3.5.1 Setting financial objectives

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    3.5.1 Setting financial objectives

    The value of setting financial objectives

    Financial Objective = a specific goal or target relating to financial performance

     

    What objectives can be based on:

    • Revenue
    • Costs
    • Profit
    • Cash flow
    • Investment levels
    • Capital structure
    • Return on investment
    • Debt as a proportion of long term funding

     

    Benefits of setting financial objectives:

    • Provides a focus for the business as a whole
    • Focus for decision making and effort
    • Can measure success and failure
    • Reduces the risk of business failure (particularly prudent cash flow objectives)
    • Improved coordination (of the different business functions) and efficiency
    • Information for shareholders – priorities of management
    • Allows external stakeholders to confirm financial viability
    • Provides a target to help make investment decisions

     

    Difficulties of setting financial objectives:

    • Not always realistic
    • External changes
    • Difficulty in measuring
    • May conflict with other objectives
    • Responsibility may lie with finance department, when it is a whole business priority

     

    Return on Investment (ROI) = this is the measure of efficiency of an investment in financial terms, used to compare the financial returns of alternative investments

    • = return on investment / cost of investment x 100 (return on investment = financial gains from the investment – cost of investments)
    • From the returns on investments, firms should be able to consider financial returns, trends in financial performance, changing levels in return

     

    The distinction between cash flow and profit

    Profit = revenue – total costs

    Cash Flow = the money flowing in and out of the business on a day to day basis

    • This is essential to prevent a firm from becoming insolvent (when a business can no longer pay its debts off)
    • Net Cash Flow = this is the money left over when a business takes its outflows from its inflows

     

    Main cash inflows:

    • Money invested by business owners
    • Loan from the bank
    • Income from sales

     

    Main cash outflows:

    • Wages and training
    • Raw materials
    • Advertising
    • Rent, mortgage, and bills
    • Taxes
    • Interest on loans
    • Maintenance and repair

     

    The distinction between gross profit, operating profit, and profit for the year

    Gross Profit = this shows how efficiently a business converts raw materials into finished goods and how much value they add

    • = revenue – cost of sales

    Operating Profit (Net Profit) = gross profit – expenses

    Profit for the Year = this is the profit available to shareholders and it includes the sale of assets, interest payments, and tax

     

    Revenue, costs, and profit objectives

    Revenue objectives:

    • Sales maximisation – volume/value
    • Targeting a specific increase in sales revenue
    • Exceeding the sales of a competitor
    • Revenue growth (% or value)
    • Market share

     

    Cost objectives:

    • Cost minimisation – this could be in terms of unit cost which are then further linked to efficiency, labour productivity, and capacity utilisation
    • Productivity – in terms of unit per worker and capacity utilisation

     

    Profit objectives:

    • Specific level of profit (in absolute terms)
    • Rate of profitability (as a % of revenues)
    • Profit maximisation
    • Exceed industry or market profit margins

     

    Cash flow objectives

    Why cash flow is important:

    • It can be used to support an application for sources of finance
    • If a business does not have enough cash available to pay its bills it could fail
    • A business that is not able to pay its suppliers will probably not receive any more supplies
    • It may be unable to pay its workers, which will at the very least cause demotivation, and encourage them to leave, at worst
    • It is the main cause of failure of small businesses
    • The principle of timing, managing when money flows in and when it flows out is vital

     

    Setting cash flow objectives:

    • This will ensure the firms can keep trading
      • Maintain a minimum closing monthly balance
      • Reduce bank overdraft by a certain amount by the end of the year
      • Create a more even spread of sales revenue
      • Spread costs more evenly
      • Setting contingency fund levels

     

    Cash flow objectives:

    • Maximum level of debt (the absolute amount, rather than the gearing ratio)
    • Amount of cash tied up in working capital (inventories, receivables)
    • Cash flow to profit %

     

    Advantages of cash flow forecasts:

    • Identify problems in advance
    • Guide to appropriate action
    • Make sure there is sufficient cash to make payments
    • Evidence for financial support
    • Avoids failure
    • Identifies if they are holding too much cash

     

    Causes of cash flow problems:

    • Poor management (spending too much)
    • If the business isn’t performing well – the outflows are greater than inflows
    • Offering customers too long to pay – slow cash inflow compared to outflow

     

    Problems to forecasting:

    • Changes in the economy
    • Changes in consumer taste
    • Inaccurate market research
    • Competition
    • Uncertainty

     

    Objectives for investment (capital expenditure) levels

    Investment objectives:

    • Replacement capital/investment – to replace assets that have depreciated (this does not add to the stock of capital goods)
    • New investment – money spent on new capital goods which enables a business to increase its capacity to produce
    • Level of capital expenditure – at either an absolute amount (e.g. invest £5m per year) or as a percentage of revenues (e.g. 5% of revenues)
    • Return on investment – usually set as a target % return, calculated by dividing operating profit by the amount of capital invested

     

    Capital structure objectives

    Capital Structure = to the balance of its finance in terms of how much is equity (or share capital) and how much is is in the form of debt

    • This is about how a business is funded in the long term through debt capital, equity capital, and debentures

     

    Capital structure objectives:

    • Gearing ratio (the percentage of total business finance that is provided by debt)
    • Debt/equity ratio (the proportion of business finance provided by debt and equity)

     

    External and internal influences on financial objectives and decisions

    Internal influences on financial objectives:

    • Business ownership – the nature of business ownership has a significant impact on financial objectives. A venture capital investor would have quite a different approach to a long-standing family ownership.
    • Size and status of the business – (e.g. start-ups and smaller businesses tend to focus on survival, breakeven and cash flow objectives. Quoted multinational businesses are much more focused on growing shareholder value)
    • Other functional objectives – almost every other functional objective in a business has a financial dimension – which often brings the finance department into conflict with other functions

     

    External influences on financial objectives:

    • Economic conditions – economic downturn can force many firms to reappraise their financial objectives in favour of cost minimisation and so they can maximise their cash inflows and balances. Significant changes in interest rates and exchange rates also have the potential to threaten the achievement of financial targets like ROCE.
    • Competitors – competitive environment directly affects the achievability of financial objectives (e.g. cost minimisation may become essential if a competitor is able to grow market share because it is more efficient)
    • Social and political change – this is often an indirect impact (e.g. legislation on environmental emissions or waste disposal may force an business to increase investment in some areas, and cut costs in others)

     

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