Financial Management Principles

The Financial Management Function

• Financial management aims to maximize output with minimal input through scientific and technical methods.
• Effective financial management involves strategic planning, organization, direction, and supervision of finances using management principles.
• Options for managing finances include self-management, hiring employees, or using third-party professionals leading to financial decisions.

Objectives of Financial Management

• Maximize profits by identifying cost-saving opportunities.
• Provide adequate shareholder returns based on earnings and market value.
• Track liquidity and cash flow to meet financial obligations.
• Ensure efficient and cost-effective fund utilization.
• Invest funds safely to obtain acceptable returns.
• Plan a balanced capital structure with a mix of debt and equity.

Functions of Financial Management

• Calculate required capital based on expense and profit policies.
• Determine the optimal mix of debt and equity in the capital structure.
• Choose funding sources like equity investors, debenture holders, and financial institutions.
• Invest capital to increase capital and generate returns.
• Procure funds through consultations, prospectuses, and considering market conditions.
• Allocate net profits for emergencies, expansion, and shareholder rewards.
• Implement financial control using forecasting, ratio evaluation, and risk management techniques.

Understanding Finance

• Finance is the money in circulation within a business.
• Money transforms into fixed assets and working capital.
• Financial Management encompasses understanding and managing finance, including financial statement analysis and capital budgeting.

The Nature and Purpose of Financial Management

• Financial management involves efficiently acquiring and using financial resources.
• Three key decision areas include investing, financing, and dividend policy.
• Financial managers decide on funding sources, investment allocations, dividend payments, and working capital management.

Financing Decisions

• Businesses must identify suitable funding sources (long or short-term).
• Consider company needs, investor demands, and available amounts.

Investment Decisions

• Financial managers ensure efficient and effective use of finance.
• Investment appraisal involves considering long-term plans and identifying projects.
• Working capital management focuses on managing liquidity, debts, inventory, and cash balances.

Dividend Decisions

• Financial managers determine cash distribution to owners versus reinvestment.
• These decisions are interconnected, influencing the need for external finance.

Relationship with Financial and Management Accounting

• Financial Accounting provides information about past plans and decisions.
• Management Accounting provides information for planning, control, and decision-making.
• Both use the same information to achieve set targets though they have different usages as highlighted in the text.

Relationship between Corporate Strategy and Corporate and Financial Objectives

• Objectives define what an organization aims to achieve.
• Strategy is the course of action to achieve objectives.

Corporate Objectives

• Apply to the entire organization and can be profit-related or address other concerns like environmental impact.
• Objectives can be profit goals, surrogate profit goals, constraints on profit, or dysfunctional goals.
• Companies may maximize returns or find an adequate outcome for these objectives.

Financial Objectives

• Shareholder wealth combines dividend and share price growth, measured by Total Shareholder Returns (TSR).
• Maximizing share prices is often a substitute for maximizing shareholder wealth.
• Justifications for maximizing shareholder wealth include easier financing, customer satisfaction, and legal duties.
• Criticisms include ignoring market imperfections and stakeholder interests.

Profit Maximization

• Profit maximization is a proxy for shareholder wealth maximization.
• Share prices are influenced by overall stock market conditions.

Earnings per Share Growth

• Earnings per share (EPS) is a key indicator for financial analysts.
• EPS growth can be artificially boosted through share consolidation or buyback schemes.

Stakeholder Objectives and Conflicts

• Companies involve stakeholders with differing objectives.
• Stakeholders can be internal, connected, or external.
• Stakeholder conflicts can occur, such as environmental efforts reducing profit.
• Corporate governance suggests considering a wider range of stakeholder objectives.

Agency Theory

• Examines duties and conflicts between parties with an agency relationship.
• Agency relationships occur when a principal employs an agent, with potential conflicts of interest.

The Divorce of Ownership and Control

• Shareholders rely on management, leading to a separation of ownership from control.
• Managers may prioritize personal wealth over shareholder wealth.

Directors and Shareholders

• Directors manage the company on behalf of shareholders.
• Directors may have personal objectives conflicting with shareholders, leading to agency costs.
• Good corporate governance minimizes these agency costs.

Corporate Governance and Ethics

Empire Building

• Executives may prioritize controlling resources over maximizing profits.
• Empire building can disappoint shareholders by focusing on size rather than returns.

Creative Accounting

• Directors can use accounting policies to artificially boost share prices.
• Examples include capitalizing expenses, avoiding depreciation, and recognizing revenue early.
• Standard setters aim to eliminate creative accounting practices.

Off-Balance-Sheet Finance

• Finances assets without recording the funding method on the balance sheet.
• FRS 5 aimed to restrict this practice, and further scrutiny is expected.

Takeover Bids

• Directors may resist takeovers to protect their jobs, even if it benefits shareholders.
• They must comply with the City Code on Takeovers and Mergers during a bid period.

Unethical Activities

• Activities may not be illegal but are undesirable to broader society.
• Examples include trading with dictatorships and emitting pollution.
• Good business ethics and CSR are increasingly important.

Managerial Reward Schemes

• Designed to align managers' decisions with shareholder objectives.
• Schemes should be clearly defined, link rewards to shareholder wealth, and match time horizons.

Goal Congruence

• Occurs when agents' objectives align with organizational objectives.
• Managers should be encouraged to aim for long-term growth rather than short-term profits.

Methods of Encouraging Goal Congruence

• Includes performance-related pay, share option schemes, long-term incentive plans, and improved transparency.

Common Types of Reward Schemes

• Remuneration linked to minimum profit levels.
• Economic value added (EVA).
• Revenue growth.
• Executive share option schemes (ESOP).

Remuneration Scheme Advantages and Disadvantages

• Remuneration linked to minimum profit levels is easy to set up, but may lead to short termism.
• EVA aligns employee and shareholder interests, but can be complex to calculate.
• Those linked to revenue growth are designed to benefit the stakeholders, but it compromises with profitability
• ESOPs encourage maximizing share value but can penalize managers during market downturns.

Criticisms of ESOPs

• Directors may quickly sell shares, and options may lose value in downturns.
• Excessive share option issuance can dilute equity interests.
• Managers may distort profits to protect share prices.

Corporate Governance

• Directs and controls the system by which companies are directed and controlled.
• Aims to reduce agency costs to an acceptable level for shareholders.

Principles of Good Governance

• Effective board leadership and control.
• Clear division of responsibilities.
• Balance of executive and independent non-executive directors.
• Regular re-election of directors.
• Independent remuneration committees offer fair retainment packages for executives.
• No director involved in setting own remuneration.
• Solid internal control systems.

Government Regulation

• UK Corporate Governance Code is in the London Stock Exchange Listing Rules.
• Non-compliance requires explanation.
• US Sarbanes-Oxley Act applies to all companies listed on US stock markets.
• Compliance is mandatory.

Listing Regulations

• Stock exchanges ensure fair and efficient markets through rules and regulations.
• Listed companies must meet listing requirements.

Measuring Achievement of Corporate Objectives

• Managers, shareholders, and stakeholders measure progress toward objectives using ratio analysis.

Ratio Analysis Categories

• Profitability and return.
• Debt and gearing.
• Liquidity.
• Investor.

Not-for-Profit Organizations (NPOs)

• Aim to benefit prescribed groups, not make money.
• Use financial and non-financial objectives, with non-financial being more complex.

Objectives of NPOs

• Difficult to quantify, especially in financial terms.
• Multiple and conflicting objectives are common.

Stakeholders of a State-Funded University

• Students, government, and employers have different desires.
• Performance measurement systems must prioritize objectives.

Value for Money (VFM) and the 3 Es

• VFM achieves the desired service level and quality at the most economical cost.
• NPOs aim to maximize the difference between benefits and costs.

The 3 Es

• Economy: Minimizing input costs.
• Efficiency: Maximizing output/input ratio.
• Effectiveness: Meeting organizational objectives.

Measuring Performance

• Difficult due to multiple, conflicting objectives and hard-to-measure outputs.

Approaches to Performance Measurement

• Judgments by experts.
• Comparisons to similar bodies or historical results.
• Inputs (e.g., teaching staff hours), noting limitations.

NPO Output Measurement

• Can include broader measures like graduate employment and publications.
• Operational measures include number of courses, unit costs, and class sizes.

Environmental Issues

• Growing concern for all parties, including companies.
• Managers understand their operations' environmental impact to satisfy public concerns and avoid penalties.

Environmental Reporting

• Becoming more common in general financial reporting.

The Triple Bottom Line Approach

• Considers environmental and social value alongside economic value.
• Companies creating all three have a sustainable bottom line.