What are financial objectives and why set them?
A financial objective is a money target a business wants to reach, often SMART (specific, measurable, agreed, realistic, timed). They come from the corporate aims and guide decisions in marketing, operations and people management. They help managers focus, measure progress, motivate staff and show investors and lenders a clear plan.
Things that shape them: the firm's overall aims, the economy, competitors, shareholder wishes, the stage of the business, and how much finance is available.
Revenue, cost, profit and cash-flow targets
- Revenue = selling price × quantity sold. Target example: grow revenue by 10% or reach a set value of sales.
- Costs = fixed costs (do not change with output, like rent) + variable costs (change with output, like materials). Target example: cut unit costs by 5%.
- Profit = revenue − total costs. Gross profit = revenue − cost of sales; operating profit = gross profit − other operating expenses; profit for the year = operating profit − interest and tax. Target example: a net profit margin of 12%.
- Cash flow = cash in − cash out over a period. Target example: never fall below a minimum balance, or improve net cash flow each month.
- Investment (capital expenditure) levels: how much to spend on long-term assets.
Profit and cash are different. Sales on credit count as revenue now, but the cash may arrive months later. A profitable firm can fail if it cannot pay its bills.
ROCE: return on capital employed
ROCE = operating profit ÷ capital employed × 100
Capital employed = total equity + non-current liabilities (or total assets − current liabilities). ROCE shows how well the business turns long-term money into profit. Compare it with: last year, competitors, and the interest rate a saver could get. A higher ROCE is usually better. A firm can raise ROCE by increasing operating profit or by using less capital (for example selling unused assets).
Capital structure and gearing
Capital structure is the mix of long-term finance: equity (shares and retained profit) and long-term debt (loans, debentures).
Gearing = non-current liabilities ÷ capital employed × 100
- High gearing (over about 50%): more interest to pay, more risk if profits fall or interest rates rise, but owners keep control and can gain more when profits rise.
- Low gearing (under about 25%): safer, but growth may be slower and owners may have to share control by issuing shares.
A capital-structure objective might be: "keep gearing below 40%".
Key formulas and definitions
- Revenue = price × quantity
- Total costs = fixed costs + variable costs (variable cost per unit × quantity)
- Profit = revenue − total costs
- Net cash flow = cash inflows − cash outflows
- Capital employed = total equity + non-current liabilities
- ROCE (%) = operating profit ÷ capital employed × 100
- Gearing (%) = non-current liabilities ÷ capital employed × 100
Worked examples
1. A firm sells 1,000 units at $20. Fixed costs are $6,000 and variable cost is $8 per unit. Find revenue, total cost and profit.
Revenue = 20 × 1,000 = $20,000. Variable costs = 8 × 1,000 = $8,000. Total = 6,000 + 8,000 = $14,000. Profit = 20,000 − 14,000 = $6,000.
2. Operating profit is $6,000. Equity is $30,000 and long-term loans are $20,000. Find ROCE.
Capital employed = 30,000 + 20,000 = $50,000. ROCE = 6,000 ÷ 50,000 × 100 = 12%.
3. For the same firm, find the gearing and say if it is high.
Gearing = 20,000 ÷ 50,000 × 100 = 40%. This is moderate, below the 50% level usually called high.
4. Revenue last year was ₹48 lakh. The target is 15% growth. What revenue is needed?
48 × 1.15 = ₹55.2 lakh.
5. A firm takes a new $30,000 loan. Equity stays $30,000, old loans $20,000. New gearing?
Loans = 50,000; capital employed = 80,000. Gearing = 50,000 ÷ 80,000 × 100 = 62.5%: now highly geared.
6. A firm has ROCE of 4% while banks pay 6% on savings. What does this suggest?
Owners would earn more by saving the money in a bank, so the firm uses its capital poorly; it should raise profit or reduce capital employed.
Common mistakes
- Mixing up profit and cash. Credit sales give profit before any cash arrives.
- Using net profit or gross profit in ROCE. Use operating profit.
- Forgetting to add loans to equity when finding capital employed.
- Thinking high gearing is always bad. It adds risk but can raise returns to owners when profits are strong.