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OVERVIEW OF FINANCIAL MANAGEMENT

Introduction to Finance
Finance is the study of how individuals, institutions, governments, and businesses acquire, spend, and manage
money and other financial assets (Melicher & Norton, 2017). According to Merriam-Webster’s Dictionary,
finance is a system that includes the circulation of money, the granting of credit, the making of investments, and
the provision of banking facilities.

Three (3) Common Areas of Finance (Brigham & Houston, 2017):

• Financial management, also known as corporate finance, focuses on decisions relating to how much and
what types of assets to acquire, how to raise the capital needed to purchase assets, and how to run the firm
to maximize its value. The same principles apply to both for-profit and not-for-profit organizations.
• Capital markets relate to where interest rates, along with stock and bond prices, are determined. Also
studied here are the financial institutions that supply capital to businesses. Banks, investment banks,
stockbrokers, mutual funds, insurance companies, and the like bring together “savers” who have money to
invest and businesses, individuals, and other entities that need capital for various purposes.
• Investments relate to decisions concerning stocks and bonds and include the following activities:
o Security analysis, which deals with finding the proper values of individual securities (i.e., stocks and
bonds);
o Portfolio theory, which deals with the best way to structure portfolios, or “baskets,” of stocks and
bonds. Rational investors want to hold diversified portfolios to limit risks, so choosing a properly
balanced portfolio is an important issue for any investor; and
o Market analysis, which deals with the issue of whether stock and bond markets at any given time
are “too high,” “too low,” or “about right.”

Finance versus Economics and Accounting

Modern finance grew out of economics and accounting nowadays. Economists developed the notion that an
asset’s value is based on the future cash flows the asset will provide, and accountants provided information
regarding the likely size of those cash flows. People working in finance need knowledge of both economics and
accounting (Brigham & Houston, 2017).

Board of Directors

Chief Executive Officer (CEO)

Chief Operating Officer (COO) Chief Financial Officer (CFO)

Marketing, Production, Human Accounting, Treasury, Credit,

Resources, and Other Operating Legal, Capital Budgeting, and
Departments Investor Relations
Figure 1. Finance within the Organization
Source: Fundamentals of Financial Management (Concise) (9th ed.), 2017, p. 6

Jobs in Finance
Finance prepares students for jobs in banking, investments, insurance, corporations, and government.
Accounting students need to know other areas of the business such as marketing, management, and human
resources; they also need to understand finance, as it affects decisions in all those areas. For example,
marketing people propose advertising programs, but those programs are examined by finance people to judge

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the effects of advertising on the firm’s profitability. Therefore, to be effective in marketing, one needs to have a
basic knowledge of finance. The same holds for management, wherein management decisions are evaluated
in terms of their effects on the firm’s value. It is also worth noting that finance is vital to individuals regardless of
their jobs.

For a finance major individual, there are vast and varied opportunities in this industry. Here are some interesting
jobs in finance (Brently University, 2016):
• Investment Banker – Helps an organization to raise capital by selling bonds or equity, and advises different
clients on a variety of financial opportunities depending on the nature of the business this finance person is
involved in.
• Financial Analyst – Works for a company or a non-profit rather than a bank and helps decision-makers
determine an investment strategy for an organization.
• Chief Financial Officer (CFO) – Leads and manages the overall financial dealings of the company. Tracking
profit and loss, then strategizing how to make the company more profitable are the main tasks of CFOs.
Management experience is needed to direct staff on how to maximize the finances of the company, which
may include various departments or divisions.
• Finance Director – Instead of having a CFO, a finance director helps the company in managing its financial
operations. Strategic planning, mergers and acquisitions, forecasting, budgeting, and financial modeling are
the expected skills for this job.
• Controller – Directs a company’s accounting practices. The responsibilities of controllers include the
development of profit and loss statements, balance sheets, financial prospectuses, and the preparation of
reports that predict the financial performance of the organization.
• Accountant – Manages and interprets financial statements. Depending on the specific career interest and
skills, an accountant may want to focus on one of the following specialties: forensic accounting, managerial
accounting, public accounting, internal auditing, or government accounting.
• Financial Examiner – Checks if the company is compliant with laws, regulations governing financial,
securities institutions, and financial and real estate transactions.
• Securities, Commodities, and Financial Services Sales Agent – Combines a job in sales with a finance
background. S/he works with buyers and sellers in financial markets to sell securities, counsel companies,
and handle trades.
• Portfolio Manager – Often works at investment management firms and oversees a fund or group of funds,
makes investment decisions, and tracks trends.
• Trader – Works closely with portfolio managers, buying and selling securities based on their requests.
• Stockbroker – Like traders, brokers buy and sell securities. Rather than working with a portfolio manager,
however, most brokers operate on behalf of a client.
• Personal Financial Advisor – Prefers working with individuals rather than companies. This role requires a
thorough knowledge of taxes, investments, how to plan financial goals, etc.

Forms of Business Organization

The basics of financial management are the same for all businesses, large or small, regardless of how they are
organized. Still, a legal structure of the firm affects its operations and thus should be recognized (Brigham &
Houston, 2017).
• Sole Proprietorship is an unincorporated business owned by one (1) individual. Proprietorship has
advantages: (1) easy and inexpensive to form; (2) subject to few government regulations; and (3) subject
to lower income taxes. However, some limitations are: (1) unlimited personal liability for the business’ debts;
(2) life of the business is limited to the life of the individual who created it; and (3) difficulty obtaining large
sums of capital.
• Partnership is a legal arrangement between two (2) or more people who decide to do business together.
As to proprietorship, this form is also easy and inexpensive to form. As for income allocation, each partner
will receive an equity on a pro rata basis. However, all of the partners are generally subject to unlimited
personal liability, which means that if a partnership goes bankrupt and any partner is unable to meet his/her

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pro rata share of the firm’s liabilities, the remaining partners will be responsible for making good on the
unsatisfied claims.
• Corporation is a legal entity separate and distinct from its owners and managers. This means that in case
of losses, the corporation can lose all of its money, but its owners can lose only the funds that they invested
in the company. Corporations also have unlimited lives, and it is easier to transfer shares of stock in a
corporation than one’s interest in an unincorporated business. These factors make it much easier for
corporations to raise the capital necessary to operate large companies.
• Cooperative is a form of business organization in which the business is owned and controlled by those
who use its services. A cooperative may be organized as a legal entity, or it may be an unincorporated
association. Cooperatives are organized primarily for providing service to their user-owners, rather than to
generate profit for investors (Hall, 2019).

When deciding on its form of organization, a firm must trade off the advantages of incorporation against a
possibly higher tax burden. However, for the following reasons, the value of any business other than a
relatively small one will probably be maximized if it is organized as a corporation (Brigham & Houston,
2017):
1. A firm’s value is dependent on its growth opportunities, which are dependent on its ability to attract
capital. Because corporations can attract capital more easily than other types of businesses, they are
better able to take advantage of growth opportunities.
2. The value of an asset also depends on its liquidity, which means the time and effort it takes to sell the
asset for cash at fair market value. Because the stock of a corporation is more straightforward to transfer
to a potential buyer that is an interest in a proprietorship or partnership, and because more investors
are willing to invest in stocks than in partnerships (with their potential unlimited liability), corporate
investment is relatively liquid. This too enhances the value of a corporation.

Creating Value for Investors

In public corporations, managers and employees work on behalf of the shareholders who own the business;
and therefore, they should pursue policies that promote stockholder value. While many companies focus on
maximizing a broad range of financial objectives, such as growth, earnings per share, and market share, these
goals should not take precedence over the main financial goal, which is to create value for investors (Brigham
& Houston, 2017).

Stockholders are not just an abstract group; they represent individuals and organizations who have chosen to
invest their hard-earned cash into the company and who are looking for a return on their investment to meet
their long-term financial goals.

1 Managerial Actions, the Economic Environment, Taxes, and the Political Climates

2 “True” Investor “True” Risk “Perceived” “Perceived”

Cash Flows Investor Cash Risk

3 Stock’s Intrinsic Value Stock’s Market Price

4 Market Equilibrium:
Intrinsic Value = Stock Price

Figure 2. Determinants of Intrinsic Values and Stock Prices

Source: Fundamentals of Financial Management (Concise) (9th ed.), 2017, p. 36

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1. Managerial actions, combined with the economy, taxes, and political conditions, influence the level and
riskiness of the company’s future cash flows, which ultimately determine the company’s stock price. It is
expected that investors like higher cash flows, but they dislike risk; so the larger the expected cash flows
and the lower the perceived risk, the higher the stock price.
2. “True” means cash flows and risk are expected by investors if they have all of the information about a
company. “Perceived” means what investors expect, given the limited information they have.
3. “Intrinsic Value” means that an estimate of a stock’s “true” value is based on accurate risk and return data.
The intrinsic value can be estimated, but not measured precisely. While in the “Market Price,” the stock
value is based on perception but possibly an incorrect information as seen by the marginal investor.
4. When a stock’s actual market price is equal to its intrinsic value, the stock is in equilibrium. When equilibrium
exists, there is no pressure for a change in the stock’s price. Market prices can—and do—differ from intrinsic
values; but eventually, as the future unfolds, the two (2) values tend to converge.

Actual stock prices are easy to determine and can be found on the Internet. However, intrinsic values are
estimates; and different analysts with different data and different views about the future form different estimates
of a stock’s intrinsic value. Investing would be easy, profitable, and essentially riskless if all stocks’ intrinsic
values are known; but it is not. Intrinsic values can be estimated, but the estimates cannot be assured if it is
right. A firm’s managers have the best information about the firm’s prospects, so managers’ estimates of intrinsic
values are generally better than those of outside investors (Brigham & Houston, 2017).

Management’s goal should be to take actions designed to maximize the firm’s intrinsic value, not its current
market price. Note, though, that maximizing the intrinsic value will maximize the average price over the long
run, but not necessarily the current rate at each point in time (Brigham & Houston, 2017).

Ideally, managers adhere to this long-run focus, but there are numerous examples in recent years where the
focus for many companies shifted to the short run. Perhaps most notably, before the current financial crisis,
many Wall Street executives received huge bonuses for engaging in risky transactions that generated short-
term profits. Subsequently, the value of these transactions collapsed, causing many of these Wall Street firms
to seek a massive government bailout. Apart from the recent problems on Wall Street, there have been other
examples where managers have focused on short-run profits to the detriment of long-term value. Many
academics and practitioners stress the vital role that executive compensation plays in encouraging managers
to focus on the proper objectives. For example, if a manager’s bonus is tied solely to this year’s earnings, it
would not be a surprise to discover that the manager took steps to pump up current profits, even if those steps
were detrimental to the firm’s long-run value. With these concerns in mind, a growing number of companies
have used stock and stock options as a key part of executive pay. The intent of structuring compensation in this
way is for managers to think more like stockholders and to work to increase shareholder value continually.
Despite the best of intentions, stock-based compensation does not always work as planned. Managers are
awarded an incentive by the stockholders (acting through boards of directors) to focus on stock prices with stock
options that could be exercised on a specified future date. An executive could exercise the option on that date,
receive stock, immediately sell it, and earn a profit. The profit was based on the stock price on the option
exercise date, which led some managers to try to maximize the stock price on that specific date, not over the
long run. That, in turn, led to some horrible abuses. Projects that looked good from a long-run perspective were
turned down because they would penalize profits in the short run and thus lower the stock price on the option
exercise day. Even worse, some managers deliberately overstated profits, temporarily boosted the stock price,
exercised their options, sold the inflated stock, and left outside stockholders “holding the bag” when the true
situation was revealed (Brigham & Houston, 2017).

Conflicts on Stockholders and Managers

It has long been recognized that managers’ personal goals may compete with shareholder wealth maximization.
In particular, managers might be more interested in maximizing their wealth than their stockholders’ wealth;
therefore, managers might pay themselves excessive salaries (Brigham & Houston, 2017).

Effective executive compensation plans motivate managers to act in their stockholders’ best interests. Useful
motivational tools include (1) reasonable compensation packages, (2) firing of managers who do not perform
well, and (3) the threat of hostile takeovers (Brigham & Houston, 2017).

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• Compensation packages should be sufficient to attract and retain skilled managers, but they should not go
beyond what is needed. Compensation policies need to be consistent over time. Also, compensation should
be structured so that managers are rewarded by the stock’s performance over the long run, not the stock’s
price on an option exercise date. This means that options (direct stock awards) should be phased in over
some years so that managers have an incentive to keep the stock price high over time. When the intrinsic
value can be measured objectively and verifiably, performance pay can be based on changes in intrinsic
value. However, because intrinsic value is not observable, compensation must be based on the stock’s
market price—but the price used should be an average over time rather than on a specific date (Brigham &
Houston, 2017).
• Corporate raiders are individuals who target corporations for takeover because they are undervalued.
• Hostile takeover is the acquisition of a company over the opposition of its management.

Conflicts on Stockholders and Debtholders

Conflicts can also arise between stockholders and debtholders. Debtholders, which include the company’s
bankers and its bondholders, generally receive fixed payments regardless of how well the company does, while
stockholders do better when the company does better. This situation leads to conflicts between these two (2)
groups, to the extent that stockholders are typically more willing to take on riskier projects.

Balancing Interests of Shareholder and Society

Shareholder Wealth Maximization, the primary financial goal of managers of publicly owned companies,
implies that decisions should be made to maximize the long-run value of the firm’s common stock. Most
managers understand that maximizing shareholder value does not mean that they are free to ignore the larger
interests of society. Consider, for example, what would happen if Linda Smith narrowly focused on creating
shareholder value, but in the process, her company was unresponsive to its employees and customers, hostile
to its local community, and indifferent to the effects its actions had on the environment. Likely, society would
impose a wide range of costs on the company. It may find it hard to attract top-notch employees; its products
may be boycotted; it may face additional lawsuits and regulations; and it may be confronted with negative
publicity. These costs would ultimately lead to a reduction in shareholder value. Thus, when taking steps to
maximize shareholder value, enlightened managers need to also keep in mind these society imposed
constraints.

From a broader perspective, firms have many different departments, including marketing, accounting,
production, human resources, and finance. The finance department’s principal task is to evaluate proposed
decisions and judge how they will affect the stock price and thus shareholder wealth. For example, suppose the
production manager wants to replace some old equipment with new automated machinery that will reduce labor
costs. The finance staff will evaluate that proposal and determine whether the savings seem to be worth the
cost. Similarly, if marketing wants to spend P10 million for advertising during the Ms. Universe event, the
financial staff will evaluate the proposal, look at the probable increase in sales, and reach a conclusion as to
whether the money spent will lead to a higher stock price. Most significant decisions are evaluated in terms of
their financial consequences, but astute managers recognize that they also need to take into account how these
decisions affect society at large (Brigham & Houston, 2017).

References
Brently University. (2016). 12 Interesting Jobs in Finance. Retrieved from Brently University:
https://www.bentley.edu/prepared/12-interesting-jobs-finance
Brigham, E. F., & Houston, J. F. (2017). Fundamentals of Financial Management (Concise) (9e). Boston, MA, Boston, United
States of America: Cengage Learning.
Chartered Financial Analyst Institute. (2018). Careers in Finance. Retrieved from Wall Street Mojo:
https://www.wallstreetmojo.com/careers-in-finance/
Hall, A. (2019). Special Types of Business Organizations. Retrieved from Attorney AAron Hall: https://aaronhall.com/special-
types-of-business-organizations-cooperatives/
Melicher, R. W., & Norton, E. A. (2017). Introduction to Finance (Markets, Investments, and Financial Management) (16th
Edition). Hoboken, NJ, New Jersey, United States of America: John Wiley & Sons, Inc.

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