Ch 1 Flashcards
Definition of Mission
Fundamental objective(s) of entity, expressed in general terms
Definition of Mission Statement
Published statement, apparently of entity’s fundamentl objective(s)
May or may not summarize true mission of entity
Definition of “hierarchy of objectives”
Arrangement of entity obj into number of different levels: higher levels general; lower more specific.
Levels may be mission / goals / targets OR strat obj / tactical obj / operational obj
Different Types of Entity
For-profit = primary objective to make profit, thus satisfy sh/h
NFP = usually have other non-fin primary objectives
Incorporated entity (aka company or corp) = legally separate from owners
Unincorported = not so - thus owner personally bears risk (partnership, sole trader)
Quoted = shares quoted / listed on a stock exchange
Unquoted = not so
Private sector entity = owned by privated investors
Public sector entity = owned by government
OTHER
Charity = type of NFP - centters on philanthropic goals and social wellbeing
Association / Union = group of individuals grouping together to accomplish a purpose (e.g. trade union, professional assoc)
Primary Strategic Objective of For-Profit Entity
Long-term goal of maximization of sh/h wealth
Primary Strategic Goal of public sector bodies, charities, trade unions, associations
Benefits for a prescribed group of people
(Secondary objective to raise maximum funds and utilize efficiently to maximize benefit - since services depend on funds available)
Objectives of Incorporated vs Unincorporated Entity
Incorporated = likely several owners, thus greater potential st/h conflict regarding objectives vs unincorporated
Objectives of quoted vs unquoted companies
Quoted = higher scrutiny from investors and market in general vs unquoted
Due to scrutiny, arguably important for quoted company to set appropriate non-fin objectives re. relationship with env and staff
Objectives of Charities
raise money for a specific cause, and spend in most effecitve way
some however are setting up retail outlets to generate trading profits - taking risks to increase returns - once regarded as inappropriate but now commonplace
Definition of Stakeholders
persons and entities that have an interested in the org’s strategy
include sh/h, customers, staff, local community
Example of for-profit entity balancing st/h needs
Setting an objective of achieving maximum profit consistent with balancing needs of various st/h
e.g. achieving a satisfactory return whilst (for example) establishing competitive employment T&C and avoiding env pollution
Agency Theory
a hypothesis attempting to explain elements of org behavior through understanding relationships between principals (sh/h) and agents (those tasked with running the entity on their behalf)
conflict may arise when agents pursue self-interest of those of principals
in practice, ordinary shares are diversely held and opportunities to assess whether mgrs are acting in their best interest are somewhat limited
Considerations when determining the financial objectives of a For-Profit Entity
EQUITY INVESTORS
they provide the risk finance – to attract funds, the company is competing with risk-free investment opps (e.g. govt bonds) – thus sh/h require returns (dividends and future share price increases)
FINANCE PROVIDERS
primary interest = ability to generate s/t and l/t CF and thus repay debts
RISK EXPOSURE
certain risks (FX/interest rate) can be managed through hedging – thus sh/h and entities can determine how much risk they are willing to take for a particular return
however, some risk is not addressed in finance theory – e.g. activity of competitors, recruitment of senior personnel
directors should thus set risk policies according to an agreed risk appetite reflecting that of the sh/h
Example specific financial objectives of for-profit entities
Profitability = e.g. annual 10% increase in earnings or EPS
Dividends = e.g. annual 5% increase
Cash Generation = e.g. annual 10% improvement in operating CF
Gearing = e.g. maximum ratio of 40% [debt to (debt plus equity)]
Financial Performance Indicator
Return to investors
Capital appreciation on shares (difference between P1 and P0 / end and start of year) + dividends
even with no dividends, capital appreciation of shares is important
{ P1 – P0 + Dividend } div P0
Financial Performance Indicator
Cash Generation
Poor liquidity = greater threat to survival than poor profitability
Cash generation vital to ensure investment in future ventures
Otherwise growth must be funded with high levels of borrowing
Financial Performance Indicator
Value Added
Measure of Performance
Defined as revenues less cost of purchased materials and services
Represents value added to entity’s products by its own efforts
Main issue is comparability (across and within industries)
Financial Performance Indicator
Profitability
Rate at which profits are generated
ADV
well-known and accepted
readily understood
comparable (provided consistency of calculation across time)
DISADV
does not explain why one business sector has more favorable prospects
insufficient insight into dynamics and balance of entity’s BUs
remote from the actions which create value, thus can only be managed directly in very small orgs
the input to the measure may vary substantially between orgs
Financial Performance Indicator
Return on Assets (ROA)
dividing annual profits by average net book value of assets
thus subject to distortions of using profits > CF (deprec, inv reval, write-offs)
also ignores time value of money – only minor concern if inflation is low
Financial Performance Indicator
Market Share
often seen as an objective for the comp in its own right – but must be judged in context of other measures such as profitability and shareholder value
unlike other measures, takes quality into account – assuming that dissatisfied customers will drive red’n in share
growing share is a l/t goal of entities to maximize outlets for prods/svcs and minimize competition
Financial Performance Indicator
Competitive Position
comparing our position to theirs – managers making decisions need to know by whom, by how much, and why they are gaining or losing ground
no single measure is useful – an array is needed to establish competitive position – the main challenge is gathering data from competitors for comparison
Stakeholder Issues in For-Profit Companies
(which may drive non-financial objectives)
EMPLOYEES – returns (salaries), job security, working conditions
MANAGERS/DIRECTORS – well-placed to prioritize their own needs - l/t goals (max sales, defence against takeovers) and s/t (profit margins leading to bigger bonuses)
SUPPLIERS – s/t prompt payment and l/t desire for regular business – importance of their needs depends on # of suppliers and relative size
GOVERNMENT – political desire to inc exports / dec imports while monitoring competition - financial desire to maximize tax revenues
COMMUNITY – including legal and social resp, pollution control, employee welfare
ENVIRONMENTAL – awareness of pollution and other issues
CUSTOMER PRESSURE – demanding ethical and responsible behavior - often conflicting with sh/h objective of wealth maximization
CUSTOMER SATISFACTION - failing here results in lost market share and eventual liquidation
Example non-financial objectives for for-profit entity
HUMAN (relationship with staff)
increasing training provision, reducing turnover
INTELLECTUAL (intangible assets, e.g. brand / reputation)
improving brand recognition
NATURAL (responsibility to environment)
reduction of pollution, increased recycling
SOCIAL (responsibility to community)
ensure 50% of employees live within 5km of office
RELATIONSHIP (towards key st/h - e.g. suppliers and customers)
pledge l/t contracts to suppliers and pay on time => improved relationships
Objectives and Stakeholders for NFPs
NFPs will also have a range of fin and non-fin objectives and will have multiple st/h groups to satisfy
varying views on “ideal” NFP objectives and what success looks like - e.g. hospitals saving lives vs having shorter waiting lists
defining measurable objectives is the major challenge in determining how to run NFPs (especially in public sector) effectively
Overview of Financial Objectives in Public Sector Orgs
Quoted company objective is max sh/h wealth, measurable through share price and dividends
Public sector org is run in interests of society of whole, thus we should try to measure the gap between costs of operation (easily measured) and benefits provided (incredibly difficult)
benefits are intangible / impossible to quantify – govt orgs use low discount rate and/or attempt to quantify non-fin benefits in standard NPV – but overall very tricky
Regulation in the Public Sector
Regulation to ensure public are not victims of monopoly that these orgs enjoy
eg. capping of sales prices, taxing of super profits, or limit on permitted profit levels
Public Sector Objectives
Cash Generation
historically, public sector growth entirely funded by govt
now, government has imposed cash limits, and public sectors orgs are turning to capital markets for funds, thus beginning to face the same choices as for-profit entities
Public Sector Objectives
Value Added
value added to an entity’s products by its own effort
problem = comparability with other industries or entities in same industry
public sector entities (e.g. health) are publishing information on their own value-add
Public Sector Objectives
Profitability
true concept of profit absent from most of the public sector
however a different measure of output may be used = e.g. surplus after all costs (input) to capital investment (output)
Public Sector Objectives
Return on Assets
although profit concept is absent, not unrealistic to expect entities to use donated assets with maximum efficiency
Interpretation of ROA in public sector affected by:
- difficulty determining value
- no resale value
- assets are for use by community at large
- dep’n charge may have “double taxation” effect on taxpayer
Public Sector Objectives
Market Share
increasingly important - e.g. universities an dhealth care
health providers must now “sell” services to trusts established to “buy” from them - and risk losing market share (within limits) if customers decide to buy elsewhere
Public Sector Objectives
Competitive Position
Public sector increasingly in competition with other public and private bodies providing same service
e.g. hospitals are competing for health trust funds, advantage here is that getting access to competitor data is easier than in private sector (presumably b/c services are in “public interest”)
Public Sector Objectives
Risk Exposure
Public sector entities are risk averse because of:
- political repercussions of failure
- taxpayers do not have alternative options to down-risk their investments (unlike sh/h)
Definition of Value For Money
Performance of an activity in such a way as to simultaneously achieve
ECONOMY, EFFICIENCY, EFFECTIVENESS
making optimum use of available rscs to achieve intended outcome
Value for Money Constituent Elements
ECONOMY - minimizing cost of resources used/req’d (inputs) - spending less
EFFICIENCY - relationship between output from gds/svcs and rscs to produce them - spending well
EFFECTIVENESS - relationship between intended and actual results (outcomes) - spending wisely
newcomer - EQUITY - extent to which svcs are available to reach intended audience - spending fairly
Value for Money Diagram
Value For Money Measurement
very difficulty to measure in practice
a relative measure > absolute
Definition and Purpose of Value for Money Audit / Study
Definition: Investigation into whether proper arrangements have been made to secure 3Es in use of resources
Purpose: seeks to determine whether VFM has been achieved in a specific area of expenditure / whether rsc use to achieve intended outcome was optimal
intention not to question policy objecties, but provide independent and rigorous analysis on how money was spent to achieve these objectives
Contents of Value for Money Audit / Study
Mix of quant and qual methods:
- financial analysis
- analysis of mgmt info
- interview / focus groups with dept/other staff
- general research
- surveys of practitioners or serice users
- benchmarking with other orgs / countries
Fundamental Issue with VFM Audits
Typical focus is EITHER on effectiveness OR on economy and efficiency - they are often in partial conflict
better service (effectiveness) requires more spending (economy)
cheaper service (economy) means lower quality (effectiveness)
Strategic Implications of International Expansion
COMPETITION
may be weaker overseas, thus attractive to firm facing competition at home
COUNTRY FACTORS
cheaper sources of raw mat and labor, plus govt grants and cheap loans to attract inward investment
CUSTOMER BENEFITS
reduced delivery times and improved relationships by locating closer to existing customers (plus ability to gain others)
ECONOMIES OF SCALE
RISK MANAGEMENT
reduced exposure to a single economy - interest rates, inflation, govt policy, FX
Financial Implications of International Expansion
POSITIVE NPV
Gain in sh/h wealth
IMPACT ON F/S
translation risk = assets denominated in foreign currency giving rise to unrealized gains/losses upon conversion to domestic currency
IMPACT ON COC
international investments often riskier than domestic, thus COC likely to increase
Three categories of ratio used to appraise financial performance
Profitability Ratios
Lender Ratios
Investor Ratios
Definitions of SOPL Profit Figures
GROSS PROFIT
Sales less Cost of Sales
High Gross Profit Margin indicative of good performance
OPERATING PROFIT
Profit from trading activities
Sales less operating costs, but before finance costs and tax
NET PROFIT
Profit after deduction of finance costs and tax
EBITDA
Earnings Before Interest, Tax, Depreciation, and Amortization
has become increasingly widely used in recent years – sceptics say because it gives a higher measure of earnings than profit from operations
EBITDA makes sense as it excludes dep’n and amort’n, both accounting adjustments and not CF – but for this reason EBITDA often mistakenly regarded as CF measure, whereas no accrual or working cap adjustments are made
Two Measures Critical to Analysis of Profitability
(1) Return on Capital Employed (ROCE)
(2) Return on Equity (ROE)
Return on Capital Employed (ROCE)
ROCE shows the overall perf of the org, expressed as a % return on total investment – thus mgmt efficiency in generating profits from available rscs
{ Operating Profit / Capital Employed } * 100
Capital Employed = total funds investment = sh/h funds + l/t debt (or total assets less CL)
Return on Equity (ROE)
ROE gives indication of how well org has performed in relation to sh/h
{ Net Profit / Equity } * 100
Equity = book value of sh/h funds
useful to compare ROE to ROCE to measure how much of business’s return pertains to sh/h – but they are not directly comparable: ROE uses net, ROCE uses operarting profit
Asset Turnover
Revenue / Capital Employed
shows how much revenue is produced per $ of investment in capital employed
Breakdown of ROCE Formula
ROCE = Operating Profit Margin * Asset Turnover
{ op prof / cap emp } = { op prof / rev } * { rev / cap emp }
ROCE fall could thus be b/c org is:
generating lower sales from capital (lower asset turnover), and/or
generating lower profit margin on sales (lower op prof mgn)
Interpretation of Profitability Ratios
generally, high levels are desirable
entity with high profit margins and high ROCE perceived as doing well – and increases over time are viewed positively
“ideal” values vary between industries, so comparisons between years and competitors is key
Definition of Gearing
The relationship between an org’s borrowings (both prior charge capital and l/t debt) and shareholder funds
the mix of debt to equity within a firm’s permanent capital
Lender Ratios
Two measures of Gearing
Capital Gearing - SOFP Measure
Interest Cover - SOPL Measure
Capital Gearing
{ debt / (debt + equity ) } * 100
Debt = redeemable pref shares, bank borrowings, bong (incl overdrafts if l/t finance sources)
Equity = ordinary and irredeemable pref shares (plus rsvs if valued at book value)
Market Values and Book Values of Equity
Market Values should be used over Book Values in Capital Gearing Ratio
If using book values, must include any reserves/retained profits attributable to ordinary sh/h:
Book Value = ordinary share cap + reserves
If using market values, reserves must be excluded as considered as included in share price:
Market Value = # shares * share price
Interest Cover
indicates the number of times profits will cover the interest charge
Profit before interest and tax / Interest Payable
used by lenders to determine vulnerability of interest payments to a drop in profit
EBITDA often used as numerator b/c better approximation of cash generated by business / available to pay interest
Debt Ratio
Total l/t debt / Total assets
measures availability of assets in the business in relation to total debt
Market Price per share
Market price used in ratio formulae is ex-div market price
Ex-div price = Cum-dividend price less upcoming dividend per share
Earnings per Share
investor ratio
earnings / # ordinary shares in issue
earnings = profit distributable to ordinary sh/h, i.e. after interest, tax, and pref dividends
EPS is a historical figure and can be manipulated by changes to a/c policies, mergers/acquisitions - although obsessed upon by analysts and execs, future earnings are of greater concern to investors (and are harder to predict)
P/E Ratio
investor ratio
measure of growth – compares market value (measure of future earnings) to current earnings
current share price / EPS
or: Total Market Cap / Total Earnings
higher P/E ratio = higher market expectation of future earnings growth (aka “market potential”)
Earnings Yield
investor ratio
reciprocal of P/E ratio: EPS / current share price
or total earnings / total market cap
market price incorporates expectations of all buyers and sellers of entity shares, thus earnings yield is indication of future earning power of entity
Dividend-Payout Ratio
Dividend per Share / EPS
or: Total Dividend / Total Earnings
usually, entity with high P/E ratio has low dividend payout ratio b/c high growth entities require more resources // stable entities have lower P/E ratio and higher dividend-payout ratios
consider investor objectives – do they want high growth/risk or lower risk with fixed dividends and lower capital growth?
Dividend Yield
investor ratio
dividend per share / current share price
or: Total Dividend / Total market Capitalization
however, dividend only part of overall return - capital gain from increase in value may far outweigh dividend
Dividend Cover
investor ratio
EPS / Dividend per share
or: Total Earnings / Total Dividend
Higher dividend cover = more likely that dividend yield can be maintained
Also indicates level of profits retained by entity for reinvestment, by considering how mnay times this year’s dividend is covered by this year’s earnings
Earnings Growth and Dividend Growth
Investor Ratios
{ (CY figure / PY figure) – 1 } * 100%
Over n years: { n√ (year n figure / earliest year figure) – 1 } * 100%
Effects of an increase in interest rates
SPENDING FALLS
higher interest rates raise cost of credit and deter spending
assuming stable incomes, higher credit cards/mortgage payments mean less free cash
fall in spending => reduced aggregate demand => unemployment
ASSET VALUES FALL
value of bonds will fall b/c of fixed lower interest rate driving reduced demand
people’s wealth reduced => turn to saving to protect wealth
this reduces expenditure in economy even further
FOREIGN FUNDS ATTRACTED
foreign speculators can earn higher rate of return cf overseas
these funds could then be loaned out to businesses
EXCHANGE RATE RISES
demand for domestic currency increases => exchange rate increases
import prices lowered and domestic inflation driven down
but exports more expensive / harder to sell
longer-term effect on balance of payments depends on elasticity of demand/supply for traded goods
INFLATION FALLS
less demand in economy => producers lower prices by squeezing margins or wages
new borrowing is postponed by high interest thus demand will fall (thus price will too)
higher exchange rate raises export prices, this threatens sales and requires cost/wage cuts – workers laid off => total demand reduced => inflation falls
Inflation Overview
Definition = rising prices
low inflation may benefit an economy // however, getting inflation to 0% may result in higher unemployment
there is agreement that 5%+ inflation is harmful
Effects of overly high inflation
DISTORTS CONSUMER BEHAVIOR
front-loading purchases in fear of price hikes => unstable markets and unnecessary shortages
REDISTRIBUTES INCOME
unfair lowering of purchasing power of those on fixed incomes or lacking bargaining power
AFFECTS WAGE BARGAINERS
trade unions will push for higher claims, especially if they previously underestimated price increases
if employers accept, wage-price spiral which exacerbates inflation issue
UNDERMINES BUSINESS CONFIDENCE
planning and prod’n difficult when impossible to predict economic future and/or accurately calculate prices and investment returns
WEAKENS COUNTRY COMPETITIVE POSITION
if inflation here is higher, exports less attractive and imports more competitive
leading to fewer of our goods selling here and abroad => bigger trade deficit
RESTRIBUTION OF WEALTH
real value of savings eroded when rate of interest < inflation
redistribution from saveers to borrowers, from payables to receivables
government is largest borrower via national debt => it gains the most
Interest Rate Parity Formula
Shows impact of interest rates on expected exchange rate – more specifically, shows that the forward rate of exchange can be found by adjusting the spot rate to reflect the differential in interest rates between the two countries
F0 = S0 * { (1+rvar) / (1+rbase) }
S0 = spot rate of exchange
F0 = forward rate of exchange
rvar / rbase = interest rates for variable and base currencies (base being USD in $1 = ¥100 or ¥105)
Impact on financial ratios
of changes in interest rates, exchange rates, and inflation
changes in interest rates / exchange rates / inflation can effect org ability to meet objectives
e.g. exchange rate change could impact sales prices and thus profitability ratios, may prevent achieving an earnings objective
Impact on Financial Ratios
of changes in margins and volumes
change in margins and volumes of activity can also impact org ability to meet objectives
e.g. fall in sales volume can hit profitability ratios => missing earnings growth target
Limitations of published accounts figures for ratio analysis
HISTORICAL RECORDS, NOT FORWARD-LOOKING
however, many countries require additional disclosures re. prospects, environmental data, market information, etc. in keeping with drive towards integrated reporting
ACCRUALS VS CASH
SOPL on accruals basis => difficult to relate to cash position
inclusion of SOCF in accounts gives impression of cash position
FINANCIAL INFORMATION ONLY
historically the case - although in recent years env and social issues have been reported upon so that users of accounts can have a fuller view of entity performance
