Management Advisory Services Kings College of the Philippines 2019

SCOPE AND OBJECTIVE OF FINANCIAL MANAGEMENT

BASIS FOR PROFIT WEALTH
Financial Management: Definitions COMPARISON MAXIMIZATION MAXIMIZATION

 It is concerned with the managerial decisions that Concept The main The ultimate goal
result in the acquisition and financing of short term objective of a of the concern is to
and long term credits for the firm. concern is to earn improve the
 It comprises the forecasting, planning, organizing, a larger amount of market value of its
directing, coordinating, and controlling of all activities profit. shares.
relating to acquisition and application of the financial
resources of an undertaking in keeping with its Emphasizes on Achieving short Achieving long
financial objective term objectives. term objectives.
 It focuses on addressing three major financial decision
areas namely, investment, financing and dividend
Consideration No Yes
decision. of Risks and
 It is all about planning investment, funding the Uncertainty
investment, monitoring expenses against budget and
managing gains from the investments.
Advantage Acts as a yardstick Gaining a large
 It is all about management of all matters related to an for computing the market share.
organization’s finances operational
efficiency of the
Scope of Financial Management entity.

1. Anticipation: Financial Management estimates the

financial needs of the company. It finds out how much Recognition of No Yes
finance is required by the company. Time Pattern of
Returns
2. Acquisition: It collects finance for the company from
different sources
To achieve wealth maximization, the finance manager has
3. Allocation: It uses this collected finance to purchase
to take careful decision in respect of:
fixed and current assets for the company
4. Appropriation: It divides the company’s profits among 1. Investment Decisions:
the shareholders, debenture holders. It keeps a part of -These relate to the selection of assets which funds will
the profit as reserves. be invested by a firm.
5. Assessment: It controls all the financial activities of the *Where do you invest the scarce resources of your
company. business?
*What makes for a good investment?
Objective of Financial Management

Objective of Financial Management 2. Financing Decision

A. Profit maximization- the capability of the firm in
producing maximum output with the limited
input, or it uses minimum input for producing
stated output. It is termed as the foremost
objective of the company.
-These relate to acquiring the optimum finance to
meet financial objectives and seeing that fixed and
working capital is effectively managed.
*Where do you raise the funds for these investments?
*Generally, what mix of owner’s money or borrowed
money do you use?

B. Wealth Maximization- ability of a company to 3. Dividend Decision

increase the market value of its common stock
over time. The market value of the firm is based
on many factors like their goodwill, sales,
services, quality of products, etc.
-These relate to the determination as to how much and
how frequently cash can be paid out of the profits of
an organization as income for its owners/shareholders.
*How much of a firm’s funds should be reinvested in
the business?
*How much should be returned to the owners?

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4. Liquidity Decisions
-Current asset management is another important
function that requires that current assets should be
managed efficiently to guard the firm against illiquidity.
Lack of liquidity in extreme situations can lead to
insolvency. A high rate of investment in current assets
would provide liquidity but would lose profitability.
This trade-off must be managed effectively.
*How much should a firm invest in current assets?
*How to manage the working capital?
Financial Management and Accounting
Accounting is an important input in financial decision-
making or into the financial management function. The
information contained in financial statements and
reports helps financial managers in gauging the past
performance and future directions of the organization.
Treatment of Funds
In accounting, the measurement of funds is based on
accrual principle. An organization may said to be
profitable in the accounting sense, but it may not be
able to meet its current obligation due to shortage of
liquidity as a result of say, uncollectible receivables. In
financial management, it is based on cash flows. This is
so because the finance manager is concerned with
maintaining solvency of the organization by providing
the cash flow necessary to satisfy its obligation and
acquiring and financing the assets needed to achieve
the goals of the organization
Decision-making
The purpose of accounting is to collect and present
financial data on the past, present and future
operations of the organization. The financial manager
uses these data for financial decision making. Financial
management begins where accounting ends.
TEN AXIOMS THAT FORM THE BASICS OF FINANCIAL
MANAGEMENT
1. The risk-return trade-off- We won’t take on
additional risk unless we expect to be
compensated with additional return
2. The time value of money- A dollar receive today is
worth more than a dollar received in the future
3. Cash flows-not profit-is King
4. Incremental Cash Flows- It’s Only what changes
that counts
5. The curse of competitive markets- Why it’s hard to
find exceptionally profitable projects
6. Efficient Capital Markets- The markets are quick
and the prices are right
7. The agency problem- managers will not work for
the owners unless it is in their best interest
Kings College of the Philippines 2019
8. Taxes bias business decisions
9. All risk are not equal and some cannot-Some risk
can be diversified away
10. Ethical behavior is doing the right thing, and
ethical dilemmas are everywhere in finance
FINANCIAL STATEMENT ANALYSIS
 Process of identifying financial strengths and
weaknesses of the firm by properly establishing
relationship between the items of the statement
of financial position and the profit and loss
account.
TOOLS AND TECHNIQUES OF FINANCIAL STATEMENT
ANALYSIS:
1. Horizontal (Trend) Analysis
-Compares line items from one period with another
period, to assess trends. Its purpose is to determine
the increase or decrease that has taken place,
expressed as either an amount or a percentage.
-An analysis of peso changes and percentage changes
over two or more years as a means of determining
improvement or deterioration of the financial
condition or results of operations of a business
enterprise.
Increase/Decrease Method (For two accounting
periods)
 𝑃𝑒𝑠𝑜 𝑐ℎ𝑎𝑛𝑔𝑒 = 𝐴𝑚𝑡. 𝑖𝑛 𝐶𝑜𝑚𝑎𝑝𝑟𝑖𝑠𝑜𝑛 𝑦𝑒𝑎𝑟 −
𝐴𝑚𝑡. 𝑖𝑛 𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟
𝑃𝑒𝑠𝑜 𝐶ℎ𝑎𝑛𝑔𝑒
 %𝐶ℎ𝑎𝑛𝑔𝑒 = ∗ 100
𝐴𝑚𝑜𝑢𝑛𝑡 𝑖𝑛 𝐵𝑎𝑠𝑒 𝑦𝑒𝑎𝑟
Trend Percentages or Index Numbers (For more than
two years)
𝐴𝑚𝑜𝑢𝑛𝑡 𝑖𝑛 𝐶𝑜𝑚𝑎𝑝𝑟𝑖𝑠𝑜𝑛 𝑌𝑒𝑎𝑟
 𝑇𝑟𝑒𝑛𝑑 % = 100 ∗
𝐴𝑚𝑜𝑢𝑛𝑡 𝑖𝑛 𝐵𝑎𝑠𝑒 𝑌𝑒𝑎𝑟
2. Vertical (common-size) Analysis
-Technique for evaluating financial statement data that
expresses each item in financial statement within a
year as percent of a base amount.
-used to evaluate the relationships within a single
financial statement.
𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑙𝑖𝑛𝑒 𝑖𝑡𝑒𝑚
%= ∗ 100
𝐵𝑎𝑠𝑒 𝐼𝑡𝑒𝑚 𝐴𝑚𝑜𝑢𝑛𝑡
3. Ratio Analysis
-Most powerful tool of financial statement analysis.
-Used for evaluating the financial health and
performance of a company by comparing ratios with a
standard.
Advantages of ratio analysis
a. Simplifies financial statements
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Management Advisory Services Kings College of the Philippines 2019

b. Facilitates inter-firm comparison 3. Inventory Turnover- measures how quickly

c. Helps in planning inventory is converted into sales. It is an index of
d. Makes inter-firm comparison possible profitability, where a high ratio signifies more profit;
e. Helps in investment decisions a low ratio signifies low profit.
𝐶𝑜𝑠𝑡 𝑜𝑓 𝐺𝑜𝑜𝑑𝑠 𝑆𝑜𝑙𝑑
Limitations of Ratio Analysis 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑂 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦

a. Limitations of financial statements

4. Ave. Sales Period/ Ave. Age of Inventory/ Inventory
b. Comparative study required
Holding Period- use to evaluate inventory
c. Ratios alone are not adequate
management. It calculates the number of days, on
d. Problems of price level changes
average that elapsed between finished goods
e. Lack of adequate standards
production and sales product.
f. Limited use of single ratios
365 𝑜𝑟 360 𝑑𝑎𝑦𝑠
g. Personal Bias 𝐴𝑣𝑒. 𝐴𝑔𝑒 𝑜𝑓 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 =
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑂
h. Incomparable

Classifications of Accounting Ratios C. LONG TERM SOLVENCY/LEVERAGE- convey a firm’s

ability to meet the interest costs and payment
A. LIQUIDITY RATIOS-measure the ability of a company to schedules of its long term obligations. A high leverage
meet its current obligation. It used to assess the short- may increase a company’s exposure to risk and
term debt-paying ability of a company. business downturns, but along with this higher risk also
comes the potential for higher returns.
1. Current Ratio/Working Capital Ratio 1. Times Interest Earned Ratio/Interest Coverage
-represents the margin of safety to creditors Ratio- a measure of a firm’s ability to meet
-an index of the firm’s technical solvency, and of the interest payments. It indicates the relation
firm’s financial stability between interest payments and the earnings that
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 are available to make those interest payments. It
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 indicates the number of times interest is covered
by the profits available to pay interest charge.
2. Liquid/ Acid test/ Quick ratio 𝐸𝐵𝐼𝑇
-It measures the firm’s ability to pay-off short term 𝑇𝑖𝑚𝑒𝑠 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑎𝑟𝑛𝑒𝑑 =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒
obligations without relying on the sale of inventories
𝐴𝑐𝑖𝑑 𝑇𝑒𝑠𝑡 𝑅𝑎𝑡𝑖𝑜 2. Debt to Asset Ratio/ Financial Leverage-measures
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠 − 𝑃𝑟𝑒𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠 the portion of a company’s capital that is provided
=
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 by borrowing.
𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
B. ACTIVITY/EFFICIENCY RATIOS/TURNOVER RATIOS- 𝐷𝑒𝑏𝑡 𝑡𝑜 𝑎𝑠𝑠𝑒𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
indicate the speed with which assets are being turned
over into sales 3. Debt to Equity Ratio
𝐷𝑒𝑏𝑡 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜
1. Account Receivable Turnover- measure of how (𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑙𝑖𝑡𝑖𝑒𝑠)
quickly accounts receivables are turned into cash. =
𝐴𝑣𝑒. 𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝐸𝑞𝑢𝑖𝑡𝑦
Account Receivable turnover in days provides
information about the number of days the average
balance of accounts receivable is outstanding before
cash is collected.
𝑆𝑎𝑙𝑒𝑠 𝑜𝑛 𝑎𝑐𝑐𝑜𝑢𝑛𝑡
𝐴𝑅 𝑇𝑂 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒

2. Average Collection Period- used to evaluate credit

management and account collection practices
𝐴𝑣𝑒. 𝐶𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑃𝑒𝑟𝑖𝑜𝑑
365 𝑜𝑟 360
=
𝐴𝑐𝑐𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟

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