01.

Background of Financial Management

Lecture Outline
 What Is Financial Management?
 What is the objective of financial management?
 The Business Environment
 Financial System
 Financial Markets
 Sources of Finance
 Financial Statements
 Agency Problem

The financial manager plays a dynamic role in a modern company’s development. This has not always been
the case. Until around the first half of the 1900s financial managers primarily raised funds and managed
their firms’ cash positions – and that was pretty much it. In the 1950s, the increasing acceptance of present
value concepts encouraged financial managers to expand their responsibilities and to become concerned
with the selection of capital investment projects.
Today, external factors have an increasing impact on the financial manager. Heightened corporate
competition, technological change, volatility in inflation and interest rates, worldwide economic
uncertainty, fluctuating exchange rates, tax law changes, environmental issues, and ethical concerns over
certain financial dealings must be dealt with almost daily. As a result, finance is required to play an ever
more vital strategic role within the corporation.
The financial manager has emerged as a team player in the overall effort of a company to create value.
The “old ways of doing things” simply are not good enough in a world where old ways quickly become
obsolete. Thus today’s financial manager must have the flexibility to adapt to the changing external
environment if his or her firm is to survive.

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What Is Financial Management?
Financial management is concerned with the acquisition, financing, and management of assets
with some overall goal in mind. Thus the decision function of financial management can be broken
down into three major areas: the investment, financing, and asset management decisions.
1. Investment Decision
The investment decision is the most important of the firm’s three major decisions when it comes
to value creation. It begins with a determination of the total amount of assets needed to be held by
the firm. Picture the firm’s balance sheet in your mind for a moment. Imagine liabilities and
owners’ equity being listed on the right side of the balance sheet and its assets on the left. The
financial manager needs to determine the dollar amount that appears above the double lines on the
left-hand side of the balance sheet – that is, the size of the firm. Even when this number is known,
the composition of the assets must still be decided. For example, how much of the firm’s total
assets should be devoted to cash or to inventory? Also, the flip side of investment – disinvestment
– must not be ignored. Assets that can no longer be economically justified may need to be reduced,
eliminated, or replaced.
2. Financing Decision
The second major decision of the firm is the financing decision. Here the financial manager is
concerned with the makeup of the right-hand side of the balance sheet. If you look at the mix of
financing for firms across industries, you will see marked differences. Some firms have relatively
large amounts of debt, whereas others are almost debt free. Does the type of financing employed
make a difference? If so, why? And, in some sense, can a certain mix of financing be thought of
as best?
3. Dividend decision
In addition, dividend policy must be viewed as an integral part of the firm’s financing decision.
The dividend-payout ratio determines the amount of earnings that can be retained in the firm.
Retaining a greater amount of current earnings in the firm means that fewer dollars will be
available for current dividend payments. The value of the dividends paid to stockholders must
therefore be balanced against the opportunity cost of retained earnings lost as a means of equity
financing.

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What is the objective of financial management?
The main objective of financial management of a firm is to maximize the welfare of the
beneficiaries of the firm. Largely, it concerns about the maximization of owners wealth.

The Business Environment

I. Sole proprietorship -A business form for which there is one owner. This single owner
has unlimited liability for all debts of the firm.

II. Partnership- A business form in which two or more individuals act as owners. In a
general partnership all partners have unlimited liability for the debts of the firm; in a
limited partnership one or more partners may have limited liability
III. Limited Liability Company
Due to the limitations in expansion prospects of the business limited liability concept emerged.
The total capital requirement is obtained by way of issuing shares. The investors who subscribe
capital and become the owners are known as shareholder or stockholder.
These shareholders have a limited liability towards business. This means that the shareholders
subscribing capital are liable only for debts incurred by the company up to the amount that
they have agreed to invest.
However, unlike the sole proprietorship and partnership, for a limited liability company has a
separate legal personality. Therefore the registration procedure involves much documentation
than the said types of businesses.
In a limited liability company generally the ownership is separate from the management of the
business. Since many owners can be the shareholders, day-to-day decisions making cannot be
done by all of these shareholders. Hence, separate governors will be appointed to take decisions
on behalf of the owner. These governors are known as the board of directors.

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Financial System
Financial system of an economy acts as the intermediary between surplus and deficits of funds.
Commercial banks, investment companies (mutual funds and real estate investments),
investment bankers (the firms who are specialized in sale of new securities), pension funds,
insurance and finance companies.
The below diagram explains the flow of funds through the finance system.

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Financial Markets
Financial market is an organized financial system where lenders of funds provide their excess
funds to the market and borrowers obtain the funds to meet the shortage of funds. This market can
be physical and virtual. Financial market provides money and capital supply to the industrial
concerns well as promote the savings and investments. Financial markets can be categorized in
many ways based on the characteristics.

Money market and capital market

Capital market is a market for long-term funds and money market is the market for short-term
funds
Primary and secondary market
The primary market refers to the set up by which the industry raises funds by issuing different
types of securities. These securities are issued directly to the investors, both individual and
institutions. The primary market discharges the important function of transfer of savings,
especially of the individual, Government and public sector undertakings. Corporations engage in
two types of primary market transactions: public offerings and private placements. The secondary
markets are those in which these securities are bought and sold after the original sale. It is therefore
the secondary markets that provide the means for Transferring ownership of corporate securities.

Sources of Finance
Sources of finance mean the ways for mobilizing various terms of finance to the industrial concern.
Sources of finance may be classified under various categories.
Period Based;
Long-term sources: When the finance is mobilized with large amount and the repayable over the
long period, it is considered as long-term sources. Share capital (ordinary shares, preference
shares), debenture, long-term loans from financial institutions and commercial banks can be
categorized as long term financing sources. Long-term source of finance needs to meet the capital
expenditure of the firms such as purchase of fixed assets.

Short-term sources: When the finance is mobilized with comparatively smaller amount and the
repayable within short period of time, it can be considered as short-term sources of finance. For
example bank overdraft customer advances, trade credit factoring and money market instruments
can be categorized under short term financing sources.

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Ownership Based;
Owner’s Capital
• Shares capital – Ordinary shares and Preference shares*
• Retained earnings
• Surplus and Profits
Borrowed capital
• Debenture
• Preference shares*
• Bonds
• Loans from Bank and Financial Institutions

Equity Shares are also known as ordinary shares, other than preference shares. Equity shareholders
are the real owners of the company. They have a control over the management of the company.
Equity shareholders are eligible to get dividend if the company earns profit. Equity share capital
cannot be redeemed during the lifetime of the company. The liability of the equity shareholders is
the value of unpaid value of shares. On the other hand Preference shares can take the form of either
equity of debt depending on the features attached to it. If the preference shares are cumulative,
voting and irredeemable, it can be categorized as equity capital for financial management purpose.
If not they can be treated as debt capital.

Familiarized with the different types of preference and ordinary shares.

Financial Statements
A financial statement is an official document of the firm, which explores the entire financial
information of the firm. The main aim of the financial statement is to provide information and
understand the financial aspects of the firm. Hence, preparation of the financial statement is
important as much as the financial decisions.

5 Components of Financial Statements;

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01. Statement of Comprehensive Income (Formally known as Income Statement or Profit and
Loss Account)
02. Statement of Financial Position (Formally known as Balance Sheet or Statement of Affairs)
03. Statement of Changes in Equity
04. Cash flow statement
05. Notes and disclosures.

Agency Problem
It has long been recognized that the separation of ownership and control in the modern corporation
results in potential conflicts between owners and managers. In particular, the objectives of
management may differ from those of the firm’s shareholders. In a large corporation, stock may
be so widely held that shareholders cannot even make known their objectives, much less control
or influence management. Thus this separation of ownership from management creates a situation
in which management may act in its own best interests rather than those of the shareholders.
We may think of management as the agents of the owners. Shareholders, hoping that the agents
will act in the shareholders’ best interests, delegate decision-making authority to them.
Costs of Agency Problems
I. Restructuring
II. Monitoring
III. Bonding
IV. Lost opportunities

“The roots of education are bitter, but the fruit is sweet.”

- Aristotle

-Thank you-

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