The financial strategies of the companies must 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 hallmark that allows it to support compliance with 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 financial function, the following are generally indicated :
- Analysis of the profitability of investments and the level of benefits.
- Analysis of working capital: liquidity and solvency.
- Rotation fund, analysis of the economic-financial balance.
- Financial structure and general level of indebtedness, with analysis of the different sources of financing, including self-financing and withholding 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 that is pursued with these, in the long-term and short-term.
Long-term financial strategies involve the following aspects:
- About investment.
- About the financial structure.
- On the retention and/or distribution of profits .
While short-term financial strategies should consider the following aspects:
- About working capital.
- About current financing.
- About cash management.
The fundamentals of each of these financial strategies for the long and short term, respectively, are presented below .
Fundamentals of long-term financial Strategies
a) About the investment.
As has already been stated, there are four types of strategies: offensive, defensive, reorientation, and survival, therefore, to define the strategy that the organization should follow regarding investment, it is essential to re-examine what the strategy proposes. the general strategy of the case in question. In this way, one of the following alternatives can be distinguished:
Generally, if the company is proposing an offensive or reorientation strategy, even, sometimes defensive, then it is very probable that the investment decisions are aimed at growth. In this case, it is appropriate to specify how it is convenient to grow, with 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 result of the fact that the demand is already greater than the supply, or because the possibility of new products and/or services have been identified that require 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 clients and suppliers seeking Greater control (in these cases through vertical mergers and/or acquisitions, that is, of a different nature of the business, but which ensures 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 disinvestment can sometimes be evaluated, that is, it is necessary in these cases to measure forces to determine if it is possible to comply with the general strategy, maintaining the level of assets current, or if, on the contrary, it will be necessary to evaluate the sale of these or part of these to survive.
However, whatever the case, growth or disinvestment, the selection of the best alternative must follow the criteria 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, to the least possible reduction in value associated with the divestment process if necessary.
For this, the financial literature recognizes that to evaluate the best alternative, it is necessary to use a series of instruments that allow the best decisions to be made. These investment financial evaluation instruments 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 (RR), and the discounted payback period (DPP); and those that do not consider the value of money over time, such as the average accounting return (AAR) and the recovery period (RP).
The most accurate instruments for evaluation are those that consider the value of money over time, and within these, the use of NPV is recommended, 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 company’s permanent financing structure 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 to the greater or lesser financial risk of the company, so in practice, more or less risky strategies are often adopted depending on the degree of risk aversion of the company. 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.
Currently, companies seek to save resources by taking advantage of debt financing as it is cheaper and because its cost is exempt from the payment of profit tax. However, to the extent that debt financing increases, the financial risk of the company also increases given the greater probability of default by it before its creditors.
From the foregoing, it can be deduced that it is not so simple to adopt the decision regarding the strategy to follow with the permanent sources of financing for the company. Operating with external financing is cheaper, but with its increase, the risk increases and in turn, the so-called insolvency costs increase, so that the tax savings achieved by the use of debts could be reduced by the increase in the aforementioned insolvency costs.
However, for the definition of the financial structure, the methods used are Earnings before interest and taxes – earnings per share, Earnings before interest and taxes – financial profitability, and the method of returns based on cash flow. Based on these methods, that financial structure can be found that, based on a certain operating or economic result, can help the company achieve the highest possible result in terms of profit per share, financial profitability, or free flow per peso invested.
The criteria to follow for the definition of this financial strategy is to achieve the highest result per peso invested, be it accounting or in terms of flow. The use of the return method based on cash flow is recommended, as it also contributes to efficiency from the perspective of liquidity.
If from the strategy regarding the definition of the financial structure of the company, it is possible to obtain a greater cash flow per peso invested, 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) Regarding the withholding and/or distribution of profits
In practice, companies define their retention strategy – profit sharing according to certain aspects, among which can be mentioned: the possibility of access to long-term loans to finance new investments, the possibility of the owners achieving higher remuneration in an alternative investment, the maintenance of the share price in the financial markets in the case of joint-stock companies, among other aspects.
The strategy regarding the retention and/or distribution of profits is closely linked to the financial structure, since 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 that were exposed in the case of the financial structure, although qualitatively the effects that could have the aspects related above.
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 general policy or strategy could temporarily be convenient to obtain the required financing, or by increasing the yield. expected, or by maintaining 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, its strategic objectives.
Fundamentals of financial strategies for the short term
a) On working capital
As already indicated, the working capital of the company is made up of its current or current assets, understanding the management of working capital as the decisions that involve the efficient administration of these, together with current financing or current liabilities. Hence, from a financial perspective, the establishment of the proportions that the company should have concerning its current assets and liabilities, in general, corresponds first.
The financial strategies on the company’s working capital usually obey the selection criteria 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 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 presupposes a high risk, since it is not possible to face the demands derived from the current financial commitments with those liquid resources of the company, at the same time 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 to operate in a more relaxed manner, without pressures 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 above 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 financing sources.
The intermediate strategy contemplates elements of the two previous ones, looking for a balance in the risk-return relationship, in such a way that the normal functioning of the company is guaranteed with acceptable liquidity parameters, but looking at the same time for 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 company’s performance 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 defining this strategy are the net working capital and the current ratio.
b) On current financing
The company’s current financing, 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 by for credits received by companies 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, their use provides the company with financing that, if not exploited, would force it to go to sources that do have an explicit financial cost.
For a better understanding, it is worth noting the case of an account payable, which does not have a financial cost, when it is paid (and even more so in advance), it reduces liquidity and forces the financial management to substitute this financing in some way. to maintain the strategy that has been adopted for working capital. In this same case, it is not generally considered that the financing of suppliers, by deferring payment, increases the risk perceived by them and consequently this increased risk is translated in some way, commonly taking the form of price increases.
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. However, it is not only about interest, 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 essential for the evaluation of these sources and the calculation of the effective rate that includes the effect of all the 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 use of the discount for prompt payment, and the payment cycle that is appropriate to the strategy. of working capital or if it is strategically convenient to resort to bank financing or a financial factoring company, defining in turn through which alternative (line of credit or another), and what guarantees to commit to obtain the required financing.
Finally, it should be noted that the criterion for defining current financing strategies points towards the selection of those sources that, adequately combine the risk-return ratio adopted by the company in correspondence with its working capital strategy, and provide the lowest financial cost. total.
c) Regarding cash management
Decisions about the company’s cash are largely resulting from the aspects already discussed concerning the company’s working capital strategy. However, due to their importance to 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 about cash are:
- Reduce inventory as much as possible, always taking care not to suffer sales losses due to shortages 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 company’s credit standing, but take advantage of any favorable prompt payment discounts.
The criteria used to measure the effectiveness of the actions associated with cash management are the quick ratio or acid test, the cash cycle and/or cash rotation, the collection cycle and/or rotation, the cycle and/or rotation of inventories, as well as the cycle and/or rotation of payments.
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 one to know the excesses and/or defects of cash that can be presented to the organization in the short term, from which it can adopt the opportune decision that provides the greatest efficiency in terms of the investment of the cash. excess or to the negotiation of the best alternative to cover the deficit.
Efficient cash management, resulting from the strategies adopted for accounts receivable, inventories, and payments, contributes to maintaining the company’s liquidity.
- 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”. Publisher of the Ministry of Higher Education. April 1997.
- Reyes, M.; “The financial strategies of the company”. Preliminary material for a textbook in preparation. The University of Havana. 2008.