BMA Chapter 2_compressed.pdf - Financial Management PDF

# Chapter 1: Introduction **This chapter aims to introduce the basic concepts of financial management and explain how you can use this book to your advantage.** - The book is designed to allow you to develop your own questions and learn independently. - The book covers all the essential principl...

# Chapter 1: Introduction **This chapter aims to introduce the basic concepts of financial management and explain how you can use this book to your advantage.** - The book is designed to allow you to develop your own questions and learn independently. - The book covers all the essential principles of financial management and will be explained with in-depth detail. - The authors bring years of experience as lecturers and have applied this expertise in the book to make the subject easier to understand. - Look for additional resources and a glossary at the end of the book. # Chapter 2: Definitions of terms **This chapter aims to explain the key terms used in financial management and eliminate any confusion.** - The book will define terms as needed but will focus on terms that often cause confusion. ## Learning Outcomes - After studying this chapter, you should understand the meanings and implications of: - Financial management - The financial manager - The terms “director” and “manager” - Risk and uncertainty - Cash and cash flow - Inventory on hand - Articles, goods and products - Equations and formulas - Capital - Liquidity and solvency - Organization - Profit and net income - Trade receivables and accounts receivable - Owner and entrepreneur ## Introduction - This chapter will explain the critical terms that often cause confusion. - Other terms will be defined as needed throughout the book. ## Financial Management - Financial management involves monitoring an organization's financial position. - There are three primary functions: - Analyzing the organization's financial position. - Managing the organization's asset structure. - Managing the organization's financial structure. ## Analyzing the Organization's Financial Position - The first task in financial management is to ensure its soundness. - This includes monitoring its liquidity and profitability. - Liquidity refers to the organization's ability to meet its short-term debts. - If there is a problem, steps need to be taken to correct it. ## Managing the Organization's Asset Structure - This function manages the organization's assets, ensuring the right kind and quality of equipment is acquired. - The goal is to ensure production is efficient and that the organization is not over-capitalized. ## Managing the Organization's Financial Structure - This function maintains the optimum proportion between shareholders' funds and long-term and short-term loans. - The goal is to determine the amount of debt the organization should maintain to accommodate the risk involved in the industry. - The underlying principle is that shareholders' funds provide the safest form of long-term financing. ## The Financial Manager - The financial manager is a senior position in the organization and is sometimes accountable only to the chairman of the board of directors. - The financial manager is responsible for the functions defined in the section on financial management. - The ultimate aim of the financial manager is to maximize the owners' wealth or interest. - Maximizing profit is a short-term concept; maximising wealth is a long-term concept. - The financial manager should also be aware of the individual who manages their own private financial affairs. - This person is a financial manager, and their actions align with the functions explained in this section. ## The Terms "Director" and "Manager" - The terms "director" and "manager" are used to describe the people leading a company, but these terms also apply to partnerships and sole proprietorships. - In a proprietorship, the individual is performing both roles. - When using these terms, they apply to any kind of business structure, whether it's a proprietorship, partnership, public company, or private company. ## Risk and Uncertainty - **Risk** is the chance of loss that could be caused by a known phenomenon. - For example, a drought could ruin crops. - We know that droughts happen but can't predict the level of loss. - **Uncertainty** means any possible unforeseen outcomes could ruin a venture. - There is no certainty event will occur. - For example, a recession could impact a company's bottom line. - **Risk** presupposes knowledge of a phenomenon, whereas **uncertainty** presupposes no such knowledge. ## Forms of Risk - Risk can be divided into two categories: - **Operating risk** is the chance that income from sales will be too small to cover operating and marketing costs. - **Financial risk** is the chance that operating profits will be too low to cover payments of interest, income tax, and preference dividends. ## Risk May Be Further Divided into Diversifiable and Non-Diversifiable Risk - **Diversifiable risk** can be reduced by investing in less risky areas. - For example, a farmer can diversify by investing in a transport business as well as farming. - **Non-diversifiable risk** cannot be mitigated through diversification. - For example, a war or recession will affect businesses across all industries. ## Cash and Cash Flow - **Cash** refers to the money in circulation for an organization. - **Cash flow** is the liquid funds that flow in and out of an organization. - **Inflows** come from sales. - **Outflows** are made for purchases, production costs, and payments to investors and employees. ## Cash Inflows and Cash Outflows - **Cash inflows** come from operations and do not include funds received from investors or dividends. - **Cash outflows** are disbursements, which are relatively predictable and include expenses like payments of accounts payable, income tax, and interest on loans. ## Inventory on Hand - **Inventory** refers to the list of goods an organization has on hand. - In a retailing organization, inventory includes finished goods ready for sale. - In a manufacturing organization, inventory includes raw materials, goods-in-process, and finished goods. ## Articles, Goods, and Products - The terms “articles,” “goods,” and “products” are used interchangeably in the context of the book. - The terms refer to raw materials, goods-in-process, or finished goods, depending on who is manufacturing the product and who is buying it. ## Equations and Formulas - An **equation** equates two sides using an “equal” sign. - A **formula** describes a process to create a desired result. - Formulas and equations are used interchangeably in the book, and the term "formula" is used to describe both calculations and processes. ## Capital - Capital has an economic and financial connotation, and its meaning varies depending on context. - **Economically**, capital is one of the four factors of production: land, labor, capital, and enterprise. - **Financially**, capital refers to the funds invested in an organization to acquire fixed assets. - **Capital** also includes the total value of equity and debt. ## Enterprise - **Enterprise** is the willingness to start and manage a business. - It is usually provided by an owner or entrepreneur. ## Liquidity and Solvency - **Liquidity** is the ability to have sufficient cash on hand to meet short-term obligations. - These obligations include things like wages, and trade and other payables. - **Solvency** is the ability to repay all debts after liquidation. ## Organization - An organization (or business) can be a huge corporation, public or private company, partnership, or even a sole proprietorship. - The term “organization” is used throughout the book to indicate an operating business. ## Profit and Net Income - **Profit** is the positive difference between income and costs. - **Loss** is the negative difference. - **Net income** is the difference between income and costs. - **Operating income** refers to the net income from operations. - **Earnings before interest and tax (EBIT)** is the same as operating profit. ## Trade Receivables and Accounts Receivable - **Trade receivables** refer to individuals or businesses owing money to a creditor for goods or services obtained on credit. - **Accounts receivable** refers to the debtor accounts and the amounts of money outstanding as a result of credit transactions. ## Owner and Entrepreneur - **Owner** is the individual who establishes a business and is responsible for its continued maintenance. - In a partnership, the partners are considered owners and bear the risk of loss jointly. - In a company, the ordinary shareholders are the true owners. - **Entrepreneur** is a person who takes on greater than normal financial risks to start a business. - Owners and entrepreneurs share many similarities. ## Significance of This Chapter - It is vital to know the meanings and significance of the terms discussed in this chapter. - Understanding the concepts of liquidity and solvency are essential for running an organization successfully. - It is important to understand whether you are operating as an entrepreneur or a supervising manager, and to stay within your decision-making authority. ## Conclusion - The terms explained in this chapter often cause confusion. - They are key concepts in financial management and will continue to be defined as needed in the book. ## Self-Test Questions 1. Explain the principal aim of the financial manager. 2. Define **risk**, and explain the various forms of **risk**. 3. What is **capital**? Explain its economic and financial connotations. 4. Define **inventory**, and explain its various constituents. 5. Define **liquidity** and **solvency**, and explain the difference between them.