Professional Documents
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Financial management G
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Essential reading A
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1 Aspects of financial management
1.1 Financial planning and control
1.1.1 Financial planning
The financial manager will need to plan to ensure that enough funding is available at the right
time to meet the needs of the organisation for short-, medium- and long-term capital.
In the medium or long term, the organisation may have planned purchases of non-current assets,
such as plant and equipment, for which the financial manager must ensure that funding is
available.
The financial manager contributes to decisions on the uses of funds raised by analysing financial
data to determine uses which meet the organisation’s financial objectives. Is project A to be
preferred over project B? Should a new asset be bought or leased?
X (a) Accounting profits are not the same as ‘economic’ profits. Accounting profits can be
smoothed to some extent by choices of accounting policies. For example:
. - Provisions, such as provisions for depreciation or anticipated losses
M (c) Profits on their own take no account of the volume of investment that it has taken to earn the
profit. Profits must be related to the volume of investment to have any real meaning.
(d) Profits are reported every year (with half-year interim results for quoted companies). They
are measures of short-term historic performance, whereas a company’s valuation is
commonly judged by considering its future performance potential.
Illustration 2: EPS
Walter Wall Carpets made profits before tax in 20X8 of $9,320,000. Tax amounted to $2,800,000.
The company’s share capital is as follows:
$
Ordinary shares (10,000,000 shares of $1) 10,000,000
8% preference shares 2,000,000
12,000,000
1 Required
Calculate the EPS for 20X8
Solution
1 The correct answer is:
$ A
Profit before tax 9,320,000 C
Less tax (2,800,000)
Profits after tax 6,520,000 C
Less preference dividend (8% of $2,000,000) (160,000) A
Earnings attributable to ordinary shareholders 6,360,000
Number of ordinary shares 10,000,000
EPS 0.636 G
L
1.2.2 Other financial targets O
In addition to targets for earnings, EPS and dividend per share, a company might set other
financial targets, such as:
B
(a) A restriction on the company’s level of gearing, or debt. For example, a company’s A
management might decide:
(i) The ratio of long-term debt capital to equity capital should never exceed, say, 1:1.
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(ii) The cost of interest payments should never be higher than, say, 25% of total profits
before interest and tax.
(b) A target for profit retentions. For example, management might set a target that dividend
B
cover (the ratio of distributable profits to dividends actually distributed) should not be less O
than, say, 2.5 times.
(c) A target for operating profitability. For example, management might set a target for the
X
profit/sales ratio (say, a minimum of 10%) or for a return on capital employed (say, a .
minimum ROCE of 20%).
These financial targets are not primary financial objectives, but they can act as subsidiary targets C
or constraints which should help a company to achieve its main financial objective without O
incurring excessive risks. They are usually measured over a year rather than over the long term.
Remember, however, that short-term measures of return can encourage a company to pursue M
short-term objectives at the expense of long-term ones, for example by deferring new capital
investments, or spending only small amounts on research and development and on training. A
major problem with setting a number of different financial targets, either primary targets or
supporting secondary targets, is that they might not all be consistent with each other. When this
happens, some compromises will have to be accepted.
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1.3 Stakeholders
1.3.1 Objectives of stakeholder groups
The various groups of stakeholders in a firm will have different goals which will depend in part on
the particular situation of the enterprise. Some of the more important aspects of these different
goals are as follows.
(a) Ordinary (equity) shareholders
Ordinary (equity) shareholders are the providers of the risk capital of a company. Usually their
goal will be to maximise the wealth which they have as a result of the ownership of the shares in
the company.
(b) Trade payables (creditors)
Trade payables have supplied goods or services to the firm. Trade payables will generally be
profitmaximising firms themselves and have the objective of being paid the full amount due by
the date agreed. On the other hand, they usually wish to ensure that they continue their trading
A relationship with the firm and may sometimes be prepared to accept later payment to avoid
jeopardising that relationship.
C (c) Long-term payables (creditors)
C Long-term payables, which will often be banks, have the objective of receiving payments of
interest and capital on the loan by the due date for the repayments. Where the loan is secured on
A assets of the company, the lender will be able to appoint a receiver to dispose of the company’s
assets if the company defaults on the repayments. To avoid the possibility that this may result in
a loss to the lender if the assets are not sufficient to cover the loan, the lender will wish to minimise
G the risk of default and will not wish to lend more than is prudent.
(d) Employees
L Employees will usually want to maximise their rewards paid to them in salaries and benefits,
O according to the particular skills and the rewards available in alternative employment. Most
employees will also want continuity of employment.
B (e) Government
A Government has objectives which can be formulated in political terms. Government agencies
impinge on the firm’s activities in different ways including through taxation of the firm’s profits,
L the provision of grants, health and safety legislation, training initiatives, and so on. Government
policies will often be related to macroeconomic objectives, such as sustained economic growth
and high levels of employment.
B (f) Management
O Management has, like other employees (and managers who are not directors will normally be
employees), the objective of maximising its own rewards. Directors, and the managers to whom
X they delegate responsibilities, must manage the company for the benefit of shareholders. The
objective of reward maximisation might conflict with the exercise of this duty.
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C 1.4 Stakeholder groups, strategy and objectives
O The actions of stakeholder groups in pursuit of their various goals can exert influence on strategy
and objectives. The greater the power of the stakeholder, the greater their influence will be. Each
M stakeholder group will have different expectations about what it wants, and the expectations of
the various groups may conflict. Each group, however, will influence strategic decision making.
Return on equity
A
Sales – Total costs Non-current Current
assets
+
assets C
C
Such ratio pyramids help in providing for an overall management plan to achieve profitability and
allow the interrelationships between ratios to be checked. A
1.7 Profitability
A company ought, of course, to be profitable if it is to maximise shareholder wealth, and obvious G
checks on profitability are: L
(a) Whether the company has made a profit or a loss on its ordinary activities
(b) By how much this year’s profit or loss is bigger or smaller than last year’s profit or loss. O
Profit before taxation is generally thought to be a better figure to use than profit after taxation, B
because there might be unusual variations in the tax charge from year to year which would not
affect the underlying profitability of the company’s operations. A
Another profit figure that should be considered is profit before interest and tax (PBIT). This is the L
amount of profit which the company earned before having to pay interest to the providers of loan
capital. This is also a good measure of operating profit, the profit that the company is making
from its business operations. By providers of loan capital, we usually mean longer-term loan
capital, such as loan notes and medium-term bank loans.
B
1.7.1 Profitability and return: the return on capital employed
O
You cannot assess profits or profit growth properly without relating them to the amount of funds X
(the capital) employed in making the profits. The most important profitability ratio is therefore
return on capital employed (ROCE), also called return on investment (ROI).
.
C
Formula to learn O
Return on capital employed = PBIT/Capital employed M
Capital employed = Shareholders’ funds plus long-term liabilities
Or
Capital employed = Total assets less current liabilities
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(c) A comparison of the ROCE with current market borrowing rates (warning: this needs to be
interpreted with care, as ROCE will often reflect higher risk than borrowing rates)
(i) What would be the cost of extra borrowing to the company if it needed more loans, and
is it earning a ROCE that suggests it could make high enough profits to make such
borrowing worthwhile?
(ii) Is the company making a ROCE which suggests that it is making profitable use of its
current borrowing?
A
Exam focus point
Remember that capital employed is not just shareholders’ funds. It is shareholders’ funds plus
G long-term liabilities.
A
Formula to learn
L Earnings
Return on equity = Shareholders' equity
B This ratio shows the earning power of the shareholders’ book investment and can be used to
O compare two firms in the same industry. A high return on equity could reflect the firm’s good
management of expenses and ability to invest in profitable projects. However, it could also reflect
X a higher level of debt finance (gearing) with associated higher risk (see Section 4.5).
C 1.7.5 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
O profit margin and also the net profit margin. Looking at the two together can be quite
M informative.
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: 28,000/70,000 = 40% and in year 2 it is 45,000/100,000 = 45%
Is this good or bad for the business? An increased profit margin must be good because this
indicates a wider gap between selling price and cost of sales. However, given that the net profit
ratio has stayed the same in the second year, expenses must be rising. In year 1, expenses were
30% of revenue, whereas in year 2 they were 35% of revenue. This indicates that administration or
selling and distribution expenses may require tighter control.
A percentage analysis of profit between year 1 and year 2 is as follows.
C
Year 1 Year 2
% % C
Cost of sales as a % of sales 60 55 A
Gross profit as a % of sales 40 45
100 100
Expenses as a % of sales 30 35 G
Net profit as a % of sales
Gross profit as a % of sales
10
40
10
45
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O
1.8 Debt and gearing ratios
B
Debt ratios are concerned with how much the company owes in relation to its size and whether it
A
is getting into heavier debt or improving its situation. Financial gearing (often simply referred to L
as ‘gearing’) 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 borrowing.
B
(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 O
have been paid.
X
The main debt and gearing ratios are covered in Chapter 12.
.
1.9 Liquidity ratios: cash and working capital
C
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 O
assets so that it can meet its debts when they fall due. The main liquidity ratios will be described
in Chapter 3 (in the Essential reading). M
1.10 Shareholders’ investment ratios
Returns to shareholders are obtained in the form of dividends received and/or capital gains from
increases 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. We must therefore consider how investors
appraise companies. We will concentrate on quoted companies.
Information that is relevant to market prices and returns is available from published stock market
information, and in particular from certain stock market ratios.
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Cum dividend: Cum dividend or cum div means the purchaser of shares is entitled to receive
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TERM the next dividend payment.
Ex dividend: Ex dividend or ex div means that the purchaser of shares is not entitled to receive
the next dividend payment.
The relationship between the cum-div price and the ex-div price is:
Market price per share (ex div) = Market price per share (cum div) – forthcoming dividend per
share.
When stock market share prices are quoted, shares go from being cum div to ex div on a given
day, and shareholders buying the shares from the time they go ex div are not entitled to the next
dividend pay-out, which will happen soon.
A Formula to learn
C Dividend yield = Dividend per share/Ex-div market price per share
C The dividend yield is the return a shareholder is currently expecting on the shares of a company.
A (a) The dividend per share is taken as the dividend for the previous year.
(b) Ex div means that the share price does not include the right to the most recent dividend.
Shareholders look for both dividend yield and capital growth. Obviously, dividend yield is
G therefore an important aspect of a share’s performance.
L
O Illustration 3: Dividend yield
B In the year to 30 September 20X8, an advertising agency declares an interim ordinary dividend of
A 7.4 cents per share and a final ordinary dividend of 8.6 cents per share.
L 1 Required
Assuming an ex-div share price of 315 cents, what is the dividend yield?
Solution
B 1 The correct answer is:
O The total dividend per share is (7.4 + 8.6) = 16 cents
.
C Illustration 4: Ratios
O
The directors of X are comparing some of the company’s year-end statistics with those of Y, the
M company’s main competitor. X has had a fairly normal year in terms of profit, but Y’s latest profits
have been severely reduced by an exceptional loss arising from the closure of an unsuccessful
division. Y has a considerably higher level of financial gearing than X.
The board is focusing on the figures given below.
X Y
Share price 450c 525c
Dividend yield 5% 4%
X Y
Price/earnings ratio 15 25
In the course of the discussion a number of comments are made, including those given below.
1 Required
Discuss comments (a) to (d), making use of the above data where appropriate.
(a) ‘There is something odd about the P/E ratios. Y has had a particularly bad year. Its P/E
should surely be lower than ours.’
(b) ‘One of the factors which may explain Y’s high P/E is the high financial gearing.’
(c) ‘The comparison of our own P/E ratio and dividend yield with those of Y is not really valid. The
shares of the two companies have different nominal values.’
(d) ‘These figures will not please our shareholders. The dividend yield is below the return an
investor could currently obtain on risk-free government bonds.’ A
Solution C
1 The correct answer is: C
(a) P/E ratio A
The P/E ratio measures the relationship between the market price of a share and the earnings
per share. Its calculation involves the use of the share price, which is a reflection of the market’s
expectations of the future earnings performance, and the historic level of earnings.
G
If Y has just suffered an abnormally bad year’s profit performance which is not expected to be
repeated, the market will price the share on the basis of its expected future earnings. The earnings L
figure used to calculate the ratio will be the historical figure, which is lower than that forecast for
the future, and thus the P/E ratio will appear high.
O
(b) Financial gearing B
The financial gearing of the firm expresses the relationship between debt and equity in the
capital structure. A high level of gearing means that there is a high ratio of debt to equity. This
A
means that the company carries a high fixed interest charge, and thus the amount of earnings L
available to equity will be more variable from year to year than in a company with a lower
gearing level. Thus the shareholders will carry a higher level of risk than in a company with lower
gearing. All other things being equal, it is therefore likely that the share price in a highly geared
company will be lower than that in a low geared firm.
B
The historical P/E ratio is dependent on the current share price and the historical level of O
earnings. A high P/E ratio is therefore more likely to be found in a company with low gearing than
in one with high gearing. In the case of Y, the high P/E ratio is more probably attributable to the
X
depressed level of earnings than to the financial structure of the company. .
(c) Comparison of ratios
C
The ratios are calculated as follows.
P/E ratio = Market share price/Earnings per share O
Dividend yield = Dividend per share/Market share price M
Even if the shares have a nominal value (which isn’t the case in every country) this nominal value
is irrelevant in calculating the ratios. This can be proved by calculating the effect on the ratios of
a share split – the ratios will be unchanged. Thus, if all other factors (such as accounting
conventions used in the two firms) are equal, a direct comparison of the ratios is valid.
(d) Comparison with risk-free securities
As outlined in (c) above, the dividend yield is the relationship between the dividend per share and
the current market price of the share. The market price of the share reflects investor expectations
about the future level of earnings and growth. If the share is trading with a low dividend yield, this
means that investors have positive growth expectations after taking the level of risk into account.
Although government bonds carry little risk, they are unlikely to offer significant growth potential
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either, and this means that the share will still be more attractive even after the low dividend yield
has been taken into account.
2 Not-for-profit organisations
2.1 Not-for-profit sectors
Although most people would know one if they saw it, there is a surprising problem in clearly
defining what counts as a not-for-profit (NFP) organisation. Local authority services, for example,
would not be setting objectives in order to arrive at a profit for shareholders, but nowadays they
are being increasingly required to apply the same disciplines and processes as companies which
are oriented towards straightforward profit goals.
A The not-for-profit sector may involve a number of different kinds of organisations with, for
example, differing legal status – charities, statutory bodies offering public transport or the
provision of services such as leisure, health or public utilities.
G The tasks of setting objectives and developing strategies and controls for their implementation can
L all help in improving the performance of charities and NFP organisations.
O 2.2 Objectives
B The primary objective of many NFP organisations will be the effective provision of a service, not
the creation of profit. This has implications for the reporting of results. The organisation will need
A to be open and honest in showing how it has managed its budget and allocated funds raised.
Efficiency and effectiveness are particularly important in the use of donated funds, but there is a
L danger that resource efficiency becomes more important than service effectiveness.
Here are some possible objectives for a NFP organisation:
(a) Surplus maximisation (equivalent to profit maximisation, eg a charity shop)
B (b) Revenue maximisation (as for a commercial business, eg a charity shop)
O (c) Usage maximisation (eg leisure centre swimming pool usage)
O (h) Client satisfaction maximisation (eg the police generating the support of the public).
Economy: Attaining the appropriate quantity and quality of inputs at the lowest cost to
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TERM achieve a certain level of outputs.
Efficiency: The relationship between inputs and outputs.
Effectiveness: The extent to which declared objectives/goals are met.
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Example: Economy, efficiency, effectiveness
(a) Economy: This dimension relates to the cost of inputs. Economy within a school could be
measured, for example, by comparing average salaries per teacher with earlier years and
budgets.
(b) 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.
(c) 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.
• Class sizes
• Courses offered.
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