1. F3 Financial Strategy by Dr. Lijuan Xiao
Room: 709 (North)

5. Chapter 1 Objectives By the end of this session you should be able to:
advise on the overall strategic financial and non-financial objectives of different types of entities
evaluate financial objectives of for profit entities
and answer questions relating to these areas.

6. Chapter 1

7. Chapter 1 1 Objectives of an entity
The objectives of an entity will differ depending on:
the type of entity (for example for-profit or not-for-profit)
the needs of the entity's different stakeholders.

8. Chapter 1 2 Different types of entity
For-profit and not-for-profit entities.
Unincorporated and incorporated entities.
Quoted and unquoted entities (or listed and unlisted).
Private sector and public sector entities.
Other types of entity (e.g. charity, association, union).

9. Chapter 1 3 Stakeholders 3.1 Introduction to stakeholders
The decisions made by an entity's managers depend on the ultimate objectives of the entity.
Entities often have many, sometimes conflicting, objectives as a consequence of having many stakeholders with both long and short term goals.
3.2 Key stakeholders and their objectives
Shareholders – require returns (dividends and/or capital growth).
Employees/managers – require job security and pay increases.
Customers – require good quality products/services and reasonable prices.
Suppliers/lenders – require payment when due.
Government – require taxes to be paid and laws to be followed.
Local community – require considerate/responsible behaviour.
Conflicts will often arise between different stakeholder groups (e.g.shareholders requiring dividends and employees requiring pay rises).

11. Question:
Describe and discuss the significance the main stakeholders of a supermarket.

12. Chapter 1 4 For-profit entities
4.1 Introduction to for-profit entities
The primary objective of a for-profit entity is the maximisation of shareholder wealth.
4.2 Financial objectives of for-profit entities
A for-profit entity’s financial objectives will be set to satisfy the shareholders and the other finance providers.

13. Examples of financial objectives in for-profit entities
Profitability e.g. annual 10% improvement in earnings, or earnings per share.
Dividends e.g. annual 5% increase in dividends.
Cash generation e.g. annual 10% improvement in operating cash flow.
Gearing e.g. a maximum [debt to (debt + equity)] ratio of 40%. In order to assess whether the entity has achieved its financial objectives, ratio analysis can be used (covered later in this chapter)

14. Chapter 1 4.3 Non-financial objectives of for-profit entities
A for-profit entity’s financial objectives will be set to satisfy the other stakeholders, such as employees, customers and the local community.
However, note that achievement of non-financial objectives can improve the image of the entity, and can have a knock-on effect on sales / profitability to help to create additional wealth for shareholders in the longer term.
Categories of non-financial objectives in for-profit entities:
 Human e.g. reduce staff turnover  Intellectual e.g. improve the brand recognition  Natural e.g. reduce the level of pollution, increase the amount of recycling  Social e.g. to make sure 50% of employees live within 5 miles of the premises  Relationship e.g. to offer all suppliers longer term contracts and to pay them on time

15. Chapter 1 5 Not-for-profit entities
5.1 Introduction to not-for-profit entities
Not-for-profit entities are not run to make profits but to benefit prescribed groups of people.
Services provided are limited primarily by the funds available, so secondary objectives are to raise the maximum possible funds each year and to use the funds efficiently to maximise the benefit generated.
This can be measured as the ‘value for money’ (VFM) generated.
Not-for-profit entities will still have a mix of financial and non-financial objectives and will still have to try to satisfy many different stakeholder groups.

16. Chapter 1 5.2 VFM VFM has three constituent elements: Economy
minimising the cost of resources used or required (inputs) – spending less
Efficiency
the relationship between the output from goods or services and the resources to produce them – spending well
Effectiveness
the relationship between the intended and actual results of public spending (outcomes) – spending wisely
Besides these three ‘E’s, a fourth ‘E’ is applied in some places:
Equity
the extent to which services are available to and reach all people that they are intended to – spending fairly.

17. Illustrations and further practice ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~
Chapter 1
Illustrations and further practice
~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~
Now try TYU questions 9, 10 and 18 from Chapter 1

18. Chapter 1
Financial performance evaluation 6
6.1 Overview

19. Chapter 1 6.2 Profitability ratios Operating profit margin =
(Operating profit / Revenue) × 100%
 This shows how much each unit generates towards profit.
Gross profit margin = (Gross profit / Revenue) × 100%.
 This shows what proportion of revenue is left once specific costs of sales have been paid.

20. Chapter 1
Return on Capital Employed (ROCE) and Return on Equity (ROE):
ROCE =(Operating profit / Capital employed) × 100%
This measures the underlying performance of the business before considering financing.
Capital employed = total funds (debt and equity) invested in the business.
ROE=Return on equity=earnings attributable to ordinary shareholders / shareholders' equity，即归属于普通股股东的利润除以普通股金额。反映的是股东投资的回报情况。
ROCE=Profit before interest and tax / capital employed，即利息所得税之前的利润除以长期的资本包括股权资本以及债券的资本，反映的是长期资本的回报情况。
这两个指标的分子和分母都不一样，ROE的分子是净利润，甚至还需要排除优先股股利，ROCE的分子则是息税前的利润；ROE的分子是归属于普通股的利润，因此分母对应的就是普通股啦；ROCE分子是所有长期资本赚来的利润，分母当然就是所有长期资本啦。包括Equity+Long-term debt.
ROE = (Net profit / Equity value) × 100%
This measures the return which relates to the shareholders.

21. Chapter 1 Breakdown of ROCE
This breakdown of ROCE will enable you to identify whether changes are caused by changes in the level of revenue generated from the entity’s asset base (asset turnover), or by a change in profit margin, or a combination of the two.

22. Chapter 1
6.3 Lender ratios
Financial gearing is a key concern of the lenders.
It can be analysed by looking at the statement of financial position or the statement of profit or loss.
The risk is that if gearing is too high, the entity will not be able to afford to service its debts.

23. Chapter 1
Statement of financial position Financial gearing can be measured as either:  Debt value / Equity value, or  Debt value / (Value of equity + debt) Market values should be used if possible, or use book values if working from financial accounts

24. Chapter 1
Statement of profit or loss Key measure: Interest cover = Profit before interest and tax (PBIT) / Interest payable A low ratio indicates high risk

25. Chapter 1 6.4 Investor ratios
If an entity is quoted, this is arguably the most important area, since the ratios in this area will show whether the rest of the market perceives the entity positively or not.

26. Chapter 1

27. Chapter 1

28. Chapter 1

29. Illustrations and further practice ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~
Chapter 1
Illustrations and further practice
Now try TYU questions 3,4,5,6,8,11and 12 from Chapter 1
~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

30. Chapter 1
Sensitivity of the attainment of financial objectives to changes in economic and business variables 7
7.1 Introduction
When economic variables (such as exchange rates, inflation rates and interest rates)and / or business variables (such as margins and volumes) change, it is important to be able to assess the likely impact on the entity and its chances of achieving its financial objectives.

31. Chapter 1 7.2 Exchange rates Terminology
GBP is STRENGTHENING / APPRECIATING means that GBP 1 is worth MORE foreign currency
e.g. GBP 1 = USD in year 1 GBP 1 = USD in year 2
The GBP has strengthened (and the USD has weakened)
GBP is WEAKENING / DEPRECIATING means that GBP 1 is worth LESS foreign currency
e.g. GBP 1 = USD in year 1 GBP 1 = USD in year 2
The GBP has weakened (and the USD has strengthened)

32. Chapter 1
Calculating forecast exchange rates – interest rate parity theory
If the spot rate is GBP 1 = USD and the interest rates are 5% and 2% in the USA and the UK respectively,
then: F0 = ×1.02/1.05=1.6471
i.e. the rate in 1 year is forecast to be GBP 1 = USD

33. Chapter 1
7.3 Assessment of the sensitivity to changes in economic and business variables
A change in economic or business variables can have an impact on an entity's ability to meet its objectives.
Economic variables
(such as interest rates, exchange rates and inflation)
e.g. a change in exchange rates could impact selling prices and hence profitability ratios, and could prevent an entity from achieving an earnings objective.
Business variables
(such as margins and volumes of activity)
e.g. a fall in sales volume can impact profitability ratios and could prevent an entity from achieving an earnings growth objective.

34. Illustrations and further practice ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~
Chapter 1
If you are asked in the exam to assess the likelihood of an entity achieving a given objective:
Step 1: revise the financial statements to reflect the expected change
Step 2: recalculate the necessary ratios.
Illustrations and further practice
Now try TYU questions 1 and 2 from Chapter 1
~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~

35. Chapter 1
OT Questions
You should now be able to answer all the TYU questions from Chapter 1 in the Study Text and questions 1 to 25 inclusive from the Exam Practice Kit.
For further reading, visit Chapter 1 from the Study Text.