OVERVIEW

This learning material covers the topics as contained in the course syllabus for AEC6 and IS521 –
Financial Management

This module has four (4) general topics:

1. Introduction to Financial Management

2. Financial Markets and Institutions
3. Understanding Financial Statements
4. Management of Working Capital

LEARNING OBJECTIVES:

At the end of these chapters, the students shall be able to:

1. Understand the nature and scope of financial management.

2. Differentiate between financial management, management accounting and financial
management.
3. Understand the importance of objectives in an organization.
4. Identify and differentiate the different decisions in finance.
5. Identify the roles and responsibilities of key personnel in an organization.
6. Identify the different kinds of financial markets.
7. Identify the different financial institutions.
8. Explain how the institutions enhance capital allocation.
9. Understand how stock markets operate.
10. Identify and understand the purpose of financial statements.
11. Identify users of financial information.
12. Explain the implication and use of basic financial ratios.
13. Understand the importance and limitations of financial statements analysis.
14. Identify the assumptions used in CVP Analysis.
15. Understand the nature and scope of working capital and the importance of its effective
management.
16. Identify the components of working capital.
17. Solve problems involving management of working capital.

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 1 INTRODUCTION TO
FINANCIAL
MANAGEMENT
Financial management is about preparing, directing and managing the money activities of a company
such as buying, selling and using money to its best results to maximize wealth or produce best value of
money. Basically, it means applying general management concepts to the cash of the company.

Taking a commercial business as the most common organizational structure, the key objectives of
financial management would be to create wealth for the business, generate cash and provide an
adequate return on investment bearing in mind the risks that the business is taking, and the resources
invested.

Personal finance deals with an individual’s decisions concerning the spending and investing of income.
It includes the answers as to how much of their earnings should they spend, how much should they
save, and how should they invest their savings.

Business finance involves same type of decisions focusing on how the firms raise money from
investors, how to invest money to earn a profit, and how to reinvest profits in the business or
distribute them back to investors.

Financial management refers to the application of general management principles to the various
financial resources. This encompasses planning, organizing, directing and controlling of the financial
activities. Financial planning is process of framing objectives, policies, procedures, programs and
budgets regarding the financial activities. This ensures effective and adequate financial and investment
policies, adequate funds have to be ensured, ensuring a reasonable balance between outflow and
inflow of funds, ensuring suppliers of funds, preparation of growth and expansion programs which
helps in long-run survival of the company, reduction of uncertainties with regards to changing market
trends which the company could be faced with, ensuring stability and profitability.

THE NATURE, GOAL AND SCOPE OF

FINANCIAL MANAGEMENT

Nature of Financial Management

Financial management, also referred to as managerial finance, corporate finance, and business
finance, is a decision-making process concerned with planning, acquiring and utilizing funds in a
manner that achieves the firm’s desired goals. It is also described as the process for and the analysis of
making financial decisions in the business context.

Financial management is part of a larger discipline called FINANCE which is a body of facts, principles,
and theories relating to raising and using money by individuals, businesses, and governments.

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This concerns both financial management of profit-oriented business organizations particularly the
corporate form of business, as well as, concepts and techniques that are applicable to individuals and
to governments.

The Goal of Financial Management

Assuming that we confine ourselves to for-profit businesses, the goal of financial management is to
make money and add value for the owners. This goal, however, is a little vague and a more precise
definition is needed in order to have an objective basis for making and evaluating financial decisions.

The financial manager in a business enterprise must make decision for the owners of the firm. He must
act in the owners’ or stakeholders’ best interest by making decisions that increase the value of the
firm or the value of the stock.

The goal of financial management is to maximize the

current value per share of the existing stock or ownership in
a business firm.

The stated goal considers the fact that the shareholders in a firm are the residual owners. By this, we
mean that they are entitled only to what is left after employees, suppliers, creditors and anyone else
with a legitimate claim are paid their due. If any of these groups go unpaid, the shareholders or
owners get nothing. So, if the shareholders are benefiting in the sense that the residual portion is
growing, it must be true that everyone else is being benefited too.

Because the goal of financial management is to maximize the value of the share(s), there is a need to
learn how to identify investments, arrangements and distribute satisfactory amount of dividends or
share in the profits that favorable impact the value of the share(s).

Finally, our goal does not imply that the financial manager should take illegal or unethical actions in
the hope of increasing the value of the equity in the firm. The financial manager should best serve the
owners of the business by identifying goods and services that add value to the firm because they are
desired and valued in the free market place.

Scope of Financial Management

The basic responsibility of the Finance Manager is to acquire 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.

Briefly, the traditional view of financial management looks into the following:

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.

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In view of 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.
3. The best pattern of financing the assets.

Financial management has a wide scope. It includes the following five A’s:

1. Anticipation. The financial needs of the company are being estimated. That is, it finds out how
much finance is required by the company.
2. Acquisition. It collects finance for the company from different sources.
3. Allocation. It uses this collected or acquired finance to purchase fixed and current assets for
the company.
4. Appropriation. It distributes part of the company profits among shareholders, debenture
holders, and some are kept as reserves.
5. Assessment. It also means controlling all the financial activities of the company. It checks if the
objectives are met. If not, it determines what can be done about it.

THE RELATIONSHIP OF FINANCIAL MANAGEMENT

TO ACCOUNTING AND ECONOMICS

Financial Management and Accounting

Financial management is a separate management area. In many organizations, accounting and finance
functions are intertwined and the finance function is often considered as part of the functions of the
accountant. Financial management is however, something more than an art of accounting and
bookkeeping. 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 such as the Statement of Comprehensive Income, Statement of Financial
Position, Statement of Changes in Shareholders’ Equity and Cash Flow Statement.

Financial statements help managers to make business decisions involving the best use of cash, the
attainment of efficient operations, the optimal allocation of funds among assets, and the effective
financing of investment and operations.

The finance manager will make use of the accounting information in the analysis and review of the
firm’s business position in decision making. In addition to the analysis of financial information
available from the books of accounts and records of the firm, a 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 of the firm’s wealth and value of the
owner’s wealth.

In view of the above, finance function is considered a distinct and separate function rather than simply
an extension of accounting function.

Financial management is the key function and many firms prefer to centralized the function to keep
constant control on the finances of the firm.

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Any inefficiency in financial management will be concluded with a disastrous situation. But, as far as
the routine matters are concerned, the finance function could be decentralized with adoption of
responsibility accounting concept. It is advantageous to decentralize accounting function to speedup
the processing of information. But since the accounting information is used in making financial
decisions, proper controls should be exercised in processing accurate and reliable information to the
needs of the firm. The centralization or decentralization of accounting and finance functions mainly
depends on the attitude of the top-level management.

Financial Management and Economics

Financial managers can make better decisions if they apply these basic economic principles. For
example, economic theory teaches to seek the best allocation of resources. To this end, financial
managers 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. In doing so, they try to find the mix of
available resources that will achieve the highest return at the least risk within the confines of an
expected change in the economic climate. Good financial management has a sound grasp of the way
economic and financial principles impact the profitability of the firm.

Financial managers do a better job when they understand how to respond effectively to changes in
supply, demand, and prices (firm-related micro factors), as well as to more general and overall
economic factors (macro factors). Learning to deal with these factors provides important tools for
effective financial planning.

The finance manager must be familiar with the microeconomic and macroeconomic environment
aspects of business.

When making investment decisions, financial managers consider the effects of changing supply,
demand, and price conditions on the firm’s performance. Understanding the nature of these factors
helps managers make the most advantageous operating decisions.

The sale of products at a profit depends heavily on how well managers are able to analyze and
interpret supply and demand conditions. Supply considerations relate specifically to the control of
production costs, where the key element is to hold costs down so that prices can be set at competitive
levels. The best machinery must be bought; and the most qualified product workers available must be
hired. The goal is to squeeze out the biggest possible profit under given supply conditions. Maintaining
a low-cost operation will enable the firm to charge competitive prices for its products and maintain its
market share while still obtaining a reasonable return.

Knowledge of economic principles can be useful in generating the highest sales possible.
Understanding and appropriately responding to changes in demand allows financial managers to take
full advantage of market conditions. To accomplish this, the best managers develop and adopt
reliable, workable statistical techniques that forecast demand and pinpoint when directional changes
in sales take place.

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

Macroeconomics looks at the economy as a whole in which a particular business concern is operating.
Macroeconomics provides insights into policies by which economic activity is controlled. The success
of

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business firm is influenced by the overall performance of the economy and is depended upon the
money and capital markets.

ORGANIZATIONAL STRATEGY

Shareholders delegate the task of running a firm to a financial manager who acts an agent of the
company. Obviously, the goal is to achieve the highest value of an equity share for the firm’s owners.
But there are no standard rules that indicate which course of action should be followed by managers
to achieve this. The ultimate guideline is how investors perceive the actions of managers.

Finance permeates the entire business organization by providing guidance for the firm’s strategic
(long-term) and day-to-day decisions. For long range planning and management control, a business
firm establishes its overall objectives. Such objectives are developed by the top management and they
usually consist of general statement or a series of statements in general terms stating what the
company expects to achieve.

Objective setting is thus an important phase in the business enterprise since upon correct objective
setting will the entire structure of the strategies, policies and plans of a company rest. Firms have
numerous goals but not every goal can be attained without causing conflict in reaching other goals.
Conflicts often arise because of the firm’s many constituents including shareholders, managers,
employees, labor unions, customers, creditors and suppliers. There are those who claim that the firm’s
goal is to maximize sales or market share, others believe the role of business is to provide quality
products and services, still others feel that the firm has a responsibility for the welfare of society at
large.

For example, the objective may be stated in such broad terms as:

 It is the goal of the company to be a leader in technology in the industry, or

 To achieve profits through a high-level manufacturing efficiency, or
 To achieve a high degree of customer satisfaction.

For the purpose though of measuring performance and degree of control, it is necessary to set
objectives or goal in more precise terms. The objectives are usually in quantitative terms and are set
within a time frame. The setting of physical targets to be accomplished within a set time period would
provide the basis of conversion of the targets into financial objectives.

Strategic Financial Management

Strategic planning 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.

The strategic financial planning involves financial planning, financial forecasting, provision of finance
and formulation of finance policies which should lead the firm’s survival and success.

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The responsibility of a finance manager is to provide a basis and information for strategic positioning
of the firm in the industry. The firm’s strategic financial planning should be able to meet the
challenges and competition, and it would lead to firm’s failure or success.

The strategic financial planning should enable the firm to judicious allocation of funds, capitalization of
relative strengths, mitigation of weaknesses, early identification of shifts in environment, counter
possible actions of competitor, reduction in financing costs, effective use of funds deployed, timely
estimation of funds requirement, identification of business and financial risk, and so forth.

The strategic planning should concentrate on multidimensional objectives like profitability, expansion
growth, survival, leadership, business success, positioning of the firm, reaching global markets and
brand positioning. The financial policy requires the deployment of firm’s resources for achieving the
corporate strategic objectives. The financial policy should align with the company’s strategic planning.
It allows the firm in overcoming its weaknesses, enables the firm to maximize the utilization of its
competencies and to direct the prospective business opportunities and threats to its advantage.
Therefore, the finance manager should take the investment and finance decisions in consonance with
the corporate strategy.

Once strategic adjustments are planned and implemented, the resulting financial statements provide
input into the planning process for the following year, and this process begins again. Understanding a
company’s strategic plan helps focus our analysis of the company’s short-term and long-term financial
objectives by placing them in proper context.

FINANCIAL OBJECTIVES

Among the primary financial objectives of a firm are the following:

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

There have been a number of different, well-developed viewpoints concerning what the primary
financial objectives of the business firm should be. The competing viewpoints are:

 The owner’s perspective which holds that the only appropriate goal is to maximize
shareholder or owner’s wealth, and

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  The stakeholders’ perspective which emphasizes social responsibility over profitability
(stakeholders include not only the owners and shareholders, but also include the business
customers, employees and local commitments).

The wealth maximization goal is advocated on the following grounds:

 It considers the risk and time value of money

 It considers all future cash flow, dividends and earnings per share
 It suggests the regular and consistent dividend payments to the shareholders
 The financial decisions are taken with a view to improve the capital appreciation of the share
price
 Maximization of firm’s value is reflected in the market price of share since it depends on
shareholder’s expectations regarding profitability, long-run prospects, timing difference of
returns, risk distribution of returns of the firm

Critics of the wealth maximization objective however say that this objective is narrow and ignores the
concept of wealth maximization of society since society’s resources are used to the advantage only of
a particular firm. The optimal allocation of society’s resources should result in capital formation and
growth of the economy which should ultimately lead to maximization of economic welfare of the
society.

Achieving the Financial Objectives

1. 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 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 as hurdle rate.
This minimum return should consider whether the money raised from debt or equity meets
the returns on investments made elsewhere on similar investments.

The following areas are examples of investing decisions of a finance manager:

a. Evaluation and selection of capital investment proposal

b. Determination of the total amount of funds that a firm can commit for investment
c. Prioritization of investment alternatives
d. Funds allocation and its rationing
e. Determination of the levels of investments in working capital (i.e. inventory,
receivables, cash, marketable securities and its management)
f. Determination of fixed assets to be acquired
g. Asset replacement decisions
h. Purchase or lease decisions
i. Restructuring reorganization mergers and acquisition
j. Analysis of securities and portfolio management

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 2. Financing. The finance manager is concerned with the ways in which the firm obtains and
manages the financing it needs to support its investments. The financing objective asserts that
the mix of debt and equity chosen to finance investments 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. In
fund raising decisions, the finance manager should keep in view how and where to raise the
money, determination of the debt-equity mix, impact of interest, and inflation rates on the
firm, and so forth.

The finance manager will be involved in the following finance decisions:

a. Determination of the financing pattern of short-term, medium-term and long-term

funds requirements
b. Determination of the best capital structure or mixture of debt and equity financing
c. Procurement of funds through the issuance of financial instruments such as equity
shares, preference shares, bonds, long-term notes, and so forth
d. Arrangement with bankers, suppliers, and creditors for its working capital, medium-
term and other long-term funds requirement
e. Evaluation of alternative sources of funds

3. Operating. This concerns working capital management. The term working capital refers to a
firm short-term asset (i.e. inventory, receivables, cash and short-term investments) and its
short-term liabilities (i.e. 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. This also involves a number of activities
related to the firm’s receipts and disbursements of cash.

Some issues that may have to be resolved in relation to managing a firm’s working capital are:

a. The level of cash, securities and inventory that should be kept on hand
b. The credit policy (i.e. should the firm sell on credit? If so, what terms should be
extended?)
c. Source of short-term financing (i.e. if the firm would borrow in short-term, how and
where should it borrow?)
d. Financing purchases of goods (i.e. should the firm purchase its raw materials or
merchandise on credit or should it borrow in the short-term and pay cash?)

FUNCTIONS OF FINANCIAL MANAGEMENT

Role of Finance Manager

In striving to maximize owners’ or shareholders’ wealth, the financial manager makes decisions
involving planning, acquiring and utilizing funds which involve a set of risk-return trade-offs. These
financial decisions affect the market value of the firm’s stock which leads to wealth maximization.

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In the short run, many factors affect the market price of a firm’s shares which are beyond
management’s control. Some of the changes in market price do not reflect a fundamental change in
the value of the

firm. In the long run, increased prices of the firm’s stock reflect an increase in the value of the firm.
Hence, financial decision-making should take a longer-term perspective.

It is the responsibility of financial management to allocate funds to current and fixed assets, to obtain
the best mix of financing alternatives, and to develop an appropriate dividend policy within the
context of the firm’s objectives. The daily activities of financial management include credit
management, inventory control, and the receipt and disbursement of funds. Less routine functions
encompass the sale of stocks and bonds and the establishment of capital budgeting and dividend
plans.

Below figure shows the financial manager’s role in achieving the primary goal of the firm.

Financial Manager Makes Decisions

Involving

Analysis and Acquisition of Utilization of

Planning Funds Funds

Impact on Risk and

Return

Affect the Market Price of

Common Stock

Lead to Shareholders’
Wealth Maximization

Relationship with Other Key Functional Managers in the Organization

Finance is one of the major functional areas of a business. For example, the functional areas of
business operations for a typical manufacturing firm are manufacturing, marketing and finance.
Manufacturing deals with the design and production of a product. Marketing involves the selling,
promotion and distribution of a product. Manufacturing and marketing are critical for the survival of a
firm because these areas determine what will be produced and how these products will be sold.
However, these other functional areas could not operate without funds. Since finance is concerned

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with all of the monetary aspects of a business, a financial manager must interact with other managers
to ascertain the goals that must be met, when and how to meet them. Thus, finance is an integral part
of total management and cuts across functional boundaries.

Corporate Governance, Ethics and Agency Issues

Corporate governance is a system of organizational control that defines and establishes the
responsibility and accountability of the major participants in an organization. Shareholders, board of
directors, managers and officers of the corporation and other stakeholders are the major participants
included here.

An organizational chart is an example of a broad arrangement of corporate governance. More detailed

responsibilities would be established within each part of the organizational chart.

Business ethics are the standards of conduct or moral judgment that apply to persons engaged in
industry or commerce. Violations of these standards in finance include, but not limited to misstated
financial statements, misleading financial forecasts or projections, fraud, bribery, kickbacks, insider
trading, excessive executive compensation, and options backdating.

Bad publicity generally results to negative impacts on a firm. Ethics programs seek to reduce lawsuits
and judgment costs, uphold and preserve a positive corporate image, build trust and confidence of the
shareholders, and to gain the loyalty and respect of all stakeholders. The expected result of such
programs is to positively affect the firm’s share price.

Shareholders are the owners of a corporation, and they purchase stocks because they want to earn a
good return on their investment without undue risk exposure. In most cases, shareholders elect
directors, who then hire managers to run the corporation on a day-to-day basis. Because managers
are supposed to be working on behalf of shareholders, they should pursue policies that enhance
shareholder value. Also, to achieve this goal, the financial manager would take only those actions that
were expected to make a major contribution to the firm’s overall profits.

When manager deviate from the goal of maximization of shareholder wealth by putting their personal
goals above the goals of shareholders, this results to agency problems and issues. This kind of
problems increases agency costs. Agency costs are the costs borne by shareholders due to the
occurrence and avoidance of agency problems. Both cases represent a reduction in the shareholders’
wealth.

REFERENCES:

• Balatbat-Cabrera, M. E., et. al. (2019-2020) Financial Management: Comprehensive Volume

• Payongayong, L.S., et. al. Financial Management 2nd Edition
• Balatbat-Cabrera, M. E., et.al. (2017) Management Accounting
• Pignataro (2013) Financial Modeling and Valuation

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