OVERVIEW OF FINANCIAL MANAGEMENT

Finance has been defined as the “art and science of managing money”. Finance consists of
three interrelated areas: (1) money and capital markets, which deals with securities markets and
financial institutions; (2) investments, which focuses on the decisions made by both individual
and institutional investors as they choose securities for their investment portfolios; and (3)
financial management, which involves decisions within firms. Financial management is the
broadest of the three areas.

The Financial Staff’s Responsibilities

The financial staff’s task is to acquire and then help operate resources so as to maximize the
value of the firm. Here are some specific activities:

1. Forecasting and planning. The financial staff must coordinate the planning process.
This means they must interact with people from other departments as they look ahead
and lay the plans that will shape the firm’sfuture.
2. Major investment and financing decisions. A successful firm usually has rapid growth
in sales, which requires investments in plant, equipment, and inventory. The financial
staff must help determine the optimal sales growth rate, help decide what specific assets
to acquire, and then choose the best way to finance those assets. For example, should
the firm finance with debt, equity, or some combination of the two, and if debt is used,
how much should be long term and how much short term?
3. Coordination and control. The financial staff must interact with other personnel to
ensure that the firm is operated as efficiently as possible. All business decisions have
financial implications, and all managers — financial and otherwise — need to take this
into account. For example, marketing decisions affect sales growth, which in turn
influences investment requirements. Thus, marketing decision makers must take
account of how their actions affect and are affected by such factors as the availability of
funds, inventory policies, and plant capacity utilization.
4. Dealing with the financial markets. The financial staff must deal with the money and
capital markets. Each firm affects and is affected by the general financial markets
where funds are raised, where the firm’s securities are traded, and where investors
either make or lose money.
5. Risk management. All businesses face risks, including natural disasters such as fires
and floods, uncertainties in commodity and security markets, volatile interest rates, and
fluctuating foreign exchange rates. However, many of these risks can be reduced by
purchasing insurance or by hedging in the derivatives markets. The financial staff is
responsible for the firm’s overall risk management program, including identifying the
risks that should be managed and then managing them in the most efficient manner.
Forms of Business Organization

There are three main forms of business organization: (1) sole proprietorships,(2) partnerships,
and (3) corporations.

A sole proprietorship is an unincorporated business owned by one individual. Going into

business as a sole proprietor is easy — one merely begins business operations. However, even
the smallest businesses normally must be licensed by a governmental unit. The proprietorship
has three important advantages: (1) It is easily and inexpensively formed, (2) it is subject to few
government regulations, and (3) the business avoids corporate income taxes. The
proprietorship also has three important limitations: (1) It is difficult for a proprietorship to obtain
large sums of capital; (2) the proprietor has unlimited personal liability for the business’ debts,
which can result in losses that exceed the money he or she has invested in the company; and
(3) the life of a business organized as a proprietorship is limited to the life of the individual who
created it. For these three reasons, sole proprietorships are used primarily for small-business
operations.

A partnership exists whenever two or more persons associate to conduct a noncorporate

business. Partnerships may operate under different degrees of formality, ranging from informal,
oral understandings to formal agreements. The major advantage of a partnership is its low cost
and ease of formation. The disadvantages are similar to those associated with proprietorships:
(1) unlimited liability, (2) limited life of the organization, (3) difficulty of transferring ownership,
and (4) difficulty of raising large amounts of capital.

Regarding liability, the partners can potentially lose all of their personal as-sets, even assets not
invested in the business, because under partnership law, each partner is liable for the
business’s debts. The first three disadvantages — unlimited liability, impermanence of the
organization, and difficulty of transferring ownership — lead to the fourth, the difficulty
partnerships have in attracting substantial amounts of capital.

A corporation is a legal entity created by a state, and it is separate and distinct from its owners
and managers. This separateness gives the corporation three major advantages: (1) Unlimited
life. A corporation can continue after its original owners and managers are deceased. (2) Easy
transferability of ownership interest. Ownership interests can be divided into shares of stock,
which, in turn, can be transferred far more easily than can proprietorship or partnership
interests. (3) Limited liability .Losses are limited to the actual funds invested. These three
factors — unlimited life, easy transferability of ownership interest, and limited liability — make it
much easier for corporations than for proprietorships or partnerships to raise money in the
capital markets.

Finance in the Organizational Structure of the Firm

Organizational structures vary from firm to firm, but the figure below presents a fairly
typical picture of the role of finance within a corporation. The chief financial officer (CFO)
generally has the title of vice-president, finance, and he or she reports to the president. The
financial vice-president’s key subordinates are the treasurer and the controller. In most firms the
treasurer has direct responsibility for managing the firm’s cash and marketable securities, for
planning its capital structure, for selling stocks and bonds to raise capital, for over-seeing the
corporate pension plan, and for managing risk. The treasurer also supervises the credit
manager, the inventory manager, and the director of capital budgeting (who analyzes decisions
related to investments in fixed assets).The controller is typically responsible for the activities of
the accounting and tax departments.

The Goals of the Corporation

Shareholders are the owners of a corporation, and they purchase stocks because they are
looking for a financial return. In most cases, shareholders elect directors, who then hire
managers to run the corporation on a day-to-day basis. Since managers are working on
behalf of shareholders, it follows that they should pursue policies that enhance shareholder
value. Consequently, we operate on the assumption that management’s primary goal is
stockholder wealth maximization, which translates into maximizing the price of the firm’s
common stock. Firms do, of course, have other objectives — in particular, the managers who
make the actual decisions are interested in their own personal satisfaction, in their employees’
welfare, and in the good of the community and of society at large. Still, stock price maximization
is the most important goal for most corporations.
Stock Price Maximization and Social Welfare

If a firm attempts to maximize its stock price, is this good or bad for society? In general, it is
good. Aside from such illegal actions as attempting to form monopolies, violating safety codes,
and failing to meet pollution control requirements, the same actions that maximize stock prices
also benefit society. First, note that stock price maximization requires efficient, low-cost
businesses that produce high-quality goods and services at the lowest possible cost. Second,
stock price maximization requires the development of products and services that consumers
want and need, so the profit motive leads to new technology, to new products, and to new jobs.
Finally, stock price maximization necessitates efficient and courteous service, adequate stocks
of merchandise, and well-located business establishments — these are the factors that lead to
sales, which in turn are necessary for profits. Therefore, most actions that help a firm increase
the price of its stock also benefit society at large. Since financial management plays a crucial
role in the operations of successful firms, and since successful firms are absolutely necessary
for a healthy, productive economy, it is easy to see why finance is important from a social
welfare standpoint.

Agency Relationships

It has long been recognized that managers may have personal goals that compete with
shareholder wealth maximization. Managers are empowered by the owners of the firm — the
shareholders — to make decisions, and that creates a potential conflict of interest known as
agency theory. An agency relationship arises whenever one or more individuals, called
principals, hire another individual or organization, called an agent, to perform some service and
delegate decision-making authority to that agent.

Managers can be encouraged to act in stockholders’ best interests through incentives that
reward them for good performance but punish them for poor performance. Some specific
mechanisms used to motivate managers to act in shareholders’ best interests include (1)
managerial compensation, (2) direct intervention by shareholders, (3) the threat of firing, and (4)
the threat of takeover.

1. Managerial compensation. Managers obviously must be compensated, and the

structure of the compensation package can and should be designed to meet two
primary objectives: (a) to attract and retain able man-agers and (b) to align managers’
actions as closely as possible with the interests of stockholders, who are primarily
interested in stock price maximization. Different companies follow different
compensation practices, but a typical senior executive’s compensation is structured in
three parts:(a) a specified annual salary, which is necessary to meet living expenses;(b)
a bonus paid at the end of the year, which depends on the company’s profitability during
the year; and (c) options to buy stock, or actual shares of stock, which reward the
executive for long-term performance. Managers are more likely to focus on maximizing
stock prices if they are themselves large shareholders. Often, companies grant senior
managers performance shares, where the executive receives a number of shares
dependent upon the company’s actual performance and the executive’s continued
 service. Most large corporations also provide executive stock options, which allow
managers to purchase stock at some future time at a given price.
2. Direct intervention by shareholders. Years ago most stock was owned by individuals,
but today the majority is owned by institutional investors such as insurance companies,
pension funds, and mutual funds. Therefore, the institutional money managers have the
clout, if they choose to use it, to exercise considerable influence over most firms’
operations.
3. The threat of firing.
4. The threat of takeovers. Hostile takeovers are most likely to occur when a firm’s stock
is undervalued relative to its potential because of poor management. In the words of one
company president, “If you want to keep your job, don’t let your stock sell at a bargain
price.”

Earnings Per Share

Funds are invested are invested in a business to earn sufficient return on investment. Goods
and services are made available to the public and are billed to the customers/clients with
sufficient markup to cover operating expenses, financing charges, income taxes and desired net
profit. Net profit realized results in an increase in assets and owners’ equity. Part of it may be
distributed to the owners of the business (or declared as dividends in the case of a corporation)
with the remainder left in business (or plowed back into it).

Earnings per Share (EPS). This refers to how much net income is earned for every share of
capital stock outstanding.

Net Income Related to Common Stock

EPS =
Weighted Average Number of Shares
Outstanding of Common Stock

In general, the higher is the EPS, the higher is the price a stock can command in the market.