Acca f9 2012 Notes

ACCA Paper F9 Financial Management For exams in 2012

Notes

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ExPress NotesACCA F9 Financial Management

Page | 2 © 2012 The ExP Group. Individuals may reproduce this material if it is for their own private study use only. Reproduction by any means for any other purpose is prohibited. These course materials are for educational purposes only and so are necessarily simplified and summarised. Always obtain expert advice on any specific issue. Refer to our full terms and conditions of use. No liability for damage arising from use of these notes will be accepted by the ExP Group. .

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Contents

About ExPress Notes 3

1. Financial Management Function 7

2. Financial Management Environment 11

3. Working Capital Management 13

4. Investment Appraisal 21

5. Business Finance 39

6. Cost of Capital 45

7. Business Valuations 53

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START About ExPress Notes

We are very pleased that you have downloaded a copy of our ExPress notes for this paper. We expect that you are keen to get on with the job in hand, so we will keep the introduction brief.

First, we would like to draw your attention to the terms and conditions of usage. It’s a condition of printing these notes that you agree to the terms and conditions of usage. These are available to view at www.theexpgroup.com. Essentially, we want to help people get through their exams. If you are a student for the ACCA exams and you are using these notes for yourself only, you will have no problems complying with our fair use policy.

You will however need to get our written permission in advance if you want to use these notes as part of a training programme that you are delivering.

WARNING! These notes are not designed to cover everything in the syllabus!

They are designed to help you assimilate and understand the most important areas for the exam as quickly as possible. If you study from these notes only, you will not have covered everything that is in the ACCA syllabus and study guide for this paper.

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official publishers, but we do not necessarily give this as part of a classroom course, as we think that it can sometimes slow people down and reduce the time that they are able to spend practising past questions.

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Everybody in the World has free access to ACCA’s own database of past exam questions, answers, syllabus, study guide and examiner’s commentaries on past sittings. This can be an invaluable resource. You can find links to the most useful pages of the ACCA database that are relevant to your study on ExPand at www.theexpgroup.com.

How to get the most from these ExPress notes

For people on a classroom course, this is how we recommend that you use the suite of learning materials that we provide. This depends where you are in terms of your exam preparation for each paper.

Your stage in study for each paper

These ExPress notes

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ACCA online past exams

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

Skim through the ExPress notes to get a feel for what’s in the syllabus, the “size” of the paper and how much it appeals to you.

Don’t use yet Don’t use yet Have a quick look at the two most recent real ACCA exam papers to get a feel for examiner’s style.

At the start of the learning phase

Work through each chapter of the ExPress notes in detail before you then work through your course notes.

Don’t try to feel that you have to understand everything – just get an idea for what you are about to study.

Don’t make any annotations on the ExPress notes at this stage.

Work through in detail. Review each chapter after class at least once.

Make sure that you understand each area reasonably well, but also make sure that you can recall key definitions, concepts, approaches to exam questions, mnemonics, etc.

Nobody passes an exam by what they have studied – we pass exams by being efficient in being able to prove what we know. In other words, you need to have effectively input the knowledge and be effective in the output of what you know. Exam practice is key to this.

Try to do at least one past exam question on the learning phase for each major chapter.

Don’t use at this stage.

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Your stage in study for each paper

These ExPress notes

ExP recommended course notes, or ExPedite notes

ExP recommended exam kit

ACCA online past exams

Practice phase Work through the ExPress notes again, this time annotating to explain bits that you think are easy and be brave enough to cross out the bits that you are confident you’ll remember without reviewing them.

Avoid reading through your notes again. Try to focus on doing past exam questions first and then go back to your course notes/ ExPress notes if there’s something in an answer that you don’t understand.

This is your most important tool at this stage. You should aim to have worked through and understood at least two or three questions on each major area of the syllabus. You pass real exams by passing mock exams. Don’t be tempted to fall into “passive” revision at this stage (e.g. reading notes or listening to CDs). Passive revision tends to be a waste of time.

Download the two most recent real exam questions and answers.

Read through the technical articles written by the examiner.

Read through the two most recent examiner’s reports in detail. Read through some other older ones. Try to see if there are any recurring criticisms he or she makes. You must avoid these!

The night before the real exam

Read through the ExPress notes in full. Highlight the bits that you think are important but you think you are most likely to forget.

Unless there are specific bits that you feel you must revise, avoid looking at your course notes. Give up on any areas that you still don’t understand. It’s too late now.

Don’t touch it! Do a final review of the two most recent examiner’s reports for the paper you will be taking tomorrow.

At the door of the exam room before you go in.

Read quickly through the full set of ExPress notes, focusing on areas you’ve highlighted, key workings, approaches to exam questions, etc.

Avoid looking at them in detail, especially if the notes are very big. It will scare you.

Leave at home. Leave at home.

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

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STARTAbout The ExP Group

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Chapter 1

Financial Management Function

KEY KNOWLEDGEThe Nature and Purpose of Financial Management

The main purpose of financial strategy is to ensure that financial resources are available to the organization in support of its overall corporate objectives, which include financial objectives. Management accounting is a set of tools and disciplines measuring corporate performance and to facilitate decision-making; it is designed and implemented in coordination with the company’s strategy. Financial accounting is concerned with maintaining the records of the transactions of the firm and preparing financial statements for the benefit of shareholders (and other external audiences) in conformity with established accounting standards.

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KEY KNOWLEDGEFinancial 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 KNOWLEDGEStakeholders and Impact on Corporate Objectives

Stakeholder groups Shareholders: As owners of the business, they rank supreme, as reflected in US/UK

models of corporate governance;

Lenders: Important if the business relies heavily on providers of loan capital (banks, bondholders);

Directors: The executive directors or senior management of the business are central since they have “hands-on” power and can serve their own interests (giving rise to agency risk);

Employees: Often referred to as a company’s “most valuable asset”; they must be motivated and adequately compensated;

Customers: No customers, no business! How influential they are or how carefully management needs to listen to their concerns depends on the type of business activity and the competitive environment;

Suppliers: Good and reliable suppliers can be critical to corporate success;

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 government’s 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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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

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. Examples of self-serving management behavior could include: (a) artificially boosting corporate profits in the short-term in order to earn bonuses; (b) paying too much to acquire another company for reasons of prestige or in order to “build empires”; (c) rejecting opportunities, such as takeover bids, or restructuring initiatives, that might jeopardize their positions (an orientation to maintaining the “status quo”).

Influencing managerial behavior

In order to cause managers to behave in a way consistent with stakeholder interests, rewards and bonus schemes need to be carefully designed. This can be seen as the “internal” dimension to corporate governance. The other dimension -- “external” – comes in the form of regulation.

Scope of strategic performance measures in private sector

Shareholder value measurements focus on creation of shareholder value as fundamental aim of profit oriented companies.

Long-term wealth maximization is not always consistent with the “artificial” inflation of profits in the short-term. If a company stops investing, for example, it can boost its short-term profitability, but this may come at the expense of the company’s medium- to long-term competitiveness.

The following are some of the financial measures typically used by companies to measure performance. Return on Investment (ROI/ROCE)

(Accounting PBIT / Accounting Capital Employed) * 100%

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Accounting Capital Employed = Total Assets – Current Liabilities = Total Non-Current Assets, net + Working Capital

Disadvantage: ROI/ROCE increases as investment centre’s fixed assets grow older, thus a ROI improvement over time (or a better ROI compared to another division) may be partly attributable to the age of the assets used.

Consequently, gross value of fixed assets may be used in measuring performance based on ROI.

Earnings Per Share (EPS) Net income less any preferred dividends divided by the number of shares outstanding.

Return on Equity Net income divided by shareholders’ equity.

KEY KNOWLEDGEFinancial and Other Objectives in Non‐for‐Profit Organisations

Profit and Not-for-profit organisations Profit-seeking organizations exist ultimately to create wealth for their owners. 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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Chapter 2

Financial Management Environment

The economic environment for business

The general economic environment, and in particular the influence of governments – through its monetary and fiscal policies – has a far-reaching impact on most businesses.

The impact of macro-economics

Businesses must also take macro-economic factors into account:

Projected level of market demand for goods and services in the economy;

In a recovery phase, how government policies are likely to be adjusted with respect to:

(a) Monetary policy: Effect on interest rates, exchange rates and inflation, (the latter may eventually increase with economic recovery); (b) Labor policy: If labor markets tighten, how fast will restrictions (imposed on foreign labor, for example) be relaxed?

(c) Fiscal policy: Tax increases (both personal and corporate);

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(d) Trade policy: to what degree is any protectionism likely to stay in place? Again, actively keeping up with reading on these issues will be the best way to prepare for this section of the exam.

The nature and role of financial markets and institutions

Financial markets and institutions have achieved such a degree of global integration that shocks in one part – as shown with the onset of the financial crisis in 2008 – can have systematic implications across all markets.

Stock markets A stock exchange is an organized and regulated market place which permits:

(i) Companies to raise capital through the issuance of new shares or debentures (collectively known as securities); the proceeds of such issuances go to the company issuing them -- this is called the “primary market”; and

(ii) Investors to buy and sell already-issued securities – called the “secondary market”.

How stock markets operate Traditionally, the operation of a stock market is accomplished through an auction system where prices are publicly posted after trades are executed; “specialists” on the trading floor have the role of creating a market in shares that are listed on the exchange: they are expected to provide two-way prices, i.e. to quote buy and sell prices, thus ensuring liquidity to the market. The New York Stock Exchange operates in this way. Outside the US, electronic trading systems have become more typical, in which traders interact not personally but by computer and telephone.

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Chapter 3

Working Capital Management

START The Big Picture

1. The nature, elements and importance of working capital

This is a core function of management which has day-to-day implications.

Working capital definition: Current assets – Current liabilities

This is an accounting definition. The discussion and analysis of working capital management focuses on the “operating” elements of current assets and liabilities:

Cash Inventory Receivables Payables

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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Raw materials received Receipt of cash Payment to supplier Sale of goods Conversion into finished goods

The above diagram shows the operating cash flows for a typical manufacturing company converting raw materials into finished goods for sale. The company needs its own cash to pay the supplier and can only recover this from the sale of the finished goods. The cash invested in inventories and receivables represents a cost to the company. This is most directly obvious in opportunity cost terms: the cash could be earning interest, reducing interest-bearing debt, or ultimately find its way into shareholders’ pockets as a dividend payment. The presence of payables indicates that cash payments (outflows) are delayed; this is beneficial to the company as long as it is not overdue on its payments, as late payment could lead to penalties or damage to the company’s reputation (creditworthiness). Managing the individual parts of working capital means managing the “whole picture” in an optimal way; doing this well can give a firm a significant competitive advantage over its competitors. Ratio Analysis Liquidity ratios

The relationship between current assets and current liabilities is used as a measure of liquidity in the firm:

Current ratio = Current assets Current liabilities

Quick ratio = Current assets - Inventories Current liabilities

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Turnover ratios

(1) Trade debtors (receivables) Trade Debtors x 365 Sales

(2) Inventory turnover Inventory x 365 COGS

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

Economic Order Quantity (EOQ) Within a company, there is a natural temptation to accumulate buffer stocks (raw materials and semi-finished goods) so that production is never interrupted.

Similarly, in order to avoid stock-outs, sales managers will insist on maintaining a plentiful level of finished goods. All of this costs money.

The EOQ is a method which seeks to minimize the costs associated with holding inventory.

To determine the total costs, the following data is required:

Q = order quantity

D = quantity of product demanded annually

P = purchase cost for one unit

C = fixed cost per order (not incl. the purchase price)

H = cost of holding one unit for one year

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The total cost function is as follows:

Total cost = Purchase cost + Ordering cost + Holding cost

which can be expressed algebraically as follows:

TC = P x D + C x D/Q + H x Q/2

It is this total cost function which must be minimized.

Recognizing that:

PD does not vary; Ordering costs rise the more frequently one places (during the year); and Holding costs rise the fewer times one places orders (due to larger quantities being

ordered each time),

It follows that there is a trade-off between the Ordering and the Holding costs.

The optimal order quantity (Q*) is found where the Ordering and Holding costs equal each other, i.e.

C x D/Q = H x Q/2

Rearranging the above and solving for Q results in

EXAMPLE

A trucking company uses disposable carburetor units with the following details:

Weekly demand 500 units Purchase price USD 15 / unit Ordering cost USD 40 / order Holding cost 7% of the purchase price

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

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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 C’s of credit, later expanded to the 5 C’s. 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;

(2) Capacity: Examines the company’s cash flow generation in the context of management’s ability to perform competently and reliably in meeting their obligations, based on an examination of their track record (either directly or via the experiences of others). Financial statement analysis is a major part of the exercise here (and in the next point);

(3) Capital: Identifies and assesses the financial “staying power” and resources of the

business; how much of a capital cushion do they have to withstand losses and how much do they have committed at risk in a proposed transaction that incentivizes them to succeed (one can refer to this as the “pain factor”);

(4) Collateral: Assesses what (if any) security the company is willing to provide in support of

the intended transaction. Banks refer to this as providing additional exits (“ways out”) from a transaction.

(5) Conditions: This is a general review of the economic environment to appreciate to what

extent a customer may be affected by a decline in general business conditions (business cycle influences).

EXAMPLE

A downturn in housing construction will affect a range of other businesses, from plumbers to building material producers and companies leasing earth-moving equipment. Anyone selling to such businesses needs to keep the “big picture” in mind so as not to be over-exposed to secondary influences. Settlement discounts 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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A company granting settlement discounts must ensure that the benefits of doing so will outweigh the costs.

EXAMPLE

Redwood Co. currently gives payment terms of 3 months to its customers. If it shortens this to one month by offering a 2% settlement discount, calculate what the impact will be if sales of USD 5m remain unchanged and all customers elect to take advantage of the discount. The company’s cost of capital is 15%. Cost of financing receivables for 3 months: 5,000,000 x 3/12 x 15% = 187,500 Cost of financing receivables for 1 month: 5,000,000 x 1/12 x 15% = 62,500 Savings in financing costs = 125,000 Cost of settlement discount: 5,000,000 x 2% = 100,000 The discount is worth implementing as the company achieves a net benefit of USD 25,000. Collection of debts A company must have in place a clear policy on the collection of debts. 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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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: (1) A monitoring system that clearly “flags” late payers, known as an aging system. This

includes identifying properly the practice of deductions mentioned above; (2) A follow-up system that assigns responsibility to specific staff doing the follow-up; this

includes an elevating of difficult cases to more senior and/or more experienced staff to handle;

(3) Training for staff involved in handing follow-ups, whether performed by phone, mail or

personal visits; (4) A policy determining when to involve refer the case to lawyers (preferably in-house, for

cost reasons) in preparation of follow-up letters. An external lawyer may carry more weight, but is also more costly;

(5) Use of a collection agent to chase the receivable. Here again, a company must calculate

the costs and benefits of involving an external agent. In such an analysis, the savings of management time (opportunity cost) is the most difficult to estimate.

Financial implications of different credit policies Evaluating a change in a credit policy requires the identification of relevant cash flows 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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Acca f9 2012 Notes

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Transcript of Acca f9 2012 Notes