Financial strategy Essay Example | Topics and Well Written Essays - 1250 words

Financial strategy - Essay Example In the recent past, companies are adopting the value based management approach which is a formal systematic approach used in managing companies with an aim of achieving the objective of maximizing value creation and shareholder value (Chapman, Hopwood, & Shields, 2009, p. 1248). Value based management focuses on the key drivers of value thus helping companies achieve their objectives (Starovic, Cooper, & Davis, 2004, 2004, p.15-17). Increasing focus on core competencies has forced companies to outsource some services to ensure that they remain relevant in terms of their revenues and expenditure in comparison with their competitors. Knowing a company’s position is important because it is useful in defining and redefining strategies to improve profit margins and to capitalize on company’s strengths to enhance shareholder value creation (Starovic, Cooper, & Davis, 2004, 2004, p.10-17). Various methods have been used to measure the shareholder’s value but the most co mmonly used are the profitability analysis, Strategic Profit Mode (SPM), and the Economic Value Added (EVA) method. One of the common methods used to measure profitability is Return On Capital Employed (ROCE) which is the operating profit after tax divide by the net capital employed. However, a major criticism on this method is that it does not measure operating profits and capital employed the way investors do. Investors are concerned about economic profits and the amount of debt and equity invested in the business but these amounts may disagree with those used in company’s financial statements because of the accounting practices in use. For instance, accounting reserves which have to be accounted for in financial statements tend to understate economic profits and the amount of equity capital actually invested in the business. ROCE provides little guidance on the profitability level because of its shortcomings. Given the shortcomings of ROCE, SPM and EVA models are preferred because they enable the company to focus on shareholder value and provide a long-term orientation in their analysis. SPM and EVA are reliable, consistent, and therefore preferred over ROCE method. The Strategic Profit Model (SPM) measures the Return On Net Worth (RONW) of a company which is a tool used to measure the changes in the shareholder value in an organization. RONW is made of three components, which include net profit, asset turnover, and financial leverage. These components are used in the calculation of RONW and they can be controlled by the managers of a company (Viswanadham and Luthra, 2005, p.478). Net profit is the difference between sales and expenses and from it net profit margin is calculated which measures how efficiently a company manufactures and sells its products. Net profit margin is the net profit as a percentage of sales. Asset turnover is the sales divided by the total assets of a company and it shows how efficiently a company employs its assets to achiev e a given level of sales. The Return On Assets (ROA) is arrived at by multiplying the net profit margin with the asset turnover and it relates the profitability of a company to the value of assets employed. The financial leverage of a company provides the relationship between the total