Factors That Form Financial Strategy - Term Paper Example

 Developing a Financing Strategy Introduction The classic approach strategy involves certain goals that the company is trying to achieve and the means that are being used by the company to achieve those goals. The decision based approach of strategy involves certain integrated and dynamic decisions to establish the company in a complex environment. The bottom up marketing view of strategy involves decisions related to what the company plans to do and how to do it (Gibbons, n.d.). The financial strategy of a company influences its financial decisions. It is used to exploit value creating opportunities. Every company seeks to ensure good returns to their investors. Financial strategies are specific to a particular company. It has two components: To raise funds in an appropriate manner Proper allocation of those funds within the organisation A company’s fundamental value should be reflected in its market value. Markets are neither perfect nor efficient. Value can be created from the market imperfection (Bender & Ward, 2008). Internal Constraints on Financial Strategy Internal constraints to the formulation of financial strategy can be in the form of limitation in production capacity, funds available, shortage of skills, pressure to provide good returns on investment. External Constraints on Financial Strategy External constraints are in the form of regulations, government influences, and economic influences. Government influences are in the form of inflation policy, and taxation policy (Ogilvie, 2009). The Financial Strategy should be changed at every stage of the Life Cycle. Financial risk and business risk should have an inverse correlation. Financial Strategy Adopted In Philips Company They have a business improvement programme called Earn to Invest (E2I) They focus on ROIC (Return on Invested capital) and profitable growth They have cut down their portfolio in businesses that do not meet their margin targets Selective investments are made and cost is managed through Earn to Invest programme (E2I) They regularly monitor external environment (Verhagen, 2008) Financial Strategy Adopted By IBM Data was maintained in a common ledger system. The common accounting data from throughout the world was employed to create a strong financial information strategy. Treasury management information and business was delivered through a common planning system across the world. The entire data from across the world was maintained in a financial information warehouse. Investments were carried out in collaborative solutions. Collaborative solutions included web conferences, online team rooms and instant messaging (McMillan, 2007). Financial Strategy for Boeing Boeing’s management had realised that its financial systems and objectives were not supporting its strategic objectives. Keeping this mind, Boeing developed certain financial strategies. They identified the strategic capabilities of the finance department The best accounting processes, budgeting and planning and reporting was compared with Boeing A single level consolidation was established and five sub consolidation systems were rationalised A single standardised general ledger across the enterprise was used (McMillan, 2007) Launch Stage In this stage a conservative financial strategy is adopted. The main goal is to enlarge sales, raise money and establish an efficient financial system. The business risk is very high and thus the costs should be variable costs. This stage involves high investment that might increase the fixed costs. The financial risk should be kept low during the launch of the product. Low risk equity sources and funds from venture capitalists are used at this stage. Centralised investment strategy is adopted, dividends are kept low or non-cash dividends can be given (Wang, n.d.). Growth Stage The main goal at this stage is development. The company has to adopt better cost management policies, proper working capital management and should have good amount of reserve capital. An integrative investment strategy is adopted. The companies have high risk in the growth stages and since debt involves high risk thus a company at this stage would not finance debt. It would rather invest on assets and carry out developments. The growth stage requires more funding (Wang, n.d.). Maturity Stage In this stage the financial strategy is of maintenance. The company has to ensure working capital management and cost management The company at this stage establishes a diversified investment strategy. The company can afford to pay higher dividends. In the maturity stage since the risk is less, the company may generate funds by financing debts. Positive cash generation takes place in the maturity stage but as the demand for the product gradually dies the cash flow also declines. Funds are not required for increasing market share or developing new market but to maintain the existing market share. Once the sales of the company start declining a modified strategy has to be adopted. (Bender & Ward, 2008). Decline Stage The company at this stage explores possibilities of sustenance through change. In the decline stage the business risk gets reduced. At this stage the risk is about how long it would be economical to carry on the business. The low business risk is complemented by source of funding involving high financial risk. There would not be any reinvestment strategy in a dying business. The dividend paid can be more than the after tax profits as there would not be an adequate justification for reinvesting in depreciation. Dividends may be equal to the total of depreciation and profits. Financial strategy is generally in the form of debt financing. Certain funds are tied up in the business. If equity investors provide these funds then a risk adjusted return is required on the investment. Cost of equity is higher than the cost of debt and refinancing would help the company to release the equity funds before it finally liquidates. Lenders of the company will be willing to lend against the assets. These borrowings are paid to the shareholders. The company goes for financing payback rather than discounted cash flow techniques (download it, n.d.). Sources of Funds for the Company at the Various Stages of the Lifecycle A start-up company initially has to go for self financing. At this stage there is nobody else’s money involved and the risk is entirely of the owner. At later stage angel investors start investing in the company. Venture capitalist may come in the scenario before product is built. They have the power to challenge the management and have 20-25% ownership of the company. Suppliers and trade credit come into the scenario in the pre-production period and early stages of product development. It is an easy source of credit. Commercial banks provide funds only after the company reports profits and revenues. Institutional investors invest just before an IPO. They may buy the stock at a premium. Asset based lenders lend certain assets and regular monthly payments have to be made to them. When a company becomes big in terms of profits and revenues then public equity comes to the scenario. The company at this stage has large amounts of funds at its disposal (Gibbons, n.d.). Financial Strategy at the Different Stages of the Life Cycle Growth Business risk high. Financial risk low. Equity funding Dividend payout is nominal Growth is high P/E is high EPS(earning per share) is low Share price is growing and volatile Launch Business risk very high Financial risk very low Funding is from equity There is no dividend payout Growth is high P/E high EPS is nominal Share price is growing and volatile Maturity Business risk medium Financial risk medium Debt funding Dividend payout is high Growth is medium or may be low P/E medium EPS high Share price is stable with limited volatility Decline Business risk low Financial risk high Funding is through debt Total dividend payout Growth negative P/E low EPS declining Share price is declining and volatile (Bender & Ward, 2008). Balance between Business Risk and Financial Risk Every business involves certain amount of risk. Financial strategy implementation involves certain amount of risk. The type of business and its characteristics determine the amount of risk that can be taken. Dividend Strategy at the Different Stages of the Lifecycle A company which has just been launched would not pay dividends to its shareholders but would rather keep the money as a safeguard against risks. Since the company has prospects of growth so it is better to invest the money rather than pay dividends and investors can make more money through this way. Companies in the mature stage can pay sufficient dividends to their shareholders as much money is not required for investment. Huge amount of money is not required as working capital in this stage and there is not much growth prospects. In the decline stage there is neither any scope for re-investment nor investment opportunities. (Bender & Ward, 2008). P/E Ratio and Share Price at the Different Stages of the Lifecycle The expectations of the market about the future growth potential of the company are reflected through the company’s P/E ratio. The EPS is negative in launch stage and then slowly increases with increasing profits. The share price of the company is determined to a large extent by the investors’ perception of the prospects of the company. In initial stages the share price fluctuates, but slowly as the company enters into maturity phase then the share price becomes stable (Bender & Ward, 2008). Examples of Companies at the Various Stages of the Life Cycle Growth Stage – Dell Dell computer is in growth stage. They are bringing in many product innovations and are slowly establishing their presence. Growth prospects are high for the company. The EPS is low. P/E is high. The share price is also increasing slowly. Maturity Stage – Coca Cola Coca Cola has experienced a very long maturity stage and is still in the maturity stage. Coca Cola’s financial strategy is to strongly protect its existing market share. This company does not have the need for market development but it has to strongly protect its market share. The company needs funds for its marketing efforts. The primary financial strategy of Coca Cola at this stage is of cost management. The company in the maturity stage has invested largely in its branding to protect its market share and maintain its profitability. Investors have confidence in the brand and have the assurance of earning good dividend and profits. The investors get high dividends. The EPS is high. The growth is also medium as it has already achieved maximum growth. The share price of the company is stable and the P/E is medium. Decline Stage - Lehman Brothers Lehman Brothers was one of the most prominent investment banks in the US. The strategy that is generally adopted in the decline stage is of change but there is not much scope of change. The only strategy is to utilize its existing assets to meet its fund requirements. There is no reinvestment strategy for a company at this stage because there is no growth prospect for the company. Growth is negative for this company, EPS is declining and P/E ratio is also low. EPS (Earning per share) EPS or earning per share is the earning after tax, divided by the total number of outstanding shares. The value of the stocks is determined by EPS. The amount investors are willing to invest in a company’s share depends on its EPS. Increasing EPS is a positive sign for a business (Lasher, 2007). EPS= Earnings/Outstanding shares P/E Ratio (Price Earning Ratio) The price earning ratio shows the amount the investors are ready to pay per dollar of the profits reported. P/E Ratio= Price per Share/ Earning per Share The P/E ratio is high for firms with less risk and good growth prospects (Brigham & Houston, 2009). Dividend Pay out Ratio The dividend payout ratio calculates the percentage of the net income paid out to investors in the form of dividend (Albrecht, 2007). Dividend Payout Ratio= Cash Dividends/Net Income Comparative Analysis of the Financial Strategies at the Different Stages of the Life Cycle Coca Cola Dell Lehman Brothers The long term current liabilities were $13,169. The total current liabilities were $16,861. The total liabilities are zero. Interest Coverage ratio was 24. The higher interest coverage ratio indicates that the company can easily meet its interest expense. The interest coverage ratio was 15.2. The lower debt ratio indicates that the company has burden in the form of debt expense. The lower the ratio the lesser is the ability of the company to meet interest expenses. The interest coverage ratio 0.816. The very low interest coverage ratio shows the inability of the company to meet its interest expenses. Hence the company is in the decline stage. Debt to equity ratio was 0.47 (Coca Cola’s debt to equity ratio has decreased from 2007-2009). The debt is kept low in comparison to equity in the capital structure. Debt to equity ratio was 0.6. In the capital structure of the company debt is kept low compared to equity as debt involves higher risk in growth stage. Lehman Brothers had at various points of time had very high debt to equity ratio which was very risky and was one of the reasons for its decline. The debt ratio was 23.3. In 2009 the company generated $8.2 billion cash from operation. The revenue if not stagnant is somewhat stable because the company is in its mature stage. The company will not experience sudden and very high increase in revenue. The revenue generated is $15.4 billion. The strong growth in revenue indicates that this company is in the growth stage and will further experience growth indicated by its increasing revenues. The company is no longer recording any profits. The net income is -5.34 billion. $3.8 billion was paid to shareholders as dividend. A company at the mature stage pays regular dividends to its shareholders. They do not pay any cash dividends and do not have any immediate plans to pay dividend. They are in the growth stage and not yet in a position to pay dividends rather they use the entire profit amount in further investments. The company is no longer in a position to pay any dividends to its shareholders. The net revenue for Coca Cola was $30,990. The net revenue for Dell in 2009 was $ 61,101. The company just like any other growth stage company is generating high profits. The past data on revenue showed high revenue of 35.9 billion. Since the company is declining recent data is not available. (Kent & Fayard, 2010). (EBIT Financial Analyses Center, 2010). (Dell, 2009). (Forbes, 2010). (Dell Inc. 2010). (Wikiinvest, 2010). Conclusion Thus, we can conclude that the implementation of an appropriate financial strategy is very crucial for a company and should be implemented at every stage of the life cycle. Financial strategy is formulated with two basic objectives namely obtaining funds and proper allocation of those funds to get the maximum benefit. The financial strategy of a company should complement its corporate strategy and add value to the company. The company uses the market inconsistencies to develop a competitive advantage which helps in creating value for the company. An ideal financial strategy is formulated by taking into account both the internal and external stakeholders of the business. References Albrecht, W. S. & Et. Al. 2007. Accounting: Concepts and Applications. Cengage learning. Bender, R. & Ward, K. 2008. Corporate Financial Strategy. Butterworth-Heinemann. Brigham, E. F. & Houston, J. F. 2009. Fundamentals of Financial Management. Cengage Learning. Dell Inc, 2010. Condensed Consolidated Statement Of Financial Position. Content. [Online] Available at: http://i.dell.com/sites/content/corporate/secure/en/Documents/FY11_Q3_rtyu_BalanceSheet.pdf [Accessed December 06, 2010]. Dell, 2009. Form 10-K. Content. [Online] Available at: http://i.dell.com/sites/content/corporate/secure/en/Documents/FY09_SECForm10K.pdf. Download it, No Date. Declining Businesses: A Case for Euthanasia? Free Files. [Online] Available at: http://www.download-it.org/free_files/fd8591f6ff52edfff38608cf85b59dd0Pages%20from%20Chapter%2010.%20Declining%20businesses%20-%20A%20case%20for%20euthanasia.pdf [Accessed December 03, 2010]. EBIT Financial Analyses Center. 2010. Coca-Cola Co. (KO). Stock Analysis On.net. [Online] Available at: http://www.stock-analysis-on.net/NYSE/Company/Coca-Cola-Co/Ratios/Long-term-Debt-and-Solvency [Accessed December 06, 2010]. Forbes, 2010. Dell Inc (Nasdaq:Dell. Forbes. [Online] Available at: http://finapps.forbes.com/finapps/jsp/finance/compinfo/Ratios.jsp?tkr=DELL [Accessed December 06, 2010]. Gibbons, F. M., No Date. Summary of Concepts, Frameworks, Tools, and Related Articles. Stanford University. [Online] Available at: http://www.stanford.edu/class/ee353//Abstracts1.htm [Accessed December 03, 2010]. Kent, M. & Fayard, G. P. 2010. Analysis of Consolidated Statements of Income. United States Securities and Exchange Commission. [Online] Available at: http://www.thecoca-colacompany.com/investors/pdfs/form_10K_2009.pdf [Accessed December 06, 2010]. Lasher, W. 2007. Practical Financial Management. Cengage Learning. McMillan, I., 2007. Finance Strategy: Delivering the Partnering Role. Case study – IBM. [Online] Available at: http://www-935.ibm.com/services/uk/bcs/pdf/fpee01713-0.pdf [Accessed November 06, 2010]. Ogilvie, J., 2009. Financial Strategy. Butterworth-Heinemann. Verhagen, P., 2008. Financial Strategy. Investor. [Online] Available at: http://www.philips.com/shared/assets/Downloadablefile/Investor/05_Verhagen_041208.pdf [Accessed December 03, 2010]. Wang, Y., No Date. Financial Strategy for Family Business Based On Life-Cycle. ISB. [Online] Available at: http://www.isb.edu/FamilyBusinessConference/FinancialStrategyforFamilyBusinessesBasedonLifecycle.pdf [Accessed December 03, 2010]. Wikiinvest, 2010. Key Metrics for LEH as Compared to. Lehman Brothers (LEH). [Online] Available at: http://www.wikinvest.com/stock/Lehman_Brothers_%28LEH%29/Data/Key_Metrics?ref=topnav [Accessed December 06, 2010]. Bibliography Bierman, H. 1999. Corporate Financial Strategy and Decision Making To Increase Shareholder Value. John Wiley and Sons. Fruhan, W., 1979. Financial Strategy: Studies in the Creation, Transfer, and Destruction of Shareholder Value. R. D. Irwin. Graham, T. & Allan, W., 2005. Management Accounting Financial Strategy. Butterworth-Heinemann. Hellmann, T. & Puri, M., 2000. The Interaction between Product Market and Financing Strategy: The Role of Venture Capital. The Review of Financial Studies. [Online] Available at: http://strategy.sauder.ubc.ca/hellmann/pdfs/RFSofficial.pdf [Accessed December 03, 2010]. Ogilvie, J. 2008. CIMA Official Learning System Management Accounting Financial Strategy Butterworth-Heinemann. Rutterford, J. & Et. Al., 2006. Financial Strategy. Wiley. Read More