SBL Notes – 2020-2021

Attempt Sir Hasan Dossani

– tfIFHE

Chapter 4
Finance in Planning & Decision Making
Funding Strategies
Funding strategies may vary from business to business. BCG Matrix can be used to decide the funding
strategy for each business unit within the group (Star, Cash Cow, Dog, Question Mark). Cash flow
projections are prepared to see whether there is a funding deficit or surplus:

Sources of Funds / Options in Case of Shortfall

▪ Equity:
 Ordinary share capital (IPO or right shares)
 Retained earnings
 Reserves
▪ Debt:
 Debentures
 Preference shares
 Leasing
 Bank loans
 Bank overdrafts or running finance
 Trade credit
 Term Finance Certificates (TFC)
▪ Others:
 Sell short-term investments
 Tighter working capital management (e.g. leading and lagging)

Factors to Consider When Deciding Funding Sources

▪ Purpose and amount
▪ Duration of requirement (short term or long term)
▪ Legal status of the company (e.g. sole proprietor, partnership or company)
▪ Debt / loan financing:
o High cost
o Interest not linked with business performance
o Availability of collaterals
o Current gearing level

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 SBL Notes – 2020-2021
Attempt Sir Hasan Dossani
– tfIFHE
▪ Equity financing:
o Cost linked with profitability
o Dilutes existing shareholding pattern
o Outside shareholders / institutional investor involvement
▪ Business risk vs financing risks
 Business risk: the chances that business will not make profit
 Financing risk: chances that business will have to pay interest on borrowed funds, despite
the fact that it is in a loss (e.g. debentures)
 When business risk is high, financing risk should be kept low (e.g. by taking equity financing
and not debentures / loans)

Options in Case of Surplus

▪ Interest bearing bank accounts
▪ Short term investment
▪ Treasury Bills
▪ Term deposits
▪ Long term investments

Changing Role of Finance and Accountants

Traditionally, finance function focused on three key roles: collections, payments and financial reporting.
However, these tasks have now become automated and hence the traditional roles of finance function as
well as accountants has transformed. Modern organizations now expect finance function to be strategic,
forward looking, proactive and focusing on creating value for the business.

Current roles for finance function (and accountants) focus more on:

▪ Support in strategic management, i.e. analyzing options, implementing and monitoring of strategies
▪ Providing in-depth analysis to business
▪ Long term business planning and scenario building
▪ Support complex decision making
▪ Performance measurement of the organization
▪ Finding areas of cost efficiency
▪ Funding sources & working capital management
▪ Managing financial risks
▪ Legal compliance
▪ Accounting and reporting

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 SBL Notes – 2020-2021
Attempt Sir Hasan Dossani
– tfIFHE
Modern Structure of Finance Function
Several working models have evolved in recent years to increase efficiencies of Finance function. These
working models are possible due to IT advancements such as internet, cloud computing, etc.

Outsourcing
Non-core tasks can be outsourced to a specialist vendor to avail economies of scale and cost savings.
Common tasks include invoicing, payment processing, bookkeeping, payroll, collections, etc. Harmon’s
Process Strategy Matric can be used in deciding which tasks can be outsourced.

Shared Services Model

In global organizations with multiple business units / locations, finance function can be centralized under
a shared service model, whereby it will provide support to all business units. This leads to significant cost
savings as well as better and standardization across the globe (covered in detail in next Chapter 5).

Ratio Analysis
Ratio analysis is used for comparison, analysis and performance measurement purposes. Limitations of
ratio analysis includes:
▪ Non-availability of comparable information
▪ Difference in accounting policies
▪ Lack of standard formula

Selected Ratios to be used in Exams:

P&L Ratios
▪ Sales trend
▪ Gross profit margin %
▪ Net profit margin %
▪ ROCE

Balance Sheet Ratios

▪ Current asset ratio
▪ Gearing
▪ Interest cover

Efficiency Ratio
▪ Revenue per employees

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 SBL Notes – 2020-2021
Attempt Sir Hasan Dossani
– tfIFHE

Long Term Decision Making –

Investment Appraisal Techniques
Once all costs and benefits of the project have been listed, then these are compared to see if the
investment in project is financially beneficial (investment appraisal). In a typical project, there would be
substantial cash outflow in the start in anticipation of long term cash inflows. Hence careful investment
appraisal is done as huge amounts are involved and it becomes difficult to pull out in the middle.

Following are commonly used investment appraisal techniques:

Payback Period
Determines the time (e.g. number of years) the company can recover its initial investment in the project.
This method is based on the cash flows. The lower the payback period, the better

Advantage:
▪ Easy to calculate and understand
▪ Emphasis on cash liquidity of a project, I.e. earlier the recovery of initial investment, the better
▪ Can be used for preliminary screening of options

Disadvantage:
▪ Ignores cash flows after the payback period (i.e. ignores the profitability of the project
▪ Ignores the amounts involved and only focuses on the time period (years)
▪ Ignores inflation aspects

Accounting Rate of Return (ARR)

Determines the % return on investment (based on accounting numbers and not cash flows). There are
numerous formulae to calculate ARR. The formula adopted by a company to calculate ARR should be
consistently applied to all projects, in order to enable correct comparison. The higher the ARR, the better.

Advantage:
▪ Easy to calculate and understand

Disadvantage:
▪ Ignores the timing of cash flows
▪ Ignores the 'amount' of the return
▪ Ignores inflation aspects

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 SBL Notes – 2020-2021
Attempt Sir Hasan Dossani
– tfIFHE

Discounted Cash Flows - Net Present Value (NPV)& Internal Rate of Return (IRR)
▪ DCF 'discounts' the cash flows of the project by using an appropriate ‘hurdle rate %’

▪ ‘Hurdle rate %’ takes into account:

 time value of money (inflation)
 cost of funds (if money is borrowed)
 Interest foregone / opportunity cost
 level of risk

▪ DCF is based on cash flow basis (I.e. relevant costing)

▪ There are two methods of investment appraisal using DCF

 Net present value (NPV) - gives the final profit / loss of the project in AMOUNT
 Internal Rate of Return (IRR) - gives the final profit / loss of the project as a PERCENTAGE

▪ Some characteristics of NPV

 A positive NPV means profit
 The higher the NPV, the better

▪ Some characteristics of IRR

 It is the % rate at which the NPV is zero
 The higher the IRR, the better
 If the IRR is higher than your target rate of return, you will accept the project
 NPV is more preferred than IRR, especially if the scale of investment is same / similar

▪ Advantage:
 Focuses on cash flows
 Considers the time value of money, cost of funds, desired profitability and risks

▪ Disadvantage:
 Difficult to ‘reliably’ estimate long-term cash inflows and outflows
 Does not consider ‘qualitative’ or ‘non-quantifiable’ benefits
 Difficult to calculate and understand

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 SBL Notes – 2020-2021
Attempt Sir Hasan Dossani
– tfIFHE

EXAM TIP FOR FINANCIAL PROJECTIONS GIVEN IN THE SCENARIO

In the case study, make sure that below 3 things are covered for any financial projection data. In case any
step is missing, then identify that step in your answer / analysis:

▪ The projections is based on cash flow (and not accounting flow)

▪ The cash flow is discounted (if over one year)
▪ Sensitivity / what-if analysis is done

Expected tfalues and Decision Trees

Expected Values
Expected Values (EV) is the weighted average value based on probabilities. E.g.:

Say, a new product research will cost $150 M and it is expected that if the product becomes successful, the
income would be $200 M (80% chance) and if the product is not successful, then the income would $30 M (20
% chance). Hence the expected value would be ($200 M X 80%) + ($ 30 M X 20%) = $166 M (i.e. weighted
average).

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 SBL Notes – 2020-2021
Attempt Sir Hasan Dossani
– tfIFHE

Decision Trees
Decision trees are diagrams which shows possible outcomes (probabilities) along with their monetary
outcome and Expected Values.

Short coming of a decision tree:

▪ It uses probabilities, which by nature are subjective and difficult to determine.
▪ The costs/benefits are also estimated, so too much estimation / subjectivity involved
▪ Just considers quantitative aspects and ignores qualitative aspects

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 SBL Notes – 2020-2021
Attempt Sir Hasan Dossani
– tfIFHE

Short Term Decision Making –

Marginal / Relevant Costing Techniques
Breakeven Analysis / Cost-Volume-Profit Analysis (CVP)
▪ Breakeven means where sales revenue equals total costs, i.e. no profit no loss position
▪ Contribution Margin = Sales Price per unit – Variable Cost per unit
▪ Breakeven volume / quantity is calculated by:

Fixed costs
Contribution Margin per
Unit

Marginal Analysis / Relevant Costing

When decision making is done between two options, only “incremental” revenue and “incremental” costs
should be considered, i.e. existing fixed costs should not be considered, if it is not changing. This is known
as marginal analysis or relevant costing. This technique is useful in four key areas of decision making

1. Accepting / Rejecting Special Contracts

ABC Ltd manufactures photo frames. The fixed cost for operating the workshop is $ 600 per month.
Each frame requires material of $ 2. Each frame requires one hour to make and labour is paid $ 12 per
hour. The frames are sold for $ 17.

The labour currently has some spare time available and an overseas retail chain has requested an
order of 400 frames at a price of $ 15. Should the business accept the order?

2. Efficient Use of Scarce Resources

When the resources are scarce or limited (e.g. production capacity), then those products are
manufactured
first which have the “highest contribution margin per limiting factor”

A business makes three different products, as follows:

Product A Product B Product

C
Selling price per unit ($) 25 20 23
Variable cost per unit ($) 9 5 11
Contribution margin 16 15 12
Machine time per unit (hours) 4 3 4
Weekly demand (units) 25 20 30

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 SBL Notes – 2020-2021
Attempt Sir Hasan Dossani
– tfIFHE
Fixed costs are not affected by the choice of product. Machine time is limited to 148 hours per week.
Which combination of products should be manufactured if the business is to produce the highest
profit?

3. Make or Buy Decisions

Shark Ltd needs a component for one of its product. It can purchase the components from Ray Ltd for
$ 20 each, or it can produce them internally for total variable cost of $ 15 per component. Should the
component produced internally or purchased from Ray, IF:

A- If Shark Ltd has spare capacity available

B- Is Shark has no spare capacity and could only produce the component internally by reducing its
output of another of its products, whose contribution margin is $ 6.

4. Closing or Continuation Decisions

Mog Town Ltd is a retail shop with 3 departments all located on the same premises, occupying similar
space. Below is the annual P&L of the 3 departments along with total for the company as a whole:

Cat Food Cat Toys Cat House TOTAL

Sales revenue 254 183 97 534
Variable cost 167 117 60 344
Contribution margin 87 66 37 190
Fixed cost (rent) 46 46 46 138
Profit / (loss) 41 20 (9) 52

Should we close Cat House department as it is incurring losses, so that our profits can increase by $ 9000?

Decision Making, Financial Reporting & Tax

Decision Making and Financial Reporting
Decision making techniques are generally based on ‘cash flows’ rather than accounting profit. This is
because using cash flows are more objective and harder to manipulate than profits. However,
shareholders focus on profitability, which is based on accrual basis for accounting. In long term, the cash
impact and profit impact of the decision would be same, but in short term, the profit and cash flow is likely
to be different from each other, due to timing differences between cash flow accounting and accrual based
accounting, e.g. capital expenditure
/ depreciation, working capital, etc.

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 SBL Notes – 2020-2021
Attempt Sir Hasan Dossani
– tfIFHE
Shareholders tend to react more on profitability rather than change in cash flows. If a decision adversely
affects current profitability it will reduce the EPS and the share prices in short term. Hence decision
makers need to consider the impact of major decisions on short term profitability / financial statements
so that appropriate disclosures could be made in the financial statements in order to give shareholders the
long term perspective.

Decision Making and Tax Implications

Another factor may be the tax implications of the decision. In addition to the normal tax rate being applied
on the project, the decision may have “more than normal” tax impact on the overall organization, such as

▪ The decision may move the organization into another tax bracket
▪ The decision may change organization’s eligibility of tax relieve (either favorable or unfavorable)
▪ The decision may impact the timing of tax payments as tax is based on profits and not cash

These factors become further factors for decision makers to consider over and above the simple outcomes
from relevant costing or investment appraisal analysis.

Budgetary Process
Introduction
Budgets are plans expressed in financial terms. It converts strategic plans into specific financial targets.
Once prepared, budgets should be closely monitored against actuals (i.e. variance analysis) to ensure that
planned activities actually take place. Budgets are important to control the organization as they provide a
yardstick against which actual performance is assessed.

▪ Period Budget is prepared for one year – e.g. January to December 2011

▪ Rolling Budget is budgets which is continuously updated for the next 12 months

Master Budgets
Budgets are prepared for each department and then summarized in Master Budget. Usually, Sales Budget
is prepared first and then other budgets are prepared on the basis of Sales Budget, such as production
budget, raw material / purchase budgets, cash flows, etc.

Flexed Budgets
Flexi budgets are revised budgets based on actual sales trend. In case the budgeted sales is not achieved,
then production and expenses budget are revised based on actual sales volume. This helps in analyzing
the performance of all departments in light of the lower sales

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 SBL Notes – 2020-2021
Attempt Sir Hasan Dossani
– tfIFHE
Advantages of Budgets
▪ Promotes forward thinking
▪ Helps to coordinate various functions of the Organization
▪ Having defined targets can motivate managers
▪ Control and performance measurement tool

Limitations of Budgets
▪ Unrealistic targets
▪ Short term focus
▪ May encourage Malpractice or Unethical practice

Effective Budgetary Controls Depends On

▪ Senior management takes the budgetary process seriously
▪ Targets should be realistic and achievable
▪ Clear responsibility and accountability should be affixed
▪ Regular comparison of budget versus actuals along with investigation of the variances, reasons
and corrective measures. Usually this activity is done monthly or quarterly

Standard Costing
Introduction
▪ Standard Costing:
Standard costing means estimating total costs based on pre-determined unit cost
▪ Variance:
Difference between total estimated costs and total actual costs
▪ Variance Analysis:
Analyzing and investigating the variances

Sales Variances
▪ Sales Price Variance:
(Actual Selling Price – Standard Selling Price) X Actual Quantity

Possible Reasons for Unfavourable Sales Price Variances:

Selling price has been lowered due to tough market conditions or due to increase market share (price
penetration strategy)

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 SBL Notes – 2020-2021
Attempt Sir Hasan Dossani
– tfIFHE

▪ Sales Volume Variance:

(Actual Sale Quantity – Standard Sale Quantity) X Standard Selling Price

Possible Reasons for Unfavourable Sales Volume Variances:

Poor performance by sales staff, poor quality of our product leading to lower customer demand,
competitor has launched a new or better product, etc.

Material Variances
▪ Material Price Variance:
(Actual Unit Cost – Standard Unit Cost) X Actual Quantity

Possible Reasons for Unfavourable Material Price Variances:

Increase in prices of materials due to shortage, better quality raw material is being is used, poor
performance by purchase department staff, etc.

▪ Material Usage Variance:

(Actual Usage Quantity – Standard Usage Quantity) X Standard Unit Cost

Possible Reasons for Unfavourable Material Usage Variances:

Poor performance of production staff, substandard raw materials, faulty machinery or production
process

Direct Labour Variances

▪ Labour Rate Variance:
(Actual Labour Rate – Standard Labour Rate) X Actual Labour Hours

Possible Reasons for Unfavourable Labour Rate Variances:

Increase in labour prices due to shortage of labour, better quality / high-skill labour is being is used,
poor performance by HR staff in negotiating prices, etc.

▪ Labour Efficiency Variance:

(Actual Labour Hours – Standard Labour Hours) X Standard Labour Rate

Possible Reasons for Unfavourable Labour Efficiency Variances:

Poor supervision, untrained / low-skill labour, poor quality raw materials is being used, faulty
machinery or production process, delay in supply of raw materials, etc.

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 SBL Notes – 2020-2021
Attempt Sir Hasan Dossani
– tfIFHE

Fixed Overheads Variances

▪ Fixed Overhead Variances
Actual Fixed Overheads – Flexed Fixed Overheads

Flexed means that the budgeted overheads are recalculated based on actual production volume and
then compared to the Actual Fixed Overheads (in order to have apple to apple comparison). Here the
concept of fixed and semi-fixed costs are considered.

Possible Reasons for Unfavourable Fixed Overheads Variances:

Poor supervision of overheads, general increase in costs not considered in the budget.

Advantages of Standard Costing

▪ Helps in accurate budgeting
▪ Provides a yardstick to measure actual costs
▪ Having defined standards improves performance as staff will make efforts to achieve the standards

Limitations of Standard Costing

▪ Can only be used for routine or repetitive processes
▪ Standards can quickly become outdated, hence regular monitoring and updation is required

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 SBL Notes – 2020-2021
Attempt Sir Hasan Dossani
– tfIFHE

Forecasting Techniques
QUALITATIVE TECHNIQUES:
▪ Delphi Technique:
Panels of experts are selected and each of them produces an independent forecast. Then the
forecasts are shared and then revised forecast is produced. The process continues until they are all
in agreement with one set of forecast

▪ Sales Force Opinions:

Input is gathered from the sales force based on their market knowledge and then converted into
an aggregate forecast

▪ Executive Opinions:
Input is gathered from various high executives based on their own knowledge and then converted
into an aggregate forecast

▪ Market Research:
Involves use of customer surveys to evaluate potential demand

QUANTITATIVE TECHNIQUES:

Least Square or Linear Regression Analysis

It uses the ‘line of best fit’ approach to find out the relationship / trend between two variables. One
variable is independent (X) and other variable is dependent (Y). For e.g. in sales data, X can be the quarter
(on X axis) and Y can be the Amount of Sales (on Y axis). Least square Analysis is based on an equation Y =
a + bX, where:

X = independent variable

Y = dependent variable

a = where the line intercepts Y axis on the graph

b = the gradient of the line

The above equation is used to predict the sales value for next quarter

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 SBL Notes – 2020-2021
Attempt Sir Hasan Dossani
– tfIFHE

Correlation Coefficient (R)

The correlation coefficient (R) shows strength of relationship between the two variables, i.e. how
much Y is dependent on X. The value of correlation coefficient (R) ranges from -1 to 1 and will be
given in the question. For e.g. the correlation coefficient can be 0.3. The coefficient of
determination (R2) shows that only 9% (0.32) of the variation in sales (Y) is due to passage of
time (X).

If correlation coefficient (and determination) is low (say <0.7), then it means that Y is not highly
dependent on X and there is a lot of seasonality factor involved in the sales trend. If correlation
coefficient (and determination) is high (say >0.7), then it means that Y is highly dependent on X
and it will be easy to predict Y based on X.

Least Square Analysis Is Appropriate Where

▪ Correlation coefficient is high (say >0.7)
▪ There is low seasonality affect in the sales trend
▪ Large pool of historic data is required e.g. annual sales data

Time Series Analysis

A Time Series Analysis uses moving average to define a trend. It identifies the seasonal variations from
data in order to determine the underlying / actual trend. In time series, X-axis will always represent time
(e.g. years, quarters, months, weeks, etc.). Example of Moving Average Method to remove seasonalization:

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 SBL Notes – 2020-2021
Attempt Sir Hasan Dossani
– tfIFHE

Time Series Analysis Is Appropriate Where

▪ Correlation coefficient is high (say >0.7)
▪ There is high seasonality affect in the sales trend

Practice Questions
P3 – Pilot Paper Q3: Forecasting | Budget (Cool Freeze)
P3 – Dec 2012 Q4: Decision Tree | Risk Management (World
Engines)

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