INTRODUCTION TO FINANCIAL

MANAGEMENT

BA, Msc AF, PMP Aidan Luvanda

 FINANCIAL MANAGEMENT

Financial management (FM) is the managerial activity which is concerned with the
planning and controlling of the financial resources.
OBJECTIVES OF FINANCIAL MANAGEMENT
1. To ensure regular and adequate supply of funds to the concern.
2. To ensure adequate returns to the shareholders which will depend upon the
earning capacity, market price of the share, expectations of the shareholders.
3. To ensure optimum funds utilization. Once the funds are procured, they should
be utilized in maximum possible way at least cost.

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 4. To ensure safety on investment, i.e., funds should be
invested in safe ventures so that adequate rate of return
can be achieved.
5. To plan a sound capital structure-There should be sound
and fair composition of capital so that a balance is
maintained between debt and equity capital.

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 RELATIONSHIP TO 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 operations. Examples
include supply and demand analysis, profit-maximizing strategies and price theory. A
basic knowledge of economics is therefore necessary to understand both the
environment and the decision techniques of managerial finance.

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 RELATIONSHIP TO ACCOUNTING

The firm’s finance and accounting activities are closely related activities and
generally overlap. Indeed managerial finance and accounting are not often
easily distinguishable. In small firms the accountant often carries out the
finance function. However, there are two basic differences between finance
and accounting:

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 EMPHASIS ON CASH FLOWS

• The accountant’s primary function is to develop and provide 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 point of sale and expenses when incurred i.e. accrual basis accounting.

• The financial manager on the other hand places primary emphasis on cash flows. He or she maintains the firm’s solvency
by planning the cash flows necessary to satisfy its obligation 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. Regardless of its profit or loss, a firm must have sufficient cash flows to meet its obligation as they
fall due.

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 The financial manager on the other hand places primary emphasis on cash flows. He or
she maintains the firm’s solvency by planning the cash flows necessary to satisfy its
obligation 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. Regardless of its profit or loss, a firm must have sufficient
cash flows to meet its obligation as they fall due.

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 There are two types of shareholders i.e. ordinary and preference. Preference shareholders
receive dividend at fixed rate, and they have a priority over ordinary shareholders. The
dividend rate for ordinary shareholders is not fixed, and it can vary from year to year
depending on the decisions of board of directors. The payment of dividends to
shareholders is not a legal obligation; it depends on the discretion of the board of directors.
Since ordinary shareholders receive dividend (or repayment of invested capital, or when
the company is wound up) after meeting the obligations of others, they are generally called
owners of residue. Dividends paid by the company are not tax deductible expenses for
calculating corporate income taxes, and they are paid out of profits after corporate taxes.

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 FINANCE FUNCTION

It may be difficult to separate the finance functions from production,

marketing and other functions, but the functions themselves can be readily
identified. The functions of raising funds, investing them in assets and
distributing returns earned from assets to shareholders are respectively
known as financing decisions, investment decision and dividend decision. A
firm attempts to balance cash inflow and outflows while performing these
functions. This is called liquidity decision and it is among the finance
decisions or functions. Thus finance functions include:

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  Long-term assets-mix or investment decision
 Capital mix or financing decision
 Profit allocation or dividend decision
 Short-term asset mix or liquidity decision
A firm performs finance functions simultaneously and continuously in the
normal course of the business. They do not necessarily occur in a sequence.
Finance functions call for skillful planning, control and execution of a firm’s
activities.

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 Let us note at the outset that shareholders are made
better off by a financial decision that increases the value of
their shares. Thus while performing the finance functions,
the financial manager should strive to maximize the
market value of shares.

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 1. INVESTMENT DECISION [CAPITAL BUDGETING]

A firm’s investment decisions involve capital expenditure.

They are therefore referred to as capital budgeting
decisions. A capital budgeting decision involves the decision
of allocation of capital or commitment of funds to long-term
assets that would yield benefit (cash flows) in the future.
Two important aspects of investment decision are:

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 a) The evaluation of the prospective profitability of new investments
Future benefits of investments are difficult to measure and cannot be predicted with certainty. Risk in investment arises
because of the uncertain returns. Investment proposals should be evaluated in terms of both expected return and risk.
Beside the decision to commit funds in new investment proposals, capital budgeting also involves replacement
decision, which is the decision of recommitting funds when asset becomes less productive or non-profitable.
 
b) The measurement of the standard/required rate of return or hurdle rate against which the expected return of new
investment could be compared.
There is a broad agreement that the correct required rate of return on investments is the opportunity cost of capital. The
opportunity cost of capital is the expected rate of return that an investor could earn by investing his or her money in
financial assets of equivalent risk. However, there are problems in computing opportunity cost of capital in practice from
the available data.

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 2. FINANCING DECISION [CAPITAL MIX DECISION]

A financial manager must decide when and where to acquire funds to

meet the firm’s investment needs. The central issue before him/her is
to determine the appropriate proportion of equity and debt. The mix
of debt and equity is known as the firm’s capital structure. The
financial manager must strive to obtain the best financing mix or
optimum capital structure for the firm. The firm’s capital structure is
considered optimum when the market value of share is maximized.

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 In absence of debt, the shareholders’ return is equal to the firm’s return. The use of debt
affects the return and risk of shareholders; it may increase the return on equity fund, but it
always increases risk as well.
A proper balance will have to be struck between return and risk. When shareholders return is
maximized with minimum risk the market value per share will be maximized and the firm’s
capital structure will be considered optimum. Once financial manager is able to determine
the best combination of debt and equity, he/she must raise the appropriate amount through
the best available sources. In practice the firm considers many other factors such as control,
flexibility, loan covenants, legal aspects etc in deciding its capital structure.

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 3. DIVIDEND DECISIONS
The financial manager must decide whether the firm should distribute
all profits, or retain them, or distribute the portion and retain the
balance. The proportion of profits distributed as dividends is called
dividend payout ratio and the retained portion of profits is known as
the retention ratio. Like debt policy, the dividend policy should be
determined in terms of its impact on the shareholders’ value.

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 The optimum dividend policy is one that maximizes the market
value of the firm’s shares. Thus, if shareholders are not indifferent to
the firm’s dividend policy, the financial manager must determine the
optimum dividend payout ratio. Dividends are generally paid in
cash; however the firm may issue bonus shares. Bonus shares are
shares issued to the existing shareholders without any charge. The
financial manager should consider the questions of dividend
stability, bonus shares and cash dividends in practice.

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 4. LIQUIDITY DECISION
Investment in current assets affects the firm’s profitability and liquidity. Current assets should be
managed efficiently for safeguarding the firm against the risk of illiquidity. Lack of liquidity (or
illiquidity) in extreme situations can lead to the firm’s insolvency. A conflict exists between
profitability and liquidity while managing current assets. If the firm does not invest sufficient funds in
current assets, it may become illiquid and therefore, risky. But it would lose profitability, as idle
current assets would not earn anything. Thus a proper trade-off must be achieved between
profitability and liquidity. The profitability-liquidity trade-off requires that the financial manager should
develop sound techniques of managing current assets. He/she should estimate firm’s needs for
current assets and make sure that funds would be made available when needed.

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 CONCLUSION
Financial decisions are directly concerned with the firm’s decision to acquire or dispose off assets
and require commitment or recommitment of funds on continuous basis. It is in this context that
finance functions are said to influence production, marketing and other functions of the firm. Hence
finance functions may affect the size, growth, profitability and risk of the firm, and ultimately, the
value of the firm.
To quote Ezra Solomon: the function of financial management is to review and control decisions to
commit or recommit funds to new or ongoing uses. Thus, in addition to raising funds, financial
management is directly concerned with production, marketing and other functions, within an
enterprise whenever decision are made about the acquisition or distribution of assets.

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 FINANCIAL MANAGER’S ROLE

1. FUND RAISING
This is the traditional approach which dominated the scope of financial management and
limited the role of the financial manager simply to raising fund. It was during the major events
such as promotion, re-organization, expansion, or diversification in the firm that the financial
manager was called up on to raise fund. In his day to day activities his significant duty was to
see that the firm had enough cash to meet its obligations. The traditional approach had been
criticized because it failed to consider the day to day management problems from
management point of view. Thus the traditional approach of looking at the role of financial
manager lacked a conceptual framework for making financial decisions; it misplaced emphasis
of raising fund and neglected the real issues related to allocation and management of funds.

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 ALLOCATION OF FUNDS
It is an analytical way of looking into financial problems of the firm. Financial management
is considered as a vital and integral part of overall management. In this broader view the
central issue of financial policy is the wise use of funds and the central process involved is
a rational matching of advantages of potential uses against the cost of alternative potential
source so as to achieve a broad financial goal which an enterprise sets for itself.
Thus, in a modern enterprise, the basic finance function is to decide about the expenditure
decisions and to determine the demand for capital for these expenditures. In other words,
the financial manager has got a role of ensuring efficient allocation of funds.

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 PROFIT PLANNING

The functions of a financial manager may be broadened to include profit

planning function. The term profit planning refers to the operating decision
in the areas of pricing, cost, volume of output and firms’ selection of product
line. Profit planning is therefore a prerequisite for optimizing investment and
financial decisions. Profit planning helps in anticipating the relationship
between cost, volume and profit (CVP) and to develop action plans to face
unexpected surprises.

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UNDERSTANDING CAPITAL MARKETS

Capital markets bring investors (lenders) and firms (borrowers) together. Hence
financial manager has to deal with capital markets where securities are traded.
He/she should fully understand the operations of capital markets and the way in
which securities are valued. He should also know how risk is measured in
capital markets and how to cope with investment and financing decisions which
often include considerable risk.

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 F I N A N C I A L G O A L : P R O F I T M A X I M I Z AT I O N V E R S U S W E A LT H
M A X I M I Z AT I O N

The firm’s investment and financing decisions are unavoidable and

continuous. In order to make them rationally, the firm must have a
goal. It is generally agreed in theory that the financial goal of the
firm should be shareholders’ wealth maximization (SWM), as
reflected in the market value of the firm’s shares. Wealth
maximization is theoretically logical and operationally feasible
normative goal for guiding financial decision making.

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 PROFIT MAXIMIZATION
In economic theory, the behavior of a firm is analyzed in terms of profit maximization.
Profit maximization implies that a firm either produces maximum output for a given
amount of input, or uses minimum input for producing a given output. The underlying
logic of profit maximization is efficiency. It is assumed that profit maximization causes the
efficient allocation of resources under the competitive market condition, and profit is
considered as the most appropriate measure of a firm’s performance. Historically this
was the objective of the firm, but it has been generally criticized in financial management
because of the following:

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I. It is argued that profit maximization as business
objective was developed in the early 19th century when the
characteristic features of the business structure were self-
financing, private property and single entrepreneurship.

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 • The only aim of the single owner was to enhance his individual wealth and personal
power which could easily be satisfied by the profit maximization objective. However, the
modern business is characterized by limited liability and a divorce between management
and ownership. The business firm today is financed by shareholders and lenders but it is
controlled and directed by professional management. The other interested parties are
customers, employees, government and the society. In practice, the objectives of these
stakeholders or constituents of the firm differ and may conflict with each other. The
manager of the firm has a difficult task of reconciling and balancing these conflicting
objectives. In new business environment profit maximization is regarded as unrealistic,
difficult, inappropriate and immoral.

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 II. THE DEFINITION OF PROFIT IS VAGUE
The precise meaning of profit maximization objective is unclear. The
definition of the term profit is ambiguous. Does it mean short or long
term profit? Does it refer to profit before or after tax? Total profit or
profit per share? Does it mean total operating profit or profit accruing
to shareholders? Economists define profit differently from accountants
and therefore as financial manager the objective becomes elusive.

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 III. TIME VALUE OF MONEY
Profit maximization ignores the concept of time value of money
i.e. it ignores the timing of returns. It does not make distinction
between returns received in different time periods. It gives no
consideration to the time value of money, and it values benefits
received in different periods of time as the same.

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 IV. PERFECT COMPETITION ASSUMPTION
It is argued that profit maximization assumes perfect
competition and in the face of imperfect modern market it
can’t be a legitimate objective of the firm.

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 V. IT IGNORES RISK
In almost all investments, there is uncertainty of returns. The streams
of benefits may possess different degree of uncertainty. Two firms
may have the same total expected earning but if the earnings of one
firm fluctuate considerably as compared to the other, it will be more
risky. Possibly owners of the firm prefer smaller but surer profits to a
potentially larger but less certain stream of benefits

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 CONCLUSION
Profit maximization fails to serve as operational criteria for
maximizing the owners’ economic welfare. It also fails to
provide an operation feasible measure for ranking
alternative courses of action in terms of their economic
efficiency.

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 SHAREHOLDERS’ WEALTH MAXIMIZATION [SWM]
SWM means maximizing the net present value (NPV) of a course of
action to shareholders. Wealth is the net cash flows expected from
all assets which resources of the firm have been committed. These
cash flows have to be discounted to their present worth using a
discount rate that takes into account all business stakeholders.

WEALTH MAXIMIZATION = -
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NPV = + + + ……………+ -

=Net cash flows in a period

=Initial outlay

K=discount rate

n=No. of years
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 The wealth maximization objective is consistent with the objective of
maximizing owners’ economic welfare. Maximizing economic welfare of
owners is equivalent to maximizing the utility of their consumption over time.
Therefore the wealth maximization principle implies that the fundamental
objective of a firm should be to maximize the market value of its shares. The
value of the company shares is represented by its market price which in turn
is a reflection of the firm’s financial decisions. The market price serves as the
firm’s performance indicator.

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 AGENCY PROBLEMS: MANAGERS
VS SHAREHOLDERS GOALS

•In large companies there is a divorce between management and ownership. The
decision-taking authority in a company lies in the hands of the managers. Shareholders
as owners of the company are the principals and the managers are the agents. Thus,
there is principal-agent relationship between shareholders and managers.
•In theory, managers should act in the best interests of shareholders; that is their
actions and decisions should lead to shareholders wealth maximization (SWM).
However, in practice managers may not necessarily act in the best interest of the
shareholders, and they may pursue their own personal goals.

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 •Managers may maximize their own wealth (in form of salaries and
perks) at the cost of shareholders, or may play safe and create
satisfactory wealth for shareholders than the maximum. They may
avoid taking high investment and financing risks that may otherwise be
needed to maximize shareholders’ wealth. Such satisficing behavior of
managers will frustrate the objective of SWM as a normative guide. It
is in the interest of managers that the firm survives over the long-run.

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 Managers also wish to enjoy independence and freedom from outside
interference, control and monitoring. Thus their actions are very likely to
be directed towards the goals of survival and self-sufficiency. Further a
company is a complex organization consisting of multiple stakeholders
such as employees, debt-holders, consumers, suppliers, government
and society. Managers in practice may, thus perceive their role as that of
reconciling conflicting objectives of stakeholders. These stakeholders’
view of managers’ role may compromise with the objective of SWM.

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 •Continuous monitoring of company’s activities by the shareholders would help to restrict managers’
freedom to act in their own self-interest at the cost of shareholders. Employees, creditors,
customers and government also keep an eye on managers’ activities. Thus, the possibility of
managers pursuing exclusively their own personal goals is reduced.
•Managers can survive only when they are successful; and they are successful when they manage
the company better than someone else. Every group connected with the company will, however
evaluate management success from the point of view of the fulfilment of its own objective. The
survival of the management will be threatened if the objective of any of these groups remains
unfulfilled. In reality, the wealth of shareholders in the long-run could be maximized only when
customers and employees, along with other stakeholders of the firm, are fully satisfied

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 THE AGENCY PROBLEMS VANISH:

 When managers own the company. Thus one way to mitigate agency
problems is to give ownership rights through stock options to managers.
 When shareholders offer monetary and nonmonetary incentives to
managers to act in their interest.
 When there is a close monitoring by other stakeholders, board of
directors and outside analysts may also help in reducing the agency
problem.

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