Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes 10-1 Chapter 10 Accounting and Financial Management

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes 10-2 Chapter 10 Overview 10.1 Entity objectives 10.2 Measuring wealth 10.3 Agency Theory 10.4 Risk and return 10.5 Financial management 10.6 Working capital 10.7 Dividend policy

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes 10-3 Chapter 10 Objectives  Identify the objectives of an entity  Explain measurement of owners’ wealth  Identify reasons managers have different goals from the entity  Understand incentives available for management to pursue the entity’s goals

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes 10-4 Chapter 10 Objectives  Identify different types of risk  Demonstrate a formula for share prices  Explain the role of financial management:  Regarding financing decisions  Regarding working capital  Regarding dividend policy

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes 10-5 Introduction This chapter introduces:  Using accounting information for financial management  The examination of entity objectives and the management of risk and return  Financing, dividends and investment

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Entity objectives  An entity may have many objectives, but a key primary objective for profit-making entities is  There is debate as to the appropriateness of this objective and measuring it is also quite difficult Maximising Owners’ Wealth

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Entity objectives  What can be measured to determine shareholder wealth?  Accounting profit  Earnings per share  Return on investment  Maximum share price

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Measuring wealth Accounting profit  Difficult to define or measure with certainty or consistency  Does not consider the level of investment required to achieve the profit  $50 versus $5000 is hard to compare unless we know the amount invested to begin with

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Measuring wealth Accounting profit  Does not consider the time value of money  Does not include or account for risk  Because of this, conventional accounting profit figures are not a completely accurate measure of wealth maximisation

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Measuring wealth Earnings per share (EPS)  The formula for EPS is:  This considers the level of investment  This measure is influenced by debt/equity levels Profit available to ordinary shareholders Number of ordinary shares

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Measuring wealth Return on investment (ROI)  The formula for ROI is:  This considers the level of investment  This measure is not influenced by debt/equity levels and is a purer measure of performance Earnings before interest and taxes Total assets

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Measuring wealth Benefits and problems of EPS & ROI  Both of these formulas consider the level of investment required  Accounting profit failed to do this  However, both of these formulas are still based on accounting profit

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Measuring wealth Share price  Although only available in an actively trading share market, the share price indicates the market’s assessment of the entity’s value  Therefore, maximising share price leads to maximising owners’ wealth

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Measuring wealth Share price  Benefits of using share price as a measure include:  Considers the time value of money  Takes risk into account  Incorporates accounting profit and investment levels

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Measuring wealth Share price  Achieving these benefits requires the share market to be efficient  This means all available information is reflected in the prices that are set for shares  Thus, share prices reflect the true value of a share  This is called the ‘efficient market hypothesis’

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Measuring wealth Share price  Is the market efficient?  Greed and fear may also affect share prices  Rumours or selectively released information may make the market less efficient  There is often a ‘herd mentality’ where people follow the herd leaders regardless of the information available

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Agency Theory Managers versus owners  Many entities have a separation of ownership and control  Managers control the organisation by acting as agents for owners  Managers’ objectives may not always be the same as those of the owners

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Agency Theory Managers versus owners  Several things prevent managers from acting to the detriment of owners  Threat of takeovers (if the share price drops)  Increase in cost of obtaining finance  Compensation plans restrict misbehaviour

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Risk and return  The primary factor which influences the share price is the interaction of risk and return Risk = variability of an outcome So more risk = more variability  Usually, greater returns are achieved by taking greater risks

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Risk and return  The 3 types of risk an entity faces are: 1. Business risk 2. Financial risk 3. Management risk (Quality of managers)

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Risk and return Business risk  This relates to investments by an entity  There are many things an entity may invest in with different risk levels  Physical assets  Different industries  Different countries

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Risk and return Financial risk  The way an investment is financed also creates risk  Two entities may invest in the same area yet finance the investment differently which leads to different levels of risk  (Imagine borrowing from a friend instead of the bank to buy a great car)

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Risk and return Financial risk  Factors which affect financial risk include:  Level of borrowing  Date borrowings must be repaid by  Changes in interest rates  Level of current assets required

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Risk and return Management risk  How effectively and efficiently assets and liabilities are managed  Two entities with the same investments and the same financial structure will still have different levels of risk due to who is in charge

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Financial management  The 3 areas of financial management are: 1. Financing (capital structure decisions) 2. Dividend decisions 3. Investment decisions  The overall aim is to help formulate and support strategies to achieve wealth maximisation for an entity

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Financial management Financing  Overall objective  Acquire funds to finance all planned activities  Specific aim  Obtain necessary funds at minimum cost, from suitable sources, for the right period of time

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Financial management Financing  Financing decisions are affected by costs: 1. The price of time 2. The price of risk 3. The maturity structure

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Financial management Financing  Financing is also affected by the current level of debt  Higher debt levels increase the risk of defaulting  Financing is also affected by the stability of earnings  Any extra debt finance may need to be paid in regular instalments

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Financial management Financing  Possible sources of finance include DEBT Commercial paper Overdraft Leases Mortgages Debentures EQUITY Preference shares Ordinary shares Retained earnings

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Financial management  Other factors affecting choice of finance: 1. Volume of funds required 2. Transaction costs 3. Restrictive conditions 4. Current economic and market conditions 5. Tax effects

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Working capital  Working capital refers to long-term finance (capital) that is constantly converted from cash to physical assets and back to cash  Working capital is the excess of current assets over current liabilities Current Assets – Current Liabilities = Working Capital

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Working capital  Working capital management (current asset management) is linked with management of liquidity  Under-capitalisation may lead to business failure  Insufficient long-term finance to support operations and thus no working capital

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Working capital  Over-capitalisation may also cause problems because assets are not being utilised effectively  Excessive inventories  Poor control of accounts receivable  Too much cash not earning any returns  Poor control of accounts payable

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Working capital  4 key areas must be managed  Cash  Creditors  Debtors  Inventory  You must find the right balance for each of these items to effectively manage working capital

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Dividend policy  This determines which percentage of the profit earned is  distributed to owners; and  how much profit is retained by the entity  Various arguments exist regarding the use of dividends and their effect on share price

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Summary  The main objective of profit-making entities is to maximise owners’ wealth  This may be measured using ‘profit’, EPS or ROI  If a share price is available this is often the most useful measurement of owners’ wealth

Copyright  2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al Prepared by Courtney Clowes Summary  Various risks exist including  Business risk  Financial risk  Management risk  Working capital needs to be managed effectively and the major components are  Cash, inventory, creditors and debtors