PCOA 07 – Financial Management

Module 1

AN OVERVIEW TO FINANCIAL MANAGEMENT

Introduction
In this module, you will learn what financial management is all about. We begin by describing how
finance is related to the overall business environment, by pointing out that finance prepares students for
jobs in different fields of business, and by discussing the different forms of business organization. This
module also discusses the goals and functions of financial management. You should be able to answer
the activity provided at the end of this module.
Learning Outcomes
At the end of this module, you should be able to:
1. Demonstrate understanding of the different forms of business organization; and
2. Discuss the goals and functions of financial management.

WHAT IS FINANCE
The field of finance is closely related to economics and accounting and financial managers need to
understand the relationships between these fields. Economics provides a structure for decision making
in such areas as risk analysis, pricing theory through supply and demand relationships, comparative
return analysis and many other important areas. Economics also provides the broad picture of the
economic environment in which corporations must continually make decisions. A financial manager
must understand the institutional structure of the Central Bank System, the commercial banking system,
and the interrelationships between the various sectors of the economy. Economic variables, such as
gross domestic product, industrial production, disposable income, unemployment, inflation, interest
rates and taxes (to name a few), must fit into the financial manager's decision model and be applied
correctly.

Accounting is sometimes said to be the language of finance because it provides financial data through
income statements, balance sheets, and the statement of cash flows. The financial manager must know
how to interpret and use these statements in allocating the firm's financial resources to generate the best
return possible in the long run. Finance links economic theory with the numbers of accounting, and all
corporate managers, whether in production, sales, research, marketing, management, or long run
strategic planning, must know what it means to assess the financial performance of the firm.

Areas of Finance
1. Financial Management - also called corporate finance, focuses on decisions relating to how
much and what types of assets to acquire, how to raise the capital needed to purchase assets,
and how to run the firm so as to maximize its value. Through-out the semester, our focus is on
financial management.
2. Capital Markets - relate to the markets where interest rates, along with stock and bond prices,
are determined. It also covers the financial institutions that supply capital to businesses.
3. Investments – relate to decisions concerning stocks and bonds and include a number of
activities: (1) Security analysis deals with finding the proper values of individual securities (i.e.,

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 stocks and bonds). (2) Portfolio theory deals with the best way to structure portfolios, or
“baskets” of stocks and bonds. (3) Market analysis deals with the issue of whether stock and
bond markets at any given time are “too high”, “too low” or “about right”.

Finance within an Organization

Most businesses and not-for-profit
organizations have an organization chart. The
board of directors is the top governing body,
and the chairperson of the board is generally
the highest-ranking individual. The CEO
comes next, but note that the chairperson of the
board often serves as the CEO as well. Below
the CEO comes the chief operating officer
(COO), who is often also designated as a
firm’s president. The COO directs the firm’s
operations, which include marketing,
manufacturing, sales, and other operating departments. The CFO, who is generally a senior vice
president and the third ranking officer, is in charge of accounting, financing, credit policy, decisions
regarding asset acquisitions, and investor relations, which involves communications with stockholders
and the press.

Jobs in Finance
Many students approaching the field of finance for the first time might wonder what career opportunities
exist. For those who develop the necessary skills and training, jobs include corporate financial officer,
banker, stockbroker, financial analyst, portfolio manager, investment banker, financial consultant, or
personal financial planner. As you progress through the course, you will become increasingly familiar
with the important role of the various participants in the financial decision-making process. A financial
manager addresses such varied issues as decisions on plant location, the raising of capital, or simply
how to get the highest return on x million dollars within a period.

Forms of Business Organization

1. Sole Proprietorship
 Considered as most common, and simplest form of business organization.
 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 the owner and the business are the same entity. (Reconcile this with
the separate entity concept you have learned in your basic accounting.)

Advantage of Sole Proprietorship

1. Simplicity in decision-making since only one person makes all the major decisions.
2. Easy and inexpensive to form and it is subject to few government regulations. An aspect of the
“same entity" 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.

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 However, there are drawbacks to this form of business organization. Due to its very nature, it is
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, the liabilities
not covered by the assets of the business. Lastly, the life of the business is limited to the life of the
proprietor.

2. Partnership
 Exists when two or more persons combine their resources to conduct business, earn profit, and
distribute among themselves the results of their operations.
 The contract evidencing its existence is called the articles of partnership.

The main advantages of a partnership are its low cost and ease of formation. The disadvantages are
similar to a sole proprietorship: unlimited liability, limited life, difficulty of transferring ownership
since this will lead to dissolution of the partnership, and difficulty of amassing a large amount of capital.

As mentioned in the previous paragraph, partnerships have typically unlimited liability. This means that
the partners are liable to pay obligations beyond their contributions. 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, accountants,
architects, and other service-oriented professionals.

3. Corporation
 Legal business entity created by the operations of the law.
 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.

1. Unlimited life. Changes in ownerships or death of owners do not dissolve the corporation.
2. Ease of transferability of ownership. Unlike a partnership where the consent of the partners is
required for the admission of an incoming partner(s), the corporation transfers ownership
through the selling and buying of shares of stocks.
3. 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.

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 Goals of Financial Management
1. Valuation Approach
The goal of financial management is to maximize not the profit alone, but the overall value of the firm.
Therefore, in considering investment proposals or decisions, the financial manager should not only
consider profit, he/she must also consider the following:
 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, which refers to when
the profits flow into the company and furthermore, when will there be an upsurge or decline of
profit; and
 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.

2. Maximization of Shareholders' Wealth

Maximization of shareholders' wealth is considered to be the expansive goal of the firm. Managers have
no direct control of the market value of the stocks. The market value of stocks may not necessarily be
high even if the company proves to be profitable and stable. This is specially 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 shareholders vary. In the 1950s to 1960s,
the main focus was on 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 manager make in order to maximize the value of the company's stock?
Does it mean that maximizing profit results to maximizing the company’s stock values?

There are two hanging questions in the previous paragraph. But for one to answer the question,
consideration must be made on the company's income or profits vis-a-vis earnings per share (EPS). It
is suggested that a review of EPS included in accounting subjects be made. As a guide in finding the
answer, consider the example below.

Observe the data of Nico Corporation:

Shares outstanding Year-end Net Income

Year 2010 100,000 500,000
Year 2011 200,000 600,000

You own 100 shares of Nico Corporation.

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 Analysis:

EPS = Net Income/Shares outstanding

Year Percentage of Ownership Share of Net Income Earnings per Share
2010 100 shares/ 100,000 shares = 1% 1% x ₱500,000=₱5,000 ₱500,000/100,000 shares = ₱5/share
2011 100 shares/ 200,000 shares = 0.5% 0.5% x ₱600,000=₱3,000 ₱600,000/200,000 shares = ₱3/share

Interpretation:

We can interpret, based on the data provided and the analysis made, that the company-wide profit
increased by ₱100,000 in 2021. Your share of net income decreased by ₱2,000. The EPS decreased by
P2/share in 2021. Furthermore, you suffered with the other shareholders an earnings dilution despite
the increase in total corporate profit.

Conclusion:

Since profits increased by ₱100,000, your share of net income decreased by ̈́₱2,000, and the company's
EPS diminished by P2/share, we can therefore infer two things. First, that profit maximization does not
necessarily mean stock 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.

If a manager is to maximize stockholder wealth, he or she must know how that wealth is determined.
Managerial actions that affect a
company’s value may not
immediately be reflected in the
company’s stock price.
The figure here illustrates the
situation. The top box indicates
that managerial actions,
combined with the economy,
taxes, and political conditions,
determine stock prices and thus
investors’ returns. The second
row of boxes differentiates what
we call “true expected returns”
and “true risk” from “perceived”
returns and “perceived” risk. By
“true,” we mean the returns and
risk that investors would expect if they had all of the information that existed about a company.
“Perceived” means what investors expect, given the limited information they actually have.

To illustrate, in early 2001, investors had information that caused them to think that Enron
(https://www.investopedia.com/updates/enron-scandal-summary/) was highly profitable and would
enjoy high and rising future profits. They also thought that actual results would be close to the expected
levels and hence, that Enron’s risk was low. However, true estimates of Enron’s profits, which were
known by its executives but not the investing public, were much lower; and Enron’s true situation was
extremely risky.

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 The third row of boxes shows that each stock has an intrinsic value, which is an estimate of the stock’s
“true” value as calculated by a competent analyst who has the best available data, and a market price,
which is the actual market price based on perceived but possibly incorrect information as seen by the
marginal investor. Not all investors agree, so it is the “marginal” investor who determines the actual
price.

When a stock’s actual market price is equal to its intrinsic value, the stock is in equilibrium, which is
shown in the bottom box. When equilibrium exists, there is no pressure for a change in the stock’s price.
Intrinsic value is a long-run concept. Management’s goal should be to take actions designed to
maximize the firm’s intrinsic value, not its current market price. Note, though, that maximizing the
intrinsic value will maximize the average price over the long run, but not necessarily the current price
at each point in time.

3. Social Responsibility and Ethical Behavior

Social responsibility is an issue that needs to be considered. Can one reconcile the need of the firm for
wealth maximization and the need of the firm to be socially responsible? Stated differently, can a firm
be socially responsible while focusing on maximizing the shareholders' wealth or maximizing the
overall value of the firm?

In most cases, the two can be reconciled. The firm, by using measures that would maximize wealth and
company market value, would be able to draw more capital, help diminish unemployment and give
services to the community. However, this is not always the case. Salary distribution, hiring practices,
product safety, minority training, anti-pollution measures, and pricing of products sold may sometimes
be inconsistent with maximizing company value.

Example: Installing expensive pollution control devices are not considered profitable. So, the question
is should companies stop using these devices? A big NO. It's easy to say no. But to resolve issues like
these, companies belonging to the same industry must do a concerted effort in being socially
responsible. This is because if only one company opts to be socially responsible, that "martyr will not
survive. For instance, if only Company X opts to acquire the anti-pollution device which is costly, the
price of the products sold by Company X needs to be increased. Company Y and Company Z, both
without the anti-pollution device, can sell their products at a lesser price. Company X will be at a
disadvantage. But will companies be willing to voluntarily participate in this concerted effort? Not
always. So, a more acceptable solution to this is to allow certain cost-augmenting measures to be
compulsory rather than voluntary to guarantee that the burden falls uniformly on all the businesses.
Relating this to the anti-pollution example, the cost of putting an anti-pollution device will now be
carried by Companies X, Y, and Z, thus making the cost less burdensome. But who will make this
compulsory? The answer is government agencies. A coordinated effort between the industry and the
government can make this solution more feasible.

Some corporations who have chosen to follow the "enlightened" path of being socially responsible,
argue that socially responsible measures and actions may not necessarily be too costly since they
advertise heavily. The costs are offset by the increase of income generated by increase in sales revenue
because customers tend to buy more from companies who are socially responsible.

Functions of Financial Management

The functions of financial management are actually the topics we shall cover in this course. Financial
management involves the prudent allotment and spreading of company funds to current assets and

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 noncurrent assets. An effective and efficient financial management entails creating a well-balanced
financing activity and formulating suitable dividend policy that fit in with the firm's business objectives.
Some of these general functions are carried out on a daily basis like cash management, inventory
management, credit management and disbursement management. Other activities not done on a daily
basis but rather irregularly include company stock and bond issuance, capital budgeting, and creating
dividend policies.

Take note that while daily and irregular activities are managed, the financial manager must be able to
balance making income and considering the inherent risks on the decisions made. This balancing act
between income and risk is referred to as risk-return trade-off. The financial manager must strike a
balance between the highest possible income with the most reasonable amount of risk. This balancing
act requires expertise that is gained through studying and experience. All these activities plus the
balance of the risk-return trade-off are done to achieve one of the goals of financial management, which
is to maximize the shareholders' wealth.

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 objectives.

2. Making Crucial Investment and Financing Decisions. Increasing sales or increasing demand for
services 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 sources 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 should work and
coordinate 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 the financial manager to have "hands-on dealings"
with the financial markets. These markets are involved in the trading of debt and equity securities. The
financial manager is often tasked 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 from financial
risks where prices of commodities, currency exchange rates, and interest rates fluctuate; or from 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

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 risk management policies and programs that involve the detection of the risks that the entity should
efficiently hedge itself against.

References

Brigham, E. and Houston, J., n.d. Fundamentals of financial management. 8th ed. 5191
Natorp Blvd Mason, OH 45040 USA: Cengage Learning, pp.9-12.
Anastacio, M. L., Dacanay, R. C., & Aliling, L. E. (2016). Fundamentals of Financial
Management (Revised ed.). REX Book Store, pp.2-8.

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