Introduction To Financial Management PDF

TOPIC 1: OVERVIEW TO FINANCIAL MANAGEMENT CATHERINE A. CABANADA ASSOCIATE PROFESSOR LEARNING OBJECTIVES: At the end of the session, students are expected to: understand the core ideas of financial management Connect financial management ideas to the overall business plan to comprehend how fi...

TOPIC 1: OVERVIEW TO FINANCIAL MANAGEMENT CATHERINE A. CABANADA ASSOCIATE PROFESSOR LEARNING OBJECTIVES: At the end of the session, students are expected to: understand the core ideas of financial management Connect financial management ideas to the overall business plan to comprehend how financial choices affect the organization's objectives. Assess financial strategy in order to maximize shareholder value while balancing the interests of other stakeholders 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 for money. Basically, it means applying general management concepts to cash of the company. The key objectives of financial management: – 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. THREE KEY ELEMENTS TO THE PROCESS OF FINANCIAL MANAGEMENT 1. FINANCIAL PLANNING - Management need to ensure that enough funding is available at the right time to meet the needs of the business. SHORT TERM - Funding may be needed to invest in equipment and stocks, pay employees and fund sales made on credit. MEDIUM AND LONG TERM - Funding may be required for significant additions to the productive capacity of the business or to make acquisitions. 2. FINANCIAL CONTROL - helps the business ensure that the objectives are being met. Financial control determines if assets are secured and being used efficiently. It also identifies if the management act in the best interest of shareholders and in accordance with business rules. 3. FINANCIAL DECISION MAKING - The key aspects of financial decision making include investment, financing and dividends. The key financing decision is whether profits earned by the business should be retained instead of distributing to shareholders via dividends. Dividends that are too high may cause the business to starve of funding to reinvest in growing revenues and profits further.  PERSONAL FINANCE deals with an individuals’ decision 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 firm raise money, from investors, how to invest money to earn profit, and how to reinvest profits in the business or distribute them back to investors. FINANCIAL GOALS 1.Profit Maximization 2.Wealth maximization 3.Sustain Liquidity 4.Resource Allocation Efficiency 5.Accelerated Productivity 6.Payment of Obligations 7.Capital cost reduction 8.Business Sustainability  Goal of a firm/manager: ▪ Is to maximize shareholders’ wealth. ▪ This can be measured by share price. An increasing price per share of common stock relative to the stock market as a whole indicates achievement of this goal.  GOALS OF THE FIRM AND THE ROLE OF THE FINANCE MANAGER ▪ Decision Rule for Managers: Only take actions that are expected to increase the share price! ▪ This rule means that whenever the financial manager decides or choose between or among alternatives, after assessing the risks and the returns, only actions that would increase share price shall be accepted. Otherwise, the alternative/s shall be rejected.  Valuation Approach Cost Approach – answers the question *how much cost would it require to reproduce or replace an asset? Market approach – the value of an asset based on the selling price of similar products Income approach (or capitalization approach)– any method of converting an expected income into an indicator of market value Discounted cash flow approach (DCF) – use expected future cashflow to estimate the future value of an investment Maximization of Shareholders Wealth Wealth Maximization - It is the concept of increasing the value of a business in order to increase the value of the shares held by its stockholders. The concept requires a company's management team to continually search for the highest possible returns on funds invested in the business, while mitigating any associated risk of loss. − It can also be defined as maximizing the shareholder’s wealth due to an increase in share price, thereby increasing the company’s market capitalization. The share price increase directly affects how competitive the company is, its positioning, growth strategy, and profits. − It seeks to maximize profits while meeting the needs of all shareholders  Shareholders - Term used to denote any person, institution or company that has ownership of at least one share of a company’s stocks. Shareholders are partial owners of a company and are entitled to a share in the profits that the said company generates. These profits are provided to stockholders by way of dividend distribution, or through an increase in stock valuation. Every shareholder has the expectation to the company that it would generate a good amount of return from their investment and safeguard their invested amount.  Wealth maximization is a chain aiming to maximize shareholder wealth by increasing the share price, which technically increases market capitalization. To maximize value for shareholders, a company must first be profitable. Only then can it consider increasing shareholder wealth. Less uncertainty is associated with cash flows than profit maximization, and they are more predictable and consistent. So, profits are less important than cash flows.  Advantages Wealth Maximization is less prone to manipulation than profit maximization It is more long-term-focused than profit maximization, which has a short-term focus. Profit maximization is easy to attain because managers may adopt unethical ways to bring short-term profits based on long-term sustainability. They consider risk and uncertainty factors while considering the discounting rate, which reflects both the time and risk. It is more related to cash flows than profits. Cash flows are more certain and regular, and there is a lack of uncertainty that otherwise is associated with profit. − Cash flow - refers to the inflow and outflow of cash and cash equivalents. Cash-flow is generated by business operations, investments, and financing. It determines a business’s cash position and cash availability.  Disadvantages It is more based on an idea that is prospective and not descriptive. − Prospective - indicates that something is expected or likely to happen. Wealth maximization is largely dependent on the business’s profitability as only after the business is profitable can it think of enhancing the wealth of the shareholders. − Business Profitability - is the ability of a company or business to generate revenue over and above its expenses. It is based on the generation of cash flows and not on the accounting profit. − Accounting Profit - is the net income available after reducing direct costs and expenses from the total revenue PROFIT MAXIMIZATION VS WEALTH MAXIMIZATION Profit Maximization Wealth Maximization It does take into account time It takes into account time value of value of money money It does not take into consideration It takes into account risk factor the uncertainty of future earnings It does not differentiate short term It considers different strategies for and long term profits short term and long term profits. ▪ Given the following opportunities, which investment is preferred? EEARNINGS PER SHARE INVESTMENT YEAR 1 YEAR 2 YEAR 3 TOTAL A P 14.00 P 10.00 P 4.00 P 28.00 B P 6.00 P 10.00 P 14.00 P 30.00 ▪ Based on the information provided, the choice is not obvious. Profit maximization is not consistent with wealth maximization. It may not lead to the highest possible share price due to the following reasons: 1. Timing is important - the receipt of funds sooner rather than later is preferred. Project B is expected to provide the higher overall increase in earnings, thus, is the more profitable project. But since the goal of the firm is to maximize value, and therefore, timing must be considered to determine which project is superior. Profit maximization may lead to value maximization, but it is not an absolute case. 2. Profits do not necessarily result in cash flows available to stockholders. In finance, cash is king. It is not unusual for a firm to be profitable yet experience a cash crunch. They may have so much profit but less do not have enough cash to continuously run the business. The most common cause is when expenses have a shorter due date than expected revenue. In such cases the firm must arrange short-term financing to meet its debt obligations before the revenue arrives. 3. Profit maximization fails to account for risk. Risk is the chance that actual outcomes may differ from expected outcomes. Financial managers must consider both risk and return because of their inverse effect on the share price of the firm. Increased risk may decrease the share price while increased return is likely to increase the share price. SOCIAL RESPONSIBILITY Social Responsibility defined Elements of Social Responsibility Basic Principles of Social Responsibility Examples of Social Responsibility Social Responsibility in Financial management How is social responsibility used in maintaining a well financial management amid the factors of the society? Social Responsibility Defined social responsibility is the way an entity, be it an organization or a single person observes responsibility towards the society apart from its goal of maximizing profit. Socially responsible companies should adopt policies that promote the well-being of society and the environment while lessening negative impacts on them Elements of Social Responsibility THE ENTITY An entity can be an organization or a single being in the person of an entrepreneur or a private person. SOCIAL AWARENESS - an entity is aware of his responsibilities to his surroundings. In the market, these players usually observe trends that affect them and from it, derive techniques to overcome, ride or improve the system. Elements of Social Responsibility OBJECTIVE/GOAL the ultimate desire of businesses is to thrive and maximize profit, but alongside this goal are its side-effects. It is life the "by-product" of a process, and it goes alongside with the goal of the entity. This by-product is to help the society where the entity finds itself/placed. Activity: Recitation Example of Social Responsibility Example of Social Responsibility Reducing carbon footprints Improving labor policies Participating in fairtrade Diversity, equity and inclusion Charitable global giving Community and virtual volunteering Socially and environmentally conscious investments Fair wages Social Responsibility in Financial Management A socially responsible bank or other financial institution attempts to manage its banking activities with integrity and hold itself accountable to stakeholders when it comes to issues like sustainability, environmental performance, and other ethical concerns.  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 corporations, and other stakeholders are the major participants included here. 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.  SCOPE OF FINANCIAL MANAGEMENT Financial management has a wide scope. It includes the following five “A”s as stated by Dr. S.C. Saxena: 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 the 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. FINANCE AREAS AND CAREER OPPORTUNITIES The following are the major areas in the field of finance. 1. FINANCIAL SERVICE - the one concerned with the design and delivery of advice and financial products to individuals, businesses, and governments. Career opportunities: within the areas of banking, personal financial planning, investments, real estate, and insurance. 2. MANAGERIAL FINANCE - concerned with the duties of the financial manager working in a business. This encompasses financial planning or budgeting, extending credit to customers or other credit administration function, investment evaluation and analysis, and obtaining of funds for a firm. Managerial finance is the management of the firm’s funds within the firm. Career opportunities: financial analyst, capital budgeting analyst, and cash manager.  The following are the professional certifications in finance: 1. Chartered Financial Analyst (CFA) - a graduate-level course of study focused largely on the investments side of finance. This is offered by the CFA Institute. 2. Certified Treasury Professional (CTP) - this program requires students to pass a single exam that is focused on the knowledge and skills needed for those working in a corporate treasury department. 3. Certified Financial Planner (CFP) - Students should pass a 10- hour exam covering a wide range of topics related to personal financial planning in order to obtain CFP status. 4. American Academy of Financial Management (AAFM) - This administers certification programs for financial professionals in a wide range of fields. Their certifications include the Charter Portfolio Manager, Chartered Asset Manager, Certified Risk Analyst, Certified Cost Accountant, Certified Credit Analyst, and many other programs. 5. Professional Certifications in Accounting - include Certified Public Accountant (CPA), Certified Management Accountant (CMA), Certified Internal Auditor (CIA), and many other programs.  JOBS IN FINANCE ▪ Banking ▪ Investments ▪ Insurance ▪ Corporations ▪ Government LEGAL FORMS OF BUSINESS ORGANIZATION A. SOLE PROPRIETORSHIP ▪ Is the most common form of business organization. ▪ It is a business owned by one person and operated for his or her own profit. ▪ He is legally responsible for the debts and taxes of the business and very involved in its day to day activities. ▪ Many sole proprietorships operate in the wholesale, retail, service and construction industries. ADVANTAGES: It is simple and the owner has freedom to make all decisions and enjoy all the profit. It has minimal legal restrictions and government regulation. It can be discontinued with great ease and the tax rate is relatively at the minimum. DISADVANTAGES: The owner may lack expertise or experience to run a business. The owner may also incur unlimited liability. Generally, the owner has relatively limited availability of outside financing. B. PARTNERSHIP ▪ is a business owned by two or more people and operated for profit. ▪ This is based on an agreement called Article of Co-Partnership. ▪ They are legally responsible for the debts and taxes of the business. ▪ Partners must agree upon amount each partner will contribute to the business, percentage of ownership of each partner, share of profits of each partner, duties each partner will perform, and the responsibility each partner has for the partnership’s debts. ▪ Typical partnership includes those professional services such as medical and dental practices, accounting, architectural and law firms. ADVANTAGES: ▪ There is ease of organization compared to corporation. ▪ In partnership, there are combined talents, more available brain power and managerial skill. ▪ In terms of financing, it can raise more capital for the firm than a sole proprietorship. DISADVANTAGES: ▪ There is unlimited liability for general partners and limited life for the firm. ▪ Partnership is dissolved when a partner withdraws or dies. ▪ And it is difficult to liquidate or transfer patnership. ▪ Two or more heads may be better for the firm but there is also a possibility of divided authority that could lead to possible disagreement on major decisions and issues. C. CORPORATION ▪ Is an entity created by law. ▪ Corporations have the legal powers of an individual in that it can be sue and be sued, make and be party to contracts, and acquire property in its own name. ▪ It is a publicly or privately-owned business entity that is seperate from its owners and has a legal right to own property and do business in its own name. But the stockholders are not responsible for the debts or taxes of the business. ▪ A corporation is governed by the Board of Directors, in case of a profit organization, or Board of Trustees in case of not-for-profit organization. ADVANTAGES: ▪ The limited liability of stockholders and perpetual life. ▪ There is ease of transferring ownership, expansion obtaining resources or financing. DISADVANTAGES: ▪ Corporations are bound by relatively more government regulations/restrictions and maybe expensive to organize. ▪ Since the corporation is considered separate from its stockholders, it must pay income tax on its profits, as well as dividend tax if it wishes to distribute these profits as dividends. 4. COOPERATIVES ▪ Is owned by more than one individual ▪ Founding members of a cooperative shall not be less than 15 individuals ▪ It is an association of individuals who joined together to contribute capital and cooperate in order to achieve certain goals. ▪ Is formed in accordance with the provisions of The Philippine Cooperative Code of 2008. ▪ It has a juridical personality ADVANTAGES: ▪ Each member is entitled to only one vote regardless of his or her shareholdings. ▪ Generally exempt from paying taxes ▪ Is easier and less costly to form because there are fewer formal business requirements ▪ Limited liability ▪ Unlimited life DISADVANTAGES: ▪ Prone to poor management ▪ Susceptible to corruption ▪ The Cooperative Code places some restrictions on the distribution of a cooperative`s profits to its members. ▪ It is more difficult for a cooperative to sustain because of the lack of management expertise. ▪ There are restrictions on the transfer of member`s shares. FINANCE, ECONOMICS AND ACCOUNTING ECONOMICS ▪ is a study of choice. ▪ It is a social science that deals with individual or collective economic activities such as production, consumption, distribution and transfer of money and wealth. ▪ This is based on the fact that our resources are scarce and need to deliberately and systematically allocated. FINANCE ▪ is the study of financial allocation and answers the questions like where to put your money and why. ▪ It is considered a form of applied economics. ▪ Marginal cost-benefit analysis is the primary economic principle that is being used in managerial finance. This principle reminds the decision makers to choose and take actions only when the firm will have a net advantage, which means that the added benefits exceed the added costs. DIFFERENCES BETWEEN FINANCE AND ACCOUNTING FINANCE ACCOUNTING The emphasis is on cash flows Accountants generally use the accrual method The financial manager focuses Accountants recognize revenues on the actual inflows and at the point of sale and expenses outflows of cash, recognizing when incurred regardless on revenues when cash is collected when cash will flow into or out of and expenses when actually the firm. paid. ROLE OF FINANCIAL MANAGERS ▪ Administer the financial affairs of all types of businesses such as private and public, large and small, profit-seeking and not-for-profit. ▪ He handles a firm’s cash, investing surplus funds when available and securing outside financing when needed. ▪ He also oversees a firm’s pension plans and manage critical risks related to movements in foreign currency values, interest rates, and commodity prices. ROLE OF TREASURER Make decisions with respect to: ▪ handling financial planning ▪ acquisition of fixed assets ▪ obtaining funds to finance fixed assets ▪ managing working capital needs ▪ managing the pension fund ▪ managing foreign exchange ▪ distribution of corporate earnings to owners The two key activities that the financial manager does as related to a firm’s balance sheet are the following: 1. INVESTMENT DECISIONS - The finance manager defines the most efficient level and the best structure of assets. Investment decisions deals with the items that appear on the asset section of the balance sheet. 2. FINANCING DECISIONS - The finance manager determines and maintains the proper combination of short and long term financing. Also, he raises the needed financing in the most economical manner. Financing decisions generally refers to the items that appear on the liability and equity section of the balance sheet. 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. ▪ When managers 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. AGENCY COSTS are the costs borne by shareholders due to the occurrence and avoidance of agency problems. ▪ The agency problems and the associated agency costs can be reduced with the following: 1. Properly constructed and implemented corporate governance structure. This should be designed to institute a system of check and balances to reduce the ability and incentives of management to deviate from the goal of shareholder wealth maximization. 2. Structured expenditures thru compensation plans. This maybe the most popular way to deal with the agency problem but this is the most expensive one. It could be either incentive or performance plans. Managers may receive performance shares and/or cash bonuses when the set performance goals are attained. 3. Market forces such as shareholder crusading from large institutional investors. Institutional investors hold large quantities of shares in many of the corporations in their portfolio. The power of institutional investors far exceeds the voting power of individual investors. This can lessen or avoid the agency problem because these groups can put pressure to management to take actions that maximize shareholder wealth. 4. Threat of hostile takeovers. It occurs when a company or group not supported by existing management attempts to acquire the firm. Because the acquirer looks for companies that are poorly managed and undervalued, this threat provokes managers to act in the best welfare of the firm’s owners.