LESSON 2
AN OVERVIEW OF FINANCIAL MANAGEMENT
TOPICS
1. Goals of Financial Management
2. Functions of Financial Management
3. Financial Manager’s Responsibility
4. Alternative Forms of Business Organization
5. Agency Relationships
LEARNING OUTCOMES
At the end of the lesson, you should be able to:
1. Differentiate goals and functions of financial management.
2. Identify financial manager’s responsibility.
3. Identify alternative forms of business organization.
TOPIC 1: GOALS OF FINANCIAL MANAGEMENT
A goal or objective is needed for financial management to be
efficient; this is to guide judgment as to whether or not a
financial decision is within the standards of the firm. Although
various objectives are possible, the ultima goal of the firm is to
maximize the wealth of the firm’s present owners. Shares of
common stock give evidence of ownership in a corporation.
Shareholder wealth is represented by the market price per
share of the firm’s common stock, which, in turn, is a reflection of the firm’s investment,
financing, and asset management decisions. The idea is that the success of a business decision
should be judged by the effect that it ultimately has on share price.
Maximization of the Value of the firm (Valuation Approach)
Anastacio, et. al (2016) emphasize the importance of profit
maximization. The ultimate measurement of performance of
the firm is not on the income generated but more on how the
income is being valued by the owners of the firm. Therefore,
the main goal of financial management is not only to maximize
profit but the over-all value of the firm, thus called Valuation
Approach. In considering investment proposals or decisions,
the following must be taken into consideration:
• The risk connected to the investment proposal or the company’s operation;
• The time design as to how and when the profits will flow into the company; and
• The quality and reliability of the profits reported by the firm.
Though a firm may pursue the profit motive it is arguable that achieving this objective alone
guarantees the satisfaction of all constituent’s interests and corporate survival. A company driven
exclusively by the profit motive may, in an attempt to maximize profit embark on high risk
projects. High risk projects have the potential for high returns but at the same time puts at
jeopardy the interest of the owners, especially fixed interest owners who do not often bargain
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for such level of risk. Profit maximization can at best be a short run objective. It implies that the
firm pursue only those decisions that will lead to immediate profit and not those that will
enhance the future earning potential. It assumes that a firm is evaluated on the basis of current
earnings alone to the exclusion of future earnings stream.
Maximization if Shareholder’s Wealth
Brigham & Houston (2015) mentions that stakeholders
are not only abstract group but they are individuals who
have invested their hard-earned cash into the firm. And
who are looking for return on their investment. This is
where the wealth of a firm increased when the present
value of its cash in- skim flow is greater than the present
value of cash outflow. The maximization of the value of
the firm is recognized as the most appropriate financial
objective which should drive the investing and financing
action of financial manager. The financial objective of value or wealth maximization recognizes
the time value of money and the risk of the earnings stream. It accounts for the possible variety
in the source of finance and the differences in the expectations of the stakeholders. Since the
equity interest is residual, their maximization in essence accounts for the interests of the others.
Hence the financial objective of wealth maximization is consistent with maximizing the owner’s
economic welfare and efficiency in resource allocation.
Value or wealth maximization objective is not ambiguous it emphasizes cash flows rather than
profit. It takes the potential earning capacity since investment in a company is not made for its
own sake but rather because of the expectation of returns, the wealth maximization objective is
therefore most appropriate and realistic.
Social Responsibility and Ethical Behavior
Van Horne & Wachowicz (2009) mentioned that the interest
of the stakeholders should also be given consideration aside
from its shareholders. These are creditors, employees,
customers, suppliers, and the communities in which a firm
operates. The interest of the stakeholders more often
conflicts with each other. Thus, the company becomes the
umbrella for the resolution of these conflicts. The
responsibility for resolving these conflicts lies with the management which must manage the
disparage forces for their common good.
Sustainability has become the focus of corporate social responsibility efforts. Firms has always
been concerned with their being productive in the long term. However, the concept of
sustainability has evolved wherein firms are able to meet the needs of the present generation
without compromising the needs of the future generations. Therefore, firms are more pro-active
in issues such as climate change, energy usage, and the likes.
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TOPIC 2: FUNCTIONS OF FINANCIAL MANAGEMENT
Financial management is involved in the cautious allotment
and distribution of a firm’s funds to current assets and non-
current assets. This is by having a well-balanced financing
activity and formulating policies that will fit the firm’s
objectives. These general functions are carried out on the
day-to-day operations of the business.
Investment decision or capital budgeting is the "oldest"
area of the recent thinking in finance. It relates to allocation
of capital and involves decisions to commit funds to long-
term assets which would yield benefits in future. One very significant aspect of this decision is
the task of measuring the prospective profitability of new investments. Future benefits are
difficult to measure and cannot be predicted with certainty. Because of the uncertain future,
capital budgeting decision involves risk. Investment proposals should, therefore, be evaluated in
terms of both expected return and risk. Besides the decision to commit funds in new investment
proposals, capital budgeting also involves the question of recommitting funds when an old asset
becomes less productive or non-profitable.
Financing decision is the second important function to be performed by the finance manager.
Broadly, he must decide when, where, and how to acquire funds to meet the firm's investment
needs. The central issue before him is to determine the proportion of equity and debt. The mix
of debt and equity is known as the firm's capital structure. The finance manager must strive to
obtain the best financing mix or optimum capital structure for his firm. The firm's capital structure
is optimum when the market value of shares is maximized.
TOPIC 3: FINANCIAL MANAGER’S RESPONSIBILITIES
Forecasting
and Planing
According to Anastacio et al (2016)
presented the activities that are
inherent to a financial manager’s job.
Making Crucial
Risk
Management
Investment
and Financing
These are:
Decisions
Financial
Manager's 1. Forecasting and Planning. The
Responsibilities
financial manager must interact
with other executives as they
jointly look ahead and lay the
Trading in
Financial
Coordinating
and
plans which will shape the firm's
Markets Controlling
future position.
2. Making Crucial Investment and Financing Decisions. On the basis of long-run plans, the
financial manager must raise the capital needed to support growth. A successful firm usually
achieves a high rate growth in sales, which requires increased investments in the plant,
equipment and current assets necessary to produce goods and services. The financial manager
must help determine the optimal rate of growth in sales, which requires increased investments
in the plant, equipment' and current assets necessary to produce goods and services. The
financial manager must help determine the optimal rate of sales growth, and he or she must help
decide on the specific investments to be made as well as on the types of funds to be used to
finance these investments. Decisions must be made about the use of internal versus external
funds, the use of debt versus equity and the use of long-term versus short-term debt.
3. Coordinating and Controlling. The financial manager must interact with executives in other
parts of the business if the firm is to operate as efficiently as possible. All business decisions have
financial implications, and all managers - financial and otherwise - need to take this into account.
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For example, marketing decisions affect sales growth, which in tum changes investment
requirements. Thus, marketing decision makers must take into account how their actions affect
(and are affected by) such factors as the availability of funds, inventory policies, and plant
capacity utilization.
4. Trading in Financial Markets. The financial manager must deal with the money and capital
markets. Each firm affects and is affected by the general financial markets, where funds are
raised, where the firm's securities are traded, and where its investors are either rewarded or
penalized.
5. Risk Management. All business entities are exposed from risks. These risks could be financial
risks such as prices of commodities, currency exchange rates, and fluctuating interest rates. It
could also be from natural calamities, such as earthquakes, floods, fires, and the recent health
pandemic, the COVID-19. A financial manager is responsible and accountable for the risk
management policies and programs of the firm that involve the detection of the risks.
TOPIC 4: ALTERNATIVE FORMS OF BUSINESS ORGANIZATION
We have always encountered the three basic forms of a business
organization namely: sole proprietorship, partnership, and
corporation. In this module, we will briefly discuss each, its
characteristics and features.
Sole Proprietorship. In all the form of business organization, this
is considered as the oldest, most common and simplest form. A
sole proprietorship is a type of business that is owned (and run)
by one person. When you run a sole proprietorship, you’re liable
for everything the business is liable for. If your business owes
someone money, you owe them that money personally. And if someone sues your business,
they’re suing you, the business owner, personally. When you run a sole proprietorship, you and
your business are identical for tax purposes (even if you
have a registered business name). Which means your
“business” doesn’t pay taxes. Instead, your business
income is considered “personal income”, so you
personally pay the taxes. Which means the tax table you
normally consult to find your personal tax rate is the same
tax table for sole proprietorship taxes. This form of
business has its simplicity in decision-making since only
one person makes all the decisions. Also, this is
inexpensive to form and is subject to few government
regulations. However, it has its drawbacks in the form of
capital. Due to its nature, it is difficult to come up with a sizeable amount of capital. Another is
that the sole proprietor is personally liable for all business obligations. The principle of unlimited
liability for the owner puts him at great risks in times of losses. For payment of business debts,
his personal property can also be used, if the business assets are insufficient. Lastly, the life of
the company is limited to the life of the proprietor.
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Partnership. A partnership is a form of business where two
or more people share ownership, as well as the responsibility
for managing the company and the income or losses the
business generates. That income is paid to partners, who
then claim it on their personal tax returns – the business is
not taxed separately, as corporations are, on its profits or
losses. Business partners are jointly and individually liable
for the actions of the other partners. Profits must be shared
with others. You have to decide on how you value each
other’s time and skills. What happens if one partner can put in less time due to personal
circumstances? Since decisions are shared, disagreements can occur. A partnership is for the
long term, and expectations and situations can change, which can lead to dramatic and traumatic
split ups. The partnership may have a limited life; it may end upon the withdrawal or death of a
partner. A partnership usually has limitations that keep it from becoming a large business. You
have to consult your partner and negotiate more as you cannot make decisions by yourself. You
therefore need to be more flexible. A major disadvantage of a partnership is unlimited liability.
General partners are liable without limit for all debts contracted and errors made by the
partnership. For example, if you own only 1 percent of the partnership and the business fails, you
will be called upon to pay 1 percent of the bills and the other partners will be assessed their 99
percent. However, if your partners cannot pay, you may be called upon to pay all the debts even
if you must sell off all your possessions to do so. This makes partnerships too risky for most
situations. The answer would be a different business structure.
Corporation. A corporation is a separate legal entity
organized and operated under state law. Like a legal
person, the corporation can enter contracts, own
property, and hire employees. A corporation is a
separate and distinct taxpayer from its owners, the
shareholders. First, because the corporation itself
has legal standing, it safeguards its owners, relieving
them of individual legal responsibility when they act
as agents of the business.
Second, the owners of shares of stock have limited liability; they are not responsible for corporate
debts. If a shareholder paid Php1,000 for 10 shares of stock and the corporation goes bankrupt,
he or she can only lose the Php1,000 invested. Third, corporate stock is transferable. Thus, the
corporation is not damaged by the death or disinterest of a particular person. An owner of stock
can sell his or her holdings at any time or pass the stock along to heirs. Yet the corporate business
organization has drawbacks as well as benefits. One disadvantage relates to taxation. As a
separate legal entity, the corporation must pay taxes. Unlike the treatment of interest on bonds,
dividends paid to shareholders are not a tax-deductible business expense for the corporation.
When the corporation passes along profits to individuals in the form of dividends, the individuals
are taxed again on these dividends. This is known as "double taxation." Another cost results from
the fact that ownership becomes separated from management. While this makes management
easier, some managers are tempted to act more in their own interests than those of the
stockholders.
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TOPIC 5: AGENCY RELATIONSHIPS
An agency relationship consists of the principal and the
agent where the principal gives the agent legal
permissions to act on the principal's behalf. In this type of
relationship, agents should not have any conflicts of
interest in executing any act the principals appoint them
to do. This relationship that exists between principal and
agent is appropriately called the "agency." The law of
agency has well-established specifications for this legal
relationship.
Agency Conflicts
An agency conflict between managers and shareholders can develop when managers have
different knowledge and perspectives than owners have. Managers may decide that the
company's health requires retaining earnings rather than issuing large dividends. The owners,
who don't have the same in-depth knowledge of the company's position, may think the managers
have failed and demand an explanation. Risk is another of the causes of agency problems
because agents and principals often assess risk differently. Shareholders may be willing to
tolerate greater risk than managers because of the lure of greater rewards. Managers who don't
see the same gains from risky moves may be more cautious. In a large corporation, for example,
the managers may enjoy many fringe benefits, such as golf club memberships, access to private
jets, and company cars. These benefits (also called perquisites or perks) may be useful in
conducting business and may help attract or retain management personnel, but there is room
for abuse. The abuse of perquisites imposes costs on the firm—and ultimately on the owners of
the fi rm. There is also a possibility that managers who feel secure in their positions may not
bother to expend their best efforts toward the business. This is referred to as shirking, and it too
imposes a cost to the firm.
Agency Costs
The agency costs definition is the internal costs incurred from asymmetric information or
conflicts of interest between principals and agents in an organization. In a corporation, the
principals would be the shareholders and the agents would be the managers. The shareholders
want the managers to run the company in a way that maximizes shareholder value. Conversely,
the managers may want to run the company in a way that maximizes the managers’ own personal
power or wealth, even if it lowers the market value of the company. These divergent interests
can result in agency costs. There are three common types of agency costs: monitoring, bonding,
and residual loss. Dealing with the agency problem is never free -- there is an agency cost
associated with coping with the agency problem. Such agency costs usually fall under the
category of operating expenses.
