Chapter 1

Financial Management and

Financial Objectives
1. The nature and purpose of financial management
1.1 What is Financial Management
Financial Management can be defined as the management of the
finance of an organization in order to achieve the financial objectives of
the organization
1.2 Financial Planning
Financial Manager need to plan to ensure that enough funding is
available at right time to meet the needs of the organization for short-,
medium- and long-term capital
1. The nature and purpose of financial management
1.3 Financial Control
The control function of the financial manager becomes relevant for
funding which has been raised. For this, the financial manager may
compare data on actual performance with forecast performance.
1.4 Financial Management Decisions
The financial manager makes decisions relating to investment, financing
and dividends. The management of risk must also be considered.
1. The nature and purpose of financial management
1.5 Management accounting, financial accounting and financial
management
Not only people inside the organization but external organization also
need information. Managerial accounts provide internally used
information and Financial accounting function provide externally used
information.
Management Information provides a common source for which
financial and management accounts are prepared.
2. Financial Objectives and the relationship with
corporate strategy
2.1 Strategy
Strategy may be define as a course of action, including the specification
of resources required, to achieve a specific objective.
Corporate strategy is concerned with the overall purpose and scope of the organization and
How value will be added to the different parts of the organization.
2.2 Corporate Objectives
Corporate objectives are relevant for the organization as a whole,
relating to key factors for business success, such as:
1) Profitability (return on investment) 2) Market share 3) Growth
4) Cash flow 5) Customer satisfaction 6) The quality of the firm’s products
7) Industrial relations 8) Added value
2. Financial Objectives and the relationship with
corporate strategy
2.3 Financial objectives
Financial targets may include targets for: earnings; earnings per share;
dividend per share; gearing level; profit retention; operating
profitability.
2.3.1 Shareholder wealth maximization
Primary objective of a company is to maximize shareholders’ wealth.
Three Possible methods for valuation of a company:
1) Statement of financial position (Balance sheet) valuation
2) Break-up Basis
3) Market Value
2. Financial Objectives and the relationship with
corporate strategy
2.3.2 Profit maximization
In much economic theory, it is assumed that the firm behave in such a
way as to maximize profits, where profit is viewed in an economist’s
sense.
Where the entrepreneur is in full managerial control of the firm, as in
the case of a small owner-managed company or partnership, the
economist’s assumption of profit maximization would seem to be very
reasonable.
Although profits do matter, they are not the best measure of a
company’s achievement.
2. Financial Objectives and the relationship with
corporate strategy
2.3.3 Earning per share growth (EPS)
Earning per share is calculated by dividing the net profit or loss
attributed to ordinary shareholders by the weighted average number of
ordinary shares.
EPS is widely used as a measure of a company’s performance and is of
particular importance is a comparing results over a period of several
years
Note that:
a) EPS is a figure based on past data
b) It is easily manipulated by changes in accounting policies and by mergers or acquisitions
2. Financial Objectives and the relationship with
corporate strategy
2.3.4 Other financial targets
In addition to target for earning a company might set other financial
targets, such as:
a) A restriction on the company’s level of gearing, or debt
b) A target for profit retentions
c) A target for operating profitability
These financial targets are not primary financial objectives, but they
can act as subsidiary targets or constraints which should help a
company to achieve its main financial objective without incurring
excessive risks.
2. Financial Objectives and the relationship with
corporate strategy
2.4 Non-financial objectives
A company may have important non-financial objectives which must
be satisfied in order to ensure the continuing participation of all
stakeholders. Without their participation, the financial objectives such
as maximizing shareholder wealth may be compromised in the future.
Examples of non-financial objectives are as follows:
a) The welfare of Employees
b) The welfare of management
c) The provision of a service
d) The fulfilment of responsibilities towards customers
e) The fulfilment of responsibilities towards suppliers
f) The welfare of society as a whole
3. Stakeholders
Stakeholders Groups
Internal Employees and pensioners
Managers
Directors
Connected Shareholders
Debt Holders (Bond holders)
Customers
Bankers
Suppliers
Competitors
External Government
Pressure groups
Local and national communities
Professional and regulatory bodies
3. Stakeholders
3.1 Objectives of stakeholder groups
Various groups of stakeholder in a firm will have different goals. Some
of the important aspects of these goals areas follows:
a) Ordinary (equity) shareholders: Usually their goal will be to maximize the
wealth which they have as a result of the ownership of the shares.
b) Trade payables (creditors): They have objective of being paid by due date. On
another hand, they usually wish to ensure that they continue their trading
relationship with the firm.
c) Long-term payables (creditors): Banks have the objectives of receiving
payments of interest and capital on the loan by the due date for the repayment.

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3. Stakeholders
3.1 Objectives of stakeholder groups
d) Employees: Employees will usually want to maximize their rewards paid to
them in salaries and benefits. Most employees will also want to continuity of
employment.
e) Government: Government has objectives which can be formulated in political
terms. Government agencies also keep an eye on firms’ activities for taxation
on profit, provision of grants, health and safety legislation and so on. Policies
will often be related to objectives, such as sustained economic growth and high
levels lf employment.
f) Management: Management has the objectives of maximizing its own rewards.
Director and management must manage the company for the benefits of
shareholders. So, the objective of reward maximization might conflict with the
exercise of this duty.
3. Stakeholders
3.2 Stakeholder groups, strategy and objectives
The action of stakeholder groups in pursuit of their goals can exert
influence on strategy and objectives. The grater the powers of
stakeholder, the greater will be their influence. Each group has will have
different wants. So, different expectations of each stakeholder group
may conflict.
Each group, however will influence strategic decision making.
3. Stakeholders
3.3 Shareholder and management
Although shareholders are the owners of the company, however
actual power of shareholders tend to restricted, except in companies
where shareholders are also directors. The day to day running of a
company is the responsibility of management.
The relationship between management and shareholders is some times
referred to as agency relationship, in which managers act as agents for
the shareholders.
3. Stakeholders
3.4 Shareholder, managers, and the company’s long-term creditors
The relationship between long-term creditors of a company, the
management and the shareholders of a company encompasses the
following factors:
a) Management may decide to rise finance for a company by taking out long-term
loans or issuing bonds in the case of larger companies.
b) Investors who provide debt finance will rely on the company’s management to
generate enough net cash inflows to make interest payment on time, and to
eventually to re pay loans
c) The money that is provided by long-term creditors will be invested to earn
profits, and the profits will provide extra dividends or retained profits for the
shareholders of the company.
3. Stakeholders
3.5 Shareholder, managers, and government
The government does not have direct interest in companies. However,
the government does often have a strong indirect intrest in companies’
affairs.
a) Taxation: Rise of taxes on sales on shareholders’ dividends.
b) Encouraging new investment: The government might provide funds towards
the cost of some investment projects
c) Encouraging a wider spread of share owners: UK Government has made some
attempt to encourage more private individuals to become shareholder.
d) Legislation: The also influences companies and the relationship shareholders,
creditors, management, employees and the general public through legislation.
e) Economic Policy: The governments economic policy will affect business activity
4. Measuring the achievement of corporate
objectives
4.1 Measuring financial performance
As part of financial control, managers need to know that how well the company is
doing. A common way of ding this is ratio analysis, which is concerned with
comparing and quantifying relationship between financial variables.
4.2 The broad categories of ratio
Ratios can be grouped into the following four categories.
a) Profitability
b) Debt and gearing
c) Liquidity
d) Shareholder’s investment ratios (stock market ratios)
4. Measuring the achievement of corporate
objectives
4.3 Ratio pyramid
The Du Pont system of ratio analysis involves constructing a pyramid of
interrelated ratios as shown bellow.
Returns on equity

Returns on investment x Total assets ÷ Equity

Returns on sales
x Asset Turnover
(Profit margin)

Net Income ÷ Sales Sales ÷ Total assets

Sales − Total Cost Non-current assets + Current assets

4. Measuring the achievement of corporate
objectives
•4.4
  Profitability
A company ought of course to be profitable if it is to maximize shareholder wealth, and
obvious checks on profitability are:
a) Weather the company has made a profit (loss) of in its ordinary activities
b) By how much this year’s profit (loss) is bigger or smaller than last year’s profit
(loss)
4.4.1 Profitability and return: the return on capital employed
You cannot assess profits or profit growth properly without relating them to the
amount of funds employed in making the profits. The most important profitability ratio
is therefore return on capital employed (ROCE) or return in investment (ROI)
4. Measuring the achievement of corporate
objectives
•   Evaluating the Return on Capital Employed (ROCE)
4.4.2
What does a company’s ROCE tells us? What should we be looking for? There are three
comparisons that can be made.
a) The change in ROCE form one year to the next
b) The ROCE being earned by other companies, if this information is available
c) A comparison of the ROCE with current market borrowing rates
4.4.3 Secondary ratios
We may analyze the ROCE by looking at the kinds of interrelationship between ratios
used in ratio pyramid. Profit margin and asset turnover together explain the ROCE, and
if the ROCE is the primary profitability ratio, these other two are the secondary ratios.
4. Measuring the achievement of corporate
objectives
•   Return on equity
4.4.4
Another measure of the firm’s overall performance is return on equity.

4.4.5 Gross profit margin, the net profit margin and profit analysis
Depending on the format of the statement of profit or loss, you may be able to
calculate the gross profit margin and also the net profit margin. Looking at the two
together can be quite informative.
4. Measuring the achievement of corporate
objectives
•   Example: Profit Margins
4.4.6
A company has the following summarized statements off profit or loss for two yerars
consecutive years.
Year 1 Year 2
$ $
Sales revenue 70,000 100,000
Less cost of sales 42,000 55,000
Gross profit 28,000 45,000
Less expenses 21,000 35,000
Net profit 7,000 10,000

Although the net profit margin is the same for both years at 10%, the gross profit
margin is not.

In year 1 it is: and in year 2 it is:

4. Measuring the achievement of corporate
objectives
4.5 Debt and gearing ratios
Financial rearing is the amount of debt finance a company uses relative to its equity
finance.

a) When a company is heavily in debt, and seems to be getting even more heavily into
debt , banks and other would be lenders are very soon likely to refuse further
borrowings.

b) When a company is earning only a modest profit before interest and tax, and has a
heavy debt burden, there will be very little profit left over for shareholders after
the interest charges have been paid.
4. Measuring the achievement of corporate
objectives
4.6 Liquidity ratios: cash and working capital
Profitability is of course an important aspect of a company’s performance, and debt or
gearing is another. Neither, however, directly addresses the key issue of liquidity. A
company needs liquid assets so that it can meet its debts when they fall due. The
main liquidity ratios will be described in chapter 4.
4. Measuring the achievement of corporate
objectives
4.7 Shareholders’ investment ratios
Returns to shareholder are obtained in the form of dividends received and capital
gains form increase in market value.

A company will only be able to raise finance if investors think that the returns they can
expect are satisfactory in view of the risks they are taking.

Indicators that can be used to assess to investor returns are:

a) Dividend yield
b) Earning per share (EPS)
c) Price earning ratio (P/E ratio)
d) Dividend cover
4. Measuring the achievement of corporate
objectives
•   Dividend yield
4.7.1
The dividend yield is the return a shareholder is currently expecting on the shares of a
company

4.7.2 Earning per share

The use of earning per share was discussed in section 2.3.3 of this chapter
4. Measuring the achievement of corporate
objectives
•   The price earnings ratio
4.7.3
The price earnings ratio is a useful yardstick for assessing the relative worth of a share

4.7.4 Example: Price earnings ratio

A company has recently declared a dividend of 12c per share. The share price is $3.72
cum div and earning for the most recent year were 30c per share. Calculate the P/E
ratio.

Solution:
4. Measuring the achievement of corporate
objectives
4.7.5 Changes in EPS: the P/E ratio and the share price
An approach to assessing what share price ought to be, which is often used in practice,
is a P/E ratio approach.

a) The relationship between the EPS and the share price is measured by the P/E ratio.

b) The P/E ratio tends to change gradually and is reasonably consistent between
companies operating in similar businesses.

c) So if the EPS goes up or down, the share price should be expected to move up or
down too, and the new share price will be the new EPS multiplied by the constant
P/E ratio.
5. Encouraging the achievement of stakeholder
objectives
5.1 Managerial reward schemes
The agency relationship arising from the separation of ownership from management is
sometimes characterized as the ‘agency problem’.

It is argued that management will only make optimal decisions if they are monitored
and appropriate incentives are given.

Examples of such remuneration incentives are:

a) Performance- related pay

b) Reward managers with shares

c) Executive share option plans (ESOPs)

5. Encouraging the achievement of stakeholder
objectives
5.1.1 Benefits consequences of linking reward schemes and performance
a) Performance-related pay may give individuals an incentive to achieve a good
performance level.
b) Effective schemes also succeed in attracting and keeping the employees that are
valuable to the organization.
c) By trying an organization’s key performance indicators to a scheme, it is clear to all
employees what level of performance is expected of them and helps communicate
their role in attempting to create organizational success.
d) By rewarding performance, an effective scheme creates an organization focused on
continuous improvement.
e) Schemes based on shares can motivate employees/managers to act in the long-
term interests of the organization by doing things to increase the organization’s
market value.
5. Encouraging the achievement of stakeholder
objectives
5.1.2 Problems associated with reward schemes
a) A serious problem that can arise is that performance-related pay and
performance evaluation system can encourage dysfunctional behavior.
b) Perhaps even more concern are the numerous examples of managers
making decisions that are contrary to the wider purposes of the
organization.
c) Schemes designed to ensure long-term achievements may not motivate
since effort and reward are too distant in time from each other.
d) It is questionable whether any performance measure can provide a
comprehensive assessment of what a single person achieves for an
organization.
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5. Encouraging the achievement of stakeholder
objectives
5.1.2 Problems associated with reward schemes
e) Self-interested performance may be encouraged at the expense of
teamwork.
f) High levels of output may be achieved at the expense of quality
g) In order to make bonuses more accessible, standards and targets may
have to be lowered, with knock-on effects on quality
h) They undervalue intrinsic rewards given that they promote extrinsic
rewards
5. Encouraging the achievement of stakeholder
objectives
5.2 Regulatory requirements
The achievement of stakeholder objectives can be enforced using
requirements such as corporate governance codes of best practice and
stock exchange listing regulations
5.2.1 Corporate Governance
Corporate governance is the system by which organizations are directed
and controlled
5. Encouraging the achievement of stakeholder
objectives
5.2.1 Corporate Governance
There are a number of key elements in corporate governance
a) The management and reduction of risk is fundamental issue in all definitions of
good governance, whether explicitly stated or merely implied.
b) The notion that overall performance is enhanced by good organizational structures
and management practice within set best practice guidelines underpins most
definitions
c) Good governance provides a framework for an organization to pursue its strategy in
an ethical and effective way from the perspective of all stakeholder groups affected,
and offers safeguards against misuse of resources, physical or intellectual.
d) Good governance is not just about externally established codes but also requires a
willingness to apply the spirit as well as the letter of the law.
e) Accountability is generally a major theme in all governance framework
5. Encouraging the achievement of stakeholder
objectives
5.2.1 Corporate Governance
Corporate governance codes of good practice generally cover the following frameworks
a) The board should be responsible for taking major policy and strategic decisions
b) Directors should have mix of skills and their performance should be assessed
regularly
c) Appointments should be conducted by formal procedures administrated by a
nomination committee
d) Division of responsibility at the head of an organization is most simply achieved by
separating the roles of chairman and chief executive
e) Independent non-executive directors have a key role in governance
f) Directors’ remuneration should be set by a remuneration committee consisting of
independent non-executive directors
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5. Encouraging the achievement of stakeholder
objectives
5.2.1 Corporate Governance
g) Remuneration should be dependent on organization and individual performance
h) Accounts should disclose remuneration policy and the packages of individual
directors
i) Board should regularly review risk management and internal control, and carry out
a wider review annually, the results of which should be disclosed in the accounts
j) Audit committee of independent non-executive directors should liaise with
external auditors, supervisors internal audit, and review the annual accounts and
internal controls
k) The board should maintain a regular dialogue with shareholders, particularly
institutional shareholders.
l) Annual reports must convey a fair and balanced view of the organization.
5. Encouraging the achievement of stakeholder
objectives
5.2.2 Stock exchange listing regulations
A stock exchange is an organization that provides a marketplace in which
to trade shares.
The stock exchange operates as two different markets:
• It is a market for issuers who wish to raise equity capital by offering
shares for sale to investors
• It is also a market for investors who can buy and sell shares at any time,
without directly affecting the entities in which they are buying the shares
To be listed on a stock exchange, a stock must meet the listing
requirements
6. Not-for-profit organizations
6.1 Voluntary and not-for-profit sectors
• Not-for-profit and public sector organizations have their own objectives,
generally concerned with efficient use of resources in the light of
specified targets
• An organization whose attainment of its prime goal is not assessed by
economic measures. However, in pursuit of that goal it may undertake
profit-making activities.'
• The not-for-profit sector may involve a number of different kinds of
organization with, for example, differing legal status – charities, statutory
bodies offering public transport or the provision of services such as
leisure, health or public utilities such as water or road maintenance.
6. Not-for-profit organizations
6.2 Objectives
Here are some possible objectives for a NFP organization
Surplus maximization (equivalent to profit maximization)
Revenue maximization (as for a commercial business)
Usage maximization (as in leisure center swimming pool usage)
Usage targeting (matching the capacity available, as in the NHS)
Full/partial cost recovery (minimizing subsidy)
Budget maximization (maximizing what is offered)
Producer satisfaction maximization (satisfying the wants of staff and volunteers)
Client satisfaction maximization (the police generating the support of the
public)
6. Not-for-profit organizations
6.3 Value for money
• Value for money is getting the best possible combination of services from
the least resources.
• It is reasonable to argue that not-for-profit organizations best serve
society's interests when the gap between the benefits they provide and
the cost of providing those benefits is greatest.
• This is commonly termed value for money and is not dissimilar from the
concept of profit maximization, apart from the fact that society's
interests are being maximized rather than profit.
6. Not-for-profit organizations
6.4 Example: Economy, efficiency, effectiveness
• Economy. The economy with which a school purchases equipment can be
measured by comparing actual costs with budgets, with costs in previous
years, with government/ local authority guidelines or with amounts
spent by other schools.
• Efficiency. The efficiency with which a school's IT laboratory is used might
be measured in terms of the proportion of the school week for which it is
used.
• Effectiveness. The effectiveness of a school's objective to produce quality
teaching could be measured by the proportion of students going on to
higher or further education.
6. Not-for-profit organizations
6.5 Performance measures
• Value for money as a concept assumes that there is a yardstick against
which to measure the achievement of objectives. It can be difficult to
determine where there is value for money, however.
• Not-for-profit organizations tend to have multiple objectives, so that
even if they can all be clearly identified it is impossible to say which is the
overriding objective 
• Outputs can seldom be measured in a way that is generally agreed to be
meaningful.

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6. Not-for-profit organizations
6.5 Performance measures
Here are a number of possible solutions to these problems.
Performance can be judged in terms of inputs.
Accept that performance measurement must to some extent be
subjective.
Most not-for-profit organizations do not face competition but this does
not mean that they are all unique.