Financial control techniques are vital to successful strategy.Such techniques apply to both the planning and operational phases of projects.We will focus on three main financial control activities: ratios, budgeting and variance analysis.
A basic understanding of financial terminology is required. Ultimately all business activities are measured in financial terms and managers require a grasp of accounting terms. Key terms include:
A simple and effective control technique is to express performance in terms of ratios. Ratios should not be used in isolation but should be considered in relation to trends and comparisons with planned or standard ratios. Remember, they are no more than indicators and rarely identify the source of a problem. However, managers can identify key ratios for their areas of responsibility. These ratios provide a quick and effective way to establish performance and highlight areas warranting more detailed analysis. Figure outlines the uses of ratios. Ratios represent a snapshot of the firm’s financial/productivity position and fall into four general categories: profitability,liquidity, debt and activity. When calculating ratios it is important to be consistent with the terms used. For example, how is profit defined – before or after tax?
Use and application of ratios
Profitability ratios :
Here, effectiveness is measured by evaluating the organization’usability to produce profit. Profit margin is expressed in terms of a ratio of profit to sales. The profit margin is a key trading concern. Clearly, the profit margin can be enhanced by raising selling price and/or reducing costs. Return on capital employed (ROCE) is expressed as net profit asa percentage of capital. It examines to what extent an investment is paying off. It can be applied to an entire business or to specific projects requiring capital investment. ROCE is used to indicate the extent to which an investment is justified or to compare investment opportunities.
Liquidity ratios :
Ratios evaluate the ability to remain solvent and meet currentliabilities.The firm needs to be able to convert assets into cash in order to meet payment demands. If the current ratio is more than 1, sufficient assets exist to meet current liabilities. The quick (or acid-test) ratio gives a stricter appraisal of solvency as it assumes stock is not automatically convertible into cash. Ideally, this ratio should be 1 to 1. However, many businesses operate with lower acceptable ratios. If the ratio is too high it may suggest that the organization does not make optimum use of its financial assets (e.g. holding too much cash).
Debt ratios :
These ratios help determine the company’s ability to handle debt and meet scheduled repayments. They examine the extent to which borrowed funds finance business operations. If creditors begin to outweigh debtors this may signify overtrading – an inability to collect money owed.
Activity ratios :
These ratios determine how effective the organization is at generating activity, such as sales from assets. These activities often relate to business cycles or processes, such as the time taken to turn over stock or collect debts. For example, the greater the stock turnover the better for the organization. An additional example, common in retailing, is sales per unit of floor space. This gives a measure of retail effectiveness. Essentially, such ratios measure the relationship between inputs to outputs.
The processes of strategic development and budgeting are intrinsically linked. To be blunt: no budget equals no strategy! The budgeting process translates marketing strategy into financial terms which, whether we like it or not, are the way all plans are expressed, evaluated and controlled. Budgeting is the single most common control mechanism. It serves not only to quantify plans but also to co-ordinate activities, highlight areas of critical importance and assign responsibility.Many industry practitioners would agree with Piercy (1997). He talks about the ‘hassle factor’ – difficulty, time, negotiation, paperwork,etc. associated with budgeting. This serves to highlight two points, Firstly, budgeting is about resource allocation. Secondly, budgeting is a political process (negotiation, bargaining, etc.) necessary to obtain required resources.
Before managers can prepare a budget there are certain fundamental requirements which must be met. These relate to:
Approaches to budgeting :
Many approaches exist to formulating a budget. Most organizations have developed a historic way of approaching the task. Recent times have seen a move towards greater objectivity and the need to justify assumption sand requirements. Common methods of budgeting are:
Variance analysis :
Finally, in this section on financial control, variance analysis is reviewed. Basically, this examines the variation between actual and planned results and is a concept applicable to a range of activities. It is commonly used along with budgetary control. The actual results are compared with budgeted forecasts and then the variance is examined in order to determine the reason for the difference. Variance analysis allows the organization to identify the main areas of concern and break problems down into component parts.For example, in marketing, variance analysis is often applied to sales price and sales volume. Standard formulae are useful in calculating the effect of these variables on overall revenue:
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