1

FINANCIAL POLICY AND

CORPORATE STRATEGY
LEARNING OUTCOMES
After reading this chapter student shall be able to understand:
❑ Strategic Financial Decision Making Framework

❑ Strategy at Different Hierarchy Levels

❑ Financial Planning

❑ Interface of Financial Policy and Strategic Management

❑ Balancing Financial Goals vis-à-vis Sustainable Growth

1. STRATEGIC FINANCIAL DECISION MAKING

FRAMEWORK
Capital investment is the springboard for wealth creation. In a world of economic uncertainty, the
investors want to maximize their wealth by selecting optimum investment and financial
opportunities that will give them maximum expected returns at minimum risk. Since management is
ultimately responsible to the investors, the objective of corporate financial management s hould
implement investment and financing decisions which should satisfy the shareholders by placing
them all in an equal, optimum financial position. The satisfaction of the interests of the
shareholders should be perceived as a means to an end, namely max imization of shareholders’
wealth. Since capital is the limiting factor, the problem that the management will face is the

© The Institute of Chartered Accountants of India

 1.2 STRATEGIC FINANCIAL MANAGEMENT

strategic allocation of limited funds between alternative uses in such a manner, that the companies
have the ability to sustain or increase investor returns through a continual search for investment
opportunities that generate funds for their business and are more favourable for the investors.
Therefore, all businesses need to have the following three fundamental essential elements:
• A clear and realistic strategy,
• The financial resources, controls and systems to see it through and
• The right management team and processes to make it happen.
We may summarise this by saying that:

Strategy + Finance + Management = Fundamentals of Business

Strategy may be defined as the long-term direction and scope of an organization to achieve
competitive advantage through the configuration of resources within a changing environment for
the fulfilment of stakeholder’s aspirations and expectations. In an idealized world, management is
ultimately responsible to the investors. Investors maximize their wealth by selecting optimum
investment and financing opportunities, using financial models that maximize expected returns in
absolute terms at minimum risk. What concerns the investors is not simply maximum profit but also
the likelihood of it arising: a risk-return trade-off from a portfolio of investments, with which they
feel comfortable and which may be unique for each individual.
We call this overall approach strategic financial management and define it as being the application
to strategic decisions of financial techniques in order to help achieve the decision -maker's
objectives. Although linked with accounting, the focus of strategic financial management is
different. Strategic financial management combines the backward-looking, report-focused
discipline of (financial) accounting with the more dynamic, forward-looking subject of financial
management. It is basically about the identification of the possible strategies capable of
maximizing an organization's market value. It involves the allocation of scarce capital resources
among competing opportunities. It also encompasses the implementation and monitoring of the
chosen strategy so as to achieve agreed objectives.

1.1 Functions of Strategic Financial Management

Strategic Financial Management is the portfolio constituent of the corporate strategic plan that
embraces the optimum investment and financing decisions required to attain the overall specified
objectives. In this connection, it is necessary to distinguish between strategic, tactical and
operational financial planning. While strategy is a long-term course of action, tactics are
intermediate plan, while operations are short-term functions. Senior management decides strategy,
middle level decides tactics and operational are looked after line management.

© The Institute of Chartered Accountants of India

 FINANCIAL POLICY AND CORPORATE STRATEGY 1.3

Irrespective of the time horizon, the investment and financial decisions involve the following
functions 1:
• Continual search for best investment opportunities;
• Selection of the best profitable opportunities;
• Determination of optimal mix of funds for the opportunities;
• Establishment of systems for internal controls; and
• Analysis of results for future decision-making.
Since capital is the limiting factor, the strategic problem for financial management is how limited
funds are allocated between alternative uses.
The key decisions falling within the scope of financial strategy are as follows:
1. Financing decisions: These decisions deal with the mode of financing or mix of equity
capital and debt capital.
2. Investment decisions: These decisions involve the profitable utilization of firm's funds
especially in long-term projects (capital projects). Since the future benefits associated with such
projects are not known with certainty, investment decisions necessarily involve risk. The projects
are therefore evaluated in relation to their expected return and risk.
3. Dividend decisions: These decisions determine the division of earnings between payments
to shareholders and reinvestment in the company.
4. Portfolio decisions: These decisions involve evaluation of investments based on their
contribution to the aggregate performance of the entire corporation rather than on the isolated
characteristics of the investments themselves.
You have already, learnt about the Financing, Investment and Dividend decisions in your
Intermediate (IPC) curriculum, while Portfolio decisions would be taken in detail later in this Study
Material.

2. STRATEGY AT DIFFERENT HIERARCHY LEVELS

Strategies at different levels are the outcomes of different planning needs. There are three levels
of Strategy – Corporate level; Business unit level; and Functional or departmental level.

2.1 Corporate Level Strategy

Corporate level strategy fundamentally is concerned with selection of businesses in which a
company should compete and with the development and coordination of that portfolio of
businesses.

1 Strategic Financial Management: Exercises, Robert Alan Hill.

© The Institute of Chartered Accountants of India

 1.4 STRATEGIC FINANCIAL MANAGEMENT

Corporate level strategy should be able to answer three basic questions:

Suitability Whether the strategy would work for the accomplishment of common
objective of the company.
Feasibility Determines the kind and number of resources required to formulate and
implement the strategy.
Acceptability It is concerned with the stakeholders’ satisfaction and can be financial
and non-financial.

2.2 Business Unit Level Strategy

Strategic business unit (SBO) may be any profit centre that can be planned independently from the
other business units of a corporation. At the business unit level, the strategic issues are about
practical coordination of operating units and developing and sustaining a competitive advantage
for the products and services that are produced.

2.3 Functional Level Strategy

The functional level is the level of the operating divisions and departments. The strategic issues at
this level are related to functional business processes and value chain. Functional level strategies in
R&D, operations, manufacturing, marketing, finance, and human resources involve the development
and coordination of resources through which business unit level strategies can be executed
effectively and efficiently. Functional units of an organization are involved in higher level strategies by
providing input to the business unit level and corporate level strategy, such as providing information
on customer feedback or on resources and capabilities on which the higher level strategies can be
based. Once the higher-level strategy is developed, the functional units translate them into discrete
action plans that each department or division must accomplish for the strategy to succeed .
Among the different functional activities viz production, marketing, finance, human resources and
research and development, finance assumes highest importance during the top down and bottom
up interaction of planning. Corporate strategy deals with deployment of resources and financial
strategy is mainly concerned with mobilization and effective utilization of mo ney, the most critical
resource that a business firm likes to have under its command. Truly speaking, other resources
can be easily mobilized if the firm has adequate monetary base. To go into the details of this
interface between financial strategy and corporate strategy and financial planning and corporate
planning let us examine the basic issues addressed under financial planning.

3. FINANCIAL PLANNING
Financial planning is the backbone of the business planning and corporate planning. It helps in defining
the feasible area of operation for all types of activities and thereby defines the overall planning framework.
Financial planning is a systematic approach whereby the financial planner helps the customer to maximize
his existing financial resources by utilizing financial tools to achieve his financial goals.

© The Institute of Chartered Accountants of India

 FINANCIAL POLICY AND CORPORATE STRATEGY 1.5

There are 3 major components of Financial planning:

• Financial Resources (FR)
• Financial Tools (FT)
• Financial Goals (FG)

Financial Planning = FR + FT + FG
For an individual, financial planning is the process of meeting one’s life goals through proper
management of the finances. These goals may include buying a house, saving for children's
education or planning for retirement. It is a process that consists of specific steps that help s in
taking a big-picture look at where you financially are. Using these steps, you can work out where
you are now, what you may need in the future and what you must do to reach your goals.
Outcomes of the financial planning are the financial objectives, financial deci sion-making and
financial measures for the evaluation of the corporate performance. Financial objectives ar e to be
decided at the very outset so that rest of the decisions can be taken accordingly. The objectives
need to be consistent with the corporate mission and corporate objectives. Financial decision
making helps in analyzing the financial problems that are being faced by the corporate and
accordingly deciding the course of action to be taken by it. The financial measures like ratio
analysis, analysis of cash flow statement are used to evaluate the performance of the Company.
The selection of these measures again depends upon the Corporate objectives.

4. INTERFACE OF FINANCIAL POLICY AND STRATEGIC

MANAGEMENT
The interface of strategic management and financial policy will be clearly understood if we
appreciate the fact that the starting point of an organization is money and the end point of that
organization is also money. No organization can run an existing business and promote a new
expansion project without a suitable internally mobilized financial base or both i.e. internally and
externally mobilized financial base.
Sources of finance and capital structure are the most important dimensions of a strategic plan. The
need for fund mobilization to support the expansion activity of firm is very vital for any
organization. The generation of funds may arise out of ownership capital and or borrowed capital.
A company may issue equity shares and/or preference shares for mobilizing ownership capital and
debentures to raise borrowed capital. Public deposits, for a fixed time period, have also become a
major source of short and medium-term finance. Organizations may offer higher rates of interest
than banking institutions to attract investors and raise fund. The overdraft, cash credits, bill
discounting, bank loan and trade credit are the other sources of short-term finance.

© The Institute of Chartered Accountants of India

 1.6 STRATEGIC FINANCIAL MANAGEMENT

Along with the mobilization of funds, policy makers should decide on the capital structure to
indicate the desired mix of equity capital and debt capital. There are some norms for debt equity
ratio which need to be followed for minimizing the risks of excessive loans. For instance, in case of
public sector organizations, the norm is 1:1 ratio and for private sector firms, the norm is 2:1 ratio.
However, this ratio in its ideal form varies from industry to industry. It also depends on the
planning mode of the organization. For capital intensive industries, the proportion of debt to equity
is much higher. Similar is the case for high cost projects in priority sectors and for projects in
underdeveloped regions.
Another important dimension of strategic management and financial policy interface is the
investment and fund allocation decisions. A planner has to frame policies for regulating
investments in fixed assets and for restraining of current assets. Investment proposals mooted by
different business units may be divided into three groups. One type of proposal will be for addition
of a new product by the firm. Another type of proposal will be to increase the level of operation of
an existing product through either an increase in capacity in the existing plant or setting up of
another plant for meeting additional capacity requirement. The last is for cost reduction and
efficient utilization of resources through a new approach and/or closer monitoring of the different
critical activities. Now, given these three types of proposals a planner should evaluate each one of
them by making within group comparison in the light of capital budgeting exercise. In fact, project
evaluation and project selection are the two most important jobs under fund allocation. Planner’s
task is to make the best possible allocation under resource constraints.
Dividend policy is yet another area for making financial policy decisions affecting the strategic
performance of the company. A close interface is needed to frame the policy to be beneficial for
all. Dividend policy decision deals with the extent of earnings to be distributed as dividend and the
extent of earnings to be retained for future expansion scheme of the firm. From the point of view of
long-term funding of business growth, dividend can be considered as that part of total earnings,
which cannot be profitably utilized by the company. Stability of the dividend payment is a desirable
consideration that can have a positive impact on share prices. The alternative policy of paying a
constant percentage of the net earnings may be preferable from the point of view of both flexibility
of the firm and ability of the firm. It also gives a message of lesser risk for the investors. Yet some
other companies follow a different alternative. They pay a minimum dividend per share and
additional dividend when earnings are higher than the normal earnings. In actual practice,
investment opportunities and financial needs of the firm and the shareholders preference for
dividend against capital gains resulting out of share are to be taken into consideration for arriving
at the right dividend policy. Alternatives like cash dividend and stock di vidend are also to be
examined while working out an ideal dividend policy that supports and promotes the corporate
strategy of the company.
Thus, the financial policy of a company cannot be worked out in isolation of other functional
policies. It has a wider appeal and closer link with the overall organizational performance and

© The Institute of Chartered Accountants of India

 FINANCIAL POLICY AND CORPORATE STRATEGY 1.7

direction of growth. These policies being related to external awareness about the firm, especially
the awareness of the investors about the firm, in respect of its internal performan ce. There is
always a process of evaluation active in the minds of the current and future stake holders of the
company. As a result preference and patronage for the company depends significantly on the
financial policy framework. Hence, attention of the corporate planners must be drawn while framing
the financial policies not at a later stage but during the stage of corporate planning itself. The
nature of interdependence is the crucial factor to be studied and modelled by using an in-depth
analytical approach. This is a very difficult task compared to usual cause and effect study because
corporate strategy is the cause and financial policy is the effect and sometimes financial policy is
the cause and corporate strategy is the effect.

5. BALANCING FINANCIAL GOALS VIS-A-VIS

SUSTAINABLE GROWTH
The concept of sustainable growth can be helpful for planning healthy corporate growth. This
concept forces managers to consider the financial consequences of sales increases and to set
sales growth goals that are consistent with the operating and financial policies of the firm. Often, a
conflict can arise if growth objectives are not consistent with the value of the organization's
sustainable growth. Question concerning right distribution of resources may take a difficult shape if
we take into consideration the rightness not for the current stakeholders but for the future
stakeholders also. To take an illustration, let us refer to fuel industry where resources are limited in
quantity and a judicial use of resources is needed to cater to the need of the future customers
along with the need of the present customers. One may have noticed the save fuel campaign, a
demarketing campaign that deviates from the usual approach of sales growth strategy and
preaches for conservation of fuel for their use across generation. This is an example of stable
growth strategy adopted by the oil industry as a whole under resource constraints and the long run
objective of survival over years. Incremental growth strategy, profit strategy and pa use strategy
are other variants of stable growth strategy.

Sustainable growth is important to enterprise long-term development. Too fast or too slow growth
will go against enterprise growth and development, so financial should play important role in
enterprise development, adopt suitable financial policy initiative to make sure enterprise growth
speed close to sustainable growth ratio and have sustainable healthy development.

© The Institute of Chartered Accountants of India

 1.8 STRATEGIC FINANCIAL MANAGEMENT

What makes an organisation financially sustainable?

To be financially sustainable, an organisation must:
➢ have more than one source of income;
➢ have more than one way of generating income;
➢ do strategic, action and financial planning regularly;
➢ have adequate financial systems;
➢ have a good public image;
➢ be clear about its values (value clarity); and
➢ have financial autonomy.
Source: CIVICUS “Developing a Financing Strategy”.

The sustainable growth rate (SGR), concept by Robert C. Higgins, of a firm is the maximum rate of
growth in sales that can be achieved, given the firm's profitability, asset utilization, and desired
dividend payout and debt (financial leverage) ratios. The sustainable growth rate is a measure of
how much a firm can grow without borrowing more money. After the firm has passed this rate, it
must borrow funds from another source to facilitate growth. Variables typically include the net
profit margin on new and existing revenues; the asset turnover ratio, which is the ratio of sales
revenues to total assets; the assets to beginning of period equity ratio; and the retention rate,
which is defined as the fraction of earnings retained in the business.

SGR = ROE x (1- Dividend payment ratio)

Sustainable growth models assume that the business wants to: 1) maintain a target capital
structure without issuing new equity; 2) maintain a target dividend payment ratio; and 3) increase
sales as rapidly as market conditions allow. Since the asset to beginning of period equity ratio is
constant and the firm's only source of new equity is retained earnings, sales and assets cannot
grow any faster than the retained earnings plus the additional debt that the retained earnings can
support. The sustainable growth rate is consistent with the observed evidence tha t most
corporations are reluctant to issue new equity. If, however, the firm is willing to issue additional
equity, there is in principle no financial constraint on its growth rate. Indeed, the sustainable
growth rate formula is directly predicted on return on equity.
Economists and business researchers contend that achieving sustainable growth is not possible
without paying heed to twin cornerstones: growth strategy and growth capability. Companies that
pay inadequate attention to one aspect or the other are doomed to fail in their efforts to establish
practices of sustainable growth (though short-term gains may be realized). After all, if a company
has an excellent growth strategy in place but has not put the necessary infrastructure in place to
execute that strategy, long-term growth is impossible. The reverse is also true.

© The Institute of Chartered Accountants of India

 FINANCIAL POLICY AND CORPORATE STRATEGY 1.9

The very weak idea of sustainability requires that the overall stock of capital assets should remain
constant. The weak version of sustainability refers to preservation of critical resources to ensure
support for all, over a long-time horizon. The strong concept of sustainability is concerned with the
preservation of resources under the primacy of ecosystem functioning. These are in line with the
definition provided by the economists in the context of sustainable development at macro level.
What makes an organisation sustainable?
➢ In order to be sustainable, an organisation must:
➢ have a clear strategic direction;
➢ be able to scan its environment or context to identify opportunities for its work;
➢ be able to attract, manage and retain competent staff;
➢ have an adequate administrative and financial infrastructure;
➢ be able to demonstrate its effectiveness and impact in order to leverage further
resources; and
➢ get community support for, and involvement in its work.
Source: CIVICUS “Developing a Financing Strategy”.

The sustainable growth model is particularly helpful in situations in which a borrower requests
additional financing. The need for additional loans creates a potentially risky sit uation of too much
debt and too little equity. Either additional equity must be raised, or the borrower will have to
reduce the rate of expansion to a level that can be sustained without an increase in financial
leverage.
Mature firms often have actual growth rates that are less than the sustainable growth rate. In these
cases, management's principal objective is finding productive uses for the cash flows that exist in
excess of their needs. Options available to business owners and executives in such cases
includes returning the money to shareholders through increased dividends or common stock
repurchases, reducing the firm's debt load, or increasing possession of lower earning liquid assets.
These actions serve to decrease the sustainable growth rate. Alternatively, these firms can attempt
to enhance their actual growth rates through the acquisition of rapidly growing companies.
Growth can come from two sources: increased volume and inflation. The inflationary increase in
assets must be financed as though it were real growth. Inflation increases the amount of external
financing required and increases the debt-to-equity ratio when this ratio is measured on a historical
cost basis. Thus, if creditors require that a firm's historical cost debt -to-equity ratio stay constant,
inflation lowers the firm's sustainable growth rate.

© The Institute of Chartered Accountants of India

 1.10 STRATEGIC FINANCIAL MANAGEMENT

Mitsubishi Corporation (MC): New Strategic Direction (charting a new path toward
sustainable growth)
Mitsubishi Corporation has abolished its traditional "midterm management plan" concept of committing
to fixed financial targets three years in the future, in favour of a long-term, circa 2020 growth vision. The
"New Strategic Direction” consists of basic concepts on management policy together with business and
market strategies. It seeks to recognize the Company’s value and upside potential as a sogo
shosha capable of "providing stable earnings throughout business cycles by managing a portfolio
diversified by business model, industry, market and geography".
MC remains dedicated to sustainable growth but as evidenced by its guiding philosophy, the
"Three Corporate Principles", its business activities are even more committed to helping solve
problems in Japan and around the world. Its chief goal is to contribute to sustainable societal
growth on a global scale.
The summary of this New Strategic Direction is:
➢ Future pull approach eyeing 2020 with a vision to double the business by building a
diversified but focussed portfolio.
➢ Clear portfolio strategy: Select winning businesses through proactiv e reshaping of portfolio.
➢ Grow business and deliver returns while maintaining financial discipline.

TEST YOUR KNOWLEDGE

Theoretical Questions
1. Explain the Interface of Financial Policy and Strategic Management.
2. Write a short note on Balancing Financial Goals vis-a-vis Sustainable Growth.

Answers to Theoretical Questions

1. Please refer paragraph 4
2. Please refer paragraph 5

© The Institute of Chartered Accountants of India