What it means
Ordinary financial management keeps the books accurate and the payments on time. Strategic financial management asks a different question: given limited capital, which activities create the most value over the next three to ten years, and how should they be paid for?
Most of the work falls into four decisions. Investment decisions choose where capital goes, financing decisions choose the mix of debt and equity, working capital decisions determine how much cash is trapped in stock and receivables, and dividend decisions determine how much is returned rather than reinvested.
The unifying test is the cost of capital, meaning the blended return that lenders and shareholders require. Any activity earning more than that rate adds value and anything earning less destroys it, however busy or well-established the activity happens to be.
That is why the discipline often looks like subtraction. Closing a product line that returns 6% and moving its capital into one that returns 15% makes the company smaller in some respects and considerably more valuable in every respect that counts.
The nuance is that strategy and finance have to be argued together rather than in sequence. A plan that is financially attractive but requires skills the company does not have will not deliver, and a strategically appealing plan that cannot be funded without breaching a loan covenant will not survive its first year.
In practice
Real-world examples.
Example
A regional hotel group reviews every property against its cost of capital and finds three of eleven sites earning below 9%. It sells two, refurbishes the third with a defined payback target, and lifts group return on capital without adding a single new hotel.
Example
A growing e-commerce retailer discovers that stock and receivables absorb $3,200,000 of cash. By shortening supplier lead times and tightening credit terms it releases $900,000, which funds a warehouse automation project with no new borrowing.
Example
A family manufacturer facing a large succession tax bill restructures its financing three years ahead of the handover, replacing an overdraft with a term loan and setting a dividend policy that builds a reserve. The strategy costs a little more in interest but removes the risk of a forced sale.
Formula
Calculation
Economic value added = NOPAT - (invested capital x weighted average cost of capital)
Return on invested capital = NOPAT / invested capital
NOPAT means net operating profit after tax, the profit the operations produce once tax is taken but before interest on borrowings.
A specialist chemicals business has invested capital of $40,000,000 and a weighted average cost of capital of 9%. Its capital charge is therefore $40,000,000 x 9% = $3,600,000, the minimum profit it must produce simply to break even in economic terms.
Last year it generated NOPAT of $5,600,000. Economic value added is $5,600,000 - $3,600,000 = $2,000,000, so the business created $2,000,000 of value above what its funders required.
The same result appears through the return spread. Return on invested capital is $5,600,000 / $40,000,000 = 14%, which is 5 percentage points above the 9% cost of capital, and 5% x $40,000,000 = $2,000,000, matching the figure above. If the board could shift $8,000,000 of that capital out of a division earning 6% and into one earning 14%, the annual gain would be 8% x $8,000,000 = $640,000 without raising a single extra dollar.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Merrowdale Chemicals, an invented specialty producer, had grown for a decade by saying yes to almost every opportunity. It employed $40,000,000 of capital, generated NOPAT of $5,600,000, and its board was pleased with a 14% return on invested capital against a 9% cost of capital, an economic value added of $2,000,000.
A new finance director broke the group into four units and applied the same test to each. Two units earned comfortably above 9%, one earned exactly the cost of capital, and a fourth, a legacy coatings line employing $8,000,000, earned 6%. The consolidated figure had been hiding a unit that consumed $240,000 of value a year, being 3% below its capital charge on $8,000,000.
Over eighteen months the board sold the coatings line and redeployed the proceeds into the strongest unit, which was capacity constrained and earning 14%. In this illustrative case group revenue fell by 15% while economic value added rose to roughly $2,640,000, and the chairman's summary was that the company had finally started managing capital rather than merely counting it.
Watch out
Common mistakes.
- Confusing it with budgeting and reporting. Producing accurate monthly accounts is essential hygiene, but it answers none of the questions about where capital should go next.
- Judging projects on accounting profit alone while ignoring the capital they tie up, which flatters anything that needs heavy stock or long payment terms.
- Setting a dividend policy by habit rather than by comparing the return shareholders can earn elsewhere with the return the business can earn on retained cash.
Questions
People also ask.
How is it different from corporate strategy?
Corporate strategy chooses which markets to compete in, while strategic financial management decides how capital and funding support those choices and whether the returns justify them.
Do small businesses need it?
Yes, and often more acutely, because a company with one funding line and limited cash has far less room to recover from a poor investment decision.
What single measure best captures it?
No single measure does the job, but return on invested capital compared with the weighted average cost of capital comes closest to a one-line verdict on whether capital is being used well.
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