Financial Management

 The planning, organizing, directing and controlling the financial activities

of an enterprise.
 Concerns with procurement, allocation and control of financial
resources.
 It refers the efficient and effective management of money (funds) in such
a manner as to achieve the goals of the organization.

Financial management is the activity concerned with planning,

raising, controlling and administering of funds used in the
business. – Guthman and Dougal
Financial Management is that area of business management
devoted to a judicious use of capital and a careful selection of the
source of capital in order to enable a spending unit to move in the
direction of reaching the goals. – JF Bradley
Financial Management is the operational activity of a business that
is responsible for obtaining and effectively utilizing the funds
necessary for efficient operations. – Massie

 Financial Management – the planning, directing, monitoring,

organizing, and controlling of the monetary resources of an
organization. – Business Dictionary

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Financial Management Process

 Managing Scarce Resources

 Organizations operate in a competitive environment where funds
are increasingly scarce. We must thereof make sure that funds and
resources are used properly and to best effect to achieve the
organizations mission and objectives.

 Managing Risk
 Organizations face internal and external risks which can threaten
and even survival. (ex. Funds being withdrawn, loss due to fraud,
Theft)
 Risk must be identified and properly managed in an organize way
to limit the damage they can cause.
  Managing Strategically
 Financial Management is a part of management as a whole. This
means that organization must keep an eye on the bigger picture.
Looking how the whole organization is being financed in the
medium and long-term not just focusing on projects and programs.

 Management by Objectives
 This involves close attentions to projects. The financial
management process mirrors the project management cycle – Plan,
Do – Review. It is a continuous cycle.

Plan – Do – Review Diagram

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10 Principles of Financial Management

1. The Risk-Return Trade-off

 We won’t take on additional risk unless we expect to be
compensated with additional return.
 Investment’s choices have different amounts of risk and expected
returns.
 The more risk an investment has, the higher its expected return
will be.
2. The Time Value of Money
 A peso received today is worth more than a dollar received in the
future.
 Because we can earn interest on money received today, it is better
to receive money earlier rather than later.

3. Cash – Not Profits – Is King

 Cash flow, not accounting profit, is used as on measurement tool.
 Cash flows, not profits, actually can be reinvested.

4. Incremental Cash Flow

 The incremental cash flow is the difference between the projected
cash flows is the project is selected, versus what they will be, if the
project is not selected.
5. The Curse of Competitive Markets
 It is hard to find exceptionally profitable projects.
 If an industry is generating large profits, new entrants are usually
attracted. The additional competition and added capacity can
result in profits being driven down to the required rate of return.
 Product differentiation, Service and Quality can separate products
from competition.

6. Efficient Capital Markets

 The Markets are quick, and prices are right.
 The values of all assets and securities at any instant in time fully
reflect all available information.

7. The Agency Problem

 Managers won’t work for the owners unless it is in their best
interest.
 An agency problem resulting from conflicts of interest between the
manager/agent and the stockholders/owners.
 Managers may make decisions that are not in line with the goal of
maximization of shareholder wealth.

8. Taxes Bias on Business Decisions

 The cash flow we consider are the after-tax incremental cash flows
to the firm as a whole.
 9. All Risk is Not Equal
 Some risk can be diversified away, and some cannot.
 The process of diversification can reduce risk, and as an result,
measuring a project’s or an asset’s risk is very difficult.

10. Ethical Behavior Is Doing the Right Thing, and Ethical

Dilemmas are Everywhere in Finance
 Each person has his or her own set of values, which forms the
basis for personal judgments about what is right thing.

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Why Financial Management is Important?

 Benefits of Good Financial Management to the Organization

 Make effective and efficient use of resources.
 Achieve objectives and fulfill commitments to stakeholders.
 Become more accountable to donors, funders, and
stakeholders.
 Gain the respect and confidence of funding agencies,
partners, and beneficiaries.
 Gain advantage in competition for increasingly scarce
resources.
 Prepare for long-term financial sustainability.
 Diversify income and manage risk.

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 Scope/Elements

1. Investment Decisions (Capital Budgeting);

2. Financial Decisions – type of source, and period, cost and returns of
financing; and
3. Dividend Decisions– shareholders or members and retained profits.
 Decisions of Financial Manager

 Investment Decisions (Capital Budgeting) – revolve around how to best

allocate money to maximize their value.
 Financing Decisions (Capital Structure) – revolve around how to pay
for investments and expenses
 Asset Management Decisions (Working Capital Management
Decisions)

Investments Decisions
 How when, where, and how much money will be spent on investment
opportunities.
 A firm has many options to invest their funds, but firm has to select the
most appropriate assets for investments which will bring maximum
benefit for the firm.
 What specific assets should be required?
 What assets (if any) should be reduced or eliminated?

Financing Decisions
 Determine how the assets will be financed.
 A company can raise finances from various sources such as by
issue of shares, debentures or by taking loan and advances. These
sources of finance can be divided into 2 categories: owner fund
(no risk involve) and borrowers fund (risk involve)
 Find the least expensive sources of fund.
 What is the best type of financing? (Mix type financing)
 What is the best financing mix? (Mixer debt and equity)
 What is the best dividend policy? (Playing a consistent percentage
of bet earnings)
 How will the funds be physically acquired?

Assets Management Decisions

 How do we manage existing assets efficiently?

 Financial Manager has varying degrees of operating responsibility over
assets.
 Greater emphasis on current asset management than fixed asset
management.
 Objectives

 To ensure regular and adequate supply of funds.

 To ensure adequate returns to the shareholders.
 To ensure optimum funds utilization.
 To ensure safety on investment (funds should be invested in safe
ventures so that adequate return can be achieved)
 To plan a sound capital structure (sound and fair compositions of
capital-balance is maintained between debt and equity capital.
 Wealth Maximization vs. Profit Maximization

Wealth Maximization
 Ability of the company to increase the value for the stakeholders of the
company, mainly through an increase in the market price of the
company’s share over some time.
 The value depends on several tangible and intangible factors like sales,
quality of products or services, etc.
 To be more specific, the universally accepted goal of a business entity
has been to increase the wealth for the shareholders of the company as
they are the actual owners of the company who have invested their
capital, given the risk inherent in the business of the company with
expectations of high returns.

Profit Maximization
 The ability of the company to operate efficiently to produce maximum
output with limited input or to produce the same output using much
lesser input. So, it becomes the most crucial goal f the company to
survive and grow in the current cut-throat competitive landscape of the
business environment.
 Profit is actually what remains out of the total revenue after paying for
all the expenses and taxes for the financial year. Now to increase the
profit, companies can either try to increase their revenue or try to
minimize their cost structure.

Arguments opposing profit maximization as the main objective of

Financial Management

1. A change in profit is also a change in risk.

Profit maximization does not consider risk or uncertainty while wealth

maximization does.

Example:

A firm has annual sales of P500,000 per year and aims to attain a 20%
increase in the succeeding year. To attain this, the firm may decide to change
its credit policy by prolonging its credit term from 30 days to 45 days.
Wealth Maximization
 Before offering an increase in credit term, the cost and benefit should
first be measured such as:
 Amount of benefit derived from the relaxation of the credit term as
against the cost of investing in accounts receivable.
 Benefits should be more than the cost of capital in account receivable.

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It fails to determine the timing benefits.

 Profit maximization does not consider the timing of benefits.

 The firm does not care if the cash flow is higher or lower in the early
years of the project.
 Higher cash flow in the early years would mean better benefits to the
firm because of the possibility of generating other potential income.
However, this is true if the alternatives under consideration will give
the same cash benefits over the number of years.
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What are the Goals of the Firm? (General Goals)

 Survival
 Avoid financial distress and bankruptcy
 Beat the competition
 Maximize sales of market share
 Minimize costs
 Maximize profits
 Maintain steady earnings growth

Shortcomings of these General Goals

Problems
 These goals are either associated with increasing profitability or reducing
risk.
 Could increase current profits while harming firm (e.g. defer
maintenance, issue common stock, to buy treasury bills, etc.)
 Does not specify timing or duration of expected returns
 Calls for a zero-payout dividend policy
 They are not consistent with the long-term interests of shareholders
So, it is necessary to find a goal that can encompass both profitability and risk.
 The Real Goal of the Firm
Maximization of Shareholder Wealth!
Shareholder’s wealth can be measured as the current value per share of
existing shares.

Strengths of Shareholder Wealth Maximization

 Takes account of: current and future profits and EPS; the timing,
duration, and risk of profits; dividend policy; and all other relevant
factors.
 Thus, share price serves as a barometer for business performance

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The Modern Organization

Modern
Organization

Shareholders Management
There exists a SEPARATION between owners and managers.

Role of Management

 Management acts as agent for the owners (shareholders) of the firm.

 An agent is an individual authorized by another person, called the
principal, to act in the latter’s behalf.
 Agency Theory

 Jensen and Mackling developed a theory of the film based on agency

theory.
 Agency Theory is a branch of economics relating to the behavior of
principals and their agents.

 Principals must provide incentives so that management acts in the

principals’ best interests and then monitor results.
 Incentives include stock options, perquisites, and bonuses.

 A potential conflict of interest between the stockholders and the

managers
 Such conflict starts when the stockholders entrust to the managers the
authority to make decisions for the firm
 The managers, with the power vested upon them, may have personal
goals that clash with the stockholders’ wealth maximization. In short,
managers may make decisions that are not in line with the goal of
maximization of shareholders’ wealth.

Agency Relationship

 The relationship is created when individual or group of people, called the

principal, hires the service of an individual or organization called an
agent, to perform a service and exercise decision-making for the
principal.

Social Responsibility

 Wealth maximization does not stop the firm from being socially
responsible.
 Assume we view the firm as producing both private and social goods
 Then shareholder wealth maximization remains the appropriate goal in
governing the firm.
 Organization of the Financial Management Function

Board of Directors

President
(Chief Executive
Officer)

Vice President Vice President Vice President

Operations Finance Marketing
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Organization of the Financial Management Function

Vice President of Finance

Controller
Treasurer
Cost Accounting
Capital Budgeting
Cost Management
Cash Management
Data Processing
Credit Management
General Ledger
Dividend Disbursement
Government Reporting
Financial Analysis / Planning
Internal Control
Pension Management
Preparing Financial Statements
Insurance / Risk Management
Preparing Budgets
Tax Analysis / Planning
Preparing Forecasts

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 Understanding Financial Statement
 Financial Statements
 Components of the Financial Statements
 Limitations of Financial Statements

ESSENCE OF THE FINANCIAL STATEMENTS

 The financial statements are the means by which the information

accumulated and processed in financial accounting is periodically
communicated to the users. Without accounting information embodied in
the financial statements, users may not be able to arrive at a sound
economic decision.

FINANCIAL STATEMENTS

 The final product of the accounting system which serves as the means by
which the information accumulated and processed in financial
accounting are communicated periodically to users.
 Known as general purpose statements

COMPLETE SET OF FINANCIAL STATEMENTS

Per revised PAS No. 1, a complete set of financial statements comprises:

1. Income Statement
2. Statements of Comprehensive Income
3. A Statement of Financial Position
4. A Statement of Changes in Owner’s Equity
5. A Statement of Cash Flows
6. Notes to Financial Statements comprising a summary of significant
accounting policies and other explanatory information
 LIMITATIONS OF FINANCIAL STATEMENT

1. Variations in the application of accounting principles

2. Financial statements are interim in nature
3. Financial statements do not reflect changes in the purchasing power of
the peso
4. Financial statements do not contain all the significant facts about the
business

FINANCIAL STATEMENT ANALYSIS

 The evaluation of the past and current performance of the firm and its
forecast in the future.
 Allows comparison of one company with one another
 Looks at the relationship inside and outside the firm, a firm of one size
can be directly compared with similar firms or with industry averages or
norms to determine how the company is fairing vis-à-vis its competitors
 Involves calculations of ratios from the different financial statements or
combining accounts coming from the balance sheet to the income
statement or vice versa
 The computed ratios help the management assess the deficiencies and
take necessary actions to improve their performance

THE ROLE OF FINANCIAL STATEMENT ANALYSIS IN DECISION – MAKING

 To assess whether or not the firm has performed well over a period of
time
 The financial analysts through the aid of financial ratios, focus on a
company’s financial strength, liquidity, safety of investment, effectiveness
of management and profitability growth rates to ascertain its value or
credit worthiness
 TOOLS AND TECHNIQUES IN FINANCIAL ANALYSIS

Horizontal Analysis
This is used to evaluate the trend in the accounts over the years. It is
shown in comparative financial statements.

a. Comparative Statements. Compared are financial data of two years

showing the increases and decreases in the account balances with their
corresponding percentages.
b. Trend Ratio. A firm’s present ratio is compared with its past and
expected future ratios to determine whether the company’s financial
condition is improving or deteriorating over time.

Vertical Analysis
It uses a significant item on the financial statement as a base value. All
other financial items on the statements are compared with it.

a. Common Size Statement. Each account in the financial

statements is expressed by dividing them to a common base
account (total assets, liabilities and equity, sales or net sales)

b. Financial Ratios
1. Liquidity Ratio – used to evaluate a company’s ability to meet
its maturing short-term
2. Activity or Asset Utilization Ratio – used to determine how
quickly various accounts are converted into sales or cash
3. Leverage Ratio (solvency) – used to determine the company’s
ability to meet its long-term obligations as they become due.
4. Profitability Ratio – shows the profitability of the operations of
the company. It highlights the firm’s effectiveness in handling
operations.
5. Market Value Ratio – relates the firm’s stock price to its
earnings
 Horizontal Analysis

Comparative Statements
- Are used to evaluate the changes or behavior patterns of the different
accounts in financial statement for two or more years. In doing the
comparison, the earlier year serves as the base year so that percentage
increase or decrease is determined by diving the difference of the base
year figure from the later year figure by the bae year figure.

= Later year – Base year x 100%

Base year

= percentage increase or decrease of an account