Chapter 1

An overview to Financial Management

Learning Objectives:
Upon finishing this session, the learner is expected to:
1. Know and explain the evolution of finance as a recognized field of study;
2. Know and explain the goals and functions of Financial Management; and
3. Research and discuss the recent economic developments establishing their
implications to financial management

Learning Contents:

Chapter Prologue:

Before reading this chapter, the authors would like to remind you to read the foreword. If
you have not, then it is suggested to read it before reading this chapter.

Let us start our learning by considering something that happened relatively recent - the
Global Financial Crisis.

In the year 2008, the stability of leading U.S. and European investment banks, insurance
companies and mortgage banks started to wane and weaken. This was mainly caused and
accounted for by various reasons. Among the reasons pinpointed by experts were the
misapplications of risk controls for bad debts, collateralization of debt insurance and fraud.
Experts also mentioned that a deceleration of economic activities and a credit crunch (worth
researching) was experienced by out-sized financial institutions in the United States and
Europe.

When these happened, it was not too long before neighboring continents, and nations
started to feel their effects. The effects are in terms of European bank failures, declines in
various stock indices, and massive declines in the market value of equities and commodities.
The de-leveraging of financial institutions lead to further liquidity problems and further
decreased the international trade. By October 2008, a currency crisis ensued, which means,
investors transferred massive capital resources into currencies which are stronger, like the yen,
the US dollar and Swiss franc which paved the way for countries to ask for the help of the
International Monetary Fund.

Let’s stop here. We have presented you a glimpse of what happened with the global
crisis. If you wish to know more about what happened, what is happening, or what is projected
to happen in relation to the crisis, you may access your chosen internet search engine and type
in “2008-2009 global financial crisis”.

What is the implication of the crisis to financial managers?

This crisis has made the contribution and role of financial managers in so far as directing
the firm’s operation or more so, the nation’s economic operation increasingly significant. In
times where in economic outcome tends to twirl and twist making them more unpredictable,
where interest rates and currency exchange rates unceasingly fluctuate, where inflation and
deflation occur, where awful shortages and overages happen, the financial manager MUST
MAINTAIN AND SUSTAIN the economic capability of an enterprise or more so, a nation. Since
financial markets are now international, the financial manager must also be able to competently
manage the global financial affairs of the enterprise. Financial managers must be equipped with
the necessary tools essential in finding ways and means to cushion or hedge the effects of
significantly negative outcomes of risk and among other things relating to borrowings, foreign
exchange transactions, equity and debt transactions and inflations.

Reflection: Picture yourself as a potential financial manager three years from now, what should
you do now to equip yourself with the necessary tools? What do you think? Whatever your
answer is make it your goal.

Goals of Financial Management

The goals of financial management could be synonymous to the goals of the enterprise.
One may consider that the utmost aspiration of the company is to yield the highest possible
profit for the firm. If we accept this answer, then the company would be evaluating each
decision they make based on the amount of income that would be flowing into the company.
The highest income generating proposal would be the best choice. However, while this
approach may be simple and highly desirable, it does have some serious drawbacks or
disadvantages.

Let us consider the first drawback. Changes in profit may also mean changes in risk.
An enterprise with earnings per share (EPS) of say P150/ per share may be less acceptable if
this EP risk or the risk that goes with those two alternatives increase.

How the second drawback for the maximizing profit approach is that it does not fully
take into account the timing when the profit/gain would be received. Consider the matrix
below which shows two alternatives as to which one would your firm consider investing into:

Earnings Per Share

Year 2010 Year 2011 Total
Nico Corporation’s Ordinary Shares P300 P450 P750
Riel Corporation’s Ordinary Shares 450 300 750

If the company’s framework of mid is merely maximizing profit, one may say that they
can invest in either Nico or Riel Corporation since the yield is the same. However, Riel
Corporation is definitely a better choice. Why? Because, Riel Corporation’s benefits occur
earlier. Corporation is definitely a better choice. Why? Because, Riel Corporation’s benefits
occur earlier. This means that your company can reinvest the P150/share (P450-P300)
difference in earnings a year earlier than if you choose to invest in Nico Corporation. Get it?
The last drawback that one may experience using the maximizing the profit approach as
the main goal of the company is the accurate measuring of the key ingredient in this approach,
which is the profit. Why? The reason is because, this is virtually impossible to achieve. You may
react by saying “well we compute income all the time in our accounting courses.” Yes it’s true
but, the definition of profit alone is many. There are various economic and accounting definitions
for profit. Each definition is subject to its own set of interpretations. Economic phenomena like
inflation and deflation and foreign exchange transaction variables complicate the matter.
Although financial accounting and reporting methods are continually evolving to solve these
issues, still many problems remain adamant.
 If yielding the highest profit is not the primordial goal of financial management or of the
company, then what is? The goal of financial management could be categorized as follows:
 Maximization of the value of the firm (Valuation Approach)
 Maximization of Shareholder Wealth
 Social Responsibility and Ethical Behavior

Valuation Approach

The discussion above is not meant to undermine the importance of profit. Let us just
emphasize that profit maximization id very important. However, this is not primordial. The
definite gauge of performance is not the income yielded but more so how the yield are valued by
the owners of the company.

What does this mean? This means that the main goal of financial management is to
maximize not profit alone, but the maximization of overall value of the firm, thus it is called the
Valuation Approach. Therefore in considering investment proposals or decisions, the financial
manager should not only consider profit, he/she must also consider among other things the:

 Risk attached to the investment proposal or the company’s operation.

 Time design as to when and how the profits will flow into the company. This refers to as
to when will the profits flow in to the company and furthermore, more when will there be
an upsurge or decline of profit (refer to example of Nico and Riel Corporation)
 The quality and reliability of the profits reported by the firm.

A wise financial manager should, therefore, take into consideration the impact of all
these to the company’s overall valuation. If a decision brings about a status quo or augments
the firm’s overall value then the decision is acceptable.

Maximization of Shareholder’s Wealth

Maximization of the Shareholder’s wealth is considered to be the expansive goal of the

firm. This, however is not an easy task. Managers have no direct control of the market value of
the firm’s stocks. The market value of stocks may not necessarily be high even if the company
proves to be profitable and stable. This is especially the case when stock market prices are
declining as influenced by economic, political, and social factors in the financial environment.

The main focus is not so much with the day-to-day movements of the stock market price,
but more so on the amplification of the long term wealth of the shareholders. This, again, is
everything but simple. Why? Because, the expectations and requirements made by the
shareholders vary. In the 1950s to 1960s, the main focus was on the increasing earnings. In the
1970s to 1980s the main concern became more conservative by focusing not so much on
income growth but on lowering risks and high current dividend payments.

What actions should a financial management make in order to maximize the value of the
company’s stock values?

We just gave you two hanging questions on the previous paragraph. But for one to
answer the question, we need to consider the company’s income or profits vis-à-vis earnings
per share (EPS). We suggest that you review your knowledge of EPS in your accounting
subjects. To guide us in finding the answer, let us consider the example below.
Example: Observe the data of Nico Corporation:
Shares outstanding Yr end Net Income
Year 2010 100,000 P500,000
Year 2011 200,000 P600, 000

You own 100 shares of Nico Corporation

Analysis:

EPS = Net Income/ Shares outstanding

Yr Percentage of Ownership Share of Net income Earnings per Share

2010 100 shs/100,000 shares = 1% x P500,000 = P500,000/100,000 shs =
1% P5,000 P5/sh
2011 100 shs/ 200,000 shares = 0.5% x P600,000 = P600,000/200,000 shs =
0.5% P3,000 P3/sh

Interpretation:
We can interpret based on the data provided and the analysis made, that the company-
wide profit increased by P100,000 in 2011. Your share of net income decreased by P2,000. The
EPS decreased by P2/share in 2011. Furthermore you suffered with the other shareholders an
earning dilution despite the increase in total corporate profit.

Conclusion:
Since profits increase by P100,000, your share of net income decreased by P2,000 and
the company’s earnings per share diminished by P2/share, we can therefore infer two things.
First, that profit maximization does not necessarily mean sock value maximization. And lastly,
considering other things being constant, if the company is truly concerned with the welfare of its
shareholders, it should focus on EPS rather than on total company profits.

Financial Manager’s Responsibilities

The responsibilities of a financial manager are closely linked with the function of financial
management. The particular activities inherent to a financial manager’s job would be:
1. Forecasting and Planning. The financial manager does not function alone. He/She
must be able to work together with other managers in formulating strategic as well as
operative plans necessary to form the company’s desired position.
2. Making Crucial Investment & Financing Decisions. Increasing sales or increasing
demand for service from companies require investing money for acquisition of property,
plant and equipment (PPE), and inventory. The financial manager must help decide on
the appropriate amount of PPE to be acquired and determine the source of funds to
finance such acquisitions.
 3. Coordinating and Controlling. It is very important for all managers, financial or
otherwise, to coordinate with each other. As mentioned in number one, the financial
manager works and coordinates with other executives to guarantee efficient operation of
the firm. All business decisions made by other executives in the firm have financial
implications. For instance, proposals made by marketing managers on improving sales
of a product line may entail acquisition of new equipment, which in turn entails cash
disbursements. Therefore, marketing managers must carefully take into account how
their decisions and actions affect other factors like fund availability, inventory
requirements, and plant acquisition, capacity and utility.
4. Trading in Financial markets. It is crucial for financial managers to have their “hands
on dealings” with the financial markets. These markets are those involved in the trading
of debt and equity securities. Financial managers are often task to trade the equity
securities of the firm in the financial market. In doing so, the firm is affected and at the
same time affecting other firms. The effect is that investors are either making or losing
money in trading.
5. Risk Management. No business entity is ever free from risks. The risk may come in
terms of financial risks where prices of commodities, currency exchange rates and
interest rates fluctuate; or the risk may even come in terms of natural calamities like
floods, fires, and earthquakes, A well-skilled financial manager however, can deter the
effects of these risks by availing of the appropriate and adequate insurance for the firm,
or by hedging in the derivatives market. In addition to this, the financial manager is also
accountable for the entity’s risk management policies and programs that involve the
detection of the risks. Risks that the entity should efficiently hedge itself against.

ALTERNATIVE FORMS OF BUSINESS ORGANIZATION

There are three basic forms of business organization. These are: (1) sole
proprietorships; (2) partnerships; and (3) corporations.

Sole Proprietorship. This considered as the oldest, most common, and simplest form of
business organization. This is a form of business entity, where there is only one owner, hence
the word sole. The customary feature of a sole proprietorship is that the owner is Inseparable
from the business. One may say that they are the same entity. (Reconcile this with the separate
entity concept you have learned in your basic accounting).
This type of entity offers a number of benefits. First of which simplicity in decision
making, since only one person makes all the major decisions. Other advantages would be that it
is easy and inexpensive to form, subject to few government regulations. An aspect of the “same
entry” concept is that taxes on a sole proprietorship are determined at the personal income tax
rate of the owner. In other words, a sole proprietorship does not pay taxes separately from the
owner. It is not subject to corporate income taxes.
However, there are drawbacks to this form of business organization. Due to its very
nature, it would be difficult for a single proprietor to come up with a sizable amount of capital.
Another aspect of the “same entity” concept is that the owner of a sole proprietorship has
complete control over the business, its operations, and is financially and legally responsible for
all debts and legal actions against the business. This “same entity” aspect of the sole
proprietorship invariably creates another drawback. The proprietor has unlimited personal
liability for the payables or financial obligations of the firm. This means that the owner is liable to
pay with his personal properties, liabilities not covered by their assets. Lastly, the life of the
company is limited to the life of the proprietor.
Partnership. This exists when two or more persons combine their resources to conduct
business, earn profit, and distribute among themselves the result of their operations. The
contract evidencing its existence is called the articles of partnership.
The main advantage of a partnership would be its low cost and ease formation. The
disadvantages are similar to a sole proprietorship: unlimited liability, limited life, difficulty of
transferring ownership since this would lead to dissolution of the partnership, difficulty of
amassing a large amount of capital.
As mentioned in the previous paragraph, partnerships are typically unlimited. This would
mean that the partners are liable to pay obligations beyond their contributions. Just like a sole
proprietorship, a partnership has unlimited liabilities. The partners are obliged to pay the
company debts with their personal properties not covered by the investments made by the
owners or not covered by the assets of the company. These partnerships are called general or
unlimited liability partnerships.
Partnership firms are common but not limited to professionals like doctors, lawyers,
accountant, architects and other service oriented professionals.
Corporation. This is a legal business entity created by the government. This does not
follow the same entity concept. It is considered as separate and distinct from its owners and
executives. The contract evidencing the existence of a corporation is called articles of
incorporation. The articles of incorporation present the rights and limitations of the entity.
This form of business entity has a number of advantages. First of which, is unlimited life.
Changes in the ownerships or death of owners do not dissolve the corporation. Another
advantage is ease of transferability of ownership. Unlike a partnership where the consent of the
partners are required for the admission of an incoming partner(s), the corporation transfers
ownership through the selling and buying of shares of stocks. Last advantage would be limited
liability. Since the owners are separate and distinct from the corporation, the owners are not
obliged to pay financial obligations not covered by company assets using their personal
properties.

Hybrid Forms of Organization

Typically, partnerships are considered general or better known as unlimited liability

partnerships. This was discussed previously. However another type of partnership exists, the
limited liability partnership (LLP). Under this type, the partnership is composed of at least one
general partner and the rest are limited partners. In this scenario, the limited partners do not
have control in company operations. As the name indicates, the limited partners are liable only
for the amount of their investments. This specific characteristic makes the LLP a hybrid because
although the firm is a partnership, it has the benefit of a corporation-like firm where the owners
are not obliged to pay company debts with their personal properties.

AGENCY RELATIONSHIPS

Whenever a person or a group of persons (principal) employs another person or group

of persons (agency), to render service(s) and at the same time delegates decision-making
authority to the agent, an agency relationship exists. In financial management parlance agency
relationships exists between the company’s shareholders and managers, and between creditors
and owners.

Agency Conflicts

We know for that a shareholder’s primary goal is wealth maximization. There could be a
conflict of interest if the manager is also a partial owner of the same firm. The manager’s
primary goal is to maximize the size of the firm, and by doing so he stabilizes job security for
himself and for all employees of the firm, and ultimately, increase his position, status,
perquisites and salary, thus the shareholder’s primary goal of wealth maximization might be set
aside. It can be argued that since there are managers owning a small portion of the corporate
share they are hungry for salary increases and perquisites at the cost of shareholders that are
not managers.

Agency Cost

There are means by which managers can be persuaded to maximize the company’s
stock price or maximize wealth and act for the shareholders’ best interest. However, this would
entail costs. The costs could come in terms of audit costs which is geared towards monitoring
managerial actions, and restricting the company that would regulate undesirable managerial
actions. The more control measures employed by management gearing towards stockholders’
benefits, the higher would be the agency costs.
It is therefore crucial, that the amount of costs to be spent in assuring that managerial
actions are for the benefit of shareholders, be viewed and assessed just like any other
investment decision made by the company. Make sure that agency costs should not exceed the
return or yield that the company will gain from implementing the control measures.

Control Mechanism

There are a number of ways to encourage managers to perform for the interest of share-
holders. Some of them are:
1. Provide Performance-based Incentive Plans
 There are ways by which performance based incentives may be given to
managers. One way is by providing managers with executive stock options. Under this
scenario, managers are given the privilege to acquire the company’s share at a fixed
price. Performance shares may also be given to managers as incentives. Performance
shares are given to managers based on their effectiveness in achieving company goals.
The relevant criteria for effective performance could be in terms of achieving high EPS,
high return on asset (ROA), or high return on equity (ROE). Another relevant criteria for
providing incentives would be economic value added(EVA). This is another way by
which an entity’s profitability is measured. EVA is derived by subtracting the cost of all
capital (interest expense among other things) from the net income after tax. If the EVA is
positive, it can be interpreted that management is adding or making added value for
shareholders. In other words the higher the EVA, the more wealth is being created by
management for its shareholders. If is EVA is negative, it can be interpreted that
management is ruining value.

2. Straight Involvement by Shareholders (Institutional).

In the late 1990’s, almost half of the shares in the Unites States were owned by
institutions like, insurance companies, pension funds and mutual funds. This being so,
they developed a significant influence over the entity’s operations. They can provide
suggestions to management in running the business. During that time, it became a
practice that when a shareholder owns stocks of at least one thousand dollars for at
least one year, that said shareholder can sponsor a proposal which must be voted at the
annual shareholder’s meeting, regardless of management’s approval.
3. Takeovers.
Shareholders in some cases do hostile takeovers. In this situation, managers of firms
acquired by the shareholders are terminated. Those managers, who are “lucky” to be
retained, lose their independence and autonomy, thus “twisting,” so to speak, the
manager’s arm to perform measures that would maximize the company’s share prices
and ultimately maximize the firm’s wealth.

CASH VERSUS ACCRUALS

The difference between cash and accrual accounting lies in the timing of when sales and purchases are
recorded in your accounts. Cash accounting recognizes revenue and expenses only when money
changes hands, but accrual accounting recognizes revenue when it’s earned, and expenses when they’re
billed (but not paid).

We’ll look at both methods in detail, and how each one would affect your business.

Cash basis accounting

The cash basis of accounting recognizes revenues when cash is received, and expenses when they are
paid. This method does not recognize accounts receivable or accounts payable.
Many small businesses opt to use the cash basis of accounting because it is simple to maintain. It’s easy
to determine when a transaction has occurred (the money is in the bank or out of the bank) and there is
no need to track receivables or payables.

The cash method is also beneficial in terms of tracking how much cash the business actually has at any
given time; you can look at your bank balance and understand the exact resources at your disposal.

Also, since transactions aren’t recorded until the cash is received or paid, the business’s income isn’t
taxed until it’s in the bank.

Accrual basis accounting

Accrual accounting is a method of accounting where revenues and expenses are recorded when they are
earned, regardless of when the money is actually received or paid. For example, you would record
revenue when a project is complete, rather than when you get paid. This method is more commonly
used than the cash method.

The upside is that the accrual basis gives a more realistic idea of income and expenses during a period of
time, therefore providing a long-term picture of the business that cash accounting can’t provide.

The downside is that accrual accounting doesn’t provide any awareness of cash flow; a business can
appear to be very profitable while in reality it has empty bank accounts. Accrual basis accounting
without careful monitoring of cash flow can have potentially devastating consequences.

What it means to “record transactions”

We’ve talked a lot so far about recording transactions in your books, and how cash and accrual dictates
“when” you do that.

But what does it mean to record a transaction?

Every business has to record all its financial transactions in a ledger—otherwise known as bookkeeping.
You’ll need to do this if you want to claim tax deductions at the end of the year. And you’ll need one
central place to add up all your income and expenses (you’ll need this info to file your taxes).

There are some good DIY bookkeeping options out there. Or if you’d rather have someone else do your
bookkeeping for you, check out Bench.

Diagram comparing accrual and cash accounting

Cash accounting
Recognizes revenue when cash has been
received
Recognizes expenses when cash has been spent
Taxes are not paid on money that hasn’t been
received yet
Mostly used by small businesses and sole
Accrual accounting
Recognizes revenue when it’s earned (eg. when the
project is complete)
Recognizes expenses when they’re billed (eg. when
you’ve received an invoice)
Taxes paid on money that you’re still owed
Required for businesses with revenue over $5 million
Cash accounting Accrual accounting
proprietors with no inventory

The effects of cash and accrual accounting

Understanding the difference between cash and accrual accounting is
important, but it’s also necessary to put this into context by looking at the
direct effects of each method.

Let’s look at an example of how cash and accrual accounting affect the
bottom line differently.

Imagine you perform the following transactions in a month of business:

1. Sent out an invoice for $5,000 for a web design project completed this
month
2. Received a bill for $1,000 in developer fees for work done this month
3. Paid $75 in fees for a bill you received last month
4. Received $1,000 from a client for a project that was invoiced last month

The effect on cash flow

Using the cash basis method, the profit for this month would be $925 ($1,000 in income minus $75 in
fees).

Using the accrual method, the profit for this month would be $4,000 ($5,000 in income minus $1,000 in
developer fees).

This example displays how the appearance of income stream and cash flow can be affected by the
accounting process that is used.

The effect on taxes

Now imagine that the above example took place between November and December of 2017. One of the
differences between cash and accrual accounting is that they affect which tax year income and expenses
are recorded in.

Using cash basis accounting, income is recorded when you receive it, whereas with the accrual method,
income is recorded when you earn it.

Following the above example, using accrual accounting, if you invoice a client for $5,000 in December of
2017, you would record that transaction as a part of your 2017 income (and thus pay taxes on it), even if
you end up receiving the payment in January of 2018.

Further Reading: A Small Business Tax Checklist

Should a small business use cash or accrual accounting?
If your business is a corporation (other than an S corp) that averages more than $25 million in gross
receipts each year, the IRS requires you to use the accrual method.

If your business doesn’t hit those criteria, you’re welcome to use the cash method.

That being said, the cash method usually works better for smaller businesses that don’t carry inventory.
If you’re an inventory-heavy business, your accountant will probably recommend you go with the
accrual method.