Chapter 1

FINANCIALMANAGEMENT – AN INTRODUCTION

What is financial management?

May be considered as:
The management of all matters associated with the finances of the organisation in order to achieve the
financial objectives of the organisation both short and long-term.

Financial management and the accounting equation

Non Current + Working = Debt + Equity
Assets Capital

Application Sourcing
‘of funds of funds

The three key decisions

Financial management is often described in terms of the three basic decisions to be made:
• The investment decisions,
• The financial decisions
• The dividend decisions

Each of these decisions has to looked at in as far greater detail later on in the course but as an outline these
are the basic considerations.

1. The investment decision

A company may invest its funds in one of these basic areas:
1. Capital assets
2. Working capital
3. Financial assets

Capital assets
A critical decision because of the strategic implications of many investments, the decision would include the
following financial considerations:
1. Return
2. Risk
3. Short-term profitability
4. Liquidity

Working capital
The cash resource available to the business on a day to day basis and used to fund the current assets such
as inventory and receivables. The key to identifying the level of investment is to balance the risk of insolvency
against the cost of funding.

Financial assets
Not a core area of the course, we tend to focus on financing from the perspective of a company rather than
the investor. This being the case the only investment to consider is short-term saving. In this circumstance then
the key considerations are, in order:
1. Risk
2. Liquidity
3. Return

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2. The financing decision
When looking at the financing of the business there are four basic questions to consider:

1. Total funding required (how much is needed?)

The funding requirement will be determined by an assessment of the following

Application of funds Source of funds
Existing asset base Existing funding
New assets Retained earnings
Disposals New loans / redemptions
Change in working capital Share issues / redemptions

2. Internally vs. Externally generated funds

A company may be able to fund business growth via internally generated funds such as retained
earnings. If those funds are limited or the company wishes to grow at a faster rate then external sources
of funds must be tapped.

3. Debt vs. equity

The gearing decision which forms the basis of two later chapters. A critical issue in terms of risk and
cost of funding.

4. Short-term vs. long-term debt

A consideration focused upon in the funding of working capital, short-term funding may have benefits
of flexibility and lower cost but is inherently risky.

3. The dividend decision

The amount of return to be paid in cash to shareholders. This is a critical measure of the company’s ability
to pay a cash return to its shareholders. The level of dividend paid will be determined by the following:
1. Profitability
2. Liquidity
3. Growth
4. Legal restrictions
5. Shareholder’s expectations

Corporate strategy and financial management

The role of the financial manager is to align the aims of financial management team with those of the wider
corporate strategy. The strategy of the business may be separated into corporate, business and operational
objectives. Financial managers should be attempting to fulfil those objectives.

The nature of financial management means that it is fundamental to the translation of strategic aims into
financial transactions.

Financial objectives
Aim: maximising shareholders’ wealth
Other aims: 1. Maximising profit 1. Time period
(PBIT) 2. Key stakeholder.

2. Maximising sales
3. Satisficing
4. Local and environmental concerns;
5. Contented workforce

1. Maximising shareholder wealth

A fundamental aim within financial management is to create and sustain shareholder’s wealth.
Wealth being the ongoing value of shares of the organisation. The importance of this concept is that
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 there is no time period to the wealth and that it is determined by the relative risk /return balance of
the business. All aspects of financial management are based on this basic premise.

The wealth of the shareholder in the company comes from:

• Dividends received
• Market value of the shares

A shareholder’s return on investment is obtained in the form of:

• Dividends received
• Capital gains from increases in the market value of the shares

Question 1
A shareholder purchased 1,000 shares in SJG Co on 1 January at a market price of $2.50 per share. On 31
December the shares had ex-div market value $2.82 per share. The dividend paid during the period was $0.27
per share.

Required:
What is the total shareholder return and what are the elements of total share return?

2. Maximising profits
Within organisations it is normal to reward management on some measure of profit such as ROI or RI.
In simple terms we would expect a close relationship between profit and shareholder’s wealth. There
are, however, ways in which they may conflict such as:

1. Short-termism
2. Cash vs. accruals
3. Risk

Short-termism
A profit target is normally calculated over one year; it is relatively easy to manipulate profit over that
period to enhance rewards at the expense of future years.

Question 2
Can you give three examples of how accounting profits can be manipulated?

Cash vs. accruals

As we will see later wealth is calculated on a cash basis and ignores accruals.

Risk
A manager may be inclined to accept very risky projects in order to achieve profit targets which in
turn would adversely affect the value of the business.

3. Satisficing
Many organisations do not profit maximise but instead aim to satisfice. This means that they attempt
to generate an acceptable level of profit with a minimum of risk. It reflects the fact that many
orgnaisations are more concerned with surviving than growth.

4. Earnings per share growth

Earnings per share is calculated by dividing the net profit or loss attributable to shareholders by the
weighted average number of ordinary shares.

Question 3
Water Wall Carpets made profits before tax in 2014 of $9,320,000. Tax amounted to $2,800,000.

The company’s share capital is as follows:

$

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Ordinary shares (10,000,000 shares of $1) 10,000,000
8% preference shares 2,000,000
12,000,000
Required:
Calculate the EPS for 2014

Question 4
Grasshopper made earnings attributable to shareholders of $8,250,000 in 2013 and $8,880,000 in 2014. The company’s
share capital was 12 million ordinary shares of $1 each in both years.

Required:
Calculate the EPS for 2013 and 2014 and EPS growth in relative and absolute term.

5. Other financial targets

a) A restriction on the company’s level of gearing or debt. For example:
• The ratio of long-term debt capital should never exceed, say, 1.1
• The cost of interest payments should never be higher than, say 25% of total PBIT
b) A target for profit retentions. E.g. dividend cover should be less than, say, 2.5 times
c) A target for operating profitability. Management might set a target for the profit/sales ratio (e.g. a
minimum of 10%) or for a return on capital employed (say, a minimum ROCE of 20%)

Question 5
LG Co has recently introduced a scheme of long range planning. Sales in the current year reached $10m
and forecasts for the next five years are $10.6m, $11.4m, $12.4m, $13.6m and $15m. The ratio of net profit after
tax to sales is 10%, and this is expected to continue throughout the planning period. Total assets less current
liabilities will remain at around 125% of sales. Equity in the current year is $8.75m.

It was suggested at the recent board meeting that:

a) If profits rise, dividends should rise by at least the same percentage.
b) An earnings retention rate of 50% should be maintained ie a payment ratio of 50%
c) The ratio of long-term borrowing to long-term funds (debt plus equity) is limited (by the market) to 30%,
which happens also to be the current gearing level of the company.

Required:
a) Prepare a financial analysis of the draft long range plan.
b) Suggest policies on dividends, retained earnings and gearing for LG Co, using the data above.

Objectives of not-for-profit organisations

These organisations are established to pursue non-financial aims but are to provide services to the community.
Such organisations like profit-seeking companies need funds to finance their operations. Their major constraint
is the amount of funds that they would be able to raise. As a result not-for-profit organisations should seek to
use the limited funds so as to obtain value for money.

Illustration 1: Conflicting objectives

Principals Students Government Employers

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 Agent University
Management

▪ The university management is accountable to multiple stakeholders (i.e. students, government

and potential employers)
▪ However the requirements of the principals of the principals may conflict.
• Students may desire small class sizes, a large library and courses that meet their personal
interests.
• The government may wish to minimise costs per student.
• 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.

Value for money

Value for money means providing a service in a way, which is economical, efficient and effective. It simply
means that getting the best possible service at the least possible cost. Public services for example are funded
by the taxpayers and in seeking value for money; the needs of the taxpayer are being served, insofar as
resources are being used in the best manner to provide essential services.

1. Economy - minimising the input costs of the organisation.

2. Efficiency – maximising the output/input ratio.
3. Effectiveness – meeting the organisation’s objectives.

Illustration 2 Three Es
University

Area Economy Efficiency Effectiveness

Possible Minimising Maximising Quality of

Measure cost per student/staff degrees
Student ratio awarded

Example . . . . in refuse collection service

The service will be economic if it is able to minimise the cost of weekly collection and not suffer from wasted
use of resources.

The service will be effective if it meet its target of weekly collection.

The service will be efficient if it is able to raise the number of collection per vehicle per week.
Performance measures

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Output of not –for-profit organisations is difficult to measure due to multiple objectives normally pursued.
Outputs from a university might be measured in terms of the following:
Broader performance measures
• Proportion of total undergraduate population attending the university (by subject)
• Proportion of students graduating and classes of degrees obtained
• Amount of private sector research funds attracted
• Number of students finding employment after graduating
• Number of publications/articles produced by teaching staff

Operational performance measures

• Unit costs for each operating ‘unit’
• Staff: student ratios; staff workloads
• Class sizes
• Availability of computers; good library stock
• Courses offered

Question 6 (inputs and outputs)

At a cost of $40,000 and 4,000 hours (inputs) in an average year, two policemen travel 8,000 miles and are
instrumental in 200 arrests (outputs)

Required:
Assess the performance of the service using meaningful measures.

Stakeholders
We tend to focus on the shareholder as the owner and key stakeholder in a business. A more comprehensive
view would be to consider a wider range of interested parties or stakeholders.

Stakeholders are any party that both an interest in and relationship with the company. The basic argument is
that the responsibility of an organisation is to balance the requirements of all stakeholder groups in relation to
the relative economic power of each group.

Group task
Required
Identify as many stakeholder groups as you can for a commercial organisation.
Key issues
1. Who they are
2. Measure they will use to assess us
3. Any possible conflicts

Conflict between stakeholder groups

The very nature of looking at stakeholders is that the level of ‘return’ is finite within an organisation. There is a
need to balance the needs of all groups in relation to their relative strength.

Group task
Required:
Using the stakeholder groups already identified suggest 5 possible conflicts of interest that need to be
considered.

Agency theory

Principal

Derives authority accountable to

from
Agent

Agency relationships occur when one or more people employ one or more persons as agent. The persons
who employ others are the principals and those who work for them are called the agent.
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In an agency situation, the principal delegates some decision-making powers to the agent whose decisions
affect both parties. This type of relationship is common in business life. For example shareholders of a company
delegate stewardship function to the directors of that company. The reasons why agents are employed will
vary but generally an agent may be employed because of the special skills offered, or information the agent
possesses or to release the principal from the time committed to the business.

Goal congruence
Goal congruence is defined as the state which leads individuals or groups to take actions which are in their
self interest and also in the best interest of the entity.

For an organisation to function properly, it is essential to achieve goal congruence at all level. All the
components of the organisation should have the overall objectives, and act cohesively in pursuit of those
objectives.

In order to achieve goal congruence, there should be an introduction of a careful designed remuneration
packages for managers and the workforce which would motivate them to take decisions which will be
consistent with the objectives of the shareholders.

Money as the prime motivator

The most direct use of money as a motivator is payment by results schemes where an employee’s pay is
directly linked to his results. However, research has shown that money is not a single motivator or even the
prime motivator.

Question 7
Identify 5 key areas of conflict between directors and shareholders and suggest what can be done to
encourage goal congruence between the two parties.

Question 8 – Not-for-Profit Performance

Limbe is a town with a population of 100,000 people. The town council of Limbe operates a bus service (Limbe
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
Limbe’’. Attempting to achieve this mission often involves operating services that would be considered
uneconomic by private sector bus companies, due 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 Limbe 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:

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Summarised Income and Expenditure Account
$000 $000
Passenger fares 1,200
Staff wages 600
Fuel 300
Depreciation 280
(1,180)
Surplus 20
Summarised Statement of Financial Position
$000 $000
Assets
Non-current assets (net) 2,000
Current assets
Inventories 240
Cash 30
270
Total assets 2,270

Equity and liabilities

Ordinary share capital ($1 shares) 2,000
Reserves 210
2,210
Current liabilities 60
Total and liabilities 2,270

Operating statistics for Limbe 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 37.4c

Required:
a) Using the information provided above, compare the performance of LBC to the industry average for
private sector companies.
b) Discuss the validity of comparing the performance of LBC with private sector bus companies,
c) 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.
(i) Economy
(ii) Effectiveness
(iii) Efficiency

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