Chapter 2 Understanding Financial Objectives

At the end of this chapter you will be able to show understanding of the range of objectives

set within the finance function/department of larger businesses

Understand how these are influenced by internal and external factors such as the nature of the firm and the action of competitors

Setting the scene Read domino’s delivers bigger profitsLook at the discussion points and make notesClass discussion

Financial Objectives Financial objectives are monetary goals set within a financial yearThey are a target and a way of measuring performanceMost PLCs will want to do maximise shareholder return (we will look at what this is in more detail in a moment)To be able to give the shareholder some return on their investment they must maximise their profitsTo do this they must minimise their costsThey must also survive by focussing on cash flowThe firm must also make a return on its internal investment – they must make a return on the capital put into the businessIn summary the main financial objectives are

Cash flow Cost minimisationReturn on capital employedShareholder return

Cash Flow targets A firm that does not set or achieve a healthy cash flow target may struggle to surviveThe targets may be very broad such as to maintain a positive cash flowOr be more specific and maintain a balance of £xAlthough cash is the oxygen of the business there is an opportunity cost to keeping cashThe cash could be used to invest and develop the business

Cost MinimisationIf you can minimise costs without affecting the revenue it will improve profitabilityAs firms grow larger there are many hidden costs - there will be plenty of opportunities to reduce costs without affecting the customer’s opinion of the good or serviceTactical decisions such as changing suppliers or more strategic decisions such as relocating abroad may be required

Return on Capital Employed ROCEThis is the profit made as a percentage of the amount of capital tied up in the businessA business might have an ROCE target where there is a minimum percentage return that it strives to achieve from the capital employed in the businessROCE is used as a measure of profitability and performanceThe target is likely to be set in accordance with the industry standard (the amount of return that most firms make within that same industry)Or it might base its target on the amount of risk that is being taken – the more risk the more return requiredAt a minimum they would expect to get back the same amount as the interest they would gain if they put the money in the bank

Shareholder’s return Most PLCs will want to do maximise shareholder returnWhat do we mean by shareholder return?Investors buy a share in a companyThis investment is a risk and they expect some return for it (something back in return for the investment)

That return normally comes at the end of each year when the company pays out dividendsFrom the profit the company gains it will pay an amount for each shareE.g. BP paid out 56 cents per share in its last financial yearIn addition the value of each share went up by 12% which means that if the investor sold their share they would buy them for more than they soldIf shareholders become dissatisfied they can sell their shares If enough shareholders sell their shares the value of the shares will go downIf enough shares become available the business will become vulnerable to takeoversShareholders also have the power to not reappoint members of the board of directors at the AGM

Internal and external influencesThe decision on what targets/objectives to set is influenced by both internal and external influencesInternal influencesCharacteristics of the firm – the size, the status and the age may all make a difference

if the firm is new they may be happy with satisficing (achieving a satisfactory level of profit)An established firm will want to maximise shareholder return

Internal and external influencesOwners – objectives will depend on the relationship between owners and managers, the number of owners and their motives

If the firm is fully floated on the stock exchange many of its owners are likely to be small shareholders who have invested their money to make money for their retirement

they will only be interested in making a return on their investment and may only care about making profit in the short term

If the shareholders are fewer in number and more directly involved they may be more interested in reinvesting profit to expand and get more future returns.

Sectors – is the business in the public or private sector?

Private sector – more interested in making profitPublic sector – providing a service to the community

Internal and external influencesExternal influences on objectivesCompetitors actions

If a competitor is trying to gain market share with an aggressive pricing policy the firm may be forced to set a cost minimisation objective so that it can also reduce its prices

Economic conditionsDirectors will be aware of current and predicted future trends in the economyIf conditions are expected to get worse they may be more cautious in setting financial objectivesA fall in consumer expectations may mean less spending which will mean less demand for goods and servicesA firm might therefore have to lower profit targetsIf a firm thinks that interest rates may rise they may increase their ROCE target

Examiner Tip

You don’t need to have a detailed understanding of external influences and the economic environment but you do need to understand that when a firm sets an objective they will be influenced by what is going on inside and out of the firm.

RecapLearning objective - show understanding of the range of objectives set within the finance function/department of larger businesses

What are these?Cash flowCost minimisationReturn on capital employedShareholder return

What do we mean by each of these?

RecapLearning objective - Understand how these are influenced by internal and external factors such as the nature of the firm and the action of competitorsWhat do we mean by internal factors?Characteristics of the firm – the size, the status and the age may all make a difference

Give me an example if the firm is new they may be happy with satisficing (achieving a satisfactory level of profit)An established firm will want to maximise shareholder return

Owners – the objectives will vary depending on the relationship between owners and managers, the number of owners and their motives

Many small shareholders - they will only be interested in making a return on their investment and may only care about making profit in the short termFewer shareholders with direct involvement - may be more interested in reinvesting profit to expand and get more future returns.

Sectors – is the business in the public or private sectorPrivate sector – more interested in making profitPublic sector – providing a service to the community

RecapLearning objective - Understand how these are influenced by internal and external factors such as the nature of the firm and the action of competitorsWhat do we mean by external factors?Competitors actions

If a competitor is trying to gain market share with an aggressive pricing policy what objective might a firm be forced to adopt?cost minimisation objective so that it can also reduce its prices

Economic conditionsDirectors will be aware of current and predicted future trends in the economyIf conditions are expected to get worse how will this affect their objective? they may be more cautious in setting financial objectivesA fall in consumer expectations may mean less what?

Spending which will mean what?

less demand for goods and servicesWhat might a firm have to do in this scenariolower profit targetsIf a firm thinks that interest rates may rise what might they need to do to their ROCE target and why?increase their ROCE target – they need to increase the return to compensate for the additional cost of the interest

Case StudyEmployee or shareholder satisfaction P12

Answer all questions