Chapter One

An over view of Financial Management

1.1 The nature and scope of financial management
Definition: Financial management is an art and science of managing money.
 As an art it requires some skills which can be used by professionals.
 As a science it involves some study and research used to come up with standards and
principles.
 Financial management includes the process and transfer of money among and between
individuals, business and government.
 It is also used as mediator between who want to save their money & who want to invest
money of others.
Scope of finance
A firm secures whatever capital it needs and employs it (finance activity) in activities which
generate returns on invested capital (production and marketing activities).

Financial Management Vs Economics & Accounting

Economics
 Financial managers need to have a good understanding of the economic environment.
 Some economic concepts are used by financial management such as:
o Demand & Supply concept
o Profit maximization principle (i.e. MR = MC)
o Pricing concept
Accounting
 Focuses on providing financial information to the user group.
 Accounting relies on past events, whereas the financial management focuses on the
future.
 Accounting deals on preparing financial statement, this must be changed to other in
understandable form by the financial manager.
Accounting Financial management
Incomes statement Analysis of F/S
Capital statement Eg. -Ratio analysis
Balance sheet Common size statements
Statement of cash flows
1.2 Financial Markets and Institutions
Financial Institutions:
Financial institutions are financial intermediaries which include insurance companies, pension
funds and investment banks.

Financial Market:
Financial markets include primary markets, where new securities are sold, and secondary
markets, where existing securities are traded.

Primary Markets Vs Secondary Markets

A primary markets is one in which a borrower issues new securities in exchange for cash from
an investor (buyer). New sales of treasury bills, stock or bonds all take place in the primary
markets. The issuers of these securities receive cash from the buyers of these securities, who in
turn receive financial claims that previously did not exist.
Secondary markets: markets where existing securities are traded among investors. Once new
securites have been sold in the primary market, an efficient mechanism must exist for their resale
if investors are to view securites as attractive opportunities. Secondary markets give investors the
means to trade existing securities.
Financial assets
Major types of financial assets are:
1. Non marketable
2. Money markets
3. Capital market
4. Derivative market
1. Non marketable financial assets: assets that represent personal transactions between the
owner and the issuer. That is, you as the owner of a savings account at a bank must open the
account personally, you must deal with the bank in maintaining the account or in closing it. In
contrast, marketable securities trade in impersonal markets-the buyer (seller) does not know who
the seller (buyer) is, and does not care.
It includes:
 Saving accounts: saving account are held at commercial banks or institutions such as
saving and loan association and credit unions. Saving accounts in insured institutions
offer a high degree of safety on both the principal and the return on that principal.
Liquidity (which can be defined as the ease with which an asset can be converted to cash)
is taken for granted.
 Nonnegotiable certificate: commercial banks and other institutions offer a variety of
savings certificate known as certificate of deposits (CDs). These certificates are available
for various maturities, with higher rates offered as maturity increases.
 Money markets deposit accounts: financial institutions offer money market deposit
accounts with no interest rate ceilings. Money markets accounts, with a required
minimum deposit to open, pay competitive money market rates and insured up with some
amount.
2. Money markets: include short term, highly liquid, relatively low risk debt instrument sold by
governments, financial institutions, and corporations to investors with temporary excess funds to
invest. Some of these instruments are negotiable and actively traded, and some are not. It
includes:
 Treasury bills: the premier money market instrument, a fully guaranteed, very
liquid IOU from the government. They are sold on auction basis.
 Negotiable certificate of deposit ( CDs): issued in exchange for a deposit of funds
by most banks, the CD is a marketable deposit liability of the issuer, who usually
stands ready to sell new CDs on demand. The deposit is maintained in the bank
until maturity, at which the time holder receives the deposit plus interest.
However, these CDs are negotiable, meaning that they can be sold in the open
market before maturity.
 Commercial paper: a short term, unsecured promissory note issued by large, well
known, and financially strong corporations (including finance companies).
Commercial paper usually sold at a discount either by the issuer or indirectly
through a dealer, with rates comparable to CDs.
  Eurodollars: dollar denominated and developed in Europe. Major international
banks transact among themselves with other participants including multinational
corporations and government. Maturities mostly short term, often less than six
months.
 Repurchase agreement (RPs): an agreement between a borrower and a lender
(typically institutions) to sell and repurchase government securities. The borrower
initiates a RP by contracting to sell securities to a lender and agreeing to
repurchase these securities at a prespecified price on a stated date. The effective
interest rate is given by the difference between the purchase price and the sale
price. The maturity of RPs is generally very short, from three days to 14 days, and
some times overnight.
 Banker's acceptance: a time draft drawn on a bank by a customer, whereby the
bank agrees to pay a particular amount at a specified future date. Banker's
acceptances are negotiable instruments because the holder can sell them for less
than face value.
3. Capital Markets: encompass fixed income and equity securities with maturities greater than
one year. Risk is generally much higher than in the money market because of the time to
maturity and the very nature of the securities sold in the capital markets. Marketability is poor in
some cases. The capital markets include both debt and equity securities, with equity security
having no maturity date. It includes:
 Fixed income securities
 Treasuries bonds
 agencies
 Municipal bonds
 corporate bonds
 Equities
 Preferred stock
 common stock
5. Derivative Markets: securities that derive their value in whole or in part by having a
claim on some underlying security. It includes
 Forward options
 futures
 swaps
 caps
 floor
Derivative markets are important to investors because they provide a way for investors to
manage portfolio risk.

1.3 Financial management decisions

Finance functions or decisions include:
- investment or long-term asset mix decision
- financing or capital mix decision
- dividend or profit allocation decision
- liquidity or short-term asset mix decision
A firm performs finance functions simultaneously and continuously in the normal operation.
Finance functions used to skilful planning, control and execution of a firm’s activities.

Investment decisions
 Investment decisions or capital budgeting involves the decision of allocation of capital or
commitment of funds to long term assets that would yield benefits in the future.
 Investment process should be evaluated in terms of both expected return and risk
Financing decisions
 Financing decisions is the second important function to be performed by the
finance manager
 Deals with when, where, and how to acquire funds to meet the firm’s investment
needs
 The mix of debt and equity is known as the firm’s capital structure. The financial
manager must strive to obtain the best financing mix or the optimum capital
structure for his or her firm.
 The firm’s capital structure is considered to be optimum when the market value of
shares is maximized.
 The use of debt affects the return and risk of shareholders, it may increase the
return on equity funds but it always increases risk. A proper balance will have to
be struck between return and risk.
Dividend decisions
 The financial manager must decide whether the firm should distribute all
profits or retain them or distribute a portion and retain the balance
 Like the capital structure policy, the dividend policy should be determined
in terms of its impact on the shares holders’ value. The optimum dividend
policy is one that maximizes the market value of the firm’s shares.
Liquidity decisions
 Current assets must be managed efficiently for safeguarding the firm against the dangers
of illiquidity and insolvency.
 An investment in current assets affects the firm’s profitability, liquidity and risk. A
conflict exists between liquidity and profitability while managing current assets.
Example, if the firm does not invest sufficient funds in current assets, it may become
illiquid. But it would lose profitability as idle current assets would not earn any thing.
Therefore, a proper tradeoff must be achieved between profitability and liquidity.
 In order to ensure that neither insufficient nor unnecessary funds are invested in current
assets, the financial manager should develop sound techniques of managing current
assets.
 Financial manager should estimate firm’s needs for current assets and make sure that
funds would be made available when needed.

1.4 The goals of financial management

The possible goals of managerial finance are:
1. Profit maximization
2. Stockholder wealth maximization
3. Managerial reward maximization: when the firms make a profit management give a
bonus for
 their employees.
4. Behavioral goal: change employees mind to think for the advancement of the
organization.
5. Social responsibility: keep the environment in well manner. Avoid environmental
pollutions.

2. Profit maximization.
Objective: - to get large amount of profits in short period of time.
- It is short term goal
- A firm may maximize its short-term profits at the expense of its long term
profitability and still realize this goal. In contrast, stockholder wealth
maximization is a long term goal, since stockholders are interested in future as
well as present profits.
- You can attain maximum profit through selling a portion of your assets but you
are endangering the existence of the business.

Advantages
- easy to calculate profits
- easy to determine the link between financial decisions and profits.

Disadvantages
- emphasis only on short-term
- ignores risk and uncertainty

3. Stockholder wealth maximization

Objective: is attained when highest market value of common stock is maintained.
Advantages
Wealth maximization is generally preferred because:
- emphasis on long-term
- recognizes risks and uncertainty

Disadvantages
- offers no clear link between financial decisions and stock price
- Leads to anxiety of management and frustrations.

The roles of financial managers

The financial manager performs the following functions:
1. Financial analysis, forecasting and planning
- Monitoring the firms financial position
- Determines the proper amount of funds to employ in the firm
2. Investment decisions
- Make efficient allocations of funds to specific assets
- Make long-term capital budget & expenditure dictions
3. Financing and capital structure decisions
- Determines both the mix of short-term and long-term financing and equity/debt
financing.
 - Raises funds on the most favorable terms possible.
4. Management of financial resources
- Manages working capital
- Maintains optimal level of investment in each of the current assets.
5. Risk management
-As future is uncertain, the financial manager should consider/expectation of risk and
protect the resources.
1.5. Forms of Business Organizations
The common forms of business organization are proprietorship, partnership, and
corporation. In the following paragraphs, we briefly describe each form and discuss its
advantages and disadvantages.
A proprietorship is owned by one individual. The popularity of this form is due to the
ease and the low cost of organizing. The primary disadvantage of proprietorships is
that the financial resources available to the business are limited to the individual
owner’s resources. The owner (proprietor) receives any profits, suffers any losses, and is
personally liable for all debts of the business. There is no legal distinction between the
business as an economic unit and the owner, but the accounting records of the business
activities are kept separate from the personal records and activities of the owner.
As a business grows and more financial and managerial resources are needed, it may
become a partnership. A partnership is owned by two or more individuals. Each owner
is a partner. Typically a partnership agreement (written or oral) sets forth such terms as
initial investment, duties of each partner, division of net income (or net loss), and
settlement to be made upon death or withdrawal of a partner. Each partner generally
has unlimited personal liability for the debts of the partnership.
A corporation is organized under state or federal statutes as a separate legal taxable
entity. The ownership of a corporation is divided into shares of stock. A corporation
issues the stock to individuals or other businesses, who then become owners or
stockholders of the corporation. A primary advantage of the corporate form is the
ability to obtain large amounts of resources by issuing stock. For this reason, most
companies that require large investments in equipment and facilities are organized as
corporations. The holders of the shares (stockholders) enjoy limited liability; that is,
they are not personally liable for the debts of the corporate entity.