Chapt
er The Goals and Functions of
1 Financial Management
Edgel Earl A. Abear, CPA, DBA
© 2003 McGraw-Hill Ryerson Limited
Session 1 - Outline
Definition of Financial Management
The Field of Finance
The Economic Environment
The Goals of Financial Management
A Risk-Return Trade-Off
Functions and Activities of Financial Management
Forms of Organization
Organization of the Financial Management Function
Developments in Financial Management
Scope of Financial Management
Financial Markets
Financial Management Decisions
Financial Risks
Summary and Conclusions
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What is Financial
Management?
The business function
involving:
Managing daily financial
activities-cash inflows and
outflows
Choosing long-term
investments of value and
obtaining the funds to pay
for them
Managing the risks taken
by the firm
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What is Financial
Management?
Concerns the acquisition,
financing, and management of
assets with some overall goal in
mind.
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The Field of Finance
Finance is related to:
Accounting, which provides information in
financial statements
Economics, which provides
decision-making tools such as pricing
theory (supply and demand), risk
analysis, comparative return analysis
information on the economic and
financial environment in which the
company operates
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The Economic Environment
The financial manager considers exchange rates
many economic factors, such as changes in technology
inflation
consumer and investor
unemployment
attitudes
industrial production
the state of financial
domestic and international
markets
competition changes in government
foreign trade statistics
policy
international capital flows etc. etc.
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The Goals of Financial
Management
Primary goal is to maximize the wealth of the
company’s shareholders (owners) by increasing the
market value (price) of their shares
May conflict with
social / ethical goals (for example, pollution control)
interests of management (for example, short-term
compensation)
Management can encourage an increase in share
price by earning an attractive return at an
acceptable level of risk
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Profitability Risk
Profitability Risk
ex.,investing in stocks vs.savings accounts
Stocks may be more profitable but are riskier
Savings accounts are less profitable and less risky
(or safer)
Financial manager must choose appropriate
combination of potential profit (return) and
level of risk (safety)
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Functions and Activities
of Financial Management
Functions involve:
raising funds for the firm at minimal cost and acceptable risk
investing those funds in company assets so as to earn an
attractive return given acceptable risks
Activities include:
Working Capital Management
short-term (S/T) financial decisions (<1 year)
ex., managing cash and other current assets
Capital Budgeting
long-term (L/T) financial decisions (>1 year)
ex., purchasing a new machine in the future
Financing decisions (capital structure)
how to raise money: loans? leases? shares? bonds?
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Working Capital Management
How do we manage existing assets
efficiently?
Financial Manager has varying degrees of
operating responsibility over assets.
Greater emphasis on current asset
management than fixed asset management.
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Capital Budgeting
Investment decision is the most
important of the three decisions.
What is the optimal firm size?
What specific assets should be
acquired?
What assets (if any) should be reduced
or eliminated?
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Financing decisions (capital
structure)
Determine how the assets (LHS of
balance sheet) will be financed (RHS of
balance sheet).
What is the best type of financing?
What is the best financing mix?
What is the best dividend policy (e.g.,
dividend-payout ratio)?
How will the funds be physically acquired?
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Figure 1-1
Functions of the Financial
Manager
Daily Occasional Profitability
Cash management
(receipt and disbursement of funds)
Intermediate financing
Bond issues
Goal:
Credit management Leasing Maximize
Inventory control Stock issues Trade-off
Short-term financing
Exchange and interest rate hedging
Capital budgeting
Dividend decisions
shareholder
Bank relations Forecasting wealth
Risk
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Strengths of Shareholder
Wealth Maximization
Takes account of: current and future profits and
EPS; the timing, duration, and risk of profits and
EPS; dividend policy; and all other relevant factors.
Thus, share price serves as a barometer for business
performance.
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What companies say about their
corporate goal?
Cadbury Schweppes: “governing objective is growth
in shareowner value”
Credit Suisse Group: “achieve high customer
satisfaction, maximize shareholder value and be an
employer of choice”
Dow Chemical Company: “maximize long-term
shareholder value”
ExxonMobil: “long-term, sustainable shareholder
value”
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The Modern Corporation
Modern Corporation
Shareholders Management
There exists a SEPARATION between owners and
managers.
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Forms of Organization:
Sole Proprietorships
Disadvantages
Advantages
Unlimited
Freedom Liability
Simplicity
Lack of Continuity
Low Start Up
Difficulty in
Costs A business owned by Raising Money
one person
Tax Benefits
Reliance on One Person
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Forms of Organization:
Partnerships
Disadvantages Advantages
Unlimited Liability
Lack of Continuity More Capital
Ownership
Greater Talent Pool
Transfer
Difficult
Ease of Formation
Possibility of Tax Benefits
Conflict
A business venture with two or more owners
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Forms of Organization:
Corporations
Advantages Disadvantages
Limited Liability Potential Shareholder
Revolts
Continuity
Higher Start-Up
Greater Likelihood Costs
of Professional
Management Regulation
Double Taxation
Easier Access to A corporation
Money is a separate legal entity
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Public and Private Corporations
Public corporations’ shares are
available for purchase on the
market for the general public
The shares in a private
corporation are held by a small
group of individuals and are not
sold to the public
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Role of Management
Management acts as an agent for the
owners (shareholders) of the firm.
An agent is an individual authorized by
another person, called the principal, to
act in the latter’s behalf.
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Role of Management
Management acts as an agent for the
owners (shareholders) of the firm.
An agent is an individual authorized by
another person, called the principal, to
act in the latter’s behalf.
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Agency Theory
Jensen and Meckling developed a theory
of the firm based on agency theory.
Agency Theory is a branch of economics
relating to the behavior of principals
and their agents.
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Agency Theory
Principalsmust provide incentives so
that management acts in the principals’
best interests and then monitor results.
Incentives include, stock options,
perquisites, and bonuses.
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Social Responsibility
Wealth maximization does not preclude
the firm from being socially responsible.
Assume we view the firm as producing
both private and social goods.
Then shareholder wealth maximization
remains the appropriate goal in
governing the firm.
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Corporate Governance
Corporate governance: represents the system
by which corporations are managed and
controlled.
Includes shareholders, board of directors,
and senior management.
Then shareholder wealth maximization
remains the appropriate goal in governing
the firm.
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Board of Directors
Typical responsibilities:
Setcompany-wide policy;
Advise the CEO and other senior executives;
Hire, fire, and set the compensation of the CEO;
Review and approve strategy, significant investments,
and acquisitions; and
Oversee operating plans, capital budgets, and financial
reports to common shareholders.
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Organization of the Financial
Management Function
Board of Directors
President
(Chief Executive Officer)
Vice President VP of Vice President
Operations Marketing
Finance
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Organization of the Financial
Management Function
VP of Finance
Treasurer Controller
Capital Budgeting Cost Accounting
Cash Management Cost Management
Credit Management Data Processing
Dividend Disbursement General Ledger
Fin Analysis/Planning Government Reporting
Pension Management Internal Control
Insurance/Risk Mngmt Preparing Fin Stmts
Tax Analysis/Planning Preparing Budgets
Preparing Forecasts
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Developments in Financial
Management
Early 1900s - emphasis was on the legal aspects of
mergers, the formation of new firms, and the
various types of securities firms could issue to raise
capital
During the depressions of the 1930s -emphasis
shifted to bankruptcy and reorganisation, to
corporate liquidity, and to the regulation of security
markets
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Developments in Financial
Management
During the 1940s and early 1950s – finance
continued to be taught as a descriptive, institutional
subject, viewed more from the standpoint of an
outsider rather than from that of a manager
Late 1950s – focus shifted to managerial decisions
regarding the choice of assets and liabilities with the
goal of maximizing the value of the firm
© 2003 McGraw-Hill Ryerson Limited
Developments in Financial
Management
During the 1940s and early 1950s – finance
continued to be taught as a descriptive, institutional
subject, viewed more from the standpoint of an
outsider rather than from that of a manager
Late 1950s – focus shifted to managerial decisions
regarding the choice of assets and liabilities with the
goal of maximizing the value of the firm
© 2003 McGraw-Hill Ryerson Limited
Developments in Financial
Management
1990sto date – focus on value maximization
continued but two trends have become increasingly
important: the globalization of business and the
increased use of information technology
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Scope of Financial Management
Money and capital markets - which deals
with securities markets and financial
institutions;
Investments - which focuses on the decisions
made by both individual and institutional
investors as they choose securities for their
investment portfolios;
Financial management - or ‘business
finance’, which involves decisions within
firms. © 2003 McGraw-Hill Ryerson Limited
Financial Markets
Global network of corporations, financial institutions,
governments and individuals that either need money or have
money to lend or invest
Money markets deal in short-term securities (<1 year)
Ex.; Treasury Bills, commercial paper
Capital markets deal in long-term securities
Ex.; common stock, preferred stock, corporate bonds,
government bonds
Financial markets determine value and allocate capital to the
most productive use on a risk-return basis
Financial market characteristics
reliance on debt, and low but volatile interest rates
internationalization
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Stocks vs. Bonds
Stock (Share)= ownership or equity
Shareholders own the company
Bond = debt or liability
Bondholders are owed $ by company
Capital raised in primary markets
Securities traded in secondary markets
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Financial Management
Decisions
Capital budgeting: The process of planning and
managing a firm’s long term investment.
Capital budgeting (or investment appraisal) is the
planning process used to determine whether a firm's
long term investments such as new machinery,
replacement machinery, new plants, new products,
and research development projects are worth
pursuing. It is budget for major capital, or
investment, expenditures.
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Financial Management
Decisions
Capital structure: The mixture of debt and
equity maintained by the firm.
Capital structure refers to the way a
company finances its assets through some
combination of equity, debt, or hybrid
securities. A firm's capital structure is then
the composition or 'structure' of its liabilities.
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Financial Management
Decisions
Working capital management: A firms short terms
asset and liabilities.
These are decisions involving managing the
relationship between a firm's short term assets and
its short-term liabilities. The goal of working capital
management is to ensure that the firm is able to
continue its operations and that it has sufficient cash
flow to satisfy both maturing short-term debt and
upcoming operational expenses.
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Working Capital Management
Cash management. Identify the cash balance which
allows for the business to meet day to day expenses,
but reduces cash holding costs.
Inventory management. Identify the level of
inventory which allows for uninterrupted
production but reduces the investment in raw
materials - and minimizes reordering costs - and
hence increases cash flow;
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Working Capital Management
Shortterm financing. Identify the
appropriate source of financing, given the
cash conversion cycle: the inventory is ideally
financed by credit granted by the supplier;
however, it may be necessary to utilize a bank
loan (or overdraft), or to “convert debtors to
cash” through “factoring”.
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Developing a financial forecast
Identify the requirements for your situation
Obtain all the facts, determine assumptions
within facts
Identify missing information, relevance,
problems; assess materiality
Identify financial patterns (trends, averages,
forecasts)
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Developing a financial forecast
Determine if additional research is needed;
identify significant macro issues or events;
identify assumptions needed for missing
information
Build the forecast
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Developing a financial forecast
Testforecast for sensitivity, review for
reasonableness and ability to monitor
Assess effectiveness of plan in meeting the
objectives (pros/cons)
Consider alternative solutions
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Responsibility of Finance
Managers
Efficiently manage entity resources
Effectively mitigate risks to attain entity
objectives
Maintain a sound financial condition within
the limits of available resources
Comply with applicable policies, laws and
regulations.
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Financial Risk
What is Risk?
Risk is the threat that an event or action
will adversely affect an entity’s ability to
achieve its objectives and/or execute its
strategies successfully.
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Types of Risks
Strategic risks -- doing the wrong
things.
Operating risks -- doing the right things
the wrong way.
Financial risks -- losing financial
resources or incurring unacceptable
liabilities.
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Types of Risks
Informational risks -- inaccurate or
non-relevant information, unreliable
systems, and inaccurate or misleading
reports.
Physical risks – loss of computer data,
fire, earthquake, degradation of the
environment, injury to people and/or
things.
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Risks have both quantitative
and
qualitative factors
We should consider quantitative factors:
Cash (monetary) loss (i.e., loss of future
cash flows)
Cost of property, equipment, or
inventory
Cost of defending a lawsuit
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Risks have both quantitative
and
qualitative factors
We should also consider qualitative risk
factors:
Increased legislation
Loss of public trust
Injury to the unit’s and/or entity’s
reputation
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How can Risks be dealt?
Ignore the risk,
Accept the risk,
Transfer the risk (insurance), or
Mitigate the risk.
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IFRS # 7 - Objective
Entities should provide disclosures in their financial
statements that enable users to evaluate:
(a) the significance of financial instruments for the
entity’s financial position and performance; and
(b) the nature and extent of risks arising from financial
instruments to which the entity is exposed during the
period and at the end of the reporting period, and how the
entity manages those risks.
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IFRS # 7 - Objective
Entities should provide disclosures in their financial
statements that enable users to evaluate:
(a) the significance of financial instruments for the
entity’s financial position and performance; and
(b) the nature and extent of risks arising from financial
instruments to which the entity is exposed during the
period and at the end of the reporting period, and how the
entity manages those risks.
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Financial Goals of the
Corporation- issues
Do firms have any responsibilities to
society at large?
Is stock price maximization good or bad
for society?
Should firms behave ethically?
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Summary and Conclusions
The financial manager:
controls the daily cash inflows
and outflows resulting from
business operations
makes the occasional investment
and financing decisions essential for
the future financial success of the
business
may work in a corporation or
other form of business organization
Their overriding goal is to maximize
the wealth of the owners by earning
an attractive return in the business
at an acceptable level of risk
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