Financial Management

An Introduction

FINANCE
Finance is the life-blood of business. Without finance neither any business can be started nor successfully run . Finance is needed to promote or establish business, acquire fixed assets, make necessary investigations, develop product keep man and machines at work ,encourage management to make progress and create values.

FINANCIAL MANAGEMENT
Financial management is one the functional area of management. It refer to that part of the management activity which is concerned with the planning and controlling of firms financial resources.

DEFINITION
Financial management is the application of planning and control function of the finance function Howard and Upton

NATURE AND SCOPE OF FINANCIAL MANAGEMENT

The nature of financial decisions would be clear when we try to understand the operation of a firm. At the very outset, the promoters makes an appraisal of various investment proposals and selects one or more of them ,depending upon the net benefits derived from each as well as on the availability of funds.

PROCESS INVOLVE IN FINANCIAL DECISION

1. Selection of investment proposals ,known as the investment decision. 2. Determination of working capital requirements, known as the working capital decision. 3. Raising of funds to finance the assets, known as the financing decision. 4. Allocation of profit for dividend payment, known as the dividend decision.

What is Finance Anyway? What is this course all about?

Accounting is the language of business. Finance uses accounting information together with other information to make decisions that affect the market value of the firm. There are three primary decision areas that are of concern.

Three decision areas in finance:

Investment decisions - What assets should the company hold? This determines the left-hand side of the balance sheet. these decision are concerned with the effective utilization of funds in one activity or the other. The investment decision can be classified under two groups(i) Long term investment decision (ii) Short term investment decision The former are referred to as the capital budgeting and the latter as the capital budgeting and the latter as working capital management.

Financing decision
Financing decisions - How should the company pay for the investments it makes? This determines the right-hand side of the balance sheet. it is also known as capital structure decision. It involves the choosing the best source of raising funds and deciding optimal mix of various source of finance. A company can not depend upon only one source of finance ,hence a varied financial structure is developed. but before using any particular source of capital ,its relative cost of capital ,degree of risk and control etc should be thoroughly examined by the financial manager. the major source of longterm capital as shares and debentures.

DIVIDEND DECISION
Dividend decisions - What should be done with the profits of the business? The dividend decision is concerned with determining how much part of the earning should be distributed among the share holders by way of dividend and how much should be retained in the business for meeting the future needs of funds internally.

Factors influencing financial decision

These factors are divided into two parts1.Micro economic factor 2.Macro economic factor Micro economic factor- micro economic factor is related to the internal condition of the firm(a) Nature and size of the firm (b) Level of risk and stability in earnings (c) Liquidity position (d) Asset structure and pattern of ownership (e) Attitude of the management

Macro economic factor

These are the Environmental factor1. The state of the economy 2. Governmental policy

All management decisions should help to accomplish the goal of the firm!
What should be the goal of the firm?

Objectives of financial management

The objective of financial management are considered usually at two levels at macro level and micro level. three primary objectives are commonly explained as the Objective of financial managementMaximization of profits Maximization of return Maximization of wealth

1. 2. 3.

Maximization of profits
Profit earning is the main aim of every economic activity. Profit maximization simply means maximizing the income of the firm . Economist are of the view that profits can be maximized when the difference of total revenue over total cost is maximum, or in other words total revenue is greater than the total cost.

Maximization of return
Some authorities on financial management conclude that maximization of return provide a basic guideline by which financial decision should be evaluated .

Maximization of wealth
According to prof solomon ezra of stand ford university , the ultimate goal of financial management should be the maximization of the owners wealth. The value of corporate wealth may be interpreted in terms of the value of the companys total assets. The finance should attempt to maximize the value of the enterprise to its shareholders. Value is represented by the market price of the companys common stock.

What about risk? Isnt risk important as well as profits?

How would the stockholders of a small business react if they were told that their manager canceled all casualty and liability insurance policies so that the money spent on premiums could go to profit instead. Even though the expected profits increased by this action, it is likely that stockholders would be dissatisfied because of the increased risk they would bear.

The common stockholders are the owners of the corporation!

Stockholders elect a board of directors who in turn hire managers to maximize the stockholders well being. When stockholders perceive that management is not doing this, they might attempt to remove and replace the management, but this can be very difficult in a large corporation with many stockholders.

More likely, when stockholders are dissatisfied they will simply sell their stock shares.
This action by stockholders will cause the market price of the companys stock to fall.

falls relative to the rest of the market (or relative to the rest of the industry) ...
Management is failing in their job to increase the welfare (or wealth) of the stockholders (the owners).

Conversely, when stock price is rising relative to the rest of the market (or industry), ...
Management is accomplishing their goal of increasing the welfare (or wealth) of the stockholders (the owners).

The goal of the firm should be to maximize the stock price!

This is equivalent to saying the goal is to maximize owners wealth. Note that the stock price is affected by managements decisions affecting both risk and profit. Stock price can be maintained or increased only when stockholders perceive that they are receiving profits that fully compensate them for bearing the risk they perceive.

Important focal points in the study of finance:

Accounting and Finance often focus on different things Finance is more focused on market values rather than book values. Finance is more focused on cash flows rather than accounting income.

Why is market value more important than book value?

Book values are often based on dated values. They consist of the original cost of the asset from some past time, minus accumulated depreciation (which may not represent the actual decline in the assets value). Maximization of market value of the stockholders shares is the goal of the firm.

Why is cash flow more important than accounting income?

Cash flow to stockholders (in the form of dividends) is the only basis for valuation of the common stock shares. Since the goal is to maximize stock price, cash flow is more directly related than accounting income. Accounting methods recognize income at times other than when cash is actually received or spent.

One more reason that cash flow is important:

When cash is actually received is important, because it determines when cash can be invested to earn a return.

[Also: When cash must be paid determines when we need to start paying interest on money borrowed.]

Examples of when accounting income is different from cash flow:

Credit sales are recognized as accounting income, yet cash has not been received. Depreciation expense is a legitimate accounting expense when calculating income, yet depreciation expense is not a cash outlay. A loan brings cash into a business, but is not income.

More examples:
When new capital equipment is purchased, the entire cost is a cash outflow, but only the depreciation expense (a portion of the total cost) is an expense when computing accounting income. When dividends are paid, cash is paid out, though dividends are not included in the calculation of accounting income.

Definitions: Operating income vs. operating cash flow

Operating income = earnings before interest and taxes (EBIT). This is the total income that the company earned by operating during the period. It is income available to pay interest to creditors, taxes to the government, and dividends to stockholders.

Operating cash flow:

Operating cash flow = EBIT + Depreciation - Taxes. This definition recognizes that depreciation expense is subtracted in computing EBIT, though it is not a cash outlay.

It also recognizes that taxes paid is a cash outlay.

Zenith Travel Balance Sheet December 31, 2010

Assets Current Assets Cash Marketable Securities Receivables Merchandise Inventories Prepaid Expenses Total Current Assets Non-Current Assets Investments Property, Plant and Equipment Intangible Assets Other Assets Total Non-Current Assets TOTAL ASSETS Liabilities Current Liabilities Accounts Payable Notes Payable Accrued Expenses Unearned Income Total Current Liabilities Non-Current Liabilities Mortgage Payable Other Non-Current Liabilities Total Non-Current Liabilities XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX

XXX XXX XXX XXX XXX XXX

XXX XXX XXX

Capital
Z. Tuazon, Capital TOTAL LIABILITIES AND CAPITAL XXX XXX

Zenith Travel
Balance Sheet December 31, 2010

Assets
Current Assets Noncurrent Assets Total Assets XXX XXX XXX

Liabilities & Capital

Current Liabilities Noncurrent Liabilities Total Liabilities
Z.Tuazon, Capital Total Liabilities & Capital

XXX XXX XXX

XXX XXX

Current Assets
Properties that are convertible to cash and used within the year Arranged from most liquid to least liquid
Cash Marketable Securities Receivables Inventory Prepaid Expenses

1) Cash
Includes: Money Other cash items
Checks, bank draft Treasury warrants Current cash funds Checks not yet encashed by creditors

Cash
Excludes:
Cash advances by the business or IOUs by officers/ employees Post-dated checks Defective checks Restricted checks Time deposits maturing after the accounting period Noncurrent cash funds Cash overage/shortage Stale checks

VALUATION OF Cash
Cash on hand Cash in bank Cash in foreign bank
Petty cash Cash in Closed Bank *At recoverable amount

*Face value/converted amount *may be combined as Cash on Hand and in Bank

CONTROL OF CASH
1. 2. 3. 4. 5. 6. 7. Dont delegate to one person the recording and handling of cash Payments should be in checks and petty cash Voucher system ORs, pre-numbered Sales Invoice Cash Registers Daily deposits Periodic audit

2) Marketable Securities
Excess cash within the year Temporary investments to earn additional money Forms: *Stocks issued by other companies-Dividends *Bonds -Interest *Commercial papers(short-term notes)-Interest

3) Receivables
Due from customers 1.Trade- from customers, sales -Account/Notes Receivable 2.Non-trade- from customers & others, other than Sales Ex: Interest receivable/ Advances Rent Receivable Advances to officers and employees

4) Merchandise Inventories
1.Goods for Sale

5) Prepaid Expenses
1.Paid in advance 2.Economic benefit not yet realized 3.Considered as assets

Non Current Assets

1) Investments
Noncurrent asset Intended for Business advantage for a long period of time Examples:
Stocks, bonds of other companies Stocks of affiliated cos. Or subsidiaries Advances to affiliated cos. / subsidiaries Investment in partnership Joint Venture Land Cash surrender value of Life Insurance Cash deposits (Long term and restricted) Noncurrent funds

2) Property, Plant and Equipment

Permanent and used for business Shown at net of accumulated depreciation Examples:
Land, building, equipment, furniture and fixtures

3) Intangible Assets
Noncurrent assets Rights privileges and economic advantage to the owner Value and life of asset difficult to determine

Sources of Intangible Assets

Rights/ privileges granted by government or legal authority
Examples:
Copyright (author, artist, publisher) Franchise (public and private) Patent (investor) Trademark (signs, symbols) Trade name Leasehold (Long term rental) Leasehold improvement Organization cost

Perceived managerial capability and customer satisfaction

Examples:
Goodwill (amortization)

Liabilities
1.Current liabilities payable within the year
Trade and nontrade payables Unearned revenues or advance collection for goods and services which are due within the year

2.Long term liabilities not due within the year

Long term notes, bonds and mortgage payables

3.Deferred credits or revenue advance collection of

income which are realizable beyond the accounting period

4.Estimated liabilities may be current or long-term;

valid and existing liabilities the amount or due date of which is not definite
e.g. estimated pension payable, estimated additional taxes

3.Contingent liabilities possible liabilities which will

depend on future circumstances, and therefore not yet considered as liabilities
Disclosed in the Financial Statement as:
Notes Parenthetical remarks Contra accounts (Notes receivable discounted) Ex. Notes receivable discounted, accounts receivable assigned, pending lawsuits, possible tax assessments

Owners Equity
Investment of the owner listed as his capital account Partnership listing of capital of each partner Statement of changes in capital (sole or partnership) shows the additions or subtractions from capital account

Stockholders Equity capital account in a

corporation. Does not include: 1. Authorized Capital Stock- authorized stock to be sold by a corporation as indicated in its charter or by-laws 2. Outstanding Capital Stock-issued stock in the possession of stockholders

Stockholders Equity is composed of: 1. Paid-in Capital 2. Retained Earnings

Paid-in Capital Stock

Total amount of investments by the owners (stockholders) Cash/other assets investment in exchage for capital stock Capital stock (evidence of ownership in part in the form of stock certificates)

Stock certificate in denomination of 1 share

or any number of shares and may have a stated par value per share

Par value or Stated value minimum amount per

share chosen by the corporation; this can be withdrawn only through a special legal action

Additional Paid-in Capital

Excess of stockholders investment to the par value of shares Not a profit, but addition to capital stock in Balance Sheet presentation

Types of Capital Stocks

1.Common Stock basic capital stock issued by
corporations
Unlimited increase in value depending on profitability of the business Rapid decrease in value in times of business losses Gives the owners voting rights, dividends, and share in corporate assets upon liquidation

Types of Capital Stocks

2. Preferred stock additional shares issued by a
corporation to attract more investors
Has priority in dividend distribution and assets upon liquidation Shown as first item in the Stockholders Equity presentation May or may not have par value

Retained Earnings
Accumulated net income of a corporation Reduced by the amount of losses Reduced by declared dividends Direct link between income statement and balance sheet Negative retained earnings means Deficit Positive retained earning for business expansion

END.