MODULE 1 FINANCIAL ENVIRONMENT

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1 MODULE 1 FINANCIAL ENVIRONMENT

2 OUTLINES Aims and objectives of profit-seeking and non-profit seeking organizations. The inter-relationship between financial management, management accounting and financial accounting. Shareholders Wealth Maximization, Profit Maximization. Principles of Corporate Governance: Relationship between the company, management and other stakeholders. Scope of Directors responsibilities, adequacy of disclosure requirements, creative accounting, window dressing, etc. The Investment decision, the Financing decision and the Dividend decision

Aims and Objectives of Profit-seeking and Non-profit seeking Organizations Objectives of Profit-seeking Organizations a) Profit maximization b) Profitability maximization c) Liquidity d) Long-term

3 Aims and Objectives of Profit-seeking and Non-profit seeking Organizations Objectives of Profit-seeking Organizations a) Profit maximization b) Profitability maximization c) Liquidity d) Long-term stability e) Growth f) Corporate wealth maximization; and g) Shareholders wealth maximization Objectives of Non-profit seeking Organizations These are organizations which are concerned with allocation of scarce national, state and local government resources land, capital and personnel which have alternative uses, to achieve the best, the maximum or the most socially effective production of goods and services. Non-profit seeking organizations are the various government ministries at Federal, State and Local government levels. Their main function is to provide value for money (VFM) services.

4 Inter-relationship between financial management, management accounting and financial accounting Management Accounting is a field of accounting that analyzes and provides cost information to the internal management for the purposes of planning, controlling and decision making. Management accounting refers to accounting information developed for managers within an organization. CIMA (Chartered Institute of Management Accountants) defines Management accounting as Management Accounting is the process of identification, measurement, accumulation, analysis, preparation, interpretation, and communication of information that used by management to plan, evaluate, and control within an entity and to assure appropriate use of an accountability for its resources. This is the phase of accounting concerned with providing information to managers for use in planning and controlling operations and in decision making. Managerial accounting is concerned with providing information to managers i.e. people inside an organization who direct and control its operations. Financial Accounting is concerned with providing information to stockholders, creditors, and others who are outside an organization. Managerial accounting provides the essential data with which organizations are actually run. Financial accounting provides the scorecard by which a company s past performance is judged. Because it is manager oriented, any study of managerial accounting must be preceded by some understanding of what managers do, the information managers need, and the general business environment.

5 Inter-relationship between FM, MA & FA cont. Financial Management is a relatively new branch of accounting, that manages the finances of a particular individual, business, or organization. The main aim of the discipline is to achieve various financial objectives. It also involves the company s financial resources for management purposes. Its key objectives are to create or improve the financial health of the organization, either by generating cash, or by adding related resources. It should study and devise plans for implementation, in order to provide a satisfactory return on investment. Financial management considers all factors, such as risks, of which it tries to manage, and how many resources are invested. Basically, financial management makes plans to ensure a productive cash flow. It governs and maintains the financial assets of a certain body. Apparently, the main concern is not the techniques of quantifying finances, but the assessment thereof. Financial management is often referred to as the science of money management. The three elements of financial management are: Financial planning, Financial Control, and Financial Decision-making. Planning often deals with funding as any management should, ensuring that adequate funding is available at the right moment. Financial control, on the other hand, ensures that the individual s assets, or company s assets, are secure, and being utilized efficiently. Obviously, financial management deals with various financial decisions, particularly the things relating to financing, dividends, and investments.

6 Shareholder Wealth Maximization and Profit Maximization Wealth Maximization Making wealth maximization as a primary objective means to increase the worth of shareholders investments. The use of the objective of wealth maximization or net present worth maximization has been advocated as an appropriate and operationally feasible criterion to chosen among the alternative financial actions. Wealth maximization means maximizing the net present value (or wealth) of course of action. The net present value of a course of action is the different between the goals achieved and those benefits. The gross present value of a course of action is found out by discounting or capitalizing its benefits at a rate which reflects their timing and uncertainty. Profit Maximization The objective of any business is to make profit. Traditionally, the business has been considered as an economic institution. As such, it has developed a common and unique measurement of efficiency VIZ profit. It is therefore, coherent to assume profit maximization as natural business goal. The appropriateness of this objective is justified on any of the following counts: Profit maximization ensures economic natural selection and at the ultimate end only profit makers survive.

7 Principle of Corporate Governance: Relationship between the company, management and other shareholders The corporate governance practice in the Company is built in conformity with the best international standards and recommendations set in the Code of Corporate Behavior of the Federal Financial Markets Service, as well as the provisions of the Code of Corporate Governance of Nigeria ratified by the Companies in Corporate governance in the Company is based on the following principles:

8 Principle of Corporate Governance Accountability The Code of Corporate Governance envisages accountability of the Board of Directors of the Company before all shareholders in accordance with the legislation in force, and is the governing document for the Board of Directors in issues related to strategy planning, administration and control over the Company s executive bodies. Fairness The Company undertakes to protect the rights of its shareholders and treat all shareholders on an equal basis. The Board of Directors enables its shareholders to receive efficient protection if their rights are violated

9 Principle of Corporate Governance cont d Transparency The Company shall provide timely disclosure of credible information on all the important facts related to its activities, including information on its financial condition, social and environmental measures, results of activities, ownership and management structures; the Company shall provide free access to such information for all interested parties. Responsibility The Company acknowledges the rights of all interested parties envisaged by the legislation in force, and aims at cooperation with such parties in order to provide steady development and ensure financial stability of the Company

10 Relationship between the company, management and other shareholders

11 Relationship between the company, management and other shareholders cont d

12 Scope of Directors` Responsibilities Responsibilities include: The board of directors of a company is primarily responsible for: determining the company s strategic objectives and policies; monitoring progress towards achieving the objectives and policies; appointing senior management; accounting for the company s activities to relevant parties, e.g. shareholders. The managing director/chief executive is responsible for the performance of the company, as dictated by the board s overall strategy. He or she reports to the chairman or board of directors.

13 Scope of directors` responsibilities Cont d Appointment The first directors of a company are appointed at the time of its registration. On registration, the persons named will be deemed to have been appointed as the first directors. Subsequent appointments are governed by the company s articles of association but any Shareholders Agreement should also be checked. Typically the articles will provide for the board of directors to fill any casual vacancies or to appoint additional directors up to the maximum number specified by the articles. On appointment a new director will be asked to provide certain personal information (i.e. full name, address, date of birth, nationality, country of residence, former names and business occupation) to be included in the relevant form which the director will be required to sign to signify consent to act as a director. It is possible for a director to file a service address at Companies House as well as his or her home address. It will be the service address (which can be the registered office of the company) that appears on the public record. The director will be reminded to acquire the share qualification (if any) specified in the articles.

14 Scope of directors` responsibilities Cont d Additionally, the director will give a general notice of any interests in contracts involving the company. Directors of quoted Plcs are required to declare their interest in the company s shares under the Disclosure and Transparency Rules. On a practical note the new director should make sure that he/she receives: a copy of the company s memorandum and articles of association; details of the business and affairs of the company, e.g. recent board minutes and management accounts; and the statutory reports and accounts for the past two years.

15 Scope of directors` responsibilities Cont d Powers The directors are generally responsible for the management of the company and they may exercise all the powers of the company. However, the extent of their authority may be constrained by the Companies Act 2006 and the articles of association. For example, articles of association often include provisions and restrictions on borrowing by the company. Generally, the directors must act collectively as a board to bind the company. However, the articles usually entitle the board to delegate powers to individual directors as considered appropriate. In practice individual directors will normally carry out many of the company s activities.

16 Scope of directors` responsibilities Cont d Statutory Duties Directors need to be aware that they are personally subject to statutory duties in their capacity as directors of a company. In addition the company as a separate legal entity is subject to statutory controls and the directors are responsible for ensuring that the company complies with such statutory controls. The Companies Act 2006 codified certain common law and equitable duties of directors for the first time. The Act sets out seven general duties of directors which are:- to act within powers in accordance with the company s constitution and to use those powers only for the purposes for which they were conferred to promote the success of the company for the benefit of its members to exercise independent judgment to exercise reasonable care, skill and diligence to avoid conflicts of interest not to accept benefits from third parties to declare an interest in a proposed transaction or arrangement

17 Scope of directors` responsibilities Cont d Liabilities Directors may incur personal liability, both civil and criminal, for their acts or omissions in directing the company. It is beyond the scope of this paper to list all the various matters for which directors can be held to be liable. However, directors should be aware of the effects of the Company Directors Disqualification Act 1986, which could lead to the disqualification from acting as a director of a company for a period of between two and fifteen years, and the Insolvency Act 1986 which gives rise to the possibility of directors being made personally liable for the company s debts, the Health and Safety at Work etc Act 1974, and the Corporate

18 The Investment Decision, Financing Decision and the Dividend Decision Investment decision is the determination made by directors and/or management as to how, when, where and how much capital will be spent on investment opportunities. The decision often follows research to determine costs and returns for each option. In Financial Decision, different sources of fund were identified which include the costs associated with each source, the availability of each source, and the characteristics of each source

19 The investment decision, financing decision and the dividend decision Cont d This decision relates to careful selection of assets in which funds will be invested by the firms. A firm has many options to invest their funds but firm has to select the most appropriate investment which will bring maximum benefit for the firm and deciding or selecting most appropriate proposal is investment decision. The firm invests its funds in acquiring fixed assets as well as current assets. When decision regarding fixed assets is taken it is also called capital budgeting decision

20 The investment decision, financing decision and the dividend decision Cont d Factors Affecting Investment/Capital Budgeting Decisions 1. Cash Flow of the Project: Whenever a company is investing huge funds in an investment proposal it expects some regular amount of cash flow to meet day to day requirement. The amount of cash flow an investment proposal will be able to generate must be assessed properly before investing in the proposal. 2. Return on Investment: The most important criteria to decide the investment proposal is rate of return it will be able to bring back for the company in the form of income for, e.g., if project A is bringing 10% return and project В is bringing 15% return then we should prefer project B. 3. Risk Involved: With every investment proposal, there is some degree of risk is also involved. The company must try to calculate the risk involved in every proposal and should prefer the investment proposal with moderate degree of risk only. 4. Investment Criteria: Along with return, risk, cash flow there are various other criteria which help in selecting an investment proposal such as availability of labour, technologies, input, machinery, etc. The finance manager must compare all the available alternatives very carefully and then only decide where to invest the most scarce resources of the firm, i.e., finance. Investment decisions are considered very important decisions because of following reasons: (i) They are long term decisions and therefore are irreversible; means once taken cannot be changed. (ii) Involve huge amount of funds. (iii) Affect the future earning capacity of the company.

21 The investment decision, financing decision and the dividend decision Cont d Financing Decision: The second important decision which finance manager has to take is deciding source of finance. A company can raise finance from various sources such as by issue of shares, debentures or by taking loan and advances. Deciding how much to raise from which source is concern of financing decision. Mainly sources of finance can be divided into two categories: 1. Owners fund. 2. Borrowed fund. Share capital and retained earnings constitute owners fund and debentures, loans, bonds, etc. constitute borrowed fund. The main concern of finance manager is to decide how much to raise from owners fund and how much to raise from borrowed fund.

22 The investment decision, financing decision and the dividend decision Cont d While taking this decision the finance manager compares the advantages and disadvantages of different sources of finance. The borrowed funds have to be paid back and involve some degree of risk whereas in owners fund there is no fix commitment of repayment and there is no risk involved. But finance manager prefers a mix of both types. Under financing decision finance manager fixes a ratio of owner fund and borrowed fund in the capital structure of the company.

23 The investment decision, financing decision and the dividend decision Cont d Factors Affecting Financing Decisions: While taking financing decisions the finance manager keeps in mind the following factors: 1. Cost: The cost of raising finance from various sources is different and finance managers always prefer the source with minimum cost. 2. Risk: More risk is associated with borrowed fund as compared to owner s fund securities. Finance manager compares the risk with the cost involved and prefers securities with moderate risk factor. 3. Cash Flow Position: The cash flow position of the company also helps in selecting the securities. With smooth and steady cash flow companies can easily afford borrowed fund securities but when companies have shortage of cash flow, then they must go for owner s fund securities only. 4. Control Considerations: If existing shareholders want to retain the complete control of business then they prefer borrowed fund securities to raise further fund. On the other hand if they do not mind to lose the control then they may go for owner s fund securities. 5. Floatation Cost: It refers to cost involved in issue of securities such as broker s commission, underwriters fees, expenses on prospectus, etc. Firm prefers securities which involve least floatation cost. 6. Fixed Operating Cost: If a company is having high fixed operating cost then they must prefer owner s fund because due to high fixed operational cost, the company may not be able to pay interest on debt securities which can cause serious troubles for company. 7. State of Capital Market: The conditions in capital market also help in deciding the type of securities to be raised. During boom period it is easy to sell equity shares as people are ready to take risk whereas during depression period there is more demand for debt securities in capital market.

24 The investment decision, financing decision and the dividend decision Cont d Dividend Decision This decision is concerned with distribution of surplus funds. The profit of the firm is distributed among various parties such as creditors, employees, debenture holders, shareholders, etc. Payment of interest to creditors, debenture holders, etc. is a fixed liability of the company, so what company or finance manager has to decide is what to do with the residual or left over profit of the company. The surplus profit is either distributed to equity shareholders in the form of dividend or kept aside in the form of retained earnings. Under dividend decision the finance manager decides how much to be distributed in the form of dividend and how much to keep aside as retained earnings. To take this decision finance manager keeps in mind the growth plans and investment opportunities. If more investment opportunities are available and company has growth plans then more is kept aside as retained earnings and less is given in the form of dividend, but if company wants to satisfy its shareholders and has less growth plans, then more is given in the form of dividend and less is kept aside as retained earnings. This decision is also called residual decision because it is concerned with distribution of residual or left over income. Generally new and upcoming companies keep aside more of retain earning and distribute less dividend whereas established companies prefer to give more dividend and keep aside less profit.

25 The investment decision, financing decision and the dividend decision Cont d Factors Affecting Dividend Decision: The finance manager analyses following factors before dividing the net earnings between dividend and retained earnings: 1. Earning: Dividends are paid out of current and previous year s earnings. If there are more earnings then company declares high rate of dividend whereas during low earning period the rate of dividend is also low. 2. Stability of Earnings: Companies having stable or smooth earnings prefer to give high rate of dividend whereas companies with unstable earnings prefer to give low rate of earnings. 3. Cash Flow Position: Paying dividend means outflow of cash. Companies declare high rate of dividend only when they have surplus cash. In situation of shortage of cash companies declare no or very low dividend. 4. Growth Opportunities: If a company has a number of investment plans then it should reinvest the earnings of the company. As to invest in investment projects, company has two options: one to raise additional capital or invest its retained earnings. The retained earnings are cheaper source as they do not involve floatation cost and any legal formalities. If companies have no investment or growth plans then it would be better to distribute more in the form of dividend. Generally mature companies declare more dividends whereas growing companies keep aside more retained earnings. 5. Stability of Dividend: Some companies follow a stable dividend policy as it has better impact on shareholder and improves the reputation of company in the share market. The stable dividend policy satisfies the investor. Even big companies and financial institutions prefer to invest in a company with regular and stable dividend policy. There are three types of stable dividend policies which a company may follow: (i) Constant dividend per share: In this case, the company decides a fixed rate of dividend and declares the same rate every year, e.g., 10% dividend on investment. (ii) Constant payout ratio: Under this system the company fixes up a fixed percentage of dividends on profit and not on investment, e.g., 10% on profit so dividend keeps on changing with change in profit rate. (iii) Constant dividend per share and extra dividend: Under this scheme a fixed rate of dividend on investment is given and if profit or earnings increase then some extra dividend in the form of bonus or interim dividend is also given.

26 References Adejola, P. A (2014): Revision Pack on Financial Management for Professionals, Conversion and Undergraduate Students, Danladi Press, Abuja. Adejola, P. A (2010): Revision Pack on Management Accounting for Professionals, Conversion and Undergraduate Students, Danladi Press, Abuja.

27 Review Questions 1. Differentiate the aims and objectives of profit-seeking and non-profit seeking organizations. 2. Highlight the basic relationship between financial management, management accounting and financial accounting. 3. Which of the following is the primary objective of a business? i.wealth Maximization ii. Profit Maximization. 4. Discuss the principles of corporate governance. 5. What do you understand by the terms creative accounting, window dressing, cosmetic accounting? 6. There are three core decision areas in finance. Highlight them.

Chapter -9 Financial Management

Chapter -9 Financial Management Business Studies (VKS) Definition Financial management is concerned with efficient acquisition and allocation of funds. In other words, financial management means estimating