INTRODUCTION ΤΟ FINANCIAL MANAGEMENT

Chapter 1

Learning Objectives

 Define financial management and the three key elements to the

process of financial management.
 Identify the major areas and opportunities available in the field of
finance.
 Determine and compare the legal forms of business organization.
 Describe the managerial finance function and its relationship to
economics and accounting.
 Determine the roles of the financial manager.
 Identify the goal of the firm, corporate governance, the role of ethics,
and the agency issue.
 Discuss business taxes and their importance in financial decisions.

Introduction

Finance plays an important role in a student’s professional and even

personal life. Each chapter of this book emphasizes the relevance of
the topic to those specializing in accountancy, management,
marketing, operations and information systerns.

In this chapter, the students are introduced into the field of finance and
opportunities in the financial services and managerial finance. The
basic legal forms of business organization such as sole proprietorship,
partnership, and corporation are described and differentiated from
each other. The strengths and weaknesses of these three (3) basic
legal forms of organizations are also identified. The managerial finance
function is defined and compared with economics and accountancy.
The financial manager’s goals of maximizing the shareholders’ wealth
and preserving stakeholder’s wealth, are discussed, as well as the role
of ethics in achieving thesegoals The chapter summarizes the three (3)
key activities of the financial manager and discusses the agency
problem-the conflict that exists between managers and owners in a
large corporation.

Financial Management
Financial Management is about preparing, directing and managing the
money activities of a company such as buying, selling, and using
money for best results to maximize wealth or to produce best value for
money. Basically, it means applying general management concepts to
the cash of the company.

Taking commercial business as the most common organizational

structure, the key objectives of financial management include: (1) to
create wealth for the business; (2) to generate cash; and (3) to provide
an adequate return on investment, bearing in mind the business risks
taken and the resources invested.

Personal finance deals with an individual’s decisions on the spending

and investing of income. It includes answers to how much of their
earnings they should spend, how much they should save, and how they
should invest their savings.

Business finance involves same type of decisions focusing on how the

firms raise money from investors, how to invest money to earn a profit,
and how to reinvest profits in the business or distribute them back to
investors.
There are three (3) key elements in the process of financial
management. These are financial planning, financial control and
financial decision making.
1. Financial planning. Management needs to ensure that enough
funding is available at the right time to meet the needs of the
business. In the short term, funding may be needed to invest in
equipment and stocks, pay employees and fund sales made on
credit. In the medium and long term, funding may be required for
significant additions to the productive capacity of the business or
to make acquisitions. This links in with the financial decision-
making process and forecasting.
2. Financial control. This element ensures business that objectives
are met. Financial control determines if assets are secured and
being used efficiently. It also confirms if management acts in the
best interest of shareholders and in accordance with business
rules.
3. Financial decision making. The key aspects of financial decision-
making include investment, financing, and dividends. Though
 investments must be financed in some way there are always
financing alternatives that can be considered which depends on
the type of source, period of financing, cost of financing, and the
net present returns generated. The key financing decision is
whether profit earned by the business should be retained instead
of being distributed to shareholders via dividends. Dividends that
are too high may cause the business to starve of funding to
reinvest in growing revenues and profits further.

Scope of Financial Management

Financial Management has a wide scope based on the Five ‘A’s of Dr. S.
C. Saxena (please insert year of publication):
1. Anticipation. The financial needs of a company are being
estimated, as it finds out how much finance is required.
2. Acquisition. It collects finance for the company from different
sources.
3. Allocation. It uses the collected or acquired finance to
purchase fixed and current assets for the company.
4. Appropriation. It distributes part of the company profits
among the shareholders, debenture holders, while some are
kept as reserves.
5. Assessment. It means controlling all the financial activities of
the company. It checks if objectives are met; if otherwise, it
determines what can be done about it.

Finance Areas and Career Opportunities

The following are the major areas in the field of finance:

1. Financial service concerned with the design and delivery of
advice and financial products to individuals, businesses, and
governments.
Career opportunities: within the areas of banking, personal
financial planning, investments, real estate, and insurance.
2. Managerial finance concerned with the duties of a Financial
Manager working in a business. This encompasses financial
planning or budgeting, credit extension to customers or other
credit administration function, investment evaluation and
analysis, and obtaining of funds acquisition for a firm.
Managerial finance is the management of the firm’s funds
within the firm.
 Career opportunities: Financial Analyst, Capital Budgeting
Analyst, and Cash Manager.

The recent global financial crisis and subsequent responses by governmental

increased global competition, and rapid technological change also regulators,
increase the importance and complexity of the financial manager’s duties.
Increasing globalization has increased demand for financial experts who can
manage cash flows in different currencies and protect against the risks that
naturally arise from international transactions.

The following are the professional certifications In finance:

The following are the professional certifications in finance:

1. Chartered Financial Analyst (CFA) – This is a graduate-level

course of study offered by CFA Institute which is focused
largely on the investments side of finance.
2. Certified Treasury Professional (CTP) – This program requires
students to pass a single exam that assesses knowledge and
skills needed in working for a corporate treasury department.
3. Certified Financial Planner (CFP) – To obtain CFP status,
students should pass a 10-hour exam covering a wide range
of topics related to personal financial planning.
4. American Academy of Financial Management (AAFM) – This
administers certification programs for financial professionals
in a wide range of fields. The certifications they issue include
the Charter Portfolio Manager, Chartered Asset Manager,
Certified Risk Analyst, Certified Cost Accountant, Certified
Credit Analyst, and many other programs.
5. Professional Certifications in Accounting – These include
Certified Public Accountant (CPA), Certified Management
Accountant (CMA), Certified Internal Auditor (CIA), and many
other programs.

Through studying or preparing to pass certification exams,

employees and/or other professionals can continue their
education beyond their undergraduate degrees. The study
focuses on an area of finance, which is possibly needed in doing
their jobs better. Furthermore, employers could advertise the
additional training their employees have completed, as a way of
attracting more businesses.
Legal Forms of Business Organization

A sole proprietorship is a business owned by one person and operated

for one’s own profit. The owner is legally responsible for the debts and
taxes of the business and very involved in its day to day activities. This
is the most common form of business organization. Many sole
proprietorship’s operate in the wholesale, retail, service, and
construction industries.
There are various advantages in forming a sole proprietorship. It is
simple and the owner has the freedom to make all decisions and enjoy
all the profit. It has minimal legal restrictions and only a few
government regulations to follow. It can be discontinued with great
ease and the tax rate is relatively at the minimum. However, the owner
may lack expertise or experience to run a business. The owner may
also incur unlimited liability. Suggestion: In cases when the owner lacks
experience or expertise in running a business, there is a tendency for
the owner to incur unlimited liabilities. Generally, the owner has
relatively limited availability of outside financing.

A partnership Is a business owned by two or more people and operated

for profit. This is based on an agreement called Article of Co-
Partnership. They are legally responsible for the debts and taxes of the
business. Partners must agree upon the amount each partner will
contribute to the business, percentage of ownership of each partner,
share of profits of each partner, duties each partner will perform, and
the responsibility each partner has for the partnership’s debts. Typical
partnerships includes those professional services such as medical and
dental practices, accounting, architectural, and law firms.

With a partnership form of business, there is ease in organization

compared to corporation. In partnership, there are combined talents,
more available brain power and managerial skills. In terms of available
financing, it can raise more capital for the firm than a sole
proprietorship. However, there is unlimited liability for general partners
and limited life for the firm. Partnership is dissolved when a partner
withdraws or dies, and it is difficult to liquidate or transfer partnership.
Two or more heads may be better for the firm but there is also a
possibility of divided authority that could lead to possible
disagreements on major decisions and issues.
 A corporation Is an entity created by law. Corporations have the legal
powers of an individual in that it can sue and be sued, make and be
party to contracts, and acquire property in its own name. It is a publicly
or privately-owned business entity that is separate from its owners and
has a legal right to own property and do business in its own name.
Thus, the stockholders are not responsible for the debts or taxes of the
business. A corporation is governed by the Board of Directors, in case
of a profit organization, or Board of Trustees, in case of not-for-profit
organization.

Some advantages of forming a corporation include the limited liability

of stockholders and perpetual life. There is ease of transferring
ownership and expansion obtaining resources or financing.
Corporations are bound by relatively more government regulations and
restrictions and may be expensive to organize.

For accounting purposes, all forms of business entities are considered

separate entities. However, the corporation is the only form of business
that is a separate legal entity.

Finance, Economics and Accounting

Economics is a study of choice. It is a social science that deals with

individual or collective economic activities such as production,
consumption, distribution and transfer of money and wealth. This is
based on the fact that our resources are scarce and need to be
deliberately and systematically allocated.

Finance is the study of financial allocation that can provide insights on

where to put one’s money and why it is necessary. It is often
considered a form of applied economics. Firms operate within the
economy and they must be aware of the economic principles, changes
in economic activity, and economic policy. Marginal cost-benefit
analysis is the primary economic principle that is being used in
managerial finance. This principle reminds decision makers to choose
options and to take actions only when it results to a firm’s net
advantage, which means that the added benefits exceed the added
costs.

One of the major differences in the focus of finance and accounting is

that accountants generally use the accrual method, while in finance,
 the emphasis is on cash flows. Accountants recognize revenues at the
point of sale and consider expenses when incurred, regardless of the
direction of cash flow in the firm.. On the other hand, the financial
manager focuses on the actual inflows and outflows of cash,
recognizing revenues when cash is collected and considering expenses
when actually paid.

Goals of the Firm and the Role of the Finance Manager

Decision rule for managers:

Only take actions that are expected to increase the share price!

This rule means that whenever the financial manager decides or

choose between or among alternatives, after assessing the risks and
the returns, only actions that would increase share price are
acceptable. Otherwise, the alternative/s shall be rejected.

The goal of a firm, and therefore of all managers, is to maximize

shareholders’ wealth. This can be measured by share price. An
increasing price per share of common stock relative to the stock
market as a whole indicates achievement of this goal.

Given the following opportunities, which investment is preferred?

Earnings per Share

Investmen Year 1 Year 2 Year 3 Total
t
A P 14.00 P 10.00 P 4.00 P 28.00
B 6.00 10.00 14.00 30.00

Based on the information provided, the choice is not obvious. Profit

maximization is not consistent with wealth maximization. It may not
lead to the highest possible share price due to the following reasons:

1. Timing is important. The receipt of funds sooner rather than later is

preferred. Project B is expected to provide the higher overall
increase in earnings, thus, is the more profitable project. But since
the goal of the firm is to maximize value, timing must be considered
 to determine which project is superior. Profit maximization may lead
to value maximization, but it is not an absolute case.
2. Profits do not necessarily result in cash flows available to
stockholders. In finance, cash is king. It is not unusual for a firm to
be profitable yet experience a cash crunch. They might have so
much profit but some may not have enough cash to continuously
run the business. The most common cause is when expenses have a
shorter due date than expected revenue. In such cases, the firm
must arrange short-term financing to meet its debt obligations
before the revenue arrives.
3. Profit maximization fails to account for risk. Risk is the chance that
actual outcomes may differ from expected outcomes. Financial
managers must consider both risk and return because of their
inverse effect on the share price of the firm. Increased risk may
decrease the share price, while increased return is likely to increase
the share price.

Financial managers administer the financial affairs of all types of

businesses such as private and public, large and small, profit-seeking
and not-for-profit. Typically, one handles a firm’s cash, invests surplus
funds when available, and secures outside financing when needed. The
financial manager also oversees a firm’s pension plans and manages
critical risks related to movements in foreign currency values, interest
rates, and commodity prices. The treasurer in a mature firm must
make decisions with respect to handling financial planning, acquisition
of fixed assets, obtaining funds to finance fixed assets, managing
working capital needs, managing the pension fund, managing foreign
exchange, and distribution of corporate earnings to owners.

The two (2) key activities that the financial manager does related to a
firm's balance sheet are the following:
1. Investment decisions. The finance manager defines the most
efficient level and the best structure of assets. Investment decisions
deal with the items that appear on the asset section of the balance
sheet.
2. Financing decisions. The finance manager determines and maintains
the proper combination of short-term and long-term financing. Also,
one raises the needed financing in the most economical manner.
Financing decisions generally refers to the items that appear on the
liability and equity section of the balance sheet..
Corporate Governance, Ethics and Agency Issues

Corporate governance is a system of organizational control that

defines and establishes the responsibility and accountability of the
major participants in an organization. Shareholders, board of directors,
managers and officers of corporations, and other stakeholders are the
major participants included here. An organizational chart is an example
of a broad arrangement of corporate governance. More detailed
responsibilities would be established within each part of the
organizational chart.

Business ethics includes the standards of conduct or moral judgment

that apply to persons engaged in industry or commerce. Violations of
these standards in finance include, but not limited to misstated
financial statements, misleading financial forecasts or projections,
fraud, bribery, kickbacks, insider trading, excessive executive
compensation, and options backdating.

Bad publicity generally results to negative impacts on a firm. Ethics

programs seek to reduce lawsuits and judgment costs, uphold and
preserve a positive corporate image, build trust and confidence of the
shareholders, and gain the loyalty and respect of all stakeholders. The
expected result of such programs is to positively affect the firm’s share
price.

Shareholders are the owners of a corporation, and they purchase

stocks because they want to earn a good return on their investment
without undue risk exposure. In most cases, shareholders elect
directors, who then hire managers to run the corporation on a day-to-
day basis. Because managers are supposed to be working on behalf of
shareholders, they should pursue policies that enhance shareholder
value. Also, to achieve this goal, the financial manager would take only
those actions that are expected to make a major contribution to the
firm’s overall profits.

When managers deviate from the goal of maximization of shareholder

wealth by putting their personal goals above the goals of shareholders,
this results to agency problems and issues. This kind of problem
increases agency costs. Agency costs are the costs borne by
shareholders due to the occurrence and avoidance of agency
problems. Both cases represent a reduction in the shareholders’
wealth.

The agency problem and the associated agency costs can be reduced
through the following:
1. Properly constructed and implemented corporate
governance structure. This should be designed to institute
a system of checks and balances to reduce the ability and
incentives of management to deviate from the goal of
shareholder wealth maximization.
2. Structured expenditures thru compensation plans. This
may be the most popular way to deal with an agency
problem but the most expensive one. It could either be
incentive or performance plans. Incentive plans tie
management performance to share price. When the
managers take actions that maximize stock, they could be
given stock options giving them the right to purchase stock
at a set price. This incentive plan may not be favorable
because of market behavior that has a substantial impact
on share price and is beyond the control of the
management. That explains why performance plans are
more popular today. In this plan, compensation is based on
performance measures, such as earnings per share and/or
its growth, or other return ratios. Managers may receive
performance shares and/or cash bonuses when the set
performance goals are attained.
3. Market forces such as shareholder crusading from large
institutional investors. Institutional investors hold large
quantities of shares in many of the corporations in their
portfolio. The power of institutional investors far exceeds
the voting power of individual investors. Managers of these
institutions should be active in monitoring the
management and in voting their shares for the benefit of
the shareholders. This can lessen or avoid an agency
problem because these groups can put pressure on
management to take actions that maximize shareholder
wealth. They may use their voting power to elect new
directors who are aligned with their objectives and will act
to replace poorly or non-performing managers.
4. Threat of hostile takeovers. It occurs when a company or
group not supported by existing management attempts to
acquire the firm. Because the acquirer looks for companies
that are poorly managed and undervalued, this threat
provokes managers to act in the best welfare of the firm’s
owners.