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What’s it? A financial objective is a target or something we want to achieve through the finance department. Financial objectives guide the finance department and its team in making decisions and focusing on relevant activities to achieve objectives.
Financial objectives can relate to revenues, costs, and profits. In a broader scope, they may also relate to return on investment, capital structure, and financial soundness (associated with financial leverage).
Factors affecting financial objectives achievement
Financial objectives are like tightrope walks for businesses. Achieving them requires a delicate balance between internal factors under the company’s control and external forces beyond its direct influence. Let’s delve deeper into these two categories:
Internal factors
Departmental performance: As the saying goes, “a chain is only as strong as its weakest link.” The finance department can’t achieve its goals in a silo. Strong performance across all departments is crucial.
For instance, the marketing department’s ability to generate leads and convert them into sales directly impacts revenue targets. Likewise, the production department’s efficiency in controlling costs plays a vital role in achieving profitability objectives.
The finance department plays a central role in facilitating communication and collaboration across departments to ensure everyone is working towards the same financial objectives.
Financial management skills: The finance department’s expertise significantly impacts achieving financial objectives. This includes skills in financial planning, budgeting, forecasting, and risk management.
A skilled finance team can develop realistic and achievable objectives, identify potential roadblocks, and implement strategies to mitigate financial risks. Investing in professional development for the finance team can provide them with the necessary tools and knowledge to navigate complex financial landscapes.
Internal controls: Robust internal controls are essential to safeguard company assets and ensure the accuracy of financial data. Weaknesses in internal controls can lead to fraud, waste, and errors, hindering the achievement of financial objectives.
The finance department plays a critical role in establishing and maintaining strong internal controls to promote financial transparency and accountability.
External factors
Economic conditions: The overall health of the economy significantly impacts a company’s financial performance. Factors like economic growth, interest rates, and inflation can all influence a company’s ability to achieve its financial objectives. During a recession, for example, consumer spending might decline, impacting revenue targets.
Conversely, a booming economy might create favorable conditions for exceeding financial goals. The finance department needs to be proactive in monitoring economic trends and adapting financial strategies accordingly.
Industry dynamics: The competitive landscape within a particular industry can significantly impact financial objectives. Factors like competition, technological advancements, and government regulations all play a role.
Companies in highly competitive industries might need to prioritize cost-reduction objectives to remain profitable. Conversely, companies operating in niche markets with limited competition might have more flexibility in their pricing strategies and revenue goals. The finance department should stay informed about industry trends to make informed decisions regarding financial objectives.
Global events: Unforeseen global events, such as natural disasters or pandemics, can disrupt supply chains, impact consumer behavior, and create financial instability. These events can significantly impact a company’s ability to achieve its financial objectives. The finance department needs to be prepared to develop contingency plans to address potential disruptions and ensure business continuity.
Why are financial objectives important?
Financial objectives are essential for several reasons. First, they give us a focus on how much money we should spend. Good financial planning allows us to have money available to meet unexpected payments, such as bills. Long story short, objectives guide us to plan our finances well, both short-term and long-term.
Second, good financial health supports business performance. What a business can achieve depends on the money available. For example, we need to invest in a new machine to support cost reduction. Without such investments, we face increased costs. It can lead to a decrease in competitiveness because products are relatively expensive due to our inability to lower costs.
On the other hand, poor financial health can impair business performance. It usually stems from poor financial planning. And it gets even worse when we don’t have financial objectives.
Third, financial metrics are usually the first indicators external stakeholders look to when examining a company’s performance. For example, investors consider how much money a company makes to decide whether to buy company stock or not. Likewise, creditors look at financial conditions to determine the company’s ability to pay.
For example, investors and creditors examine net income, revenues, and expenses trends and relate them to business performance.
Long story short, they check the financial metrics first and then confirm them by looking at the business performance metrics and not the other way around.
Setting SMART financial objectives
Like the criteria for objectives in other business functions, good financial objectives must meet the “SMART” criteria:
- Specific
- Measurable
- Achievable
- Relevant
- Time-bound
Specific. What financial metrics will we measure? Is it cost, revenue, profit, or capital? What are our objectives for these metrics? We must define it clearly. So, all staff knows and understand.
Measurable. Measurable objectives allow us to assess whether the target has been achieved. Unlike other business functions, financial objectives are usually more measurable. We don’t need to quantify them because the finance department deals with numbers.
Achievable. Good objectives should be challenging but achievable using existing resources and competencies. Objectives that are too easy are unlikely to lead to our best performance. On the other hand, if they are too difficult, they lower staff morale.
Relevant. Objectives must fit the context, support business objectives and objectives in other business functions, and be relevant to the business and the environment in which the company operates.
For example, double-digit income growth is an irrelevant objective during a recession. Instead, it may be more appropriate to maintain revenue while taking steps to reduce costs.
Time-bound. Financial objectives are usually related to financial reporting, such as quarterly or annual. However, we might also set for a longer horizon, such as three or five years. Deadlines give us a sense of urgency. They also encourage us to take corrective steps to improve performance before the deadline.
Key types of financial objectives
Businesses exist to make a profit by offering products to consumers. Therefore, they seek to maximize profits, and profit can be the primary financial objective.
Then, we might break down our profit objectives into two parts: revenue objectives and cost goals.
Generally, profits are identical to the money the company makes after paying all costs. In this case, we identify profits as cash generated.
But, in accrual financial reporting, cash is not the same as profit. For this reason, companies may focus more on cash flow than profit objectives.
In addition to these goals, examples of other financial objectives are:
- Return on investment objectives
- Financial leverage objectives
- Capital structure objectives
Revenue objectives
Revenue objectives are related to how much money is made from selling the product. Examples of revenue objectives include:
- Revenue growth
- Revenue maximization
Revenue growth is usually measured as a percentage. So, for example, let’s say we aim to grow our revenue by 10% next year.
Alternatively, it can also refer to a nominal objective, although it is not as common. For example, let’s say we aim to increase revenue by $1 million.
Revenue maximization. Total revenue is maximized when marginal revenue is zero. To maximize revenue, companies usually consider the strategies adopted.
For example, if we adopt cost leadership, we might charge a low price to entice consumers to buy more. Thus, the sales volume increases, and we can maximize revenue.
Or, if we adopt a differentiation strategy, we charge prices high enough without destroying existing sales. So, even though the sales volume is unchanged, the higher price allows us to get a higher margin per unit and maximize revenue.
Cost objectives
Cost objectives require us to minimize costs without compromising product or service quality. Also, they do not interfere with the operation.
Why are cost objectives important? First, profits increase when costs fall. So, even if income doesn’t change, we can make more profit (money) by paying less for expenses.
Second, lower costs support a competitive strategy. It makes us more competitive. With a lower cost structure, we can lower prices to attract more customers to buy.
Third, minimizing costs is usually necessary during difficult times, such as a recession. Companies are facing pressure on earnings as demand falls. To maintain profitability, we must be able to save more and lower costs by taking efficiency measures.
How do we minimize costs? It can be done in various ways:
- Using cheaper raw materials
- Take a cheaper loan
- Invest in more efficient machines
- Automate operations processes and activities
- Hiring more productive workers
Profitability objectives
Profitability objectives combine revenue and cost objectives. We might set profit objectives first, then break them down into revenue and cost objectives.
Profit objectives can be:
- Nominal objectives. For example, it relates to operating profit or net income metrics.
- Profit margin objectives. For instance, we use the net profit margin or operating profit margin metrics.
- Profit maximization. This requires us to operate at a level where marginal cost equals marginal revenue.
Cash flow objectives
Cash flow objectives relate to money coming in and going out. These objectives are common to small businesses. They seek to increase cash inflows and minimize cash outflows while keeping the business afloat. It can be achieved through:
- Reduce loans
- Increase sales
- Minimize costs
- Increase inventory turnover
- Reduce credit sales
Accrual accounting makes a profit not the same as cash. So, profit only represents money on paper. Meanwhile, cash represents actual money.
Therefore, some large businesses may focus more on cash flow than profit. They view cash as more important than profit because it represents the money they make from their business.
Thus, a company may be poor in profits but rich in cash. Amazon is a good example.
Healthy financial leverage
Leverage describes how much a company depends on debt to finance operations and generate profits. High leverage indicates high debt dependence. It can jeopardize financial security and health.
Why is leverage dangerous? Debt is an obligation. So, the company has to pay it regardless of financial condition. So, even when recording a loss, the company must still pay its debts.
Failure to pay debts leads to insolvency. This situation may force creditors to file for bankruptcy with the company.
For this reason, keeping leverage under control is another financial objective. Healthy leverage is the key to long-term financial security.
With low leverage, companies can take new loans to invest, especially when competition requires companies to increase capital expenditures.
Conversely, raising debt capital is difficult if the leverage is too high. If companies could do so, they would have to pay higher interest because lenders demand a higher premium to compensate for the higher risk. High interest rates further worsen the company’s financial health.
Return on investment
External stakeholders such as shareholders and investors use return on invested capital (ROIC) as a metric to assess business performance. They compare a company’s ROIC with its competitors to determine how well the company is performing.
If the company’s ROIC is higher than its competitors’, it has a competitive advantage. If consistently maintained, the company achieves a sustainable competitive advantage.
For this reason, ROIC has become another metric for financial objectives. In addition, maintaining a higher ROIC than competitors makes it easier for companies to deal with external stakeholders. For example, when issuing shares or debt securities, demand is high, making it easier for them to raise funds.
Optimal capital structure
Maximizing shareholder wealth is a crucial financial goal. It requires the company to achieve an optimal capital structure, which maximizes the company’s market value and minimizes the cost of capital.
What is capital structure? It tells us the proportion of debt and equity in the company’s capital. Companies need both to finance the business (assets).
Some companies rely more on debt. While others rely on equity.
Although debt creates liabilities and affects leverage, the cost of debt is cheaper than the cost of equity. Thus, at a certain level, the company must increase its debt to achieve an optimal capital structure and minimal capital cost.
