FM - Financial Management

Contents
The Nature and Purpose of Financial Management ................................................................... 2
FINANCIAL MANAGEMENT ...................................................................................................... 2
THE RELATIONSHIP BETWEEN FINANCIAL MANAGEMENT AND FINANCIAL AND
MANAGEMENT ACCOUNTING ................................................................................................. 3
Financial Management Objectives .............................................................................................. 4
THE ROLE OF FINANCIAL MANAGEMENT ................................................................................ 4
FINANCIAL OBJECTIVES............................................................................................................ 4
FINANCIAL DECISIONS ............................................................................................................. 4
FINANCIAL CONSTRAINTS ........................................................................................................ 4
NOT-FOR-PROFIT ORGANISATIONS ......................................................................................... 5
Stakeholders and impact on corporate objectives ..................................................................... 6
STAKEHOLDERS & THEIR OBJECTIVES ...................................................................................... 6
AGENCY THEORY ...................................................................................................................... 6
MEASURING CORPORATE ACHIEVEMENTS ............................................................................. 7
RETURN ON CAPITAL EMPLOYED ............................................................................................ 7
RETURN ON EQUITY................................................................................................................. 8
EARNINGS PER SHARE ............................................................................................................. 8
DIVIDEND PER SHARE .............................................................................................................. 9
CORPORATE GOVERNANCE ..................................................................................................... 9
Financial and other objectives in not-for-profit organisations ................................................. 11
OBJECTIVES ............................................................................................................................ 11
PERFORMANCE MANAGEMENT ............................................................................................ 11

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The Nature and Purpose of Financial Management
FINANCIAL MANAGEMENT

Financial management is the efficient sourcing and use of financial resources to ensure the
objectives of the organisation are achieved. It includes both short- and long-term sources of
finance and objectives.

The purpose of financial management is to:

 Create wealth for the business;

 Generate income; and

 Provide an adequate return on investment, while taking the risks into account.

Financial management involves decision-making in the following areas:

 Investment

- Decisions on projects that are long-term investments, for example, the purchase
of a factory.

 Finance

- Decisions on where finance can be sourced.

- The impact of different sources on the company's gearing and risk must be
considered.

 Dividend

- Decisions need to be made about how shareholder wealth should be increased.

- The financial impact of these decisions on the company's value must be

considered.

 Risk Management

- This area examines the financial risk from exchange rates and interest rates.

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THE RELATIONSHIP BETWEEN FINANCIAL MANAGEMENT AND FINANCIAL AND
MANAGEMENT ACCOUNTING

Financial management is a long-term activity with a long-term view of raising finances and
controlling resources. It’s objective is to achieve the organisation's objectives.

Management accounts are prepared to provide information for operational decision-making.

The time frame for management accounting is much shorter, and there is no standard format
for preparing them.

The information needs of management accounts are like those of financial management, and
management accounts can be used to monitor and assess the organisation's financial
management.

Financial accounts give a historical view of the company and are usually prepared annually in
accordance with company law. The financial accounts are used by parties external to the
organisation, such as government bodies, potential investors and financial institutions.
Moreover, they do not provide detailed information for operational decision-making like
management accounts do.

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Financial Management Objectives
THE ROLE OF FINANCIAL MANAGEMENT

Financial managers guide an organisation to achieve the predetermined objectives. They do so

by controlling, coordinating, allocating resources, making decisions, and motivating employees.

To enable financial managers to perform their role, it is important to establish the financial
objectives in the first place.

FINANCIAL OBJECTIVES

Financial objectives are classified into primary objectives and secondary objectives.

 Primary Objectives
Primary objectives define the reason for existence of an organisation. The primary
objective of a profit-making organisation is usually assumed to be the maximisation of
shareholder wealth. This can be achieved by increasing the company’s share price and by
paying out dividends.

 Secondary Objectives
Secondary objectives promote the achievement of primary objectives. For example,
improving staff morale and customer service are examples of secondary objectives.
Achieving them is likely to result in better profitability for a business.

FINANCIAL DECISIONS

The decisions made by financial managers can be categorised into three groups:

 Financing Decisions: How will the company raise necessary finance?

 Investment Decisions: Where will the company invest this finance?

 Dividend Decisions: Whether company should reinvest or distribute profits?

FINANCIAL CONSTRAINTS

The ability of financial managers to achieve financial objectives is constrained by a number of

factors. These factors must be considered as part of the decision-making process. Examples of
constraints include:

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 Regulations and anti-competition laws imposed by governments;

 Restrictions, such as loan covenants, imposed by banks; and

 Personal priorities of managers (agency problem).

NOT-FOR-PROFIT ORGANISATIONS

Not-for-profit organisations usually do not have any shareholders. Some examples include
governments, public sector schools, hospitals and charities. Although not-for-profit
organisations do not strive for maximisation of shareholder wealth, finance is still an important
area to manage.

 Value for Money

The performance of not-for-profit organisations is controlled by providing value for money.
This is measured in term of economy, efficiency and effectiveness.

 Economy: Obtaining quality inputs at the lowest price;

 Efficiency: Maximising output from a given quantity of input; and

 Effectiveness: Achieving organisational objectives.

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Stakeholders and impact on corporate objectives
STAKEHOLDERS & THEIR OBJECTIVES

A stakeholder is somebody who has an interest in the business, not necessarily a financial
interest.

Stakeholder Objective
Ordinary shareholders / Equity investors To maximise the value of their investment.
To maximise profits leading to increased bonuses
The organisation’s directors
and fending off takeovers.
The organisation’s employees and their trade Fair salaries, safe working conditions and job
unions security.
A quality product or service that gives value for
Customers
money.

To get paid on time, to build long term

Suppliers relationships
and get repeat custom.
Finance providers To get their capital repaid in full with interest.
To ensure that the organisation is following the
relevant
Government agencies
legislation such as tax, employment and health and
safety.
To ensure the organisation has a positive impact on
The community its
surrounding community and environment.

There are many different stakeholders with different objectives. It is not possible to fulfil all of
their objectives.

AGENCY THEORY

Ordinary shareholders own the organisation and employ directors to manage it for them on
their behalf. The directors are the shareholder’s agents.The director’s job is to act in the best
interests of the shareholders. However, there can be conflict between the shareholders and the
directors as their objectives are not the same.

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Agency theory deals with problems arising due to the competing objectives between the
principal and agent.

To avoid agency problems the objectives of the directors and the shareholders should be
aligned.

The objectives of directors and shareholders can be aligned by:

 Basing directors salaries on achievements of the shareholders objectives.

 Giving directors and employees shares as part of their remuneration package.

MEASURING CORPORATE ACHIEVEMENTS

A shareholders return on investment is made up of dividends and the capital gain.

Measuring the organisation’s ability to maximise shareholder wealth can be done with ratios.

RETURN ON CAPITAL EMPLOYED

Formula :

ROCE = Profit before interest and Tax / Capital Employed * 100%

Capital employed is measured as equity, plus interest-bearing finance, so long term loans plus
share capital and reserves.

This ratio is useful because:

 It shows how much return is being generated for the amount invested.

 It can be used to compare the returns offered by different companies.

Shareholders will compare the return to those offered by risk-free investments and the returns
offered by other companies.

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RETURN ON EQUITY

Formula :

ROE = Profit after tax and preference dividends / (ordinary share capital + reserves) * 100%

This ratio is useful because:

 It measures how much profit a company generates for its ordinary shareholders taking only
their investment into account.

The disadvantages of ROE:

 It is sensitive to gearing.

 May not reflect the maximisation of shareholder wealth

EARNINGS PER SHARE

Formula :

EPS = Profit after interest, tax and preference dividends / no. of ordinary shares in issue

This gives the amount of profit per share.

This ratio is useful because:

 Previous years can be compared if there has been no change in circumstances or

accounting policy.

The disadvantages of EPS:

 Does not reflect the actual earnings received by the shareholders.

 Cannot be used to compare other companies.

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DIVIDEND PER SHARE

Formula :

DPS = Total Ordinary Dividend/ Total Number of shares issued

This ratio is useful because:

 It calculates the actual dividend per share.

 Previous years can be compared.

Companies dividends convey a message to their shareholders and it should be a consistent one.
Changing the dividend rate can impact on the share price. It is important the dividend paid out
conveys a consistent message. The company dividend policy needs to be in line with the
financial needs of its shareholders. Often the shareholder profile depends on the dividend
policy. Any changes in dividend policy can cause shareholders to sell their shares.

CORPORATE GOVERNANCE

Organisations should implement corporate governance codes of best practice.

Corporate governance codes have the following impact:

 Increase directors accountability.

 Aim to reduce the shareholder’s risk due to unethical behaviour.

 Directors salaries are decided by an independent remuneration committee.

 A more balanced board of directors by appointing Non-executive directors.

 The chairman should be independent when they were appointed.

 The chairman of the board of directors can never be CEO, these roles are separate.

Although corporate governance is usually not obliged under law companies must comply with
corporate governance codes of best practice to gain a stock exchange listing on most
exchanges.

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A stock exchange listing means:

 The company must produce financial reports annually.

 Give detailed information about the director’s salaries.

 Pay attention to their corporate social responsibilities.

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Financial and other objectives in not-for-profit organisations
Much of this syllabus is covered in F5 Performance analysis under: “Not-for-profit organisations
and the public sector”. Please refer back to these notes.

OBJECTIVES

To provide for a need in society on continuing basis.

 Value for money.

 Stewardship

PERFORMANCE MANAGEMENT

Performance measurement is measured using financial and non-financial indicators.

Non-financial data is very important in a not-for-profit to measure the achievement of non-

quantifiable goals.

Performance management can be seen as a waste of limited resources in a not-for-profit

organisation. It is, however, important for the organisation’s success and the achievement of its
objectives.

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