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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 10-6
10.1 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 10-7
10.1 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 10-8
10.2 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 10-9
10.2 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 10-10
10.2 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 shareholdersNumber of ordinary shares
Copyright 2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al
Prepared by Courtney Clowes 10-11
10.2 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 taxesTotal assets
Copyright 2004 McGraw-Hill Australia Pty Ltd. PPTs t/a Accounting by Jackling et al
Prepared by Courtney Clowes 10-12
10.2 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 10-13
10.2 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 10-14
10.2 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 10-15
10.2 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 10-16
10.2 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 10-17
10.3 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 10-18
10.3 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 10-19
10.4 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 10-20
10.4 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 10-21
10.4 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 10-22
10.4 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 10-23
10.4 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 10-24
10.4 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 10-25
10.5 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 10-26
10.5 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 10-27
10.5 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 10-28
10.5 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 10-29
10.5 Financial managementFinancing
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 10-30
10.5 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 10-31
10.6 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 10-32
10.6 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 10-33
10.6 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 10-34
10.6 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 10-35
10.7 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 10-36
SummaryThe 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 10-37
SummaryVarious risks exist including
Business risk
Financial risk
Management riskWorking capital needs to be managed
effectively and the major components areCash, inventory, creditors and debtors
Recommended