Strategic Financial

Management
Financial Ratios, Principal-Agent Conflict, Stakeholder Theory and Overall Finance
Function

Dayana Mastura Baharudin

 Financial Management
The acquisition and deployment of financial resources to achieve key objectives
 A financing decision

Acquisition of The need to obtain suitable sources of finance

Financial
Resources Risk will be a consideration

Some sources of finance create risk for a

business (interest rate risk of increasing during
economic downturn or global pandemic Covid-
19)
 Business financial resources
being used effectively

Deployment Whether or not to invest in

of Financial projects? (investment
decision)
Resources
Whether or not to return
surplus cash to shareholders?
(dividend decision)
Key financial objectives - Profits

PROFIT MAXIMIZATION IS ASSUMED TO BE THE IN CONTRAST, SHAREHOLDERS OFTEN EXPRESS WHY?

MAIN FINANCIAL OBJECTIVE OF A BUSINESS DISAPPOINTMENT IN A COMPANY’S
PERFORMANCE EVEN WHEN PROFITS ARE
RISING
 It is historic and not future
oriented. It does not measure the
future potential of a company
Drawbacks –
Profit as a It does not measure liquidity or
risk, despite both are important
financial commercial issues
objective
It can be manipulated by the use
or abuse of accounting policies
 Profits distributable to
shareholders/Number of
ordinary shares
Earnings per
share (EPS)
Distributable profits =
Profit after interest, tax
and preference dividends
 For-profit company – maximization of
shareholder wealth is assumed to be the
main financial objective

Key financial The wealth of the shareholders in a

objective – company comes from:

Shareholder
wealth Dividends received
maximisation

Market value of the shares

 These forecast was a result
Depends on the forecast from a financial analysis of
The perceived risk of these
future cash flows of the the impact of a firm’s long-
cash flows
company,and term business plan, i.e
corporate strategy

Market value of shares

(Dividend + change in share price) /
Share price at the start of the year

The ability of a firm to create wealth for

its shareholders is measured by the TSR

Total shareholder return (TSR)

A Framework for Maximizing Shareholder
Wealth

Maximisation
of
shareholder's
wealth

Risk
Investment Dividend Financing Management
Decision Decision Decision
ANALYSES PROPOSED INVESTMENTS TO ENSURE THEY
ARE BENEFICIAL TO THE INVESTOR AND MAXIMISE
SHAREHOLDER WEALTH.
Investment Decision
INVESTMENTS ARE CRUCIAL IN HELPING A FIRM TO
ACHIEVE KEY CORPORATE OBJECTIVES SUCH AS MARKET
SHARE AND QUALITY, AND IN ACHIEVING FINANCIAL
OBJECTIVES SUCH AS IMPROVING EARNINGS PER SHARE
(EPS).
 Mainly focus on how much
debt should a firm use, and
the key aim is to minimize
the cost of debt
Financing
Decision
Sometimes there are
benefits in employing debt
as part of the firm’s capital
Dividend Decision

Considers on how much to pay out to shareholders

It is determined by how much a firm has decided to spend on

investments (the investment decision);

And how much of the finance needed for this – it has decided to raise
xternally (the finance decision);

And how good is the interrelationship between these key decisions

(investment and finance decision)
Risk Management

RISK NEEDS TO BE CONSIDERED HOW TO INVEST IT; AND WHETHER TO PAY A RISK MATTERS TO
IN DETERMINING WHAT TYPE OF DIVIDEND SHAREHOLDERS AND
FINANCE TO RAISE; THEREFORE NEEDS TO BE
CAREFULLY MANAGED
 It involves the problem of directors
controlling a company whilst
shareholders own the company.

Agency In the past, a problem was identified

whereby the directors might not act

Theory in the shareholders (or other

stakeholders) best interests.

Agency theory considers this problem

and what could be done to prevent
it.
Key Concepts of Agency Theory

An agent is employed by Agency refers to the

a principal to carry out a task relationship between a principal
on their behalf.  and their agent. 

By accepting to undertake a task

Agency costs are incurred by
on their behalf, an agent
principals in monitoring agency
becomes accountable to the
behaviour because of a lack of
principal by whom they are
trust in the good faith of
employed. The agent
agents. 
is accountable to that principal.
 Separation of Ownership and Control
• Companies that are quoted on a stock market such as the London Stock
Exchange are often extremely complex and require a substantial investment
in equity to fund them, i.e. they often have large numbers of shareholders. 
• Shareholders delegate control to professional managers (the board of
directors) to run the company on their behalf. 
• The Directors (agents) have a fiduciary responsibility to the shareholders
(principal) of their organisation (usually described through company law as
'operating in the best interests of the shareholders'). 
• Shareholders normally play a passive role in the day-to-day management of
the company. 
• Directors own less than 1% of the shares of most of the UK's 100 largest
quoted companies and only four out of ten directors of listed companies
own any shares in their business. 
• Separation of ownership and control leads to a potential conflict of
interests between directors and shareholders. 
• The agents' objectives (such as a desire for high salary, large bonus and
status for a director) will differ from the principal's objectives (wealth
maximisation for shareholders).
Agency Theory and Corporate Governance
•  Examination of theories behind corporate governance provides a foundation for
understanding the issue in greater depth and a link between an historical perspective and its
application in modern governance standards.
• Historically, companies were owned and managed by the same people. For economies to grow
it was necessary to find a larger number of investors to provide finance to assist in corporate
expansion. 
• This led to the concept of limited liability and the development of stock markets to buy and
sell shares.
• Limited liability: limited risk and so less interest in the firm. 
• Stock market: wide and limited individual ownership and the ability to simply sell without the
need to take any interest in the firm. 
• Delegation of running the firm to the agent or managers. 
• Separation of goals between wealth maximisation of shareholders and the personal objectives
of managers. This separation is a key assumption of agency theory. 
• Possible short-term perspective of managers rather than protecting long-term shareholder
wealth. 
• Divorce between ownership and control linked with differing objectives creates agency
problems.
Principal-Agent Relationship: Shareholders
and Directors

The conflict of interests between

The separation of ownership and
principal (shareholder) and agent
control in a business leads to a The principals need to find ways of
(director) gives rise to the
potential conflict of interests ensuring that their agents act in
'principal-agent problem' which is
between directors and their (the principals') interests. 
the key area of corporate
shareholders.
governance focus. 

As a result of several high profile

corporate collapses, caused by
over-dominant or 'fat cat' directors,
there has been a very active
debate about the power of boards
of directors, and how stakeholders
(not just shareholders) can seek to
ensure that directors do not abuse
their powers. 
Various reports have been
published, and legislation has been
enacted, in the UK and the US,
which seek to improve the control
that stakeholders can exercise over
the board of directors of the
company.
Principal- Agent Relationship: Shareholders
and Auditors

The other principal-agent relationship dealt with by corporate governance guidelines is that of the company with its auditors.

The audit is seen as a key component of corporate governance, providing an independent review of the financial position of the organisation. 

Auditors act as agents to principals (shareholders) when performing an audit and this relationship brings similar concerns with regard to trust and
confidence as the director-shareholder relationship. 

Like directors, auditors will have their own interests and motives to consider. 

Auditor independence from the board of directors is of great importance to shareholders and is seen as a key factor in helping to deliver audit quality.
However, an audit necessitates a close working relationship with the board of directors of a company. 

This close relationship has led (and continues to lead) shareholders to question the perceived and actual independence of auditors so tougher controls and
standards have been introduced to protect them. 

Who audits the auditors?

The Cost of Agency Relationships

Agency costs arise largely from

principals monitoring activities of
agents, and may be viewed in costs of management providing annual
monetary terms, resources consumed report data such as committee
incentive schemes and remuneration
or time taken in monitoring. Costs are activity and risk management analysis,
packages for directors 
borne by the principal, but may be and cost of principal reviewing this
indirectly incurred as the agent data 
spends time and resources on certain
activities. Examples of costs include:

the cost of accepting higher risks than cost of monitoring behaviour, such as
cost of meetings with financial
shareholders would like in the way in by establishing management audit
analysts and principal shareholders 
which the company operates  procedures.
Residual Loss

THIS IS AN ADDITIONAL TYPE OF AGENCY THESE COSTS ARE ABOVE AND BEYOND AND ARE A DIRECT LOSS TO
COST AND RELATES TO DIRECTORS THE REMUNERATION PACKAGE FOR THE SHAREHOLDERS.
FURNISHING THEMSELVES WITH EXPENSIVE DIRECTOR,
CARS AND PLANES ETC.
 Meetings between Voting rights at the
the directors and AGM in support of,
key institutional or against,
investors.  resolutions. 

Agency
Problem Proposing
resolutions for vote Accepting
Resolution by shareholders at
AGMs. 
takeovers. 

Measures
Divestment of
shares is the
ultimate threat.
The need for Corporate Governance

There are a number of codes of conduct

and recommendations issued by
governments and stock exchanges.
If the market mechanism and shareholder The UK Corporate Governance Code (2010)
Although compliance is voluntary (in the
activities are not enough to monitor the  for Corporate Governance adopted by the
sense it is not governed by law), the fear OECD code on ethics. 
company then some form of regulation is Financial Services Authority (FSA) in the
of damage to reputation arising from
needed.  UK. 
governance weaknesses and the threat of
delisting from stock exchanges renders it
difficult not to comply. 

Specific regulation regarding director Malaysian Code of Corporate Governance Malaysian Code of Corporate Governance
ACCA codes. 
remuneration and city code on takeovers. 2012 (MCCG 2012) 2017 (MCCG 2017) – to date
 Stakeholder Theory

• The basis for stakeholder theory is that

companies are so large and their impact
on society so pervasive that they should
discharge accountability to many more
sectors of society than solely their
shareholders.
 To ensure that the interest of other
stakeholder groups are not neglected, non-
financial measures can be used in addition to
financial measures. Some examples as follows;

Staff – staff turnover (percentage of staff

Non-Financial leaving during a year)

Performance
measures Customers – complaints and market share

Suppliers – non-defect products, fast delivery,

after-sales service
 Debt ratios –
Profitability leverage
ratios – level,
managerial important for
Financial performance banks to
evaluate
Performance
Measures Liquidity
ratios –
Shareholder
investor
important to ratios –
suppliers and important to
customers shareholders
Profitability Ratios

Return on capital
Profit from operations =
employed (ROCE) = (Profit
Profit before interest and
from operations/Capital
tax
employed) x 100

Capital employed = (equity Return on Equity (ROE) =

+ long-term debt) OR (total Profits after interest and
assets – current liabilities) tax / Shareholders funds
Debt Ratios

Debt ratios are concerned

with how much the company
Alternatively, this could be
Gearing = Book value of debt owes in relation to its size
calculated as
/ Book value of equity and whether it is getting
debt/(debt+equity)
into heavier debt or
improving its situation

The Interest cover or or

Interest cover = Profit from coverage ratio is a measure
operations / Interest of the affordability of
interest payments
 Current ratio = Current assets / Current liabilities

Acid test ratio = (Current assets – Inventory) /

Liquidity Current liabilities

Ratios A firm should have enough current assets to meet

its commitments to pay its current liabilities. A
ratio of more than 1 indicates minimum liquidity
coverage.

Most inventories are not very liquid asset and some

businesses have slow inventory turnover especially
during the financial crisis
Shareholder Investor Ratios

Dividend yield = (Dividend per share / Market price per share ) x 100

Earnings per share (EPS) = Profits distributable to ordinary shareholders / Number of

ordinary shares issued

Price/earnings (P/E) ratio = Market price per share / EPS

The value of the P/E ratio reflects the market’s appraisal of the share’s future prospects –
the more highly regarded a company, the higher will be its share price and its P/E ratio
 Value for money – Defined as getting the best possible
combination of services from the least resources, which means
maximizing the benefits for the lowest possible cost.

Not-for-profit Value for money involves 3Es

organisations: Economy – purchase of inputs of appropriate quality at

Value for minimum cost

Money Efficiency – use of these inputs to maximise output

Effectiveness – use of these inputs to achieve its goals (quality,

speed of response)
 Activity 1: Financial Objectives
• B Berhad has just released its financial results for the year and its profits before tax
increased by 38% over the previous year. This was due largely to a doubling of sales
in South-East Asia. However, the share price in B Berhad fell by almost 20%
immediately after the profit announcement.

• Required: Which of the following is the least likely explanation for the fall in share
price?
• A. Sales in South-East Asia had been expected to increase by more than 100%
• B. The depreciation charge was higher due to a change in accounting policy
• C. The level of B Berhad’s business risk has incrased over the year
• D. Delays in the launch of new products are expected in the coming year
 Activity 2: Total Shareholder Return

• A shareholder purchased 1000 shares in S Berhad on 1 January

20X1 at a market price of RM 2.50 per share. On 31 December
20X1 the shares had a market value of RM 2.82 per share. The
dividend paid during 20X1 was RM 0.28 per share.

• Required:
• Calculate Total Shareholder Return (TSR)