Sample Notes: Finance And Accounting Strategy

A2 Level Business – Detailed Notes

Chapter 10.4: Finance and Accounting Strategy

10.4.1 The Use of Accounting Data to Enable Strategic Decision-Making

Use of Financial Statements in Strategy Development

1. Income Statement (Profit and Loss Account)

• Shows revenue, costs, gross profit, operating profit, and net profit over a period.
• Assists in:
  • Identifying cost control or revenue growth strategies.
  • Evaluating profit margins and deciding on price/cost adjustments.
  • Measuring efficiency of operations.

2. Statement of Financial Position (Balance Sheet)

• Shows assets, liabilities, and equity at a specific point in time.
• Assists in:
  • Assessing liquidity (working capital management).
  • Evaluating financial structure (debt vs equity).
  • Planning investment or divestment strategies.

3. Statement of Cash Flows

• Summarises cash inflows/outflows from operating, investing, and financing activities.
• Assists in:
  • Ensuring solvency and managing cash reserves.
  • Planning strategies for capital expenditure or debt repayment.

Contents of an Annual Report and Their Usefulness

Key Sections:

1. Chairman’s Statement – Strategic overview and company vision.
2. CEO/Managing Director’s Review – Operational performance and future outlook.
3. Financial Statements – Includes income statement, balance sheet, cash flow.
4. Notes to Accounts – Detailed disclosures about assumptions, methods, liabilities, risks.
5. Corporate Governance Report – Policies, board structure, internal control.
6. CSR and Sustainability Reports – Ethical and environmental practices.
7. Auditor’s Report – Independent verification of financial accuracy.

Usefulness to Stakeholders:

• Investors: Understand profitability, risk, and growth potential.
• Managers: Guide future strategies based on past performance.
• Creditors: Assess solvency and ability to repay debt.
• Employees: Gauge job security and company direction.
• Government: Monitor tax compliance and economic impact.
• Community/NGOs: Assess ethical and environmental responsibility.

10.4.2 The Use of Accounting Data and Ratio Analysis in Strategic Decision-Making

Assessment of Business Performance Over Time and Against Competitors

• Use trend analysis (same firm over several periods) and benchmarking (against rivals).
• Enables businesses to track:
  • Growth patterns
  • Operational efficiency
  • Profitability and liquidity performance
  • Competitiveness in the market

Impact of Accounting Data and Ratios on Strategy

1. Profitability Ratios

• Gross Profit Margin, Operating Margin, Net Profit Margin
• Impact:
  • Low profitability may lead to cost-cutting or price increases.
  • High margins can support expansion or product development.

2. Liquidity Ratios

• Current Ratio, Quick Ratio
• Impact:
  • Poor liquidity may prompt cash flow control or delayed investment.
  • High liquidity might allow short-term growth or inventory building.

3. Efficiency Ratios

• Inventory Turnover, Receivables Turnover, Asset Turnover
• Impact:
  • Highlight inefficiencies in asset use.
  • May lead to outsourcing, automation, or supplier negotiation.

4. Gearing (Leverage) Ratios

• Gearing Ratio, Interest Cover
• Impact:
  • High gearing may restrict further borrowing and affect dividend strategy.
  • May lead to focus on debt reduction or equity issue.

5. Investment Ratios

• Earnings Per Share (EPS), Dividend Yield, Price/Earnings (P/E) Ratio
• Impact:
  • Used by investors to evaluate share performance.
  • Drives decisions on dividend policy, share buybacks, or reinvestment.

Impact of Debt or Equity Decisions on Ratio Results

• Raising Debt:
  • Increases gearing ratio and interest cover risk.
  • May reduce EPS due to interest costs.
  • Improves return on equity if returns exceed interest costs.
• Raising Equity:
  • Lowers gearing but dilutes ownership.
  • May reduce EPS temporarily.
  • Seen as safer and improves long-term solvency.

Impact of Changes in Dividend Strategy

• Higher Dividends:
  • Reduces retained earnings for reinvestment.
  • Increases dividend yield, improves investor appeal.
  • May lead to cash flow strain in low-profit periods.
• Lower Dividends / Higher Retention:
  • Supports internal growth strategies.
  • May reduce investor satisfaction, lowering share price.
  • Improves liquidity and long-term resilience.

Impact of Business Growth on Ratios

• Rapid growth may:
  • Strain liquidity (increased inventory, receivables).
  • Increase gearing if debt-funded.
  • Improve profitability over time via economies of scale.
  • Lead to temporary inefficiencies and reduced margins.

Impact of Other Business Strategies on Ratio Results

• Cost Leadership Strategy:
  • Improves profit margins.
  • Increases asset turnover if volume-based.
• Differentiation Strategy:
  • May reduce efficiency ratios but boost gross margins.
• Restructuring or Mergers:
  • Alters gearing, asset base, and earnings.
  • Short-term volatility in ratios.
• Global Expansion:
  • Affects currency exposure, fixed asset base, and cash flow.

Limitations of Using Published Accounts and Ratio Analyses

1. Historical Data:
   • Financial statements are backward-looking, not predictive.
2. Window Dressing:
   • Firms may manipulate figures to appear healthier (e.g. delaying payments).
3. Non-Financial Factors Ignored:
   • Customer loyalty, innovation, employee morale aren’t reflected.
4. Different Accounting Policies:
   • Makes comparisons across firms/countries difficult.
5. Inflation Effects:
   • Asset values may be understated.
6. Timing Issues:
   • Accounts may not capture real-time changes in performance or conditions.
7. One-off Events:
   • Profits/losses may be distorted by exceptional items.
8. Ratios Don’t Provide Context:
   • Need to be interpreted with industry norms, market conditions, and internal goals.