BUS601: Financial Management

7a. Evaluate decisions that the firm makes on future performance 

• What are the planning and control functions of management?
• Why is creating a strategic business plan an essential part of business success?
• What are the 5Ps of strategic management, and define each one?

Making decisions and managing the business daily is undoubtedly a critical management function. But that alone isn't enough to ensure that the business will survive and grow. Additional important roles for the manager to recognize involve planning for the future and exercising the appropriate controls to ensure that the firm is performing as expected. The role of planner requires the firm's leadership to look ahead and try to anticipate the future. Questions to consider include: what new products will the market be looking for; do we have sufficient skills and technical expertise to support growth; in what new directions is the competition moving; can we continue to add value to the business? These questions, and many more, are why companies will spend the time and resources needed to create a dynamic strategic plan for the business to follow going forward. Once the strategy has been approved, the manager's role becomes that of a controller. Control is reviewing progress against the strategic plan and taking corrective action where needed if the results are less than projected.

The business environment is dynamic, global, competitive, and faced with changing customer wants and needs. Today, it is essential that a firm takes the necessary time to carefully develop a strategic plan for the business that thinks strategically about what is happening in the market. The plan should identify growth opportunities, identify the firm's need for capital to make appropriate investments, and identify goals and objectives to increase revenue while controlling costs. The strategic plan is a blueprint that the organization can follow as it moves through the years that will serve to guide decisions and actions that the business will take. As the environment is dynamic, the strategies must be dynamic as well. This implies that they will require constant review, and decisions will need to be made to make course corrections depending on what is occurring in the market.

There are several approaches to the development of a strategic plan, but we will focus on the 5Ps of strategy, including 1) plan, 2) ploy, 3) pattern, 4) position, and 5) perspective. This is an easy way to think through the steps that you can follow to develop a strategy logically and objectively. The plan refers to the specific goals that the firm's executives have established to achieve identified goals. Ploy is one part of the strategy and involves keeping your competitors 'in the dark' about your product and service plans. Walmart, for example, does not announce where it will open new stores until the last minute. It goes as far as booking plane and hotel reservations in multiple locations to maintain secrecy. To make the strategic plan an effective part of the organization, the firm needs to follow a pattern or be consistent in implementing the strategy. One part of the strategic plan will address the firm's position relative to its competitors in the marketplace. This can include strategies where the firm chooses to be an innovator of technological products (large investment in R&D) or a follower of other companies. It is important for the members of the organization who will be developing and implementing the strategy to share their perspectives of the market, competition, and customers.

To review, see: 

• Defining Strategic Management and Strategy
• Understanding the Strategic Management Process

 

7b. Explain the various forecasting methods

• What is a budget, and why is it important for a business?
• What is an operating budget, and what are some of the items included in this budget?
• What is a financial budget, and how does it differ from the operating budget?
• How can a business use budgets to evaluate performance?

Business management usually conducts operations and makes decisions within their budgets. A budget provides a framework that covers management's best estimates of the revenue coming into the firm, the expenses required for operations, and a projection of expected profits. The budgeting process starts with a review of historical activity, which allows us to review what was accomplished in prior periods. Next, it is necessary to evaluate the current business environment, including customer demand trends, economic conditions, competitive activity, interest rates, etc. Finally, based on research, you need to make assumptions about what will happen in each of these categories in the future. With all of this analysis, management will create the budgets for the next year or even three years into the future.

A company's operations focus on the day-to-day activities required to plan for and produce the products or services that the firm will be offering to the market, and the operations budget addresses these activities. Specifically, this budget is made up of several other budgets, including:

• Sales budget – forecasted plan for what will be sold, how many will be sold, and when they will be sold;
• Production budget – expense projected for plant, equipment, and labor;
• Direct material budget – cost of materials, parts, and supplies to support operations;
• Direct labor budget – labor expense for personnel needed in production; and
• Overhead budget – projected expense to maintain the facilities, rent, taxes, office expenses, etc.

Budgeting must also consider the financial needs and expected performance of the company. The firm will also compile the financial budget, which includes a plan for cash flow, the financial report – especially the balance sheet – and a plan for capital expenses. The financial budget lays out the plan that management has on how they will generate revenue through sales, the collection expectations for this revenue, the cash flow expected from planned investments, including acquisitions, and the future capital requirements to replace plants and equipment. One important piece of information from these budgets is a recognition of when revenue will come in and when capital will need to be available for investments. This information is required for developing the firm's capital plan.

The operating and financial budgets provide useful information for the firm's management that they can use as plans are made for each department in the business. They provide guidance on how much funds have been projected for salaries, materials, production, sales and marketing initiatives, etc. Perhaps more importantly, these budgets are used to evaluate the firm's actual performance against the plan and provide a basis for identifying issues that require management intervention. For example, if the operating budget has a sales forecast of $5 million in the 1st quarter, and the actual sales are $3.5 million, there is a negative variance between forecast and actual. Management will evaluate why there is a difference and determine specific action plans to address the issues. There can also be a positive variance. For example, consider the financial budget forecasting cash flow of $2 million, and the actual result is $3.1 million. While this is a positive result, management will still want to understand how this happened and perhaps take steps to reinforce what contributed to the positive variance.

To review, see Budgeting.

 

7c. Calculate the additional funds needed (AFN) by the firm

• What is the concept of additional funds needed (AFN)?
• When is AFN required to manage a business?

It is generally accepted that businesses are interested in growing, expanding product and service offerings, increasing the generation of revenue, and realizing a profit. One way to do these things is by adding additional assets to the firm. Assets are anything of value and can be represented by several different categories. Consider a firm that has successfully introduced its product offerings into the marketplace but is producing at full capacity. For the business to increase sales, it will need to add additional equipment and perhaps more manufacturing space. Management knows that these capital expenditures are necessary to generate new and increasing sales. But will the additional revenue be sufficient to cover the capital needed and the cost of that capital? Additional funds needed (AFN) is frequently used to answer this question.

A good rule for applying the additional funds needed calculation is before management makes the final decision to acquire new assets dedicated to the firm's growth. It should be part of the financial analysis when considering this type of investment. The AFN equals the projected increase in assets minus the spontaneous increase in liabilities – any increase in retained earnings. To use the AFN formula, you will need to know the assets directly tied to sales, spontaneous liabilities, prior year sales, projected sales, profit margin, projected net income, and the retention ratio from net income. If the result of this calculation is a negative number, then no additional funds will be required. The return from the addition of new assets will cover the cost of the investment and generate additional income for the company's use.

To review, see Additional Funds Needed.

 

7d. establish basic guidelines for corporate governance 

• What is corporate governance?
• Who are parties that would be interested in corporate governance?
• Is there a role for government regulation and oversight of corporations? Why?

Throughout this course, we have discussed the responsibility that a firm's executives have to make decisions that provide the expected returns to shareholders and make decisions that support this goal. But the firm needs to determine its policies regarding how it will operate and how they will protect its stakeholders' interests and publish these policies internally and externally to the organization. There are legal and ethical issues involved. In the U.S., there is government oversight through the Securities and Exchange Commission (SEC), which provides regulations to ensure that stakeholders are protected, especially from fraudulent activities.

In a public corporation, the Board of Directors is responsible for providing oversight of management and the decisions made on behalf of shareholders. The firm must recognize that investors have provided funds to the business with the expectation that those funds will be used to make sound investment decisions that will increase the firm's value. The idea of a fiduciary responsibility states that decision-makers will use proper due diligence, including research and analysis when deciding to invest shareholders' money. The larger the firm, the greater number of interested parties, or stakeholders. These parties include shareholders, lenders, employees, suppliers, and local communities. A truly ethical firm will make every effort to meet the minimum requirements for good corporate governance and look for opportunities to exceed these requirements. This responsibility has been greatly increased with firms' global reach and participation in today's business arena.

To review, see:

• Corporate Governance: Linking Corporations and Society
• Governance and Accountability
• The Board of Directors: Role and Composition

 

Unit 7 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

• 5Ps of strategy
• additional funds needed
• budget
• controller
• fiduciary
• financial budget
• operations budget
• pattern
• perspective
• plan
• planner
• ploy
• position
• Securities and Exchange Commission
• strategic plan