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453Fianancial Management & International Finance

Study Note - 5

FINANCIAL STRATEGY

5.1 Understanding Financial Strategy

INTRODUCTION :

Financial strategy is a topic of importance to middle and senior line managers, who face regu-larly a multiplicity of financial issues in their organisation. A sound financial strategy seeks toanswer :

a. How does a Chief Financial Officer (CFO) determine the long-term target capitalstructure?

b. When to form holding and subsidiary structure or branch offices or subsidiariesoverseas?

c. When and how should a company go public ?

d. Is it better to take a company private in a leveraged buyout or to borrow money andrepurchase stock?

e. Can a CFO use derivatives in structuring acquisitions and share buybacks?

f. How does a CFO benefit out of doing business in other countries?

g. Above all, how can a CFO make sure that everyone in the company contributes tothe common objective of maximising shareholder value?

h. How much should one pay for a company ?

i. What is the best way to fight a hostile bid ?

FINANCIAL STRATEGY, NEEDS :

Strategic financial decisions are based on rigorous cash-flow forecasts, together with accurateestimation and management of risk. It focuses on shareholder value creation, explore ways ofincreasing that value both real and perceived through :

a. astute choice of financing methods

b. financial restructuring, such as recapitalisations, share buybacks and leveragedbuyouts

Financial Strategy, needs

Best Practices in Creating a Strategic Finance Function

Checklist for a Strategic Function

This Section includes :

http://success-gurus.blogspot.com


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Fianancial Management & International Finance454

COST-VOLUME-PROFITCOST-VOLUME-PROFITCOST-VOLUME-PROFITCOST-VOLUME-PROFITCOST-VOLUME-PROFIT

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Financial Strategy

c. asset restructuring, such as takeovers, mergers and acquisitions, spin-offs and equitycarve-outs

d. credible and compelling communication with shareholders

e. developing a strong culture where all decision makers are motivated to create value

f. understanding how to increase the value of the company by appropriate investment

g. developing knowledge about the financial markets particularly how the marketsperceive the CFOs decisions and how CFO can change their perceptions

h. appreciating the financial strategy issues that affect the organisation.

i. undertaking financial analysis of the organisation and interpreting the results inthe context of lending and investing decisions.

j. assessing the financial risks that the organization faces, in particular credit, interestand foreign exchange risk and adopting risk-hedging strategies that suit the risk

profile of the organisation.

k. understanding how the organization should measure financial performanceinternally and how the financial performance is assessed by stakeholders in a globalcontext.

l. Benchmarking strategies with competitors in Industry globally without restrictingComparisons to only local players.

BEST PRACTICES IN CREATING A STRATEGIC FUNCTION :

In the wake of recent accounting scandals and in the increasingly competitive business

environment, many CFOs and the finance organizations they lead have started to take on newstrategic roles within the enterprise. They are aiming at enforcing stricter control processes toensure legal and regulatory compliance, offering strategic insights into the internal and external

business environment, and connecting the business strategy with daily operations throughperformance tracking.

The trend toward a more strategic role is echoed by the responses of participants in recentresearch conducted by APQC, an internationally recognized nonprofit organization thatprovides best-practice research, metrics, and measures. The participants indicated that, threeyears down the road, they anticipate spending 30% more time on decision support andmanagement. According to the same research, however, in spite of their aspirations, participants

have not made much progress toward a greater strategic role. Finance organizations, no matterwhat their size, report to APQC that they still spend almost two-thirds of their time ontransaction processing and controls and only one-third on decision support and management.

The difficulty in evolving the finance role lies in bridging the current gap between the financefunction that emphasizes greater efficiency and the finance function that becomes a partner inmanaging the business. The best companies have found that reaching the goal of a more strategicfinance function warrants a two-step approach, as follows:



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1. These companies improve the efficiency of the various functions that come under the financeumbrella and, in the process, free up corporate resources for other activities. As one globaltreasury manager put it, We must develop a finance function that is as efficient as it can

be, replicate it globally, and then use it effectively to help us quickly establish brands and

enter new markets. Companies like this one choose a variety of approaches to streamlineand automate finance functions while ensuring that they keep customers happy (in the

case of shared-services arrangements).

2. With the efficiency of the transaction and control functions assured, these companies canturn to devising a more strategic approach for finance giving finance not only more of adecision-making responsibility in risk management and compliance but also a proactiverole in managing the daily cash position and thus increase resources for quick strategicmoves.

One global consumer products company took a two-step approach to a more strategic path forfinance. In the first step, the company developed a more efficient cash management, accountspayable, and accounts receivable group of functions in its worldwide operations, based ongreater transparency of information. In the second step, the company developed

straight-through processing along every level of the finance function, leveraging its globalreach to maximize cash management efficiency, foreign exchange exposure, and the globalsupply chain to help fund growth, participate in new marketing and distribution arrangements,and comply with worldwide regulations.

CHECKLIST FOR A STRATEGIC FINANCE FUNCTION :

The best companies, and their CFOs, recognize the importance of ready access to the right

information to drive the right choices between different variables. To help determine whetheryour finance function is moving toward a strategic approach, take a moment and decide whetheryour system does the following:

Accelerates closing processes through automation, workflow, and collaboration

Improves business analysis and decision support by providing historical and forward-looking views, including benchmarks

Deploys performance management tools that analyze the company and its resources

Maximizes cash flow through improved billing, receivables, collections, payments, andtreasury management

Increases effectiveness of compliance efforts through comprehensive auditing, deeperreporting, and management of internal controls (Sarbanes-Oxley)

In addition, a truly integrated and systematic foundation should help any one to achieve the

following:

Develop a closed-loop management process of strategy formulation, communicationand measurement



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Financial Strategy

Monitor the performance of strategic key success factors using external and internalbenchmarks

Use tools that support a financial planning process that integrates global strategicplanning and specific operational planning problems in a closed-loop process

In a similar way, you can also determine whether you are on the right track if your financialsoftware provides the following:

A single source for financial information (a prerequisite for managing business processesbeyond financials, more effectively)

More timely access to accurate data, improving communication between finance andoperations

Increased alignment between front- and backoffice applications, enabling managementto better administer and track business strategy and decisions

Reduced cost of compliance with industry regulations (U.S. Financial AccountingStandards Board and Sarbanes-Oxley)

Improved security and controls and reduced risk of contractual and regulatorynoncompliance

Improved predictability, particularly with budget

One CFO admitted, Until we began to appreciate the importance of simplicity in thinkingthrough our finance function and making it more strategic, we did not realize the way thattechnology can help you deal with complexity, and allow you to achieve the strategic goalsfinance should achieve.

Are You a Strategic CFO?

As far as theyve come, many senior finance executives still have the nagging feeling that theycould be doing more.

Lisa Yoon, CFO.com

January 11, 2006

Bean counter. Numbers cop. Chief financial officers have long outgrown those stereotypes;today a more appropriate description might be business partner, strategist, first deputy to theCEO.

Yet as far as theyve come, many senior finance executives still have the feeling that they couldbe doing more. Dan Chenoweth, a Denver-based business consultant and former finance ex-ecutive, believes there are several reasons why finance chiefs dont always play a big enoughrole at the strategy table:

First is the lingering self-perception of being the reporter; some CFOs dont viewthemselves as a partner with the rest of the senior team.

Another reason is the famous finance-chief personality reserved, reactive, even pas-sive in the strategic-planning process.



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Finally, says Chenoweth, CFOs still tend to view their ultimate responsibility as fiduciary saving company funds and reining in spending rather than taking on the broaderrole of value creator.

That CFOs have these characteristics and self-perceptions is an increasingly invalid generali-

zation, maintains Steve Wasko, chief financial officer of Northbrook, Illinois-based NanosphereInc. He points to a shift in management philosophy from a model centered around the chiefexecutive, in which senior managers carried out the CEOs vision, to todays increasingly team-oriented approach, in which the CFO and other senior managers help shape the companysdirection and run the show.

Melissa Cruz, CFO of Waltham, Massachusetts-based BladeLogic, takes a more abstract view:The role of the CFO is about imagining the future with the management team, she explains,and then translating that into financial action.

Chenoweth does agree that there has been a profound change in the role of CFOs in recentyears, but adds that they could do more to blow their own horn at the strategy table.

Do you still see CFOs with green eyeshades? says Wasko. Absolutely. But companies thathave such CFOs are at a disadvantage.



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Financial Strategy

5.2 Financial and Non-Financial Objective of Different Organizations

INTRODUCTION :

It is not possible to manage what you cannot control and you cannot control what you cannotmeasure ! - Peter Drucker.

We consider the advantages and disadvantages of stakeholder-oriented firms that areconcerned with employees and suppliers as well as shareholders compared to shareholder-oriented firms. Societies with stakeholder-oriented firms have higher prices, lower output,and can have greater firm value than shareholder-oriented societies. In some circumstances,firms may voluntarily choose to be stakeholder-oriented because this increases their value.Consumers that prefer to buy from stakeholder firms can also enforce a stakeholder society.With globalization entry by stakeholder firms is relatively more attractive than entry byshareholder firms for all societies.

Inexorable change is the order of the day, and conventional theories and business practices arenot providing the necessary guidance and support for decision-making. Change in every aspect

and in the entire outlook is a constant factor. Business leaders are dissatisfied with the traditionalmeasurement tools as organizations today increasingly perform in real time environment. Newtools are being developed to measure the outcome of changes and their effective contribution

NEED FOR A RANGE OF PERFORMANCE MEASURES :

Measurement system of performance has to progress from being reactive to being proactiveand finally to be responsive, as the right metrics drive world class performance. Criteria ofsuccess are different from product to process, company perspective to stakeholder perspective,revenue to reputation and financial to non-financial.

The three roles of measurement are:

a. Effectiveness Are we doing the right things?

b. Efficiency Are we doing them well?

c. Excellence Are we doing them consistently, responsively to meet c h a n g i n grequirements

Why do we measure?

a. To know current status, degree of achievement and how far to go for ultimate goalsto be achieved;

Need for a range of Performance Measures

Financial Vs. Non-Financial Measures

Shareholders Impact of Non Financial Objectives




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b. For strategic alignments to communicate and reinforce messages to employees oncompany focus, direction and targets.

c. For strategic learning: to know what works and what does not work & to take betterdecisions:

to identify pockets of excellence practices and universalize them

to identify relationships between measures

measurement is the trigger for excellence in performance & continuous

improvement

Strategic Management control of cost

Organisational control is the process whereby an organisation ensures that it is pursuing

strategies and actions which will enable it to achieve its goals.

As to the selection of a range of performance measures which are appropriate to aparticular company, this selection ought to be made in the light of the companys strategicintentions which will have been formed to suit the competitive environment in whichit operates and the kind of business that it is. It is generally in line with the long termvision, mission and strategies of the company.

For example, if technical leadership and product innovation are to be the key source of

a manufacturing companys competitive advantage, then it should be measuring itsperformance in this area relative to its competitors. If a service company decides todifferentiate itself in the marketplace on the basis of quality of service, then, amongstother things, it should be monitoring and controlling the desired level of quality. The

focus thus lies on quality and not just volume at any cost or price.

Whether the company is in the manufacturing or the service sector, in choosing an

appropriate range of performance measures it will be necessary, however, to balancethem, to make sure that one dimension or set of dimensions of performance is notstressed to the detriment of others. While most companies will tend to organise theiraccounting systems using common accounting principles, they might differ widely inthe choice, or potential choice, of performance indicators.

Authors from differing management disciplines tend to categorise the various

performance indicators that are available as follows:

competitive advantage flexibility

financial performance resource utilisation

quality of service innovation

These six generic performance dimensions fall into two conceptually different catego-

ries. Measures of the first two reflect the success of the chosen strategy, i.e., ends orresults. The other four are factors that determine competitive success, i.e., means ordeterminants.



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Financial Strategy

Another way of categorising these sets of indicators is to refer to them either as up-

stream or as downstream indicators, where, for example, improved quality of serviceupstream leads to better financial performance downstream.

Table 1. Upstream Determinants and Downstream Results

Performance Dimensions Types of Measures

Competitiveness Relative market share and position Salesgrowth, Measures reg customer base

Financial Performance Profitability, Liquidity, Capital Structure,Market Ratings, etc.

Quality of Service Reliability, Responsiveness, Appearance,Cleanliness, Comfort, Friendliness, Communication,Courtesy, Competence, Access, Availability, Security etc.

Flexibility Volume Flexibility, Specification and Speed

of Delivery FlexibilityResource Utilisation Productivity, Efficiency, etc.

Innovation Performance of the innovation process, Performance of individual innovations, etc.

Source: Performance Measurement in Service Businesses by Lin Fitzgerald, Robert Johnston, Stan

Brignall, Rhian Silvestro and Christopher Voss, page 8.

FINANCIAL VS. NON-FINANCIAL MEASURES :

In many companies across the world, the familiar way is to view everything in terms of thebottom line. In this sort of corporate environment, financial indicators remain the fundamental

management tool and could be said to reflect the capital markets obsession with profitabilityas almost the sole indicator of corporate performance. Opponents of this approach suggestthat it encourages management to take a number of actions which focus on the short term atthe expense of investing for the long term. It results in such action as cutting back on R & Drevenue expenditure in an effort to minimise the impact on the costs side of the current yearsP & L, or calling for information on cost benefit on expenses at too frequent intervals so as to besure that targets are being met, both of which actions might actually jeopardise the companysoverall performance rather than improve it.

Presently, there is a realization among managers that because of the pre-eminence of moneymeasurement in the commercial world, the information derived from the many stages preced-ing the preparation of the annual accounts, such as budgets, standard costs, actual costs andvariances, are actually just a one dimensional view of corporate activity. Increasingly, a largenumber of managers have recognized in recent years that a big part of a companys true valuedepends upon intangible factors such as organizational knowledge, customer satisfaction, prod-uct innovation and employee morale, rather than on physical assets like machinery or realestate. While companies recognize the importance of these intangible factors, understandingand measuring their role in value creation poses a formidable challenge. Human resourcesdepartments may know how to tabulate payroll for a certain plant, for instance, but if asked to



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measure the motivation of its employees, they would probably be on uncertain ground. Andyet, employee motivation and turnover are as crucial to that plants profitability as the size ofits payroll. That is the reason, employees are now called as resources and the personnel de-partment is called as human resources department.

Companies attach high value to financial performance. One reason could be that businesseshave been tracking such performance longer than they have been trying to monitor how theyare doing in areas such as employee satisfaction. Still, despite the importance of financial per-formance, executives ranked four other areas as being more important for future value genera-tion: Employee satisfaction, supplier performance, product innovation and customer satisfac-tion.

The ability to manage alliances is seen as another crucial driver of future value. There aremassive gaps between what executives believe are key drivers of future economic value andtheir organizations ability to measure performance in these areas. The biggest gap is in thecustomer category, which indicates that companies are still wrestling with ways to measurecustomer loyalty and satisfaction. Companies are also giving more weightage to assess howwell they are managing alliances and fostering employee satisfaction as executives believe that

both these areas are crucial drivers of future value.

Unless organizations come to grips with these issues, its performance measures will fail tosupport its strategic objectives. Lack of good performance measures, could fail a good strategy.Besides, if companies track their performance in these key areas, this could lead to more de-pendable disclosure of their future prospects. It has also been found that with higher transpar-ency and disclosure, the companys cost of capital could go down due to reduced risk forinvestors.

Stakeholders of an organization

Few people would argue with the idea that commercial businesses aim to make profits andthat decisions in these businesses are focused around how best to achieve this objective. Thedesire to be profitable need not, however, be all embracing and in practice it can be seen thatcompanies are likely to pursue a wide range of objectives, which are both financial and non-financial in nature.

The first thing to note is that the suggestion that companies seek to make profits is a littleimprecise. Does this mean that profit is sought at all costs, that maximising profit is the soleaim, or that managers/owners are happy with a specific satisfactory level of profit? Theexact answer will vary between businesses, as the priorities of owners and managers differ,

but it is possible to establish some basic guidelines.

It is useful to remember that although a company is a separate entity in the legal sense, inreality it is made up of a collection of individuals and interest groups, all of whom have per-sonal objectives to fulfil. Management will constantly be trying to balance the return to thesegroups e.g., shareholders or employees and discussion on corporate objectives really comesdown to a compromise which takes account of what the different groups are seeking. Conse-quently some objectives may be financial in nature, such as a rise in earnings per share, whilstothers will be non-financial e.g., shorter working hours, or an increase in the level of wasterecycling in a manufacturing process.



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Financial Strategy

A useful starting point for analysing non-financial objectives, is to specify the variety of stake-holders which may seek to influence company objectives, because they are affected by acompanys operations. The list includes:

Equity investors In other words the owners of the business, who will be looking for a decent

financial return on their investment.Creditors This group will want to ensure that the business maintains the liquidity at reason-able level required to repay its dues on time.

Customers Who will be concerned about product/service quality, price adherence to deliv-ery schedule.

Employees Improved working atmosphere and conditions of work will be important to thisgroup and so they may have a mix of financial and non-financial concerns.

Managers Whose personal objectives may to some extent conflict with those of the owners.For example, a manager may seek to increase staff levels, as a way of increasing his personal

status, but this may be lead to reduced profits.The community at large Communities are affected by company activities in a number ofways such as the use of land in a local area, the potential for pollution from effluents, commer-cial sponsorship of community projects and the impact of business activity on local transportsystems. Corporate Social Responsibility (CSR) is very important for each company to fulfill itssocial obligations.

Government, both Central State, are interested in higher tax revenues from the corportes sothat the Government can project a better budget estimates and actuals.

Faced with such a broad range of interest groups, managers are likely to find that they cannotsimultaneously maximise profits and the wealth of their shareholders whilst also keeping all

the other parties happy. In this situation, the only practical approach is to try and work tosatisfy the various objectives rather than maximise any individual one. Adopting such a strat-egy means, for example, that the company might earn a satisfactory return for its shareholders,whilst at the same time paying reasonable wages to satisfy employees, and avoiding pollutingthe environment, hence being a good citizen. As a result, profit is no longer the sole corpo-rate objective, and the pursuit of non-financial objectives has begun to be increasingly impor-tant, as part of a portfolio of corporate objectives which spread right out into the community ofwhich they are a part.

Non-Financial Performance Indicators

Professor Robert Kaplan of Harvard Business School in The Evolution of Management Ac-

counting states : ..... if senior managers place too much emphasis on managing by the finan-cial numbers, the organisations long term viability becomes threatened. That is, to providecorporate decision makers with solely financial indicators is to give them an incomplete set ofmanagement tools.

The case is two-fold: that firstly not every aspect of corporate activity can be expressed in termsof money and secondly that if managers aim for excellence in their own aspects of the busi-ness, then the companys bottom line will take care of itself.



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Some of the important measures are given below:

1. Balanced Score Card (BSC) offers four perspectives

A. Financial How do we look to our owners

B. Customer How do customers see us

C. Internal What we must excel at

D. Business development How can we develop business further

BSC puts strategy and vision at centre and not control. The BSC drives performance through-out the organization

2. Bench Marking

3. Economic Value Addition

4. Market Value Addition5. Employee Value Addition

The non-financial indicators relate to the following functions:

a. manufacturing and production

b. sales and marketing

c. human resouces

d. research and development

e. the environment

f. systems support

Therefore, whether a company is a manufacturer or a service provider, to be successful, itsmanagement should ensure that:

a. products move smoothly and swiftly through the production cycle without anyinterruption or delay;

b. warranty repairs are kept to a minimum and turned round quickly

c. suppliers delivery performance is constantly monitored

d. quality standards are continually reviewed and upgraded

e. sales orders are effected without backlog

f. customer satisfaction assessment yardsticks are reviewed regularly

g. labour turnover statistics are analysed so as to identify managerial weaknesses

h. R & D costs are kept at reasonable levels

i. the accounting and finance departments understand the needs of business



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Financial Strategy

A representative list of performance measures is given below:

1. Manufacturing and Production Indicators

a. Production process

indicators deriving from time and motion studies

production line efficiency

ability to change the manufacturing schedule in line with the changes in

marketing plan

reliability of component parts of the production line

production line repair record

keeping failures of finished goods to a minimum

ability to produce against the marketing plan

product life cycle

introducing concepts such as kaizan for continuous improvement in pro-

cesses

b. Production quality

measurement of scrap

tests for components, sub-assemblies and finished products

fault analysis

most likely reasons for product failures

actual failure rates against target failure rates

complaints received against the quality assurance testing programme

annualised failures as a % of sales value

failures as a % of units shipped

various indicators of product / service quality

various indicators of product / service reliability

going to the extent of six sigma analysis to ensure quality.

c. External relationships with suppliers

inventory levels and timing of deliveries

just in time inventory control measurements

stock turnover ratio

weeks stocks held



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suppliers delivery performance

analysis of stock-outs

parts delivery service record

% of total requests supplied in time

% supplied with faults

quality and pricing when compared to supplies to competitors from the same

sources

d. Sales delivery and service

shipments vs. first request date

average no. of days shipments delayed

action taken report on response time between enquiry and execution

2. Sales and Marketing

measurements based on staying close to the customer

complaints rework

re-packaging / ease of opening

quality of packaging materials

customer satisfaction analysis

price of products comparisons

unsuccessful visit reports and analysis to find causes & effect remedies monitoring repeated lost sales by individual salesmen

sales commission analysis

monitoring of enquiries and orders

sales per 100 customers

strike rate - turning enquiries into orders

analysis of sales by product line

by geographical area

by individual customer

by salesmen

matching sales orders against sales shipments - mismatch analysis

backlog of orders analysis

flash reports on sales



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Financial Strategy

publication of sales teams performance internally

analysis of basic salaries and sales commissions

share of the market against competitors

share of new projects in the industry

new product / service launch analysis

time to turn around repairs

delays in delivering to customers and level of customer goodwill

value of warranty repairs to sales over a period of time

3. People

head count control

head count by responsibility

mix of staff analysis

mix of business analysis vs. staff personnel needs

skilled vs. non skilled

management numbers vs. operations staff

own labour / outside contractor analysis

workload activity analysis

vacancies existing and expected

labour attrition rate

labour turnover vs. local economy

% of overtime worked to total hours worked

absence from work

staff morale

cost of recruitment

number of applicants per advert

number of employees per advertising campaign

staff evaluation techniques

evaluation of staff development plans

monitoring of specific departments, eg. Accounting

speed of reporting to internal managers vs. HQ



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accuracy of reporting as measured by misallocations and mispostings

monitoring of departments performance long term

pay and conditions vs. competition

level of motivation and morale

employee satisfaction index analysis

4. Research and Development

evaluation vs. basic R&D objectives, strategic objectives and project objec-

tives

product improvement against potential market acceptance

R&D against technical achievement criteria, against cost and markets

R&D priority vs. other projects

R&D vs. competition

R&D technical milestones

analysis of market needs over the proposed product / service life of R&D

outcome

top management audit of R&D projects

major programme milestones

failure rates of prototypes

control by visibility - releases, eg. definition release, design release, trial re-

lease, manufacturing release, first shipment release, R&D release

competitor focus and market segment analysis before finalizing on outcome

of R&D

5. Environment

work place environment yardsticks

cleanliness

tidiness

pollution and effluent disposal mechanism and effectiveness

catering facilities vs. competition

other facilities vs. competition

compliance with legal requirements

contribution to society

education, medical and other facilities provided to the society



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Financial Strategy

SHAREHOLDER IMPACT OF NON-FINANCIAL OBJECTIVES :

The impact of the pursuit of non-financial objectives upon shareholder wealth is not clear cut.There are many writers who would argue that companies which pursue a wide range of objec-tives find that they create for themselves a very positive public image and this serves to in-

crease shareholder wealth. Others would argue that community type projects simply add tocosts and thus erode profit, thereby reducing shareholder wealth. In reality, the truth probablylies somewhere between these two extremes. Carefully selected projects, particularly thosewhich are community related, may well serve as a form of indirect advertising and raise thecorporate profile and associated shareholder wealth. Other projects may simply represent agesture of goodwill, on which no return is either sought or earned.

For example, suppose that a company decides to pursue an image of high product quality as asecondary objective. The aim is clearly non-financial in nature, but it will involve spendingmoney on quality control and management projects which could add to costs and reduce prof-its. There is substantial research evidence from people like Juran, which suggests that quality

is free. In other words, the gains from higher sales levels and reduced costs of warranty claimsexceed the costs of the investment in quality improvements. Where this is the case, then theshareholders actually gain from the fact that the company has chosen to pursue a non-financialobjective.

In other cases, the shareholder impact will be much more difficult to identify. Some companieshave a very good reputation in terms of the facilities which they provide for employees. Suchprovision clearly costs money and absorbs funds which could be used elsewhere within a

business and so it might be easy to take the view that pursuit of the objective of employeewelfare is detrimental to shareholders. In fact, it may work that such policies serve to reducestaff turnover rates and increase productivity. It is quite possible for the aggregate benefits

from such a policy to exceed the costs, so that shareholders see profits rise over the longerterm. As with many things, whether a strategy has a positive or negative effect depends uponthe time frame within which it is being judged.

Financial costs incurred for non-financial aspects such as quality, R&D, employee welfare etcmay reduce the bottom-line in profit statements but would in the long run improve share-holder wealth.

The pursuit of non- financial objectives is associated with all types of organisations. To seeknon-financial objectives is not to ignore the financial, but merely to acknowledge that no singleaim is of overriding importance. At the same time, non- financial objectives do not necessarily

conflict with the financial and can in fact serve to prosper the interests of shareholders. Astrong public image and good publicity must be important too, including, for example, for theMissionaries of Charity or the Ramakrishna Mission. The difficulty lies in reaching the right

balance, which keeps shareholders happy but also allows other interest groups to believe thata company also has their interest at heart as well. The good manager must learn to be good at

juggling.



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Business Insight

Business insight is the capability of organizing and analyzing financial, operational, andexternal information, enabling decision-makers to understand and act, before their com-petitors, to create sustainable shareholder value.

Gone are the days when it was a major exercise for Unilever to identify and assess theperformance of the 1,600 brands that comprised its global portfolio. As part of a newcorporate growth strategy, the global portfolio has been reduced to 400 key brands,and a new data warehouse has been implemented. Global, regional, and national brandmanagers now have access to consistent data on sales performance and changes incustomer awareness and attitude toward each brand.

This information enables brand management to readily identify when and where to targetpromotional investments. Procurement directors have access to a rich data set of global vendor

spend information upon which to predicate vendor negotiations. Unilever significantly in-creased the transparency of critical information in the areas of procurement, brand manage-ment, customer management, and finance.

The results? A 2.1 billion reduction in direct procurement costs, a global view of the health of400 key brands, and a single view of its most strategic (and most profitable) customers. Thecompany also gained a single-stream reporting process by consolidating three different pro-cesses for producing financial, management, and category reports. Now all reports tally, elimi-nating substantive reconciliation at all levels of the business.

At a time when Unilever needed to boost its share price and profitability, the transformation of

its performance reporting capabilities (with Accentures help) enabled the enterprise to achievedramatic improvements. During a time of flat industry performance, Unilever realized bothtop-line growth and increased shareholder value.

(10/1/2003) CFO Project Volume 2 By Paul A.Boulanger, Accenture



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Financial Strategy

5.3 Impact on Investment, Finance and Dividend Decisions

Critical and Growing Need of Investment, Finance and Dividend Decisions

The Continued Evolution and responding to the Challanges

Looking Forward


INTRODUCTION :

One of the more compelling reasons for companies to actively pursue the development ofbusiness performance management capabilities is that technology is now at the stage where it

can deliver on the vision promised for years. Integration technologies such as Kalido andInformatica have advanced to the point where they can more easily establish a common per-formance management language without remediating frontline transaction systems and com-promising flexibility at the local business level. Business analytics applications now containout-of-the-box functionality with the richness to develop metrics management, deliver onlineself-service reporting, and support an intuitive discovery process through drill-down and in-formation exploration that is useful to frontline managers and executives alike.

CRITICAL AND GROWING NEED OF INVESTMENT, FINANCE AND DIVIDENDDECISIONS :

The need to use performance management information effectively has been articulated foryears. However, we are at a pivotal point in the evolution of performance management. It ismore critical than ever for enterprises to address these capabilities. Decisions made now, capa-

bilities constructed now, will shape a companys competitive position for years to come.

Why now? Four primary drivers are galvanizing organizations to address their use of informa-tion to drive business results. First, most companies have made little progress. Their execu-tives are deeply dissatisfied with their organizations ability to leverage information for com-petitive advantage. Second, companies are experiencing unprecedented demands for account-ability in the current regulatory and economic environment. They require increased insight

into the real drivers of business results. Third, technology is now at the stage where it candeliver on the vision promised for years. And last but not least, their competitors are moving.

Recall the pep talk given to the salesmen in the movie Glengarry Glen Ross: Were addinga little something to this months sales contest. As you all know, first prize is a Cadillac ElDorado. Anybody want to see second prize? Second prize is a set of steak knives. Third prize isyoure fired. The stakes are rising. Being unable to generate the competitive advantages thateffective access to information can deliver is an increasingly dangerous position.



19/49


Organizations and their executives are deeply dissatisfied with the state of their performancemanagement information capabilities. Corporations are increasingly awash in information,yet continue to struggle in creating real insight to drive performance. There are several rea-sons for this continued struggle. Many companies have implemented enterprise resource plan-ning (ERP) systems in ways that have not facilitated the generation of useful information.Accenture recently conducted a survey of 163 companies that had implemented ERP systems.The mean number of instances (separate and distinct implementations of the same softwareacross regions or business units) was eight, with 32 percent having implemented from six tomore than 20 distinct instances. This distributed ERP implementation strategy has resulted indisparate, disconnected sources of operational information.

Further, with the decentralized governance of IT manifest in many companies, individual usergroups have driven their own development of data warehouses and data marts, contributingto increased fragmentation of information with little progress toward a single version of thetruth. At some large companies, the data architecture is so fragmented that no one will takeaccountability. The response is armies of analysts using batteries of spreadsheets, manuallygenerating performance information. The cost of this analyst function within finance alone canexceed 0.5 percent of revenue.

Also propelling the need for business insight is the regulatory and economic environment.Corporations are experiencing unprecedented demand for accountability. The Sarbanes-OxleyAct in the United States is demanding that executives understand exactly what their compa-nies financial results are saying and communicate these results clearly to the market. Thesignoff required of U.S. CEOs and CFOs is more than credits and debits. Rather, it is aboutunderstanding that reported business results are fairly represented based on personal knowl-edge. This translates into reporting transparency being able to explain cause-and-effect re-lationships behind business results. Further, as markets continue to struggle and the invest-ment environment languishes, companies that can increase the depth of their disclosure willcreate higher confidence and valuation in the market. According to a variety of analysts, as

baby boomers retire and begin consuming their wealth, they will be replaced by a smallergeneration, ending a savings and investment bulge. Analysts portend that we will see this inthe next 10 years, putting downward pressure on stocks. Falling prices will force companies toprovide even more useful information to attract investors.

Lastly, your competitors are moving. Leveraging information to derive business insight is be-coming a significant competitive advantage. While there are far more instances of companiesthat have not made substantive progress than of progressive companies that have developedthe capability to leverage information to their advantage, there are examples that should giveexecutives pause:

A global downstream oil producer was operating in 125 countries with several hun-

dred separate operating companies having their own IT systems and reporting tools. Itwas unable to report consistent and timely information across operating units. By de-veloping a performance management capability, key management information such ascustomer profitability could be segmented to support better business decision-makingat a country level while enabling data to be aggregated for regional and global report-



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Financial Strategy

ing. As a result of improved customer profiling and reporting, the business unit in-creased its profitability and delivered overall savings of $140 million annually to theparent company.

Based on this success, the company applied the concept to its retail division, where it

was experiencing intense competition for fuel sales and eroding profit margins. Non-fuel sales needed to be increased to generate higher margins and growth. However,disparate IT systems made the company unable to access product performance or cat-egory management information. By implementing a common reporting solution, cat-egory managers got a standard view of sales from thousands of retail sites. The resultsrevealed that 20 percent of non-fuel items generated 94 percent of sales. Armed withthese data, the company achieved a 10-percentage-point increase in non-fuel sales andgross margins.

In the aftermath of a major acquisition, another global oil producer needed to integrate

its existing lubricants business with the newly acquired company. At the same time, it

wanted to shift management focus from cost-plus to a value-based approach similar tothat used in consumer packaged good companies. By deploying a performance man-agement capability, the company created a common information resource while main-taining regional autonomy for local reporting requirements. A centralized reportingsolution was implemented rapidly across the global organization to meet the informa-tion requirements of the finance, supply chain, and marketing functions. Web-basedtools were used for the business units to submit data and for general administration.Standard and ad hoc reports enabled consistent and comparative analysis of key mea-sures so that the merged business could be managed effectively, both globally andlocally. A successful integration of the two businesses after the acquisition realizedsignificant synergy savings.

THE CONTINUED EVOLUTION AND RESPONDING TO THE CHALLANGES :

Companies are coalescing around a vision for management information that has a variety ofcommon elements. Generally agreed-upon characteristics of an effective decision-support ca-pability start with housing information using a common taxonomy at a level of common use.A major chemical company worked to define common units of measure, product codes, cus-tomer codes, and other key data elements globally. This enabled the company to define eco-nomic value created by products in geographic regions by key customers and by a variety ofother dimensions.

The Continued EvolutionCommonality must be supported by processes used to compile information so that it is trustedas accurate. Tight integration with source systems, strong central governance, and internalcontrols are all part of ensuring that when end users access information, they believe it to betrue. Too often, review meetings start with a discussion around the veracity of the perfor-mance at hand. Moving up the hierarchy of needs requires organizations to construct informa-tion-aggregation processes that ensure integrity. High-integrity information enables an orga-nization to divest of competing sources of the same topical information. Eliminating redun-



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dant data marts and reporting processes ensures that management is working off of a singleversion of the truth, a critical but elusive capability for many companies.

Lastly, information is aggregated to benefit decision-makers. Given that decision-making hap-pens at all levels of an organization, an effective performance management information envi-

ronment provides broad access to a wide community of users through self-service and intui-tive portals that facilitate the discovery process without extraneous aggregation effort.

Many companies have yet to achieve these basics. However, leading practice continues toevolve. Increasingly, technologies are available that enable companies to leverage informationdelivery techniques, such as alerts and data visualization, which increase the speed of recogni-tion and assimilation. Companies also are developing performance management capabilitiesthat support a cascading metrics approach; theyre hardwiring strategy to operations withinformation architecture constructed around a common view of how the business is to be man-aged. Corporate strategy is manifested in how frontline operations are measured. Information

is increasingly forward-looking, with everything positioned in terms of where we will be ratherthan where we have been.

Content is evolving as well. The line is blurring between financial and operational informa-tion, embedding in information delivery tools the ability to rapidly derive cause-and-effectrelationships between business drivers and business results. No longer is the P&L important;the drivers behind the P&L are what is measured and managed. As information services evolve,the potential to include external information increases, providing both information and con-text. Managers should feel differently about a 500-basis-point drop in operating margin if theyknow that five of their top competitors experienced a greater decrease during the same period.The power of infusing a companys internal information with external information that mea-

sures shifts in cross-company supply chains, industry direction, and competitors positionshas the potential to be the single biggest evolution in management information since the de-velopment of the database (see Figure 1 on the next page).

The ability to leverage information to create insight into business performance will create com-petitive advantages in cost structure, go-to-market strategy, and supply chain managementthat separate successful businesses from those getting the steak knives, or worse. Businessinsight is the capability of efficiently organizing and analyzing financial, operational, and ex-ternal information, enabling decision-makers to understand and act, before their competitors,to create sustainable shareholder value.

Executives use enhanced information capabilities to add value in all key management pro-cesses. Strategic decision-making occurs with more accurate and relevant information. Orga-nizations are better aligned through the communication and monitoring of key value drivers.Product portfolios and profitability are optimized. Customer offerings, product cross-sellingapproaches, and pricing strategies are tailored according to superior segmentations and analy-ses of sales information and customer behavior. Marketing effectiveness is improved based onthe impact of a customers lifetime value. Credit policies are better managed on the basis of



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COST-VOLUME-PROFIT

ANALYSIS

Financial Strategy

customers total global relationship with the business. Supply chains become more visible,

allowing global and regional sourcing strategies to be pu rsued . Working capital and taxes are

minimized and global foreign exchange positions op timized.

Responding to the Challenge

How do comp anies begin to develop the capability to better leverage information and create

competitive advantage? With a focus on business value. The first, and perhaps most impor-

tant , best practice for achieving business insight is to base the design of business insight capa-

bilities on a rigorous analysis of what drives value in your organization. What information

needs to be at the fingertips of decision-makers to keep them better informed , help them make

better decisions faster, and to support tactical performance reviews?

In many organizations, technical architecture and data availability determine what informa-

tion decision-makers have access to. However, the best results are achieved when the deci-

sion-makers information needs drive the information strategy, rather than the information

that is readily available to IT. The information needs of critical management processes come

first, followed by what content to include (see Figure 2). The process of analyzing your com-

petitors, for example, could include not only th e trad itional competitive wins and losses but

Figure 1: Cretical Performance Information Components

360Insight

Competitors

Employees Markets/Customers

Operations Vendors/Suppliers

EconomicProjects

Financial News

Equity Markets

Debt Markets

RevenueReporting

Cost CenterStatement

Cost byCategory

P&L Statement

Balance Sheet

Cash FlowStatement

MarketDynamics

Customer NewsMarket Share

Share ofCustomer Spend

Cost to Serve

CustomerProfitability

FinancialTurnover

Satisfaction

Skill Coverage

Training

Staffing Plans

ProductionVolumes

Quality Yields

Rework Costs

Capacity

Safety

MarketDynamics

NewTechnologiesVendors News

Share ofVendor SalesGlobal Vendor

Spend Analysis

MarketDynamics

Industry Trends SubstituteTechnologies

NewTechnologies

CompetitorNews

CompetitorWins/Losses

Accenture 2002. All Rights reserved



23/49


also market dynam ics and indu stry trends valuable external information that p rovides con-

text for future action. The information needs of each management process and the resulting

content required drive the most appropriate access and delivery channels and, finally, data

management and technical architecture. Value comes first, with technology being an enabler,

not a d estination.

Figure 2: Value-Driven Information Architecture Development

For companies that have yet to develop business insight capabili ties, there are a number of

responses.

First, respond with urgency. Management n eeds to take d ecisive action, making tou gh d eci-

sions, driving development and adoption of a common framework for performance manage-

ment, isolating those elements that are tru ly business-un it or region specific, and standard iz-

ing cross-comp any. Demand adh erence to a corporate standard and create governance struc-

tures to manage data stand ards, IT development, and other critical success factors.

Second, respond with entirety. Add ress the entire management cycle. Integrate strategic plan-

ning, business planning, and target setting w ith performance management. Comp anies must

become more disciplined in holding the organization accountable for stated operating objec-

tives and the capability developments associated with investment. This implies that perfor-

mance management is grounded in targets, plans, and initiatives built into business plans.

Companies that develop performance information capabilities divorced from planning pro-

cesses miss the opp ortun ity to strengthen accountability and focus. Many mid-level managers

comp lain of having to prepare volum inous reports in response to seemingly rand om corporate

queries. If, rather, there is agreement on what will be measured at each level of the organiza-

Strategy

Development

Product Portfolio

Management

Customer Relationship

Management

Credit

Management

Supply Chain

Optimization

Treasury

Management

Performance

Management

Compliance/Risk

Management

FinancialMarkets/

Customers

Vendors/

SuppliersCompetitors Operations Employees

Reporting

Applications

Analytic

Applications

Contextual

Information

Visual

Presentation

Access/

Distribution

Security/User

Categorization

Data Model Policies and Procedures Reference Data Data Retention

Interfaces Data Population Storage Applications

Accenture 2002 All Right reserved

Management Process Information Needs

Information Content

Information access and Delivery

Data Management

Technical Architecture



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COST-VOLUME-PROFIT

ANALYSIS

Financial Strategy

tion, and those measures cascade from and relate to the corporate strategy, and they are the

basis for both plann ing/ forecasting and p erformance reporting, management d iscussion and

query tends to have greater focus an d impact, and responses require less organizational effort.

Third, respond with vision. Develop a three- to five-year target information architecture for

your bu siness to support d ecision-makers information requirements, then be p repared to adap tthe plan as the business evolves. Be able to dissect and articulate the plan for various compo-

nents. Armed with a performance management framework and prioritized view of informa-

tion, have an end state in mind for how the enterprise will manage data. What will be held

consistent corporate-wide rather than allowed to vary by business or geography? How will

data ow nership be assigned in the organization and wh at processes are required to m aintain

quality, controls, and integrity? Have a view as to how legacy applications will integrate with

a central data store. What integration technologies will be required? Develop an u nd erstand-

ing of wh at performance management ap plications will be employed and how th ey will inter-

act with the data repository. Will you n eed an activity-based costing engine to d erive produ ct

and customer profitability, or will more simplistic allocation schemes be employed? How will

your planning applications integrate with your performance reporting applications? Have aplan for how information will be distributed th roughout the organization. How will stand ard

reporting be autom ated and pu shed ou t to the organization? How will online analytical pro-

cessing (OLAP) technologies be employed to streamline and support high-powered analytics?

Only by having a vision tha t informs investm ent in specific capabilities, coupled with a coher-

ent program that governs project direction toward a common goal, will you create an inte-

grated information architecture that dramatically imp roves the organizations access to and

use of inform ation (see Figure 3).

Figure 3: Components of Information Architecture

Lastly, respond with action. Start taking the steps now to move your company in the right

direction. A number of short-term actions can be taken to begin developing the competence in

man aging an enterprise performance information capability.

External ReportingInternal Reporting / AnalysisAd Hoc Query / OLAPScoreboards / Dashboards

KPI DefinitionsReporting HierarchiesData StandardsBook / Tax COAs

External DataUnstructured Data

Integration TechnologiesERP/Legacy Applications

Planning / ModelingBudgeting/ForecastingConsolidationABC/Dimensional Profitability

Workflow Collaboration

Security Admin./Devl Tools

InformationHub

Application ReferenceData

Reportingand Analysis

SourceSystems

Accenture 2002 All Right reserved



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Begin by moving the organization toward common management metrics and planning pro-cesses. Establish corporate key operating metrics. Drive management discussions around thesemetrics, and demand that individual components of the business use metrics aligned with thestated corporate metrics. While this concept has been an established leading practice for over adecade, many companies have yet to take this crucial step.

For performance reporting and analytics, determine the most urgent management process infor-mation needs and start there. For some organizations, procurement processes yield significant,measurable value from improved information. In the Unilever example, customer and productprofitability were determined to be of high value as well. Create a positive case study within aspecific management process to serve as an internal reference for the power of improved deci-sion support.

With your data architecture, begin the process of creating a common taxonomy. Start with themost valuable elements, such as customers. Launch projects to standardize data companywideand institute organization control and data ownership. Drive consolidation and rationalizationof data stores, controlling the rampant development of data warehouses and data marts. Con-

strain IT budget expenditures that do not align with the target end state. This may mean forcingindividual user groups to postpone the gratification of constructing their one-off reporting tools.

Drive toward an integration standard. Select, pilot, and demonstrate the power of an integrationtechnology. In operational applications, allow for variation across division and geography whererequired, but control nonessential variation in application development and data structures.

These short-term measures can begin to shift the organizations thinking about the managementof information and create the discipline associated with leading practice performanceinformation.

LOOKING FORWARD AT LAST :

For far too long, performance management and reporting has been a backward-looking exercise

or a guessing game. Finance executives have analyzed the impact of prior decisions and resultsto determine how future plans should be developed to improve results or decrease risks. Theyhave monitored trends for key business drivers and attempted to identify the causes of variancein operating performance.

Business insight allows you to look ahead. In the near term, you can easily identify trends, keydrivers, and other factors that influence chosen business strategies. You can make capital allo-cation decisions to develop an investment portfolio aligned with your strategies. Longer term,a robust business insight capability delivers even more, placing CFOs front and center as the chiefexecutives primary strategy resource. Based on corporate positions and projections of the ma-

jor factors driving strategy, you can create long-term business strategies. Business insight enablesyou to choose appropriate industries in which to compete, and it enables you to identify the

major factors that will influence your companys ability to grow, compete, and remain profitable.Equally important, you can develop credible early warning systems that identify challengeswhen company positions are incorrect.

As the chief financial steward of a nimble organization, you will more effectively deliver thecritical information that decision-makers and frontline operators need to make faster, more ef-fective decisions. Based on better insight into internal and external business circumstances, yourcompany will understand, act, and prevail, conquering competitors and creating significant (andsustainable) shareholder value.



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Financial Strategy

5.4 Alternative Financing Strategy in the Context of RegulatoryRequirements.

INTRODUCTION :

Regulatory requirements are required to be complied with to ensure that a firm is adequatelycapitalized to meet multiple objectives. The best example would be the case of banks whichaccept deposits from the public and deploys the generated funds across various assets likecorporate and retail loans. Since public confidence is the foundation for banks survival, regu-latory authorities prescribe adequate capital for the banks to be maintained, known as theCapital Adequacy Ratio (CAR).

REGULATORY REQUIREMENTS WHETHER AFFECTS THE CHOICE OF THECAPITAL STRUCTURE :

Credit risk is the risk of default from the borrowers. Operatinal risk is the risk of some of theprocedures going wrong and market risk is the risk of market volatility affecting the values of

banks investments in various financial assets.

Banks and Financial Institutions

Banks allocate resources across various assets through their lending operations. In the process,

banks are exposed to various types of risks which are broadly classified into three types, CreditRisk, Operational Risk and Market Risk. Banks are also expected to comply with the RBI guide-lines on the creation of necessary risk management architecture and also the guidelines onBasel II. Capital Adequacy computation has to be done under Basel II requirements effectiveMarch 31, 2008.

According to Basel committee norms, banks have to maintain adequate tier I capital as a cush-ion to take care of all these risks and protect the depositors. Risk is inherent in the nature of the

banking business. The Reserve Bank of India prescribes a risk weight for the various assets ofa bank like the corporate loans, retail loans and the investments in financial assets like bonds,shares, derivatives etc. Using these weights, the risk weighted assets are computed. Banks

have to maintain 10% capital adequacy ratio, which means that the banks tier I capital in theform of equity shares, will go up as the value of risk weighted assets go up. This way the banksdepositors are protected. This is an example of how regulatory requirements affect the capitalstructure of a bank. Insurance companies are also subjected to this kind of capital adequacyratios. Banks and Non-banking finance companies can raise debt up to 10 times of net worth ofthe company.

Regulatory requirements whether affects the choice of the Capital Structure

Reasons for the regulatory requirements in the choice of the Capital Structure



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Debt to equity ratio prescribed by banks

Many times banks prescribe the minimum debt to equity ratio for projects to ensure that thepromoters bring adequate money as equity contribution. Therefore, when a corporate firmgoes for borrowing for a project, it has to bring sufficient equity or deploy the internal accruals

to satisfy the requirements of the banks. The following example illustrates this point :

TRISTAR FOODS plc

Input data Amount (Rs.)

Cost of value machine 150,000Salvage value of new machine 10,000Production (Its. Per day) 300Working days per year 300Working life of machine (years) 6

Income per It. (net) 0.80Salvage value of old machine 5,000Warehouse cost 15,000Allocated cost of marketing/year 20,000Increase in working capital 5,000Depreciation rate 25%Corporate tax rate 30%Capital gains tax rate 30%Opportunite cost of capital (Debt) 12.5%Post tax cost of debt 8.8%

ESTIMATION OF CASHFLOWS Y E A R S

0 1 2 3 4 5 6

Cost of new machine (150,000)

Salvage value (old machine) 5,000

Change in working capital (5,000) 5,000

Salvage value (new machine) 10,000

Revenue 72,000 72,000 72,000 72,000 72,000 72,000

Depreciation (37,500) (37,000) (37,000) (37,000)

Ebit 34,500 34,500 34,500 34,500 72,000 72,000

Ebit *(1-T) 24,150 24,150 24,150 24,150 50,400 50,400Opearting cash flow 61,650 61,650 61,650 61,650 50,400 50,400

Capital gains tax -1500 (3,000)

Warehouse cost (15,000) (15,000) (15,000) (15,000) (15,000) (15,000)

Cashflows (151,500) 46,650 46,650 46,650 46,650 35,400 47,000

Npv 52,394.39

Irr 19.83%



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Financial Strategy

The above example, as discussed earlier, shows the cash flows for a project with NPV

and IRR.

What should be the amount of debt and equity for this project which requires 150000 asinvestment?

A bank may decide to fix the debt that they are willing to lend to this project based onthe debt service coverage ratio. Debt service coverage ratio is computed as follows:

(Net operating profit before long term interest and depreciation and after tax)/(Instal-ment + long term interest )

Debt service coverage ratio protects the annual amount due to the lender namely theinterest and instalment amount. There has to be adequate coverage for this say about2.0 times.

Let us say that the bank prescribes an average debt service coverage ratio of 2.5 times

for this project and wants to know how much of debt it can finance and how much of

equity the promoter has to bring in=Nopat+Depreciation 61650 61650 61650 61650 50400 50400

Instalment + Interest on term loan 23159 23159 23159 23159 23159 23159

DSCR (times) 2.66 2.66 2.66 2.66 2.18 2.18 2.50

The table above shows the debt service coverage ratio and the average debt service ratio

for all the years which is 2.5. This means how much of debt is shown in the following

table:

Total investment 150000

Debt 1.67 1.00

Debt 93881.33

Equity 56118.67

Instalment amount

Debt 93881.33

Interest 0.13

Term 6.00Instalment amount 23158.63

This table shows that a debt equity ratio of 1.67 will be optimum to support 2.5 debt

service coverage ratio. This means that the bank will lend 93881.33 and the promoter

has to bring 56118.67. Of course, generally the amounts would be rounded off to

nearest reasonable lacs for ease of accounting.



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REASONS FOR THE REGULATORY REQUIREMENTS IN THE CHOICE OF THECAPITAL STRUCTURE :

The recent gloom of global economic slowdowns and the failure of corporate governance hascreated threat to the Indian economy and the investors trust on corporate sector is at stake.

However timely action by the Government by extending several stimulus packages andincentives to create demand and regain confidence of the public & appropriate action by theGovernment in the Ministry of Corporate Affairs have saved the image of the systems andregained the faith of the stake holders.

Despite a political vision, well articulated schemes and adequate funding, many majorprogrammes are not on schedule. And the benefits are not reaching the intended beneficiaries.This trend ought to be reversed through better organization, better transparency, better feedbackand better visibility of timely actions through purposeful auditing of social cost and benefit toachieve growth.

In India, the importance of competition policy and related regulatory regimes has increased

greatly since 1991 when a massive wave of liberalization eliminated many controls oninvestment, capital market, foreign trade and prices. While regulation has significant relevancein the current economic scenario, cost data fed regulatory issues are also many and worthconsidering. While examining the relevance and usefulness of cost data of companies for tarifffixation/approvals in public utilities like electricity, for ensuring objective subsidy policy, toensure operational regulation within competitive practices are some of the areas that wouldrequire adequate cost audit mechanism as these factors are not addressed in financial reportingmechanism.

In the social sectors like; healthcare and education which are soft infrastructural issues foreconomic growth, the need for regulation is strongly felt. Strict regulation of the healthcare

services is the need of the hour. The fee structures at private healthcare centers need to beformalized and monitored to prevent exploitation of the patients. The National KnowledgeCommission has also highlighted that the barriers and quality, cost & content of the highereducation needs to be addressed.

Inventory Valuation

Inventory plays a vital role in assessing the true profits of the company. Inventory is one of theimportant constituents of the Current Assets of the Company. Inventory Valuation is reflectedin the Balance Sheet based on the certificate issued by the management. Although the choice oftechnique for closing inventory valuation does not change the economic reality of events thathave occurred, but their effect on taxes and retained earnings go a long way in influencing net

income and its distribution as return to shareholders. Stock volatility and ratio of stock toearnings indicate the continued vulnerability of the inventory valuation issue towardsmanipulation.

In this context it may be mentioned here that as per SEBI circular on clause 49, one of the roleof the Audit Committee is to review the annual financial statements and major accountingentries involving estimates based on the exercise of judgment by management before submissionto the Board. In almost all the companies, Inventory values are certified by the management.



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5.5 Modeling and Forecasting Cash Flows and Financial Statements

Modeling Cash Flows

Interpretation of Financial Statements


INTRODUCTION :

Financial strategy requires knowledge of alternatives available. The alternatives have to beeach with different new aspect adding value to the proposition. A robust financial model thatcan facilitate exploration of the consequences of the various alternative choices will be mostuseful for a finance manager to quickly understand the implications of increasing debt to eq-uity ratio, or a change in tax structure and how it affects the earnings per share or any other

chosen objective.

MODELING CASH FLOWS :

Modeling can be best explain with the help of the illustration.

The illustration given below shows how a given set of assumptions can be used to model for

forecasting cash flows, financial statements and valuation of the firm

Sales growth 10%

Current assets/Sales 15%

Current liabilities/Sales 8%

Net fixed assets/Sales 77%

Costs of goods sold/Sales 50%

Depreciation rate 10%

Interest rate on debt 10.00%

Interest paid on cash and marketable securities 8.00%

Tax rate 40%

Dividend payout ratio 40%

Year 0 1 2 3 4 5

Income statement

Sales 1,000 1,100 1,210 1,331 1,464 1,611

Costs of goods sold (500) (550) (605) (666) (732) (805)

Interest payments on debt (32) (32) (32) (32) (32) (32)Interest earned on cash and marketable securities 6 9 14 20 26 33

Depreciation (100) (117) (137) (161) (189) (220)

Profit before tax 374 410 450 492 538 587

Taxes (150) (164) (180) (197) (215) (235)

Profit after tax 225 246 270 295 323 352

Dividends (90) (98) (108) (118) (129) (141)

Retained earnings 135 148 162 177 194 211



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Financial Strategy

INTERPRETATION OF FINANCIAL STATEMENTS :

This part shows the projected income statement based the basic assumptions. These assump-tions can include capital structure changes like debt, equity, leasing etc.

Balance sheet

Cash and marketable securities 80 144 213 289 371 459

Current assets 150 165 182 200 220 242

Fixed assets

At cost 1,070 1,264 1,486 1,740 2,031 2,364

Depreciation (300) (417) (554) (715) (904) (1,124)

Net fixed assets 770 847 932 1,025 1,127 1,240

Total assets 1,000 1,156 1,326 1,513 1,718 1,941

Current liabilities 80 88 97 106 117 129

Debt 320 320 320 320 320 320

Stock 450 450 450 450 450 450

Accumulated retained earnings 150 298 460 637 830 1,042

Total liabilities and equity 1,000 1,156 1,326 1,513 1,718 1,941

This part shows the projected balance sheet based on the earlier assumptions

Year 0 1 2 3 4 5

Free cash flow calculation

Profit after tax 246 270 295 323 352

Add back depreciation 117 137 161 189 220

Subtract increase in current assets (15) (17) (18) (20) (22)

Add back increase in current liabilities 8 9 10 11 12

Subtract increase in fixed assets at cost (194) (222) (254) (291) (333)

Add back after-tax interest on debt 19 19 19 19 19

Subtract after-tax interest on cash and mkt.

securities (5) (9) (12) (16) (20)

Free cash flow 176 188 201 214 228



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Valuing the firm

Weighted average cost of capital 20%

Year 0 1 2 3 4 5

FCF 176 188 201 214 228

Terminal value 2,511

Total 176 188 201 214 2,740

NPV 1,598


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Financial Strategy

5.6 Sensitivity Analysis for Changes in ExpectedValues In The Models And Forecasts

Sensitivity Analysis, Cost of Capital and NPV

Emerging Trends in Financial Reporting

Financial Reporting Supply Chain


INTRODUCTION :

Sensitivity analysis refers to studying of the impact of changes on one or more variables on theresults, which can either be NPV or IRR or EPS etc. This will help in understanding the criticalvariables on which the results depend. It is also one way of understanding the risks related to

a project or policy. The following illustration shows how sensitivity analysis can be performedon a model of projected cash flows for capital budgeting.

Sensitivity analysis helps in decision making. When a project proves to be very sensitive tocertain aspects such as raw material price, power cost, selling price etc the management has toprovide adequate weightage to these aspects before the investment decision is frozen.

SENSITIVITY ANALYSIS, COST OF CAPITAL AND NPV :

The lending institutions also heavily depend on this analysis before they decide on lendingquantum or lending itself. If a project is very sensitive to some parameters and if the lenderperceives them as critical, the decision of lending is based very much on that.

Illustration of sensitivity analysis- Cost of capital and NPV

Sensitivity analysis

Cost capital and NPV

563.86

0.15 563.86

0.20 450.76

0.25 358.40

0.30 282.12

0.35 218.46

0.40 164.84

0.45 119.28

The above table shows the impact of cost of capital on the NPV of the project. Itshows that even if the cost of capital becomes 45%, the project is viable and showsa positive NPV



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Illustration of Capital expenditure, NPV and IRR

Sensitivity analysisCapex, NPV and IRR

563.86 63%

280 562.51 62.97%

300 549.02 59.66%

350 515.32 52.66%

400 481.61 47.00%

450 447.90 42.33%

500 414.20 38.39%

800 211.96 23.35%

1000 77.13 17.54%

1200 -57.70 13.36%

This table shows the impact of capital expenditure changes on the results of the

project namely the NPV and IRR

It can be seen that the NPV turns negative only when the investment touches

1200

Capital expenditure and cost of capital on NPV

Sensitivity analysis-Capex, Cost of capital and NPV

563.9 0.2 0.2 0.3 0.3 0.4280.0 562.5 449.3 356.9 280.6 216.9

300.0 549.0 435.0 341.9 265.0 200.8

350.0 515.3 399.1 304.3 226.0 160.7

400.0 4

ICWAI Understanding Financial Strategy-Financial Management & International Finance study material...

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