Chapter 1: 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.

1 The nature and purpose of financial management

Financial management is concerned with the efficient acquisition anddeployment of both short- and long-term financial resources, to ensurethe objectives of the enterprise are achieved.

Decisions must be taken in three key areas:

• investment – both long-term investment in non-current assets and short-term investment in working capital;
• finance – from what sources should funds be raised?
• dividends – how should cash funds be allocated to shareholders and how will the value of the business be affected by this?

 An understanding of these three key areas is fundamental for the examination.

In taking these decisions, the financial manager will need to take account of:

• the organisation's commercial and financial objectives
• the broader economic environment in which the business operates
• the potential risks associated with the decision and methods of managing that risk.

The F9 syllabus covers all these key aspects of financial management.

The investment decision

To operate, all business will need finance and part of thefinancial manager's role is to ensure this finance is used efficientlyand effectively to ensure the organisation's objectives are achieved.This can be further broken down into two elements:

• Investment appraisal considers the long-term plans of the business and identifies the right projects to adopt to ensure financial objectives are met. The projects undertaken will nearly always involve the purchase of non-current assets at the start of the process.
• For a business to be successful, as well as identifying and implementing potentially successful projects, it must survive day to day. Working capital management is concerned with the management of liquidity – ensuring debts are collected, inventory levels are kept at the minimum level compatible with efficient production, cash balances are invested appropriately and payables are paid on a timely basis.

The financing decision

Before a business can invest in anything, it needs to have somefinance. A key financial management decision is the identification ofthe most appropriate sources (be it long or short term), taking intoaccount the requirements of the company, the likely demands of theinvestors and the amounts likely to be made available.

The dividend decision

Having invested wisely, a business will hopefully be profitable andgenerate cash. The final key decision for the financial manager iswhether to return any of that cash to the owners of the business (in theform of dividends) and if so, how much.

The alternative is to retain some of the cash in the business whereit can be invested again to earn further returns. This decision istherefore closely linked to the financing decision.

The decision on the level of dividends to be paid can affect thevalue of the business as a whole as well the ability of the business toraise further finance in the future.

Financial management should be distinguished from other important financial roles:

• management accounting – concerned with providing information for the more day to day functions of control and decision making
• financial accounting – concerned with providing information about the historical results of past plans and decisions.

Financial roles

Management accounting and financial management are both concernedwith the use of resources to achieve a given target. Much of theinformation used and reported is common to both functions.

The main difference is in the time scales. Financial management is concerned with the long-term raising of finance and the allocation and control of resources;it involves targets, or objectives, that are generally long-term bynature, whilst management accounting usually operates within a 12-monthtime horizon.

Management accounting is concerned with providing information for the more day-to-day functions of control and decision making. This will involve budgeting, cost accounting, variance analysis, and evaluation of alternative uses of short-term resources.

Financial accounting is not directly involved in theday-to-day planning, control and decision making of an organisation.Rather, it is concerned with providing information about the historical resultsof past plans and decisions. Its purpose is to keep the owners(shareholders) and other interested parties informed of the overallfinancial position of the business, and it will not be concerned withthe detailed information used internally by management accountants andfinancial managers.

The following table illustrates the distinction between some of the tasks carried out by each of these financial roles:

2 The relationship between corporate strategy and corporate and financial objectives

 Objectives/targets define what the organisation is trying to achieve. Strategy considers how to go about it.

Objectives and strategy

The diagram above is key to understanding how financial management fits into overall business strategy

The business should recognise its overriding purpose or mission anddevelop broad-based goals for the business to pursue to ensure itfulfils that purpose.

Each goal is then further broken down into detailed commercial andfinancial objectives, each of which should have appropriateidentifiable, measurable targets so that progress towards them can bemonitored.

The distinction between 'commercial' and 'financial' objectives isto emphasise that not all objectives can be expressed in financial termsand that some objectives derive from commercial marketplaceconsiderations

These are then cascaded down throughout the organisation throughthe setting of targets so that all parts of the business are working toachieve the same overall goal. For example, the receivables days targetof the credit control department should be linked to the cash needs ofthe investment projects, and the projects should be selected to achievethe overall corporate aim such as improving the share price. This inturn then satisfies the shareholders by increasing their wealth.

Once objectives and targets are set, the enterprise must then workto achieve them by developing and implementing appropriate strategies.Strategies will be developed at all levels of the business.

• Corporate strategy concerns the decisions made by senior management about matters such as the particular business the company is in, whether new markets should be entered or whether to withdraw from current markets. Such decisions can often have important financial implications. If, for example, a decision is taken to enter a new market, an existing company in that market could be bought, or a new company be started from scratch.
• Business strategy concerns the decisions to be made by the separate strategic business units within the group. Each unit will try to maximise its competitive position within its chosen market. This may involve for example choosing whether to compete on quality or cost.
• Operational strategy concerns how the different functional areas within a strategic business unit plan their operations to satisfy the corporate and business strategies being followed. We are, of course, most interested in the decisions facing the finance function. These day-to-day decisions include all aspects of working capital management.

Almost all strategies developed by the business will have financialimplications and the financial manager has a key role to play inhelping business strategies succeed.

Additional question - Objectives and strategy

The following list contains some commercial objectives/targets,some financial objectives/targets and some strategies, all at differentlevels of the business. Identify which is which.

• Implement a Just-In-Time (JIT) inventory system.
• Increase earnings per share (EPS) by 5% on prior year.
• Acquire a rival in a share-for-share purchase.
• Buy four new cutting machines for $250,000 each.
• Achieve returns of 15% on new manufacturing investment.
• Improve the ratio of current assets to current liabilities from 1.7 to 1.85.
• Reduce unsold inventory items by 12%.
• Update manufacturing capacity to incorporate new technology.
• Improve brand awareness within the UK.

The answer to this question can be found after the chapter summary diagram at the end of this chapter.

3 Financial objectives

Shareholder wealth maximisation

 Shareholderwealth maximisation is a fundamental principle of financial management.You should seek to understand the different aspects of the syllabus(e.g. finance, dividend policy, investment appraisal) within thisunifying theme.

Many other objectives are also suggested for companies including:

• profit maximisation
• growth
• market share
• social responsibilities

Financial objectives

Shareholder wealth maximisation

If strategy is developed in response to the need to achieveobjectives, it is obviously important to be clear about what thoseobjectives are.

Most companies are owned by shareholders and originally set up tomake money for those shareholders. The primary objective of mostcompanies is thus to maximise shareholder wealth. (This could involveincreasing the share price and/or dividend payout.)

Profit maximisation

In financial management we assume that the objective of thebusiness is to maximise shareholder wealth. This is not necessarily thesame as maximising profit.

Firms often find that share prices bear little relationship toreported profit figures (e.g. biotechnology companies and other 'neweconomy' ventures).

There are a number of potential problems with adopting an objective of profit maximisation:

• Long-run versus short-run issues: In any business it is possible to boost short-term profits at the expense of long-term profits. For example discretionary spending on training, advertising, repairs and research and development (R&D) may be cut. This will improve reported profits in the short-term but damage the long-term prospects of the business. The stock exchange will normally see through such a tactic and share prices will fall.
• Quality (risk) of earnings: A business may increase its reported profits by taking a high level of risk. However the risk may endanger the returns available to shareholders. The stock exchange will then generally regard these earnings as being of a poor quality and the more risk-averse shareholders may sell. Once again the share price could fall.
• Cash: Accounting profits are just a paper figure. Dividends are paid with cash. Investors will therefore consider cash flow as well as profit.

Earnings per share (EPS) growth

A widely used measure of corporate success is EPS as it provides ameasure of return to equity. EPS growth is therefore a commonly pursuedobjective.

However it is a measure of profitability, not wealth generation,and it is therefore open to the same criticisms as profit maximisationabove.

The disadvantage of EPS is that it does not represent income of theshareholder. Rather, it represents that investor's share of the incomegenerated by the company according to an accounting formula.

Whilst there is obviously a correlation between earnings and thewealth received by individual shareholders, they are not the same.

Maximising and satisficing

A distinction must be made between maximising and satisficing:

• maximising – seeking the maximum level of returns, even though this might involve exposure to risk and much higher management workloads.
• satisficing – finding a merely adequate outcome, holding returns at a satisfactory level, avoiding risky ventures and reducing workloads.

Within a company, management might seek to maximise the return tosome groups (e.g. shareholders) and satisfy the requirements of othergroups (e.g. employees). The discussion about objectives is really aboutwhich group's returns management is trying to maximise.

4 Stakeholder objectives and conflicts

A stakeholder group is one with a vested interest in the company.

Typical stakeholders for an organisation would include:

Internal

• company employees
• company managers/directors

Connected

• equity investors (ordinary shareholders)
• customers
• suppliers
• finance providers (debt holders / bankers)
• competitors

External

• the government
• the community at large
• pressure groups
• regulators.

Many argue that managers should balance the needs and objectives of all stakeholders.

 Conflict between and within groups of stakeholders and the need for management to balance the various interests is a key issue.

The stakeholder view

We've already stated that the primary objective of a company is tomaximise the wealth of shareholders. However, modern organisations varyin type, and talk of pursuing single objectives is perhaps a littlesimplistic. Many argue that a business must adopt the stakeholder view,which involves balancing the competing claims of a wide range ofstakeholders, and taking account of broader economic and socialresponsibilities.

Professor Charles Handy is a prominent advocate of this view,arguing that maximisation of shareholder wealth, while important, cannotbe the single overall objective of organisations, and account must betaken of broader economic and social responsibilities. Increasingglobalisation, and the fact that some multinational companies have aturnover in excess of the incomes of small countries, puts theseresponsibilities sharply into focus. Typical stakeholders for anorganisation might include the following.

• Equity investors (ordinary shareholders) – within any economic system, the equity investors provide the risk finance. There is a very strong argument for maximising the wealth of equity investors. In order to attract funds, the company has to compete with risk-free investment opportunities, e.g. government securities. The attraction is the accrual of any surplus to the equity investors. In effect, this is the risk premium which is essential for the allocation of resources to relatively risky investments in companies.
• Company managers/directors – such senior employees are in an ideal position to follow their own aims at the expense of other stakeholders. Their goals will be both long-term (defending against takeovers, sales maximisation) and short-term (profit margins leading to increased bonuses).
• Company employees – obviously, many trade unionists would like to see their members as the residual beneficiaries of any surplus the company creates. Certainly, there is no measurement problem: returns = wages or salaries. However, maximising the returns to employees does assume that risk finance can be raised purely on the basis of satisficing, i.e. providing no more than an adequate return to shareholders.
• Customers – satisfaction of customer needs will be achieved through the provision of value-for-money products and services. There remains, of course, the requirement for organisations to accurately identify precisely what those needs are.
• Suppliers – suppliers to the organisation will have short-term goals such as prompt payment terms alongside long-term requirements including contracts and regular business. The importance of the needs of suppliers will depend upon both their relative size and the number of suppliers.
• Finance providers – providers of finance (banks, loan creditors) will primarily be interested in the ability of the organisation to repay the finance including interest. As a result it will be the organisation's ability to generate cash both long- and short-term that will be the basis of interest to these providers.
• The government – the government will have political and financial interests in the organisation. Politically they will wish to increase exports and decrease imports whilst monitoring companies via the Office of Fair Trading (OFT). Financially they require long-term profits to maximise taxation income. Equally importantly the government via its own agencies or via the legal system will seek to ensure that organisations observe health and safety, planning and minimum wage legislation. Also, on behalf of the community at large, the government must consider modifying the behaviour of both individuals and organisations for environmental/health reasons, e.g. banning smoking in certain public places and restricting the advertising of tobacco companies.
• The community at large – this is a particularly important group for public sector enterprises and will have, in particular, environmental expectations from private sector or regulated organisations, such as organic foods, safe trains and cleaner petrol. For organisations there are problems of measurement – what are returns to the community at large? The goals of the community will be broad but will include such aspects as legal and social responsibilities, pollution control and employee welfare.

Critics of the stakeholder view argue that while the interests ofthese other groups must obviously be balanced and managed, onlyshareholders have a relationship with organisations which is one of riskand return, and so practically the long-term financial objective of aprivate sector organisation is to maximise the wealth of equityinvestors. The debate will continue, but there seems to be an acceptancethat organisations need to have a greater awareness of the societies inwhich they operate and this is reflected in the later debate on ethics.

Additional question - Stakeholder conflicts

Suggest the potential conflicts in objectives which could arise between the following groups of stakeholders in a company.

The answer to this question can be found after the chapter summary diagram at the end of this chapter.

5 The role of management and goal congruence

Agency theory

Agency theory is often used to describe the relationships betweenthe various interested parties in a firm and can help to explain thevarious duties and conflicts that occur:

Agency relationships occur when one party, the principal, employs another party, the agent, to perform a task on their behalf. In particular, directors (agents) act on behalf of shareholders (principals).

How to reduce the problems caused by agency relationships

 Findingways to reduce the problems of the agency relationship and ensure thatmanagers take decisions which are consistent with the objectives ofshareholders is a key issue.

Agency theory

Agency theory can help to explain the actions of the various interest groups in the corporate governance debate.

For example, managers can be seen as the agents of shareholders,employees as the agents of managers, managers and shareholders as theagents of long- and short-term creditors, etc. In most of theseprincipal-agent relationships, conflicts of interest will exist.

The problem lies in the fact that once the agent has been appointedhe is able to act in his own selfish interests rather than pursuing theobjectives of the principal.

The divorce of ownership and control

By far the most important conflict of those mentioned above is thatbetween the interests of shareholders who own the company and thedirectors/managers who run it.

• Shareholders are reliant upon the management of the company to understand and pursue the objectives set for them.
• Although shareholders can intervene via resolutions at general meeting, the managers are usually left alone on a day-to-day basis.
• Management are uniquely placed to make decisions to maximise their own wealth or happiness rather than the wealth of the shareholders.

During the past 20 years or so, and particularly following theMaxwell scandal and others, attention has focused increasingly on theactivities of directors. There has been an allegation that directorshave been making corporate decisions in their own interests rather thanfor the benefit of the company as a whole and the shareholders inparticular. Examples include the following:

Remuneration

The UK recession in 2008 – 2009 led to many companies reportingsharply reduced profits and laying off staff or cutting levels ofemployee pay. At the same time many directors were awarded largeincreases in pay or large bonuses. The greatest media attention focusedon the companies who received government assistance as part of abail-out package but continued to reward their top executives highly.

Empire building

The high level of corporate takeover activity in the 1980s led tomany chief executives believing that building as large a group aspossible was a valid aim in itself, an objective described as empirebuilding. Executives gained prestige from successful bids and from beingin charge of large conglomerates, but the returns to shareholders wereoften disappointing.

Creative accounting

The directors are responsible for selecting the accounting policiesto be used by their company, subject to accounting standards and theopinion of the auditors. Despite the constraints upon them, thedirectors are still free to use creative accounting techniques toflatter their published accounts and perhaps artificially boost theshare price. Examples of such techniques are: capitalising expenses onthe balance sheet (e.g. development expenditure, advertisingexpenditure), not depreciating non-current assets, maximising the valueof intangibles on the balance sheet (e.g. putting a value to brands),recognising revenue on long-term contracts at the earliest possibletime, and other forms of off-balance-sheet financing (see below).

Those charged with setting accounting standards have a continuingwork programme that aims to cut out creative accounting practices asmuch as is practically possible.

Off-balance-sheet finance refers to ways of financing assets where the method of funding is not recorded on the balance sheet.

One example is the use of leased, rather than purchased, assets. Inthe UK, before SSAP 21 a lessee's obligation to the lessor was omittedfrom the lessee's balance sheet and he could therefore report a lowergearing ratio and raise new funds at lower interest rates. SSAP 21required that assets acquired under finance leases must be capitalisedon the lessee's balance sheet together with the corresponding obligationto the lessor. The introduction of FRS 5 aimed to restrictoff-balance-sheet finance still further, for example by requiring quasisubsidiaries to be consolidated into the group accounts. The collapse ofEnron in the US in late 2001 has put the spotlight on the various formsof off-balance-sheet finance used, and further scrutiny and regulationis inevitable.

Takeover bids

Boards of directors often spend considerable amounts of time andmoney attempting to defend their companies against takeover bids, evenwhen it appears that the takeover would be in the best interests of thetarget company's shareholders. These directors are accused of trying toprotect their own jobs, fearing that they will be retired if theircompany is taken over. Directors of public companies must now complywith the City Code on Takeovers and Mergers during a bid period.

Unethical activities

Unethical activities might not be prohibited by the Companies Actsor stock exchange regulations, but are believed by many to beundesirable to society as a whole. Examples are trading with countriesruled by dictatorships, testing products on animals, emitting pollutionor carrying out espionage against competitors. The importance of good business ethics and corporate social responsibility (CSR) has been recognised in recent years and it is hoped that further progress is being made in the new millennium.

Although directors are supposed to be acting in the interests ofthe shareholders of their company, they stand accused in recent years ofhaving made decisions on the basis of their own self-interest.

Managerial reward schemes

One way to help ensure that managers take decisions which areconsistent with the objectives of shareholders is to introduce carefullydesigned remuneration packages. The schemes should:

• be clearly defined, impossible to manipulate and easy to monitor
• link rewards to changes in shareholder wealth
• match managers' time horizons to shareholders' time horizons
• encourage managers to adopt the same attitudes to risk as shareholders.

Common types of reward schemes include:

• remuneration linked to:
  • minimum profit levels
  • economic value added (EVA)
  • turnover growth
• executive share option schemes (ESOP).

Managerial reward schemes

Types of remuneration schemes include:

Remuneration linked to minimum profit levels

This scheme would be easy to set up and monitor.

Disadvantages are that the scheme may lead to managers takingdecisions that would result in profits being earned in the short-term atthe expense of long-term profitability. It could also lead to managersunder-achieving, i.e. relaxing as soon as the minimum is achieved. Thescheme might also tempt managers to use creative accounting to boost theprofit figure.

Remuneration linked to economic value added (EVA)

EVA is a measure of the increase in the value of shareholder wealthin the period. Schemes such as these are therefore designed to moreclosely align the interests of the employee and the shareholder.

A potential disadvantage is that calculating the bonus may be complex.

Remuneration linked to turnover growth

Growth of the business and higher production levels can lead toeconomies of scale which in turn can help the business compete moresuccessfully on price.

However, turnover growth could be achieved at the expense ofprofitability, e.g. by reducing selling prices or by selecting highrevenue product lines which may not necessarily be the most profitable.Maximising turnover is therefore unlikely to maximise shareholderwealth.

An executive share option scheme (ESOP)

This scheme has the advantage that it will encourage managers tomaximise the value of the shares of the company, i.e. the wealth of theshareholders. When an executive is awarded share options, the theory isthat it is in their interests for the share price to rise, so they willdo whatever possible to improve the share price. Their interests will bebest served by working towards a goal that is also in the interests ofthe shareholders.

Such schemes are normally set up over a relatively long periodthereby encouraging managers to make decisions to invest in positivereturn projects which should result in an increase in the price of thecompany shares. However, efficient managers may be penalised at timeswhen share prices in general are falling.

There are several criticisms of ESOPs.

• When directors exercise their share options, they tend to sell the shares almost immediately to cash in on their profit. Unless they are awarded more share options, their interest in the share price therefore ends when the option exercise date has passed.
• If the share price falls when options have been awarded, and the options go 'underwater' and have no value, they cannot act as an incentive.
• If a company issues large quantities of share options, there could be some risk of excessive dilution of the equity interests of the existing shareholders. As a result, it has been suggested that companies should recognise the cost of share options to their shareholders, by making some form of charge for options in the income statement.
• Directors may distort reported profits (creative accounting) to protect the share price and the value of their share options.

Additional question - Managerial reward schemes

Gretsch Inc, a listed company, has developed a highly successfulnew product and is thus growing rapidly. However, with this growth thefirm is experiencing cash flow problems. Managers are currently awardedbonuses if there is growth in reported earnings per share (EPS).

Comment on the current remuneration scheme.

The answer to this question can be found after the chapter summary diagram at the end of this chapter.

Corporate governance codes

The director/shareholder conflict has also been addressed by therequirements of a number of corporate governance codes. The followingkey areas relate to this conflict.

• Non-executive directors (NEDs)
  • important presence on the board
  • must give obligation to spend sufficient time with the company
  • should be independent.
• Executive directors
  • separation of chairman and chief executive officer (CEO)
  • submit for re-election
  • clear disclosure of financial rewards
  • outnumbered by the NEDs.
• Remuneration committees.
• Nomination committees.
• Annual general meeting (AGM).

Corporate governance codes

After a number of high-profile firms collapsed, concerns over howthe companies had been run led to a determination to ensure goodcorporate governance in future. A number of committees met and producedreports containing recommendations on how to improve corporategovernance procedures. One of the areas addressed was the conflictbetween director and shareholder interests. Below is a selection of thecurrent requirements:

NEDs

• At least half of the members of the board, excluding the chairman, should be independent NEDs. These are directors who do not take part in the running of the business. They attend board meetings, provide advice, listen to what is said and are generally meant to act as a control on the actions of the executive directors. Independence means they are free of any business or other relationship, which could materially interfere with the exercise of their independent judgement. Boards should disclose in the annual report which of the NEDs are considered to be independent.
• NEDs should get extra fees for chairing company committees but should not hold share options in their company. There was concern that allowing NEDs to hold share options in a company could encourage corporate excess or wrongdoing.
• One of the independent NEDs should be appointed a senior independent NED who would act as a champion for the interests of shareholders.
• Prospective NEDs should conduct due diligence before accepting the role. They should satisfy themselves that they have the knowledge, skills, experience and time to make a positive contribution to the company board.
• On appointment, the NEDs would also undertake that they have the time to meet their obligations. Company nomination committees would examine their performance, and make an assessment of whether they were devoting enough time to their duties.

Executive directors

• The chairman and the CEO roles should be separate, and a CEO should not become chairman of the same company.
• The chairman should be independent at the time of his appointment. Note that the effect of this, combined with the point about independent NEDs making up at least half of the board, will be to place independent NEDs in a majority on the board.
• All directors should submit themselves for re-election at least every three years.
• There should be clear disclosure of directors' total emoluments and those of the chairman and highest-paid UK director.
• Boards should set as their objective the reduction of directors' contract periods to one year or less.

Remuneration committees

• Executive directors' pay should be subject to the recommendations of a remuneration committee made up wholly of independent NEDs.
• Remuneration committees should objectively determine executive remuneration and individual packages for each executive director.
• The broad framework and cost of remuneration should be a matter for the board on the advice of the remuneration committee.

Nomination committees

• This committee will consist of NEDs with the aim of bringing an independent view to the selection and recruitment of both executive directors and NEDs.
• It will meet when required and effectively 'headhunt' directors. It will be a high-profile committee so as to demonstrate to stakeholders that a reasonable degree of objectivity exists in the selection process.

AGM

• Companies whose AGMs are well attended should consider providing a business presentation, with a question and answer session.
• Shareholders should be able to vote separately on each substantially separate issue; and the practice of 'bundling' unrelated proposals in a single resolution should cease.

Stock exchange listing requirements and other regulations

Although adherence to the principles of the corporate governancecodes is voluntary, they are often referred to in the listingrequirements of stock exchanges.

Other regulations

Stock exchange listing requirements

The UK Combined Code is attached to the UK Listing Rules so thatlisted companies in the UK are under pressure to comply. Under anamendment to the UK Listing Rules, listed companies must:

• disclose how they have applied the principles and complied with the Code's provisions in their annual report and accounts
• state and explain any deviation from the recommended best practice.

Similarly some aspects of governance have moved into the statute books.

The Directors' Remuneration Report Regulations 2002 in the UK amends the Companies Act 1985 and apply to quoted companies. The main provisions of the Regulations are as follows:

• a directors' remuneration report must be produced each year containing details of:
  • the remuneration for the year of each individual director
  • 'golden handshakes'
  • payments into a pension scheme for a director
  • details of share option arrangements
• the report should be submitted to the shareholders for approval by vote at the AGM.

6 Measuring achievement of corporate objectives

It is necessary for managers, shareholders and other stakeholdersto have ways of measuring the progress of the company towards itsobjectives. This is commonly done via ratio analysis.

Ratio analysis compares and quantifies relationships between financial variables.

Ratio analysis can be grouped into four main categories:

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

The specific ratios covered in the F9 syllabus will be looked at indetail in chapter 17 although some of them may already be familiar toyou from previous papers.

7 Objective setting in not for profit organisations

The primary objective of not for profit organisations (NFPs orNPOs) is not to make money but to benefit prescribed groups of people.

As with any organisation, NFPs will use a mixture of financial and non-financial objectives.

However, with NFPs the non-financial objectives are often more important and more complex because of the following.

• Most key objectives are very difficult to quantify, especially in financial terms, e.g. quality of care given to patients in a hospital.
• Multiple and conflicting objectives are more common in NFPs, e.g. quality of patient care versus number of patients treated.

Objective setting in NFPs

A number of factors influence the way in which managementobjectives are determined in NFPs, which distinguish them fromcommercial businesses:

• wide range of stakeholders
• high level of interest from stakeholder groups
• significant degree of involvement from funding bodies and sponsors
• little or no financial input from the ultimate recipients of the service
• funding often provided as a series of advances rather than as a lump sum
• projects typically have a longer-term planning horizon
• may be subject to government influence/government macroeconomic policy.

For a company listed on the stock market we can take themaximisation of shareholder wealth as a working objective and know thatthe achievement of this objective can be monitored with reference toshare price and dividend payments.

For an NFP the situation is more complex. There are two questions to be answered:

• in whose interests is it run?
• what are the objectives of the interested parties?

Many such organisations are run in the interests of society as awhole and therefore we should seek to attain the position where the gapbetween the benefits they provide to society and the costs of theiroperation is the widest (in positive terms).

The cost is relatively easily measured in accounting terms.However, many of the benefits are intangible. For example, the benefitsof such bodies as the National Health Service (NHS) or local educationauthorities (LEAs) are almost impossible to quantify.

Because of the problem of quantifying the non-monetary objectivesof such organisations most public bodies operate under objectivesdetermined by the government (and hence ultimately by the electorate).

Value for money (VFM) and the 3 Es

VFM can be defined as 'achieving the desired level and quality of service at the most economical cost'.

VFM

Because a significant number of NFPs are funded from the publicpurse, the lack of clear financial performance measures has been seen asa particular problem. It is argued that the public are entitled toreassurance that their money (in the form of taxes for public sectororganisations or donations for charities) is being properly spent.

In addition, the complex mix of objectives with no absolutepriority has also led to concern that the money may be being directedtowards the wrong ends.

These issues, along with a growth in the perceived need for greateraccountability among public officials, led to the development of theconcept of evaluating VFM in public sector organisations. The principlesdeveloped are now widely applied in NFPs.

Systems analysis

A more detailed analysis of what is meant by VFM can be achieved byviewing the organisation as a system set up to achieve its objectivesby means of processing inputs into outputs.

The three Es

Assessing whether the organisation provides value for moneyinvolves looking at all functioning aspects of the organisation.Performance measures have been developed to permit evaluation of eachpart separately.

Economy: Minimising the costs of inputs required to achieve a defined level of output.

Efficiency: Ratio of outputs to inputs – achieving a high levelof output in relation to the resources put in (input driven) orproviding a particular level of service at reasonable input cost (outputdriven)

Effectiveness: Whether outputs are achieved that match the predetermined objectives.

 Useof the 3Es as a performance measure and a way to assess VFM is a keyissue for examination questions that relate to NFPs and public sectororganisations.

3Es

Known as the 3 Es these measures are fundamental to anunderstanding of VFM. An organisation achieving economy, efficiency andeffectiveness in each part of the system is considered to be providinggood VFM.

Public sector organisations are subject to regular VFM (or bestvalue) reviews and the results have important impacts on future plansand funding decisions.

Economy

Acquiring resources of appropriate quality and quantity at thelowest cost. Note that whilst obtaining low prices is an importantconsideration it is not the only one. Achieving true economy willinclude ensuring the purchases are fit for purpose and meet anypredetermined standards.

Efficiency

Maximising the useful output from a given level of resources, orminimising the inputs required to produce the required level of output.

Some public services fall within the first definition as they tryto provide as much of a service as possible with strictly limitedresources and few opportunities to generate further income sources. Thisis defined as 'input-driven' efficiency. This would include servicessuch as library provision.

However in many areas, there is a statutory obligation to provide aparticular standard of service, for example prison services, whichcannot be significantly reduced or withdrawn. In this case theobligation is to provide the service at a reasonable cost and is knownas 'output-driven' efficiency.

In both areas, the key consideration is whether the resources usedwere put to good use and the methods and processes carried out representbest practice.

Effectiveness

Ensuring that the output from any given activity is achieving the desired result.

For example the cheapest site on which to build and run a sportscentre may be a disused brownfield site on the edge of town. However, ifthe council's objectives included reduction in car use and accessibleopportunities for health improvement, then the output of the buildingprocess – the sports centre, even if built economically andefficiently, would not be considered effective as it failed to meet thestated objectives.

Measuring the achievement of objectives in NFPs

Since the services provided are limited primarily by the funds available, key financial objectives for NFPs will be to:

• raise as large a sum as possible
• spend funds as effectively as possible.

Targets may then be set for different aspects of each accounting period's finances such as:

• total to be raised in grants and voluntary income
• maximum percentage of this total that fund-raising expenses represents
• amounts to be spent on specified projects or in particular areas
• maximum permitted administration costs
• meeting budgets
• breaking even in the long run.

The actual figures achieved can then be compared with these targets and control action taken if necessary.

Test your understanding 1 – Not for profit organisations

A subsidised college canteen service is to be evaluated by thelocal council to assess amongst other things, whether it is financiallysound and offers value for money.

Suggest appropriate measures of achievement that could be set for the service.

Chapter summary

Answer to additional question - Objectives and strategy

Answer to additional question - Stakeholder conflicts

Note: You may have come up with different suggestions. Thepoint is to recognise that there is a huge range of potential conflictsof interest and senior management will need to work to achieve abalance.

Answer to additional question - Managerial reward schemes

Advantages

• Goal congruence – managers will work to achieve growth in EPS, which will make shareholders feel that their wealth is increasing.
• The figure is difficult (but not impossible!) to manipulate from one period to another as it will be audited.

Disadvantages

• There is little incentive for managers to control working capital and cash flow – a pressing problem. Growth may be at the expense of liquidity and ultimately compromise the firm's future survival.
• Managers may gain bonuses simply because of the products concerned rather than their own efforts. A target growth in EPS would be better.
• Long-term shareholder value and EPS are not well correlated.
• There is only one measure that focuses on final effects rather than operational causes.

Test your understanding answers

Test your understanding 1 – Not for profit organisations

Financial measures:

• proportion of overall funds spent on administration costs
• ability to stay within budget/break even
• revenue targets met.

Economy targets:

• costs of purchasing provisions of suitable nutritional quality
• costs of negotiating for and purchasing equipment
• negotiation of bulk discounts
• pay rates for staff of appropriate levels of qualification.

Efficiency targets:

• numbers of portions produced
• cost per meal sold
• levels of wastage of unprepared and of cooked food
• staff utilisation
• equipment life.

Effectiveness targets:

• numbers using the canteen
• customer satisfaction ratings
• nutritional value of meals served.

Rating :	Ratings & Comments  (Click the stars to rate the page)

Tags: