The nature and purpose of financial management

Financial management is concerned with the efficient acquisition and deployment of both short- and long-term financial resources, to ensure the 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?

Key decisions

The investment decision

To operate, all business will need finance and part of the financial manager's role is to ensure this finance is used efficiently and 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 some finance. A key financial management decision is the identification of the most appropriate sources (be it long or short term), taking into account the requirements of the company, the likely demands of the investors and the amounts likely to be made available.

The dividend decision

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

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

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

Contrasting financial management, management accounting and financial accounting

Management accounting and financial management are both concerned with the use of resources to achieve a given target. Much of the information 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 by nature, whilst management accounting usually operates within a 12-month time 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 the day-to-day planning, control and decision making of an organisation.Rather, it is concerned with providing information about the historical results of past plans and decisions. Its purpose is to keep the owners(shareholders) and other interested parties informed of the overall financial position of the business, and it will not be concerned with the detailed information used internally by management accountants and financial managers.

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

The link between financial management and corporate 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 and develop broad-based goals for the business to pursue to ensure it fulfils that purpose.

Each goal is then further broken down into detailed commercial and financial objectives, each of which should have appropriate identifiable, measurable targets so that progress towards them can be monitored.

The distinction between 'commercial' and 'financial' objectives is to emphasise that not all objectives can be expressed in financial terms and that some objectives derive from commercial market place considerations

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

Once objectives and targets are set, the enterprise must then work to 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 financial implications and the financial manager has a key role to play in helping business strategies succeed.

Financial objectives

Shareholder wealth maximisation is a fundamental principle of financial management.

Many other objectives are also suggested for companies including:

• profit maximisation
• growth
• market share
• social responsibilities

Shareholder wealth maximisation

If strategy is developed in response to the need to achieve objectives, it is obviously important to be clear about what those objectives are.

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

Profit maximisation

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

Firms often find that share prices bear little relationship to reported profit figures (e.g. biotechnology companies and other 'new economy' 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 a measure of return to equity. EPS growth is therefore a commonly pursued objective.

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

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

Whilst there is obviously a correlation between earnings and the wealth 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 to some groups (e.g. shareholders) and satisfy the requirements of other groups (e.g. employees). The discussion about objectives is really about which group's returns management is trying to maximise.

The stakeholder view

We've already stated that the primary objective of a company is to maximise the wealth of shareholders. However, modern organisations vary in type, and talk of pursuing single objectives is perhaps a little simplistic. Many argue that a business must adopt the stakeholder view,which involves balancing the competing claims of a wide range of stakeholders, and taking account of broader economic and social responsibilities.

Professor Charles Handy is a prominent advocate of this view,arguing that maximisation of shareholder wealth, while important, cannot be the single overall objective of organisations, and account must be taken of broader economic and social responsibilities. Increasing globalisation, and the fact that some multinational companies have a turnover in excess of the incomes of small countries, puts these responsibilities sharply into focus. Typical stakeholders for an organisation 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 of these other groups must obviously be balanced and managed, only shareholders have a relationship with organisations which is one of riskand return, and so practically the long-term financial objective of a private sector organisation is to maximise the wealth of equity investors. The debate will continue, but there seems to be an acceptance that organisations need to have a greater awareness of the societies in which they operate and this is reflected in the later debate on ethics.

Agency theory

Agency theory is often used to describe the relationships between the various interested parties in a firm and can help to explain the various 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).

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

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

The divorce of ownership and control

By far the most important conflict of those mentioned above is that between the interests of shareholders who own the company and the directors/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 the Maxwell scandal and others, attention has focused increasingly on the activities of directors. There has been an allegation that directors have been making corporate decisions in their own interests rather than for 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 reporting sharply reduced profits and laying off staff or cutting levels of employee pay. At the same time many directors were awarded large increases in pay or large bonuses. The greatest media attention focused on the companies who received government assistance as part of a bail-out package but continued to reward their top executives highly.

Empire building

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

Creative accounting

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

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

Takeover bids

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

Unethical activities

Unethical activities might not be prohibited by the Companies Acts or stock exchange regulations, but are believed by many to be undesirable to society as a whole. Examples are trading with countries ruled by dictatorships, testing products on animals, emitting pollution or 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.

Risk management

One of the key matters to consider when developing a financial policy framework is the way risk and risk management is to be incorporated into the decision making process.

A number of policy decisions must be made:

• What is the firm's appetite for risk?
• How should risk be monitored?
• How should risk be dealt with?

Appetite for risk

Shareholders will invest in companies with a risk profile that matches that required for their portfolio. Management should be wary of altering the risk profile of the business without shareholder support. An increase in risk will bring about an increase in the required return and may lead to current shareholders selling their shares and so depressing the share price.

Inevitably management will have their own attitude to risk. Unlike the well-diversified shareholders, the directors are likely to be heavily dependent on the success of the company for their own financial stability and be more risk averse as a consequence.

Monitoring risk

The essence of risk is that the returns are uncertain. As time passes, so the various uncertain events on which the forecasts are based will occur. Management must monitor the events as they unfold, reforecast predicted results and take action as necessary. The degree and frequency of the monitoring process will depend on the significance of the risk to the project's outcome.

Dealing with risk

Risk can be either accepted or dealt with. Possible solutions for dealing with risk include:

• mitigating the risk - reducing it by setting in place control procedures
• hedging the risk - taking action to ensure a certain outcome
• diversification - reducing the impact of one outcome by having a portfolio of different ongoing projects.

Policy decisions about which methods are to be preferred should be made in advance of specific actions being required.

Risk and the financial manager can be explored in further detail here.

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