David Allen CBE, CIMA’s 1983-1984 president, continues his series exploring the advantages of strategic financial management.
As we saw in last month’s article, financial management is very different from accounting. It’s a subset of economics which is concerned with how society allocates scarce resources between competing opportunities.
Later in this series, we shall look at the application of such thinking to charities and the public sector, but this edition concentrates on the profit seeking sector of the economy, the dynamism of which is rooted in two attributes:
1. Those enterprises which are most effective in meeting society’s greatest needs will earn the greatest profits relative to the capital employed in doing so.
2. When deciding in which enterprises to invest, people will choose those offering the prospect of the greatest return.
Combining those attributes, we see that those enterprises which are meeting society’s most important needs will be best placed to plough back part of their profit, and to attract additional capital, and will therefore be able to grow.
Those falling short will find themselves running out of money, and being forced to shrink: think Adam Smith’s ‘invisible hand’ and Charles Darwin’s ‘survival of the best fitted for the environment’!
This means that top managers need to be looking in two directions – external and internal – as they steer their enterprises towards long term financial health.
Internal and external aspects
The external aspect is concerned with the relationship between the enterprise and the capital market, with a view to:
- identifying the sources of funds available to the organisation, ranging from borrowings, through various hybrids, to equity
- assessing the likely reward expectations of the providers, in the form of interest, taxation and dividends
- employing the mix of sources which is deemed to minimise the overall average return expected (also known as the cost of capital).
The internal aspect, meanwhile, analyses the relationship between the enterprise and its constituent businesses, aiming to identify opportunities to invest, be they in tangible or intangible assets; assess the likely returns generated by each opportunity; and deploy funds in support of those deemed to be viable.
‘Viable’ in this context means offering the prospect of a return in excess of the cost of capital. Thus, what the enterprise sees as the rate of return necessary to warrant the employment of funds, the businesses see as the criterion for their deployment. If, on average, the providers of funds expect a return of 15% per annum, there is no point in investing a project offering the prospect of a return of 12% per annum.
This emphasises the importance of making a realistic assessment of the cost of capital:
- an enterprise which uses too low a figure is likely to take on uneconomic projects and quickly face a liquidity crisis
- an enterprise which uses too high a figure is likely to cede opportunities to better placed competitors, and find itself shrinking
- an enterprise which gets it right will be in a position to feed areas of strength and starve areas of weakness, thereby maximising its chances of survival.
Getting the mind right
As discussed in last month’s piece, all six of the tasks mentioned above are subjectively judgemental, rather than objectively verifiable, and therefore require a different mindset from that appropriate to accounting.
As well as the cost of capital, there is another link between the two aspects described above, namely forecast cash flows: what businesses see as the excess of profit over expansion, the enterprise sees as the excess of distributions over new financing.
Putting the two links together leads naturally to a unifying financial objective, for an enterprise in the distributable profit seeking sector of the economy, namely ‘the maximisation of the net present value of projected cash flows, discounted at the cost of capital.’ Most importantly, this can be translated into a criterion for the making and monitoring of strategic decisions of all kinds.
In next month’s article, we shall explore cash flow in more depth, and discover that its definition for financial management purposes does not match any figure in the standard format for published accounts.
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