The Role of Financial Management

Chapter # 1

ACADEMYFINANCE.WEEBLY.COM

February 26, 2018

Authored by: Muhammad Shoaib

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 Financial Management 1

CONTENTS

Financial Management ........................................................................................................................ 2

Investment Decisions: ...................................................................................................................... 2
Financing Decisions: ......................................................................................................................... 2
Asset Management Decisions: ...................................................................................................... 2
Goals of The Firm ................................................................................................................................... 3
Value Creation: ................................................................................................................................... 3
Time Value of Money is Ignored: .............................................................................................. 3
Risk is Ignored: ................................................................................................................................ 3
Dividend Payment is Ignored: ................................................................................................... 3
Agency Problem: ................................................................................................................................ 3
Corporate Social Responsibility: ............................................................................................... 4
Corporate Governance:.................................................................................................................... 4
Sarbanes-Oxley Act of 2002: ..................................................................................................... 5
Public Accounting Oversight Board (PCAOB): .................................................................... 5

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2 The Role of Financial Management

THE ROLL OF FINANCIAL

MANAGEMENT
In the past financial managers were only responsible to arrange the funds for the
company. In new era of finance and management, the concept of time value of money
brought a massive change in responsibilities of a financial manager. Now financial
managers are also responsible to cope up the uncertainty and change in macro-
economic factors in their decisions. Now financial management has broader scope than
that of before.

FINANCIAL MANAGEMENT

Financial Management is concerned with investment, Financing and Asset

Management decisions by keeping a clear objective in mind.

INVESTMENT DECISIONS:

In investment decisions, financial manager is concerned to the value of total assets. The
total value of assets is the value of a company so this number should be considered very
carefully. When this figure is decided, it is also decided the mixture of current and non-
current assets.

FINANCING DECISIONS:

In financing decision, financial managers are responsible to decide about mixture of

debt and equity. The capital structure decisions are considered in financing decisions.
Managers decide about how much should be financed through capital and how much
should be financed by equity.

ASSET MANAGEMENT DECISIONS:

Once assets are acquired by financing through an appropriate financing source, next
step is to manage these assets. Non-current assets are held by operational managers, so
they are responsible for non.-current assets. Financial managers are responsible for
management of current asset. Usually current assets are financed by current liability, so
financial manager is actually responsible for management of working capital.

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 Goals of The Firm 3

GOALS OF THE FIRM

VALUE CREATION:

As economics defines a business as “a legal activity that is done for the purpose of
earning profit.” It is clear from this definition that “profit maximization” is the core
objective of a business. But as a financial management objective, it may deceive the
shareholders.

A financial manager can maximize the profit of a firm through getting money from
shareholders and investing it in T-Bills. In this way, profit will be maximized but earning
per share will decrease. So it is also considered that “EPS Maximization” should be an
appropriate objective for financial management.

Earning per share is not considered as an appropriate financial management objectives

due to some drawbacks.

TIME VALUE OF MONEY IS IGNORED:

In EPS maximization, time value of money is ignored. If a project is generating Rs500000

after 5 years may be preferred to a project producing Rs 100000 each year. The time
factor of money is ignored in EPS maximization objective.

RISK IS IGNORED:

Another disadvantage of EPS Maximization is that the risk associated to EPS is ignored. If
a company is producing an equal EPS each year is better than a company which is
producing a very high EPS after 3 or 4 years. Ultimately, it has low share price.

DIVIDEND PAYMENT IS IGNORED:

Dividend payment is an important aspect for a financial management to attract the

market investors. In EPS Maximization this is ignored, as managers try to retain all
earrings to invest in more projects even with a lower rate of return. Shareholders may
reluctant to invest in those companies who doesn’t pay dividends.

Now financial management is concerned to the maximization of shareholders wealth.

Shareholders wealth is represented by market price of the share. And the market price
of the share depends on financial managers good decisions related to asset
management, investment and financing. Market price is a reflector of management’s
performance.

AGENCY PROBLEM:

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4 The Role of Financial Management

In a large corporations shareholders do not have control over the management. They
don’t have much influence over management decisions. So there is a chance of conflict
of interest between management and the shareholders, who are the owners of the firm.
Organizations work on the basis of Agency Theory.

According to agency theory, managers act as agents of shareholders. Shareholders

dedicate complete decision authority to managers. They are hoping that managers will
pursue theirs visions and interest and try to maximize their wealth. But sometimes this is
not the case in every organization. Sometimes there is conflict between management’s
interests and shareholders interest. This is called agency problem.

Jensen and Mackling, in 1976, presented a theory under agency contract that
shareholders can strict their agents (management) by providing them incentives and
through proper monitoring. Incentives may include awarding shares, bonuses, furnish
offices etc. monitoring can be done through audit. Monitoring agents involves some
unavoidable costs. Managers must be awarded by the shares, so that they can feel like
an owner and they try to maximize their own wealth.

Another aspect of monitoring the managers is the efficient labor market. If the labor
market is efficient good managers will get more job opportunities rather than the bad
managers. Value of a company will represents the performance of its managers. If labor
market is efficient then managers will be more conscious towards the value of the
company.

CORPORATE SOCIAL RESPONSIBILITY:

Maximization of wealth doesn’t mean that the managers should ignore social corporate
responsibility. Corporate social responsibility means managers should consider
stakeholders as well as shareholders. These stakeholders include creditors, employees,
customers, suppliers, communities in which a company operates, and others. Corporate
social responsibility has an important concept of “Sustainability”.

Sustainability is “Meeting the needs of the present without compromising the ability of
future generations to meet their own needs.” Therefore, more and more companies are
being proactive and taking steps to address issues such as climate change, oil depletion,
and energy usage. Now only that firm can maximize its shareholders wealth if it is
socially responsible.

CORPORATE GOVERNANCE:

Corporate governance refers to the system by which corporations are managed and
controlled. It encompasses the relationships among a company’s shareholders, board of
directors, and senior management. These relationships are important to make strategies
and implement these strategies in to the organization. There are three important
elements of corporate governance.

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 Goals of The Firm 5

Shareholders: Shareholders are the owners of the organization. They elect the board of
directors.

Board of Directors: Board of directors set the strategies, implement them. They are also
responsible to hire and fire the CEO. They also monitor different operational expect of
the business.

Top Executive Officers: There is a team of top-level managers who runs the business.
These executive officers head different department of the business. Like marketing,
management and Finance etc. They responsible to implement business strategies.

SARBANES-OXLEY ACT OF 2002:

Sarbanes-Oxley mandates reforms to combat corporate and accounting fraud, and

imposes new penalties for violations of securities laws. It also calls for a variety of higher
standards for corporate governance, and establishes the Public Company Accounting
Oversight Board (PCAOB).

PUBLIC ACCOUNTING OVERSIGHT BOARD (PCAOB):

Private-sector, nonprofit corporation, created by the Sarbanes-Oxley Act of 2002 to

oversee the auditors of public companies in order to protect the interests of investors
and further the public interest in the preparation of informative, fair, and independent
audit reports.

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