Financial Strategies and Accounts

[FINANCIAL STRATEGIES AND
ACCOUNTS]

ACCOUNTS]
Understanding Financial
Objectives
Financial Aims: the broad, general goals of the finance and
accounting function or department within an organisation.
Financial Objectives: the specific, focused targets of the finance
and accounting department within an organisation.
Financial Strategies: long-term or medium term plans, devised at
senior management level, and designed to achieve the firms
financial objectives.
Financial Tactics: short-term financial measures adopted to meet
the needs of a short-term threat or opportunity.
Financial Objectives
The examples set out below illustrate the types of financial objective
that a business might pursue;
Cash Flow
Many businesses get into financial difficulties because of lack of
cash flow rather than lack of overall profitability. Consequently, it is
vital that businesses set themselves cash-flow targets to ensure
they are able to keep operating. E.g.
Maintaining a minimum closing monthly cash balance, for
example a minimum cash balance of 10,000 would be a
sensible target for a small newsagents
Reducing the bank overdraft by a certain sum by the end of the
year
For new start-up companies, it is likely an overdraft will be
needed to support everyday expenses
Interest means it is not advisable to sustain an overdraft,
therefore businesses may set objectives with this in mind
Creating a more even spread of sales revenue
Spreading costs more evenly
Achieving a certain level of liquid, non-cash items
Raising certain levels of cash at a particular point in time
Setting contingency funds
Cost Minimisation
A business that reduces its costs can benefit in two ways; keeping
prices the same therefore having a higher profit margin, or reducing
the selling price to attract more customers. E.g.
Achieving a certain cost reduction in the purchase of raw
materials

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Reducing wage costs per unit

Lowering levels of wastage
Relocating the business to the least cost site
Reducing the cost per thousand customers of the business
promotion and advertising
Improving the efficiency of production by reducing variable costs
per unit
ROCE Targets
The success of a business is invariably demonstrated by its profit
levels. Clearly, large firms will achieve higher profit levels than
smaller businesses, so the profit needs to be compared to the size
of a business. E.g.
Achieve an ROCE that exceeds the level recorded for the
previous year by a certain percentage
Achieve an ROCE that compares favourably to the average ROCE
achieved in the UK
Achieve an ROCE that exceeds the level of a particular
competition
Shareholders Returns
A business must satisfy the needs of its shareholders/owners. Many
shareholders assess a business in terms of dividends received
because a high dividend is likely to be linked to high profit levels
and sound financial performance. E.g.
High dividend per share which will indicate a well performing
business and will benefit shareholders with increased dividends
High dividend yield - shows the dividend paid as an percentage
of the market value of the share. This can be compared to
interest rates in banks or alternative investments
Increasing the share price as this tends to reflect the value of the
business, therefore if a business retains its profits and grows
successfully, the share price should increase
High earnings per share. Show profit made by each individual
share in a business, and is a good indicator of efficiency

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Internal Influences on Financial Objectives

Internal factors that affect financial objectives are those within a
business, such as its workforce, resources and financial position.
Corporate Objectives:
The overall aims of an organisation are a key influence on the
objectives of a functional area, such as the finance department. The
finance department must ensure that its objectives are consistent
with the corporate objectives of the business.
Human Resources (HR):
Achieving financial objectives depends on the efforts and skills of
the workforce. Effective planning of the workforce and a good
recruitment and training policy can enable a business to increase its
profitability, by increasing the efficiency of the workforce. However,
there can be a conflict between the needs of the workforce and the
business financial objectives.
Finance:
A business in a healthy financial situation is in a much better
position to achieve high levels of profits and cash-flow. It can fund
investment into items such as research and development, new
technology and marketing campaigns that may help improve its
overall financial performance. Consequently a such a business can
set more challenging objectives.
Operational Factors:
The finance department relies on each of the functional areas in
order to reach its objectives. If the operations management function
of a business is operating efficiently, the firm will be able to
produce goods of high quality and low cost. This will lead to good
sales revenue and high profit margins, and enable the business to
achieve quite challenging financial objectives.

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Resources Available:
A business, which over time has built up a strong resource base, will
be able to target and achieve a strong financial performance. These
resources might be in the form of premises, well-known brand
names, or the quality of the workforce.
The Nature of the Product:
The success of a business is heavily influenced by its product and
services it offers. In many cases, successful businesses have
happened to be in the right place at the right time.
External Influences on Financial Objectives

External factors are those outside the business, such as the state of
the economy and the actions of competitors. PESTLE describes
external factors that can affect a business.
Political Factors:
Financial objectives are often guided towards the wishes of the
shareholders. However, the great openness has also led to
expectations on businesses to serve the needs of other groups, such
as the workforce, customers, the local community and the
environment.
Economic Factors:
The state of the economy is a major influence on the financial
performance of businesses. For example, if an economy is in
recession, customers will purchase fewer products and so lower
sales and profit targets will be set. For businesses dealing with
luxury products, it is likely that these targets will be significantly
lower. For some businesses, such as those selling staple foods, there
will only be a limited.
Social Factors:
Society is constantly changing and businesses must adjust to suit
society. People now expect access to businesses 24/7 if possible.
This change in expectations can make it difficult for businesses to
set targets that involve lower costs, but at the same time it opens
up opportunities for targeting greater revenue and creating new
ways of generating income.
Technological Factors:
Technological change can lead to improvements in communication.
A particular benefit is that financial targets can be monitored more
regularly and more closely, and objectives or strategies modified in
the light of changing circumstances.

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Legal Factors:
In some industries, legal requirements have a big impact on the
objectives of a business, and changes in these requirements will
lead to modified financial objectives.
Environmental Factors:
Growing environmental awareness among consumers and actions
by pressure groups have had financial implications for businesses.
Acquiring supplies and raw materials from environmentally friendly
sources is now an aim for many businesses as they try to minimise
their carbon footprint.
Other external factors that can influence financial objectives include
market factors (as products go through the product life cycle,
objectives will have to be modified), competitors actions and
performance (competing may lead to lower profit margins or limited
competition may increase them), and suppliers (as they can have a
major impact on costs).
Using Financial Data to

Measure and Assess
Performance
Two key financial documents kept by a firm are:
Balance Sheet
A document describing the financial position of a
company at a particular point in time, by comparing
items owned by the company (assets) with the amounts
it owes (liabilities)
Income Statement
An account showing the income and expenditure (and
thus profit or loss) of a firm over a period of time
(usually a year)
Revenue/Capital Expenditure
Business expenditure can be classed as either revenue expenditure
or capital expenditure.

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Capital expenditure is when cash is spent on an item that will
be used over and over again that will help the business in
future years a non-current (fixed) asset
Revenue expenditure covers spending on day to day items
such as wages, office consumables, operating expenses,
rental payments and marketing expenditure.
The significance of the distinction between capital and revenue
expenditure lies in accountancy practice. A basic rule of accounting
is matching or accruals concept. When calculating a firms profit any
income should be matched to the expenditure involved in creating
that income. Revenue expenditure offers little problems, however
capital expenditure needs to be allocated over several years (the
lifetime of the asset). For example, if a machine cost 50,00 and
would be used for 5 years, the expenditure would be 10,000 per
year for 5 years rather than a lump sum.
Prudence is another accounting convention. Accounts should
ensure that the worth of the business in not exaggerated, therefore
firms are slightly pessimistic in estimating the value of its assets
Depreciation is a fall in value of an asset over time, reflecting the
wear and tear of the asset as it becomes older. The three causes of
depreciation are time, use and obsolescence.
Balance Sheets
The balance sheet looks at the accumulated wealth of the business
and can be used to assess its overall worth. It lists the resources
that a business owns and the items it owes.
In addition, it shows the capital provided by the owners. Capital is
provided through either the purchase of shares or the agreement to
allow the company to retain or plough-back profit into the
business, known as reserves, rather than using it to pay further
dividends to the shareholders.
Assets: Items that are owned by an organisation. Assets are
generally grouped into two categories: non-current and current.

o In general, non-current assets are purchased to allow the
business to operate continuously. Land and buildings, machinery
and vehicles are acquired so that firm has the equipment from
which to operate. These are examples of tangible assets.
Intangible assets include goodwill (brand names and patents).
o Current assets are short term items that circulate in a business
on a daily basis and can be expected to turn into cash within a

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year. Examples of current assets are inventories (stocks),
debtors, the bank balance and cash. Inventories are valued at
cost paid, rather than expected sale price.
Liabilities: Debts owed by an organisation to suppliers,
shareholders, investors or customers who have paid in advance.

o Examples of non-current liabilities include debentures and longterm or medium-term loans. Debentures are fixed interest loans
with a repayment date set a long-time into the future
o Examples of current liabilities are creditors, bank overdrafts,
corporation tax owing and shareholders dividends due for
repayment.
Capital: Funds provided by shareholders to set up the business,

fund expansion and purchase fixed assets. It generally takes two
forms:
o Share Capital: Funds provided by shareholders through the
purchase of shares.
o Reserves: Those items that arise from increases in the value of
the company, which are not distributed to shareholders as
dividends, but are retained by the business for future use.
It is important to know the purpose of the balance sheet;
Recognising the value of the business
Gaining an understanding of the nature of the firm.
Identifying the companys liquidity position.
Showing sources of capital.
Recognising the significance of changes over time.
Income Statements
An income statement describes the income and expenditure of a

business over a given period of time.
Purpose of the profit and loss account
o Regular calculations of profit throughout the year help
managers to review progress before the final end-of-year
accounts are completed.
o To satisfy legal requirements to do so.
o Publication allows stakeholders to see if a firm is meeting their
needs.
o Comparisons can be made between two different firms.
o Potential investors can see if the firm is able to provide a good
return.

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o Helps identify whether the profit earned by the business is
sustainable (profit quality)
The profit and loss account is divided into three sections, these are;
the trading account, the profit and loss account and the
appropriation account:
The trading account records the turnover of the company and
the cost of sales. Therefore this account calculates the gross
profit. Gross profit indicates how efficient a business is at
converting its raw materials or stock into a finished product.
The profit and loss account, on the other hand, looks at the
turnover minus the fixed costs; thus calculating the operating
profit. This is the revenue earned from everyday trading
activities minus the costs of carrying out these activities.
The appropriation account is a statement which shows what
happens to profit; how it is used or distributed. Typically, it will
show how much profit is retained by the business and how
much is given to the shareholders.
The profit and loss account is structured in a specific way for three
main reasons.
1. The first reason is that the trading account enables a business
to see how efficiently it is at turning materials into sales
revenue.
2. The profit and loss account shows the efficiency of a firm in
controlling its overheads and expenses.
3. The appropriation account is of particular interest to share
holders. A business that is using most of its profits to pay high
dividends will please shareholders looking for a quick return.
However, shareholders with a long-term interest in the
business may prefer to see high retained profits, as these will
be reinvested into the business to boost profits in the future.
Working Capital
Liquidity the ability to convert an asset into cash without loss or
delay
The working capital shows the net current assets of a firm. It is the
day-to-day finance used in a business, consisting of current assets
minus current liabilities. It is a measure of liquidity, and firms
generally want to have between 1.5 and 2 times as many assets

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than liabilities. Less than this, the firm is becoming illiquid, more
than this it is too cautious and should invest more.
working capital=current assetscurrent liabilities
Of course the balance sheet is just a snapshot of the working capital
position at a point in time (the balance sheet date). In reality, a
business is constantly settling liabilities, taking money from
customers, buying inventories and so on. This is known as the
working capital cycle, as illustrated below:
In the diagram above:
The business uses cash to acquire inventories (stocks)
The stocks are put to work and goods and services produced.
These are then sold to customers
Some customers pay in cash but others buy on credit. Eventually

they pay and these funds are used to settle any liabilities of the
business (e.g. pay suppliers)
And so the working cycle repeats

Influences on working capital levels:
Time taken to sell stock

Time taken by customers to pay for goods
Credit period offered by suppliers
Causes of difficulties:
Failure to control inventory levels

Poor controls of receivables
Poor controls of payables
Cash flow problems

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Poor internal planning and coordination
External factors
Solving problems:
Inventory control - Low inventory levels mean no storages
costs, however you miss out in purchasing economies of scale.
Just In time system is effective
Receivables control receivables should be kept to a
minimum, however the offer of credit may increase sales
though
If credit is offered, credit control must be strict
Invoices and reminders
Chasing up people
Taking people to court
Credit rating
Profit Quality/Utilization
Profit Quality:
One of the issues to consider when looking at the income statement
is to look at whether the reported profit is high quality or low
quality. A high quality profit is one which can be repeated or
sustained. A low quality profit is one which it is difficult to repeat.
The profit is likely to benefit from one or more exceptional items
which will not repeat.
Profit Utilisation:
This shows the ways in which a business uses its profit of surplus
cash, and there are mainly two ways in which does this. Firstly, it
can decide to pay dividends to shareholders. This means other
shareholders may have interest in the firm, boosting the share price
and the level of investment, however it means they may have cash
flow problems in the short term. The other option is to retain the
profits and put them straight back into the business. This will not
satisfy shareholders as much, but depending on the firms financial
position, may be necessary. It can also be used to buy back shares,
meaning in future it pays fewer dividends.
Using Financial Accounts to Assess Business

Performance

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The balance sheet and income statement provide much useful

information for a user of accounts to better understand how the
business is doing. Some useful analytical tasks would include:
Comparing performance over time:
A danger with just looking at one years results is that the numbers
can hide a longer term issue in the business. By looking at data over
several years, it is possible to see whether a trend is emerging.
Comparing performance against competitors or the industry as a
whole:
A comparison against competitors provides a useful way for
management and shareholders to assess relative performance. Has
the business revenues grown as fast as close competitors? How has
the business performed compared with the market as a whole?
Benchmarking against bestinclass businesses:
Comparison against other businesses who are not direct competitors
can also be useful particularly if they help set the standard that
the business aims to achieve. Care has to be taken with this,
though. The benchmark business might operate in a very different
industry, with significantly different profit margins and balance
sheet norms.
Strengths and Weaknesses of Financial Data

Some valuations are partially
Balance Sheet has been designed
to help people judge a companys

performance can assess size, net
assets, liquidity position and
sources of capital of a firm.
Income Statement can help
calculate a firms profit level,

assess whether or not to buy
shares, look at profit quality and
how profit is being used.
Stakeholders can expect regular
and accurate data

Published accounts are checked by
independent auditors
subjective
Different accounting methods can
be employed
Accounts show what has happened
rather than why
Published accounts focus on
profitability/liquidity and ignore
other objectives that may be
important to a business
A firms financial situation changes
daily, and can be manipulated to
provide a favourable view on the
day they were prepared window
dressing
There are strengths and weaknesses involved in using a firms

financial data to judge performance. They are based on the

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accuracy of the data as a measure of current performance and
potential performance.
Interpreting Published
Accounts
Financial information is always prepared to satisfy in some way the
needs of various interested parties (the "users of accounts").
Stakeholders in the business (whether they are internal or external
to the business) seek information to find out three fundamental
questions:
1. How is the business trading?
2. How strong is the financial position?
3. What are the future prospects for the business?
For outsiders, published financial accounts are an important source
of information to enable them to answer the above questions. To
some degree or other, all interested parties will want to ask
questions about financial information which is likely to fall into one
or other of the following categories, and be about:
Performance Area
Profitability
Financial Efficiency
Liquidity and Gearing
Key Issues
Is the business making a profit?
How efficient is the business at
turning revenues into profit?
Is it enough to finance
reinvestment?
Is it growing?
Is it sustainable (high quality)?
How does it compare with the
rest of the industry?
Is the business making best use
of its resources?
Is it generating adequate
returns from its investments?
Is it managing its working
capital properly?
Is the business able to meet its
shortterm debts as they fall
due?
Is the business generating
enough cash?
Does the business need to raise
further finance?
How risky is the finance

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structure of the business?
Shareholder Return
What returns are owners

gaining from their investment
in the
business?
How does this compare with
similar, alternative investments
in
other businesses?
Profitability Ratios
Return On Capital Employed (ROCE):
This ratio shows the operating profit as a percentage of the capital
employed. Operating profit is considered to be the best measure of
performance, as it focuses only on the businesses main trading
activities. It also can be used to compare between firms overseas,
as it is profit before tax, meaning various tax rates in different
countries are not considered.
ROCE ( ) =
operating profit profit before tax

100
total equity+ non current liabilities
With ROCE, the higher the percentage figure, the better. The figure
needs to be compared with the ROCE from previous years to see if
there is a trend of ROCE rising or falling. Generally, ROCE tend to be
10-15%, however anything above interest rates is usually deemed
acceptable.
It is also important to ensure that the operating profit figure used for
the top half of the calculation does not include any exceptional
items which might distort the ROCE percentage and comparisons
over time.
To improve its ROCE a business can try to do two things:
Improve the top line (i.e. increase operating profit) without a

corresponding increase in capital employed, or
Maintain operating profit but reduce the value of capital
employed
Gearing
Gearing focuses on the capital structure of the business that
means the proportion of finance that is provided by debt relative to

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the finance provided by equity (or shareholders). It measures the
proportion of assets invested in a business that are financed by
longterm borrowing.
In theory, the higher the level of borrowing (gearing), the higher the
risks to a business, since the payment of interest and repayment of
debts are not "optional" in the same way as dividends. However,
gearing can be a financially sound part of a business's capital
structure, particularly if the business has strong, predictable cash
flows.
Gearing ( )=
noncurrent liabilities
100
total equity +noncurrent liabilities
A business with a gearing ratio of more than 50% is

traditionally said to be highly geared.
A business with gearing of less than 25% is traditionally
described as having low gearing
Something between 25% 50% would be considered normal
for a wellestablished business which is happy to finance its
activities using debt.
Liquidity Ratios
Two liquidity ratios the current ratio and the acid test ratio are
used in order to assess the ability of a firm to meet its short-term
liabilities.
Although profit is the main measure of company success, firms can
be vulnerable to cash-flow problems, so the ability of a firm to meet
its immediate payments is a key test.
Solvency the ability of a firm to pay its debts on time.
Current Ratio:
This is a simple measure that estimates whether the business can
pay debts due within one year out of the current assets. A ratio of
less than one is often a cause for concern, particularly if it persists
for any length of time.
The formula for the current ratio is:
Current R atio=
Current Assets
Current Liabilities
A current ratio of around 1.72.0 is pretty encouraging for a

business. It suggests that the business has enough cash to be able
to pay its debts, but not too much finance tied up in current assets
which could be reinvested or distributed to shareholders.

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A low current ratio (say less than 1.01.5) might suggest that the
business is not well placed to pay its debts. It might be required to
raise extra finance or extend the time it takes to pay creditors.
Acid Test:
Not all assets can be turned into cash quickly or easily. Some
notably raw materials and other stocks must first be turned into
final product first. This ratio therefore adjusts the Current Ratio to
eliminate certain current assets that are not already in liquid form.
Since inventories are assumed to be the most illiquid part of current
assets, they are removed from the current assets total.
The formula for the acid test ratio is:
Acid Test =
Curent AssetsInvetories
Current Liabilities
Some care has to be taken interpreting the acid test ratio. Around
1:1 ratio is standard, however the value of inventories a business
needs to hold will vary considerably from industry to industry (e.g.
selling fresh cakes or selling cars).
A good discipline is to find an industry average and then compare
the current and acid test ratios against for the business concerned
against that average.
Financial Efficiency Ratios

Financial Efficiency ratios measure the efficiency with which a
business manages specific assets and liabilities. They allow the
business to scrutinise the effectiveness of certain areas of its
operation.
Receivables Days
The debtor days ratio focuses on the time it takes for trade debtors
to settle their bills. The ratio indicates whether debtors are being
allowed excessive credit. A high figure (more than the industry
average) may suggest general problems with debt collection or the
financial position of major customers.
The formula to calculate debtor days is:
Receivables Days=
Receivables
365
Revenue
The average time taken by customers to pay their bills varies from
industry to industry, although it is beneficial for all firms to have a

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minimum debtor days ratio. It is often compared against the firms
Payables Days ratio.
Among the factors to consider when interpreting debtor days are:
The industry average debtor days needs to be taken into account
A business can determine through its terms and conditions of sale
how long customers are officially allowed to take
There are several actions a business can take to reduce debtor
days, including offering earlypayment incentives, aged-debtor
analysis or by using invoice factoring
Payables Days
Payables Days is a similar ratio to debtor days and it gives an insight
into whether a business is taking full advantage of trade credit
available to it. It estimates the average time it takes a business to
settle its debts with trade suppliers. As an approximation of the
amount spent with trade creditors, the convention is to use cost of
sales in the formula which is as follows:
Payables Days=
Payables
365
Cost of Sales
In general a business that wants to maximise its cash flow should

take as long as possible to pay its bills. However, there are risks
associated with taking more time than is permitted by the terms of
trade with the supplier. One is the loss of supplier goodwill; another
is the potential threat of legal action or latepayment charges. As an
average, 28 days is normally acceptable for receivables/payables
days, however varies significantly between industries.
Asset Turnover
This ratio considers the relationship between revenues and the total
assets employed in a business. A business invests in assets
(machinery, inventories etc) in order to make sales. A good way to
think about the asset turnover ratio is considering how effectively
the business is using its assets to generate revenue.
The formula for asset turnover is:
Asset Turnover=
Revenue
Net Assets
A high figure shows that the business is using its assets efficiently in
order to achieve sales revenue. A low figure shows its assets are not
being used efficiently.
Care needs to be taken with the asset turnover ratio. For example:
The number will vary enormously from industry to industry. A
capitalintensive business may have a lower asset turnover than
a labour intensive one

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The asset turnover figure for a specific business can also vary
significantly from year to year. For example, a business may
invest in new production capacity in one year but the extra
revenues might not arise until the following year
The asset turnover ratio takes no direct account of the
profitability of the revenues generated
Inventory Turnover
Stock turnover helps answer questions such as "have we got too
much money tied up in inventory"? An increasing stock turnover
figure or one which is much larger than the average for an industry
may indicate poor inventory management.
The stock turnover formula is:
Inventory Turnover=
Cost of Goods Sold

Average Inventories Held
Interpreting the stock turnover ratio needs to be done with some

care. For example:
Some industries necessarily have very high levels of stock
turnover.
Some businesses have to hold large quantities of stock to meet
customer needs. They may have to stock a wide range of
product types, brands, sizes etc
Stock levels can vary during the year, often caused by seasonal
demand. Care needs to be taken in working out what the
average stock held is
A business can take a range of actions to improve its stock turnover,
such as selling off slow-moving stock, using lean production/just-intime or rationalise product ranges. This ratio is irrelevant in some
industries such as many in the service sector.
Shareholder Ratios
A prime concern of shareholders is their return on investment. The
returns from investing in shares of a company come in two main
forms:
1. The payment of dividends out of profits
2. The increase in the value of the shares (share price) compared
with the price that the shareholder originally paid for the
shares
Dividend per Share

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One very straightforward shareholder ratio is dividend per share.
This shows the value of the total dividend per issued share for the
financial year.
The formula for dividend per share is:
Dividend per Share=
total dividends paid

number of shares issued
An ordinary shareholder would probably be pleased with a higher

dividend per share as possible, however some with a large interest
in the firm may wish for it to retain profits for future growth and
therefore more dividends in the future.
The problem with this ratio is that it lacks context. We dont know:
a) How much the shareholder paid for the shares i.e. what the
dividend means in terms of a return on investment
b) How much profit per share was earned which might have been
distributed as a dividend
Dividend Yield
The dividend yield builds on the dividend per share by expressing it

as a percentage of the current market price of the shares. This way,
you can see the return and compare it to other investments, bank
interest rates and other firms.
Dividend Yield ( )=
divident per share

100
market price per share
Value and limitation of ratio analysis

The main strength of ratio analysis is that it encourages a
systematic approach to analysing performance. However, it is also
important to remember some of the drawbacks of ratio analysis:
Ratios deal mainly in numbers they dont address issues like
product quality, customer service, employee morale which may
ignore corporate objectives
Ratios largely look at the past, not the future.
Ratios are most useful when they are used to compare
performance over a long period of time or against comp - this
information is not always available
Financial information can be subject to window dressing
External factors need to be considered when drawing any
conclusions from these ratios
They show what happened rather than why
Selecting Financial Strategies

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Raising Finance
Cash is vital to any business and once a business is established it
often faces the challenge of raising finance to support expansion. A
good way to look at the financeraising options for a business is to
categorise them into sources which are from within the business
(internal) and from outside providers (external).
Internal Sources of Finance
The main internal sources of finance for an established business are:

Retained profits
Reductions in working capital

Disposal of assets / sale & leaseback
Retained Profits:
Retained profit is by some way the most important and significant
source of finance for an established profitable business. When a
business makes a net profit, the owners have a choice: either
extract it from the business by way of dividend, or reinvest it by
leaving profits in the business. Some of the retained profit might be
in the bank; some might be spent on additional plant & machinery;
perhaps some are reinvested in more inventories or used to reduce
overdrafts or loans. The total value of retained profits in a company
can be seen in the equity section of the balance sheet.
No interest charges, so they are cheap (though not free)
opportunity cost
They are very flexible management have complete control
over how they are reinvested and what proportion is kept
rather than paid as dividends
They do not dilute the ownership of the company
They restrict the value of dividends
Opportunity Cost
Can be said to hoard too much cash in the business
If retained profits don't result in higher profits, there is the
argument that shareholders could make better returns by
having the cash for themselves
Reduction in Working Capital:
Some businesses undoubtedly operate with excess inventories and
trade debtors. More efficient management of these current assets
can release cash. However, a reduction in working capital has to be
sustainable for it to become a longterm source of finance.
In most cases, a business that is growing will find that it has to
finance an increase in working capital over the longerterm (i.e. net
current assets will have to grow).

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Sale / Sale & Leaseback of Assets:

Selling noncurrent assets such as spare land and buildings or
redundant plant & equipment can result in a oneoff cash inflow.
However it is unlikely to be a longterm solution for a business that
needs to raise significant finance.
Asset disposals often occur when management grow the business
through acquisitions. The business they buy may have excess assets
which can be sold, or fixed assets become redundant when the
acquired businesses are merged into fewer locations.
The sale will give an immediate injection of cash into the
company
Can help when retrenching or when you have excess capacity
A one-off source of finance
If leasing back, you may end up paying more than you would
have if you had have kept the asset
External Sources of Finance

There are many ways for a larger business to raise finance from
external providers. The main methods are outlined below.
Selling Shares:
Both private and public companies can raise finance by selling new
shares in the company. Ordinary Share Capital is money given to a
company by shareholders in return for a share certificate that gives
them part ownership of the company and entitles them to a share of
the profits.
Scope for lots of investment no limit on the amount
Can add value to the company if share prices increase
Need to pay more dividends
Lose control of part of the company
Loan Capital:
The three main methods of raising loan capital are:
Bank overdrafts
Bank loans
Debentures
Bank Overdrafts are when a bank allows an individual or
organisation to overspend its current account in the bank up to an
agreed (overdraft) limit for a stated period of time. Interest is paid
per day you are overdrawn.
Bank Loans are sums of money provided by a bank for a specific,
agreed purpose. Interest rates can fluctuate and banks will need
proof of ability to repay the loan.

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Debentures are a longterm source of finance. A debenture is a form
of bond or longterm loan which is issued by the company. The
debenture typically carries a fixed rate of interest over the course of
the loan.
Cost Minimisation
Cost minimisation aims to achieve the most costeffective way of
delivering goods and services to the required level of quality. For
this reason, it is vital to have communication with all departments
when undertaking cost minimisation to ensure they are not
adversely affected.
Popular sources of cost reductions in a wellestablished business
include:
Eliminating waste & avoiding duplication (lean production)
Simplifying processes and procedures
Outsourcing noncore activities (e.g. payroll administration, call
handling)
Negotiating better pricing with suppliers
Using the most effective methods of training and recruitment
Introducing flexible working practices to better match
production and demand
Actions aimed at minimising costs need to be taken with care. The
danger is that overaggressive pruning of overheads, using cheaper
raw materials or cutting pay rates might have a adverse effect on
quality and customer service.
Also, the business can be left with insufficient capacity to handle
unexpected or shortterm increases in demand and cost reductions
by one department may surprise and/or annoy other functions if
they are not properly communicated and coordinated.
Profit Centres
A popular approach to managing financial performance in a multi
site or multilocation business is to use profit centres. A profit centre
is a separatelyidentifiable part of a business for which it is possible
to identify revenues and costs (i.e. calculate profit).
Examples of profit centres would include individual shops in a retail
chain, local branches in a regional or nationwide distribution
business, a geographical region or a team or individual (e.g. a sales
team)
Provides insights into
exactly where profit is
earned
Supports budgetary control
Can be timeconsuming to
both setup and monitor
Difficulties in allocating
costs

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Can improve motivation of
those responsible
Comparisons can be made
between similar profit
centres
Improves decisionmaking
at a local level (likely to be
closer to customer needs)
Finance can be allocated
more efficiently where it
makes the best return
May lead to conflict and

competition
Potentially demotivating if
targets are too tough or if
cost allocations are unfair
Profit centres may pursue
their own objectives rather
than those of the broader
business
Making Investment Decisions

If a business wishes to grow, it needs to invest. The cash spent on
investment in a business is normally referred to as capital
expenditure. This can be contrasted with spending on daytoday
operations (e.g. paying for materials, staff costs) which is known as
revenue expenditure.
The distinction between capital and revenue expenditure is that
capital expenditure is on noncurrent assets which have an
economic life in the business they are intended to be kept, rather
than sold or turned into products.
There are several reasons why a business needs to invest in capital
expenditure:
To add extra production capacity
To replace wornout, broken or obsolete machinery and
equipment
To support the introduction of new products and production
processes
To implement improved IT systems
To comply with changing legislation & regulations
Investment Appraisal is a quantitative, scientific approach to
investment decision making, which investigates the expected
financial consequences of an investment, in order to assist the
company in its choices.
There are several methods available which help management make
the decisions about which projects to invest in, which are described
and illustrated further below:
Payback
Net Present Value (NPV)

Average Rate of Return (ARR)

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Payback
The payback period is the time it takes for a project to repay itself
from the net return provided by the investment, and is usually
measured in terms of years and months.
Simple and easy to calculate +
Ignores cash flows which arise
easy to understand the results/
after the payback has been
compare projects
reached Doesnt consider the
Focuses on cash flows good for
time value of money
use by businesses where cash is
May encourage shortterm
a scarce resource
thinking
Emphasises speed of return; may
Ignores qualitative aspects of a
be appropriate for businesses
decision
subject to significant market
Does not actually create a
change
decision for the investment
To work out the payback period, the cash flow and cumulative cash
flow needs to be looked at. Using the cash flow column, you can
work out which year the cumulative cash flow goes from a positive
value to a negative one. In this year, the project has paid for itself.
In payback calculations, it is assumed that costs and income occur
at regular intervals throughout the year. Therefore in the year that
an investment pays for itself, the net return over the year is split up
into the 52 weeks over which it is earned. You then work out how
many weeks it takes to pay off the remained of the outstanding loss
caused by the investment.
Net Present Value (NPV)

-
the net return on an investment when all revenues and costs

have been converted to their current worth
Offered the choice of 100 now or 100 in one years time, most
rationale people would opt to receive the 100 now. This is because
you could invest the 100 in a savings account and get interest on
the investment the opportunity cost of money (time value of
money).
NPV recognises that there is a difference in the value of money over
time.
In effect, cash flows received earlier in an investment project are
considered to be worth more than those received in the future. You
could use the interest rate which could be obtained on saving or
compare it to profit that could be made off an alternative
investment when deciding what discount factors to use.
When you have discounted the projected cash flow, you can
calculate the cumulative cash flow. After x amount of years, if the
NPV is positive, the project is financially worthwhile, whilst if it is
negative, it is not. NPV gives a definite recommendation.
Takes account of time value
of money, placing emphasis
More complicated method

users may find it hard to

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on earlier cash flows
Looks at all the cash flows
involved through the life of
the project
Has a decisionmaking
mechanism reject projects
with negative NPV
understand
Difficult to select the most
appropriate discount rate
may lead to good projects
being rejected
The NPV calculation is very
sensitive to the initial
investment cost
Average Rate of Return (ARR)

-
total net returns divided by the expected lifetime of the

investment, expressed as a percentage of the initial cost
Firms want to achieve as high a percentage return as possible. A

benchmark that is often used to see if the ARR is satisfactory is the
interest rate that the firm must pay on any money borrowed to
finance the investment. If the percentage return on the project
exceeds the interest rate that the business is paying, the project is
financially worthwhile.
total net return
no . of years
ARR ( )=
100
Initial Cost
ARR provides a percentage return
which can be compared with a
target return
ARR looks at the whole profitability
of the project
Focuses on profitability a key issue
for shareholders
Does not take into account cash

flows only profits (they may not be
the same thing)
Takes no account of the time value
of money
Treats profits arising late in the
project in the same way as those
which might arise early
Evaluating Investment Appraisal

Given the range of investment appraisal methods and the need for a
business to allocate resources to capital expenditure in an
appropriate way, what key factors do management need to consider
when making their investments?
The key issues to consider are:
Risks and uncertainties
All business investments involve some level of risk. An investment
needs to earn a return that compensates for the risk.
The risk of a capital investment will vary according to factors such
as:
Risk
Length of the
project
Issue
The longer the project, the greater the risk
that estimated revenues, costs and cash
flows prove unrealistic

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Source of the data
Is the data used reliable and accurate?
The size of the

investment
The more capital invested, the higher the

risk of a project
The economic and

market
environment
Most projects will make assumptions about

demand, costs, pricing etc which can
become inaccurate through changing market
and economic conditions
The experience of
the management
team
A project in a market in which the

management team has strong experience is
a lowerrisk proposition than one in which
the business is taking a step into the
unknown!
Qualitative influences
An investment decision is not just about the numbers. A
spreadsheet calculation for NPV or ARR might suggest a particular
decision, but management also need to take account of qualitative
issues such as:
The impact on employees
Product quality and customer service
Consistency of the investment decision with corporate objectives
The business brand and image, including reputation
Implications for production and operations, or disruption to the
existing setup
A business responsibilities to society and other external
stakeholders
Quantitative influences
The investment appraisal comes up with a result, but how is a
decision made?
Many firms set investment criteria against which they judge
investment projects.
The use of investment criteria is intended to help guide
management through these decisions and address the potential
conflicts, however because there is so much risk involved with the
accuracy of forecasts, it is difficult to be very certain with any
quantitative method used.

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