Financial Strategy

What is financial strategy

• A financial strategy is a written down plan or guideline that deals with key elements in raising funds, managing organisation funds and the implementation of the organisation objectives within the limited financial capabilities.

• Financial strategies are very important for the survival of any institution, because without good financial strategies, organizations will run bankrupt.

What does a financial strategy involves?

• Acquiring needed capital (source of finance)• Developing projected financial

statements/budgets• Management/usage of funds• Evaluating the worth of business

Financial Strategy

Sources of Funds Projected Financial Statements/Budgets

Management of Funds Evaluating value of business

Tangible Net Worth No of times of annual profit

Market based apprach

Based of value of similar firm

Based of P/E measure MP per share * shares outstanding + premium

Economic Value Added

Few decisions that may require finance/ accounting policies:

• To raise capital with short term debt, long term debt, preferred stock or common stock

• To lease or buy the assets

• To determine dividend payout policies

• To determine the amount of cash that is required in hand etc…

Source of funds• Business requires additional capital, besides net profit from operations and

sale of assets. Other sources of funds are Debt and Equity. (which determine the capital structure of a firm)

• Determining optimal mix of debt and equity in firm capital structure is vital.

• Firm should have enough debt in its capital structure to boost ROI (if earning is more than cost of debt).

• In adverse situation high debt can lead to poor stockholders return and jeopardize company’s survival.

• Fix debt obligations must be met regardless of the circumstances.

• Issuances of stock can have issues like ownership, control of enterprise which can lead to hostile takeovers, mergers and acquisitions.

2. Projected Financial Statements/Budgets

• A financial budget is the document that details how funds will be obtained and spent for a specified period of time. (annual budgets are more common).

• Financial budgets are viewed as the planned allocation of firm’s resources based on forecasts of the future.

• The different types of budgets include cash budgets, operating budgets, sales budget, profit budget, factory budget, capital budget, expense budget, divisional budget, variable budget, flexible budget, fixed budget etc. These are important in guiding strategy implementation.

• Budgets allows an organization to examine the expected results of various actions (implementation decisions) and approaches.

• Financial budgets limitations are: Cumbersome to make, expensive, Over budgeting / under budgeting can cause problems, they can become substitute for objectives, budgets hides inefficiencies if based solely on precedence rather than periodic evaluation of circumstances.

Continue…..• Eg. Increase in promotion expenditure by 50%

(market development strategy), R&D expenditure increase by 70% (Product Development) or to sell common stock to raise capital for diversification.

• A pro forma income statement and balance sheet allow organization to compute projected financial ratios, compare them with prior years and industry averages under various strategy implementation scenarios.• Companies prepare projected financial statements

to project future expenses and earnings more reasonably.

Management and usage of funds• It deals with investments and Asset mix decisions. It involves decisions like

capital investment, fixed asset acquisition, current assets, loans, advances, dividend decisions, and relationship with share holders.

• Usage of funds is important since it relates to the efficiency and effectiveness of resource utilization in the process of strategy implementation.

• Management of fund is important area of financial strategy and strategic decisions are made for the system of finance, accounting, budgeting, management control system, cash, credit, and risk management, cost control and reduction, tax planning. All this leads to optimum utilization of funds.

• Organizations that implements strategies of stability, growth, and retrenchment cannot escape proper management of funds.

Evaluating the Worth of a Business• Integrative, Intensive, Diversification strategies are implemented by

acquiring other firms, and retrenchment may result in sale of division of organization. Here it is strategically important to establish financial worth / cash value of business.

• There are approaches to determination of business worth

1. The first approach is to determine tangible net worth or stock holder’s equity. Net worth is sum of common stock, additional paid in capital, and retained earnings. After this we add or subtract additional amount of goodwill, overvalued, and undervalued assets. The total obtained provides a reasonable estimate of firms monetary value.

Continue…• The second approach is measuring the value of firms based on future

benefits its owners may derive through net profits. Establish business worth as five times the firm’s current annual profit. Note: Firms suppress earnings in financial statement to minimize taxes.

• The third approach is letting market determine a business worth.

1. Base the firm’s worth on selling price of similar company and make a comparison.

2. Use price earning ratio where we divide the market price of common stock by annual earnings per share and multiply this number by the firm’s average net income for the past five years.

3. Outstanding shares method where we multiply number of shares outstanding by the market price per share and add a premium. The premium is simply a per share amount that a person or firm is willing to pay to control or acquire the company.

Continue…Economic value added• In corporate finance Economic Value Added (EVA) is an

estimate of a firm's economic profit – being the value created in excess of the required return of the company's investors (being shareholders and debt holders).

• EVA = NOPAT – WACC(invested capital)

• NOPAT = EBIT(1-t)• Invested capital = net working cap + net fixed assets Or

BV of long term debt + BV of equity.