Strategic Financial Management: Critical Assessment
Critical Assessment, Application and Evaluation of Issues and Techniques of Strategic Financial Management
1. INTRODUCTION
Strategic financial management is made up of two key concepts "strategy" and "financial management". Strategy has to do with a particular course of action a company stays true to over a long period of time, whilst financial management entails the prudent and efficient management of a firm's finances to achieve the objective of maximizing shareholder wealth. Put together, strategic financial management entails efficient allocation of a firm's finances with a long term view in mind for the purpose of increasing shareholder wealth.
The allocation of a firm's resources, from the perspective of strategic financial management, may or may not be targeted directly at core profit generating activities such as the production of new goods and services. This is because in the grand scheme of strategy and business success, it takes more than just producing quality goods and services to survive and enjoy sustained goodwill from the general public. Intangibles like trust, respect, goodwill, environmental friendliness, accountability and transparency, which constitute major benefits of corporate social responsibility, go a long way to strengthen the relationships that exist between companies and their stakeholders.
Earlier in this presentation, it has been indicated that firms exist to maximize shareholders' wealth. If that is the case, it may then be argued that the release of funds into corporate social responsibility initiatives amounts to wastage of the company's scarce resources as such moves, on the surface, may not appear to be in the best interest of the company's primary objective of shareholder wealth maximization. But then some empirical studies provide evidence to the contrary (Waddock & Graves 1997; Van De Velde 2005) despite some studies however reporting mixed findings (McWilliams & Siegel 2000; Lima Crisóstomo et al. 2011). Deducing from the aforementioned studies, corporate social responsibility appears to yield more positive dividends in developed markets than developing and emerging markets. Waddock & Graves (1997) in a study to establish a link between corporate social performance and financial performance found that corporate social responsibility (CSR) was positively associated with prior financial performance. Moreover, CSR was also found to be positively associated with future financial performance, lending credence to the theory that good management and CSR are positively related (Waddock & Graves 1997).
Based on the foregoing, it is safe to assume that corporate social responsibility and financial analysis make up key techniques of strategic financial management. The remaining portion of the presentation is thus divided into two parts. The first part of this presentation takes a look at stakeholder and corporate social responsibility issues using Tesco as case study. The second and the last part focus on financial analysis with particular reference to financial ratios using a hypothetical company, Benedict Co. as case study
2. STAKEHOLDERS AND CORPORATE SOCIAL RESPONSIBILITY
A. Explanation of the Term 'Stakeholder' and Identification of Types of Stakeholders
The term 'stakeholder' refers to an individual or a group of individuals who have a 'stake' or an interest in a company and can thus affect or be affected by the policies and activities of the company in question. Companies don't operate in a vacuum. Any wonder, the stakeholder theory holds that the activities of companies affect the society in which they operate. In fact, there exists an interdependent dynamic relationship between a company and its customers, employees, suppliers, investors, community and others. The relationship between a company and its stakeholders is not one-way as there is mutual dependence. For example, without the use of the skills and expertise of employees, a company would find it most difficult to produce its goods and services, whereas employees depend on the company for their paychecks.
The types of stakeholder of Tesco as identified in Tesco's 2016 Annual Report are as follows:
· Customers – people who purchase Tesco's goods and services
· Social and environmental stakeholders – NGOs and environmentalists.
· Investors (Tesco 2016) – provides the financing which Tesco uses to operate its business.
B. An Analysis of How the Environmental and Social Review and the Corporate Governance Report Help Tesco Demonstrate its Performance in terms of its Corporate and Social Responsibilities to two of its Stakeholders
The field of corporate social responsibility (CSR) has grown exponentially in the last decade (Van De Velde 2005). Nevertheless, there remains a protracted debate about the legitimacy and value of corporate responses to corporate social responsibility concerns. Interestingly, Tesco in its 2016 Annual Report aspires to becoming to becoming a leader in the retail industry as far as corporate responsibility is concerned. But why is that? Using extensive data over a period of five years, Van De Velde (2005) conducted a study to explore and test the sign of the relationship between corporate social responsibility and financial performance. The dataset included most of the S&P 500 firms and covered the years 1996-2000. The relationship under investigation was tested by using empirical methods. The results from the study showed that the sign of the relationship is positive and statistically significant, thus confirming the view that corporate social responsibility is significantly associated with a company's profitability. Perhaps, this piece of evidence explains why Tesco hopes to go all out in its corporate social responsibilities. Aside that, John Allan, the Corporate Responsibility Committee Chairman in the 2016 Annual Report has indicated that CSR was important to rebuilding trust and transparency across a wide spectrum of its stakeholders. This clearly suggests that Tesco appears to be making progress in its CSR efforts.
Analyzing the 2016 Annual Report, evidence of Tesco's progress in CSR can be found in its (i) Environmental and Social Review, and (ii) Corporate Governance Report sections of its annual report.
i. Environmental and Social Review: How Tesco Demonstrates its CSR Performance to Environmental and Social Stakeholders
The initiatives deployed under the Environmental and Social Review of the 2016 Annual Report demonstrates Tesco's performance in terms of its corporate and social Responsibilities to environmental and social stakeholders. The initiatives were:
· The launch of an 'Eat Happy/ Farm to Fork' project seeks to create awareness amongst school children about the process of food production and making healthy eating choices. Through this campaign Tesco is able to promote healthy eating to children to reduce child obesity whilst at the same time subtly imprinting the Tesco brand on the minds of these young children – the possible future consumer base of Tesco.
o Strategic Financial Management Value of Project: In a sense, Tesco is strategically nurturing its future potential consumers by directing some of its resources into its 'Eat Happy/ Farm to Fork' project. By this project Tesco and its products over the long term become also associated with healthy foods and healthy eating thereby boosting the Tesco brand.
· The creation of a 'Bags of Help' scheme. This scheme was launched after the UK government slapped a levy on plastic bags. As at the end of 2016, £11.5 m has been generated under the scheme from the sales of carrier bags. The funds raised are then channeled into local projects to develop under-utilised outdoor areas. Plastic bags are non-biodegradable and so are detrimental to the environment. As a show of support to its environmental and social stakeholders, Tesco launched the 'Bags of Help' scheme demonstrating that it is environmentally and socially responsible member of society. Among other things, the scheme ensures that awarded projects deliver a physical environmental improvement and/or encourage use and long term sustainability of outdoor spaces (https://www.groundwork.org.uk/Sites/tescocommunityscheme/pages/Category/apply-for-a-boh-grant-tes2, date accessed 26/5/2018).
o Strategic Financial Management Value Scheme: The scheme engenders goodwill amongst customers and potential customers towards Tesco. With the development of under-utilised outdoor areas, Tesco gets to extend its reach and influence in areas which it may have had no footprint thereby creating awareness amongst the inhabitants living around the under-utilised outdoor areas about Tesco and what it does, which ultimately helps in maximizing shareholder wealth.
· The rolling out of the Community Food Connection project is another way Tesco demonstrates its CSR performance to its environmental and social stakeholders. The project is aimed at reducing food waste. This project is being run through a partnership with UK charity FareShare, utilising the technology platform developed by Food Cloud, an Irish social enterprise. The platform allows communication where surplus levels of food have been identified at stores and provides for the worthwhile distribution of this food through carefully vetted and responsible local charities and community groups. Aside reducing food waste, by this project Tesco in somewhat also tackles hunger albeit at the community level by channeling surplus from where there is excess to areas where food is lacking or insufficient. This project has generated a lot of good will and trust towards Tesco in a big way long term.
ii. Corporate Governance Report: How Tesco Demonstrates its CSR Performance to Investors
Investors are an important stakeholder of any company be it publicly traded or otherwise. This section analyses the Corporate Governance Report to demonstrate Tesco's CSR performance to investors. During the year under review i.e. 2016, a lot of activities were conducted to show investors how much CSR is valued at Tesco. Some of these activities are:
· The Chairman, CEO and CFO held regular meetings throughout the year with institutional shareholders and updated the Board on the outcome of those meetings;
· Roundtable events and investor road shows were organised and conferences attended in the UK, Europe and North America;
· Institutional shareholders were invited to attend the Company's full-year and half-year results presentations. The presentation slides and a webcast of the full-year and half-year results presentations were made available at www.tescoplc.com along with transcripts of all the results presentations and trading statement conference calls;
· The Chairman and Remuneration Committee Chairman held meetings with major shareholders to discuss governance and strategy;
· Socially Responsible Investors were also engaged by holding calls to discuss various issues and responding to queries; and
· A survey of a cross-section of shareholders was undertaken during the year in order to assess shareholder perception of the Company.
3. ANALYSIS AND EVALUATION OF FINANCIAL POSITION OF BENEDICT CO. USING FINANCIAL RATIOS
Financial ratios are the tools of financial analysis. The selection of the type of financial ratios to use in financial analysis depends on the type of stakeholder for whom the analysis is being conducted. For the purpose of this report, financial analysis of Benedict Co. is being conducted to meet the requirements of the following stakeholders: (i) Potential customers; (ii) Investors; (iii) Lenders; (iv) Suppliers. In view of the foregoing, this section explores the purpose and relevance of the chosen ratios.
A. PURPOSE AND RELEVANCE OF CHOSEN RATIOS
POTENTIAL CUSTOMERS
The financial ratios of interest to a potential customer of Benedict Co. will be the company's inventory holding period and inventory turnover mathematically expressed as:
Inventory holding period = Inventories x 365 days
Cost of sales
Inventory turnover = Cost of Sales (times)
Inventories
That is because a potential customer of a company is most likely only concern with whether the company has the goods that is to be purchased in its inventory or not. Holding period measures the number of days on average that inventories are held and will depend upon type of goods sold. Meanwhile, turnover is the number of times the stock is turned over per year. A flower seller will have a holding period of 7 days whereas a jeweler may have sixty to ninety days, or longer. However, inventory must always be kept as short as possible as cash is tied up in it and additional storage costs may be incurred.
INVESTORS
Successful investors are thorough in how they analyse a company before committing to a financial investment into the company. They use a gamut of financial ratios. These ratios range from price ratios, profitability ratios, to liquidity ratios, to debt ratios.
Price Ratios
Price ratios are used to gauge how reasonable a stock price is. It must be noted however that price ratios are relative in nature, implying that the use of price ratios are most effective when used as basis to compare companies. Some price ratios that will be considered in this part of the report are dividend per share and dividend yield. Dividend per share (DPS) measures the amount of a company's earnings that is paid out to investors for each share owned. The dividend yield as a financial analysis ratio is used to compare different stocks that pay dividend to determine the best dividend-paying stock within a particular industry. They are mathematically expressed as follows:
Dividend per share = Total Dividend paid
Total No. of Issued shares
Dividend Yield = Dividend per share x 100%
Price per share
Profitability Ratios
Profitability ratios show how efficient a firm is in translating business activities into profits. An example of a profitability ratio is the return on capital employed. Return on Capital Employed (ROCE) shows how much profit from operations is generated from every dollar of capital (equity and debt capital) invested in the business. This ratio is probably the single most important measure of performance – it compares profit with the amount of capital invested.
Return on Capital Employed, ROCE = Profit on operations (PBIT) x 100%
Total Equity + NCL
Liquidity Ratios
Liquidity ratios show how able a company is in fulfilling its short term obligations. A firm without enough liquidity may be forced to take decisions that are inimical to the long term strategic interest of the company just to raise funds to service short term debt obligations. Examples of a liquidity ratio are current ratio and quick ratio.
The current ratio measures an organization's capacity to pay its short term debts with current assets and it is mathematically expressed as:
Current ratio = Current assets
Current liabilities
The quick ratio share a lot of similarities with current ratio as the former also measures the ability of a firm to fulfill its short term obligations. Nonetheless, the key difference between these two ratios is the fact that quick ratio discounts the influence of inventory. This is because the ratio presupposes that selling inventory would take several weeks or months. In essence, the quick ratio only factors those assets that could be utilized to settle short term assets within 24 hours. The quick ratio is expressed mathematically as:
Quick ratio (or acid test) at 20X0 = Current assets – inventories
Current liabilities
LENDERS
Financial position indicates how the business is funded over the long-term and gearing measures the level of long-term debt as a percentage of equity (ordinary shares and reserves) or total funds (equity plus debt). Gearing is one of the financial ratios lenders will look at when considering advancing a loan to Benedict Co. Gearing is a measure of debt as a percentage of the total capital (share and debt) funding the business and it is expressed mathematically as:
Gearing = NCL x 100%
Total equity +NCL
Another ratio of interest to the lender is the interest cover. The interest cover indicates the margin of safety in terms of how many times the PBIT covers the finance costs on long-term borrowing. These must be repaid and thus it is important to measure how many times greater PBIT is compared to the interest costs. If this is low this is a worry in that if revenues fell and costs increased by only a small amount the interest may not be covered which would have significant negative consequences for the business.
SUPPLIERS
Suppliers will use trade payables' payment period and trade receivables collection period as their financial ratios of choice.
The trade receivables collection period shows how many days on average receivables take to pay for credit sales. This measures how efficiently the business is collecting money due and a reduction in days over time is the ideal. This ratio is expressed mathematically as:
Trade receivables' collection period at 20X0 = Trade receivables x 365 days
Revenue
The trade payables' payment period measures the speed it takes to make payment on credit purchases. Delaying payment can cause problems. Positive if payables are longer than receivables and constant ratio year on year indicates a stable company. This ratio is mathematically expressed as:
Trade payables' payment period = Trade payables x 365 days
Cost of sales
B. RESULTS FOR EACH CHOSEN RATIO AND REASONS FOR MOVEMENTS BETWEEN THE TWO YEARS
Inventory turnover at 20X0 = 5.57 times
Inventory turnover at 20X1 = 3.08 times
Inventory turnover for Benedict Co. reduced from 5.57 times in 20X0 to 3.08 times in 20X1. This observation may have been due to a slowing down of sales.
Inventory holding period at 20X0 = 65.45 days
Inventory holding period at 20X1 = 118.63 days
The increase in inventory holding period from 65.45 days in the year 20X0 to 118.63 days in the year 20X1 may be attributed to a reduction in inventory turnover from 5.57 times in 20X0 to 3.08 times in 20X1. Lower inventory holding period helps in freeing up cash tied up in the inventory.
Dividend per share at 20X0 = $0.20
Dividend per share at 20X1 = $0.25
The DPS rose from $0.20 in 20X0 to $0.25 in 20X1 suggesting that Benedict Co. is efficient at returning money to investors. This increase in dividend may have been due to better than expected earnings by Benedict Co.
Dividend Yield at 20X0 = 5.6 %
Dividend Yield at 20X1 = 4.5 %
The dividend yield for Benedict Co. reduced from 5.6 % in 20X0 to 4.5 % in 20X1. This movement decline in dividend yield may have been due to the increase in reserves from $7.9m in 20X0 to $10m in 20X1. This piece of data is important because some investors depend on the nature of a dividend yield, whether it is low, high or steady, to make stock selection decision. The reduction in the dividend yield may appeal to some investors and not to others.
Gearing at 20X0 = 23.6 %
Gearing at 20X1 = 31.7 %
The gearing for the company in question increased from 23.6 % in 20X0 to 31.7% in 20X1, possibly due to the company taking on more debts in 20X1.
Trade receivables' collection period at 20X0 = 55.7 days
Trade receivables collection period at 20X1 = 90.1 days
The trade receivables' collection period increased from 55.7 days in 20X0 to 90.1 days in 20X1, suggesting a delay in payment period.
Trade payables' payment period at 20X0 = 108.24 days
Trade payables' payment period at 20X1 = 155.13 days
Trade payables payment period increased from 108.24 in 20X0 days to 155.13 days in 20X1. This could have been due to the reduced inventory turnover time. The payables payment period is however longer than the receivables collection period which is positive.
C. A HIGHLIGHT OF ASPECTS OF PERFORMANCE OF BENEDICT CO. WHICH WILL GIVE CAUSE FOR CONCERN
· Benedict Co's current ratio was found to be lower than the industry average of 1.6. This is an issue that has to be dealt with otherwise it could engender disastrous consequences as current assets may not be sufficient enough to cover short term debt obligations.
· The increase in the inventory holding period from 65.45 days to 118.63 days is another issue of concern. This means that money tied up in inventory will take longer to get freed up.
· A reduction in inventory turnover from 5.57 times in 20X0 to 3.08 times in 20X1 is another issue of grave concern.
- CRITICALLY EVALUATE THE APPLICATION OF FINANCIAL RATIOS IN INTERPRETING AND MEASURING THE PERFORMANCE OF A COMPANY
The application of financial ratios in interpreting and measuring the performance of companies has its own unique setbacks. Some of these pitfalls are:
· Ratios are based on previous performance and conditions prevailing in the past. They may not be valid for making forward investment forecasts.
· Differences in accounting policies and estimates eg depreciation and stock valuation, may well distort the values recorded in the financial statements and comparisons would thus be invalid.
· Published accounts generally contain summarised information and detailed information may be required.
· Financial statements are based on historical costs and thus in periods of high inflation any form of comparison becomes practically meaningless. The values over the years will have little relationship to each other and thus non-comparable.
References
Lima Crisóstomo, V., de Souza Freire, F. & Cortes de Vasconcellos, F., 2011. Corporate social responsibility, firm value and financial performance in Brazil. Social Responsibility Journal, 7(2), pp.295–309. Available at: http://www.emeraldinsight.com/doi/10.1108/17471111111141549.
McWilliams, A. & Siegel, D., 2000. Corporate social responsibility and financial performance: Correlation or misspecification? Strategic Management Journal, 21(5), pp.603–609.
Tesco, 2016. Annual Report and Financial Statements 2016,
Van De Velde, E., 2005. Corporate social responsibility and financial performance. Corporate governance, 5(3), pp.129–138.
Waddock, S. a. & Graves, S.B., 1997. The Corporate Social Performance - Financial Performance Link. Strategic Management Journal, 18(4), pp.303–319.
Lima Crisóstomo, V., de Souza Freire, F. & Cortes de Vasconcellos, F., 2011. Corporate social responsibility, firm value and financial performance in Brazil. Social Responsibility Journal, 7(2), pp.295–309. Available at: http://www.emeraldinsight.com/doi/10.1108/17471111111141549.
McWilliams, A. & Siegel, D., 2000. Corporate social responsibility and financial performance: Correlation or misspecification? Strategic Management Journal, 21(5), pp.603–609.
Tesco, 2016. Annual Report and Financial Statements 2016,
Van De Velde, E., 2005. Corporate social responsibility and financial performance. Corporate governance, 5(3), pp.129–138.
Waddock, S. a. & Graves, S.B., 1997. The Corporate Social Performance - Financial Performance Link. Strategic Management Journal, 18(4), pp.303–319.
Appendix 1 – Calculations of Financial Ratios
Inventory holding period at 20X0 = Inventories x 365 days = 2,600 x 365 = 65.45
Cost of sales 14,500
= 65.45 days
Inventory holding period at 20X1 = Inventories x 365 days = 5,200 x 365 = 118. 63
Cost of sales 16,000
= 118.63 days
Inventory turnover at 20X0 = Cost of Sales (times) = 14,500 (times) = 5.57 times
Inventories 2,600
Inventory turnover at 20X1 = Cost of Sales (times) = 16,000 (times) = 3.08 times
Inventories 5,200
Dividend per share at 20X0 = Total Dividend paid = 3.6 = $0.20
Total No. of Issued shares 18
Dividend per share at 20X1 = Total Dividend paid = 4.5 = $0.25
Total No. of Issued shares 18
Dividend Yield at 20X0 = Dividend per share x 100% = 0.20 x 100 % = 5.6 %
Price per share 3.60
Dividend Yield at 20X1 = Dividend per share x 100% = 0.25 x 100% = 4.5 %
Price per share 5.60
Gearing at 20X0 = NCL x 100% = 8,000 x 100% = 23.6 %
Total equity +NCL 25,900+8000
Gearing at 20X0 = NCL x 100% = 12,000 x 100% = 31.7 %
Total equity +NCL 25,900+12000
Trade receivables' collection period at 20X0 = Trade receivables x 365 days
Revenue
= 3,800 x 365
24,900
= 55.7 days
Trade receivables' collection period at 20X1 = Trade receivables x 365 days
Revenue
= 7,600 x 365 days
30,800
= 90.06 days
Trade payables' payment period at 20X0 = Trade payables x 365 days
Cost of sales
= 4300 x 365
14,500
= 108.24 days
Trade payables' payment period at 20X1 = Trade payables x 365 days
Cost of sales
= 6800 x 365
16,000
= 155.13 days
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