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Introduction to financial management
The financial manager plays a significant role in the planning and decision making processes of the business.The role of the financial manager continues to change over time and is reflective of the economy of the country and the business cycles. Financial management, in its most basic form, revolves around a capacity to raise funds from external sources. However, when there is an economic recession, there is a sharper focus on simply surviving. In a more buoyant, or even boom time, financial management is concerned with analyses of cash flows inside the firm and developing ways of controlling these flows, e.g. in investment and budgeting decisions. In times of inflation (an increase in the general level of prices), fluctuating interest rates, changing corporate tax rates and deregulation of industries, the task of the financial manager is made all the more challenging.
All managers in the organization, regardless of their job descriptions, work with financial personnel and procedures to get their job done. Managers who understand the financial decision making process will be able to address financial concerns better, and will therefore, more often, get the resources they want to accomplish their goals.
This topic includes the following parts:
- Finance: an overview
- Three types of business organizations
- The goal of the financial manager
- The five principles of finance
Part 1: Finance: an overview
Financial management is the study of how people and businesses evaluate investments and raise funds to finance them; it addresses the following three questions:
- ‘What long-term investments should the firm undertake?’ (Titman et al. 2016, p. 4). The process of answering this question is known alternatively as capital budgeting, investment appraisal and project evaluation. Although all three titles are encountered in financial literature, to keep consistent with the textbook ‘capital budgeting’ will be used throughout this subject when referring to this investment process.
- ‘How should the firm raise money to fund these investments?’ (Titman et al. 2016, p. 4). Such decisions are referred to as capital structure decisions and relate to the firm’s selected balance between debt (what the firm owes) and equity (what the firm owns).
- ‘How can the firm best manage its cash flows as they arise in its day-to-day operations?’ (Titman et al. 2016, p. 4).
The related process is termed working-capital management and monitors the relativity of the firm’s current assets (items such as cash and inventory or stock) and its current liabilities (short-term debts).
Why study finance?
Some of you might be asking yourself at this point ‘Why do I need to study finance as I don’t intend to become a finance manager?’ All of you working as managers in your organizations should have a clear idea of certain important aspects of finance. As a manager, you must be involved with forward planning for the organization for which you need to understand what the financial statements really mean. You would also be expected to decide how the limited resources available to the business should be allocated between competing options. An understanding of finance is important to carrying out these management tasks. In this respect, one of the objectives of this subject is to enable students to effectively communicate with their finance colleagues.
Finance plays an important role, not only at your work but also in your personal life. Whether you are planning to take a loan to buy a car or a house, you need to pay a fixed installment regularly over a period. The question arises, how much would each installment need to be and for how long? At your work place, you are asked to decide on the contribution to be invested in your superannuation fund. At every step of life, you have to examine and understand financial issues.
Part 2: Three types of business organizations
There are three main legal forms of business organization:
- Sole proprietorship or sole trader –‘a business owned by a single individual’ (Titman et al. 2016, p. 5), e.g. a handyman. The owner keeps all the profits and is responsible for all the debts. In other words, he has unlimited liability.
- Partnership –an association of two or more individuals joining together as co-owners to operate a business for profit, e.g. a legal practice operated by a number of legal practitioners (Titman et al. 2016, p. 5). All partners share the profit or loss of the business and have unlimited liability for the business’s debt.
- Corporation –an entity that legally functions separately and apart from its owners, e.g. Singapore Airlines. Liability of the owner is limited to the amount of their holding in the company.
In comparing these organizational forms, the following should be considered:
- organization regulations and costs
- liability of owners
- continuity of the business
- transferability of ownership
- management control
- ease of capital raising
- come taxes.in
Part 3: The goal of the financial manager
If you have previously studied economics, then upon reading the title for this part you would have no doubt said that the goal of the financial manager is to simply maximize profit. However, there are problems in adopting such a goal, namely:
- timing of returns
- Uncertainty of returns.
From a financial management perspective, the goal of the financial manager is to maximize shareholder wealth as this goal is consistent with:
- maximizing firm value
- Maximizing share value.
And thus, this perspective is focused on the company or corporation.
In the company form of business organization, the shareholders (the principal) have hired the managers (the agent) to run the company for them (the agency relationship); but, will the managers act in the best interests of the shareholders, and if a conflict of interest arises would the managers pursue their own goals rather than the goals of the owners? This conflict is called as the agency problem in finance. Many corporations address agency issues through adequate employee compensation schemes and greater focus on corporate governance between boards of directors and senior management.
The objective of maximizing shareholder’ wealth does not mean that other stakeholders associated with the business management(employees, customers, suppliers, the community and so on) can be ignored. If a business wishes to survive and prosper over the longer-term, satisfying the needs of other groups will also be necessary to maximize the wealth of the owners in the long-term. Firms have a social responsibility to the governments, communities and countries in which they invest and operate, and to the people they employ.
It is important to emphasize that, in working towards the goal of maximizing shareholders’ wealth, the financial manager must follow strict ethical guidelines. In a world of incomplete contracts were not every possible future contingency can be anticipated and therefore contracted upon, the survival of any business depends on trust placed by stakeholders on the organization. Ethical behavior is a quintessential component of that, and its importance is testified by the numerous cases of business failures due to ethical lapses. Ethical errors are fundamentally different from judgment errors in business: they are related to pursuing actions that are questionable or fraudulent and, as such, must be avoided from the outset.
Part 4: The five basic principles of finance
1. Money has a time value
If you were offered the choice of $1000 today or $1000 in one year’s time, which would you choose? You should choose the former as presumably you would invest the money to generate an amount of more than $1000 at the end of one year. So in general we can say that an amount received today is worth more than that same amount received any time in the future. Compound interest is used in the commercial application of this principle.
2. There is a risk-return trade-off
‘We will not take on additional risk unless we expect to be compensated with additional return’ (Titman et al. 2016, p. 12). You may draw on your own personal experience in understanding this relationship which is modeled graphically in Figure 1.2 On page 13 of the textbook. It is a model as it assumes that the relationship is linear. Thus, there is reward for bearing a risk and the greater the risk the greater will be the potential reward. Please note that here we are talking about expected return not actual return.
3. Cash flows are the source of value
Cash flows and not accounting profits are used for measuring wealth. This marks a point of departure between the disciplines of accounting and finance. Dividends paid to shareholders are an example of such cash flows. Please note for future reference that depreciation of an asset is an accounting book entry and not a cash flow. Also, only incremental cash flows should be considered while making choices. An incremental cash flow is the difference between the cash flows if a new project/asset was taken on and the cash flows if the project/asset was not taken on. Those of you who have studied economics will recognize that this principle relates to the concept of opportunity cost. In a nutshell, this principle states that ‘it’s only what changes that counts’ when considering investments in projects/assets.
4. Market prices reflect information
This is more of an assumption than an actual principle. Efficient markets are markets in which the values of all assets and securities (shares, bonds, etc.) at any point in time fully reflect all available information. This translates into an assumption that the markets are quick to respond to changes in relevant factors and the prices are right,
e.g. there is no such thing as ‘insider trading’.
5. Individuals respond to incentives
This principle relates to the incentivizing of managers and recognizes that a manager will not work for the business owners unless it’s in that manager’s best interest to do so. In this context, agency costs represent any cost incurred, such as reduced share price associated with potential conflict between managers and investors when these two stakeholders are not the same.
This topic set a foundation for the study of financial management assignment help. Financial management was defined, the three types of business organization were introduced, the goal of the financial manager was defined and the five principles of financial management were introduced.
Titman, S, Martin, T, Keown, AJ & Martin, JD 2016, financial management: principles and applications, 7th edn, Pearson Australia, Vic.