CHAPTER ONE

FINANCIAL MANAGEMENT: AN OVERVIEW

Finance: A Short Overview
According to Brigham (2001) finance consists of three interrelated areas particularly in association with the career
of graduates.
Money and Capital Market This deals with securities market and financial institutions; professionals with
knowledge in finance go to work for financial institutions, including banks, insurance companies, mutual funds
and investment banking firms. For success here, one needs knowledge of valuation techniques, the factors that
cause interest rate to rise and fall, the regulations to which financial institutions are subject, and the various types
of financial instruments. One also needs a general knowledge of all aspects of business administrations, because
the management of a financial institution involves accounting, marketing, personnel, computer system as well as
financial management.
Investments Investment focuses on the decisions made by both individual and institutional investors as they
choose securities for their investment portfolios. Broadly speaking, the investment area deals with financial assets
such as stock/share and bonds. Some of the most important issues are determinants of the price of financial assets
such as a share; the potential risks and rewards associated with investing in financial assets; and determination of
the best mixtures of the different financial assets to be held.

Financial management or business finance which involves decisions within firms. It is the broadest of the three
areas.

Ross et.al (2001) described finance in four basic areas of emphasis: corporate finance or business finance,
investments, financial institutions and international finance. The different emphasis of the authors is the inclusion
of international finance where finance processionals are to be engaged in business finance, investments and
financial institutions at international level.

Hence, finance as a field is broader which concerns with how money is raised, where is to be invested, and how it
is managed and the respective decisions passed. The emphasis of this course is the financial management stream of
finance.
Financial Management
Financial management is a recently emerged discipline which still has no unique body of knowledge of its own,
and draws heavily on economics for its theoretical concept even today. It is an area exposed for changes related
with the concurrent globalization effect and increase in information technology.

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Brigham (2001) described the historical perspective and the evolution of financial management as:
When financial management emerged as a separate field of study in the early1900s, the emphasis was on the
legal aspects of mergers, the formation of new firms, and the various types of securities firms could issue to raise
capital. During the depression of the 1930s the emphasis shifted to bankruptcy and reorganization, corporate
liquidity, and the regulation of security markets. During the 1940s and early 1950s, it continued to be taught as a
descriptive, institutional subject viewed more from the standpoint of an outsider rather than that of a manager.
However, a movement toward theoretical analysis began during the late 1950s and the focus shifted to
managerial decisions designed to maximize the value of the firm. The focus on value maximization continues as
we begin the 21st century. However, two other trends are becoming increasingly important: (1) the globalization
of business and (2) the increased use of information technology. Both of these trends provide companies with
exciting new opportunities to increase profitability and reduce risks. However, these trends are also leading to
increased competition and new risks.

Setting aside the trends of change in financial management, different scholars define financial management in
different technicalities, however, with similar major emphasis.

Pandey (1999) stated financial management in the form of managerial activity which is concerned with the
planning and controlling of a firm’s financial resources.

According to Solomon (1969) financial management is concerned with the efficient use of important economic
resources namely, capital funds.
Phillippatus presented financial management as:
It is concerned with managerial decisions that result in the financing and acquisition of long-term and short-
term credits for the firm. As such it deals with the situation that requires selection of specific assets, the
selection of specific liability as well as the problem of size and growth of an enterprise. The analysis of this
decision is based on the expected inflows and outflows of funds and their effects upon managerial objectives.

Generally, financial management can be simply defined as the decision and process of making optimal use of a
firm’s financial resources for the purpose of maximizing the owner’s/shareholders wealth. Moreover, accounting
to Khan and Jain (2000) it is an integral part of management and is not totally independent.

Other Disciplines Related to Finance

Khan and Jain (2000) while reasoning out the non-independent aspect of financial management and its interrelated
features with other streams have identified the following relationships.

Finance and Economics The relevance of economics to financial management can be seen from the two broader
areas of economics: macroeconomics and microeconomics.

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Since macroeconomics is concerned with the overall institutional environment and firms operate in the
macroeconomics environment, the awareness of this broader economic environment is fundamental for financial
management decisions. Specifically, a financial manager has to: i) recognize and understand how monetary policy
affects the cost and the availability of funds; ii) be versed in fiscal policy and its effect on the economy; iii) be
aware of the various financial institutions; iv) understand the consequences of various levels of economic activity
and the changes in economic policy for decision environment.

Because microeconomics is mainly dealt with the economic decisions of individuals and organizations, it defines
the actions that will permit firms to achieve their objectives. The theories of supply and demand relationships and
profit maximization strategies; issues related to mix of production factors, optimal sales level and pricing
strategies; the concept of measurement of utility preference, risk and determination of value; and the rationale of
depreciating assets are among the fundamental features of microeconomics relevant in financial management.

Finance and Accounting Finance and accounting are closely related and they also have distinctive features.
They are closely related because accounting is an important input in financial decision making. They are different
because: i) they treat funds differently, and ii) finance begins when accounting ends. Accounting measurement of
funds (income and expenses) is mainly based on accrual principles while the viewpoint of finance relating to funds
is based on cash flows. The purpose of accounting is mainly collection and presentation of financial data while
finance is for making decisions based on accounting data.

Marketing and Finance If you are interested in marketing, you need to know finance because, for example,
marketers constantly work with budgets, and they need to understand how to get greatest payoff from marketing
expenditures and programs. Analyzing costs and benefits of projects of all types is one of the most important
spects of finance, so the tools you learn in finance are vital in marketing research, the design of marketing and
distribution channels, and product pricing among others. The financial manager has also to consider the impact of
new product development and promotion plans in marketing areas.

Management and Finance One of the most important areas in management is strategy. Thinking about business
strategy without simultaneously thinking about financial strategy is an excellent step for disaster, and as a result,
management strategists must have a very clear understanding of the financial implications of business plans.
1.2 Scope and Functions Financial Management

The scope of financial management has evolved from the traditional to the modern approach. Under the traditional
approach, the major emphasis of financial management was considered in a narrower sense. Its emphasis was how
corporations raise fund and it was totally has of an external orientation. The modern approach views financial

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management in a broader sense and provides a conceptual and analytical framework for financial decision making.
According to this approach, the finance function covers both acquisitions of funds as well as their allocation. In
other words, financial management is concerned with the solutions of the three major problems relating to the
financial operations of a firm, corresponding to three questions of investment, financing, and dividend decisions.
Thus, financial management, in the modern sense can be broken down into three major decisions as functions of
finance: i) the investment decisions, ii) the financing decisions, and iii) the dividend policy decision (Khan and
Jain, 2000).
i) Investment (Asset-Mix) Decisions the investment decisions relates to the selection of assets in which funds
will be invested by the firm. The assets may long term assets which yield return in the future over longer periods;
and short term assets which are coverable into cash at normal operation of the business without decrease in value,
usually within a year. When the investment is made on long-term assets it is considered as capital budgeting while
the other is working capital.

Capital budgeting decision is concerned with long-term assets and their compositions. Measurement of investment
proposals is the major exercise of capital budgeting decision. It evaluates the business risk composition of the firm
where risk and uncertainty of a certain project proposal is evaluated against a certain established standards.
Moreover, it is concerned with judgment of the benefit of the firm with concept of the cost of capital.
Working capital management is concerned with the management of current assets. It is an important and integral
part of financial management as a short term survival is the prerequisite for the long term success.

ii) Financing (Capital-Mix) Decisions financing decision is the second important function of financial
management. It is emphasized when, where and how to acquire funds to meet the firm’s investment needs. The
central issue, therefore, is to determine the 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 the optimum
capital structure for the firm. The firm’s capital structure is considered to be optimum when the market value of
shares is maximized. The use of debt affects the return and risk of shareholders; it may increase the return on
equity funds but it always increases risk. A proper balance will have to be struck between return and risk. When
the shareholder’s return is maximized with minimum risk, the market value per share will be maximized and the
firm’s capital structure would be considered optimum. Once the 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.
iii) Dividend or Profit Allocation Decisions Dividend decision is the third major financial decision. The
emphasis is whether the firm should distribute all profits, or retain them, or distribute a portion and retain the
balance. Like the debt-equity policy, the dividend policy should be determined in terms of its impact on the
shareholders’ value. The optimum dividend policy is one that maximized the market value of firm’s shares.

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Thus, if shareholders are not indifferent to the firm’s dividend policy, the financial manager must determine the
optimum dividend-payout ratio. The financial manager should also consider the questions of dividend stability,
bonus share and cash dividends in practice.
1.3 Objectives of Financial Management
Firm’s investment and financial decisions are unavoidable and continuous. In order to make these decision
rationally, the firm must have a goal or objective (Pandey, 1999). Objectives provide a framework for optimal
financial decision making. Following sections show the profit maximization and wealth maximization objectives
of a firm and present the concern for the shareholders’ wealth maximization. The wealth maximization is
identified as theoretically logical, operationally feasible, and normative framework for guiding the financial
decision making.
A) Profit Maximization
A business firm is profit-seeking organization. Hence, profit maximization is well considered to be an important
objective of financial management. Profit maximization means maximizing birr income of firms. Firms produce
goods and services. They may function in a market economy, or in a government controlled economy. In market
economy, prices of goods and services are determined in competitive markets. Firms in a market economy are
expected to produce goods and services desired by society as efficiently as possible. In a market economy, goods
and services in great demand command higher prices. This results in higher profit for firms; more of such goods
and services are produced. A higher profit opportunity attracts other firms to produce such goods and services.
Ultimately, with intensifying competition an equilibrium price is reached at which demand and supply match. In
the case of goods and services which are not required by society, their prices and profits fall. Such goods and
services are dropped out by producers in favor of more profitable opportunities.

In the economic theory, the behavior of firm is analyzed in terms of profit maximization. While maximizing
profit, a firm either produces maximum output for a given amount of output, or uses minimum input for producing
a given output. Thus, the underlying logic of profit maximization is efficiency. It is assumed to cause the efficient
allocation of resources under the competitive market conditions, and profit is considered as the most appropriate
measure of the firm’s performance. But, the profit maximization suffers from the following limitations:
i) Ambiguity in Definition the precise meaning of the profit maximization objective is not clear. 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 profits or profit per share? Does it mean total operating profit or profit accruing to shareholder? These cases
are difficult to specify and make the term vague.

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ii) Time Value of Money the profit maximization objective does not make a distinction between returns received
at different time periods. It gives no consideration to the time value of money or timing of benefits. It values
benefits received today and benefits received after a period as the same.
iii) Quality of Benefits the streams of benefits may possess different degree of certainty. The term quality refers
to the degree of certainty with which benefits are expected. Two firms may have same total expected earnings, but
if the earnings of one firm fluctuate considerably as compared to the other, it will be more risky. Possibly, owners
of the firm would prefer smaller but assured profits to a potentially larger but less certain stream of benefits.

Generally, profit maximization criterion is inappropriate and unsuitable as an operational objective of investment,
financing and dividend decisions of a firm. It is not only vague but it also ignores two important dimensions of
financial analysis namely risk and time value of money.
B) Wealth Maximization
Wealth Maximization is also known as value maximization or net present worth maximization. In the current
financial literatures, value maximization is almost universally accepted as an appropriate operational decision
criterion for financial management decisions. It removes the technical limitations of profit maximization criterion.
Its operational features satisfy all the three requirements of a suitable operational objective of financial courses of
action, namely, exactness, quality of benefits and the time value of money.
The value of an asset should be viewed in terms of the benefits it can produce. The worth of a course of action can
similarly be judged in terms of the value of the benefits it produces less the cost of undertaking it. A significant
element in computing the value of a financial course of action is the precise estimation of the benefits associate
with it. The wealth maximization criterion is based on the concept of cash flows generated by the decisions rather
than accounting profit. Cash flow is precise concept with a definite connotation. Measuring benefits in terms of
cash flows avoids the ambiguity associated with accounting profits. This is the first operational feature of the net
present worth maximization criterion.
The second important feature of the wealth maximization criterion is that it considers both the quantity and quality
of dimensions of benefits. At the same time, it also incorporates the time value of money. The operational
implication of the uncertainty and timing dimensions of the benefits originates from a financial decision.
Adjustments should be made in the cash flow pattern, firstly, to incorporate risk and, secondly, to make an
allowance for differences in the timing of benefits. The value of stream of cash flows is calculated by discounting
its element back to the present at a discount rate. The discount rate reflects both time and risk. In applying the
value maximization criterion, the time value is used in terms of worth to the owners. The discount rate that is
employed is, therefore, the rate that reflects the time and risk preferences of the owners or suppliers of capital. A
large discount rate is the result of higher risk and longer time period.

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For the above reasons, the net present value maximization is superior to the profit maximization as an operational
objective. As a decision criterion, it involves a comparison of value to cost. An action that has discounted value
exceeding its cost can be said to create value.
A financial action that has a positive NPV creates wealth for shareholders and, therefore, is desirable. A financial
action resulting in negative NPV should be rejected since it would destroy shareholders’ wealth. Between
numbers of mutually exclusive projects the one with higher NPV should be adopted. Therefore, the wealth will be
maximized if this criterion is followed in making financial decisions.
1.4 The Role of Financial Managers
A financial manager is a person who is responsible in a significant way to carry out the finance functions. A
financial manager is responsible for shaping the fortunes of the enterprise, and is involved in the most vital
decision of the allocation of capital. A financial manager plays a dynamic role in a modern company’s
development. Weighted corporate competition, technology changes, volatility in inflation and interest rates,
worldwide economic uncertainty and ethical concerns over certain financial dealings must be dealt with almost
daily.
The role of a financial manager changes and old ways of doing things are not good enough in a world where old
ways become obsolete. Today’s financial manager must have the flexibility to adapt to the changing external
environment if his or her firm is to survive. The financial manger’s ability to adapt to changes, raise fund, invests
in asset, and manages wisely will affect the success of a firm.

Hence, a financial manager through efficient acquisition, financing and managing assets contribute to the firm in
particular and to the strength and growth of an economy as a whole.

Moreover, the following specific tasks of financial staff can be stated as major responsibilities.
Forecasting and planning the financial staff must coordinate the planning process. This means that they must
interact with people from other departments as they took ahead and lay the plans that will shape the firm’s future.
Major Investment and Financing Decision 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 these assets. For example,
should the firm finance with debt, equity or some contributions of the two, and if debt is used, how much should be
long term and how much short term?
Contribution and Control The financial staff must interact with other personnel to ensure that the firm is
operating as efficiently as possible. All business decisions must 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 into account of how

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their actions affect and are affected by such factors as the availability of funds, inventory policies, and plant
capacity utilization.
Dealing with the Financial Markets The financial staff must deal with 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.
Risk Management All business face risk, including natural disasters such as fires and floods, uncertainties in
commodity markets, volatile interest rates and fluctuating foreign exchange rates. However, many of these risks
can be reduced by purchasing insurance or by hedging in 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.

• Forms of business organization

1. Proprietorship: an unincorporated business owned by one individual

 Advantages:
Easy and inexpensive to form
Subject to less government regulations
Lower income taxes
 Disadvantages:
Unlimited personal liability
Limited lifetime of business
Difficult to raise capital
2. Partnership: an unincorporated business owned by two or more people
Advantages vs. disadvantages: similar to those of proprietorship, in general

3. Corporation: legal entity created by a state

 Advantages:
Limited liability
Easy to transfer the ownership
Unlimited lifetime of business
Easy to raise capital
 Disadvantages:
Double taxation (at both corporate and individual levels)
Cost of reporting