The Use of Financial Statements in Developing Strategies
Using accounting data strategically
→ Accounting data provides financial information that helps managers understand the current position and performance of a business.
→ Financial statements can be used to identify:
- profitability
- liquidity
- efficiency
- gearing
- investor returns
- changes in revenue and costs
- changes in assets and liabilities.
→ Managers can then use this information to develop long-term strategies.
Statement of Profit or Loss
→ Shows the financial performance of the business over a period.
→ Managers can examine:
- revenue
- cost of sales
- gross profit
- operating expenses
- operating profit
- taxation
- profit for the year.
→ Revenue falling → investigate declining demand → consider new products, new markets or changes to marketing strategy.
→ Gross profit margin falling → cost of sales may be increasing → consider cheaper suppliers, improved productivity or changes to pricing.
→ Operating expenses increasing → profit margin may fall → consider cost reduction or greater efficiency.
→ Profit increasing → more funds may be available for expansion, investment or dividends.
Statement of Financial Position
→ Shows the financial position of the business at a particular date.
→ Managers can examine:
- non-current assets
- current assets
- current liabilities
- non-current liabilities
- equity and reserves.
→ High inventory → too much capital may be tied up in stock → consider improved inventory management or JIT.
→ High trade receivables → customers may be taking too long to pay → strengthen credit control.
→ High gearing → financial risk may be greater → consider reducing borrowing or increasing equity finance.
→ Low liquidity → difficulty paying short-term liabilities may exist → improve working capital management or arrange appropriate finance.
Accounting Ratios
→ Ratios allow managers to identify trends and compare performance.
Profitability ratios
→ ROCE → assesses how effectively capital is being used.
→ Gross profit margin → assesses the profitability of trading activities.
→ Profit margin → assesses operating profitability.
Liquidity ratios
→ Current ratio and acid test ratio → assess the ability to meet short-term obligations.
Efficiency ratios
→ Inventory turnover → assesses how quickly inventory is sold.
→ Trade receivables turnover → assesses how quickly customers pay.
→ Trade payables turnover → assesses how quickly suppliers are paid.
Gearing
→ Gearing ratio → assesses the extent to which the business relies on long-term debt.
Investment ratios
→ Dividend yield, dividend cover and P/E ratio → provide information about returns and investor expectations.
Using trends and comparisons
→ A single year’s figure may not provide enough information.
→ Managers can compare accounting data with:
- previous years
- competitors
- industry averages
- business targets
- forecasts.
→ Profit margin 18% → 15% → 12%
→ The downward trend may indicate increasing costs, falling prices or increased competition.
→ Management could respond by reviewing pricing, costs, products and markets.
Developing strategy from accounting data
→ Accounting data → identify financial strengths and weaknesses → investigate causes → consider strategic alternatives → choose strategy → implement → monitor financial results
Example
→ A business discovers that its profit margin has fallen for three consecutive years.
→ Analysis shows that revenue has remained stable but operating expenses have increased significantly.
→ Management could consider:
- reducing unnecessary costs
- improving productivity
- investing in technology
- restructuring operations
- changing suppliers
- reviewing marketing expenditure.
→ The financial data therefore helps management identify a strategic problem and develop possible solutions.
Limitations of Using Financial Statements for Strategy
→ Historical information → financial statements mainly report what has already happened.
→ Inflation → changes in prices can make comparisons misleading.
→ Accounting policies → different businesses may use different accounting methods.
→ Non-financial factors are excluded → customer satisfaction, employee motivation, brand image and environmental performance may not appear fully in financial statements.
→ Figures can be affected by estimates → depreciation and provisions may involve judgement.
→ External changes → future demand, competition, technology and government policies cannot be predicted simply from past accounts.
→ Therefore, financial statements should be combined with market research, forecasts and qualitative information when developing strategy.
Contents of an Annual Report
What is an annual report?
→ An annual report is a document produced by a company each year providing information about its financial performance, financial position, activities, strategy and future direction.
→ It is particularly important for companies with shareholders because it communicates how the business has performed and how management intends to develop it.
Main contents
→ Statement of profit or loss
Shows revenue, costs and profit for the year.
→ Statement of financial position
Shows assets, liabilities and equity at the end of the accounting period.
→ Cash flow information
Shows the movement of cash into and out of the business.
→ Accounting ratios and financial analysis
May provide information about profitability, liquidity, efficiency, gearing and investor returns.
→ Chairperson/directors’ statement
Provides an overview of the company’s performance, major developments and future direction.
→ Strategic report/business review
Explains the business model, markets, major risks, strategy, performance and future opportunities.
→ Corporate governance information
Explains how the company is managed and controlled, including the role of directors and governance arrangements.
→ Directors’ report
Provides information about directors, significant developments and other required corporate information.
→ Auditor’s report
Provides an independent assessment of whether the financial statements have been properly prepared according to relevant accounting requirements.
→ Notes to the financial statements
Provide additional detail explaining accounting policies, figures, liabilities, commitments and other financial information.
→ Information about shareholders and dividends
May provide details of share ownership, dividends and shareholder matters.
→ Sustainability/ESG information
Many companies also provide information about environmental, social and governance performance.
Usefulness of an Annual Report to Stakeholders
Shareholders
→ Assess profitability and financial performance.
→ Examine dividends and dividend cover.
→ Assess the company’s strategy and future prospects.
→ Decide whether to buy, hold or sell shares.
→ Assess the performance of directors and management.
Managers and directors
→ Review business performance.
→ Identify strengths and weaknesses.
→ Compare actual results with objectives and previous years.
→ Develop future strategies.
→ Identify areas requiring investment or cost reduction.
Potential investors
→ Assess whether the business is an attractive investment.
→ Compare profitability, risk, growth prospects and investor returns with other businesses.
→ Use information such as profit, dividends, gearing and P/E ratio when making investment decisions.
Lenders and banks
→ Assess whether the business is financially stable.
→ Examine profitability, cash flows, liquidity and gearing.
→ Determine the risk of providing loans.
→ Decide whether to provide finance and what terms may be appropriate.
Employees
→ Assess job security and the financial health of their employer.
→ Understand business plans and future expansion or restructuring.
→ Use information when negotiating pay and employment conditions.
Suppliers
→ Assess whether the business is likely to pay for goods and services.
→ A financially stable business may be considered a lower credit risk.
→ Helps suppliers decide whether to offer trade credit.
Government
→ Assess business activity and economic contribution.
→ Use financial information for taxation and regulatory purposes.
→ Monitor compliance with relevant laws and regulations.
Customers
→ A financially stable business may be more likely to continue supplying products and providing after-sales service.
→ Information about strategy, quality, sustainability and corporate responsibility may influence customer perceptions.
Local communities and pressure groups
→ May use information about:
- employment
- environmental impact
- community activities
- sustainability
- corporate responsibility.
→ This can help stakeholders assess the wider impact of the business.
Annual Report: Business and Stakeholder Use
| Stakeholder | Information used | Purpose |
|---|---|---|
| Managers | Profit, costs, ratios, strategy | Develop and monitor strategy |
| Shareholders | Profit, dividends, share information | Assess investment and management |
| Potential investors | Profitability, growth, risk, P/E | Decide whether to invest |
| Banks/lenders | Cash flow, liquidity, gearing | Assess lending risk |
| Employees | Profit, strategy, future plans | Assess job security and future prospects |
| Suppliers | Liquidity, financial position | Decide whether to provide credit |
| Government | Financial and corporate information | Taxation and regulation |
| Customers | Strategy, stability, sustainability | Assess reliability and reputation |
| Communities | Employment, environmental and social information | Assess wider business impact |
Accounting Data → Strategic Decision-Making
→ Financial statements → provide financial information.
→ Ratio analysis and trend analysis → identify changes and problems.
→ Management investigation → identify the causes.
→ External and non-financial information → provide wider context.
→ Strategic alternatives → developed and evaluated.
→ Strategy selected → implemented using available resources.
→ Financial performance monitored → strategy adjusted where necessary.
Key exam point
→ Accounting data is essential for strategic decision-making, but it should not be used in isolation.
→ Financial statements explain what has happened financially.
→ Strategic decision-making requires managers to also consider why it happened, what is likely to happen in the future, and how external and non-financial factors may affect the business.