Fundamentals of Finance PDF

Handout 1 UNIVERSITY OF JAFFNA – SRI LANKA FACULTY OF MANAGEMENT STUDIES AND COMMERCE DEPARTMENT OF FINANCIAL MANAGEMENT...

Handout 1 UNIVERSITY OF JAFFNA – SRI LANKA FACULTY OF MANAGEMENT STUDIES AND COMMERCE DEPARTMENT OF FINANCIAL MANAGEMENT BBAF 11043 FUNDAMENTALS OF FINANCE Learning Outcomes: After completing this topic, you will be able to; Define the meaning of finance and financial management Describe the goals and scope of finance and financial management Explain why maximizing the value of the firm is an appropriate goal for a business Describe the finance function related to economics, accounting and other managerial functions Identify the primary activities of the financial manager 1 INTRODUCTION Business concern needs finance to meet their requirements in the world. Any kind of business activity depends on the finance. Hence, finance is called as lifeblood of business organization. Whether the business concerns are big or small, they need finance to fulfil their business activities. In the modern world virtually every organization, public and private, runs on money. The entire business activities are directly related with making profit. A business concern needs finance to meet their all requirements. 2 MEANING AND DEFINITION OF FINANCE: Finance is defined as art and science of managing money. It includes financial service and financial instruments. Finance function is the procurements of funds and their effective utilization in business concern. Finance may be called as capital, investment, fund etc., but each term is having different meanings and unique characteristics. Increasing profit is the main aim of any kind of economic activity. According to Khan and Jain, “Finance is the art and science of managing money”. The Oxford dictionary stated, “Finance” connotes ‘management of money’. Webster’s Ninth New collegiate Dictionary defines as “finance is the science on study of the management of funds’ and the management of fund as the system that includes circulation of money, granting of credit, making of investments, and the provisions of banking facilities. 3 CORPORATE FINANCE: Corporate finance is the study of a business's money-related decisions, which are essentially for business's decisions. The primary goal of corporate finance is to figure out how to 1 maximize a company's value by making good decisions about investment, financing and dividends. In other words, how should businesses allocate scarce resources to minimize expenses and maximize revenues? Money touches everything we do. And finance, the management of money, is behind most everything we see each day. Corporate finance is concerned with budgeting, financial forecasting, cash management, credit administration, investment analysis and fund procurement of the business concern and the business concern needs to adopt modern technology and application suitable to the global environment. Corporate finance has three main areas of concern: (a) Capital budgeting: What long term investments should the firm take? (b) Capital structure: Where will the firm get the long term financing to pay for its investments? Also, what mixture of debt and equity should it use to fund operations? (c) Working capital management: How should the firm manage its everyday financial activities? Finance will be broadly divided into two areas: (1) investments and financial markets and (2) the financial management of companies. (a) Investments Purchasing some assets or valuable things is an investment. A real asset is an object or thing, such as car, a house, a factory, or machinery. Real assets have value because they provide some kind of service, such as transportation, shelter, or the ability to produce something. On the other hand, financial assets are legal documents, pieces of paper. Most financial assets are either stocks or bonds, and their claim to future income is based on ownership or debt, respectively. Companies issue financial assets to raise money. They generally use that money to buy real assets that are used in running their businesses. A person or organization buying financial assets is said to be investing in that asset, and we generally call that buyer an investor. (b) Financial Markets: Both kinds of financial assets are issued by companies and purchased by investors in financial markets. A financial market isn’t exactly a place; rather, it’s a framework or organization in which people can buy and sell securities in accordance with well-defined rules and regulations. The best-known financial market is the stock market. It is centered in several places around the country, called stock exchanges. 2  (c) Financial Management: Financial management is an integral part of overall management. Financial Management means planning, organizing, directing and controlling the financial activities such as procurement and utilization of funds of the enterprise. It means applying general management principles to financial resources of the enterprise. i,e the management and control of money and money-related operations within a business. The term financial management has been defined by Solomon, that “Financial Management is concerned with the efficient use of an important economic resource namely, capital funds”. Kuchal explained that “The Financial Management deals with procurement of funds and their effective utilization in the business”. Howard and Upton stated that “Financial management is an application of general managerial principles to the area of financial decision-making”. Thus, Financial Management is mainly concerned with the effective funds management in the business. In simple words, Financial Management as practiced by business firms can be called as Corporate Finance or Business Finance. 4 SCOPE OF FINANCIAL MANAGEMENT Financial management is one of the important parts of overall management, which is directly related with various functional departments like human resource, marketing and production. Financial management covers wide area with multidimensional approaches. The following are the important scope of financial management. i. Financial Management and Economics Economic concepts like micro and macroeconomics are directly applied with the financial management approaches. Investment decisions, micro and macro environmental factors are closely associated with the functions of financial manager. Financial management also uses the economic equations like money value discount factor, economic order quantity etc. Financial economics is one of the emerging area, which provides enormous opportunities to finance, and economical areas. ii. Financial Management and Accounting Accounting records includes the financial information of the business concern. In the past periods, both financial management and accounting are treated as a same discipline and then it has been merged as Management Accounting because this part is very much helpful to finance manager to take decisions. But nowadays financial management and accounting discipline are separate and interrelated. 3 In most industrial companies, the majority of the people involved in money-oriented activities are accountants, so people sometimes get the ideas that accounting and finance are synonymous. Accounting is a system of record keeping designed to describe a firm’s operations to the world in a fair and unbiased way. The records are used periodically to produce financial statements that present the company’s results to anyone who reads them. However, several other financial functions are performed in most companies. These include raising money, analyzing results, and handling relationships with outsiders such as banks, shareholders, and representatives of the investment community. Most of these functions are performed by the treasury department. iii. Financial Management or Mathematics Modern approaches of the financial management applied large number of mathematical and statistical tools and techniques. They are also called as econometrics. Economic order quantity, discount factor, time value of money, present value of money, cost of capital, capital structure theories, dividend theories, ratio analysis and working capital analysis are used as mathematical and statistical tools and techniques in the field of financial management. iv. Financial Management and Production Management Production management is the operational part of the business concern, which helps to multiply the money into profit. Profit of the concern depends upon the production performance. Production performance needs finance, because production department requires raw material, machinery, wages, operating expenses etc. These expenditures are decided and estimated by the financial department and the finance manager allocates the appropriate finance to production department. The financial manager must be aware of the operational process and finance required for each process of production activities. v. Financial Management and Marketing Produced goods are sold in the market with innovative and modern approaches. For this, the marketing department needs finance to meet their requirements. The financial manager or finance department is responsible to allocate the adequate finance to the marketing department. Hence, marketing and financial management are interrelated and depends on each other. vi. Financial Management and Human Resource Financial management is also related with human resource department, which provides manpower to all the functional areas of the management. Financial manager should carefully evaluate the requirement of manpower to each department and allocate the finance to the human resource department as wages, salary, remuneration, commission, bonus, pension and 4 other monetary benefits to the human resource department. Hence, financial management is directly related with human resource management. 5 ORGANIZATION OF THE FINANCIAL MANAGEMENT FUNCTION Companies have finance departments that are responsible for these functions. The executive in charge of the finance department is the company’s Chief Financial Officer (CFO). The title Vice President of Finance is sometimes used instead of CFO. In either case, the position usually reports to the president of the company. The activities include keeping records, paying employees and vendors, receiving payments from customers, borrowing, purchasing assets, selling stock, paying dividends, and a number of others. It’s important to notice that accounting is included in this broad definition of finance and that the accounting function is usually found within the finance department. 5.1 Structure of the Finance Department The following figure is an organization chart for a typical manufacturing firm that gives special attention to the finance function. Board of Director President Chief Executive Officer Vice President Vice President Vice President Operations Finance Marketing Chief Financial Officer Treasurer Controller Investors Corporate Pension Tax Budget & Internal Relation Finance Management Analysis Audit Cash Credit Financial Cost Management Management Reporting Accounting 5 The financial manager raises capital from the capital markets. As the head of one of the three major functional areas of the firm, the vice president of finance, or chief financial officer (CFO), generally reports directly to the president, or chief executive officer (CFO). In large firms, the financial operations overseen by the CFO will be split into two branches, with one headed by a treasurer and the other by a controller. The controller’s responsibilities are primarily accounting in nature. Cost accounting, as well as budgets and forecasts, concerns internal consumption. External financial reporting is provided to the stockholders. The treasurer’s responsibilities fall into the decision areas most commonly associated with financial management. The treasurer’s function is to raise and manage company funds while the controller oversees whether funds are correctly applied. The finance department normally consists of both the accounting department headed by the controller and the treasury department headed by the treasurer. Both of these positions report to the chief financial officer. The treasury functions are called finance and the controller functions are called accounting. Either controller or treasurer can become CFOs. The majority of jobs in the investment industry and in financial institutions such as banks and insurance companies are in finance rather than accounting. Accounting is the language of finance. 6 OBJECTIVES OF FINANCIAL MANAGEMENT The financial management is generally concerned with procurement, allocation and control of financial resources of a concern. It is the essential part of the financial manager. Therefore, the financial manager must determine the basic objectives of the financial management. Objectives of Financial Management may be broadly divided into two parts such as: i. Profit maximisation ii. Wealth maximisation Profit maximization The main aim of any kind of economic activity is earning profit. Profit is the measuring techniques to understand the business efficiency of the concern. Profit maximization is also the traditional and narrow approach, which aims at, maximizes the profit of the concern. Profit maximization consists for the following important features. i. Profit maximization is also called as cashing per share maximization. It leads to maximize the business operation for profit maximization. ii. Ultimate aim of the business concern is earning profit, hence, it considers all the possible ways to increase the profitability of the concern. 6 iii. Profit is the parameter of measuring the efficiency of the business concern. So it shows the entire position of the business concern. iv. Profit maximization objectives help to reduce the risk of the business. Wealth Maximization Wealth maximization is one of the modern approaches, which involves latest innovations and improvements in the field of the business concern. The term wealth means shareholder wealth or the wealth of the persons those who are involved in the business concern. Wealth maximization is also known as value maximization or net present worth maximization. This objective is an universally accepted concept in the field of business. 7 FUNCTIONS OF FINANCIAL MANAGER Finance function is one of the major parts of business organization, which involves the permanent, and continuous process of the business concern. Finance is one of the interrelated functions which deal with personal function, marketing function, production function and research and development activities of the business concern. At present, every business concern concentrates more on the field of finance because, it is a very emerging part which reflects the entire operational and profit ability position of the concern. Deciding the proper financial function is the essential and ultimate goal of the business organization. Finance manager is one of the important role players in the field of finance function. He must have entire knowledge in the area of accounting, finance, economics and management. His position is highly critical and analytical to solve various problems related to finance. A person who deals finance related activities may be called finance manager. Finance manager performs the following major functions i. Estimation of capital requirements: A finance manager has to make estimation with regards to capital requirements of the company. This will depend upon expected costs and profits and future programs and policies of a concern. Estimations have to be made in an adequate manner which increases earning capacity of enterprise. ii. Determination of capital composition: Once the estimation have been made, the capital structure have to be decided. This involves short- term and long- term debt equity analysis. This will depend upon the proportion of equity capital a company is possessing and additional funds which have to be raised from outside parties. 7 iii. Choice of sources of funds: For additional funds to be procured, a company has many choices like- a. Issue of shares and debentures b. Loans to be taken from banks and financial institutions c. Public deposits to be drawn like in form of bonds. iv. Investment of funds: The finance manager has to decide to allocate funds into profitable ventures so that there is safety on investment and regular returns is possible. v. Disposal of surplus: The net profits decision has to be made by the finance manager. This can be done in two ways: a. Dividend declaration - It includes identifying the rate of dividends and other benefits like bonus. b. Retained profits - The volume has to be decided which will depend upon expansion, innovational, diversification plans of the company. vi. Management of cash: Finance manager has to make decisions with regards to cash management. Cash is required for many purposes like payment of wages and salaries, payment of electricity and water bills, payment to creditors, meeting current liabilities, maintenance of enough stock, purchase of raw materials, etc. vii. Financial controls: The finance manager has not only to plan, procure and utilize the funds but he also has to exercise control over finances. This can be done through many techniques like ratio analysis, financial forecasting, cost and profit control, etc. viii. Interrelation with Other Departments: Finance manager deals with various functional departments such as marketing, production, human resource, system, research, development, etc. Finance manager should have sound knowledge not only in finance related area but also well versed in other areas. He must maintain a good relationship with all the functional departments of the business organization. The decision function of financial management can be broken down into three major areas: (1) investment decision, (2) financing decision, and (3) Asset management decision and dividend decision. In other words, the firm decides how much to invest in short-term and long-term assets and how to raise the required funds. (a) Investment decision: The investment decision is the most important of the firm’s three major decisions. It begins with a determination of the total amount of assets needed to the firm. The financial manager needs to determine the amount of assets of the balance sheet – that is the size of the firm. 8 (b) Financing decision: The second major decision of the firm is the financing decision. Here the financial manager is concerned with the makeup of the liability side of the balance sheet. Some firms have large amounts of debt, while others are almost debt free. In addition, dividend policy must be viewed as an integral part of the firm’s financing decision. (c) Asset management decision: The third important decision of the firm is the asset management decision. Once assets have been acquired and appropriate financing provided, these assets must still be managed efficiently. The financial manager is charged with varying degrees of operating responsibility over existing assets. These responsibilities require that the financial manager be more concerned with the management of current assets than with that of fixed assets. 8 AGENCY RELATIONSHIP IN CORPORATE FINANCE: Agency Relationships occur when one or more individuals (the principals) hire another individual (the agent) to perform a service on behalf of the principals. In an agency relationship, decision-making authority is often delegated to the agent. Due to a separation of ownership and control in many corporations, a divergence frequently exists between the owners’ goals (shareholder wealth maximization) and the managers’ goals (such as job security). Eg. Managers may be more concerned with long run survival (job security) causing them to minimize (or limit) the amount of risk incurred by the firm. 8.1 Agency Problem: Inefficiencies that arise in agency relationships are called agency problems. Agency problems occur when managers maximize their own welfare instead of that of the principals. Examples of agency problems can include a preoccupation by management with their job security, excessive privilege consumption, and managerial shirking. Shareholders incur agency costs to minimize agency problems. Agency costs include: a. The cost of management incentives designed to induce managers to act in the shareholders’ interests. b. Expenditures to monitor management’s action and performance; c. Bonding expenditures to protect shareholders from managerial fraud; and d. The opportunity cost of lost profits arising from complex organizational structures that prevent timely responses to opportunities. 9 8.2 Agency conflict between Stockholders (the principals) and Managers (the agents) If the firm’s managers engage in divergent activities as opposed to what expected by the shareholders, agency conflict arises between them. In order to protect stockholders interest managers often must not be insisted in their activities with the firm. 8.3 Agency conflict between Stockholders and Creditors If the firm engages in high-risk activities, the creditors may not share the rewards. In order to protect their interests’ creditors are left holdings the bag if things don’t work out well. In order to protect their interests’ creditors often insist on certain protective covenants in their contracts with the firm. Agency problems and agency costs can be reduced when financial markets operate efficiently. For example, the existence of an efficient takeover market ensures that managers act in the best interest of shareholders; if they do not, managers face the prospect of their firm being taken over by an outsider and losing their jobs. SUMMARY Finance is such an important part of modern life that almost everyone can benefit from understanding it better. On the most basic level, these problems are about how to allocate money. Finance is about how best to decide among these and other investment alternatives. This is the basic problem in any business concern. This is discussed in this unit. And it is able to explain the definition of corporate finance, scope, organization and functions of financial management. Further the agency problem also has been discussed in this unit. SELF-PRACTICE QUESTIONS 1. What is finance? Define corporate finance. 2. Discuss the objectives of financial management. 3. Explain the scope of the financial management. 4. Discuss the role of financial manager. 5. Explain the agency relationship in financial management Issued by Prof. Rathiranee Yogendrarajah Professor in Financial Management, 10 Department of Financial Management Issued on 22nd May 2024