Strategy Formulation
1 Introduction
This chapter is concerned with the principles of strategic planning. Most of the chapter relates to topics which you have studied before and is therefore revision. Additionally, there are topics in this chapter that are covered in much greater detail in other syllabuses. In this examination, you will not be examined in detail on these areas, but do not be afraid of drawing on your other knowledge when answering questions.
2 Business planning
Businesses must plan and control their operations so that decisions can be taken in line with the company’s objectives.
2.1 Plans are usually classified into:
Strategic plans, which are concerned mainly with external problems, and in particular with deciding which products or services to produce for which market.
Tactical plans, which are concerned with ensuring that the company’s resources are adequate for carrying out the strategic plans in order to reach the desired objective
Operational plans, which are concerned with the way in which the company is to be run from day to day in order to optimise performance
A business plan is often regarded as being a combination of a strategic plan and a financial plan. The financial plan sets out quantified financial targets, which usually take the form of forecast financial statements. These are based on forecasts, and are derived from an analysis of past results and predictions of future changes within the economy/industry/company.
3 Financial analysis
Although you must be aware of several key measures of financial performance, it is important that you do not fall into the trap of simply calculating every ratio imaginable for every year available. What the examiner is after is much more of an over-view and being able to determine the key measures and to comment adequately.
The following points should be considered:
What is it that you are being asked to comment on?
For example, if you are looking at the information from the shareholders perspective, then growth (or otherwise) in the share price will be of great interest.
However, if you are looking at how well the managers are performing, the growth (or otherwise) in the profit (to the extent to which they control it) is perhaps of more importance.
Growth:
Always make some comment as to the level of growth. The amount of detail required depends on the information available and the number of marks allocated, but growth in turnover, in profit, and in share price are all potentially relevant.
Look at the overall level of growth and look for any trends, do not waste time doing detailed year-by-year analysis.
Areas for analysis:
Subject again to exactly what you are being asked to comment on, the following areas are likely to be worthy of consideration:
Profitability – how well a company performs, given its asset base
Liquidity – the short term financial position of the company
Gearing – the long-term financial position of the company
Investors ratios – how well investors will appraise the company
Bases for comparison:
Most measures mean little on their own, and are only really useful when compared with something.
Depending on the information given in the question, any comparison is likely to be one of the following:
with previous years for the same company
with other similar companies
with industry averages
4 Common ratios
The following is a list of the most common ratios that may be appropriate. However, do not simply calculate every ratio for every question – think about what you are trying to consider and choose the most appropriate ratios. If relevant by all means calculate additional ratios – there is no one set of ratios.
Choosing the ratios starts with what the question already gives you. Where ratios are supplied for a competitor or for the industry, calculate the same ratios for the company, on the same definitions: a competitor's gearing given on market values as debt ÷ (debt + equity) cannot be compared with the company's gearing worked on book values, or as debt ÷ equity. Use the definitions below exactly — interest cover is profit before interest and tax ÷ interest, not profit before or after tax.
4.1 Profitability ratios
Note: Capital employed = shareholders funds plus ‘creditors amounts falling due after more than one year’ plus long term provisions for liabilities and charges.
Net profit margin × asset turnover = ROCE
4.2 Liquidity ratios
4.3 Gearing ratios
4.4 Investor ratios
5 EBITDA
EBITDA is a financial performance measure that has appeared relatively recently. It stands for ‘earnings before interest, taxes, depreciation and amortisation’ and is particularly popular with high-tech startup businesses.
Consideration of earnings before interest and tax has long been common – before interest in order to measure the overall profitability before any distributions to providers and capital, and before tax on the basis that this is not under direct control of management.
The reason that EBITDA additionally considers the profit before depreciation and amortisation is in order to approximate to cash flow, on the basis that depreciation and amortisation are non-cash expenses.
A major criticism, however, of EBITDA is that it fails to consider the amounts required for fixed asset replacement.
Summary financial information for Repse plc is given below, covering performance over the last four years.
Year 1 | Year 2 | Year 3 | Year 4 | |
Turnover | 43,800 | 48,000 | 56,400 | 59,000 |
Cost of sales | 16,600 | 18,200 | 22,600 | 22,900 |
Salaries and Wages | 12,600 | 12,900 | 11,900 | 11,400 |
Other costs | 5,900 | 7,400 | 12,200 | 13,400 |
Profit before interest and tax | 8,700 | 9,500 | 9,700 | 11,300 |
Interest | 1,200 | 1,000 | 200 | 150 |
Tax | 2,400 | 2,800 | 3,200 | 3,600 |
Profit after interest and tax | 5,100 | 5,700 | 6,300 | 7,550 |
Dividends payable | 2,000 | 2,200 | 2,550 | 3,600 |
Average debtors | 8,800 | 10,000 | 11,100 | 11,400 |
Average creditors | 3,100 | 3,800 | 5,000 | 5,200 |
Average total net assets | 33,900 | 35,000 | 47,500 | 50,300 |
Shareholders’ funds | 22,600 | 26,000 | 44,800 | 48,400 |
Long term debt | 11,300 | 9,000 | 2,700 | 1,900 |
Number of shares in issue (‘000) | 9,000 | 9,000 | 12,000 | 12,000 |
P/E ratio (average for year) | ||||
Repse plc | 17.0 | 18.0 | 18.4 | 19.0 |
Industry | 18.0 | 18.2 | 18.0 | 18.2 |
The increase in share capital was as a result of a rights issue.
Review Repse’s performance in light of its objective being to maximise shareholder wealth.
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6 Long-term versus short-term objectives
Most of the syllabus for the examination is concerned with achieving the long-term objectives of the company.
However, the position of the company in the short-term can not be ignored and can result in a conflict.
For example, a strategy aimed at long-term growth in the company might involve substantial investment that results in a fall in profitability in the short-term. The financial manager needs obviously to be aware of this conflict, consider the implications, and consider possible ways of mitigating the problem.
Another example concerns the working capital requirements of the company. A long-term strategy for growth might involve short-term cash deficiencies. The financial manager needs to be concerned with identifying the short-term implications and planning for ways of dealing with them.