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

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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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