What’s it: A financial objective is a target or something we want to achieve through the finance department. They guide the finance department and its team to make decisions and focus on relevant activities to achieve objectives.
Financial objectives can be related to revenues, costs, and profits. And in a broader scope, they may also be related to return on investment, capital structure, and financial soundness (associated with financial leverage).
What factors affect how well financial objectives are achieved?
Often, business performance strongly exposes financial performance. Thus, how well the financial targets are achieved highly depends on the results in other departments, particularly concerning revenues and operating costs. Therefore, this department must be good at managing and monitoring money and encourage other departments to achieve the set budget.
In addition to internal factors, achievement also depends on external factors. For example, an increase in interest rates makes finance costs increase. Consequently, it affects the finance department in achieving financial leverage and capital structure objectives.
Why do companies set financial objectives?
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. And 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 look at trends in net income and examine what is happening to revenues and expenses. Then, they relate it 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.
How are financial objectives set?
Like the criteria for objectives in other business functions, good financial objectives must meet the “SMART” criteria:
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 or not. Unlike other business functions, financial objectives are usually more measurable. We don’t need to quantify it because the finance department deals with numbers.
Achievable. Good objectives should be challenging but possible to achieve using existing resources and competencies. Objectives too easy are unlikely to lead to our best performance. On the other hand, if it is too difficult, it lowers staff morale.
Relevant. Objectives must fit the context. They must support business objectives and objectives in other business functions. In addition, they are also 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, for example, quarterly or annually. However, we might also set for a longer horizon, such as three or five years. Deadlines give us a sense of urgency. It also encourages us to take corrective steps to improve performance before the deadline.
What are some examples of financial objectives?
Business exists to make a profit by offering products to consumers. Therefore, they seek to maximize profits. So, 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 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. It also allows us to maximize revenue.
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 combine revenue objectives and cost objectives. We might set profit objectives first. Then, we break it down into revenue objectives 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
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, it is difficult to raise debt capital 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. And 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. In addition to maximizing the company’s market value, the optimal capital structure also 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.
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