Chapter 2 Understanding Financial Objectives

1. 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

2. Setting the scene Read domino’s delivers bigger profits Look at the discussion points and make notes Class discussion

3. Financial Objectives Financial objectives are monetary goals set within a financial year They are a target and a way of measuring performance Most 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 profits To do this they must minimise their costs They must also survive by focussing on cash flow The firm must also make a return on its internal investment – they must make a return on the capital put into the business In summary the main financial objectives are Cash flow Cost minimisation Return on capital employed Shareholder return

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

5. Cost Minimisation If you can minimise costs without affecting the revenue it will improve profitability As 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 service Tactical decisions such as changing suppliers or more strategic decisions such as relocating abroad may be required

6. Return on Capital Employed ROCE This is the profit made as a percentage of the amount of capital tied up in the business A business might have an ROCE target where there is a minimum percentage return that it strives to achieve from the capital employed in the business ROCE is used as a measure of profitability and performance The 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 required At 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

7. That return normally comes at the end of each year when the company pays out dividends • From the profit the company gains it will pay an amount for each share • E.g. BP paid out 56 cents per share in its last financial year • In 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 sold • If shareholders become dissatisfied they can sell their shares • If enough shareholders sell their shares the value of the shares will go down • If enough shares become available the business will become vulnerable to takeovers • Shareholders also have the power to not reappoint members of the board of directors at the AGM Shareholder’s return Most PLCs will want to do maximise shareholder return What do we mean by shareholder return? Investors buy a share in a company This investment is a risk and they expect some return for it (something back in return for the investment)

8. Internal and external influences The decision on what targets/objectives to set is influenced by both internal and external influences Internal influences Characteristics 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

9. Internal and external influences Owners – 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 profit Public sector – providing a service to the community

10. Internal and external influences External influences on objectives Competitors 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 conditions Directors will be aware of current and predicted future trends in the economy If conditions are expected to get worse they may be more cautious in setting financial objectives A fall in consumer expectations may mean less spending which will mean less demand for goods and services A firm might therefore have to lower profit targets If 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.

11. Recap Learning objective - show understanding of the range of objectives set within the finance function/department of larger businesses What are these? Cash flow Cost minimisation Return on capital employed Shareholder return What do we mean by each of these?

12. Recap Learning objective - Understand how these are influenced by internal and external factors such as the nature of the firm and the action of competitors What 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 term Fewer 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 sector Private sector – more interested in making profit Public sector – providing a service to the community

13. Recap Learning objective - Understand how these are influenced by internal and external factors such as the nature of the firm and the action of competitors What 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 conditions Directors will be aware of current and predicted future trends in the economy If conditions are expected to get worse how will this affect their objective? they may be more cautious in setting financial objectives A fall in consumer expectations may mean less what? Spending which will mean what? less demand for goods and services What might a firm have to do in this scenario lower profit targets If 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

14. Case Study Employee or shareholder satisfaction P12 Answer all questions