A FRAMEWORK FOR FINANCIAL DECISIONS
Business financial decisions are not made in a vacuum. An ‘obvious’ decision may often have to be tempered by an appreciation of the restrictions imposed by the prevailing environment.
Although it is beyond our scope to consider the full social, political and economic complexity of the financial decision-making context, we provide an overview of the key features of the UK financial and economic system. A sound grasp of the framework for financial decisions is essential if the reader is to appreciate fully the issues discussed in subsequent chapters of this book.
Part I provides an introduction to the scope and the fundamental concepts of financial management. Chapter 1 provides a broad picture of the subject and the important role it plays in business. It examines the nature of financing and investment decisions, the role of the financial manager and the fundamental objective for corporate financial management.
This leads on, in Chapter 2, to consideration of the financial and tax environment in which businesses operate. Particular attention is devoted to the characteristics and operation of the London Stock Exchange, which provides a barometer of the suc- cess of financial decisions via the market’s valuation of the company’s shares. The extent to which any market can provide ‘accurate’ valuations is also considered.
Central concepts in financial management are the time-value of money and present value, which are discussed in Chapter 3. The chapter also provides an understanding of the valuation of bonds and shares. Concepts of value and its measurement play important roles in subsequent chapters, where investment, financing and other key decisions are discussed.
An overview of financial management
The objectives of Tomkins, summarised at the start, suggest that its management has a clear idea of its purpose and key objectives. Its mission is to deliver economic value to its shareholders in the form of dividend and capital growth.
An organisation such as Tomkins, with a broad range of products, understands the importance of meeting the requirements of its existing and potential customers. But it also recognises that the most important ‘customers’ are the shareholders – the owners of the business. Its objectives, strategies and decisions are all directed towards creating value for them.
One of the challenges in any business is to make investments that consistently yield rates of return to shareholders in excess of the cost of financing those projects and better than the competition. This book centres on that very issue: how can firms create value through sound investment decisions and financial strategies?
This chapter provides a broad picture of financial management and the fundamental role it plays in achieving financial objectives and operating successful businesses. First, we consider where financial management fits into the strategic planning process for a new business.
This leads to an outline of the finance function and the role of the financial manager, and what objectives he or she may follow. Central to the subject is the nature of these financial objectives and how they affect shareholders’ interests. Finally, we introduce the underlying principles of finance, which are developed in later chapters.
Starting a business: Brownbake Ltd
Ken Brown, a recent business graduate, decides to set up his own small bakery business. He recognises that a clear business strategy is required, giving a broad thrust to be adopted in achieving his objectives. The main issues are market identification, competitor analysis and business formation.
He identifies a suitable market with room for a new entrant and develops a range of bakery products that are expected to stand up well, in terms of price and quality, against the existing competition.
Brown and his wife become the directors of a newly-formed limited company, Brownbake Ltd. This form of organisation has a number of advantages not found in a sole proprietorship or partnership:
- Limited liability. The financial liability of the owners is limited to the amount they have paid in. Should the company become insolvent, those with outstanding claims on the company cannot compel the owners to pay in further capital.
- Transferability of ownership. It is generally easier to sell shares in a company, particularly if it is listed on a stock market, than to sell all or part of a partnership or sole proprietorship.
- Permanence. A company has a legal identity quite separate from its owners. Its existence is unaffected by the sale of shares or death of a shareholder.
- Access to markets. The above benefits, together with the fact that companies enable large numbers of shareholders to participate, mean that companies can enjoy financial economies of scale, giving rise to greater choice and lower costs of financing the business.
Brown should have a clear idea of why the business exists and its financial and other objectives. He must now concentrate on how the business strategy is to be implemented. This requires careful planning of the decisions to be taken and their effect on the business. Planning requires answers to some important questions.
What resources are required? Does the business require premises, equipment, vehicles and material to produce and deliver the product?
Once these issues have been addressed, an important further question is: how will such plans be funded? However sympathetic his bank manager, Brown will probably need to find other investors to carry a large part of the business risk.
Eventually, these operating plans must be translated into financial plans, giving a clear indication of the investment required and the intended sources of finance. Brown will also need to establish an appropriate finance and accounting function (even if he does it himself), to keep himself informed of financial progress in achieving plans and ensure that there is always sufficient cash to pay the bills and to implement plans.
Such issues are the principal concern of financial management, which applies equally to small businesses, like Brownbake Ltd, and large multinational corporations, like Tomkins plc.
1.2 THE FINANCE FUNCTION
In a well-organised business, each section should arrange its activities to maximise its contribution towards the attainment of corporate goals. The finance function is very sharply focused, its activities being specific to the financial aspects of management decisions. Figure 1.1 illustrates how the accounting and finance functions may be structured in a large company. This book focuses primarily on the roles of finance director and treasurer.
It is the task of those within the finance function to plan, raise and use funds in an efficient manner to achieve corporate financial objectives. Two central activities are as follows:
- Providing the link between the business and the wider financial environment.
- Investment and financial analysis and decision-making.
Link with financial environment
The finance function provides the link between the firm and the financial markets in which funds are raised and the company’s shares and other financial instruments are traded. The financial manager, whether a corporate treasurer in a multinational
company or the sole trader of a small business, acts as the vital link between financial markets and the firm. Corporate finance is therefore as much about understanding financial markets as it is about good financial management within the business. We examine financial markets in Chapter 2.
1.3 INVESTMENT AND FINANCIAL DECISIONS
Financial management is primarily concerned with investment and financing deci- sions and the interactions between them. These two broad areas lie at the heart of financial management theory and practice. Let us first be clear what we mean by these decisions.
The investment decision, sometimes referred to as the capital budgeting decision, is the decision to acquire assets. Most of these assets will be real assets employed within the business to produce goods or services to satisfy consumer demand. Real assets may be tangible (e.g. land and buildings, plant and equipment, and stocks) or intangible (e.g. patents, trademarks and ‘know-how’). Sometimes a firm may invest in financial assets outside the business, in the form of short-term securities and deposits. The basic problems relating to investments are as follows:
- How much should the firm invest?
- In which projects should the firm invest (fixed or current, tangible or intangible, real or financial)? Investment need not be purely internal. Acquisitions represent a form of external investment.
The financing decision addresses the problems of how much capital should be raised to fund the firm’s operations (both existing and proposed), and what the best mix of financing is. In the same way that a firm can hold financial assets (e.g. investing in shares of other companies or lending to banks), it can also sell claims on its own real assets, by issuing shares, raising loans, undertaking lease obligations etc.
A financial security, such as a share, gives the holder a claim on the future profits in the form of a dividend, while a bond (or loan) gives the holder a claim in the form of interest payable. Financing and investment decisions are therefore closely related.