Financial Management Function PDF

# The financial management function ## Chapter Learning Objectives Upon completion of this chapter, you will be able to: * explain the nature and purpose of financial management * distinguish between financial management and financial and management accounting * discuss the relationship between f...

# The financial management function ## Chapter Learning Objectives Upon completion of this chapter, you will be able to: * explain the nature and purpose of financial management * distinguish between financial management and financial and management accounting * discuss the relationship between financial objectives, corporate objectives and corporate strategy * identify and describe a variety of financial objectives, including: * shareholder wealth maximisation * profit maximisation * earnings per share growth * identify stakeholders, their objectives and possible conflicts * discuss the possible conflict between stakeholder objectives * discuss the role of management in meeting stakeholder objectives, including the use of agency theory * explain ways to encourage the achievement of stakeholder objectives, including: * managerial reward schemes * regulatory requirements * discuss the impact of not-for-profit status on financial and other objectives * discuss the nature and importance of Value for Money as an objective in not-for-profit organisations * discuss ways of measuring the achievement of objectives in not-for-profit organisations ## The Financing, Investment and Dividend Decisions The financial management function covers the three interconnected decisions: * **The Financing Decision:** This involves determining the optimal mix of debt and equity to finance the company's operations. * **The Investment Decision:** This involves selecting the most profitable investment projects, considering factors like cost of capital, profitability, and risk. * **The Dividend Decision:** This involves deciding how much of the company's profits to distribute to shareholders and how much to retain for reinvestment. ## The Relationship Between Corporate Strategy and Corporate and Financial Objectives * **Objectives:** Define what the organisation is trying to achieve. * **Strategy:** Considers how to achieve those objectives. These are interconnected. For example, a corporate goal could be to expand into new markets. The strategy might be to develop a new product line or to acquire an existing company. The financial objectives might include increasing revenue, reducing costs, and improving profitability. The financial objectives might also include making sure the business has enough cash to finance its operation. The financial objectives are all designed to help the business achieve its corporate strategy. ## Shareholder Wealth Maximisation and Profit Maximisation * **Shareholder wealth maximisation** is often considered the primary objective of a company. This involves maximizing the company's value to its shareholders. The main ways this is done are increasing share price and dividend payout. * **Profit maximization** is often seen as the objective of a company. This involves achieving a higher profit margin on its operations. However, maximizing profit does not always lead to maximizing shareholder wealth. There are a number of factors that can prevent this from happening: * **Long-run vs. short-run issues:** It is possible to maximize short-term profits at the expense of long-term profits. For example, cutting back on research and development in order to increase profits now may hurt the company's long-term prospects. * **Quality of earnings:** The quality of earnings can be affected by the riskiness of a business's operations. For example, a company can generate high profits by taking on a lot of risk. However, this may make the company's earnings less sustainable in the long term. * **Cash flow:** Shareholders are ultimately interested in the cash flow of a company, not just its profits. A company can generate high profits, but still have low cash flow. This would make it difficult for the company to reinvest its profits back into the business or to pay dividends to shareholders. ## Stakeholder Groups and Their Objectives * **Stakeholder groups** are those with an interest in the company. These groups can be internal (employees, managers, and directors) or external (customers, suppliers, finance providers, and the government). Each stakeholder group has its own unique set of objectives, which may conflict with the objectives of other stakeholders. * **The Stakeholder View** states that companies should not only maximize shareholder wealth but also consider the needs of all stakeholders. This is a more complex and nuanced view of corporate social responsibility. ## Agency Theory * **Agency Theory** explains the relationship between a **principal** (who hires an agent to perform a task on their behalf), and the **agent**. For example, the principal is a shareholder who hires managers (agents) to run the company. This relationship often runs into challenges. The primary problem is that the agent (the manager) may have different goals than the principal (the shareholder). * The most common conflict of interest is between **shareholders** and **directors**, who are hired to run the company on behalf of the shareholders. This conflict can be exacerbated by a lack of communication between shareholders and directors, as well as by poor corporate governance. * **To mitigate these challenges** companies have to ensure managers are rewarded in ways that are aligned with the goals of shareholders. Reward schemes can help align managers with the interests of shareholders by providing incentives for managers to make decisions that are in the best interests of the company. ## Corporate Governance Codes These codes are designed to ensure that directors make decisions in the best interests of the company and its shareholders. These codes often address the conflict between shareholders and directors, and sometimes also address the issue of executive compensation. ## Measuring Corporate Objectives Businesses typically use **ratio analysis** to measure their performance. This involves comparing key financial ratios across different periods. The most common categories of ratio are: * **Profitability and return** * **Debt and gearing** * **Liquidity** * **Investor ratios** ## Objective Setting in Not-for-Profit Organisations * The primary objective of a **not-for-profit organization** is not to make money, but rather to deliver a specific service or benefit to a particular group of people. * **Value for money (VFM)** is a key concept when it comes to assessing the effectiveness of a not-for-profit organization. This focuses on whether the organization is providing its services effectively and efficiently. The 3 Es (Economy, Efficiency, and Effectiveness) are often used to assess VFM. ## The Role of Independent Non-Executive Directors (NEDs) * Independent NEDs play a critical role in corporate governance. Their role is to provide independent advice to the board and to help the company achieve its objectives. * NEDs are not involved in the running of the business, but they are responsible for attending board meetings, provide honest feedback, and hold the company accountable for its performance. ## Financial Management for Not-for-Profit Organisations * **Financial management** is just as important for not-for-profit organizations as it is for commercial organizations. It involves: * **Budgeting:** Planning how to allocate available funds to different programs and activities. * **Monitoring:** Tracking the organization’s progress towards meeting its financial objectives. * **Reporting:** Providing clear and transparent financial information to stakeholders. ## Conclusion * Financial management plays an essential role in the success of any organization, whether it is a for-profit or a not-for-profit organization. * Effective financial management involves understanding the organization’s objectives, developing a sound financial strategy, and ensuring that the organization has the resources it needs to achieve its goals. * This is a complex area requiring a balanced and considered approach. Managers must make sure that all stakeholders, including shareholders, employees, customers, and the government, are taken into account. It is important to consider the impact of decisions on all stakeholders in order to ensure that the company is acting both ethically and responsibly.