Financial Management Concept An Introduction

Perhaps Henry Ford, a relatively successful businessman, stated one of the most important
things to remember about running a business: A business that makes nothing but money is a
poor kind of business. Now Mr. Ford, of course, was talking about simply being greedy and
not being concerned with customer happiness or community well-being among other nonmonetary considerations.
His point, however, is right on target, and that is that simply making a profit is not enough to
ensure the long-run success of a business firm. Whether a manager has control of an entire
conglomerate corporation, one small department in that corporation, or an entire small
business, it is necessary that the manager make decisions in a rational and objective manner
considering both the monetary and non-monetary implications of that decision.
Regardless of the situation faced by a manager, no decision can be made without considering
the time frame in which that decision will be implemented. Similarly, there is always a risk that
the actual results of a decision will not be those desired or expected. The effects of time and
risk on financial decision making are essential factors to be considered in every business
decision.
Since all decisions can be shown to have some direct or indirect financial implications, all
managers, not just financial managers, should have an understanding of the financial
ramifications of each decision made. Before we can undertake a study of business finance we
must first consider some of the major alternative types of financial decisions, and the most
often stated objectives of business organizations to include the positive and negative aspects of
each.
In any business, it is expected that the objectives and goals of the owners supersede those of
the management of the firm when the two groups are not comprised of the same individuals. In
a corporation, for example, the management team is expected to act as agents for the
shareholders as they were appointed to act on their behalf. Management decisions do not
always benefit shareholders. It is possible for management to act in its own best interests at
the expense of the shareholders. When this occurs the resulting decision creates what is
referred to as a principal-agent or agency problem.

Business Organizations
While we are primarily concerned with the corporate form of business organization, it is
appropriate to consider that there are other forms of business organizations which can be
created. Many of the financial decision issues to be addressed here will apply to those
organizations as well. The primary differences between the corporation and the other legal
business organizations lie in the areas of tax law, organization control, and liability. The primary
alternatives to formation as a corporation are to form as a sole proprietorship or a partnership.
The characteristics of the three basic forms of organization are provided in Figure 1.

Figure 1. Characteristics of Sole Proprietorships, Partnerships, and Corporations

Characteristic Sole Proprietorship

Partnership

Corporation

Ownership

Single Owner

Limited and General

Partners

Multiple Stockholder
Owners

Control

Proprietor/Owner

As Specified in
Agreement

Management As Owner
Agents

Limited Easier to
Limited Based on Limited Based on the
obtain, and based on
Capital Access Financial Strength of Financial Strength of the
the Financial Strength
the Proprietor
Partners
of the Entity Itself

Taxation

Liability

Pass-Through to
Proprietor

Pass-Through to
Partners

Double Taxation:
Corporate tax on
Corporate Income, and
Personal Tax on
Dividends Paid to
Stockholders

Total or Unlimited
Liability

Total or Unlimited
Liability for General
Partners, Limited
Liability for Limited
Partners

Limited Liability for

Stockholders

Sole Proprietorships
Sole proprietorships are unincorporated entities which are owned by one individual. That
individual has total control of the organization. Even in those cases where the proprietor hires
other employees, the proprietor has control over investment, financing, and all other decisions
in the firm. The proprietor may delegate but doing so is simply a form of exercising control.
One of the benefits of the sole proprietorship is that it is relatively easy to create. Another
comes in the form of single taxation of income as all the income flows directly to the proprietor
on a pre-tax basis. One of the biggest negatives for sole proprietors is that they are completely
liable for any wrongdoing attributable to the organization, as in the case of damages suffered
by customers from faulty products. Other negative factors include the limited ability of the firm
to raise additional funds since the full liability of the firm rests with the limited resources of the
proprietor, and the fact that at the death of the proprietor, the organization may cease to exist.

Partnerships
Partnerships may be structured with only General Partners or with both General Partners and
Limited Partners. While a partnership may have limited partners, generally contributing only
money and not involved with managing the organization, a partnership organization must also
have a General Partner. Limited partners have, by definition, a limited amount of liability for
wrongdoing by the organization, while a general partner is burdened with unlimited personal
liability. Partners in a partnership may also be classified, for tax purposes as active, or
passive, a designation that relates to the partners level of participation in managing the
organization.
The control of the organization can be stipulated in partnership agreements but is generally
provided based on the percentage of ownership in the organization. Partnerships, because
they have more than one owner can often obtain more financing than sole proprietorships. As
with sole proprietorships, partnership income is taxable only at the personal level as it flows
directly through the firm to them on a pre-tax basis.

Corporations
A corporation, created or incorporated under state law, according to the 1819 Supreme Court is
an artificial being, invisible, intangible, and existing only in contemplation of the law. The
court went on to say that the corporation has no soul to be damned and no body to be
kicked.
Our more current and less artful definition of a corporation, that it is a business organization
structured under state law, defined as a legal person and providing limited liability protection
to its equity investors or owners makes the same points but perhaps in a little less aggressive
manner. Corporations also exist because, as R.H. Coase noted long ago, corporations can
reduce various transaction costs.
Corporate entities are owned by stockholders, investors who have made an equity investment
in the firm via the purchase of the firms stock. That stock can be either common or preferred.
Common stockholders are referred to as the residual owners entitled to returns only after all
other investors have been compensated while preferred stockholders have preferential claims
and receive their returns before those paid to the common stockholders. Common
stockholders, therefore, are taking greater risk with their investment than are other
corporation investors, and in exchange are therefore provided more control.
The stockholders in a corporation are empowered to elect a Board of Directors comprised of
individuals generally selected for their individual managerial skills. The Board is authorized to
make certain corporate decisions, as specified in the corporations charter, on behalf of the
stockholders. The board is charged with procuring the services of qualified managers to run the
firm and to make decisions on behalf of the owners.

Managers are charged with the day to day operations of the organization and are, along with
the Board of Directors, considered the agents of the owners or principals in the firm. Managers
are therefore obligated to act on the owners behalf in all transactions. When the management
acts in its own interest, to the detriment of the stockholders, the result is an agency or
principal-agent problem. Examples of agency problems include making corporate investment
decisions that result in greater risk than is desired by the majority of the owners, or granting
salaries or other perks to themselves at the expense of the owners returns.
Created under state laws, corporations as legal entities provide corporate equity investors
protection from losses in excess of their investment. State laws of incorporation provide that
corporate stockholders have limited liability protection. Corporate stockholders, by law
therefore, cannot be held individually responsible or liable for corporate wrongdoing. The
corporation is viewed as a person by law and the stockholders are therefore generally
protected from any liability beyond their financial investment in the firm.
Since the ownership of a corporation is split into shares of that entity, it can be relatively easy
to sell those shares in small units of ownership - something that is not easily done with a sole
proprietorship or with partnership units. The shares of publicly traded corporations are
particularly marketable and liquid. Privately held corporation shares are less marketable than
their publicly traded brethren but are still easier to purchase or sell than the ownership units of
sole proprietorships or partnerships.
Unlike sole proprietorships or partnerships, the death of a stockholder in a corporation does not
result in the death of the business entity as well. Corporations, as noted, are legal persons and
continue to exist at the death of individual stockholders.
There is one significant negative issue that differentiates corporations from sole proprietorships
and partnerships. That is the problem of double taxation. Because they are considered legal
persons, corporations must pay corporate taxes on all taxable income. After those taxes are
paid, the residual income can be paid to stockholders in the form of dividends. Those
stockholders, in turn, must pay taxes on their dividends. This means that the same dollar of pretax corporate income has been taxed twice, once at the corporate level, and once at the
individual level.

Financial Management Decisions

It is important to managers in all areas of the business environment to have some
understanding of financial management. Financial management decisions must be made in
consideration of both their long and short term effects. Long-term plans based on financial
management considerations are called strategic plans, while short-term financial management
plans are called tactical plans. Further, no decision should be made without consideration of
both the direct and the indirect costs and benefits associated with that decision.

Given the dynamic environment in which financial managers must operate, they must be
flexible and capable of adjustment to rapid changes in the financial marketplace. Within this
framework, financial managers perform several functions. As shown in Figure 2, the functions
can be categorized into three ongoing separate but interrelated decision areas: financing or
capital acquisition, investment or capital distribution, and operating or capital management.
Figure 2. Financial Management Decisions

Examples of the types of decisions and issues confronting management in these three financial
management areas are provided in Figure 3.
Figure 3. Examples of Financial Management Decisions

Financing or Capital
Acquisition

Investment or Capital
Distribution

Operating or Capital
Management

Amount of funds to be
obtained

Which of the alternative

investments available to
the firm should be
selected

Determination of funds to be
provided by operations

Determination of funds to be
What to do with
Choice of purchase or
provided from other sources
organization cash inflows leasing of assets selected
insurance payouts, nonbusiness sources
Payment of operating
expenses, interest, taxes,
dividends

Determination as to the
assets best fitting the
asset mix

Decisions and planning for

adequate funding to pay
expenses

Choice to expand or
Payoff of debt principal,
Decision to retain earnings or
retract firm size and asset
repurchase of stock
pay dividends
investments

Financing or Capital Acquisition

In order to purchase assets it is necessary to have adequate funding for those assets. Obtaining
financing means not only obtaining the required capital in the correct amount but also at the
lowest possible cost, both in monetary and non-monetary terms. Monetary considerations
include obtaining the most beneficial terms and constraints on those funds. Non-monetary
terms, for example, might be the ability of a lender to convert the debt obligation of the
borrower into common stock equity or ownership in the firm at some point in the future.

Investment or Capital Distribution

When a firm considers which property whether land, buildings, machinery, or other equipment
necessary to provide products or services to customers that decision is an investment or capital
allocation decision. Capital is one of those words that can take on many meanings and in this
context can be used for either the long-term financing provided to the firm for allocation to
specific assets or resources or it may refer to the long-term assets themselves.
It is necessary of course to purchase those business assets based not only on their unique
individual characteristics but also on their relationship to the mix of assets as a whole. Assets
must fit the existing asset mix to ensure the firm does not expend more money than necessary,
and to ensure the assets have a productive capacity at an appropriate level relative to other
assets.
The investment or capital distribution decision, deals with identifying those investments, both
short- and long-term, which should be purchased by the firm. In other words, the capital
distribution or investment decision deals with trying to determine how the funds obtained as a
result of the financing and/or operating decisions can be most efficiently allocated to the firm.
Asset investment includes the selection of both intangible (financial) assets and tangible (real)
assets. Intangible assets are those assets or resources providing some benefit to the firm but
which is nonphysical in nature. Tangible assets are resources which do not meet the definition
of intangible assets to include investments in machinery, equipment, buildings and land.

Operating or Capital Management

Once assets have been obtained the firm must operate at a level which provides necessary cash
flows and adds value to the firm. To make value-adding decisions, managers must plan for the
usage of available resources or assets in a profitable manner to include scheduling asset use,
purchasing inventory, managing accounts receivables, the determination of possible dividend
payout, and the control of everyday expenses for operations, liabilities, and taxes.

The operating or capital management decision deals with the ongoing receipt and
disbursement of funds. This decision is complex since it deals not only with how funds obtained
from operations should be disbursed but also with how funds should be managed within the
firm. The operating decision is concerned with such areas as working capital management,
financial analysis of the firm, cash management, and with decisions including the repayment of
bond interest, and retaining funds for payment of preferred or common dividends.

Management Goals and Objectives

One of the key issues faced by management is the determination of a goal or objective to be
pursued. A survey of company owners or managers would certainly provide a myriad of goals
or objectives. It is probably safe to say that the most commonly cited goals or objectives might
include maximizing a firms size, utility or satisfaction, profits, or value.

Size
Pursuing size is often viewed as an appropriate objective for a firm. The bigger the firm, the
better. Regrettably there are many firms that have pursued this goal and found it to be
problematic. Managing to maximize size can mean many things. Firms become larger by
expansion of current product or service lines or by expansion into other areas of operation.
Management skills in one industry or product line do not necessarily transfer easily into others.
Further, bigger firms are not necessarily worth more than smaller firms. Consider, for example,
two firms A and B operating in the different lines of business, and that Company B takes over
Company A. If As value prior to takeover by firm B is $10 per share and firm Bs pre takeover
value is also $10 per share, why would investors be willing to pay more than $20 per share for
the combined firm when they could have purchased the same two firms in for $20 without the
takeover of A by B? Unless there are some synergistic or operating efficiency benefits, there is
no logical reason for a value increase.
In addition, size does not provide a mechanism for cash flow, risk, or return assessment and
thus there is no way to consider the true value of a firm based on size as an objective. Finally,
just because a firm is big it is not necessarily good for the community as a whole. A large firm is
not necessarily one that is good for the economy or the communities in which it operates.

Utility or Satisfaction
Pursuing utility or satisfaction is another commonly cited objective for a firm. The key question
here is the pursuit of whose satisfaction? Firms can seek to maximize the happiness or
satisfaction, measured in economic units called utils, for customers, creditors, employees,
owners, or any number of other interested parties.

The problem of determining whose happiness to maximize is compounded by the fact that
making any of the interested parties happy cannot be translated into a monetary improvement
in the value of the firm to the owners. As was the case with maximizing size, maximizing utility
does not provide a mechanism for cash flow, risk, or return assessment and thus again, there is
no way to consider the true value of a firm based on utility or satisfaction as an objective.
Finally, as was the case with maximizing size, the objective of happiness, no matter what
constituency is selected, does not necessarily result in benefits for the general economy or for
the firms operating locales.

Profit
The third and probably most often named objective or goal for firm managers to pursue is the
maximization of profits. For a smaller firm, or for firms that are in trouble this in fact may be an
appropriate goal with an underlying goal of just staying alive for another day. Theoretically,
however, the objective of maximizing profit is a flawed one.
To begin, profit is simply just an accounting number. Profit can be increased or decreased
depending on the accounting standards applied. Examples of alternatives include using first-in,
first-out (FIFO) or last-in, last-out (LIFO) inventory costing, and straight-line or accelerated
depreciation write-offs. In addition, firms pay cash not profits, and receive cash not profits.
While profits can be relatively easily identified from financial statements the decisions that
create those profits can often be geared toward increasing short-term rather than more
preferable long-term profits.
As mere accounting numbers there is no way to assess the beneficial impact to investors in
terms of returns, risk taken, or value added. One related problem here is the ability of
management to select accounting standards or timing to be applied thereby controlling, to
some extent the profits presented. Finally, maximizing profit does not, as with the other
alternative goals discussed, ensure an increase in value, at least in part due to the ambiguity of
the accounting number, and it does not ensure value added to the economy or community at
large.

Value or Stockholder Wealth

The last of the financial management goals or objectives to be discussed is the maximization of
value or stockholder wealth. Maximizing stockholder wealth, based on a firms price per share
is theoretically the goal or objective best suited for the financial management of a firm. As
Peter Lynch, perhaps the ideal image of a portfolio manager once stated, I think you have to
learn that theres a company behind every stock, and that theres only one real reason why
stocks go up. Companies go from doing poorly to doing well or small companies grow to large
companies. In short, managing the firm to improve and optimally to maximize stock price is
the basis for obtaining investors.

The value or wealth maximization objective has the advantage of emphasizing both the longterm and the short-term effects of decisions. Consideration of the size and timing of cash flows
rather than profits also allows the consideration of the risk factors and thus the appropriate
returns associated with each decision.
Keep in mind that the pursuit of wealth maximization does not eliminate other goals and
objectives which in turn can lead to the desired maximization of value. For example, a firm
must necessarily strive to satisfy customers with both products and service. If that is
accomplished sales revenues will result and profits, if expenses are managed properly, will
accrue to the firm and thus to the owners. As a result cash flows are provided and it is these,
when taken into account with the required rate of return commensurate with risks taken,
which are utilized to determine the value of the firm.
The use of cash flows rather than accounting profit is beneficial since, with cash flows,
accounting ambiguity is eliminated regardless of the accounting standards applied. As a result
the method allows consideration of the actual returns, rather than simply the profits accruing
to stockholders.
Finally, maximizing value, unlike the other alternative goals and objectives discussed does allow
the determination of the value of the firm and thus the success or failure of management
decisions. When a firm is adding value or wealth to stockholders it implies that the firm is
operating in a successful manner and can provide benefits to both the firm and its constituents
to include employees, customers, suppliers, and the economy at large. The managerial process
of creating value in the firm is presented in Figure 4.
Figure 4. Process of Creating Value in the Firm

Shareholder Wealth or Value

The shares of a business organization can themselves be viewed as a product. As with any
product, their value is nothing more than what consumers of that product are willing to pay. In
the case of company stock, the stock investor will determine the value of the shares in the
capital marketplace.
Since the maximization of shareholder wealth is theoretically the optimal financial goal of the
firm it is important to understand what that means. Shareholders invest in companies to obtain
flows of funds to be received at some point in the future. Those funds may be in the form of
actual cash dividends or in the form of a selling price per share which exceeds the purchasing
price per share. Theirs is a long-term not a short-term goal as would be appropriate if we were
to strive to maximize profits.
Maximizing shareholder wealth or value means simply to maximize the value of the firm as
evidenced by the firms price per share or total value. The total value of a firm is based on the
firms capitalization defined simply as the price per share multiplied by the number of common
shares outstanding in the hands of investors. Any asset whether a share of stock, a collectible
work of art, or an apartment complex is valued based on the present value of all streams of cash
flow to be received in the future. Thus managements pursuit of cash flow with the objective of
maximizing the value of the firm will be reflected in that price per share as determined in the
marketplace.
The price per share for publicly traded firms can, as noted, be observed in the marketplace.
The number of shares outstanding can be obtained from the firms financial statements. If, for
example a firm has a current market price of $25.00 per share and there are a total of 200,000
shares outstanding the firms total wealth or market value can be determined as:
Firm Value or Total Market Value = Price per Share X Number of Common Shares Outstanding
Firm Value or Total Market Value = $25.00 per share X 200,000 shares = $5,000,000

Principal-Agent Problems
When managers and owners enter into business relationships the managers of the firm create
an agency relationship with those owners. That relationship carries with it a fiduciary
responsibility to those owners. As agents of the owners or principals the management of any
business is expected to act in the best interests of the stockholders. The managers of the firm
are in effect, agents of the firms stockholders or principals. There are two basic reasons for the
owners of the firm to employ outsiders or managers to run the company on a day to day basis.
First, the owners of a firm will enter into a formal relationship or contract with managers
because of the perceived skills those managerial personnel bring to the firm. Keeping in mind

that owners are investing in a firm to obtain cash flows and increased value, the more skilled
the management the greater the likelihood of success in that endeavor.
Second, when the owners are also the managers of a firm, there is a greater likelihood that they
will be more risk averse in their decisions than an outside manager. In a corporation with many
owners, the risk is spread across owners and not borne by a sole proprietorship, thus reducing
the risk of each shareholder but increasing the need for outside managers to act as agents on
behalf of all the owners. Because there is a direct relationship between risks taken and
expected return, the return to the firm is likely to be greater with outside management making
decisions.
On occasion situations arise in which the decisions of the management are not necessarily
made in the best interests of the stockholder but, rather, in the best interest of the managers
making those decisions. These are occasions which reflect what is commonly referred to as the
principal-agent or agency problem.
The agency problem, therefore, exists when there is dissimilarity between the interests of
managers and shareholders. This means that, management appointed by the stockholders to
run the firm, may pursue objectives which are not those that would be the top priority
objectives of the stockholders. This type of a problem is especially likely to arise when
management is to receive compensation from the improvement of profits. Decisions which
improve profits are generally short-term in nature, as opposed to value-maximization decisions,
which are long-term. Agency problems have become a matter of increasing managerial
importance in recent years and carry what are called agency costs.
Agency costs can be seen as real and observable costs such as excessive spending on offices,
landscaping, and perquisites for management. None of these may be necessary nor do they
necessarily provide additional cash flow to the firm. Other agency costs may be less directly
observed. If management is not running the firm profitably due to poor skills, self-serving
decisions, non-essential investments, or perhaps even worse, not investing in equipment
necessary to keep the firm competitive, there will be a reduction in share prices or value, and
less access to necessary funds as a result of the observed poor performance of the firm.
There are several approaches to mitigating the potential for agency problems. Market factors
provide insight for eliminating or at least controlling agency issues. First, when firms monitor
the performance of their organizations, poor managers will be identified as a result of poor
performance and can be replaced with good managers identified by the performance of the
firms they manage. Second, good management personnel can be secured and retained by
providing them with compensation in the form of market-related salaries and non-monetary
perquisites. A third approach to reducing the possibility of agency problems is to provide an
incentive in the form of ownership to managers. Giving managers ownership shares in the firm
makes the firm a personal agenda item not simply a place of employment.

Ethics
As noted earlier, company managers to include the Board of Directors owe a fiduciary
responsibility to the owners or stockholders of that company. Their responsibility is to act on
their behalf, to improve the value of their investments in the company. Ethics is an area of
study or interest that is concerned with morals, values, and both good and bad behavior.
Ethics in business has become an important area of concern and study in recent years. Prime
examples of business disasters resulting from the application of bad ethical behaviors by
managers include firms like Enron, Worldcom, and Tyco. Enrons troubles resulted from
manipulation of the firms financial statements in an effort to hide losses and create earnings.
Worldcom also manipulated statements to pump up the firms earnings while Tyco ran into
ethical problems by masking huge loans, and payouts to a couple of the firms corporate
leaders.
While manipulating financial documents or cooking the books is a common form of unethical
behavior there are others to include discrimination in hiring or promotion decisions, and
ignoring or taking inadequate protections against harmful environmental situations as in the
case of the Exxon Valdez in Alaska in March of 1989.
Because of the importance of ethics in business, everyone wants to feel as if they have been
dealt with fairly. Companies have taken great steps toward trying to reduce the potential for
unethical behavior whether intentional or not. Companies have created entire departments
devoted to training and the creation of policies on what is deemed ethical and unethical
behavior, and the creation of the position of ethics officers to oversee these policies. An
additional concern is the importance of recognizing that employees from different countries
may need to be trained to understand the corporations domestic ethical culture as well as the
legal ramifications of certain behaviors which may have been accepted as the norm in their own
cultures but which are unacceptable within the corporation.
The individuals affected by ethical decisions are called stakeholders. Stakeholders can include
suppliers, customers, employees, or even whole communities. Almost every business decision
can be found to have some ethical implication and thus the importance of understanding both
the cultural and legal implications of business decisions. There are a number of techniques or
procedures for assessing the right or wrong of a decision, but perhaps Mark Twain said it best:
Always do right. This will gratify some people and astonish the rest.