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Establishing a financial objective— A practical approach
Establishing a Financial Objective-A
Practical Approach
11
Establishing a Financial ObjectiveA Practical Approach David Allen*
Just about the only feature of the business environment which has remained constant in recent years is its rate of change. ln particular, changes in the internal and external values of the worlds leading currencies, in taxation laws, and in accounting practice, have combined to confuse the tasks of objective setting and performance measurement. This article sets out to clear a path through that confusion. It considers the various factors to be taken into accownt when establishing a financial objective for use as a criterion in resowrce allocation decisions. It shows how, in the U.K., a growth rate objective is an essential companion to a return on investment objective.
Current regulations in the financial and tax spheres in the United Kingdom combine to add an interesting twist to the above analysis. In effect, as we shall see, they make it possible for a growing company to manage with a lower return on capital than a static or declining one. A new version of the old ‘survival of the fittest’ syndrome ! An ‘adequate’ return, in this context, is one which covers the cost of capital to the company. The key to a comprehensive structure of financial control, therefore, is to be found in the successful completion of the following tasks : *
identifying the various sources of funds available, and evaluating the returns expected by each;
Of the various factors contributing to the successful continuance of any commercial undertaking, one stands out as an absolutely vital necessity: the maintenance of a healthy relationship between the profits it earns, and the capital it employs.
*
mixing those sources in proportions designed to minimize the overall average return, taking due account of taxation;
*
interpreting that average in a form suitable for use as a criterion in resource-allocation decisions.
This relationship is generally pictured as a two-fold
The last few years have been characterized by a rapid rate of change in many important features of the economic environment in which businesses operate. In particular, there have been significant movements in the internal and external values of the world’s leading curto tax laws. rencies, and substantial amendments Unfortunately, no consensus has yet emerged as to how these changes should be catered for in published accounts. There is, however, widespread recognition of the fact that they make it necessary for the key tasks listed above to be kept under continuous review.
one :
(4 The
cash flow aspect. As time goes by, the amount of capital required to finance a company’s operating assets increases-perhaps because of an expansion of activity, but nowadays mainly as a result of inflation. To the extent that this increase is not covered by retained profits, it necessitates a further input of funds by shareholders or lenders.
(b) The return on capital aspect. The ratio of profits to capital employed is a measure of economic performance, and a prime determinant of the company’s ability to attract and retain funds. In reality, these two pressures generally work in unison. Companies showing an adequate return on capita! are able to expand-both by ploughing back profits, and by attracting additional capital with the prospect of future dividends. Meanwhile, those falling short will find new finance difficult to come by, and will be forced to reduce the scale of their activities.
The remainder of this paper describes the steps necessary to carry out such a review. It shows how to arrive at an optimum combination of profitability and growth objectives. It must be remembered, however, that we are dealing with a dynamic situation. The solution rate varies as conditions change, and, to an extent, as between companies in different circumstances. In other words, it is the logic of what follows which matters: the figures, though realistic, are primarily illustrative.
‘The author is Management Information Director, Cadbury Schweppes group. His address is: The White Lodge, 15 Alderbrook Road, Solihull, West Midlands.
Figure 1 shows the framework of this logic. The company is seen as an entity which possesses a collection of
12
Long Range Planning Vol. 12
1979
December
Total Capital
fi
Total OF$$J
Return on Assets
!
Equity
-f
q.-----
Interest
-
Figure 1. Financial network ‘operating assets’, usually categorized under the main headings of plant, stock, and debtors less creditors. These assets are utilized in such a way as to generate an excess of income over related expenditure, which we call ‘trading profit’. This trading profit has to cover, in the case of a continuing business : interest on borrowed money; taxation; and earnings (partly distributed and partly retained) for the equity shareholders. To assist in the illustration, a continuing example will be developed, using realistic though necessarily hypothetical figures. Our mythical company is called ABC Ltd., and for the sake of argument it is assumed to be a manufacturing company. It operates in a variety of product and market sectors, in a trade such that its operating assets are spread approximately as follows: Plant 45 per cent, Stock 35 per cent, Debtors less creditors 20 per cent.
The Equity
Interest
The logical starting point, in evaluating the cost of capital, is with the ultimate owners of the business, the equity shareholders. In particular, we need to pay attention to the market value of the company’s shares, because it is that, rather than their net worth in the company’s books, which the shareholders see as their investment. In turn, the share price depends to an extent on earnings, so we have a ‘chicken and egg situation’. In order to break into this cycle, we need to make an assumption regarding the ratio of share price to net worth. For reasons which will be justified later, our continuing example assumes a ratio of 1.6: 1. Specifically, it assumes that ABC has a net worth of ~lOm, but a market capitalization of L16m (say 10 million shares quoted at 160 p each). The reward to the equity investor takes two forms, namely dividend income and capita! growth through
an increase in the share price. In theory, he is indifferent as to the relative proportions. Should he require cash, he can sell part of his holding as easily as waiting for the next dividend payment. Moreover, from an economic point of view, there is no pressure on an adequately profitable company to pay dividends. If ir has the opportunity to invest at a maintained rate of return, it makes sense to keep the money in the business. Given the present rules relating to Advance Corporation Tax, in fact, declaration of a dividend amounts, for most companies, to a voluntary contribution to the Exchequer, as we shall see later. Yet, dividends remain the order ofthe day, even when in cash flow terms they are financed by increased borrowings, or occasional rights issues. This is partly a reflection of the tax status of some institutional investors, but probably owes more to the feeling that ‘a profit is an opinion, but a dividend is a fact’. In other words, declaration of a dividend is seen as a demonstration of financial strength. The presumption, dating back to the days of monetary stability. is that it represents a surpius created by the business. which can be distributed without impairing the capability to continue operations on broadly the same scale. Statistics in the financial press give an idea of the ‘conventional wisdom’ regarding dividend levels. At the time of writing, the average dividend yield for the totality of shares quoted on the London Stock Exchange was 6 per cent. On this basis, ABC needs to be paying something like Llrn (6 per cent of Ll6m) in order to keep up with the market. Over and above the dividend requirement, there is the question ofshare price growth. Other things being equal, the investor will expect this to ‘keep pace with inflation’. If we assume 10 per cent inflation, therefore, ABC’s
Establishing a Financial Objective-A shareholders will be looking for a rise in their share price, over tb.e year, of 16 p, bringing it up to 176 p. This means an increase in market capitalization of El*6m, commensurate on our assumptions with an increase in net worth of E1.Orx-r. This increase in net worth can only come out of retained earnings, bringing the total profit after tax required up to 20 per cent of net worth, i.e. E2m on _&lOm in ABC’s case. Profit after tax is, of course, the Earnings Figure used in Earnings Per Share and Price/Earnings calculations. Taking again the aggregate Stock Exchange position, at the time of writing, the overall average P/E ratio was 8. Applying this to the earnings figures above, it puts the ABC market capitalization at 8 x A2m, i.e. the Ll6m assumed at the outset, thus completing the circle. The 1.6: 1 ratio is now seen, therefore, to reflect the relationship between the 20 per cent required to cover dividends and inflation, and the 123 per cent required to match the earnings yield implied by a P/E ratio of 8. To ABC of course, the ‘20 per cent of net worth’ requirement 1s all important, and this figure is insensitive to changes in the general market mood. At this stage, readers might care to follow through the effects of a bullish market taking average share prices, and ABC’s with it, up by some arbitrary percentage. It will be seen that the consequent changes in dividend yields, share price/net worth ratios, and P/E ratios all balance out, leaving the 20 per cent requirement unchanged.
Taxation Meanwhile, we have to evaluate what profit before tax is required to produce a profit after tax of 20 per cent of net worth, i.e. in ABC’s case E2m. On the face of it, given a corporation tax rate of 52 per cent, it would appear that something over jE4m of profit before tax would be required to leave L2m after tax. That is the theoretical, ultimate situation, and is the single most damaging result of the failure to agree on a system of accounting for inflation. The macroeconomic implications of this state of affairs are enormous. Rates of return are, after all, measures of trade-off between present and future. On the figures given, investors are happy to trade off at the 10 per cent mark, but companies are discouraged from indulging in projects offering less than 40 per cent. Littie wonder that as a nation we are not investing enough ! The economic case for extracting money from businesses which have succeeded in using it effectively (often, in order to give it to those who have failed) has always been suspect. But when the basis of the levy was a profit figure grossly distorted by inflation, it became untenable unless the corporate sector was to be forced into bankruptcy.
Practical Approach
13
To prevent this, the Government have introduced certain ‘reliefs’ in the form of postponements of corporation tax liabilities. The extent of these postponements is determined by reference to the increased investment in plant and stocks, as shown in successive baiance sheets. Here we have a very close link between growth and profits, so it is necessary to take note of the basis for calculating the postponement. It is in fact a two-step process. Firstly, the accounted profits are reduced by the increased investment in plant, to give a figure called ‘profit after capital allowances’. Then, from this is deducted stock relief, calculated as the increase in stock, minus 15 per cent of profit after capital allowances. This was a very rough and ready package, introduced to fill the gap until an acceptable system of accounting for inflation was operational. The important point to note is that it does not distinguish benveen inflationary and real increases in investment. Companies showing a real expansion pay less tax than those just keeping up with inflation. No doubt this reinforces the Government’s ‘Indusrrial Strategy’ (but it is worth noting that the 15per cent element in the stock relief means that the more profitable companies get less relief). In theory, therefore, it is possible to calculate the rate of expansion which would just suffice to offset the accounted profits, and therefore bring the taxable profits to nil. To do this, however, given the taxation rules outlined above, would require the actual increase in plant and stock to exceed accounted profits. Add to this the increase in debtors (which is totally ignored for tax purposes) and we have the makings of a substantial cash crisis, summed up in the expression ‘overtrading’. As a working hypothesis, therefore, we can say that compames will, for cash flow reasons, tend to expand at something less than the rate which would eliminate their tax liability. To see how much less, we need to consider Advance Corporation Tax (‘ACT’), and in terms of our example, go back to the point at which a dividend of Alrn was decided upon. Payment of that dividend makes the company liable to pay ACT of about EO.Srn to the Revenue. The logic for this is that the dividend is seen as a gross payment of El*Srn. less income tax at the standard rate of, say, 33 per cent which is the LO*Srn extracted. The &O.Srn is also regarded as an advance payment of the company’s corporation tax liability, i.e. the first Al*Srn of ABC’s taxable profits have already suffered 33 per cent tax, and only 19 per cent need to be paid as ‘mainstream’ tax. Unfortunately, ACT is not refundable in situations where the taxable profits fall short of the grossed up dividends figure. The ACT is effectively a minimum tax charge. The grossed up dividends figure, therefore, is an important breakwater. Taxable profits up to that figure attract a 19 per cent liability to tax, but above it, 52 per cent. This has such a dramatic effect that as a general rule, the optimum growth rate is the one which brings the taxable
14
Long Range Planning Vol. 12
December
profit down to the grossed up dividends. ABC on that basis should aim for sufficient reliefs to bring its taxable profits down to Ll.5m. If it succeeds, then its only tax liability is the LO.5 m induced by the dividend payment, and, much later, a small mainstream charge. Its profit before tax objective, on this logic, need only ( !) be L2*5m, attributable as to LO*5rn tax, Elm dividends, and Elm retentions. In general terms, therefore, we are saying that profit before tax needs to be 25 per cent of the book value of equity capital : still a disarmingly high figure.
1979 they are expected annum.
to earn a trading profit of E20 per
Most accountants fight shy of analysing balance sheets by activity (e.g. product, market, factory) because of the difficulty of apportioning such general items as tax liabilities and overdrafts. The approach outlined above shows that such apportionment is unnecessary. It is the operating asset figure hotuever@anced which matters. Table 1 shows a balance sheet format which emphasizes this point. Table 1. Balance sheet format
Gearing
ABC
At this stage, it is comforting to recall that shareholders are not the only source of capital: it is also possible to borrow money at rates of interest significantly below 25 per cent per annum. Let us imagine that ABC augments its ElOm of shareholders’ funds with L5rn of borrowings at, say, 10 per cent per annum.
The second factor concerns the shareholders, who recognize that gearing has the effect of magnifying losses as well as profits. The higher the borrowings, the greater the risk of fluctuation in earnings and share price. The greater the risk associated with a share, the lower the price/earnings ratio, and hence the higher the earnings figure necessary to meet market expectations. Thus, beyond a certain point, an increase in gearing will not lower the overall return required. That certain point will vary somewhat according to the spread of assets, but the figures used above are a good general guide. We have reached the stage, therefore, ofhaving an objective ratio of trading profit to total assets of 20 per cent per annum. This is an expression which means something to people in the operating units within the group. They need not worry about where the finance came from, or how the trading profit will be distributed. All they need to know is that for every Al00 of assets they employ,
Balance sheet f 000s
Resources committed
The efiect is that it need only make a 20 per cent overall return on its assets of LlSm. The E3m trading profit so achieved is sufficient to pay &0.5m interest as required, and still leave the E2.5m profit before tax calculated above. In these circumstances, we say that a 20 per cent return on assets has been ‘geared up’ to a return on equity capital of 25 per cent. So why not borrow even more, and bring the average down further? Quite apart from the law of diminishing returns (though the first E5m brought the rate down 5 points to 20 per cent, the next E5m would only bring it down a further 23 points to 175 per cent) there are two very important factors at work. The first of these concerns the banker. He is prepared to lend at such low rates of interest only in conditions of negligible risk. This is achieved by providing only a minority of the capital, and having the right to full repayment, ahead of the shareholders getting anything, should things go wrong.
Ltd.
Equity Borrowings
10,000 5000
Total
15,000
Assets employed Plant Stock Debtors (Creditors)
6750 5250 5000 (2000)
. 3000
Total
15,000
Expansion One question we left somewhat pending was what expansion is necessary to provide sufficient capital allowances and stock relief to get the accounted profits of A2.5rn down to a taxable figure of /_1*5m, using the ABC figures. Assuming for the moment that any expansion is evenly spread over the three categories of assets, this becomes matter a of algebra. Table 2 shows the results of that algebra to be that a 10 per cent expansion does the trick. The increase of AO*5m in plant brings the profit after capital allowances to Al*8m. Consequently, a stock increase of LO*Srn gives rise to a stock relief claim of approximately AOo3m, bringing the taxable profits down to the required /_1*5rn_ Perhaps even more importantly, from the point of view of demonstrating the inherent balance of these figures, is to see how the Al*5m of expansion is financed. Ll&n is provided by retained profits, leaving AO*5rn of additional borrowing requirements. This is an increase of 10 per cent, exactly in line with the increase in equity capital, and in line with inflation. The status 4~0, in real terms, has been maintained. This emphasizes the growing importance of the ‘Funds Flow Analysis’. There is now an accounting standard on
Establishing a Financial Objective-A Table 2. Taxation ABC Ltd.
Tax Computations fOOOs
Profit per accounts Less increase in plant
2500 675
Profit after capital allowances
1825
Stock relief Stock increase (15% of 1825)
525 (275) 260
Taxable profit
1575
the subject, but as with the balance sheet problem mentioned earlier, the orthodox layout seems to miss the point. Table 3 attempts to redress this by summarizing the ABC situation in a more meaningful form. The expansion of Ll*5rn is offset against the trading profit of E3*0m to produce a net ‘operating cash inflow’ of E 1=5m. This subtotal is capable of analysis by product, market, etc., thus bringing a cash flow discipline to operating units within the business. The external view of this operating cash flow comprises the payments of interest and dividends, partially offset by increased borrowings. Table 3. Funds flow Funds flow analysis
ABC Ltd.
f 000s (Expansion)/Contraction Plant Stock Debtors-Creditors
(675) (525) (300) -
(1500)
Trading profit
3000
Operating cash flow
1500
(Distributions) Interest Taxation Dividends
Net (increase)
(500) (500) (1000) in borrowings
(2000)
Practical Approach
15
Growth below that rate pushes up the tax charge: above it creates cash flow pressures, so there is very little room for manoeuvre. There are, however, some situations which provide an opportunity for fine tuning: the remaining notes offer some pointers.
Direction
of Expansion
A somewhat slower rate of expansion can generate the same tax relief if it is more concentrated in the area of plant-Treferably at the expense of debtors, but even at the expense of stocks help. Instead of holding stocks as a buff& against demand fluctuations, it might be preferable to have idle plant capable of being brought into use quickly. Expansion into activities previously carried on by customers (vertical integrationj can also help, as well as straightforward mechanization. A side effect is to reduce the proportion of funds borrowed, because of the lower cash flow (reinforced by the banks’ preference to lend against current assets rather than fixed). This variation will be of interest to companies whose borrowings are aiready on the high side.
Unused
ACT
We saw that ACT once paid is not refundable. But it can be carried forward to be offset against ftrture years’ have significant taxable profits. Many companies balances in their books, and could therefore make higher profits for a while until that balance is used up. In most circumstances, however, going for higher profits will militate against rapid expansion. This variation is again primarily for the already overgeared company.
Geographical
Balance
The ACT, capital allowances and stock relief situations are very much U.K. matters. The U.K. effective tax rate of 19 per cent compares favourably with the effective rates elsewhere. For international companies it might pay ‘to reconsider transfer pricing policies so as to make as much of the profit as possible in the U.K. This can be particularly effective for a company with a sizeable balance of unused ACT.
(500)
Currency Special Situations The above analyses have shown that given today’s conditions of inflation, taxation, etc., and using figures culled from aggregate stock market statistics, there is a ‘natural’ return on assets requirement of 20 per cent per annum, and a ‘natural’ growth rate of 10 per cent per annum., if the company is to maintain its equilibrium.
Translation
It is possible for the net worth of a business to increase by more than the profit arising from trading operations. This can arise where the company has investments denominated in a currency which is appreciating against sterling. In other words 20 per cent is the return required in sterling, but if the Deutschmark is expected to appreciate at 5 per cent, a German operating unit need only aim at 15 per cent return in its local currency.
16
Long Range Planning Vol. 12
December
1979
Unused Borrowing Capability
Dividends
If a company is undergeared, then its current cost of capital will tend to be over 20 per cent. It would be very wrong for it to use this as a criterion for evaluation of investment opportunities. Use of a higher cut-off rate than a normal competitor would stifle expansion, push up the tax charge, and hence the average capital cost in a very vicious spiral.
Talking ofvirtuous circles, it is worth coming back to the dividend question, using the ABC figures for i!lustration. Let us now think what would have happened if the company had not paid the Alrn in dividends, and hence not paid the EOe5rn in ACT, but had invested Al.5rn in further expansion to yield EO*3m extra profit. The expansion would have brought enough reliefs to eliminate the tax liability, so that the aggregate profit before tax of ,42.8m would have been entirely attributable to the equity shareholders. On a P/E of 8 the market capitalization would have risen to E22.4. An increase of 44.8rn in return for forgoing Elm of dividends! That’s a return worth considering.
The reality is that the incremental cost of borrowing is only, say 15 per cent. If this is used as a criterion, expansion will be faster, tax reliefs greater, and a virtuous circle can get underway.
Practical Approach
11
Establishing a Financial ObjectiveA Practical Approach David Allen*
Just about the only feature of the business environment which has remained constant in recent years is its rate of change. ln particular, changes in the internal and external values of the worlds leading currencies, in taxation laws, and in accounting practice, have combined to confuse the tasks of objective setting and performance measurement. This article sets out to clear a path through that confusion. It considers the various factors to be taken into accownt when establishing a financial objective for use as a criterion in resowrce allocation decisions. It shows how, in the U.K., a growth rate objective is an essential companion to a return on investment objective.
Current regulations in the financial and tax spheres in the United Kingdom combine to add an interesting twist to the above analysis. In effect, as we shall see, they make it possible for a growing company to manage with a lower return on capital than a static or declining one. A new version of the old ‘survival of the fittest’ syndrome ! An ‘adequate’ return, in this context, is one which covers the cost of capital to the company. The key to a comprehensive structure of financial control, therefore, is to be found in the successful completion of the following tasks : *
identifying the various sources of funds available, and evaluating the returns expected by each;
Of the various factors contributing to the successful continuance of any commercial undertaking, one stands out as an absolutely vital necessity: the maintenance of a healthy relationship between the profits it earns, and the capital it employs.
*
mixing those sources in proportions designed to minimize the overall average return, taking due account of taxation;
*
interpreting that average in a form suitable for use as a criterion in resource-allocation decisions.
This relationship is generally pictured as a two-fold
The last few years have been characterized by a rapid rate of change in many important features of the economic environment in which businesses operate. In particular, there have been significant movements in the internal and external values of the world’s leading curto tax laws. rencies, and substantial amendments Unfortunately, no consensus has yet emerged as to how these changes should be catered for in published accounts. There is, however, widespread recognition of the fact that they make it necessary for the key tasks listed above to be kept under continuous review.
one :
(4 The
cash flow aspect. As time goes by, the amount of capital required to finance a company’s operating assets increases-perhaps because of an expansion of activity, but nowadays mainly as a result of inflation. To the extent that this increase is not covered by retained profits, it necessitates a further input of funds by shareholders or lenders.
(b) The return on capital aspect. The ratio of profits to capital employed is a measure of economic performance, and a prime determinant of the company’s ability to attract and retain funds. In reality, these two pressures generally work in unison. Companies showing an adequate return on capita! are able to expand-both by ploughing back profits, and by attracting additional capital with the prospect of future dividends. Meanwhile, those falling short will find new finance difficult to come by, and will be forced to reduce the scale of their activities.
The remainder of this paper describes the steps necessary to carry out such a review. It shows how to arrive at an optimum combination of profitability and growth objectives. It must be remembered, however, that we are dealing with a dynamic situation. The solution rate varies as conditions change, and, to an extent, as between companies in different circumstances. In other words, it is the logic of what follows which matters: the figures, though realistic, are primarily illustrative.
‘The author is Management Information Director, Cadbury Schweppes group. His address is: The White Lodge, 15 Alderbrook Road, Solihull, West Midlands.
Figure 1 shows the framework of this logic. The company is seen as an entity which possesses a collection of
12
Long Range Planning Vol. 12
1979
December
Total Capital
fi
Total OF$$J
Return on Assets
!
Equity
-f
q.-----
Interest
-
Figure 1. Financial network ‘operating assets’, usually categorized under the main headings of plant, stock, and debtors less creditors. These assets are utilized in such a way as to generate an excess of income over related expenditure, which we call ‘trading profit’. This trading profit has to cover, in the case of a continuing business : interest on borrowed money; taxation; and earnings (partly distributed and partly retained) for the equity shareholders. To assist in the illustration, a continuing example will be developed, using realistic though necessarily hypothetical figures. Our mythical company is called ABC Ltd., and for the sake of argument it is assumed to be a manufacturing company. It operates in a variety of product and market sectors, in a trade such that its operating assets are spread approximately as follows: Plant 45 per cent, Stock 35 per cent, Debtors less creditors 20 per cent.
The Equity
Interest
The logical starting point, in evaluating the cost of capital, is with the ultimate owners of the business, the equity shareholders. In particular, we need to pay attention to the market value of the company’s shares, because it is that, rather than their net worth in the company’s books, which the shareholders see as their investment. In turn, the share price depends to an extent on earnings, so we have a ‘chicken and egg situation’. In order to break into this cycle, we need to make an assumption regarding the ratio of share price to net worth. For reasons which will be justified later, our continuing example assumes a ratio of 1.6: 1. Specifically, it assumes that ABC has a net worth of ~lOm, but a market capitalization of L16m (say 10 million shares quoted at 160 p each). The reward to the equity investor takes two forms, namely dividend income and capita! growth through
an increase in the share price. In theory, he is indifferent as to the relative proportions. Should he require cash, he can sell part of his holding as easily as waiting for the next dividend payment. Moreover, from an economic point of view, there is no pressure on an adequately profitable company to pay dividends. If ir has the opportunity to invest at a maintained rate of return, it makes sense to keep the money in the business. Given the present rules relating to Advance Corporation Tax, in fact, declaration of a dividend amounts, for most companies, to a voluntary contribution to the Exchequer, as we shall see later. Yet, dividends remain the order ofthe day, even when in cash flow terms they are financed by increased borrowings, or occasional rights issues. This is partly a reflection of the tax status of some institutional investors, but probably owes more to the feeling that ‘a profit is an opinion, but a dividend is a fact’. In other words, declaration of a dividend is seen as a demonstration of financial strength. The presumption, dating back to the days of monetary stability. is that it represents a surpius created by the business. which can be distributed without impairing the capability to continue operations on broadly the same scale. Statistics in the financial press give an idea of the ‘conventional wisdom’ regarding dividend levels. At the time of writing, the average dividend yield for the totality of shares quoted on the London Stock Exchange was 6 per cent. On this basis, ABC needs to be paying something like Llrn (6 per cent of Ll6m) in order to keep up with the market. Over and above the dividend requirement, there is the question ofshare price growth. Other things being equal, the investor will expect this to ‘keep pace with inflation’. If we assume 10 per cent inflation, therefore, ABC’s
Establishing a Financial Objective-A shareholders will be looking for a rise in their share price, over tb.e year, of 16 p, bringing it up to 176 p. This means an increase in market capitalization of El*6m, commensurate on our assumptions with an increase in net worth of E1.Orx-r. This increase in net worth can only come out of retained earnings, bringing the total profit after tax required up to 20 per cent of net worth, i.e. E2m on _&lOm in ABC’s case. Profit after tax is, of course, the Earnings Figure used in Earnings Per Share and Price/Earnings calculations. Taking again the aggregate Stock Exchange position, at the time of writing, the overall average P/E ratio was 8. Applying this to the earnings figures above, it puts the ABC market capitalization at 8 x A2m, i.e. the Ll6m assumed at the outset, thus completing the circle. The 1.6: 1 ratio is now seen, therefore, to reflect the relationship between the 20 per cent required to cover dividends and inflation, and the 123 per cent required to match the earnings yield implied by a P/E ratio of 8. To ABC of course, the ‘20 per cent of net worth’ requirement 1s all important, and this figure is insensitive to changes in the general market mood. At this stage, readers might care to follow through the effects of a bullish market taking average share prices, and ABC’s with it, up by some arbitrary percentage. It will be seen that the consequent changes in dividend yields, share price/net worth ratios, and P/E ratios all balance out, leaving the 20 per cent requirement unchanged.
Taxation Meanwhile, we have to evaluate what profit before tax is required to produce a profit after tax of 20 per cent of net worth, i.e. in ABC’s case E2m. On the face of it, given a corporation tax rate of 52 per cent, it would appear that something over jE4m of profit before tax would be required to leave L2m after tax. That is the theoretical, ultimate situation, and is the single most damaging result of the failure to agree on a system of accounting for inflation. The macroeconomic implications of this state of affairs are enormous. Rates of return are, after all, measures of trade-off between present and future. On the figures given, investors are happy to trade off at the 10 per cent mark, but companies are discouraged from indulging in projects offering less than 40 per cent. Littie wonder that as a nation we are not investing enough ! The economic case for extracting money from businesses which have succeeded in using it effectively (often, in order to give it to those who have failed) has always been suspect. But when the basis of the levy was a profit figure grossly distorted by inflation, it became untenable unless the corporate sector was to be forced into bankruptcy.
Practical Approach
13
To prevent this, the Government have introduced certain ‘reliefs’ in the form of postponements of corporation tax liabilities. The extent of these postponements is determined by reference to the increased investment in plant and stocks, as shown in successive baiance sheets. Here we have a very close link between growth and profits, so it is necessary to take note of the basis for calculating the postponement. It is in fact a two-step process. Firstly, the accounted profits are reduced by the increased investment in plant, to give a figure called ‘profit after capital allowances’. Then, from this is deducted stock relief, calculated as the increase in stock, minus 15 per cent of profit after capital allowances. This was a very rough and ready package, introduced to fill the gap until an acceptable system of accounting for inflation was operational. The important point to note is that it does not distinguish benveen inflationary and real increases in investment. Companies showing a real expansion pay less tax than those just keeping up with inflation. No doubt this reinforces the Government’s ‘Indusrrial Strategy’ (but it is worth noting that the 15per cent element in the stock relief means that the more profitable companies get less relief). In theory, therefore, it is possible to calculate the rate of expansion which would just suffice to offset the accounted profits, and therefore bring the taxable profits to nil. To do this, however, given the taxation rules outlined above, would require the actual increase in plant and stock to exceed accounted profits. Add to this the increase in debtors (which is totally ignored for tax purposes) and we have the makings of a substantial cash crisis, summed up in the expression ‘overtrading’. As a working hypothesis, therefore, we can say that compames will, for cash flow reasons, tend to expand at something less than the rate which would eliminate their tax liability. To see how much less, we need to consider Advance Corporation Tax (‘ACT’), and in terms of our example, go back to the point at which a dividend of Alrn was decided upon. Payment of that dividend makes the company liable to pay ACT of about EO.Srn to the Revenue. The logic for this is that the dividend is seen as a gross payment of El*Srn. less income tax at the standard rate of, say, 33 per cent which is the LO*Srn extracted. The &O.Srn is also regarded as an advance payment of the company’s corporation tax liability, i.e. the first Al*Srn of ABC’s taxable profits have already suffered 33 per cent tax, and only 19 per cent need to be paid as ‘mainstream’ tax. Unfortunately, ACT is not refundable in situations where the taxable profits fall short of the grossed up dividends figure. The ACT is effectively a minimum tax charge. The grossed up dividends figure, therefore, is an important breakwater. Taxable profits up to that figure attract a 19 per cent liability to tax, but above it, 52 per cent. This has such a dramatic effect that as a general rule, the optimum growth rate is the one which brings the taxable
14
Long Range Planning Vol. 12
December
profit down to the grossed up dividends. ABC on that basis should aim for sufficient reliefs to bring its taxable profits down to Ll.5m. If it succeeds, then its only tax liability is the LO.5 m induced by the dividend payment, and, much later, a small mainstream charge. Its profit before tax objective, on this logic, need only ( !) be L2*5m, attributable as to LO*5rn tax, Elm dividends, and Elm retentions. In general terms, therefore, we are saying that profit before tax needs to be 25 per cent of the book value of equity capital : still a disarmingly high figure.
1979 they are expected annum.
to earn a trading profit of E20 per
Most accountants fight shy of analysing balance sheets by activity (e.g. product, market, factory) because of the difficulty of apportioning such general items as tax liabilities and overdrafts. The approach outlined above shows that such apportionment is unnecessary. It is the operating asset figure hotuever@anced which matters. Table 1 shows a balance sheet format which emphasizes this point. Table 1. Balance sheet format
Gearing
ABC
At this stage, it is comforting to recall that shareholders are not the only source of capital: it is also possible to borrow money at rates of interest significantly below 25 per cent per annum. Let us imagine that ABC augments its ElOm of shareholders’ funds with L5rn of borrowings at, say, 10 per cent per annum.
The second factor concerns the shareholders, who recognize that gearing has the effect of magnifying losses as well as profits. The higher the borrowings, the greater the risk of fluctuation in earnings and share price. The greater the risk associated with a share, the lower the price/earnings ratio, and hence the higher the earnings figure necessary to meet market expectations. Thus, beyond a certain point, an increase in gearing will not lower the overall return required. That certain point will vary somewhat according to the spread of assets, but the figures used above are a good general guide. We have reached the stage, therefore, ofhaving an objective ratio of trading profit to total assets of 20 per cent per annum. This is an expression which means something to people in the operating units within the group. They need not worry about where the finance came from, or how the trading profit will be distributed. All they need to know is that for every Al00 of assets they employ,
Balance sheet f 000s
Resources committed
The efiect is that it need only make a 20 per cent overall return on its assets of LlSm. The E3m trading profit so achieved is sufficient to pay &0.5m interest as required, and still leave the E2.5m profit before tax calculated above. In these circumstances, we say that a 20 per cent return on assets has been ‘geared up’ to a return on equity capital of 25 per cent. So why not borrow even more, and bring the average down further? Quite apart from the law of diminishing returns (though the first E5m brought the rate down 5 points to 20 per cent, the next E5m would only bring it down a further 23 points to 175 per cent) there are two very important factors at work. The first of these concerns the banker. He is prepared to lend at such low rates of interest only in conditions of negligible risk. This is achieved by providing only a minority of the capital, and having the right to full repayment, ahead of the shareholders getting anything, should things go wrong.
Ltd.
Equity Borrowings
10,000 5000
Total
15,000
Assets employed Plant Stock Debtors (Creditors)
6750 5250 5000 (2000)
. 3000
Total
15,000
Expansion One question we left somewhat pending was what expansion is necessary to provide sufficient capital allowances and stock relief to get the accounted profits of A2.5rn down to a taxable figure of /_1*5m, using the ABC figures. Assuming for the moment that any expansion is evenly spread over the three categories of assets, this becomes matter a of algebra. Table 2 shows the results of that algebra to be that a 10 per cent expansion does the trick. The increase of AO*5m in plant brings the profit after capital allowances to Al*8m. Consequently, a stock increase of LO*Srn gives rise to a stock relief claim of approximately AOo3m, bringing the taxable profits down to the required /_1*5rn_ Perhaps even more importantly, from the point of view of demonstrating the inherent balance of these figures, is to see how the Al*5m of expansion is financed. Ll&n is provided by retained profits, leaving AO*5rn of additional borrowing requirements. This is an increase of 10 per cent, exactly in line with the increase in equity capital, and in line with inflation. The status 4~0, in real terms, has been maintained. This emphasizes the growing importance of the ‘Funds Flow Analysis’. There is now an accounting standard on
Establishing a Financial Objective-A Table 2. Taxation ABC Ltd.
Tax Computations fOOOs
Profit per accounts Less increase in plant
2500 675
Profit after capital allowances
1825
Stock relief Stock increase (15% of 1825)
525 (275) 260
Taxable profit
1575
the subject, but as with the balance sheet problem mentioned earlier, the orthodox layout seems to miss the point. Table 3 attempts to redress this by summarizing the ABC situation in a more meaningful form. The expansion of Ll*5rn is offset against the trading profit of E3*0m to produce a net ‘operating cash inflow’ of E 1=5m. This subtotal is capable of analysis by product, market, etc., thus bringing a cash flow discipline to operating units within the business. The external view of this operating cash flow comprises the payments of interest and dividends, partially offset by increased borrowings. Table 3. Funds flow Funds flow analysis
ABC Ltd.
f 000s (Expansion)/Contraction Plant Stock Debtors-Creditors
(675) (525) (300) -
(1500)
Trading profit
3000
Operating cash flow
1500
(Distributions) Interest Taxation Dividends
Net (increase)
(500) (500) (1000) in borrowings
(2000)
Practical Approach
15
Growth below that rate pushes up the tax charge: above it creates cash flow pressures, so there is very little room for manoeuvre. There are, however, some situations which provide an opportunity for fine tuning: the remaining notes offer some pointers.
Direction
of Expansion
A somewhat slower rate of expansion can generate the same tax relief if it is more concentrated in the area of plant-Treferably at the expense of debtors, but even at the expense of stocks help. Instead of holding stocks as a buff& against demand fluctuations, it might be preferable to have idle plant capable of being brought into use quickly. Expansion into activities previously carried on by customers (vertical integrationj can also help, as well as straightforward mechanization. A side effect is to reduce the proportion of funds borrowed, because of the lower cash flow (reinforced by the banks’ preference to lend against current assets rather than fixed). This variation will be of interest to companies whose borrowings are aiready on the high side.
Unused
ACT
We saw that ACT once paid is not refundable. But it can be carried forward to be offset against ftrture years’ have significant taxable profits. Many companies balances in their books, and could therefore make higher profits for a while until that balance is used up. In most circumstances, however, going for higher profits will militate against rapid expansion. This variation is again primarily for the already overgeared company.
Geographical
Balance
The ACT, capital allowances and stock relief situations are very much U.K. matters. The U.K. effective tax rate of 19 per cent compares favourably with the effective rates elsewhere. For international companies it might pay ‘to reconsider transfer pricing policies so as to make as much of the profit as possible in the U.K. This can be particularly effective for a company with a sizeable balance of unused ACT.
(500)
Currency Special Situations The above analyses have shown that given today’s conditions of inflation, taxation, etc., and using figures culled from aggregate stock market statistics, there is a ‘natural’ return on assets requirement of 20 per cent per annum, and a ‘natural’ growth rate of 10 per cent per annum., if the company is to maintain its equilibrium.
Translation
It is possible for the net worth of a business to increase by more than the profit arising from trading operations. This can arise where the company has investments denominated in a currency which is appreciating against sterling. In other words 20 per cent is the return required in sterling, but if the Deutschmark is expected to appreciate at 5 per cent, a German operating unit need only aim at 15 per cent return in its local currency.
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Long Range Planning Vol. 12
December
1979
Unused Borrowing Capability
Dividends
If a company is undergeared, then its current cost of capital will tend to be over 20 per cent. It would be very wrong for it to use this as a criterion for evaluation of investment opportunities. Use of a higher cut-off rate than a normal competitor would stifle expansion, push up the tax charge, and hence the average capital cost in a very vicious spiral.
Talking ofvirtuous circles, it is worth coming back to the dividend question, using the ABC figures for i!lustration. Let us now think what would have happened if the company had not paid the Alrn in dividends, and hence not paid the EOe5rn in ACT, but had invested Al.5rn in further expansion to yield EO*3m extra profit. The expansion would have brought enough reliefs to eliminate the tax liability, so that the aggregate profit before tax of ,42.8m would have been entirely attributable to the equity shareholders. On a P/E of 8 the market capitalization would have risen to E22.4. An increase of 44.8rn in return for forgoing Elm of dividends! That’s a return worth considering.
The reality is that the incremental cost of borrowing is only, say 15 per cent. If this is used as a criterion, expansion will be faster, tax reliefs greater, and a virtuous circle can get underway.