Chapter one: Introduction

1. An Overview of Financial Management

Finance may be defined as the art and science of managing money. Finance also is referred as
the provision of money at the time when it is needed.
Finance is one of the important and integral part of business concerns, hence, it plays a major
role in every part of the business activities. It is used in all the area of the activities under the
different names.
Finance can be classified into two major parts:
 Private Finance, which includes the Individual, Firms, Business or Corporate Financial
activities to meet the requirements.
 Public Finance which concerns with revenue and disbursement of Government such as
Central Government, State Government and Semi-Government Financial matters.

Definition of Financial Management

Financial management is an integral part of overall management. It is concerned with the duties
of the financial managers in the business firm.
 The term financial management has been defined by Solomon, “It is concerned with the
efficient use of an important economic resource namely, capital funds”
 The most popular and acceptable definition of financial management as given by S.C.
Kuchal is that “Financial Management deals with procurement of funds and their
effective utilization in the business”.
 Howard and Upton: Financial management “as an application of general managerial
principles to the area of financial decision-making.
 Weston and Brigham: Financial management “is an area of financial decision-making,
harmonizing individual motives and enterprise goals”.
 Joshep and Massie: Financial management “is the operational activity of a business that
is responsible for obtaining and effectively utilizing the funds necessary for efficient
operations.
Thus, Financial Management is mainly concerned with the effective funds management in the
business. In simple words, Financial Management as practiced by business firms can be called as
Corporation Finance or Business Finance.

1.1The nature and scope of financial management

1.1.1 Nature of financial management

Functions of Finance Manager

Finance function is one of the major parts of business organization, which involves the
permanent and continuous process of the business concern. Finance is one of the interrelated
functions which deal with personal function, marketing function, production function and
research and development activities of the business concern. At present, every business concern
concentrates more on the field of finance because, it is a very emerging part which
reflects the entire operational and profit ability position of the concern. Deciding the proper
financial function is the essential and ultimate goal of the business organization.
Finance manager is one of the important role players in the field of finance function.
He must have entire knowledge in the area of accounting, finance, economics and
management. His position is highly critical and analytical to solve various problems related
to finance. A person who deals finance related activities may be called finance manager.
Finance manager performs the following major functions:

1. Forecasting Financial Requirements

It is the primary function of the Finance Manager. He is responsible to estimate the financial
requirement of the business concern. He should estimate, how much finances required to acquire
fixed assets and forecast the amount needed to meet the working capital requirements in future

.2. Acquiring Necessary Capital

After deciding the financial requirement, the finance manager should concentrate how the
finance is mobilized and where it will be available. It is also highly critical in nature.

3. Investment Decision
The finance manager must carefully select best investment alternatives and consider the
reasonable and stable return from the investment. He must be well versed in the field of capital
budgeting techniques to determine the effective utilization of investment. The finance manager
must concentrate to principles of safety, liquidity and profitability while investing capital

4. Cash Management
Present day’s cash management plays a major role in the area of finance because proper cash
management is not only essential for effective utilization of cash but it also helps to meet the
short-term liquidity position of the concern.

5. Interrelation with Other Departments

Finance manager deals with various functional departments such as marketing, production,
personnel, system, research, development, etc. Finance manager should have sound knowledge
not only in finance related area but also well versed in other areas. He must maintain a good
relationship with all the functional departments of the business organization.

Objectives of Financial Management

Objectives of Financial Management may be broadly divided into two parts such as:
A. Profit maximization
B. Wealth maximization
A) Profit Maximizations as a Decision Criterion

Profit maximization is considered as the goal of financial management, in this approach, actions
that increase profits should be undertaken and actions that decrease profits are avoided. Thus, the
investment, financing and dividend decisions also be noted that the term objective provides a
normative framework decisions should be oriented to the maximization or profit. The term
profits are used in two senses. In one sense it is used as an owner – oriented. In this concept it
refers to the amount and share of national income that is paid to the owners of business. The
second way is operational concept i.e. profitability, this concept signifies economic efficiency
i.e. profitability refers to the situation where output exceeds input and, the value credited by the
use of resources is greater than the input resources. Thus, in the entire decisions one test is used
i.e. select asset, projects and decision that are profitable and reject those which are not profitable.
Profit maximization criterion is criticized on several grounds .Firstly; the reasons for the
opposition that are based on misapprehensions about the workability and fairness of the private
enterprise itself. Secondly, profit maximization suffers from the difficulty of applying this
criterion in the actual real world situations.

B) Wealth Maximization

Wealth maximization decision principle is also known as value maximization or net present –
worth maximization is widely accepted as an appropriate operational decision principle for
financial management decision. It removes the technical limitations of profit maximization
criterion and it pokes the three requirements of a suitable operational objective of financial
courses of action. These three features are exactness, quality of benefits, and the time value of
money.
1. Exactness: The value of an asset should be determined in terms of returns it can produce.
Thus, the worth of a course of action should be valued in terms of the returns less the cost of
undertaking the particular course of action is the exactness in computing the benefits
associated with the course of action. The wealth maximization criterion is based on cash
flows generated and not on accounting profits. The computation of cash inflows and cash
outflows is precise. As against this, the computation of accounting is not exact.
2. Quality, Quantity, Benefits and Time Value of Money: The second feature of wealth
maximization criterion is that it considers both the quality and quantity dimensions of
benefits. Moreover, it also incorporates the time value of money. As stated earlier, the quality
of benefits refers to certainty with which benefits are received in future. The more certain
the expected cash flows, the better the quality of benefits and higher value. To the contrary,
the less certain the flows, the lower the quality and hence, value of benefits. It should also
benefit that money has time value. It should also be noted that benefits received in earlier
years should be valued highly than benefits received later.
The operational implication of uncertainty and timing dimension of the benefits associated with
financial decision is that adjustments need to be made in the cash flow pattern. It should be made
to incorporate risk and to make an allowance for differences in timing of benefits. Net present
value maximization is superior to the profit maximization as on operational objective.
Note, Profit maximization as the objective of financial management; it aims at improving
profitability, maintaining the stability and reducing losses and inefficiencies.

1.1.2 Scope of financial management

Financial management approach measures the scope of the financial management in
various fields, which include the essential part of the finance.
The approach to the scope of financial management is divided, for purposes of exposition into
two broad categories: a) the traditional approach and (b) the modern approach.
a) Traditional Approach: - The traditional approach to the scope of financial management
refers to its subject-matter, in academic literature in the initial stages of its evolution as a
separate branch of an academic study. This approach is based on the past experience
and the traditionally accepted methods. Main part of the traditional approach is rising of
funds for the business concern. Traditional approach consists of the following important
area.
 Arrangement of funds from lending body.
 Arrangement of funds through various financial instruments.
 Finding out the various sources of funds.
b) Modern Approach: - The modern approach views the term financial management in abroad
sense and provides a conceptual and analytical framework for financial decision making.
According to modern approach, the finance function covers both acquiring of funds as well as
their allocations. Thus, apart from the issues involved in acquiring external funds, the main
concern of financial management is the efficient and wise allocation of funds to various uses. It
is viewed as an integral part of the overall management. The main concerns of modern approach
are:-
What is the total volume of funds an enterprise should commit?
What specific assets should an enterprise acquire?
How should the funds required be financed?

1.2Financial Markets and Institutions

1.2.1 Financial Institutions
Financial institutions are financial intermediaries, which are specialized financial firms that
facilitate the transfer of funds from savers to demanders of capital. They accept savings from
customers and lend this money to other customers or they invest it. In many instances, they pay
savers interest on deposited funds. In some cases, they impose service charges on customers for
the services they render. For example, many financial institutions impose service charges on
current accounts.
The key participants in financial transactions of financial institutions are individuals, businesses,
and government. By accepting the savings from these parties, financial institutions transfer again
to individuals, business firms, and governments. Since financial institutions are generally large,
they gain economies of scale in the transfer of money between savers and demanders. By pooling
risks, they help individual savers to diversify their risk.
The major classes of financial institutions include commercial banks, savings and loan
associations, mutual savings banks, credit unions, pension funds and life insurance companies.
Among these, commercial banks are by far the most common financial institutions in many
countries worldwide. In Ethiopia too, commercial banks are the major institutions that handle the
savings and borrowing transactions of individuals, businesses, and governments.
1.2.2 Cash Flows to and from the Firm
The interplay between the corporation and the financial markets is illustrated in Figure 1.2. The
arrows in Figure 1.2 trace the passage of cash from the financial markets to the firm and from the
firm back to the financial markets.

1.2.3 Financial Markets

Financial markets are markets in which financial instruments are bought and sold by suppliers
and demanders of funds. They, unlike financial institutions, are places in which suppliers and
demanders of funds meet directly to transact business.

Functions of Financial Markets

Generally, financial markets play three important roles in functioning of corporate finance.
 1. They assist the capital formation process. Financial markets serve as a way through
which firms can obtain the capital they need for their operations and investment.
2. Financial markets serve as resale markets for financial instruments. They create
continuous liquid markets where firms can obtain the capital they need from individuals
and other businesses easily.
3. They play a role in setting the prices of securities. The price of a financial instrument is
determined through the interaction of demand and supply of the security in the financial
markets.

Classification of Financial Markets

There are many types of financial markets and hence several ways to classify them. For our
purpose, here we shall consider the following two classifications.

1. Classification on the basis of maturity

This is based on the maturity dates of securities
i) Money Markets
ii) Capital Markets

2. Classification on the basis of the nature of securities

This is based on whether the securities are new issues or have been outstanding in the market
place.
i) Primary Markets
ii) Secondary Markets
1.2.4 Money markets versus Capital markets
Money markets versus capital markets. Money markets are the markets for short-term, highly
liquid debt securities. The New York, London, and Tokyo money markets are among the world ’s
largest. Capital markets are the markets for intermediate- or long-term debt and corporate stocks.
The New York Stock Exchange, where the stocks of the largest U.S. corporations are traded, is a
prime example of a capital market. There is no hard-and-fast rule, but in
a description of debt markets, short-term generally means less than 1 year, intermediate-term
means 1 to 10 years, and long-term means more than 10 years.

1.2.5 Primary versus Secondary Markets

Financial markets function as both primary and secondary markets for debt and equity securities.
The term primary market refers to the original sale of securities by governments and
corporations. The secondary markets are those in which these securities are bought and sold after
the original sale. Equities are, of course, issued solely by corporations. Debt securities are issued
by both governments and corporations.
1.3 Financial management decisions
The financial manager must be concerned with three basic types of decisions. Those decisions
are concerned with the special activities or purposes of financial management. The functions of
financial management are planning for acquiring and utilizing funds by a firm as well as
distributing funds to the owners in ways that achieve goal of the firm.
In general, the functions of financial management include three major decisions a firm must
make. These are:
 Investment decisions
 Financing decisions
 Dividend decisions

1.3.1 Investment Decisions

They deal with allocation of the firm’s scarce financial resources among competing uses. These
decisions are concerned with the management of assets by allocating and utilizing funds within
the firm. Specifically, the investment decisions include:
i) Determining the asset mix or composition: - determining the total amount of the
firm’s finance to be invested in current and fixed assets.
ii) Determining the asset type: - determining which specific assets to maintain within
the categories of current and fixed assets.
iii) Managing the asset structure, i.e., maintaining the composition of current and fixed
assets and the type of specific assets under each category.
The investment decisions of a firm also involve working capital management and capital
budgeting decisions. The former refers to those decisions of a firm affecting its current assets and
short – term liabilities. The later, on the other hand, involves long – term investment decisions
like acquisition, modification, and replacement of fixed assets.
Generally, the investment decisions of a firm deal with the left side of the basic accounting
equation: A = L + OE (Assets = Liabilities + Owners’ Equity).

1.3.2 Financing Decisions

The financing decisions deal with the financing of the firm’s investments, i.e., decisions whether
the firm should use equity or debt funds in order to finance its assets. They are also concerned
with determining the most appropriate composition of short – term and long – term financing.
In simple terms, the financing decisions deal with determining the best financing mix or capital
structure of the firm. The financing decisions of a firm are generally concerned with the right
side of the basic accounting equation.
1.3.3 Dividend Decisions
The dividend decisions address the question how much of the cash a firm generates from
operations should be distributed to owners in the form of dividends and how much should be
retained by the business for further expansion. There are tradeoffs on the dividend policy of a
firm. On the one hand, paying out more dividends will make the firm to be perceived strong and
healthy by investors; on the other hand, it will affect the future growth of the firm. So the
dividend decision of a firm should be analyzed in relation to its financing decisions.

1.4 Goal of the firm

Assuming that we restrict ourselves to for-profit businesses, the goal of financial management is
to make money or add value for the owners. This goal is a little vague, of course, so we examine
some different ways of formulating it in order to come up with a more precise definition. Such a
definition is important because it leads to an objective basis for making and evaluating financial
decisions.

1.4.1 Possible Goals

If we were to consider possible financial goals, we might come up with some ideas like the
following:
o Survive.
o Avoid financial distress and bankruptcy.
o Beat the competition.
o Maximize sales or market share.
o Minimize costs.
o Maximize profits.
o Maintain steady earnings growth.
These are only a few of the goals we could list. Furthermore, each of these possibilities presents
problems as a goal for the financial manager. For example, it’s easy to increase market share or
unit sales; all we have to do is lower our prices or relax our credit terms. Similarly, we can
always cut costs simply by doing away with things such as research and development. We can
avoid bankruptcy by never borrowing any money or never taking any risks, and so on. It’s not
clear that any of these actions are in the stockholders’ best interests.
Profit maximization would probably be the most commonly cited goal, but even this is not a very
precise objective. Do we mean profits this year? If so, then we should note that actions such as
deferring maintenance, letting inventories run down, and taking other short-run cost-cutting
measures will tend to increase profits now, but these activities aren’t necessarily desirable.

The goal of maximizing profits may refer to some sort of “long-run” or “average” profits, but it ’s
still unclear exactly what this means. First, do we mean something like accounting net income or
earnings per share? Second, what do we mean by the long run? As a famous economist once
remarked, in the long run, we’re all dead! More to the point, this goal doesn ’t tell us what the
appropriate trade-off is between current and future profits. The goals we’ve listed here are all
different, but they do tend to fall into two classes.

The first of these relates to profitability. The goals involving sales, market share, and
cost control all relate, at least potentially, to different ways of earning or increasing profits. The
goals in the second group, involving bankruptcy avoidance, stability, and safety, relate in some
way to controlling risk. Unfortunately, these two types of goals are somewhat contradictory.
The pursuit of profit normally involves some element of risk, so it isn’t really possible to
maximize both safety and profit. What we need, therefore, is a goal that encompasses both
factors.
1.4.2 The Goal of Financial Management
The financial manager in a corporation makes decisions for the stockholders of the firm.
Given this, instead of listing possible goals for the financial manager, we really need to
answer a more fundamental question: From the stockholders’ point of view, what is a good
financial management decision? If we assume that stockholders buy stock because they seek to
gain financially, then the answer is obvious: good decisions increase the value of the stock, and
poor decisions decrease the value of the stock. Given our observations, it follows that the
financial manager acts in the shareholders’ best interests by making decisions that increase the
value of the stock. So, the goal of financial manager is maximize the current value per share
of the existing stock.

The goal of maximizing the value of the stock avoids the problems associated with the different
goals we listed earlier. There is no ambiguity in the criterion, and there is no short-run versus
long-run issue. We explicitly mean that our goal is to maximize the current stock value. If this
goal seems a little strong or one-dimensional to you, keep in mind that the stockholders in a firm
are residual owners. By this we mean that they are only entitled to what is left after employees,
suppliers, and creditors (and anyone else with a legitimate claim) are paid their due. If any of
these groups go unpaid, the stockholders get nothing. So, if the stockholders are winning in the
sense that the leftover, residual, portion is growing, it must be true that everyone else is winning
also. Because the goal of financial management is to maximize the value of the stock, we need to
learn how to identify those investments and financing arrangements that favorably impact the
value of the stock. This is precisely what we will be studying. In fact, we could have defined
corporate finance as the study of the relationship between business decisions and the value of the
stock in the business.

A More General Goal

Given our goal as stated in the preceding section (maximize the value of the stock), an obvious
question comes up: What is the appropriate goal when the firm has no traded stock?
Corporations are certainly not the only type of business; and the stock in many corporations
rarely changes hands, so it’s difficult to say what the value per share is at any given time.

As long as we are dealing with for-profit businesses, only a slight modification is needed. The
total value of the stock in a corporation is simply equal to the value of the owners ’ equity.
Therefore, a more general way of stating our goal is as follows: maximize the market value of
the existing owners’ equity. With this in mind, it doesn’t matter whether the business is a
proprietorship, a partnership, or a corporation. For each of these, good financial decisions
increase the market value of the owners’ equity and poor financial decisions decrease it. In fact,
although we choose to focus on corporations in the chapters ahead, the principles we develop
apply to all forms of business. Many of them even apply to the not-for-profit sector. Finally, our
goal does not imply that the financial manager should take illegal or unethical actions in the hope
of increasing the value of the equity in the firm. What we mean is that the financial manager best
serves the owners of the business by identifying goods and services that add value to the firm
because they are desired and valued in the free marketplace.

1.5 Basic forms of business organizations

The basics of financial management are the same for all businesses, large or small, regardless of
how they are organized. Still, a firm’s legal structure affects its operations and thus should be
recognized. There are three different legal forms of business organization are sole proprietorship,
partnership, and corporation.
1.5.1. Sole Proprietorship
A sole proprietorship is a business owned by one person. This is the simplest type of business to
start and is the least regulated form of organization. Depending on where you live, you might be
able to start up a proprietorship by doing little more than getting a business license and opening
your doors. For this reason, there are more proprietorships than any other type of business and
many businesses that later become large corporations start out as small proprietorships.
The owner of a sole proprietorship keeps all the profits. That’s the good news. The bad news is
that the owner has unlimited liability for business debts. This means that creditors can look
beyond business assets to the proprietor’s personal assets for payment. Similarly, there is no
distinction between personal and business income, so all business income is taxed as personal
income.
1.5.2. Partnership
A partnership is similar to a proprietorship, except that there are two or more owners (partners).
In a commonly known general partnership, all the partners share in gains or losses, and all have
unlimited liability for all partnership debts, not just some particular share. The way partnership
gains (and losses) are divided is described in the partnership agreement.
The advantages and disadvantages of a partnership are basically the same as those of a
proprietorship. Partnerships based on a relatively informal agreement are easy and inexpensive to
form. General partners have unlimited liability for partnership debts, and the partnership
terminates when a general partner wishes to sell out or dies. All income is taxed as personal
income to the partners, and the amount of equity that can be raised is limited to the partners’
combined wealth. Ownership of a general partnership is not easily transferred, because a transfer
requires that a new partnership be formed.
Based on our discussion, the primary disadvantages of sole proprietorships and partnerships as
forms of business organization are (1) unlimited liability for business debts on the part of the
owners, (2) limited life of the business, and (3) difficulty of transferring ownership. These three
disadvantages add up to a single, central problem: the ability of such businesses to grow can be
seriously limited by an inability to raise cash for investment.
1.5.3. Corporation
The Corporation is the most important form of business organization. A corporation is a legal
“person” separate and distinct from its owners, and it has many of the rights, duties, and
privileges of an actual person. Corporations can borrow money and own property, can sue and be
sued, and can enter into contracts. A corporation can even be a general partner or a limited
partner in a partnership, and a corporation can own stock in another corporation.
Not surprisingly, starting a corporation is somewhat more complicated than starting the other
forms of business organization. Forming a corporation involves preparing articles of
incorporation (or a charter) and a set of bylaws. The articles of incorporation must contain a
number of things, including the corporation’s name, its intended life (which can be forever), its
business purpose, and the number of shares that can be issued. This information must normally
be supplied to the state in which the firm will be incorporated. For most legal purposes, the
corporation is a “resident” of that state.
The bylaws are rules describing how the corporation regulates its own existence. For example,
the bylaws describe how directors are elected. These bylaws may be a very simple statement of a
few rules and procedures, or they may be quite extensive for a large corporation. The bylaws
may be amended or extended from time to time by the stockholders.
In a large corporation, the stockholders and the managers are usually separate groups. The
stockholders elect the board of directors, who then select the managers. Management is charged
with running the corporation’s affairs in the stockholders’ interests. In principle, stockholders
control the corporation because they elect the directors. As a result of the separation of
ownership and management, the corporate form has several advantages. Ownership (represented
by shares of stock) can be readily transferred, and the life of the corporation is therefore not
limited. The corporation borrows money in its own name. As a result, the stockholders in a
corporation have limited liability for corporate debts. The most they can lose is what they have
invested. The relative ease of transferring ownership, the limited liability for business debts, and
the unlimited life of the business are the reasons why the corporate form is superior when it
comes to raising cash.