Finance and Accounting Strategy (A Level 9609)
Hello future business leaders! This chapter is where everything comes together. You’ve learned how to calculate ratios and understand accounts (Topics 10.1 & 10.2). Now, we move beyond calculation to strategy.
Think of accounting data as a business's health report. A doctor (the manager) doesn't just read the numbers (ratios); they use those numbers to decide on a long-term plan (the strategy) to keep the patient healthy or help them grow stronger.
We will explore how financial information dictates the major, long-term decisions a business makes. This knowledge is crucial for evaluation questions!
10.4.1 The Use of Accounting Data to Enable Strategic Decision-Making
Strategic decisions are big choices that set the direction of the business for years. They include things like whether to launch a new product line, enter a new country, or invest millions in a new factory.
A. Using Financial Statements in Developing Strategies
The two core financial statements (Statement of Profit or Loss and Statement of Financial Position) are the starting point for setting long-term financial goals and strategies.
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Statement of Profit or Loss (Income Statement): This tells managers if their current strategy is working in terms of generating sales, controlling costs, and achieving profits.
- Strategic Insight: If gross profit margin is too low, the strategy might need to focus on finding cheaper suppliers or increasing selling prices (differentiation strategy).
- Strategic Insight: If profit from operations is high, the business might strategise to expand into new markets using those retained earnings.
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Statement of Financial Position (Balance Sheet): This shows the financial structure of the business—what assets it owns and how those assets are funded (liabilities and equity).
- Strategic Insight: If the business has a lot of short-term debt (Current Liabilities), the strategy might need to prioritize increasing liquidity before pursuing risky long-term investments.
B. The Contents and Usefulness of the Annual Report
The Annual Report is a comprehensive document published by public limited companies (PLCs) to inform shareholders and other stakeholders about the company’s performance and future strategy.
It’s much more than just the financial statements.
Key Contents of an Annual Report:
The report combines hard, numerical data with qualitative analysis:
- Financial Statements: The audited accounts (Profit or Loss, Financial Position).
- Chairman’s/CEO’s Report: A narrative summary of the year, discussion of key achievements, and future outlook (the stated strategy).
- Corporate Social Responsibility (CSR) Report: Details non-financial performance (environmental, social, and ethical impact).
- Auditor's Report: Independent verification that the financial statements are a 'true and fair' view of the company's position.
Usefulness to Stakeholders:
- Shareholders (current & potential investors): Use the Profit or Loss data and the CEO’s report to assess the return on their investment (dividend yield, P/E ratio) and decide whether to buy, hold, or sell shares. They look at future strategy to judge growth potential.
- Lenders (Banks): They focus on the balance sheet and liquidity ratios (which we'll cover next) to ensure the business can repay its loans. They use the strategy section to judge the long-term viability of the company.
- Employees: Use the report (especially CSR sections and financial stability) to gauge job security and future prospects (e.g., expansion plans).
Quick Review: The Annual Report is the key bridge between financial performance (the numbers) and strategic direction (the future plan) for stakeholders.
10.4.2 The Use of Accounting Data and Ratio Analysis in Strategic Decision-Making
Ratios are powerful because they allow managers to quickly assess relative performance, compare different companies, and identify strategic weaknesses or strengths.
A. Assessment of Business Performance
Ratios are essential for strategic analysis through two primary comparisons:
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Trend Analysis (Over Time): Comparing current ratios to those of previous years.
- Example: If the Return on Capital Employed (ROCE) has fallen from 20% to 12% over three years, the strategy of management is clearly failing to generate sufficient returns, necessitating a fundamental change in operations or financing.
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Benchmarking (Against Competitors): Comparing ratios to industry averages or key competitors.
- Example: If your competitor's Profit Margin is 15% and yours is 8%, your business needs a strategy focused on either reducing costs or successfully differentiating the product to allow for higher pricing.
B. Impact of Accounting Data and Strategic Decisions on Ratio Results
Every major strategic decision has a knock-on effect on the financial structure and, therefore, the ratios. Managers must anticipate these impacts.
1. The Impact of Debt or Equity Decisions (Gearing)
When a business needs finance for expansion (a strategic choice), it faces a fundamental choice: Debt (e.g., bank loan, debentures) or Equity (e.g., issuing new shares).
This decision directly affects the Gearing Ratio:
$$Gearing (\%)= \frac{Non-current\ liabilities}{Capital\ employed} \times 100$$
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Strategic Choice: High Debt (High Gearing Strategy)
Impact: Increases the gearing ratio. This means the business relies more on borrowed funds.
Pro: High potential returns for shareholders (if interest is less than ROCE). Control is retained (lenders don't get voting rights).
Con: High risk. If profits fall, interest payments become very difficult to meet, potentially leading to liquidation. -
Strategic Choice: High Equity (Low Gearing Strategy)
Impact: Decreases the gearing ratio. The business is funded more by owners/shareholders.
Pro: Lower risk, greater stability during economic downturns.
Con: Existing shareholder control may be diluted (new shares mean more owners). May miss out on profitable expansion opportunities if unwilling to borrow.
Did you know? Industries that are very stable (like utility companies) often adopt a higher gearing strategy because their cash flows are predictable, meaning the risk of default is lower.
2. The Impact of Changes in Dividend Strategy
A business must decide how much of its profit to pay out as dividends and how much to keep as retained earnings (internal finance).
This impacts two investment ratios:
$$Dividend\ yield\ (\%)= \frac{Dividend\ per\ share}{Market\ price\ per\ share} \times 100$$
$$Dividend\ cover = \frac{Profit\ for\ the\ year}{Annual\ dividend}$$
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Strategic Choice: High Dividend Payout (High Dividend Yield, Low Dividend Cover)
Strategy: Appeals to investors seeking regular income (often mature, low-growth companies).
Impact: Reduces retained earnings, limiting internal funds available for future strategic investments (e.g., Research and Development). -
Strategic Choice: Low/Zero Dividend Payout (Low Dividend Yield, High Dividend Cover)
Strategy: Retain maximum profit for strategic investment and growth (common in high-growth technology companies).
Impact: Maximizes funds for expansion, but may discourage income-seeking investors.
3. The Impact of Business Growth (e.g., Acquisition or Organic Growth)
Growth strategies (e.g., mergers or takeovers) require significant capital and immediately impact the Statement of Financial Position and efficiency ratios.
- Initial Impact: The cost of acquisition usually requires borrowing (increasing Gearing) or issuing shares (diluting P/E Ratio).
- Short-term Strategy Impact: Post-merger integration costs might increase expenses, initially lowering Profit Margins. Inventory systems might merge, affecting Inventory Turnover.
- Long-term Strategic Goal: If the growth is successful (achieving synergies), the strategy should lead to improved ROCE and overall Profitability Ratios due to economies of scale.
4. The Impact of Other Business Strategies on Ratio Results
- Cost Leadership Strategy: Focus on reducing costs. Strategic success is seen in rising Gross Profit Margins and Operating Profit Margins.
- Just-in-Time (JIT) Implementation: This Operations Strategy focuses on minimizing inventory. Its success is financially verified by a high Rate of Inventory Turnover (meaning stock isn't held for long).
- Aggressive Credit Policy: If Marketing decides to allow customers longer to pay (to boost sales), this Operations Strategy results in a higher Trade Receivables Turnover (Days). This may boost sales but damages liquidity (lower Current Ratio).
Memory Aid: Remember the link between functional strategies and financial outcomes. If the Operations team wants JIT, the Finance team checks the Inventory Turnover. If Marketing wants to offer long credit terms, the Finance team checks the Trade Receivables turnover and the Current Ratio.
C. The Limitations of Using Published Accounts and Ratio Analyses
While ratios are vital, they tell an incomplete story. For true strategic decision-making, managers must recognize their limits:
- Historical Data: Published accounts reflect past performance (usually up to the last financial year). Strategic decisions are about the future, meaning the data may already be outdated.
- Different Accounting Policies: Companies can legally use different accounting methods (e.g., valuing inventory or calculating depreciation). This makes direct competitor comparisons difficult, even if the ratios look similar.
- Non-Financial Factors Excluded: Ratios ignore crucial strategic issues like customer loyalty, brand reputation, quality of management, and the strength of the workforce—all vital for long-term success.
- Context is Key (Industry Specifics): A high Gearing Ratio (e.g., 70%) might be normal and acceptable in the highly stable utilities industry, but catastrophic for a volatile tech start-up. Ratios must always be interpreted relative to the industry context.
- Manipulation: Accounts can sometimes be legally managed (or even illegally manipulated) to present a better picture to stakeholders, meaning the ratios calculated may not reflect the true underlying position.
Strategy Conclusion: Therefore, strategic decisions should never be based solely on ratios. They must combine quantitative data (the ratios) with qualitative factors (market conditions, managerial experience, ethics, and competitive environment) for a comprehensive evaluation.
Key Takeaway: Finance and Accounting Strategy is about using the numbers you calculate (ratios) to justify, measure, and refine the long-term direction of the business (debt vs. equity, growth, efficiency). Always discuss the limitations!