Financial management

/Managerial Finance /

D. Duressa 2013 1
1. overview of financial management

Chapter objectives
 After studying this section you will be able to
– the field of finance
– Scope of managerial finance/ Financial management
– The place of managerial finance in organization
– The role of finance manager
– The environment of managerial finance decisions
– Forms of business organizations

–
D. Duressa 2013 2
The scope and Environment of Financial
Management
 The Field of Finance
– What is finance ?
 Finance is the general term used to refer to the
money resources available to governments, business
firms, not for profit organizations or individuals and
the management of these resources
 Virtually all individuals, organizations, governments
at various levels, business firms and not for profit
organizations earn, raise, spend or invest money
 the word finance is used in various contexts, in
referring to money, how money is generated or its
management
 Finance is the art and science of managing money
D. Duressa 2013 3
 Finance cont’d

 Finance is concerned with the process,

institutions, markets and instruments involved
in the transfer of money among and between
individuals, businesses, and governments

 The study of finance, therefore, necessarily

includes the institution (the financial system
and organizations, markets and regulatory
principles involved), the process and how to
cope with the system to properly manage
money
D. Duressa 2013 4
Cont’d

 The study of finance is often classified into

three specialized fields, namely
– Financial management (managerial finance)
– Investment
– Financial markets and institutions
 each of these are interrelated and complement one
another
 We are basically concerned with the field of financial
management or managerial finance here.

D. Duressa 2013 5
Financial management

 Is about making decisions, decisions about what

assets or products to invest in, how to manage cash,
and how to raise funds for growth.
 It is concerned with the acquisition, financiering and
management of assts with some overall objectives in
mind
 The functions of financial management is to plan for,
acquire, and utilize funds in a way that maximizes
the value of the organization
 A great deal of time is spent on financial planning
and coordination of a series of interdependent
decisions.
D. Duressa 2013 6
Decision functions of financial
management
 Financial management functions can be broken
down into three broad areas, namely
– Investment decisions
– Financing decisions, and
– Asset management decisions
 Investment decision
– Determination of total amount of assets needed to run
operation of the organization
– The type and mix of assets
– How much of the firms’ investment should be devoted to:
 Cash
 Receivables
 Inventories fixed assets etc
– It involves capital budgeting decision, that is, the evolution
and choice of fixed assets, replacement decisions,
retirement and deposal etc
D. Duressa 2013 7
 Financing decision

 Represented the right hand side of a balance

sheet
 Determination of source of finance to match
the investment decisions
 Determination of financing mix
 Dividend policy is viewed as integral part of
the financing decisions as it affects the
financial structure/capital structure/, how
much to distribute, how much to plow back in
business for further expansion
D. Duressa 2013 8
 Asset management
 Involves efficient utilization of assets
 Includes management of working capital
– Optimum cash balance
– Management of receivables –credit policy decisions,
collections, bad debt issues
– Inventory management, reduction of carrying and
ordering cost, avoid obsolescence, etc
– Management of fixed assets,
 Optimum level of assets, capacity utilization, productivity,
maintenance and repair, protraction, replacement etc

D. Duressa 2013 9
 The firm’s
balance sheet
Investment decisions Financing decisions

Asset
management Assets Liabilities & owners’
Decision
Current assets equity
Cash Liabilities
Receivables Current liabilities
Inventories long-term debt
Non-current Owners’ equity
assets External equity
Long-term Internal equity
investments
Fixed assets
D. Duressa 2013 10
 Scope of financial management
decisions

 Fincial management decision is related to

almost all functional areas
 The finance manger has to plan, acquire
and guide the utilization of fincial resources
to maximize the value of the firm
 Production plan, marketing or commercial
activity, investment, human resource etc
decisions necessarily require involvement of
fincial management decisions.
D. Duressa 2013 11
Scope cont’d

 Types of business
– Service-
 Characteristics, no inventory, deals with intangible goods
– Merchandising- characteristics, inventory, deals with material
goods, no creation of marketable goods
– Manufacturing
 Inventories, creation of tangible goods
 Forms of business organizations (discuss characteristics)
– Sole Proprietorship – owned by one person
– Partnership -owned by two or more
– Corporation – owned by several shareholders
 Financial management decision is more complex in corporate forms
than others due to complex nature of the organization
 Development of the field also owes to this form of organization

 Question is financial management applicable to

Governmental entities? D. Duressa 2013 12
 Typical organization of financial
management function

Vice President for Finance (CFO)

Controller Treasurer

General investment
financial Cash
reporting ledger
management

Bank relations
Cost and
budgeting
D. Duressa 2013 13
 The framework for financial
management decisions
 Financial management decisions are
made within the framework of the
following
– Maximization of goal of the firm
– Identification of important decision variables
– Application of decision rules
– And there are constraints to the main
decision criteria
– These are
 The agency problem
D. Duressa 2013 14
 Ethical and social considerations
 Objective (goal) of the firm

 What is the goal of the firm?

 Maximization of the wealth of stockholders
(shareholders)
 Maximization of wealth of stockholders come out of
the value of the firm
 Value of the firm is expressed in terms of the price
of (market value of) share in the market.
 The value the firms cannot be expressed in terms
of profit maximization
 Profit maximization may not necessarily lead to the
maximization of value of the firm.
D. Duressa 2013 15
Goal cont’d

 Concept of Profit is vague

– Accounting profit may not necessarily indicate increase in value of
the firm
– Maximization of profit in a short term may compromise long term
objective of the firm
 Profit ignores the time dimension of financial decisions
– Profit is calculated on accrual basis of accounting matching costs
incurred long time ago with revenues yet to be collected
 Profit maximization does not deal with risk dimension in
concrete terms – high profit is associated with high risk
– High exposure to risk may result in decline in price of shares in the
market
 Value maximization decision involves a comparison of value to
costs

D. Duressa 2013 16
 Goals cont’d

maximization of wealth of stockholders

Maximization of the market value of shares

Maximization of value of the firm

= goal of financial management

decision is to maximize the value of the firm
D. Duressa 2013 17
Cont’d

 Within wealth maximization framework

– Financial management decision requires
dealing with
 Uncertainty (risk)
 Timing of returns or cash flows

 Ambiguity of accounting profit

D. Duressa 2013 18
Decision variables and decision rules

 Risk and expected return

– Identify risk associated with a given investment
opportunity
– Estimate the return of the investment
opportunity
– Determine the risk weighted return
 Decision rule is the way of using the
relevant variables to make choices
consistent with goal of the organization
D. Duressa 2013 19
Cont’d
Financial manager

Financial decision alternatives

Risk return trade-off

Increase share price ? yes

Accept
no
D. Duressa 2013 20

Reject
Constraints – context

 Social welfare
– employees
– Consumers
– Creditors
– Corporate social responsibility
(stakeholder wealth preservation)
 The agency problem
– The manager owner relations
– The owner creditor relations
D. Duressa 2013 21
Financial markets

 Fincial markets play key role in finance

 Financial managers need to effectively deal
with and make use of the benefits of
financial markets
 Financial markets are often categorized as:
– Money market and
– Capital market
– Also primary market and secondary market

D. Duressa 2013 22
Financial market cont’d

 Financial markets serve three purposes

– Facilitating the acquisition and investment of
money
 Bringing cash needy firms and investors together
 Enables investment of surplus money
 Creates financial assets
– Encouraging capital formation
 Low cost and convenient
– Establishing market price and rate of return
 Price of financial assets established
 Rate of return on investment established
D. Duressa 2013 23
Tax and legal
environment
 Tax and legal environment affect the
financial management decisions
 The form of business organizations
discussed earlier differ in their degree
of influence
 Taxes influence financial decisions
– Choice of investment
– Financing decision
D. Duressa 2013 24
Finance and other disciplines

 Economics -basic theory

 Accounting- information
 Mathematics- model building for
theory
 Statistics-probability distribution for
uncertain decisions

D. Duressa 2013 25
end of first session

Thank you !

D. Duressa 2013 26