Unit 1: Earnings and Cash Flow Analysis

 Inadequacy of accounting numbers

 Emphasis on free cash flow
 Interpretation of financial ratios
Meaning and Scope of Finance
 Finance in general sense is viewed as money or
wealth.
 In the modern world, it is viewed as a resource as
well as a discipline, a subject of study.
 When the finance is defined as a resource, it is
simply a monetary means which is used to acquire
the assets by an entity.
 The finance as a discipline, a subject of study, deals
with various decisions regarding how an individual
entity such as individual, business, or government
manages (surplus or deficit) of the funds.
Meaning and Scope of Finance continue . . .
 The finance in a broad sense is the mobilization of
funds from surplus generating sectors to deficit
facing of economy.
 It acquires the funds from various possible sources
and managed so as to allocate the accumulated
funds among and between individuals, businesses,
and governments.
 This process is believed to accomplish the objective
of maximizing wealth through maximizing market
price per share.
Meaning and Scope of Finance continue . . .
 Areas of finance (classification): public finance, personal
finance, and business finance.
 Public finance is concerned with acquisition and utilization
of funds by the government units in order to promote the
public utility sectors to benefits the society and thus well
beings of people.
 The personal finance refers raising and utilization of funds
by the household sectors (individuals and families) to fulfill
their needs.
 The business finance is art and science that acquires,
manages, and utilizes the funds by business entity, who aims
to maximize the wealth of its shareholders. This business
finance is called by many names: corporate finance,
managerial finance, financial management, etc.
Functions of Financial Management
Decisions carried out to achieve objectives of the firm
 Executive finance function
 Routine finance function

Executive finance function

 Carry out at top level
 It requires managerial skills in their planning,
execution, and control
 Consists investment decision, financing decision,
dealing with financial market, dividend decision,
working capital decision.
Functions of Financial Management continue . . .
Investment Decision
Decision regarding acceptance or rejection of long-
term investment projects (capital budgeting
decision)
Financing Decision
Concerned with acquisition of funds from most
appropriate sources.
Dealing with Financial Markets
Dealing/negotiating with suppliers of funds: banks
and other institutions
Dividend Decision
Decision regarding the allocation of net income into
dividend and retained earnings.
Working Capital Decision
Decision regarding the investment in current assets.
Routine Finance Function
These are daily clerical finance function that do not require
specialized skills of finance. Some of the routine finance
functions are as follows:
 Supervision of cash receipts and disbursements
 Safeguarding of cash balances
 Record keeping of the financial performance of the firm
 Reporting to the top management
 Supervision of fixed assets and current assets, etc.
Goals of Financial Management
The goal is the purpose that a firm aims to achieve.
 Profit maximization
 Wealth maximization
Profit Maximization Goal
 It gives more emphasis to increase profits and the projects that
decrease profits are avoided.
 This goal believes that only the profit maximization goal can
increase the economic efficiency of individual firms.
 However, many people have criticized this goal on following
grounds.
1. Ambiguity
 Profit is a vague term. It conveys different meanings to
different people.
 For example, the term profit may mean long-term profit or
short-term profit, profit after tax or profit before tax, gross
profit or net profit, earning per share, return on equity, etc.
Goals of Financial Management continue . . .
2. Ignores the Time Value of Money Benefits
Benefits received in earlier periods are more valuable than the
benefits received in the future period. This concept does not
considered in this profit maximization goal.
Year Future Cash Flows
Project A Project B
1 Rs 5,000 Rs 0
2 10,000 15,000
3 20,000 20,000
Total Rs 35,000 Rs 35,000
Both have total return of Rs 35,000 and profit
maximization goal treats these two projects equally.
However, in reality Project is superior over Project B.
Goals of Financial Management continue . . .
2. Ignores Quality of Benefits
Quality of benefits refers to the degree of certainty with which the
future benefits can be expected from the financial course of
action. Greater the uncertainty of expected benefits, lower the
quality of benefits.

Expected Cash Inflows

State of Economy Probability
Project A Project B

Weak 50% Rs 20,000 Rs 0

Strong 50% Rs 20,000 Rs 40,000
Both the project will be same which is Rs 20,000 [{Rs 20,000 x 0.5 +
Rs 20,000 x 0.5} or {Rs 0 x 0.5 + Rs 40,000 x 0.5}]. However, level of
risk is higher for Project B. Profit maximization treats both
projects same, but in reality Project A is to be selected.
Goals of Financial Management continue . . .
3. Not Suitable for Modern Business
 Profit maximization objective was developed in the 19th century when the
majority of business was self-financing. The modern business is
characterized with separate ownership and management. The owners and
managers have their own rights and responsibilities. The owners or
investors, therefore, cannot impose profit maximization goal on the
companies.
 Maximizing profits goal is considered outdated, unethical, unrealistic,
difficult and unsuitable in today’s context. It increased conflict of interest
among a number of stakeholders such as customers, employees,
government, society etc. It might lead to inequality of income and wealth.
So it is doubtful that it leads to optimum social welfare as advocated.
 Goals of Financial Management continue . . .
Shareholders’ Wealth Maximization Goal
 Due to the several problems associated with profit maximization, the goal of
financial management has been recognized as maximization of the current value per
share of the existing stock, known as shareholders’ wealth maximization.
 A decision that has a positive net present value creates wealth for shareholders and
a decision that has a negative net present value destroys wealth of shareholders.
 Stock price maximization is considered superior goal to profit maximization goal due
to following reasons:
1. Shareholders wealth maximization goal is clear
2. It considers the timing of cash flows
3. It considers quality of benefits
4. It reduces the conflict of interest among the stakeholders of a firm
 Agency Problem
Agency problem is the conflict of interest between the principal and agent. In the financial
management agency problem refers to the potential conflict of interest between.
- Stockholders and Managers
- Stockholders and Creditors
Stockholders and Managers
Problem, here, refers to the divergence of interest between owner and the manager. Some
of the examples of how this problem can manifest itself include:
 Managers are willing to increase their salaries and perquisites, rather than increase
shareholders dividends.
 Managers are interested in maximizing the size of firms so that any hostile takeover
(unfriendly control) is less likely and also it increases their power, status and salaries.
 Agency Problem continue . . .
 Managers might use corporate funds to contribute to their favorite charitable
institutions or political parties for their glory and personal satisfaction.
 Shareholders are willing to undertake new project and managers are not willing to
take new risky project.
Remedial Measures
 Management compensation (Basic salary, bonus, executive stock option,
performance shares)
 Direct intervention by shareholders (forcing to change management)
 Threat of firing
 Threat of takeover
Shareholders and Creditors
The conflict of interest between them arises when the managers (on behalf of company)
make decisions for shareholders value maximization by ignoring the interest of the
creditors.
 The creditors are viewed as principal and the shareholders are viewed as the agent.
Shareholders and Creditors continue . . .
 Shareholders have residual claim on the income as well as earnings of the firm.
 Creditors make investment their capital to earn fixed rate of interest and to get
the principal paid back upon maturity. On the other hand, shareholders invest
their capital to maximize the market price of their shares.
 Creditors oppose the high risk because they are not entitled to get the extra
return from additional risk.
Remedial Measures
 Compensate creditors for increased risk
 Protective terms and conditions for creditors
(Such as restrictions on dividend, restructuring capital structure, etc.)