Financial Objectives – Measures
Financial objectives - key measures
Cash flow targets
A clichéd but nevertheless relevant saying amongst bank managers goes like this:
Revenue is vanity Profit in sanity CASH IS KING
The
logic behind the saying is straightforward. Many businesses focus on
growing revenues and take great pleasure from being boasting about the total
sales they achieve. However, what if those sales are not profitable? A
business that runs out of cash becomes insolvent and fails. In contrast,
a business that generates strong profits and turns them into positive cash flow
is in a very strong position to achieve all of its objectives.
A
variety of possible cash flow objectives might be set by a business depending
on its financial position and corporate strategy. For example:
- Reduce bank
borrowings to a target level – perhaps by repaying amounts owed under bank
loans or restricting the use of bank overdraft facilities
- Minimise the
time taken by customers who pay on credit to settle outstanding invoices –
this is traditionally a major concern of smaller businesses and an obvious
focus for a cash flow objectives
- Extend the
period taken to pay suppliers to maximum permitted period – e.g. paying
trade creditors at the end of any agreed credit period
- Building a
buffer balance of cash as a precaution against unforeseen circumstances
- Minimising
the amounts paid out in interest charges
- Reducing the
seasonal swings in cash flow – perhaps by finding new uses for excess
production capacity in quiet periods, or developing markets which are
counter-seasonal to existing revenues
Returns on investment objectives
The
funds invested in a business need to earn a return. Ideally that return
at least matches, and ideally exceeds, the target return set by management.
The
main performance measure of return in a commercial business is Return
on Capital Employed(“ROCE”) - sometimes also referred to as Return on
Capital.
ROCE
is essentially about how well a business turns assets into profit.
This matters for a business because of the concept of opportunity cost.
Faced
with a choice of investing £500,000 in a new business project or giving it back
to the shareholders as a dividend, what should the business do? If the
project generates a return on investment of over 10%, then the shareholders
would probably prefer the project to go ahead rather than receiving the
dividend. It depends on what their required rate of return is.
ROCE
can be used in several ways:
- To help
evaluate the overall performance of the business
- To provide a
target return for individual projects
- To benchmark
performance with competitors
Your
studies on investment appraisal make use of the concepts introduced above –
this is an important area.
Shareholders’ returns
A
basic recap to begin with. Shareholders are the owners of a
limited company and they gain their financial reward from share
ownership in two ways:
- A share of
the profits earned by the company – paid out as a dividend
- Growth in
the value of their shareholding (compared with the cost of buying the
shares) – which is “realised” when the shareholder sells the shares to
someone else
The
vast majority of limited companies are “private” in that their shares are not
publicly traded on a regulated stock market. However, that does not stop
the shareholders of private limited companies from buying and selling shares
privately.
Shareholders
in public companies whose shares are traded on the Stock Exchange have a daily
insight into the returns their investment is making:
- The share
price indicates the market value of the business (share price x
number of shares in issue)
- The latest
share price can be shown as a multiple of the most recent annual earnings
(or profits) per share, to show a valuation ratio known as the
Price/Earnings (or P/E) ratio
- The latest
annual dividend can be compared with the share price to indicate an annual
return (“dividend yield”)
The
financial objectives that a public company might, therefore, set in relation to
shareholder returns might include:
- Target
growth in the share price
- Increases in
the dividend per share over time
- Increases in
earnings per share
- Read it too :Organisational Behaviour Principles
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