A2as Bus Revised Support 11246

GCE Business Studies
A2(1) Making Business Decisions
Student Notes
MAKING BUSINESS DECISIONS

The theme of this unit is about making business decisions. A wide range of
business decisions are taken every day by managers, employees, customers and
other stakeholders of a business. The following sections consider issues related
to the important decisions likely to be made in a business context.
BUSINESS OBJECTIVES
Chapter Aims:
Evaluate the purpose of a Mission Statement;

Evaluate differing Business Objectives;
Evaluate the nature of short-term and long-term objectives;
Evaluate the meaning of goals in business, including Survival, Profit
Maximisation and Growth;
Evaluate the term Market Share within a business context;
Evaluate the nature and consequences of conflict within the context of
business objectives.
Introduction:
This chapter discusses key definitions related to the mission statement of a
business, including an introduction to various short and long-term objectives that
a business might have. Related to this is a discussion of various goals which
might be pursued in the course of business. The nature of conflict is discussed
too.
Mission Statement
To enable the full potential of all learners to be achieved and recognised

A mission statement is a description of the key objectives of a business.
The Purpose of a Mission Statement:
Within the context of decision making, a business should draw up a mission
statement for a number of reasons, enabling it to:
Set out the purpose of the business
Document the main aim(s) of the business
Provide an insight to the long-term objective(s) of the business
Communicate to stakeholders the focus of short-term business activities
Motivate employees within the business
Attract customers to the business
Publicise in qualitative terms, the aspirations of the management team

within the business
The mission statement should be a clear and succinct representation of the

enterprise's purpose for existence. It should incorporate socially meaningful and
measurable criteria addressing concepts such as the moral/ethical position of the
enterprise, public image, the target market, products/services, the geographic

domain and expectations of growth and profitability.
Usefulness of Mission Statements
In terms of decision making, the extent to which a mission statement is useful will
depend on the reason why it was prepared in the first place.
Benefits:
A mission statement might be useful in the following circumstances:
It can assist the management team to focus on the main purpose of the
business
It summarises the aim(s) of the business, which in turn should support the
main purpose of the business
It enables the management team to develop long-term plans for the

business
It allows the management team to communicate to relevant stakeholders

the goals of the business
It can motivate staff within the business
It can act as a useful device in order to attract publicity for the business in
a positive manner
Drawbacks:
Alternatively, the publication of a mission statement might have some negative
implications:
It may result in an inability of the management team to relate the mission

statement to the actual decision making process or purpose of the
business either unintentionally or deliberately
Staff may not be motivated to read the mission statement, instead

focusing on their individual roles within the business, letting the
management team take responsibility for all key decisions
Negative publicity may be attracted if a business fails to achieve the goals

stated within the mission statement as stakeholders are likely to have
expectations about the extent to which a business will act in this manner
There may exist an alternative motive on the part of the management

team i.e. a variation might exist between the stated aim of the
management team and actual aims pursued
Business Objectives:
A business objective can be defined as a goal which a business is seeking to
achieve. A business is likely to have a number of objectives typically one
overall key objective supplemented by a number of related or subsidiary
objectives. Objectives will change depending on economic conditions and the
decisions which have to be made by the management team at a given point in
time, however the most common objectives are:
1. Survival
iStockphoto/Thinkstock
In terms of decision making, the key objective is to ensure that a business

continues to operate for the foreseeable future, as a going concern. This can be
seen in a number contexts:
New starts in this situation a business is faced with various decisions

regarding the success of the initial start-up and survive the early stages of
trading;
Existing businesses in this situation a business might encounter a

downturn in economic performance due to internal (poor
management/inappropriate product portfolio) and/or external factors
(recession), hence the decisions taken in this situation will be aimed at
ensuring survival on an ongoing basis;
Takeover in this situation a business might be the subject of a takeover

bid by another business, which will ensure the survival of the existing
business.
Survival may be the only option open to an organisation. Although this may not
be in the interests of shareholders who are seeking a return from their
investment, it may be the only viable option, ensuring that shareholders do not
lose their initial capital commitments.
2. Profit Maximisation
In terms of decision making, this objective can be taken to mean operating a

business at that level of output (measured in terms of sales revenues and/or
sales quantities) whereby a business achieves the maximum available profit. In
reality, very few businesses achieve profit maximisation (due to pressure from
stakeholders, industry regulators and other parties), instead, aiming to achieve a
position whereby a satisfactory level of profit can be achieved. However, profit
maximisation may mean that other objectives are sacrificed as the organisation
seeks to make as much profit as possible.
3. Growth
In terms of decision making, this is likely to be the most common objective and is
likely to be considered within the context of an existing business. Growth can be
measured in various ways, including measurement of sales quantities, revenues,
profit levels or market share for example. Indeed, achievement of growth of
revenues or market share might secure the future prospects of a business,
enhance the competitive position within the industry or minimise the chance of
business failure. Various growth strategies are available in order to achieve this
objective. However, the objective of growth can mean that profits need to be
reinvested into the organisation, meaning that shareholders may not receive
dividends as high as they were expecting.
4. Social Responsibility
Social responsibility typically refers to the practices of a company or organization.

A company with strong levels of social responsibility will prove to be an asset to
the community and society where it is based. Social responsibility requires a
balance of responsible business practices, sound business decisions and strong
ethics and morals. However, acting in a socially responsible manner may mean
that the objective of profit maximization is not achieved. These two objectives can
conflict with one another in cases where business practices that seek to
maximize profits can only be achieved by not being socially responsible.
5. Employee Welfare
Creatas Images/Thinkstock
The provision of employee welfare is an important objective; this relates to issues

such as wages & salaries; comfortable and safe working conditions, training and
development; pensions etc. The value of many businesses is critically-dependent
on attracting and retaining high quality employees which makes managing the
welfare of such people even more important. However, ensuring that employee
welfare is achieved can be costly and in some cases when employees receive
training they can use this to apply for other jobs with competitors.
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6. Corporate image
The corporate image or reputation of an organization is an important objective. A

good corporate image can generate interest from potential customers and also
help to keep existing customers.
Bad publicity can have a detrimental impact on an organization. Customers can
become very suspicious of an organization which has a poor corporate image
and look for alternative organizations to meet their needs.
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7. Concern for the environment
Wavebreak Media/Thinkstock
Some customers have a genuine desire to ensure that business practices take
into account environmental issues. In some cases this will help them to decide
which organization they will buy their product or services from. This can therefore
be used by organizations to achieve a competitive advantage. However, some
organizations use this objective as a means of saving money rather than having
a genuine concern for the environment.
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Factors determining business objectives:

There are a variety of factors which can determine the objectives of a business.
These include:
Owners the ownership of a business will influence key business

objectives.
Small Business the ultimate responsibility for decision making rests with
the owner in a sole trader business (or partners in a partnership), thus it is
likely that they exert personal control over the decisions taken in order to
support the primary objective of making a profit.
Large Business in most cases, the responsibility for decision making will
rest with the board of directors, thus it is likely that the board will consider a
variety of related issues in relation to the primary profit objective.
Stakeholder Power the power of specific stakeholder groups relative to

the business is likely to influence key business objectives, as it is likely
that different stakeholder groups will have different objectives.
Shareholders in the context of a limited company, shareholders will be

motivated by profits and are thus likely to be the most dominant group of
stakeholders.
Size the size of a business will influence key business objectives, as it is

likely that businesses of different sizes will have different objectives.
Small Business such businesses are likely to be concerned with

achieving a satisfactory level of profit or breakeven position, in order to
ensure survival.
Large Business such businesses are likely to be concerned with
maintaining market share/revenues and securing growth of the business in
the long-term.
Pressure Groups a business may be forced to reconsider key business

objectives if, for example, a pressure group yielded sufficient power to
influence a particular course of action, e.g. a drugs manufacturer who
tests products using animals, might be subject to negative publicity
brought about by the actions of pressure groups concerned with the
safety/welfare of animals.
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Timescale the timescale within which business decisions are taken is

likely to influence key business objectives. It is likely that the objectives of
a business will change in the short-term (i.e. up to 1 year) and long-term
(i.e. 2+years) very often the primary objective will be the same. Most
businesses will aim for survival or building market share in the short-term
(measured in terms of revenues or profits), with a long-term focus on
profitability/growth in terms of revenues and market share within the
context of a competitive market.
Internal/External pressure the combination of pressure exerted by

sources internal or external to a business is likely to influence key
business objectives examples of such pressure can usually be traced to
stakeholder groups yielding influence over key business decisions.
Internal changes in personnel within the management team are likely to

give rise to internal pressure in respect of the decisions to be taken in relation
to the key business objectives for example, the appointment of a managing
director with a marketing background might lead to a business pursuing
marketing type goals in order to achieve success (e.g. increase customer
numbers or sales revenues or increased promotional activity aimed at
increasing the profile of the business amongst customers), compared to a
managing director with an accounting background who might decide that
costs need to be reduced within a business, in order to improve profitability.
External changes in the external environment brought about by the
government as a result of legislation might force a business to re-evaluate
the decision making process in order to achieve key objectives for example,
the law requires that business owners make reasonable adjustments to their
premises in order to facilitate physically disabled customers access to their
premises. This might mean that decisions are taken to ensure that all
entrances/exits have automatic opening/closing facilities to accommodate the
needs of disabled staff/customers, which in turn means that additional funds
are required to pay for modifications to premises thus increasing cost and
decreasing profits. Such a decision might be a positive one, in that, not only
does a business attract able-bodied customers but also physically disabled
customers, thus increasing revenue streams in the long-term.
Risk the conduct of business involves a degree of risk and this will
influence key business objectives. This will be dependent in part, upon
the attitude to risk adopted by the management team in relation to the
decision making process in a business.
Risk Taking in this case, the management team could decide that in
order for the business to succeed, it must take a risk (or gamble) that
revenues/profits can be gained from sales of existing products in new
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markets (e.g. overseas). The risk taken is that a market exists for such
products and that by entering the overseas market; increased
revenues/profits will accrue, at least covering expenses and secure market
share. On the other hand, there is that chance that no demand for the
products of the business exists and therefore the business will fail.
Businesses that take such a gamble against huge odds in the context of
many unknown factors are referred to as risk takers.
Risk Avoiding in this case, the management team could decide that in
order to survive, it must avoid taking risks, and that by continuing to serve
the needs of existing customers in existing markets it will secure a
satisfactory revenue/profit stream for the business at least this will
maintain current market share. Businesses that do not take such risks
and play safe, preferring relative certainty in the decision making process
are referred to as risk averse.
Culture culture refers to the way things are done in a business, hence
is likely to play a large part in the decision making process and likely to
influence key business objectives. The way things are done will depend to
a large extent on the processes and procedures followed and the
behaviour of people within a business entity as it attempts to meet
objectives. Cultures vary from people centred (i.e. a business might
focus on meeting the needs of customers and staff as a priority) to
competition orientated (i.e. a business might focus on meeting profit or
market share objectives in the first instance.
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Market Share
This refers to the proportion of customers or sales that a business has

successfully conducted business with in relation to the total number of customers
or sales that exist within the overall market. Market share can be measured in
various ways including sales revenues, quantities or customer numbers. In a
decision making context, it is important that a business can build market share in
the short term (in order to survive) with a long term focus on maintaining growth
in market share (in order to grow the business).
Short-term Objectives:
These are objectives which are designed to be achieved in the short-term. The
short term is generally defined as a period of up to 1 year. Most businesses
would prepare plans focussing on key objectives which might be achieved in this
timeframe such plans are referred to as Operating Plans. Short term
objectives should be drawn up in line with the long term objectives of the
organisation. However in some cases changes in the internal or external
environment may mean that short term objectives need to be changed. This may
have an impact on the long term objectives of the firm.
Long-term Objectives:
These are objectives which are designed to be achieved in the long-term. The
long term is generally defined as a period beyond 1 year.
Many larger
businesses would prepare plans summarising key objectives which might be
achieved going forward into the future over a longer time span such plans are
referred to as Strategic Plans. These objectives should be achieved through the
implementation of short term plans, however as already noted, changes in the
operating environment can have an impact on this.
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Conflict:
Stockbyte/Thinkstock
Conflict can be defined as the contradiction of ideas or objectives, which

generally mean that one objective, cannot be achieved or that it might be
achievable at the expense of another related/subsidiary objective.
Many business objectives complement each other and are acceptable to a broad
range of stakeholders. For example, an objective for a business start-up of
achieving survival would be supported by nearly all the stakeholders. It is in noones interest for a business to fail! However, once a business becomes better
established and larger, then potential conflicts begin to arise.
Business expansion versus higher short-term profit:
An objective of increasing the size and scale of a business might be supported by
managers, employees, suppliers and the local community largely for the extra
jobs and sales that expansion would bring.
However, an expansion is often associated with increased costs in the short-term
(e.g. extra marketing spending, new locations opened, more production capacity
added). This might result in lower overall profits in the short-term, which may
cause conflict with the business shareholders or owners. In the longer-term,
however, most business owners would be pleased to support an expansion if it
increases the overall value of the business.
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Job losses versus keeping jobs

This has been a big issue for many businesses during a period of economic
downturn. In order to reduce costs and save cash, business managers have
often made redundancies amongst the workforce or introduced other measures
such as short-time working to reduce wage costs. This will have been supported
by business owners and managers.
However, it creates a potential conflict with stakeholders such as employees
(who are directly affected), the local community (affected by local job losses) and
suppliers (who suffer from a reduction in business).
Below are some other potential causes of conflicts between stakeholders:
Short-term thinking by managers may discourage important long-term

investment in the business
New developments in the business such as a major product launch or a new

factory may require extra finance to be raised, which reduces the control of
existing investors
Investing in new machinery to achieve better efficiency may result in job

losses
Extending products into mass markets may result in lower quality standards
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Generally speaking, a business will need to continuously achieve its key

objective in order to succeed in the market. Conflict tends to arise when one or
more business objectives are unclear. It has been suggested that business
objectives should be SMART
Specific objectives must be stated precisely

Measurable objectives must be capable of measurement in order to determine
achievement of them
Agreed objectives must be understood and approved by key stakeholders
Realistic objectives must be capable of attainment, grounded in reality relative
to the business resources
Time Bound objectives must be achievable with a particular timeframe
If an objective does not fit into any of the above criteria, then it is likely that this
will give rise to conflict and thus have negative consequences on the business
entity.
Key Terms:
Mission Statement; Business objective; Short-term; Long-term; Goals; Survival;
Profit maximisation; growth; market share; conflict.
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Test Your Knowledge:

Explain what is meant by the term mission statement.
Explain what is meant by the term conflict.
Evaluate three possible objectives that a business might have.
State two reasons why a business would use a mission statement
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Mission Statement:
Case Study:
Read the following information and answer the questions that follow.
Walk-it Limited builds and maintains various city centre infrastructure projects
under tender from the UK government. Such projects include provision of
temporary car parks on derelict city centre sites and building bridges across
natural barriers, e.g. rivers. The headquarters of the company are located in
Larne.
Walk-it Limited entered into a contract to build a footbridge across the River
Foyle in Derry City Centre, which would link the two parts of the City separated
by the river. Construction work on the new footbridge will finish in December this
year, and users (including disabled persons) will be able to use the footbridge as
from the start of January. The footbridge will have a series of moving walkways
built into it to assist user mobility. It is proposed to charge all users a toll for use
of the footbridge, whereby each person using the bridge would pay a 50 pence
toll charge.
The footbridge will be conveniently located such that, it links the main shopping
district with bus, rail, taxi and car-parking facilities enabling commuters to enjoy
the benefits of similar park and ride schemes operating in other major UK cities.
This would reduce congestion at peak times in addition to providing a new
landmark for the city of Londonderry, in which approximately 100,000 people live.
The nearest bridge (Craigavon Bridge) which pedestrians could use is located
some distance away and necessitates a time-consuming detour away from the
main shopping district, thus the footbridge is convenient, particularly for those
with restricted access to transport facilities.
Walk-it Limited would operate and maintain the footbridge for a period of 25
years after construction. The footbridge will face competition with existing bus
and taxi services. The management team at Walk-it Limited have indicated that
they must attract a minimum of 200,000 users each year in order for the
footbridge to be commercially viable. Management estimate that 250,000 users
will use the footbridge per year for the first two years, growing to an estimated
400,000 users each year thereafter following extensive promotion of the facility
using various media networks.
The mission statement of Walk-it Limited states: Walk-it Limited is a private
company operating key infrastructure projects. It aims to increase market share
and profitability, promoting confidence in the use of transport projects, doing so in
an efficient, profitable, safe and innovative manner. Walk-it Limited will cooperate with relevant stakeholders as appropriate in order to achieve objectives.
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Questions:
Q1: Explain the purpose of a mission statement. Illustrate your answer with
reference to the case study.
Q2: Walk-it Limited is likely to have short term and long term objectives.
Outline two examples of each with reference to the case study.
Q3: With reference to Walk-it Limited, discuss the extent to which the
following objectives might be successfully achieved:
(a) survival;
(b) growth;
(c) profit maximisation.
Q4: Referring to Walk-it Limited, evaluate the use of a mission statement in
relation to the possible achievement of business objectives.
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Suggested Solutions
Q1:
Mission Statement: The purpose of this statement is to indicate the reason for
the existence of a business entity. It is a useful mechanism through which the
management team can communicate the objectives and values of the
organisation, influence employee behaviour and attitudes and assist achievement
of common business objectives.
With reference to Walk-it Limited, the mission statement states that: Walk-it
Limited is a private company operating key infrastructure projects. It aims to
increase market share and profitability, promoting confidence in the use of
transport projects, doing so in an efficient, profitable, safe and innovative manner.
Walk-it Limited will co-operate with relevant stakeholders as appropriate in order
to achieve objectives.
This will guide the management team and others toward achieving business
objectives.
Q2:
Long Term Objectives
Walk-it Limited could aim to: (i) build and maintain a city centre infrastructure
project, operating and maintaining a footbridge for a period of 25 years after
construction; (ii) maintain footbridge viability - management estimate that
400,000 users each year are required after the first two years to ensure growth.
Short Term Objectives
Walk-it Limited could aim to: (i) initially build and maintain a footbridge across
Lough Foyle, establishing market share in the transport market; and (ii) build
market share, by attracting a minimum of 200,000 users each year in order for
the footbridge to be commercially viable.
Q3:
Achievement of Business Objectives:
The extent to which Walk-it Limited might successfully achieve the key objectives
is as follows:
Survival: it is likely that Walk-it Limited will survive as a business during the first
two years of operation, it requires 200,000 users per year for the footbridge to
breakeven. It is expected to carry 250,000 passengers in each of the first two
years. This is 50,000 more than breakeven thus assumed to yield some profit
each year to enable the company to survive. It will also focus on building market
share during this period, carrying 200,000 users per year compared to bus, rail
and taxi services.
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Growth: it is likely that Walk-it Limited will focus on achieving growth in sales
revenues and market share as from year three, since it is estimated the
footbridge will have 400,000 users each year. This represents a substantial
increase relative to the breakeven point, yielding profits and is likely to be as a
result of the heavy advertising undertaken by the company. This objective is
likely to be achieved over the long term, within the context of a city where
100,000 live and as users become more familiar with its existence and market
share increases.
Profit Maximisation: it is likely that this objective will not be achieved in the short
term, as there will be substantial costs related to construction and maintenance,
operating the footbridge and increasing market share. Walk-it Limited is
assumed to operate in a competitive market (compared to bus, rail and taxi
services) and with the influence of the public, it is not likely to set toll charges
that yield profit maximisation.
Q4:
Evaluation of Mission Statement: the extent to which the achievement of
business objectives will be achieved in accordance with the stated mission
statement of Walk-it Limited will have an impact in terms of both positive and
negative aspects.
Positive aspects include:
(i) achievement of increased levels of efficiency and profitability, subject to
increased levels of public confidence in the use of the footbridge;
(ii) achievement of safety in the provision of the footbridge, since this is
specifically mentioned, this will benefit employees too, and arises from increased
public confidence;
(iii) the element of competition noted in the mission statement would imply that
Walk-it Ltd will provide users with a service that they can afford to pay, thus
increasing user numbers;
(iv) the provision of efficient, safe and innovative services is dependent upon the
extent to which the needs of employees can be met, through training, working
conditions and other issues;
(v) increased user numbers could lead to increased market share, thus
increasing public confidence, which in turn would meet the objectives of the
management team and government;
(vi) co-ordinated bus and rail services linking to the footbridge will make the
company more efficient and profitable the mission statement implies that the
company with work with other stakeholders.
Alternatively, a number of negative aspects include:
(i) Walk-it Ltd has a vision of efficient, safe and innovative operations/services,
implying modern facilities, which would require investment, which in turn will be
expensive;
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(ii) costs must be managed in order to compete effectively with other public
service transport providers;
(iii) Walk-it Ltd may be required to operate the footbridge in a way that is not
profitable due to the terms of the contract granted by the government;
(iv) safe and innovative facilities require funding which will increase the cost base
of Walk-it Ltd and in turn reduce profitability;
(v) Walk-it Ltd may encounter resistance to change from key stakeholders which
would reduce its ability to meet the mission statement contents.
It is possible to conclude that the mission statement is of value to an organisation
such as Walk-it Ltd and should ensure that it is successful.
Evaluation will be expected throughout this answer.
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STAKEHOLDER OBJECTIVES
Chapter Aims:
Evaluate different stakeholder groups in business;

Evaluate the nature of different stakeholder objectives;
Evaluate the nature of conflict between business and stakeholder
objectives;
Evaluate various strategies available to deal with conflict within the context
of stakeholder and business objectives.
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Introduction:
This chapter discusses key definitions related to the objectives of various
stakeholder groups within a business.
Stakeholder:
A stakeholder is a person or group who has a direct influence on the business
entity.
Stakeholder Groups:
There are a number of stakeholder groups related to a business entity. These
include:
Owners
Managers
Employees
Suppliers
Customers
Creditors
Society
Government
Stakeholder Objectives:
Each stakeholder group is likely to have their own set of objectives in relation to a
business, and will therefore usually adopt a different perspective regarding the
activities of the business, which in turn, is likely to influence the business in
different ways. Depending on where the balance of power lies, it could be that
the business is more powerful and can manipulate stakeholder behaviour in a
way that would be consistent with the achievement of business objectives.
However, there are situations in which the power of stakeholders would appear to
be more influential. Either way, the relationship between the business and
various stakeholder groups is likely to feature in the context of making business
decisions.
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Influence of Stakeholder groups:

Stakeholder groups which are likely to influence the decision making process in a
business include:
Owners
Creatas/Jupiterimages/Thinkstock
This stakeholder group are traditionally seen as the most powerful, since
ultimately the responsibility for decisions taken in the business rests with them,
however, this is also dependent upon the type of business entity. Consider the
following:
Sole Trader responsibility for decision making in a sole trader business will rest
with the sole trader, including providing finance, setting up the business, trading
and operating the business on a daily business. In this type of business, the
most powerful stakeholder is likely to be the sole trader, unless the decisions
have been delegated to staff (examples of such businesses include small
businesses providing a retail service, professional service or something similar).
Partnership responsibility for decision making in a partnership business will rest
with the partners, including provision of finance, establishing the business,
trading and operating the business on a daily basis. In this type of business, the
most powerful stakeholder group is likely to be the partners, unless the decisions
have been delegated to a managing partner or manager (examples of such
businesses include limited partnerships such as firms of professionals (e.g.
accountants, lawyers, architects).
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Limited Companies responsibility for strategic and operational decision making

in such organisations is likely to be delegated to the board of directors, however
shareholders are likely to be consulted and provided with opportunities to
approve the key decisions in a business at various annual general meetings of
the company. It is possible that in some companies (particularly private limited
companies), the major shareholders are also members of the board of directors.
Nationalised Industries (and government agencies) responsibility for strategic
and operational decision making in such business entities/agencies is likely to be
delegated to the board of directors (or panel of government representatives),
however, the government (on behalf of taxpayers) is likely to be consulted and
provided with opportunities to approve the key decisions at various meetings of
the business entity/agency.
Managers
Digital Vision/Thinkstock
Members of the management team are typically responsible for making key
decisions in a business entity in relation to the daily operation of the business, in
addition to decision making within a longer term strategic context. The extent to
which managers are the most powerful stakeholder group in a business will
depend on the control that can be exercised over the use of resources thus the
greater the control that the management team exercise over use of resources,
the more powerful this stakeholder group is likely to be. In a profit-orientated
business, it is likely that managers will be motivated to achieve success since
their terms/conditions of employment will be linked to business performance.
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Employees
Employees will typically make decisions on behalf of their employer in order to

fulfil the key objectives of the business and ensure the smooth running of the
business on a daily basis. Such decisions are likely to be of a routine nature and
might provide some motivation to staff.
Many larger businesses have
mechanisms in place that enable communication between employees (staff) and
management to occur on a regular basis. Employees, as a stakeholder group,
can exercise power to the extent that they are heavily involved in daily operations
and interfacing with customers, or where the output of an employees workload
contributes significantly to the employers objectives.
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Suppliers
Suppliers can be seen as the initial link in the supply chain, supplying other
business entities with resources and/or component parts for onward sale to final
customers further along the supply chain. Power in terms of this stakeholder
group can be seen to the extent that suppliers can exert control over initial
supplies to their immediate customers, although they will be dependent upon
such customers to return payment and contribute to their profitability. In terms of
decision making, a business will be reliant upon suppliers to participate fully in all
aspects of the supply chain in order to contribute effectively to the achievement
of business objectives.
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Customers
liquidlibrary/jupiterimages/Thinkstock
Customers are typically thought of as being the end-consumer of the products or

services of a business, that is, the final link in the supply chain. The ultimate
decision a customer will make is to proceed with the acquisition of a
product/service from the vendor, and to that extent can be seen to be a powerful
stakeholder group outside of a business entity. The level of competition within
the industry might provide leverage to customers enabling them to shop around
to secure the most appropriate product/service. Customer focused businesses
are likely to engage customers fully and put in place substantial customer care
arrangements in order to maximise the buying experience for customers.
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Creditors
Hemera/Thinkstock
In relation to a business entity, creditors as a stakeholder group are most likely to

be related to the business through a financial link. A business could potentially
have different types of creditors. Consider the following:
Short term short term creditors are typically trade creditors or suppliers from
whom the business has acquired resources (e.g. goods for sale, expenses such
as electric, rates and payments for tax)
Long term long term creditors could be represented by financial institutions who
provide funding for business in the form of loans, debentures and other financial
instruments
In terms of decision making within a business, the ultimate power of this
stakeholder group can be seen initially through the provision of financial
resources to the business from which it has benefited in order to achieve its key
objectives, but also in terms of default a creditor can take legal action which
might affect the future ability of a business entity to continue trading e.g.
instigation of bankruptcy proceedings in the event of non-payment thus restricting
the ability of a business to operate.
33
Society the relationship between a business entity and society in general will
take many forms, given the diversity of business activities and the multi-cultural
society evident in the modern age. The power that society might exert in relation
to a business entity will largely depend on moral and social issues impacting
business decisions and ultimately business activities. In relation to making
business decisions, various ways in which business interacts positively with
society in a local sense can include the employment of staff from local
communities where businesses are located, contribution of the multiplier effect
within local economies due to staff spending their wages locally, and perhaps
various promotional activities undertaken locally aimed at increasing product
awareness in return for sponsorship of community activities. On the other hand,
local communities are likely to exert influence if a business entity undertakes
controversial or business activities which do not find favour to society in general,
e.g. testing beauty products using animals or noise and/or air pollution. Pressure
groups typically ensure that such issues are addressed by business.
Government
The relationship between a business entity and government in general will take
many forms, given the diversity of business activities and the complexity of
modern business practice and politics. The power that government might exert in
relation to a business entity will depend on the legislative regime in place. In
recent times, there has been an increase in government intervention in relation to
34
business activity for example, nationalisation of sectors of the UK banking

industry, increasing regulation of utility industries, increasing scope of taxation in
relation to business activity, legislating for health and safety, disability
discrimination and smoking, and deregulation of international trade. Government
is likely to be the most powerful stakeholder external to a business entity, since it
has the backing of parliament to regulate entire industries, levy taxes and
manage the economy of the nation. Business entities however, can usually lobby
the government in order to influence government opinion.
Conflict and Stakeholder Groups:
Conflict can be defined as the potential contradiction of ideas or objectives

between various groups of stakeholders, which will usually mean that a particular
objective of one specific group of stakeholders can be achieved at the expense of
another.
The following are examples of:
the potential for conflict between stakeholder groups
the potential for conflict between business objectives
35
Investors such as shareholders in limited companies want to gain regular income,

security of investment and some input to the decisions of the business this
would bring investors into conflict with customers, who want to acquire
products/services at a reasonable cost without leading to super-profits for
example;
Individual managers want to retain responsibility for their decisions, control over
resources and compensated appropriately for their contribution towards meeting
business objectives this might lead to conflict with shareholders as the latter
stakeholder group may want to maintain a constant focus on profitability, when
an alternative objective might be securing an increase in market share in the
short-term;
Employees want to aim for high levels of compensation and prospects of secure
employment fierce competition within an industry might mean that management
have decided that cost savings are required in order for a business to remain
competitive, hence salaries are frozen at current rates with no bonuses payable
in order to save money and thus lead to conflict between managers and
employees;
Customers of the business want to procure goods/services of high quality at the
lowest possible cost managers within a business might decide to use lower
quality materials which are cheaper and hence increase profitability, but the end
product might not be as durable as the customer expects, hence this might cause
conflict between customers and managers;
Suppliers want to take advantage of secure and profitable orders from their
counterparts in the supply chain the management team of a business might
decide to change suppliers in order to source quality materials at a cheaper price
thus reducing unit cost and increasing profits for a business, but might result in a
supplier going out of business hence this leads to conflict between managers and
suppliers;
Government want to secure low levels of inflation and unemployment, yet
maximise tax receipts to fund government policies in times of recession,
unemployment tends to rise, fewer people pay tax and greater numbers of people
claim benefits, thus increasing government expenditure which can lead to
inflationary pressures.
This can lead to conflict between business and
government;
Society want to see thriving business entities in order to secure harmonious
relationships within local communities aimed at securing employment for local
employees, yet minimising pollution generated from business activities a
business might argue that some pollution is necessary in order to keep costs to a
minimum and secure employment hence leading to conflict between managers
and society.
36
Strategies to deal with Conflicting Objectives
There are a range of strategies that an organisation can use to deal with
conflicting objectives that may arise amongst stakeholders.
Improving Communication
If stakeholders are fully aware of what the aims and implications of the objectives
that have been set are, they may be more willing to accept them. An effective
communication system will ensure that all stakeholders are fully aware of the
objectives that have been set and how they may have an impact on individuals.
The benefits of the objectives to each stakeholder should be clearly highlighted
and areas where long term gains may arise at the expense of short term gains
should be explained. This process can however be time consuming and costly
and communication can be misinterpreted.
Arbitration / Satisfying
In some cases it may be necessary to liaise with stakeholders and try to find a
solution that is acceptable to all interested parties. This will involve negotiation
with all stakeholders and trying to find a compromise which is in the best interests
of all concerned. However this can be time consuming and costly, and may even
lead to a situation where the initial objectives are completely lost in the process.
37
Ignoring the Problem / Enforcing a Solution

Sometimes organisations will decide to simply ignore the issue of conflicting
objectives and proceed with the initial plan. Although this approach is speedy and
will allow decision makers to progress with their initial objectives, it can result in
more conflict than initially envisaged if stakeholders feel that their voices are not
being heard.
The Stakeholder Concept
The Stakeholder Concept means that businesses give due recognition to various
stakeholder groups throughout the decision making process of a business. This
could take various forms including negotiation, face-to-face meetings, inclusion of
stakeholders in key decisions and other arrangements. The aim is to ensure
early resolution of any potential conflict.
Advantages of adopting a stakeholder approach include:
A more positive attitude from employees and easier recruitment of

specialised staff.
A positive public relations experiences from society in general towards the

business.
It is easier access to resources if suppliers are treated fairly.
It can result in increased levels of customer satisfaction.
It can lead to increased levels of profitability and market share brought

about by the early resolution of conflict between stakeholder groups.
Disadvantages of adopting a stakeholder approach:
It is a time-consuming process trying to to resolve disputes and

incorporate stakeholder opinions into the decision making processes of
the business.
The disclosure of confidential information to stakeholder groups might

result in loss of competitive advantage.
More costly as additional arrangements are required to be made to

incorporate stakeholder opinions into the decision making processes of a
business.
38
Key Terms:
Stakeholder; objectives; owners; managers; employees; suppliers; customers;
creditors; society; government; conflict; strategy.
Explain what is meant by the term stakeholder.

Analyse six stakeholder groups commonly found in a business context.
Evaluate three ways in which stakeholder objectives could differ from
39
Case Study:
The Magilligan-Greencastle Ferry is a short ferry service operated using a roll-onroll-off ferry for the benefit of foot passengers, cars and small freight vehicles
(e.g. vans). The ferry operates from a terminal, located in Magilligan, on the
outskirts of Limavady, and is operated by a private company. The location of the
ferry service within the North West of Northern Ireland means that it is a key
transport service provided for the benefit of the travelling public to various
destinations, including Donegal, Londonderry, Coleraine and other towns located
throughout the North West and County Donegal, through the provision of
scheduled services. In addition, the ferry service facilitates inbound tourism.
The location of the ferry terminal is convenient to the border with the Republic of
Ireland, thus includes a catchment area as far north as Falcarragh, in competition
to other forms of public transport such as taxi and bus services. Management
have decided to review the operation of the ferry service and have indicated that
the future of the service is in doubt, due to deteriorating economic conditions,
high maintenance costs and declining passenger numbers.
The proposed closure, which was reported in the national media, could cause
major disruption to the business operations and travel arrangements of many
stakeholders, including tourists, commuters, business customers, small
businesses in the North West and neighbouring communities. Should the service
be withdrawn, it would mean that commuters, tourists and other users would face
on average, a time-consuming 30-mile trip in order to travel from Limavady (and
surrounding area) to the Republic of Ireland/Donegal, along with traffic
congestion and poor road networks. Fares levied on passengers have risen in
recent years from a price of 5 about 10 years ago, to their current level of 20
per passenger.
Questions:
Q1: Define the term stakeholder.
Q2: Define the term conflict.
Q3: With reference to the Magilligan-Greencastle Ferry Service, identify any four
stakeholder groups, analysing one way in which each group would have a
legitimate interest in the ferry service.
Q4: Evaluate the potential for conflict between four different stakeholder groups,
particularly in light of the proposed closure of the ferry service.
40
Suggested Solutions (to include the following salient points):

A1:
Stakeholder: someone who has a real or psychological interest in a business
entity. In the context of the Magilligan-Greencastle ferry service, it is likely that
there will be a range of stakeholders both internal and external to the business.
Each stakeholder group might well be affected by the operation of the ferry
service or in the event of closure, the withdrawal of the ferry service. One
example of a stakeholder group will be passengers.
A2:
Conflict: this can be described as a contradiction in terms of trying to achieve
different business objectives, whereby one objective will be achieved at the
expense of another, or as a difference between stakeholder groups in relation to
attitude, goals, experience and other matters related to achievement of the
primary objective of the business. An example of conflict will be the withdrawal of
ferry services for passengers forcing them to make alternative transport
arrangements.
A3:
Stakeholder Groups Magilligan-Greencastle Ferry Service:
Typically includes anyone who has significant dealings with the business or
operation of the ferry service, including (answers referring to any four groups will
suffice):
Employees - staff who operate the Magilligan-Greencastle Ferry Service for the
benefit of passengers would want to ensure provision of safe and efficient ferry
services.
Customers - these include ferry passengers (commuters and tourists) and
motorists who use the Magilligan-Greencastle Ferry Service, who rely on the
ferry service to go about their daily business;
Suppliers - these include taxi services, bus services or those who contribute to
the transport systems in operation to/from the ferry terminal for the benefit of
passengers or those suppliers who supply the Magilligan-Greencastle Ferry
Service with goods and services to enable it to function effectively and efficiently;
Society - these include those residents/businesses located close to the ferry
terminals in either Magilligan or Greencastle, and who may be subject to the
operations of the ferry service;
Management - the management team are responsible for the operation of the
Magilligan-Greencastle Ferry Service on a daily basis, who are anxious to run the
business on a profitable basis.
41
A4:
Stakeholder Group Conflict Magilligan-Greencastle Ferry Service:
Conflicting objectives will arise between various stakeholder groups as follows
(analysis using any four groups will suffice):
Employees - staff who operate the Magilligan-Greencastle Ferry Service for the
benefit of passengers would want to ensure provision of safe and efficient ferry
services, in addition to securing employment, thus they would be interested to
ensure continuation of the ferry service but unlikely to be concerned that the
management team are required to cut costs or make a profit for investors in the
long term, hence giving rise to conflicting objectives.
Customers - these include ferry passengers (commuters and tourists) and
motorists who use the service, thus saving extensive and frustrating road trips,
and therefore rely on the Magilligan-Greencastle Ferry Service to go about their
daily business the withdrawal of the service would create uncertainty for such
passengers as they are not likely to be concerned with ensuring profitability of the
service for the benefit of the owners thus giving rise to conflicting objectives;
Suppliers - these include taxi services, bus services or those who contribute to
the transport systems in operation to/from the ferry terminals in Magilligan or
Greencastle for the benefit of passengers or those suppliers who supply the ferry
operators with goods and services to enable it to function effectively and
efficiently the proposed withdrawal of the ferry service will mean that the
suppliers will lose a key customer and suffer a drop in revenues/profitability,
which would lead to conflicting objectives between the two stakeholder groups.
Society - these include those residents/businesses located close to the ferry
terminal and who may be subject to the operations of the ferry service, e.g. noise
and/or air pollution with the proposed withdrawal of the service, it might be that
such pollution will cease. This will benefit the local community as they will likely
appreciate the reduction in pollution however, management would be interested
in the continued viability of the Magilligan-Greencastle Ferry Service for their
benefit (secure employment), giving rise to conflicting objectives;
Management - the management team are responsible for the operation of the
ferry service on a daily basis, who are anxious to run the business on a
profitable basis, hence the steady increases in prices/fares in order to raise
sufficient funds to pay operating and fixed costs of providing the service. This
stakeholder group would also wish to secure employment and thus interested in
the continued viability of the business. The decision to withdraw the MagilliganGreencastle Ferry Service would lead to conflicting objectives with stakeholder
groups including passengers, suppliers, local community and employees.
42
BUSINESS STRATEGY AND PLANNING

Chapter Aims:
Explain the meaning of the term business plan;

Identify business objectives;
Understand concepts available to analyse current business position,
including SWOT analysis and PESTEL analysis;
Understand various approaches to decision making in business, including
concepts available to develop business strategies, including Ansoff and
Boston matrixes;
Identify and explain various issues related to dealing with implementation
of business strategies.
Introduction:
This chapter discusses key concepts related to the analysis of the current
business position, and suggests some concepts available to facilitate such an
analysis and develop strategies for business decision making.
43
Business Plan:
A business plan is a plan of action prepared by the business entity for a future
time period. This document will summarise the key assumptions and decisions
that are likely to be made by the management team going forward into the future.
A business plan summarises the key objectives of a business and the main plans
which are likely to be followed in order to achieve the stated objectives.
Contents of a Business Plan:
A business plan is likely to contain the following elements:
The Business this section will summarise the name/address of the business;
the aims of the business; type of business entity established.
Product/Service this section will describe in summary format, the
product/service being provided to the market; the quantities to be provided; the
proposed sales price(s).
Market this section will summarise the results of market research or pilots;
estimates of market size; likely growth estimates of the market; identification of
likely
customers;
identification
of
likely
competitors
and
their
strengths/weaknesses and challenges posed by them; alternative methods of
promotion/advertising.
Resources:
Staff this section will summarise the key personnel required to operate the
business; the experience and skills likely to be possessed by workforce; details of
working arrangements and compensation packages.
Operational this section will summarise the key decisions/issues to be taken in
relation to functional areas of the business; types of premises required; likely
location of the business; likely types, specifications and age of equipment
required (fixed assets); policies to manage growth in business operations/market
demand.
Financial this section will summarise the key financial projections related to the
business; likely profit based on sales quantities/revenues; anticipated breakeven
point in terms of quantities/revenues; cashflow forecast summarising cashflows
in/out and respective timing; banking arrangements; capital required; investment
in non current assets required; likely levels of debt.
44
Benefits and Drawbacks of Preparing a Business Plan:

Potential benefits of preparing a Business Plan:
They enable the management team to make business decisions

effectively
They provides the management team with an insight to the key

strategic decisions to be made regarding achievement of business
objectives
They enables the management team to budget and plan for resources
in order to achieve key objectives
They enable the management team to secure debt finance in order to

fund the business if required
They facilitate the management team in making comparisons with

actual performance and deciding areas for improvement
Potential drawbacks of preparing a Business Plan:
They are time consuming to prepare
They may not always be accurate, particularly regarding the

assumptions made about markets, customer behaviour and financial
impacts of key decisions
A business plan might reveal too much information about the

business, which might be useful to a competitor
The use of a business plan will assist a business in making business decisions,
related to financial, marketing, production and other support activities in relation
to competing within the market.
45
Business Objectives:
Hemera/Thinkstock
As stated earlier, the key business objectives are:

Survival
Profit Maximisation
Growth
Social Considerations
Employee Welfare
Corporate Image
Concern for the Environment
In order to achieve these objectives an organisation should carry out strategic
planning.
46
The Strategic Planning Process
Analysing the current position:

In order to put a strategic plan in place an organisation needs to analyse its
current position in the market.
Two common techniques that can be used to facilitate an analysis of the current
position facing a business include: (i) a SWOT analysis; and (ii) a PESTEL
Analysis.
47
SWOT analysis:
A SWOT analysis involves the examination of the strengths and weaknesses of a

business and a review of the opportunities and threats facing a business. The
strengths and weaknesses tend to be issues internal to a business, whilst
opportunities and threats tend to focus on issues external to a business entity.
A SWOT analysis is meant to provide an in-depth identification, explanation and
analysis of the various issues facing a business, in order to provide a reference
point for decision making in pursuit of key business objectives.
The preparation of a SWOT analysis requires careful consideration of each of the
following elements:
48
Strengths:
These are considered to be things which are of benefit to a business and which
enable it to achieve key objectives. Examples of strengths which a business
might possess include:
Things that they do effectively or efficiently

Things that they have an excellent reputation for
An ability to enhance profitability
Creativity/innovation in business
Excellent reputation
High levels of repeat business
A unique characteristic related to their field of expertise
Weaknesses:
These are considered to be things which pose a challenge to a business and
which must be addressed in order to ensure success in a competitive
environment. Examples of weaknesses which a business entity might possess
include:
Poor standards of quality in product/service delivery
Bad reputation
Disruptions to daily operating activities
Exposure to financial difficulties/lack of investment
Personality clashes between members of the senior management team
Opportunities:
These are considered to be issues which enable a business to potentially
succeed in the context of the competitive environment and achieve key
objectives. Examples of opportunities which a business might aim for include:
Securing access to natural or raw materials/specific resources
Successful completion of a takeover of another business in order secure market
share
Investment in capital projects
Taking advantage of technological developments
Threats:
These are considered to be issues which might prevent a business from
succeeding within the context of the competitive environment and thus achieving
key objectives. Examples of threats which a business should address include:
Legislative developments
Competitor actions
Political developments
Lack of control regarding access to natural or raw materials/specific resources
49
A SWOT analysis is a useful way of collecting relevant information about the

business entity and summarising the key external issues facing the business. It
also provides the basis for further planning and development of strategies aimed
at achieving key business objectives.
SWOT Analysis worked example:
Case Study: Belfast International Airport Limited (BIAL)
During 2006, Belfast International Airport published a 25-year business plan in
response to a request from the UK government. The plan summarised the views
of the management team in relation to how they might address the issue of
providing sustainable airport capacity for the period up to 2030. The plan
considered the key assets at the Airports disposal, its key strengths and the
challenges faced in the coming years and its role in sustaining regional economic
development.
The Airport has reported increased growth in passenger numbers using the
facilities, rising from 1.5m in 1984 to 4.8m in 2005, and this is forecasted to grow
to approximately 7m by the year 2015. This currently accounts for approximately
67% of passenger numbers using airports within Northern Ireland. In addition to
long-established airlines operating from the Airport, the Airport has reported an
increase in new business, such that additional airlines are flying to/from the
Airport, including Aer Lingus plc, easyJet plc and Continental Airlines (USA). It is
estimated that 2m people live within a 2-hour drive of the Airport, and that 80% of
Northern Irelands industrial base is located within one hour of the Airport.
Challenges facing the Airport are numerous, including its out-of-town location, the
fact that there is only one access road to/from the Airport (A57), a poor transport
infrastructure (no rail-link operates directly into the terminal), the loss of
passengers to other regional airports (estimated at over 1m per year), and
emergence of Dublin Airport, City of Belfast Airport and City of Derry Airport as
credible alternatives to passengers and airlines operating therein. Belfast
International Airport Limited has recently received unfavourable press, in that, the
car parking charges levied are amongst the highest in the UK for a public car
park. In addition, the Airport has lost a number of key airline customers who
have opted to operate their services from other regional airports.
Strengths: (i) BIAL appears to have approximately 67% of NI aviation market; (ii)
BIAL has increasing throughput of passenger numbers (4.8m, 2005); (iii) good
reputation, attracting new airlines (Aer Lingus plc).
Weaknesses: (i) BIAL loss of airline customers to rivals; (ii) unfavourable press
high parking charges.
Opportunities: (i) increased growth of passenger numbers to 7m by 2015; (ii)
active role in regional economic development; (iii) increased market opportunities
50
- 2m people live within a 2-hour drive of airport, and 80% of NI industry located
within 1 hour drive; (iv) BIAL provides air services to new destinations.
Threats: (i) lack of good road network only one access road (A57); (ii) out-oftown location, no rail links; (iii) emergence of Dublin Airport, Belfast City Airport
and City of Derry Airport as credible alternatives to passengers.
PESTEL Analysis:
A PESTEL analysis involves the examination of the main features of the external
environment in which the business operates. A PESTEL analysis is meant to
provide, in summary form an identification, explanation and analysis of the
various external or environmental issues facing a business, in order to provide a
reference point for decision making in pursuit of key business objectives such
issues which should receive consideration in the analysis include political,
economic, social, technological, environmental and legal matters. PESTEL
analysis may be used to identify the Opportunities and Threats part of the SWOT
analysis.
Political:
This considers the key political issues facing a business entity, which exist both
in a domestic and international context. Common issues include the introduction
of new legislation affecting business, e.g. smoking bans in public places, such as
places of work, pubs, clubs and restaurants; consumer protection legislation,
health and safety regulations, distance selling directive; trade barriers including
administrative restrictions, war and other matters which present a risk in the
context of international trade.
Economic:
This considers a wide range of economic issues facing a business entity, which
exist both in a domestic and international context. Common issues include
challenges presented by recessionary conditions which exist within the national
and global economy, issues related to the credit crunch, the extent to which
government objectives are being achieved (e.g. low inflation, low unemployment
and increasing levels of trade and economic growth), consumer confidence, cost
structures within a business (e.g. impact of minimum wage settlements) and
impact of government fiscal policy, monetary policy, supply side policy and
foreign exchange policy. On a more positive side, a business might consider
how to take advantage of the conditions presented in the context of economic
growth.
Social:
This considers the key social issues prevalent within society at a given point in
time, which might have an impact on the performance of a business entity.
Common issues include challenges presented by changes in the opinion of
society about specific business issues. Examples include issues such as
51
management of nuclear waste products, use of live animals to test drugs or

beauty products, the termination of unwanted pregnancies by private medical
clinics upon payment of medical fees, and managing the impact of a smoking ban
on business premises where such premises are deemed to be accessible to the
public. The important strategic issue in terms of a business will likely be how
best to ensure that such challenges contribute to profitability of the business and
hence, survival.
Technological:
This considers the key issues facing a business entity, which exist in a fastchanging technological world. The availability of information technology and
other updated technologies rapidly changes working practices, and if used
properly can enhance business performance. Examples might include the
conduct of transactions using mobile broadband facilities, use of the internet to
complete deals and updated models of production equipment. An important
issue in terms of business is to ensure that technological changes are embraced
in a way that makes an effective contribution to the key objectives of the
business, e.g. profitability or increased market share.
Environmental:
This considers the key environmental issues facing a business, which have
gained increasing levels of importance in the modern business world. Typically,
this includes reference to green issues, i.e. ensuring a degree of protection for
the environment, greater use of recycling and minimisation of waste. The scope
of environmental issues could be interpreted much more widely, to include issues
such as use of cloning technologies in biological research and eradication of
disease, genetically modified crops and their entry into the food chain, the
minimisation of disease amongst farm animals across international borders, the
reduction of carbon emissions and adoption of alternative energy sources over
the next 20 30 years are all topical issues which create opportunities for
business, but carry a degree of risk in relation to public opinion which might
influence the success or otherwise of such businesses to meet their key
objectives.
Legal:
This considers the key legal issues within the external environment which
typically face a business. Examples of legislative changes in recent times
include the requirement by a business to pay all relevant taxes to the government
by certain deadlines, the introduction of smoking bans in workplaces, the
payment of a minimum wage to staff in the UK, the requirement to have vehicles
tested every year after 4 years (MOT tests), the requirement to undertake risk
management in relation to all activities related to health and safety in the
workplace such issues tend to lead to increases in costs for a business,
however, significant opportunities do exist to conduct a successful business
(measured in terms of meeting key objectives), brought about by changes in
legislation some businesses specialise in assisting other businesses meet the
52
requirements of various forms of legislation e.g. tax specialists, health/safety

advisors and risk management specialists.
PESTEL Analysis worked example:
Case Study: Belfast International Airport Limited
During 2006, Belfast International Airport published a 25-year business plan in
response to a request from the UK government. The plan summarised the views
of the management team in relation to how they might address the issue of
providing sustainable airport capacity for the period up to 2030. The plan
considered the key assets at the Airports disposal, its key strengths and the
challenges faced in the coming years and its role in sustaining regional economic
development.
The Airport has reported increased growth in passenger numbers using the
facilities, rising from 1.5m in 1984 to 4.8m in 2005, and this is forecasted to grow
to approximately 7m by the year 2015. This currently accounts for approximately
67% of passenger numbers using airports within Northern Ireland. In addition to
long-established airlines operating from the Airport, the Airport has reported an
increase in new business, such that additional airlines are flying to/from the
Airport, including Aer Lingus plc, easyJet plc and Continental Airlines (USA). It is
estimated that 2m people live within a 2-hour drive of the Airport, and that 80% of
Northern Irelands industrial base is located within one hour of the Airport.
Challenges facing the Airport are numerous, including its out-of-town location, the
fact that there is only one access road to/from the Airport (A57), a poor transport
infrastructure (no rail-link operates directly into the terminal), the loss of
passengers to other regional airports (estimated at over 1m per year), and
emergence of Dublin Airport, City of Belfast Airport and City of Derry Airport as
credible alternatives to passengers and airlines operating therein. Belfast
International Airport Limited has recently received unfavourable press, in that, the
car parking charges levied are amongst the highest in the UK for a public car
park. In addition, the Airport has lost a number of key airline customers who
have opted to operate their services from other regional airports.
Political (BIAL required to prepare 25-year plan by government, addressing

sustainable airport capacity);
Economic (role of BIAL in regional economic development is favourable at
present; decision of airlines to operate at BIAL promotes environmental
opportunities for greater economic development);
Social (BIAL provides links to new destinations, presenting opportunities for
passenger travel; enable passengers to fly more frequently);
53
Technological (key assets at BIALs disposal will sustain its competitive position
into the future);
Environmental (out-of-town location does not appear to present any issues in
terms of noise or other types of pollution);
Legal (it is assumed that BIAL operates to the highest safety standards,
consistent with CAA, hence the increased numbers of passengers and airlines
using the facilities).
In addition to the above tools, organisations might also use the following to help
with decision making:
The Ansoff Matrix:
In terms of making key marketing decisions within the business, the Ansoff Matrix
is a useful tool. The product-market framework can assist management analyse
the strategic position of the firm, and enable formulation of strategies to meet key
objectives. The Ansoff Matrix is shown below:
54
Four strategic options are open to a business in terms of the decision making
process. In summary, the matrix subdivides the options into four quadrants
(representing the specific strategy to be followed, and thus the strategic decision
to be taken by the management team), depending on (i) whether or not the
product is existing or new; and (ii) whether or not the risk level attached to each
product type is high or low. Each option is considered below:
Market Penetration the aim of this strategy is to increase market share,
achievable using the existing product range of the business. In terms of the
decision making process, a low level of risk is associated with this strategic
option. Markets which are maturing or in decline will be much harder for a firm to
penetrate, than a market in which growth is possible to achieve.
Market Development the aim of this strategy is to increase market share or
profitability of the existing product range for the business. In terms of the
decision making process, higher levels of risk are associated with this strategic
option. It might be considered a feasible strategy since the products are already
established in existing markets, but the management team consider that further
development of the market might lead to achievement of key objectives. By
entering new global markets for example, the existing product range can be used
to gain leverage and increase market share; alternatively segmenting an existing
market might target customers more effectively.
Product Development the aim of this strategy is to increase market share, but
take advantage of existing customer base. This is done by undertaking a range
of product development activities. Product Life Cycles tend be much shorter,
forcing manufacturers to constantly re-evaluate their product ranges and
ensuring that, through this process, product developments occur which meet the
needs of customers. In terms of key decisions to be taken it is recognised that
existing products can be modified or new products introduced which is thought to
represent a low risk approach towards achieving key objectives since existing
branding policies can be successfully deployed.
Diversification the aim of this strategy is to increase market share but will
require a business to attract a new customer base for its new product range.
Two possible interpretations are possible depending on the decision taken by the
management team (i) related diversification strategy means that the business is
entering new markets with existing products modified slightly; or (ii) unrelated
diversification means that the business is targeting new markets with completely
new products. Either way, the decision to be taken will involve a high degree of
risk for the business if it is to succeed in achieving key business objectives.
55
Benefits and Drawbacks of The Ansoff Matrix:

Potential benefits of use of the Ansoff Matrix are as follows:
It facilitates an analysis of the relevant strategic decisions to be taken
It provides a simplistic analysis of the likely strategic plans for a

business
It indicates the likely outcome of product marketing strategies within

context business plan
Potential drawbacks of use of the Ansoff Matrix are as follows:
Critics suggest that the analysis provided by the Ansoff Matrix is too
simplistic and does not reflect economic reality
It focuses on product portfolio or market potential rather than resources

required to support each strategy
It does not guarantee success even if a particular strategy is followed

by the business
Use of the Ansoff Matrix will assist a business entity in making business
decisions, related to strategic options facing the business as it competes in the
market.
Case Study: Ansoff Matrix (Belfast International Airport):
Products
M
A
R
K
E
T
Existing
New
Product
Market Penetration
Development
Domestic Flights: UK
New UK destinations,
Int'l: Continental; e.g. easyJet
current airlines,
Parking; Duty Free;
Charter Market
Market Development
Diversification
New Airlines e.g. AerLingus,
Cargo facility, hotel,
New
Corporate/business
foreign
Destinations
facilities
Low
High
Levels of Risk
R
I
S
K
Low
High
56
Boston Matrix:
In terms of making key decisions within the business, the Boston Matrix is a
useful tool. The market share-market growth framework can assist management
analyse the product positioning of the business entitys product lines. This will
enable the formulation of strategies to meet key objectives. The Boston Matrix is
shown below:
57
Four strategic options are open to a business in terms of the decision making
process. In summary, the matrix subdivides the options into four quadrants
(representing the specific product classification, and thus the likely strategic
decisions to be taken by the management team), depending on: (i) whether or
not the product attracts a high or low percentage market share; and (ii) whether
or not the potential market growth rates are high or low. Each option is
considered below:
Question Mark/ Problem Children these are products which attract low levels
of market share but attain high levels of market growth for the business. These
products are likely to generate either a surplus/deficit (in terms of cash flows) or a
profit or loss for the business, depending on the level of financial support
provided by the business to ensure their success in the market. Question marks
tend to be newly launched products.
Stars these are products which attract high levels of market share and also
attain high rates of market growth for the business. These products are likely to
generate surplus revenue streams/profits for the business and perform very well
relative to the competition, but may require minimal levels of financial support in
terms of competing in the market. These may be products that have been newly
launched, have generated a lot of interest and have been well received by
consumers.
Cash Cows these are products which attract high levels of market share but
attain low levels of market growth for the business. These products are likely to
generate surplus revenue streams/profits for the business and perform
reasonably well relative to the competition, but may require moderate levels of
financial support in terms of competing in the market. These tend to be well
established products in the market place.
Dogs these are products which attract low levels of market share and also
attain low levels of market growth for the business. These products are likely to
generate minimal levels of surplus cash flows or losses and indicate a product
range in the decline stage, in terms of the product life cycle.
The main objective for a business in terms of managing the product portfolio, is to
ensure a balance between the number of products in each category or quadrant
of the matrix. The idea is to ensure that the products labelled as stars or cash
cows generate sufficient cash flows to fund the products labelled as problem
children or dogs problem children could either succeed or fail due to the
market response or the support provided by the business towards such product
lines. It is unlikely that a business would commit substantial levels of financial
support to product lines classified as dogs.
58
Benefits and Drawbacks of Boston Matrix:

Potential benefits of use of a Boston Matrix are as follows:
It facilitates an analysis of the product mix
It provides a simplistic analysis of the product portfolio for a business
It indicates the likely cashflow position of product positioning within the

context of the market
Potential drawbacks of use of a Boston Matrix are as follows:
Critics suggest that the analysis provided by the Boston Matrix is too
simplistic and does not reflect economic reality
It focuses on market share growth, rather than consolidation of same
It does not recognise the interdependent nature of support that can

arise between products in the product portfolio
Use of the Boston Matrix will assist a business entity in making business
decisions, related to financial, marketing, production and other support activities
in relation to competing within the market.
Case Study: Boston Matrix (Belfast International Airport):

High
High
Market
Growth
Low
Market Share
STARS
Established Domestic Flights:
UK: ie. easyJet.
Established Int'l Flights: ie.
Continental - USA.
Duty Free;
CASH COWS
Charter Flights to Europe, USA.
Established Domestic Flights:UK.
Short Term Parking
Low
PROBLEM CHILDREN
Cargo operations; new
airlines serving existing
UK/foreign Destinations
DOGS
Long term parking;
Lease land surplus to
Requirements,
Charter flights
59
Alternative Strategies:
In summary, alternative strategies are open to an existing business in order to

secure achievement of key business objectives. In terms of the decision making
process, they are quite different and can represent one of the most crucial
decisions the management team of a firm can take. Such strategies include: (i)
Growth; (ii) Stability; and (iii) Retrenchment. Each is now considered below:
60
Growth
Growth as a strategy can be achieved in many different ways:
Organic Growth:
This occurs when a business expands using its own resources in order to
achieve business objectives.
Benefits and Drawbacks of an Organic Growth Strategy:
Potential benefits of an organic growth strategy:
This strategy may represent a cheaper strategic option in order to

achieve growth
An organic growth strategy avoids culture clashes between two

business organisations
Existing management team can control the pace of expansion
Potential drawbacks of an organic growth strategy:
This strategy may take longer to achieve key strategic objectives

compared to a takeover/merger, which can have an instantaneous
effect
It does not guarantee success of a long term growth strategy
Takeover:
As the name suggests, a takeover occurs when one business acquires another
this can take the form of acquisition of key fixed assets or control over the
important strategic decisions to be taken in the business taken over. It can also
be the case that, the business taken over will continue to trade as a separate
business entity, or it might be wholly integrated into the business conducting the
takeover. Consider the following situations:Sole Trader a sole trader business is likely to be acquired through the outright
purchase of the assets with all decision making power transferred to the new
owner. Very often the purchase price paid will exceed the book value of assets
and this price differential is referred to as goodwill. In many cases, the business
once taken over, will indicate that it is under new management.
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Partnership a partner is likely to see their stake in the partnership acquired by

outright purchase by another individual who wishes to become part of the new
partnership arrangement. It is likely that in most cases, the old partnership will
be dissolved and a new partnership formed with the purchase price paid
representing the new partners share of the investment in the business.
Depending on the ratio of the new investment to total capital/investment, this will
indicate if the new partner has any role in decision making in the business.
Private Limited Company business organisations such as these are normally
taken over by invitation of the current shareholders, in which case, the existing
shares are bought out by the new investors, which will be representative of the
assets in the company. In terms of decision making, the extent to which new
investors will exercise control will depend on the ratio of their shareholding to the
total shareholdings in the company.
Public Limited Company business organisations such as these are normally
taken over by investors purchasing the shares on the open market, via the stock
exchange. The share price will be a function of profitability, market sentiment,
book value of assets and future dividend streams likely to accrue to
shareholders. In terms of decision making, the extent to which new investors will
exercise control will depend on the ratio of their shareholding to the total
shareholdings in the company. A shareholder can take control of a company by
acquiring as little as 15 percent of the total share issue. A company who
purchases 3 percent of the total shares in another company is required to declare
this matter to the stock exchange.
Takeovers occur for various reasons or motives. Examples of the motives for a
takeover include:
To enable the predator (i.e. a business buying the shares) to enter new
markets or increase existing market share in terms of revenues/profits
To provide security for the acquired business or enable it to operate as

a going concern
To enable the predator to acquire certain assets or access to unique

resources not available elsewhere
To make a profit/return on investment
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Hostile Takeover / Acquisition:

This refers to a situation where one company has attempted to acquire another
business; however the management team in the business to be taken over
lodges objections to the proposed takeover for various reasons. They will
attempt to persuade the owners of the business that the takeover is not in their
best interests and aim to stop it proceeding.
Takeover by Invitation:
This refers to a situation where one company attempts to acquire another
business with the full co-operation of both management teams. This is likely to
occur where the takeover is in the best interest of both business entities and/or
the owners.
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Mergers:
Quite simply, a merger can be thought of as the joining together of two or more
companies, to form one larger organisation, through the combination or
integration of all assets and resources to produce synergistic benefits for the
merged entity. (2 + 2 =5)
A merger can often take a number of forms:
Horizontal Integration whereby two businesses in identical lines of business
and similar stages of production join together.
Backward Vertical Integration whereby two businesses in identical lines of
business but different stages of production, join together, particularly where one
business has control of supplies/resources to be supplied to the other business,
further along the supply chain.
Forward Vertical Integration whereby two businesses in identical lines of
business but again at different stages of production, join together, particularly
where on business has control over distribution channels/access to customers for
the goods being supplied by the other firm, earlier in the supply chain.
Lateral Integration whereby two businesses involved with related product lines
which do not compete with each other, join together.
Conglomerate Merger whereby two businesses involved in unrelated product
lines join together in order to diversify.
64
Benefits and Drawbacks of Takeovers and Mergers:

Potential benefits of takeovers and mergers:
They provides a predator company with an opportunity to expand the

business easily and quickly
Acquiring another business might prove to be a cheaper option than an

organic growth strategy
An acquisition might represent and effective use of surplus cash by the

predator company
An acquisition might enable a predator company to defend its market

position/share
A takeover might yield financial benefits in response to external

economic changes
An acquisition of a non-UK based business might provide an

opportunity for the predator company to enter foreign markets
Globalisation has presented businesses with opportunities to join

together to take advantage of global trading rather than focus on
specific global regions
An acquisition enables businesses to take advantage of economies of

scale
Potential drawbacks of takeovers and mergers:
The predator company may face hostile reaction or opposition to a

takeover and this may draw negative publicity
The takeover might not yield synergistic benefits as envisaged
Takeovers tend to lead to culture clashes which require careful

management in order to succeed
Takeover and merger activity is expensive, which results in customers

being charged more for products at some stage
Some takeovers may not be in the public interest and may be deemed
anti-competitive
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A takeover could give rise to a small number of firms dominating the

market resulting in loss of consumer confidence and greater regulation
A takeover does not provide any guarantee against job losses
STABILITY
When firms are satisfied with their current rate of growth and profits, they may
decide to use a stability strategy. This strategy is essentially a continuation of
existing strategies. Such strategies are typically found in industries having
relatively stable environments. The firm is often making a comfortable income
operating a business that they know, and see no need to make the financial
investment that would be required to undertake a growth strategy. Stability may
also be the only option open to a business during a period of recession or
economic downturn.
Retrenchment
Retrenchment involves a reduction in the scope of a businesss activities, which
also generally leads to a reduction in the number of employees, the sale of
assets associated with a discontinued product or service line, possible
restructuring of debt through bankruptcy proceedings, and in the most extreme
cases, liquidation of the firm.
Firms pursue a turnaround strategy by undertaking a temporary reduction

in operations in an effort to make the business stronger and more viable in
the future. These moves are popularly called downsizing. The hope is that
this temporary measure will allow the firm to pursue a growth strategy at
some future point.
A divestment decision occurs when a firm elects to sell one or more of the
businesses from its portfolio. Typically, a poorly performing unit is sold to
another company and the money is reinvested in another business within
the portfolio that has greater potential.
Bankruptcy involves legal protection against creditors or others allowing
the firm to restructure its debt obligations or other payments, typically in a
way that temporarily increases cash flow. Such restructuring allows the
firm time to attempt a turnaround strategy.
Liquidation is the most extreme form of retrenchment. Liquidation involves
the selling or closing of the entire operation. There is no future for the firm;
employees are released, buildings and equipment are sold, and customers
no longer have access to the product or service. This is a strategy of last
resort.
66
Explain what is meant by the term business plan.

Explain what is meant by the term strategy.
Explain what is meant by the term hostile takeover.
Evaluate the various types of merger which can occur in a business.
Evaluate the three strategies available to a firm.
Key Terms:
Business Plan; Business Strategy; Objectives; SWOT analysis; PESTEL
analysis; decision making; Ansoff matrix; Boston Matrix; Market Penetration;
Product Development; Market Development; Diversification; Stars; Cash Cows;
Problem Children; Question Marks; Dogs; Market Growth; Market Share; Growth;
Stability; Retrenchment.
67
Case Study:
The management team at Larne Harbour in Northern Ireland recently published a
performance review in respect of the level of business undertaken at the port in
recent years (see website). The notes/statistics summarise the results of key
aspects of the operation of the business and issues likely to affect future
operating performance, the key strengths and the challenges currently being
faced, including its role in sustaining regional economic development.
The management team at the Harbour reported the following:
1. a decline in passenger numbers using the facilities, falling from
approximately 942,800 in 2007 to 893,722 in 2008;
2. a decline in commercial vehicles using the facilities, falling from 438,050 in
2007 to 404,320 in 2008;
3. a decline in tourist vehicles using the facilities, falling from 242,454 in 2007
to 230,383 in 2008;
4. use of a deep-water port, not subject to tidal restrictions benefiting
shipping (unlike nearby ports);
5. continued support from parent company domiciled overseas.
In addition to long-established ferry services operating from the port (to
destinations such as Cairnryan, Troon and Fleetwood, the port has reported a
change in market demand for the port facilities, such that cruise ships are going
to/from the port as part of their international itineraries. The terminal building
provides shops, car hire facilities, catering facilities and links to public sector
transport services.
It is estimated that 1.5m people live within a 2-hour drive of the port, and that a
large percentage of Northern Irelands industrial base is located within an hours
drive of the port. The port is also located about a 2-hour drive from the border
with the Republic of Ireland (a strategic market for passengers and cargo).
The challenges facing the port are numerous, including:
1. an out-of-town location;
2. only one access road to/from the port (A8) to the rest of the island;
3. a poor road transport infrastructure (the road directly into the terminal
requires upgrading to a dual carriageway standard);
4. the loss of passengers to other regional ports located nearby and also to
Dublin Port, as credible alternatives to passengers, ferry operators and
shipping companies;
5. high levels of competition created with the provision of no-frills airline
services from various local airports.
68
Questions:
Q1: Explain what is meant by a business plan. Indicate two reasons why it is
necessary for a business to prepare such a plan.
Q2: List the main contents which are commonly found within a business plan,
such as that prepared by the management team at Port of Larne.
Q3: Prepare a SWOT Analysis and a PESTEL Analysis demonstrating how
each would assist in making strategic decisions at the Port of Larne.
Q4: Using relevant information, prepare an Ansoff matrix and a Boston Matrix
as an aid to decision-making, using the Port of Larne as an example.
69
Suggested Solutions (to include the following salient points):

A1:
Business Plan: a formal statement of a set of business objectives, the reasons
why they are strategically attainable, and the plan for reaching those objectives. It
may also contain background information about the business organisation (for
example, Port of Larne) attempting to reach the objectives stated.
In relation to Port of Larne, the reasons for the preparation of a business plan are
that: (i) it would force the management team to review current operating and
financial performance and set new targets for the budget period, e.g. consider
how to reverse the decline experienced in passenger numbers as reported; and
(ii) it would enable the management team at Port of Larne to make decisions in
relation to how the business will operate in the next financial year, e.g. open 24
hours a day or restrict operations to 8 hours per day, thus limiting the number of
ferry services available.
A2:
Contents of a Business Plan:
The Business this section will summarise the name/address of the business
(Port of Larne Ltd, Larne); the aims of the business (port operator, facilitating
shipping); type of business entity established (private limited company).
Product/Service this section will describe in summary format, the
product/service being provided to the market (berthing facilities for shipping,
terminal facilities for passengers/cargo and storage); the quantities to be
provided (893,722 passengers, 404,320 commercial vehicles and 230,383
tourists).
Market this section will summarise estimates of market size (893,722
passengers, 404,320 commercial vehicles and 230,383 tourists); likely growth
estimates of the market (942,800 passengers, 438,050 commercial vehicles and
242,454 tourists as per 2007 levels of demand); identification of likely customers
(tourists, commercial vehicles and passengers); identification of likely competitors
(Ports of Belfast, Warrenpoint, Derry and Dublin), strengths/weaknesses and
challenges posed by them; alternative methods of promotion/advertising (national
media and internet).
Resources:
Staff this section will summarise the key personnel required to operate the
business (management, employees, subcontractors and hauliers); the
experience and skills likely to be possessed by workforce(shipping experience,
port management experience and health/safety experience); details of working
arrangements and compensation packages (e.g. salary levels, pension amounts,
working hours, shift patterns, and holidays).
70
Operational this section will summarise the key decisions/issues to be taken in

relation to functional areas of the business (port operations, berths numbers
and type, cargo and storage arrangements); types of premises required
(warehouses, terminal, car parks); likely location of the business (port, harbour
facilities); likely types, specifications and age of equipment required (fixed assets,
e.g. berths, ramps, docking facilities, terminal building, IT equipment); policies to
manage growth in business operations/market demand (e.g. organic growth
policies).
Financial this section will summarise the key financial projections related to the
business (budgeted revenues and profits); anticipated breakeven point in terms
of quantities/revenues (per customer group, e.g. tourists, commercial vehicles
and passengers); cashflow forecast summarising cashflows in/out and respective
timing; banking arrangements; capital required; investment in fixed assets
required; likely levels of debt (provided by the holding company a private limited
company domiciled overseas).
A3:
SWOT Analysis/Pestel Analysis:
SWOT analysis:
Strengths: (i) Port of Larne appears to have a large share of the sea transport
market; (ii) Port of Larne has a deep-sea port; (iii) good reputation, attracting
existing shipping companies, new shipping lines and cruise lines; (iv) links to
public sector transport services.
Weaknesses: (i) Port of Larne loss of customers to rivals such as other ports and
airports on the island.
Opportunities: (i) can grow passenger numbers by attracting international cruises;
(ii) active role in regional economic development storage/warehouse
developments; (iii) increased market opportunities 1.5m people live within a 2hour drive of Port of Larne, and a large percentage of NI industry located within
1-hour drive from Port of Larne; (iv) re-establish the port as a gateway to
European destinations.
Threats: (i) lack of good road network only one access road (A8); (ii) out-oftown location; (iii) emergence of Dublin, Belfast, Derry and Warrenpoint ports as
credible alternatives to passengers/shipping companies.
71
PESTEL Analysis:
Political government have not addressed the issue of improving the road
infrastructure, meaning poor road transport links (A8) with rest of the island,
which potentially impacts demand at the Port of Larne; closer development with
public sector transport links would be of benefit;
Economic - role of Port of Larne in regional economic development is favourable
at present (cargo/passenger business); decision of shipping companies to
operate at Port of Larne promotes environmental opportunities for greater
economic development, as does the attraction of international cruise
liners/tourists;
Social Port of Larne provides links to new destinations, acting as a gateway to
UK and Europe, presenting opportunities for tourism, commercial vehicles and
passenger travel; enable passengers to travel by sea more frequently;
emergence of no-frills airlines could possibly explain the decline in passenger
numbers suffered by the Port of Larne as cheap airfares would tempt customers
towards air travel rather than conventional ferries in order to save time;
Technological - key assets at Port of Larnes disposal will sustain its competitive
position into the future, including the fact that it is a deep-sea channel and not
subject to tidal restrictions;
Environmental - out-of-town location does not appear to present any issues in
terms of noise or other types of pollution;
Legal - it is assumed that Port of Larne operates to the highest safety standards,
consistent with health/safety regulations.
72
A4:
Ansoff/Boston Matrix: Port of Larne
Products
M
A
R
K
E
T
Existing
New
Product
Market Penetration
Development
Shipping links to UK ports
New UK destinations,
Terminal facilities e.g. car hire
current shipping lines
Catering; Shops.
Cruise
Market
Market Development
Diversification
New shipping lines;
Cargo facility,
New
Corporate/terminal
foreign
Destinations
facilities
Low
High
Levels of Risk
R
I
S
K
Low
High
The above matrix will facilitate decision making in the context of Port of Larne,
summarising the key product/market relationships.
Boston Matrix Port of Larne:
High
High
Market
Growth
Low
Market Share
STARS
Established sea routes to
Troon, Fleetwood, C/ryan.
Established Int'l sea routes:
Cruise Liners,
Terminal
facilities;
CASH COWS
Global cruises e.g. Europe, USA.
Established Domestic routes:UK.
Short Term Parking
Low
PROBLEM CHILDREN
Cargo operations; new
Shipping cos serving
UK/foreign Destinations
DOGS
Public sector transport links;
RORO facilities slower than air
The above matrix will facilitate decision making in the context of Port of Larne,
summarising the key market share/market growth relationships of the product
lines (port facilities) provided by the management team.
73
DECISION TREE ANALYSIS

Chapter Aims:
Explain the purpose of a Decision Tree;

Identify and undertake related calculations;
Understand the nature of various decisions and expected values;
Understand the usefulness and limitations of using decision trees in
business.
Zoonar/Thinkstock
Introduction:
This chapter discusses key definitions related to decision trees, which may be
used in support of decision making in a business, including an introduction to
related terminology required to be used when preparing a decision tree diagram.
Related to this is a discussion of various goals which might be pursued in the
course of business.
Decision Tree:
A decision tree is a graphical representation of a decision making process within
a business, which aims to highlight the most cost-effective decision. The treeshape diagram represents various business decision making scenarios, whereby
each decision has its own individual branch on the tree, which in turn leads to
additional branches representing outcomes that are possible given the alternative
courses of action that could be decided upon.
An outcome is given by: (i) a monetary value (estimated); and (ii) a probability (or
likelihood) of occurrence. Monetary values are multiplied by the probabilities to
yield an Expected Value, thus it is expected that the management team within a
business will choose that action which yields the maximum expected value.
74
Preparing a Decision Tree General Terms:

Decision Tree shows the logical decisions which will occur over time
Expected Value the payoff associated with the chain of events/decisions
already taken
Nodes intersections or junction points along the decision tree (usually
referenced D1, D2 .etc), represented as a square (box) or triangular shape
Branch arcs or interconnectors between the nodes
Decision node a branch leaving a given node, denoted by a square
Decision Analysis Process steps:
1
2
3
4
identify decision alternatives

identify states of nature
plot the values, calculate the results and determine payoff associated
with each decision alternative and state of nature combination
plot decision tree drawn usually from left to right across the page
75
The following diagram below illustrates the above terminology:

Decision Tree Diagram - Terminology
Expected Value
Success 0.5
Failure 0.5
Branch
Expected
Value
Decision Node
D1
Decision Value
Branch
D2 xx
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Benefits and drawbacks of Decision Trees:

Potential benefits of decision trees are:
They are suited to situations in business where there appears to be a logical
sequence of events
They are suited to situations in the context of decision making where conditions
of uncertainty exist
They are highly effective in situations that are best represented by past similar
events
They are useful in terms of providing realistic estimates in financial terms of
decisions to be taken in the context of new situations
Potential drawbacks of decision trees are:
Limited to the extent to which they account for uncertainty in the business
situation
Based on estimated data/information only
Limited to quantitative information only, ignoring qualitative issues
Key Terms:
Decision Tree; Decision; branch; outcome; expected value; probability;
weightings; sequence; events.
Explain what is meant by the term decision tree.

Explain what is meant by the term probability.
Explain what is meant by the term expected value.
State two reasons why businesses use decision tree analysis.
Evaluate Decision Trees as a tool for decision making
77
Case Study:
Mourne Water Ltd bottle and distribute spring water from a natural spring located
high in the Mourne Mountains in County Down. The management team are of
the opinion that in order to compete in global markets, the product range must
appeal to a wider variety of consumers. One product line is the sale of spring
water (still) in 1 litre bottles. If this product line continues unaltered, the
management team estimate that there is a 0.70 probability of annual sales falling
to 50,000 and only a 0.30 probability that market share revenues might be
maintained at the current level of 360,000.
The still water product line can be modified slightly by introducing a new flavour
(Blueberry & Elderflower). The cost of adding the new flavour to the product
range is estimated to total 100,000. The management team need to decide on
the amount of expenditure required to fund marketing activities aimed at
increasing consumer awareness in domestic and global markets.
The
management team are of the opinion that a minimal advertising campaign would
cost 30,000 and have a 0.20 probability of success, raising annual sales to
600,000. If the advertising campaign was unsuccessful, sales of the new
flavour are likely to be 300,000.
Alternatively, spending 100,000 to extensively advertise the new flavour
(Blueberry & Elderflower), the management team estimate that sales revenues
will reach 1m if successful. Given the current strength of the brand, the
management team estimate that there would be a 0.90 probability of this
occurring, whilst failure of such an expensive advertising campaign is estimated
to yield sales revenues amounting to 600,000.
The management team are of the opinion that decision tree analysis might assist
their marketing plans, as it will indicate the expected value of each decision, and
provide an insight as to the most feasible outcome.
Questions:
Q1: Construct a decision tree using relevant information which would show the
management team at Mourne Water Ltd the most favourable option open to
them.
Q2: Evaluate the usefulness of decision trees as a tool for making decisions,
by a business such as Mourne Water Ltd.
78
A1:
Decision Tree Diagram Mourne Water Limited
360,000
Success 0.3
143,000
Failure 0.7 50,000
Remains Unaltered
D1
760,000
600,000
Success 0.2
New Flavour
-100,000
D2 860,000
Light
Touch
Campaign
360,000
Failure 0.8
-30,000
300,000
Extensive
Campaign
-100,000
1,000,000
Success 0.9
960,000
Failure 0.1
600,000
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A2:
Evaluation:
The use of a decision tree as a tool for decision making does have some
advantages and disadvantages.
The benefits of using decision trees include the following:
1. the management team at Mourne Water Ltd can use a decision tree
effectively in a situation where a logical sequence of events can be
followed, such as the events making up the projects;
2. the use of a decision tree by the management team at Mourne Water Ltd
is suited to a project where there has been a similar past event, providing
quantitative information and producing realistic estimates for a new
situation, e.g. product promotion;
3. the use of a decision tree will facilitate the management team at Mourne
Water Ltd to think logically about the proposed project that is, addition of
flavouring and advertising the product range;
4. the use of a decision tree will enable the management team at Mourne
Water Ltd to sequence the proposed events and facilitate their planning in
respect of production activities (i.e. facilitate addition of flavouring) and
marketing (i.e. planning the promotion campaign);
5. the use of a decision tree will enable the management team at Mourne
Water Ltd to assess the expected costs of success in addition to the
potential costs of failure, e.g. of the promotional campaign.
The disadvantages of using decision trees include the following:
1.
a decision tree will not consider all of the uncertainty facing a business
such as Mourne Water Ltd consumers may not acquire a taste for the
flavour proposed, thus sales targets may not be achieved;
2.
the information/data upon which a decision tree is based may be
inaccurate/incomplete, which will limit the usefulness of it, as a tool for
making decisions by the management team at Mourne Water Ltd, e.g.
estimated demand for the product may not materialise due to incorrect
sampling methods in the pilot;
3.
a decision tree focuses only on the quantitative aspects of decisions
made by the management team at Mourne Water Ltd (largely ignoring
qualitative issues) consumer tastes/dietary needs may have changed
by the time the new product/flavour reaches the market.
Final judgement: it is possible to conclude that a decision tree is a useful tool
which could be employed by the management team at Mourne Water Ltd, as an
aid to making business decisions.
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CONTINGENCY PLANNING:
Chapter Aims:
Explain the nature of contingency planning within a business;

Identify and undertake related alternative courses of action;
Understand the information need for contingency planning.
Introduction:
This chapter discusses key definitions related to contingency planning within a
business, including an introduction to various short and long-term alternatives
that a business might have open to it. Related to this is a discussion of various
goals which might be pursued in the course of business. The nature of financial
information published by large companies is considered.
Contingency Plan:
A contingency plan is an alternative course of action which a business entity
might follow if the original plan or actual business activity does not conform to
expectations or is disrupted in some way.
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Reasons for Contingency Planning:

Contingency Planning usually occurs as a result of unforeseen circumstances or
unresolved problems which face a business organisation from time to time. The
following is a list of examples of problems or issues which often give rise to
contingency plans:
Financial a business may face cashflow problems and in the long term face
bankruptcy. Issues which give rise to cashflow problems include too much
money tied up in stock which is slow to turn over, too much money tied up in
debtors which is not being recovered quickly enough and funding growth (or
purchase of non-current assets) using available cash resources which will
therefore reduce the amount of cash available for working capital requirements.
Production orientated a business may face problems if a key piece of
equipment is not available or broken down. This could lead to a failure to meet
production output targets and therefore orders received. The adoption of JIT
methodology places increasing reliance on suppliers which might force a
business to find alternative suppliers or source cheaper material for use in
production, which in turn might reduce quality.
Human resource orientated a business may face industrial relations problems
if industrial action takes place, which usually leads to an inability to continue
production activities in order to meet sales targets. Availability of staff with
specialist skills or knowledge might present problems leading to an inability to
meet key objectives.
Environmental a business might face environmental issues if the activities
undertaken in support of key objectives face opposition from various stakeholder
groups. Common examples in this context also include pollution (noise, air and
water), moral and ethical issues which a business is often forced to consider at
the request of various stakeholder groups.
Corporate a business might face problems in common with its industry rivals,
which affect it at every level. A classic example is the liquidity problems facing
the banking industry in the UK, which has led to a number of key financial
institutions receiving funds from the UK taxpayer, thus placing private enterprises
into public ownership through the process of nationalisation.
Legal a business might face problems if specific products within the product
range are deemed to be unfit for sale or are the subject of nationwide recalls due
to poor quality. Situations such as these often lead to litigation and damage the
reputation of a business which make it difficult to meet key objectives.
Marketing a business might face problems as a result of any individual issues
arising from the above functional areas within the business or a combination of
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such issues. Such issues in turn might cause difficulties in relation to the
achievement of marketing, promotion and public relations objectives for the
business entity.
Advantages and Disadvantages of Contingency Planning:
There are a number of benefits to be gained from drawing up contingency plans.
These include:
It forces the management team to consider alternative courses of action in the
event of disruption or deviation from original plan
It provides the management team with an alternative method of achieving key
business objectives
It facilitates the business decision making process and enables management to
negotiate the optimum deal in the interests of the business
There are a number of disadvantages drawing up contingency plans. These

include:
It is time consuming and costly
It may never be implemented which may be a waste of resources
It relies on possible forecasted events that may not be accurate
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Contingency Plan Elements:

In a situation whereby a business cannot proceed with the original plan, an
alternative plan or contingency plan may be adopted. The precise contents of
a contingency plan will depend on the specific issue(s) facing a business at a
given time, however, the following is a summary of some of the key decisions the
management team within a business will consider as part of a contingency plan:
Finance within the context of liquidity problems in the short term, this might
include the use of reserves to fund working capital requirements or seeking
alternative sources of funding for long term projects, e.g. leasing, hire purchase.
It might also involve radical changes to the working capital policies of the
business in relation to stock (in order to reduce stockholdings or the value of
stocks held), debtors (in order to reduce both the value of debtors outstanding
and the time taken to collect monies) and cash (a cash budget might be prepared
analysing potential cash surpluses/deficits. This might enable the business to
meet key objectives.
Production within the context of using JIT systems a business might wish to
consider the use of alternative arrangements within the supply chain it might for
example reduce reliance on one particular supplier to supply materials, thus seek
alternative suppliers, source alternative cheaper quality materials, seek
improvements in terms/conditions of supply of material in order to meet key
objectives.
Human Resources the resolution of staffing issues will usually involve
negotiation aimed at addressing the issues causing a deviation from original plan.
Examples of such discussions might lead to increased rates of pay for staff,
reductions in working hours, adoption of flexible working arrangements or
improved productivity, all of which are aimed at enabling the business to meet
key objectives.
Marketing within the context of a contingency plan, the marketing activity will
likely focus on seeking improvements in the public relations profile of the
business, improving the corporate image, providing reassurance to stakeholders,
restoring confidence in the management team to resolve any outstanding issues.
Ways in which such objectives might be achieved include use of national media,
such as advertising campaigns using television, radio, newspaper and internet.
Management a contingency plan should ensure that the corporate policies an
organisation follows lead to towards the achievement of key business objectives.
Sometimes this might necessitate a change of personnel within the top
management team, the introduction of new corporate policies aimed at reducing
costs, increasing financial stability and responding to issues which cause public
concern, e.g. continued payment of financial bonuses in the event of business
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failure, or award of above-inflation pay increases to members of the top

management team when other staff are awarded zero percent increases in pay.
Key Steps:
The following are the main steps within a contingency plan:
Establish Start Position identify critical issues and identify alternative courses
of action
Assess Potential Impact analyse the critical success factors and likelihood of
success
Formulate Plan formulate and select most feasible plan, involve relevant
stakeholder groups
Test Plan develop a test plan or pilot actions to be taken under contingency
arrangements, ensuring stakeholder involvement and undertake post-audit
Undertake Training brief all stakeholders on alternative courses of action
necessary in the event of implementation of a contingency plan and facilitate
training and development to ensure achievement of successful outcome
Maintain Planning Process ensure that contingency plan is kept up-to-date
and relevant
Update/Amend Plan ensure that contingency plan is feasible keeping it under
review and feedback into each of the relevant steps
The adoption of the above process should result in minimisation of risk to the
business entity and enable it to cope with any contingencies that should arise.
Key Terms:
Contingency Plan; Crisis; Failure; Confidence; Goals; Alternative courses of
action.
85
Explain what is meant by the term confidence.

Explain what is meant by the term crisis.
Explain what is meant by the term alternative courses of action.
State one reason why businesses should undertake contingency planning.
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Case Study:
Go&Fly Airport is located in the Northern Ireland countryside. Go&Fly Airport is
operated by a private company. The strategic location of the Airport means that
it is a key transport gateway for the travellers to/from various national and
international destinations, including London, Liverpool and Spain, achieved
through the provision of scheduled and charter services. In addition, the Airport
makes a valuable contribution to inbound tourism, as measured by increasing
numbers of tourists using the airport facilities.
The location of the airport means that it is convenient for passengers travelling
from the Republic of Ireland. The management team believe that the catchment
area reaches south to Sligo and Galway, placing it in competition with other
regional airports closer to Belfast. Management were recently criticised for lax
safety standards in operation at the Airport, following an enquiry by an aviation
consultant on behalf of the regulatory authority, the CAA. As a result of the
findings of this investigation, the Airport was forced to close for a period of
approximately 5 days during 2007, to facilitate completion of essential repairs to
the runway and other facilities.
The closure of the Airport, which was widely reported in the media at the time,
caused major disruption to the business operations and travel arrangements of
many stakeholders, including airlines (as customers of the Airport), airline
passengers, airline staff, the general public, airport staff, subcontractors, and
neighbouring communities. Given the extent of the closure and the effect it had
on stakeholders, it could be suggested that there was no evidence of
contingency planning at the Airport to deal with the situation.
Questions:
Q1: Define the term Contingency Planning.
Q2: Explain two reasons why the management team at Go&Fly Airport should
undertake contingency planning.
Q3: Analyse the potential impact that the temporary closure of Go&Fly Airport is
likely to have on any three stakeholder groups.
Q4:Evaluate the key elements of a contingency plan which might be used by the
management team to deal with the temporary closure of Go&Fly Airport.
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Suggested Solutions (to include the following main points):

A1:
Contingency Planning: this is generally taken to mean an alternative set of
plans drawn up by the management team of an organisation which may be
implemented in the event that an original plan does not proceed as intended.
The management team at Go&Fly Airport would be expected to undertake
contingency planning in the event of an emergency situation or breach of safety
regulations at the airport.
A2:
The management team at Go&Fly Airport should undertake a degree of
contingency planning for various reasons such that: (i) it enables the
management team to respond quickly and decisively to any deviations from the
original plan, e.g. undertake repair work to runways to ensure high standards of
air safety; and (ii) it enables the management team to make decisions in
response to a crisis situation which may occur, e.g. the temporary closure of the
airport based on the recommendations of an aviation consultant.
A3:
The temporary closure of Go&Fly Airport is likely to impact various stakeholder
groups in the following ways:
Airlines: the closure would cause major disruption to the business operations and
travel arrangements of airlines (as customers of Go&Fly Airport). Aircraft are
typically used on other routes after they have departed from an airport, thus any
aircraft grounded cannot fly, or any aircraft diverted to another airport will disrupt
the operations of the airline.
Passengers: the closure would cause major disruption to the travel and holiday
plans of passengers, since they will have booked flights to arrive at their
destinations, for example for job interviews, football matches, holidays and other
family matters. The closure will cause delays and result in cancellations and/or
additional costs as families may rebook on alternative flights from neighbouring
airports, which in turn means additional travel, time and costs.
Management Team: the closure would cause major problems for the
management team, as they will be required to address the key issues of health
and safety, safety in the air, restoring the reputation of the airport in relation to
other stakeholder groups, restoring confidence of the owners in the operation of
the airport and the general public that air travel is safe. The closure would also
have meant that Go & Fly Airport lost sales revenues.
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A4:
Contingency Plan Elements:
Elements of a Contingency Plan: it is suggested that normal procedure for
contingency planning includes issues such as: (i) examining potential crisis
situations; (ii) planning for each crisis; (iii) test the plan, e.g. special training
event, simulation etc.
It would have been expected that the management team at Go&Fly Airport would
have involved key functional areas of the team in resolving the issue of the
closure, including marketing, human resources, finance, and business
operations. Some key tasks which the respective departments would have been
expected to undertake would typically have included the following:
Marketing: (i) the issue of press releases to keep key stakeholder groups abreast
of developments; (ii) the issue of guidance to travellers to assist them to make
alternative travel arrangements; (iii) the deployment of alternative air services
using other regional airports; (iv) the use of public relations in managing the
closure and eventual re-opening.
Human resources: (i) facilitate the identification of key personnel required to
remedy the breach in safety standards; (ii) facilitate the training of key personnel
required to manage the closure and eventual re-opening; (iii) arranging for the
subcontracting of remedial work using suitable personnel.
Finance: (i) the finance function will ensure provision of sufficient finance to
undertake the remedial work to attain safety standards; (ii) the finance function
will ensure provision of finance to meet the expenses/costs of the closure and
marketing activities required to support alternative transport arrangements by
stakeholder groups; (iii) the finance function will facilitate the completion of an
audit into the closure in order to avoid any further closures.
Business operations: (i) this function will monitor the remedial work and ensure
that the work meets safety standards; (ii) this function will oversee the
health/safety requirements demanded of Go&Fly Airport in respect of aviation
safety and health/safety at work laws; (iii) this function will assist in reinstating
normal business operations once the airport reopens.
89
COMPANY ACCOUNTS:
Chapter Aims:
Explain the nature of the financial statements of a business;

Understand the information contained within the financial statements of a
business entity;
Understand the usefulness and limitations of using published accounting
information.
Introduction:
This chapter discusses key definitions related to the accounting statements of a
business, including a discussion of the extent to which financial statements are
useful for making business decisions. The nature of financial information
published by large companies is considered.
Financial Statements:
The financial statements are the documents which summarise the financial
position of a business entity.
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Reasons for Financial Statements:

There are a number of reasons why a business would draw up financial
statements. The primary reason why financial statements are prepared is that
they enable the management team to summarise the financial position of a
business entity at the end of the accounting period. The extent to which the
financial statements are useful can be illustrated with reference to various
stakeholder groups who are likely to have an interest in the business:
The owners of the business (shareholders) will want access to more detailed
financial information regarding the financial position of the company at the year
end. This includes reference to revenues and profitability (income statement)
and the net worth of the business (summarised in terms of assets and liabilities
within the statement of financial position). This enables shareholders to evaluate
the extent to which the management team have operated the business on their
behalf, i.e. performed their stewardship function.
Government agencies will require access to the financial statements in order to

verify the extent of the companys liabilities to various forms of taxation and
duties, including corporation tax, income tax, VAT, excise duties and other taxes
91
including rates and taxes related to specific industries which the company is
obliged to collect on behalf of government, e.g. insurance premium tax. This
enables management to act in the best interests of shareholders by minimising
tax liabilities.
Financial institutions will require sight of the financial statements in order to verify
the overall financial position of the business within the context of providing debt
finance. This is important for two reasons as the lender will want: (i) evidence of
the companys ability to meet interest payments (highly profitable); and (ii)
evidence that the company is a secure investment, i.e. has sufficient cashflows to
meet regular payments and a sufficient asset base in order to provide security for
a loan. This enables the management team to obtain finance at a reasonable
cost to the business in order to fund business activities.
92
Staff/employees will want access to the financial statements in order to form an

assessment of the financial position, with a view to: (i) securing continued
employment; (ii) securing improved terms/conditions of employment and; (iii)
participating in improving productivity and working conditions generally. This
enables management team to secure the best possible use of human resources
in order to meet key objectives.
Photos.com/Thinkstock
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Suppliers might wish to gain sight of the financial statements in order to inspect
the financial position and therefore make decisions regarding the
creditworthiness of the company. This is important as it allows the management
team to secure access to resources based on agreed terms and conditions with
suppliers, which in turn allows the business to meet the needs of customers and
key objectives. Effective supply chain management requires close co-operation
between suppliers and the business, hence this might facilitate such
developments for the benefit of all stakeholders.
Goodstock/Thinkstock
Investors might wish to gain sight of the financial statements in order to facilitate
their decisions with respect to acquiring an interest in the business. The financial
statements should provide an indication of profitability, solvency and enable
investors to perform basic ratio analysis in order to decide if the company is a
worthwhile investment. This decision will be confirmed with other information
related to the company, e.g. annual reports, stockbroker comments.
94
The Management Team will rely on the financial statements for a number of
reasons:
To determine the profitability of the business during the financial period and
facilitate a comparison with previous accounting periods and/or budgets
To facilitate a review of the financial position in terms of the assets/liabilities held
by the business and provide guidance in relation to effective working capital
management
To enable decisions to be taken in relation to all aspects of the financial position
of the business, for example, implementation of cost reduction programmes,
evaluation of capital projects, determination of cashflows to fund growth
To allow the management team to determine the financial resources available to
achieve key objectives, for example, to facilitate a takeover the business needs
to secure access to funds to complete the deal; to block a hostile takeover, the
company might need to verify that the bid received significantly undervalues the
business
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Financial Statements:
This section outlines the purpose and nature of some of the key financial
statements which are normally produced within a business for the purposes of
financial reporting. It is important to recognise that a key aim of operating in
business is to make a profit.
Financial reporting in concerned mainly with recording financial transactions and
presenting the summarised results of all such transactions in a set of financial
statements comprising the Trading, Profit and Loss Account and Balance Sheet
and for larger organisations, a Cash Flow Statement.
Financial reporting tends to be historical in nature, focusing on financial
transactions which have already occurred within the financial year under review.
The purpose of the financial statements is to summarise the financial position
(Statement of Financial Position) of a business in terms of its assets/liabilities and
profitability (Income Statement).
The documentation of all financial transactions within the financial statements will
assist a review of the financial performance of the business. A business entity
will often find that a number of users will make reference to the financial
statements, including for example, business owners, bank officials, government
officials, investors, members of the public and other stakeholders, each of whom
will use the information provided for their own purposes, e.g. lending decisions
96
(owners and lenders), agreement of tax liabilities (government) and provision of

capital (investors).
A business entity is required to prepare financial statements covering a specific
time-period during which the business traded referred to as an accounting
period. This is normally taken to be a period of one year and can also be
referred to as the financial year. Within a UK or N. Ireland context, many
businesses adopt the calendar months of December or March as their financial
year-end - this is an important decision to be taken by the top management team,
as it will determine the period during which a business will be liable to taxation on
the profits reported.
A Public Limited Company (plc) is required to provide detailed information in
respect of the financial position, considering items such as interest on loans,
taxation, dividend payments and other matters including for example, transfers to
reserves. In all cases, the most common approach adopted is to present the
financial statements in a vertical format (layout).
Final Accounts:
The Financial Statements are often referred to as the Final Accounts, which
include the Income Statement and the Statement of Financial Position.
The Income Statement:
In simple terms, the Income Statement summarises the results of trading

(continuing) operations. The main expenses of the business are deducted from
97
sales revenues and a profit/loss after tax reported initially. Some businesses
may also report profits/losses arising from operations which have been
discontinued during the financial year. The end result is to report a profit or loss
for the financial period under review, in addition to a key financial measure
earnings per share.
The Income Statement is normally used to show the financial results from trading
operations. The purpose of this statement is to determine, by calculation, the
Gross Profit/Loss for the accounting period. In its simplest form, this account
also summarises any additional revenues or expenses of the business for the
accounting period and shows the overall Profit/Loss before and after taxation, for
the accounting period.
Statement of Financial Position:
In simple terms, the Statement of Financial Position summarises the assets,

liabilities and capital of a business at a particular date. Such statements differ
from the Income Statement in that, the financial position of the business is shown
as at a specific point in time, which could change within a short timeframe
thereafter. A Statement of Financial Position is sometimes referred to as a snapshot of the business finances at a given point in time.
98
A Statement of Financial Position typically lists the following information:

Non-Current Assets: amounts representing items owned by the business, such
as premises, vehicles, fixtures and fittings and are generally held over the long
term.
Current Assets: closing inventories, amounts paid in advance, trade receivables,
cash, money deposited in the bank.
Current Liabilities: amounts representing items owed by the business, such as
trade payables, bank overdrafts
Non- Current Liabilities: amounts representing items owed by the business over
the long term, including debentures (loans) and other forms of debt finance to the
providers of capital.
Share Capital: amounts representing the monies invested in the business by the
owners, including any profits accumulated over previous accounting periods.
The Authorised Share Capital is the amount of capital the company is legally
allowed to raise. The Issued Share Capital is the amount of capital the company
has actually raised and allotted shares for. The total number of shares issued by
the company may be stated, including the types of share (ordinary or preference)
and nominal value of the shares issued may be disclosed.
Reserves: amounts representing the accumulated profits/losses which belong to
the members of the company (shareholders). Examples include General
Reserve and/or Profit/Loss Reserve these reserves can be used to pay
dividends to shareholders at the discretion of management. A Share Premium is
an additional amount of money a company receives upon issue of shares for the
first time. It arises when the issue price is greater than the nominal value of the
shares, and is common if the shares are popular or oversubscribed (i.e. too many
shareholders apply for shares compared to the number of shares available for
allotment). A share premium is an example of a non-distributable reserve,
which means that it cannot be used to pay dividends to shareholders unless
permission is granted by a court.
It is important to note that not all the profits may be distributed by a company in
any one accounting period. The closing balance on the Appropriation Account (if
published) is sometimes referred to as a Profit and Loss Reserve. Sometimes a
limited company may wish to retain profits and transfer these to a General
Reserve. Both types of reserves are shown in the Capital section of the balance
sheet.
Taxation: Since a limited company is a separate entity from its shareholders, it
differs from sole traders in that it must pay Corporation Tax on the profits made
during an accounting period. In terms of the preparation of the financial
99
statements there is a requirement that expenses for taxation must be shown

within the Profit and Loss Account. The amount which the company has to pay
by way of Corporation Tax is determined each year by the government at the rate
laid down in law. The amount of tax to be paid is recorded in the Profit and Loss
Account after the interest payments to debenture-holders have been stated. The
payment of the tax will normally occur within nine months after the financial year
end, and thus the tax due for payment will also be recorded within the Current
Liabilities section of the balance sheet.
Dividends: The return which a shareholder can expect on their shares (i.e.
investment in the company) is referred to as a Dividend. Sometimes a company
can pay a dividend half-way through a financial year, which is referred to as an
interim dividend. Normally, a dividend is paid after the financial year end when
the profits are known (where a company pays an interim dividend, the dividend
declared at the financial year end will be referred to as a final dividend).
Normal procedure is that the dividend is proposed by the directors (hence
recorded in the Appropriation Account) and paid after the dividend has been
approved by shareholders at an Annual General Meeting (hence recorded it is
also recorded within the Current Liabilities section within the Statement of
Financial Position).
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The following example shows an example of a public limited companys Financial

Statements. Using the data within the Trial Balance stated within the example:
Example: Bangor Eye-Pods plc, located in Bangor,
producing and selling the latest hand-held video games
throughout Europe.
The following is a trial balance for the financial year ended
31st December 2012:
Dr
Cr
000
000
Authorised and Issued Share
Capital (1) ordinary shares
3000
Sales
5900
Purchases
500
Opening inventory
100
Selling & Distribution Costs
300
Administration Expenses
200
Debenture Interest
100
Premises
2000
Vehicles
5000
Equipment
1000
Debentures
1100
Retained Earnings
0
Bank
800
10000
10000
Notes:
1. Closing inventory is valued at
100,000
2. Proposed Dividend is
600,000
3. Corporation Tax should be provided for, amounting to
400,000
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Suggested Solution: Bangor Eye-Pods plc Income Statement for the year
ended 31st December 2012.
000
Sales Turnover
5,900
Cost of Sales
(500)
Operating Profit
5,400
Selling & Distribution Costs
(300)
Admin. Expenses
(200)
Profit before interest and tax
4,900
Interest on loans
(100)
Profit before tax
4,800
Tax
(400)
Profit after tax
4,400
Bangor Eye-Pods plc Income Statement as at 31st December 2012

NBV
000
Non-current Assets
Premises
2,000
Vehicles
5,000
Equipment
1,000
8,000
Current Assets
Total Assets
900
8,900
Equity
Authorised and Issued Ordinary Share Capital
Retained Earnings
Capital Employed
3,000
3,800
6,800
Non-Current Liabilities
Debentures
1,100
Total Equity and Liabilities
1,000
8,900
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Note:
Profit & Loss Appropriation Account

Opening Balance
Add Profit after tax
Less Dividend proposed
Closing Balance
000
0
4,400
4,400
(600)
3,800
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Accounting Concepts:
Hemera/Thinkstock
A number of basic assumptions are normally adopted when preparing a set of

financial statements. These are often referred to as Accounting Concepts. The
accounting concepts, when applied to a set of company accounts attempt to
make the accounting information more relevant, useful, timely and easily
understood. Consider the following:
Going Concern: the business is assumed to continue in operation for the
foreseeable future. In other words there is nothing to indicate during the
preparation of the financial statements, that the business will cease to exist
unless otherwise stated. Practically speaking, this means that assets (e.g.
inventory, non-current assets) are valued at cost on the assumption that they are
worth a greater amount. Should the business cease to exist, such values would
be stated at realisable value (i.e. the value at which they could be sold).
Accruals Concept (Matching Concept): this concept establishes the principle that,
in the determination of an accurate financial position, revenues and costs related
to the business must be recorded when they are earned or incurred, as opposed
to when the monies are received or paid. Thus, the income statement is
prepared for an accounting period, during which all revenues must be matched to
the costs incurred in generating such revenue streams for the business.
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Consistency: the principle involved in this context is that, when preparing the
financial statements, a consistent approach must be taken when
adopting/implementing accounting policies (e.g. inventory valuation methods
adopted, depreciation methods used). This applies to recording transactions and
measuring items.
Prudence: this concept requires that when preparing the financial statements, it
is prudent to recognise revenue only when it is realised in an acceptable form
whilst allowing for all expenses and losses as soon as they are known about.
Accounting adjustments are often made to the information contained (balances)
within
the Trial Balance. There are a number of reasons for such adjustments,
including (i)
accounting for timing differences between the matching of costs/revenues in an
accounting period; and (ii) various events will occur immediately after the
financial yearend which require inclusion in the financial statements, e.g. inventory valuations
to derive
closing inventory values. Additional adjustments in terms of limited company
accounts are
required to incorporate items such as corporation tax due and unpaid, and
dividends
proposed.
Limitations of Published Financial Statement Information:
Public limited companies are required by law to publish their financial statements,
usually on an annual basis for the benefit of shareholders. Whilst this may be
seen as useful in some respects, the publication of such information does have
its limitations. Consider the following:
The publication of such information by a company usually takes place at least
three months after the financial year end, hence some of the information may be
out-of-date, therefore not reflecting economic reality
It is difficult for users of the financial statements to fully understand the contents
of the financial statements, since many of the figures quoted are subject to
manipulation and summary reporting techniques, meaning that it is impossible for
an external stakeholder to gain a full understanding of the financial position
The publication of the financial statements by themselves concentrates mainly on
the quantitative issues affecting the business and is therefore limited. Public
limited companies are however, obliged to publish additional information such as
an annual report, an economic outlook and governance statements which could
mean that users suffer information overload
105
It is difficult for users to compare the financial performance with other companies,
since each company tends to adopt their own accounting policies, which mean
that some companies may account for some expenses differently from others,
making it difficult to determine precisely the profitability and solvency of the
business
The publication of financial statements implies that a company is subject to closer
public scrutiny, therefore it is forced to reveal a summary financial position,
providing some information regarding its business affairs, which might be useful
to competitors or a predator company in a takeover situation
The financial statements do not disclose all the intimate details about a
companys financial position nor does the statutory audit guarantee the future of
the business. Illegal practices such as fraud, money laundering and similar
activities might go undetected leaving the company exposed to bankruptcy or
criminal proceedings.
Key Terms:
Company Accounts; Accounting Statements; Turnover; Sales; Operating Profit;
Profit Before Tax; Taxation; Profit After Tax; Interim Dividend; Proposed
Dividend; Interest; Non Current Assets; Current Assets; Current Liabilities; Long
Term Debt; Share Capital; Profit and Loss Reserve; Share Premium; General
Reserve; Capital Employed; Shareholders; Debentures.
Explain what is meant by the term financial statements.

Explain what is meant by the term net profit.
Explain what is meant by the term share premium.
Evaluate the use of Published Financial Accounts
106
Case Study:
The following is the summarised financial data related to two companies
operating within the financial services sector of the Northern Ireland economy.
Company
Financial Year ended:
Sales Revenue
Profit Before Tax (Operating
Profit)
Taxation
Dividends
Retained Earnings
Non-Current Assets
Current Assets
Current Liabilities
Long Term Debt (Debentures)
Net Assets
Issued Share Capital (20p
shares)
Profit and Loss Reserves
Capital Employed
YAH plc
31st December
2012
m
17.8
3.2
HAH plc
31st December
2012
m
893.1
17.1
2.2
1.0
0.0
3.0
14.1
0.0
72.9
2.1
(10.0)
(18.6)
46.4
264.6
96.7
(115.0)
(1.9)
244.4
1.4
15.8
45.0
46.4
228.6
244.4
Questions:
Q1: Outline two reasons why it necessary for public companies to prepare
accounting statements.
Q2: Explain the financial position as revealed by the summarised financial
statements of YAH plc and HAH plc.
Q3: State three limitations of using information contained within the published
accounting statements.
Q4: Discuss three ways in which published accounting statements might be
useful for making investment decisions, by investors (shareholders) in
companies such as YAH plc and HAH plc.
107

A1:
Public limited companies such as YAH plc and HAH plc are required to prepare
accounting statements for the following reasons: (i) there is a legal requirement
for public limited companies to publish annual financial information for the benefit
of shareholders, to inform them of the financial position of the company in which
they have invested funds (i.e. to determine if their investment has been
worthwhile); and (ii) to enable investors and other stakeholder groups to hold
management to account and monitor financial performance of the company (i.e.
check on managements stewardship of financial resources).
A2:
Key aspects of the financial position of YAH plc and HAH plc, for the financial
year ended 31st December 2008: YAH plc and HAH plc employ different sources of funding, including equity
and debt finance. YAH plc is financed by 7,000,000 20p shares, whilst
HAH plc is financed by 79,000,000 20p shares. This analysis assumes
use of Ordinary shares, constituting the share capital for each company. It
is also assumed that the Authorised Share Capital is equal to the Issued
Share Capital.
Each company is financed by profits which have accumulated over
previous financial periods (represented by Profit and Loss Reserves),
amounting to 45m and 228.6m for YAH plc and HAH plc respectively.
The Profit and Loss Reserve is an additional element of Shareholders
Equity and thus is attributable to them in the event of a distribution by way
of dividends.
The summarised financial data outlines how the capital employed has
been represented throughout the business. The Fixed Assets (which are
expected to be made up of premises, equipment, vehicles and similar
assets), figures for YAH plc and HAH plc are 72.9m and 264.6m
respectively, which are in excess of the shareholders funds in each
company, suggesting that each business is asset rich - such assets help
each business function in the long term.
The Current Assets of each company are 2.1m and 96.7m for YAH plc
and HAH plc respectively, typically represented by assets held in the short
term, such as stock, debtors, prepayments, bank deposits and cash.
With regard to the Current Liabilities, which would include items such as
creditors, accruals and bank overdraft, this amounts to 10m for YAH plc
and 115m for HAH plc respectively.
Each company also uses long term debts in order to finance elements of
their business operations, possibly including acquisitions of assets. YAH
plc have borrowed 18.6m, whilst HAH plc have borrowed 1.9m
typically represented by Debentures.
108
The Net Assets figure for each company is the summation of the figures
for Fixed Assets, Working Capital and Long Term Debt (that is, 46.4m for
YAH plc and 244.4m for HAH plc).
The Capital Employed also totals an equivalent amount (46.4m for YAH
plc and 244.4m for HAH plc).
With respect to the summarised Income Statement, the turnover (Sales
Revenues) reported by each company amounted to 17.8m and 893.1m
for YAH plc and HAH plc respectively. This figure is well in excess of Cost
of Sales (not reported), as the Profit Before Tax (Operating Profit) figures
are positive at 3.2m and 17.1m respectively for YAH plc and HAH plc.
Corporation Tax is paid on the profits of each company, hence the
expense as stated, amounting to 2.2m and 3m respectively for each
company (YAH plc and HAH plc).
Each company paid dividends to their shareholders for the financial year,
representing a return on investment (shareholders) this is also deducted
from the operating profit, amounting to 1m and 14.1m for YAH plc and
HAH plc respectively. On a per share basis, the dividend amounted to
approximately 14.3 pence for the shareholders of YAH plc, whilst the
corresponding amount was approximately 17.9 pence for the shareholders
of HAH plc.
As a result of the deduction of taxes and dividends from operating profits
in each company, the Retained Earnings for the financial year under
review amount to zero in each case (which in turn is included in the Profit
and Loss Reserve data).
A3:
Three limitations of published financial statement information:
(i)
In relation to companies such as YAH plc and HAH plc, it can be
difficult to undertake comparisons with quoted companies in the same
industry due to the use of different accounting policies in each
company. This may be considered a drawback to investors in
particular;
(ii)
Individual companies such as YAH plc and HAH plc are required to
publish further reports, such as directors report, cash flow statement
and notes to the accounts for consideration of investors, which in turn
make it difficult to draw comparisons and absorb information quickly for
investment decision making. This may be a drawback to investors in
particular;
(iii)
The publication of financial statement information does not reveal in
complete detail, the financial position of an individual quoted company
such as YAH plc and HAH plc. This might be a problem for some
stakeholder groups.
109
A4:
Three ways in which published financial statement information might be of use to
shareholders in the context of making investment decisions:
(i)
In relation to YAH plc and HAH plc, publication of such information will
communicate to investors information about the ability of the
management team of each company to operate the business efficiently
and effectively (i.e. the extent to which the stewardship function has
been exercised). This is likely to be of benefit to investors as they can
decide if it is worthwhile to continue to invest in either company;
(ii)
In relation to YAH plc and HAH plc, the published financial statements
of quoted UK companies are audited independently, thus are more
likely to be relied upon as a guide, to the financial performance of each
of the respective companies. This is likely to be of benefit to
shareholders as it enables them to form an opinion as to the long term
growth/income prospects of each company under consideration;
(iii)
In relation to companies such as YAH plc and HAH plc, the published
financial statements will assist quoted companies in acquiring debt
financing, as lenders can assess the financial stability and profitability
of an individual company, however this might be a problem for
shareholders as the more highly geared a company becomes, the
more risky an investment it is since debts levels increase as does the
amount of interest to be paid, which in turn has the effect of reducing
profits the publication of such information enables shareholders to
monitor this issue.
110
RATIO ANALYSIS:
Chapter Aims:
Explain the nature of ratio analysis as used in business;

Understand the information contained within the financial statements and
posited by a set of accounting ratios of a business entity;
Understand the usefulness and limitations of using ratio analysis to
interpret accounting information.
Introduction:
This chapter discusses key definitions related to ratio analysis, including an
introduction to various issues which are likely to emerge from conducting ratio
analysis using a set of published financial statements. Related to this is a
discussion of the likely areas for decision making, which might be relevant within
the context of a business. The usefulness of accounting ratios is also
considered.
Ratio Analysis:
Accounting ratios attempt to explain additional aspects of the financial position
of a business entity not revealed by the publication of financial statements on
their own.
Accounting Ratios:
There are a number of financial objectives which a business is likely to have.
Such objectives change over time depending on the circumstances of the
business, however accounting ratios can assist decision making on the part of
various stakeholders, when analysing financial performance of a business.
Performance Ratios:
Users of financial statement information are required to assess/review the
financial performance of a business entity. This is carried out with reference to
the figures contained with the financial statements and involves calculating and
analysing ratios derived from the financial data.
The key areas of interest to users of financial statements include aspects of
performance, liquidity, gearing and shareholder ratios. Consider the following:
111
Performance Ratios:
Indicators of financial performance are of interest to business owners and others
since, in the first instance, the concept of profit is easily understood. Examples of
users who are interested in the profitability of the business include owners,
lenders, tax authorities and staff. There are a number of ratios which can be
used in this context.
Return on Capital Employed: This is often referred to as the primary ratio it
is generally the first ratio calculated when analysing the financial performance of
a business. The ratio compares the operating profit to the capital invested in the
business acting as a benchmark of returns on investments, facilitating
comparisons to be drawn with other forms of investment, e.g. interest received on
bank deposits.
The formula used to calculate the return on capital employed is:
(Profit before Tax + finance costs +preference dividends)
(Total Assets Current Liabilities)
x 100% =
R.O.C.E. (%)
Note: within the context of limited company accounts, the recommended profit
figure that should be used to calculate this ratio is the net profit before interest
and tax figure. The rationale for this is that managers/business owners cannot
be held accountable for tax charges (since they are imposed by government), but
they can be held accountable for profits accumulated before the impact of
taxation.
Gross Profit Margin (Percentage):
This ratio indicates the profitability of trading operations. The Gross Profit is
calculated by deducting the Cost of Sales from Sales revenues, and represents
funds available to meet the operating expenses of the business. The formula
used to calculate the Gross Profit Percentage is:
Gross Profit
Sales Revenues
x 100%
GP %
As a guide, the gross profit percentage should be reasonably consistent year on

year. Substantial differences in this ratio could indicate problems with inventory
management, purchase costs and/or sales performance.
Note: within the context of limited company accounts, the equivalent figure that
may be used is Operating Profits this is dependent upon the information
available.
112
Net Profit Margin (Percentage):

This ratio indicates the profitability of running the business. The Net Profit is
calculated by deducting the total expenses from Gross Profit, and will indicate
how successful the business is with respect to managing costs and keeping costs
under control. The formula used to calculate the Net Profit Percentage is:
Net Profit
Sales Revenues
x 100%
NP %
As a guide, the net profit percentage should be reasonably consistent year on

year. Substantial differences in this ratio could indicate problems with cost
management and expenses.
Note: within the context of limited company accounts, the equivalent figure that
may be used is Profit before Interest and Tax.
Liquidity Performance:
Indicators of liquidity are important since they provide an indication of the
solvency of the business (i.e. the ability of the business to pay its debts). The
business owner will want to be reassured that the business is solvent. Lenders
will want to check the solvency of the business before granting loans, in order to
safeguard their funds.
There are a number of ratios that may be used in this context:
The Current Ratio:
The data for this ratio is drawn from the balance sheet. It compares the total of
the current assets to the total of the total current liabilities, and indicates if the
business can pay its immediate short term debts from available resources. The
formula used to calculate the Current Ratio is:
Current Assets
Current Liabilities
x: 1
This is usually expressed as a ratio. A common benchmark adopted in business

is that of a ratio of 2:1, indicating that debts should be met twice from available
funds/resources.
The Acid Test Ratio:
The Acid Test Ratio extends the use of the Current Ratio in that the Current
Assets are adjusted for inventory values (i.e. inventories are excluded). This
builds upon the concept that liquid funds are used to settle immediate debts
liquid funds represent cash or near cash resources. Inventories the most illiquid
113
of all current assets since it has to be sold before it can be converted to cash,
hence its exclusion.
The formula used to calculate the Acid Test Ratio is:

Current Assets-Closing inventory
Current Liabilities
x:1
As with the Current Ratio, this is expressed as a ratio. A common benchmark

adopted in business is that of a ratio of 1:1, indicating that debts should be met
once from available funds/resources. A lower ratio in this respect would indicate
difficulty in meeting the debts of the business, thus the business could be
insolvent.
Gearing:
Indicators of gearing are important since they provide an indication of the long
term debt commitments of the business (i.e. the ability of the business to pay its
loans). The business owner will want to be reassured that the business can meet
its long term debt obligations. Lenders will want to check the ability of the
business before granting loans, in order to safeguard their funds. In its simplest
form, the key ratio that may be used in this context is:
Non Current Liabilities (Debt Capital)
(Equity Capital + Reserves + debt Capital)) X 100%
Gearing %
It is important to appreciate the significance of the gearing ratio. A highly geared

business implies greater levels of financial risk, in terms of debt owed to lenders,
and also the higher interest payments which must be met. Lower geared
businesses tend to be low risk propositions.
Note: within the context of limited company accounts, equity capital is taken to
include Profit and Loss Reserves.
Shareholders Ratios:
Indicators of shareholders wealth are important since they provide a measure of
the long term wealth of an investor in the business. Shareholders (owners) will
want to be reassured that their investment is profitable, at least in the short term,
and that it is likely to yield capital gains in the longer term. In this context, two
ratios that may be useful are:
114
Earnings Per Share:

The formula used to calculate earnings per share is:
Profit After Tax
Number of Shares in Issue =
x pence
As a measure of performance, this ratio indicates the profitability of the company
in the first instance. It is expressed in terms of pence per share, and should
ideally be as high as possible. Considered in isolation, it is limited but compared
to a previous year or another company can provide a better insight into the profit
movements experienced over time on a per share basis. This ratio is normally
disclosed as a note to the income statement.
Return on Equity:
This ratio can be used to measure the return on the funds contributed by
shareholders, as represented by equity in the business. In the context,
shareholders equity is defined as ordinary shareholders capital plus reserves.
The formula used to calculate Return on Equity is:
Return on Equity
Profit After Tax

Shareholders Equity
x 100% = x%
As with the other ratios, the return on equity is limited when calculated on its own.
To enable a more substantial evaluation, it should be compared to other
measures of return, including ROCE and/or with previous accounting periods or
other firms in the industry.
Issues related to the use of Accounting Ratios:
115
Although the calculation of accounting ratios appears routine, it is important to

place each ratio in context of the financial statements when analysing and
passing judgement on the financial performance of a business.
The process of evaluating the financial performance of the business should
incorporate the accounting ratios, which in turn should indicate potential
strengths and weaknesses of a business, or at the very least point the business
owner in the direction of areas for further investigation.
Benefits of Ratio Analysis:
Conducting ratio analysis can yield the following benefits:
Accounting ratios assist a user of financial statements understand the

financial position in addition to that revealed by a statement of data alone
Accounting ratios can assist a user of financial statements identify areas of

potential strength/weakness within a business, thus facilitate decision
making
Accounting ratios can be used to identify and explain trends in relation to

specific areas of performance within a business
Accounting ratios enable financial comparisons to be undertaken over time

or between separate business entities efficiently and effectively
Limitations of Ratio Analysis:
Accounting ratios are only as accurate as the underlying financial

statements, thus any analysis may be limited in scope;
Accounting ratios only provide a snap-shot view of the financial

performance of the business at one point in time, which may not be
representative of the entire business performance over time;
Accounting ratios may be defined in different ways. Alternative definitions

can be employed with respect to some ratios, e.g. gearing or debtors
collection period.
Comparisons of financial performance and accounting ratios between

companies may be difficult due to the adoption of different accounting
policies between business entities.
116
Worked Example:
The following example shows a range of ratios which may be calculated based
upon a set of financial data:
The interim financial statements for two public companies quoted on the Belfast
Stock Exchange have been summarised below, for the 6-month period ended
June 2012. Imagine that you are about to invest 100,000 in each of the two
companies on behalf of a client. In order to assess the financial performance of
the business you are required to conduct ratio analysis in order to aid your
investment decision.
Company A
Company B
Summary Financials
Interim Accounts
Interim Accounts
June 2012
June 2012
m
m
Turnover
140
196
(100)
Cost of Sales
(82)
Operating (Gross) Profit
58
96
Selling & Distribution Expenses (30)
(44)
(40)
Administration Expenses
( 6)
Profit Before Interest and Tax
22
12
( 2)
Interest
(2)
Profit Before Tax
20
10
Taxation
(18)
( 8)
Profit After Tax
2
2
Non-current Assets
Current Assets:
Stocks
Debtors
Cash
Total Current Assets
Total Assets
70
70
22
40
10
10
1
1
Share Capital (1 ordinary shares)

Retained Earnings
60
Total Equity
90
Non Current Liabilities
Debentures
Current Liabilities:
Creditors
Bank
Total Current Liabilities
42
42
112
112
30
30
24
54
20
50
1
1
2
112
6
2
8
112
117
Summary of accounting ratios:

Performance Ratios:
Definition
employed
Return on Capital
Employed
(Profit before Tax + finance
Gross Profit Margin

Net Profit Margin
Liquidity Ratios
Current Ratio
Acid Test Ratio
Gearing
Shareholder Ratios
Earnings Per Share
Return on Equity
Company A:
Interim Financial
Results
20%
Company B:
Interim Financial
Results
11.5%
Operating (Gross)
Profit/Sales
Profit before
interest and
tax/Sales
41.4%
48.9%
15.7%
6.1%
Current
Assets/Current
Liabilities
(Current Assetsinventory)/Current
Liabilities
Debt/Total Equity
21.1 times
5.25 times
11 times
0.25 times
22%
93%
Profit After
Tax/Number of
Shares
Profit After
Tax/Total Equity
6.7p
6.7p
2.2%
3.7%
costs +preference
dividends)
(Total
Assets Current
Liabilities)
x
100%
=
R.O.C.
E. (%)
118
Interpretation of Accounts Narrative:

The following key points explain key aspects of the financial performance of the
two companies:
In order to explain any differences in performance, it is important to realise that
we are comparing the actual financial performance of two separate companies
within the same industry for the same financial year.
Performance:
ROCE: the return on capital employed for Company A is calculated as 20 per
cent, compared to that of Company B of 11.5 per cent. This would imply that
Company A is able to provide investors with a greater return on their investment
due mainly to the relatively high level of profitability of trading operations as
revealed by the operating profit this would suggest that management are
keeping cost behaviour under constant review and control.
GP %: in terms of profitability, the gross profit margin achieved by Company A is
41.4%, compared to that calculated for Company B of 48.9%. These results are
largely consistent with each other, however, Company B would appear to have
better control of supplier costs in this respect or charges customers a slightly
higher mark up percentage.
NP%: in terms of running the business, management appear to exercise careful
control of costs in respect of Company A as the net profit margin is calculated as
15.7% compared to 6.1% calculated for Company B. Company A would appear
to have less overheads or at least better control of their overheads than
Company B, which could explain the greater level of margin. It might also be the
case that Company B has higher levels of interest payments on debt finance
(since it has higher debt levels), which has the effect of depressing the net profit
margin.
Liquidity Performance:
Current Ratio: the current ratio of approximately 21.1 times and 5.25 times for
Company A and Company B respectively indicates that both businesses are
solvent, and would not initially appear to indicate cause for concern. A closer
review of the composition of current assets does indicate that most of the funds
are tied up in inventory holdings, which would require further investigation is it
necessary to have such funds tied up in expensive stockholdings in each
company? Both results are in excess of the recommended benchmark of 2
times.
Acid Test Ratio: the acid test ratio refines the current ratio, by excluding stock,
indicating if the debts of the business can be met from liquid funds (i.e. cash or
near cash resources). In this case, Company A is calculated at 11 times whilst
119
Company B has a result of 0.25 times. In respect of Company B, this indicates

insolvency, since it is close to zero and below the accepted benchmark of 1:1.
Company A does not have as much money tied up in inventory and thus is still
solvent, since it is able to repay short term debts from cash/near cash resources.
This area of working capital management requires further investigation in
Company B to resolve the issue and avoid insolvency.
Gearing:
In terms of gearing both Company A and Company B employ debt finance within
each of their businesses. The gearing ratio for Company B is calculated at 93%,
whilst Company A is calculated at 22% - the higher figure, representing a much
higher level of debt in the balance sheet approximately 4 times greater than
Company A, thus Company A is relatively low risk meaning that they should be
able to afford both the debt repayments and interest charges. It is likely that the
debt finance has been used to finance purchase of non-current assets or fund
expansion of business activities in each company.
Shareholder Ratios:
Earnings Per Share:
The earnings per share represent the profit available to ordinary shareholders in
each company (after all the expenses have been accounted for), on a per share
basis. This ratio is normally stated on the face of the income statement for each
company, and indicates the relative profitability of the business. In this case,
both companies have an EPS of 6.7 pence indicating that they are both
profitable, although the net profit margin stated earlier does indicate that
Company B has a higher level of costs in the business, which might be reduced
in order to improve upon the EPS figure calculated.
Return on Equity:
The return on equity for Company A is calculated as 2.2 per cent, compared to
that of Company B of 3.7 per cent. This would imply that Company B is able to
provide investors with a greater return on their investment, in this instance
expressed as a percentage of equity, due to (i) the higher level of profitability of
trading operations as revealed by the operating profit this would suggest that
management are keeping cost behaviour under constant review; and (ii) the
lower amount of equity funds invested in Company B that are supporting the
business Company B does place a greater reliance on the use of debt finance.
Conclusion: Company A appears profitable and solvent, with good cost control,
however Company B is profitable but insolvent, which implies that inventory
management/control is worthy of further investigation as revealed by the figures
in the financial statements and supported by the accounting ratios analysed.
120
Differences between Cash and Reported Profit:

It will often be the case that the closing balance on the cash/bank account will not
equal the profit reported at the end of an accounting period. This will be due to
differences between the calculation of profit and the closing cash balances. The
determination of profit is subject to various accounting adjustments to take
account of timing differences and non-cash expenses of running a business, e.g.
depreciation expenses are deducted from gross profit but do not involve the
transfer of cash; transfers to/from general reserves also mean that the two
figures will not be the same.
Key Terms:
Ratio Analysis; Interpretation of Accounts; Liquidity; Gearing; Investing; Return
on Capital Employed; Gross Profit Margin; Net Profit Margin; Liquidity Ratios;
Current Ratio; Acid Test Ratio; Gearing Ratio; Shareholders; Shareholders
Ratios; Earnings per Share; Return on Equity.
Explain what is meant by the term ratio analysis.

Explain what is meant by the term Return on Capital Employed.
Analyse one reason why the net profit may not necessarily be the same as
the closing cash balance in an accounting period for a business.
Evaluate three reasons why accounting ratios would be useful to managers in
running a business.
121
Case Study:
The following is the summarised financial data related to a company operating
within the aerospace sector of the Northern Ireland economy.
Company
Financial Year ended:
Sales
Profit Before Tax (Operating
Profit)
Taxation
Dividends
Retained Earnings
Q2O plc
Q2O plc
30th Sept 2009 30th Sept 2008
17,800,000
893,100,000
3,200,000
17,100,000
2,200,000
1,000,000
0.0
3,000,000
14,100,000
0
Non-current Assets
Current Assets
Total Assets
Issued Share Capital (50p
shares)
Profit and Loss Reserves
Total Equity
Non Current Liabilities
Debentures
Current Liabilities
72,900,000
2,100,000
75,000,000
1,400,000
264,600,000
96,700,000
361,300,000
15,800,000
45,000,000
46,400,000
228,600,000
244,400,000
18,600,000
10,000,000
1,900,000
115,000,000
75,000,000
361,300,000
Questions:
Q1: Explain what is meant by the term Gearing.
Q2: Using the case study information, calculate four different accounting ratios
for each financial year for Q2O plc.
Q3: Discuss the financial position of Q2O plc over the two-year period noted
above (you must use the accounting ratios you have just calculated).
Q4: Discuss the extent to which ratio analysis is useful to investors, when
analysing the financial performance of businesses such as Q2O plc.
122
A1:
Gearing: this is defined as the proportion of debt as a total of equity funds
employed to finance a business. In this case, the gearing ratio for Q2O plc would
express the debenture figures quoted (18,600,000) for 2009 and 2008
(1,900,000) respectively as a proportion of total debt and equity figures for each
financial year under review.
A2:
Return on Capital Employed: this can be taken to mean the return on
investment which an investor will often calculate, in order to calculate the
percentage return on funds invested in a business. This ratio is of importance to
a number of stakeholders, since it is also known as the primary ratio, i.e. usually
the first to be analysed by investors. It can be broken down into two elements
profitability and efficiency each of which can be analysed to determine the
factors which have the greatest influence upon the total return to investors.
A2:
Accounting Ratios: Q2O plc
1. Return on Capital Employed:
Profit Before Tax
+ Interest
---------------------------------- x 100%
Total Equity & Debt
2009
3,200,000
------------x 100%
65,000,000
2008
17,100,000
--------------- x100%
246,300,000
Return on Capital Employed:
= 4.9%
=7%
2. Net Profit Margin:

Profit Before Tax
---------------------- x 100%
x100%
Sales
2009
17,800,000
Net Profit Margin
= 18.0%
3. Current Ratio:
Current Assets
---------------------Current Liabilities
2009
2,100,000
-----------10,000,000
2008
96,700,000
-------------115,000,000
Current Ratio:
= 0.2 times
= 0.8 times
4. Gearing:
Long Term Debt
---------------------- x 100%
x100%
Total Equity and Debt
2009
2008
2008
3,200,000
-------------
18,600,000
------------65,000,000
= 29%
17,100,000
--------------
x 100%
893,100,000
= 1.9%
1,900,000
---------------
x 100%
246,300,000
= 1%
A3:
Financial Position for the years 2009 and 2008 - Comments:
123
ROCE: Results of 4.9% (2009) and 7% (2008) respectively are calculated.

Representing low levels of return on such an investment in this particular
business, however it does allow a comparison with alternative investments such
as interest on a low interest yield account.
The low return calculated for each year is of concern to management and
investors, since providers of capital may have been expecting higher levels of
return, although the low levels of ROCE may be a feature of the industry in
general this issue will require further investigation.
The results indicate that Q2O plc performed better during 2008, providing a
slightly higher return on investment it is possible that external factors are
responsible for the decline in performance, since the revenues, operating profit
and total assets figures are substantially lower in 2009 than they were in 2008,
e.g. a disposal of part of the business or severe economic downturn in the
industry/global economy.
Net Profit Margin: Results of 18% and 1.9% are reported for Q2O plc for the
financial years 2009 and 2008 respectively. These results indicate that margin
on turnover had been very low during the 2008 financial year, however, this has
increased to a reasonable level in respect of the 2009 financial year. These
results may be typical of the industry sector suggesting that profit margins are
under pressure in a highly competitive industry and/or overheads within the
company have been closely reviewed in order to minimise cost and increase
profits. Overall, the company has improved profitability over the period.
Current Ratio: Results of 0.2 times (2009) and 0.8 times (2008) are calculated for
Q2O plc in respect of each financial year both results are lower than the
recommended benchmark of 2 times.
This issue will be a cause for concern for the management team and investors,
since it appears that the company is unable to meet its debts from liquid
resources, e.g. cash/bank deposits and near-cash assets, therefore insolvent.
This reflects the management of working capital by the management team in the
business over the year, and the figures indicate that this has deteriorated
substantially.
The management team will need to review the working capital requirements of
their business operations, and investigate which elements of working capital are
leading to the results obtained. Whilst the figures have decreased in terms of
their absolute values, the proportion of individual working capital elements
reported will require further investigation, for example, stockholdings must be
reviewed in order to ensure proper stock management, debtors must be reviewed
to ensure proper operation of credit control policies and/or cash balances held by
the company must be reviewed to ensure effective cash management. In
addition, the amount owing to trade creditors by the company must be reviewed
124
in order to reduce the amount owing initially, but also facilitate an improvement in
the current ratio and management of working capital.
Gearing: Results of 29% and 1% are reported for Q2O plc in respective of the
financial years 2009 and 2008. Initially it appears that the company has a low
level of gearing, since the amounts are smaller compared to the funds invested in
terms of shareholder equity. A closer inspection of the data reveals that a large
increase in debt finance has occurred during the 2009 financial year, rising from
1,900,000 to 18,600,000 hence the increase in gearing reported. This would
imply that the interest expense incurred by each company to service the debt has
also increased which might impact profitability, which by deduction, would mean
that the expenses are high resulting in low profitability ratios.
Conclusion: it is possible to conclude from the ratio analysis that there are two
areas worthy of investigation by the management team of this company (i) the
low profitability (which might be leading to depressed ROCE ratios); and, (ii) the
low results reported in respect of the current ratio (suggesting that the company
has low levels of solvency). Both ratios indicate a higher degree of financial risk
related to the company, which might deter investors from investing in the
company in future.
A4:
Usefulness of ratio analysis:
Undertaking ratio analysis in respect of a companys published financial
statements could facilitate an interpretation of the financial position. There are a
number of advantages and disadvantages of using ratio analysis:
In relation to a company such as Q2O plc, the advantages are:
1. enables financial comparisons to be made with similar businesses in the same
industry;
2. enables trends to be identified and analysed in relation to the financial
performance of a company such as Q2O plc;
3. accounting ratios can be used as a motivator to encourage managers to
improve operating and financial performance of the business.
In relation to a company such as Q2O plc, the disadvantages are:
1. ratio analysis provides only a snapshot view of the financial position at a
given point in time, which quickly becomes out of date since economic conditions
can change rapidly;
125
2. accounting ratios are only as accurate as the underlying data, hence the extent
to which they be relied upon for making investment decisions will be limited;
3. financial comparisons with other companies will be problematic since
differences in accounting policies may mean that different interpretations are
placed on the data within the financial statements.
Conclusion: it is possible to conclude that the advantages gained from the
calculation of accounting ratios and their interpretation are likely to outweigh the
disadvantages ratio analysis can be useful in facilitating an interpretation of the
financial position of a company such as Q2O plc.
126
INVESTMENT APPRAISAL:
Chapter Aims:
Explain the nature of investment appraisal techniques commonly used in

business;
Understand the information contained within the investment appraisal
analyses in relation to a business entity;
Understand the usefulness and limitations of using investment appraisal
techniques to evaluate investment options facing a business.
Introduction:
This chapter discusses key definitions related to investment appraisal techniques
which are commonly used within a business, in order to assist the decision
making process aimed at achieving the financial objectives that a business might
have. The usefulness of the various investment appraisal techniques are also
considered.
127
Investment Appraisal:
Investment Appraisal attempts to assist the evaluation of the financial position of
projects which have been proposed by a business entity. This is usually
undertaken with reference to three techniques, including Average Rate of Return,
Payback and Discounting.
Reasons for Investment Appraisal:

There are a number of reasons why a business would undertake investment
appraisal such as:
To replace/update equipment currently in use
To remain competitive within the industry
To facilitate expansion of business operations and growth within the business
To enable a business to invest in equipment in order to meet legislative
requirements, e.g. health and safety
To invest surplus cash and ensure continued investment in the asset base.
128
Investment Appraisal Methods:

Introduction:
Capital investment refers to investment of a long term nature involving large
amounts of money and usually requiring the purchase of fixed assets for use
within the business. In order to investigate the various projects available to a
business, it is essential that each project is evaluated with reference to its pattern
of cashflows and where relevant, profits. In order to determine the suitability of a
project, a number of investment appraisal methods are adopted which provide a
standardised approach in respect of deciding the most favourable project in
which to invest.
Capital investment requires that the business commits money now, with the
expectation of reasonable returns at some stage in the future. As large amounts
of funding are involved and the impact of such decisions on the future of the
business is critical, careful appraisal of such investments is necessary. The
following sections outline three different methods of which may be used to
assess the suitability of different capital projects.
The Role of Capital Investment:
The importance of capital investment decisions can be seen with reference to the
overall financial objective of the business (i.e. profitability):
Substantial capital sums are involved;
Project is of a long term nature;
Project is unlikely to be stopped in the short term without incurring a loss;
Such investments are likely to be subject to a degree of uncertainty, making it
difficult to plan ahead beyond a one year period;
Such projects may have the potential to impact the survival of the business.
The Various Types of Capital Project:
Capital projects are undertaken in order to ensure that the business can achieve
its operational and strategic goals. Such investments vary in nature. Some
examples of projects that may be implemented in support of business activities
include:
Investment in cost-saving equipment aimed at reducing operating costs;
Investment in another business (takeover) in order to gain market share;
129
The purchase of fixed assets e.g. plant, fixtures and fittings in order to generate
revenue streams;
Expansion of current facilities in company outlets, ie. factory, production plants;
Acquisition of overseas operations aimed at securing entry to new markets,
development of new product lines.
Special/ad hoc projects.
The Investment decision:
The decision to invest in a large capital project can be viewed as part of a
sequence of decisions undertaken by the business in relation to the decisionmaking process. The main elements of the process would normally include:
The search for potential capital investment projects.
Identification of potential costs and benefits of alternative projects.
Assessment of the profitability of each alternative project.
Consideration of qualitative issues related to the investment project.
Project selection with reference to financial risk, cash flows, and funding
arrangements.
Implementation of most suitable project, consistent with business objectives.
Feedback and review of project progress.
Difficulties Associated with Capital Investment Projects:
Might be difficult to decide project lifespan
Might be difficult to estimate annual cashlfows accurately
Might be difficult to decide upon an appropriate discount factor
Conflicting targets might exist a business might reject a profitable project in
favour of one which has a short payback period
Too many unrealistic assumptions might distort the results e.g. over-estimation
of customer demand or sales prices might lead to a shortfall in sales revenues,
hence lower levels of cashflows
Might be difficult to determine scrap value and disposal arrangements of assets
130
Might be difficult to determine the precise measure of return expected from the
project, and thus the most appropriate investment appraisal method to adopt.
The management team of a business will typically choose from a range of
alternative methods of investment appraisal.
Three methods will be discussed in this section, including:
(i)
(ii)
(iii)
Average Rate of Return (ARR)

Payback; and
Discounting (Net present Value)
The following example is used to facilitate the discussion of the various methods
of investment appraisal:
A local ferry company is considering the purchase of a new high speed vessel to
operate services across the Irish Sea from Ireland to the UK. It is faced with the
choice between a Catamaran and a Hovercraft, both costing 120m. The
estimated future cash flows and related costs are:
Initial Investment
Cost at start of project
Net Cash Flows:
Year 1
2
3
4
5
6
Catamaran
m
Hovercraft
m
120
120
30
30
40
60
50
30
60
50
40
36
20
10
In order to simplify the analysis, it is assumed that net cash flows have
taken into account depreciation of the asset and that the asset has no
residual value at the end of the project.
Project Evaluation:
131
Average Rate of Return (ARR):

This method expresses the average annual profit of a project as a percentage of
the initial capital investment. When projects are mutually exclusive (i.e. when
only one project can be selected), the project with the highest ARR will be
selected.
Workings:
Initial Outlay
Net cash inflows:
Year 1
2
3
4
5
6
Total cash inflow
Total net profits*
Average annual profits
Over project lifespan
Catamaran
m
(120)
Hovercraft
m
(120)
30
30
40
60
50
30
60
50
40
36
20
10
240
120
216
96
20
16
Formula used in calculation of ARR:

o ARR
=
(average annual profits/initial investment)
o Catamaran ARR
=
(20/120)x 100%
=
16.7%
o Hovercraft ARR =
(16/120)x 100%
=
13.3%
Decision: on the basis of ARR, the Catamaran would be preferred.
Benefits of ARR:
o Calculations should be reasonably straightforward.
o It takes account of all cash flows.
o Can be treated as a return measure, equivalent to a return on capital
ratio.
o Easily understood.
Drawbacks of ARR:
o This method ignores the timing of cash flows.
Commentary on ARR results:
The Hovercraft produces greater cash flows in years 1 and 2 (i.e. early years of
project), whereas the Catamaran becomes more profitable towards the end of the
project lifespan. The additional 50m which the Hovercraft earns compared to
the Catamaran in years 1 and 2 could be invested which, if reconsidered, may
alter the relative merits of the two vessels.
132
Payback:
This method of investment appraisal indicates how long it will take before the
original capital investment is recovered. In this case, the project with the
shortest payback period would be chosen.
Workings (adapting previous worked example):
Year 0
Year 1
2
3
4
5
6
Catamaran
Net Cumulative
Cash Cash flows
Flow
m
m
(120) (120)
30
(90)
30
(60)
40
(20)
60
40
50
90
30
120
Hovercraft
Net Cumulative
Cash Cash flows
Flow
m
m
(120) (120)
60
(60)
50
(10)
40
30
36
66
20
86
10
96
Narrative: payback for the Catamaran occurs in the 4th year. Only 20m of the
60m earned in year 4 is required to complete the payback. Assuming that cash
flows occur evenly throughout the year, 20m is earned after one third of the
year, thus exact payback is 31/3 years. With respect to the Hovercraft, payback is
one quarter of the way through year 3. Therefore, the payback is 2.25 years.
Decision: On this basis, the Hovercraft would be chosen.
Benefits of payback:
o Takes account of how quickly the business recoups its investment,
and can be interpreted as a measure of risk.
o Easily understood.
Drawbacks of payback:
o This method ignores the timing and amounts of cash flows after
payback period.
o Ignores the profitability of the project.
133
Net Present Value (Discounting):

Discounting takes into consideration the timing of cash flows. It is based on the
principle that a given sum of money received now is more valuable than at any
time in the future, the reason being that the sum can be invested today to earn a
return. For example, 10 invested now at an interest rate of 10% would be worth
11 in one years time and 12.10 in two years time. In other words, 12.10
received in two years has a present value of 10. Cash flows received at
different times need to be adjusted to take account of the time value of money.
This adjustment of future cash flows into present values is known as the
discounted cash flow (DCF) technique. This can be formulated in an equation as
follows:
o PV =
(An)/(1 + r)n
Where,
An
r
n
is defined as the future cash flow in a given period.

is defined as the discount rate expressed as a decimal
is defined as the time period under review.
The discount rate employed is normally representative of the opportunity cost of

the initial capital invested, which may be the present rate of interest, obtained
from alternative forms of investment.
The Net Present Value (NPV) method discounts all future cash flows to present
values and then compares the total present value of all cash inflows with the
present value of all cash outflows.
The project with the highest positive Net Present Value would be chosen (it is
generally assumed that projects yielding a negative NPV would be rejected).
Year 0
Year 1
2
3
4
5
6
Catamaran
Cash Discount
Present
Flow Factor (10%) Value (m)
m
(120) 1.0
(120.00)
30
0.909
27.27
30
0.826
24.78
40
0.751
30.04
60
0.683
40.98
50
0.621
31.05
30
0.564
16.92
Net Present Value (NPV)
51.04m
134

Hovercraft
Cash Discount
Present
Flow Factor (10%) Value (m)
m
Year 0
(120) 1.0
(120)
Year 1
60
0.909
54.54
2
50
0.826
41.30
3
40
0.751
30.04
4
36
0.683
24.59
5
20
0.621
12.42
6
10
0.564
5.64
Net Present Value (NPV)
48.53m
Decision: On this basis, the Catamaran would be chosen, since it appears to
yield greater levels of cash flow over the project lifespan.
Narrative:
o
o
o
o
o
The calculation of NPV is achieved in a sequence of steps:

Determine lifespan of project.
Determine initial outlay.
Determine annual cash flows.
Match discount factor with each year of project.
Multiply annual cash flows by discount factor to compute the present
value for each year of project.
o Sum all annual present values to determine net present value.
o Reach decision.
Benefits of NPV:
o Takes account of timing of cash flows.
o Easily used.
Drawbacks of NPV:
o It can be difficult to determine the discount rate to be used in project.
o It can be difficult to accurately forecast the annual cash flows
throughout project lifespan.
Concluding Remarks:
o Discounting is considered to be the more superior method of
investment appraisal, compared to payback and accounting rate of
return.
o ARR ignores timing of returns.
o Payback ignores the cash flows occurring after payback period.
o All methods depend on accuracy of cash flows estimates.
135
o Investment appraisal is one piece of a complex decision process

affecting business activities non-financial issues may also require
consideration.
Qualitative Factors:
The use of investment appraisal techniques such as Average Rate of Return,
Payback and Discounting provides the management team within a business with
a quantitative analysis of the proposed investment. There may however, be a
range of qualitative issues which the management team may be required to
consider before proceeding with the project. In some cases, the qualitative
issues might lead to a decision which contradicts the recommendation of the
quantitative evaluation e.g. rejection of highly profitable projects. Examples of
qualitative issues include:
Social businesses might be required to invest in special air-conditioning units or
amend their premises in order to meet the needs of smokers and retain custom
(particularly pubs, clubs and restaurants). Such projects would not necessarily
yield surplus revenues for a business but might increase the levels of custom if
customers that smoke are aware of the available facilities and that their presence
is more socially acceptable.
Technical businesses might invest in the most up to date equipment, which
might improve productivity and in turn lead to staff redundancies. This may
create unfavourable press speculation and force the business to reconsider or
postpone such investment plans.
Environmental a business might not be able to proceed with a planned project
due to environmental concerns, e.g. noise pollution, litter, air pollution and other
forms of pollution. A company might wish to set up a waste disposal plant
however, it may be located too close to residential areas which in turn might lead
to protests from community groups, pressure groups and other businesses.
Economic a business might not be able to proceed with a planned project if the
funding is not available from the providers of capital or in the context of
recessionary conditions, most businesses are postponing investment plans due
to deteriorating economic conditions, preferring to save money in the short term.
Political a business may not be able to proceed with a project due to political
pressure. Government may impose strict limitations regarding the operation of
the project or might deem that the investment is in breach of planning law,
competition rules or some other statutory regulation which is beyond the control
of the business.
136
Legal a business may not be able to proceed with a planned investment project
if it is in breach of legislation, e.g. it may be unable to get planning permission to
build premises if the location is within an environmentally sensitive area.
Key Terms:
Investment Appraisal; Payback; Average Rate of Return; Profits; Investment;
Present Value; Cash flow; Discount Factor; Discounting; Project lifespan; Scrap
Value; Net Present Value; Decision Making; Recommendation; Accept; Reject.
Explain what is meant by the term investment appraisal.

List three main quantitative methods of investment appraisal.
State one reason why the use of discounting may be preferable compared to
the use of profit-based investment appraisal techniques in a business.
State two reasons why it is beneficial for a business to undertake investment
appraisal techniques when evaluating capital projects.
137
Case Study:
Mo Gass is the Finance Manager of Fone plc, a manufacturer of mobile
telephones. In the budget for the next financial year, she has allocated
5,000,000 to the Research and Development department for investment in new
telecommunications equipment. The following table summarises information
related to two machines being considered by Fone plc. Each machine has a
useful economic life of five years and zero scrap value at the end of that period.
Project
Cost
Net Cash flows
Year 1
Year 2
Year 3
Year 4
Year 5
Discount Factors (11%):
Year 1: 0.901; Year 2: 0.812;
Year 3: 0.731; Year 4: 0.659;
Year 5: 0.593
Machine A
m
5
Machine B
m
5
3.5
3.0
2.0
1.0
0.0
0.5
1.0
2.0
6.0
10.0
The board of directors have advised that no additional funding is available for
investment, therefore one of the above machines can be acquired if financially
viable.
Questions:
Q1: Define the terms: payback, average rate of return and net present
value.
Q2: Using the case study information, calculate the payback period, average
rate of return, and net present value for the two projects under
consideration by Fone plc.
Q3: Discuss with reasons which machine should be purchased by Fone plc.
Q4: Evaluate three qualitative factors which a business such as Fone plc
should consider when making investment decisions.
138

A1:
Payback: this is defined as the length of time taken to recover the initial
investment in a project.
Average Rate of Return: this is defined as the return on investment for a project
(similar in concept to the Return on Capital Employed ratio) which indicates the
relative profitability of the project.
Net Present Value: this is defined as the present value of cashflows in a project,
basically measured as the net difference of monies in/out of a project, after the
application of a discount factor.
A2:
Fone plc:
Payback Period: Machine A: 1 year, 6 months; Machine B: 3 years, 3 months.
Average Rate of Return: Machine A: Average annual profits (9.5m-5m = 4.5m
profit; therefore average profit = 4.5m/5) are 0.9m, thus ARR = 0.9m/5m =
18%. Machine B: average annual profits (19.5m-5m = 14.5m profit; therefore
average profit = 14.5m/5) are 2.9m, thus ARR = 2.9m/5m = 58%.
Net Present Value:
NPV:
Machine A:
NCF
Year
m
DF 11%
0
-5.0 1
1
3.5
0.901
2
3.0
0.812
3
2.0
0.731
4
1.0
0.659
5
0.0
0.593
NPV
Machine B:
NCF
PV m m
DF 11%
-5.00
-5.0 1
3.15
0.5
0.901
2.44
1.0
0.812
1.46
2.0
0.731
0.66
6.0
0.659
0.00
10.0 0.593
2.71
NPV
PV m
-5.00
0.45
0.81
1.46
3.95
5.93
7.60
A3:
Decision: The correct decision would be to invest in Machine B.
The reasons for this are: (i) Machine B yields the highest NPV at 7.6m
(approximately) compared to Machine A which yields a positive NPV of
approximately 2.71m this in turn maximises the value of the firm and should
therefore be accepted; (ii) Machine B yields the highest ARR of 58% (compared
to Machine A), meaning that it is a highly profitable investment.
A4:
139
Qualitative Factors:
Fone plc should consider a range of qualitative factors which might influence the
investment appraisal decision, in addition to that analyses provided using
quantitative evaluation techniques.
Qualitative factors which should be considered by Fone plc in relation to this

particular investment project:
1.
2.
3.
within the context of Fone plc, it is assumed that the project will proceed
subject to financial restrictions stated that is, no additional funds are
available for investment;
within the context of Fone plc, it is assumed that resources (human,
material etc) that are surplus to requirements can be redeployed
elsewhere in the business once this project proceeds the impact on
staffing levels/redundancies is not stated but may be assumed to be
minimal;
within the context of Fone plc, it is assumed that the output of the new
machine (B) will be of improved quality or enhance the capability of the
Research & Development department compared to existing
machine/output.
140
Test Your Knowledge Quiz Answers:

Business Objectives
Explain what is meant by the term mission statement.

A short statement indicating the purpose of a business entity, usually
containing some reference to the key beliefs of the organisation. Usually
expressed in terms of qualitative objectives.
Explain what is meant by the term conflict.

Within the context of trying to achieve business objectives, conflict can be
taken to mean that notion that one primary objective takes priority over
secondary objectives of the business, meaning that secondary objectives
may not necessarily be achieved unless they are consistent with the
primary objective.
List three possible objectives that a business might have.

Survival
Growth
Profit Maximisation
State two reasons why a business would use a mission statement.

A business might wish to communicate to relevant stakeholders the
reason for its existence;
The management team of a business entity might want to focus the efforts
of stakeholders on achievement of key business objectives, consistent
with the mission statement.
Stakeholder Objectives
Explain what is meant by the term stakeholder.

A person or organisation having a real or substantial interest in another
organisation, which is likely to impact its behaviour.
List six stakeholder groups commonly found in a business context.
Owners
141
Managers
Employees
Suppliers
Customers
Creditors
List three ways in which stakeholder objectives could differ from

Employees are likely to be interested in securing employment and maximum
levels of compensation in relation to the work performed/targets achieved,
whereas the management team of the business are likely to aim to run
manage the business efficiently, securing value for money;
Managers are likely to aim for growth in revenues in order to increase market
share, however some existing customers might feel that customer service will
suffer as resources are spread too thinly across a wider customer base;
Shareholders are likely to aim for profit maximisation in order to gain
maximum value from their investment, however, it may not be possible to
achieve this due to the influence of regulatory authorities, meaning that
satisfactory prices (or satisficing price levels) are levied, thus profit
maximising prices cannot be charged to customers.
Business Strategy and Planning

Explain what is meant by the term business plan.

A document summarising the objectives and plans of the business for a
specific time period. In terms of 1 year it can be referred to as an Operating
Plan or in terms of up to 5 years, it is usually referred to as a Strategic Plan.
Explain what is meant by the term strategy.

This can be taken to mean the method or approach adopted by a business
entity in order to achieve specific goals, e.g. competitive advantage.
Explain what is meant by the term hostile takeover.

The acquisition of a business by another, whereby the management team of
the business attempting to be taken over are opposed to the takeover
approach by the predator company.
Explain the various types of merger which can occur in a business.
142
Horizontal Integration whereby two businesses in identical lines of

business and similar stages of production join together;
Backward Vertical Integration whereby two businesses in identical lines
of business but different stages of production, join together, particularly
where one business has control of supplies/resources to be supplied to the
other business, further along the supply chain;
Forward Vertical Integration whereby two businesses in identical lines of
business but again at different stages of production, join together, particularly
where on business has control over distribution channels/access to
customers for the goods being supplied by the other firm, earlier in the supply
chain;
Lateral Integration whereby two businesses involved with related product
lines which do not compete with each other, join together;
Conglomerate Merger whereby two businesses involved in unrelated
product lines join together in order to diversify.
Decision Tree Analysis
Explain what is meant by the term decision tree.

A flow chart diagram summarising potential future events and the effects of
decisions to be taken or probable events in a sequential order.
Explain what is meant by the term probability.

The chance or likelihood that a particular event will occur.
Explain what is meant by the term expected value.

A weighted average expectation of an outcome taken as a result of an earlier
decision.
State two reasons why businesses use decision tree analysis.

A business would use decision tree analysis in scenarios whereby it wishes to
plan or audit a logical sequence of events that are likely to occur within a
project under consideration;
A business would use decision tree analysis in order to determine expected
values in relation to a project under consideration an thus decide if it is
financially viable;
143
Contingency Planning
Explain what is meant by the term confidence.

Can be taken to mean the extent to which stakeholders are reassured about
the plans and actions of the management team that the original plan will
proceed in accordance with stated objectives, or, that an alternative plan of
action will achieve stated objectives should a deviation from the original plan
occur.
Explain what is meant by the term crisis.

Within the context of contingency planning, this can be taken to mean the
extent to which the original plan or objectives are not being achieved and the
response of the business organisation to rectify the situation.
Explain what is meant by the term alternative courses of action.

These are taken to mean the likely or feasible options open to a business in
the event that the original plan or course of action does not proceed or
achieve the stated objective(s)
State one reason why businesses should undertake contingency

planning.
A business would undertake contingency planning in order to effectively
manage a situation where the original plan or objective(s) cannot be
achieved due to a deviation in actual policy/plan.
Company Accounts
Explain what is meant by the term financial statements.

These are the documents which summarise the financial position of a
business entity, usually in terms of profitability (income statement) and net
worth (balance sheet or statement of financial position).
Explain what is meant by the term net profit.

This is calculated as the difference between total revenues and total costs of
running a business for the accounting period, expressed as a positive figure,
indicating that surplus revenues have been achieved.
144
Explain what is meant by the term working capital.

Working capital is the difference between the current assets and the current
liabilities in a business, representing the funding required to operate a
business on a daily basis.
Explain what is meant by the term share premium.

Share premium is the revenues received by a limited company in addition to
the funds received from shareholders in respect of allotted shares, which
arises when the issue price of a share is greater than the nominal value of a
share.
Ratio Analysis
Explain what is meant by the term ratio analysis.

An approach to explaining or analysing the financial position of a business
entity by calculating ratios, that is, forming mathematical relationships
between specific numerical items within the financial statements.
Explain what is meant by the term Return on Capital Employed.

This is a measure of the profitability of an investment, calculated by
expressing the profit (a measure of return) as a ratio of the investment
required (capital), usually in terms of a percentage.
Explain one reason why the net profit may not necessarily be the same
as the closing cash balance in an accounting period for a business.
The net profit may not necessarily equal the closing cash balance for an
accounting period due to timing differences between the actual
payment/receipt of expenses/revenues and the period in which they should
have occurred.
State two reasons why accounting ratios would be useful to managers

in running a business.
Accounting ratios enable a manager to assess the financial performance of
the business, in terms of profitability, liquidity and investment potential;
Accounting ratios enable a manager to make decisions in order to improve
financial performance, by identifying trends or changes in financial data
across accounting periods.
145
Investment Appraisal
Explain what is meant by the term investment appraisal.

This is the examination or review of proposed investment projects which a
business entity wishes to invest in, using standard appraisal techniques,
usually of a quantitative nature, but can also involve the consideration of
qualitative techniques.
List three main quantitative methods of investment appraisal.

Payback
Average Rate of Return
Discounting (NPV)
State one reason why the use of discounting may be preferable

compared to the use of profit-based investment appraisal techniques in
a business.
The use of discounting (NPV) is preferable as it considers financial risk by
restating future cash flows in terms of present values. The use of cashflows
throughout the project is more reliable than profit estimates hence yields a
more robust result in terms of guiding decision making within a business.
State two reasons why it is beneficial for a business to undertake

investment appraisal techniques when evaluating capital projects.
It is beneficial for a business entity to undertake investment appraisal as it
forces the management team to plan for future events, e.g. project lifespan,
initial outlay required or disposal arrangements;
It is beneficial for a business entity to undertake investment appraisal as it
enables managers to determine the most feasible investment project in
according to established criteria, e.g. payback period, profitability or net
present value, or order to maximise value for the business.
146

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GCE Business Studies

A2(1) Making Business Decisions

MAKING BUSINESS DECISIONS

Evaluate the purpose of a Mission Statement;

To enable the full potential of all learners to be achieved and recognised

Set out the purpose of the business

Document the main aim(s) of the business

Provide an insight to the long-term objective(s) of the business

Communicate to stakeholders the focus of short-term business activities

Motivate employees within the business

Attract customers to the business

Publicise in qualitative terms, the aspirations of the management team

The mission statement should be a clear and succinct representation of the

enterprise, public image, the target market, products/services, the geographic

It enables the management team to develop long-term plans for the

It allows the management team to communicate to relevant stakeholders

It can motivate staff within the business

It may result in an inability of the management team to relate the mission

Staff may not be motivated to read the mission statement, instead

Negative publicity may be attracted if a business fails to achieve the goals

There may exist an alternative motive on the part of the management

In terms of decision making, the key objective is to ensure that a business

New starts in this situation a business is faced with various decisions

Existing businesses in this situation a business might encounter a

Takeover in this situation a business might be the subject of a takeover

In terms of decision making, this objective can be taken to mean operating a

Social responsibility typically refers to the practices of a company or organization.

The provision of employee welfare is an important objective; this relates to issues

The corporate image or reputation of an organization is an important objective. A

7. Concern for the environment

Factors determining business objectives:

Owners the ownership of a business will influence key business

Stakeholder Power the power of specific stakeholder groups relative to

Shareholders in the context of a limited company, shareholders will be

Size the size of a business will influence key business objectives, as it is

Small Business such businesses are likely to be concerned with

Pressure Groups a business may be forced to reconsider key business

Timescale the timescale within which business decisions are taken is

Internal/External pressure the combination of pressure exerted by

Internal changes in personnel within the management team are likely to

This refers to the proportion of customers or sales that a business has

Conflict can be defined as the contradiction of ideas or objectives, which

Job losses versus keeping jobs

Short-term thinking by managers may discourage important long-term

New developments in the business such as a major product launch or a new

Investing in new machinery to achieve better efficiency may result in job

Generally speaking, a business will need to continuously achieve its key

Specific objectives must be stated precisely

Test Your Knowledge:

Evaluate different stakeholder groups in business;

Influence of Stakeholder groups:

Limited Companies responsibility for strategic and operational decision making

Employees will typically make decisions on behalf of their employer in order to

Customers are typically thought of as being the end-consumer of the products or

In relation to a business entity, creditors as a stakeholder group are most likely to

business activity for example, nationalisation of sectors of the UK banking

Conflict and Stakeholder Groups:

Conflict can be defined as the potential contradiction of ideas or objectives

Investors such as shareholders in limited companies want to gain regular income,

Strategies to deal with Conflicting Objectives

Ignoring the Problem / Enforcing a Solution

Advantages of adopting a stakeholder approach include:

A more positive attitude from employees and easier recruitment of