Lesson 1

An Introduction to Financial Management

Nature of Financial Management

Financial Management is a decision-making process concerned with planning, acquiring and

utilizing funds in a manner that achieves the firm’s desired goals. In a business context, it is
described as the process for and the analysis of making financial decisions. Financial management is
just part of larger discipline which is finance. Finance is a body of facts, principles, and theories
relating to raising and using money by individuals, businesses, and governments.

The goals of financial management is to maximize the current value per share of the existing stock
or ownership in a business firm.

Scope of Financial Management

Financial manager acquires funds needed by the firm and investing those funds in profitable
ventures that will maximize the firm’s wealth, as well as, generating returns to the business concern
is its basic responsibility.

Traditional approach:
1. Procurement of short-term as well as long-term funds from financial institutions.
2. Mobilization of funds through financial instruments such as equity shares, preference
shares, debentures, bonds, notes, and so forth.
3. Compliance with legal and regulatory provisions relating to funds procurement, use and
distribution as well as coordination of the finance function with the accounting function.

Modern approach:
Finance manager is expected to analyze the business firm and determine the following:
1. The total funds requirements of the firm;
2. The assets or resources to be acquired; and
3. The best pattern of financing the assets.

Types of financial decisions

Three major types of decisions that the Finance Manager of a modern business firm will be involved
in are:
1. Investment decisions
2. Financing decisions
3. Dividend decisions

Investment decisions
It involves determining how scare or limited resources in terms of funds of the business firms are
committed to projects. The firm should select only those capital investment proposals whose net
present value is positive and the rate of return exceeding the marginal cost of capital. In investment
decision, the firm should also consider the profitability of each individual project proposal that will
contribute to the overall profitability of the firm and lead to the creation of wealth.

Financing decisions
It involves decision that mix of debt and equity chosen to finance investment that will maximize the
value of investments made.
In deciding which financing is chosen, the firm should consider the cost of finance available in
different forms and the risks attached to it. It involves the consider when selecting the debt-equity
mix or capital structure decision. If the cost of capital of each component is reduced, the overall
weighted average cost of capital and minimization of risks in financing will lead to the profitability
of the organization and create wealth to the owner.

Dividend decisions
It is concerned with the determination of quantum of profits to be distributed to the owners, the
frequency of such payments and the amounts to be retained by the firm.

Relationship Between Financial Management, Accounting and Economics

Financial management vs accounting

Financial management is a separate management area. In many organization, accounting and
finance functions are intertwined and the finance functions often considered as part of the
functions of the accountant. Accounting function discharges the function of systematic recording of
transactions relating to the firm’s activities in the books of accounts and summarizing the same for
presentation in the financial statements. Whereas finance manager, will make use of accounting
information in the analysis and review of the firm’s business position in decision making.
Additionally, finance manager uses the other methods and techniques like capital budgeting
techniques, statistical and mathematical models, and computer applications in decision making to
maximize the value fot he firm’s wealth and value of the owner’s wealth.

Financial management vs economics

Financial managers can make better decisions if they apply this basic economic principle. For
example, economic theory teaches us to seek the best allocation of resources. To this end, financial
manages are given the responsibility to find the best and least expensive sources of funds and to
invest these funds into the best and most efficient mix of assets. Good financial management has a
sound grasp of the way economic and financial principles impact the profitability of the firm.

The finance manager must be familiar with the microeconomic and macroeconomic environment
aspects of business. financial managers do a better job when they understand how to respond
effectively to changes in supply, demand, and prices (micro factors) as well as to more general and
overall economic factors (macro factors).

Microeconomics delas with the economic decisions of individuals and firms. It focuses on the
optimal operating strategies based on the economic data of individual and firms.

Macroeconomics looks at the economy as a whole in which a particular business concern is

operating. Macroeconomics provides insight into policies by which economic activity is controlled.
Review Questions:
1. What is the purpose of financial management?
2. What is the difference between finance and accounting?
3. Explain the shareholder wealth maximization goal of the firm and how it can be measured.
4. What are the three types of financial management decisions?
5. What are some of the micro and macro-economics factors that influence the decisions of a
firm?

Financial Objectives and Organizational Strategies

Objective setting is an important phase in the business enterprise since upon correct objectives
setting will the entire structure of the strategies, policies and plans of a company rest.

Strategic Financial Management

Is long-range in scope and has its focus on the organization as a whole. The concept is based on an
objective and comprehensive assessment of the present situation of the organization and the setting
up of targets to be achieved in the context of an intelligent and knowledgeable anticipation of
changes in the environment. This involves financial planning, financial forecasting, provision of
finance and formulation of finance policies which should lead the firm’s survival and success.

Strategic financial planning should help the firm wisely allocate funds, build on strengths, address
weaknesses, spot changes in the environment early, respond to competitors, lower financing costs,
use resources efficiently, estimate funding needs on time, and identify business and financial risks,
among other things.

A company's strategic or business plan shows how it aims to reach its goals. Success relies on
properly analyzing market demand and supply. The company needs to evaluate the demand for its
products and services and the availability of its resources. The plan should also consider
competition, identify opportunities, and account for potential risks.

Short and Medium-Term

 Maximization of return on capital employed or return on investment
 Growth in earnings per share and price/earnings ratio through maximization of net income
or profit and adoption of optimum level of leverage
 Minimization of finance charges
 Efficient procurement and utilization of short-term, medium-term, and long-term funds

Long-Term
 Growth in the market value of the equity shares through maximization of the firm’s market
share and sustained growth in dividend to shareholders
 Survival and sustained growth of the firm.

Responsibilities to achieve the financial objectives

Investing
The finance manager is responsible for determining how scarce resources or funds are committed
to projects. The investing function deals with managing the firm’s assets. Because the firm has
numerous alternative uses of funds, the financial manager strives to allocate funds wisely within the
firm. This task requires both the mix and type of assets to hold. The asset mix refers to the amount
of peso invested in current and fixed assets.
The investment decisions should aim at investments in assets only when they are expected to earn a
return greater than a minimum acceptable return which is also called a hurdle rate. This minimum
return should consider whether the money raised from debt or equity meets the returns on
investment made elsewhere on similar investments.

Example:
 Evaluation and selection of capital investment proposal
 Asset replacement decisions
 Purchase or lease decisions

Financing
The finance manager is concerned with the ways in which the firm obtains and manages the
financing it needs to support its investment. The financing objective assets that the mix of debt and
equity chosen to finance investment should maximize the value of investments made. Financing
decisions call for good knowledge of costs of raising funds, procedures in hedging risk, different
financial instruments and obligation attached to them.

Example:
 Determination of the best capital structure or mixture of debt and equity financing
 Arrangement with bankers, suppliers, and creditors for its working capital, medium-term
and other long-term funds requirement.

Operating
Finance manager concerns working capital management. The term working capital refers to a firm
short-term asset (inventory, receivables, cash, and short-term investments) and its short-term
liabilities (accounts payable, short-term loans). Managing the firm’s working capital is a day-to-day
responsibility that ensures that the firm has sufficient resources to continue its operations and
avoid costly interruptions.

Example:
 The level of cash, securities and inventory that should be kept on hand
 Source of short-term financing
 The credit policy

Functions of Financial Management

Role of finance manager:

The financial management function is usually associated with a top officer of the firms such as a
Vice President of Finance or some other Chief Financial Officer (CFO). The Vice President of finance
coordinates the activities of the treasurer and the controller. The Controller’s office handles cost and
financial accounting, tax payments, and management information systems. The Treasurer’s office is
responsible for managing the firm’s cash and credit, its financial planning, and its capital
expenditures.

Corporate Governance is the process of monitoring managers and aligning their incentives with
shareholders goals.

Ethical Behavior
Ethics are of primary importance in any practice of finance. Finance professionals commonly
manage other people’s money.