CHAPTER ONE:

FUNDAMENTALS OF
FM
Dr. Md. Saiful Alam FCMA
Associate Professor
Department of Accounting & Information Systems
University of Dhaka
s.alam@du.ac.bd
FINANCE

 Finance is the life-blood of business.

 Without finance neither any business can be started nor successfully run .

 Finance is needed to
 promote or establish business,
 acquire fixed assets,
 make necessary investigations,
 develop product,
 keep man and machines at work ,
 encourage management to make progress and
 create values.
FINANCIAL MANAGEMENT

 Financial management is one the functional area of management.

 It refers to that part of the management activity which is concerned with the planning

and controlling of firms financial resources.

DEFINITION

 “Financial management is the application of planning and control function of the

finance function” Howard and Upton
NATURE AND SCOPE OF FINANCIAL MANAGEMENT

 The nature of financial decisions would be clear when we try to understand the

operation of a firm.

 At the very outset, the promoters makes an appraisal of various investment proposals

and selects one or more of them ,depending upon the net benefits derived from each

as well as on the availability of funds.

PROCESS INVOLVE IN FINANCIAL DECISION

 1. Selection of investment proposals ,known as the investment decision.

 2. Determination of working capital requirements, known as the working capital

decision.

 3. Raising of funds to finance the assets, known as the financing decision.

 4. Allocation of profit for dividend payment, known as the dividend decision.

Accounting is the language of business

 Finance uses accounting information together with other information to make decisions

that affect the market value of the firm.

 There are three/four primary decision areas that are of concern (if we consider working capital finance

decision separately, then it is four) .

 What is Finance Anyway?

Three decision areas in finance:

 Investment decisions - What assets should the company hold? This determines the left-

hand side of the balance sheet. these decision are concerned with the effective utilization

of funds in one activity or the other. The investment decision can be classified under two

groups-

 (i) Long term investment decision

 (ii) Short term investment decision

 The former are referred to as the capital budgeting and the latter as the capital budgeting

and the latter as working capital management.

Financing decision

 Financing decisions - How should the company pay for the investments it makes?

 This determines the right-hand side of the balance sheet. it is also known as capital structure decision.

 It involves the choosing the best source of raising funds and deciding optimal mix of various source of

finance.

 A company can not depend upon only one source of finance ,hence a varied financial structure is developed.

 But before using any particular source of capital ,its relative cost of capital ,degree of risk and control etc.

should be thoroughly examined by the financial manager.

 The major source of long-term capital as shares and debentures.

DIVIDEND DECISION

 Dividend decisions - What should be done with the profits of the business?

 The dividend decision is concerned with determining how much part of the earning

should be distributed among the share holders by way of dividend and how much

should be retained in the business for meeting the future needs of funds internally.
Factors Affecting Financing Decision

 These factors are divided into two parts-

 1.Micro economic factor

 2.Macro economic factor

 Micro economic factor- micro economic factor is related to the internal condition of the firm- (a) Nature

and size of the firm (b) Level of risk and stability in earnings (c) Liquidity position (d) Asset structure

and pattern of ownership (e) Attitude of the management

 Macro economic factor These are the Environmental factor- 1. The state of the economy 2.

Governmental policy
Goal of the Firm

 All management decisions should help to accomplish the goal of the firm!
 What should be the goal of the firm?
Objectives of financial management

 The objective of financial management are considered usually at two levels –at macro

level and micro level.

 Three primary objectives are commonly explained as the Objective of financial

management-

• Maximization of profits • Maximization of return • Maximization of wealth

Maximization of profits

 Profit earning is the main aim of every economic activity.

 Profit maximization simply means maximizing the income of the firm .

 Economist are of the view that profits can be maximized when the difference of total

revenue over total cost is maximum, or in other words total revenue is greater than the

total cost.
Maximization of return

 Some authorities on financial management conclude that maximization of return

provide a basic guideline by which financial decision should be evaluated .

Maximization of wealth

 The ultimate goal of financial management should be the maximization of the owners

wealth.

 The value of corporate wealth may be interpreted in terms of the value of the

company’s total assets.

 The finance should attempt to maximize the value of the enterprise to its shareholders.

 Value is represented by the market price of the company’s common stock.

What about risk? Isn’t risk important as well as profits?

 How would the stockholders of a small business react if they were told that their

manager canceled all casualty and liability insurance policies so that the money spent

on premiums could go to profit instead.

 Even though the expected profits increased by this action, it is likely that stockholders

would be dissatisfied because of the increased risk they would bear.

The common stockholders are the owners of the corporation!

 Stockholders elect a board of directors who in turn hire managers to maximize the

stockholders’ well being.

 When stockholders perceive that management is not doing this, they might attempt to

remove and replace the management, but this can be very difficult in a large

corporation with many stockholders.

Contd…

 More likely, when stockholders are dissatisfied they will simply sell their stock shares. This action

by stockholders will cause the market price of the company’s stock to fall.

 When stock price falls relative to the rest of the market (or relative to the rest of the industry) ...

Management is failing in their job to increase the welfare (or wealth) of the stockholders (the owners).

 Conversely, when stock price is rising relative to the rest of the market (or industry), ...

Management is accomplishing their goal of increasing the welfare (or wealth) of the stockholders (the

owners).
The goal of the firm should be to maximize the stock price!

 This is equivalent to saying the goal is to maximize owners’ wealth.

 Note that the stock price is affected by management’s decisions affecting both risk and

profit.

 Stock price can be maintained or increased only when stockholders perceive that they

are receiving profits that fully compensate them for bearing the risk they perceive.
Some Important Trends

 Three important trends should be noted.

 First, numerous corporate fraud and misdeeds led to profound changes in business practices.
Executives at Enron, WorldCom, and other companies lied when they reported financial results, leading
to huge stockholder losses. These companies’ CEOs later claimed not to have been aware of what was
happening.

 A second trend is the increased globalization of business. Developments in communications technology

have made it possible for firms like Wal-Mart to obtain real-time data on sales of hundreds of thousands
of items in stores from China to Chicago, and to manage those stores from Bentonville, Arkansas.

 A third trend that’s having a profound effect on financial management is ever-improving information
technology (IT). These improvements are spurring globalization, and they are also changing financial
management.
Important focal points in the study of finance

 Accounting and Finance often focus on different things

 Finance is more focused on market values rather than book values.

 Finance is more focused on cash flows rather than accounting income.

Why is market value more important than book value?

 Book values are often based on dated values. They consist of the original cost of the

asset from some past time, minus accumulated depreciation (which may not represent

the actual decline in the assets’ value).

 Maximization of market value of the stockholders’ shares is the goal of the firm.
Why is cash flow more important than accounting income?

 Cash flow to stockholders (in the form of dividends) is the only basis for valuation of the common

stock shares. Since the goal is to maximize stock price, cash flow is more directly related than

accounting income.

 Accounting methods recognize income at times other than when cash is actually received or spent.

 When cash is actually received is important, because it determines when cash can be invested to

earn a return. [Also: When cash must be paid determines when we need to start paying interest on

money borrowed.]
Examples of when accounting income is different from
cash flow

 Credit sales are recognized as accounting income, yet cash has not been received.

 Depreciation expense is a legitimate accounting expense when calculating income, yet depreciation

expense is not a cash outlay.

 A loan brings cash into a business, but is not income.

 When new capital equipment is purchased, the entire cost is a cash outflow, but only the depreciation

expense (a portion of the total cost) is an expense when computing accounting income.

 When dividends are paid, cash is paid out, though dividends are not included in the calculation of accounting

income.
Definitions: Operating income vs. operating cash flow

 Operating income = earnings before interest and taxes (EBIT).

 This is the total income that the company earned by operating during the period.

 It is income available to pay interest to creditors, taxes to the government, and dividends to

stockholders.

 Operating cash flow = EBIT + Depreciation - Taxes.

 This definition recognizes that depreciation expense is subtracted in computing EBIT, though it is not a

cash outlay.

 It also recognizes that taxes paid is a cash outlay.