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Summary CIMA F3 Notes
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Chartered Institute of Management Accountants Strategic Level F3F3 Financial Strategy
Structure
A.Financing policy decisions (15%)
1. Strategic financial objectives
2. Non-financial objectives
3. Development of financial strategy
B.Sources of long-term funds (25%)
4. Financing: equity finance
5. Financing: debt finance
6. Financing: capital finance
7. Dividend policy
C.Financial risks (20%)
8. Financial risk
9. Currency risk management
10.Interest rate risk management
D.Business valuation (40%)
11.Financial risk and strategic implications of mergers and acquisitions
12.Business valuation
13.Pricing issues and post-transaction issues
Jack Gould 1 of 36
,Chartered Institute of Management Accountants Strategic Level F3
F3A1: Strategic financial objectives
• Mission: fundamental objective of the entity expressed in general terms; entity’s basic purpose
• Mission statement: published statement outlining the entity’s fundamental objective(s)
• Objectives: specific targets (arranged into a hierarchy) the entity sets itself, translating the
mission into a series of mileposts to ensure it stays on course; objectives differ depending on:
A.Type of entity:
• Incorporated: legally separate entity from owner(s); may have several owners thus more likely for conflict of stakeholder interests
• Unincorporated: entity and owner are legally the same, thus owner bears responsibility of all risks; usually sole trader/partnerships
• Quoted: incorporated entity may apply to become quoted on a stock exchange; easier for investors to value entity/trade its shares
• Unquoted: does not have available share price; difficult to value entity/trade its shares
• Private limited company (Ltd): shares not offered to the general public; always unquoted
• Public limited company (plc): shares may be sold to, and traded by, the general public; may be quoted/listed or unquoted/unlisted
• Charity: NFP established to raise money for a specific cause focused on philanthropic goals
• Association/union: group of individuals who agree to form an entity to accomplish a purpose
• Private sector: owned by private investors • Public sector: owned by the government
B.Stakeholder needs: stakeholders are groups/individuals with an interest in the entity; entities
have conflicting objectives due to having different stakeholders, leading to stakeholder conflict
• Shareholders: require returns; dividends and/or capital growth via share price increase
• Employees/managers: require pay rises, promotions, job security, training
• Suppliers/lenders: require payment when due
• Government: require taxes to be paid and laws to be followed
• Customers: require good quality products/services and reasonable prices
• Local community: require considerate/responsible behaviour
• Agency theory (principal-agent problem): conflict of interest can arise when there is separation of
ownership and control; company owners (principals/shareholders) are not those who run its day-
to-day business (agents/directors), who may act in their own self-interest; for-profit and NFP issue
FOR-PROFIT ENTITIES: primary objective is long-term maximisation of shareholder wealth;
however this must be balanced with other objectives driven by needs of other stakeholders, as
dissatisfied stakeholders in the short-term may lead to long-term erosion of shareholder wealth
• Financial objectives: set to satisfy shareholders and finance providers; should be quantitative
• Non-financial objectives: set to satisfy other stakeholders and minimise conflict; achieving them
improves reputation, thus assisting financial objectives by indirectly improving sales/profits
• Human: the entity’s relationship with its staff; ie reduce staff turnover
• Intellectual: entity’s intangible assets, such as knowledge, brands, processes, patents; ie obtain patents for a new product yearly
• Natural: entity’s responsibility to the environment; ie reduce the level of pollution, or increase recycling
• Social and relationship: entity’s responsibility to key stakeholders; ie ensure 50% of employees live within 5 miles of the office
Financial considerations of for-profit entities Non-financial considerations of for-profit entities
Equity investors (ordinary shareholders): provide finance so require return Managers: seek
as dividends/capital growth via share price rises; thus firms should maximise • Short-term: achieve bonus targets
shareholder wealth to attract funds; ie 5% annual increase in dividends • Long-term: defend against takeover, maximise sales
Finance providers: provide loan finance; hence firms must generate cash
Employees: seek salary, job security, good conditions
for repayment including interest; ie maximum gearing of 40%
Risk exposure: set risk policies based on risk appetite of shareholders
Return to investors: capital growth from ownership of shares, reflecting the Suppliers: seek
fact both dividends and share price rises are important • Short-term: prompt payment terms
(P1 − P0 ) + D i v i d e n d
Annu al ret ur n to investors = • Long-term: contracts and regular business
P0
P1 = share price at the end of year, P0 = share price at the start of year
Profitability: rate at which profits are generated; accepted measure limiting Government: various interests in the firm
focus to one output measure thus overlooks context; however is useful for • Political interests: increase exports, decrease imports
comparability; ie 10% annual improvement in earnings • Financial interests: profits maximise tax income
Cash generation: poor liquidity is a greater threat to short-term survival than Environmental concerns: increasing awareness, thus
poor profitability, however lacks comparability; ie 10% annual improvement in firms produce reports alongside financial statements to
operating cash flow emphasise their commitment to the environment
Value added: represents value added to products by entity efforts, thus
reflects wealth it creates for employees (via salary), society (via payment of Community at large: social responsibility, pollution
tax), and shareholders (via dividends, retained earnings); lacks comparability control, employment opportunities, employee welfare
Va l u e a d d e d = R e v e n u e − Co s t o f p u r c h a s e d m a t e r i a l s /s e r v i c e s
Return on Assets (RoA): subject to distortions as a result of using profit,
rather than cash flows, to determine performance Customer pressure: increasingly keen to trade with
Annu al prof its ethical and responsible businesses
RoA =
Av e r a g e n e t b o o k v a l u e o f a s s e t s
Market share: must be seen as long-term goal Customer satisfaction: difficult to formally measure
Competitive position: established using various frameworks/models
Jack Gould 2 of 36
,Chartered Institute of Management Accountants Strategic Level F3
Enhancing shareholder wealth: while the overall aim of all listed firms is to maximise shareholder
wealth, specific financial aims in a firm's annual report would not normally make reference to this
• Decrease cash for bonuses
• Increase brand reputation and recognition
• Invest in projects with positive NPV
• Decrease average cost of capital
• If entity is all-equity financed, raising debt finance will decrease its cost of capital
• Moving profitable operations to low tax regimes
NOT FOR-PROFIT (NFP) ENTITIES: primary objective is provision of an acceptable level of service
to key stakeholders; since services provided are limited by available funds, secondary objective is to
raise maximum funds and to use such funds efficiently to maximise benefited generated
• Public sector entities: ie hospitals, nationalised industry, government; generally run to the benefit
of society overall and often regulated; but major problem is obtaining a measurable objective:
• Budgetary compliance: usually set by government • Value added
• Risk exposure: risk averse due to political repercussions of failure • Return on Assets (RoA): interpretation impacted in the public
• Profitability: largely absent as a concept in its truest form, but may sector as concept of profit is largely absent
be used to relate inputs to outputs • Market share: increasingly relevant
• Cash generation • Competitive position: increasingly relevant
Value for money (VFM) / 3Es: useful means of appraising NFP performance under the umbrella
term ‘cost-effectiveness’; the optimal use of resources to achieve the intended outcome
1. Economy (input 2. Efficiency (links input to output): 3. Effectiveness (output measure):
measure): minimise the relationship between products relationship between inputs and
cost of resources (inputs) (outputs) and resources (inputs) actual results of public spending
used; spend less used to produce them; spend well (outcomes); spend wisely
… a fourth E is suggested: 4. Equity: extent to which services reach all people intended; spend fairly
• VFM audit: investigating whether arrangements have been made for securing 3Es in use of
resources; focuses on specific area of expenditure to conclude if VFM has been achieved
• Purpose: independent analysis on the way money has been spent to achieve policy objectives
For profit entity Not for profit entity
Aim to maximise shareholder wealth Aim to provide an acceptable level of service to key stakeholders and are concerned with VFM
Aim to satisfy a wide range of stakeholders Aim to satisfy a wide range of stakeholders
Have financial and profit objectives Do not have profit orientated objectives, but may have financial objectives
INTERNATIONAL OPERATIONS: entities are increasingly expanding across national boundaries in
the modern business environment, resulting in some additional considerations:
Strategic considerations of international expansion Financial considerations of international expansion
Risk management: interest rates, foreign exchange rates, government policy Maximisation of shareholder wealth: by undertaking
Competition: foreign markets may have weaker/stronger competition positive NPV projects internationally
Customers: may enhance/worsen customer relationships by moving closer/
further away; while also exposing the firm to pool of potential new customers Impact on financial statements: assets/transactions
denominated in a foreign currency must be converted
Economies of scale to the domestic (functional) currency, thus exposing the
entity to translation risk as exchange rates fluctuate
Costs: higher distribution costs; possibly lower raw materials and labour costs
Ethical issues: taking advantage of less developed labour laws Impact on cost of capital: likely to change to reflect
Cultural issues: differences in language, customs, and advertising increased associated risk
FINANCIAL PERFORMANCE APPRAISAL: investors (shareholders and lenders) appraise entity
performance to asses whether it represents a good investment, necessitating ratio analysis:
• Gross profit = Revenue / sales - Cost of goods sold (COGS)
• Operating profit / Profit before interest and tax (PBIT) = Gross profit - Operating expenses
• Profit before tax = Operating profit - Finance costs (Interest payable)
• Earnings / Net income / Profit after tax (PAT) = Profit before tax - Tax
PROFITABILITY RATIOS: ideal value varies; important to compare over time and between entities
• Gross profit margin: % of revenue retained after cost of goods sold (COGS) are deducted
G r o s s p r o f i t = R e v e n u e − Co s t o f g o o d s s o l d (C O G S )
Gr oss pr o f it
Gr oss pr o f it m argi n = × 100 %
Re ve n u e
• Operating profit margin: profit after operating expenses (indirect costs such as administration
and distribution costs) but before interest (finance costs) and tax are deducted
O p e r a t i n g p r o f i t = G r o s s p r o f i t − O p e r a t i n g e x p e n s e s = P r o f i t b e f o r e i n t e r e s t a n d t a x (PB I T )
Oper a t i ng pr o f it
Oper a t i ng pr o f it m argi n = × 100 %
Re ve n u e
Jack Gould 3 of 36
, Chartered Institute of Management Accountants Strategic Level F3
• Return on capital employed (ROCE): efficiency with which profits are generated from available
assets/resources; measures underlying business performance before considering financing
• Revaluation upwards of non-current assets: increases equity (capital employed); reduces ROCE
• Increased borrowings: increases debt (capital employed); reduces ROCE
• Lower asset turnover: lower sales (revenue) from capital employed, reduces ROCE
• Lower operating profit margin: lower profit margin on sales achieved, reduces ROCE
Ca p i t a l e m p l o y e d = T o t a l a s s e t s − C u r r e n t l i a b i l i t i e s
Ca p i t a l e m p l o y e d = S h a r e h o l d e r s′ f u n d s (t o t a l e q u i t y) + L o n g -t e r m d e b t (i n t e r e s t b e a r i n g b o r r o w i n g s )
Oper a t i ng pr o f it
R e t u r n o n Ca p i t a l E m p l o y e d (R O C E ) = × 100 %
Ca p i t a l e m p l o y e d
• Return on equity (ROE): measures return relating to shareholders
• ROCE vs ROE: useful comparison to measure amount of underlying return pertaining to
shareholders; but are not directly comparable due to using operating vs net profit respectively
Ne t p r o f i t = O p e r a t i n g p r o f i t − I n t e r e s t a n d T a x Ne t p r o f i t
R e t u r n o n Eq u i t y (R OE ) = × 100 %
Eq u i t y = B o o k v a l u e o f s h a r e o l d e r s′ f u n d s Eq u i t y
• Asset turnover: efficiency with which revenue is generated from available assets/resources
Re ve n u e
A sset t ur n o ver =
Ca p i t a l e m p l o y e d
ROC E = O p er a t i n g pr o f i t m a r g i n × A ss e t t u r n o v er
• Earnings before interest, tax, depreciation and amortisation (EBITDA): argued that removal
of accounting adjustments (depreciation and amortisation) which do not represent cash flows
eliminates a major area of bias; thus EBITDA regarded as a key measure of financial performance
• Earnings before bad bits (EBB): sceptics suggest EBITDA is favoured as it publicises a higher
measure of earnings that operating profit
• Not a cash flow measure: because financial statements still prepared on an accruals basis
LENDER RATIOS: assessing the risk the entity will not be able to service its debts
• Capital gearing (SOFP measure): mix of debt to equity within an entity’s permanent capital; the
relationship between an entity’s long-term debt and shareholders’ funds
• Debt = long-term debt: includes redeemable preference shares and interest bearing
borrowings (such as debentures, bonds, mortgages) (calculate at par value, usually $100)
• Equity = shareholders’ funds: includes ordinary and irredeemable preference shares (and
reserves if valuation is at book value)
• Book value of equity = ordinary share capital (retained profits attributable to ordinary
shareholders) and accumulated reserves (and include extra equity generated by a takeover)
• Market value of equity (use where possible) = number of shares x market share price
(exclude reserves as they are already incorporated into market share price)
D eb t D eb t
G ear ing % = OR G ear ing =
D e b t + Eq u i t y Eq u i t y
• Interest cover (SOPL measure): number of times profit will cover finance costs (interest
payable); determines vulnerability of interest payments to a fall in operating profit (PBIT)
• Investors may use EBITDA rather than PBIT: as it may be better approximation to cash
generated and available to pay interest with
Oper a t i ng pr o f it P r o f i t b e f o r e i n t e r e s t a n d t a x (PB I T )
Inter est co ver = =
Fin a n ce costs In ter est p a ya ble
• Debt ratio: measures availability of assets in relation to total debt
T o t a l l o n g -t e r m d e b t
D eb t r a t i o =
Tot a l a ssets
INVESTOR (STOCK-MARKET) RATIOS: market driven performance measures for a quoted entity
• Earnings per share (EPS): historical figures and can be manipulated by changes in accounting
policies, mergers or acquisitions
Ea r n i n g s = P r o f i t a f t e r i n t e r e s t , t a x a n d p r e f e r e n c e d i v i d e n d s = P r o f i t a t t r i b u t a b l e t o o r d i n a r y s h a r e h o l d e r s
Ea r n i n g s
E PS =
Nu m b er o f or d i n a r y sh a r es i n i ss u e
• Price to earnings (P/E) ratio: compares market value (a measure of future earnings) to current
earnings; indicates level of market confidence in/expectation of potential/future earnings growth
• Current market share price: assumed to be ex-dividend market share price
• Cum-dividend (before payment): if buying a share today, investor will participate in forthcoming dividend
• Ex-dividend (after payment): if buying a share today, investor will not participate in forthcoming dividend
E x - d i v i d e n d m a r k e t s h a r e p r i c e = C u m - d i v i d e n d m a r k e t s h a r e p r i c e − Fo r t h c o m i n g d i v i d e n d p e r s h a r e
C u r r e n t m a r k et sh a r e pr i ce Tot a l va lu e ca pit a li sa t ion Eq u i t y v a l u e
P /E r a t i o = OR P /E r a t i o = =
E PS To t a l e a r n i n gs To t a l e a r n i n gs
Jack Gould 4 of 36
 
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