CHAPTER 1&2:

Introduction to Financial Management

The Difference Between Accounting
and Finance
Accounting
◦ A record-keeping system, invented to reflect the
financial operation of a firm.
◦ The record can be used to produce financial
statements
◦ Such as Statement of Financial Position (Balance Sheet),
Statement of Profit and Loss (Income Statement) and Cash
Flow Statement
◦ These statements reflect the firm’s financial standing and
performance.
The Difference Between Accounting
and Finance
Finance
◦ Consists of 3 key decisions/activities:
◦ Financing decision to decide the level of funds required,
which types of funds to raise and the raising of funds.

◦ Investment decision to decide on the amount to be invested

into which types of assets.

◦ Dividend decision to establish a dividend policy to retain

earnings for reinvestment or pay dividends to shareholders.
The Difference Between Accounting
and Finance
◦ Although account and finance do not involve the same
aspects, they are closely related.
◦ To have a good financial management, many
accounting information are required such as financial
statements.

Financing Investing

Dividend
Policy
Key Financial Decisions / Activities
Statement of Financial Position /
Balance Sheet

Assets Shareholders’ Equities

◦ Fixed assets
Liabilities
◦ Current assets
◦ Long term liabilities
◦ Current liabilities

A= L+ E
Financing decision/activity
Left Investment decision/activity
Right
(Capital Structure)
Financial Management
Financial Management
◦ is how we manage financial activities to maximise
shareholders' wealth.
◦ concerned with the acquisition, financing and
management of assets with some overall goals in
mind.
◦ A good financial planning and management will
increase the value of a firm and shareholders' wealth.
The Main Objective of the Firm /
Goal of the Corporation
The most important goal of most corporations is to
maximise shareholder’s wealth.

◦ Why don't we just maximise profit instead? Is it the

same with maximising shareholders wealth?
◦ The answer is no, not the same.
Financial Objectives of the Firm:
Profit Maximisation
◦ It refers to how much dollar profit the company makes.
◦ Example: current profits could be increased by cutting
R&D expenditures.
◦ It is a short-term approach, mostly concerned about short-
term benefits.
◦ It ignores the timing of returns, magnitude of returns and
risk.
◦ Fulfilling objective of earning profit may not help in creating
wealth in the long run.
 Financial Objectives of the Firm:
Profit Maximisation
Seller A
Seller B
$20 $15

1 2 3 4 1 2 3 4
Let say you have bought a fish which cost $20 from seller A before you realise seller B
sells at a cheaper price (other factors remain the same). Which
$15 seller
$15 would
$15 you go to$45
if
$20
you $20
are going to buy fish next time? How about third and fourth time?
 Financial Objectives of the Firm:
Profit Maximisation
Year Earnings (RM)
Project A Project B
1 250,000 Nil
2 Nil 250,000

◦ According to the profit maximisation approach, project A is equal to project B since

both projects are generating earnings of RM250,000
◦ Rationally, these two projects are not equal because the sooner the earnings are
received, it can be invested to earn returns. This is based on time value of money
 Financial Objectives of the Firm:
Profit Maximisation
Year Earnings (RM)
Product X Product Y
1 12,500 11,500
2 12,500 11,500
Total 25,000 23,000

◦ A profit maximisation approach would favour product X over product Y because the
total projected earnings after two years are higher.
◦ However, if product X is more risky than product Y, then the decision is not as
straightforward as the figures seem to indicate, because of the trade-off between
risk and return
Financial Objectives of the Firm:
Shareholder’s Wealth Maximisation
◦ Profit should not be the only objective of the company.
◦ Rather, company should have a look on how to create wealth.
◦ If company focus on maximising shareholder’s wealth, it means
company focus on the value of a company, i.e value of the stock.
◦ It is a long-term approach which considers the timing of returns,
magnitude of returns, and risk.
◦ Example: company may invest in R&D to improve the quality of
products, although it may be costly but it creates value in the
long run.
◦ Maximising shareholder’s wealth = maximising share price =
maximising firm’s value
Factors Affecting Stock/Share Price
of A Company
◦ Stock/Share price is always the best indicator of
shareholders' wealth.
◦ The firm’s stock price is dependent on the following
factors:

Riskiness of
Timing of cash
Cash Flow expected cash
flow
flow
Factors Affecting Stock/Share Price
of A Company
1. Cash Flow
◦ The expectation that the firm will generate cash in
future.
◦ Cash flow is the actual cash generated or paid by the
firm, accounting profits ≠ cash flow.
◦ Financial managers concentrate on increasing cash
inflows and decreasing cash outflows.
◦ The higher the expected cash inflows and the lower
the expected cash outflows, the higher the firm’s
stock price will be.
Factors Affecting Stock/Share Price
of A Company
2. Timing of cash flow
◦ Refers to when the firms expect to receive cash and
when they expect to pay out cash.
◦ $100 today or $100 three years from today?
◦ "A dollar received today is worth more than a dollar
received a year from now“, this is because we can
earn interest on money received today.
◦ The sooner the cash inflows and the later the cash
outflows, the higher the firm’s stock price will be.
Factors Affecting Stock/Share Price
of A Company
3. Riskiness of expected cash flow
◦ The less certain owners and investors are about a
firm’s expected future cash flows, the lower they will
value the company.
◦ Concept in finance is “higher risk, higher return” (risk-
return trade off).
◦ For an asset with uncertain cash flows (risky), a
rational investor will demand for a higher return than a
risk-less asset.
◦ As risk increases, stock price goes down and vice
versa.
Profit Maximisation vs. Shareholder’s
Wealth Maximisation
◦ Profit versus value, which one is more important to company?
◦ Profit is a subset of value or small part of value.
◦ Value of company may consist of profit, quality, market share,
R&D, branding, etc.
◦ Hence, profit is not everything!
◦ Creating value will help create profit. But, making profit does
not necessarily create value for a company.
 Financial vs. Non-financial Objectives

• Financial objectives: Shareholder’s wealth maximisation vs.

profit maximisation

• Non-financial objectives:
– Preserve the well being of stakeholders
– Establish brands and quality standards
– Establish effective communication with customers, suppliers,
employees
 Stakeholders and Impact on Corporate
Objectives
◦ Stakeholders include all groups of individuals who have a direct
economic link to the firm including employees, customers, suppliers,
creditors, etc.
◦ Companies should avoid actions that could harm the interest of its
stakeholders, not to maximise but to preserve stakeholder well being
(non-financial objective).
◦ For example: donate money to the community to build schools and
hospitals, to prevent pollutions of environment, to take good care of the
employees, etc.
◦ Such a view is considered to be ‘socially responsible’ – Corporate Social
Responsibility (CSR).
 Stakeholders and Impact on Corporate
Objectives
◦ CSR is defined as the voluntary activities undertaken by a company to
operate in an economic, social and environmentally sustainable manner.
◦ Many companies believe that CSR can create value for the company.
◦ Moreover, ethics (standards of conduct or moral judgment) has become
an overriding issue in both our society and the financial community.
◦ Ethical violations attract widespread publicity and negative publicity
often leads to negative impacts on a firm.
◦ Firms should practise good ethics to establish positive brand image (non-
financial objective).
 The Financial Manager’s
Responsibilities

1. Forecasting and planning

◦ The financial manager must interact with other executives
as they look ahead and lay the plans which will shape the
firms’ future position.
 The Financial Manager’s
Responsibilities

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 manager must help determine the optimal
rate of sales growth, and must help decide on the specific
assets to acquire and the best way to finance these
investments.
The Financial Manager’s
Responsibilities

3. Coordination and control

◦ The financial manager must interact with other
executives 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.
The Financial Manager’s
Responsibilities

4. Dealing with the capital market

◦ The financial manager must deal with the money
and capital markets.
◦ All firms affect and are affected by the general
financial markets where funds are raised, where the
firm’s securities are traded, and where its investors
are either rewarded or penalised.
The Financial Manager’s
Responsibilities

5. Risk management
◦ Responsible for the firm’s overall risk management
program, including identifying the risk that should be
managed and then managing them in most efficient
manner.
◦ E.g. the risk of fires and floods, uncertainties in
commodity and security prices, many of these risks
can be reduced by purchasing insurance or
diversification.
Cash and Cash Flow
◦ Cash is very important in the running of business. A
business that makes losses can last for a few years
but if a business is short of cash, it will collapse in a
very short period of time.

◦ Cash can be defined as money, in the form of notes

and coins. It is the most liquid of assets and
represents the lifeblood for growth and investment.
Cash and Cash Flow
Cash flow
◦ A term for receipts and payments of cash.
◦ It represents the cash movement for a particular
organisation.
◦ Cash flow can be subdivided into two movements:
◦ cash inflow
◦ cash outflow

Net cash flow = the cash received in a period - the

cash paid out in the same period
 Cash Inflow vs. Cash Outflow
Cash Inflow Cash Outflow
1. Cash received from sales: 1. Payment to suppliers for goods
• Immediately from cash customers purchased and employee for wages,
• From customers for sales made on bonuses
credit 2. Payments to government in terms of
taxes
2. Cash received from providers of 3. Payment to suppliers of finance:
finance:  Dividend payments to shareholders
• Equity share capital invested in the  Interest payments to bondholders,
business banks
• Long term loans provided by banks 4. Payments to cover the purchase cost
and other financial institutions of non-current assets such as buildings
and equipment.
3. Cash received from 5. Payment to acquire investment:
disposal/liquidation:  New businesses or takeover of
• Sale of non-current assets after their companies
useful life  Short term financial instruments to
• The liquidation of short term use surplus cash to turn a quick
investments profit
Cash and Cash Flow
 Managing cash and cash flows represents the most important aspect in
business.
 A company needs to purchase raw materials to be used in the
production of goods and services, to pay their labours, to rent factory
and to acquire the necessary tools that are required.
 The goods purchased will then be sold to customers who will only pay
some time later in the future.
 Due to this time lag between paying for the factors of production and
receiving money from customers, the company must be able to balance
and efficiently manage the flow of cash.
Motives of Holding Cash
1. The transactions motive
 make necessary payments to keep the business going, such as
wages, taxes and payments to suppliers.

2. The precautionary motive

 some unforeseen expenses may arise
 businesses tend to cover themselves against this by arranging
overdraft facilities with their banks.

3. The speculative motive

 in case an opportunity to invest and earn money arises.
Cash flow problem may arise due to
the following circumstances:
Business that is loss making
• If a business continually makes losses, it will eventually have cash flow
problems.

Inflation
• In a period of rising prices, a business need increasing amount of cash
just to replace used up and worn out assets.

Growth
• As its sales increases, the growing company may need additional
financing to sustain the growth.

Seasonal business
• When a business has seasonal or cyclical sales, it may have cash flow
difficulties at certain times of the year.
Ways to Overcome Cash Shortages
◦ When there is a need of cash in the near future, a company
may be able to take the following steps to overcome cash
difficulties:

Postponing cash Accelerating

outflows cash inflows

Sell assets /
Obtain financing
investments
Profit vs. Cash Flow
◦ Profit = sales - cost of sales
◦ Operational cash flow = cash received - cash paid
◦ Cash received differs from sales because of
changes in the amount of receivables
◦ Cash paid differs from the cost of sales because of
changes in the amount of payables
Cash Accounting vs. Accruals
Accounting
◦ Accruals Concept – Revenues and costs are
recognised as they are earned or incurred, not as
money is received or paid.

◦ Cash Accounting – It is a system of accounting for

costs and income on the basis of payments and cash
receipts.
Finance vs Accounting View
◦ Finance generally uses cash flows (cash accounting)
◦ Accounting generally stresses profits (accruals concept).

Example:
Suppose that Midland Company is in the business of refining and
trading gold. At the end of the year, it sold 2500 ounces of gold for
RM1 million. The company had acquired the gold for RM900,000 at
the beginning of the year. The company paid cash for the gold when
it was purchased. Unfortunately, it has yet to collect from the
customer to whom the gold was sold.
 Based on accruals
Based on cash accounting 
concept
Sales RM1,000,000 Cash inflows RM
0
Cost of Sales 900,000 Cash outflows
Profit 100,000 (900,000)
Net cash flows (900,000)
   
By generally accepted The perspective of corporate
accounting principles, the finance is different. It is
sale is recorded even though interested in whether cash
the customer has yet to pay. flows are being created by the
Midland seems to be operation of Midland.
profitable.