FINANCIAL MANAGEMENT FUNCTION. The nature and purpose of financial management

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1 A FINANCIAL MANAGEMENT FUNCTION 1. The nature and purpose of financial management 2. Financial objectives and relationship with corporate strategy 3. Stakeholders and impact on corporate objectives 4. Financial and other objectives in not for profit organisations The nature and purpose of financial management What is financial management? Financial management is concern with the management of all matters associated with the cash flow of an organisation both short term and long term. How the company uses its funds typically by buying noncurrent assets and funding its working capital and where the funds came from typically from the shareholders (equity) or by borrowing money from third parties (loans/debt). A decision to invest in capital assets should be considered against: Return Return Risk Short term profitability Liquidity The return of an investment is the profit that is derived from the acquired asset. Profit may be calculated in several ways; financial accounting profit or net present value (which is a measure of the surplus cash received less the cash paid out over the life of the product, expressed in terms of the current value of the cash flow). Risk Risk is the probability that an event will occur. It is not based on a hunch that an event might occur it is a quantified assessment of what might occur. Short term profitability The short term profitability of an investment is important because if too little profit is made during the early stages of the project the organisation may struggle to keep financing the project for the longer term. Liquidity Liquidity has to do with the additional strain on cash that the new project requires. The investment in the project must include an amount for the increased working capital requirement that the organisation will need. The additional cost must be included in the decision criteria.

2 What is working capital? Working capital is the cash resource available to the business on a day to day basis and used to finance the current assets such as inventory and receivable. Without it the business would run out of cash and become insolvent. What are some disadvantages of working capital? Working capital does not directly provide any returns. Returns come from using the capital assets that depend on the working capital. The business therefore has to balance the amount of working capital it has. Too much and the cost of having money tied up in working capital increases and profitability decreases. When looking at the financing of a business there are four basic points to consider: Total funding required (difference between what it requires and what it has) Internally generated vs. externally generated Debt vs. equity Long term vs. short term debt Calculate the funding an organisation requires? Existing assets + new investments Disposal of investments +/ changes in working capital Calculate the funding an organisation has? Existing funding + retained earnings ( losses) + new equity raised ( reduced) + new loans ( redemptions) Calculate total funding required? Funding an organisation requires funding an organisation has When looking to pay dividends there are five basic points to consider: Profitability Liquidity Growth Investors expectation Legal requirements Financial objectives and relationship with corporate strategy The aims of the financial management team should be aligned with those of the wider corporate strategy. Some objectives of commercial companies include:

3 Maximising shareholder s wealth Maximising profits Satisficing/satisfying Maximising shareholder s wealth Shareholders wealth comes primarily from the value of the company s shares, therefore, if the directors manage the business in such a way that the share price is maximised then they have maximised shareholders wealth. Time period may differ between shareholders themselves and the management of the business some shareholders may be looking for a quick return (get in and get out fast), some may be looking to build the business for the long term (in it for the long haul). A high share price may be quickly achieved if directors pursue risky strategy but this may be a strategy that will go badly wrong resulting in a collapse of the share price and the share market. In practice if shareholders are unhappy with the management of the business they can sell their shares but the point is that directors should be aware of these issues to ensure that their objectives really are those of the shareholders. Maximising profits Management is rewarded on some measure of profit and we expect some correlation between profit increasing and shareholders wealth increasing but there may be some conflicts: Short termism profit is calculated over one year, relatively easy to manipulate resulting in high returns for managers but affect long term interest of shareholders Cash vs. Profit Wealth is calculated on a cash basis Risk managers may be incline to accept risky projects to achieve profit targets which may affect adversely the value of the business Satisficing / Satisfying Satificing is where an organisation is primarily concern about surviving rather than growing this mean that it attempts to generate an acceptable level of profit with minimal risk. Stakeholders and impact on corporate objectives Stakeholders are any party that has An interest in the company A relationship of some sort with the company Can exert influence over the company The main stakeholders of a company can be listed as follows:

4 Shareholders Employees and unions HM Revenue and Customs Local Council Local people living close to the business Customers Debt holders Organisations have a responsibility to balance the requirements of all stakeholder groups in relation to the relative economic power or influence of each stakeholder. Depending on the degree of influence which each stakeholder possesses, the company must deliver the various stakeholders the return that the stakeholder is seeking. The level of returns within an organisation is finite therefore there is a need to balance the needs of all groups in relation to their relative strength. Give example of conflicts between stakeholders? Employees and unions demand more pay or a shorter working week and this affects the level of profitability expected by shareholders. Neighbours may complain about the level of pollution the company produces. Customers may demand extra services from employees or complain that prices of products/services are too high. Debt holders want returns regardless of the business profitability. Shareholders may demand large dividends which can weaken the company s asset base. How can goal congruence be achieved? 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. In order to achieve goal congruence there should be introduction of 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 share holders. Including share options as part of a manager s remuneration package incentivises the managers to try and maximise the share price as this will maximise the capital gains they will achieve. It will at the same time satisfy shareholders. Performance related pay incentivises both managers and the workforce to maximise shareholders wealth. Objectives and targets are set and if they are met then bonuses are paid in accordance with an agreed formula.

5 Financial and other objectives in not for profit organisations Not for profit organisations are established to pursue non financial aims and exist to provide services to the community. Such organisations need fund 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. Value for money simply means getting the best possible service at the least possible cost. Value for money involves providing a service which is economical, efficient and effective. Economy means resourcing and purchasing the inputs at minimum cost consistent with the required quality of the output. Effectiveness means doing the right thing. Efficiency means doing the right thing well. THEN END

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