Strategic LeveL. PAPER F3 Financial Strategy. cima OFFICIAL REVISION CARDS

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1 Strategic LeveL PAPER F3 Financial Strategy cima OFFICIAL REVISION CARDS

2 Financial STRATEGY Published by: Kaplan Publishing UK Unit 2 The Business Centre, Molly Millars Lane, Wokingham, Berkshire RG41 2QZ Copyright 2015 Kaplan Financial Limited. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means electronic, mechanical, photocopying, recording or otherwise without the prior written permission of the publisher. Acknowledgements The CIMA Publishing trademark is reproduced with kind permission of CIMA. Notice The text in this material and any others made available by any Kaplan Group company does not amount to advice on a particular matter and should not be taken as such. No reliance should be placed on the content as the basis for any investment or other decision or in connection with any advice given to third parties. Please consult your appropriate professional adviser as necessary. Kaplan Publishing Limited and all other Kaplan group companies expressly disclaim all liability to any person in respect of any losses or other claims, whether direct, indirect, incidental, consequential or otherwise arising in relation to the use of such materials. British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library ISBN Printed and bound in Great Britain 2

3 Financial STRATEGY How to use Revision Cards The concept Revision Cards are a new and different way of learning, based upon research into learning styles and effective recall. The cards are in full colour and have text supported by a range of images, making them far more effective for visual learners and easier to remember. Unlike a bound text, Revision Cards can be rearranged and reorganised to appeal to kinaesthetic learners who prefer to learn by doing. Being small enough to carry around means that you can take them anywhere. This gives the opportunity to keep going over what you need to learn and so helps with recall. The content has been reduced down to the most important areas, making it far easier to digest and identify the relationships between key topics. Revision Cards, however you learn, whoever you are, wherever you are... 3

4 Financial STRATEGY How to use them Revision Cards are a pack of approximately 52 cards, slightly bigger than traditional playing cards but still very easy to carry and so convenient to use when travelling or moving around. They can be used during the tuition period or at revision. They are broken up into 3 sections. An overview of the entire subject in a mind map form (orange). A mind map of each specific topic (blue). Content for each topic presented so that it is memorable (green). Each one is a different colour, allowing you to sort them in many ways. Perhaps you want to get a more detailed feel for each topic, why not take all the green cards out of the pack and use those. You could create your own mind maps using the blue cards to explore how different topics fit together. And if there are some topics that you understand, take those out of the pack, leaving yourself only the ones you need to concentrate on. There are just so many ways you can use them. 4

5 Financial STRATEGY Contents 1. Objectives and Development of Financial Strategy 2. Integrated Reporting 3. Hedge Accounting 4. Financing Equity and Debt Finance 5. Capital Structure 6. Dividend Policy 7. Financial Performance Measurement 8. Financial and Strategic Implications of Mergers and Acquisitions 9. Business Valuation 10. Pricing and Post-transaction Issues 5

6 Financial STRATEGY Core areas of the syllabus The syllabus comprises of: A Formulation of financial strategy 25% B Financing and dividend decisions 35% C Corporate finance 40% Quality and accuracy are of the utmost importance to us so if you spot an error in any of our products, please send an to mykaplanreporting@kaplan.com with full details, or follow the link to the feedback form in MyKaplan. Our Quality Co-ordinator will work with our technical team to verify the error and take action to ensure it is corrected in future editions. 6

7 overview financial strategy RevisionCards

8 Financial STRATEGY Strategic aspects Capital structure Corporate finance (40%) Financing and dividend decisions (30%) Equity finance Pricing / post transaction issues Business valuation Financial Strategy Dividend policy Development of financial strategy Debt finance CHOICES CHOICES CHOICES ca$h Objectives Hedge accounting Formulation of financial strategy (25%) Integrated reporting 8

9 Objectives and development of financial strategy financial strategy RevisionCards

10 Financial STRATEGY Objectives and development of financial strategy Profit making Different types of entity Not for profit ca$h Objectives and development of financial strategy Investment decision CHOICES Dividend decision CHOICES CHOICES Three interlinked decisions Financing decision 10

11 Financial STRATEGY Objectives and development of financial strategy Objectives: Profit making v not-for-profit organisations Profit making organisations: A company (profit making organisation) has shareholder wealth maximisation as its primary objective. The needs of other stakeholders need to be considered too, since dissatisfied stakeholders in the short term may lead to an erosion of shareholder wealth in the long term. Not-for-profit organisations: The primary objective is to provide an acceptable level of service to its key stakeholders. Financial objectives will tend to focus on costs, and the efficient, effective and economic use of resources. 11

12 Financial STRATEGY Objectives and development of financial strategy Organisations set objectives which will satisfy key stakeholders, such as: Shareholders require returns (dividends and / or capital growth) Employees / managers require job security and pay increases Customers require good quality products / services and reasonable prices Suppliers / Lenders require payment when due Government require taxes to be paid and laws to be followed Local community require considerate / responsible behaviour The impact of external, economic forces (such as interest rates, inflation, exchange rates) needs to be considered before objectives can be set. Conflicts will often arise between different stakeholder groups (e.g. shareholders requiring dividends and employees requiring pay rises). 12

13 Financial STRATEGY Objectives and development of financial strategy Performance appraisal Investors (shareholders and lenders) will often appraise the performance of an entity, to assess whether it represents a good investment. The most readily available source of information is the published accounts, but these have the following limitations: figures are historic records, not forward looking. the accruals concept means that the income statement will not relate to the entity s cash position. financial information might not give a full picture of the entity s position. 13

14 Financial STRATEGY Objectives and development of financial strategy Profitability ratios Operating profit margin = (Profit before interest and tax (PBIT) / Turnover) x 100%. Gross profit margin = (Gross profit / Turnover) x 100%. Return on Capital Employed (ROCE) and Return on Equity (ROE): ROCE = (Operating profit / Capital employed) x 100% This measures the underlying performance of the business before considering financing. Capital employed = total funds (debt and equity) invested in the business. ROE = (Profit after tax (PAT) / Equity value) x 100% This measures the return which relates to the shareholders. Note that ROE is post tax and ROCE is pre tax, so the ratios are not directly comparable. 14

15 Financial STRATEGY Objectives and development of financial strategy Financial gearing ratios Financial gearing can be analysed by looking at the balance sheet (statement of financial position) or the income statement. The risk is that if gearing is too high, the entity will not be able to afford to service its debts. Balance sheet (statement of financial position) Financial gearing can be measured as either: Debt value / Equity value, or Debt value / (Value of equity +debt) Market values should be used if possible, or use book values if working from financial accounts. Income statement Key measure: Interest cover = Profit before interest and tax (PBIT) / Interest (Finance charges) A high ratio indicates low risk. 15

16 Financial STRATEGY Objectives and development of financial strategy Stock market ratios For quoted companies, stock market ratios will give a market driven measure of performance. P/E ratio Share price / EPS Dividend cover EPS/Dividend per share (DPS) Dividend yield DPS/Share price A high P/E ratio indicates that the market has confidence in the company High dividend cover will reassure investors that dividend levels are likely to be maintained even if profits fall A basic measure of yield to shareholders Note that: EPS (earnings per share) = (Profit after tax and preference dividends) / No. of shares A better measure of shareholder return (taking account of capital gains as well as dividends, would be [(closing share price opening share price) + dividend] / opening share price 16

17 Financial STRATEGY Objectives and development of financial strategy Investment decision v Financing decision v Dividend decision CHOICES CHOICES CHOICES Investment decision what projects should be undertaken? Financing decision how should the necessary funds be raised? Dividend decision how much cash should be paid out to shareholders? Links between these 3 decisions When deciding which investments to undertake, the firm needs to decide how finance will be raised. If large amounts of finance are available, this will enable the firm to undertake more / better investments. If investments generate lots of cash, this will enable the firm to pay large dividends. If more equity finance is raised, higher cash levels will be needed for dividends to satisfy the shareholders. 17

18 Financial STRATEGY Objectives and development of financial strategy Forecasting exchange rates Terminology: GBP is STRENGTHENING / APPRECIATING means that GBP1 is worth MORE foreign currency e.g. GBP1 = US$1.60 in year 1 GBP1 = US$1.70 in year 2 The GBP has strengthened (and the US$ has weakened). GBP is WEAKENING / DEPRECIATING means that GBP1 is worth LESS foreign currency e.g. GBP1 = US$1.60 in year 1 GBP1 = US$1.50 in year 2 The GBP has weakened (and the US$ has strengthened). 18

19 Financial STRATEGY Objectives and development of financial strategy Forecasting exchange rates Interest Rate Parity: The forward rate can be predicted if we know the interest rate differential between the two countries. Forward rate (A$/B$) = Spot rate (A$/B$) x 1+ B$ interest rate 1+ A$ interest rate Expectations theory: The future exchange rate can be predicted if we know the interest rate differential between the two countries. Future rate (A$/B$) = Spot rate (A$/B$) x 1+ B$ interest rate 1+ A$ interest rate Note on CIMA notation: Exchange rates will always be quoted in the format A$/ B$2.5, which means there are 2.5B$ to each 1A$ 19

20 RevisionCards

21 Integrated reporting financial strategy RevisionCards

22 Financial STRATEGY Integrated reporting Integrated reporting (<IR>) Financial reporting International Integrated Reporting Council (IIRC) Integrated reporting Global reporting initative (GRI) G4 Guidelines Economic Environmental Social Non-financial reporting 22

23 Financial STRATEGY Integrated reporting Introduction Financial statements provide historic financial information, but they do not provide a full picture of how the entity is performing. The important additional non-financial information can be reported in a number of ways. For example, the Global Reporting Initiative (GRI) guidelines and the International Integrated Reporting Council (IIRC) Integrated Reporting framework (<IR> framework). ca$h 23

24 Financial STRATEGY Integrated reporting The limitations of financial statements Past financial performance, good or bad, is not necessarily an accurate predictor of future performance. Financial statements do not tell you about changes in senior management, loss of major customers, competitive environment, future prospects etc. Financial statements can be altered legally by adjusting certain types of reserves. Financial results can be improved by reducing or eliminating discretionary expenditures even if this cost cutting is at the expense of long term growth and profits. ca$h To see the big picture, it is necessary to have at least two consecutive periods of financial statements for comparison. Trends will only become apparent this way. 24

25 Financial STRATEGY Integrated reporting The limitations of financial statements (continued) Even audited financial statements can be subject to a degree of manipulation. Off balance sheet financing is lawful, but can have an impact on a company s financial health. The fact that a company is publicly traded and its financial statements are readily available does not guarantee that the company in question is financially stable and creditworthy. 25

26 Financial STRATEGY Integrated reporting GRI The Global Reporting Initiative Aim General standard disclosures (SEVEN) Entities report performance Strategy and Analysis, Organisational indicators so that users can monitor Profile, Identified Material Aspects and their performance from economic, Boundaries, Stakeholder Engagement, environmental and social perspectives. Report Profile, Governance, Ethics and Integrity. Specific standard disclosures Disclosures on Management Approach (DMA) Indicators Economic Environmental Social (four subcategories: Labour practices and decent work, Human rights, Society, Product responsibility) 26

27 Financial STRATEGY Integrated reporting Principles for defining report content: Stakeholder inclusiveness Sustainability context Materiality Completeness Principles for defining report quality: Balance Comparability Accuracy Timeliness Clarity Reliability 27

28 Financial STRATEGY Integrated reporting <IR> Framework The concept of integrated reporting (<IR>) Integrated Reporting (<IR>) is seen by the IIRC as the basis for a fundamental change in the way in which entities are managed and report to stakeholders. A stated aim of <IR> is to support integrated thinking and decision-making. Three fundamental concepts underpinning integrated reporting: Value creation for the organisation and for others The capitals The value creation process Seven guiding principles: Strategic focus and future orientation Connectivity of information Stakeholder relationships Materiality Conciseness Reliability and completeness Consistency and comparability 28

29 Financial STRATEGY Integrated reporting <IR> Framework Content elements Organisational overview and external environment Governance Business model Risks and opportunities Strategy and resource allocation Performance Outlook Basis of preparation and presentation Problems with the current approach to non-financial reporting Impact and effectiveness of disclosures depends on: Relevance Reliability Comparability The fact that there are two complementary sets of guidelines (GRI and <IR>) is certainly a problem, as is the fact that compliance with the guidelines is voluntary in many jurisdictions. 29

30 RevisionCards

31 Hedge accounting financial strategy RevisionCards

32 Financial STRATEGY Hedge accounting Financial instruments IFRS 7 : Disclosures Financial assets and liabilities Hedge accounting IAS 39/ IFRS 9 Derivatives 32

33 Financial STRATEGY Hedge accounting Introduction Integrated reporting can help to give an impression of the nonfinancial performance of an entity, while analysis of the financial statements is the best way of assessing the financial performance of an entity. It is therefore critical that all an entity s financial instruments are disclosed appropriately in the financial statements, to allow stakeholders to build up an accurate picture of the entity s financial performance. 33

34 Financial STRATEGY Hedge accounting DERIVATIVES Have 3 Characteristics 3. Settled in the future 1. Little or no initial investment 2. Value changes in response to a change in underlying factor All Derivatives Are FVTPL Unless Hedging Relationships Have 3 Characteristics HEDGED ITEM The item we are trying to protect i.e. overseas receivable They are being used as part of a hedging relationship HEDGING INSTRUMENT Usually the derivative we have taken out to mitigate the risk i.e. forward contract HEDGING RISK What risk we are tying to eliminate i.e. exchange rate risk 34

35 Financial STRATEGY Hedge accounting Which identifies the; ITEM, INSTRUMENT & RISK At inception we need formal documents in place Can we hedge account? How are we measuring effectiveness? Is hedge effective? Change in instrument = % Change in item 35

36 Financial STRATEGY Hedge accounting How do we hedge account? 3 Types Of Hedges Fair Value Hedge Hedge of a recognised asset or liability Cash Flow Hedge Hedge against changes in an expected cash flow Net Investment Hedge Hedge of a net investment in a foreign operation Recognise BOTH the hedging instrument and hedged item at fair value with gains and losses going to P & L. Remeasure hedging instrument at fair value with gain going to equity for effective portion, ineffective portion to P & L. Parent invests in foreign subsidiary hedges by taking out a foreign currency loan to hedge against changes in the investment due to exchange rates. Treat in same way as cashflow hedge. 36

37 Financial STRATEGY Hedge accounting Objective of IFRS7 To require entities to provide disclosures in their financial statements that enable users to evaluate: (a) the significance of financial instruments for the entity s financial position and performance; and (b) the nature and extent of risks arising from financial instruments to which the entity is exposed during the period and at the end of the reporting period, and how the entity manages those risks. ca$h 37

38 Financial STRATEGY Hedge accounting IFRS 7 Financial instruments: disclosures Qualitative disclosures describe management s objectives, policies and processes for managing those risks. Quantitative disclosures provide information about the extent to which the entity is exposed to risk, based on information provided internally to the entity s key management personnel. Three categories of risks are identified in IFRS7: Credit risk Liquidity risk Market risk 38