STRATEGIC MANAGEMENT6. Financial strategy

Financial situation of Hungarian firms

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IntroductionMany financial decisions are based on data and

documents of accounting (book-keeping).Income statement summarises all the revenues,

then subtracts all the expenses realised over a period of time. The bottom line is the profit or loss realised (see the next slide).

Balance sheet is a cross-sectional picture of a firm’s financial position at a given time. It shows the value of their assets and liabilities (see the slide).

Cash-flow report shows the flows of the money.

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The form of an income statement

SalesLess: cost of goods sold

other expenses except interestsEBIT (earnings before interests and taxes)

Less: interestsOperating profit

Less: taxesNet income

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The form of a balance sheet

Assets Equity Land, plant equipment Common stock

Other properties Retained earningsCurrent assets Current liabilities Cash Long-term liabilities Receivables Inventory Net incomeTotal of assets Total of equity,

liabilities4

Everyday mistake of an enterprise balance that it does not register some intellectual properties and the goodwill.

Goodwill is an intangible but saleable asset arising from the reputation of a business and its relations with its customers.

In the balance of a successful company the value of goodwill can be greater than the value of all other assets. So, selling a firm, it is extremely important to count in its price the value of goodwill. It was not the case in the privatisation of some Hungarian firms.

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Financial strategiesAfter world war II. firms based their strategies first of all

on financial motives. Later the market-orientation became most important.

But till today decisions - on capital acquisition, - on capital allocation (investments),- on cash flow management and - on creation and/or maintenance of the firm’s profitability

remained important tasks of strategy makers. The realisation methods of these tasks are as follow: 6

The first question of all rational decision is: what are the main points of view (goals) in the given topic? Classics said: it is the profit increase.

But A. Rappaport showed that more effective goal is the increase of the value of the firm. Accountants think that the firm’s value is equal with the value of equity. According to businessmen however, value of a firm is the present value of its future incomes.

Present value (V0) of a value from a future year t (Vt) can be calculate with the formula: V0 = Vt / (1 + i)t

, where i is the interest rate.7

There can be big differences between the results of the profit based and business oriented firm’s value evaluations. One of the main cause of this, that

• the first calculations do not pay attention to the value of the goodwill, but

• in many cases this could be the main factor, because a goodwill loss could decrease considerably the demand.

Parkinson remarked that in modern corporations the great financial decisions are accepted by some committees, where members are not rational.

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Capital acquisitionIn a firm the possibilities of capital acquisition (and

types of financing) vary in accordance to the stage in its life-cycle.

1. In general the foundation of a firm can only be financed by „3F” (founders, family, friends).

2. Business angels (persons or institutions respectively, which buy share from the enterprise's equity capital) can help the capital acquisition of a start-up company, and seed capital can also help market entry. Because of the great risks of a start-up, often the expected return of this investments is very high (can be 20-30 %, even more per year).

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3. In the growth stage the firm’s investments have to be financed partly by own funds (equity), but in some cases by venture capital (VC) as well. VC is a bank specialised to high risks of the investments to new companies. The minimal value of these investments is high (e.g. 1000 thousand $), and the expected return of its investments is very high (e.g. 20 % pro year) as well.

When a business becomes successful, reaches the maturity phase, the VC institution sells it (e.g. in the stock exchange). But many of its investments are failures.

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4. After a successful growth period enterprises can get capital from the stock exchange (when they sell their shares).

A big company can always demand credits from the banks as well.

(Of course, if a manager can guarantee the repayment /so, he is a rich man/ he always receive bank credit.)

The volume of possible credit is equal from one half to two third of the value of firm’s assets.

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InvestmentsThe effectiveness of an investment can evaluate

with the help of the so called ROI (return on investment) index, which is the present value of the income resulted by this investment divided by the value of the capital invested.

With the help of the risk discount we can add the effects of the uncertainty of the future to the results of the present value calculations. The formula is the following: V0 = Vt / (1 + i + +β)t

, where β is the coefficient of uncertainty.

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Exercise. How many should we pay for a bill, which will mature after a year and its value will be 100 USD, further we expect that the interest rate will be 5 % and we estimate that the coefficient of uncertainty is 0,02?

V0 = 100 / ( 1 + 0,05 + 0,02 ) = 93,5 USD

• And how we can evaluate the „investment” of buying this bill for 93,5 USD? Of course, we will receive the interest and the risk premium, but we will not realise entrepreneurial profit.

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Cash flow managementThe main goal of cash flow management is the creation

and maintenance of the firm’s liquidity. It creates rules of scheduling revenues and expenses.

If in a period the expected revenues are higher, than the expenses, it is possible to put the surplus in a bank for some interest.

If the latter are higher than the previous, it is neither possible nor desirable to make all possible investments immediately, the capital allocation strategy sets priorities (e.g. in base of ROI’s values) and timing for them.

Other solution can be the recovering the lack through credits. But good debt management is an important task as well: if the debt ratio becomes high (e.g. more than 0,3), the firm’s credibility goes bad.

Debt ratio: ratio of liabilities and total assets.14

Profitability controlCreation and maintenance of profitability is the

main task of managers. A manager has 3 types of strategic tools for it:- increase of prices, (The price of a product is optimal, if its volume of sales multiplied by its price is maximal.)- increase of sales volumes (if the prices and the production growth are harmonised by the marketing strategy), finally- reduction of costs by rationalisation.

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Data of basic financial documents can help the mapping of the profitability problems. E.g. one can calculate the following indexes:

1.Return on capital employed (ROE) is the ratio of net income per equity and shows the effectiveness of the firm.

2.Return on assets (ROA) is the ratio of net income per total assets and shows the return of the assets.

3. Multiplication of properties (MP) is the ratio of total assets per equity.

ROE = ROA * MP16

Financial situation of Hungarian firms

The main features are as follows:• There is a capital shortage at about one third

of firms (first of all at some new SMEs). • Many firms fight against cash flow problems

(first of all because of frequent late payments or non-payments).

• Plans always have to count with the high Hungarian inflation (but it can be forecasted – figure).

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18Source: Own figure

If Hungary will be member of European Monetary Union, it will improve the financial situation of the Hungarian firms.

The Maastricht criteria in Hungary:• inflation is higher than 3% (today 5,4%),• Interest rate is higher than 3%,• in 2010 current account balance is acceptable

(active with 344 million euros), • Dept is higher than the 60% of the GDP, • exchange rate is highly fluctuating.

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Without financial knowledge it is impossible to work out a good strategy.

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Thank you for your attention!

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