INTRODUCTION TO FINANCIAL MANAGEMENT

Financial management is that managerial activity which is concerned with the

planning and controlling of the firm’s financial resources to achieve its
objectives. The subject of financial management is of immense interest to
practising managers because among the most crucial decisions of the firm are
those which relate to finance, and an understanding of the theory of financial
management provides them with conceptual and analytical insights to make
those decisions skilfully
Finance deals with decisions about money—that is, how money is raised and
used by companies and individuals. Everyone deals with financial decisions,
both in business and in their personal lives. For this reason, and because
there are financial implications in nearly every business-related decision, it is
important that everyone has at least a general knowledge of financial concepts
so that they can make informed decisions about their money.
Financial management decisions
The financial manager makes decision relating to financing, investing,
dividends and working capital requirement as discussed below.
1. Investment Decisions
A firm’s investment decisions involve capital expenditures. They are,
therefore, referred as capital budgeting decisions. A capital budgeting decision
involves the decision of allocation of capital or commitment of funds to long-
term assets that would yield benefits (cash flows) in the future. Two important
aspects of investment decisions are (a) the evaluation of the prospective
profitability of new investments, and (b) the measurement of a cut-off rate
against which the prospective return of new investments could be compared.
Future benefits of investments are difficult to measure and cannot be
predicted with certainty. Risk in investment arises because of the uncertain
returns. Investment proposals should, therefore, be evaluated in terms of both
expected return and risk.
Besides the decision to commit funds in new investment proposals, capital
budgeting also involves replacement decisions, that is, decision of
recommitting funds when an asset becomes less productive or non-profitable.
2. Financing Decisions
A financing decision is the second important function to be performed by the
financial manager. Broadly, he or she must decide when, where from and how
to acquire funds to meet the firm’s investment needs. The central issue before
him or her is to determine the appropriate proportion of equity and debt. The
mix of debt and equity is known as the firm’s capital structure. The financial
manager must strive to obtain the best financing mix or the optimum capital
structure for his or her firm. The firm’s capital structure is considered
optimum when the market value of shares is maximized.
The use of debt affects the return and risk of shareholders; it may increase
the return on equity funds, but it always increases risk as well. A proper
balance will have to be struck between return and risk. When the
shareholders’ return is maximized with given risk, the market value per share
will be maximized and the firm’s capital structure would be considered
optimum. Once the financial manager is able to determine the best
combination of debt and equity, he or she must raise the appropriate amount
through the best available sources. In practice, a firm considers many other
factors such as cost, speed, flexibility, loan covenants, legal aspects etc. in
deciding its capital structure.
3. Liquidity / working capital Decision
Investment in current assets affects the firm’s profitability and liquidity.
Management of current assets that affects a firm’s liquidity is yet another
important finance function. Current assets should be managed efficiently for
safeguarding the firm against the risk of illiquidity. Lack of liquidity (or
illiquidity) in extreme situations can lead to the firm’s insolvency. A conflict
exists between profitability and liquidity while managing current assets. If the
firm does not invest sufficient funds in current assets, it may become illiquid
and therefore, risky. It would lose profitability, as idle current assets would
not earn anything. Thus, a proper trade-off must be achieved between
profitability and liquidity. The profitability-liquidity trade-off requires that the
financial manager should develop sound techniques of managing current
assets. He or she should estimate the firm’s needs for current assets and
make sure that funds would be made available when needed.
Working capital management is therefore a key factor in an organization’s
long-term success. The business must have clear policy on management of
each component of working capital. The management of cash, receivables,
payables, accruals and other meaning of short-term financing is a direct
responsibility of the finance manager.
4. Dividend Decisions
A dividend decision is the fourth major financial decision. The financial
manager must decide whether the firm should distribute all profits, or retain
them, or distribute a portion and retain the balance. The proportion of profits
distributed as dividends is called the dividend-payout ratio and the retained
portion of profits is known as the retention ratio. Like the debt policy, the
dividend policy should be determined in terms of its impact on the
shareholders’ value. The optimum dividend policy is one that maximizes the
market value of the firm’s shares. Thus, if shareholders are not indifferent to
the firm’s dividend policy, the financial manager must determine the optimum
dividend-payout ratio
The financial management thus plays very key roles in an organization among
which include the following
• Forecasting of future capital requirement

The finance manager has to make estimation with regard to capital

requirement of the company based on the planning strategies. For instance,
if the company intends to purchase capital equipment, the role of the finance
manager is to forecast cash outlays including the opportunity costs and cost
saving if any of implementing this strategy
• Determination of proper mix of capital (capital structure)

Once the future capital requirement has been determined, the capital mix has
to be decided. This involves the proportion of short term and long-term debt,
preference share capital and equity that the company shall employ over the
strategic planning horizon. Normally this decision will depend on how heavily
indebted a company already is and whether or not they qualify to issue equity
• Sourcing the funds
The entity needs to evaluate all the avenues for raising funds in terms of
flexibility, speed, cost and risk. Sources of funds include bank loans, venture
capital, stock exchange listing and issue of bonds among others. The company
therefore has to make a choice between raising the funds internally through
retained earnings or externally by issue of shares or borrowing from outsiders
or a combination of both.
• Investment of funds

The corporate financial manager has to decide on where any funds raised
should be invested to guarantee safety on investment and regular and
adequate return on investments. Each investment needs to be evaluated in
terms of risk and return. Some investments could have high returns yet the
possibly of loss is equally very high.
• Management of surplus earnings

The finance manager has to decide as to whether profits should be distributed

to shareholders as dividends or reinvested in the business or what portion of
the profits will be distributed as dividends and what portion to be reinvested
in the business. This decision will depend on the dividend policy of the
company which is also dependent on several other factors.
• Working capital management

Every entity requires short term liquid resources for the day to day running
of the business. They include cash, sufficient stock, debtors and creditors.
The finance manager therefore has to decide the level of working capital
required to operate the company and ensure regular and adequate supply of
such working capital.
 • Financial analysis and control

When all the above financial decisions have been implemented, management
needs to evaluate and also exercise control over the finances. This can be done
through many techniques like ratio analysis, financial forecasting, budgeting
and budgetary control, cost control etc. this will ensure that the corporate
objectives are achieved.

The role of Treasury function

Most large companies have a separate treasury function to undertake some
of the finance roles. The treasury function is usually responsible for obtaining
finance and managing relations with financial stakeholders of the company
who include the shareholders and lenders
The increasingly complex financial environment characterized by
development in technology, increasing volatility in interest rates and exchange
rates, combined with increasing globalization of business have all contributed
to greater opportunities and risks for entities. This creates the need for
entities to be able to manage both their ability to undertake these
opportunities and their exposure to risk
Therefore, a separate treasury function could place the company in a better
position to develop appropriate skills to deal with these risk exposures and at
same time achieve economies of scale by for instance borrowing at lower rates
or netting-off inter-company balances
Key activities for the treasury function
The treasury function is likely to focus on the following key areas;
✓ Risk management: This involves understanding and quantifying the
risks faced by company, their likelihood of occurrence and deciding
whether or not to manage the risk. For firms that are facing significant
interest rate or exchange rate risks, risk management is likely to be
appropriate. Specific techniques of currency and interest rate risk
management will be covered later in this chapter
✓ Liquidity management: This is the management of short-term funds to
ensure that the entity has access to the cash that it needs in a cost-
efficient manner, that is, ensuring that the entity is not holding
unnecessarily high levels of cash or incurring high cost from needing to
organize unforeseen short-term borrowing. This is a key function of
treasury management
✓ Funding: This involves deciding on the suitable form of finance to be
employed by the entity (and by implication the level of dividend paid)
and maintaining a good working relationship with the providers of
funds
✓ Investing: Investing any cash in government securities and other liquid
assets not only to generate returns but also ensure quick availability
when cash is needed in an organization
Centralization of treasury activities
The question arises in a large international group whether the treasury
activities should be or decentralized
When a treasury management is centralized, each operating company only
hold minimum cash balance for day today operation all surplus cash to the
head office for the overall management.
If decentralized, each operating company must have a treasury department
responsible for that company’s own treasury operations
Advantages of centralized treasury function
✓ No need to have treasury skills duplicated throughout the group. One
highly trained central department can assemble highly skilled team,
offering skills that cannot be available if every company had their own
treasury
✓ The group’s foreign currency risk can be managed more effectively from
a centralized treasury since only them can fully appreciate the total risk
exposure of the group. A total hedging policy is more efficiently carried
out by the head office rather than each company doing their own
hedging.
✓ Necessary borrowings can be arranged in bulk at lower interest rates
than for small amounts, at lower interest rates than for small
borrowing. Similarly, bulk deposit of surplus funds will attract high
rates of interest than small amounts
✓ A centralized treasury can be run as a profit centre to raise additional
profit for the group
✓ It enables the group to avoid having a mix of cash surplus and deficits
in different locations of the company thereby by eliminating the
possibility of one company borrowing at high interest rates when
another company has idle cash
✓ Transfer prices can be established to minimize overall group tax
liability.

Advantages of decentration of treasury

✓ Greater autonomy leads to greater motivation. Individual will manage

their cash balances more attentively if they are responsible for them
rather than just remitting them to the head office
✓ Local operating units should have a better feel for the local conditions
than head office and can respond more quickly to the local
developments

Treasury function as cost centre or profit centre

When the treasury function is a cost centre, this implies that the costs of
operation of this centre are apportioned to the different subsidiaries that
benefit from the treasury function in accordance with the benefits that such
as subsidiary obtain from the treasury function. When it is not possible to
apportion the cost of the treasury function in a fair manner, these costs are
charged to the head office expenses

Forms of business organizations

Financial decisions are taken within the environment of the nature of
business. There are three forms of business:
❖ Sole proprietorship
❖ Partnership
❖ corporations

Sole proprietorship
A proprietorship is an unincorporated business owned by one individual.
Starting a proprietorship is fairly easy—just begin business operations. In
many cases, however, even the smallest business must be licensed by the
local authority in which it operates. The main advantages of sole
proprietorship include:
✓ it is easily and inexpensively formed since no formal procedures are
followed
✓ it is a one-person owned business which facilitates decision making
✓ it is characterized by assets, liabilities and equity which belong to this
single owner
✓ all profits are enjoyed by the owner who contribute capital towards its
formation
This mode of business also has its own disadvantages including:
- The proprietor has unlimited personal liability for business debts. With
unlimited personal liability, the proprietor (owner) can potentially lose
all of his or her personal assets, even those assets not invested in the
business; thus, losses can far exceed the money that he or she has
invested in the company
- limited life span which depends on the life and interest of its single
owner
- It is difficult for a proprietorship to obtain large sums of capital because
the firm’s financial strength generally is based on the financial strength
of the sole owner.
- the owner bears all the losses and risk of the business. The owner
cannot have this burden shared with other entrepreneurs
Partnership
A partnership is the same as a proprietorship, except that it has two or more
owners. Partnerships can operate under different degrees of formality, ranging
from informal, oral understandings to formal agreements filed with registrar
of companies. Most legal experts recommend that partnership agreements
also called partnership deed be put in writing
Features of a partnership include the following
 • Partnerships are made up of two or more persons who have agreed to
pool their knowledge and funds in order to run the business venture
jointly to earn profit
• Partners are not distinct from their business. In this regard, the
contracts entered into by one partner on behalf of the others binds them
all. Each of the partner is individually liable for the debts that the
enterprise may have incurred
• Partners are usually governed by a written agreement known as a
partnership deed
• The life of the partnership ends when any of the partners is unable to
continue with the business due to old age, death, bankruptcy or any
other legal or natural difficulty. In case of discontinuation of a
partnership, each partner is entitled to a share into the business
accumulated earnings according to the terms stipulated in the
partnership or equally in the absence of such a written agreement
• Partnerships are like sole proprietorship since they are characterized
by limited life (depending on the circumstance of any partner), have
limited access to capital (since its depends on the member partners’
contributions and cannot raise funds from securities market) and the
individual partners have unlimited liability
The advantages of a partnership are the same as for a proprietorship:
1. Formation is easy and relatively inexpensive.
2. It is subject to few government regulations.
3. It is taxed like an individual, not a corporation

The disadvantages are also similar to those associated with proprietorships:

1. Owners have unlimited personal liability.
2. The life of the organization is limited.
3. Transferring ownership is difficult.
4. Raising large amounts of capital is difficult.
Corporations
A corporation is a legal entity created by a law. It is separate and distinct from
its owners and managers. These business enterprises seek to overcome the
risks associated with sole proprietorships and partnerships. The Uganda
Companies Act 2012, defines corporations as either public limited companies
or private limited companies
- the members who make up the corporation are known as shareholders
because each contributes to the capital of the enterprise according to
the number of shares acquired
- the corporation is taken as a separate entity from the shareholders who
own it, hence, the shareholders’ responsibility in case of liability is only
limited to the share capital contributed. Personal wealth of the
shareholders cannot be used or called upon to settle the liability the
corporation has incurred
 - the corporation as a business entity has unlimited life not tied to the
circumstances of an individual shareholder since an existing
shareholder can exit by selling his or her share to another willing person
- the corporation especially the public limited company has access to
more funds as compared to sole proprietorship or partnership since the
corporation can raise capital from the public through sale of shares
- the corporation is also a separate entity owned by the shareholders who
exercise their rights through electing a board of directors to govern the
corporation on their behalf

Objectives of financial management

The objective of financial management may be broadly divided into two
parts i.e.
Profit maximization
Wealth maximization
Profit maximization
This is the traditional objective and refers to a situation where the firm
seeks to maximize its revenue while minimizing its costs. In simple terms,
the manager seeks to maximize the profit. Although the objective of profit
maximization is of great importance, it is not by itself a sufficient criterion
for effective management of a business. By concentration on current profit
maximization, management may pay little or no attention to other long-
term investments such as quality, after sale services, research and
development, management development, satisfaction of staff and their
employment conditions. This could increase profitability in the short run
but is likely to negatively affect the future growth and development and
possibly even the long-term survival of the organization.
Advantages of profit maximization
• When profit is maximized, the shareholders will be satisfied as their
primary objective is to maximize their returns
• Maximizing profit is seen as a sign of efficiency and therefore, a
yardstick against which the performance of the company is measured
• Profitability meets the social needs.
Weaknesses of profit maximization
i) Profit as an objective is vague: In this objective, profit is not defined
precisely and correctly. The definition of the term is ambiguous.
Does it mean short-term or long-term profit, does it refer to profit
before or after tax, total profit or profit per share, operating profit or
profit accruing to the shareholders. The vagueness in the definition
of profit makes it a slippery objective to be targeted by a firm
ii) Profit maximization objective ignores the timing of the profit.
Investors are not indifferent to when the profit flows will actually be
realized. By not adjusting for the time value of money, then the profit
maximization objective fails to address the concerns of the investors
 iii) The objective is oriented towards benefiting shareholders in an
exclusive way. This is justifiable if there are no other stakeholders
or if the interest of other stakeholders coincides with the interest of
shareholders. Where stakeholders are not shareholders, or where
their interest conflict, then profit maximization as the only objective
cannot be sustained in the long run
iv) It ignores risk. Profit maximization does not consider risk of the
business concern. Risk may be internal or external which will affect
the overall operation of the business concern.

Wealth maximization
Wealth maximization is the broader objective which recognizes the strength
of profit maximization while resolving the conflict that surrounds this profit
maximization objective. The term wealth refers to the net benefit accruing to
the firm in the form of cash flows from all the assets in which the firm has
invested. These net benefits should be adjusted for the time value of money
to reflect their present worth.
Wealth = Present value of cash inflows – cost of investment.
When wealth is maximized, the market will view the firm in the most
favourable terms, therefore, its shares will fetch the highest possible price.
Since the market is the barometer of the society, then the market price per
share will reflect the intrinsic value attached to the firm by the various
interested parties. Therefore, the maximization of wealth, which in turn is
reflected in the market price per share, addresses the interest of all parties
interested in the business. By discounting the cash flows to their present
worth using the market capitalization rate, the objective of wealth
maximization overcomes the weakness of not taking into account the time
value of money
The objective of wealth maximization has found favour with financial
managers because it is not inconsistent with that of profit maximization but
only broader in scope. The financial manager should not only seek to
maximize profit for the benefit of the investors, but also consider the interest
of other parties in the firm. By maximizing wealth other than profit, the
manager addresses these concerns
Arguments in favour of wealth maximization
❖ It emphasizes that benefits are measured in terms of cash flows. In
investment and financing decision, it is the flow of cash which is
important and not the accounting profit.
❖ It considers the time value of money. It recognizes that the benefits
emerging from a project in different years are not identical in value. This
is why annual cash benefits of a project are discounted at a discount
rate to calculate the total NPV of these cash benefits.
❖ At the same time, it gives due weight to the risk factor by making
necessary adjustments in the discount rates. Thus, a cash benefit of a
project with higher risk exposure is discounted at a higher discount
 rate while a low discount rate is applied to discount expected cash
benefits of a less risky project.

Therefore, in view of the above reasons wealth maximization objective is

considered superior to profit maximization objective.
Agency theory
Agency theory explains the relationship between the principal and the agent.
It seeks to explain why managers might engage in behaviour that is not in the
best interest of the shareholders
In agency relationship, the shareholders who are the owners of the company
contract the directors (management) to run the affairs of the company.
Shareholders are the principals and the managers are the agents. The reasons
for the separation of ownership from management include the following;
✓ Professional managers may be more qualified to run the business
because of their technical expertise and experience
✓ Given economic uncertainties, investors would like to hold diversified
portions of securities. Such diversification is achievable only when
ownership and management are separate
✓ Most enterprises require large sums of capital to achieve economies of
scale. Hence it becomes necessary to pool capital from many investors.
It is not practical for many owners to participate actively in
management
✓ It permits unrestricted change in owners through share transfers
without affecting the operations of the firm. It ensures that the “know
how” of the firm is not impaired despite changes in management
While agency relationships often work well, problems may arise if agents and
principals have different goals. The information asymmetry between the
principal and the agent (agents almost always have more information about
the resources they are managing than the principal) offers agents the
opportunity to take actions that are not in the best interest of the principal.
While the shareholders are aware of this information asymmetry, they have
no choice but to trust that the agent will serve their interests. At the same
time, there are mechanisms in place to monitor agents, evaluate their
performance, and take corrective action if necessary to ensure that the agents
run the affairs of the company not for their own interest but to improve the
welfare of the shareholders.
Conflict of interest between shareholders and managers
• Salaries and allowances:

Managers may reward themselves high salaries and allowance hence reducing
the earning attributable to the equity shareholders and eventually the
dividends paid to shareholders.
• Difference in risk portfolios.
Managers may undertake low risk projects for fear of being fired if they invest
in highly risky projects and they fail. Most low risky projects will generate low
returns thereby not maximizing shareholders wealth. Shareholders expect
directors to invest in projects generating high returns.
• Motivation problem

Managers may be entitled to a fixed income irrespective of how much profit

they generate for the shareholders. Unless managers own shares in the firm
in which case they share in the dividends, they may not work as hard to
maximize shareholders wealth. They will opt to maximize their own interest.
• Difference in investment evaluation horizon

Since most managers are employed on a contract basis, they will tend to
maximize the wealth by investing in short term projects which cover their
duration of employment. The going concern of the company depends on the
investments extending in the long term. Short term investments will not
maximize shareholders wealth in the long term.
• Creative accounting
Managers can manipulate figures in the financial statements to report high
profit which can only be achieved in the short term. Creative accounting is
made to make the financial statement more appealing to the shareholders, for
example, failure to provide for bad debts.
Mitigation of agency problem
In order to minimize the conflicts and ensure that the agent works for the
benefits of the principle; shareholders try to ensure that managers act in the
best interest of the shareholders by
• Auditing financial statement. Because managers know that their
actions will be checked by an independent person, they will act in the
best interest of the owners
• Effective monitoring has to be done to see to it that management is
pursing the vision and the objective of the firm
• Incentive may be offered in the form of cash bonus and rewards that
are linked to certain performance targets. The owners must promise to
reward management when they achieve certain targets. In this way,
managers will act in a way not to hurt the interest of the owners in order
to get those rewards
• Owners should offer share options that grant managers the right to
purchase equity shares at a certain price thereby giving them a stake
in ownership and performance shares when certain goals are achieved
• Limiting managerial discretion in certain areas and reviewing the
actions and performance of managers periodically. The power of
managers needs to be restricted. Some decisions need to be taken or
approved by owners and performance and compliance reviews are
undertaken regularly
• Threat of firing can also be seen as an incentive for efficiency.
• The problem can be avoided by bonding managers. Owners of the
business can sign a bonding agreement with managers to work for
 certain period of time before being allowed to seek for opportunities
elsewhere. Within the bonding period managers will work cautiously
avoiding to hurt the interest of the owners
• Threats of takeover. As noted, managers would do everything possible
to frustrate takeovers as they are aware that they are going to lose jobs.
To ensure they act on the best interest of shareholders, the
shareholders may threaten to accept a takeover bid if their set targets
are not met by managers.

Other stakeholders may include:

• Shareholders are the legal owners of the company. They provide the
company with risk capital. In exchange they expect management to
maximize return on their investment. If they are not satisfied with
management performance, shareholders may sell their shares or
replace management
• Employees offer the company their time and skills and in exchange
expect appropriate income, job satisfaction, job security and good
working conditions. If they are not satisfied with the company,
employees may go work for someone else.
• Customers are clients of the company, so they are company’s source of
revenue. In exchange, they want quality, dependable products that
represent value for money. If they are not satisfied with the company’s
products/prices, they may switch to competitors
• Suppliers provide the company with inputs. In exchange they want a
stable, long-term relationship with the company and timely payments.
If they are not happy with the company, they will try to seek out more
dependable buyers
• Governments provide the rules and regulations that govern business
practices and maintain fair competition. In exchange they require all
companies to follow these rules. If rules are not followed, the
government can take civil or criminal action against the company and
senior management
• Lenders/creditors provide the company with capital in the form of debt.
In return, they expect interest and principal payments to be made on
time in full. If creditors are not happy with the company, they may make
credit terms stricter or not offer the company credit at all
• Unions represent the interests of company employees. They seek benefit
for their members commensurate with their contributions to the
company. If they are not satisfied with the company, unions may engage
in disruptive labour disputes
The various conflicts between stakeholder objectives
Quiet often the stakeholder objectives may conflict. For example, the objective
of maximizing wealth as desired by the shareholders may conflict with those
of the following stakeholders
o Employee objective of maximizing benefits earned from the business.
Since such benefits like salaries, wages and other emoluments increase
cash outflow, this inevitably reduces the net worth of the business
thereby conflicting with the shareholder’s objective of maximizing
wealth
o The objective of management is also to maximize its benefits from the
business. Just like the case of employees, this constitutes a cash
outflow which conflicts with wealth maximization objective
o Creditors seek to obtain their obligation in full and as early as possible.
Again, creditors’ obligation like repayment of principal and interest
constitutes a cash outflow which contradicts the shareholders’ objective
of maximizing wealth
o Government objective is to regulate the activities of the business so as
to protect the common good of society. This protection may hinder use
of societal resources and hence conflict with the shareholder objective
of maximizing wealth
o Tax authorities have an objective of maximizing tax revenue yet tax
constitutes a cash outflow from the business which contradicts with
the shareholder objective of maximizing wealth