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Fundamentals of Financial Management (BBS II Year)

Chapter: 1 (Introduction to Financial Management)

Chapter Outlines:
Introduction to Financial Management
Importance of Financial Management
Finance in the Organizational Structure of the Firm
Finance Functions
Role and Responsibilities of Financial Manager
Goals of Corporation
Financial Management and Related Departments
The Agency Problem

1. Introduction to Financial Management
Literally, finance refers to the funds or money.
Finance basically deals with the procurement or acquisition of the required funds from the cost effective
sources and utilize such funds productively creating the value for the organizations or firms.
In other words, financial management is the managerial activity that ensures financing needs and options
are met effectively and efficiently.
Business finance, managerial finance, and corporate finance are synonymous to financial management.
However, the term business finance is narrow and traditional. During the early stage of industrialization in
the United States and other European countries, the term business finance was in use.
On passage of time, corporate finance came into use because of corporate forms and structure of
businesses.
Traditionally, the business finance was focused only on assessing the requirements of funds and procuring
it. However, the scope widened and the financial management now deals with the questions like what long
term investment should be made? Where the firm will get the long term fund? How firm will manage its
daily financial activities? And how the firm should compensate its shareholders and many more.

2. Importance of Financial Management
Financial Management has gained immense attention in todays modern world of business. Not only the funds
related activities but other functions providing sustainable growth of the business is also assured by the proper
financial management practices. To be specific and simple, followings are regarded as the primary importance
of the financial management.

a. Setting clear Goal: The proper financial management practices enable managers to differentiate between
the goal of profit maximization and stock price maximization. Managers can be clear on how stock price
maximization is superior to profit maximization goal.

b. Effective Utilization of Resources: The acquired funds are always to be used in optimum way. However,
the firms might face with the surplus and deficit of resources on various times. In such circumstances, the
financial management enables the firm to make use of scarce use of resources in rational way and take the
maximum possible advantages and return from excess resources.

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c. Sources of Financing: The firms incorporating the proper financial management practices never have to be
short on the required funds. It is because the financial planning and forecasting makes it easy for the
managers to determine the amount of funds needed and the possible sources. It always ensures that the
required funds are available at the time when it is actually needed. In addition, the managers can develop a
low cost capital structure consisting definite portion of debt and equity. It further helps firm in reducing the
overall cost of capital.

d. Dividend Decision: Among others, the financial management assists managers to decide on what and how
the dividends to its shareholders should be paid. Financial management provides clear picture on the
investment opportunities in the market, the liquidity condition of the firm, expectation of the shareholders
etc. These factors are important in determining the dividend payout schemes for the firms.

3. Finance in the Organizational Structure
It is not possible for the shareholders to run their business or firm due to large number of shareholders in
large companies. So, the shareholders elect the Board of Directors (BoD) which represents the interests of
the shareholders in the company.
BoD frames the policies, strategies, makes decision and appoints the management to run the company.
Usually, the top management of the company is Chief Executive Officer (CEO) or Managing Directors.
Likewise, the finance function of a company comes under the responsibility of the Chief Financial Officer
(CFO) assisted by the Treasurer (accounting function) and the Controller (finance function).
CFO directly reports to CEO and is responsible in making financial plans, policy making and making
decisions.

4. Finance Functions
There are two approaches of finance functions. The first approach is too narrow and traditional which relates to
procurement or raising of funds. In other hand, second approach focuses on procurement of funds and their
effective utilization. In addition, there are two types of finance function namely:

a. Executive finance functions
It requires the managerial abilities and skills to perform the executive finance functions. Executive function
includes the planning, execution and control. Major executive functions are:

Investment Decision: Managers need to assess the benefits of the certain projects in order to decide
whether or not to invest in such projects. It uses the capital budgeting techniques in which the net
present value of the project is computed.

Financing Decision: It deals with the source from where the required funds to be procured. It involves
deciding upon needs and sources of funds and negotiation for external financing. The financial
managers analyze the various options of financing like common stock, preferred stocks, bonds,
commercial papers and bank loans etc. Decisions are made based on the cost effectiveness and the
general market conditions.

Dividend Decision: Dividend is return for the shareholders but not the obligation. The decision whether
or not the dividend should be distributed are made by the financial managers based on various factors.
The company may distribute all income as dividends, retain all income and distribute certain amount as
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dividends. While making such decisions, the financial managers need to analyze the available
investment opportunities, practice of the company, legal requirements, expectation of the shareholders,
profit condition of the company etc.

Working Capital Decision: Working capital is needed to carry out the day to day or short term
activities of the company. So, company maintains cash balance, bills and account receivables, inventory
etc. This decision is also known as the current asset management. Since the working capital decision
affects the profitability, liquidity and risks, the financial managers should make the acceptable trade-off
between all these factors. For example, excessive holdings of current asset may reduce the profits since
the cash holdings does not earn high returns and may be much less than the cost of capital.

b. Routine functions
Routine or incidental finance function involves the activities that support the executive finance functions. It does
not require the managerial skills and abilities rather it is clerical and usually performed by operating level
employees. It involves lot of paper work and time. Some of the routine finance functions are:
Supervision of cash receipts and disbursements and cash balances.
Custody and safeguarding the valuable documents like securities, contracts, insurance policies etc.
Record keeping of financial transactions and other details.
Supervision of the fixed and current assets and report the management.

5. Roles and Responsibilities of Financial Manager
As it have already been discussed that the finance managers basically have to spare their time in making the
investment, financing, asset management and others, there are some other vital roles and responsibilities that the
financial managers need to perform. In performing such roles, the finance manager should always emphasize on
increasing the value of the firm and the shareholders. Some of them are as follows:

a. Analysis of Financial Aspect of all Decisions: Financial managers are responsible for making the cost and
benefit analysis of the plans and decisions made by other departments. It is finance managers who decide
on whether or not to provide the funds for certain plans that other department have come up with? For
example, the marketing department plans for aggressive marketing and advertisement of the products or
services of firm. Such plans of marketing department requires fund. So, the finance managers need to
analyze the cost and possible increase in sales revenue from such marketing campaigns.

b. Analysis of Investment Decision: Financial managers should always work closely with other departmental
heads. So, the combined future plans of all departments bring about the investment opportunities for the
firm. Thus, finance manager are responsible for the feasibility analysis of such investment. Furthermore,
the finance managers should always stress on whether or not the investment is providing the expected
return as predicted before the investment decision was made.

c. Analysis of Financing Decision: Once the required funds and sources of funds are located, the finance
managers should devise the optimal capital structure to finance the investment opportunities. It is
associated with the cost that the firm has to pay for borrowed funds and the return it gets from the
investment made.

d. Analysis of Dividend Policy Decision: The firm has three alternatives regarding the earnings or profit. It
can distribute all of its earnings as dividend to its shareholders, retain all of its earnings or distribute part of
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the earnings and retain remaining. In choosing the alternatives provided, the finance managers should
analyze the shareholders dividend needs, cost of funds, investment opportunities, shareholders tax
liability etc.

e. Analysis of Financial Condition of the Firm: The finance managers constantly need to watch the
financial condition of the firm. In doing so, s/he is responsible for ensuring the profitability, leverage,
liquidity, and risk conditions are under the standard acceptable levels. For this purpose, the managers can
analyze the financial statements of the firm and compare it with the industry average periodically.
f. Analysis of Financial Markets: Since the any required financing is borrowed from the financial markets,
the mangers should understand the financial markets and its dynamics. Managers should analyze the
interest rate changes in different securities, the stock price of own stock and of competitors stock, the
effect of dividend and other decision on stock price of firm etc.

g. Analysis of Risk: The firm operates in both internal and external environment. The changes in the internal
and external environment sometimes provide strength and opportunities but some other time threats and
risks. The risks can be interest rate risk, market risk, foreign exchange risk, credit risk etc. Such risk should
be assessed timely and feasible risk minimizing or hedging techniques should be adopted to minimize the
possible loss.


6. Goals of Corporation
Goals are the desired end that any organization strives to achieve. It is the purposes for which various functions
including finance function are carried out. Goals of an organization provide the guidelines for the decision
making. Widely discussed financial goals of an organization are profit maximization and shareholders wealth
maximization.

a. Profit Maximization
Under this goal, the projects or investments that increase profits are undertaken and the one with fewer profits
are rejected. The managers select such projects and assets that are sure to increase the profits of the
organization. The supporters of this goal argue that profit is test of economic efficiency, effective utilization of
resources and represents the total welfare. However, the profit maximization goal is not free from criticisms
which are as follows:
Ambiguity or Unclear: Profit maximization goal is unclear. It is not clear whether the after tax or
before tax profit should be maximized, net profit or gross profit, earning per share or return on equity
etc. So, this goal creates confusion in managerial decision makings.

Ignores Time Value of Money: Benefits received earlier are better since it can be reinvested that can
increase the terminal wealth of investments. However, the profit maximization considers the total value
of the benefit or profits but not the timing of cash flows.

Ignores the Quality of Benefits: If the benefits are certain, such benefits or profits are considered to
be of quality. Profit maximization goal merely focuses on the amount of profit rather than its certainty
or degree of risks associated with. Profit maximization goal some time may mislead the managers to
select the projects with higher degree of risks.

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Unsuitable in Modern Business Environment: Traditionally businesses were family owned and self
financed. But todays business are characterized by separate ownership and management and market
oriented. It has various stakeholders which creates the unsuitability of profit maximization goal. Profit
maximization is considered as unethical, unrealistic and difficult.

b. Shareholders Wealth Maximization (Stock Price Maximization)
Wealth maximization goal is widely accepted that seeks to maximize the wealth or net worth of the
shareholders. Shareholders wealth is maximized when an investment decision generates the positive net
present value. Net present value is the difference between the present value of benefits and present value of
costs. The company undertaking the financially viable projects sends good information in the market pushing
up demand for the shares of that company and drives up the price as well. So, shareholders wealth
maximization is also called stock price maximization. Some advantages of this goal as opposed to profit
maximization are as follows:

Clarity of Goal: Shareholder wealth maximization goal is clear since every decision are to be made
based on evaluation of cash flows rather than accounting profit. Financial managers always try to make
the cash flows to the shareholders as big as possible.

Considers the Time Value of Money: This goal considers the cash flow and its present value. The cash
flows received in earlier period can be reinvested. So, this goal takes concern of time value of money.

Quality of Benefits: According to this goal, the cash flows with lower degree of risks are discounted with
lower required rate of return while risky cash flows are subjected to higher required rate of return. It
makes the difference in the net present value of the same project with equal cash flows. So, it is easier for
managers to undertake the decisions.

Reduces the Conflicts: Wealth maximization goal can serve the interest of multiple stakeholders of the
company like owners or shareholders, employees, customers, creditors and society. Under this goal,
company allocates the resources efficiently that help in producing high quality goods and services at
competitive price. It serves the interest of the customers. In addition, the wealth maximization can be
ensured only when employee are fairly compensated. Moreover, to allocate the benefit for shareholders,
the company should first settle the claim of creditors.


7. Financial Management and Related Departments
Having said that the financial manager should analyze the financial aspects of the all decisions made by other
departments, it is not difficult to understand how the finance is related with other departments. However, the
relationship of financial management with following departments is of great importance.

a. Marketing Department: The activities of marketing department like product survey, demand forecasting,
marketing campaign, new product development, pricing product etc. have financial implications. So, the
finance managers should make the cost and benefit analysis in order to determine the financial viability of
the marketing activities.

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b. Production Department: Product development, product manufacturing, quality control, raw material
purchase, inventories etc. are the function of the production department. The financial managers should
always ensure the production process never interrupts due to shortage of funds and other resources.

c. Human Resource Department: HRM department wants to maintain the qualified and motivated pool of
employees in the firm. For, this HRM department has to standardize its recruitment, selection, utilization,
training and development, motivation, employee compensation, rewards process and practices. All of these
activities require funds which come under the responsibilities of finance managers. Finance department can
help HRM department to achieve its goals.

8. The Agency Problem
The agency problem is the conflict of interest between the principal and the agent of the company. The basic
reason behind the agency problem is the separation between the ownership (Principals) and management
(agents) of the company. Basically, the agency problem is severe between the shareholders and managers.
However, the agency problems between the shareholders (through managers) and creditors are persistent.

a. Agency Problem between Shareholders and Managers
In practice, the top management of the company is concerned with their personal wealth, prestige, salary, job
security, life style, fringe benefits etc. So, it is uncertain that managers will work in best interest of the
shareholders which results in eroding the shareholders wealth. In addition, managers have tendency to increase
the size of firms in order to avoid the hostile takeovers that increase the power, status and salaries of the
managers. Managers may practice Poison Pill in which managers poses the company unattractive to be taken
over and Greenmail in which the management go for stock repurchases to gain control of the company. The
agency problem between the shareholders and the managers can be reduced by following ways:

Managerial Compensation: Performance shares and Executive stock options may be provided to
managers that motivate the managers to work in best interest of the shareholders. Better performing
managers should be compensated well that creates the harmony in between the interest of shareholders
and managers. However, financial viability of such compensation packages should be assessed.

Direct Intervention by Shareholders: Controlling and institutional shareholders holding more than 5
percent shares can pass the resolution calling for the discussion during the Annual General Meeting.
Likewise, extra ordinary general meetings can be called where the discussion are carried out to resolve
the conflicts.

Threat of Firing: Threat firing for poor performing managers can align managers to work in the best
interest of shareholders since the firing deteriorates the career and the prestige of the managers.

Threats of Hostile Takeovers: If the share price of company is undervalued and facing the crisis in
terms of financial viability and management performance, there is always risk of hostile takeovers of
such companies. Hostile takeovers may punish the managers in the market and can be fired from job as
well. So, managers may act in direction of shareholders interests.

b. Agency Problem between Shareholders and Creditors
When the managers make decisions to maximize the wealth of shareholders ignoring the interest of
creditors, the conflict arises between the shareholders and the creditors. Shareholders seeks to increase their
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wealth using the debt borrowed from creditors while creditors always resists such decisions thinking that
cannot participate in extra earning of the company i.e. the creditors do not entitle to extra income but they
have to bear extra risks. Some ways by which the agency problem between the shareholders and creditors
can be minimized are as follows:

Risk Premiums for Creditors: If the company is planning to undertake the risky projects, the creditors
need to be compensated with the higher risk premiums.

Protective Terms and Covenants: Protective Terms can be provisioned in the indenture of the debts
that restricts the company to undertake some risky activities. Such restrictions can be restructuring the
capital structure, payment of dividend, sale of assets repurchase of shares, acquisition and merger etc.

9. Development of Financial Management
Finance was the part of economics till late 1800s and emerged as the separate discipline during early
1900s.
Industrialization in US and other European countries stimulated the need of corporate finance. The key
financial issues were raising the new capital for formation of new business and expansion.
Due to shortage of regulations and increased fraudulent activities during early period, investors were
reluctant to invest in shares of the company. So, financial managers had to focus on legal aspects.
(Outsiders Viewpoint)
During the great depression 1930s, the focus shifted to the survival aspects rather than their expansion
and modernization.
Amendments in company law and regulation increased the investors confidence. Now, the finance was
related with the day to day problems faced in the finance functions like fund analysis, planning and
control.
During 1950s various corporate finance theories and tools were developed that changed the emphasis to
insiders viewpoint.
After 1990s, two trends namely globalization and communication and technology restructured the finance
functions. Multinational business finance emerged.
Financial decision makings are made with the software and data based computer information systems.
Today the corporate finance has become more analytical and quantitative. Development of capital
structure theory, efficient market theory, capital budgeting technique, option pricing model, arbitrage
pricing model etc.



Reference

Paudel, R. B., Baral, K. J., Gautam, R. R., Dahal, G. B., & Rana, S. B. (2012). Fundamentals of Financial
Management (3rd ed.). Kathmandu: Asmita Book Publishers and Distributors P(Ltd.).