Module in AE 19 (Financial Management)

Course Code: AE 19

Course Title: Financial Management

Unit Credit: 3 Units

Contact Hours/Week: 3 Hours

Prerequisite: AE 15 (Intermediate Accounting 1)

Course Description:

This course exposes the students to the accounting aspects of finance in order to develop
appropriate financial strategies. It also includes various ways on how to interpret the figures
presented in the financial statements. Analysis of financial statements utilizing horizontal analysis,
vertical analysis and ratio analysis. The students are expected to prepare financial statements and
make a corresponding analysis. It covers on how to manage current assets and current liabilities of
the business. It further includes the optimal level of cash, different policies over receivable
management, optimal level of inventory and management of discounts taken over accounts payable
settlement.

Introduction

This module is devised to impart fundamental concepts of financial management, such as its
nature, purpose, scope and significance. It intends to provide the students ample knowledge in
understanding financial statements through the use of various financial analysis tools and
techniques, such as horizontal, vertical and ratio analysis and communicating the interpretations
thereof to concerned parties.

Additionally, this module discusses on the preparation and analysis of the statement of cash flows
which is a part of the complete set of financial statements for any organization.

In this module, students are familiarized with the management of working capital (current assets
and current liabilities). Various techniques in managing cash, accounts receivables, inventories
and accounts payable are incorporated in this module.

More importantly, this module seeks to imbue the students with a high degree of ethical behavior
in the conduct of their roles and responsibilities as future finance managers or financial analysts.
 MODULE ONE
INTRODUCTION TO FINANCIAL MANAGEMENT

Learning Objectives:

1. Define finance management and the three key elements to the process of financial
management.
2. Identify the major areas and opportunities available in the field of finance.
3. Determine and compare the legal forms of business organization.
4. Describe the managerial finance function and its relationship to economics and accounting.
5. Determine the roles of finance manager.
6. Identify the goal of the firm, corporate governance, the role of ethics, and the agency issue.
7. Discuss business taxes and their importance in financial decisions.

OVERVIEW

• Finance plays an important role in the student’s professional and even personal life. Each
part of this module emphasizes the relevance of the topic to majors in accounting,
management, marketing, operations and information systems.

• In this module, students were introduced into the field of finance and the opportunities in
the financial services and managerial finance.

• The basic legal forms of business organization such as the sole proprietorship, partnership,
and corporation are described and differentiated from each other. The strengths and
weaknesses of these basic legal forms of organizations were identified.

• The managerial finance function is defined and compared with economics and accounting.
The financial manager’s goals, which are to maximize the shareholders’ wealth and to
preserve stakeholder wealth, were discussed.

• The role of ethics in achieving these goals is presented. This module then summarizes the
three key activities of the financial manager. It also includes discussion of the agency
problem – the conflict that exists between managers and owners in a large corporation.

FINANCIAL MANAGEMENT

• Financial Management is about preparing, directing and managing the money activities of
a company such as buying, selling and using money to its best results to maximize wealth
or produce best value for money. Basically, it means applying general management
concepts to the cash of the company.

• Taking a commercial business as the most common organizational structure, the key
objectives of financial management would be to create wealth for the business, generate
 cash and provide an adequate return on investment bearing in mind the risks that the
business is taking, and the resources invested.

• Personal finance deals with an individuals' decisions concerning the spending and investing
of income. It includes the answers as to how much of their earnings should they spend,
how much should they save, and how should they invest their savings.

• Business finance involves same type of decisions focusing on how the firms raise money
from investors, how to invest money to earn a profit, and how to reinvest profits in the
business or distribute them back to investors.

THREE KEY ELEMENTS TO THE PROCESS OF FINANCIAL MANAGEMENT

1. Financial Planning. Management needs to ensure that enough funding is available at the
right time to meet the needs of the business. In the short term, funding may be needed to
invest in equipment and stocks, pay employees and fund sales made on credit. In the
medium and long term, funding may be required for significant additions to the productive
capacity of the business or to make acquisitions. This links in with the financial decision-
making process and forecasting.

2. Financial control helps the business ensure that the objectives are being met. Financial
control determines if assets are secured and being used efficiently. It also identifies if the
management act in the best interest of shareholders and in accordance with business rules.

3. Financial decision making. The key aspects of financial decision-making include

investment, financing and dividends. Investments must be financed in some way. However,
there are always financing alternatives that can be considered, which will depend on the
source, period of financing, cost of financing and the net present returns generated. The
key financing decision is whether profit earned by the business should be retained instead
of distributing to shareholders via dividends. Dividends that are too high may cause the
business to starve of funding to reinvest in growing revenues and profits further.

SCOPE OF FINANCIAL MANAGEMENT

Financial management has a wide scope. It includes the following five 'A's as stated by Dr. S. C.
Saxena:
1. Anticipation. The financial needs of the company are being estimated. That is, it finds out
how much finance is required by the company.
2. Acquisition. It collects finance for the company from different sources.
3. Allocation. It uses this collected or acquired finance to purchase fixed and current assets
for the company.
4. Appropriation. It distributes part of the company profits among the shareholders, debenture
holders, and some are kept ass reserves.
5. Assessment. It also means controlling all the financial activities of the company. It checks
if the objectives are met. If not, it determines what can be done about it.
FINANCE AREAS AND CAREER OPPORTUNITIES
The following are the major areas in the field of finance:

1. Financial service - the one concerned with the design and delivery of advice and financial
products to individuals, businesses, and governments. Career opportunities: within the
areas of banking, personal financial planning, investments, real estate, and insurance.

2. Managerial finance - concerned with the duties of the financial manager working in a
business. This encompasses financial planning or budgeting, extending credit to customers
or other credit administration function, investment evaluation and analysis, and obtaining
of funds for a firm. Managerial finance is the management of the firm's funds within the
firm.

Career opportunities: financial analyst, capital budgeting analyst, and cash manager.

The recent global financial crisis and subsequent responses by governmental regulators,
increased global competition, and rapid technological change also increase the importance
and complexity of the financial manager's duties. Increasing globalization has increased
demand for financial experts who can manage cash flows in different currencies and protect
against the risks that naturally arise from international transactions.

The following are the professional certifications in finance:

1. Chartered Financial Analyst (CFA) - a graduate-level course of study focused largely

on the investments side of finance. This is offered by the CFA Institute.
2. Certified Treasury Professional (CTP) - this program requires students to pass a single
exam that is focused on the knowledge and skills needed for those working in a
corporate treasury department
3. Certified Financial Planner (CFP) - Students should pass a 10-hour exam covering a
wide range of topics related to personal financial planning in order to obtain CFP status.
4. American Academy of Financial Management (AAFM) - This administers certification
programs for financial professionals in a wide range of fields. Their certifications
include the Charter Portfolio Manager, Chartered Asset Manager, Certified Risk
Analyst, Certified Cost Accountant, Certified Credit Analyst, and many other
programs.
5. Professional Certifications in Accounting - include Certified Public Accountant (CPA),
Certified Management Accountant (CMA), Certified Internal Auditor (CIA), and many
other programs.

LEGAL FORMS OF BUSINESS ORGANIZATION

Sole Proprietorship

• A sole proprietorship is a business owned by one person and operated for his or her own
profit. He is legally responsible for the debts and taxes of the business and very involved
in its day-to-day activities. This is the most common form of business organization. Many
sole proprietorships operate in the wholesale, retail, service, and construction industries.
 • There are various advantages in forming a sole proprietorship. It is simple and the owner
has freedom to make all decisions and enjoy all the profit. It has minimal legal restrictions
and government regulation. It can be discontinued with great ease and the tax rate is
relatively at the minimum. However, the owner may lack expertise or experience to run
business. The owner may also incur unlimited liability. Generally, the owner has relatively
limited availability of outside financing.
Partnership

• A partnership is a business owned by two or more people and operate on an agreement

called Article of Co-Partnership. They are legally responsible for the debts and taxes of the
business. Partners must agree upon amount each partner will contribute to the business,
percentage of ownership of each partner, share of profits of each partner, duties each
partner will perform, and the responsibility each partner has for the partnership's debts.
Typical partnership includes those professional services such as medical and dental
practices, accounting, architectural and law firms.

• With a partnership form of business organization, there is ease of organization compared

to corporation. In partnership, there are combined talents, more available brain power and
managerial skill. In terms of available financing, it can raise more capital for the firm than
a sole proprietorship. However, there is unlimited liability for general partners and limited
life for the firm. Partnership is dissolved when a partner withdraws or dies, and it is difficult
to liquidate or transfer partnership. Two or more heads may be better for the firm but there
is also a possibility of divided authority that could lead to possible disagreement on major
decisions and issues.

Corporation

• A corporation is an entity created by law. Corporations have the legal powers of an

individual in that it can sue and be sued, make and be party to contracts, and acquire
property in its own name. It is a publicly or privately-owned business entity that is separate
from its owners and has a legal right to own property and do business in its own name. But
the stockholders are not responsible for the debts or taxes of the business. A corporation is
governed by the Board of Directors, in case of a profit organization, or Board of Trustees
in case of not-for-profit organization.

• Some advantages of forming a corporation include the limited liability of stockholders and
perpetual life. There is ease of transferring ownership, expansion obtaining resources or
financing. Corporations are bound by relatively more government regulations/restrictions
and maybe expensive to organize.

• For accounting purposes, all forms of business entities are considered separate entities.
However, the corporation is the only form of business that is a separate legal entity.

FINANCE, ECONOMICS AND ACCOUNTING

• Economics is a study of choice. It is a social science that deals with individual or collective
economic activities such as production, consumption, distribution and transfer of money
and wealth. This is based on the fact that our resources are scarce and need to deliberately
and systematically allocated.
 • Finance is the study of financial allocation and answers the questions like where to put
your money and why. It is often considered a form of applied economics. Firms operate
within the economy and they must be aware of the economic principles, changes in
economic activity, and economic policy. Marginal cost- benefit analysis is the primary
economic principle that is being used in managerial finance. This principle reminds the
decision makers to choose and take actions only when the firm will have a net advantage,
which means that the added benefits exceed the added costs.
• One of the major differences in the focus of finance and accounting is that accountants
generally use the accrual method while in finance, the emphasis is on cash flows.
Accountants recognize revenues at the point of sale and expenses when incurred regardless
on when cash will flow into or out of the firm. On the other hand, the financial manager
focuses on the actual inflows and outflows of cash, recognizing revenues when cash is
collected and expenses when actually paid.

GOALS OF THE FIRM AND THE ROLE OF THE FINANCE MANAGER

Decision rule for managers:
Only take actions that are expected to increase the share price!

This rule means that whenever the financial manager decides or choose between or among
alternatives, after assessing the risks and the returns, only actions that would increase share price
shall be accepted. Otherwise, the alternative/s shall be rejected.

The goal of a firm, and therefore of all managers, is to maximize shareholders' wealth. This can be
measured by share price. An increasing price per share of common stock relative to the stock
market as a whole indicates achievement of this goal.

Given the following opportunities, which investment is preferred?

Earnings per Share Year

Investment Year 1 Year 2 Year 3 Total
A P14.00 P10.00 P4.00 P28.00
B 6.00 10.00 14.00 30.00

Based on the information provided, the choice is not obvious. Profit maximization is not consistent
with wealth maximization. It may not lead to the highest possible share price due to the following
reasons:
1. Timing is important- the receipt of funds sooner rather than later is preferred. Project B is
expected to provide the higher overall increase in earnings, thus, is the more profitable
project. But since the goal of the firm is to maximize value, and therefore, timing must be
considered to determine which project is superior. Profit maximization may lead to value
maximization, but it is not an absolute case.

2. Profits do not necessarily result in cash flows available to stockholders. In finance, cash is
king. It is not unusual for a firm to be profitable yet experience a cash crunch. They might
have so much profit but less do not have enough cash to continuously run the business. The
most common cause is when expenses have a shorter due date than expected revenue. In
such cases, the firm must arrange short-term financing to meet its debt obligations before
the revenue arrives.
 3. Profit maximization fails to account for risk. Risk is the chance that actual outcomes may
differ from expected outcomes. Financial managers must consider both risk and return
because of their inverse effect on the share price of the firm. Increased risk may decrease
the share price, while increased return is likely to increase the share price.
Financial managers administer the financial affairs of all types of businesses such as private and
public, large and small, profit-seeking and not-for-profit. Typically, he handles a firm's cash,
investing surplus funds when available and securing outside financing when needed. He also
oversees a firm's pension plans and manages critical risks related to movements in foreign currency
values, interest rates, and commodity prices. The treasurer in a mature firm must make decisions
with respect to handling financial planning, acquisition of fixed assets, obtaining funds to finance
fixed assets, managing working capital needs, managing the pension fund, managing foreign
exchange, and distribution of corporate earnings to owners.

TWO KEY TYPES OF FINANCIAL DECISION

1. Investment decisions. The finance manager defines the most efficient level and the best
structure of assets. Investment decisions deals with the items that appear on the asset
section of the balance sheet.

2. Financing decisions. The finance manager determines and maintains the proper
combination of short- and long-term financing. Also, he raises the needed financing in the
most economical manner. Financing decisions generally refers to the items that appear on
the liability and equity section of the balance sheet.

CORPORATE GOVERNANCE, ETHICS AND AGENCY ISSUES

• Corporate governance is a system of organizational control that defines and establishes the
responsibility and accountability of the major participants in an organization. Shareholders,
board of directors, managers and officers of the corporations, and other stakeholders are the
major participants included here. An organizational chart is an example of a broad arrangement
of corporate governance. More detailed responsibilities would be established within each part
of the organizational chart.

• Business ethics are the standards of conduct or moral judgment that apply to persons engaged
in industry or commerce. Violations of these standards in finance include, but not limited to
misstated financial statements, misleading financial forecasts or projections, fraud, bribery,
kickbacks, insider trading, excessive executive compensation, and options backdating.

• Bad publicity generally results to negative impacts on a firm. Ethics programs seek to reduce
lawsuits and judgment costs, uphold and preserve a positive corporate image, build trust and
confidence of the shareholders, and to gain the loyalty and respect of all stakeholders. The
expected result of such programs is to positively affect the firm's share price.

• Shareholders are the owners of a corporation, and they purchase stocks because they want to
earn a good return on their investment without undue risk exposure. In most cases, shareholders
elect directors, who then hire managers to run the corporation on a day-to-day basis. Because
managers are supposed to be working on behalf of shareholders, they should pursue policies
 that enhance shareholder value. Also, to achieve this goal, the financial manager would take
only those actions that were expected to make a major contribution to the firm's overall profits.

• When managers deviate from the goal of maximization of shareholder wealth by putting their
personal goals above the goals of shareholders, this results to agency problems and issues. This
kind of problems increases agency costs. Agency costs are the costs borne by shareholders due
to the occurrence and avoidance of agency problems. Both cases represent a reduction in the
shareholders' wealth.

The agency problem and the associated agency costs can be reduced with the following:

1. Properly constructed and implemented corporate governance structure. This should be

designed to institute a system of checks and balances to reduce the ability and incentives
of management to deviate from the goal of shareholder wealth maximization.

2. Structured expenditures thru compensation plans. This maybe the most popular way to deal
with the agency problem but this is the most expensive one. It could either be incentive or
performance plans. Incentive plans tie management performance to share price. When the
managers take actions that maximize stock, they could be given stock options giving them
the right to purchase stock at a set price. This incentive plan may not be favorable because
of market behavior that has a substantial impact on share price and is beyond the control
of the That's why performance plans are more popular today. In this plan, compensation is
based on performance measures, such as earnings per share and/or its growth, or other
return ratios. Managers may receive performance shares and/or cash bonuses when the set
performance goals are attained.

3. Market forces such as shareholder crusading from large institutional investors. Institutional
investors hold large quantities of shares in many of the corporations in their portfolio. The
power of institutional investors far exceeds the voting power of individual investors.
Managers of these institutions should be active in the monitoring of management and vote
their shares for the benefit of the shareholders. This can lessen or avoid the agency problem
because these. It pressures on management to take actions that maximize shareholder
wealth. They may use their voting power to elect new directors who are aligned with their
objectives and will act to replace poorly or non-performing managers.

4. Threat of hostile takeovers. It occurs when a company or group not supported by existing
management attempts to acquire the firm. Because the acquirer looks for companies that
are poorly managed and undervalued, this threat provokes managers to act in the best
welfares of the firm's owners.

Reference:

JoMich Lee. (2020, October 18). Introduction to Financial Management. Youtube.

https://www.youtube.com/watch?v=0wzlfS7N9Zo