Chapter 1

Part A: Foundations

Overview of financial management

Last updated November 20265 sectionsabout 15 min read

Key takeaways

Financial management makes three decisions: the investment decision (which assets and projects to fund), the financing decision (where the funds come from) and the dividend decision (how much profit to pay out and how much to retain).
The primary financial objective is shareholder wealth maximisation, preferred to profit maximisation because profit can be manipulated by policy choices, ignores timing and ignores risk.
Agency theory treats managers as the shareholders' agents; the costs of controlling them are monitoring costs, bonding costs and the residual loss.
Section 143 of the Companies Act, 2015 takes the enlightened shareholder value position: directors promote the success of the company for its members while having regard to employees, suppliers, customers, the community and the environment.
Economic value added (NOPAT less WACC times capital employed) shows whether managers earned more than the cost of the capital they used; a firm can report a profit and still destroy value.

Financial management is the part of running a business that decides where money comes from, what it is spent on, and how much of what it earns goes back to the people who put it in. Every later chapter of this guide is one of those three decisions worked out in detail: the financing decision (the chapters on financing, financial markets and capital structure), the investment decision (the chapters on the time value of money, valuation, capital budgeting and working capital) and the dividend decision (the chapter on dividends). This chapter sets out who makes them, for whom, against what objective, how the decision-makers are judged and paid, and where the ethical lines lie.

Framework for this chapter

The three decisions of financial management (investment, financing and dividend) and the objective of shareholder wealth maximisation; agency theory (Jensen and Meckling, 1976) and stakeholder theory (Freeman, 1984); the directors' general duties in sections 142 to 147 of the Companies Act, 2015, in particular section 143's duty to promote the success of the company for the benefit of its members as a whole while having regard to employees, suppliers, customers, the community and the environment; the Code of Corporate Governance Practices for Issuers of Securities to the Public, 2015 for listed companies.

The finance manager's role

The finance manager makes, or advises the board on, three decisions. The investment decision (capital budgeting) asks which long-term assets and projects the firm should commit funds to, judged by whether they earn more than the funds cost, and, in the short term, how much working capital to hold (see the chapter on working capital management). The financing decision asks where the funds should come from, the mix of equity and debt and the specific instruments (see the chapters on financing and capital structure), and at what cost of capital.

The dividend decision asks how much of the profit earned should be paid out to shareholders and how much retained to fund growth (see the chapter on the dividend decision). Around these sit the routine responsibilities: forecasting and planning, managing liquidity and cash (both developed in later chapters), managing risk, dealing with the capital markets and the banks (see the chapter on financial institutions and markets), and reporting to the board and the shareholders.

To shareholders

To maximise the value of their investment, the return earned on the capital they supplied relative to the risk they bear, and to account to them honestly for how it has been used; the finance manager is their agent (see Agency, stakeholders and governance, below).

To employees

To keep the firm solvent so that it can pay wages and provide secure employment, to fund fair remuneration, and to invest in the training and equipment that make their work productive.

To society and the community

To conduct the firm's affairs responsibly: paying suppliers on time, not externalising costs onto the environment, and having regard to the community the firm operates in, which section 143 of the Companies Act, 2015 requires directors to consider.

To government

To comply with company, tax, competition and sector law, to pay taxes when due and account for the taxes the firm collects as agent (PAYE, VAT), and to provide the returns and disclosures the regulators require.

To lenders, suppliers and customers

To honour the firm's contracts, service its debt, and give the counterparties who extend it credit or rely on its products the information they need; a firm that cannot pay its creditors cannot serve its shareholders either.

Financial and non-financial objectives

The primary financial objective in the theory of financial management is the maximisation of shareholder wealth, measured for a listed company by the market value of its shares (price times number of shares) and for an unlisted one by the present value of the cash flows the business will generate for its owners. It is preferred to profit maximisation for three reasons:

Profit is an accounting figure that can be manipulated by policy choices, while value depends on cash.
Profit ignores timing, whereas value discounts later cash flows (see the chapter on the time value of money).
Profit ignores risk, whereas a higher-risk stream of the same profit is worth less.

Other financial objectives, growth in earnings per share, a target return on capital employed, liquidity, and a target level of gearing, are usually intermediate goals that serve wealth maximisation rather than rivals to it.

Non-financial objectives, employee welfare, customer satisfaction, product quality, environmental responsibility, and the firm's standing in the community, overlap with the financial objective in the long run, since a firm that mistreats its staff or customers loses them, but conflict with it in the short run whenever they cost money that would otherwise be profit.

Corporate strategy is the set of long-term choices about which markets to compete in and how, and the financial objective constrains it: a strategy is acceptable only if the investments it requires are expected to earn more than their cost of capital (see the chapter on capital budgeting), so financial management is the discipline that tests strategy against the shareholders' required return.

Financial and non-financial objectives and where they conflict

Objective	Measured by	Conflicts with
Shareholder wealth maximisation	Share price, market capitalisation, total shareholder return	Short-term non-financial spending; employee and creditor security when risk is increased
Profit maximisation	Accounting profit, earnings per share	Wealth maximisation when profit is raised by cutting investment or taking on risk
Growth	Sales growth, asset growth, market share	Profitability and liquidity when growth is bought with thin margins or debt
Liquidity and survival	Current ratio, cash balances, interest cover	Return, since idle cash and low gearing earn less
Employee welfare	Pay levels, turnover, safety record	Profit in the short run; aligned with value in the long run
Social and environmental responsibility	Compliance, emissions, community investment	Profit in the short run; reputation and licence to operate in the long run

Agency, stakeholders and governance

Agency theory describes the relationship in which one party (the principal) engages another (the agent) to act on its behalf, and observes that where their interests differ and the principal cannot fully observe the agent, the agent will tend to pursue its own interest at the principal's expense. In the firm, shareholders are the principals and the directors and managers their agents: managers may prefer higher pay, larger empires, lower risk and a quieter life to the maximum value of the shares, and the divergence is the agency problem.

Its costs, agency costs, are the monitoring costs the shareholders incur (audit, non-executive directors, reporting), the bonding costs managers incur to reassure shareholders (performance-linked contracts), and the residual loss from decisions that still favour managers. The remedies are the subject of the next section and of corporate governance: align managers' interests with shareholders' through incentive pay and share ownership, monitor them through independent boards, audit committees and disclosure, and expose them to the threat of removal by the shareholders or by a takeover.

Stakeholder theory rejects the premise that the firm exists for its shareholders alone: it holds that the firm is a coalition of groups, shareholders, employees, customers, suppliers, lenders, the government and the community, each with a legitimate claim on it, and that management's task is to balance those claims rather than maximise one.

Kenyan company law takes a position between the two: section 143 of the Companies Act, 2015 makes the directors' duty one of promoting the success of the company for the benefit of its members as a whole (the shareholder objective), but requires them, in doing so, to have regard to the long term, to employees, suppliers and customers, to the community and the environment, and to the company's reputation (the stakeholder considerations), an approach described as enlightened shareholder value.

Corporate governance is the system of rules, practices and institutions through which the agency problem is managed and stakeholder interests protected: an independent board, board committees, disclosure, shareholder rights and the external audit, covered in detail in the Introduction to Law and Governance and Company Law syllabi.

Measuring and rewarding managers

Accounting measures

Profit and earnings per share (EPS), return on capital employed (ROCE) and return on investment (ROI) for a division; simple and familiar, but based on accounting profit, which managers can influence by policy choices, and which ignores risk and the cost of the capital tied up.

Residual income and economic value added

Residual income charges the division or firm for the capital it uses: profit less a capital charge at the required rate. Economic value added (EVA) is the same idea applied to the whole firm: net operating profit after tax less the weighted average cost of capital times the capital employed, adjusted to remove accounting distortions; a positive EVA means the managers created value above the cost of the funds they used.

Market measures

Share price and total shareholder return (dividend plus capital gain over the period), and market value added (MVA), the excess of the firm's market value over the capital invested in it (see Valuing ordinary shares, in the chapter on valuation); the most direct measures of the shareholder objective, but affected by market movements the managers do not control.

Non-financial and balanced measures

Customer satisfaction, quality, innovation, employee development and market share, combined with the financial measures in a balanced scorecard, so that managers are not rewarded for a short-term financial result bought at the expense of the drivers of future value.

Compensation and incentives

Pay:

Fixed salary rewards nothing in particular.
Annual bonuses tied to profit or EPS reward short-term accounting results and invite manipulation.
Share options, share awards and employee share ownership plans (see Methods of issuing shares, in the chapter on financing) reward share price growth and align managers with shareholders, though options reward risk-taking and can be repriced when the price falls.
Long-term incentive plans vesting over several years on total shareholder return or EVA targets are the current best practice.
The Code requires a remuneration committee of non-executive directors to set executive pay and the shareholders to approve the policy.

Economic value added

EVA = NOPAT - (WACC x Capital employed)

NOPAT: Net operating profit after tax, before interest, adjusted for accounting distortions
WACC: The weighted average cost of capital, the return the providers of capital require
Capital employed: The equity and debt capital invested in the business at the start of the period

Worked computation: has management added value? (not a decided case)

Kilifi Cement PLC reports net operating profit after tax of KES 1,800 million for the year on capital employed of KES 12,000 million; its weighted average cost of capital is 14%.

Capital charge = 14% x 12,000 = KES 1,680 million. EVA = 1,800 - 1,680 = KES 120 million: management earned KES 120 million more than the providers of capital required, so value was added, and a bonus scheme based on EVA would pay out.

Had the profit been KES 1,500 million, EVA would be 1,500 - 1,680 = KES -180 million: the firm was profitable in accounting terms, and a profit-based bonus would still have paid, but it earned less than its capital cost and destroyed value, which is exactly the divergence between profit and value described under Financial and non-financial objectives.

Ethical issues

Creative accounting and misleading reporting: choosing accounting policies, or timing transactions, to flatter profit or hide liabilities, which breaches the directors' duty and the Companies Act's requirement of a true and fair view, and which the audit (the Auditing and Assurance syllabus) exists to detect
Insider dealing: using unpublished price-sensitive information to trade in the company's shares, an offence under the Capital Markets Act (Cap 485A)
Conflicts of interest and related party transactions: directing the company's business to entities the manager owns, or taking corporate opportunities personally, contrary to sections 146 and 151 of the Companies Act, 2015
Manipulating performance measures to trigger bonuses: cutting maintenance, research or training to lift short-term profit, or delaying payments to inflate year-end cash
Excessive or hidden remuneration, and rewarding failure, which the Code addresses through the remuneration committee and shareholder approval of the pay policy
Aggressive tax avoidance and evasion (covered in CPA Public Finance and Taxation, in the chapter introducing taxation), bribery and corruption in obtaining contracts (the Bribery Act, 2016), and money laundering (the Proceeds of Crime and Anti-Money Laundering Act, 2009)
Treatment of creditors and employees in distress: trading while insolvent, which exposes directors to wrongful trading liability under the Insolvency Act, 2015, and preferring some creditors over others
Environmental and social externalities: profiting by imposing costs on the community or the environment that the firm does not bear

The finance manager's professional obligations, as a member of the Institute of Certified Public Accountants of Kenya, add the Code of Ethics' fundamental principles of integrity, objectivity, competence, confidentiality and professional behaviour, and the duty of an accountant in business not to be associated with misleading information and to resist pressure to produce it (the Professional Ethics chapter of the Introduction to Law and Governance syllabus).

Value, not profit, and the agency problem behind every governance rule

Two ideas carry this chapter. First, the objective is shareholder wealth (cash, timing and risk), and profit is only an imperfect proxy, which is why EVA and market measures exist. Second, managers are agents whose interests diverge from the principals', which is why incentive pay, independent boards, audit and disclosure exist. A question about any governance mechanism is answered by naming the agency cost it reduces.

Self-check

(a) State the three decisions of financial management and give one example of each. (6 marks)

(b) Explain why shareholder wealth maximisation is preferred to profit maximisation as the objective of the firm. (6 marks)

(d) A division reports profit of KES 40 million on capital employed of KES 250 million, and the firm's cost of capital is 18%. Compute the division's residual income and comment. (2 marks)

Show worked answer

(a) The investment decision: which projects and assets to commit funds to, such as a new plant; the financing decision: where the funds come from, such as a rights issue or a bank loan; the dividend decision: how much profit to pay out and how much to retain, such as setting the payout ratio (6 marks).

(b) Profit is an accounting figure open to manipulation by policy choices, whereas value depends on cash flows; profit ignores the timing of returns, whereas value discounts later cash flows; and profit ignores risk, whereas a riskier stream of the same profit is worth less; wealth maximisation captures cash, timing and risk (6 marks).

(c) Managers, as agents, may pursue their own interests (pay, size, low risk) at the expense of the shareholders, the principals, who cannot fully observe them; the divergence and the costs of controlling it are the agency problem (3 marks). Mechanisms: incentive pay and share ownership aligning managers' interests with shareholders'; monitoring through independent non-executive directors, audit committees and disclosure; and the threat of removal by shareholders or through a takeover (3 marks).

(d) Residual income = 40 - (18% x 250) = 40 - 45 = KES -5 million; the division is profitable but earns less than the cost of the capital it uses, so it destroys value (2 marks).