Chapter 1 – Financial Management

Function
Chapter agenda

What is FM

Mission-goals-
objectives-
strategy

Stakeholder
Stakeholders
management

Managerial
FM function
reward schemes
Agency theory
Corporate
governance

Multiple
objectives

Not for Profit

VFM
Organisations

Performance
measurement

ACCA - Financial Management

Rukmal Devinda
What is FM ?
In any profit oriented organisation, the fundamental objective is to create more wealth for
their owners. In that managers must make 3 key decisions.

1. Investing – Investing refers to both short term and long term investments.
Short term investments are in working capital whilst long term investments focus on
large scale investment projects.

2. Financing – In order to make investments, firms should have funds. Funds are mainly
sourced from equity and debt. Managers must raise funds from the appropriate
source.

3. Dividends – Equity & debt holders provide capital/funds for business. These are used
in investments which generates returns for capital providers. Managers must decide
how to distribute returns to capital provider as it can affect the value of the firm.

In making these decision financial managers must take into account the following 3 factors.

1. Commercial and financial objectives of the firm

2. Broader economic environment in which the business operates

3. Risks associated with the decision and methods of managing that risk.

ACCA - Financial Management

Rukmal Devinda
The link between mission, goals, objectives & strategies

Mission
In its simplest mission sets out the whole purpose of the business

Goals
The firm should develop broad goals so that it full-fill the mission

Objectives
Goals are dissected into detailed commercial and financial objectives. Objectives should be
SMART.

The reason why objectives are divided into commercial & financial is because commercial
objectives cannot be expressed in monetary terms.

E.g. A commercial objective of a business could be to expand into new markets. The
financial objective of this move will be to increase the ROCE & EPS.

ACCA - Financial Management

Rukmal Devinda
Strategies
Once objectives and targets are set, the firm must then develop a plan to achieve them.
These plans are the corporate strategies.

Corporate strategies are set in all levels of a firm.

Corporate strategy
Also known as 'long-term planning' or 'corporate planning'. This is undertaken by the senior
management. They plan long term strategies and formulate long term objectives.

Business strategy
This involves breaking down long term plans, strategies into manageable chunks i.e. shorter
term plans for individual areas (departments/divisions) of the business.

Operational strategy
This involves making day-to-day decisions about what to do next and how to deal with
problems as they arise.

Financial objectives
At the end of the day, all businesses must maximise financial benefits of their owners.

Shareholder wealth maximization is the core concept/driving force of FM.

When maximising shareholder wealth, following factors should also be taken into account.

• Growth & development of the business

• Market share and power
• Treating employees right
• Full-filling regulatory obligations
• Concern on social welfare & environment

How are financial objectives measured?

Profitability ratios and investors ratios whether or not a firm has achieved its financial
objectives. (Ratios are discussed in FM in Chapter 19)

Profitability ratios – ROCE, GP margin, OP margin etc.

Investor ratios - EPS, PE, Dividend yield etc.

ACCA - Financial Management

Rukmal Devinda
Stakeholders of a business
There are a number of stakeholders a business.

They can be classified under the following headings.

Internal Connected External

Employees Equity holders Government
BoD (Board of Directors) Customers Regulators
Suppliers Pressure groups
Competitors Community
Financiers (banks)

When discussing about stakeholders, a key topic is stakeholder conflict management.

Managers must satisfy all the stakeholders when running the business. This inevitably gives
rise to conflicts.

The primary objective of any business is to maximise wealth to shareholders.

This, however conflicts with other many other key objectives.

Some examples for conflicts arisen

• Shareholders/owners seek high profits and so may be reluctant to see the business
pay high wages to staff

• A business decision to move production overseas may reduce staff costs. It will
therefore benefit owners but will inevitably result in job losses for many of its
employees.

• Firms will always want to delay payments for suppliers to improve short term cash
flows whereas the suppliers will want their payment ASAP.

• Firms want the highest profit possible on sales whereas customers want low prices
for high quality goods

In managing these conflicts, managers should balance the needs and objectives of all
stakeholders.

ACCA - Financial Management

Rukmal Devinda
Agency theory
This states that agents should act in the best interests of their principals. This is the principal
agent relationship.

However in reality, this does not hold as agents always tend to maximise their own benefits
at the expense of their principals.

Consider any accounting scandal that has happened in your country. These happen majorly
due to the agents i.e. board of directors committing fraud to maximise their own benefits.
However at the end, everyone loses out as these fraud finally lead to insolvency of firms.

Principal agent problem arise due to the divorce of ownership & control.

This means that, the ones who run the firm and own the firm are two different parties.

Think of any listed company.

Shareholders in these companies rely upon the management to pursue the objectives set
for them.

However in the recent past, with large scale company collapses it has been deemed that
directors have been making corporate decisions in their own interests rather than
for the benefit of the company as a whole and the shareholders in particular.

The following are proof to the statement above.

• High remuneration – Managers pay themselves thumping salaries and benefits &
bonuses. This reduces cash available for investments, dividend payments employee
& societal welfare purposes.

• Empire building – In its simplest this is the pursuit to enlarge the size, scope, and
influence of an individual or organization's power. This is often carried out through
mergers and acquisitions, vertical integration, and strategic alliances. This is
unhealthy for a firm, as managers often become more concerned with acquiring
greater resource control than with optimally allocating resources.

• Creative accounting -Despite the rigid accounting standards and subsequent audits,
directors use creative accounting techniques to show a better financial position &
artificially boost the share price. This involves capitalising expenses on the Bal sheet,
not depreciating NCA etc.

• Off balance sheet financing – This allows certain debt to be taken off from the
balance sheet (from the public)

ACCA - Financial Management

Rukmal Devinda
Reward schemes for managers
To ensure that managers take decisions which are consistent with the objectives of
shareholders, reward and remuneration packages must be carefully developed.

Reward policies should

• be clearly defined, impossible to manipulate and easy to monitor

• link rewards to changes in shareholder wealth/growth of the business (Share price)

• encourage managers to not undertake highly risky decisions that are not

Reward schemes

An executive share option scheme (ESOP) – This is when directors are allotted shares as a
reward. The logic is that if directors make decisions that lead to shareholder wealth
maximization, share price increases and as a result their wealth increases.
Therefore this encourages managers to maximise the value of the shares of the company,

Remuneration linked to economic value added (EVA) - EVA measures economic profit of a
firm. It is the difference between rate of return and cost of capita. Thus it measures the
change in shareholder wealth.

ACCA - Financial Management

Rukmal Devinda
Corporate governance (CG)
• The conflict between agents and principals have been addressed by corporate
governance codes

• Corporate governance in its simplest is how organisations are directed and

controlled.

• The aim of corporate governance initiatives is to ensure that companies are run well
in the interests of their shareholders and wider community.

• In the US Sarbanes and Oxley Act (2002) introduced a rigorous set of corporate
governance laws after the major accounting scandals such as Enron & WorldCom.

• UK also introduced a set of best practice corporate governance initiatives under UK

Governance Code.

• The following must be considered under CG

Executive directors (EDs)

• These are the BoDs

• They are considered the top brass of any business
• According to CG principles Chairman and Chief Executive Officer (CEO) roles should
be held by two different individuals
• All EDs must submit for re-election
• Financial rewards to EDs must be clearly disclosed in the financial statements.

Non-Executive directors (NEDs)

• NEDs must be independent from the company and must not get involved with the
day to day mgmt. of the operations.

• NEDs constructively challenge and help develop proposals on strategy.

• NEDs monitor the actions of EDs and evaluate the performance in meeting agreed
goals and objectives.

• NEDs determine appropriate levels of remuneration of executive directors and play a

major role in appointing and removing, executive directors

• NEDs ensure that EDs act in the best interests of shareholders.

• Companies generally recruit retired politicians, celebrities and Founders of other

companies as NEDs as they have a commanding power.

ACCA - Financial Management

Rukmal Devinda
Measuring the performance of a business
In order to measure the performance of a business, managers will need to use financial as
well as non-financial metrics.

Financial metrics are mainly ratios.

Non-financial metrics can be derived by referring to models such as the Balanced Score
Card. (Discussed in PM in ACCA)

Not-for-profit organisations (NFPs)

• These organisations do not focus on generating revenues, however they are
allocated a fixed budget within which they are expected to operate.

• Benefits generated are not quantified hence if a cost/benefit analysis is to be carried

this will involve a high a level of judgements made which is subjective.

E.g. Imagine an environmental organisation carrying out a REFORESTATION program. There

will be an expenditure budget for the project. Also they may raise funds from different
sources such as donations and grants to finance the project.

The project may generate number of indirect social benefits such as increased agricultural
output due to improved rainfall, increased in fisheries output etc which may cannot be
quantified using a standard methodology. Hence a higher degree of judgements will need to
be incorporated if a cost-benefit analysis is to be carried out.

Value for money is a concept that is widely used in not-for-profit organisations. However
“value” is not measured accurately.

ACCA - Financial Management

Rukmal Devinda
Multiple objectives of NFPs
In a typical not-for-profit organisation there can be multiple stakeholders.

Maximisation of benefits of these stakeholders is the primary objective of these

organisations. In achieving this there will be a mix of financial and non-financial objectives.

Multiple stakeholders in not-for-profit organisations give rise to multiple objectives.

As a result, there is a need to prioritise objectives or to make compromises between
objectives.

With NFPs, the non-financial objectives are often more important and more complex,
because of the following:

• Most key objectives are very difficult to quantify, especially in financial

terms e.g. quality of care given to patients in a hospital

• Multiple and conflicting objectives are more common in NFPs, e.g. quality
of patient care versus the number of patients treated.

Value for money (VFM)

This is a widely used method of assessing public sector performance. This comprises of three
elements:

Economy – an input measure. Are the resources used the cheapest possible for the quality
required?

𝐼𝑛𝑝𝑢𝑡
𝐸𝑐𝑜𝑛𝑜𝑚𝑦 =
𝐶𝑜𝑠𝑡

Efficiency – here we link inputs with outputs. Is the maximum output being achieved from
the resources used?

𝑂𝑢𝑡𝑝𝑢𝑡
𝐸𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑐𝑦 =
𝐼𝑛𝑝𝑢𝑡

Effectiveness – an output measure looking at whether objectives are being met.

𝑉𝑎𝑙𝑢𝑒
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒𝑛𝑒𝑠𝑠 =
𝑂𝑢𝑡𝑝𝑢𝑡

!"#$% )$%#$% *+,$-

Value For Money = 𝑥 𝑥
&'(% !"#$% )$%#$%

ACCA - Financial Management

Rukmal Devinda
Performance measurement of NFPs
Though not-for-profit organisations are not driven by incomes and profits, it does not mean
that they can operate without the need to plan and control.

As a matter of fact due to high level of expenditures and limited funding, these enterprises
are now under increased pressure to do their activities in a cost efficient way.

This requires in identifying and implementing performance metrics.

E.g. University is an example of a non-profit making organisation. The following typical

performance metrics can be observed.

• Overall costs compared with budget

• Numbers of students
• Amount of research funding received
• Proportion of successful students (by grade)
• Quality of teaching – as measured by student and inspector

Therefore it should be noted, there are no standardized set of metrics that can be employed
to measure the performance of a NFP as the metrics depend on the type of NFP.

ACCA - Financial Management

Rukmal Devinda