the use of financial statements in developing strategies

10.4 Finance and Accounting Strategy – Use of Accounting Data

Objective

To understand how the four principal financial statements, the information contained in the annual report and ratio analysis provide the quantitative evidence needed to develop, evaluate and adjust business strategies.

1. The Four Principal Financial Statements

Exam tip: When answering Paper 4, cite the specific statement that supports your argument (e.g., use the cash‑flow statement to justify a proposed acquisition).

2. The Annual Report – A Strategic Information Package

The annual report bundles the financial statements with narrative sections that help managers and external stakeholders assess strategic direction.

• Directors’ Report – outlines the company’s objectives, performance against targets and future plans.
• Strategic Report / Management Discussion & Analysis (MD&A) – interprets the numbers, discusses risks and explains how resources will be deployed.
• Notes to the Accounts – detailed breakdowns of figures, accounting policies (e.g., depreciation method, inventory valuation) and contingent liabilities.
• Auditor’s Report – independent opinion on the reliability of the financial statements.
• Corporate Governance & CSR Statements – show how non‑financial considerations are integrated into strategy.

Exam tip: Use the Directors’ Report to extract stated strategic objectives and the MD&A to obtain evidence of risk management or resource allocation when constructing a strategic answer.

3. Ratio Analysis – Turning Numbers into Strategic Insight

3.1 Key Ratio Categories

3.2 Essential Ratio Formulas (quick reference)

3.3 Benchmarking & Trend Analysis

• Compare each ratio with industry averages (or a key competitor) to identify relative strengths and weaknesses.
• Analyse the trend over at least three years to spot improving or deteriorating performance – a vital input for the SWOT analysis in environmental scanning.

4. Linking Accounting Data to the Strategic Planning Cycle

1. Environmental Scanning
   • Use liquidity, profitability, efficiency and solvency ratios to assess internal strengths and weaknesses.
   • Combine ratio findings with external analysis tools (PEST, Porter’s Five Forces) to produce a financially‑informed SWOT.
2. Strategy Formulation
   • Set quantitative objectives – e.g., “ROCE ≥ 14 %”, “Current Ratio ≥ 1.5”, “CCC ≤ 45 days”.
   • Select a strategic route (cost‑leadership, differentiation, market development, acquisition) that is supported by the financial evidence.
3. Implementation
   • Prepare flexible or incremental budgets that embed the target ratios.
   • Develop cash‑flow forecasts and capital‑expenditure plans using the cash‑flow statement and the statement of changes in equity.
   • Allocate resources to high‑margin product lines or to debt‑financed acquisitions as indicated by the ratio analysis.
4. Strategic Control
   • Calculate variances: Variance = Actual – Budget (or Target). Positive/negative variances trigger corrective action.
   • Monitor ratios each quarter; if a target is missed, investigate the cause (e.g., rising inventory turnover may signal over‑stocking).
   • Adjust tactics – tighten credit control if the CCC lengthens, or seek additional finance if the current ratio falls below the set threshold.

5. Using Ratios in Strategic Decision‑Making – Worked Example

Company X – Two growth options

1. Launch a new high‑margin product line.
2. Acquire a competitor to increase market share.

Key figures (excerpt from latest accounts)

Ratio calculations

• ROCE = \(\frac{12}{80}\times100 = 15\%\)
• Current Ratio = \(\frac{30}{15}=2.0\)
• D/E Ratio = \(\frac{20}{60}=0.33\)

Interpretation

• ROCE 15 % > industry average 12 %: Capital is being used efficiently – supports a product‑development strategy that promises high returns.
• Current Ratio 2.0: Strong short‑term liquidity – the firm can finance a new product launch from internal cash flow without external borrowing.
• D/E 0.33 (low leverage): Room to raise debt if the acquisition requires financing, but the modest ROCE suggests the acquisition could dilute overall profitability unless clear synergies exist.

Recommendation – Prioritise the high‑margin product launch, funded by existing cash flow, while keeping the acquisition as a contingency pending a detailed synergy and profitability analysis (e.g., NPV, ARR).

Extension: Investment Appraisal Integration

• For each option, calculate Net Present Value (NPV) and Accounting Rate of Return (ARR) to capture time‑value of money and cash‑flow patterns.
• Combine the appraisal results with ratio analysis to ensure the project will not breach liquidity or gearing targets.

6. Limitations of Ratio Analysis (Exam‑style reminder)

• Ratios are based on historical data – they may not reflect future market conditions.
• Different accounting policies (e.g., depreciation methods, inventory valuation) can distort comparability.
• Industry averages can be broad; a firm may be an outlier for legitimate strategic reasons.
• Ratios do not capture non‑financial factors such as brand strength, customer loyalty or regulatory risk.
• Over‑reliance on a single ratio can lead to mis‑diagnosis; always consider the full set of ratios and qualitative information.

7. Key Points to Remember

• All four financial statements provide quantitative evidence for strategic decisions; the statement of changes in equity reveals financing and dividend policy.
• Ratio analysis converts raw data into performance indicators across liquidity, profitability, efficiency and solvency.
• Benchmark ratios against industry data and analyse trends to identify internal strengths and weaknesses.
• The annual report combines numbers with narrative analysis – use the Directors’ Report and MD&A as evidence in exam answers.
• Strategic objectives should be expressed in measurable financial terms (target ratios, cash‑flow levels, return thresholds).
• Integrate ratio analysis with external tools (PEST, Porter) and with investment appraisal techniques (NPV, ARR) for a holistic strategy.
• Continuous monitoring, variance analysis and corrective action ensure that strategies remain financially viable and can be adapted when required.