Introduction to Financial Management

Finance is the art and science of managing money

in all walks of life – personal or corporate

 Accounts Vs. Finance

 Key Differences Between
Accounting and Finance
1. Accounting is a methodical record keeping of
transactions of business while Finance is the study of the
management of funds in the best possible manner.
2. Accounting is a subset of Finance
3. The accounting information is helpful for the users of the
financial statement for understanding the financial
position of the business while Finance is useful in
forecasting the performance of the entity in the future.
4. Accounting uses Income Statement, Balance Sheet, Cash
Flow Statement, etc. as its tools. On the other hand,
Leverage, Capital Budgeting, Ratio Analysis, Risk Analysis,
Working Capital Management, etc. are financial tools.
5. There are four branches of accounting while there are
only three branches of finance.
 Accounting

 Accounting is the complete process of identifying,

recording, classifying, summarizing, reporting,
interpreting and analysing the financial information.
It is an art of systematically recording the
transactions, for keeping a proper track of financial
statements on the basis of Accounting Standard
(AS). With the help of the financial statement of an
entity, internal audit, and tax audit is conducted at
the end of the financial year.
 Corporate Finance

 Corporate Finance is concerned with the efficient and

effective management of the finances of an organization in
order to achieve the objectives of that organization.
This involves
 Planning & Controlling the provision of resources (where
funds are raised from)
 Allocation of resources (where funds are deployed)
 Control of resources (whether funds are being used
effectively or not)
 Corporate Finance

 Finance is the science & arts of the acquisition and

allocation (i.e. Spending or investment) of funds
effectively. It is a broader term, which studies about
money and capital market along with the
arrangement and management of funds by business.
The major aspect of finance is the “time value of
money” i.e. the value of money changes over time.
 Two Key Concepts in Corporate Finance

 The fundamental concepts in helping managers to

value alternative choices are

 Relationship between Risk and Return

 Time Value of Money

 Relationship between Risk
and Return
 This concept states that an investor or a company takes on
more risk only if higher return is offered in compensation.
 Return refers to
 Financial rewards gained as a result of making an
investment.
 The nature of return depends on the form of the investment.
 A company that invests in fixed assets & business
operations expects return in the form of profit (measured
on before-interest, before-tax & an after- tax basis)& in the
form of increased cash flows.
 Relationship between Risk and
Return
 Risk refers to
Possibility that Actual return may be different from the expected return.
 When Actual Return > Expected Return
This is a Welcome Occurrence.
 When Actual Return < Expected Return
This is a Risky Investment.
 Investors, Companies & Financial Managers are
more likely to be concerned with Possibility that
Actual Return < Expected Return
 Investors & Companies demand higher expected
return Possibility of actual return being different
from expected return increases.
Relationship between Risk and
Return: Risks

Financial Risk

Market Risk Credit Risk Liquidity Operational

Risk Risk
 What is Financial
Management?
 Financial Management is concerned with the duties of
the financial managers in the business firm.

 It is the managerial activity which is concerned with

planning and controlling of the firms financial resources

 There exists an inseparable relationship between finance

and other functions of the business like production,
marketing, etc. as all of them include decision making
process which requires finance .
 Role of The Financial Manager

(2) (1)

Firm's Financial Financial

manager (4a)
operations markets

(3) (4b)

(1) Cash raised from investors

(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors
 Aim of Financial Manager
 While accountancy plays an important role within
corporate finance, the fundamental problem
addressed by corporate finance is economic, i.e. how
best to allocate the scarce resource of capital.

 Aim of Financial Manager is the optimal allocation of

the scarce resources available to them.

 Financial managers are responsible for making

decisions about raising funds (the financing decision),
allocating funds (the investment decision) and how
much to distribute to shareholders (the dividend
decision).
 First step that any firm has to make to define the
business that it wants to be in

 Once that is done, the  Investment decisions

next step is to develop a
(Capital budgeting and
plan to invest in buildings,
machineries, other fixed working capital)
assets, working capital etc.
 The next step is decide  Finance decisions
from where to raise the
funds for the above (Capital structure )
investments
 Distribution of profits and  Dividend policy decisions
retaining profits is another
critical matter to look into.
Decisions under Financial
Management
Which investment/s should
Investment the company accept and
what are the financial
implications of undertaking
the same?

How should the company finance

Financing those investments? What should
be the mix of owners’ contribution
equity and borrowed funds, i.e.,
debt at any given point in time?

How much of the income generated

Dividend from operations should be returned to
shareholders in the form of dividends
and how much is to be retained for
further investment?
 Investment
decisions

Capital budgeting
Working capital

Financial Decision

Financing
decision Dividend decision

Debt Equity Retained

Profit
Earnings
 Role of The Financial Manager

 The high level of interdependence existing between

these decision areas should be appreciated by
financial managers when making decisions

 Can you think how these decisions may be inter-

related?
Interrelationship b/w Investment,
Financing & Dividend Decisions
Agency & Corporate Governance
Shareholders
including institutions and
Creditors
private individuals
including banks, suppliers
and bond holders

THE COMPANY
Management

Employees

Customers

Diagram showing the agency relationships that exist betweenthe

various stakeholders of a company
Agency & Corporate Governance

 Managers do not always act in the best interest of their

shareholders, giving rise to what is called the ‘agency’
problem.
 Agency is most likely to be a problem when there is a
divergence of ownership and control, when the goals of
management differ from those of shareholders and when
asymmetry of information exists.

 An example of how the agency problem can manifest itself

within a company is where managers diversify to reduce the
overall risk of the company, thereby safeguarding their job
prospects.

 Shareholders could achieve this themselves by diversification.

 Agency & Corporate Governance

 Monitoring and performance-related benefits are two

potential ways to optimise managerial behavior and
encourage ‘goal congruence’.

 Due to difficulties associated with monitoring,

incentives such as performance- related pay and
executive share options can be a more practical way
of encouraging goal congruence.
Objective of Financial
Management

Profit Maximisation
Vs
Wealth Maximization
 Why not just Profit Maximization?
 It is Vague – profits is not always a true indicator of the
business performance as it can be influenced by macro
and micro economic factors.

 It Ignores Risk Factor (uncertainty factor)

 It is a short term objective whereas wealth management is

a long term objective

 It Ignores Time Value factor

 So the focus is more on WEALTH MANAGEMENT through

EFFECTIVE DECISION MAKING.
 Maximising Shareholders' Wealth
➢ The objective of a company in the financial context is to
maximise the value of the company for its owner that is
by maximising the shareholders' wealth.
➢ Shareholders' wealth is reflected by the company's
share price in the market.
➢ This objective is more appropriate compared with just
maximisation of profits as it takes into account the
impacts of all financial decisions.
➢ Shareholders will react to poor investment decisions by
causing the company's share price to fall and in
contrary, they will react to good investment decisions by
increasing the company's share price.
➢ Maximising shareholders' wealth means that the
management is supposed to maximise the present
return value that is expected to be received by its
shareholders in the future.
➢ It is measured by the ordinary share price's market
value. The share price reflects the share value
according to the opinion of the owners.

➢ It takes into account the uncertainties or risks, timing

and other important factors to the owners.

➢ Therefore, all problems related to the objective in

maximising profits can be overcome when the
manager prioritised the objective in maximizing
shareholders' wealth.

➢ This objective also enables the decision scenario to be

made by taking into account any complications and
difficulties in the real business world.

➢ Finance managers must prioritise the company's

shareholders as they are the actual owners of the
company.
 Profit Maximization Wealth Maximization
Objective
Larger Profits Highest value for common equity
Time frame
Short term Long term
Time Value of Money
Ignores time value of money Considers time value of money
Ignores timing of return Recognises timing of return
Risk and uncertainty
Ignores risk and uncertainty Recognises risk and uncertainty
 Financial Management &
Management Disciplines
 Marketing : to forecast the increase in revenues resulting
from an advertising campaign
 Accounting : to estimate the tax savings from a
restructuring
 Economics: to determine the increase in demand from
lowering the price of a product
 Organizational Behaviour: to estimate the productivity
gains from a change in management structure
 Strategy: to predict a competitor’s response to a price
increase
 Operations: to estimate the cost savings from a plant
modernization
 FINANCIAL MANAGEMENT

MAXIMISATION OF SHAREHOLDERS VALUE

FINANCIAL DECISION

Investment Liquidity Financing Dividend

decision decision decision Decision

Return Risk