Strategic Management – MGT603 VU

Lesson 38
FINANCE/ACCOUNTING ISSUES
Learning objectives
The main objective of this chapter to enable to students about accounting and finance issue relating to
strategy implementation.
Like marketing and human resource concern while implementing strategy the other important issue is
accounting and finance. Several issue that concern with accounting and finance to strategy
implementation: obtaining desired amount of needed capital, developing pro forma financial
statements, preparing financial budgets, and evaluating the worth of a business. Some examples of
decisions that may require finance/accounting policies are:
1. To raise the amount of capital by issuing shares or obtaining a debt from external parties.
2. To enhance the inventory turn over level
3. To make or buy fixed assets.
4. To extend the time of accounts receivable.
5. To establish a certain percentage discount on accounts within a specified period of time.
6. To determine the amount of cash that should be kept on hand
7. To determine an appropriate dividend payout ratio.
8. To use LIFO, FIFO

Acquiring Capital to Implement Strategies

Without sufficient amount of capital the strategy can not be proceed. Two basic sources of capital for
an organization are debt and equity. Creditors have a debt right and owners have an equity right in the
business. An appropriate mix of debt and equity in a firm's capital structure plays an important role for
strategy implementation. The most important is debt and equity analysis. The debt to equity ratio
(D/E) is a financial ratio, which is equal to an entity's total liabilities divided by shareholders' equity.
The two components are often taken from the firm's balance sheet (or statement of financial position),
but they might also be calculated using their market values if both the company's debt and equity are
publicly traded. It is used to calculate a company's "financial leverage" and indicates what proportion of
equity and debt the company is using to finance its assets.

D/E = Debt (total liabilities) / Equity

A similar ratio is debt to total assets (D/A)
D/A = debt / assets = debt / (debt + equity)

It also include an Earnings per Share/Earnings before Interest and Taxes (EPS/EBIT) analysis is the
most widely used technique for determining whether debt, stock, or a combination of debt and stock is
the best alternative for raising capital to implement strategies. This technique involves an examination
of the impact that debt versus stock financing has on earnings per share under various assumptions as
to EBIT.

DEBIT
A financial measure defined as revenues less cost of goods sold and selling, general, and administrative
expenses. In other words, operating and no operating profit before the deduction of interest and
income taxes.

Earning Per share

A company's profit divided by its number of outstanding shares. If a company earning Rs. 2 million in
one year had Rs. 2 million shares of stock outstanding, its EPS would be Rs. 1 per share. In calculating
EPS, the company often uses a weighted average of shares outstanding over the reporting term. The
one-year (historical) EPS growth rate is calculated as the percentage change in earnings per share. The
prospective EPS growth rate is calculated as the percentage change in this year's earnings and the
consensus forecast earnings for next year.
Theoretically, an enterprise should have enough debt in its capital structure to boost its return on
investment by applying debt to products and projects earning more than the cost of the debt. In low

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earning periods, too much debt in the capital structure of an organization can endanger stockholders'
return and jeopardize company survival. Fixed debt obligations generally must be met, regardless of
circumstances. This does not mean that stock issuances are always better than debt for raising capital.
Some special concerns with stock issuances are dilution of ownership, effect on stock price, and the
need to share future earnings with all new shareholders.
EPS/EBIT analysis is a valuable tool for making capital financing decisions needed to implement
strategies, but several considerations should be made whenever using this technique. First, profit levels
may be higher for stock or debt alternatives when EPS levels are lower. For example, looking only at
the earnings after taxes (EAT) values in Table 8-3, the common stock option is the best alternative,
regardless of economic conditions. If the Brown Company's mission includes strict profit
maximization, as opposed to the maximization of stockholders' wealth or some other criterion, then
stock rather than debt is the best choice of financing.
Another consideration when using EPS/EBIT analysis is flexibility. As an organization's capital
structure changes, so does its flexibility for considering future capital needs. Using all debt or all stock
to raise capital in the present may impose fixed obligations, restrictive covenants, or other constraints
that could severely reduce a firm's ability to raise additional capital in the future.

Pro Forma Financial Statements

Pro forma (projected) financial statement analysis is a central strategy-implementation technique because it
allows an organization to examine the expected results of various actions and approaches.
“A financial statement showing the forecast or projected operating results and balance sheet, as in pro
forma income statements, balance sheets, and statements of cash flows.”

USES OF PRO FORMA STATEMENTS

BUSINESS PLANNING A company uses pro forma statements in the process of business planning
and control. Because pro forma statements are presented in a standardized, columnar format,
management employs them to compare and contrast alternative business plans. By arranging the data
for the operating and financial statements side-by-side, management analyzes the projected results of
competing plans in order to decide which best serves the interests of the business.
In constructing pro forma statements, a company recognizes the uniqueness and distinct financial
characteristics of each proposed plan or project. Pro forma statements allow management to:
• Identify the assumptions about the financial and operating characteristics that generate the
scenarios.
• Develop the various sales and budget (revenue and expense) projections.
• Assemble the results in profit and loss projections.
• Translate this data into cash-flow projections.
• Compare the resulting balance sheets.
• Perform ratio analysis to compare projections against each other and against those of similar
companies.
• Review proposed decisions in marketing, production, research and development, etc., and assess
their impact on profitability and liquidity.
Simulating competing plans can be quite useful in evaluating the financial effects of the different
alternatives under consideration. Based on different sets of assumptions, these plans propose various
scenarios of sales, production costs, profitability, and viability. Pro forma statements for each plan
provide important information about future expectations, including sales and earnings forecasts, cash
flows, balance sheets, proposed capitalization, and income statements.
Management also uses this procedure in choosing among budget alternatives. Planners present sales
revenues, production expenses, balance sheet and cash flow statements for competing plans with the
underlying assumptions explained. Based on an analysis of these figures, management selects an annual
budget. After choosing a course of action, it is common for management to examine variations within
the plan.
It includes:
1. Pro forma income statement
2. Pro forma balance sheet etc.

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Pro forma income statement

A pro forma income statement is similar to a historical income statement, except it projects the future
rather than tracks the past. Pro forma income statements are an important tool for planning future
business operations. If the projections predict a downturn in profitability, you can make operational
changes such as increasing prices or decreasing costs before these projections become reality.
Pro forma income statements provide an important benchmark or budget for operating a business
throughout the year. They can determine whether expenses can be expected to run higher in the first
quarter of the year than in the second. They can determine whether or not sales can be expected to be
run above average in June. The can determine whether or not your marketing campaigns need an extra
boost during the fall months. All in all, they provide you with invaluable information—the sort of
information you need in order to make the right choices for your business.
How do I create a pro forma income statement?
Sit down with an income statement from the current year. Consider how each item on that statement
can or will be changed during the coming year. This should, ideally, be done before year’s end. You will
need to estimate final sales and expenses for the current year to prepare a pro forma income statement
for the coming year.

Pro forma balance sheet

A pro forma balance sheet is similar to a historical balance sheet, but it represents a future projection.
Pro forma balance sheets are used to project how the business will be managing its assets in the future.
For example, a pro forma balance sheet can quickly show the projected relative amount of money tied
up in receivables, inventory, and equipment. It can also be used to project the overall financial
soundness of the company. For example, a pro forma balance sheet can help quickly pinpoint a high
debt-to-equity ratio.
This type of analysis can be used to forecast the impact of various implementation decisions (for
example, to increase promotion expenditures by 50 percent to support a market-development strategy,
to increase salaries by 25 percent to support a market-penetration strategy, to increase research and
development expenditures by 70 percent to support product development, or to sell $1 million of
common stock to raise capital for diversification). Nearly all financial institutions require at least three
years of projected financial statements whenever a business seeks capital. A pro forma income
statement and balance sheet allow an organization to compute projected financial ratios under various
strategy-implementation scenarios. When compared to prior years and to industry averages, financial
ratios provide valuable insights into the feasibility of various strategy-implementation approaches.

A Pro Forma Income Statement and Balance Sheet

Prior
Projected
Year Remarks
Year 2005
2005
PRO FORMA INCOME
STATEMENT
Sales 1000 1500 50% increase
Cost of Goods Sold 700 1050 70% of sales
Gross Margin 300 450
Selling Expense 100 150 10% of sales
Administrative Expense 100 150 10% of sales

Earnings Before Interest and Taxes 100 150

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Interest 50 50
Earnings Before Taxes 50 100
Taxes 25 50 50% rate
Net Income 25 50
Dividends 10 20
Retained Earnings 15 30
PRO FORMA BALANCE
SHEET
Assets
Cash 5 7.75 Plug figure
Accounts Receivable 2 4.00 Incr. 100%
Inventory 20 45.00
Total Current Assets 27 56.75
Land 15 15.00
Plant and Equipment 50 80.00 Add 3 new plants at
$10 million each
Less Depreciation 10 20.00
Net Plant and Equipment 40 60.00
Total Fixed Assets 55 75.00
Total Assets 82 131.75
Liabilities
Accounts Payable 10 10.00
Notes Payable 10 10.00
Total Current Liabilities 20 20.00
Long-Term Debt 40 70.00 Borrowed $30 million
Additional Paid-in-Capital 20 35.00 Issued 100,000 shares
at $150 each
Retained Earnings 2 6.75 2 + 4.75
Total Liabilities and Net Worth 82 131.75

There are six steps in performing pro forma financial analysis:

1. Prepare income statement before balance sheet (forecast sales)
2. Use percentage-of-sales method to project CGS and expenses
3. Calculate projected net income
4. Subtract dividends to be paid from Net Income and add remaining to Retained Earnings
5. Project balance sheet times beginning with retained earnings
6. List comments (remarks) on projected statements
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Financial Budgets
“Document that details how funds will be obtained and spent for a specified period of time.”
Types of Budgets
– Cash budgets
– Operating budgets
– Sales budgets
– Profit budgets
– Factory budgets
– Capital budgets
– Expense budgets
– Divisional budgets
– Variable budgets
– Flexible budgets
– Fixed budgets
Annual budgets are most common, although the period of time for a budget can range from one day to
more than ten years. Fundamentally, financial budgeting is a method for specifying what must be done
to complete strategy implementation successfully. Financial budgeting should not be thought of as a
tool for limiting expenditures but rather as a method for obtaining the most productive and profitable
use of an organization's resources. Financial budgets can be viewed as the planned allocation of a firm's
resources based on forecasts of the future.
Financial budgets have some limitations. First, budgetary programs can become so detailed that they are
cumbersome and overly expensive. Over budgeting or under budgeting can cause problems. Second,
financial budgets can become a substitute for objectives. A budget is a tool and not an end in itself.
Third, budgets can hide inefficiencies if based solely on precedent rather than periodic evaluation of
circumstances and standards. Finally, budgets are sometimes used as instruments of tyranny that result
in frustration, resentment, absenteeism, and high turnover. To minimize the effect of this last concern,
managers should increase the participation of subordinates in preparing budgets.

Evaluating the Worth of a Business

Evaluating the worth of a business is central to strategy implementation because integrative, intensive,
and diversification strategies are often implemented by acquiring other firms. Other strategies, such as
retrenchment and divestiture, may result in the sale of a division of an organization or of the firm itself.
All the various methods for determining a business's worth can be grouped into three main approaches
1. What a firm owns
2. What a firm earns
3. What a firm will bring in the market.

The first approach in evaluating the worth of a business is determining its net worth or stockholders'
equity. Net worth represents the sum of common stock, additional paid-in capital, and retained
earnings.
The second approach to measuring the value of a firm grows out of the belief that the worth of any
business should be based largely on the future benefits its owners may derive through net profits.
The third approach, letting the market determine a business's worth, involves three methods.
1. First, base the firm's worth on the selling price of a similar company. A potential problem,
however, is that sometimes comparable figures are not easy to locate, even though substantial
information on firms that buy or sell to other firms is available in major libraries.
2. The second approach is called the price-earnings ratio method. To use this method, divide the market
price of the firm's common stock by the annual earnings per share and multiply this number by the
firm's average net income for the past five years.
3. The third approach can be called the outstanding shares method. To use this method, simply multiply
the number of shares outstanding by the market price per share and add a premium. The premium
is simply a per share dollar amount that a person or firm is willing to pay to control (acquire) the
other company.

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