CHAPTER-ONE

AN OVERVIEW OF FINANCIAL MANAGEMENT

1.1 INTRODUCTION
Finance According to Khan and Jain can be defined as the art and science of managing money.
The major areas of finance are financial service and corporate finance. Financial services are
concerned with the design and delivery of advice and financial product to individuals, business
and governments. It involves a variety of interesting carrier opportunities within the area of
banking and related institution, personal financial planning, and investment real estate, insurance
and so on. Corporate finance (also known as financial management or managerial finance) is
concerned with duties of financial managers (CEOs) in the business firm. Financial mangers
actively manage the financial affairs of any business, namely financial and non-financial, private
and public, large and small, profit seeking and not for profit.
On the other hand, According to Ross, Westerfield and Jordan , corporate finance is the study of
the way to answer this three questions Such as ‘What long-term investments should you take
on?’ ‘Where will you get the long-term financing to pay for your investment?’ How will the
firm manager its daily financial activities
1.2 Approaches to financial management/Scope of Financial Management
Finance was a branch of economics till 1890 and emerged as a separate field of study in early
1900s. Since then, the duties and responsibilities of the financial managers have undergone
continuous change. The two main reasons for the ongoing change in the functions of finance are:
i. The continuous growth and increasing diversity of the national and international
economy, and
ii. The time to time development of new analytical tools that have been adopted by
financial managers
Financial management approach measures the scope of the financial management in various
fields, which include the essential part of the finance. Financial management is not a
revolutionary concept but an evolutionary. The definition and scope of financial management has
been changed from one period to another period and applied various innovations. Theoretical
points of view, financial management approach may be broadly divided into two major parts.
1. Traditional Approach
Traditional approach is the initial stage of financial management, which was followed, in the
early part of during the year 1920 to 1950. This approach is based on the past experience and the

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traditionally accepted methods. Main part of the traditional approach is rising of funds for the
business concern. Traditional approach consists of the following important area.
 Arrangement of funds from lending body.
 Arrangement of funds through various financial instruments
 Finding out the various sources of funds.
In general, under the traditional approach, the scope and role of financial management was
considered in a very narrow sense of procurement of funds from external sources.
2. The modern Approach(After 1950)
The modern approach views the term financial management in a broader sense and provides a
conceptual framework for financial decision making.
According to this approach the scope of financial management involves the solutions of the three
major problems faced by an organization. These are:
 Investing
 Financing and
 Dividend policy.
Besides, unlike the old approach, here, the financial manager’s role includes both acquiring
of funds from external sources and allocating of the funds efficiently within the firm
thereby making internal decisions.
In general, Modern Approach focuses on Effective Utilization of Funds.
 The functions of financial management
This refers to the special activities or purposes of financial management. The functions of
financial management are planning for acquiring and utilizing funds by a firm as well as
distributing funds to the owners in ways that achieve goal of the firm.
In general, the functions of financial management include three major decisions a firm must
make. These are:
1. Investment Decision
• This decision relates to the careful selection of assets in which funds will be invested
by the firm.
• The asset that can be acquired by a firm may be long term asset and short term asset.
• Long term assets is called capital budgeting relates to selection of an asset or
investment proposal which would yield benefit in future. It involves three elements.
• Measurement of the worth of the proposal
• Evaluation of the investment proposal in terms of risk associated with it and

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 • Evaluation of the worth of the investment proposal against certain norms or standard. The
standard is broadly known as cost of capital.
• The short term or current assets is called working capital relates to the allocation
of funds as among cash and equivalents, receivables and inventories.
– Proper management of working capital ensures firm’s liquidity and
profitability.
 Generally, the investment decisions of a firm deal with the left side of the basic
accounting equation: A = L + OE (Assets = Liabilities + Owners’ Equity).
2. Financing Decision
Financing decisions involve the acquisition of funds needed to support long-term investments
and is concerned with the financing mix or capital structure.
• While taking this decision, financial management weighs the advantages and
disadvantages of the different sources of finance.
• The business can either finance from its shareholder funds which can be subdivided
into equity share capital, preference share capital and the accumulated profits.
 Borrowings from outsiders include borrowed funds like debentures
and loans from financial institutions.
 The financing decisions of a firm are generally concerned with the right side of the basic
accounting equation.
3. Dividend Decision
• This decision relates to the appropriation of profits earned.
• Firms distribute all profits or retain them or distribute a portion and retain the
balance with it.
• Which course should be allowed? The decision depends upon the preference of the
shareholders and investment opportunities available to the firm.
• Dividend decision has a strong influence on the market price of the share.
 There are tradeoffs on the dividend policy of a firm. On the one hand, paying
out more dividends will make the firm to be perceived strong and healthy by
investors; on the other hand, it will affect the future growth of the firm.
• So the dividend policy is to be determined in terms of its impact on shareholder’s
value.
• The optimum dividend policy is one which maximizes the value of shares and
wealth of the shareholders.

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1.3 Functions of finance manager
The financial staff’s task is to acquire and then help operate resources so as to maximize the
value of the firm. Here are some specific activities:
1. Forecasting and planning. The financial staff must coordinate the planning process. This
means they must interact with people from other departments as they look ahead and lay the
plans that will shape the firm’s future.
2. Major investment and financing decisions. A successful firm usually has rapid growth in
sales, which requires investments in plant, equipment, and inventory. The financial staff must
help determine the optimal sales growth rate, help decide what specific assets to acquire, and
then choose the best way to finance those assets. For example, should the firm finance with debt,
equity, or some combination of the two, and if debt is used, how much should be long term and
how much short term?
3. Coordination and control. The financial staff must interact with other personnel to ensure
that the firm is operated as efficiently as possible. All business decisions have financial
implications, and all managers — financial and otherwise — need to take this into account. For
example, marketing decisions affect sales growth, which in turn influences investment
requirements. Thus, marketing decision makers must take account of how their actions affect and
are affected by such factors as the availability of funds, inventory policies, and plant capacity
utilization.
4. Dealing with the financial markets. The financial staff must deal with the money and capital
markets. Each firm affects and is affected by the general financial markets where funds are
raised, where the firm’s securities are traded, and where investors either make or lose money.
5. Risk management. All businesses face risks, including natural disasters such as fires and
floods, uncertainties in commodity and security markets, volatile interest rates, and fluctuating
foreign exchange rates. However, many of these risks can be reduced by purchasing insurance or
by hedging in the derivatives markets. The financial staff is responsible for the firm’s overall risk
management program, including identifying the risks that should be managed and then managing
them in the most efficient manner.
In summary, people working in financial management make decisions regarding which assets
their firms should acquire, how those assets should be financed, and how the firm should conduct
its operations. If these responsibilities are performed optimally, financial managers will help to
maximize the values of their firms, and this will also contribute to the welfare of consumers and
employees.

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1.4 Goals of Financial Management
If we were to consider possible financial goals, we might come up with some ideas like the
following:
 Survive.  Minimize costs.
 Avoid financial distress and bankruptcy.  Maximize profits.
 Beat the competition  Maintain steady earnings growth
 Maximize sales or market share.
Effective procurement and efficient use of finance lead to proper utilization of the finance by the
business concern. It is the essential part of the financial manager. Hence, the financial manager
must determine the basic objectives of the financial management. Financial Management
objectives may be broadly divided into two parts such as:
1. Profit maximization
2. Wealth maximization
 Profit maximization
Is a function of maximizing revenue and /or minimizing costs.
If a firm is able to maximize its revenues for a given level of costs or minimizing costs for a
given level of revenues, it is considered to be efficient.
Profit maximization focuses on the total amount of benefits of any courses of action. This
decision rule as applied to financial management implies that the functions of managerial finance
should be oriented to making of money. Under the profit maximization decision criteria, actions
that increase profit of a firm should be undertaken; and actions that decrease profit should
be rejected. Similarly, given alternative courses of actions, decisions would be made in favor of
the one with the highest expected profits.
Profit maximization, though widely professed, should not be used as a good goal of a firm in
financial management. This is because it fails to meet many of the characteristics of a good goal.
Drawbacks of Profit Maximization
1. Ambiguity. The term profit or income is vague and ambiguous concept. It is very illusive and
has no precise quonotation. Different people understand profit in different several ways. There
are many different economic and accounting definitions of profit, each open to its own set of
interpretations. Even in accounting profit might refer to short-term or long-term profit, total
profit or profit on a per share basis (earnings per share), and before or after text profit. Then, the
question or the problem would be which profit is to be maximized? Maximizing one may lead to
minimizing the other.

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2. Timing of Benefits. The profit maximization criterion ignores the differences in the time
pattern of benefits received from investment proposals. This criterion does not consider the
distinction between returns (benefits) received in different time periods and treats all benefits as
equally valuable irrespective of the time pattern differences in benefits. In other words, the profit
maximization ignores the time value of money, i.e., money today is better than money
tomorrow. Also it does not consider the sooner, the better principle.
To understand this limitation better let us consider the following example.
Example Akaki Manufacturing Share Company wants to choose between two projects: project X
and project Y. both projects cost the same, are equally risky and are expected to provide the
following benefits over three years period.
BENEFITS (PROFITS)
YEAR PROJECT X PROJECT Y
1 Br. 25,000 Br. –0-
2 50,000 50,000
3 –0- 25,000
TOTAL Br. 75,000 Br. 75,000
The profit maximization criterion ranks both projects as being equal. However, project X
provides higher benefits in earlier years and project Y provides larger benefits in later years. The
higher benefits of project X in earlier years could be reinvested to earn even higher profits for
later years. Profit seeking organizations must consider the timing of cash flows and profits
because money received today has a higher value than money received tomorrow. Cash flows in
early years are valued more highly than equivalent cash flows in later years.
3. Quality of Benefits (Risk of Benefits). Profit maximization assumes that risk or uncertainty
of future benefits is of no concern to stockholders. Risk is defined as the probability that actual
benefit will differ from the expected benefit. Financial decision making involves a risk-return
trade-off. This means that in exchange for taking greater risk, the firm expects a higher return.
The higher the risk, the higher the expected return.
Example Nyala Merchandising Private Limited Company must choose between two projects.
Both projects cost the same. Project A has a 50% chance that its cash flows would be actual over
the next three years. Project B, on the other hand, has a 90% probability that its cash flows for
the next three years would be realized.

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 BENEFITS
YEAR PROJECT A PROJECT B
1 Br. 60,000 Br. 45,000
2 65,000 50,000
3 95,000 85,000
TOTAL Br. 220,000 Br. 180,000
Under profit maximization, project A is more attractive because it adds more to Nyala than
project B. However, if we consider the risk of the two projects, the situation would be reversed.
Expected benefit of project A = Br. 220,000 x 50% = Br. 110,000
Expected benefit of project B = Br. 180,000 x 90% = Br. 162,000
In fact, risk can be measured in different ways, and different conclusions about the riskness of a
course of action can be reached depending on the measure used. In addition to the probability
distribution, illustrated above, risk can also be measured on the basis of the variation of cash
flows.
The more certain the expected cash flow (return), the higher the quality of benefits (i.e., low risk
to investor). Conversely, the more uncertain or fluctuating the expected benefits, the lower the
quality of benefits (i.e., high risk to investors).
 Wealth Maximization
Wealth maximization is one of the modern approaches, which involves latest innovations and
improvements in the field of the business concern. The term wealth means shareholder wealth or
the wealth of the persons those who are involved in the business concern. Wealth maximization
is also known as value maximization or net present worth maximization. This objective is a
universally accepted concept in the field of business. So, the goal of financial management is
maximizing the wealth of owners (i.e. shareholders).
According to this model, it is made clear that there are two ways in which the wealth of
shareholders changes. These are:
 Through changing dividend payments, and
 Through the change in the market price of common shares
Hence, the change in shareholders' wealth, or change in the value of business firms, may be
calculated as follows:
i. Multiply the dividend per share paid during the period by the number of shares
owned.

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 ii. Multiply the change in shares price during the period by the number of shares
owned.
iii. Add the dividends and the change in the market value of shares, computed in step 1
and 2 above, to obtain the change in the shareholders' wealth during the period.
In order to maximize the wealth of shareholders, a business firm must seek to provide the larges
attainable combination of dividends per share and stock price appreciation.
 Nevertheless, the problem is that while a business firm may have some degree of
freedom in setting its dividend policy that is in accordance with wealth maximization
goal, it cannot influence the share prices, which are basically set by the interaction of
buyers and sellers in the securities/stock markets.
 Stock prices tend to reflect the perception of the stockholders regarding the ability of the
business firm to earn profits and the degree of risks that the business firm assumes in
earning its profit.
The ultimate risk that the business firm usually faces is the probability that it will fail or go
bankrupt. In such an event,
 The owners/shareholders of the business firm would see their investment becoming
worthless; and
 The creditors would likely see that at least some portion of their loans go unpaid.
These events have impacts on the market prices of shares, which, in turn, have impacts on the
objective/goal of a business firm, that is, wealth maximization of shareholders.
In summary, wealth maximization as a decision criterion is considered to be an ideal goal of a
firm in financial management. There are several reasons why wealth maximization decision
criterion is superior to other criteria. First, it has an exact measurement unlike profit
maximization. It depends on cash flows (inflows and outflows). Second, wealth maximization
as a decision criterion considers the quality as well as the time pattern of benefits. Third, it
emphasizes on the long-term and sustainable maximization of a firm’s common stock price in the
financial market. Fourth, wealth maximization gives recognition to the interest of other
stakeholders and to the societal welfare on the long-term basis.
1.5 CONFLICT OF GOALS BETWEEN MANAGEMENT AND OWNERS AND
AGENCY PROBLEM
As you understand, in a corporate form of business organization owners (stockholders) do not
run the activities of the firm. Rather, the stockholders elect the board of directors, who in

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 turn assign the management on behalf of the owners. So, basically, managers are agents of
the owners of the corporation and they undertake all activities of the firm on behalf of these
owners. Managers are agents in a corporation to maximize the common stockholders’ well-
being. However, there is a conflict of goals between managers and owners of a corporation
and mangers may act to maximize their interest instead of maximizing the wealth of owners.
Managers are interested to maximize their personal wealth, job security, life style and fringe
benefits.
The natural conflict of interest between stockholders and managerial interest create agency
problems. Agency problems are the likelihood that mangers may place their personal goals a
head of corporate goals. Theoretically, agency problems are always there as long as mangers are
agents of owners.
Corporations (owners) are aware of these agency problems and they incur some costs as a
result of agency. These costs are called agency cost and include:
1. Monitoring expenditures – are expenditures incurred by corporations to monitor or
control the activities of managers. A very good example of a monitoring expenditure is fees
paid by corporations to external auditors.
2. Bonding expenditures – are cost incurred to protect dishonesty of mangers and other
employees of a firm. Example: fidelity guarantee insurance premium.
3. Structuring expenditures – expenditures made to make managers fell sense of ownership
to the corporation. These include stock options, performance shares, cash bonus etc.
4. Opportunity costs – unlike the previous three, these costs are not explicit expenditures.
Opportunity costs are assumed by corporations due to hindrances of decisions by them as a
result of their organizational structure and hierarchy.
On top of the above costs assumed by corporations, there are also other ways to motivate
managers to act in the best interest of owners. These ways include making know managers
that they would be fired if they do not act to maximize shareholders wealth and that the
corporation could be overtaken by others if its value is very much lower than other firms.
1.6 The relationship between financial management and other field of study
Financial management, as integral part of the overall management, is not a totally independent
area. It draws heavily on related disciplines and field of study, such Economics, Accounting,
Marketing, Production, Quantitative methods and so on.

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A. Financial Management and Economics
The field of finance is closely related to economics. Financial managers must understand the
economic framework and be alert to the consequences of varying levels of economic activity and
changes in economic policy. They must also be able to use economic theories as guidelines for
efficient business operation. Examples include supply-and-demand analysis, profit-maximizing
strategies, and price theory. The primary economic principle used in managerial finance is
marginal analysis, the principle that financial decisions should be made and actions taken only
when the added benefits exceed the added costs. Nearly all financial decisions ultimately come
down to an assessment of their marginal benefits and marginal costs.
B. Financial Management and Accounting
The firm’s finance (treasurer) and accounting (controller) activities are closely related and
generally overlap. Indeed, managerial finance and accounting are not often easily
distinguishable. In small firms the controller often carries out the finance function, and in large
firms many accountants are closely involved in various finance activities. However, there are
two basic differences between finance and accounting; one is related to the emphasis on cash
flows and the other to decision making.
Emphasis on Cash Flows
The accountant’s primary function is to develop and report data for measuring the performance
of the firm, assessing its financial position, and paying taxes. Using certain standardized and
generally accepted principles, the accountant prepares financial statements that recognize
revenue at the time of sale (whether payment has been received or not) and recognize expenses
when they are incurred. This approach is referred to as the accrual basis. The financial manager,
on the other hand, places primary emphasis on cash flows, the intake and outgo of cash. He or
she maintains the firm’s solvency by planning the cash flows necessary to satisfy its obligations
and to acquire assets needed to achieve the firm’s goals. The financial manager uses this cash
basis to recognize the revenues and expenses only with respect to actual inflows and outflows of
cash.
Decision Making
The second major difference between finance and accounting has to do with decision making.
Accountants devote most of their attention to the collection and presentation of financial data.
Financial managers evaluate the accounting statements, develop additional data, and make
decisions on the basis of their assessment of the associated returns and risks. Of course, this does

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not mean that accountants never make decisions or that financial managers never gather data.
Rather, the primary focuses of accounting and finance are distinctly different
C. Financial Management and Mathematics
Modern approaches of the financial management applied large number of mathematical and
statistical tools and techniques. They are also called as econometrics. Economic order quantity,
discount factor, time value of money, present value of money, cost of capital, capital structure
theories, dividend theories, ratio analysis and working capital analysis are used as mathematical
and statistical tools and techniques in the field of financial management.
D. Financial Management and Production Management
Production management is the operational part of the business concern, which helps to multiple
the money into profit. Profit of the concern depends upon the production performance.
Production performance needs finance, because production department requires raw material,
machinery, wages, operating expenses etc. These expenditures are decided and estimated by the
financial department and the finance manager allocates the appropriate finance to production
department.
The financial manager must be aware of the operational process and finance required for each
process of production activities.
E. Financial Management and Marketing
Produced goods are sold in the market with innovative and modern approaches. For this, the
marketing department needs finance to meet their requirements. The financial manager or
finance department is responsible to allocate the adequate finance to the marketing department.
Hence, marketing and financial management are interrelated and depends on each other.
F. Financial Management and Human Resource
Financial management is also related with human resource department, which provides
manpower to all the functional areas of the management. Financial manager should carefully
evaluate the requirement of manpower to each department and allocate the finance to the human
resource department as wages, salary, remuneration, commission, bonus, pension and other
monetary benefits to the human resource department. Hence, financial management is directly
related with human resource management.

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1.7 Financial Markets and the Corporation
Financial markets are markets in which financial instruments are bought and sold by suppliers
and demanders of funds. They, unlike financial institutions, are places in which suppliers and
demanders of funds meet directly to transact business.
 Functions of Financial Markets
Generally, financial markets play three important roles in functioning of corporate finance.
They assist the capital formation process. Financial markets serve as a way through which firms
can obtain the capital they need for their operations and investment.
Financial markets serve as resale markets for financial instruments. They create continuous
liquid markets where firms can obtain the capital they need from individuals and other
businesses easily (serve as a secondary market).
They play a role in setting the prices of securities. The price of a financial instrument is
determined through the interaction of demand and supply of the security in the financial markets.
 Classification of Financial Markets
There are many types of financial markets and hence several ways to classify them. For our
purpose, here we shall consider the following two classifications.
1. Classification on the basis of maturity
This is based on the maturity dates of securities
 Money Markets - are financial markets in which securities traded have maturities of
one-year or less. Examples of securities traded here include treasury bills, commercial
papers, and short – term promissory notes and so on.
 Capital Markets - are financial markets in which securities of long-term funds are
traded. Major securities traded in capital markets include bonds, preferred and
common stocks.
2. Classification on the basis of the nature of securities
This is based on whether the securities are new issues or have been outstanding in the market
place.
 Primary Markets - are financial marketers in which firms raise capital by issuing new
securities.
 Secondary Markets - are financial markets in which existing and already outstanding
securities are traded among investors. Here the issuing corporation does not raise new
finance.

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  Financial Institutions
Financial institutions are financial intermediaries, which are specialized financial firms that
facilitate the transfer of funds from savers to demanders of capital. They accept savings form
customers and lend this money to other customers or they invest it. In many instances, they pay
savers interest on deposited funds. In some cases, they impose service charges on customers for
the services they render. For example, many financial institutions impose service charges on
current accounts.
The key participants in financial transactions of financial institutions are individuals, businesses,
and government. By accepting the savings from these parties, financial institutions transfer again
to individuals, business firms, and governments. Since financial institutions are generally large,
they gain economies of scale in the transfer of money between savers and demanders. By pooling
risks, they help individual savers to diversify their risk.
The major classes of financial institutions include commercial banks, savings and loan
associations, mutual savings banks, credit unions, pension funds and life insurance companies.
Among these, commercial banks are by far the most common financial institutions in many
countries worldwide. In Ethiopia too, commercial banks are the major institutions that handle the
savings and borrowing transactions of individuals, businesses, and governments.
 Financial Instruments
Financial instruments are written and formal documents of transferring funds between and
among individuals, businesses, and governments. They include loans and borrowing contracts,
promissory notes, commercial papers, treasury bills, bonds, and stocks.
Under normal circumstances, two parties are involved in any financial instrument. For holders,
who have invested their money, financial instruments are financial assets. A financial asset gives
the holder the right to claim against the income and assets of its issuer. For the issuer, on the
other hand, financial instruments represent either liabilities or equity items. For instance, if you
consider a bond, it represents an investment (financial asset) for the holder, and a debt item for
its issuer. Similarly, if you consider a common stock, it represents an investment and equity item
for the holder and issuer respectively. The issuer gives the financial asset to the purchaser
(holder) in exchange for some valuable consideration, usually in the form of cash or another
financial asset.

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