Summary Notes: Introduction to Business

Finance Decisions
Chapter No. 1
1. Strategic Financial Management
Definitions of Strategy
 Chandler: Long-term goals, actions, and resource allocation.
 Drucker: Activities to achieve objectives and adapt to changes.
 Johnson, Scholes, and Whittington: Long-term direction, resource configuration, and
stakeholder fulfillment.

Common Themes:

 Organized activities to achieve objectives.

 Long-term perspective.

 Adaptability to changing environments.

Financial Strategy
 Integral part of corporate strategy.

 Includes setting objectives, identifying resources, analyzing data, making financial decisions, and
monitoring performance.

The Nature of Financial Management

 Planning and controlling financial affairs to achieve objectives.
 Key decisions include:

 Product and market choices.

 Long-term investments.

 Funding sources (debt vs. equity).

 Managing cash flow.

  Tax optimization.

 Dividend policies.

 Risk management.

2. Financial Objectives
Financial Objectives and Corporate Strategy
 Every organization has a primary objective:

 Commercial organizations: Maximize shareholder wealth.

 State-owned entities: Provide public services.

 Charities: Fulfill charitable purposes within financial constraints.

Primary Corporate Objective

 Maximizing shareholder wealth (market value of the company).

 Requires balancing with the needs of other stakeholders.

Wealth Maximization
 Main objective: Increase shareholder wealth through dividends and share price growth.

 Challenges:

 Setting appropriate time periods for targets.

 Measuring wealth creation.

 Share price influenced by market sentiment.

Profit Maximization
 Clear and simple target but often short-term focused.

 Issues:

 Short-term actions might harm long-term profitability.

 Managers may prioritize short-term gains due to personal incentives.

Growth in Earnings Per Share (EPS)

  EPS growth can indicate long-term shareholder wealth increase.

 Problems:

 Borrowing can artificially boost EPS but increase financial risk.

Measuring Financial Objectives

 Use of ratio analysis for comparisons:

 Over time.

 With other companies.

 Against industry averages.

Key Ratios
 Return on Capital Employed (ROCE): Measures profitability relative to capital.
 Return on Shareholder Capital (ROSC): Measures return on equity investment.
 Earnings Per Share (EPS): Indicates profit per share.
 Total Shareholder Return (TSR): Includes dividends and share price changes.

Other Objectives
 Non-financial objectives can also link to wealth maximization:

 Competitive salaries.

 Staff training.

 Product development.

 Social responsibility.

Role of the Financial Manager

 Advisory role on financial strategy and policies.

 Three fundamental decisions:

 Investment: Which investments to undertake.

 Financing: How to raise capital cost-effectively.

 Dividend: Balance between profit distribution and reinvestment.

 Additional responsibilities include financial planning, control, and risk management.

These summary notes encapsulate the key concepts of strategic financial management and financial
objectives essential for business finance decisions.

Chapter No. 2

Introduction to Investment Appraisal

Contents
1. Capital Expenditure, Investment Appraisal, and Capital Budgeting
2. Accounting Rate of Return (ARR) Method
3. Payback Method

1. Capital Expenditure, Investment Appraisal, and Capital Budgeting

Section Overview
 Features of Investment Projects
 Investment Appraisal
 The Basis for Making an Investment Decision
Decision-making is crucial in performance management, particularly for business managers who must
continuously evaluate which investment opportunities to pursue or avoid. Poor investment decisions can
lead to significant financial losses and business failure. Thus, understanding various investment appraisal
techniques is essential for making sound business finance decisions.

Investment appraisals should be based on a risk-return trade-off and aim to maximize shareholders’
wealth, aligning with the corporate and financial strategy of a business.

1.1 Features of Investment Projects

Investment projects often have the following characteristics:
  Involve purchasing an asset with a long useful life and a significant initial cost.
 Generate returns primarily from net income over the project's lifespan.
 The asset may have a residual value at the end of its useful life.
 May require an investment in working capital.
 Can involve buying another business or setting up a new venture with long-term financial returns.
1.2 Investment Appraisal
Before undertaking projects, they should be thoroughly assessed and evaluated. Projects should be
undertaken only if they:

 Provide a suitable financial return.

 Have an acceptable level of investment risk.
Investment appraisal is the process of evaluating proposed investment projects to decide whether the
capital expenditure is justified, and the project should proceed.

Process:

1. Idea Generation: Good project ideas can come from senior management, functional divisions, or
external researchers.
2. Analyzing Project Appraisals: Decisions are based on expected future cash flows and
profitability forecasts.
3. Creating Firm-Wide Capital Budget: Prioritize projects based on available resources, expected
cash flows, and the company's strategic plan.
4. Monitoring Decisions and Conducting Post-Audits: Follow up on decisions to identify
systematic errors and improve operations.
1.3 Basis for Making an Investment Decision
Decisions are typically made for financial reasons, but non-financial considerations can also be important.
Financial bases for decisions include:

Accounting Rate of Return (ARR): Measures the accounting profit as a percentage of the
capital invested.
 Payback Period: Time taken to recover the initial cash investment.
 Discounted Cash Flow (DCF): Evaluates the size and timing of expected future returns.
DCF Methods:

 Net Present Value (NPV): Calculates the present value of expected costs and benefits, with the
project undertaken if NPV is positive.
 Internal Rate of Return (IRR): Compares the expected return with the minimum required
return, with the project accepted if the expected return exceeds the required return.
2. Accounting Rate of Return (ARR) Method
Section Overview
 Definition of ARR
 Decision Rule for the ARR Method
 Advantages and Disadvantages of Using the ARR Method
ARR measures the net accounting profit from an investment as a percentage of the capital invested.

2.1 Definition of ARR

ARR is the accounting profit (usually before interest and tax) expressed as a percentage of the capital
invested. It is similar to return on capital employed (ROCE) but specific to a capital project. ARR
includes:

 Sunk costs.
 Carrying amounts of assets.
 Depreciation and amortization.
 Allocated fixed costs.
Formula for ARR:
ARR=Average Annual ProfitAverage Investment×100ARR=Average InvestmentAverage Annu
al Profit×100

2.2 Decision Rule for the ARR Method

Decisions are made by comparing the ARR to a target return:

 Accept if ARR > target.

 Reject if ARR < target.
2.3 Advantages and Disadvantages of Using the ARR Method
Advantages:

 Easy to understand and calculate.

 Uses familiar accounting concepts.
Disadvantages:

 Not linked to wealth maximization.

 Can be calculated differently, leading to confusion.
 Based on accounting profits, not cash flows.
 Ignores the time value of money.
 Requires setting a subjective minimum target ARR.

3. Payback Method
Section Overview
 Definition of Payback
 Decision Rule for the Payback Method
 Advantages and Disadvantages of the Payback Method
 Forecasting Cash Flows
 Bailout Payback Period
Payback measures how long it takes to recover the initial investment from net cash returns.

3.1 Definition of Payback

The payback period is calculated by:
Payback Period=Initial InvestmentAnnual Cash InflowsPayback Period=Annual Cash In
flowsInitial Investment For uneven cash flows, cumulative cash proceeds are used to reach the initial
investment.

3.2 Decision Rule for the Payback Method

Projects are evaluated based on a maximum acceptable payback period:

 Accept if payback ≤ maximum period.

 Reject if payback > maximum period.
 Among competing projects, choose the one with the quickest payback.
3.3 Advantages and Disadvantages of the Payback Method
Advantages:

 Simple to calculate and understand.

 Focuses on cash flows, important for liquidity concerns.
Disadvantages:

 Ignores the wealth maximization objective.

 Subjective target payback period.
 Ignores cash flows after the payback period.
 Ignores the timing of cash flows during the payback period.

Practice Questions
Practice Question 1:

 Calculate ARR using different methods for capital employed.

 Evaluate project acceptance based on calculated ARR.
Practice Question 2:
  Calculate the payback period for projects A and B.
 Determine project acceptance based on the company’s payback rule.
 Discuss the appropriateness of the payback method for decision-making.
3.4 Forecasting Cash Flows:

 Model cash flows in real and money terms, considering the impact of inflation.
3.5 Bailout Payback Period:

 Consider the possibility of abandoning the project, with bailout cash flows added to basic project
flows.
Example calculations illustrate these concepts and help understand the practical application of these
methods.

Chapter 7
Summary Notes on Evaluating Financial Performance with Formulas

1. Introduction to Critical Success Factors (CSFs)

 Definition: Essential components of strategy for out-performing competition (Johnson
and Scholes).
 Purpose: Identify and excel in factors crucial for market success.
 Example: Accounting firm considering new office in Sukkur City identifies potential
CSFs:

 Employing top-quality accountants

 Charging lower fees

 Obtaining minimum corporate and private clients

 Offering comprehensive audit and accountancy services

 Attractive city-center location

 Application: Agree on CSFs to set performance targets and focus efforts.
2. CSFs for Products and Services
 Relation to Customer Needs: Features that influence purchase decisions.
 Examples:

 Parcel delivery service: Prompt collection and reliable delivery.

 Sports car: Competitive performance and superior reliability.

3. CSFs and Key Performance Indicators (KPIs)

 Identification Stages:

 Assessing strategic position: Understand why products/services succeed.

 Making strategic choices: Select strategies for competitive advantage.

 Strategy implementation: Set performance targets (KPIs) for each CSF.

 KPI Definition: Quantified targets measuring performance on CSFs.

4. Six-Step Approach to Using CSFs (Johnson and Scholes)

1. Identify CSFs for profitability: Consider customer needs and marketing mix (4Ps).
2. Identify critical competencies: Necessary actions to achieve superior performance.
3. Develop critical competencies: Gain competitive advantage in CSFs.
4. Identify KPIs for competencies: Ensure KPIs support competitive advantage in CSFs.
5. Emphasize critical competencies: Make it difficult for competitors to match.
6. Monitor KPI achievement: Compare with competitors’ performance.

5. Financial Performance Indicators (FPIs)

 Overview:

 Measure overall financial health over a period.

 Use multiple metrics for comprehensive assessment.

 Main Aspects:

 Profitability: Sales revenue, costs, and profit ratios.

 Liquidity: Availability of cash to meet liabilities.

 Financial risk: Risks related to financial structure or borrowing.

6. FPIs for Measuring Profitability
 Key Ratios:

 Sales Growth:

Sales Growth=(SalesCurrent Year−SalesPrevious YearSalesPreviou

s Year)×100Sales Growth=(SalesPrevious YearSalesCurrent Year
−SalesPrevious Year)×100
 Gross Profit Margin:

Gross Profit Margin=(Gross ProfitSales)×100Gross Profit Margin=(

SalesGross Profit)×100
where
Gross Profit=Sales−Cost of Goods Sold (COGS)Gross Profit=Sales
−Cost of Goods Sold (COGS)

 Net Profit Margin:

Net Profit Margin=(Net ProfitSales)×100Net Profit Margin=(Sales

Net Profit)×100
 Cost/Sales Ratios:

Cost to Sales Ratio=(Specific CostSales)×100Cost to Sales Ratio=(

SalesSpecific Cost)×100

7. FPIs for Measuring Liquidity

 Key Ratios:

 Current Ratio:

Current Ratio=Current AssetsCurrent LiabilitiesCurrent Ratio=Curr

ent LiabilitiesCurrent Assets
 Quick Ratio (Acid-Test Ratio):

Quick Ratio=Current Assets−InventoryCurrent LiabilitiesQuick Rat

io=Current LiabilitiesCurrent Assets−Inventory

8. FPIs for Measuring Financial Risk

 Key Ratios:
  Debt to Equity Ratio:

Debt to Equity Ratio=Total LiabilitiesShareholders’ EquityDebt to

Equity Ratio=Shareholders’ EquityTotal Liabilities
 Interest Coverage Ratio:

Interest Coverage Ratio=Earnings Before Interest and Taxes (EBIT)

Interest ExpenseInterest Coverage Ratio=Interest ExpenseEarnings
Before Interest and Taxes (EBIT)
 Debt Ratio:

Debt Ratio=Total DebtTotal AssetsDebt Ratio=Total AssetsTotal D

ebt

These notes provide a concise overview of the key concepts and methodologies for evaluating
financial performance, focusing on critical success factors, key performance indicators, and
financial performance indicators, with the inclusion of relevant numeric formulas.

3-Assessing Business Strategies

Section Overview
 Key Points:

 Assessing business strategy.

 Evaluating the suitability, feasibility, and acceptability of a strategy.

 Conducting financial impact analysis.

Basis for Assessing Business Strategy
 Johnson and Scholes Framework:

 Suitability: Addresses strategic requirements given the circumstances.

 Feasibility: Practical and implementable.

 Acceptability: Acceptable to significant stakeholders.

 Financial Analysis: Critical to assess acceptability and feasibility, including using DCF
analysis considering risk-return trade-off.

3.1 Suitability of a Strategy

 Objective Achievement:

 Enhancing shareholder value through NPV calculation for investments.

 Improving key performance areas by recalculating performance measures.

 Assessing business risk and its acceptability.

 Questions for Suitability:

 Does the strategy meet strategic objectives?

 Is the business risk acceptable?

3.2 Feasibility of a Strategy

 Implementation Capability:

 Judgement by management is essential.

 Key Questions for Feasibility:

 Finance: Sufficient funding available?

 Quality: Can required quality levels be achieved?

 Skills: Adequate marketing and employee skills?

 Resources: Availability of raw materials?

 Technology: Sufficient IT and technology infrastructure?

 Financial Assessment:
  Return on investment.

 Risk-return balance.

 Cost-benefit analysis.

 Impact on profitability and share price.

3.3 Acceptability of a Strategy

 Stakeholder Acceptance:

 Key stakeholders must accept the strategy.

 Strategies are likely rejected if not acceptable to key stakeholders.

 Aspects of Acceptability:

 Return on Investment: Expected returns must be satisfactory.

 Risk Level: Risk must be acceptable relative to the return.

 Investor Support: Acceptance by investors, especially regarding additional

finance.

 Ethics: Ethical considerations by employees and investors.

Key Numeric Formulas

 Net Present Value (NPV):

NPV=∑𝑡=0𝑛𝑅𝑡(1+𝑟)𝑡−𝐶0NPV=t=0∑n(1+r)tRt−C0

where 𝑅𝑡Rt is the net cash inflow at time 𝑡t, 𝑟r is the discount rate, and 𝐶0C0 is the
initial investment.

 Discounted Cash Flow (DCF):

DCF=∑𝑡=0𝑛𝐶𝐹𝑡(1+𝑟)𝑡DCF=t=0∑n(1+r)tCFt

where 𝐶𝐹𝑡CFt is the cash flow at time 𝑡t, and 𝑟r is the discount rate.
These notes outline the critical elements of assessing business strategies, focusing on their
suitability, feasibility, and acceptability, along with essential financial assessment techniques.