Financial strategy of an organisation is essentially concerned with procurement and utilization of funds. The basic purpose is to ensure adequate and regular supply of funds fulfilling the present and future requirements of the business enterprise.
Financial strategy deals with areas such as financial resources, analysis of cost structure, estimating profit potential, accounting functions and so on.
In short, financial strategy deals with the availability of sources, usages, and management of funds. It focuses on the alignment of financial management with the corporate and business objectives of an organisation to gain strategic advantage.
1. Meaning and Aims of Financial Strategy 2. Areas of Financial Strategy 3. Components 4. Key Elements 5. Types 6. Functions 7. Key Issues or Considerations 8. Careful Attention.
Financial Strategies in Strategic Management
Financial Strategy – Meaning and Aims of Financial Strategy
Financial strategy of an organisation is essentially concerned with procurement and utilization of funds. The basic purpose is to ensure adequate and regular supply of funds fulfilling the present and future requirements of the business enterprise.
Financial strategy deals with areas such as financial resources, analysis of cost structure, estimating profit potential, accounting functions and so on. In short, financial strategy deals with the availability of sources, usages, and management of funds. It focuses on the alignment of financial management with the corporate and business objectives of an organisation to gain strategic advantage.
According to Thomas Wheelen and David Hunger, “Financial strategy examines the financial implications of corporate and business-level strategic options and identifies the best financial course of action. It can also provide competitive advantage through a lower cost of funds and a flexible ability to raise capital to support a business strategy. Financial strategy usually attempts to maximize the financial value of a firm.”
Aims of Financial Strategy:
Financial strategy aims to maximize the financial value of a firm. Financial strategy can provide competitive advantage through low costs funds. In any financial strategy, achieving the desirable debt equity ratio by borrowing for long term financial needs and generating cash flow internally is a crucial issue. Studies point out that high debt levels lead to improved productivity and improved cash flows. Studies also point out that diversification strategy mainly influences the financial strategy. Equity financing is much preferred for related diversification whereas debt financing is preferred for unrelated diversification.
Next dimension of financial strategy is the leveraged buyout. In a leveraged buyout, a company is acquired in a transaction, which is mainly financed by funds arranged from a third party such as a bank or financial institution. The main problems with leveraged buyout are too much expectations, management burn out, utilization of slack and lack of strategic management and decline of the firm.
Dividend management is another dimension of financial strategy. Many computer manufacturers do not declare dividends at all. Instead they utilize those funds for further growth of the firm, which in turn results in higher sales, high profits, and capital appreciation of stocks.
Established firms nowadays identify a tracking stock, which is a type of common stock but tied to only one portion of the total business. It is treated like a subsidiary. The firm can exercise control over the high growth business unit and treat it like a subsidiary to manage its own growth with outside money. It can go public and issue IPO and pay dividend. It cannot be acquired like a subsidiary as it is tied to parent company. AT&T (AT&T Wireless), Sprint (Sprint PCs), J.C. Penny (Eckerd Drugs) and Staples use this strategy.
Financial Strategy – 4 Broad Areas of Financial Strategy
In general, financial strategies involve four broad areas stated below:
1. Evaluating Financial Performance:
The financial position of a company at a given time can be evaluated by such typical financial statements as income statements, balance sheets and cash flow statements. These statements can be analysed by using some quantitative measures such as financial ratios. These ratios may be based on sales, or profits or return-on-investment (ROI) and so on.
These ratios standardize financial information. These can be compared with the same ratios for a previous time period in order to evaluate any change in the financial position. These ratios can point out the strategic situation or steps to minimize risks.
Financial forecasting is used to estimate a firm’s future financial needs. Based on these forecasts, various budgets can be prepared. Based on these budgets, proper allocation of funds to various activities can be made. Such budgets and expenses are a function of future sales and revenues. Accurate forecasts made on the scientific techniques can provide a basis for strategic decisions.
3. Capital Structure Planning:
Capital structure decisions require a reasonable mix of debt and equity capital. This is measured by the debt equity ratio. This can create an optimum mix of debt and equity capital in order to minimize the various risks involved in excessive borrowing. Good capital structure produces financial stability. It relates to sound strategic decisions.
4. Other Financial Considerations:
There are many financial activities and decisions that may influence strategic planning.
Some of these include the following:
i. Cash flow budgets,
ii. Budgetary control activities,
iii. Marginal costing and profit planning,
iv. Cost of capital and equity financing,
vi. Corporate restructuring and diversification,
Financial Strategy – Components of a Financial Strategy
The important components of a financial strategy are discussed below:
Component # 1. Financing Decision:
The availability of funds is a major prerequisite for the execution of many chosen strategies.
Broadly speaking, finance may be available from two sources:
i. External – The external sources of funds may consist of equity capital and/or borrowed capital. Ownership capital may be raised by issue of (a) equity shares, or (b) preference shares. Borrowed capital, on the other hand, can be raised by issue of debentures, term loans, public deposits, and other loans and credits.
ii. Internal – Internal funds are generated by way of retention of profits’ (keeping free reserves) and provision of depreciation on fixed assets.
The finance manager must ensure that funds are provided at a reasonable cost and with minimum risk. He has to decide about the optimal financing mix (mix of debt and equity) or capital structure of the organisation.
Some of the strategic decisions involved are:
(a) What sources of long-term funds should be tapped and in what proportion?
(b) To what extent should long-term debt be resorted?
(c) Should the firm take recourse to lease financing?
(d) Should the firm employ trade credits, if so, to what extent?
It is the responsibility of the finance department to secure funding for the current and future operations of the company. This requires the department to keep in touch with global interest rates, currency fluctuations, and financial policy decisions. Securing funding also requires the finance department to develop and maintain good relationships with financial institutions and other funding sources.
The financial strategic plan of a company regarding the sources, usage and management of funds should consider the following points:
(a) Capital structure – The planning of capital structure centres around the desirable mix of debt and equity, which must be ‘optimum’.
(b) Debt-equity ratio – It is required to be maintained while raising additional capital. It should be balanced.
(c) Cost of capital – The overall cost of capital is represented by the weighted average cost of debt and equity. The cost of debt is generally lower than the cost of equity due to tax advantage. But with increasing financial leverage (debt financing) the financial risk also increases. Hence, the finance strategy has to consider this issue.
(d) Lease financing – Leasing is a method under which a firm can make use of an asset without holding the title to it. It is a specialised means of gathering funds. If the cost of leasing is found higher than the cost of borrowing, it is better to buy the asset by borrowing necessary funds. The leasing strategy needs to be formulated after evaluating the alternatives.
(e) Leverage decisions – Leverage is the employment of sources of funds to get the advantage in running of business favourably. It is a relationship between interrelated variables whereby the percentage change in a variable reflects a percentage change in another variable. This is a strategic decision.
(f) Trading on Equity – The increase in debentures has further increased the earnings per share of the shareholders. Thus the presence of debt helps in increasing the earnings available to equity shareholders. This is known as trading on equity. Trading on equity is useful when the return on the investment is greater than the rate of interest of borrowed funds. It is of advantage to those companies, which are continuously stable in their earnings.
Because of the stiff global competition that multinational companies face, they often find themselves seeking alternative financial instruments to meet their funding needs. Alternative financing can be used to raise funds for company expansion or operations. Some innovative instruments that have been derived from traditional sources include bound interest and principal payments that have been separated, securities linked to foreign currencies, and variable-rate securities. There are also junk bonds and zero-coupon bonds.
Component # 2. Investment Decisions:
Investment decisions are a vital aspect of financial strategy. Financial investment refers to putting money into securities, i.e., shares or debentures, real estate, mortgages, etc. An investment operation is one which upon thorough analysis promises safety of principal and a satisfactory return. Investment is identified with safety.
It should be noted that funds involve cash and are available in limited quantity, the company has to make very prudent decisions regarding the total amount of assets to be held in the enterprise, make-up of these assets and the risk involved in investing funds. Strategic decisions regarding the type of capital assets to be acquired should be made within the boundaries of corporate strategy.
A firm may have a number of capital expenditure proposals in hand within a product-market posture. Financial strategy should, therefore, provide a specific technique with which to choose the most useful proposal for the firm.
For a successful, safe and profitable investment decision, the following factors must be considered:
i. Hurdle rate – Investment strategy seeks to maximize the firms’ wealth. It must provide for a minimum rate of return or cut-off rate that must be earned to gain reasonable profit. Hence, an organisation’s financial strategy must clearly state the hurdle rate for a particular project.
ii. Capital rationing – Capital rationing policy sets limits on the firm’s planned investment for a specific year based on the amount of cash available.
iii. Risk factor – Risk factor should also be considered while making investment decisions. On the basis of risk analysis, a project can be judged as highly risky or low risky. Financial strategy can provide clear guidelines about the risks involved in the projects.
While formulating investment strategy, the following factors must be properly considered:
i. Amount of investment
ii. Objective of investment portfolio
iii. Selection of investment—types of securities, selection of industries, selection of companies
iv. Timing of purchase
v. Identification of industries with growth potential.
Component # 3. Dividend Decisions:
The dividend decision of the firm is of crucial importance for the finance manager. It determines the amount of profit to be distributed among shareholders and the amount of profit to be retained in the business for financing its long-term growth. The objective of the dividend policy is to maximize the value of the firm to its shareholders.
It is important to decide —’how much of profits is to be paid out as dividends and how much is to be retained for growth?’ A firm has to strike a good balance between paying reasonable amount of dividend to shareholders and the growth requirements of the firm. The company has also to resolve another issue – how much is to be paid as cash dividend and how much as stock dividend (bonus shares). All these issues need to be addressed in the financial strategy.
Component # 4. Working Capital Management:
Working capital is required for the day-to-day working of the company. It is referred to as the management of current assets. Management of working capital is very important because it can maximize the shareholder’s wealth, if managed efficiently. The sources of working capital include trade credit, bank loans, bill discounting, overdraft, etc. Strategic decisions in this regard essentially influenced by trade-offs between liquidity and profitability.
Component # 5. Cash Flow Management:
Cash flow management for the firm includes managing the liquidity of the firm and minimizing financial costs. The finance department must also strive to minimize taxes. Multinational firms must deal with the differing monetary, political, and financial aspects of these assignments since they operate in many countries. Strategic decisions in this regard must be taken carefully.
The flexibility of a firm to adjust to a changing environment often depends upon its ability to obtain monetary supplies. Multinational firms have increased monetary demands resulting from currency and interest rate fluctuations. However, one of the advantages of being a multinational firm is that various financial markets will be available in which to raise funds. The finance department must coordinate the monetary flows in and out of these markets so that stakeholders such as stockholders and creditors see their required rates of return.
Component # 6. Managing Growth and Risks:
Growth is expensive because it consumes capital and, therefore, must be managed carefully. Collection of all relevant information to evaluate investment opportunities is imperative to avoid bad decisions. Capital budgeting is required of all finance students; this is because money is not free. Finally, risk must be ascertained. All risk needs to be accounted for so the company is never in an unexpected position. Strategic decisions in this regard must be taken carefully.
Financial Strategy – 4 Key Elements to Financial Strategy
There are four key elements to Financial Strategy:
1. Acquiring Capital to Implement Strategies / Sources of Funds:
Successful strategy implementation often requires additional capital. Besides net profit from operations and the sale of assets, two basic sources of capital for an organization are debt and equity. Determining an appropriate mix of debt and equity in a firm’s capital structure can be vital to successful strategy implementation.
Theoretically, an enterprise should have enough debt in its capital structure to boost its return on investment, but too much debt in the capital structure of an organization can endanger stockholders’ return and jeopardize company survival.
The major factors regarding in this which have to be made by strategists are:
i. Selecting right capital structure;
ii. Procurement of capital and working capital borrowings;
iii. Reserves and surplus as sources of funds;
iv. And relationship with lenders, banks and financial institutions.
2. Projected Financial Statements / Budgets:
Projected financial statement analysis is a key to implement financial strategy because it allows an organization to examine the expected results of various actions and approaches.
Projected Financial Statements:
This type of analysis can be used to forecast the impact of various revenue and cost provisions on the future cash flow. Normally some sort Decision Support System (DSS) are created in Excel spreadsheets to prepare projected financial statements. Nearly all financial institutions require a projected financial statements whenever a business seeks capital.
A projected (or pro forma) income statement and balance sheet allow an organization to compute projected financial ratios under various strategy-implementation scenarios. Primarily as a result of the Enron collapse and accounting scandal, companies today are being much more diligent in preparing projected financial statements.
Projected Financial Budgets:
A financial budget is also a document that details how funds will be obtained and spent for a specified period of time. Annual budgets are most common, although the period of time for a budget can range from one day to more than ten years.
Fundamentally, financial budgeting is a method for specifying what must be done to complete strategy implementation successfully. Financial budgets can be viewed as the planned allocation of a firm’s resources based on forecasts of the future.
There are almost as many different types of financial budgets as:
i. Cash budgets,
ii. Operating budgets,
iii. Sales budgets,
iv. Profit budgets,
v. Factory budgets,
vi. Capital budgets,
vii. Expense budgets,
viii. Divisional budgets,
ix. Variable budgets,
x. Flexible budgets, and
xi. Fixed budgets.
When an organization is experiencing financial difficulties, budgets are especially important in guiding strategy implementation.
Financial budgets have some limitations:
i. First, budgetary programs can become so detailed that they are cumbersome and overly expensive. Over budgeting or under budgeting can cause problems.
ii. Second, financial budgets can become a substitute for objectives. A budget is a tool and not an end in itself.
iii. Third, budgets can hide inefficiencies if based solely on precedent rather than on periodic evaluation of circumstances and standards.
iv. Finally, budgets are sometimes used as instruments of dictatorship in which some senior objective prepare everything. To minimize the effect of this last concern, managers should increase the participation of subordinates in preparing budgets.
3. Management / Usage of Funds:
Plans and policies for the usage of funds deal with investment or asset-mix decisions i.e., which asset to be purchased and which to dispose off, etc.
Some key decisions included in this are:
ii. Fixed asset acquisition;
iii. Current assets;
iv. Loans and advances;
v. Dividend decisions; and
vi. Relationship with shareholders.
Usage of funds is important since it relates to the efficiency and effectiveness of resource utilization in the process of strategy implementation.
Implementation of projects under the expansion and diversifications strategies results in increase in capital expenditures. If planning is not done properly then capital expenditure can be inefficient leading to less than an optimum utilization of resources.
An example is of Modi Cement, which followed a deliberate policy of generous capital investment in setting up its plant based on the latest technology. As compared to its competitor Jaypee Rewa’s plant, which cost Rs. 120 crore, Modi’s plant had an investment of Rs. 153 crore.
The result was high interest liability and depreciation, causing a serious dent in profitability in the initial years. Similarly, payout policies for dividends and bonus distribution play an important role in the usage of funds.
The management of funds is an important area of financial strategies. It basically deals with decisions related to capital expenditures, dividend policy, investment, cost control and tax planning, etc.
The management of funds can play a pivotal role in strategy implementation. For instance, Gujarat Ambuja Cements, currently a highly profitable cement company in the country, has achieved tremendous financial success primarily on the basis of its policies of cost control. This company has been particularly successful in maintaining a low cost for power, which is a major input in cement manufacturing.
4. Evaluating the Worth of a Business:
Evaluating the worth of a business is also important financial strategy implementation because company may acquire another firm under diversification, or divest under retrench strategy. Thousands of transactions occur each year in which businesses are bought or sold in the United States. In all these cases, it is necessary to establish the financial worth or cash value of a business to successfully implement strategies.
All the methods of evaluating a business’s worth can be grouped into three main approaches:
In the first approach, the worth of a business is determined through net worth or stockholders’ equity. Net worth represents the sum of common stock, additional paid-in capital, and retained earnings.
After calculating net worth, add or subtract an appropriate amount for goodwill and overvalued or undervalued assets. This total provides a reasonable estimate of a firm’s monetary value. If a firm has goodwill, it will be listed on the balance sheet, perhaps as – “intangibles”.
The second approach is based on largely the future benefits business owners may derive through net profits. A conservative rule of thumb is to establish a business’s worth as five to ten times the firm’s current annual profit.
In the third approach, the market determined a business’s worth through three popular methods –
i. First, base the firm’s worth on the selling price of a similar company per unit of its capacity, if similar transaction happened recently.
ii. The second approach is called the price-earnings ratio method. To use this method, divide the market price of the firm’s common stock by the annual earnings per share and multiply this number by the firm’s average net income for the past five years.
iii. The third approach can be called the outstanding shares method. To use this method, simply multiply the 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 (acquire) the other company.
Financial Strategy – Types: Capital Structure Strategy, Dividend Strategy, Capital Budgeting Strategy and Working Capital Strategies
Finance is the fundamental resource for starting and conducting of a business. In fact, companies need finance to implement their strategies. Financial strategies are centered on acquiring capital, reducing cost of capital, making complex investment decisions through capital budgeting, financing and dividend decisions, capital structure, working capital strategies in terms of accounts receivables, inventory, cash management, etc.
Capital can be equity capital and loan capital/debt capital. Equity capital provides security, and free from paying interest and financial risk. Debt capital though, requires the payment of a fixed interest regularly, provides huge surplus during the periods of business boom. Therefore, companies prefer to have both equity capital and debt capital.
Type # i. Capital Structure Strategy:
Capital structure is the mix of equity capital, preference capital, retained earnings and debt capital. Companies formulate optimum capital structure strategy in order to balance the advantages and disadvantages/risks of various kinds of capital like equity capital, preference capital and debt capital.
Optimum capital structure possess the following features:
a. Generation of maximum rate of return on capital employed for the purpose of maximisation of wealth of equity shareholders.
b. Excessive debt capital results in risk of solvency of the company. Hence, companies should limit the debt capital at a point where the risk begins.
c. Companies should adopt a flexible structure in order to adapt the structure to the economic situations.
d. The amount of debt capital should be within the capacity of the company to generate future cash flows.
e. Capital structure of the company should result in control of risk involved in debt capital.
Thus, an appropriate capital structure strategy helps the firm in reducing the cost of capital, risks involved in debt capital management and enchasing the equity shareholder’s wealth.
Type # ii. Dividend Strategy:
Dividend strategy is to decide the amount of profits to be distributed to the shareholders after retaining certain amount of profits as a surplus for the future investment of the company and earning benefit to the shareholder.
This in turn enables the company to generate the capital for future investment purpose which involves the least cost of capital as well as risk. As such, L&T follows the balanced dividend and retained earnings/surplus strategy.
Dividend strategy is to maximise the shareholder’s return in the long run by maximising the value of investment. Thus, dividend strategy balances the current return and capital gains. Dividend strategy balances the current return and capital gains. Dividend strategy enables the shareholders to satisfy their desire for steady income and reduces the tax burden on income in addition to meet the company’s goal of less costly capital structure.
Thus, appropriate dividend’s strategy enables the firm to reduce the cost of capital, minimise risk, and enhance the shareholders’ value.
Type # iii. Long-Term Investment/Capital Budgeting Strategy:
After acquiring the capital, through capital budgeting strategy, companies invest capital, capital investment is also called capital budgeting. Capital budgeting is concerned with the investment in fixed assets or long-term assets.
Companies make capital budgeting decisions for the establishment of the business, expansion, diversification, and modernisation, replacement of long-term assets, acquisition, and merger and amalgamation strategies of the company.
Companies sometimes sell the long-term assets in order to replace the old assets, to tide over the financial difficulties due to recession in the business, or decline in the sales of the company and the like. Sale of assets involves disinvestment decisions. Capital budgeting involves disinvestment decisions.
Capital budgeting strategies are affected by the corporate strategies like expansion, diversification, takeover, merger, amalgamation as well as retirement like disinvestment, turnaround and liquidation of the business.
Capital budgeting strategy enhances the productivity of the business, returns, profitability, and shareholders’ wealth. Capital budgeting decisions influences the-
a. Growth rate and direction of the business;
b. Risk element involved in the business due to the commitment of funds for long-term;
c. The commitment of large amount of funds; and
d. Fixation of funds in particular asset permanently, making the irreversible of the decision impossible.
Capital budgeting strategy involves the following phases:
a. Identification or origination of investment opportunities based on corporate strategy and business unit level strategies;
b. Forecasting the costs and benefits of the investment opportunities over the long run;
c. Evaluation of the net benefits from each of the opportunity;
d. Authorisation for progressing and spending capital expenditure;
e. Control of capital projects.
After formulating of long-term investment strategies, companies craft short-term capital/working capital strategies.
Type # iv. Working Capital Strategies:
There are two aspects of working capital, viz., gross working capital and net working capital. Company’s investment in current assets is called gross working capital. Current assets include cash, accounts receivables, short-term securities, bills receivables and inventory.
Difference between current assets and current liabilities is called net working capital. Current liabilities include accounts payable, bills payable and outstanding expenses.
Companies should maintain an adequate working capital to operate the daily and routine activities of the business. The shortage of working capital affects the creditworthiness of the companies and results in failure to pay even employees salary. In contrast, excessive working capital results in idle funds and in turn leads to high cost of capital.
Strategies relating to each aspect of working capital strategies are cash management, accounts receivables and inventory management.
a. Cash Management:
Management of cash brings into sharp focus on the trade-off between risk and return. Cash management deals with cash flows into and out of the company, cash flows among different departments of the company and cash balances held by the company to finance the deficits or to invest the surplus.
Continuous deficit of cash creates risks and problems to the company while continuous surplus of cash result in high cost of capital. The companies have to plan for optimum cash and maintain it in order to prevent the possible problems of deficit as well as surplus of cash.
Cash should be managed efficiently. The surplus or deficit of cash can be managed through float of cash represented by incoming collections, payment made sooner than necessary, scattered deposit balances and excessive and unrewarding balances in checking accounts. This stage includes efficient management of near-cash in order to produce the highest return consistent with a low risk.
Companies prefer cash budgets to control cash flows. Cash budgets serve the purpose, only when the company accelerates its collections and postpones payments within allowed limits.
b. Accounts Receivables:
Companies sell on credit due to a competition, bargaining power of the buyer/market intermediaries, relationship and network with the market intermediaries/ manufacturer’s, practices within the industry and requirements of the buyer. Companies make optimum credit policy in order to maximise the operating profit and reduce incremental cost.
Amount of accounts receivables depends a volume of credit sales and collection period. Credit policy determines the volume of credit sales, credit period, credit standards, terms and collection efforts.
All customers may not pay during the credit period. Hence, companies make efforts to accelerate the collection in order to reduce bad debt losses. Companies, in addition, monitor receivables based on the average collection period and ageing schedules. When companies fail to collect the receivables, sells such receivables to specialized firms.
This practice is called ‘factoring’. Factors or companies involved in factoring advance cash against receivables to solve the problem of shortage of cash, for a certain rate of commission.
c. Inventory Management:
Inventories constitute raw materials, work-in-progress and finished goods. Inventories constitute more than 60% of current assets. Efficient inventory management is essential in order to operate the production process uninterruptedly, to guard the production process against the risks involved in the supply of raw material and in the price fluctuations of raw material.
At the same time, the cost of inventory should be minimised to the greatest extent possible in order to contribute to the low cost of production.
There are two conflicting objectives of inventory management. A production manager prefers less quantity of inventory in order to reduce the cost of inventory whereas the marketing manager prefers larger quantity of inventory in order to have uninterrupted supply of finished products. The finance manager balances these conflicting objectives of inventory management.
Therefore, the efficient inventory management should:
I. Ensure continuous supply of raw materials to facilitate uninterrupted production;
II. Maintain sufficient quantity of raw materials in times of short supply and anticipate price changes;
III. Maintain finished goods of sufficient quantity for continuous sales operation and efficient customer service;
IV. Minimise the carrying cost and time, and
V. Control investment in inventories and keep it at an optimum level.
Financial Strategy – 2 Main Functions: Acquiring of Funds and Cash Flow Analysis
1. Acquiring of Funds:
Acquiring of funds is preceded by the Investment Decision. In other words, allocation of funds is needed for creating assets with a view to produce goods and services. This process is known as capital budgeting. Since the funds involved are of a sizeable magnitude, it is necessary that the capital on different assets has to be budgeted in such a manner that the committed production of goods and services may be carried with the minimum of wastages apart from providing optimal return on investment.
The investment decisions are made with the help of the following techniques:
(i) Net Present Value Method.
(ii) Internal Rate of Return Method.
(iii) Pay Back Period Method.
(iv) Accounting Rate of Return Method.
After identification of assets in which investment is to be made in such a manner that a better return is obtained besides achieving the possibility of realising short term and long term objectives and goals in the form of production of goods and services; the next set of decision relates to the sources of finance technically known as financing decisions.
Every business enterprise needs two types of finances – (i) Long term and (ii) Short term. Long term finances are needed to finance investment in long term assets such as land, buildings, plant and machinery, equipment etc. and short term finance is needed to finance the working capital needs of the enterprise which relate to materials purchase, payment of wages and manufacturing overheads. Working capital is needed to finance such assets which could be converted into cash within a period of one year.
Financing decisions are made in the light of the cost of capital. It is necessary to work out the cost of each source of long term and short term capital. All long term sources of finance may be divided under two heads – (a) equity and (b) borrowings.
Since both equity and borrowings involve cost, it becomes necessary to make a comparative analysis of both the sources and take a decision in favour of the source which involves lower cost of production provided it does not flout the statutory condition of debt/equity ratio laid down by the Reserve Bank of India. Borrowings more often prove cheaper owing to the element of leverage associated with it.
Apart from the above, following factors are also taken into account while making financial strategic decisions:
(i) Policy of the organisation regarding centralisation or decentralisation of ownership. If the organisation’s policy is to decentralise ownership, it may rely more on equity and less on borrowings. In case the policy is centralisation of ownership, it will rely more on borrowing and lesser on equity.
(ii) Another influencing factor may be the gestation period. If the company has a longer gestation period, it will prefer greater reliance on equity with a view to curtail its short term liability in the form of regular interest payments. In the event of gestation period being shorter, the decision will be taken on merit i.e. cost of acquiring the capital.
(iii) Apart from the factors identified above, the company has to maintain the prescribed debt/equity ratio as laid down by statutory authority-being the Reserve Bank of India in our case. The R.B.I, has laid down 2 : 1 and in certain cases 3:1. Like long-term, there are sources for obtaining the short term capital, (i) Institutional like banks and (ii) Non-institutional like borrowings from friends and relatives, private finance components etc.
The decision regarding the preference for a particular source will depend on the following factors:
(b) Quicker availability without formalities
(c) Cost of capital.
2. Cash Flow Analysis:
Cash flow analysis is essential for financial strategies in the light of the following factors:
(i) Cash is essential for survival, growth and profitability of the organisation;
(ii) Cash flow process is the centre nerve of the organisation as it may be stated as the asset transformation process.
Every organisation has to start with a certain amount of cash which may be devoted to the purchase of assets and other essential goods and services. The acquired assets and the purchased goods and services may be used for the production of goods or services. Goods and services so produced will create inventories. Inventories, if not converted into cash, will create demand for cash which may be met only through borrowings.
It will, in turn, affect the cash flow position adversely. The position will not change materially if the inventories have been sold on credit. Credit creates receivables and unless the debtors pay, it will not augment cash flow of the organisation.
For developing financial strategy following questions pertaining to financial management are required to be answered:
1. Determining the magnitude and characteristics of necessary funds to conduct business operations:
(i) What are cash flow requirements?
(ii) How are credit and collections to be handled?
(iii) Are long term bonds, stock issues, or short term borrowings to be used?
2. Allocating Resources in the most efficient manner:
(i) Are the long term benefits from the proposed project commensurate with the long term cost?
(ii) What types of budgets are to be developed?
3. Serving as an interface with creditors and shareholders concerning the financial condition of the organisation:
(i) What methods are to be used in paying dividends?
(ii) What credit terms are expected from suppliers?
(i) Are profit centre accountability systems to be introduced?
(ii) Are financial statements to be prepared for each unit of the organisation?
(iii) What reports are to be prepared for various levels of management, and when?
5. Providing financial data for determining the feasibility of various strategic alternatives:
(i) What is the value of the company which is under consideration for acquisition?
(ii) What are the financial implications of the proposed liquidation of a certain part of the organisation?
Sources of cash flow into the organisation and the usage of that cash by the organisation is called the “sources and usage of funds flow analysis”. It requires an effective system of recording, monitoring and controlling of the operations of the organisation strategy.
Financial Strategy – Key Issues or Considerations
It should be noted that strategic success cannot be achieved through a set of ‘rules’ and priorities which apply in equal measure to all organisations and at all times. In fact, there are certain key issues that organisations of all types face in building their financial strategies.
These are discussed below:
1. Managing for Value:
Managing for value is an important consideration for, and responsibility of financial managers. It is creating value for shareholders or ensuring the best use of public money. Long-term success of financial strategies is determined by the extent to which they deliver best value in the eyes of major stakeholders. It is important that managers understand what ‘managing for value’ means and how it might be achieved. Managing for value is concerned with maximizing the long-term cash-generating capability of an organisation.
Value creation is determined by three main factors:
i. Funds from operations,
ii. Investment in (or disposal of) assets, and
iii. Financing costs.
i. Funds from operations are a major contributor to value creation. In the long-term, this concerns the extent to which the organisation is operating profitably. This is determined by –
(a) Sales revenue —made up of sales volume and the prices that the organisation is able to maintain in its markets.
(b) ‘Production’ and selling costs—both made up of fixed and variable elements.
(c) Overhead or indirect costs.
ii. Investment in assets – This will affect value creation as follows –
(a) Costs of capital investment.
(b) Disposal of fixed assets.
(c) Reduction in current assets.
(d) Elements of working capital such as stock, debtors and creditors will increase or decrease shareholder value.
iii. Financing costs – The mix of capital in the business between debt and equity will determine the cost of capital.
2. Funding Strategy Development:
In all organisations managers need to decide how the organisation will be financed and strategic developments supported. These decisions will be influenced by ownership—for example, whether the business is privately held or publicly quoted —and by the overall corporate goals of the organisation.
i. Financial and business strategies need to match.
ii. The greater the risk to shareholders or lenders, the greater the return these investors will require.
iii. The business risk should be balanced with the financial risk to the organisation.
iv. Debt brings greater financial risk than equity since it carries an obligation to pay interest.
v. As a generalization, the greater the business risk the lower should be the financial risk taken by the organisation.
3. Financial Expectations of Stakeholders:
The financial expectations of stakeholders will vary —both between different stakeholders and in relation to different strategies. This should influence managers in both strategy development and implementation. It is clear that the owners are not the only ones who have a stake in organisations.
Other stakeholders also have financial expectations from organisation. These include institutional shareholders, bankers, suppliers and employees, the community and the customers. The issue is the extent to which business strategies should address these considerations and how they can be squared with creating value for the owners.
Overall, managers need to be conscious of the financial impact on various stakeholders of the strategies they are pursuing or planning to pursue. They also need to understand how these expectations could enable the success of some strategies whilst limiting the ability of an organisation to succeed with other strategies.
Financial Strategy – Careful Attention Needed towards Financial Strategies
The following financial strategies need careful attention:
i. Capital Structure:
A capital structure policy is related to the debt-equity ratio, i.e., the optimum mix of equity capital and debt capital. This decision is influenced by the factors like burden of interest payment, risk of excessive borrowing and the objective of the company for maximization of owners’ wealth.
The factors like the overall weighted cost of capital, the debt capacity of the firm in terms of adequacy of cash inflows to meet the fixed interest rate burden and principal amount, and the need for flexibility in the capital structure are also considered in deciding the capital structure.
ii. Sources of Finance:
Sources of finance are very closely related to the capital structure. There are two major sources of funds. They are external sources and internal sources.
External sources of funds include equity capital, preference capital, debenture capital, public deposits and loans from financial institutions like commercial banks, development banks etc.
Internal sources of funds include reserves of the company for long-term purposes and bank balances of the company and cash in hand with the company for short-term purposes. In addition, inter-corporate investments are also considered as part of the sources of finance.
iii. Capital Expenditure Planning:
The Capital Expenditure Planning gets the most importance in almost all the organizations. The reason for this is large size of investments and the accompanying costs and risks, which calls for more deeper and systematic analysis of the projects and their financial implications.
The process of planning capital expenditure adopted by all the organizations involves three major steps:
i. Classification of capital expenditure proposals.
ii. Evaluation of capital expenditure proposals in terms of cash flows.
iii. Ranking of the proposals and then selection.
iv. Capital Structure Planning:
Capital Structure Planning is the cornerstone of financial planning process of all organizations primarily because of the cost, control and risk considerations which in turn influences overall value of the firm. Capital structure planning provides the framework for the makeup of a firm’s long-term financing of debt, preferred stocks and equity stock. The central thrust is minimization of cost of capital and maximization of value of stocks.
General practice is that fixed capital needs are met through equity and long-term debts and current asset requirements were funded through bank borrowings and other sources. Important sources of funding are equity, borrowing from financial institutions, lease financing, bonds/debentures and fixed deposits.
According to the cost principle, ideal pattern of capital structure is one that tends to minimize cost of financing and maximizes earnings per share. From this angle, debt should occupy a prominent place in the capital structure of an organization because it is the cheapest source of financing.
The risk principle suggests that such a pattern of capital structure should be devised so that the firm does not run the risk of bringing on a receivership with all its difficulties and losses. Since bond is a commitment for a long period, it involves risk. Thus, it places greater reliance of common stock for financing capital needs of the firm.
According to the control principle, a pattern should be chosen which does not disturb the controlling position of the residual owners. Management desiring to retain control must raise funds through bonds since equity stock carries voting rights, issue of new equity shares will dilute control of existing shareholders.
According to flexibility principle, an enterprise should strive towards achievement of such combination of resources, which the management finds it easier to maneuver sources of funds in response to major changes in need of funds.
Determination of optimal level of debt is of prime importance. Because of tax deductibility of interest payments, use of financial leverage increases the potential earnings of the owners. However, the firm is required to bear increasing cost explicit and implicit in borrowing funds owing to increased financial risk.
Up to a certain level, tax benefits of leverage tend to be higher than the cost associated with debt financing. Beyond that limit cost of debt begins to outweigh tax benefits. Debt limit should be fixed at this point because total value of the firms stops rising with leverage. This level is the optimum level of debt. EBIT-EPS analysis is a widely employed method to determine the most appropriate level of debt.
v. Cash Flow Planning:
Long-term as well as short-term cash forecasting is done. In long-term cash forecasting, projection was made about cash receipts and payments for future period of 2 to 5 years. Short-term cash forecast is also prepared to include all cash receipts and payments expected to occur during the next one year.
The forecasts are prepared on the basis of information about estimated sales, production plan, purchasing plan, financing plan and capital expenditure budget. Such forecasts enable the management to know in advance the cash status of the organization at different points of time and thereby aid them in evolving suitable strategy.
A firm should seek to receive cash in shortest possible time but not retain it for a long time in order to avoid any additional cost to them. Adequate cash enables the firm to pay trade bill and take advantage of trade discounts. It also meets the unexpected adversities and is useful for exploiting favourable opportunities.
Also strong cash position ensures a high credit standing. But keeping any excess stock of cash is largely a waste of resources because it is a non-earning asset and the same could be invested elsewhere to earn some income, i.e., the firm will fail to maximize its profits at the expense of high liquidity.
Cash planning exercise is undertaken to estimate the amount of cash needed for different purposes so that a business enterprise neither has surplus of cash nor paucity of it. If cash inflows and outflows were perfectly synchronized and could be forecasted with certainty, a company would need no cash balances at all. Since such ideal situation does not exist at all, finance manager must undertake the cash planning exercise.
A business enterprise carries stock of cash primarily for transaction purposes and builds secondary reserves (highly liquid riskless securities) to meet precautionary and speculative motives. Factors influencing amount of cash holdings are terms of purchase and sales, collection period of receivables, credit position of the company, nature of demand of the company’s product etc. With the help of cash budgets, finance manager can predict inflows and outflows of cash during some future span of time and thereby determine cash requirements of the company.
For effective utilization of cash, the strategies fall under two major categories:
a. Strategy towards accelerating cash inflows.
b. Strategy towards decelerating cash outflows.
Suitable policy regarding investment of idle cash should be established. The idle cash should be invested so as to earn a reasonable amount of income without foregoing liquidity.
vi. Working Capital Planning:
A great thrust is given to working capital planning because of the management’s concern for high liquidity without impairing the profitability. The determination of working capital required depends on operating cycle, current ratio, level of inventory, ratio of sundry debtors to sales and inventory turnover ratio etc.
vii. Inventory Planning:
Efficient inventory management calls for minimization of investments in inventory and meeting the demand for different types of inventory efficiently, effectively and adequately so as to minimize the direct and indirect costs of holding inventories minimizes the risks and losses due to stock out and to keep investment in inventories at a reasonable level.
Hence, management should formulate a suitable inventory policy stating minimum inventory, size of production run or purchase orders, timing of reordering the inventory turnover etc.
viii. Receivables Planning:
The prime objective is to maximize value of die enterprise by striking a mean between liquidity, risk and profitability. Credit sale of bolster up sales but are attached with cost of dispensation of credit facilities and collection of accounts receivables.
It should also design an appropriate collection policy for the firm. The basic objective is to ensure the earliest possible payment of receivables without any customer losses through ill will. The overall objective of minimization of investment in receivables and reduction bad debt losses will be accomplished only if the creditworthiness of applications is evaluated to ensure that they confirm to the credit standards prescribed by the firm.
ix. Dividend Planning:
The policy regarding the proportion of profit to be distributed to shareholders as dividend and the proportion of the profit retained in the company as reserves is the important consideration.
This decision is affected by the factors like:
a. The shareholders’ preference as to current dividend income against capital gains.
b. The re-investment opportunities and financial needs of the company.
c. Advantages and disadvantages of cash dividend and stock dividend.
Dividend decision should be formulated in such a way as to optimize price of the firm’s share in the market. The split between retention and dividend should be such as to attract potential investors and raise the market price to the highest attainable level. The management should bear in mind environmental factors such as – general condition of economy, state of capital markets, state regulations and tax policy.
For example, if the state of capital market is relatively comfortable and raising funds from different sources poses no problem, the management may be tempted to declare high dividends, to maintain the confidence of existing stockholders and attract potential ones.
x. Taxation Planning:
Objectives of taxation planning pursued by companies are reducing long- term tax liability, for future investment, for generating cash flows and for optimizing diversification decisions. The tax rates being very high, it is important for the management to plan taxes.
Also there are main provisions in the tax law, which could be availed to their advantage. Companies are guided in their tax planning exercises by the consideration of tax incentives and concessions granted by the government to accelerate the rate of development.