Financial Strategy:

 Structure & Performance Assessment Considerations

          Looking forward in time, as your company achieves your most important strategic goals, chances are good that you will begin to generate significant cash.

          In the real world, when management is presented with large cash flows, it prefers to spend the money rather than give it back to shareholders. Management might enter a new market, buy a promising startup, acquire a competitor, splurge on a corporate jet, or push for higher salaries and bonuses. Owners generally resist such moves. They use performance measures and the authority of the board of directors to control financial structure and keep management in check.

          The struggle between management and owners varies from company to company. A major factor in the outcome is the degree to which ownership is concentrated. Your situation in the simulation would be comparable to a wholly owned subsidiary or to a company with a very large voting block of conservative stockholders. You cannot do any of the things managers love to do. Instead, you must maximize the present and future wealth of the owners.

Structure Defined
“Financial Structure” is simply the Liabilities and Owner’s Equity side of the balance sheet expressed in percentages. Given your performance measures, what should your financial structure be? Why?

 
1) What should your accounts payable policy be? Accounts payable (AP) is debt. You are leveraging your vendor’s money. However, at 30 days they withhold deliveries and production falls by 1%. Your production costs go up as workers stand idle during parts shortages. At a 60 day policy production falls by 8%. At a zero day policy there are no shortages. Given your measures, what should your AP policy be?

2) Current debt is typically used to fund inventory and accounts receivable (AR) . However, those accounts could also be backed by retained earnings. Given your measures, what should be your policy towards current debt?

3) Long term debt is used to fund plant and equipment. However, you could use equity (common stock plus retained earnings) . If you eliminate long term debt, its interest payment will disappear, and earnings will go up. However, the profits used to pay off the debt could have been invested in new plant and equipment, or you could have paid dividends to shareholders.

4) The market continues to grow. Chances are you will make significant investments in new plant and equipment. What mix of long term debt, stock issues, and retained earnings will you use to fund investments? Why your particular mix?

5) List your performance ratios and the priority weights that you want to give to them. The most you can weight each measure is 40%. Your weights must ad up to 100%. Therefore, you must select at least three measures.

6) Predict the effect your performance measures will have on these tactics:

  Inventing a new product 

  Reducing price

  Adding automation

  Adding capacity

  Increasing promotion and sales budgets

  Abandoning a segment to concentrate on a niche position

  Harvesting an old product

This document, which discusses financial structure and performance measures, will assist you in your policy decisions.

THE RIGHT SIDE OF THE BALANCE SHEET
Financial structure is the right side of the balance sheet. It reflects the stakeholders that have a claim against the assets. Here is a typical Capstone® balance sheet:
Starting Balance Sheet

If you imagine using a bulldozer to scrape the assets into a pile, a group of representatives would surround to the rubble and lay claim to it:

·       Retained earnings is the portion of profits not distributed to shareholders as dividends. While technically the money belongs to the shareholders, it is controlled by management.

The balance sheet always balances because we are matching “stuff” with “people that paid for the stuff.” These people have separate agendas. They choose measures that support their agenda, and they pressure management to meet or exceed their performance targets.

Financial Structure Is A Policy Decision: Ultimately, your financial structure is a policy decision, not an outcome. True, the numbers are an outcome—if total equity is $49,999,583.39, we have a precise outcome. But we might also say, “We want our equity to fund 50% of our assets, and we will make adjustments via dividends, stock issues, and stock repurchases to maintain this percentage.” That is a policy statement.
Performance measures are both policy decisions and outcomes. They shape and constrain the financial structure.

In the final analysis--it should be noted that the different competitive strategies best align with particular financial structures & performance measurements. To wit:

Competitive & Financial Strategy & Success Measure Relationships