Charter Market S E Market Development Diversification K T New Airlines e.g. AerLingus, Cargo facility, hotel,

S New New foreign Destinations

Corporate/business facilities High

Low High Levels of Risk

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Boston Matrix: In terms of making key decisions within the business, the Boston Matrix is a useful tool. The market share-market growth framework can assist management analyse the product positioning of the business entity’s product lines. This will enable the formulation of strategies to meet key objectives. The Boston Matrix is shown below:

http://www.howtobeamarketer.com/images/stories/demo/Marketer96.jpg

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Four strategic options are open to a business in terms of the decision making process. In summary, the matrix subdivides the options into four quadrants (representing the specific product classification, and thus the likely strategic decisions to be taken by the management team), depending on: (i) whether or not the product attracts a high or low percentage market share; and (ii) whether or not the potential market growth rates are high or low. Each option is considered below: Question Mark/ Problem Children – these are products which attract low levels of market share but attain high levels of market growth for the business. These products are likely to generate either a surplus/deficit (in terms of cash flows) or a profit or loss for the business, depending on the level of financial support provided by the business to ensure their success in the market. Question marks tend to be newly launched products. Stars – these are products which attract high levels of market share and also attain high rates of market growth for the business. These products are likely to generate surplus revenue streams/profits for the business and perform very well relative to the competition, but may require minimal levels of financial support in terms of competing in the market. These may be products that have been newly launched, have generated a lot of interest and have been well received by consumers. Cash Cows – these are products which attract high levels of market share but attain low levels of market growth for the business. These products are likely to generate surplus revenue streams/profits for the business and perform reasonably well relative to the competition, but may require moderate levels of financial support in terms of competing in the market. These tend to be well established products in the market place. Dogs – these are products which attract low levels of market share and also attain low levels of market growth for the business. These products are likely to generate minimal levels of surplus cash flows or losses and indicate a product range in the decline stage, in terms of the product life cycle. The main objective for a business in terms of managing the product portfolio, is to ensure a balance between the number of products in each category or quadrant of the matrix. The idea is to ensure that the products labelled as ‘stars’ or ‘cash cows’ generate sufficient cash flows to fund the products labelled as ‘problem children’ or ‘dogs’ – problem children could either succeed or fail due to the market response or the support provided by the business towards such product lines. It is unlikely that a business would commit substantial levels of financial support to product lines classified as ‘dogs’.

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Benefits and Drawbacks of Boston Matrix: Potential benefits of use of a Boston Matrix are as follows:

· It facilitates an analysis of the product mix

· It provides a simplistic analysis of the product portfolio for a business

· It indicates the likely cashflow position of product positioning within the context of the market

Potential drawbacks of use of a Boston Matrix are as follows:

· Critics suggest that the analysis provided by the Boston Matrix is too simplistic and does not reflect economic reality

· It focuses on market share growth, rather than consolidation of same

· It does not recognise the interdependent nature of support that can

arise between products in the product portfolio Use of the Boston Matrix will assist a business entity in making business decisions, related to financial, marketing, production and other support activities in relation to competing within the market. Case Study: Boston Matrix (Belfast International Airport): High Market Share Low

STARS PROBLEM CHILDREN

High Established Domestic Flights: UK: ie. easyJet. Cargo operations; new

Market Established Int'l Flights: ie. Continental - USA. airlines serving existing

Growth Duty Free; UK/foreign Destinations CASH COWS DOGS Low Charter Flights to Europe, USA. Long term parking; Established Domestic Flights:UK. Lease land surplus to Short Term Parking Requirements, Charter flights

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Alternative Strategies:


In summary, alternative strategies are open to an existing business in order to secure achievement of key business objectives. In terms of the decision making process, they are quite different and can represent one of the most crucial decisions the management team of a firm can take. Such strategies include: (i) Growth; (ii) Stability; and (iii) Retrenchment. Each is now considered below:

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Growth Growth as a strategy can be achieved in many different ways: Organic Growth: This occurs when a business expands using its own resources in order to achieve business objectives. Benefits and Drawbacks of an Organic Growth Strategy: Potential benefits of an organic growth strategy:

· This strategy may represent a cheaper strategic option in order to achieve growth

· An organic growth strategy avoids culture clashes between two

business organisations

· Existing management team can control the pace of expansion Potential drawbacks of an organic growth strategy:

· This strategy may take longer to achieve key strategic objectives compared to a takeover/merger, which can have an instantaneous effect

· It does not guarantee success of a long term growth strategy

Takeover: As the name suggests, a takeover occurs when one business acquires another – this can take the form of acquisition of key fixed assets or control over the important strategic decisions to be taken in the business taken over. It can also be the case that, the business taken over will continue to trade as a separate business entity, or it might be wholly integrated into the business conducting the takeover. Consider the following situations:- Sole Trader – a sole trader business is likely to be acquired through the outright purchase of the assets with all decision making power transferred to the new owner. Very often the purchase price paid will exceed the book value of assets and this price differential is referred to as ‘goodwill’. In many cases, the business once taken over, will indicate that it is under new management.

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Partnership – a partner is likely to see their stake in the partnership acquired by outright purchase by another individual who wishes to become part of the new partnership arrangement. It is likely that in most cases, the old partnership will be dissolved and a new partnership formed with the purchase price paid representing the new partner’s share of the investment in the business. Depending on the ratio of the new investment to total capital/investment, this will indicate if the new partner has any role in decision making in the business. Private Limited Company – business organisations such as these are normally taken over by invitation of the current shareholders, in which case, the existing shares are bought out by the new investors, which will be representative of the assets in the company. In terms of decision making, the extent to which new investors will exercise control will depend on the ratio of their shareholding to the total shareholdings in the company. Public Limited Company – business organisations such as these are normally taken over by investors purchasing the shares on the open market, via the stock exchange. The share price will be a function of profitability, market sentiment, book value of assets and future dividend streams likely to accrue to shareholders. In terms of decision making, the extent to which new investors will exercise control will depend on the ratio of their shareholding to the total shareholdings in the company. A shareholder can take control of a company by acquiring as little as 15 percent of the total share issue. A company who purchases 3 percent of the total shares in another company is required to declare this matter to the stock exchange. Takeovers occur for various reasons or motives. Examples of the motives for a takeover include:

· To enable the predator (i.e. a business buying the shares) to enter new markets or increase existing market share in terms of revenues/profits

· To provide security for the acquired business or enable it to operate as

a going concern

· To enable the predator to acquire certain assets or access to unique resources not available elsewhere

· To make a profit/return on investment

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Hostile Takeover / Acquisition: This refers to a situation where one company has attempted to acquire another business; however the management team in the business to be taken over lodges objections to the proposed takeover for various reasons. They will attempt to persuade the owners of the business that the takeover is not in their best interests and aim to stop it proceeding. Takeover by Invitation: This refers to a situation where one company attempts to acquire another business with the full co-operation of both management teams. This is likely to occur where the takeover is in the best interest of both business entities and/or the owners.

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Mergers: Quite simply, a merger can be thought of as the joining together of two or more companies, to form one larger organisation, through the combination or integration of all assets and resources to produce synergistic benefits for the merged entity. (2 + 2 =5) A merger can often take a number of forms: Horizontal Integration – whereby two businesses in identical lines of business and similar stages of production join together. Backward Vertical Integration – whereby two businesses in identical lines of business but different stages of production, join together, particularly where one business has control of supplies/resources to be supplied to the other business, further along the supply chain. Forward Vertical Integration – whereby two businesses in identical lines of business but again at different stages of production, join together, particularly where on business has control over distribution channels/access to customers for the goods being supplied by the other firm, earlier in the supply chain. Lateral Integration – whereby two businesses involved with related product lines which do not compete with each other, join together. Conglomerate Merger – whereby two businesses involved in unrelated product lines join together in order to diversify.

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Benefits and Drawbacks of Takeovers and Mergers: Potential benefits of takeovers and mergers:

· They provides a predator company with an opportunity to expand the business easily and quickly

· Acquiring another business might prove to be a cheaper option than an

organic growth strategy

· An acquisition might represent and effective use of surplus cash by the predator company

· An acquisition might enable a predator company to defend its market

position/share

· A takeover might yield financial benefits in response to external economic changes

· An acquisition of a non-UK based business might provide an

opportunity for the predator company to enter foreign markets

· Globalisation has presented businesses with opportunities to join together to take advantage of global trading rather than focus on specific global regions

· An acquisition enables businesses to take advantage of economies of

scale Potential drawbacks of takeovers and mergers:

· The predator company may face hostile reaction or opposition to a takeover and this may draw negative publicity

· The takeover might not yield synergistic benefits as envisaged

· Takeovers tend to lead to culture clashes which require careful

management in order to succeed

· Takeover and merger activity is expensive, which results in customers being charged more for products at some stage

· Some takeovers may not be in the public interest and may be deemed

anti-competitive

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· A takeover could give rise to a small number of firms dominating the market resulting in loss of consumer confidence and greater regulation

· A takeover does not provide any guarantee against job losses

STABILITY

When firms are satisfied with their current rate of growth and profits, they may decide to use a stability strategy. This strategy is essentially a continuation of existing strategies. Such strategies are typically found in industries having relatively stable environments. The firm is often making a comfortable income operating a business that they know, and see no need to make the financial investment that would be required to undertake a growth strategy. Stability may also be the only option open to a business during a period of recession or economic downturn.

Retrenchment

Retrenchment involves a reduction in the scope of a business’s activities, which also generally leads to a reduction in the number of employees, the sale of assets associated with a discontinued product or service line, possible restructuring of debt through bankruptcy proceedings, and in the most extreme cases, liquidation of the firm.

· Firms pursue a turnaround strategy by undertaking a temporary reduction in operations in an effort to make the business stronger and more viable in the future. These moves are popularly called downsizing. The hope is that this temporary measure will allow the firm to pursue a growth strategy at some future point.

· A divestment decision occurs when a firm elects to sell one or more of the businesses from its portfolio. Typically, a poorly performing unit is sold to another company and the money is reinvested in another business within the portfolio that has greater potential.

· Bankruptcy involves legal protection against creditors or others allowing the firm to restructure its debt obligations or other payments, typically in a way that temporarily increases cash flow. Such restructuring allows the firm time to attempt a turnaround strategy.

· Liquidation is the most extreme form of retrenchment. Liquidation involves the selling or closing of the entire operation. There is no future for the firm; employees are released, buildings and equipment are sold, and customers no longer have access to the product or service. This is a strategy of last resort.

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Test Your Knowledge: · Explain what is meant by the term ‘business plan’. · Explain what is meant by the term ‘strategy’. · Explain what is meant by the term ‘hostile takeover’. · Evaluate the various types of merger which can occur in a business. · Evaluate the three strategies available to a firm.

Key Terms: Business Plan; Business Strategy; Objectives; SWOT analysis; PESTEL analysis; decision making; Ansoff matrix; Boston Matrix; Market Penetration; Product Development; Market Development; Diversification; Stars; Cash Cows; Problem Children; Question Marks; Dogs; Market Growth; Market Share; Growth; Stability; Retrenchment.

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Case Study: Read the following information and answer the questions that follow. The management team at Larne Harbour in Northern Ireland recently published a performance review in respect of the level of business undertaken at the port in recent years (see website). The notes/statistics summarise the results of key aspects of the operation of the business and issues likely to affect future operating performance, the key strengths and the challenges currently being faced, including its role in sustaining regional economic development. The management team at the Harbour reported the following:

1. a decline in passenger numbers using the facilities, falling from approximately 942,800 in 2007 to 893,722 in 2008;

2. a decline in commercial vehicles using the facilities, falling from 438,050 in 2007 to 404,320 in 2008;

3. a decline in tourist vehicles using the facilities, falling from 242,454 in 2007 to 230,383 in 2008;

4. use of a deep-water port, not subject to tidal restrictions benefiting shipping (unlike nearby ports);

5. continued support from parent company domiciled overseas. In addition to long-established ferry services operating from the port (to destinations such as Cairnryan, Troon and Fleetwood, the port has reported a change in market demand for the port facilities, such that cruise ships are going to/from the port as part of their international itineraries. The terminal building provides shops, car hire facilities, catering facilities and links to public sector transport services. It is estimated that 1.5m people live within a 2-hour drive of the port, and that a large percentage of Northern Ireland’s industrial base is located within an hour’s drive of the port. The port is also located about a 2-hour drive from the border with the Republic of Ireland (a strategic market for passengers and cargo). The challenges facing the port are numerous, including:

1. an out-of-town location; 2. only one access road to/from the port (A8) to the rest of the island; 3. a poor road transport infrastructure (the road directly into the terminal

requires upgrading to a dual carriageway standard); 4. the loss of passengers to other regional ports located nearby and also to

Dublin Port, as credible alternatives to passengers, ferry operators and shipping companies;

5. high levels of competition created with the provision of ‘no-frills’ airline services from various local airports.

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Questions: Q1: Explain what is meant by a ‘business plan’. Indicate two reasons why it is necessary for a business to prepare such a plan. Q2: List the main contents which are commonly found within a business plan, such as that prepared by the management team at Port of Larne. Q3: Prepare a SWOT Analysis and a PESTEL Analysis demonstrating how each would assist in making strategic decisions at the Port of Larne. Q4: Using relevant information, prepare an Ansoff matrix and a Boston Matrix as an aid to decision-making, using the Port of Larne as an example.

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Suggested Solutions (to include the following salient points): A1: Business Plan: a formal statement of a set of business objectives, the reasons why they are strategically attainable, and the plan for reaching those objectives. It may also contain background information about the business organisation (for example, Port of Larne) attempting to reach the objectives stated. In relation to Port of Larne, the reasons for the preparation of a business plan are that: (i) it would force the management team to review current operating and financial performance and set new targets for the budget period, e.g. consider how to reverse the decline experienced in passenger numbers as reported; and (ii) it would enable the management team at Port of Larne to make decisions in relation to how the business will operate in the next financial year, e.g. open 24 hours a day or restrict operations to 8 hours per day, thus limiting the number of ferry services available. A2: Contents of a Business Plan: The Business – this section will summarise the name/address of the business (Port of Larne Ltd, Larne); the aims of the business (port operator, facilitating shipping); type of business entity established (private limited company). Product/Service – this section will describe in summary format, the product/service being provided to the market (berthing facilities for shipping, terminal facilities for passengers/cargo and storage); the quantities to be provided (893,722 passengers, 404,320 commercial vehicles and 230,383 tourists). Market – this section will summarise estimates of market size (893,722 passengers, 404,320 commercial vehicles and 230,383 tourists); likely growth estimates of the market (942,800 passengers, 438,050 commercial vehicles and 242,454 tourists as per 2007 levels of demand); identification of likely customers (tourists, commercial vehicles and passengers); identification of likely competitors (Ports of Belfast, Warrenpoint, Derry and Dublin), strengths/weaknesses and challenges posed by them; alternative methods of promotion/advertising (national media and internet). Resources: Staff – this section will summarise the key personnel required to operate the business (management, employees, subcontractors and hauliers); the experience and skills likely to be possessed by workforce(shipping experience, port management experience and health/safety experience); details of working arrangements and compensation packages (e.g. salary levels, pension amounts, working hours, shift patterns, and holidays).

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Operational – this section will summarise the key decisions/issues to be taken in relation to functional areas of the business (port operations, berths – numbers and type, cargo and storage arrangements); types of premises required (warehouses, terminal, car parks); likely location of the business (port, harbour facilities); likely types, specifications and age of equipment required (fixed assets, e.g. berths, ramps, docking facilities, terminal building, IT equipment); policies to manage growth in business operations/market demand (e.g. organic growth policies). Financial – this section will summarise the key financial projections related to the business (budgeted revenues and profits); anticipated breakeven point in terms of quantities/revenues (per customer group, e.g. tourists, commercial vehicles and passengers); cashflow forecast summarising cashflows in/out and respective timing; banking arrangements; capital required; investment in fixed assets required; likely levels of debt (provided by the holding company – a private limited company domiciled overseas). A3: SWOT Analysis/Pestel Analysis: SWOT analysis: Strengths: (i) Port of Larne appears to have a large share of the sea transport market; (ii) Port of Larne has a deep-sea port; (iii) good reputation, attracting existing shipping companies, new shipping lines and cruise lines; (iv) links to public sector transport services. Weaknesses: (i) Port of Larne loss of customers to rivals such as other ports and airports on the island. Opportunities: (i) can grow passenger numbers by attracting international cruises; (ii) active role in regional economic development – storage/warehouse developments; (iii) increased market opportunities – 1.5m people live within a 2-hour drive of Port of Larne, and a large percentage of NI industry located within 1-hour drive from Port of Larne; (iv) re-establish the port as a gateway to European destinations. Threats: (i) lack of good road network – only one access road (A8); (ii) out-of-town location; (iii) emergence of Dublin, Belfast, Derry and Warrenpoint ports as credible alternatives to passengers/shipping companies.

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PESTEL Analysis: Political – government have not addressed the issue of improving the road infrastructure, meaning poor road transport links (A8) with rest of the island, which potentially impacts demand at the Port of Larne; closer development with public sector transport links would be of benefit; Economic - role of Port of Larne in regional economic development is favourable at present (cargo/passenger business); decision of shipping companies to operate at Port of Larne promotes environmental opportunities for greater economic development, as does the attraction of international cruise liners/tourists; Social – Port of Larne provides links to new destinations, acting as a gateway to UK and Europe, presenting opportunities for tourism, commercial vehicles and passenger travel; enable passengers to travel by sea more frequently; emergence of ‘no-frills’ airlines could possibly explain the decline in passenger numbers suffered by the Port of Larne as cheap airfares would tempt customers towards air travel rather than conventional ferries in order to save time;

Technological - key assets at Port of Larne’s disposal will sustain its competitive position into the future, including the fact that it is a deep-sea channel and not subject to tidal restrictions; Environmental - out-of-town location does not appear to present any issues in terms of noise or other types of pollution; Legal - it is assumed that Port of Larne operates to the highest safety standards, consistent with health/safety regulations.

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A4: Ansoff/Boston Matrix: Port of Larne Products

M Existing Market Penetration Product Development Low

A Shipping links to UK ports New UK destinations, R R Terminal facilities e.g. car hire current shipping lines I K Catering; Shops. Cruise Market S E Market Development Diversification K T New shipping lines; Cargo facility, High

S New New foreign Destinations

Corporate/terminal facilities

Low High Levels of Risk The above matrix will facilitate decision making in the context of Port of Larne, summarising the key product/market relationships. Boston Matrix – Port of Larne: High Market Share Low

STARS PROBLEM CHILDREN

High Established sea routes to Troon, Fleetwood, C/ryan. Cargo operations; new

Market Established Int'l sea routes: Cruise Liners, Shipping co’s serving

Growth Terminal facilities; UK/foreign Destinations

CASH COWS DOGS Low Global cruises e.g. Europe, USA. Public sector transport links; Established Domestic routes:UK. RORO facilities slower than air Short Term Parking The above matrix will facilitate decision making in the context of Port of Larne, summarising the key market share/market growth relationships of the product lines (port facilities) provided by the management team.

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DECISION TREE ANALYSIS Chapter Aims:

· Explain the purpose of a Decision Tree; · Identify and undertake related calculations; · Understand the nature of various decisions and expected values; · Understand the usefulness and limitations of using decision trees in

business.

© Zoonar/Thinkstock

Introduction: This chapter discusses key definitions related to decision trees, which may be used in support of decision making in a business, including an introduction to related terminology required to be used when preparing a decision tree diagram. Related to this is a discussion of various goals which might be pursued in the course of business. Decision Tree: A decision tree is a graphical representation of a decision making process within a business, which aims to highlight the most cost-effective decision. The tree-shape diagram represents various business decision making scenarios, whereby each decision has its own individual ‘branch’ on the tree, which in turn leads to additional branches representing outcomes that are possible given the alternative courses of action that could be decided upon. An outcome is given by: (i) a monetary value (estimated); and (ii) a probability (or likelihood) of occurrence. Monetary values are multiplied by the probabilities to yield an Expected Value, thus it is expected that the management team within a business will choose that action which yields the maximum expected value.

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Preparing a Decision Tree – General Terms: Decision Tree – shows the logical decisions which will occur over time Expected Value – the payoff associated with the chain of events/decisions already taken Nodes – intersections or junction points along the decision tree (usually referenced D1, D2 ….etc), represented as a square (box) or triangular shape Branch – arcs or interconnectors between the nodes Decision node – a branch leaving a given node, denoted by a square Decision Analysis Process – steps:

1 identify decision alternatives 2 identify states of nature 3 plot the values, calculate the results and determine payoff associated

with each decision alternative and state of nature combination 4 plot decision tree – drawn usually from left to right across the page

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The following diagram below illustrates the above terminology: Decision Tree Diagram - Terminology £ Expected Value Success 0.5 Failure 0.5

Branch £ Expected Value Decision Node

D1 £ Decision Value Branch D2 £xx

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Benefits and drawbacks of Decision Trees: Potential benefits of decision trees are: They are suited to situations in business where there appears to be a logical sequence of events They are suited to situations in the context of decision making where conditions of uncertainty exist They are highly effective in situations that are best represented by past similar events They are useful in terms of providing realistic estimates in financial terms of decisions to be taken in the context of new situations Potential drawbacks of decision trees are: Limited to the extent to which they account for uncertainty in the business situation Based on estimated data/information only Limited to quantitative information only, ignoring qualitative issues Key Terms: Decision Tree; Decision; branch; outcome; expected value; probability; weightings; sequence; events. Test Your Knowledge: · Explain what is meant by the term ‘decision tree’. · Explain what is meant by the term ‘probability’. · Explain what is meant by the term ‘expected value’. · State two reasons why businesses use decision tree analysis. · Evaluate Decision Trees as a tool for decision making

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Case Study: Read the following information and answer the questions that follow. Mourne Water Ltd bottle and distribute spring water from a natural spring located high in the Mourne Mountains in County Down. The management team are of the opinion that in order to compete in global markets, the product range must appeal to a wider variety of consumers. One product line is the sale of spring water (still) in 1 litre bottles. If this product line continues unaltered, the management team estimate that there is a 0.70 probability of annual sales falling to £50,000 and only a 0.30 probability that market share revenues might be maintained at the current level of £360,000. The still water product line can be modified slightly by introducing a new flavour (Blueberry & Elderflower). The cost of adding the new flavour to the product range is estimated to total £100,000. The management team need to decide on the amount of expenditure required to fund marketing activities aimed at increasing consumer awareness in domestic and global markets. The management team are of the opinion that a ‘minimal’ advertising campaign would cost £30,000 and have a 0.20 probability of success, raising annual sales to £600,000. If the advertising campaign was unsuccessful, sales of the new flavour are likely to be £300,000. Alternatively, spending £100,000 to extensively advertise the new flavour (Blueberry & Elderflower), the management team estimate that sales revenues will reach £1m if successful. Given the current strength of the brand, the management team estimate that there would be a 0.90 probability of this occurring, whilst failure of such an expensive advertising campaign is estimated to yield sales revenues amounting to £600,000. The management team are of the opinion that decision tree analysis might assist their marketing plans, as it will indicate the expected value of each decision, and provide an insight as to the most feasible outcome. Questions: Q1: Construct a decision tree using relevant information which would show the management team at Mourne Water Ltd the most favourable option open to them. Q2: Evaluate the usefulness of decision trees as a tool for making decisions, by a business such as Mourne Water Ltd.

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A1: Decision Tree Diagram – Mourne Water Limited £360,000 Success 0.3 £143,000 Failure 0.7 £50,000

Remains Unaltered

D1 £760,000 £600,000 Success 0.2 New Flavour -£100,000 Light £360,000 Touch Failure 0.8 Campaign D2 £860,000 -£30,000 £300,000 Extensive Campaign £1,000,000 -£100,000 Success 0.9 £960,000 Failure 0.1 £600,000

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A2: Evaluation: The use of a decision tree as a tool for decision making does have some advantages and disadvantages. The benefits of using decision trees include the following:

1. the management team at Mourne Water Ltd can use a decision tree effectively in a situation where a logical sequence of events can be followed, such as the events making up the projects;

2. the use of a decision tree by the management team at Mourne Water Ltd is suited to a project where there has been a similar past event, providing quantitative information and producing realistic estimates for a new situation, e.g. product promotion;

3. the use of a decision tree will facilitate the management team at Mourne Water Ltd to think logically about the proposed project – that is, addition of flavouring and advertising the product range;

4. the use of a decision tree will enable the management team at Mourne Water Ltd to sequence the proposed events and facilitate their planning in respect of production activities (i.e. facilitate addition of flavouring) and marketing (i.e. planning the promotion campaign);

5. the use of a decision tree will enable the management team at Mourne Water Ltd to assess the expected costs of success in addition to the potential costs of failure, e.g. of the promotional campaign.

The disadvantages of using decision trees include the following:

1. a decision tree will not consider all of the uncertainty facing a business such as Mourne Water Ltd – consumers may not acquire a taste for the flavour proposed, thus sales targets may not be achieved;

2. the information/data upon which a decision tree is based may be inaccurate/incomplete, which will limit the usefulness of it, as a tool for making decisions by the management team at Mourne Water Ltd, e.g. estimated demand for the product may not materialise due to incorrect sampling methods in the pilot;

3. a decision tree focuses only on the quantitative aspects of decisions made by the management team at Mourne Water Ltd (largely ignoring qualitative issues) – consumer tastes/dietary needs may have changed by the time the new product/flavour reaches the market.

Final judgement: it is possible to conclude that a decision tree is a useful tool which could be employed by the management team at Mourne Water Ltd, as an aid to making business decisions. Evaluation will be expected throughout this answer.

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CONTINGENCY PLANNING: Chapter Aims:

· Explain the nature of contingency planning within a business; · Identify and undertake related alternative courses of action; · Understand the information need for contingency planning.


Introduction: This chapter discusses key definitions related to contingency planning within a business, including an introduction to various short and long-term alternatives that a business might have open to it. Related to this is a discussion of various goals which might be pursued in the course of business. The nature of financial information published by large companies is considered. Contingency Plan: A contingency plan is an alternative course of action which a business entity might follow if the original plan or actual business activity does not conform to expectations or is disrupted in some way.

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Reasons for Contingency Planning: Contingency Planning usually occurs as a result of unforeseen circumstances or unresolved problems which face a business organisation from time to time. The following is a list of examples of problems or issues which often give rise to contingency plans: Financial – a business may face cashflow problems and in the long term face bankruptcy. Issues which give rise to cashflow problems include too much money tied up in stock which is slow to turn over, too much money tied up in debtors which is not being recovered quickly enough and funding growth (or purchase of non-current assets) using available cash resources which will therefore reduce the amount of cash available for working capital requirements. Production orientated – a business may face problems if a key piece of equipment is not available or broken down. This could lead to a failure to meet production output targets and therefore orders received. The adoption of JIT methodology places increasing reliance on suppliers which might force a business to find alternative suppliers or source cheaper material for use in production, which in turn might reduce quality. Human resource orientated – a business may face industrial relations problems if industrial action takes place, which usually leads to an inability to continue production activities in order to meet sales targets. Availability of staff with specialist skills or knowledge might present problems leading to an inability to meet key objectives. Environmental – a business might face environmental issues if the activities undertaken in support of key objectives face opposition from various stakeholder groups. Common examples in this context also include pollution (noise, air and water), moral and ethical issues which a business is often forced to consider at the request of various stakeholder groups. Corporate – a business might face problems in common with its industry rivals, which affect it at every level. A classic example is the liquidity problems facing the banking industry in the UK, which has led to a number of key financial institutions receiving funds from the UK taxpayer, thus placing private enterprises into public ownership through the process of nationalisation. Legal – a business might face problems if specific products within the product range are deemed to be unfit for sale or are the subject of nationwide recalls due to poor quality. Situations such as these often lead to litigation and damage the reputation of a business which make it difficult to meet key objectives. Marketing – a business might face problems as a result of any individual issues arising from the above functional areas within the business or a combination of

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such issues. Such issues in turn might cause difficulties in relation to the achievement of marketing, promotion and public relations objectives for the business entity. Advantages and Disadvantages of Contingency Planning: There are a number of benefits to be gained from drawing up contingency plans. These include: It forces the management team to consider alternative courses of action in the event of disruption or deviation from original plan It provides the management team with an alternative method of achieving key business objectives It facilitates the business decision making process and enables management to negotiate the optimum deal in the interests of the business There are a number of disadvantages drawing up contingency plans. These include: It is time consuming and costly It may never be implemented which may be a waste of resources It relies on possible forecasted events that may not be accurate

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Contingency Plan Elements: In a situation whereby a business cannot proceed with the original plan, an alternative plan – or contingency plan may be adopted. The precise contents of a contingency plan will depend on the specific issue(s) facing a business at a given time, however, the following is a summary of some of the key decisions the management team within a business will consider as part of a contingency plan: Finance – within the context of liquidity problems in the short term, this might include the use of reserves to fund working capital requirements or seeking alternative sources of funding for long term projects, e.g. leasing, hire purchase. It might also involve radical changes to the working capital policies of the business in relation to stock (in order to reduce stockholdings or the value of stocks held), debtors (in order to reduce both the value of debtors outstanding and the time taken to collect monies) and cash (a cash budget might be prepared analysing potential cash surpluses/deficits. This might enable the business to meet key objectives.

Production – within the context of using JIT systems a business might wish to consider the use of alternative arrangements within the supply chain – it might for example reduce reliance on one particular supplier to supply materials, thus seek alternative suppliers, source alternative cheaper quality materials, seek improvements in terms/conditions of supply of material in order to meet key objectives. Human Resources – the resolution of staffing issues will usually involve negotiation aimed at addressing the issues causing a deviation from original plan. Examples of such discussions might lead to increased rates of pay for staff, reductions in working hours, adoption of flexible working arrangements or improved productivity, all of which are aimed at enabling the business to meet key objectives. Marketing – within the context of a contingency plan, the marketing activity will likely focus on seeking improvements in the public relations profile of the business, improving the corporate image, providing reassurance to stakeholders, restoring confidence in the management team to resolve any outstanding issues. Ways in which such objectives might be achieved include use of national media, such as advertising campaigns using television, radio, newspaper and internet. Management – a contingency plan should ensure that the corporate policies an organisation follows lead to towards the achievement of key business objectives. Sometimes this might necessitate a change of personnel within the top management team, the introduction of new corporate policies aimed at reducing costs, increasing financial stability and responding to issues which cause public concern, e.g. continued payment of financial bonuses in the event of business

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failure, or award of above-inflation pay increases to members of the top management team when other staff are awarded zero percent increases in pay.

Key Steps: The following are the main steps within a contingency plan: Establish Start Position – identify critical issues and identify alternative courses of action Assess Potential Impact – analyse the critical success factors and likelihood of success Formulate Plan – formulate and select most feasible plan, involve relevant stakeholder groups Test Plan – develop a test plan or pilot actions to be taken under contingency arrangements, ensuring stakeholder involvement and undertake post-audit Undertake Training – brief all stakeholders on alternative courses of action necessary in the event of implementation of a contingency plan and facilitate training and development to ensure achievement of successful outcome Maintain Planning Process – ensure that contingency plan is kept up-to-date and relevant Update/Amend Plan – ensure that contingency plan is feasible keeping it under review and feedback into each of the relevant steps The adoption of the above process should result in minimisation of risk to the business entity and enable it to cope with any contingencies that should arise. Key Terms: Contingency Plan; Crisis; Failure; Confidence; Goals; Alternative courses of action.

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Test Your Knowledge: · Explain what is meant by the term ‘confidence’. · Explain what is meant by the term ‘crisis’. · Explain what is meant by the term ‘alternative courses of action’. · State one reason why businesses should undertake contingency planning.

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Case Study: Read the following information and answer the questions that follow. Go&Fly Airport is located in the Northern Ireland countryside. Go&Fly Airport is operated by a private company. The strategic location of the Airport means that it is a key transport gateway for the travellers to/from various national and international destinations, including London, Liverpool and Spain, achieved through the provision of scheduled and charter services. In addition, the Airport makes a valuable contribution to inbound tourism, as measured by increasing numbers of tourists using the airport facilities. The location of the airport means that it is convenient for passengers travelling from the Republic of Ireland. The management team believe that the catchment area reaches south to Sligo and Galway, placing it in competition with other regional airports closer to Belfast. Management were recently criticised for lax safety standards in operation at the Airport, following an enquiry by an aviation consultant on behalf of the regulatory authority, the CAA. As a result of the findings of this investigation, the Airport was forced to close for a period of approximately 5 days during 2007, to facilitate completion of essential repairs to the runway and other facilities. The closure of the Airport, which was widely reported in the media at the time, caused major disruption to the business operations and travel arrangements of many stakeholders, including airlines (as customers of the Airport), airline passengers, airline staff, the general public, airport staff, subcontractors, and neighbouring communities. Given the extent of the closure and the effect it had on stakeholders, it could be suggested that there was no evidence of ‘contingency planning’ at the Airport to deal with the situation. Questions: Q1: Define the term ‘Contingency Planning’. Q2: Explain two reasons why the management team at Go&Fly Airport should undertake contingency planning. Q3: Analyse the potential impact that the temporary closure of Go&Fly Airport is likely to have on any three stakeholder groups. Q4:Evaluate the key elements of a ‘contingency plan’ which might be used by the management team to deal with the temporary closure of Go&Fly Airport.

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Suggested Solutions (to include the following main points): A1: Contingency Planning: this is generally taken to mean an alternative set of plans drawn up by the management team of an organisation which may be implemented in the event that an original plan does not proceed as intended. The management team at Go&Fly Airport would be expected to undertake contingency planning in the event of an emergency situation or breach of safety regulations at the airport. A2: The management team at Go&Fly Airport should undertake a degree of contingency planning for various reasons such that: (i) it enables the management team to respond quickly and decisively to any deviations from the original plan, e.g. undertake repair work to runways to ensure high standards of air safety; and (ii) it enables the management team to make decisions in response to a crisis situation which may occur, e.g. the temporary closure of the airport based on the recommendations of an aviation consultant. A3: The temporary closure of Go&Fly Airport is likely to impact various stakeholder groups in the following ways: Airlines: the closure would cause major disruption to the business operations and travel arrangements of airlines (as customers of Go&Fly Airport). Aircraft are typically used on other routes after they have departed from an airport, thus any aircraft grounded cannot fly, or any aircraft diverted to another airport will disrupt the operations of the airline. Passengers: the closure would cause major disruption to the travel and holiday plans of passengers, since they will have booked flights to arrive at their destinations, for example for job interviews, football matches, holidays and other family matters. The closure will cause delays and result in cancellations and/or additional costs as families may rebook on alternative flights from neighbouring airports, which in turn means additional travel, time and costs. Management Team: the closure would cause major problems for the management team, as they will be required to address the key issues of health and safety, safety in the air, restoring the reputation of the airport in relation to other stakeholder groups, restoring confidence of the owners in the operation of the airport and the general public that air travel is safe. The closure would also have meant that Go & Fly Airport lost sales revenues.

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A4: Contingency Plan Elements: Elements of a Contingency Plan: it is suggested that normal procedure for contingency planning includes issues such as: (i) examining potential crisis situations; (ii) planning for each crisis; (iii) test the plan, e.g. special training event, simulation etc. It would have been expected that the management team at Go&Fly Airport would have involved key functional areas of the team in resolving the issue of the closure, including marketing, human resources, finance, and business operations. Some key tasks which the respective departments would have been expected to undertake would typically have included the following: Marketing: (i) the issue of press releases to keep key stakeholder groups abreast of developments; (ii) the issue of guidance to travellers to assist them to make alternative travel arrangements; (iii) the deployment of alternative air services using other regional airports; (iv) the use of public relations in managing the closure and eventual re-opening. Human resources: (i) facilitate the identification of key personnel required to remedy the breach in safety standards; (ii) facilitate the training of key personnel required to manage the closure and eventual re-opening; (iii) arranging for the subcontracting of remedial work using suitable personnel. Finance: (i) the finance function will ensure provision of sufficient finance to undertake the remedial work to attain safety standards; (ii) the finance function will ensure provision of finance to meet the expenses/costs of the closure and marketing activities required to support alternative transport arrangements by stakeholder groups; (iii) the finance function will facilitate the completion of an audit into the closure in order to avoid any further closures. Business operations: (i) this function will monitor the remedial work and ensure that the work meets safety standards; (ii) this function will oversee the health/safety requirements demanded of Go&Fly Airport in respect of aviation safety and health/safety at work laws; (iii) this function will assist in reinstating normal business operations once the airport reopens. Evaluation will be expected throughout this answer.

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COMPANY ACCOUNTS: Chapter Aims:

· Explain the nature of the financial statements of a business; · Identify and undertake related calculations; · Understand the information contained within the financial statements of a

business entity; · Understand the usefulness and limitations of using published accounting

information.


Introduction: This chapter discusses key definitions related to the accounting statements of a business, including a discussion of the extent to which financial statements are useful for making business decisions. The nature of financial information published by large companies is considered. Financial Statements: The financial statements are the documents which summarise the financial position of a business entity.

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Reasons for Financial Statements: There are a number of reasons why a business would draw up financial statements. The primary reason why financial statements are prepared is that they enable the management team to summarise the financial position of a business entity at the end of the accounting period. The extent to which the financial statements are useful can be illustrated with reference to various stakeholder groups who are likely to have an interest in the business: The owners of the business (shareholders) will want access to more detailed financial information regarding the financial position of the company at the year end. This includes reference to revenues and profitability (income statement) and the net worth of the business (summarised in terms of assets and liabilities within the statement of financial position). This enables shareholders to evaluate the extent to which the management team have operated the business on their behalf, i.e. performed their stewardship function.


Government agencies will require access to the financial statements in order to verify the extent of the company’s liabilities to various forms of taxation and duties, including corporation tax, income tax, VAT, excise duties and other taxes

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including rates and taxes related to specific industries which the company is obliged to collect on behalf of government, e.g. insurance premium tax. This enables management to act in the best interests of shareholders by minimising tax liabilities.


Financial institutions will require sight of the financial statements in order to verify the overall financial position of the business within the context of providing debt finance. This is important for two reasons as the lender will want: (i) evidence of the company’s ability to meet interest payments (highly profitable); and (ii) evidence that the company is a secure investment, i.e. has sufficient cashflows to meet regular payments and a sufficient asset base in order to provide security for a loan. This enables the management team to obtain finance at a reasonable cost to the business in order to fund business activities.

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Staff/employees will want access to the financial statements in order to form an assessment of the financial position, with a view to: (i) securing continued employment; (ii) securing improved terms/conditions of employment and; (iii) participating in improving productivity and working conditions generally. This enables management team to secure the best possible use of human resources in order to meet key objectives.

© Photos.com/Thinkstock

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Suppliers might wish to gain sight of the financial statements in order to inspect the financial position and therefore make decisions regarding the creditworthiness of the company. This is important as it allows the management team to secure access to resources based on agreed terms and conditions with suppliers, which in turn allows the business to meet the needs of customers and key objectives. Effective supply chain management requires close co-operation between suppliers and the business, hence this might facilitate such developments for the benefit of all stakeholders.

© Goodstock/Thinkstock

Investors might wish to gain sight of the financial statements in order to facilitate their decisions with respect to acquiring an interest in the business. The financial statements should provide an indication of profitability, solvency and enable investors to perform basic ratio analysis in order to decide if the company is a worthwhile investment. This decision will be confirmed with other information related to the company, e.g. annual reports, stockbroker comments.

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The Management Team will rely on the financial statements for a number of reasons: To determine the profitability of the business during the financial period and facilitate a comparison with previous accounting periods and/or budgets To facilitate a review of the financial position in terms of the assets/liabilities held by the business and provide guidance in relation to effective working capital management To enable decisions to be taken in relation to all aspects of the financial position of the business, for example, implementation of cost reduction programmes, evaluation of capital projects, determination of cashflows to fund growth To allow the management team to determine the financial resources available to achieve key objectives, for example, to facilitate a takeover the business needs to secure access to funds to complete the deal; to block a hostile takeover, the company might need to verify that the bid received significantly undervalues the business

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Financial Statements:


This section outlines the purpose and nature of some of the key financial statements which are normally produced within a business for the purposes of financial reporting. It is important to recognise that a key aim of operating in business is to make a profit. Financial reporting in concerned mainly with recording financial transactions and presenting the summarised results of all such transactions in a set of financial statements comprising the Trading, Profit and Loss Account and Balance Sheet and for larger organisations, a Cash Flow Statement. Financial reporting tends to be historical in nature, focusing on financial transactions which have already occurred within the financial year under review. The purpose of the financial statements is to summarise the financial position (Statement of Financial Position) of a business in terms of its assets/liabilities and profitability (Income Statement). The documentation of all financial transactions within the financial statements will assist a review of the financial performance of the business. A business entity will often find that a number of users will make reference to the financial statements, including for example, business owners, bank officials, government officials, investors, members of the public and other stakeholders, each of whom will use the information provided for their own purposes, e.g. lending decisions

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(owners and lenders), agreement of tax liabilities (government) and provision of capital (investors). A business entity is required to prepare financial statements covering a specific time-period during which the business traded – referred to as an ‘accounting period’. This is normally taken to be a period of one year and can also be referred to as the ‘financial year’. Within a UK or N. Ireland context, many businesses adopt the calendar months of December or March as their financial year-end - this is an important decision to be taken by the top management team, as it will determine the period during which a business will be liable to taxation on the profits reported. A Public Limited Company (plc) is required to provide detailed information in respect of the financial position, considering items such as interest on loans, taxation, dividend payments and other matters including for example, transfers to reserves. In all cases, the most common approach adopted is to present the financial statements in a ‘vertical format’ (layout).

Final Accounts: The Financial Statements are often referred to as the ‘Final Accounts’, which include the Income Statement and the Statement of Financial Position. The Income Statement:


In simple terms, the Income Statement summarises the results of trading (continuing) operations. The main expenses of the business are deducted from

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sales revenues and a profit/loss after tax reported initially. Some businesses may also report profits/losses arising from operations which have been discontinued during the financial year. The end result is to report a profit or loss for the financial period under review, in addition to a key financial measure – earnings per share. The Income Statement is normally used to show the financial results from trading operations. The purpose of this statement is to determine, by calculation, the Gross Profit/Loss for the accounting period. In its simplest form, this account also summarises any additional revenues or expenses of the business for the accounting period and shows the overall Profit/Loss before and after taxation, for the accounting period. Statement of Financial Position:


In simple terms, the Statement of Financial Position summarises the assets, liabilities and capital of a business at a particular date. Such statements differ from the Income Statement in that, the financial position of the business is shown as at a specific point in time, which could change within a short timeframe thereafter. A Statement of Financial Position is sometimes referred to as a ‘snap-shot’ of the business finances at a given point in time.

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A Statement of Financial Position typically lists the following information: Non-Current Assets: amounts representing items owned by the business, such as premises, vehicles, fixtures and fittings and are generally held over the long term. Current Assets: closing inventories, amounts paid in advance, trade receivables, cash, money deposited in the bank. Current Liabilities: amounts representing items owed by the business, such as trade payables, bank overdrafts Non- Current Liabilities: amounts representing items owed by the business over the long term, including debentures (loans) and other forms of debt finance to the providers of capital. Share Capital: amounts representing the monies invested in the business by the owners, including any profits accumulated over previous accounting periods. The Authorised Share Capital is the amount of capital the company is legally allowed to raise. The Issued Share Capital is the amount of capital the company has actually raised and allotted shares for. The total number of shares issued by the company may be stated, including the types of share (ordinary or preference) and nominal value of the shares issued may be disclosed. Reserves: amounts representing the accumulated profits/losses which belong to the members of the company (shareholders). Examples include General Reserve and/or Profit/Loss Reserve – these reserves can be used to pay dividends to shareholders at the discretion of management. A Share Premium is an additional amount of money a company receives upon issue of shares for the first time. It arises when the issue price is greater than the nominal value of the shares, and is common if the shares are popular or oversubscribed (i.e. too many shareholders apply for shares compared to the number of shares available for allotment). A share premium is an example of a ‘non-distributable’ reserve, which means that it cannot be used to pay dividends to shareholders unless permission is granted by a court. It is important to note that not all the profits may be distributed by a company in any one accounting period. The closing balance on the Appropriation Account (if published) is sometimes referred to as a ‘Profit and Loss Reserve’. Sometimes a limited company may wish to retain profits and transfer these to a ‘General Reserve’. Both types of reserves are shown in the Capital section of the balance sheet. Taxation: Since a limited company is a separate entity from its shareholders, it differs from sole traders in that it must pay ‘Corporation Tax’ on the profits made during an accounting period. In terms of the preparation of the financial

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statements there is a requirement that expenses for taxation must be shown within the Profit and Loss Account. The amount which the company has to pay by way of Corporation Tax is determined each year by the government at the rate laid down in law. The amount of tax to be paid is recorded in the Profit and Loss Account after the interest payments to debenture-holders have been stated. The payment of the tax will normally occur within nine months after the financial year end, and thus the tax due for payment will also be recorded within the ‘Current Liabilities’ section of the balance sheet. Dividends: The return which a shareholder can expect on their shares (i.e. investment in the company) is referred to as a Dividend. Sometimes a company can pay a dividend half-way through a financial year, which is referred to as an ‘interim’ dividend. Normally, a dividend is paid after the financial year end when the profits are known (where a company pays an interim dividend, the dividend declared at the financial year end will be referred to as a ‘final’ dividend). Normal procedure is that the dividend is ‘proposed’ by the directors (hence recorded in the Appropriation Account) and paid after the dividend has been approved by shareholders at an Annual General Meeting (hence recorded it is also recorded within the ‘Current Liabilities’ section within the Statement of Financial Position).

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The following example shows an example of a public limited company’s Financial Statements. Using the data within the Trial Balance stated within the example: Example: ‘Bangor Eye-Pods’ plc, located in Bangor, producing and selling the latest hand-held video games throughout Europe. The following is a trial balance for the financial year ended 31st December 2012: Dr Cr £’000 £’000 Authorised and Issued Share Capital (£1) ordinary shares 3000 Sales 5900 Purchases 500 Opening inventory 100 Selling & Distribution Costs 300 Administration Expenses 200 Debenture Interest 100 Premises 2000 Vehicles 5000 Equipment 1000 Debentures 1100 Retained Earnings 0 Bank 800 10000 10000 Notes: 1. Closing inventory is valued at £100,000 2. Proposed Dividend is £600,000 3. Corporation Tax should be provided for, amounting to £400,000

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Suggested Solution: Bangor Eye-Pods plc Income Statement for the year ended 31st December 2012.

£’000 Sales Turnover 5,900 Cost of Sales (500) Operating Profit 5,400 Selling & Distribution Costs (300) Admin. Expenses (200) Profit before interest and tax 4,900 Interest on loans (100) Profit before tax 4,800 Tax (400) Profit after tax 4,400 Bangor Eye-Pods plc Income Statement as at 31st December 2012 NBV £’000 Non-current Assets Premises 2,000 Vehicles 5,000 Equipment 1,000

8,000 Current Assets 900 Total Assets 8,900 Equity Authorised and Issued Ordinary Share Capital 3,000 Retained Earnings 3,800

Capital Employed 6,800 Non-Current Liabilities Debentures 1,100

1,000 Total Equity and Liabilities 8,900

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Note: Profit & Loss Appropriation Account £’000 Opening Balance 0 Add Profit after tax 4,400

4,400 Less Dividend proposed (600) Closing Balance 3,800

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Accounting Concepts:


A number of basic assumptions are normally adopted when preparing a set of financial statements. These are often referred to as ‘Accounting Concepts’. The accounting concepts, when applied to a set of company accounts attempt to make the accounting information more relevant, useful, timely and easily understood. Consider the following: Going Concern: the business is assumed to ‘continue in operation for the foreseeable future’. In other words there is nothing to indicate during the preparation of the financial statements, that the business will cease to exist unless otherwise stated. Practically speaking, this means that assets (e.g. inventory, non-current assets) are valued at cost on the assumption that they are worth a greater amount. Should the business cease to exist, such values would be stated at realisable value (i.e. the value at which they could be sold). Accruals Concept (Matching Concept): this concept establishes the principle that, in the determination of an accurate financial position, revenues and costs related to the business must be recorded when they are earned or incurred, as opposed to when the monies are received or paid. Thus, the income statement is prepared for an accounting period, during which all revenues must be matched to the costs incurred in generating such revenue streams for the business.

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Consistency: the principle involved in this context is that, when preparing the financial statements, a consistent approach must be taken when adopting/implementing accounting policies (e.g. inventory valuation methods adopted, depreciation methods used). This applies to recording transactions and measuring items. Prudence: this concept requires that when preparing the financial statements, it is prudent to recognise revenue only when it is realised in an acceptable form whilst allowing for all expenses and losses as soon as they are known about. Accounting adjustments are often made to the information contained (balances)

within the Trial Balance. There are a number of reasons for such adjustments,

including (i) accounting for timing differences between the matching of costs/revenues in an accounting period; and (ii) various events will occur immediately after the

financial year- end which require inclusion in the financial statements, e.g. inventory valuations

to derive closing inventory values. Additional adjustments in terms of limited company

accounts are required to incorporate items such as corporation tax due and unpaid, and

dividends proposed.

Limitations of Published Financial Statement Information: Public limited companies are required by law to publish their financial statements, usually on an annual basis for the benefit of shareholders. Whilst this may be seen as useful in some respects, the publication of such information does have its limitations. Consider the following: The publication of such information by a company usually takes place at least three months after the financial year end, hence some of the information may be out-of-date, therefore not reflecting economic reality It is difficult for users of the financial statements to fully understand the contents of the financial statements, since many of the figures quoted are subject to manipulation and summary reporting techniques, meaning that it is impossible for an external stakeholder to gain a full understanding of the financial position The publication of the financial statements by themselves concentrates mainly on the quantitative issues affecting the business and is therefore limited. Public limited companies are however, obliged to publish additional information such as an annual report, an economic outlook and governance statements which could mean that users suffer information overload

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It is difficult for users to compare the financial performance with other companies, since each company tends to adopt their own accounting policies, which mean that some companies may account for some expenses differently from others, making it difficult to determine precisely the profitability and solvency of the business The publication of financial statements implies that a company is subject to closer public scrutiny, therefore it is forced to reveal a summary financial position, providing some information regarding its business affairs, which might be useful to competitors or a predator company in a takeover situation The financial statements do not disclose all the intimate details about a company’s financial position nor does the statutory audit guarantee the future of the business. Illegal practices such as fraud, money laundering and similar activities might go undetected leaving the company exposed to bankruptcy or criminal proceedings. Key Terms: Company Accounts; Accounting Statements; Turnover; Sales; Operating Profit; Profit Before Tax; Taxation; Profit After Tax; Interim Dividend; Proposed Dividend; Interest; Non Current Assets; Current Assets; Current Liabilities; Long Term Debt; Share Capital; Profit and Loss Reserve; Share Premium; General Reserve; Capital Employed; Shareholders; Debentures. Test Your Knowledge: · Explain what is meant by the term ‘financial statements’. · Explain what is meant by the term ‘net profit’. · Explain what is meant by the term ‘share premium’. · Evaluate the use of Published Financial Accounts

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Case Study: Read the following information and answer the questions that follow. The following is the summarised financial data related to two companies operating within the financial services sector of the Northern Ireland economy.

Company YAH plc HAH plc Financial Year ended: 31st December

2012 31st December

2012 £m £m Sales Revenue 17.8 893.1 Profit Before Tax (Operating Profit)

3.2 17.1

Taxation 2.2 3.0 Dividends 1.0 14.1 Retained Earnings 0.0 0.0 Non-Current Assets 72.9 264.6 Current Assets 2.1 96.7 Current Liabilities (10.0) (115.0) Long Term Debt (Debentures) (18.6) (1.9) Net Assets 46.4 244.4 Issued Share Capital (20p shares)

1.4 15.8

Profit and Loss Reserves 45.0 228.6 Capital Employed 46.4 244.4

Question’s: Q1: Outline two reasons why it necessary for public companies to prepare accounting statements. Q2: Explain the financial position as revealed by the summarised financial statements of YAH plc and HAH plc. Q3: State three limitations of using information contained within the published

accounting statements. Q4: Discuss three ways in which published accounting statements might be

useful for making investment decisions, by investors (shareholders) in companies such as YAH plc and HAH plc.

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Suggested Solutions (to include the following main points): A1: Public limited companies such as YAH plc and HAH plc are required to prepare accounting statements for the following reasons: (i) there is a legal requirement for public limited companies to publish annual financial information for the benefit of shareholders, to inform them of the financial position of the company in which they have invested funds (i.e. to determine if their investment has been worthwhile); and (ii) to enable investors and other stakeholder groups to hold management to account and monitor financial performance of the company (i.e. check on management’s stewardship of financial resources). A2: Key aspects of the financial position of YAH plc and HAH plc, for the financial year ended 31st December 2008:-

· YAH plc and HAH plc employ different sources of funding, including equity and debt finance. YAH plc is financed by 7,000,000 20p shares, whilst HAH plc is financed by 79,000,000 20p shares. This analysis assumes use of Ordinary shares, constituting the share capital for each company. It is also assumed that the Authorised Share Capital is equal to the Issued Share Capital.

· Each company is financed by profits which have accumulated over previous financial periods (represented by Profit and Loss Reserves), amounting to £45m and £228.6m for YAH plc and HAH plc respectively. The Profit and Loss Reserve is an additional element of Shareholders Equity and thus is attributable to them in the event of a distribution by way of dividends.

· The summarised financial data outlines how the capital employed has been represented throughout the business. The Fixed Assets (which are expected to be made up of premises, equipment, vehicles and similar assets), figures for YAH plc and HAH plc are £72.9m and £264.6m respectively, which are in excess of the shareholders funds in each company, suggesting that each business is ‘asset rich’ - such assets help each business function in the long term.

· The Current Assets of each company are £2.1m and £96.7m for YAH plc and HAH plc respectively, typically represented by assets held in the short term, such as stock, debtors, prepayments, bank deposits and cash.

· With regard to the Current Liabilities, which would include items such as creditors, accruals and bank overdraft, this amounts to £10m for YAH plc and £115m for HAH plc respectively.

· Each company also uses long term debts in order to finance elements of their business operations, possibly including acquisitions of assets. YAH plc have borrowed £18.6m, whilst HAH plc have borrowed £1.9m – typically represented by Debentures.

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· The Net Assets figure for each company is the summation of the figures for Fixed Assets, Working Capital and Long Term Debt (that is, £46.4m for YAH plc and £244.4m for HAH plc).

· The Capital Employed also totals an equivalent amount (£46.4m for YAH plc and £244.4m for HAH plc).

· With respect to the summarised Income Statement, the turnover (Sales Revenues) reported by each company amounted to £17.8m and £893.1m for YAH plc and HAH plc respectively. This figure is well in excess of Cost of Sales (not reported), as the Profit Before Tax (Operating Profit) figures are positive at £3.2m and £17.1m respectively for YAH plc and HAH plc.

· Corporation Tax is paid on the profits of each company, hence the expense as stated, amounting to £2.2m and £3m respectively for each company (YAH plc and HAH plc).

· Each company paid dividends to their shareholders for the financial year, representing a return on investment (shareholders) – this is also deducted from the operating profit, amounting to £1m and £14.1m for YAH plc and HAH plc respectively. On a per share basis, the dividend amounted to approximately 14.3 pence for the shareholders of YAH plc, whilst the corresponding amount was approximately 17.9 pence for the shareholders of HAH plc.

· As a result of the deduction of taxes and dividends from operating profits in each company, the Retained Earnings for the financial year under review amount to zero in each case (which in turn is included in the Profit and Loss Reserve data).

A3: Three limitations of published financial statement information:

(i) In relation to companies such as YAH plc and HAH plc, it can be difficult to undertake comparisons with quoted companies in the same industry due to the use of different accounting policies in each company. This may be considered a drawback to investors in particular;

(ii) Individual companies such as YAH plc and HAH plc are required to publish further reports, such as directors report, cash flow statement and notes to the accounts for consideration of investors, which in turn make it difficult to draw comparisons and absorb information quickly for investment decision making. This may be a drawback to investors in particular;

(iii) The publication of financial statement information does not reveal in complete detail, the financial position of an individual quoted company such as YAH plc and HAH plc. This might be a problem for some stakeholder groups.

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A4: Three ways in which published financial statement information might be of use to shareholders in the context of making investment decisions:

(i) In relation to YAH plc and HAH plc, publication of such information will communicate to investors information about the ability of the management team of each company to operate the business efficiently and effectively (i.e. the extent to which the stewardship function has been exercised). This is likely to be of benefit to investors as they can decide if it is worthwhile to continue to invest in either company;

(ii) In relation to YAH plc and HAH plc, the published financial statements of quoted UK companies are audited independently, thus are more likely to be relied upon as a guide, to the financial performance of each of the respective companies. This is likely to be of benefit to shareholders as it enables them to form an opinion as to the long term growth/income prospects of each company under consideration;

(iii) In relation to companies such as YAH plc and HAH plc, the published financial statements will assist quoted companies in acquiring debt financing, as lenders can assess the financial stability and profitability of an individual company, however this might be a problem for shareholders as the more highly geared a company becomes, the more risky an investment it is since debts levels increase as does the amount of interest to be paid, which in turn has the effect of reducing profits – the publication of such information enables shareholders to monitor this issue.

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RATIO ANALYSIS: Chapter Aims:

· Explain the nature of ratio analysis as used in business; · Identify and undertake related calculations; · Understand the information contained within the financial statements and

posited by a set of accounting ratios of a business entity; · Understand the usefulness and limitations of using ratio analysis to

interpret accounting information. Introduction: This chapter discusses key definitions related to ratio analysis, including an introduction to various issues which are likely to emerge from conducting ratio analysis using a set of published financial statements. Related to this is a discussion of the likely areas for decision making, which might be relevant within the context of a business. The usefulness of accounting ratios is also considered. Ratio Analysis: Accounting ratios attempt to explain additional aspects of the financial position of a business entity not revealed by the publication of financial statements on their own. Accounting Ratios: There are a number of financial objectives which a business is likely to have. Such objectives change over time depending on the circumstances of the business, however accounting ratios can assist decision making on the part of various stakeholders, when analysing financial performance of a business. Performance Ratios: Users of financial statement information are required to assess/review the financial performance of a business entity. This is carried out with reference to the figures contained with the financial statements and involves calculating and analysing ratios derived from the financial data. The key areas of interest to users of financial statements include aspects of performance, liquidity, gearing and shareholder ratios. Consider the following:

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Performance Ratios: Indicators of financial performance are of interest to business owners and others since, in the first instance, the concept of profit is easily understood. Examples of users who are interested in the profitability of the business include owners, lenders, tax authorities and staff. There are a number of ratios which can be used in this context.

Return on Capital Employed: This is often referred to as the ‘primary ratio’ – it is generally the first ratio calculated when analysing the financial performance of a business. The ratio compares the operating profit to the capital invested in the business acting as a benchmark of returns on investments, facilitating comparisons to be drawn with other forms of investment, e.g. interest received on bank deposits.

The formula used to calculate the return on capital employed is:

(Profit before Tax + finance costs +preference dividends) (Total Assets – Current Liabilities) x 100% =

R.O.C.E. (%)

Note: within the context of limited company accounts, the recommended profit figure that should be used to calculate this ratio is the ‘net profit before interest and tax’ figure. The rationale for this is that managers/business owners cannot be held accountable for tax charges (since they are imposed by government), but they can be held accountable for profits accumulated before the impact of taxation.

Gross Profit Margin (Percentage): This ratio indicates the profitability of trading operations. The Gross Profit is calculated by deducting the Cost of Sales from Sales revenues, and represents funds available to meet the operating expenses of the business. The formula used to calculate the Gross Profit Percentage is:

Gross Profit

Sales Revenues x 100% = GP %

As a guide, the gross profit percentage should be reasonably consistent year on year. Substantial differences in this ratio could indicate problems with inventory management, purchase costs and/or sales performance.

Note: within the context of limited company accounts, the equivalent figure that may be used is ‘Operating Profits’ – this is dependent upon the information available.

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Net Profit Margin (Percentage): This ratio indicates the profitability of running the business. The Net Profit is calculated by deducting the total expenses from Gross Profit, and will indicate how successful the business is with respect to managing costs and keeping costs under control. The formula used to calculate the Net Profit Percentage is:

Net Profit

Sales Revenues x 100% = NP %

As a guide, the net profit percentage should be reasonably consistent year on year. Substantial differences in this ratio could indicate problems with cost management and expenses.

Note: within the context of limited company accounts, the equivalent figure that may be used is ‘Profit before Interest and Tax’. Liquidity Performance: Indicators of liquidity are important since they provide an indication of the ‘solvency’ of the business (i.e. the ability of the business to pay its debts). The business owner will want to be reassured that the business is solvent. Lenders will want to check the solvency of the business before granting loans, in order to safeguard their funds. There are a number of ratios that may be used in this context: The Current Ratio: The data for this ratio is drawn from the balance sheet. It compares the total of the current assets to the total of the total current liabilities, and indicates if the business can pay its immediate short term debts from available resources. The formula used to calculate the Current Ratio is:

Current Assets Current Liabilities = x: 1

This is usually expressed as a ratio. A common benchmark adopted in business is that of a ratio of 2:1, indicating that debts should be met twice from available funds/resources. The Acid Test Ratio: The Acid Test Ratio extends the use of the Current Ratio in that the Current Assets are adjusted for inventory values (i.e. inventories are excluded). This builds upon the concept that liquid funds are used to settle immediate debts – liquid funds represent cash or near cash resources. Inventories the most illiquid

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of all current assets since it has to be sold before it can be converted to cash, hence its exclusion.

The formula used to calculate the Acid Test Ratio is:

Current Assets-Closing inventory Current Liabilities = x:1

As with the Current Ratio, this is expressed as a ratio. A common benchmark adopted in business is that of a ratio of 1:1, indicating that debts should be met once from available funds/resources. A lower ratio in this respect would indicate difficulty in meeting the debts of the business, thus the business could be insolvent.

Gearing: Indicators of ‘gearing’ are important since they provide an indication of the long term debt commitments of the business (i.e. the ability of the business to pay its loans). The business owner will want to be reassured that the business can meet its long term debt obligations. Lenders will want to check the ability of the business before granting loans, in order to safeguard their funds. In its simplest form, the key ratio that may be used in this context is: Non Current Liabilities (Debt Capital) (Equity Capital + Reserves + debt Capital)) X 100% = Gearing % It is important to appreciate the significance of the gearing ratio. A highly geared business implies greater levels of financial risk, in terms of debt owed to lenders, and also the higher interest payments which must be met. Lower geared businesses tend to be low risk propositions. Note: within the context of limited company accounts, equity capital is taken to include Profit and Loss Reserves. Shareholders Ratios: Indicators of shareholders wealth are important since they provide a measure of the long term wealth of an investor in the business. Shareholders (owners) will want to be reassured that their investment is profitable, at least in the short term, and that it is likely to yield capital gains in the longer term. In this context, two ratios that may be useful are:

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Earnings Per Share: The formula used to calculate earnings per share is: Profit After Tax

Number of Shares in Issue = x pence As a measure of performance, this ratio indicates the profitability of the company in the first instance. It is expressed in terms of pence per share, and should ideally be as high as possible. Considered in isolation, it is limited but compared to a previous year or another company can provide a better insight into the profit movements experienced over time on a per share basis. This ratio is normally disclosed as a note to the income statement. Return on Equity: This ratio can be used to measure the return on the funds contributed by shareholders, as represented by equity in the business. In the context, shareholders equity is defined as ordinary shareholders capital plus reserves. The formula used to calculate Return on Equity is:

Return on Equity = Profit After Tax Shareholders Equity x 100% = x%

As with the other ratios, the return on equity is limited when calculated on its own. To enable a more substantial evaluation, it should be compared to other measures of return, including ROCE and/or with previous accounting periods or other firms in the industry. Issues related to the use of Accounting Ratios:

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Although the calculation of accounting ratios appears routine, it is important to place each ratio in context of the financial statements when analysing and passing judgement on the financial performance of a business. The process of evaluating the financial performance of the business should incorporate the accounting ratios, which in turn should indicate potential strengths and weaknesses of a business, or at the very least point the business owner in the direction of areas for further investigation. Benefits of Ratio Analysis: Conducting ratio analysis can yield the following benefits:

· Accounting ratios assist a user of financial statements understand the financial position in addition to that revealed by a statement of data alone

· Accounting ratios can assist a user of financial statements identify areas of

potential strength/weakness within a business, thus facilitate decision making

· Accounting ratios can be used to identify and explain trends in relation to

specific areas of performance within a business

· Accounting ratios enable financial comparisons to be undertaken over time or between separate business entities efficiently and effectively

Limitations of Ratio Analysis:

· Accounting ratios are only as accurate as the underlying financial statements, thus any analysis may be limited in scope;

· Accounting ratios only provide a ‘snap-shot’ view of the financial

performance of the business at one point in time, which may not be representative of the entire business performance over time;

· Accounting ratios may be defined in different ways. Alternative definitions

can be employed with respect to some ratios, e.g. gearing or debtors collection period.

· Comparisons of financial performance and accounting ratios between

companies may be difficult due to the adoption of different accounting policies between business entities.

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Worked Example: The following example shows a range of ratios which may be calculated based upon a set of financial data: The interim financial statements for two public companies quoted on the Belfast Stock Exchange have been summarised below, for the 6-month period ended June 2012. Imagine that you are about to invest £100,000 in each of the two companies on behalf of a client. In order to assess the financial performance of the business you are required to conduct ratio analysis in order to aid your investment decision. Company A Company B Summary Financials Interim Accounts Interim Accounts June 2012 June 2012 £m £m Turnover 140 196 Cost of Sales (82) (100) Operating (Gross) Profit 58 96 Selling & Distribution Expenses (30) (44) Administration Expenses ( 6) (40) Profit Before Interest and Tax 22 12 Interest (2) ( 2) Profit Before Tax 20 10

Taxation (18) ( 8) Profit After Tax 2 2 Non-current Assets 70 70 Current Assets: Stocks 22 40 Debtors 10 1 Cash 10 1

Total Current Assets 42 42 Total Assets 112 112

Share Capital (£1 ordinary shares) 30 30 Retained Earnings 60 24 Total Equity 90 54

Non Current Liabilities Debentures 20 50 Current Liabilities:

Creditors 1 6 Bank 1 2 Total Current Liabilities 2 8 Total Equity and Liabilities 112 112

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Summary of accounting ratios: Performance Ratios: Definition

employed Company A: Interim Financial Results

Company B: Interim Financial Results

Return on Capital Employed

(Profit before Tax + finance costs +preference

dividends) (Total

Assets – Current Liabilities)

x 100% =

R.O.C.E. (%)

20% 11.5%

Gross Profit Margin Operating (Gross) Profit/Sales

41.4% 48.9%

Net Profit Margin Profit before interest and tax/Sales

15.7% 6.1%

Liquidity Ratios Current Ratio Current

Assets/Current Liabilities

21.1 times 5.25 times

Acid Test Ratio (Current Assets-inventory)/Current Liabilities

11 times 0.25 times

Gearing Debt/Total Equity 22% 93% Shareholder Ratios Earnings Per Share Profit After

Tax/Number of Shares

6.7p 6.7p

Return on Equity Profit After Tax/Total Equity

2.2% 3.7%

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Interpretation of Accounts – Narrative: The following key points explain key aspects of the financial performance of the two companies: In order to explain any differences in performance, it is important to realise that we are comparing the actual financial performance of two separate companies within the same industry for the same financial year. Performance: ROCE: the return on capital employed for Company A is calculated as 20 per cent, compared to that of Company B of 11.5 per cent. This would imply that Company A is able to provide investors with a greater return on their investment due mainly to the relatively high level of profitability of trading operations as revealed by the operating profit – this would suggest that management are keeping cost behaviour under constant review and control. GP %: in terms of profitability, the gross profit margin achieved by Company A is 41.4%, compared to that calculated for Company B of 48.9%. These results are largely consistent with each other, however, Company B would appear to have better control of supplier costs in this respect or charges customers a slightly higher mark up percentage. NP%: in terms of running the business, management appear to exercise careful control of costs in respect of Company A as the net profit margin is calculated as 15.7% compared to 6.1% calculated for Company B. Company A would appear to have less overheads or at least better control of their overheads than Company B, which could explain the greater level of margin. It might also be the case that Company B has higher levels of interest payments on debt finance (since it has higher debt levels), which has the effect of depressing the net profit margin. Liquidity Performance: Current Ratio: the current ratio of approximately 21.1 times and 5.25 times for Company A and Company B respectively indicates that both businesses are solvent, and would not initially appear to indicate cause for concern. A closer review of the composition of current assets does indicate that most of the funds are tied up in inventory holdings, which would require further investigation – is it necessary to have such funds tied up in expensive stockholdings in each company? Both results are in excess of the recommended benchmark of 2 times. Acid Test Ratio: the acid test ratio refines the current ratio, by excluding stock, indicating if the debts of the business can be met from ‘liquid’ funds (i.e. cash or near cash resources). In this case, Company A is calculated at 11 times whilst

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Company B has a result of 0.25 times. In respect of Company B, this indicates insolvency, since it is close to zero and below the accepted benchmark of 1:1. Company A does not have as much money tied up in inventory and thus is still solvent, since it is able to repay short term debts from cash/near cash resources. This area of working capital management requires further investigation in Company B to resolve the issue and avoid insolvency. Gearing: In terms of gearing both Company A and Company B employ debt finance within each of their businesses. The gearing ratio for Company B is calculated at 93%, whilst Company A is calculated at 22% - the higher figure, representing a much higher level of debt in the balance sheet – approximately 4 times greater than Company A, thus Company A is relatively low risk meaning that they should be able to afford both the debt repayments and interest charges. It is likely that the debt finance has been used to finance purchase of non-current assets or fund expansion of business activities in each company. Shareholder Ratios: Earnings Per Share: The earnings per share represent the profit available to ordinary shareholders in each company (after all the expenses have been accounted for), on a per share basis. This ratio is normally stated on the face of the income statement for each company, and indicates the relative profitability of the business. In this case, both companies have an EPS of 6.7 pence indicating that they are both profitable, although the net profit margin stated earlier does indicate that Company B has a higher level of costs in the business, which might be reduced in order to improve upon the EPS figure calculated. Return on Equity: The return on equity for Company A is calculated as 2.2 per cent, compared to that of Company B of 3.7 per cent. This would imply that Company B is able to provide investors with a greater return on their investment, in this instance expressed as a percentage of equity, due to (i) the higher level of profitability of trading operations as revealed by the operating profit – this would suggest that management are keeping cost behaviour under constant review; and (ii) the lower amount of equity funds invested in Company B that are supporting the business – Company B does place a greater reliance on the use of debt finance. Conclusion: Company A appears profitable and solvent, with good cost control, however Company B is profitable but insolvent, which implies that inventory management/control is worthy of further investigation as revealed by the figures in the financial statements and supported by the accounting ratios analysed.

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Differences between Cash and Reported Profit: It will often be the case that the closing balance on the cash/bank account will not equal the profit reported at the end of an accounting period. This will be due to differences between the calculation of profit and the closing cash balances. The determination of profit is subject to various accounting adjustments to take account of timing differences and non-cash expenses of running a business, e.g. depreciation expenses are deducted from gross profit but do not involve the transfer of cash; transfers to/from general reserves also mean that the two figures will not be the same. Key Terms: Ratio Analysis; Interpretation of Accounts; Liquidity; Gearing; Investing; Return on Capital Employed; Gross Profit Margin; Net Profit Margin; Liquidity Ratios; Current Ratio; Acid Test Ratio; Gearing Ratio; Shareholders; Shareholders Ratios; Earnings per Share; Return on Equity. Test Your Knowledge: · Explain what is meant by the term ‘ratio analysis’. · Explain what is meant by the term ‘Return on Capital Employed’. · Analyse one reason why the net profit may not necessarily be the same as

the closing cash balance in an accounting period for a business. · Evaluate three reasons why accounting ratios would be useful to managers in

running a business.

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Case Study: Read the following information and answer the questions that follow. The following is the summarised financial data related to a company operating within the aerospace sector of the Northern Ireland economy.

Company Q2O plc Q2O plc Financial Year ended: 30th Sept 2009 30th Sept 2008 £ £ Sales 17,800,000 893,100,000 Profit Before Tax (Operating Profit)

3,200,000 17,100,000

Taxation 2,200,000 3,000,000 Dividends 1,000,000 14,100,000 Retained Earnings 0.0 0 Non-current Assets 72,900,000 264,600,000 Current Assets 2,100,000 96,700,000 Total Assets 75,000,000 361,300,000 Issued Share Capital (50p shares)

1,400,000 15,800,000

Profit and Loss Reserves 45,000,000 228,600,000 Total Equity 46,400,000 244,400,000 Non Current Liabilities Debentures 18,600,000 1,900,000 Current Liabilities 10,000,000 115,000,000 Total Equity and Liabilities 75,000,000 361,300,000

Questions: Q1: Explain what is meant by the term ‘Gearing’. Q2: Using the case study information, calculate four different accounting ratios for each financial year for Q2O plc. Q3: Discuss the financial position of Q2O plc over the two-year period noted above (you must use the accounting ratios you have just calculated). Q4: Discuss the extent to which ratio analysis is useful to investors, when analysing the financial performance of businesses such as Q2O plc.

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A1: Gearing: this is defined as the proportion of debt as a total of equity funds employed to finance a business. In this case, the gearing ratio for Q2O plc would express the debenture figures quoted (£18,600,000) for 2009 and 2008 (£1,900,000) respectively as a proportion of total debt and equity figures for each financial year under review. A2: Return on Capital Employed: this can be taken to mean the return on investment which an investor will often calculate, in order to calculate the percentage return on funds invested in a business. This ratio is of importance to a number of stakeholders, since it is also known as the ‘primary ratio’, i.e. usually the first to be analysed by investors. It can be broken down into two elements – profitability and efficiency – each of which can be analysed to determine the factors which have the greatest influence upon the total return to investors. A2: Accounting Ratios: Q2O plc 1. Return on Capital Employed: 2009 2008 Profit Before Tax + Interest 3,200,000 17,100,000 ---------------------------------- x 100% ------------- x 100% --------------- x100% Total Equity & Debt 65,000,000 246,300,000 Return on Capital Employed: = 4.9% = 7 % 2. Net Profit Margin: 2009 2008 Profit Before Tax 3,200,000 17,100,000 ---------------------- x 100% ------------- x 100% -------------- x100% Sales 17,800,000 893,100,000 Net Profit Margin = 18.0% = 1.9% 3. Current Ratio: 2009 2008 Current Assets 2,100,000 96,700,000 ---------------------- ------------ -------------- Current Liabilities 10,000,000 115,000,000 Current Ratio: = 0.2 times = 0.8 times 4. Gearing: 2009 2008 Long Term Debt 18,600,000 1,900,000 ---------------------- x 100% ------------- x 100% --------------- x100% Total Equity and Debt 65,000,000 246,300,000 = 29% = 1% A3: Financial Position for the years 2009 and 2008 - Comments:

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ROCE: Results of 4.9% (2009) and 7% (2008) respectively are calculated. Representing low levels of return on such an investment in this particular business, however it does allow a comparison with alternative investments such as interest on a low interest yield account. The low return calculated for each year is of concern to management and investors, since providers of capital may have been expecting higher levels of return, although the low levels of ROCE may be a feature of the industry in general – this issue will require further investigation. The results indicate that Q2O plc performed better during 2008, providing a slightly higher return on investment – it is possible that external factors are responsible for the decline in performance, since the revenues, operating profit and total assets figures are substantially lower in 2009 than they were in 2008, e.g. a disposal of part of the business or severe economic downturn in the industry/global economy. Net Profit Margin: Results of 18% and 1.9% are reported for Q2O plc for the financial years 2009 and 2008 respectively. These results indicate that margin on turnover had been very low during the 2008 financial year, however, this has increased to a reasonable level in respect of the 2009 financial year. These results may be typical of the industry sector – suggesting that profit margins are under pressure in a highly competitive industry and/or overheads within the company have been closely reviewed in order to minimise cost and increase profits. Overall, the company has improved profitability over the period. Current Ratio: Results of 0.2 times (2009) and 0.8 times (2008) are calculated for Q2O plc in respect of each financial year – both results are lower than the recommended benchmark of 2 times. This issue will be a cause for concern for the management team and investors, since it appears that the company is unable to meet its debts from liquid resources, e.g. cash/bank deposits and near-cash assets, therefore insolvent. This reflects the management of working capital by the management team in the business over the year, and the figures indicate that this has deteriorated substantially. The management team will need to review the working capital requirements of their business operations, and investigate which elements of working capital are leading to the results obtained. Whilst the figures have decreased in terms of their absolute values, the proportion of individual working capital elements reported will require further investigation, for example, stockholdings must be reviewed in order to ensure proper stock management, debtors must be reviewed to ensure proper operation of credit control policies and/or cash balances held by the company must be reviewed to ensure effective cash management. In addition, the amount owing to trade creditors by the company must be reviewed

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in order to reduce the amount owing initially, but also facilitate an improvement in the current ratio and management of working capital. Gearing: Results of 29% and 1% are reported for Q2O plc in respective of the financial years 2009 and 2008. Initially it appears that the company has a low level of gearing, since the amounts are smaller compared to the funds invested in terms of shareholder equity. A closer inspection of the data reveals that a large increase in debt finance has occurred during the 2009 financial year, rising from £1,900,000 to £18,600,000 – hence the increase in gearing reported. This would imply that the interest expense incurred by each company to service the debt has also increased which might impact profitability, which by deduction, would mean that the expenses are high resulting in low profitability ratios.

Conclusion: it is possible to conclude from the ratio analysis that there are two areas worthy of investigation by the management team of this company – (i) the low profitability (which might be leading to depressed ROCE ratios); and, (ii) the low results reported in respect of the current ratio (suggesting that the company has low levels of solvency). Both ratios indicate a higher degree of financial risk related to the company, which might deter investors from investing in the company in future. A4: Usefulness of ratio analysis: Undertaking ratio analysis in respect of a company’s published financial statements could facilitate an interpretation of the financial position. There are a number of advantages and disadvantages of using ratio analysis: In relation to a company such as Q2O plc, the advantages are: 1. enables financial comparisons to be made with similar businesses in the same industry; 2. enables trends to be identified and analysed in relation to the financial performance of a company such as Q2O plc; 3. accounting ratios can be used as a motivator to encourage managers to improve operating and financial performance of the business. In relation to a company such as Q2O plc, the disadvantages are: 1. ratio analysis provides only a ‘snapshot’ view of the financial position at a given point in time, which quickly becomes out of date since economic conditions can change rapidly;

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2. accounting ratios are only as accurate as the underlying data, hence the extent to which they be relied upon for making investment decisions will be limited; 3. financial comparisons with other companies will be problematic since differences in accounting policies may mean that different interpretations are placed on the data within the financial statements. Conclusion: it is possible to conclude that the advantages gained from the calculation of accounting ratios and their interpretation are likely to outweigh the disadvantages – ratio analysis can be useful in facilitating an interpretation of the financial position of a company such as Q2O plc.

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INVESTMENT APPRAISAL:


Chapter Aims:

· Explain the nature of investment appraisal techniques commonly used in business;

· Identify and undertake related calculations; · Understand the information contained within the investment appraisal

analyses in relation to a business entity; · Understand the usefulness and limitations of using investment appraisal

techniques to evaluate investment options facing a business. Introduction: This chapter discusses key definitions related to investment appraisal techniques which are commonly used within a business, in order to assist the decision making process aimed at achieving the financial objectives that a business might have. The usefulness of the various investment appraisal techniques are also considered.

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Investment Appraisal: Investment Appraisal attempts to assist the evaluation of the financial position of projects which have been proposed by a business entity. This is usually undertaken with reference to three techniques, including Average Rate of Return, Payback and Discounting.


Reasons for Investment Appraisal: There are a number of reasons why a business would undertake investment appraisal such as: To replace/update equipment currently in use To remain competitive within the industry To facilitate expansion of business operations and growth within the business To enable a business to invest in equipment in order to meet legislative requirements, e.g. health and safety To invest surplus cash and ensure continued investment in the asset base.

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Investment Appraisal Methods: Introduction: Capital investment refers to investment of a long term nature involving large amounts of money and usually requiring the purchase of fixed assets for use within the business. In order to investigate the various projects available to a business, it is essential that each project is evaluated with reference to its pattern of cashflows and where relevant, profits. In order to determine the suitability of a project, a number of investment appraisal methods are adopted which provide a standardised approach in respect of deciding the most favourable project in which to invest. Capital investment requires that the business commits money now, with the expectation of reasonable returns at some stage in the future. As large amounts of funding are involved and the impact of such decisions on the future of the business is critical, careful appraisal of such investments is necessary. The following sections outline three different methods of which may be used to assess the suitability of different capital projects. The Role of Capital Investment: The importance of capital investment decisions can be seen with reference to the overall financial objective of the business (i.e. profitability): Substantial capital sums are involved; Project is of a long term nature; Project is unlikely to be stopped in the short term without incurring a loss; Such investments are likely to be subject to a degree of uncertainty, making it difficult to plan ahead beyond a one year period; Such projects may have the potential to impact the survival of the business. The Various Types of Capital Project: Capital projects are undertaken in order to ensure that the business can achieve its operational and strategic goals. Such investments vary in nature. Some examples of projects that may be implemented in support of business activities include: Investment in cost-saving equipment aimed at reducing operating costs; Investment in another business (takeover) in order to gain market share;

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The purchase of fixed assets e.g. plant, fixtures and fittings in order to generate revenue streams; Expansion of current facilities in company outlets, ie. factory, production plants; Acquisition of overseas operations aimed at securing entry to new markets, development of new product lines. Special/ad hoc projects. The Investment decision: The decision to invest in a large capital project can be viewed as part of a sequence of decisions undertaken by the business in relation to the decision-making process. The main elements of the process would normally include: The search for potential capital investment projects. Identification of potential costs and benefits of alternative projects. Assessment of the profitability of each alternative project. Consideration of qualitative issues related to the investment project. Project selection with reference to financial risk, cash flows, and funding arrangements. Implementation of most suitable project, consistent with business objectives. Feedback and review of project progress. Difficulties Associated with Capital Investment Projects: Might be difficult to decide project lifespan Might be difficult to estimate annual cashlfows accurately Might be difficult to decide upon an appropriate discount factor Conflicting targets might exist – a business might reject a profitable project in favour of one which has a short payback period Too many unrealistic assumptions might distort the results – e.g. over-estimation of customer demand or sales prices might lead to a shortfall in sales revenues, hence lower levels of cashflows Might be difficult to determine scrap value and disposal arrangements of assets

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Might be difficult to determine the precise measure of return expected from the project, and thus the most appropriate investment appraisal method to adopt.

The management team of a business will typically choose from a range of alternative methods of investment appraisal. Three methods will be discussed in this section, including:

(i) Average Rate of Return (ARR) (ii) Payback; and (iii) Discounting (Net present Value)

The following example is used to facilitate the discussion of the various methods of investment appraisal:

A local ferry company is considering the purchase of a new high speed vessel to operate services across the Irish Sea from Ireland to the UK. It is faced with the choice between a Catamaran and a Hovercraft, both costing £120m. The estimated future cash flows and related costs are:

Catamaran Hovercraft £’m £’m Initial Investment Cost at start of project 120 120 Net Cash Flows: Year 1 30 60 2 30 50 3 40 40 4 60 36 5 50 20 6 30 10

In order to simplify the analysis, it is assumed that net cash flows have taken into account depreciation of the asset and that the asset has no residual value at the end of the project.

Project Evaluation:

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Average Rate of Return (ARR): This method expresses the average annual profit of a project as a percentage of the initial capital investment. When projects are mutually exclusive (i.e. when only one project can be selected), the project with the highest ARR will be selected. Workings:

Catamaran Hovercraft £m £m

Initial Outlay (120) (120) Net cash inflows: Year 1 30 60 2 30 50 3 40 40 4 60 36 5 50 20 6 30 10

Total cash inflow 240 216 Total net profits* 120 96

Average annual profits Over project lifespan 20 16

Formula used in calculation of ARR: o ARR = (average annual profits/initial investment) o Catamaran ARR = (20/120)x 100% = 16.7% o Hovercraft ARR = (16/120)x 100% = 13.3%

Decision: on the basis of ARR, the Catamaran would be preferred. Benefits of ARR:

o Calculations should be reasonably straightforward. o It takes account of all cash flows. o Can be treated as a return measure, equivalent to a return on capital

ratio. o Easily understood.

Drawbacks of ARR:

o This method ignores the timing of cash flows. Commentary on ARR results: The Hovercraft produces greater cash flows in years 1 and 2 (i.e. early years of project), whereas the Catamaran becomes more profitable towards the end of the project lifespan. The additional £50m which the Hovercraft earns compared to the Catamaran in years 1 and 2 could be invested which, if reconsidered, may alter the relative merits of the two vessels.

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Payback: This method of investment appraisal indicates how long it will take before the original capital investment is ‘recovered’. In this case, the project with the shortest payback period would be chosen. Workings (adapting previous worked example):

Catamaran Hovercraft Net Cumulative Net Cumulative Cash Cash flows Cash Cash flows Flow Flow £m £m £m £m

Year 0 (120) (120) (120) (120) Year 1 30 (90) 60 (60) 2 30 (60) 50 (10) 3 40 (20) 40 30 4 60 40 36 66 5 50 90 20 86 6 30 120 10 96 Narrative: payback for the Catamaran occurs in the 4th year. Only £20m of the £60m earned in year 4 is required to complete the payback. Assuming that cash flows occur evenly throughout the year, £20m is earned after one third of the year, thus exact payback is 31/3 years. With respect to the Hovercraft, payback is one quarter of the way through year 3. Therefore, the payback is 2.25 years.

Decision: On this basis, the Hovercraft would be chosen. Benefits of payback:

o Calculations should be reasonably straightforward. o It takes account of all cash flows. o Takes account of how quickly the business recoups its investment,

and can be interpreted as a measure of risk. o Easily understood.

Drawbacks of payback:

o This method ignores the timing and amounts of cash flows after payback period.

o Ignores the profitability of the project.

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Net Present Value (Discounting): Discounting takes into consideration the timing of cash flows. It is based on the principle that a given sum of money received now is more valuable than at any time in the future, the reason being that the sum can be invested today to earn a return. For example, £10 invested now at an interest rate of 10% would be worth £11 in one year’s time and £12.10 in two years’ time. In other words, £12.10 received in two years has a present value of £10. Cash flows received at different times need to be adjusted to take account of the time value of money. This adjustment of future cash flows into present values is known as the discounted cash flow (DCF) technique. This can be formulated in an equation as follows:

o PV = (An)/(1 + r)n

Where, An is defined as the future cash flow in a given period. r is defined as the discount rate expressed as a decimal n is defined as the time period under review.

The discount rate employed is normally representative of the opportunity cost of the initial capital invested, which may be the present rate of interest, obtained from alternative forms of investment. The Net Present Value (NPV) method discounts all future cash flows to present values and then compares the total present value of all cash inflows with the present value of all cash outflows. The project with the highest positive Net Present Value would be chosen (it is generally assumed that projects yielding a negative NPV would be rejected). Workings (adapting previous worked example):

Catamaran Cash Discount Present Flow Factor (10%) Value (£m) £m

Year 0 (120) 1.0 (120.00) Year 1 30 0.909 27.27 2 30 0.826 24.78 3 40 0.751 30.04 4 60 0.683 40.98 5 50 0.621 31.05 6 30 0.564 16.92

Net Present Value (NPV) £51.04m

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Workings (adapting previous worked example): Hovercraft Cash Discount Present Flow Factor (10%) Value (£m) £m

Year 0 (120) 1.0 (120) Year 1 60 0.909 54.54 2 50 0.826 41.30 3 40 0.751 30.04 4 36 0.683 24.59 5 20 0.621 12.42 6 10 0.564 5.64 Net Present Value (NPV) £48.53m

Decision: On this basis, the Catamaran would be chosen, since it appears to yield greater levels of cash flow over the project lifespan. Narrative: The calculation of NPV is achieved in a sequence of steps:

o Determine lifespan of project. o Determine initial outlay. o Determine annual cash flows. o Match discount factor with each year of project. o Multiply annual cash flows by discount factor to compute the present

value for each year of project. o Sum all annual present values to determine net present value. o Reach decision.

Benefits of NPV:

o Calculations should be reasonably straightforward. o It takes account of all cash flows. o Takes account of timing of cash flows. o Easily used.

Drawbacks of NPV:

o It can be difficult to determine the discount rate to be used in project. o It can be difficult to accurately forecast the annual cash flows

throughout project lifespan. Concluding Remarks:

o Discounting is considered to be the more superior method of investment appraisal, compared to payback and accounting rate of return.

o ARR ignores timing of returns. o Payback ignores the cash flows occurring after payback period. o All methods depend on accuracy of cash flows estimates.

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o Investment appraisal is one piece of a complex decision process affecting business activities – non-financial issues may also require consideration.

Qualitative Factors: The use of investment appraisal techniques such as Average Rate of Return, Payback and Discounting provides the management team within a business with a quantitative analysis of the proposed investment. There may however, be a range of qualitative issues which the management team may be required to consider before proceeding with the project. In some cases, the qualitative issues might lead to a decision which contradicts the recommendation of the quantitative evaluation – e.g. rejection of highly profitable projects. Examples of qualitative issues include: Social – businesses might be required to invest in special air-conditioning units or amend their premises in order to meet the needs of smokers and retain custom (particularly pubs, clubs and restaurants). Such projects would not necessarily yield surplus revenues for a business but might increase the levels of custom if customers that smoke are aware of the available facilities and that their presence is more socially acceptable. Technical – businesses might invest in the most up to date equipment, which might improve productivity and in turn lead to staff redundancies. This may create unfavourable press speculation and force the business to reconsider or postpone such investment plans. Environmental – a business might not be able to proceed with a planned project due to environmental concerns, e.g. noise pollution, litter, air pollution and other forms of pollution. A company might wish to set up a waste disposal plant however, it may be located too close to residential areas which in turn might lead to protests from community groups, pressure groups and other businesses. Economic – a business might not be able to proceed with a planned project if the funding is not available from the providers of capital or in the context of recessionary conditions, most businesses are postponing investment plans due to deteriorating economic conditions, preferring to save money in the short term. Political – a business may not be able to proceed with a project due to political pressure. Government may impose strict limitations regarding the operation of the project or might deem that the investment is in breach of planning law, competition rules or some other statutory regulation which is beyond the control of the business.

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Legal – a business may not be able to proceed with a planned investment project if it is in breach of legislation, e.g. it may be unable to get planning permission to build premises if the location is within an environmentally sensitive area. Key Terms: Investment Appraisal; Payback; Average Rate of Return; Profits; Investment; Present Value; Cash flow; Discount Factor; Discounting; Project lifespan; Scrap Value; Net Present Value; Decision Making; Recommendation; Accept; Reject. Test Your Knowledge: · Explain what is meant by the term ‘investment appraisal’. · List three main quantitative methods of investment appraisal. · State one reason why the use of discounting may be preferable compared to

the use of profit-based investment appraisal techniques in a business. · State two reasons why it is beneficial for a business to undertake investment

appraisal techniques when evaluating capital projects.

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Case Study: Read the following information and answer the questions that follow. Mo Gass is the Finance Manager of Fone plc, a manufacturer of mobile telephones. In the budget for the next financial year, she has allocated £5,000,000 to the Research and Development department for investment in new telecommunications equipment. The following table summarises information related to two machines being considered by Fone plc. Each machine has a useful economic life of five years and zero scrap value at the end of that period.

Project Machine A Machine B £m £m Cost 5 5 Net Cash flows Year 1 3.5 0.5 Year 2 3.0 1.0 Year 3 2.0 2.0 Year 4 1.0 6.0 Year 5 0.0 10.0 Discount Factors (11%): Year 1: 0.901; Year 2: 0.812; Year 3: 0.731; Year 4: 0.659; Year 5: 0.593

The board of directors have advised that no additional funding is available for investment, therefore one of the above machines can be acquired if financially viable. Questions: Q1: Define the terms: ‘payback’, ‘average rate of return’ and ‘net present value’. Q2: Using the case study information, calculate the ‘payback period’, ‘average

rate of return’, and ‘net present value’ for the two projects under consideration by Fone plc.

Q3: Discuss with reasons which machine should be purchased by Fone plc. Q4: Evaluate three qualitative factors which a business such as Fone plc

should consider when making investment decisions.

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Suggested Solutions (to include the following main points): A1: Payback: this is defined as the length of time taken to recover the initial investment in a project. Average Rate of Return: this is defined as the return on investment for a project (similar in concept to the Return on Capital Employed ratio) which indicates the relative profitability of the project. Net Present Value: this is defined as the present value of cashflows in a project, basically measured as the net difference of monies in/out of a project, after the application of a discount factor. A2: Fone plc: Payback Period: Machine A: 1 year, 6 months; Machine B: 3 years, 3 months. Average Rate of Return: Machine A: Average annual profits (£9.5m-£5m = £4.5m profit; therefore average profit = £4.5m/5) are £0.9m, thus ARR = £0.9m/£5m = 18%. Machine B: average annual profits (£19.5m-£5m = £14.5m profit; therefore average profit = £14.5m/5) are £2.9m, thus ARR = £2.9m/5m = 58%. Net Present Value: NPV: Machine A: Machine B:

Year NCF £m DF 11% PV £m

NCF £m DF 11% PV £m

0 -5.0 1 -5.00 -5.0 1 -5.00 1 3.5 0.901 3.15 0.5 0.901 0.45 2 3.0 0.812 2.44 1.0 0.812 0.81 3 2.0 0.731 1.46 2.0 0.731 1.46 4 1.0 0.659 0.66 6.0 0.659 3.95 5 0.0 0.593 0.00 10.0 0.593 5.93 NPV 2.71 NPV 7.60

A3: Decision: The correct decision would be to invest in Machine B. The reasons for this are: (i) Machine B yields the highest NPV at £7.6m (approximately) compared to Machine A which yields a positive NPV of approximately £2.71m – this in turn maximises the value of the firm and should therefore be accepted; (ii) Machine B yields the highest ARR of 58% (compared to Machine A), meaning that it is a highly profitable investment. A4:

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Qualitative Factors: Fone plc should consider a range of qualitative factors which might influence the investment appraisal decision, in addition to that analyses provided using quantitative evaluation techniques. Qualitative factors which should be considered by Fone plc in relation to this particular investment project:

1. within the context of Fone plc, it is assumed that the project will proceed subject to financial restrictions stated – that is, no additional funds are available for investment;

2. within the context of Fone plc, it is assumed that resources (human, material etc) that are surplus to requirements can be redeployed elsewhere in the business once this project proceeds – the impact on staffing levels/redundancies is not stated but may be assumed to be minimal;

3. within the context of Fone plc, it is assumed that the output of the new machine (B) will be of improved quality or enhance the capability of the Research & Development department compared to existing machine/output.

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Test Your Knowledge – Quiz Answers: Business Objectives Test Your Knowledge: · Explain what is meant by the term ‘mission statement’.

A short statement indicating the purpose of a business entity, usually containing some reference to the key beliefs of the organisation. Usually expressed in terms of qualitative objectives.

· Explain what is meant by the term ‘conflict’.

Within the context of trying to achieve business objectives, conflict can be taken to mean that notion that one primary objective takes priority over secondary objectives of the business, meaning that secondary objectives may not necessarily be achieved unless they are consistent with the primary objective.

· List three possible objectives that a business might have.

Survival Growth Profit Maximisation

· State two reasons why a business would use a mission statement.

A business might wish to communicate to relevant stakeholders the reason for it’s existence; The management team of a business entity might want to focus the efforts of stakeholders on achievement of key business objectives, consistent with the mission statement.

Stakeholder Objectives Test Your Knowledge: · Explain what is meant by the term ‘stakeholder’.

A person or organisation having a real or substantial interest in another organisation, which is likely to impact it’s behaviour.

· List six stakeholder groups commonly found in a business context.

· Owners

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· Managers · Employees · Suppliers · Customers · Creditors · List three ways in which stakeholder objectives could differ from

business objectives. Employees are likely to be interested in securing employment and maximum levels of compensation in relation to the work performed/targets achieved, whereas the management team of the business are likely to aim to run manage the business efficiently, securing value for money; Managers are likely to aim for growth in revenues in order to increase market share, however some existing customers might feel that customer service will suffer as resources are spread too thinly across a wider customer base; Shareholders are likely to aim for profit maximisation in order to gain maximum value from their investment, however, it may not be possible to achieve this due to the influence of regulatory authorities, meaning that satisfactory prices (or satisficing price levels) are levied, thus profit maximising prices cannot be charged to customers.

Business Strategy and Planning Test Your Knowledge: · Explain what is meant by the term ‘business plan’.

A document summarising the objectives and plans of the business for a specific time period. In terms of 1 year it can be referred to as an Operating Plan or in terms of up to 5 years, it is usually referred to as a Strategic Plan.

· Explain what is meant by the term ‘strategy’.

This can be taken to mean the method or approach adopted by a business entity in order to achieve specific goals, e.g. competitive advantage.

· Explain what is meant by the term ‘hostile takeover’.

The acquisition of a business by another, whereby the management team of the business attempting to be taken over are opposed to the takeover approach by the predator company.

· Explain the various types of merger which can occur in a business.

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Horizontal Integration – whereby two businesses in identical lines of business and similar stages of production join together; Backward Vertical Integration – whereby two businesses in identical lines of business but different stages of production, join together, particularly where one business has control of supplies/resources to be supplied to the other business, further along the supply chain; Forward Vertical Integration – whereby two businesses in identical lines of business but again at different stages of production, join together, particularly where on business has control over distribution channels/access to customers for the goods being supplied by the other firm, earlier in the supply chain; Lateral Integration – whereby two businesses involved with related product lines which do not compete with each other, join together; Conglomerate Merger – whereby two businesses involved in unrelated product lines join together in order to diversify.

Decision Tree Analysis Test Your Knowledge: · Explain what is meant by the term ‘decision tree’.

A flow chart diagram summarising potential future events and the effects of decisions to be taken or probable events in a sequential order.

· Explain what is meant by the term ‘probability’.

The chance or likelihood that a particular event will occur. · Explain what is meant by the term ‘expected value’.

A weighted average expectation of an outcome taken as a result of an earlier decision.

· State two reasons why businesses use decision tree analysis.

A business would use decision tree analysis in scenarios whereby it wishes to plan or audit a logical sequence of events that are likely to occur within a project under consideration; A business would use decision tree analysis in order to determine expected values in relation to a project under consideration an thus decide if it is financially viable;

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Contingency Planning Test Your Knowledge: · Explain what is meant by the term ‘confidence’.

Can be taken to mean the extent to which stakeholders are reassured about the plans and actions of the management team that the original plan will proceed in accordance with stated objectives, or, that an alternative plan of action will achieve stated objectives should a deviation from the original plan occur.

· Explain what is meant by the term ‘crisis’.

Within the context of contingency planning, this can be taken to mean the extent to which the original plan or objectives are not being achieved and the response of the business organisation to rectify the situation.

· Explain what is meant by the term ‘alternative courses of action’. These are taken to mean the likely or feasible options open to a business in

the event that the original plan or course of action does not proceed or achieve the stated objective(s)

· State one reason why businesses should undertake contingency

planning.

A business would undertake contingency planning in order to effectively manage a situation where the original plan or objective(s) cannot be achieved due to a deviation in actual policy/plan.

Company Accounts Test Your Knowledge: · Explain what is meant by the term ‘financial statements’.

These are the documents which summarise the financial position of a business entity, usually in terms of profitability (income statement) and net worth (balance sheet or statement of financial position).

· Explain what is meant by the term ‘net profit’.

This is calculated as the difference between total revenues and total costs of running a business for the accounting period, expressed as a positive figure, indicating that surplus revenues have been achieved.

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· Explain what is meant by the term ‘working capital’.

Working capital is the difference between the current assets and the current liabilities in a business, representing the funding required to operate a business on a daily basis.

· Explain what is meant by the term ‘share premium’.

Share premium is the revenues received by a limited company in addition to the funds received from shareholders in respect of allotted shares, which arises when the issue price of a share is greater than the nominal value of a share.

Ratio Analysis Test Your Knowledge: · Explain what is meant by the term ‘ratio analysis’.

An approach to explaining or analysing the financial position of a business entity by calculating ratios, that is, forming mathematical relationships between specific numerical items within the financial statements.

· Explain what is meant by the term ‘Return on Capital Employed’.

This is a measure of the profitability of an investment, calculated by expressing the profit (a measure of return) as a ratio of the investment required (capital), usually in terms of a percentage.

· Explain one reason why the net profit may not necessarily be the same

as the closing cash balance in an accounting period for a business.

The net profit may not necessarily equal the closing cash balance for an accounting period due to timing differences between the actual payment/receipt of expenses/revenues and the period in which they should have occurred.

· State two reasons why accounting ratios would be useful to managers

in running a business. Accounting ratios enable a manager to assess the financial performance of the business, in terms of profitability, liquidity and investment potential; Accounting ratios enable a manager to make decisions in order to improve financial performance, by identifying trends or changes in financial data across accounting periods.

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Investment Appraisal Test Your Knowledge: · Explain what is meant by the term ‘investment appraisal’.

This is the examination or review of proposed investment projects which a business entity wishes to invest in, using standard appraisal techniques, usually of a quantitative nature, but can also involve the consideration of qualitative techniques.

· List three main quantitative methods of investment appraisal.

Payback Average Rate of Return Discounting (NPV)

· State one reason why the use of discounting may be preferable compared to the use of profit-based investment appraisal techniques in a business.

The use of discounting (NPV) is preferable as it considers financial risk by restating future cash flows in terms of present values. The use of cashflows throughout the project is more reliable than profit estimates hence yields a more robust result in terms of guiding decision making within a business.

· State two reasons why it is beneficial for a business to undertake

investment appraisal techniques when evaluating capital projects. It is beneficial for a business entity to undertake investment appraisal as it forces the management team to plan for future events, e.g. project lifespan, initial outlay required or disposal arrangements; It is beneficial for a business entity to undertake investment appraisal as it enables managers to determine the most feasible investment project in according to established criteria, e.g. payback period, profitability or net present value, or order to maximise value for the business.

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