Inroduction of Financial Management and Ratio Analysis

COPYRIGHT © 2010 BY Mohammad Faizan Farooq FFQA 1
FINANCIAL MANAGEMENT
FOR
ACCA PAPER
F9
MOHAMMAD FAIZAN FAROOQ QADRI ATTARI

ACCA finalist, CAT, LLB…, B.com
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ACCA (Finalist)
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FINANCIAL MANAGEMENT
FINANCIAL OBJECTIVES
ECONOMIC ENVIRONMENT
AND
FINANCIAL MARKETS
Prepared & Complied by: Mohammad Faizan Farooq Qadri Attari

ACCA (Finalist)
AIM OF THE PAPER
The aim of the paper is to develop knowledge and skills expected of a financial
manager, relating to issues affecting investment, financing and dividend policy
decisions.
OUTLINE OF THE SYLLABUS

1. Financial management function
2. Financial management environment
3. Working capital management
4. Investment appraisal
5. Business finance
6. Cost of capital
7. Business valuation
8. Risk management
FORMAT OF THE EXAM PAPER

The syllabus is assessed by a three hour paper-based examination.
The examination consists of 4 questions of 25 marks each. All questions are
compulsory.

ACCA (Finalist)
WHAT IS FINANCIAL MANAGEMENT?
May be considered as:
The management of all matters associated with the cash flow of the organisation
both short and long-term.
Financial management and the accounting equation
The three key decisions

Financial management is often described in terms of the three basic decisions to be
made:
● the investment decision,
● the financial decision,
● the dividend decision.
1. The investment decision

A company may invest its funds in one of three basic areas:
1. Capital assets
2. Working capital
3. Financial assets
Capital assets
A critical decision because of the strategic implications of many investments, the
decision would include the following financial considerations:
1. Return
2. Risk
3. Cash flow
4. Profit.

ACCA (Finalist)
Working capital
The cash resource available to the business on a day-to-day basis and used to fund
the current assets such as inventory and receivables. The key to identifying the
level of investment is to balance the risk of insolvency against the cost of funding.
Financial assets Not a core area of the course, we tend to focus on financing from the
perspective of a company rather than the investor. This being the case the only
financial investment to consider is short-term saving. In this circumstance then the
key considerations are, in order:
1. Risk
2. Liquidity
3. Return.
2.The financing decision

When looking at the financing of a business there are 4 basic questions to consider:
1. total funding required,
2. internally generated vs externally sourced,
3. debt or equity,
4. long-term or short-term debt.
Total funding required

The funding requirement will be determined by an assessment of the following
Application of funds Source of funds
Existing asset base Existing funding
New assets Redemption of existing debt
Disposals Funds generated through trading
Change in Working Capital
Financial intermediaries
Financial institutions Financial intermediaries provide the
following functions:
Merchant banks Provide Maturity transformation A bank can make
large corporate loans, a 10-year loan (long-term) while still
often syndicated. Manage allowing its depositors to take money out
investment portfolios for whenever they want; so short-term
corporate clients. deposits become long-term investments.
Pension funds Invest to Aggregation of funds A bank can aggregate
meet future pension lots of small amounts of money into a
liabilities. large loan.
Insurance companies Pooling losses Any losses sustained from a
Invest to meet future bad debt will not impact directly
liabilities on an individual depositor.

ACCA (Finalist)
Financial markets
A financial market brings a firm into direct contact with its investors. The trend
to borrowing directly from investors is sometimes called disintermediation.
Financial markets are split into those that provide short-term finance (money
markets) and those that provide long-term finance (capital Markets).
Money markets Capital markets

If a company or a government If a company needs to raise funds
needs to raise funds for the short- for the long-term, it can access the
term, they can access the capital markets; this is a market
money markets and issue: on which the following are traded:
(a) Treasury bills (issued by (a) Junk bonds (unsecured)
governments)
(b) Debentures / loan notes
(b) Certificates of deposit (issued by (secured on an asset or by
companies) covenants)
(c) Commercial paper (issued by (c) Shares traded on the main

companies with a high credit rating) Stock Market
(d) Bills of exchange (company IOU (d) Shares in Alternative

signed by customer, may be Investment Market
‘accepted’)
Euromarkets
In recent years a strong market has built up which allows large
companies with excellent credit ratings to raise finance in a foreign
currency. This market is organised by international commercial banks.
The key features of Eurobonds are summarised below. This market is
much bigger than the market for domestic bonds / debentures.
Advantages
1. Cheap debt finance
Can be sold by investors, and a wide pool of investors share the risk
2. Unsecured, no covenants
Only issued by large companies with an excellent credit rating
3. Long-term debt in a foreign currency
Typically 5-15 years, normally in euros or dollars but possible in
any currency

ACCA (Finalist)
Internally vs externally generated funds
A company may be able to fund business growth via internally generated funds
such as retained earnings. If those funds are limited or the company wishes to
grow at a faster rate then external sources of funding must be tapped.
Debt vs equity
The gearing decision which forms the basis of two later chapters. A critical issue in
terms of risk and cost of funding.
Short-term vs long-term debt

A consideration focussed upon in the funding of working capital, short-term funding
may have benefits of flexibility and lower cost but is inherently risky.
3. The dividend decision

The amount of return to be paid in cash to shareholders. This is a critical measure
of the companies ability to pay a cash return to its shareholders. The level of
dividend paid will be determined by the following:
1. Profitability
2. Cash flow
3. Growth
4. Legal restrictions
5. Shareholder expectations.
QUESTION

ACCA (Finalist)
Corporate strategy and financial management
The role of the financial manager is to align the aims of financial management team
with those of the wider corporate strategy. The strategy of the business may be
separated into corporate, business and operational objectives. Financial managers
should be attempting to fulfil those objectives.
The nature of financial management means that it is fundamental to the translation
of strategic aims into financial transactions.
Financial objectives
Financial objectives of commercial companies may include:
1. Maximising shareholders wealth
2. Maximising profits
3. Satisficing.
1. Maximising shareholders’ wealth

A fundamental aim within financial management is to create and sustain
shareholders wealth.Wealth being the ongoing value of shares of the organisation. The
importance of this concept is that there is no time period to the wealth and that it is
determined by the relative risk/ return balance of the business. All aspects of financial
management are based on this basic premise.
2. Maximising profits
Within organisations it is normal to reward management on some measure of profit
such as ROI or RI. In simple terms we would expect a close relationship between profit
and shareholders wealth. There are, however, ways in which they may conflict such as:
1. Short-termism.
2. Cash vs accruals.
3. Risk.
Short-termism
A profit target is normally calculated over one year, it is relatively easy to
manipulate profit over that period to enhance rewards at the expense of future
years.
Cash vs accruals
As we will see later, wealth is calculated on a cash basis and ignores accruals.
Risk
A manager may be inclined to accept very risky projects in order to achieve profit
targets which in turn would adversely affect the value of the business.

ACCA (Finalist)
3. Satisficing
Many organisations do not profit maximise but instead aim to satisfice. This means
that they attempt to generate an acceptable level of profit with a minimum of risk.
It reflects the fact that many organisations are more concerned with surviving than
growth.
4. Objectives of not-for-profit organisations

These organisations are established to pursue non-financial aims but are to provide
services to the community. Such organisations like profit-seeking companies need
funds 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.
QUESTION FFQA
At the end of 2004 Rameez raja Attari made an announcement, as part of a stock
market briefing, that their quarter 4 profits had risen by 30%. Immediately after the
announcement the share price fell.
Required
(a) Discuss why shareholders might be dissatisfied, despite higher profits? (6 marks)
Profits are historic, shareholders care about the future – perhaps they were
concerned by information in the press briefing concerning where Rameez Raja
Attari were planning to invest, investment decisions are very important to investors
Investment decisions require new finance, shareholders care about debt levels –
perhaps they were concerned by information in the press briefing concerning this –
financing decisions are very important to investors
Profits are not cash flows, shareholders often want to see what returns they will be
getting as dividends – perhaps they were concerned by information in the press
briefing concerning the level of dividend that Rameez Raja Attari was planning to
pay for 2004 (zero!) – dividend decisions are very important to investors
Also profit can be manipulated by depreciation policy and by short-termism

ACCA (Finalist)
Value for money
Value for money means providing a service in a way, which is economical, efficient
and effective. It simply means that getting the best possible service at the least
possible cost. Public services for example are funded by the taxpayers and in
seeking value for money; the needs of the taxpayer are being served, insofar as
resources are being used in the best manner to provide essential services.
Economy measures the cost of obtaining the required quality inputs needed to
produce the service. The aim is to acquire the necessary input at the lowest
possible cost.
Effectiveness means doing the right thing. It measures the extent to which the
service meets its declared objectives.
Efficiency means doing the right thing well. It relates to the level of output
generated by a given input. Reducing the input: output ratio is an indication of
increased efficiency.
Example ---- in refuse collection service,
The service will be economic if it is able to minimise the cost of weekly collection
and not suffer from wasted use of resources.
The service will be effective if it meet it target of weekly collection.
The service will be efficient if it is able to raise the number of collection per vehicle
per week.

ACCA (Finalist)
Stakeholders
We tend to focus on the shareholder as the owner and key stakeholder in a
business. A more comprehensive view would be to consider a wider range of
interested parties or stakeholders.
Stakeholders are any party that has both an interest in and relationship with the
company. The basic argument is that the responsibility of an organisation is to
balance the requirements of all stakeholder groups in relation to the relative
economic power of each group.
(a) Internal – staff, managers
(b) Connected – finance providers (shareholders, banks), customers, suppliers
(c) External – government, trade unions , pressure groups
Conflict between stakeholder groups

The very nature of looking at stakeholders is that the level of „return is finite within
an organisation. There is a need to balance the needs of all groups in relation to
their relative strength.
Measuring the achievement of stakeholder objectives

(a) Profitability – important to assess managerial performance
(b) Debt – important to banks
(c) Liquidity – important to suppliers and customers
(d) Shareholder investor ratios – important to shareholders
Profitability ratios include:

ROCE = Profit from operations
Capital employed
ROCE = Profit margin × Asset turnover
Profit from operations x Revenue

Revenue Capital Employed
Profit from operations = before interest and tax
Debt ratios
Gearing = Book value of debt
Book value of equity
Interest cover = Profit from operations

Interest

ACCA (Finalist)
Liquidity ratios
Current ratio = Current assets
Current liabilities
Acid Test ratio = Current assets (less inventory)

Current liabilities
Shareholder investor ratios

Dividend yield = Dividend per share x100
Market price per share
Earnings per share = Profits distributable to ordinary shareholders

Number of ordinary shares issued
Price-earnings ratio = Market price per share

EPS
The value of the P/E ratio reflects the market’s appraisal of the share’s future prospects
the more highly regarded a company, the higher will be its share price and its P/E ratio.
QUESTION

ACCA (Finalist)
Agency theory
Agency relationships occur when one or more people employ one or more persons
as agent. The persons who employ others are the principals and those who work
for them are called the agent In an agency situation, the principal delegate some
decision-making powers to the agent whose decisions affect both parties. This type of
relationship is common in business life. For example shareholders of a company
delegate stewardship function to the directors of that company. The reasons why an
agents are employed will vary but the generally an agent may be employed because of
the special skills offered, or information the agent possess or to release the principal
from the time committed to the business.

ACCA (Finalist)
Goal Congruence
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.
For an organisation to function properly, it is essential to achieve goal congruence
at all level. All the components of the organisation should have the same overall
objectives, and act cohesively in pursuit of those objectives.
In order to achieve goal congruence, there should be introduction of a 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
shareholders.
Money as a prime motivator

The most direct use of money as a motivator is payment by results schemes
whereby an employees pay is directly linked to his results. However, research has
shown that money is not a single motivator or even the prime motivator.
Corporate governance
In the UK corporate governance regulations have been designed to monitor the actions
of management. Here are some of the main requirements:
Board of directors
1. Separate CEO & chairman
2. Minimum 50% non executive directors
3. Chairman independent
4. Max 1 year notice period
5. NEDs should be independent (3 year contract, no share options)
Key committees
Remuneration committee
Pay & incentives of executive directors
Audit committee
Risk management
NEDs only
Nomination committee
Choice of new directors

ACCA (Finalist)
QUESTION
The following information relates to Ertin plc, a fictitious company incorporated in
England.
The agenda of a board meeting of Ertin plc is as follows.

• Minutes of the last meeting
• Proposed investment in France
• Consideration of the remuneration of board members
• Proposal for the formation of an audit committee, with Mrs F M Barnfield, P T Figler
and Dr P Dorecton as nominated committee members
Required
Identify weaknesses in the corporate governance of Ertin plc and describe what actions
are required to comply with best practice.
• Not enough NEDs (min 50%)

• NEDs don’t seem to be independent, and should not be paid share options
• Remuneration should not be discussed by the main board
• Audit committee should only include NEDs
• • No split between Chair & Chief Executive

ACCA (Finalist)
MACRO ECONOMIC
Government objectives for the economy are referred to as macroeconomic objectives or
targets. The three main targets are usually:
(a) Economic growth & high employment
(b) Low inflation
(c) Balance of payments stability
Each of these policies will have an impact on a firm’s investment, financing and dividend
policy decisions.
Policies for achieving macroeconomic targets

Fiscal policy
How much the government decides to spend, and to raise as tax revenue
Monetary policy
Control over the money supply and of interest rates
Exchange rate policy

If the value of the £ is forced down in value it makes imports
more expensive and exports cheaper
Competition policy
Policies to encourage competition e.g. blocking takeovers
Green policy
Policies to encourage protection of the environment
Competition policy
eg the Competition Commission prevents takeovers that are against the public interest
Government assistance for business

grants may be available to attract firms to invest in depressed areas
Corporate governance regulation

ACCA (Finalist)
Advantages to a firm of a listing on the main Stock Market
Public profile, investor confidence (audited accounts, regular briefings, NEDs, 3 years of
successful trading history), access to wider pool of equity finance, allows owners to
realise some of their investment
Advantages to a firm of a listing on the Alternative Investment Market

Lower membership fees & compliance requirements (no successful trading history or
corporate governance requirements)
Advantages to a firm on the issuing debentures

Debentures are a liquid investment, so will often be cheaper than a bank loan. A
debenture will be called in if its terms are breached, a bank may be more willing to
renegotiate a loan whose terms have been breached (they hope to do more business
with the company). Another advantage of debentures is that often they can be
redeemed over a range of dates at the company’s discretion.

ACCA (Finalist)

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COPYRIGHT © 2010 BY Mohammad Faizan Farooq FFQA 1

MOHAMMAD FAIZAN FAROOQ QADRI ATTARI

If someone found using my

Prepared & Complied by: Mohammad Faizan Farooq Qadri Attari

OUTLINE OF THE SYLLABUS

FORMAT OF THE EXAM PAPER

Prepared & Complied by: Mohammad Faizan Farooq Qadri Attari

Financial management and the accounting equation

The three key decisions

1. The investment decision

Prepared & Complied by: Mohammad Faizan Farooq Qadri Attari

2.The financing decision

Total funding required

Prepared & Complied by: Mohammad Faizan Farooq Qadri Attari

Money markets Capital markets

(c) Commercial paper (issued by (c) Shares traded on the main

(d) Bills of exchange (company IOU (d) Shares in Alternative

Prepared & Complied by: Mohammad Faizan Farooq Qadri Attari

Short-term vs long-term debt

3. The dividend decision

Prepared & Complied by: Mohammad Faizan Farooq Qadri Attari

1. Maximising shareholders’ wealth

Prepared & Complied by: Mohammad Faizan Farooq Qadri Attari

4. Objectives of not-for-profit organisations

Also profit can be manipulated by depreciation policy and by short-termism

Prepared & Complied by: Mohammad Faizan Farooq Qadri Attari

Prepared & Complied by: Mohammad Faizan Farooq Qadri Attari

Conflict between stakeholder groups

Measuring the achievement of stakeholder objectives

Profitability ratios include:

ROCE = Profit margin × Asset turnover

Profit from operations x Revenue

Profit from operations = before interest and tax

Interest cover = Profit from operations

Prepared & Complied by: Mohammad Faizan Farooq Qadri Attari

Acid Test ratio = Current assets (less inventory)

Shareholder investor ratios

Earnings per share = Profits distributable to ordinary shareholders

Price-earnings ratio = Market price per share

Prepared & Complied by: Mohammad Faizan Farooq Qadri Attari

Prepared & Complied by: Mohammad Faizan Farooq Qadri Attari

Money as a prime motivator

Prepared & Complied by: Mohammad Faizan Farooq Qadri Attari

The agenda of a board meeting of Ertin plc is as follows.

• Not enough NEDs (min 50%)

Prepared & Complied by: Mohammad Faizan Farooq Qadri Attari

Policies for achieving macroeconomic targets

Exchange rate policy

Government assistance for business

Corporate governance regulation

Prepared & Complied by: Mohammad Faizan Farooq Qadri Attari

Advantages to a firm of a listing on the Alternative Investment Market

Advantages to a firm on the issuing debentures

Prepared & Complied by: Mohammad Faizan Farooq Qadri Attari

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