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Finance and Accounting 2

Posted by Stephen E. Roulac, Phd on Feb 10, 2020 4:45:24 PM

Stephen E. Roulac, Phd

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Ignoring the Stock Price
Companies that ignore their stock price do so at their peril.

While it is crucially important to concentrate on the basic business of the company, if a company is not mindful of what happens to its stock price, it may find it is in for a rude shock. If the stock price falls too low, investors may lose confidence in management, and critical investors may sell out. If the stock price falls too low, a takeover may happen. A company needs to pay attention both to its basic business and it its stock price.

Ignoring the company’s stock price is a mistake.
Lacking Financial Return Targets
When a company commits capital to a new venture, it is important to have a goal for the return on investment of the capital from that venture.

It can be dangerous to proceed to commit capital, if you have no idea what return you want on that capital. Capital, after all, has a cost. Those who provide the capital expect to get a return on that capital, or, at the very least, will charge you interest for that capital. If you are not clear about what return you wish to make on the capital you invest in the new venture—which objective needs to be informed by the expectations of those who provide you the capital—then you have no way of knowing whether the venture will be successful or not.

Embarking on a new venture without a clear idea of the return on the investment objective can be a mistake.

Failing to Calculate Return on Investment
Sometimes, in the excitement of the promised benefits from a new investment, the actual calculation of the return that is expected from that investment is disregarded.

If the calculation of the return on investment is not made, evaluating that investment—on a stand-alone basis, in comparison to other investment opportunities, and in terms of the company’s cost of capital—is not possible. Any capital commitment should be made on the basis of a careful calculation of the return on investment (ROI) expected from that capital commitment. The ROI calculation is fundamental to strategy.

Making a capital commitment without calculating the return on investment can be a
mistake.

Investing in Projects Unrelated to Business Goals
Too often, companies make investments that are interesting in the abstract, but which have no ultimate relationship to the business’s permanent goals.

Capital expenditures should have a direct linkage and relationship to business goals.
Unless it is possible to demonstrate clearly, specifically, and emphatically how that investment will improve the company’s performance in those areas that are the company’s priorities, the company should not go ahead. Making investments unrelated to business goals means that the company is committing resources in ways that are unrelated to its desired outcomes.

To make a capital investment unrelated to business goals can be a mistake.

Pricing and Cost Mismatch
Some companies are confused about the imperative of matching price and cost.

If a company aspires to be the low-price seller, then it must have a cost structure to match its pricing priorities. Correspondingly, a company that offers high-priced products must incur the costs that are involved in creating quality that the high price promises.

Failing to connect price and cost and quality is a mistake.

Confusing Pricing Markups with Pricing Discounts
Some pricing approaches can confuse discount and markup—much to the detriment of one side of the transaction.

Consider the confusion that can ensue depending upon interpretation of how to apply a markup for retail value above costs. Considering a 30% markup and $13 million of inventory cost, one approach might be to suggest that the relevant cost figure would be $9.1 million, which is 70% of $13 million. But an alternative calculation would say that the relevant figure is $10 million, for 130% of that number is $13 million. The $10 million figure is about 77% of 13 million. The difference is whether pricing is approached from the perspective of a 30% markup or a 30% discount.

Confusion concerning pricing markups and pricing discounts can result in an expensive
mistake.

First Spending the Money then Figuring Out How To Pay for It
When embarking upon a new venture, the temptation is strong to address all that you want to do and should do.

What you want to do and should do costs money. No small number of companies rush out and spend money on what they want to do and should do, and only later stop to figure out how they might get the money to pay for it. Unless the source of money is confirmed to be available, you may never get to do all that you want to do and should do, because you ran out of money. This, in sum, is the story of how many new economy dot.com companies became dot.bomb companies.

It is a mistake to rush out to spend money before you figure out how you will pay for it.

Misperceived Role of Risk in Assessing Financial Commitments
Companies engaged in negotiations of major decisions understandably place particular emphasis on the magnitude of the financial commitments. The risk context of significant decisions should be carefully considered.

A substantial decision involving a significant financial commitment made absent consideration of the context of risk is susceptible to miscalculation. A payment that is dependent upon an outcome being achieved has a very different value than a payment that is guaranteed. A level of compensation that may be very appropriate for a certain level of business performance being delivered could be highly inappropriate if that payment is guaranteed independent of business performance. What may be fully appropriate in a high-risk environment may be entirely inappropriate in a low-risk environment.

A substantial commitment made without sufficient consideration of the risk context of
that decision may result in a mistake.

Using Profit for ROI Calculations
The calculation of ROI—acronym for return on investment—can be a perilous undertaking.

The purpose of the ROI calculation is to measure what return is really received. Profit can be ephemeral—it may be received or it may not. Profit cannot be spent, cannot be used to make another reinvestment, and cannot be put in the bank. Cash can be spent, invested and deposited in the bank. If you want to do an accurate ROI analysis, you use cash flows, not profit.

Thinking profit is what you should use in calculating ROI is a mistake.

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