FINANCIAL MANAGEMENT 121

FBS 121
UNIT 1
Introduction to
Financial Management &
Management Accounting

LEARNING AREA 1
INTRODUCTION TO:
FINANCIAL MANAGEMENT AND MANAGEMENT ACCOUNTING

LEARNING OUTCOME:
After having completed this learning area you as a learner will understand the context of
Financial Management in an enterprise and the role and importance of Management
Accounting in an enterprise.
ASSESSMENT CRITERIA:
The learner must be able to do the following on completion of this learning area:

Define what Financial Management is

Understand the objective of financial management in maximising the value of an

enterprise for its stakeholders

Define the role of the financial manager within the enterprise

Understand the role of corporate finance in relation to accounting and the economic
environment and markets

Describe the various forms of an organisation found

Identify ways in which the forms of an ownership can change

Understand the role of financial and non-financial objectives of the firm, with particular
emphasis being placed on sustainable wealth creation, shareholder value
maximisation, the environmental and social contexts within which an enterprise
operates and the trade-off often required in meeting objectives

Define the agency problem and understand the role and importance of the agency
theory in an enterprise

Differentiate between financial reporting (financial accounting) and management

accounting

Understand the decision-making process and identify the different types of information
which management needs depending on the stage at which management is at in the
decision-making process

Understand the impact of the changing competitive environment on the enterprise

INTRODUCTION
TO
FINANCIAL
MANAGEMENT ACCOUNTING

MANAGEMENT

AND

TABLE OF CONTENTS
Page
1

Introduction ..................................................................................................

Definition of Financial Management .............................................................

The Objectives of Financial Management and Maximising the Value

of an Organisation ........................................................................................

Role of the Financial Manager within an Enterprise .....................................

The role of corporate Finance in relation to Accounting and the

Economic Environment ................................................................................

The Various Forms of Business Organisations ............................................

Change in the Ownership of Organisations..................................................

The Role of Financial and Non-financial Objectives of the Firm ...................

Agency Problem and the Role and Importance of the Agency Theory
in an Enterprise ............................................................................................

Financial Reporting (Financial Accounting) and Management

Accounting ...................................................................................................

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11

The Decision-making Process ....................................................................

10

12

The Impact of the Changing Competitive Environment on the

Enterprise.....................................................................................................

11

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1 INTRODUCTION
The primary purpose of engaging in business is essentially for the delivery of products or
services required by a wider population who have a need for these products and services.
The definition of products and services includes both physical items such as clothing and
foodstuffs as well financial products such as a range of banking packages as examples. The
delivery of these products and services has a financial implication as money, essentially in
the form of cash, is required for the delivery thereof. To ensure for both a sustainable
existence for the delivery of the products and services as well as providing returns to both
the providers of this cash and rewarding the physical efforts and associated risks of those
providing the products and services, cash needs to be effectively managed and controlled.
For this reason financial management has developed out of necessity into the subject area
upon which you are about to embark.
2 DEFINITION OF FINANCIAL MANAGEMENT
Financial management is that managerial activity which, through planning and controlling of
the organisation's financial resources, ensures that the objectives stated above are met. This
is accomplished by planning, directing, monitoring, organising and controlling the monetary
resources of an organisation.
Financial Management can be defined as:
Financial Management means planning, organizing, directing and controlling the financial
activities of the enterprise. It means applying general management principles to financial
resources of the enterprise. It concerns itself with the management of the finances of an
organisation in order to achieve the financial objectives of the organisation. The key
objectives of financial management would be to:

Create wealth for the business

Generate cash, and
Provide an adequate return on investment bearing in mind the risks that the business
is taking and the resources invested

There are three key elements to the process of financial management:

Financial Planning
Management need to ensure that enough funding is available at the right time to meet the
needs of the business. In the short term, funding may be needed to invest in equipment and
stocks, pay employees and fund sales made on credit.
In the medium and long term, funding may be required for significant additions to the
productive capacity of the business or to make acquisitions.
Financial Control
Financial control is a critically important activity to help the business ensure that the business
is meeting its objectives. Financial control addresses questions such as:

Are assets being used efficiently?

Are the businesses assets secure?
Do management act in the best interest of shareholders and in accordance with
business rules?

Financial Decision-making
The key aspects of financial decision-making relate to investment, financing and dividends:

Investments must be financed in some way however there are always financing
alternatives that can be considered. For example it is possible to raise finance from
selling new shares, borrowing from banks or taking credit from suppliers
A key financing decision is whether profits earned by the business should be retained
rather than distributed to shareholders via dividends. If dividends are too high, the
business may be starved of funding to reinvest in growing revenues and further profits.

The course Financial Management over the duration of your studies will be split into two key
areas. viz:
Management Accounting This concerns itself with the internal operating activities of an
enterprise. Typically it focuses on the manufacturing environment dealing with issues such
as what is the cost of producing a product or delivering a service, the impact of decisions
taken in the manufacturing process e.g. replacing, expanding of products etc. and ensuring
that these costs are incurred as cost effectively as possible.
This will essentially dealt with in your second, third and final year of studies.
Financial Management Accounting This concerns itself with the funding activities of an
enterprise. Typically it focuses on the markets dealing with issues such as what are the
forms of funding available in the market place, the costs associated with each of the
respective funds, structuring thereof and optimising levels of inventory and funding. It also
includes valuation of entities and determination of share prices.
This will essentially dealt with in your third and final year of studies.
This subject is about collecting data, analysing it and converting it into useful information to
facilitate the process of managing situations in general and business specifically.

THE OBJECTIVES OF FINANCIAL MANAGEMENT AND MAXIMISING THE VALUE

OF AN ORGANISATION

The Scope of Financial Management can be summarised as follows:

Investment Decisions includes investment in fixed assets (called capital budgeting).
Investments in current assets are also a part of investment decisions called working capital
decisions.
Financial Decisions They relate to the raising of finance from various resources which will
depend upon decisions as to type of source, period of financing, cost of financing and the
returns thereon.
Dividend Decisions The finance manager has to take decision with regards to the net profit
distribution. Net profits are generally divided into two:
Dividend for shareholders - Dividend and the rate of it has to be decided.
Retained profits - Amount of retained profits has to be finalized which will depend upon
expansion and diversification plans of the enterprise.

The Objectives of Financial Management

Financial management is generally concerned with procurement, allocation and control of
financial resources of a concern. The objectives can be

To ensure that products and services are appropriately determined in terms of their cost
To ensure that appropriate decisions, in terms investing and funding, are made leading
to the optimising of the organisations value
To ensure regular and adequate supply of funds to the concern.
To ensure adequate returns to the shareholders which will depend upon the earning
capacity, market price of the share, expectations of the shareholders?
To ensure optimum funds utilization. Once the funds are procured, they should be
utilized in maximum possible way at least cost.
To ensure safety on investment, i.e, funds should be invested in safe ventures so that an
adequate rate of return can be achieved.
To plan a sound capital structure. There should be sound and fair composition of capital
so that a balance is maintained between debt and equity capital.

ROLE OF THE FINANCIAL MANAGER WITHIN AN ENTERPRISE

Traditionally the role of the financial manager (known as an accountant or accounts

manager) was limited to managing business finance or 'counting the beans.' This has,
however, changed from its traditional view to one which extends itself to a wider range of
functions. This was largely brought about by the advancements in computer and information
technology, emergence of multi-product and multi-division corporations with complex and
dynamic organizational set-ups, increasing global competition etc.
Essentially the role of the financial manager (FM) can be depicted as follows:

Business management - i.e. FM has a key role in overall business management

Prudent or rational use of capital resources - proper allocation and utilization of funds
Careful selection of the source of capital - Determining the debt equity ratio and
designing a proper capital structure for the corporate
Goal achievement - ensuring the achievement of business objectives viz. wealth or profit
maximization.

The functions of financial management will include:

1. Establishing capital requirements
This will depend upon expected costs and profits, available capacities and future
programmes and policies of the enterprise.
2. Determination of capital composition
This involves the raising of appropriate proportions short-term and long-term debt and
equity. The choices may include loans, debentures, shares etc.
3. Investment of funds
The finance manager has to facilitate identification of profitable ventures ensuring
safety on investment and regularity of returns.
4. Distribution of surplus
Decisions requiring what proportion of funds need to be retained and what proportion
needs to be distributed to relevant stakeholders.

5. Management of cash
Cash is required for many purposes like payment of wages and salaries, payment of
electricity and water bills, payment to creditors, meeting current liabilities,
maintenance of enough stock, purchase of raw materials, etc.
6. Financial controls
This can be done through many techniques like ratio analysis, financial forecasting,
cost and profit control, etc.
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THE ROLE OF CORPORATE FINANCE IN RELATION TO ACCOUNTING AND THE

ECONOMIC ENVIRONMENT

Finance and accounting activities are closely linked and are at times overlapping. Often
times this role is performed by one person in some small and medium sized entities. This
said, it should be noted that there are two main differences between the two. Accounting is
prepared on the accrual basis of accounting while finance places more emphasis on cash
flows. The second difference comes in with decision-making. Accountants devote most of
their attention in the collection and presentation of financial data. Financial managers, on the
other hand, evaluate these accounting statements and develop additional data to be able to
make decisions on the basis of their assessments.
It is expected of finance professionals to understand the economic activity and changes in
economic policy. They must be able to use economic theories as guidelines for efficient
business operation. Therefore the field of finance is closely related to activities in the
economic environment. The primary economic principle that is used in finance is marginal
cost-benefit analysis, the principle that financial decisions should be made and actions be
taken only when benefits exceed the costs.
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THE VARIOUS FORMS OF BUSINESS ORGANISATIONS

There are various forms of organisations that can be found. In South Africa there are four
most common legal forms of organisations. These are close corporations, companies,
partnerships and sole proprietorships, among many other specialised forms. In future studies
emphasis will be placed on companies.
Close Corporations
The Close Corporation Act of 1984 gave rise to what has become South Africas most
popular legal form, the close corporation (CC). A CC may have a minimum of 1 member and
a maximum of 10 members. Members may only be natural persons, as defined. Members
have a limited liability in terms of debt incurred by the entity. Members may not transfer their
interest in the CC to non-members without consent from other members.
It should be noted that with the Companies Act 71 of 2008 no new CCs may be formed. Old
CCs may continue trading but are encouraged to change to companies. This may be seen
as the Department of Trade and Industrys way of culling CCs out of the system and
promoting companies as legal entities.
Companies
A company is often referred to as a legal entity and that is because it has the powers of an
individual in that it can sue and can be sued and enters into contracts in its own name. This
type of entity was first introduced by the Companies Act 61 of 1973. The act has since been
rewritten to the Companies Act 71 of 2008.

Owners of a company are known as shareholders as ownership takes place when one buys
shares in a company. There are mainly ordinary shares and preference shares, with ordinary
shares being the most popular way of obtaining ownership in a company. In return for
injecting capital into the entity, through buying shares, shareholders receive dividends or
capital growth through the increase in share price. Dividends are defined as periodic
distributions of earnings to the shareholders of a company.
Companies are controlled in a democratic manner. This is evidenced through the many
requirements in the Companies Act. Shareholders entrust the control of the entity to a board
of directors that is elected by them. There are many requirements set out in the Companies
Act to ensure that the board comprises of the right calibre of people to control the entity,
other than an old-boys club. The board comprises of executive, non-executive and
independent directors. Executive directors are those that are charged with the day-to-day
running of the entity while non-executives do not. Independent directors are those that do not
have any close relationship with the company. The board may also have sub-committees
such as the audit committee, remuneration committee, among many others. This is to assist
the board in executing their responsibility to develop strategic goals for the company, hiring
and firing, setting general policies, guiding corporate affairs and compensating and
monitoring key personnel.
It should be noted that companies may take various forms and these forms are set out in the
Companies Act.
Partnerships
A partnership consists of between two and twenty individuals doing business together. Their
association is documented in a partnership agreement, a contract between the partners.
Unlike a close corporation, all partners have unlimited liability and each is legally liable for all
the debts in the partnership. A partnership is dissolved each time a partner dies.
Sole Proprietorship
This is also known as a sole trader. This is a business owned by one person who operates it
for their own profit. Sole proprietors are normally small in size. The trader has unlimited
liability.

CHANGE IN THE OWNERSHIP OF ORGANISATIONS

Close Corporations
Members of a CC may sell their interest to other natural persons once permission is granted
by the other members to transfer the interest.
Companies
There are various ways to transfer ownership in a company; the most popular way is through
a sale of shares. For public-interest companies, these shares are traded openly on the stock
exchanges. In South Africa shares are traded in the Johannesburg Stock Exchange.
Partnerships
With every new partner that joins the partnership and every partner that leaves the
partnership, a new partnership agreement is prepared.

Sole Proprietorship
Owners of small businesses may sell their operations to interested parties at a value
deemed fair by all parties.

THE ROLE OF FINANCIAL AND NON-FINANCIAL OBJECTIVES OF THE FIRM

This document has thus far been placing emphasis on financial objectives. It should be
noted that firms objectives can at times not be quantified and these are known as nonfinancial objectives.
After the market exuberance of the dot com bubble in the late 1990s, the sobering up period
that followed the bust brought with it a renewed interest in the concept of shareholder value.
Since then, all kinds of companies have been publicly proclaiming their commitment to
increasing long-term value for their shareholders. One look at the statements of directors or
chief executives in annual reports can confirm this. Headlines such as, Value is the acid test
of good governance, Is good governance good value? or Returning value by
governance, all taken from the Financial Times in the last few years, show the influence that
accounting scandals and the market downturn of the early 2000s have had on corporate
discourse.
Shareholder value is often a financial objective but in recent times there has been a growing
emphasis on sustainability of the value created. Sustainability often takes into account some
non-financial factors such as the environment where the entity operates.
Is the shareholder wealth maximisation objective consistent with concern for social
responsibility? In most cases, it is. As far back as 1776, Adam Smith recognised that, in a
market-based economy, the wider needs of society are met by individuals pursuing their own
interests: It is not from the benevolence of the butcher, the brewer, or the baker, that we
expect our dinner, but from their regard to their own interest. The needs of customers and
the goals of businesses are matched by the invisible hand of the free market mechanism.
There will always be individuals in business seeking short-term gains from unethical
activities. But, for the vast majority of firms, such activity is counterproductive in the longer
term. Shareholder wealth rests on companies building long-term relationships with suppliers,
customers and employees, and promoting a reputation for honesty, financial integrity and
corporate social responsibility. After all, a major companys most important asset is its good
name.
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AGENCY PROBLEM AND THE ROLE AND IMPORTANCE OF THE AGENCY

THEORY IN AN ENTERPRISE

As discussed above, the goal of a financial manager is to maximise shareholders wealth.

What this means is that the shareholders entrust the financial manager as an agent to make
decisions in order to reach the goals set. Theoretically most financial managers would agree
with the goal of maximising shareholder wealth, however in practice they may concern
themselves with their own personal wealth and job security. Given the problem above,
financial managers may shun away from taking decisions that may jeopardise their personal
goals and this may lead to less-than-maximum wealth creation. This conflict between
shareholders and personal goal of financial managers is known as the agency problem.
The agency problem may be defined as the likelihood that managers may place personal
goals ahead of corporate goals. A company can be viewed as simply a set of contracts, the
most important of which is the contract between the firm and its shareholders. This contract
describes the principalagent relationship, where the shareholders are the principals and the
management team the agents. An efficient agency contract allows full delegation of decisionmaking authority over use of invested capital to management without the risk of that authority
being abused. However, left to themselves, managers cannot be expected to act in the
shareholders best interests, but require appropriate incentives and controls to do so. Agency

costs are the difference between the return expected from an efficient agency contract and
the actual return, given that managers may be tempted to act more in their own interests
than the interests of shareholders.
10 FINANCIAL REPORTING
ACCOUNTING

(FINANCIAL

ACCOUNTING)

AND

MANAGEMENT

Most people are first introduced to accounting in the form of financial accounting. Financial
accounting is concerned with providing information to various users of financial statements.
In contrast, management accounting is concerned with providing information to managers for
decision-making purposes. Management accounting therefore provides information essential
for the organisation to run while financial accounting provides data on how well the company
ran in the past year.
From the above one can deduct that although the source of data may be the same, there are
differences between financial and management accounting. These are summarised in the
table below:
Financial Accounting
There is statutory requirement (Companies
Act) for entities to produce financial
statements periodically, normally annually.
Financial statements are prepared using
generally accepted accounting principles, in
South Africa this is the International Financial
Reporting Standards (IFRS).
Financial
accounting
report,
financial
statements, are prepared for the entire entity.
Financial statements are mostly prepared on
a historical basis.
Financial statements are produced on an
annual basis for most entities, some sectors
might require less detailed financial
statements more frequent than annual.

Management Accounting
Management accounting is optional and
information is only produced if its benefits
exceed its costs.
There is no prescribed form in which
management accounting information can be
presented. Information is provided based on
management needs for decision-making.
Management accounting focuses on all parts
of the organisation, from the organisation as
a whole to product lines.
Management accounting is concerned with
future information as well as past
information.
Management accounting requires information
much quicker than annual. Some reports
might be daily, weekly or monthly.

11 THE DECISION-MAKING PROCESS

Information produced by management accountants must be judged in light of its ultimate
effect on the outcome of decisions. It is therefore important that one understands the
decision-making process. The process consists of 6 stages:
1. Identifying objectives
For one to be able to make a good decision there needs to be a desired outcome and
to reach that outcome a certain direction needs to be followed. The first stage in the
decision-making process should be to specify the companys goals or organisations
objectives.
2. The search for alternative courses of action
This stage of the decision-making process involves searching for a range of possible
courses of action and/or strategies that might enable the objectives to be achieved.
To achieve some of its goals entities might consider the Ansoff Growth model.

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3. Select appropriate alternative courses of action

Data from the alternative courses of action must then be gathered and evaluated
against the identified objective. The course that best responds to the objective must
be selected.
4. Implementation of the decisions
Once the course of action has been selected, it should be implemented as part of the
budgeting and long-term planning process.
5. Compare actual and planned outcomes
To monitor performance, managers produce performance reports and present them
the higher-ranked managers who are responsible for implementation of various
decisions. These reports compare actual outcomes with planned outcomes and
should be prepared regularly.
6. Respond to divergences from plan
Effective control requires that corrective action be taken so that actual outcomes
conform to planned outcomes.

12 THE IMPACT OF THE CHANGING COMPETITIVE ENVIRONMENT ON THE

ENTERPRISE
Businesses are faced with a changing competitive environment on a regular basis. It has
been argued that management accounting should be more outward looking and should help
firms evaluate its competitive position relative to the rest of the industry. This can be done
through collecting data on prices and costs, sales volumes and market shares and cash
flows and resources availability for its main competitors. To have a competitive edge,
managers should be aware of who their main competitors are and should ensure that they
stay ahead of them.
Michael E. Porter advocated using value-chain analysis to gain competitive advantage. The
aim of this value-chain analysis is to find linkages between value-creating activities which
result in lower cost and/or enhanced differentiation. Porter also formulated the popular
Porters Five Forces of Competitive Advantage. Porter believes that the following are the five
forces:

Bargaining power of customers;

Threat of new entrants;
Threats of substitute products;
Bargaining power of suppliers; and
Competitive rivalry within an industry.

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