Component 2: Analysing financial performance — Eduqas A-Level Business

Financial control depends on comparing what was planned with what actually happened, item by item and period by period, and the gap between the two is the number managers act on. It is labelled by its effect on profit rather than by its arithmetic sign: revenue above plan or a cost below plan is favourable, revenue below plan or a cost above plan is adverse, so a materials overspend is adverse even though the figure has grown. The purpose is management by exception, where only significant gaps are investigated, which saves management time and points it at causes such as a supplier price rise, an over optimistic sales target or a breakdown that forced overtime. The trade-off is that the figure reports what happened and never why, and targets set too tight demotivate the people held to account for them.

A budget variance measures the arithmetic difference between budgeted figures and actual financial outcomes (Variance = Actual - Budget). For revenue and profit, higher actuals than budgeted represent a Favourable (F) variance, while lower actuals represent an Adverse (A) variance. For costs, lower actual expenditure than budgeted is Favourable (F), while higher expenditure is Adverse (A). Calculations must clearly state the numerical variance, specify the currency (£), and designate every figure as Favourable or Adverse.

A budget is an agreed financial plan for a future period, and the variance is what the actual figure did next to that plan: actual minus budget, labelled favourable when it improves profit and adverse when it damages it. The point of working one out is diagnostic. A favourable sales revenue figure at a garden centre after a hot spring tells the owner that demand moved, not that the staff got better; an adverse labour cost figure usually means overtime, agency cover or a pay deal the plan never carried. Managers then run management by exception, chasing only the lines that moved materially, and flex the plan to actual output first, because a cost budget set for 10,000 units says nothing useful once 13,000 were made.

Budgets coordinate resources, set departmental targets, and control expenditure. Variance analysis evaluates performance by identifying favourable and adverse discrepancies, allowing management by exception to investigate significant deviations. However, budgets can create inter-departmental conflict, encourage short-term budget-holding, and demotivate staff if imposed autocratically. Variances may stem from external shocks (e.g. commodity inflation) rather than managerial failure. Stakeholders face differing impacts: employees may face bonus cuts, while shareholders seek financial discipline.

Treat it as a photograph of what a business owns and owes on one date, usually the last day of the financial year, rather than a film of the year like the income statement. One side lists non-current assets, the long lived items such as premises and machinery held at cost less accumulated depreciation, then current assets: inventory, receivables and cash. Against those sit current liabilities falling due within a year, trade payables, overdraft and tax, and long-term borrowing such as a mortgage. Net assets, whatever is left once everything owed is deducted, must equal total equity, share capital plus reserves and retained earnings, because every pound of asset was funded either by an owner or by a lender. A bank reads it to see what a loan could be secured on.

Three terms examiners like together because each answers a different question about the same statement. The first is the money available to meet the next few months of bills, current assets less current liabilities, and it is why profitable firms still fail: Carillion had a full order book and no cash. Too little leaves suppliers unpaid, too much leaves cash idling in unsold stock and slow paying customers. The second measures the long-term funds tied up in the business, the owners' stake plus borrowing that is not due within the year, and it is the denominator that makes profit comparable between a corner shop and a national chain. The third spreads the cost of a van or a machine across the years that use it, a non cash charge that follows the matching principle.

Key balance sheet calculations include: Working Capital = Current Assets - Current Liabilities. Capital Employed = Non-Current Liabilities + Total Shareholders' Equity (or Total Assets - Current Liabilities). Straight-line Depreciation = (Historic Cost - Estimated Residual Value) / Useful Economic Life in years, reducing the carrying value of fixed assets evenly over time. Capital employed is the denominator for ROCE, while operating profit margins are based on sales revenue.

Start by comparing this year against last, because a single column tells you almost nothing. Four questions do most of the work. Is there enough short-term cover, judged by net current assets and the current ratio. How is the firm funded, by owners or by lenders, which is the gearing question. What has happened to the asset mix, for instance a jump in machinery funded by a new loan. And are retained earnings rising, which suggests profit is being ploughed back rather than paid out. The limits matter as much as the readings: it is one date, so payables settled the day before the year end flatter liquidity, assets sit at cost less accumulated charges rather than market value, and brands, patents and staff skill are largely invisible.

This is the headline test of how hard the money invested in a business is working: operating profit divided by the long-term funding base, multiplied by one hundred, written as a percentage. A firm making operating profit of 1.2 million on a funding base of 8 million returns fifteen per cent. Whether that is good is never absolute. Compare it with last year, with a rival in the same sector, and above all with the cost of the finance, because earning five per cent while borrowing at seven destroys value and a lender will notice. It ranks investment options and judges whether an acquisition earned its price. Its blind spot is that running assets into the ground shrinks the denominator, so an old, heavily depreciated business can look more efficient than one that has just reinvested.

Liquidity ratios assess short-term solvency. Current Ratio = Current Assets / Current Liabilities, with 1.5:1 to 2:1 typically regarded as prudent. Acid Test (Quick) Ratio = (Current Assets - Inventories) / Current Liabilities, with 1:1 regarded as safe because inventory cannot be liquidated instantly. Interpretation must consider industry norms: a supermarket operates safely with lower ratios due to rapid cash turnover, whereas manufacturers require higher buffers. Equal cash-financed changes alter ratios depending on whether the ratio is initially above or below 1.

This one asks how much of the long-term funding came from lenders rather than owners, taking long-term borrowing over capital employed, multiplied by one hundred and written as a percentage. Three million of loans inside ten million of funding is thirty per cent. Above roughly half is usually called high geared and under a quarter low geared. High is not automatically bad, and that is where the marks are: debt is cheaper than equity, interest is an allowable expense against tax, and existing shareholders keep control instead of diluting it through a new share issue. The risk is fixed interest that must be paid in a bad year, which is why a heavily borrowed builder is exposed when rates rise or orders dry up. Read it beside interest cover.

One statement covers a period and the other freezes a single day, and mixing the two up is where most answers lose their application marks. Revenue less cost of sales gives gross profit, and gross profit less expenses gives operating profit, which feeds gross profit margin and operating profit margin, each calculated as the profit figure divided by revenue and multiplied by 100 to give a percentage. The snapshot of assets, liabilities and equity carries the liquidity and gearing work: current ratio as current assets divided by current liabilities, the acid test with inventory stripped out of the top line, and gearing as non-current liabilities divided by capital employed multiplied by 100. A lender, an investor or the board reads both together before committing money, but every figure is historic and none of it shows the order book.

A ratio on its own is a number with no meaning, so the work is comparison in two directions. Trend analysis lines up three or more years to show whether a margin is drifting, and inter-firm comparison sets the business against a close rival or an industry average to show whether the drift is the firm or the sector. Because the figures are percentages and ratios rather than totals, a small firm can be measured against a large one fairly. The comparison is only as good as the like-for-like: different year ends, different accounting policies, a revaluation, a one-off asset sale or a different capital structure all move ratios without anything real changing. A grocery chain running an operating margin near three per cent is not underperforming a luxury brand on twenty per cent, it is in a different industry.

Judgement here means holding four things together rather than reciting them in turn: profitability, liquidity, efficiency and the way the business is financed. A firm can be profitable and still fail, because overtrading leaves it unable to pay wages while it waits on receivables, and a firm can look liquid while earning a return below the cost of its borrowing. The verdict also depends on who is asking. A bank looks hardest at gearing above roughly fifty per cent and at whether operating profit covers the interest; a shareholder looks at return on capital employed against what the money would earn elsewhere; a supplier looks at the acid test before granting credit. Strong answers weigh the evidence, reach a supported conclusion, and say what extra information or future event would change it.

Published accounts are prepared by the directors, and within the rules there is room to flatter them. Timing is the usual lever: chasing customers to pay before the year end, delaying payment to suppliers, selling and leasing back a property, or revaluing land so that gearing falls without a penny being repaid. Two ordinary forces distort the figures as well. A change in demand shows up as unsold inventory and a falling inventory turnover long before it reaches the profit line, and inflation inflates revenue so that a rise of three per cent in a year of four per cent inflation is a fall in real terms. The practical response is to read the notes to the accounts, follow the cash rather than the profit, and look at several years. Carillion reported profits and collapsed in January 2018.