NPTEL

COURSE ON ENTREPRENEURSHIP
Perspectives of Business Strategy and Economic Development

WEEK 7 – LECTURES 31, 32, 33, 34 and 35

Course Module 8 (Part)

Raising Finances and Developing Financial Strategy

Prof. C Bhaktavatsala Rao, Ph.D.

Ajit Singhvi Chair Professor

Department of Management Studies

Indian Institute of Technology Madras
 NPTEL

COURSE ON ENTREPRENEURSHIP
Perspectives of Business Strategy and Economic Development

WEEK 7 – LECTURE 35
Course Module 8 (Part)

Raising Finances and Developing Financial Strategy

Part 5

Prof. C Bhaktavatsala Rao, Ph.D.

Ajit Singhvi Chair Professor

Department of Management Studies

Indian Institute of Technology Madras
Definition of Financial Strategy
• Financial Strategy of a firm is a set of integrated financial goals and
activities planned for a firm covering multiple domains of the company so
that the firm can grow profitably, maximising value for its shareholders

• Financial strategy of a firm is developed pursuant to the business strategy

and the various supporting functional strategies of the firm. Financial
strategy, however, is not a mere expression of all other strategies in
financial terms.

• Financial strategy must also, on its own, take advantage of environmental

opportunities and insulate the firm from environmental risks, taking into
account the firm’s strengths and weaknesses.

• Financial strategy of a firm typically covers a reasonably long term horizon

of at least 5 years. The first year of the financial plan also serves as the
annual budget of the company.

• Financial strategy addresses several key questions that arise from, and
impact, the financial position of the company.
Business Strategy of a Firm – A Recap

Product
Strategy

Human
Technology
Resources
Strategy
Strategy

Business
Strategy

Financial Operations
Strategy Strategy

Sales and
Marketing
Strategy
Financial Strategy of a Firm addresses questions such as…

The profit and loss statement and

What are the What is the profit the balance sheet of the company
assets and or loss arising
provide a picture of the financial
liabilities of the from the firm’s
firm? operations? health and strength of the firm at
a glance.

What are the

implications of
Establishing product profitability What is the different
based on an analysis of product- profitability of manufacturing
wise prices and costs is an each of the options in terms of
important driver of both tactical products, and the breakeven levels,
and strategic operations of the product portfolio profitability
firm. as a whole? parameters , and
the means of
finance

How should the

Firms are moving away from
business be How will the firm
singular measures of firm’s
funded? Through maximise its
performance, and instead use a set
equity, debt and value to its
of measures that lead to wealth
internal shareholders?
maximisation
generations?
Financial Strategy of a Firm Involves a Few Critical Decisions

Investment

Each decision, singularly and

Decisions

collectively, impacts the

Financing
Return
Financial Decisions
Decisions Liquidity Risk
Decisions
Dividend
Decisions

It is the responsibility of the financial and business leaders to take optimal financial decisions on
one hand and establish the optimal risk-return tradeoff of various business decisions on the other.
Financial Decisions Are Influenced by Many Factors
A firm is required to take its financial decisions and frame its financial strategy based on several
perspectives from the ecosystem in which it exists, be it the industry or the broader economy

The Firm

The Industry

The National Economy

The Global Economy

Global liquidity has become as important a determinant of the financial path of firm as the internal
profitability has been.
 Economic and Business Factors Relevant for Financial Strategy
A number of factors, including and not limited to the following, are relevant for developing financial strategy

Consumer
GDP growth Inflation Demographics Subsidies
optimism

Consumer Purchasing
Sectoral growth Unemployment Jobs formation
spending power

Gross domestic Money in Income Credit Gross capital

savings circulation inequalities availability formation

Financial International Balance of Foreign direct

Interest rates
market stability trade payments investments

Similar global
International Government
Exchange rates Overall debt economic
ratings debt
parameters

The nature of each business influences the pattern of correlation between economic and business factors
Financial Strategy is Closely Linked to Other Factors
Corporate governance, ethics, compliance, business continuity and risk management are now integral
to financial management.

Corporate Governance

Ensuring that the company is run on

prudential lines

Ethics and Compliance

Ensuring that the firm is an honest corporate

citizen

Business Continuity and Risk Management

Ensuring that business is made robust against

potential disruptions and risks

Financial management is relied upon to ensure operational integrity and business continuity of a
firm, not merely wealth maximisation
Investment Decisions are Based on Project Viability Analysis
A number of tools and techniques are available to assess project viability and take capital investment
decisions

Every project is long term in nature with current and future cash outflows and cash inflows

Time value of money is an important concept in

Generally expressed by the required rate of return
financial management

The required rate of return is set higher than the cost of capital of the firm

Cost of capital is the compensation for time and risk Cost of Capital is the weighted average of the cost of
involved in projects debt and equity of the firm

Equity may not have explicit cost as the payments of dividends is not mandatory
However, the opportunity cost of equity capital The Cost of Capital could also be set based on
must be imputed in the cost of capital calculations investor expectations of dividends and capital gains

Start-ups which rely overwhelmingly on equity capital tend to ignore the importance of assessing the
cost of equity. Start-ups must assess their projects with appropriate hurdle rates related to CoC.
Financing Decisions are Based on Scale, Scope and Efficiency
A business or a firm should be managed efficiently and effectively. The quantum of funds required for
operations and the surpluses generated from operations determine the financing decisions.

As a principle, fixed assets must be financed by long term debt or equity

Fixed assets must provide reasonable return in the Otherwise, projects become non-performing assets
envisaged timeframe (NPAs)

Equally, liquid assets must be financed by short term working capital

Predictability and stability of business assures good Per contra, to be effective in WC management, the firm must
inventory management be able to predict the demand for its products accurately

Inventory management is a critical aspect of working capital management

Just in Time inventory management reduces the cash Inventory turns, ie., the speed with which inventory is
locked up idly in inventory converted into cash, influences profitability

Start-ups must start injecting debt to fund the operations at the appropriate time to minimize equity
dilution. This requires validated prototypes, and a robust sales and production model.
 Financial Forecasting and Modelling
Financial forecasting is an integral part of business planning, but is more than mere conversion of
business plan into financial numbers. A number of variables have to be forecast by the financial analysts.

Capital
(Interest rates)

Materials and Utilities

Physical and
(Commodity rates) Conversion Financial
Standards Performance

Organisation
(Wages and salaries)

Ability to predict the future trend of various input variables is a collaborative cross-functional effort
with the trends and metrics getting expressed financially
Financial Ratio Analysis
The current and projected performance of the firm has to be benchmarked utilizing ratio analysis.
Internal past and projected ratios, and the comparative ratios of other firms in the industry

Liquidity ratios measure the

Liquidity Ratios firm’s ability to meet current
Types of Ratios

obligations

Explanations
Leverage ratios show the
Leverage Ratios proportions of debt and equity
in financing the firm’s assets

Activity ratios reflect the firm’s

Activity Ratios efficiency in utilising its assets

Profitability ratios measure

Profitability Ratios overall performance and
effectiveness of the firm

A comprehensive discussion of ratio analysis can be found in the book “Financial Management” by
I M Pandey (Vikas Publishing House Pvt Ltd., 2010).
Financial Ratio Analysis Indicates the Financial Health of the Firm - 1
Various ratios are typically indicative of the foundational attributes of the company based on which
the financial strategy and business strategy of the firm can be structured
Profitability Analysis

Current and future Solvency of operations

Liquidity Analysis
profitability in the face of adversities

Efficiency in conversion
Sources of profit and loss
of assets into cash

Cash generation and

Return on investment
coverage

Ability to remain profitable

Efficiency in working
with and without new
projects capital management

Profitability and the liquidity of the firm go in hand. Excess liquidity funded by debt saps profitability.
Financial Ratio Analysis Indicates the Financial Health of the Firm - 2
Various ratios are typically indicative of the foundational attributes of the company based on which
the financial strategy and business strategy of the firm can be structured

Effectiveness in asset Soundness relative to

Capital Structure
Asset Utilisation

utilisation for sales industry characteristics

Asset heaviness Vs. Asset Adequacy of cash

lightness of the business generation to support debt

Valuation of the firm

The risk level of fixed and relative to equity
sunk costs premiums and dilutions

The pros and cons of Headroom to raise equity

integration and/or debt

Deployment of assets not only impacts profitability but also impacts capital structure requirements.
Simplified Income Statement and Balance Sheet
(Rs Crore)
Year 1 Year 2 Year 3 Year 4 Year 5
PROFIT & LOSS ACCOUNT
Net Sales
Cost of Goods Sold
Gross Profit
Non-Manufacturing Expenses
PBIT
Interest
PBT
Tax
PAT
Dividend
Retained Earnings
BALANCE SHEET
Share Capital
Reserves
Net Worth
Borrowings
Capital Employed
Net Fixed Assets
Net Current Assets
Net Assets
Financial Ratio Analysis
Year 1 Year 2 Year 3 Year 4 Year 5 Average
PERCENTAGE OF SALES
Profit & Loss Items
Cost of Goods Sold
Administrative Expenses
- Selling Expenses
- Other Expenses
- Interest
PAT
Balance Sheet Items
Net Fixed Assets
Inventory
Debtors
Cash and Bank Balance
Current Assets
Current Liabilities
Net Current Assets
Net Assets
PROFITABILITY ANALYSIS
Assets Turnover
NS/NA
Profit Margin: PBIT /NS (%)
Return on Investment: PBIT/NA (%)
Leverage Factor: PAT/PBIT (%)
Debt Ratio: NA/NW (i.e., 1+D/E)
Return on Equity: PAT/NW (%)
Retention Ratio: RE/PAT (%)
Growth in Equity: RE/NW (%)
Growth in Sales (%)
PAT : Profit After Tax; PBIT: Profit Before Interest & Tax; NA: Net Assets; NS: Net Sales; NW: Net Worth; RE: Retained Earnings; NCA: Net Current Assets;
PBT: Profit Before Tax
Financial Sensitivity Analysis

Scenarios
Asset
Growth Margin Growth 15% Growth 10%
Ratio
12% 2.5% Margin 2.0% Margin 3.0%
80%
Asset Ratio 75% Asset Ratio 70%
NFA
NCA
Total
RE
Funds Needed
Total
Simplified Funds Flow Statement
(Rs Crore)
SOURCES OF FUNDS
Profit After Tax
Depreciation
Funds from Operations
Borrowings

USES OF FUNDS
Gross Block
Capital Works-in-progress
Dividends
Increase in Net Current Assets (NCA)

CHANGES IN NET CURRENT ASSETS

Current Assets
Inventory
Debtors
Cash and Bank Balance
Other Assets
Change in Current Assets
Less: Current Liabilities
Change in NCA
Financial Strategy Must Address the Following Questions
Financial modelling helps answer key strategic questions to fine-tune the business strategy and plan

Are the goals and strategies, including day to day and long term operations, of the firm financially sustainable?

What can be financially done to make the goals, strategies, and operations of the firm feasible and viable?

What are the capital structure and financial instrument options available to support capital investment
projects for growth?

Can the firm raise the required funds (debt and/or equity) to support short term and long term operations
on acceptable terms and in an acceptable timeframe?

Are the covenants of fund raising in the interests of the company, and its current shareholders?

What should be the most appropriate dividend policy to balance the needs to reward shareholders and retain
the earnings to power future growth?

What is the sensitivity of company’s financial profile to unanticipated adversities?

Financial modelling and analysis has to be strategic in nature to shape long term business plans well
Dividend Decision is Crucial for an Operating Firm
Dividend policy determines the amount of earnings to be distributed to the shareholders and the amount to be
retained in the firm. Dividend decision is based on current operations and future potential of the company.

Low Dividend Payout – High Dividend Payout

High Capital Gains – High Capital Gains
High Company Company

Capital Gains
Current Vs.
Future Gains

Low Low Dividend Payout – High Dividend Payout

Low Capital Gains – Low Capital Gains
Company Company

Low High

Dividend Yield

Dividend payouts and capital gains of a firm are not necessarily correlated, either positively or inversely
Capital Budgeting Tools
A number of capital budgeting tools and techniques are used by companies to decide on project selection

Discounted • Net Present Value (NPV)

Cash Flow • Internal Rate of Return (IRR)
(DCF) Criteria • Profitability Index (PI)

Non- • Payback (PB)

discounted
• Discounted payback
Cash Flow
• Accounting Rate of Return (ARR)
Criteria

The assumptions on cash flows and the cost of capital would determine how correct the results would be
Net Present Value (NPV)
The NPV method is the classic economic method of evaluating alternative investment proposals

Set realistic cash flow

assumptions and
forecasts

Calculate cost of
capital and set the
Accept the project if
discount rate as the
NPV is positive
opportunity cost of
capital

Compute NPV as the Calculate present

surplus of cash inflows value of cash inflows
over cash outflows and cash outflows

In the event of many projects, projects should be ranked based on NPV; however NPVs vary based on CoC
Other Capital Budgeting Techniques
Various other rules seek to provide different perspectives to study projects, all of them being sensitive to cash
flows and discounting rates used

Internal Rate of Return

The rate of return at which NPV becomes zero has to be determined. That rate should be
higher than the opportunity cost of capital

Payback
One of the simplest and most popularly used methods, the payback period is derived by
dividing cash outlay by the annual cash inflow

Limitations
All methods , including NPCV, IRR and Payback, have their value and limitations. A study of
cash flow patterns is vital to choose the appropriate tool.

In the event of many projects, projects should be ranked based on NPV; however NPVs vary based on CoC
Other Financial Models
The discipline of Finance has several models of accounting and finance which can be put to good use

ABC Analysis
Working Receivables
Capital and Payables
Models Models

Risk
Black-Scholes
Management
Model
Models

M&A Models
Financial Break-even
Models Analysis

Enterprise Cash
Valuation Forecasting
Models Models

Discriminant Capital Asset

Analysis Pricing Model
Cash Flow
Models

All financial modelling should be set in the context of business and industrial and economic structures
Key Financial Goals
A company has to consider multiple financial goals contextually but cash verily is the king

•Book value of net worth •Price-Earnings

•Market value per share •Market rate of return
•Cash flow per share •Return on investment
•EBITDA •Net profit to net worth
•Net profit margin
•Market share

Level Ratio
Maximisation Maximisation

Liquidity Growth
Maximisation Maximisation

•Profits •Earnings per share

•Cash flows •Total assets
•Sales

Sustainable operating profitability should be the goal of all start-up founders and enterprise leaders
Key Profitability Indicators
A company cannot be judged by just one measure of profitability; multiple ratios are required

EBITDA to
Sales
Return on
EBIT to
Equity
Sales
plus Debt

Return on PBT to
Equity Sales
Profitability

PAT to
PAT to
Net
Sales
Assets

EBIT to EBIT to
Net Total
Assets Assets

Financial decisions impact the health of profitability measures; financial analysis has to be dynamic
Financial Strategy Should Guide but not Dictate Business Strategy
While financial analysis is very important, strategy cannot be determined solely through financial goals

A company cannot be governed only by profit maximisation

or shareholder wealth maximisation criteria

Financial priorities can dramatically change with

volatility in economic and business environment

A company’s strategic enterprise value is determined not

only by financial value but by other intangibles

Financial strategy, without relation to business realities

could be draconian and destroy long term investor wealth

In the event of many projects, projects should be ranked based on NPV; however NPVs vary based on CoC
Thank you!

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