Financial Management I

Lecture Power point

By: Dawit Amaha

MSc. In Accounting and Finance
Department of Accounting and Finance
Haramaya University
E-mail: [email protected]
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Academic year 2023

 Chapter - One
Overview of Financial Management
1.1. Introduction
 To start any business we need capital/finance.
 Capital is the amount of money required to start a
business.
 The mobilization of finance is an important task for
an entrepreneur because;
 finance is one of the significant factors which
determine the nature and size of any enterprise.
 finance is required to acquire various fixed and
current assets.
 This is to be noted that;
 identification of sources of finance is critical as
it avoids the financial hardships of an2
enterprise.
1.2. Meaning of Finance
 Finance is the study/management/ of money.
 Finance is defined as the management of money
and includes activities such as investing, borrowing,
lending, budgeting, saving, and forecasting.
 Finance is the science of managing financial
resources i.e. the process of acquiring needed
funds and the best use of available financial
sources.
 It is basically concerned with the nature, creation,
regulation and study of money, banking, credit,
investments, assets, and liabilities that make up
financial systems.
 It focuses on how the individuals, businessmen,
investors, government and financial institutions
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deal with money.

1.3. Classification of Finance
Finance is classified into three categories
2. Personal finance:- This deals with the planning
and managing personal financial activities such as
income generation, spending, saving, investing,
and protection.
3. Public finance:- This deals with the
administration/management of a country’s
revenue, expenditures, and debt.
3. Business finance:- Is pertaining to the
mobilization and management of funds by various
business enterprises (banking, insurances, trade
agencies, and manufacturing enterprises).
Financial management actually concerned with
business finance.
The following are the basic forms of business
organizations 4

a) Sole proprietorship
1.4. Definition of Financial Management
 Financial Management is defined as the
management of financial resources and best uses
of such resources to attain the desired objective of
a firm (mainly to maximize the Shareholder's
wealth).
 Financial Management comprises “the forecasting,
planning, organizing, directing, coordinating and
controlling of all activities relating to acquisition
and application of the financial resources in line
with financial objectives.” (Raymond Chambers)
 Two aspects of financial management are;
procurement of funds and an effective use of these
funds to achieve business objectives.
 Financial resources of a business is obtained from
two sources, i.e.
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 resource owned and sacrificed by the firm
(internal fund) and
1.9. Financial Markets Institutions
 Financial market is a place where the business
families can raise their long and short-term
financial requirements.
 The development of financial markets indicates
the development of economic system.
 For mobilization of savings and for rapid capital
formation, healthy growth and development of
financial markets are crucial.
 These markets help promotion of investment
activities; encourage entrepreneurship and
development of a country.

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Financial Institutions and Markets

If a corporation needs to borrow from the bank or issue new securities.

Financial Institutions
 Financial institutions are financial intermediary
 Financial institutions received deposit from depositor and lend to
borrower
Issue Debt Deposit
cash Bank
Company (financial Depositor
Interest Interest
institutions)

Example of financial institutions

1. Depository financial institutions
 Government or private Banks
2. Non-Depository financial institutions
 Insurance company
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 Mutual fund
 Pension trust fund (fiduciary fund)
1. Capital market:
 Capital market is a financial market in which
long-term debt and equity instruments are
traded (maturity of one year or greater).
 Capital markets are concerned with long-term
finance.
Further the capital markets are divided into
two;
a) Primary market
• A market only new securities are issued to
the public.
 It is a place where borrowers directly
exchange financial securities for long-term
funds.
 The securities issued directly to the
individuals, institutions, through the
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underwriters etc.
b) Secondary market
2. Money Market
 Money market is a financial market in which
only short-term debt instruments are traded
(maturity of less than one year)
 It handles transactions like short-term
government obligations, bankers
acceptances, commodity papers, treasury
bills etc.
 It is a place where the lending and borrowing
of short-term funds are arranged and
 It comprises short-term credit instruments
and individuals who participate in the lending
and borrowing business.
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Financial Instruments
 There are mainly two kinds of securities such as;
1. Ownership securities.
a) Common stock :- It is also known as equity
shares, who are the real owners of the business
will enjoy the profit or loss suffered by the
company.
b) Preferential stock :- these stock holders have
two preferential rights
 to get fixed rate of dividend at the end of every
year irrespective of profits / losses of the
company
 to get back the investment first when the
company goes into liquidation.
2. Loan securities
• Bonds:- Bondholders are the money suppliers to
a business unit entitled for a fixed rate of interest
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at the end of each year.
 These securities or instruments are being traded
1.5. Financial Management Decisions
 These are decisions relating to financial matters of
a business firm.
 Financial decisions are of three types:
1. Financing decisions
2. Investing decisions
3. Dividend decisions
1. Financing Decisions:
 A financial decision which is concerned with the
amount of finance to be raised from internal
(shareholders fund) and external (borrowed capital
like, bank loans) sources.
 There must be a proper balance between various
sources (optimum capital structure) 11
2. Investment Decision:
 A Investment decision which is concerned with how
the firm’s funds are invested in different assets.
 Investment decision can be categorized as long-
term or short-term.
a) Long-term investment decisions are called capital
budgeting decisions which involve huge amounts
of long term investments and are irreversible except
at a huge cost.
 Is the process of making investment decisions in
capital expenditures, benefits of which are
expected over a long period of time exceeding one
year such as setting new units, expansion of
present units, etc.
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b) Short-term investment decisions are called working
capital decisions, which affect day to day
3. Dividend Decision:
 A financial decision which is concerned with
deciding how much of the profit earned by the
company should be distributed among shareholders
(dividend) and how much should be retained for the
future contingencies (retained earnings).
 A decision has to be taken whether;
 All the profits are to be distributed,
 To retain all the profit in business or
 To keep a part of profit in the business and
distribute others among shareholders.
 All financial decisions have same objective i.e.
maximization of shareholder’s wealth.
 All financial decisions influence one another and are
inter-related.
 An efficient financial management thus, has to be
taken the optimal joint decisions by evaluating 13
each of the decisions involved in relation to its effect
on SH’s wealth and market value of the company’s
1.6. The Objective of Financial
Management
 The overall company's goal is shareholders'
wealth maximization which is reflected through;
 the increased dividend per share and
 the rises of the prices of shares
 This overall goal of wealth maximization needs to
take into account the ff specific objectives of
financial management.
1. determining how large the business firm should
be and how fast should it grow.
2. determining the best percentage composition of
the firm's assets (asset portfolio decision, or
decisions related to capital uses).
3. determining the best percentage composition of
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the firm's combined liabilities and equity

(decisions related to capital sources).
1. Determining the Size and Growth Rate:
 The size of the business is measured by the value of
its total assets.
 If the book values are used; the size of the firm is
equal to the total assets as indicated in the balance
sheet.
 When this method of size determination is used,
 the growth rate of firm is measured by the
yearly percentage change in the book values of
all the asset items of the B/sheet.
2.Determining assets composition (portfolios)
 Assets represent investments or uses of capital that
the business makes in seeking to earn a rate of
return for its owners.
• The most common asset categories are cash,
inventories, and fixed assets. 15
 The percentage composition of the assets of the
firm is computed as ratio of the book value of each
 The choice of the percentage composition of
assets item affects the level of business risk.
 The financial manager is directly involved in
assets structure decisions that makes business
firm more successful in a way it will maximize the
wealth of shareholders.
 The wealth maximizing assets structure can be
described in either of the following ways:
a. The asset structure that yields the largest
profits for a given level of exposures to
business risk, or
b. The asset structure that minimizes exposure
to business risk that is needed to generate the
desired profits. 16

 The asset structure of the business firm is the

3. Determining the Composition of Liabilities
and Equity
 Liabilities and Equity are the sources of capital of
the business firms.
 The most common financing sources are
 common stocks, preferred stocks and retained
earnings.
 accounts and notes payable,
 accrual items such as taxes, wages, loans and
debt securities,
 The liability and equity percentage
composition of the business is measured by
dividing the book value of each liability or equity
item by the total book values of all liabilities and
equity. 17
 The mix of liabilities and equity of the business is
known as the capital structure.
1.7. Goals of Organizations
 The financial objective of the firm is the
maximization of owns economic welfare.
 However, there is a disagreement as to how the
economic welfare of owners can be maximized.
 The well-known and widely discussed criteria
which are put forth for this purpose are; a)
profit maximization and b) wealth
maximization
A. Profit maximization – increasing the birr income
of the firm
 Profit maximization is the objective of any
economic activity.
 The performance and efficiency of a firm are
evaluated in terms of profitability. 18
 Every business has to earn profit to cover its
costs and provide funds for future growth.
Favorable Arguments for Profit Maximization
 The following important points are support of the
profit maximization objectives of the business
concern:
 Main aim is earning profit.
 Profit is the main source of finance
 It is a barometer of the performance and efficiency
of a firm
 It covers the cost of running a business
 It provides a fund for future growth
 Without profit a business can not survive
 It provides support in emergencies
Unfavorable Arguments for Profit Maximization
 The ff points are against the objectives of profit
maximization: 19
 Leads to exploiting workers and consumers
 Creates immoral practices such as corrupt practice,
Criticisms or Limitations of profit maximization
objective
• Although the profit maximization objective is widely
known objective of the firm, some theories have
raised doubts on the validity of this objective.
• They criticized on the following grounds:
1. It is ambiguous (lack clarity).
 The precise meaning of profit maximization
objective is unclear.
 Is it profit after tax or before tax?
 Is it operating profit or net profit available to
shareholders?
 Does it mean short term profit or long term
profit? 20
 The profit maximization objective of the firm has
greater relevance to short-run. In long-run, a firm
2. It doesn’t account of the time value of
money.
 The profit maximization objective ignores the
timing of earnings.
 It treats all earnings as equal when they occur
in different periods.
 It doesn’t differentiate between the profit of
the current year with profits earned in last
years.
 It doesn’t differentiate between the cash
received today with a cash received in the
future (after one year).
3. It doesn't take account of risk associated
with stream of cash flow of a project.
 It fails to consider the fluctuations in profit
earned from year to year. 21
 The total profit from two projects may be same
but the profit from one project may be
4. If all firms keep profit maximization as primary
objective,
 They may commit unfair practice to maximize
profit (like, exploitation of labors and
consumers)
 It may lead to immoral marketing and killing of
the computation.

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B. Wealth maximization- maximizing values of
company (expressed in value of stock).
 The objective of wealth maximization is a
universally accepted concept in the field of
business.
 Wealth means shareholder’s wealth who involved in
the business.
 A shareholder’s current wealth in the firm is the
product of the number of shares owned multiplied
with the current stock price per share.
 The individual shareholder can use this wealth to
maximize his individual utility.
 The benefit of investment can be measured in
terms of the stream of future expected cash flows
generated by the decision.
 Wealth maximization decision criterion involves a
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comparison of value to cost.
 Projects that has a discounted value, exceeds its
  Such projects/actions/ increase the value of the
firm and should be accepted.
 The one with greater NPV chosen over the
others.
 In the wealth maximization, the emphasis is on
increasing value (market value of the organization)
and not necessarily profit.
 Stockholders wealth explained by increase in
market values of firms share and increase in
dividend per share.
Favorable Arguments for Wealth Maximization
 Is superior to profit maximization, improve the
value or wealth of the shareholders.
 Considers the comparison of the value to cost
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associated with business
 Considers both time and risk of business
Criticism on Wealth Maximization
 Objectives of wealth maximization may face
difficulties when ownership and management
are separated.
 Management alone enjoy certain benefits.
 Wealth maximization concept is useful for
equity shareholders and not debenture holders
and society.
 Ultimate aim of wealth maximization objectives
is to maximize profit.
 Wealth maximization activated only with the
help of profitable position of the business.
 So, we can say that profit maximization is a
subset of wealth.
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 Being a subset, it will facilitate wealth creation.
1.8. Functions of Finance Manager
 Finance manager is one of the important role
players in the field of finance function.
 Finance manager performs the following major
functions:
1. Forecasting and planning financial
requirements
2. Determining Capital Structure
3. Choice of sources of funds
4. Acquiring necessary funds
5. Investment/utilization of funds
6. Management of Cash
7. Disposal of Profits or Surplus
8. Financial control. 26
9. Interrelation with other Departments
End of Chapter – One

Thank You!!!

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