Pages: ACCA Paper F9 Acca Acca

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ACCA Paper F9
Financial Management
For exams in 2011
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Notes
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ExPress Notes
ACCA F9 Financial Management
Contents
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1. 2. 3. 4. 5. 6. 7. Financial Management Function Working Capital Management Investment Appraisal Business Finance Cost of Capital Business Valuations Risk Management
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Chapter 1
Financial Management Function
The main purpose of financial strategy is to ensure that financial resources are available to nancial strategy pport the organization in support of its over corporate objectives, which include financial overall objectives.
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ent nt Management accounting is a set of tools and disciplines measuring corporate performance tate decision-making; it is designed and implemented in coordination with the and to facilitate decisionpanys strategy. companys strateg ancial accoun ncial accou Financial accounting is concerned with maintaining the records of the transactions of the d pre firm and prep preparing financial statements for the benefit of shareholders (and other external audiences) in conformity with established accounting standards.
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DGE KEY KNOWLEDGE pose The Nature and Purpose of Financial Management
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KEY KNOWLEDGE Financial Objectives and the Relationship with Corporate Strategy
In pursuing its financial objectives, the firm must ensure that those objectives are congruent i.e. consistent with its overall corporate strategy.
KEY KNOWLEDGE Stakeholders and Impact on Corporate Objectives
vily Lenders: Important if the business relies heavily on provid providers of loan capital (banks, bondholders);
Employees: Often referred to as a co companys most valuable asset; they must be quately com motivated and adequately compe compensated; rs: o Customers: No customers, no business! How influential they are or how carefully gement ement li management needs to l listen to their concerns depends on the type of business activity d and the competitive e environment; Goo Suppliers: Good and reliable suppliers can be critical to corporate success; ernm Government: They have two major interests: (a) they receive revenue via taxes and (b) benefit indirectly when firms create employment. Environmental and other regulatory concerns are also within the scope of the governments interest; Public: The general public, its opinions and ability to exert pressure through lobby groups are all relevant factor for businesses that pollute, are involved in nuclear power, or carry out other activities that may be controversial (e.g. abortion clinics).
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x x x x
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ors man Directors: The executive directors or senior management of the business are central se since they have hands-on power and can ser their own interests (giving rise to serve agency risk);
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k upreme, refl ref Shareholders: As owners of the business, they rank supreme, as reflected in US/UK models of corporate governance;
Stakeholder groups
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Conflicting stakeholder interests Conflicting interests can exist between various stakeholder groups. Management must examine the degrees of stakeholder influence and actively manage the relationship with relevant stakeholders. Agency theory
Influencing managerial behavior
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NOWLEDGE KEY KNOWLEDGE nancial ncial Ot Financial and Other Objectives in Non for Profit Organisatio Organisation Organisations
Profit and Not-for-profit o nd ot-for-profit organisations ofit-seeking org fit-seeking organizations exist ultimately to create wealth for their owners. Profit-seeking orga ofit (o Non-profit (or not-for-profit) organizations are created to accomplish a pre-defined mission, such as the delivery of a service; they are expected to do so in an economical manner.
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ay c ten In order to cause managers to behave in a way consistent with stakeholder interests, o de rewards and bonus schemes need to be carefully designed. This can be seen as the e governance. internal dimension to corporate governance The other dimension -- external comes in the form of regulation.
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a) Examples of self-serving management behavior could include: (a) artificially boost boosting ) corporate profits in the short-term in order to earn bonuses; (b) paying too mu to acquire much uild mpires; another company for reasons of prestige or in order to build empires; (c) r rejecting nitiatives, iatives, mig opportunities, such as takeover bids, or restructuring initiatives, that might jeopardize their quo positions (an orientation to maintaining the status quo).
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t Agency theory addresses the risk that management will not act in the best interest of the shareholders, but will make decisions that will serve its own interests.
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KEY KNOWLEDGE Financial Management Environment

1. The economic environment for business The general economic environment, and in particular the influence of governments ts usiness usinesses through its monetary and fiscal policies has a far-reaching impact on most businesses. 2. The nature and role of financial markets and institutions
Financial markets and institutions have achieved such a degree of global integration th that lobal bal is shocks in one part as shown with the onset of the financial crisis in 2008 can h have systematic implications across all markets.
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Chapter 2
Working Capital Management
1. The nature, elements and importan of working capital ts importance This is a core function of management which has day-to-day implications. n manag
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x x x x Cash ash Inventory Receivables Receiv Payables
Working capital definition: Current assets Current liabilities Curren This is an accounting definition. The discussion and analysis of working capital management ccounting definit focuses on the operating elements of current assets and liabilities: s he operating
2. Management of inventories, accounts receivables, accounts payable and cash These elements are linked through the Cash conversion cycle, also known as the Cash Operating Cycle.
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START The Big Picture
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Raw materials received Receipt of cash Payment to supplier
s The cash invested in inventories and receivables represents a co to the company. This is cost could most directly obvious in opportunity cost terms: the cash could be earning interest, reducing nto shareholders pockets as a dividend interest-bearing debt, or ultimately find its w way into shar payment. cates The presence of payables indicates that cash p payments (outflows) are delayed; this is s ong beneficial to the company as long as it is not overdue on its payments, as late payment com could lead to penalties or damage to the companys reputation (creditworthiness). dual al work Managing the individual parts of working capital means managing the whole picture in an ing ng optimal way; doing this well can give a firm a significant competitive advantage over its competitors. nalysis sis Ratio Analysis
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Liquidity ratios quidity uidity
The relationship between current assets and current liabilities is used as a measure of elationsh ationsh n liquidity in the firm: Current ratio = Current assets Current liabilities
Quick ratio = Current assets - Inventories Current liabilities
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pical manufactu The above diagram shows the operating cash flows for a typical manufacturing company he mpany need converting raw materials into finished goods for sale. The company needs its own cash to e pay the supplier and can only recover this from the sale of the finished g goods.
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Sale of goods
Conversion into finished goods
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ExPress Notes
Turnover ratios
(1) Trade debtors (receivables) Trade Debtors x 365 Sales (2) Inventory turnover
(3) Trade creditors (payables) Trade Payables x 365 COGS
Economic Order Quantity (EOQ)
mptat mptation ccum Within a company, there is a natural temptation to accumulate buffer stocks (raw materials duction never interrupted. uction neve and semi-finished goods) so that production is n k-outs, -outs, mana Similarly, in order to avoid stock-outs, sales managers will insist on maintaining a plentiful f level of finished goods. All of this costs money money. ich min The EOQ is a method which seeks to minimize the costs associated with holding inventory. f To determine the total costs, the fol following data is required:
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Q = order quantity
D = quantity of pr product demanded annually P = purchase cost for one unit purch C = fixe cost per order (not incl. the purchase price) fixed H = cost of holding one unit for one year
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Inventory x 365 COGS
ExPress Notes
The total cost function is as follows: Total cost = Purchase cost + Ordering cost + Holding cost which can be expressed algebraically as follows: TC = PxD + C x D/Q + H x Q/2
It is this total cost function which must be minimized. Recognizing that: x x x PD does not vary; Ordering costs rise the more frequently one places (during the year); and he a Holding costs rise the fewer times one places orders (due to larger quantiti being quantities e quantit ordered each time),
The optimal order quantity (Q*) is found where the Ordering and Holding costs equal each a other, i.e. C x D/Q = H x Q/2
Rearranging the above and solving for Q results in g
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x x x x Weekly Week demand Purchase price Ordering cost Holding cost
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EXAMPLE XAMPLE
A trucking compan uses disposable carburetor units with the following details: ucking compa company 500 units USD 15 / unit USD 40 / order 7% of the purchase price
Assume a 50 week year. What is the optimal order quantity?
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It follows that there is a trade-off between the Ordering and the Holdin costs. Holding ing nd Hold
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ExPress Notes
Assessing the creditworthiness of customers When assessing the creditworthiness of (potential) clients, companies can use the approach typically employed by banks, referred to (originally) as the 3 Cs of credit, later expanded to the 5 Cs. They are (1) Character: Focuses on the reputation of the principals/decision makers at a company; credit checking agencies and bank references assist to this end;
ral (5) Conditions: This is a general review of the e economic environment to appreciate to what y extent a customer may be affected by a decline in general business conditions (business cycle influences).
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Settlement discounts
EXAMPLE AMPLE
A downturn in housing construction will affect a range of other businesses, from plumbers to ownturn ho housi ilding ding building material producers and companies leasing earth-moving equipment. Anyone selling ch busine to such businesses needs to keep the big picture in mind so as not to be over-exposed to ry secondary influences.
The objective of granting a settlement discount is to give customers a financial incentive to pay their bills more quickly (before the standard due date).
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rity omp ompany i (4) Collateral: Assesses what (if any) security the company is willing to provide in support of er the intended transaction. Banks refer to this a providing additional exits (ways out) as ovid from a transaction.
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resou resour (3) Capital: Identifies and assesses the financial staying power and resources of the ave e lo business; how much of a capital cushion do they have to withstand losses and how osed sed much do they have committed at risk in a proposed transaction th incentivizes them to that actor); ctor); succeed (one can refer to this as the pain factor);
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t managemen (2) Capacity: Examines the companys cash flow generation in the context of management managements ons, ability to perform competently and reliably in meeting their obligations, based on an riences others nces others). examination of their track record (either directly or via the experiences of others) ere ne Financial statement analysis is a major part of the exercise here (and in the next point);
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A company granting settlement discounts must ensure that the benefits of doing so will outweigh the costs.
EXAMPLE
Cost of financing receivables for 3 months: 5,000,000 x 3/12 x 15%
Cost of financing receivables for 1 month: mo month 5,000,000 x 1/12 x 15% 2
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Savings in financing cost costs s 2% 5,000,000 x 2
Cost of settlement discount: nt discount t
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Collection of debts ction debt
The discount is worth impleme implementing as the company achieves a net benefit of USD 25,000. t orth implem
A company must have in place a clear policy on the collection of debts. ompany mus mpany mu
Even if a good screening/assessment procedure is in place for accepting and reviewing customers, late payments are a fact of life and must be handled pro-actively. Much time can be spent in chasing late payments and if this process is not well-organized, management may come to the conclusion that it is not worthwhile. This is especially true in cases where a company is growing very quickly and celebrates the signing of contracts and issuance of invoices as signs of success. If, however, these invoices are not collected in due time (or at all), then the company is throwing away the rewards of success.
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= = = =
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187,500 187 187, 62,500 125,000 100,000
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Redwood Co. currently gives payment terms of 3 months to its customers. If it shortens this t th to one month by offering a 2% settlement discount, calculate what the impact will be if vantage th sales of USD 5m remain unchanged and all customers elect to take advantage of the discount. The companys cost of capital is 15%.
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ExPress Notes
Deductions Another phenomenon which results in significant write-offs of receivable is the practice of deductions in which a customer pays less than the full amount of the invoice, giving a reason for withholding the difference. This amounts to a renegotiation of the original invoice and is often accepted as a fait accompli by the supplier. A company managing its receivables diligently will have the following:
efe law (4) A policy determining when to involve refer the case to lawyers (preferably in-house, for w-up letters. e ex cost reasons) in preparation of follow-up lette An external lawyer may carry more weight, but is also more costly; o (5) Use of a collection agent to chase the receiv receivable. Here again, a company must calculate f ext exte the costs and benefits of involving an external agent. In such an analysis, the savings of opportunity pportunity i management time (opportunity cost) is the most difficult to estimate. ons f cre policies Financial implications of different c credit
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cre credi Evaluating a change in a credit policy requires the identification of relevant cash flows d (th structured as before (the change) and after scenarios.
EXAMPLE
A company has current annual sales of USD 3,000,000 of which 50% is cash and 50% on 2 month credit terms. The contribution on credit sales is 25% of the selling price. The company is considering reducing its credit terms to 1 month and expects all (credit) customers to accept it with a 2% discount. No change in sales volume is anticipated. The company uses a 15% cost of capital.
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her perform performe (3) Training for staff involved in handing follow-ups, whether performed by phone, mail or personal visits;
follow(2) A follow-up system that assigns responsibility to specific staff doing the follow-u this follow-up; /or r experienc includes an elevating of difficult cases to more senior and/or more experienced staff to handle;
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g (1) A monitoring system that clearly flags late payers, known as an aging system. This bove includes identifying properly the practice of deductions mentioned above;
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ExPress Notes
Analysis:
Contribution USD - Before modification of terms: 375,000 (25% x 1.5m) - After modification: 345,000 (23% x 1.5m) Net change: (30,000)
The change is not worthwhile.
3. Determining working capital needs and funding strategies ng g
The level of working capital required in a business depends on the industry it operates in, in the length of its working capital cycle and the range of funding options open to it. Retaining ange o flexibility is a key requirement. While overdraft financing is ex nancing expensive, it does permit spontaneous drawdowns and rapid repayments. yme yments
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Receivables USD - Financing cost before modification: 37,500 (1.5m x 2/12 x .15) /12 12 .15 - After modification: 18,750 (1.5m x 1/12 x .15) Net change: 18,750
ExPress Notes
Chapter 3
Investment Appraisal
START The Big Picture
The appraisal process is predicated on the fact that capital expenditures are investments icated cated fer which will (hopefully) confer future benefits referred to as the payback. The payback may be ne. a lengthy (and risky) one. nted 2. Non-discounted cash flow te techniques
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Payback method ethod Initial Investment: al Investment Year Yea 1 Year 2 Year 3 Year 4 Year 5 Total Payback
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40,000 Cash flows (A) 5,000 6,000 12,000 13,000 15,000 51,000 Year 5
1. The nature of investment decisions and the appraisal process ions th
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Cashflows (B) 15,000 13,000 12,000 6,000 5,000 51,000 Year 3
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START About ExPress Notes

How to get the most from these ExPress notes

Prior to study, e.g. deciding which optional papers to take

At the start of the learning phase

ACCA online on past exams ast e

Dont use at this stage.

Your stage in study for each paper

These ExPress notes

ExP recommended exam kit

ACCA online past exams

Our ExPress notes fit into our portfolio of materials as follows:

START About The ExP Group xP P

Financial Management Function

KEY KNOWLEDGE Stakeholders and Impact on Corporate Objectives

Influencing managerial behavior

KEY KNOWLEDGE Financial Management Environment

Working Capital Management

START The Big Picture

Raw materials received Receipt of cash Payment to supplier

Quick ratio = Current assets - Inventories Current liabilities

Conversion into finished goods

(3) Trade creditors (payables) Trade Payables x 365 COGS

Economic Order Quantity (EOQ)

Inventory x 365 COGS

Rearranging the above and solving for Q results in g

Assume a 50 week year. What is the optimal order quantity?

Cost of financing receivables for 3 months: 5,000,000 x 3/12 x 15%

Cost of financing receivables for 1 month: mo month 5,000,000 x 1/12 x 15% 2

Cost of settlement discount: nt discount t

The change is not worthwhile.

3. Determining working capital needs and funding strategies ng g

START The Big Picture

1. The nature of investment decisions and the appraisal process ions th

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