READCASTBY

Hafiz Muhammad Adnan Rana

F9 ACCAJune 2011

Part A Financial Management Function

Chapter 1 – Financial management and financial objectives

Source: F9 - Financial Management, BPP Publications, June 2010 Edition

Chapter 1

Financial Management And Financial Objectives

1 The nature and purpose of financial management2 Financial objectives and the relationship with corporate strategy3 Stakeholders4 Measuring the achievements of corporate objectives5 Encouraging the achievement of stakeholder objectives6 Not for profit organizations

Introduction:

In this chapter, after introducing the nature and purpose of financial management, we consider the objectives of Sialkot Sports Limited (organization). We go on to examine the influence of stakeholders (refer F1) on stakeholder objectives.

The final part of this chapter examines objectives in not-for-profit organizations like Sialkot Hospital Limited.

Exam Guide:

The material in this chapter is examinable as an entire discussion question or as a question involving calculations such as ratios and discussion. When doing a ratio analysis question, you must make sure you apply your answer to the organization (say Sialkot Sports Limited) in the question. The Sialkot Sports Limited (organization) will not necessarily be a public quoted company with shareholders.

1 The nature and purpose of financial management

1.1/1.4 What is financial management

Mr Adnan, ACCA is a Finance manager of Sialkot Sports Limited (SSL) who usually takes the following decisions to achieve the financial objectives (profit maximization) of Sialkot Sports Limited:

1-Investment2-Finance3-Dividend

4-Risk Management (Ref-fast forward and paragraph of 1.1)Connected Thinking:In Pakistan private and public companies are defined in Section 2(28) of Companies Ordinance, 1984 and the subject matter is share capital while in UK private sector means organizations which are not owned by government for providing public services like electricity, gas and water etc.

Solve question related to 1.4 on page 6 of BPP edition 2010 and also refer to PodCast (audio).

1.2 Financial planning

Finance manager of Sialkot Sports Limited always make sure sufficient funds are available for short, medium and long term plans of SSL and such plans are as follows:(Para 1)

(a’) ensure that sufficient funds are available for working capital of SSL (short term).

Note:Working capital is also called “net current assets” and is current assets minus current liabilities. And working capital cycle is accounts receivables days (ratio) plus inventory turnover days (ratio) minus accounts payable days (ratio).

(b’) ensure that sufficient funds are available for non current assets of SSL (medium/long term)

Decisions in (a) and (b) above are taken by Mr ACCA after analyzing the financial data by using Ratios (some of them are identified in (a) above and also in the light of financial objectives of SSL. Source of information for decision making are cost data (short term decision making (refer F5 chapters on short term decision making) as well as financial data (refer F7 chapters regarding financial ratios).

1.3 Financial control

Because 1.2 relates to planning the other part of the hierarchy is control (refer F1 for planning and control diagram). Mr ACCA usually carry outs the comparison of actual performance with forecasted (not budgeting) performance (refer F5 for difference between forecast and budget and standard cost).

1.5 Management accounting, financial accounting and financial management

Mr ACCA is finance manager of SSL and is responsible for producing financial statements which are used by external users (refer F1 for stakeholders). Example of information is EPS (refer F7 for topic Ratios) – (ref 2nd para)

Mr CMA is management accountant of SSL and is responsible for producing cost statements which are used by internal users (directors and managers). Example of information is variance analysis (refer F5 for topic variance analysis) – (ref 2nd para)

Mr ACCA is also performing the function of financial management of SSL (already discussed in 1.1 above). Example of information is projected cash flow statement (refer T10 for topic Cash Flows) – (ref 5th para)

2 Financial objectives and the relationship with corporate strategy

2.1 Strategy

Comments:StrategySialkot Sports Limited has decided to purchase (outflow of resources) state-of-the-art machine to produce footballs on machine so that the deadlines (objective) of orders of Manchanter United are met on time. Because orders are usually late by 10 days (goal to reduce) and this is earning bad name for SSL.(refer para 1)

Financial strategy The strategy to purchase state-of-the-art machine is a strategy……. and investment (NPV – outflow minus inflow) and objectives to meet to deliver on time is financial strategy to avoid losses to SSL (refer key term)

Read case study related to 2.1 on page 7 of BPP edition 2010 and also refer to PodCast (audio).

2.2 Corporate objectives (connected with 4)

Corporate objectives of Sialkot Sports Limited are related to Key Success Factors (KSF) which are as follows:

Return on Investment (refer F5) Market Share of SSL is 30% Growth (refer T7 and F5 for forecasting) Cash Flow (Cash flow statement and cash budget) Customer satisfaction (surveys and questionnaires) Product Quality Relationships with stakeholders (refer F1/T5) Added Value (refer F5)

2.3 Financial objectives

Generally financial targets of SSL are earnings, earning per share (EPS refer F7), dividend per share (DPS refer F7), Gearing level (refer Ratios in F7), Profit retention (retained earnings) and operating profitability (both in income statement and cash flows). These are described in the following five sub headings: (fast forward)

2.3.1 Shareholder wealth maximization

Company value and share value is calculated by three methods:

(a) SSL has prepared its statement of financial position on going concern basis because SSL will continue its operations for foreseeable period (going concern assumption) and total assets value is important for investor and also profit figure is reviewed.

(b) break up basis only uses when company is liquidated (no going concern assumption)

(c) market value method only related to shares of Sialkot Sports Limited (public companies - whose shares are listed on stock exchange)

Comments:

From perspective of shareholders theirs’ return can be calculated as follows:

=(P1-PO+D1)/PO

where P1 is share price at the end of periodwhere Po is share price at the start of periodwhere D1 is dividend paid

From perspective of management of SSL they expect that earnings and dividends per share (both are ratios) are rising so share price (capital gain) for shareholders will be available which will attract them to invest in the SSL shares.

From perspective of SSL the financial objective is to increase 10% of thrice profit, dividend per share, and earnings per share.(refer 2.3.1)

2.3.2 Profit maximization

Profit figure calculated by Accountant of SSL is different from profit figure on the desk of Finance Manager who is considering risk (perceived by shareholders, however this is also the risk (business risk or financial risk – refer gearing ratios of F7) perceived by SSL (as per (b) below) despite of profitable operations of SSL but SSL itself hdue to the following factors:

(a) Accounting profits are manipulated (creative accounting – refer T5, F1 and F7) by creating/not creating provisions (IAS 37), Accumulated Depreciation (IAS 16), capitalization of expense (IAS 38) and adding FOH to closing inventory (F2 – Marginal and Absorption costing)

(b) Already covered (c) Profit alone is not performance measure of investment. Rather ROCE (ratio –

refer F7), EPS (ratio – refer F7) and Dividend Yield (ratio – refer F7) are used.(d) Profits figures are used by short term investors while performance of company

need to be analyzed in detail by long term investors (subsidiary or associate level investment).

Solve question related to 2.3.2 on page 10 of BPP edition 2010 and also refer to PodCast (audio).

2.3.3 Earning per share growth (Ratio – Refer F7 and also refer IAS 33)

Shareholders of SSL should read directors report (where past 5 to 10 years dividend history is given and also earnings are reported for calculation of EPS).

Solve question on page 10 of F9 (BPP-June 2010 edition). Also, refer to PodCast (audio).

2.3.4 Other financial target

(a) SSL has decided that its debt equity ratio (refer F7) will never exceed 1:1 (refer - i)

(b) SSL has decided that dividend cover (refer F7) should never exceeds 2.5 times.(c) SSL has decided that minimum Profit ratio (refer F7) should be 10% and

minimum ROCE (refer F7) should be 20%.

Comments:

These targets (secondary financial targets) are not financial objectives (primary financial targets) but help SSL to achieve its main financial objectives. (para 2)

2.3.5 Example: financial target

Solve example on page 11 and question on page 12 of F9 (BPP-June 2010 edition). Also, refer to PodCast (audio).

2.4 Non financial objectives (connected with 6)

(a) welfare of employees-good wages and salaries (self explanatory)-comfortable and safe working environment (Health and Safety at work)-training (part of health and safety policy developed by management)-career development (advancement in career)-good pension (monthly payment after retirement)-redundancy payments (payments at the time of terminating contracts of employees)

(b) welfare of management-high salaries-company cars (cultus for assistant managers and 1800 cc for Directors etc)-perks (house rent, Hajj and Umra, free petrol, telephone etc)

(c) provision of service-PTCL-Sui Gas Companies

(d) fulfillment of responsibilities towards customers (quality of products)-on time delivery-quality of goods/service-honest and fair dealing -after-sale services

(e) fulfillment of responsibilities towards suppliers (timely payments)-long term relationship-prompt payment

(f) welfare of society as a whole-compliance with applicable laws and regulations-control of pollution and harmful externalities (such as excessive traffic)-adoption of “green” environment policies

Comments:

Other non financial objectives are growth, diversification and leadership in research and development and quality of products. However, also these non financial objectives are sometimes more important to fulfill than financial objectives.

3 Stakeholders (connected with 5)

Sialkot Sports Limited understands that there are followings individual and groups whose interest is directly affected by the activities of SSL.(fast forward/key term)

Internal Employees and pensioners (old employees)Managers (at all level)

Connected Shareholders Debenture holdersCustomersBankersSuppliersCompetitors

External GovernmentPressure groupsLocal and national communitiesProfessional and regulatory bodies

3.1 objectives of stakeholders groups

(a) ordinary shareholders-Dividend-Profitable operations of SSL

(b) trade payablesrefer 2.4 (e)

(c) long term payables Timely payment of installment (principal portion + interest portion).

(d) employeesrefer 2.4 (a)

(e) government

-government grants (refer IAS 20 F7)-tax on profit of SSL-health and safety regulation compliance-training of employees

(f) managementrefer 2.4 (b)

3.2 stakeholder groups, strategy and objectives

Comments:

As we have learned from 3.1 and 2.4 that stakeholders have interest in Sialkot Sports Limited and this effects the strategic decision making.

3.3 shareholders and management

Shareholders of Sialkot Sports Limited are owners of SSL and directors are working on theirs’ behalf (under stewardship or agency relationships (refer F1 and key term).

Directors prepares the financial statements and submits them for approval from shareholders in theirs’ AGM. Shareholders have no right to inspect books of accounts. Auditor provides them assurance on the financial statements. However, they also base theirs’ decisions on financial statements, information from stock brokers and investment journals including daily newspapers. (para 1& 2)

Directors can be removed by shareholders. However, directors are usually encouraged by profit-related pay (bonus) to motivate them. (Para 3/4/5)

3.4 shareholders, managers and the company’s long term creditors

(a) directors takes the decision to obtain finance from banks etc.(b) creditors provide the loan on the security of assets. And in case of non payment

they exercise the security or apply to court for winding up of the company.(c) Shareholders hopes that finance is injected into Sialkot Sports Limited and this

will result in more profit for both dividend and retained earnings.

3.5 shareholders, managers and government

(a) TaxationSialkot Sports Limited acts as tax collector of income tax on salaries of employees and VAT/Sales Tax on sales of SSL.

Shareholders decided whether to go for capital gain (short term purchase and sale of shares) or earn dividend (on which tax is deducted).

(b) encouraging new investmentsrefer Government Grants (IAS 20 – F7)

(c) encouraging a wider spread of share ownershipownership by private shareholders of electricity, gas and telecommunications industries is encouraged.

(d) legislation-Companies Ordinance, 1984 in Pakistan-Legislation on employment-Health and Safety regulations-Legislation on consumer protection-Consumer rights-Environmental legislation

(e) economic policyfiscal policy and monetary policies

refer chapter 2 for details.

4 Measuring the achievement of corporate objectives

4.1 Measuring financial performance

Financial control (comparison between actual and budgeted figures to identify variances) in Sialkot Sports Limited (SSL) is achieved by ratio analysis (refer F7) (other ways are standard costing – refer F2). (fast forward and 4.1).

Comments:

The key to obtain meaningful information from ratio analysis is comparison. That is comparing ratios over a number of periods from 2005 to 2010 to establish that business of Sialkot Sports Limited is improving or declining. And also comparing ratios between similar businesses.

Exam focus point

Examiners have said, more than once, that knowledge of how to calculate and interpret key ratios is a weak point for many candidates. Mare sure that it is one of your strong points.

4.2 The broad categories of ratios

profitability and return debt and gearing liquidity shareholders’ investment ratios (stock market ratios)

4.3 Ratio pyramids (called Du Pont System of Ratio Analysis) (refer page 17 of F9 (BPP – June 2010 edition)

4.4 Profitability

4.4.1 profitability and return: the return on capital employed

Profit growth of Sialkot Sports Limited is only assessed with relation to the amount of funds (capital employed) and is calculated with the following formula:

Return on capital employed = PBIT/Capital Employed (refer key term)

Where PBIT is taken because to know the amount of profit which the company earned before paying interest to providers of loan finance. Also, tax is not considered because there is always unusual (under or over provision) of taxation and in fact tax charge would not affect profitability of the Sialkot Sports Limited.

Whereas capital employed is shareholders fund (equity) plus long term liabilities and long term provision. Alternatively this figures is calculated by deducting current liabilities from total assets.

4.4.2 evaluating the ROCE

Sialkot Sports evaluate ROCE in three ways:

(a) comparing 2010 ROCE with 2009 ROCE(b) comparing ROCE of SSL with ROCE of other companies(c) comparing ROCE of SSL that is 20% (assumed) which is compares with current

borrowing cost (interest rate of 15% - assumed) and in this case ROCE is suggesting that more profit will be available to pay for interest (haram).

ROCE of SSL is also compared with current borrowing interest rate and is satis- factory.

4.4.3 secondary ratios

Profit margin and asset turnover together explains the ROCE.

Profit margin = PBIT/sales revenueAssets turnover = Sales revenue/Capital employed

Strong sales growth is usually indicated with high sales volume growth as well as increase in sales revenue and sales growth is one of the signs of prosperous company.

Exam focus point

Remember that capital is not just shareholders’ funds; this was highlighted as a frequent mistake in previous exams.

4.4.4 return on equity

Return on Equity = Earnings attributable to ordinary shareholders/shareholders equity (refer key term)

A high return on equity reflect that Sialkot Sports Limited has effectively managed its expenses and has invested in profitable projects.

4.4.5 gross profit margin, the net profit margin and profit analysis

gross profit margin = gross profit/sales revenuenet profit margin = net profit/sales revenue

4.4.6 example: profit margin

Solve example F9 (BPP – page 19) – June 2010 edition. Also, refer to PodCast (audio)

4.5 debt and equity ratios

Debts ratios of Sialkot Sports Limited uses debt ratios to consider how much the company owes in relation to its size and whether it is getting higher debts or improving the situation.

Gearing is the amount of debt finance (long term liabilities) as compared to equity finance. Refer chapter 14 for debt and equity ratios of Sialkot Sports Limited.

4.6 liquidity ratios: cash and working capital

Sialkot Sports Limited needs liquid assets so that it can meet its payment of debts when they fall due in 2010 and onwards. The main liquidity ratios are described in Chapter 4.

4.7 shareholders’ investment ratios

Sialkot Sports Limited will only raise equity finance if investors of SSL think that the return (dividend and capital gain – increase in market share price) is satisfactory in view of the business and finance risk of Sialkot Sports Limited (refer para 2)

4.7.1 the dividend yield

Dividend yield = dividend per shares/market price per share * 100

Comments:

Gross figures of dividend (including withholding tax) is considered. And in turn gross dividend yield is compared with gross interest yield of bonds. So that investors should make a decision to either invest in Sialkot Sports Limited or invest in bonds.

General points in key term of 4.7

Cum dividend means that purchaser of shares is entitle to receive the next dividend payment.

Ex dividend means that the purchase of shares is not entitle to receive the next dividend payment.

And this relationship is explained below:

Market price per share (ex dividend) = Market price per share (cum dividend) – forthcoming dividend per share.

4.7.2 example: dividend yield

Solve example F9 (BPP – page 20) – June 2010 edition. Also, refer to PodCast (audio)

4.7.3 earning per share (EPS)

Earning capacity of Sialkot Sports Limited is calculated per share as follows:

EPS = profit distributable to ordinary shareholders/weighted average number of shares(refer key term)

4.7.4 the price earnings ratio

The P/E ratio is the used to assess the worth of a single share of Sialkot Sports Limited.

P/E ratio = Market price per share/EPS

4.7.5 example: price earnings ratio

Solve example F9 (BPP – page 21) – June 2010 edition. Also, refer to PodCast (audio)

4.7.6 changes in EPS: the P/E ratio and the share price

Price Earning Ratio of Sialkot Sports Limited is concerned with:

(a) relationship of EPS with market share price(b) P/E is fluctuating very much or not. Generally, P/E does not vary much.

(c) If EPS (denominator) of P/E ratio is changes then share price (numerator) should also change giving a new share price.

For example, if EPS of SSL in 2009 was 30c and share price $3.6, its P/E ratio is 12. However, in 2010 if EPS is 33c and we expect that P/E ratio is same i.e 12 then share price goes up. How ? there are two methods. One is by putting the figure in the formula and calculating and another is simply multiplying P/E with EPS and it comes to $3.96.

Exam focus pointThe examiner has commented that students have had problems with these rations and emphasized how important it to be familiar with them.

Solve question on page 21 of F9 (BPP – June 2010 edition)

5 Encouraging the achievement of stakeholder objectives

5.1 Managerial reward schemes

Owners of Sialkot Sports Limited monitors the management (Directors) of SSL and provides the incentives (listed below) to management. So that theirs’ personal goals meets with goals of SSL (goal congruence) – (refer fast forward and key term)

Performance related pay- and bonuses are given to directorsShares to managers – SSL is a public limited company and was incorporated so. In this case management buy-out was not possible (old managers buys the company at the time private company goes public) but management buy-in is possible (new managers buy the company)Executive share options plans (ESOPs) – SSL has given (grant date) its directors the options to purchase shares of SSL at a fixed price after a certain period (exercise date). (Also refer IFRS-2)

5.1.1 Beneficial consequences of linking reward schemes and performance(a) performance related pay has motivated employees of SSL(b) ESOP also has motivated the executives (full time directors of SSL) of SSL(c) Key Performance Indicators (refer F5) are incorporated at schemes at SSL(d) Goal congruence is achieved(e) Long term earnings of the SSL are ensured by offering shares in schemes because if the EPS will increase then share price will increase (refer F7/or 4.7.4 of this book for P/E ratio)

5.1.2 Problems associated with reward schemes(a)(b) Every manager has taken his own decisions at theirs’ cost centers which is termed as dysfunctional decision making because these decisions may be

contrary to the wider purposes of SSL.(c)(d)(e) Although short term profit taking (short termism) is discouraged but still managers may not think they will be around that long! Till the benefits from long term investments will increase the economic benefits of SSL. Because managers and employees are committed to what is measured, rather than the objectives of the organization. (f)(g) Quality of products are impaired because standards and targets are lowered to make bonuses more accessible. (h) Employees ignore the satisfaction while working at SSL and opportunity for

growth that the job provides to the employees.

5.2 Regulatory requirements

Confidence of shareholders of Sialkot Sports Limited and other stakeholder is restored by audit of financial statements. However, this is internal factor and there are two external factors; one is Code of Corporate Governance (part of the stock exchange listing regulations in Pakistan) and other is Lahore Stock Exchange Listing Regulations..(refer fast forward)

5.2.1 Corporate governance (these relates to UK)

After series of financial scandals Code of Corporate Governance (CCG) was issued which is a system that directs and controls Sialkot Sports Limited (SSL).

(refer fast forward)

Key elements of CCG

(a) Management of Risk faced by SSL(b) Performance of SSL is enhanced(c) Framework is provided for scope of activities of SSL(d) Management commitment of SSL is required to apply the spirit as well as the

letter of the law.(e) Accountability (justification of actions) is encouraged.

Areas covered in CCG

(a) BOD has the responsibility for strategy and policy decision.(b) Directors representing BOD of SSL have appropriate skills.(c) HR committee oversees all the appointments in SSL.(d) Responsibilities of CEO and Chairman (both are different persons in SSL) are

separate.(e) Non-Executive Directors (for NED refer F1, P1, P3 – these are those

executives that are not permanent employees of SSL) and represent in BOD.(f) & (g) Salary of full time directors is set by Remuneration committee of

NED’s and may vary according to individual performance.(h) As per IAS 24 (refer 24) remuneration of key management personnel is in financial statements of SSL.(i) BoD has responsibility to review risk management and internal control system of SSL.(j) Audit committee of NED is encouraged which deals with both external as well as internal auditors and review audited accounts and internal controls of SSL.(k) AGM is held by SSL annually.(l) Annual report of SSL not only includes Directors Report, Financial Statements but also includes review report of auditors on statement of compliance with Code of Corporate Governance prepared and included by BoD in Financial statements.

5.2.2 Stock exchange listing regulations (these relates to UK)

Comments:

Public limited companies are required to follow rules and regulations for listing on stock exchange. And these rules and regulations indirectly ensures stock market operates fairly and efficiently for all parties involved.

Stock exchange is an organization (company limited by guarantee) that provides a market place in which to trade shares in two ways:

Primary market – Sialkot Sports Limited has obtained equity finance by issuingshares form public (new shares) or right shares(existing shareholders)

Secondary market – Buyers and sellers purchase and sale shares to earn capitalGain (refer F6).

6 Not for profit organizations

Sialkot Hospital Limited is a not for profit organization (NPO). Its main objective is efficient use of resources (rather than profit). (refer fast forward)

Comments:

In Pakistan WAPDA, Pakistan Railways, Pakistan Airline are examples of public companies which means serving public which are owned by Government. This is ironically different from public limited companies (concept of companies used with reference to stock exchanges).

However, as regards NGO’s; they can be both NPO and public companies (not the one that is listed or not listed on stock exchange but the one that serves the community). But one has to be very careful they provide money for a purpose (mission) that is why they called it missionaries (promoting certain religion not cast – mind you).

In Pakistan NPO are registered under Section 42 of Companies Ordinance, 1984 while NGO’s are given the option to either register itself under Section 42 if they want theirs operations throughout Pakistan or register itself with local laws of a Province of Pakistan where they want to work.

6.1 Voluntary and not-for-profit sectors6.2 Objectives6.3 Value for money6.4 Example: Economy, efficiency, effectiveness6.5 Performance measures6.6 Example: Performance measures6.7 Example: Inputs and outputs

Connected thinking:

From 6.1 to 6.7 please refer F5 Chapter of BPP June 2010 edition. Please refer to my audio lecture (PodCast) of relevant chapters. There is no need in wasting time and efforts here.

Quick Quiz on Page 30 of F9-BPP (June 2010 edition)Please refer to my audio lecture (PodCast ).

Exam Question Bank – Q 1 - on Page 367 of F9-BPP (June 2010 edition)Please refer to my audio lecture (PodCast ).