The financial management function

The financial management function

Nature and purpose of financial management

Financial management is the management of activities associated with the efficient acquisition and use of short and long-term financial resources to ensure the objectives of the company are achieved.

There are three key decisions in financial management:

Investment –investment in projects (long-term) and working capital (short-term).
Financing – the appropriate balance of equity and debt.
Dividend – when and how much dividends are paid.

Relationship between financial management and financial, management accounting

Management accounting: provide information for the day to day functions of control and decision making.
Financial accounting: provide information about the historical results of past decisions in the form of Financial Statements.
The statement of profit or loss can be used to identify the differences between these two. Any decisions before profits before interest and tax could be associated with management accounting as it determines the selling price, sales volume and production costs of inventories as well as other operating expenses. Any decisions after profits before interest and tax could be associated with financial management as it determines interest

Financial Management

expenses and how much profits are left to shareholders.

Sales revenue	x
Costs of sales	(x)
Gross profits	X
Operating expenses	(x)
Profits before interest and tax	x
Interest expenses	(x)
Profits before tax	x
Tax expenses	(x)
Profits after tax	x

Exam rehearsal question:

Which of the following statements concerning financial management are correct?

It is concerned with investment decisions, financing decisions and dividend decisions
It is concerned with financial planning and financial control
It considers the management of risk
1 and 2 only
1 and 3 only
2 and 3 only
1, 2 and 3

Comment: D

Exam rehearsal question:

Which of the following would you expect to be the responsibility of financial management?

Producing annual accounts
Producing monthly management accounts
Advising on investment in non-current assets
Deciding pay rates for staff

Comment: C. Advising on investments in non-current assets is a key role of financial management.

Exam rehearsal question:

Which of the following is LEAST likely to fall within financial management?

The dividend payment to shareholders is increased
Funds are raised to finance an investment project
Surplus assets are sold off
Non-executive directors are appointed to the remuneration committee

Comment: D

Exam rehearsal question:

Which of the following statements is correct?

One of the problems with maximising accounting profit as a financial objective is that accounting profit can be manipulated
A target for a minimum level of dividend cover is a target for a minimum dividend payout ratio
The welfare of employees is a financial objective
One reason shareholders are interested in earnings per share is that accounting profit takes account of risk

Comment: A

Exam rehearsal question:

Which of the following statements are correct?

Maximising market share is an example of a financial objective
Shareholder wealth maximisation is the primary financial objective for a company listed on a stock exchange
Financial objectives should be quantitative so that their achievement can be measured
1 and 2 only
1 and 3 only
2 and 3 only
1, 2 and 3

Comment: C

Exam rehearsal question:

Which of the following statements describes the main objective of financial management?

A Efficient acquisition and deployment of financial resources to ensure achievement of objectives
B Providing information to management for day-to-day functions of control and decision-making
C Providing information to external users about the historical results of the organization
D Maximisation of shareholder wealth

Comment: A

Financial objectives and the relationship with corporate strategy

Commercial and Financial Objectives; Strategies

Commercial objectives – direction of businesses, ie to expand in a new market.
Strategies – steps of how to meet commercial objectives, ie to enter into a new market, businesses would acquire a company.
Financial objectives – usually expressed in financial ratios, ie earnings per share (EPS).
Business levels - levels in the business can be divided into corporate, business and operational. Corporate level management focuses on the long term of the business whereas the business level management focuses on the medium term of the business and the operational level staff ensures tasks are done properly. An example of how these can be linked together is shown below.

	Commercial objectives	Financial objectives	Strategy
Corporate level	New market expansion	Earnings per share (EPS)	Merges and Acquisitions (M&A)
Business level	Update new equipment	Project returns such as NPV of costs	Lease or buy
Operational level	Maintain liquidity levels	Cash levels	Credit offered

Maximisation of shareholders wealth

Financial objectives need to be set in place to maximise shareholders wealth if the business is a publicly traded entity. Total shareholder return (TSR) could be used in this case.

Calculation:

Total shareholder return (TSR) = Dividend yield + capital gain
Dividend yield = DPS/Share price
Capital gain = Share price now – Share price before / Share price before
EPS = Profits after tax/Weighted average number of shares

Exam rehearsal question:

The following information relates to a company:

Year	0	1	2	3
Earnings per share (cents)	30	31.8	33.9	35.7
Dividends per share (cents)	13.0	13.2	13.3	15.0
Share price at the start of the year	1.95	1.98	2.01	2.25

Required:

Calculate the total shareholder return for the third year.
Calculate the mean growth in EPS.

Comment:

Dividend yield = DPS/Share price = 15/225 = 0.067

Capital gain = Share price now – Share price before / Share price before = 225-201/201 =0.119

Total shareholder return (TSR) = Dividend yield + capital gain = 0.067 + 0.119 = 0.186 or 18.6%

Mean growth in EPS = (35.7/30)1/3 -1 = 6%

Exam rehearsal question:

Increasing which TWO of the following would be associated with the financial objective of shareholder wealth maximisation?

Share price
Dividend payment
Reported profit
Earnings per share
Weighted average cost of capital

Comment: A and B.

The sources of shareholder wealth are share prices and dividend payments. so increasing both of these would be associated with the objective of shareholder wealth maximisation.

Exam rehearsal question:

HDW Co is a listed company which plans to meet increased demand for its products by buying new machinery costing $5 million. The machinery would last for four years, at the end of which it would be replaced. This investment will increase production capacity by 9,000 units per year and all of these units are expected to be sold as they are produced.

The NPV of this project is estimated to be $4.1 million.

Required:

Identify TWO financial objectives of a listed company such as HDW Co and discuss how each of these financial objectives are supported by the planned investment in new machinery. (6 marks)

Comment:

Objective one: maximise shareholders wealth:

For public listed companies, the maximization of shareholders’ wealth is the primary objective and this is reflected as the increase in total shareholders’ returns such as an increase in dividend yield and capital gain.

The NPV of the investment in new machinery is positive and this means that HDW Co’s value would increase as a result of undertaking the project by $4.1 million and hence shareholder’s wealth would increase by this value.

HDW Co has cash returns of $4.1 million may then increase the dividends payment to shareholders, ie increase in dividends yield. Share price may also increase as the value of HDW Co increases.

Objective two: improve earnings per share (EPS):

For public listed companies, they are required to publish EPS figure to show whether performance has improved over time. An increase in EPS over the years suggests that management in HWD Co did a good job.

The NPV of the investment in new machinery is positive and this means that HDW Co will earn additional cash profits and this increases its profit after tax, thus, EPS should increase.

However, if the project finance is in the form of shares, this increases the number of shares issued by the business which in turn, decreases the EPS figure.

Maximisation of profits and revenues

Profits and sales revenue maximisation would not necessarily maximise shareholders’ wealth because:

They could be manipulated by accounting policies.
They are more of a short term measure, ie less than one year.

They are based on accruals concept whereas shareholders wealth is a cash concept.

Exam rehearsal question:

Which of the following statements concerning profit are correct?

Accounting profit is not the same as economic profit
Profit takes account of risk
Accounting profit can be manipulated by managers
1 and 3 only
1 and 2 only
2 and 3 only
1, 2 and 3

Comment: A

Maximising and sacrificing

To sacrifice some returns to shareholders may sometimes in turn, maximise their long term wealth, ie avoiding risky projects.

Exam rehearsal question:

Which of the following actions is LEAST likely to increase shareholder wealth?

The weighted average cost of capital is decreased by a recent financing decision
The financial rewards of directors are linked to increasing earnings per share
The board of directors decides to invest in a project with a positive NPV
The annual report declares full compliance with the corporate governance code

Comment: B

Increases in shareholder wealth will depend on increases in cash flow, rather than increases in earnings per share, i.e. increases in profit. If the financial rewards of directors are linked to increasing earnings per share, for example, through a performance-related reward scheme, there is an incentive to increasing short-term profit at the expense of longer growth in cash flows and hence shareholder wealth.

Stakeholders

Examples of stakeholders	Needs (interest)
Employees	Increase rewards
Shareholders	Maximise wealth
Customers	Affordable products
Suppliers	Be paid early
Lenders	Receive interests timely
Government	Collect tax on time

Conflicts arise among different groups of stakeholders, ie an increase in employees rewards reduces shareholders return.

Ways to encourage the achievement of stakeholder objectives

To encourage goal congruence between managers and the organisation, rewards should be carefully designed and regulatory requirements should be carefully followed.

Rewards – examples include performance-related pay such as bonus and share options; shares scheme and other benefits. There is usually a lock up period for the shares and share option schemes, ie 3 -5 years.

Corporate governance – these are systems by which organisations are directed and controlled, ie to have suitable directors to sit on board and appropriate risk management procedures are in place.

Stock exchange listing regulations – most stock exchange requires sensitive information to be disclosed timely to investors, ie a major shareholder in a company disposed of a large number of shares in that company.

Exam rehearsal question:

PV Co, a large stock-exchange-listed company, is evaluating an investment proposal to manufacture Product W33, which has performed well in test marketing trials conducted recently by the company’s research and development division. Product W33 will be manufactured using a fully-automated process which would significantly increase noise levels from PV Co’s factory. This appraisal of this project reveals that the NPV is positive.

Required:

Discuss how the objectives of PV Co’s stakeholders may be in conflict if the project is undertaken. (5 marks)

Comment:

As a large listed company, PV Co’s primary financial objective is assumed to be the maximisation of shareholder wealth.

To achieve this objective, PV Co should undertake projects, such as this one, which have a positive NPV and generate additional value for shareholders.

However, not all of PV Co’s stakeholders have the same objectives and the acceptance of this project may create conflicts among different objectives.

Due to Product W33 being produced using an automated production process, it could mean employees will be paid less than they currently earn.

If this move is part of a longer-term move away from manual processes, it could also create conflicts with government objectives of having a low unemployment rate.

Exam rehearsal question:

Required:

Discuss FOUR ways to encourage managers to achieve stakeholder objectives. (8 marks)

Comment:

Share option plans:

Share options plans could be offered to key directors allowing them to buy company’s shares at a low price in the future.

This would motivate directors to increase company’s share price so that the option could be exercised in the future, for instance, investing in positive NPV projects and decreasing its costs of capital.

Performance related pay:

Directors’ pay could be linked to the profits target or earnings per share target of the company.

This would motivate directors to improve company’s performance over time in order to get the pay. However, the downside is that profits may be manipulated in some way to get this pay or short term behaviours may be expected from management.

Corporate governance:

Following the corporate governance code could ensure shareholders’ wealth is protected, for instance, by implementing strong internal control procedures.

Only non-executive directors are allowed to be included in the remuneration committee to set the pay for executive directors and this makes sure that the directors’ pay is independently set by the business.

Disclosures:

Timely disclosures about sensitive information affecting the business share price could help investors/shareholders make their economic decisions as to whether buying or selling their shares in this company.

Examples of these may include the disclosure about related party transactions and the latest product research and development phase.

Case study – Stakeholders conflict

In 2019, SoftBank planned to acquire Line Corporation which is an internet and mobile application company. Yahoo (Japan) is controlled by Z holding company which is then controlled by SoftBank. SoftBank believes the merger between these companies would improve synergies. However, the minority shareholders of Line Corporation (for example, Metrica Partners Pte. Ltd. which is a fund owning shares in Line Corporation) complained that the offer price from SoftBank is too low and they planned to take this issue to court. Some minority shareholders believe the reasons why the offer price is low to Line Corporation is because two key managers are seconded from SoftBank to the board of Z holding company making the deal unfair. This is an example of conflicts among large and minority shareholders.

Financial and other objectives in not-for-profit organisations (NFPOs)

NFPOs are organisations to meet other objectives such as serving the public interest rather than making profits.

Both listed companies and NFPOs need accounting ratios to measure their financial objectives.

VFM (3Es) as objectives

NFPOs can take VFM as their objectives:

Economy - can be achieved if business can obtain appropriate quality of inputs at the lowest cost. Measures such as adherence to budgets; breaking even in the long run.
Efficiency - can be achieved if business can obtain as many outputs as possible from inputs. Measures such as utilisation rates of resources and costs per successful treated patients (if for hospital).
Effectiveness - can be achieved if business outputs are in line with objectives set. Measures such as satisfaction rates and the number of successful students (if for school).

The 3Es objectives should be carefully balanced when performance in NFPOs is measured, ie an economy decision may not be effective and efficient. An efficient decision may not be economy and effective at all.

Case study – VPM concept in public sector organisations

Case one:

Government allows the agent to sell lands to the public.

Consideration: May not be effective

Whether this is the best price sold to the public? For example, corruption activities may take place when government sold lands at a low price to that agent but this is not fair to other people in society.

Case two:

Government spent $20 million to buy a piece of machinery which did not exist when auditors checked it.

Consideration: May not be economy and effective

Whether the asset is stolen by somebody from the government?

Case three:

Government spent $2,000 to buy a bar of chocolate and a teddy bear.

Consideration: Not economy

This is not economic at all and it may imply corruption activities.

Case four:

People borrowed books from the library, but they did not return them back. Therefore, the library decided to charge $5 million as penalties. However, nobody in the library decided to chase money back from those people and subsequently they wrote them off as bad debt expenses.

Consideration: Not effective

The library did not implement the policy, ie not effective.

Case five:

A college spent lots of money into refitting the classroom into the hotel to accommodate overseas students. However, there are few students check-in.

Consideration:

This is not economy as government spent lots of money into refitting the classroom; and not efficient because hotel rooms are not fully utilised.

Case six:

The faucet is made of up gold in government.

Consideration:

This is an example of extravagance and it is not effective nor economy.

Exam rehearsal question:

Which of the following statements are correct?

Share option schemes always reward good performance by managers
Performance-related pay can encourage dysfunctional behaviour
Value for money as an objective in not-for-profit organisations requires the pursuit of economy, efficiency and effectiveness
1 and 2 only
1 and 3 only
2 and 3 only
1, 2 and 3

Comment: C

Exam rehearsal question:

ARP is a charity providing transport for people visiting hospitals.

Which of the following performance measures would BEST fit with efficiency in a value for money review?

Percentage of members who re-use the service
Cost per journey to hospital
A comparison of actual operating expenses against the budget
Number of communities served

Comment: B

Cost per journey to hospital is a measure of efficiency.

Percentage of members who re-use the service is a measure of effectiveness.

A comparison of actual operating expenses against the budget is an economy measure.

Number of communities served is an effectiveness measure.

Exam rehearsal question:

Required:

Compare and contrast the financial objectives of a stock exchange listed company and the financial objectives of a not-for-profit organisation such as a large charity. (11 marks)

Comment:

Similarities:

Both listed companies and not-for-profit organisations (NFPOs) need to use accounting ratios to measure their performance such as target return on capital employed, or a target level of income per employee, or a target current ratio.

Both listed companies and NFPOs need to control the use of cash, and both types of organisations therefore use budgets.

Value for money (VFM) measures could be applied in both listed companies and NFPOs focusing on economy, efficiency and effectiveness.

For example, keeping spending with the budget is a measure of economy.

To increase the utilisation rates of resources is a measure of efficiency, ie utilisation rates of beds in hospitals or utilisation rates of machines.

To achieve the organisations’ objectives is a measure of effectiveness, ie to maximise shareholders wealth in listed companies or to increase the number of successful students in schools.

Differences:

However, there is a different focus on the 3Es concept in listed companies and NFPOs.

For example, listed companies may focus on increasing sales revenue to maximise shareholders wealth whereas NFPOs may focus on less profitable projects maximising the satisfaction rates for stakeholders.

Outputs from most NFPOs are not quantifiable, ie an objective for charity may be to help poor people in the society while for listed companies, their outputs may be in the form of service or tangible products where performance could be measured directly using number of returning customers.

More stakeholders are needed to be carefully managed in NFPOs than in listed companies, ie interests from different tax payers vary for governments whereas for listed companies, an eye could be kept on shareholders and a few major stakeholders only.

Conclusion:

Comparing the financial objectives of a stock exchange listed company and a not-for-profit organization shows that while significant differences can be found, there is a considerable amount of common ground in terms of financial objectives.

Dive deeper, conquer those exams, and truly make your mark by grabbing your spot in our ACCA online course today at www.globalapc.com – let’s crush this together!

Categories: : Financial Management (FM)