Business

ACCA P3
Analysis
BPP PASS
CARD
 14: Finance

Topic List
The finance function
This chapter considers the important issues to
Finance and strategy be evaluated when assessing alternative
Financial management decisions financial strategies for an organisation.
Cash forecasts Obtaining
equity funds
Bank loans and loan capital
Budgets
Evaluating strategic options
Ratio analysis
Comparison of accounting
figures
 The finance Finance Financial Cash Obtaining equity Bank loans and Budgets
function and strategy management decisions forecasts funds loan capital

Transformation of the role of the accountant and the finance function

In recent times there has been a noticeable shift in the role that the finance function plays in modern
organisations, moving away from being a mechanism for simply reforting on performance, to taking on a
broader advisory and strategic role.

The role of the traditional The finance function as a

finance function
business partner
◾ Processing transactions Many finance functions have re-focused their
◾ Maintaining accounting records roles as business partners, adopting a more
◾ Producing month-end reports commercial, action-oriented approach.
◾ Report results to internal and external
stakeholders
◾ Effective corporate governance and
control
 Important areas where the finance functions role
has developed include:

◾ Providing more useful information on business units, projects

and customers
◾ Collaborating in the formulation of corporate objectives, strategic
plans and budgets
◾ Supplying business cases for new investments
◾ Communicating and interpreting financial and non-financial
information for a range of stakeholders
◾ Helping operational and strategic managers understand
information on which decisions are based
 The finance Finance Financial Cash Obtaining equity Bank loans and Budgets
function and strategy management decisions forecasts funds loan capital

The hybrid accountant

The evolution of the role of the finance function has had implications for finance professionals –
leading to the creation of the term the 'hybrid accountant'.
Growing numbers of accountants spend the majority of their time as internal consultants or
business analysts.

Importance of decision making to organisations

A large part of the modern accountant's role is to work closely with the business to improve
strategic decision making to enhance the business' ability to create value. This presents some
challenges for traditional accounting systems though.

The challenge for modern accountants

The challenge lies in providing more relevant information for decision making. Traditional
accounting systems may not always provide this.
◾ Historical costs are not necessarily the best guide to decision making
◾ Strategic issues are not easily detected by accounting systems
◾ Financial models of some sophistication are needed to enable accountants to provide useful
information
Strategic management accounting
Strategic management accounting is a form of management accounting in which emphasis is placed on
information about factors which are external to the organisation, as well as non-financial and
internally generated information.

The role of the strategic management accountant

The role of the strategic management accountant encompasses:
◾ Financial analysis: indicates the current position of a business and its financial performance in
comparison with competitors, as well as breaking it down into product and customer profitability
analyses
◾ Financial planning: quantifies the goals and objectives of the business, normally in a budget
◾ Financial control: Financial information is an essential part of the feedback mechanism
comparing planned with actual performance
The finance Finance Financial Cash Obtaining equity Bank loans and Budgets
function and strategy management decisions forecasts funds loan capital

Strategic management Traditional management

accounting accounting
Orientation External orientation (focus on Internal orientation
customers, competitors, suppliers
and other stakeholders)
Direction Forward looking (relevant costs Backward looking
and revenues)
Goal congruence Requires inputs from many areas Largely focused on traditional
of the business (helps to ensure finance inputs
goal congruence by translating
business activities into the
common language of finance)
 Information provided by strategic management accountants include:

◾ Competitor analysis ◾ Pricing decisions

◾ Financial effect of competitor response ◾ Product-market decisions
◾ Product profitability ◾ Capacity expansion
◾ Portfolio analysis ◾ Brand valuation
◾ Customer profitability ◾ Shareholder wealth
 The finance Finance Financial Cash Obtaining equity Bank loans and Budgets
function and strategy management decisions forecasts funds loan capital

There are three broad issues of finance

1 Managing for value 2 Financial expectations of
◾ Creating value for shareholders stakeholders
◾ Revenue/cash generation ◾ Employee salary expectations
◾ Dividend payments/share price ◾ Shareholders – dividends or capital growth?
◾ Understanding cost and value ◾ Trading partners expecting solvency and liquidity
drivers ◾ Customers expecting value for money
◾ Obtaining value for money (public
sector)
3 Funding strategies
◾ Degree of financial risk accepted and implication
of proposed strategies for gearing

Decline
Launch Growth Maturity

Business risk Very high High Medium to low Low

Financial risk, therefore Keep very low Keep low May be increased Can be high
Funding Venture capital Equity Debt and equality Secured Debt
Dividends Nil Nominal, if any High Total
 The finance Finance Financial Cash Obtaining equity Bank loans and Budgets
function and strategy management decisions forecasts funds loan capital

In seeking to attain the financial objectives of an organisation, a financial manager has to make decisions on
three topics:

Investment Financing Dividend

decisions decisions decisions
Investment decisions include: Financial decisions include: Dividend decisions may affect
◾ New projects ◾ Long-term capital views of the company's long-
◾ Takeovers structure: need to term prospects, and thus the
◾ Mergers determine source, cost shares' market value.
◾ Sell-off/divestment and risk of long-term Payment of dividends limits
finance
The financial manager must: the amount of retained
◾ Short-term working earnings available for re-
◾ Identify investment capital management: investment.
opportunities balance between
◾ Evaluate them profitability and liquidity
◾ Decide optimal funding is crucial

Consider interaction of decisions, eg paying out dividends leaves less funds available to finance
investments.
 The finance Finance Financial Cash Obtaining equity Bank loans and Budgets
function and strategy management decisions forecasts funds loan capital

Cash forecasting should ensure that sufficient funds will be available, when needed, to sustain
the activities of an enterprise at an acceptable cost.
A cash budget or forecast is a detailed budget of estimated cash inflows and outflows
incorporating both revenue and capital items.
Cash forecasts can help in planning the structure of an organisation's finances
◾ How much cash is required
◾ When it is required
◾ How long it is required for
◾ Whether it will be available from anticipated sources
A business will also need to take account of economic variables (such as inflation,
interest rates) and business variables (such as changes in the competitive environment).
Cash deficits will be funded in different ways, depending on whether they are short or long
term. Businesses should have procedures for investing surpluses with appropriate levels of risk
and return.
 The finance Finance Financial Cash Obtaining equity Bank loans and Budgets
function and strategy management decisions forecasts funds loan capital

Equity is the issued ordinary share capital plus reserves which represent the investment in a
company by its ordinary shareholders.

Retained profits are a source of equity Equity shares maybe issued to:
funding. This approach is flexible and does ◾ Raise cash
not change the pattern of shareholdings.
◾ To obtain a stock market listing
However, shareholders may prefer the cash
to be distributed as dividends. ◾ To take over another company (by issuing
shares to the shareholders of the other
company)
 The finance Finance Financial Cash Obtaining equity Bank loans and Budgets
function and strategy management decisions forecasts funds loan capital

Overdrafts and loans

Overdrafts are used for short-term financing needs. A maximum facility is granted; the bank will
want any long- term balance reduced. Overdrafts are repayable on demand; security may be over
specific assets or over the whole business.
Loans are medium and long-term. The organisation won't be subject to the publicity
requirements or costs of a loan stock issue on the stock exchange but will have to make regular
interest payments. Security or restrictive covenants may be imposed.

Overdrafts Loans

◾ Designed for day-to-day help Overdrafts ◾ Medium/long-term purposes

◾ Only pay interest when ◾ Interest and repayments set in
overdrawn vs Loans advance
◾ Bank has flexibility to review ◾ Bank won't withdraw at short notice
◾ Can be renewed ◾ Shouldn't exceed asset life
◾ Won't affect gearing calculation ◾ Can have loan-overdraft mix
Loan capital or loan stock is debentures and other long-term loans to a business. It has a
nominal value, which is the debt owed by the company, and interest is paid at a stated
coupon on this amount.

Example
Company issues "10% loan stock"
Coupon is therefore 10% of the nominal value
So, $100 of stock will receive $10 interest each year (gross before tax)
 The finance Finance Financial Cash Obtaining equity Bank loans and Budgets
function and strategy management decisions forecasts funds loan capital

Budgets convert strategic plans into specific targets

Mission Strategic objectives Strategic plans Budgets
Sets overall direction Shows how mission Shows how objectives Short-term plans and targets to
will be achieved will be pursued fulfil strategic objectives

Benefits of budgets Features of successful budgetary control

◾ Promote forward thinking systems
◾ Helps co-ordinate aspects of organisation ◾ Senior management take system
◾ Motivates performance seriously
◾ Provides basis for system of control ◾ Clear responsibilities and accountability
◾ Provides system of authorisation
◾ Targets are challenging but achievable
Limitations of budgets ◾ Established data collection, analysis and
◾ Benefits may be in conflict with each reporting routines
other ◾ Targeted reporting
◾ May demotivate if unattainable ◾ Short reporting periods
◾ Slack may be built in
◾ Focus on short-term ◾ Timely reporting
◾ Unrealistic budgets may lead to poor ◾ Provokes action
decisions
 Evaluating Ratio Comparison of
strategic options analysis accounting figures

Relevant costs and marginal costing are useful for evaluating strategic options.

Accepting/rejecting special Make or buy decisions

contracts ◾ Use marginal costing to identify
◾ Determine contribution (revenue less contribution for both options
costs) ◾ Select highest but there may be other
◾ Accept if positive contribution factors to consider
◾ May be other factors to consider, eg Closing or continuation decisions
negative contribution but may lead to ◾ Determine contribution to overall
more lucrative contracts organization made by individual
department
Efficient use of scarce resources
◾ Departments that make a positive
◾ Most profitable combination is contribution should not be closed even
where the contribution per unit of if it makes a net loss overall (fixed costs
the scarce resource (eg labour) is incurred regardless)
maximised
 Evaluating Ratio Comparison of
strategic options analysis accounting figures

Remember! Consider the requirements of the question and the contents of the scenario carefully before
calculating ratios. The examining team will be looking for relevant ratios accompanied by meaningful
comments, including appropriate comments on the limitations of ratio analysis.
Profitability and return Liquidity ratios

◾ Return on capital employed (ROCE) ◾ Current ratio ◾ Quick (acid test)

◾ Profit margin ratio
◾ Asset turnover ◾ Inventory turnover ◾ Account payable
◾ Account receivable
days days
Debt and gearing
Stock market ratios
◾ Debt ratio (Total debts/Assets)
◾ Capital gearing (Proportion of debt in ◾ Dividend yield ◾ Interest yield
long-term capital) ◾ Earnings per share ◾ Dividend cover
◾ Interest cover ◾ Price/earnings ratio
◾ Cash flow ratio (Cash inflow/Total debts)
 Evaluating Ratio Comparison of
strategic options analysis accounting figures

Comparisons with companies Comparisons with previous

in different industries Comparisons with years

other companies in ◾
% growth in profit
Investors aiming for ◾
% growth in turnover
diversified portfolios need same industry ◾
Changes in gearing ratio
to know differences ◾
Changes in current/quick
These can put improvements ratios
between industrial sectors.
on previous years into ◾ Changes in
◾ Sales growth perspective if other
◾ Profit growth inventory/receivables turnover
companies are doing better, ◾ Changes in EPS, market
◾ ROCE and provide further evidence
◾ P/E ratios price, dividend
of effect of general trends.
◾ Dividend yields Remember, however:
◾ Growth rates ◾ Inflation – can make
◾ Retained profits figures misleading
◾ Non-current asset levels ◾ Results in rest of
industry/environment, or
economic changes to give
context