Study Notes: Business Finance & Accounting

Financial objectives - key measures

Cash flow targets

A clichéd but nevertheless relevant saying amongst bank managers goes like this:

Revenue is vanity
Profit in sanity
CASH IS KING

The logic behind the saying is straightforward.  Many businesses focus on growing revenues and take great pleasure from being boasting about the total sales they achieve.  However, what if those sales are not profitable? A business that runs out of cash becomes insolvent and fails.  In contrast, a business that generates strong profits and turns them into positive cash flow is in a very strong position to achieve all of its objectives.

A variety of possible cash flow objectives might be set by a business depending on its financial position and corporate strategy.  For example:

• Reduce bank borrowings to a target level – perhaps by repaying amounts owed under bank loans or restricting the use of bank overdraft facilities
• Minimise the time taken by customers who pay on credit to settle outstanding invoices – this is traditionally a major concern of smaller businesses and an obvious focus for a cash flow objectives
• Extend the period taken to pay suppliers to maximum permitted period – e.g. paying trade creditors at the end of any agreed credit period
• Building a buffer balance of cash as a precaution against unforeseen circumstances
• Minimising the amounts paid out in interest charges
• Reducing the seasonal swings in cash flow – perhaps by finding new uses for excess production capacity in quiet periods, or developing markets which are counter-seasonal to existing revenues

Returns on investment objectives

The funds invested in a business need to earn a return.  Ideally that return at least matches, and ideally exceeds, the target return set by management.

The main performance measure of return in a commercial business is Return on Capital Employed (“ROCE”) - sometimes also referred to as Return on Capital.

ROCE is essentially about how well a business turns assets into profit.  This matters for a business because of the concept of opportunity cost. 

Faced with a choice of investing £500,000 in a new business project or giving it back to the shareholders as a dividend, what should the business do?  If the project generates a return on investment of over 10%, then the shareholders would probably prefer the project to go ahead rather than receiving the dividend. It depends on what their required rate of return is.

ROCE can be used in several ways:

• To help evaluate the overall performance of the business
• To provide a target return for individual projects
• To benchmark performance with competitors

Your studies on investment appraisal make use of the concepts introduced above – this is an important area.

Shareholders’ returns

A basic recap to begin with.  Shareholders are the owners of a limited company and they gain their financial reward from share ownership in two ways:

• A share of the profits earned by the company – paid out as a dividend
• Growth in the value of their shareholding (compared with the cost of buying the shares) – which is “realised” when the shareholder sells the shares to someone else

The vast majority of limited companies are “private” in that their shares are not publicly traded on a regulated stock market.  However, that does not stop the shareholders of private limited companies from buying and selling shares privately.

Shareholders in public companies whose shares are traded on the Stock Exchange have a daily insight into the returns their investment is making:

• The share price indicates the market value of the business (share price x number of shares in issue)
• The latest share price can be shown as a multiple of the most recent annual earnings (or profits) per share, to show a valuation ratio known as the Price/Earnings (or P/E) ratio
• The latest annual dividend can be compared with the share price to indicate an annual return (“dividend yield”)

The financial objectives that a public company might, therefore, set in relation to shareholder returns might include:

• Target growth in the share price
• Increases in the dividend per share over time
• Increases in earnings per share