The business financial strategies should be in correspondence with the master strategy that has been decided from the strategic planning process of the organization. Consequently, each strategy must bear the distinctive seal that allows it to support the fulfillment of the general strategy and with it the mission and strategic objectives.
However, whatever the general strategy of the company, from the functional point of view, the financial strategy must cover a set of key areas that result from the strategic analysis that has been carried out.
As key aspects in the finance function, the following are generally pointed out:
- Analysis of the profitability of investments and the level of profits Analysis of working capital: liquidity and solvency Rotation fund, analysis of economic-financial balance Financial structure and general level of indebtedness, with analysis of the different sources of financing including self-financing and retention and / or profit sharing policy. Financial costs. Risk analysis of loans granted to customers.
These key aspects respond to the strategies and / or policies that from the financial point of view should govern the performance of the company, which could be grouped, depending on the effect to be pursued with them, in the long term and in the short term.
Long-term financial strategies involve the following aspects:
- On the investment On the financial structure On the retention and / or distribution of profits.
While financial strategies for the short term should consider the following aspects:
- On working capital On current financing On cash management
The following are the fundamentals of each of these financial strategies for the long and short term, respectively.
Fundamentals of long-term financial strategies
a) About the investment.
As already stated, there are four types of strategies: offensive, defensive, reorientation and survival, so, to define the strategy to be followed by the organization regarding investment, it is essential to reexamine what the investment raises. general strategy of the case in question. In this way, one of the following alternatives can be distinguished:
- Growth Divestment.
Generally, if the company is pursuing an offensive or redirection strategy, sometimes even defensive, then investment decisions are highly likely to be aimed at growth. In this case, it is necessary to specify how it is convenient to grow, there are different possibilities among which the so-called internal and external growth stand out.
Internal growth is due to the need to expand the business as a consequence of the demand that is already greater than the supply, or because of the fact of having identified the possibility of new products and / or services that demand the expansion of the current investment, or simply because current costs affect the competitiveness of the business. In these cases, decisions generally have to be made considering alternatives to increase existing assets, or to replace them with more modern and efficient ones.
External growth is carried out following the strategy of eliminating competitors (generally through horizontal mergers and / or acquisitions, that is, of the same nature as the business in question), or as a result of the need to eliminate barriers with customers and suppliers seeking greater control (in these cases through mergers and / or vertical acquisitions, that is, of a different nature of the business, but ensuring the corresponding production-distribution chain).
Another way is due to the strategy of investing financial surpluses in the most profitable way possible, so in these cases the diversification of the investment portfolio is chosen, thus reducing risk and seeking to maximize return.
When the general strategy points towards survival, financial strategies of non-growth and even divestment can sometimes be evaluated, that is, it is necessary in these cases to measure forces to know if compliance with the general strategy is possible, while maintaining the level of assets. current, or if on the contrary, it will be necessary to evaluate the sale of these or part of them to survive.
Now, whatever the case, growth or divestment, the selection of the best alternative must follow the criterion of maximizing the value of the company, that is, the decision adopted must contribute to increasing the wealth of the owners of the company, or in any case, the least possible reduction in value associated with the divestment process if necessary.
For this, the financial literature recognizes that for the evaluation of the best alternative it is necessary to use a series of instruments that allow making the best decisions. These instruments for financial evaluation of investments are: those that take into account the value of money over time, namely, the net present value (NPV), the internal rate of return (IRR), the rate of return (IR) and the discounted payback period (PRD); and those that do not consider the value of money over time as they are, the average accounting profitability (RCP) and the payback period (PR).
The most accurate instruments for evaluation are those that consider the value of money over time, and within these it is advisable to use NPV, since it allows knowing how much the value of the company will increase if the project is carried out.
b) On the financial structure
The definition of the permanent financing structure of the company must be defined in correspondence with the economic result that it is capable of achieving. In this sense, it is worth noting that the strategies in this regard point directly towards the greater or lesser financial risk of the company, so in practice, on many occasions more or less risky strategies are adopted depending on the degree of aversion to the risk of investors and administrators, or simply as a consequence of actions that lead to greater or lesser indebtedness, that is, not a priori or elaborated, but resulting.
At present, companies are looking for resource savings by taking advantage of debt financing as it is cheaper and its cost is exempt from payment of income tax. However, to the extent that debt financing increases, the financial risk of the company also increases due to the greater probability of default on the part of it before its creditors.
From the foregoing it can be deduced that the adoption of the decision regarding the strategy to follow with the permanent sources of financing of the company is not so simple. Obviously, operating with third-party financing is cheaper, but with its increase the risk increases and in turn increases the so-called insolvency costs, so that the tax savings achieved by the use of debts could be reduced by the increase in the referred insolvency costs.
Now, to define the financial structure, the methods used are: Earnings before interest and taxes - earnings per share, Earnings before interests and taxes - financial profitability, and the method of returns based on the cash flow. cash. From these methods, a financial structure can be found that, based on a certain economic or operating result, can help the company achieve the highest possible result in terms of earnings per share, financial profitability or free flow per peso invested.
The criteria to be followed for the definition of this financial strategy is to achieve the highest result per peso invested, be it accounting or in terms of cash flow. The use of the returns method based on cash flow is recommended, as it contributes to efficiency also from the perspective of liquidity.
If, based on the strategy regarding the definition of the financial structure of the company, it is possible to obtain greater cash flow per invested weight, the success that this represents in terms of liquidity may contribute to the better performance of the rest of the functional strategies, and with it that of the master strategy.
c) On the retention and / or distribution of profits
In practice, companies define their retention strategy - profit distribution according to certain aspects, among which may be mentioned: the possibility of access to long-term loans to finance new investments, the possibility of owners to achieve higher remuneration in an alternative investment, maintaining the price of shares in financial markets in the case of joint-stock companies, among other aspects.
The strategy in relation to the retention and / or distribution of profits is closely linked to that of the financial structure, as this decision has an immediate impact on the permanent financing of the company, and consequently causes variations in the structure of permanent sources..
On this basis, it is important to recognize that the methods and criteria that must be considered for the definition of this strategy from the quantitative point of view are the same as those presented for the case of the financial structure, although qualitatively the effects that could have the related aspects previously.
In other words, the policy should be aimed at respecting that financial structure defined as optimal, but without losing sight of the fact that some deviation from this policy or general strategy may temporarily be convenient in order to obtain the required financing, or by virtue of increasing performance. expected, or by holding the stock price.
The definition regarding the retention and / or distribution of the company's profits must be carried out with great care, trying not to violate the optimal financial structure or the liquidity parameters required for the normal operation of the company, and therefore, of your strategic objectives.
Fundamentals of financial strategies for the short term
a) On working capital
As has already been pointed out, the company's working capital is made up of its current or current assets, with working capital management understood as the decisions that involve the efficient administration of these, together with current financing or current liabilities. Hence, from a financial perspective, it first corresponds to the establishment of the proportions that the company should have with respect to its current assets and liabilities in general.
Financial strategies on the company's working capital usually obey the selection criterion of the central axiom of modern finance, namely the risk-return ratio. In this sense, there are three basic strategies: aggressive, conservative and intermediate.
The aggressive strategy assumes high risk in order to achieve the highest possible return. It means that practically all current assets are financed with current liabilities, maintaining a relatively small net working capital or working capital. This strategy assumes a high risk, as it is not able to meet the demands derived from the current financial commitments with those liquid resources of the company, in parallel the highest possible total return is achieved as a consequence of the fact that these assets that generate lower returns are financed at the most low cost.
For its part, the conservative strategy contemplates a low risk in order to operate in a more relaxed way, without pressure related to the demands of creditors. It means that current assets are financed with current and permanent liabilities, maintaining a high net working capital or working capital. This strategy guarantees the operation of the company with liquidity, but the foregoing determines the reduction of the total return as a consequence of the fact that these assets that generate lower returns are financed at a higher cost derived from the presence of permanent sources of financing.
The intermediate strategy includes elements of the previous two, seeking a balance in the risk-return relationship, in such a way that the normal operation of the company is guaranteed with acceptable liquidity parameters, but seeking at the same time the participation of permanent sources that promote the above, do not determine the presence of excessively high costs and thus an acceptable total return can be achieved, that is, not as high as with the aggressive strategy, but not as low as with the conservative one.
The definition is adopted in correspondence with the analysis carried out of the performance of the company during previous periods, its goals and projections, the behavior of competitors and the sector, and the degree of willingness to risk of its administrators.
The generally recognized criteria for the definition of this strategy are the net working capital and the current ratio.
b) On current financing
The current financing of the company, called current liabilities, is made up of spontaneous sources (accounts and bills payable, wages, salaries, taxes and other withholdings derived from the normal operation of the entity), as well as bank and non-bank sources (represented for the credits that companies receive from banks and other organizations), reports a financial cost that depending on the source is presented explicitly or not.
Spontaneous sources generally do not have an explicit financial cost; However, its use provides the company with financing that, if not exploited, would force it to resort to sources that do have an explicit financial cost.
For a better understanding, it should be noted the case of an account payable, which apparently does not have a financial cost, when it is paid (and even more so in advance), it reduces liquidity and forces financial management to substitute this financing in some way. to maintain the strategy that has been adopted in relation to working capital. In this same case, it is generally not considered that supplier financing, by deferring payment, increases the risk perceived by it and consequently this increase in risk is translated in some way, commonly taking the form of a price increase.
For their part, bank sources present an explicit cost that is nothing more than the interest demanded by these institutions for the financing they grant. Now, it is not only about interest, but it is also important to evaluate other collateral costs such as commissions, and the requirement of compensatory balances that immobilize part of the financing, being fundamental for the evaluation of these sources the calculation of the effective rate that includes the effect of all costs associated with obtaining it.
In this way, it can be seen that the definition of how the company should be financed in the short term responds to certain specific strategies, such as the case of taking advantage of the prompt payment discount, of the payment cycle that is appropriate in turn to the strategy of working capital or if it is strategically convenient to go to bank financing or a factoring financial company, defining in turn by means of which alternative (line of credit or other), and which guarantees to commit to obtain the required financing.
Finally, it should be noted that the criterion for the definition of current financing strategies points towards the selection of those sources that, by suitably combining the risk - return ratio adopted by the company in correspondence with its working capital strategy, provide the lowest financial cost total.
c) About cash management
Decisions on the company's cash are largely the result of the aspects already discussed with respect to the strategy on the company's working capital. However, due to their importance of performance, they are generally treated specifically, emphasizing the policies that must be followed with the conditioning factors of the company's liquidity, namely, inventories, collections and payments. In this sense, the fundamental actions in relation to cash are:
- Reduce inventory as much as possible, always taking care not to suffer losses on sale due to shortage of raw materials and / or finished products. Accelerate collections as much as possible without using very restrictive techniques so as not to lose future sales. Discounts for cash payments, if economically justifiable, can be used to achieve this objective: Delay payments as long as possible, without affecting the credit reputation of the company, but take advantage of any favorable discounts for prompt payment.
The criteria used to measure the effectiveness of the actions associated with cash management are: the rapid ratio or acid test, the cash cycle and / or cash turnover, the cycle and / or turnover of collections, the inventory cycle and / or rotation, as well as the payment cycle and / or rotation.
Among the instruments that allow compliance with the cash management strategy is financial planning, specifically the use of the cash budget.
The use of the cash budget allows knowing the excesses and / or shortcomings of cash that can be presented to the organization in the short term, from which it can adopt the appropriate decision that provides the greatest efficiency in terms of the investment of the excess or the negotiation of the best alternative to cover the deficit.
Efficient cash management, resulting from the strategies adopted in relation to accounts receivable, inventories and payments, contributes to maintaining the liquidity of the company.
References
- Van Horne, J., Wachowicz, J.; "Fundamentals of Financial Management", Tenth Edition, Prentice Hall, 1998.Menguzzato and Renau. "The strategic direction of the company. An innovative approach to management ”. Publishing House of the Ministry of Higher Education. April 1997. Reyes, M.; "The financial strategies of the company." Preliminary material for a textbook in preparation. University of Havana. 2008.
In the following video-conference, Professor Luis Sanz, from INCAE Business School, introduces some concepts on how to align the corporate strategy and the financial strategy of organizations. Good material to complement your learning about the main business financial strategies.
