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

Subtract the budgeted figure from the actual figure for the same item over the same period, then label the answer by its effect on profit rather than by its sign. Suppose a bakery budgets revenue of £250,000 and takes £262,000: that is a favourable revenue variance of £12,000. It budgets costs of £180,000 and spends £191,000: an adverse cost variance of £11,000. The net effect on budgeted profit is £1,000 favourable, and that combined figure is the one a board reacts to. A percentage variance, the variance divided by the budgeted figure and multiplied by one hundred, lets items of different size be ranked, so a small overspend on a very large cost line is not mistaken for a crisis while a large percentage gap on a small line is spotted.

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.

Setting and policing a financial plan is a control system, and its effects run well past the finance office. A delegated budget hands a department head real authority, which Herzberg would count as responsibility and a genuine motivator, while a figure imposed from head office is a hygiene factor that can only demotivate. The trade-offs are where the evaluation marks sit: tight targets protect cash and reassure lenders, yet they invite gaming, padding the bid one year and spending the surplus in March so it is not clawed back. Stakeholders feel it differently. Staff meet frozen training lines, suppliers meet stretched payment terms, customers meet a cheaper specification, and shareholders see the cost control land in operating profit.

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.

Three short pieces of arithmetic an examiner can set from one balance sheet extract. Current assets minus current liabilities gives a figure in pounds, so 180,000 of current assets against 120,000 of current liabilities leaves 60,000 to trade with. The long-term funding base is the owners' stake plus borrowing not repayable within the year, also in pounds, and every profitability and gearing ratio is built on it, so an error here carries through the whole question. The straight line charge takes purchase cost, subtracts any expected residual or scrap value, then divides by useful life in years, giving a constant amount each year: a van bought for 24,000 with a scrap value of 4,000 and a five year life is charged at 4,000 a year, and its carrying value falls by that each year.

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.

Two liquidity checks that ask whether a firm can pay what falls due within twelve months. The first divides current assets by current liabilities and is written as a ratio, so 240,000 against 150,000 reads as 1.6 to one. The second strips inventory out before dividing, on the grounds that unsold stock is the slowest item to turn into cash. Rules of thumb put the first near one and a half to two and the second close to one, but sector beats the textbook: a supermarket sells for cash and pays suppliers weeks later, so Tesco trades well below one and would be wasting money holding more. A jeweller with slow moving stock needs far more cover. Too high is its own problem, cash and inventory sitting idle instead of earning a return.

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.