FINANCIAL MANAGEMENT FUNCTION

Financial management – the management of activities associated with the efficient acquisition and use of short- and long-ter
financial resources.
The three key decision areas of financial management are investing, financing and dividend policy. More specifically:
 What types of funds should be raised − equity capital or debt capital?
 How should the funds be raised?
 On which proposed investments should the funds be spent?
 How much dividend should be paid to the shareholders?
 How much working capital should the organisation have and how should it be financed?
 How should risk be managed?
These decisions are inter-related:
 An increase in dividends (the dividend decision) will reduce the level of retained cash and increase the
need for external finance (the financing decision) in order to fund capital investment projects (the
investment decision).
 An increase in capital expenditure (the investment decision) would also increase the need for finance (the
financing decision). One possible source of finance is internal, by reducing dividends (the dividend
decision).

The Nature and Purpose of Financial

Management
The main purpose of financial strategy is to ensure that financial resources are available to the
organization in support of its overall corporate objectives, which include financial objectives.
Management accounting is a set of tools and disciplines measuring corporate performance and to
facilitate decision-making; it is designed and implemented in coordination with the company’s strategy.
Financial accounting is concerned with maintaining the records of the transactions of the firm and
preparing financial statements for the benefit of shareholders (and other external audiences) in
conformity with established accounting standards.
Key Knowledge – Financial Objectives and the
Relationship with Corporate Strategy
In pursuing its financial objectives, the firm must ensure that those objectives are congruent – i.e.
consistent – with its overall corporate strategy.

Key Knowledge – Stakeholders and Impact on

Corporate Objectives
Stakeholder groups
• Shareholders: As owners of the business, they rank supreme, as reflected in US/UK models of
corporate governance;

Lenders: Important if the business relies heavily on providers of loan capital (banks, bondholders);
• Directors: The executive directors or senior management of the business are central since they have
“hands-on” power and can serve their own interests (giving rise to agency risk);
• Employees: Often referred to as a company’s “most valuable asset”; they must be motivated and
adequately compensated;
• Customers: No customers, no business! How influential they are or how carefully management needs
to listen to their concerns depends on the type of business activity and the competitive environment;
• Suppliers: Good and reliable suppliers can be critical to corporate success;
• Government: They have two major interests: (a) they receive revenue via taxes and (b) benefit
indirectly when firms create employment. Environmental and other regulatory concerns are also
within the scope of the government’s interest;
• Public: The general public, its opinions and ability to exert pressure through lobby groups are all
relevant factor for businesses that pollute, are involved in nuclear power, or carry out other activities
that may be controversial (e.g. abortion clinics).

Conflicting stakeholder interests

Conflicting interests can exist between various stakeholder groups.
Management must examine the degrees of stakeholder influence and actively manage the relationship
with relevant stakeholders.
Agency theory
Agency theory addresses the risk that management will not act in the best interest of the shareholders,
but will make decisions that will serve its own interests.
Examples of self-serving management behavior could include: (a) artificially boosting corporate profits in
the short-term in order to earn bonuses; (b) paying too much to acquire another company for reasons of
prestige or in order to “build empires”; (c) rejecting opportunities, such as takeover bids, or
restructuring initiatives, that might jeopardize their positions (an orientation to maintaining the “status
quo”).
Influencing managerial behavior
In order to cause managers to behave in a way consistent with stakeholder interests, rewards and
bonus schemes need to be carefully designed. This can be seen as the “internal” dimension to corporate
governance. The other dimension -- “external” – comes in the form of regulation.

Scope of strategic performance measures in private sector

Shareholder value measurements focus on creation of shareholder value as fundamental aim of profit
oriented companies.
Long-term wealth maximization is not always consistent with the “artificial” inflation of profits in the
short-term. If a company stops investing, for example, it can boost its short-term profitability, but this
may come at the expense of the company’s medium- to long-term competitiveness.
The following are some of the financial measures typically used by companies to measure performance.
Return on Investment (ROI/ROCE)
(Accounting PBIT / Accounting Capital Employed) * 100%
Accounting Capital Employed = Total Assets – Current Liabilities = Total Non-Current Assets, net +
Working Capital
Disadvantage: ROI/ROCE increases as investment centre’s fixed assets grow older, thus a ROI
improvement over time (or a better ROI compared to another division) may be partly attributable to the
age of the assets used.
Consequently, gross value of fixed assets may be used in measuring performance based on ROI.
Earnings Per Share (EPS)
Net income less any preferred dividends divided by the number of shares outstanding.
Return on Equity
Net income divided by shareholders’ equity.
Key Knowledge – Financial and Other Objectives in Non-
for-Profit Organisations
Profit and Not-for-profit organisations
Profit-seeking organizations exist ultimately to create wealth for their owners.
Non-profit (or not-for-profit) organizations are created to accomplish a pre-defined mission, such as the
delivery of a service; they are expected to do so in an economical manner.
ACCA

2.1 Strategy

A strategy is a course of action to achieve an objective. A strategy might be short-term or long-term, depending on the
objective.
Corporate strategies relate to the general direction of the entire organisation.
For example, a car manufacturer may have a strategy over the next 10 years focusing on sustainable energy,
collectively owned transportation, and driving automation. Its investments and actions would be directed towards
achieving objectives in these areas

2.2 Corporate Objectives

Corporate objectives are relevant to the entirety of an organisation.

In practice, companies are likely to have a variety of different corporate objectives which may include several of the
following:
 Profit targets
 Market share targets
 Share price growth
 Local and environmental concerns
 Contented workforce
 Meeting short-term targets
 Long-term plans.
These objectives can be classified as follows:
 Profit goals − objectives which lead directly to increased profits (e.g. cost reduction measures).
 Surrogate profit goals − objectives which lead indirectly to increased profits (e.g. maintaining a contented
workforce).
 Constraints on profit − objectives which actually restrict profit (e.g. ensuring that the company's operations
do no harm to the environment).
 Dysfunctional goals − objectives which do not provide a benefit even in the long run (e.g. the pursuit of
market leadership at all costs).
A company may aim at either maximising or satisficing these objectives.
 Maximising involves seeking the best possible outcome.
 Satisficing involves finding an adequate outcome.

2.3 Financial Objectives

Financial objectives might include targets for earnings per share, dividend per share, gearing level and operating
profitability.
2.3.1 Maximisation of Shareholder Wealth
In theoretical terms, a single corporate (financial) objective is assumed and this is the maximisation of shareholder
wealth.
Shareholder wealth is the combination of dividend and share price growth, which together are referred to as total
shareholder returns (TSR).

TSR = × 100
If a company’s shares are traded on a stock market, shareholder wealth increases when the share price rises. This
happens if the company makes good profits, which it either pays out as dividends or reinvests to support future growth
in both the business and in dividends (assuming the profits have been achieved without undue business or financial
risk which would concern shareholders).
The objective of maximising share prices is therefore often used as a substitute for maximising shareholder wealth.

Example 1 TSR and Changes in Dividends and Share Prices

An investor purchased 100 shares in ABC Co at the beginning of 20X0 at the market price of $10 per share. During the year,
the investor received a dividend of $1.20 per share and by the end of 20X0 the shares had an ex-div market value of $12.90
per share.
TSR = $(12.90 − 10 + 1.20)/$10 = 0.41 or 41%
This is made up of two components:
1. Capital gain: $(12.90 − 10)/$10 = 0.29 or 29%
2. Dividend yield: Dividend/price at the beginning of the period = $1.20/$10 = 0.12 or 12%
The objective of maximising shareholder wealth can be justified in the following ways:
 The company which provides the highest returns for its investors will find it easiest to raise new finance
and grow in the future. This should ensure optimal resource allocation within the economy and maximise
the overall wealth of the nation.
 Companies that achieve the highest returns for their investors will be those that are providing customers
with what they require; this is again consistent with the nation's economic health.
 Companies that fail to provide adequate returns may become targets for hostile takeovers.
 Directors have a legal duty to run the company on behalf of the shareholders. It is generally considered a
reasonable assumption that the shareholders of listed companies (mainly institutional investors) seek to
maximise wealth.
Criticisms of the above include the following:
 It ignores market imperfections − it might not be in the public interest to allow monopolies to maximise
returns as this may cause high prices for consumers.
 It ignores social needs like health, education, police and so on.
 Maximising TSR ignores the interests of other stakeholders (e.g. employees, customers and arguably,
society as a whole).
 In the case of unlisted companies, even the shareholders may not require maximised returns (e.g. some
closely held companies are run as "lifestyle” companies whose main objective is to create prestige for the
owners).
2.3.2 Profit Maximisation
In practice, many companies find the theoretical objective of maximising TSR hard to follow because:
 A listed company's share price is often influenced more by overall stock market conditions than the
company's individual performance.
 In the case of unlisted companies, there is no quoted share price to be maximised.
Therefore in practice, profit maximisation is also often used as a proxy for shareholder wealth maximisation.
Unfortunately, profit is not necessarily a reliable proxy:
 The value of the company's equity is more closely connected with its cash generation than accrual-based
accounting profits.
 Management may become "myopic", that is, aim to boost short-term profit at the expense of long-term
growth (e.g. by cutting investment in research or training).
 Excessive pressure to maximise profits can lead to manipulation of data, and in extreme cases, fraudulent
accounting.
 Accounting profit reports debt financing costs (i.e. interest expense) but not equity financing costs (i.e.
required return of shareholders).Reported profit can therefore be maximised by using zero debt in the
company's capital structure. However, the company will then pay more tax as it loses the benefit of tax
allowable interest expense (“tax shield”).
2.3.3 Earnings per Share Growth
Earnings per share (EPS) is calculated as:

EPS =
EPS growth is a key indicator for financial analysts who advise the institutional investors in listed companies. Analysts
often publish quarterly forecasts for a company's EPS.

Exam advice

If preference shares have been classified as non-current liabilities, preference dividends would be included in finance costs an
therefore already deducted from profit.

This leads to pressure on management to meet the analysts' expectations. Because it is based on accounting profits,
EPS shares all of the problems listed above. Additionally:
 EPS can be cosmetically boosted by undertaking a share consolidation (i.e. replacing several existing
shares with one new share).
 EPS can be legitimately increased through a share buyback scheme (i.e. using surplus cash to
repurchase and cancel part of the share capital). Research shows, however, that company directors often
perform a buyback for personal gain; the share price usually rises on the announcement of a buyback
scheme, increasing the value of any shares issued to directors through executive share option schemes
(see s.3.4).
Example 2 EPS

During the year ended 31 March 20X5, George Co reported EPS of 10.3 cents. The company had 400,000 shares in issue at
31 March 20X5.
On 1 October 20X5 George Co issued 60,000 shares at the market price. Profit after tax for the year ended 31 March 20X6 w
$57,000. There were no preference dividends.
For the year ended 31 March 20X6, EPS = $57,000/430,000 (W) = 13.3 cents.
EPS growth was ((13.3÷10.3) −1) × 100 = 29.1%
WORKING
Weighted average number of shares:
400,000 × 6/12 200,000
460,000 × 6/12 230,000
_______
 Example 2 EPS

430,000

2.4 Not-for-profit Organisations (NPOs)

2.4.1 Objectives
Not-for-profit organisations (NPOs) include a number of different types of organisation, for example charities and the
public sector. Such organisations are not constrained by cost/profit objectives to the same extent as companies.
However, they are often constrained by having multiple stakeholders with potentially conflicting objectives.
Consider a state-funded university in Example 3:
Example 3 Conflicting Objectives

 The university management is accountable to multiple stakeholders (i.e. students, government and potential
employers).
 However the requirements of the stakeholders may conflict.
o Students may desire small class sizes, a large library and courses that meet their personal
interests.
o The government may wish to minimise costs per student.
o Potential employers may want graduates with relevant skills for industry (e.g. engineering
graduates as opposed to anthropology graduates).
 Designing a performance measurement system where multiple and conflicting objectives exist is obviously very
difficult.
 Management must try to rank its principals/stakeholders and prioritise objectives.

2.4.2 Value for Money

The objective of NPOs is to maximise the difference between the benefits generated and the costs of their operations.
The maximisation of this difference is commonly known as Value for Money and is similar to profit maximisation apart
from society’s interests being maximised rather than profit.
There is an increasing emphasis on Value for Money and achieving the "3 Es", which are:
1. Economy − securing resources as economically as possible, in other words minimising the input costs of
the organisation.
2. Efficiency − employing resources as efficiently as possible within the organisation, in other words
maximising the output/input ratio.
3. Effectiveness − using resources as effectively as possible to meet the organisation’s objectives.
 Example 4 Three Es

2.4.3 Measuring Performance

As well as having multiple, conflicting objectives, it is often difficult to measure the output of NPOs in a way which is
considered meaningful. For example, is a high proportion of first-class degrees awarded alone an adequate measure
of the quality of teaching in a university?
To overcome these issues performance can be measured by:
 Using judgments by experts, accepting that measurement must, to some extent, be subjective;
 Where possible, using comparisons to other similar bodies (e.g. for the public sector) or against historical
results;
 Using inputs (e.g. teaching staff hours paid or costs), bearing in mind the obvious disadvantage of such
an approach − that high levels of input do not necessarily guarantee an objective is more likely to be
achieved. For example, teaching staff might only be teaching for, say, 75% of the hours they are paid for.
It is not impossible to measure the output of NPOs in a meaningful way, however. Continuing with the university
example, outputs might be measure in terms of:
 Broader performance measures − number of students finding employment after graduation, number of
publications by teaching staff, proportion of students graduating;
 Operational performance measures − number of courses offered, unit costs for each operating “unit”,
class sizes, etc.
The following activity assumes knowledge of ratios from Management Accounting.
Activity 1 Not-for-profit Performance

Lewisville is a town with a population of 100,000 people. The town council of Lewisville operates a bus service
(Lewisville Bus Company, or LBC) which links all parts of the town with the town centre. The service is non-profit
seeking and its mission statement is "to provide efficient, reliable and affordable public transport to all the citizens of
Lewisville". Attempting to achieve this mission often involves operating services that would be considered uneconomic
by private sector bus companies, due either to the small number of passengers travelling on some routes or the low
fares charged.
However, one member of the council has recently criticised the performance of the Lewisville bus service compared
with those operated by private sector bus companies in other towns. She has produced the following information for
the most recent financial year:
 Summarised Income and Expenditure Account
$000 $000

Passenger fares 1,200

Staff wages 600

Fuel 300

Depreciation 280

(1,180)

Surplus 20

Capital employed $2,210,000

Operating statistics for Lewisville bus service
Total passengers carried 2,400,000 passengers

Total passenger miles travelled 4,320,000 passenger miles

Industry average ratios for private sector bus companies

Return on capital employed 10%

Return on sales (net margin) 30%

Asset turnover 0.33 times

Average cost per passenger mile $0.37

Required:
1. Using the information provided above, compare the performance of the LBC to the industry
average for private sector companies.
2. Discuss the validity of comparing the performance of the LBC with private sector bus companies.
3. Explain the meaning of the following terms in the context of performance measurement and
suggest a measure of each one appropriate to a public sector bus service:
1. Economy;
2. Effectiveness; and
3. Efficiency.
*Please use the notes feature in the toolbar to help formulate your answer.

2.5 Environmental Issues

An area of growing concern to all parties, companies included, is that of the environment or green issues.
It is important that managers understand how the organisation's operations affect the environment, in order to satisfy
public concerns and, increasingly, to avoid any penalties or costs due to environmental regulations.
For these reasons, environmental reporting is becoming more common as part of general company financial reporting.
Some organisations have adopted the triple bottom line approach, which is a method of true cost accounting. This
approach considers the effect of production decisions in terms of environmental and social value, as well as economic
value. Those companies that create environmental and social value alongside economic value are often considered to
have a sustainable triple bottom line.
3.1 Agency Theory

Agency theory examines the duties and conflicts that occur between the parties within a company that have an
agency relationship.

A company can be viewed as a set of contracts between each of these various interest groups. The company will not
succeed unless all of the groups are working towards the same objectives. Although most research has focused on
the potential conflicts between directors and shareholders, there are other potential sources of tension within a
company.
For example, when a company's assets are close to the level of its liabilities, the debt investors will pressure the
directors to only undertake low risk projects. This is because the debt investors have nothing to gain from risky
projects (they receive fixed returns), but everything to lose (if assets fall below liabilities, the company may become
unable to service its debts).
Equity investors, on the other hand, may encourage the directors to take on risky projects. This is because equity
investors participate in any excess returns, but due to the protection provided by their limited liability status, they
cannot be forced to cover any losses.

3.2 Stakeholders
A company’s stakeholders can be grouped as follows:
 Internal − e.g. employees, directors;
 Connected − e.g. shareholders, customers, suppliers, competitors; and
 External − e.g. local and national communities, government, pressure groups.
Clearly, conflict between these various stakeholders is possible. For example, efforts to reduce environmental effects
(a community objective) is likely to reduce profit and, therefore, shareholder wealth.
While shareholders are clearly the key stakeholders, modern corporate governance suggests that directors should
take into account the objectives of a wider range of interested parties. Directors are therefore expected to show
responsibility to creditors (e.g. reasonable payment terms), employees (e.g. health and safety) and ultimately to
society as a whole through corporate social responsibility (e.g. minimising pollution, investing in social projects, etc).
Therefore, the overall corporate objective may become satisficing (i.e. producing satisfactory rather than maximum
returns for shareholders). With the rise of the ethical investor on world stock markets, it appears that many
shareholders are in fact willing to accept slightly lower returns in exchange for their companies following a wide range
of both financial and non-financial objectives.

3.3 Directors and Shareholders

In larger companies, the shareholders entrust the management of the company to the directors. This is referred to as
the separation of ownership from control. The directors are managing the company on behalf of the shareholders and
should always act in the best interests of the shareholders, while also taking into account the objectives of other
stakeholder groups.
This may not always be the case, as the directors may have other personal objectives, such as:
 increasing personal remuneration levels;
  maximising bonus payments;
 empire building; and/or
 job security.
In addition to the personal aspects shown above, a small number of directors have been guilty of not fulfilling their
fiduciary duties by encouraging an organisation to:
 use creative accounting, which can flatter the accounts (also known as window dressing);
 use off balance sheet financing (e.g. keeping liabilities off the statement of financial position by using
special purpose vehicles);
 reject takeover offers, with the directors' goal being to protect their own jobs rather than acting in the
interests of their shareholders; and/or
 disregard environmental issues, with directors allowing pollution emitting processes and product testing
on animals.
If directors follow personal objectives which conflict with those of their shareholders, this leads to agency costs (i.e.
lost potential returns for shareholders). This is often referred to as an agency problem.
Good corporate governance procedures (see s.3.5) should be implemented to minimise the effect of agency costs.
Unfortunately, the implementation of corporate governance brings its own costs (particularly in the case of the
Sarbanes-Oxley Act [2002] in the United States). A cost-benefit approach should therefore be taken to determine an
appropriate level of control over directors.
It can be argued that the actual return to shareholders = Maximum potential return − agency costs − cost of engaging
in corporate social responsibility.
To some degree, shareholders should be more active in monitoring the behaviour of directors. Most shares in listed
companies are held by institutional investors (e.g. pension funds). Fund managers have often been guilty of operating
in a very passive way. For example, proxy voting rights are not always exercised by institutional investors. Until there
is a rise in shareholder activism, it remains likely that some directors will continue to work in their own best interest.
3.4 Encouraging the Achievement of Stakeholder Objectives– Managerial Reward Schemes

Goal congruence occurs when the objectives of agents acting within an organisation align with the objectives of the
organisation. For example, managers should be encouraged to aim for long-term growth and prosperity rather than
short-term reported profitability.
Methods of encouraging goal congruence between directors and shareholders include:
 Performance-related pay − problems associated with relating pay or bonuses to the size of profit include
short termism (e.g. not investing for future growth to maintain high profits in the short term).
 Executive share option scheme − the evidence is mixed regarding the success of such schemes in
motivating directors to improve performance (e.g. a company's share price may rise due to a general rise
in the stock market rather than the quality of its management).
 Long-term incentive plans (LTIPs) − paying a bonus to directors if the company's performance over
several years is good when benchmarked against that of competitors.
 Transparency in corporate reporting.
 Increased shareholder activism (e.g. using voting rights).
 Improved corporate governance (e.g. through the appointment of truly independent non-executive
directors).

3.5 Encouraging the Achievement of Stakeholder Objectives– Corporate Governance

Definition

Corporate governance − the system by which companies are directed and controlled. The objective of corporate governance
may be considered as the reduction of agency costs to a level acceptable to shareholders.

3.5.1 Principles of Good Governance

Various countries have developed their own codes on corporate governance. Although detailed knowledge of
specific codes is not required, candidates should have an awareness of the main principles that underlie these codes:
 Every company should be headed by an effective board which should lead and control the company.
 There should be a clear division of responsibilities at the head of the company between running the board
(chairman) and running the business (CEO); no single individual should dominate.
 The board should have a balance of executive and independent non-executive directors.
  All directors should be required to submit themselves for re-election on a regular basis.
 Remuneration committees should be comprised of independent non-executive directors.
 Remuneration committees should provide the packages needed to attract, retain and motivate executive
directors and avoid paying more.
 No director should be involved in setting his own remuneration.
 The board should maintain a solid system of internal control to safeguard shareholders' investment and
the company's assets.
3.5.2 Government Regulation
The UK Corporate Governance Code is included in the Listing Rules of the London Stock Exchange. Although
compliance is not obligatory, any listed company which does not comply with the Corporate Governance Code must
explain its reasons for non-compliance.
The US Sarbanes–Oxley Act applies to all companies listed on a US stock market, including their foreign subsidiaries.
Compliance is mandatory.
3.5.3 Listing Regulations
Stock exchanges put in place rules and regulations to ensure that the stock market operates fairly and efficiently for all
parties involved in the market. A company must meet the listing requirements set out in the listing rules as part of its
approval process to become listed on a stock exchange.