36 – Finance and accounting strategy

36.1 The use of accounting data in strategic decision-

making
Strategic decision-making requires detailed information from several sources.
Accounting data is essential for making strategic decisions.

The use of financial statements in developing strategies

A business cannot develop or decide on a new strategy unless:

 The current profitability and financial performance of the business are

analysed.
 The availability of sources of finance is assessed. Liquidity ratios assess
current liquidity and gearing ratio assess in financial decisions.
 The relative success of the company’s current strategies can be compared
with those of other similar businesses. Financial statement data and ratio
results can be compared with other businesses in the same industry.

The contents of an annual report

 Financial statements. The contents and importance of both the statement of
profit or loss and statement of financial position.
 Chairman’s statement. This is a general report on the major achievements
of the company over the past year and the future prospects of the business. It
also explains how the political and economic environment might affect the
company’s prospects.
 Chief executive’s report. This is a more detailed analysis of the last
financial year, often broken down by area or main product divisions. Major
new projects are explained. Any mergers or takeovers, closures or
rationalisations that have occurred during the year are briefly referred to.
 Auditors’ report. This is the report by an independent firm of accountants
on the accuracy of the accounts and the validity of the accounting methods
used. If there are no problems with the accounts, the auditors state that the
accounts give a ‘true and fair view’ of the business’s performance and
current position. If there are real concerns, then the auditors include in their
report details of disagreements between themselves and the management
over the reliability of the accounts.
 Notes to the accounts. The main accounts contain only the basic
information needed to assess the position of the company. They do not
contain precise details, such as the types of individual fixed assets, the main
long-term loans or the depreciation methods used. These and other details
are contained at the end of the annual report and accounts in the notes to the
accounts.

Usefulness of an annual report

The annual report and published accounts of a company are useful to all
stakeholder groups.
36.2 The use of accounting data and ratio analysis
Strategic decisions are difficult to reverse and can involve significant resources.
To improve the chances of these decisions being successful, a thorough analysis
of accounting data and ratio results is usually essential.

Assessment of business performance over time and against

competitors
One accounting ratio result alone is of very limited value. Ratios give a much
clearer picture of relative business performance when they are compared with:

 Ratios for previous time periods. This is called trend analysis. It allows
managers and other stakeholders to assess:

 Is profitability falling or rising over time?

 Is liquidity more of a problem now than last year?
 Are financial efficiency and gearing falling or rising over time?
 Do the investor ratios indicate that buying shares is a better investment
now than in previous time periods?

 Ratios from other companies in a similar industry. This is called inter-

firm comparison. It allows managers and other stakeholders to assess:

 Is this company’s profitability better or worse than its competitors?

 Is there a greater risk of low liquidity than in other businesses?
 Is this business more efficient in managing its finances and is it more
highly geared than competitors?
 Would it be a better investment to buy shares in competitor
companies?
The impact of accounting data and ratio analysis on
business strategy
Developing new business strategies often starts with a detailed analysis of the
company’s accounts, using ratio analysis to highlight particular issues.

Ratio analysis over time has indicated the problem of declining profitability for
company A. directors of the business have also made ratio comparisons with
competitors. Company A is the only large business in the industry with
declining profitability. The directors identify two strategies for the business to
adopt:

 Reduce overhead expense by delayering the organisation.

 Increase promotional spending to improve brand identity and customer
loyalty and increase prices.

Example 2

Directors of company B are worried about the high gearing ratio. This is higher
than those of most competitors. They identify two strategies for businesses to
adopt.

 Reduce dividend payments next year to retain more profit. The reduced cash
outflow can be used to repay some debt.
 Delay payment to some suppliers as eight days is a shirt credit period to be
offered by suppliers. This will slow down cash outflows and may allow
some repayment of debt.
Example 3

Company C manufactures home office furniture and sells to retailers. The

directors want to take action to improve financial efficiency. They have
identified two strategies the business could adopt.

 Introduce a just-in-time system and only order from businesses prepared to

guarantee small shipments of supplies.
 Only sell products online so that customers have to pay before goods are
distributed.

These three examples illustrate that accounting data and ratio results can help
managers identify future strategic decisions. In each case, though, the final
strategic decision could not be made before:

 Further analysis of the problems that ratios have highlighted.

 Assessment of the resources available to pay for a new strategy.
 The likely impact of the strategy on achieving the objectives of the business
is evaluated.
]The impact of debt or equity decisions on ratio results
Sources of finance impact on ratio results in different ways. The two main
external long-term sources of finance available to companies are bank (long-
term) loans (debt) or sales of new shares (equity). How will decision to raise
finance from these two sources impact on ratio results?

Example

Points to note:
 Higher debt raises gearing but increasing equity reduces it.
 Higher interest rates make a highly geared strategy costly and risky.
 If the new factory is very profitable, shareholders would benefit from high
gearing as the profit of the factory does not have to be distributed to a greater
number of shareholders.
The impact of changes in dividend strategy on ratio results
Shareholders in public limited companies expect regular dividend payments
from the companies they have bought shares in. dividends are return for
investing funds into the business. Company directors decide on the level of
dividends each year. The level of dividends paid out to shareholders each year
will depend on the profit after tax, the liquidity of the business, and the need to
keep share prices from falling if a new share issue is planned.

The impact of business growth on ratio results

Business growth is a common corporate objective. The rate of growth, the
resulting economies of scale and whether growth is financed from debt or equity
will all impact on ratio results.
Example
The directors of Company F have a growth objective for the business. They plan
to take over another business which also produces recyclable plastic. This
acquisition would nearly double the size of Company F. there would be great
economies of scale. Some factories will be closed to rationalise production.
Reducing operating expenses in this way will result in a lower foxed cost per
unit. The redundant factory assets will be sold off. Some of the money raised
will be used to pay back a proportion of the debt that will be used to finance the
takeover.
 The impact of other business strategies on ratio results
There are, of course, many different strategies that businesses can adopt. Each
one is likely to impact on the published accounts and ratio analysis of these
accounts in different ways. Each strategy may also impact on ratios in different
ways depending on whether the short-term or long-term effect is being
considered.

Business strategy Possible impact on ratios

Rationalisation  Reductions in operating expenses should increase the
operating profit margin and RoCE.

New product  Short term: profit and liquidity may fall due to the expenses
development and cash needs of the new product research and development.
RoCE and liquidity ratios could fall. Returns to shareholders
might fall in the short term.

 Long-term: if the product is successful, higher profit margins,

higher RoCE and improved liquidity ratios should result.
Returns to shareholders should increase.

Market development  Short-term: costs of entering the new market can be high,
reducing profit margin and RoCE.

 Cash outflows for developing the new market could reduce

liquidity.

 Long-term: if a new market leads to higher sales, especially at

high prices, then profit margins should increase, as well as
returns to shareholders.

Low price strategy  This reduces gross profit and operating profit margins unless
higher output reduces fixed costs per unit and leads to greater
economies of scale. These cost reductions could increase profit
margins and RoCE.
Limitations of ratio analysis
 One ratio result is not very helpful. To allow meaningful analysis to be
made, a comparison needs to be made with:
 other businesses, called inter-firm comparisons
 other time periods, called trend analysis. See Figure 36.2 for an
example of trend analysis, showing the retailer Tesco’s RoCE.

 Inter-firm comparisons are most effective when companies in the same

industry are being compared. Financial years end at different times for
different businesses. A rapid change in the economic environment could
have an adverse impact on a company publishing its accounts in June
compared with a January publication for another company.

 Trend analysis needs to take into account changing circumstances over time
that could have affected the ratio results. These factors may be outside the
company’s control, such as an economic recession.

 Some ratios can be calculated using slightly different formulae, and care
must be taken to only make comparisons with results calculated using the
same ratio formula.

 Companies can value their assets in rather different ways, and different
depreciation methods can lead to different capital employed totals, which
will affect certain ratio results. Deliberate manipulation or window dressing
of accounts would make a company’s key ratios look more favourable, at
least in the short term.

 Ratios can only be measured from numerical data. Analysts of company

performance are becoming more concerned with non-numerical aspects of
business performance. These include customer loyalty, environmental
policies and approaches to human rights in developing countries that the
business may operate in.

 Ratios are very useful analytical tools, but they do not solve business
problems of underperformance. Ratio analysis can highlight problems that
need to be tackled, such as falling profitability or liquidity. These problems
can be tracked back over time and compared with other businesses.
However, ratios alone do not indicate the true cause of business problems. It
is up to good managers to locate these causes and develop effective
strategies to overcome them.
Limitations of annual reports and published accounts
Companies will only publish the minimum of accounting information, as
required by company law. Company directors want to avoid sensitive
information being studied by competitors, or even pressure groups that could
take action against the interests of the business. Information that does not
have to be published in a company’s annual report and accounts includes:

 Details of the sales and profitability of each of the company’s products and
divisions.
 Research and development plans of the business and proposed new products.
 Details of future plans for expansion or rationalisation of the business.
 Evidence of the company’s impact on the environment and the local
community, although this social and environmental audit is sometimes
included voluntarily by companies.
 Future budgets or financial plans.

Other limitations include:

 Only historic data is included. This might not be a good indicator of future
performance.
 Only two years of accounting data have to be included.
 Intangible assets are rarely fully valued in the accounts which could
undervalue knowledge-based companies.
 The accounts are not always comparable with other companies if, for
example, different methods of valuing or depreciating assets have been used,

Are the published accounts really accurate?

Stakeholders are often concerned about the accuracy of the published accounts.
Accounting is not quite often as objective as some observers often believe. No
company is allowed to publish accounts that it knows to be deliberately and
illegally misleading. They have to be checked by an independent firm of
accountants known as auditors. However, accounting decisions are not always
based on exact concepts. There are several instances when, in compiling
accounts, it is necessary to use judgement and estimation.

These judgements can often lead to a difference of opinion between

accountants, for example over the precise value of unsold inventories or the
value of other assets. Where companies make judgements that present their
accounts in a favourable way, then the accountants could be accused of window
dressing the accounts.
This might be done to influence a bank to lend more money to the business or to
encourage investors to buy shares in the same business. There are several ways
in which accountants might use window dressing to boost the short-term
performance of a business without actually breaking the law regarding
accounting disclosure. These include:

 Selling assets, such as buildings, at the end of the financial year, to give the
business more cash and improve the liquidity position.
 Reducing the amount of depreciation of fixed assets, such as machines or
vehicles, in order to increase declared profit and increase asset values.
 Ignoring the fact that some trade receivables which have not paid for goods
delivered may, in fact, never pay: they are bad debts.
 Giving inventory levels a higher value than they may be worth.
 Delaying paying bills or incurring expenses until after the accounts have
been published.

For these reasons, published accounts of companies, and the ratios based on
them, need to be analysed with considerable caution by stakeholders. They are a
useful starting point for investigation the performance of a business. One annual
report and set of accounts on its own, will never provide the answers to all the
questions that shareholders should be asking.