Chapter 1 – The Financial Management Function

Financial Management

- Long-term raising of finance

- Allocation of resources
- Control of resources
- Identifying financial objectives of a company i.e. what a company is trying to
achieve (targets) and ensuring these are achieved by having an effective
financial strategy by making effective decisions in 3 key areas
o Investment
o Financing
o Dividends

Management Accounting

- Providing both current and forecast information for day-to-day decisions in order
to help managers achieve financial objectives.
- Management accountants are involved in:
o Planning – identifying where business would like to be and setting
budgets.
o Decision making- decisions on how to achieve the plan
o Control – ensuring decision are implemented correctly

Financial accounting

- Gives information about past performance of the company thus allows

stakeholders to see how successful financial management has been in the past.
- Legally required and determined by accounting standards

Financial objectives and the relationship with corporate strategy

Corporate objectives are targets that need to be met in order for a business to achieve
its overall mission and goals

- Commercial objectives- market share, growth, customer satisfaction

- Financial objectives- expressed in financial terms

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The corporate strategy of the business is course of action require to achieve the
corporate objectives. These are usually separated into corporate, business and
operational. The financial objectives of an organisation usually follow from the overall
corporate strategy and corporate objectives that organisation has.

Financial objectives

Shareholder wealth maximisation

- The fundamental principle of financial management
- Wealth is delivered to shareholders through payment of dividends and increase
in share price.
- Applying shareholder wealth maximisation to internal decisions can be difficult.

Profit maximisation
- Problems of undue risk to achieve profit targets, short termism and
manipulation of profits.
- Long term profit maximisation should be consistent with shareholder
wealth maximisation
EPS
- A measure of corporate success
- Still based on profits
- See if earnings per share have grown to see if there was
maximisation of profit and shareholders wealth
- Earnings can be used to pay a dividend or to reinvest to create
capital growth.

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Shareholders Ratios

1. Total Shareholder Return - Measures the total return on investment (based on

income and capital growth) for shareholders. Dividend per share + Change in
price / Price at start of year

Made up from 2 components- the dividend you received through the year and
the increase in the price of your share.

2. No of Shares (which is also the Share Capital) - Ordinary Shares/ Par Value

3. Dividend per share - Dividends payable /no of shares (share capital)

4. Dividend Yield- if you purchased a share today, what % income return would
you expect in your investment? What I'm investing against what I'm earning.
Dividends per share/ Share price

5. Earnings per share - The amount of earnings the company has generated for the
shareholders on each share they hold. Measure of the company’s profitability by
the outstanding stock shares (also known as no of shares) - PAT/ No of Shares

6. Price earnings ratio: how much you are paying for every $1 earnings. Share
price/ EPS

7. Mean Growth - 100 X ((Final earnings per share / Beginning earnings per share) ^
1/ no of jumps) -1

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Financial Position Ratios

1. Gearing (Book Value) - Compare the company's equity to its debt. Long term
debt / Equity + Long Term Debt

2. Gearing Ratio (Market Value) - Long term debt*Market value / Long term
debt*Market value / Ordinary Shares *Capital price

Diff between book value and market value - A company's book value is the
amount of money shareholders would receive if assets were liquidated and
liabilities paid off. Market value is the value of a company according to the
markets based on the current stock price and the number of outstanding shares.

3. Interest cover- how many times the profit is covered by interest payable.
PBIT/Interest payable

4. Operational Gearing - to what extent are our fixed costs vs variable costs.
Contribution / PBIT or Fixed Costs/ Total Costs

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Financial performance Ratios

1. Capital employed - Total assets less current liabilities OR Share capital + Reserves
+ Long term loans.

2. Return on Capital Employed - Measures efficiency generating profits from all

capital employed. Turnover/ Capital employed

3. Return on shareholders’ funds- Shows how much money is returned to the owners
as a percentage of how much they have invested. PBIT/ Shareholders funds
(Equity)

4. Gross profit Margin - Measures our ability to sell goods for more than they cost to
make. Gross profit/ Revenue

5. Net Profit Margin - Measures our ability to make an overall profit on goods sold.
Net profit/ Revenue

6. Asset turnover - measures how efficiently a company asset are used to generate
sales. Revenue/Capital employed

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Stakeholder objectives and conflicts
A stakeholder is an individual or group of individuals with an interest in the organisation

Internal – employees, managers/directors

Connected – ordinary shareholders, customers, suppliers, finance providers, competitors
External – government, pressure groups, regulators, the community at large

Stakeholder view
- Balance shareholder wealth with the objectives of the other stakeholders
- These objectives may work against the primary objective of a company to
maximise shareholder wealth, e.g. a company may not be able to meet the
labour union’s demands regarding working conditions or a shorter working week
and retain the profitability to satisfy the expectations of the shareholders.
- It is the manager’s role to balance the objectives of different stakeholders

Shareholders are owners of a company who appoint directors to manage the

company for them, directors are the shareholders agents and should always act in the
best interest of the shareholders.

Agency Theory
One party the principal shareholders, employs another party, the agent to perform a
task on its behalf. It states that directors will always put the shareholders objectives first
but do not ignore other stakeholders’ objectives as then it will be difficult to maximise
shareholders wealth.

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Agency problem – directors not acting in ways which increase shareholder wealth by
being tempted to act in their own best interest rather than shareholders. This may be
addresses by using a mixture of appropriate managerial reward schemes.

Ways to encourage managers to achieve stakeholder objectives and align their

objectives with those of the shareholders’

 Performance-related pay (PRP)

Link part of the remuneration to performance (meeting targets) e.g. achieving a

specified increase in EPS could be consistent with maximising shareholders wealth
- may lead to short termism or manipulation of profits
- hence, long-term incentive plans (LTIPs) considered as more effective than PRPs

 Executive share option scheme (ESOP)

Directors have the option to purchase shares at a specified price on a specified future
date
Encourages directors to maximise the value of shares through their decisions

Director/shareholder conflict addressed by regulatory requirements

 Corporate governance codes of best practice

Apply best practice to many key areas relating to executive remuneration, risk
assessment and risk management, auditing, internal control, executive responsibility
and board accountability. Support the key role played by non-executive directors

 Stock exchange listing regulations

Ensure a fair and efficient market for trading company securities such as shares and
loan notes. Encourage disclosure of price-sensitive information in supporting pricing
efficiency and help to decrease information asymmetry, one of the causes of the
agency problem.
Stakeholders would have a clearer picture of how managers are attending to their
objectives

Reduce information asymmetry by monitoring the decisions and performance of

managers.
Auditing the financial statements of a company to confirm the quality and validity of
the information provided to stakeholders

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Financial and other objectives in not – for – profit organisation

• Public sector and privately owned bodies, e.g. charities

• Primary objective: not to make money but to benefit prescribed groups of people
• Key objectives may be difficult to quantify, e.g. quality of care given to the patients in
a hospital
• Multiple and conflicting objectives in NFPs, e.g. quality of patient care versus number
of patients treated

Example:
 comparing actual performance to appropriate financial targets- measuring
outputs and performances against strategic business operational plans
 KPI’s
 Comparing actual performance to non - financial targets – nonfinancial reports
e.g. occupancy levels, number of complaints, patient numbers
 Questioning users
 Appointing experts to monitor performance.

Value for Money assessed using 3 E’s

Economy – minimising the costs of inputs required to achieve a defined level of output
Efficiency – achieving a high level of output in relation to the resources used or
providing a reasonable level of service at reasonable input cost
Effectiveness – whether outputs are achieved that match the predetermined objectives

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