UNIT 3. INTRODUCTORY CONCEPTS

In the previous topic with Jones Travel you started to look at concepts concerning profitability, funding, investment, budgeting and problem-solving. This gives you a quick insight into some of the important concepts for analysing and interpreting financial statements.

It will be essential for you to always have a mental picture of the structure of a Profit & Loss Statement and Balance Sheet and particularly the main classifications eg. expenses, current assets, long term liabilities. These are the component parts of the business.

As managers go about their planning and decision-making tasks they know that sooner or later all of their ideas will have to be quantified and expressed in profit and loss and balance sheet terms. This will become more obvious when we look at budgeting and feasibility studies.

These financial statements therefore become the pivot around which the whole of the business can be understood, planned and controlled. In a sense it is that simple. So if you remember this advice now, it will be of immense value to you for doing the subject well and becoming an effective manager.

We would like to introduce you to the concept of fixed and variable costs. It is very important to look at each of our expenses and decide whether or not the expense tends to be relatively fixed in the short run (say 12 months) or whether it tends to vary directly in proportion to the volume of business activity. In the long term of course all costs will vary.

Have a look at the expenses listed in the Profit & Loss Statement for Jones Travel (contained in the previous topic). In approximate terms we would suggest that most of these expenses are fixed costs. Examples of variable costs would be sales commission and telephone calls (as distinct from telephone rent). If sales commission for example is a fixed percentage of the value of sales then if sales doubled we would expect sales commission to double.

Another concept is "budgeting". A budget is a set of figures that gives quantitative expression to a whole series of plans, actions and decisions relative to the forward planning of the business. We should remember that in the final analysis that most business activities have a financial impact and therefore will be recorded in one form or another in the financial statements.

We normally expect to see a budgeted cash flow, budgeted profit and loss statement, budgeted balance sheet and budgeted funds statement.

Let us look now at the relationship between a budget and a marketing plan. A budget is the final expression of a marketing plan. The figures we have in Jones Travel for income, salaries, stationery, telephone and travel will directly relate to the marketing plan. We should even expect there to be further detailed sales budgets prepared by customer type, product type and/or geographic area and furthermore that key personnel in the agency would be allocated specific targets for income and expenses.

It is sometimes helpful to remind ourselves about the main functions of management... planning, organising, staffing, direction and control. Budgeting plays a integral part in helping managers to manage. We have already said that there is a link between budgeting and planning. So too between organising and budgeting as the various job descriptions in the organisation chart have financial objectives built into them. Where these financial objectives and activities are critical for job performance then obviously this will influence staff selection and appraisal. Budgets will also focus on key problems and opportunities to be addressed under the heading of direction. Finally the control function looks at the management information system for the organisation of which the major part is the budgeting and accounting system. The financial statements which reflect actual performance are measured against the budget to highlight variations which must be investigated and actioned.

Another concept worth introducing at this point is "ratio analysis" is introduced. This will be explained in greater detail later in topics 5,6,7 & 8. Suffice to say at this stage a ratio is merely an alternative way of expressing a percentage relationship. For example, if we have $131 current assets and $100 current liabilities, we say the relationship between these two items is 1.31 which is another way of saying that current assets are 131% of current liabilities.

This is called a liquidity ratio which can be simply explained by saying that we have $1.31 of current assets for every $1 of current liabilities. Normally in business we like to see $2 of current assets for every $1 of current liabilities although for travel agencies a lower liquidity ratio is acceptable.

By looking at business performance in the area of liquidity in this way we have a useful statistic to compare with similar statistics for previous periods or with our competition. By making these comparisons we can form opinions as to whether our performance is "good" or "bad" or "better" or "worse" than our previous performance or than that of others in the industry.

"Return on investment" is a crucial concept which will also be explained later. For instance if you put $1000 into the bank and earned $100 interest in one year you would say that your return on investment was 10%. In this way you can compare this investment with other investments and make your final decisions on the basis of the best return given the level of risk involved.

Copyright © Bill Wright 1994