DEFINITION OF FINANCIAL MANAGEMENT
Financial Management is a discipline concerned with the generation and allocation
of scarce resources (usually funds) to the most efficient user within the firm (the
competing projects) through a market pricing system (the required rate of return).
A firm requires resources in form of funds raised from investors. The funds must
be allocated within the organization to projects which will yield the highest return.
2. SCOPE OF FINANCE FUNCTIONS
The functions of Financial Manager can broadly be divided into two: The Routine
functions and the Managerial Functions.
2.1 Managerial Finance Functions
Require skilful planning, control and execution of financial activities. There are four
important managerial finance functions. These are:
(a) Investment of Long-term asset-mix decisions
These decisions (also referred to as capital budgeting decisions) relates to the
allocation of funds among investment projects. They refer to the firm's decision to
commit current funds to the purchase of fixed assets in expectation of future cash
inflows from these projects. Investment proposals are evaluated in terms of both
risk and expected return.
Investment decisions also relates to recommitting funds when an old asset becomes
less productive. This is referred to as replacement decision.
(b) Financing decisions
Financing decision refers to the decision on the sources of funds to finance
investment projects. The finance manager must decide the proportion of equity and
debt. The mix of debt and equity affects the firm's cost of financing as well as the
financial risk. This will further be discussed under the risk return trade-off.
(c) Dividends decision
The finance manager must decide whether the firm should distribute all profits to
the shareholder, retain them, or distribute a portion and retain a portion. The
earnings must also be distributed to other providers of funds such as preference
shareholder, and debt providers of funds such as preference shareholders and debt
providers. The firm's divided policy may influence the determination of the value of
the firm and therefore the finance manager must decide the optimum dividend -
payout ratio so as to maximize the value of the firm.
(d) Liquidity decision
The firm's liquidity refers to its ability to meet its current obligations as and when
they fall due. It can also be referred as current assets management. Investment in
current assets affects the firm's liquidity, profitability and risk. The more current
assets a firm has, the more liquid it is. This implies that the firm has a lower risk of
becoming insolvent but since current assets are non-earning assets the profitability
of the firm will be low. The converse will hold true.
,The finance manager should develop sound techniques of managing current assets
to ensure that neither insufficient nor unnecessary funds are invested in current
assets.
2.2 Routine functions
For the effective execution of the managerial finance functions, routine functions
have to be performed. These decisions concern procedures and systems and involve
a lot of paper work and time. In most cases these decisions are delegated to junior
staff in the organization. Some of the important routine functions are:
(a) Supervision of cash receipts and payments
(b) Safeguarding of cash balance
(c) Custody and safeguarding of important documents
(d) Record keeping and reporting
The finance manager will be involved with the managerial functions while the
routine functions will be carried out by junior staff in the firm. He must however,
supervise the activities of these junior staff.
3. OBJECTIVES OF A BUSINESS ENTITY
Any business firm would have certain objectives which it aims at achieving. The
major goals of a firm are:
Profit maximization
Shareholders' wealth maximization
Social responsibility
Business Ethics
Growth
(a) Profit maximization
Traditionally, this was considered to be the major goal of the firm. Profit
maximization refers to achieving the highest possible profits during the year. This
could be achieved by either increasing sales revenue or by reducing expenses.
Note that:
Profit = Revenue – Expenses
The sales revenue can be increased by either increasing the sales volume or the
selling price. It should be noted however, that maximizing sales revenue may at the
same time result to increasing the firm's expenses.
The pricing mechanism will however, help the firm to determine which goods and
services to provide so as to maximize profits of the firm.
The profit maximization goal has been criticized because of the following:
(a) It ignores time value of money
(b) It ignores risk and uncertainties
(c) it is vague
(d) it ignores other participants in the firm rather than the shareholders
,(b) Shareholders' wealth maximization
Shareholders' wealth maximization refers to maximization of the net present value
of every decision made in the firm. Net present value is equal to the difference
between the present value of benefits received from a decision and the present
value of the cost of the decision. (Note this will be discussed further in Lesson 2).
A financial action with a positive net present value will maximize the wealth of the
shareholders, while a decision with a negative net present value will reduce the
wealth of the shareholders. Under this goal, a firm will only take those decisions
that result in a positive net present value.
Shareholder wealth maximization helps to solve the problems with profit
maximization. This is because, the goal:
i. considers time value of money by discounting the expected future
cashflows to the present.
ii. it recognises risk by using a discount rate (which is a measure of
risk) to discount the cashflows to the present.
(c) Social responsibility
The firm must decide whether to operate strictly in their shareholders' best interests
or be responsible to their employers, their customers, and the community in which
they operate. The firm may be involved in activities which do not directly benefit the
shareholders, but which will improve the business environment. This has a long
term advantage to the firm and therefore in the long term the shareholders wealth
may be maximized.
(d) Business Ethics
Related to the issue of social responsibility is the question of business ethics. Ethics
are defined as the "standards of conduct or moral behaviour". It can be thought of
as the company's attitude toward its stakeholders, that is, its employees, customers,
suppliers, community in general, creditors, and shareholders. High standards of
ethical behaviour demand that a firm treat each of these constituents in a fair and
honest manner. A firm's commitment to business ethics can be measured by the
tendency of the firm and its employees to adhere to laws and regulations relating to:
i. Product safety and quality
ii. Fair employment practices
iii. Fair marketing and selling practices
iv. The use of confidential information for personal gain
v. Illegal political involvement
vi. bribery or illegal payments to obtain business
(e) Growth
This is a major objective of small companies which may even invest in projects with
negative NPV so as to increase their size and enjoy economies of scale in the future.
, 4. 0 AGENCY THEORY
An agency relationship may be defined as a contract under which one or more
people (the principals) hire another person (the agent) to perform some services on
their behalf, and delegate some decision making authority to that agent. Within the
financial management framework, agency relationship exist between:
(a) Shareholders and Managers
(b) Debt holders and Shareholders
4.1 Shareholders versus Managers
A Limited Liability company is owned by the shareholders but in most cases is
managed by a board of directors appointed by the shareholders. This is because:
i) There are very many shareholders who cannot effectively manage the firm all
at the same time.
ii) Shareholders may lack the skills required to manage the firm.
iii) Shareholders may lack the required time.
Conflict of interest usually occur between managers and shareholders in the fol-
lowing ways:
i) Managers may not work hard to maximize shareholders wealth if they
perceive that they will not share in the benefit of their labour.
ii) Managers may award themselves huge salaries and other benefits more than
what a shareholder would consider reasonable
iii) Managers may maximize leisure time at the expense of working hard.
iv) Manager may undertake projects with different risks than what shareholders
would consider reasonable.
v) Manager may undertake projects that improve their image at the expense of
profitability.
vi) Where management buy out is threatened. ‘Management buy out’ occurs
where management of companies buy the shares not owned by them and
therefore make the company a private one.
Solutions to this Conflict
In general, to ensure that managers act to the best interest of shareholders, the
firm will:
(a) Incur Agency Costs in the form of:
i) Monitoring expenses such as audit fee;
ii) Expenditures to structure the organization so that the possibility of
undesirable management behaviour would be limited. (This is the cost of
internal control)
Financial Management is a discipline concerned with the generation and allocation
of scarce resources (usually funds) to the most efficient user within the firm (the
competing projects) through a market pricing system (the required rate of return).
A firm requires resources in form of funds raised from investors. The funds must
be allocated within the organization to projects which will yield the highest return.
2. SCOPE OF FINANCE FUNCTIONS
The functions of Financial Manager can broadly be divided into two: The Routine
functions and the Managerial Functions.
2.1 Managerial Finance Functions
Require skilful planning, control and execution of financial activities. There are four
important managerial finance functions. These are:
(a) Investment of Long-term asset-mix decisions
These decisions (also referred to as capital budgeting decisions) relates to the
allocation of funds among investment projects. They refer to the firm's decision to
commit current funds to the purchase of fixed assets in expectation of future cash
inflows from these projects. Investment proposals are evaluated in terms of both
risk and expected return.
Investment decisions also relates to recommitting funds when an old asset becomes
less productive. This is referred to as replacement decision.
(b) Financing decisions
Financing decision refers to the decision on the sources of funds to finance
investment projects. The finance manager must decide the proportion of equity and
debt. The mix of debt and equity affects the firm's cost of financing as well as the
financial risk. This will further be discussed under the risk return trade-off.
(c) Dividends decision
The finance manager must decide whether the firm should distribute all profits to
the shareholder, retain them, or distribute a portion and retain a portion. The
earnings must also be distributed to other providers of funds such as preference
shareholder, and debt providers of funds such as preference shareholders and debt
providers. The firm's divided policy may influence the determination of the value of
the firm and therefore the finance manager must decide the optimum dividend -
payout ratio so as to maximize the value of the firm.
(d) Liquidity decision
The firm's liquidity refers to its ability to meet its current obligations as and when
they fall due. It can also be referred as current assets management. Investment in
current assets affects the firm's liquidity, profitability and risk. The more current
assets a firm has, the more liquid it is. This implies that the firm has a lower risk of
becoming insolvent but since current assets are non-earning assets the profitability
of the firm will be low. The converse will hold true.
,The finance manager should develop sound techniques of managing current assets
to ensure that neither insufficient nor unnecessary funds are invested in current
assets.
2.2 Routine functions
For the effective execution of the managerial finance functions, routine functions
have to be performed. These decisions concern procedures and systems and involve
a lot of paper work and time. In most cases these decisions are delegated to junior
staff in the organization. Some of the important routine functions are:
(a) Supervision of cash receipts and payments
(b) Safeguarding of cash balance
(c) Custody and safeguarding of important documents
(d) Record keeping and reporting
The finance manager will be involved with the managerial functions while the
routine functions will be carried out by junior staff in the firm. He must however,
supervise the activities of these junior staff.
3. OBJECTIVES OF A BUSINESS ENTITY
Any business firm would have certain objectives which it aims at achieving. The
major goals of a firm are:
Profit maximization
Shareholders' wealth maximization
Social responsibility
Business Ethics
Growth
(a) Profit maximization
Traditionally, this was considered to be the major goal of the firm. Profit
maximization refers to achieving the highest possible profits during the year. This
could be achieved by either increasing sales revenue or by reducing expenses.
Note that:
Profit = Revenue – Expenses
The sales revenue can be increased by either increasing the sales volume or the
selling price. It should be noted however, that maximizing sales revenue may at the
same time result to increasing the firm's expenses.
The pricing mechanism will however, help the firm to determine which goods and
services to provide so as to maximize profits of the firm.
The profit maximization goal has been criticized because of the following:
(a) It ignores time value of money
(b) It ignores risk and uncertainties
(c) it is vague
(d) it ignores other participants in the firm rather than the shareholders
,(b) Shareholders' wealth maximization
Shareholders' wealth maximization refers to maximization of the net present value
of every decision made in the firm. Net present value is equal to the difference
between the present value of benefits received from a decision and the present
value of the cost of the decision. (Note this will be discussed further in Lesson 2).
A financial action with a positive net present value will maximize the wealth of the
shareholders, while a decision with a negative net present value will reduce the
wealth of the shareholders. Under this goal, a firm will only take those decisions
that result in a positive net present value.
Shareholder wealth maximization helps to solve the problems with profit
maximization. This is because, the goal:
i. considers time value of money by discounting the expected future
cashflows to the present.
ii. it recognises risk by using a discount rate (which is a measure of
risk) to discount the cashflows to the present.
(c) Social responsibility
The firm must decide whether to operate strictly in their shareholders' best interests
or be responsible to their employers, their customers, and the community in which
they operate. The firm may be involved in activities which do not directly benefit the
shareholders, but which will improve the business environment. This has a long
term advantage to the firm and therefore in the long term the shareholders wealth
may be maximized.
(d) Business Ethics
Related to the issue of social responsibility is the question of business ethics. Ethics
are defined as the "standards of conduct or moral behaviour". It can be thought of
as the company's attitude toward its stakeholders, that is, its employees, customers,
suppliers, community in general, creditors, and shareholders. High standards of
ethical behaviour demand that a firm treat each of these constituents in a fair and
honest manner. A firm's commitment to business ethics can be measured by the
tendency of the firm and its employees to adhere to laws and regulations relating to:
i. Product safety and quality
ii. Fair employment practices
iii. Fair marketing and selling practices
iv. The use of confidential information for personal gain
v. Illegal political involvement
vi. bribery or illegal payments to obtain business
(e) Growth
This is a major objective of small companies which may even invest in projects with
negative NPV so as to increase their size and enjoy economies of scale in the future.
, 4. 0 AGENCY THEORY
An agency relationship may be defined as a contract under which one or more
people (the principals) hire another person (the agent) to perform some services on
their behalf, and delegate some decision making authority to that agent. Within the
financial management framework, agency relationship exist between:
(a) Shareholders and Managers
(b) Debt holders and Shareholders
4.1 Shareholders versus Managers
A Limited Liability company is owned by the shareholders but in most cases is
managed by a board of directors appointed by the shareholders. This is because:
i) There are very many shareholders who cannot effectively manage the firm all
at the same time.
ii) Shareholders may lack the skills required to manage the firm.
iii) Shareholders may lack the required time.
Conflict of interest usually occur between managers and shareholders in the fol-
lowing ways:
i) Managers may not work hard to maximize shareholders wealth if they
perceive that they will not share in the benefit of their labour.
ii) Managers may award themselves huge salaries and other benefits more than
what a shareholder would consider reasonable
iii) Managers may maximize leisure time at the expense of working hard.
iv) Manager may undertake projects with different risks than what shareholders
would consider reasonable.
v) Manager may undertake projects that improve their image at the expense of
profitability.
vi) Where management buy out is threatened. ‘Management buy out’ occurs
where management of companies buy the shares not owned by them and
therefore make the company a private one.
Solutions to this Conflict
In general, to ensure that managers act to the best interest of shareholders, the
firm will:
(a) Incur Agency Costs in the form of:
i) Monitoring expenses such as audit fee;
ii) Expenditures to structure the organization so that the possibility of
undesirable management behaviour would be limited. (This is the cost of
internal control)
