Financial goal setting

• Goal Setting- meaning & smart goals• Financial goals will address overall

profitability, return on investment, return on equity, revenue growth, and overall financial strength of the company

• The two important financial goals of organization can be profit maximization and wealth maximization.

profit maximization• Simply a single-period or a short-term goal to be achieved within one year

Management mainly focus on efficient utilization of capital resources to maximize profits WITHOUT considering the consequences of its actions towards the company’s future performance.

Drawbacks/disadvantages of Profit Maximization Goal: A. It is only a SHORT TERM concept

b. It does NOT consider the time value of money

c. It IGNORES risk

wealth maximization• maximizing of the total market /market price of the existing shareholders’ common stock

• it has the following advantages:

• time value of money wherein a dollar received today is worth more han it is to be received say 1 year later. By considering time value of money, this will lead to an overall increase in the company’s earning

• management needs to consider the uncertainty or risk factor. It accept a certain degree of risk when it is compensated with the same level of return

• Increase in shareholders’ wealth will directly lead to increase in cash flows. It is not concern only with accounting earnings/profits but CASH FLOWS.

• To achieve shareholders’ wealth maximization, the firm has to achieve all the short-term target like sales/earnings growth and dividend payout targets. Only when these short term targets being achieved, the firm will then be attractive to the potential investors which might raise the stock price..

• This requires investing in projects that are likely to provide positive returns to the company. Hence wealth maximization accounts for the timing and risk of the expected benefits.

FedEx Long Term Goals

• Grow revenue• Achieve 10%+ operating margin• Increase EPS by 10%-15% per year• Increase cash flow• Increase returns

Analysis of Incremental ROI

• ROI – A performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments. Return on capital employed= EBIT/ capital employed

Analysis of Incremental ROI

• an investor has $1,000• Project X- ROR = 100%) Project Y- ROR = 75%)

EOY NCF ($)

0 - 10

1 +20

EOY NCF ($)

0 - 1000

1 +1750

Investor expects MARR of 20%.• Calculation: ROR of the incremental (Y - X) (more costly

- less costly). • EOY 0: -1000 - (-10) = - 990 • EOY 1: +1750 - (+ 20) = + 1730

• Incremental ROR = ( 1,730 - 990) / 990 = 0.747 = 74.7% • Because the incremental ROR = 74.7% > MARR = 20%,

the incremental investment in Y over X is desirable.

EOY Incremental NCF ($)

0 - 990

1 +1730

Sensitivity Analysis

• The best & the worst possible situation is estimated.

• To estimate by how much the cost & revenue would need to differ their estimated values before the decisions would change.

• It assesses the impact of critical variables on the project profitability.

Sensitivity Analysis- egParticulars RSSales 16000

(VC)

MaterialLabour

(8000)(4000)

Contribution 4000(Fixed cost) (3200)

Profit 800

If material cost increases by 800Particulars RSSales 16000

(VC)

MaterialLabour

(8800)(4000)

Contribution 3200(Fixed cost) (3200)

Profit Nil

If sales decreases by 800Particulars RSSales 15200

(VC)

MaterialLabour

(8000)(4000)

Contribution 3200(Fixed cost) (3200)

Profit NIL

Developing financial goals along organizational hierarchy

• Responsibility centers• Responsibility budgeting• Responsibility accounting

• Responsibility centers A responsibility center is a set of activities assigned to a manager, a group of managers, or other employees.

• Responsibility budgeting• Responsibility budget shows a plan in terms of

performance target that is attributed to the individual/ manager who is accountable for the responsibility centre.

• Responsibility accounting• The objective is to measure the result of each

responsibility center. • It enables accountability for financial results

and outcomes to be allocated to individuals throughout the organization.

• Actual results are collected & compared with the budgeted ones to measure performance deviation.

Example- United textile mills Ltd.

• 3units i.e. responsibility centres1) Spinning2) Weaving3) Finishing

Facts

• Net profit- 272 mio

• ROI- 17.5%• Cost of capital-

12.5%

Responsibility budgeting

Responsibility centre

Spinning Weaving Finishing

Cost 3000 800 800

Profit 300 94 200

Investment 1500 1200 300

ROI 12.5 12.5 12.5

RA- Division-wise P&L account

Technique of ResponsibilityBudgeting

• incremental budgeting• zero base budgeting• programme based budgeting

incremental budgeting It means basing the budget for a department or function on that of the

previous period, usually adjusting for inflation by a percentage increase.

• Eg:- Quenchit Ltd is a water bottling company. Transport costs for last year amounted to Rs.120,000.

• Planned expansion is expected to result in Rs.10,000 additional transport costs (estimated at current prices).

• Inflation is expected to be 3%.

• The transport budget for the next year could be based on:• Rs.120,000 + Rs.10,000 = Rs.130,000 to allow for expansion,• then Rs.130,000 x 103% = Rs.133,900 to allow for inflation.

zero base budgeting

• Unlike the traditional (incremental) budgeting in which past sales and expenditure trends are assumed to continue, ZBB requires each activity to be justified on the basis of cost-benefit analysis, assumes that no present commitment exists, and that there is no balance to be carried forward.

programme based budgeting

• It is applicable to NGOs• It means breaking down the work of the

organisation into ‘programmes’ designed towards achieving its various objectives.

• It is usually the case that insufficient funds are available to achieve all the desired objectives, and decisions have to be made as to which programmes are to be carried out.

Analytical framework for Developing Responsibility Budgets

FRAMEWORK OF BUDGETING• 1.Corporate Strategy, Planning and Budgeting• 2.Budget Period• 3.ProgrammeBudget and Responsibility Budget• 4.Organisationfor Budgeting• 5.Budget Base• 6.Limiting Factor• 7.Participation