Special Topics in Financial Management

Module1 - Nature, Basic Concepts and Scope of Financial

Management

Week 1-3: Unit Learning Outcomes: At the end of the unit, you are expected to

a. Understand the nature, basic concepts and scope of financial management

and know the role of financial manager in managing the available financial
resources of a business.

Big Picture A in Focus: Understand the nature, basic concepts and scope of
financial management and know the role of financial manager in managing the
available financial resources of a business

The following are terms to be remembered as we go through in studying this unit.

Please refer to these definitions as supplement in case you will encounter difficulty in
understanding the basic concepts of financial management.

• Financial management- The art and science of managing a firm’s money so that it
can meet its goals.
• Cash flows- The inflow and outflow of cash for a firm.
• Return - The opportunity for profit.
• Risk - The potential for loss or the chance that an investment will not achieve the
expected level of return.
• Risk-return trade-off - A basic principle in finance that holds that the higher the risk,
the greater the return that is required.

The following are the special topics in financial management that may be useful
for you to understand deeply the nature, concepts and existing issues in relation to
financial management. Please note that you are not limited to exclusively refer to these
resources. Thus, you are expected to utilize other books, research articles and other
resources that are available in the university’s library e.g. ebrary, search.proquest.com
etc., and even online tutorial websites.
1. SCOPE AND ENVIRONMENT OF FINANCIAL MANAGEMENT

1.1 Overview of Financial Management and Importance of Financial Management

Cycle:

1.2 Finance is the lifeblood of business organization. It needs to meet the requirement of the
business concern. Each and every business concern must maintain adequate amount of
finance for their smooth running of the business concern and also maintain the business
carefully to achieve the goal of the business concern. The business goal can be achieved
only with the help of effective management of finance. We can’t neglect the importance of
finance at any time at and at any situation. Some of the importance of the financial
management is as follows:

1.2.1 Financial Planning. Financial management helps to determine the

financial requirement of the business concern and leads to take financial
planning of the concern. Financial planning is an important part of the
business concern, which helps to promotion of an enterprise
1.2.2 Acquisition of Funds.Financial management involves the acquisition of
required finance to the business concern. Acquiring needed funds play a
major part of the financial management, which involve possible source of
finance at minimum cost.
 1.2.3 Proper Use of Funds. Proper use and allocation of funds leads to
improve the operational efficiency of the business concern. When the
finance manager uses the funds properly, they can reduce the cost of
capital and increase the value of the firm.
1.2.4 Financial Decision. Financial management helps to take sound financial
decision in the business concern. Financial decision will affect the entire
business operation of the concern. Because there is a direct relationship
with various department functions such as marketing, production
personnel, etc.
1.2.5 Improve Profitability. Profitability of the concern purely depends on the
effectiveness and proper utilization of funds by the business concern.
Financial management helps to improve the profitability position of the
concern with the help of strong financial control devices such as budgetary
control, ratio analysis and cost volume profit analysis.
1.2.6 Increase the Value of the Firm. Financial management is very important
in the field of increasing the wealth of the investors and the business
concern. Ultimate aim of any business concern will achieve the maximum
profit and higher profitability leads to maximize the wealth of the investors
as well as the nation.
1.2.7 Promoting Savings. Savings are possible only when the business
concern earns higher profitability and maximizing wealth. Effective
financial management helps to promoting and mobilizing individual and
corporate savings.

Now days financial management is also popularly known as business finance or corporate
finances. The business concern or corporate sectors cannot function without the importance of the
financial management.

2 THE ROLE OF FINANCE AND THE FINANCIAL MANAGER

2.1 How do finance and the financial manager affect the firm’s overall strategy?
Any company, whether it’s a small-town bakery or General Motors, needs money to
operate. To make money, it must first spend money—on inventory and supplies,
equipment and facilities, and employee wages and salaries. Therefore, finance is critical
to the success of all companies. It may not be as visible as marketing or production, but
management of a firm’s finances is just as much a key to the firm’s success.
2.2 Financial management—the art and science of managing a firm’s money so that it can
meet its goals—is not just the responsibility of the finance department. All business
decisions have financial consequences. Managers in all departments must work closely
with financial personnel. If you are a sales representative, for example, the company’s
credit and collection policies will affect your ability to make sales. The head of the IT
department will need to justify any requests for new computer systems or employee
laptops.
2.3 Revenues from sales of the firm’s products should be the chief source of funding. But
money from sales doesn’t always come in when it’s needed to pay the bills. Financial
managers must track how money is flowing into and out of the firm (see (Figure)). They
 work with the firm’s other department managers to determine how available funds will be
used and how much money is needed. Then they choose the best sources to obtain the
required funding.
2.4 For example, a financial manager will track day-to-day operational data such as cash
collections and disbursements to ensure that the company has enough cash to meet its
obligations. Over a longer time horizon, the manager will thoroughly study whether and
when the company should open a new manufacturing facility. The manager will also
suggest the most appropriate way to finance the project, raise the funds, and then monitor
the project’s implementation and operation.
2.5 Financial management is closely related to accounting. In most firms, both areas are the
responsibility of the vice president of finance or CFO. But the accountant’s main function
is to collect and present financial data. Financial managers use financial statements and
other information prepared by accountants to make financial decisions. Financial
managers focus on cash flows, the inflows and outflows of cash. They plan and monitor
the firm’s cash flows to ensure that cash is available when needed.

3 THE FINANCIAL MANAGER’S RESPONSIBILITIES AND ACTIVITIES

3.1 Financial managers have a complex and challenging job. They analyze financial data
prepared by accountants, monitor the firm’s financial status, and prepare and implement
financial plans. One day they may be developing a better way to automate cash collections,
and the next they may be analyzing a proposed acquisition. The key activities of the financial
manager are:

• Financial planning: Preparing the financial plan, which projects revenues,

expenditures, and financing needs over a given period.
• Investment (spending money): Investing the firm’s funds in projects and securities
that provide high returns in relation to their risks.
• Financing (raising money): Obtaining funding for the firm’s operations and
investments and seeking the best balance between debt (borrowed funds) and equity
(funds raised through the sale of ownership in the business).

4 THE GOAL OF THE FINANCIAL MANAGER

4.1 How can financial managers make wise planning, investment, and financing
decisions? The main goal of the financial manager is to maximize the value of the firm to
its owners. The value of a publicly owned corporation is measured by the share price of
its stock. A private company’s value is the price at which it could be sold.
4.2 To maximize the firm’s value, the financial manager has to consider both short- and long-
term consequences of the firm’s actions. Maximizing profits is one approach, but it should
not be the only one. Such an approach favors making short-term gains over achieving
long-term goals. What if a firm in a highly technical and competitive industry did no
research and development? In the short run, profits would be high because research and
development is very expensive. But in the long run, the firm might lose its ability to
compete because of its lack of new products.
5 HOW CASH FLOWS THROUGH A BUSINESS

(Attribution: Copyright Rice University, OpenStax, under CC BY 4.0 license.)

5.1 This is true regardless of a company’s size or point in its life cycle. At Corning, a
company founded more than 160 years ago, management believes in taking the long-
term view and not managing for quarterly earnings to satisfy Wall Street’s expectations.
5.2 The company, once known to consumers mostly for kitchen products such as Corelle
dinnerware and Pyrex heat-resistant glass cookware, is today a technology company that
manufactures specialized glass and ceramic products. It is a leading supplier of Gorilla
Glass, a special type of glass used for the screens of mobile devices, including the
iPhone, the iPad, and devices powered by Google’s Android operating system. The
company was also the inventor of optical fiber and cable for the telecommunications
industry. These product lines require large investments during their long research and
development (R&D) cycles and for plant and equipment once they go into production.
5.3 This can be risky in the short term, but staying the course can pay off. In fact, Corning
recently announced plans to develop a separate company division for Gorilla Glass,
which now has more than 20 percent of the phone market—with over 200 million devices
sold. In addition, its fiber-optic cable business is back in vogue and thriving as cable
service providers such as Verizon have doubled down on upgrading the fiber-optic
network across the United States. As of 2017, Corning’s commitment to repurposing
some of its technologies and developing new products has helped the company’s bottom
line, increasing revenues in a recent quarter by more than 16 percent.
5.4 As the Corning situation demonstrates, financial managers constantly strive for a balance
between the opportunity for profit and the potential for loss. In finance, the opportunity for
profit is termed return; the potential for loss, or the chance that an investment will not
achieve the expected level of return, is risk.
5.5 A basic principle in finance is that the higher the risk, the greater the return that is
required. This widely accepted concept is called the risk-return trade-off. Financial
managers consider many risk and return factors when making investment and financing
decisions. Among them are changing patterns of market demand, interest rates, general
economic conditions, market conditions, and social issues (such as environmental effects
and equal employment opportunity policies).
 1. What is the role of financial management in a firm?
2. How do the three key activities of the financial manager relate?
3. What is the main goal of the financial manager? How does the risk-return trade-off
relate to the financial manager’s main goal?

6 EVALUATING FIRMS PERFORMANCE.

6.1 When evaluating a stock, investors are always searching for that one golden key
measurement that can be obtained by looking at a company's Financial Statements.
6.2 What Is the Best Measure of a Company's Financial Health? To accurately evaluate
the financial health and long-term sustainability of a company, a number of financial
metrics must be considered.
6.3 Four main areas of financial health that should be examined are liquidity, solvency,
profitability, and operating efficiency. However, of the four, likely the best
measurement of a company's health is the level of its profitability.
6.4 There are a number of financial ratios that can be reviewed to gauge a company's overall
financial health and to make a determination of the likelihood of the company continuing
as a viable business. Standalone numbers such as total debt or net profit are less
meaningful than financial ratios that connect and compare the various numbers on a
company's balance sheet or income statement. The general trend of financial ratios,
whether they are improving over time, is also an important consideration.
6.5 Liquidity.
6.5.1 Liquidity is a key factor in assessing a company's basic financial health.
The current ratio is sometimes referred to as the “working capital” ratio
and helps investors understand more about a company’s ability to cover
its short-term debt with its current assets.
6.5.2 The two most common metrics used to measure liquidity are the current
ratio and the quick ratio. Of these two, the quick ratio, also sometimes
referred to as the acid test, is the more precise measure. This is because,
in dividing current assets by current liabilities, it excludes inventory from
assets and excludes the current part of long-term debt from liabilities.
Thus, it provides a more realistically practical indication of a company's
ability to manage short-term obligations with cash and assets on hand. A
quick ratio lower than 1.0 is a danger signal, as it indicates current
liabilities exceed current assets.
6.5.3 The current ratio is a liquidity ratio that measures a company's ability to
pay short-term obligations or those due within one year. It tells investors
and analysts how a company can maximize the current assets on its
balance sheet to satisfy its current debt and other payables.
6.5.4 The current ratio compares all of a company’s current assets to its current
liabilities. These are usually defined as assets that are cash or will be
turned into cash in a year or less, and liabilities that will be paid in a year
or less.
 6.5.5 Weaknesses of the current ratio include the difficulty of comparing the
measure across industry groups, overgeneralization of the specific asset
and liability balances, and the lack of trending information.
6.5.6 The formula:

Current Ratio=Current liabilities

Current assets

6.5.7 A current ratio that is in line with the industry average or slightly higher is
generally considered acceptable. A current ratio that is lower than the
industry average may indicate a higher risk of distress or default. Similarly,
if a company has a very high current ratio compared to their peer group, it
indicates that management may not be using their assets efficiently.
6.5.8 A company may have a very high current ratio, but its accounts receivable
may be very aged, perhaps because its customers pay very slowly, which
may be hidden in the current ratio. Analysts must also consider the quality
of a company’s other assets versus its obligations as well. If the inventory
is unable to be sold, the current ratio may still look acceptable at one point
in time, but the company may be headed for default.
6.5.9 Illustration:
The current ratio for three companies—Apple (AAPL), Walt Disney (DIS), and
Costco Wholesale (COST)—is calculated as follows for the fiscal year ended
2017:

Company Current Current Current Ration

Assets Liabilities
Apple Inc. $128.65 $100.88 128.65/110.81 =
billion billion 1.28

Walt $15.89 billion 19.6 billion 15.89/19.6 = 0.81

Disney Co.
Costco $17.32 billion 17.5 billion 17.32/17.5 = .0.98
Wholesale

6.5.10 For every $1 of current debt, COST had $.98 cents available to pay for the
debt at the time this snapshot was taken. Likewise, Disney had $.81 cents
in current assets for each dollar of current debt. Apple had more than
enough to cover its current liabilities if they were all theoretically due
immediately and all current assets could be turned into cash.

6.6 Solvency.
6.6.1 Closely related to liquidity is the concept of solvency, a company's ability
to meet its debt obligations on an ongoing basis, not just over the short
term. Solvency ratios calculate a company's long-term debt in relation to
its assets or equity.
 6.6.2 The debt-to-equity (D/E) ratio is generally a solid indicator of a
company's long-term sustainability because it provides a measurement of
debt against stockholders' equity, and it is therefore also a measure of
investor interest and confidence in a company. A lower D/E ratio means
more of a company's operations are being financed by shareholders
rather than by creditors. This is a plus for a company since shareholders
do not charge interest on the financing they provide.
6.6.3 D/E ratios vary widely between industries, but regardless of the specific
nature of a business, a downward trend over time in the D/E ratio is a
good indicator a company is on increasingly solid financial ground.
6.6.4 The debt-to-equity (D/E) ratio is calculated by dividing a company’s total
liabilities by its shareholder equity. These numbers are available on the
balance sheet of a company’s financial statements.
6.6.5 The ratio is used to evaluate a company’s financial leverage . The D/E
ratio is an important metric used in corporate finance. It is a measure of
the degree to which a company is financing its operations through debt
versus wholly-owned funds. More specifically, it reflects the ability of
shareholder equity to cover all outstanding debts in the event of a
business downturn.
6.6.6 D/E Ratio Formula and Calculation:

Debt /Equity = Total Liabilities

Total Shareholder’s Equity

6.6.7 The information needed for the D/E ratio is on a company's balance sheet
. The balance sheet requires total shareholder equity to equal assets
minus liabilities, which is a rearranged version of the balance sheet
equation:

Assets=Liabilities Shareholder Equity

6.7 Operating Efficiency.

6.7.1 A company's operating efficiency is key to its financial success. Its
operating margin is the best indicator of its operating efficiency. This
metric indicates not only a company's basic operational profit margin after
deducting the variable costs of producing and marketing the company's
products or services, but it also provides an indication of how well the
company's management controls costs.
6.7.2 Good management is essential to a company's long-term sustainability.
Good management can overcome an array of temporary problems, while
bad management can lead to the collapse of even the most promising
business.
6.7.3 Financial ratios can be used to assess a company's overall health;
standalone numbers are less useful than those that compare and contrast
specific numbers on a company's balance sheet, such as the price-to-
earnings (P/E) or debt-to-equity (D/E) ratios.
6.7.4 Operating margin measures how much profit a company makes on a
dollar of sales after paying for variable costs of production, such as wages
and raw materials, but before paying interest or tax. It is calculated by
dividing a company’s operating income by its net sales.
6.7.5 A company’s operating margin, also known as return on sales ,is a good
indicator of how well it is being managed and how risky it is. It shows the
proportion of revenues that are available to cover non-operating costs, like
paying interest, which is why investors and lenders pay close attention to
it.
6.7.6 Highly variable operating margins are a prime indicator of business risk.
By the same token, looking at a company’s past operating margins is a
good way to gauge whether a company's performance has been getting
better. Operating margin can improve through better management
controls, more efficient use of resources, improved pricing, and more
effective marketing.
6.7.7 In its essence, operating margin is how much profit a company makes
from its core business in relation to its total revenues. This allows
investors to see if a company is generating income primarily from its core
operations or from other means, such as investing.
6.7.8 Example:
General Motors (GM) was a prime example of this. In the 1980s and 1990s,
GM was making the bulk of its profits from financing cars as opposed to making
and selling actual cars, its core operations. Therefore, its operating margins
were very low. Since then, its automotive business generates more income
than its financing business.

The formula for operating margin is:

Operating Margin = Operating Earnings

Revenue

6.7.9 When calculating operating margin, operating earnings is the same as

earnings before interest and taxes (EBIT). EBIT, or operating earnings, is
revenue minus cost of goods sold and the regular selling, general, and
administrative costs of running a business, excluding interest and taxes.

6.7.10 For example, if a company had the following:

• Revenues of $2 Million,
• Cost of Goods Sold of $700,000,
• Administrative Expenses of $500,000
• Operating Earnings would be $2 million - ($700,000 + $500,000) =
$800,000.
• Its Operating Margin would then be is:
$800,000 / $2 Million = 40%.
 Operating Margin = P800,000 = 40%
P2,000.000

6.7.11 If the company was able to negotiate better prices with its suppliers,
reducing its cost of goods sold to $500,000, then it would see an
improvement in its operating margin to 50%.

6.8 Profitability.
While liquidity, basic solvency, and operating efficiency are all important factors
to consider in evaluating a company, the bottom line remains a company's bottom line:
its net profitability. Companies can indeed survive for years without being profitable,
operating on the goodwill of creditors and investors, but to survive in the long run, a
company must eventually attain and maintain profitability.

6.8.1 Net Profit Margin. The best metric for evaluating profitability is net margin
,the ratio of profits to total revenues.
• The net profit margin is equal to how much net income or profit is
generated as a percentage of revenue.
• Net profit margin is the ratio of net profits to revenues for a company or
business segment.
• Net profit margin is typically expressed as a percentage but can also be
represented in decimal form.
• Net profit margin helps investors assess if a company's management is
generating enough profit from its sales and whether operating costs and
overhead costs are being contained.
• Net profit margin is one of the most important indicators of a company's
financial health. A larger net margin, especially as compared to industry
peers, means a greater margin of financial safety, and also indicates a
company is in a better financial position to commit capital to growth and
expansion.

6.8.2 Formulas and Calculation for Net Profit Margin

Net profit Margin = R−COGS−E−I−T * 100

R

Net income * 100

Where:

R = Revenue

COGS – The cost of goods Sold

 E= Operating and other expenses

I= interest

T = Tax

Steps:

1. On the income statement, subtract the cost of goods sold, operating

expenses, other expenses, interest (on debt), and taxes from revenue.
2. Divide the result by revenue.
3. Convert the figure to a percentage by multiplying it by 100.
4. Alternatively, locate net income from the bottom line of the income
statement and divide the figure by revenue. Convert the figure to a
percentage by multiplying it by 100.

6.9 The Bottom Line.

No single metric can identify the overall financial and operational health of a
company. Liquidity will tell you about a firm's ability to ride out short-term rough
patches and solvency tells you about how readily it can cover longer-term debt and
obligations. Efficiency and profitability say something about its ability to convert inputs
into cash flows and net income. All of these factors together, however, are necessary
to get a complete and holistic view of a company's stability.

Self-Help: You can also refer to the sources below to help you
further understand the lesson
Juneja, P. (2020). Financial management – meaning, objectives and functions. Retrieved
October 2, 2020 at the Financial Study Guide Journal

Pfaff, P. (2015). Mini case:Fin 07, Business Ethics Program. Retrieved October 2, 2020
at 1992 Arthur Anderson & Co, SC.

Tennent, J. & The Economist (2014). The economist guide to financial management:
principles and practice (economist books)