ACCA P3 Business Analysis - 2010 - Study text

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Chapter 15: Finance and business strategy

intends to pay to its shareholders (which depends on the company’s dividend

policy).

Estimates can also be made about the amount of funding required for capital

investments, including investments in additional working capital.

For each year of the planning period: $

Total investment requirements X

Funding available from retained profits Y

Funding shortfall (or surplus) (X – Y)

The finance and accounting function will normally prepare the estimates of both

investment requirements each year, and also estimates of retained profits.

Filling the funding gap

A funding shortfall is a funding gap that has to be closed. The funding gap might

accumulate over the period of the business plan. For example, if there is a funding

shortfall of $4 million in Year 1, $2 million in Year 2 and $5 million in Year 3, there is

a total funding gap of $11 million over the three-year period. The gap might be

closed by raising additional finance of $11 million in Year 1. Alternatively, the entity

might raise $4 million in Year 1 and $7 million in Year 2.

A funding strategy should be developed, to decide how the funding gap can be

closed. There are two ways of closing the funding gap:

 changing business strategies, so that the capital investment requirement is

reduced, or

 obtaining additional funds.

Financial gearing

The main external sources of funding are:

 equity finance (issuing new shares)

 debt finance (bank borrowing or issuing bonds)

 leasing finance.

A company should not use short-term finance (credit from suppliers and a bank

overdraft) to finance long-term capital requirements.

You should already be aware that debt capital is usually cheaper than equity capital.

Equity shareholders should expect a higher return than providers of debt capital,

because their investment risk is higher. Companies also receive tax relief on interest

payments on debt, but do not get tax relief on dividend payments to shareholders.

Since debt capital is cheaper than equity, companies might be expected to prefer

borrowing to issuing new shares.

However, with high levels of financial gearing (a high ratio of debt capital to equity

capital) the financial risk for the company is higher. There is a greater is that the

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company will be unable to meet its obligations to pay interest on the debt and repay

the debt capital on schedule.

 High gearing may therefore increase the risk of legal action by lenders and

insolvency.

 A highly-geared company may also have difficulty in raising additional debt

finance, except at a much higher interest cost.

Funding strategy may therefore be based on achieving or maintaining a suitable

level of financial gearing, by obtaining required funds through a mixture of retained

profits and external funding (equity, debt and lease finance). There are no ‘rules’

about the maximum level of financial gearing that is safe or desirable.

Example

A company has estimated that it will need an additional $40 million of capital in the

next three years. Of this total, it is expected that $10 million will come from retained

profits.

The market value of its equity is currently $80 million and its total long-term debt is

$60 million.

The board has agreed the following finance strategy:

 At least one third of its total capital value should be in the form of equity and at

least one-third should be in the form of debt capital.

 The remaining one-third of capital value may be either equity or debt.

 The choice between debt and equity for external funding should comply with

this strategy requirement, and should also seek to minimise the company’s cost

of capital.

Other influences on funding strategy

There might be other factors that affect a company’s choice between equity and debt

as a source of new finance. Small and medium-sized enterprises (SMEs) whose

shares are not traded on a stock market often have difficulty in obtaining new

equity finance, and they are usually unable to raise debt finance by issuing bonds.

These companies must therefore rely for long-term funding mainly on retained

earnings, bank loans and lease finance.

 In your examination, if you are asked to discuss funding strategy for a private

company, do not write an answer that discusses funding options that are

available to a public company but not a private company. The examiner has

commented: ‘In our experience, candidates too readily associate funding

opportunities and stakeholder expectations of a plc [public company] with a case

study scenario which is clearly describing a private limited company.

 A private company might choose a strategy of becoming a public company so

that it will be able to issue new shares on a stock market and improve its access

to external equity funding.

Chapter 15: Finance and business strategy

You should also try to be aware of the current financial markets, and how

conditions in the financial markets might affect funding decisions. At the time of

writing this text:

 Borrowing costs are fairly low, and many companies have increased their

financial gearing in order to benefit from low costs of borrowing. A typical

strategy for public companies has been to borrow long-term funds and use the

money to buy back (and cancel) shares. Shareholders have generally welcomed

this strategy because it returns capital to them, often at a favourable price for

their shares.

 Private equity companies have taken advantage of low costs of debt to buy up

public companies and ‘take them private’. A private equity company, or

consortium of private equity companies, make a takeover bid for a targeted

public company, ad they acquire all its shares. The purchase is financed largely

with debt capital. The company is then converted into a private company, and

specialist managers are appointed to run it. Within the next few years, the

appointed managers are expected to improve the financial returns from the

acquired company. In most cases, the acquired company takes on much higher

levels of debt. After about five years, the private equity firm often plans to turn

the company into a public company again, and bring it back to the stock market

at a much higher price than its original purchase cost.

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Financial analysis for business strategy

 The nature of financial analysis for business strategy

 Assessing the financial implications of strategic choices

 Financial analysis and the Business Analysis examination

2 Financial analysis for business strategy

2.1 The nature of financial analysis for business strategy

The finance and accounting function provides financial information to senior

management that helps them to evaluate the current strategic position and make

financial projections and forecasts for the future.

 Financial analysis of historical performance and the current position. An analysis

of financial performance and financial position contributes to a strategic position

analysis. Management need to understand the financial strengths and

weaknesses of the entity.

 Financial analysis can also be used to assess whether the objectives of a business

strategy are realistic. For example, suppose that in the past three years, the gross

profit ratio (ratio of gross profit to sales) has been 10%, and the business plan for

the next three years predicts a gross profit ratio of 15% in Year 1, 20% in Year 2

and 25% in Year 3. This scale of improvement in the gross profit ratio is likely to

be unrealistic, and management should re-assess the expected benefits of their

proposed business strategies.

 Business plans are often expressed in financial terms, and senior management

need financial forecasts or projections.

 There should be financial assessments of proposed new business strategies. Will

a particular strategy provide an adequate return on investment? The anticipated

benefits should be measured in financial terms, and compared with the expected

costs.

 A financial analysis of the actual benefits obtained should be prepared as part of

the post-completion audit of projects.

2.2 Assessing the financial implications of strategic choices

The techniques for assessing the financial implications of business strategies should

be familiar to you. In your examination, you might be given a case study or scenario

and where you are required to apply financial ratio analysis to a current strategic

situation or to a proposed business strategy.

Any of the following aspects of financial analysis might be appropriate.

Chapter 15: Finance and business strategy

Efficiency ratios

Efficiency ratios can be used to assess how efficiently resources are used. Business

strategies might be based on achieving realistic improvements in resource

utilisation.

Efficiency ratios are usually calculated for:

 labour: the entire work force or particular groups of employees

 the use of equipment and machinery

Examples of efficiency measurements are:

 output per man per hour

 output per machine hour

 annual sales revenue per employee

 percentage of time spent idle or ‘downtime’ for equipment and machines

Improvements in efficiency add value to the value chain because they reduce costs.

Gearing ratios

Financial gearing has already been discussed in terms of funding strategy. Gearing

ratios might be used to assess the amount of funding risk in a business strategy.

For example, suppose that a company has a plan for growth that will be funded

mainly from external sources, in particular bank loans. The financial gearing (ratio

of debt to equity capital) might increase as a result of the new funding from, say,

50% to 125%. The ability of the company to support such a large increase in gearing

might be questioned, and the funding strategy might therefore be re-assessed.

Liquidity ratios

Liquidity refers to the ability of an entity to pay its liabilities when these fall due for

settlement. An entity needs cash (or access to additional cash) to pay its employees

and suppliers.

Financial analysis might show that a company could have cash flow problems, and

insufficient liquidity, when:

 it is consistently making losses and its operating cash flows are negative, or

 the size of the business is growing, and the company is financing the growth by

increasing trade payables and its bank overdraft, instead of obtaining additional

long-term funds.

Companies that finance business growth mainly through short-term finance (bank

overdrafts and trade payables) are overtrading. Overtrading exposes a company to

the risk that it will run out of cash (will not have sufficient liquidity), because:

 suppliers are demanding payment for overdue debts, or

 a bank removes the company’s overdraft facility.

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An analysis of liquidity might show that a company has an inappropriate funding

strategy, which is inconsistent with its business strategy for growth.

Liquidity can be measured by cash flow forecasts, or with liquidity ratios such as

the current ratio and quick ratio.

Profitability ratios

Profitability ratios can be used to assess the viability of chosen business strategies.

Gross profit ratios and net profit ratios might both be used for an analysis.

 Profitability must be sufficient to provide a suitable financial return on

investment.

 Each business strategy should be expected to provide a suitable financial return.

 Historical profit margins can be compared with planned profit margins, to

assess whether the planned profits are realistic.

 Actual profit margins can be compared with the planned profits for a strategy, to

assess whether the expected benefits were actually achieved and whether costs

were properly controlled.

Investment ratios

Investment ratios can be used by shareholders and other investors to assess whether

a company is providing attractive returns, in comparison with competitors and with

companies in other industries. Investors might compare the financial performance

of different companies in terms of:

 growth in earnings per share each year

 accounting return on capital employed

 price/earnings ratio (ratio of market price to earnings per share)

 dividend yield

 annual dividend growth.

2.3 Financial analysis and the Business Analysis examination

If you are required to carry out a financial analysis for a case study in your

examination, you must remember that the analysis should be made from a strategic

perspective. In particular:

 Look at trends and changes over time. Compare the situation now with the

financial position several years earlier.

 If you are given estimated figures for the next year or the next several years,

calculate whether historical trends are expected to continue into the future. If

historical trends are not expected to continue, you should ask why. Could the

estimate for the future be over-optimistic?

 Consider the possible implications of any trend or change that you have

identified.

Chapter 15: Finance and business strategy

Example

You are given the following information about sales of a product.

Year 1

Year 2

Year 3

Year 4 (estimate

for next year)

Sales revenue $12 million $14 million $15 million $16.5 million

Sales volume index 100 115 130 150

This information can be analysed as follows:

Year 2

Year 3

Year 4 (estimate

for next year)

Increase in sales revenue 16.7% 7.1% 10%

Increase in sales volume 15% 13% 15.4%

Therefore increase/(decrease) in prices 1.5% (5.2%) (4.7%)

(Workings) [(1.167/1.15) – 1] [(1.071/1.13) – 1] [(1.10/1.154) – 1]

The above information shows that although sales revenue is growing each year,

sales volume is growing at an even higher rate. This shows that unit prices for

products are falling. This could be the consequence of a market skimming price

strategy for a new product: prices will be reduced over time. Alternatively, the

falling prices could indicate strong competition in the market from rival business

entities. A consequence of the falling prices, unless unit costs are also falling, is that

the gross profit margin (and probably the net profit margin) will be expected to fall.

Financial analysis and strategic analysis

You should also try to put your financial analysis into the context of business

strategy. In particular, you should try to assess what the trends in the financial

ratios might indicate. For example:

 Falling unit prices might be a part of a strategy to increase market share. If so, do

the sales figures suggest that the strategy is succeeding?

 The rate of growth in sales volume, profitability and investment in R&D can all

be indications of the current position of a product in its life cycle. For example,

little or no growth in annual sales and a high net profit margin could indicate a

product that is in the ‘maturity’ phase of its life cycle (and a product that is a

‘cash cow’). It may be possible to link the financial analysis to the BCG matrix,

especially if you are also given figures for market share.

Paper P3: Business analysis

Paper P3

Business analysis

CHAPTER

Leadership and human

resources management

Contents

1 Leadership

2 Human resources management

3 Selection and performance appraisal

4 Reward management

5 Job design

6 Development and training

Paper P3: Business analysis

Leadership

 Human resourcesandHumanResourceDevelopment(HRD)

 Abriefhistoryofleadershiptheory

 Transactionalandtransformationalleadership

 The leaderasastrategicvisionary

1 Leadership

1.1 Human resources and Human Resource Development (HRD)

Business entities need to develop new business strategies to remain competitive in

their industries and markets. In a complex and continually-changing environment,

it is not sufficient to keep business strategies the same, making only minor

incremental changes. New strategies inevitably involve change, which may be

substantial.

An earlier chapter explained that new business strategies are developed as a

combination of:

 intended strategies (planned strategies) and

 emergent strategies.

Intended strategies can be decided and introduced by senior management, but the

successful implementation of these strategies depends on the willingness of

employees to accept the change and adapt to new processes or systems, and new

business strategy objectives.

Emergent strategies are developed by employees themselves, and ‘emerge’ from the

way in which the entity responds to developments in its environment. For an entity

to develop and implement successful emergent strategies:

 it must be innovative

 its employees must have the skills, knowledge and motivation to be innovative

 employees must be given effective leadership by management, and should be

encouraged to innovate

 the entity should use the knowledge of its employees to find ways of developing

business strategy.

The leadership given to employees, and the ability of an entity to develop and the

knowledge of its employees, are now seen as key aspects of successful business

strategy development.

Human Resource Development (HRD) is an aspect of the resource-based view of

strategy development. This is the view that entities should develop business

strategies in a way that seeks to obtain sustainable competitive advantage from the

strengths of the entity’s resources. Employees are a key resource, and should be

ACCA P3 Business Analysis - 2010 - Study text - Emile Woolf Publishing

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