Business Finance Chapter 1 - The role and environment of managerial finance

Finance can be defined as the art and science of managing money.

In business context finance involves: how firms raise money from investors, how firms invest money to earn profit, and how
they decide whether to reinvest profits or distribute them back to investors.
Importance of business finance
Business finance plays an important role for all organizations for the following reasons:
Maximization of wealth: Business finance ensures that a shareholder’s wealth is maximized. It is also important to understand
that wealth maximization is different from profit maximization. Wealth maximization is holistic and ensures the growth of an
organization.
Ensure constant availability of money : For any business to survive, it should be in optimum financial condition. This includes
the availability of funds at the time they are needed. Unless there are enough funds, the business may not be able to function
properly.
Attaining optimum capital structure: This requires a perfect combination of shares and debentures. This way the organization
will be able to maintain a perfect balance and not give away too much equity.
Effective utilization of funds: This is another reason for the high importance of business finance and its efficient utilization. A
business should be able to cut down unnecessary costs and not invest funds in assets that are not required. An exhaustive
course in financial management, diploma in banking and finance or any other course related to finance can give your career in
financial management a head start. Or, if you are already in the field, it can give your career the necessary boost.
What is Financial Management in Businesses?
Financial management can be defined as the activities involving planning, raising, controlling, and administering money that is
used in the business. Financial management involves procuring funds for buying fixed assets, raw materials, and working
capital. Now that we know what financial management is, it is also important to understand that proper financial management
helps businesses supply better products and services to customers besides offering other benefits.
Objectives of Business Finance
The principal objectives of finance are to raise capital to earn adequate profit through investment, conservation, and efficient
utilization of investable capital.
7 objectives of business finance are;
=-Raising of Capital =-Investment of Capital =-Protection of Capital =-Minimization of Cost =-Maximization of Profit
=-Maximization of Wealth =-Maintain Firm Value
Raising of Capital: Finance’s first and foremost objective is to raise the capital needed for the organization concerned.
The financial manager attempts to raise the capital economically so that excess funds do not remain idle or a shortage of funds
does not create a bottleneck in running the business.
Investment of Capital: The second objective is to invest the capital raised appropriately and in proper sequence. By investment
of funds, we mean financial managers should decide where corporate money may be invested.
Generally, money should be invested where it will do the most good. In a corporate setting, this means being profitable.
Protection of Capital: It is also the objective of finance to protect the capital invested in the business. Uncertainty always
prevails in the business world.If the investment is made unwisely and un-prudently, it may bring disaster to the business unit.
Therefore, to fulfill the objective of finance, the risk of loss and protection of capital must be given due consideration.
Minimization of Cost: One objective of finance is to minimize the cost of funds to maximize shareholders’ wealth. That involves
examining all alternative sources of financing.A firm may decide to issue bonds instead of stock. Bonds are riskier than stocks;
on the other hand, bonds cost less than stocks. Here, the firm accepts the risk of borrowing in exchange for a lower cost of
funds.
Maximization of Profit: One of the important objectives of finance is to maximize the firm’s profit. The financial manager would
take actions expected to make a major contribution to the firm’s overall profits.
For each alternative being considered, the financial manager would select the one expected to result in the highest monetary
return.
Maximization of Wealth: The other most important objective of the firm is to maximize the wealth of the owners for whom it is
being operated. The wealth of corporate owners is measured by the share price of the stock, which in turn is based on the
timing of returns, magnitude, and risk.
Maintain Firm Value: One of the important objectives of finance is to maintain the firm’s value. It is generally believed that the
firm’s value is maximized when the cost of capital is minimized.
The optimum capital structure exists the value of the firm is maintained constantly. So, maintain firm value associated with the
formation of optimum capital structure.
Functions of Business Finance
Financial managers are all those individuals whose decision-making responsibility affects the firm’s financial health.
The principal functions of finance and the ones that will study listed below:
=-Decision-Making Functions of Business Finance =-Executive Functions of Business Finance / Routine Functions of Business Finance
1. Decision-Making Functions of Business Finance:
The functions of raising funds, investing them in assets, and distributing returns earned from assets to shareholders are
respectively discussed below;
=-Investment Decision =-Financing Decision =-Dividend Decision =-Liquidity Decision
Investment Decision: An investment decision involves the decision to the allocation of capital to long-term assets that would
provide benefits in the future. Two important aspects of the decision are;
 The evaluation of the prospective profitability of new investment, and
 The measurement of an expected return against the prospective return of new investments could be compared.
Financing Decision: Financing decision decides when, where, and how to acquire funds to meet the firms’ investment needs.
The central issue to determine is the proportion of equity and debt.
The mix of debt and equity is known as the firm’s capital structure. The financial manager must strive to obtain the best
financing mix or the optimum capital structure for the firm.
Dividend Decision: The financial manager must decide whether the firm should distribute all profits, retain them, or distribute a
portion and retain the balance. Like the debt policy, the dividend policy should be determined regarding its impact on the
shareholders’ value. The optimum dividend policy maximizes the market value of the firm’s shares.
Thus, if shareholders are not indifferent to the firm’s dividend policy, the financial manager must determine the optimum
dividend payout ratio.
Liquidity Decision: Current assets management that affects a firm’s liquidity is yet another important finance function, in
addition to managing long-term assets. Current assets should be managed efficiently to safeguard the firm against the dangers
of illiquidity and insolvency. Investment in current assets affects the firm’s profitability, liquidity, and risk. A conflict exists
between profitability and liquidity while managing current assets. Thus a proper trade-off must be achieved between
profitability and liquidity.
2. Executive Functions of Business Finance (Routine Functions of Business Finance)
For the effective execution of the finance functions, certain other functions have to be routinely performed:
=-Planning =-Financing =-Investing =-Capital Structure =-Dividend =-Current Asset =-Short-term Financing
=-Assessing Growth =-Cash Management =-Safeguarding =-Caretaking =-Record & Document
Planning: Planning for the ongoing activities of the firm and ensuring that the firm responds to the changing financial and
economic environment.
Financing: Evaluating, securing, and serving long-term financing from within the firm or from financial securities.
Investing: Investment and management of long-term assets through the capital budgeting process.
Capital Structure: Determination of the required rate of return through attention to the firm’s capital structure and
alternative sources of funds.
Dividend: Distribution of profits to the firm’s stockholders via a cash dividend policy.
Current Asset: Securing, managing, and investing in current assets such as cash, accounts receivable, and inventory.
Short-term Financing: Obtaining short-term financing from creditors or financial markets.
Assessing Growth: Assessing the viability of growth via merging and ensuring the economic vitality of the firm.
Cash Management: Supervised cash receipts and payments and safeguarded cash balances.
Safeguarding: Custody and safeguarding of securities, insurance policies, and other valuable papers.
Caretaking: Taking care of the mechanical details of new outside financing.
Record & Document: Record keeping and reporting the financial information. A firm performs finance functions
simultaneously and continuously in the normal course of the business.
They do not necessarily occur in a sequence. Finance functions require skillful planning, control, and execution of a firm’s
activities.
The product life cycle is broken into four stages: introduction, growth, maturity, and decline. 00:00/0

Major Areas & Opportunities in Finance: Finance and Business

Two broad areas:
Financial Services: is the area of finance concerned with the design and delivery of advice and financial products to individuals,
businesses, and government
**Career opportunities include banking, personal financial planning, investments, real estate, and insurance.
Managerial Finance: is concerned with the duties of the financial manager in the business firm.
The financial manager actively manages the financial affairs of any type of business, whether private or public, large or small,
profit-seeking or not-for-profit.
They are also more involved in developing corporate strategy and improving the firm’s competitive position.
Legal forms of business ownership:
Sole Trader: A business owned by one person and operated for his or her own profit
Partnership: A business operated by two or more people together for a profit.
Corporation: An intangible business entity created by law and is a separate ‘entity’ to its owners.
 Strengths and Weaknesses of the Common Legal Forms of Business Organization:
Sole proprietorship: Partnership: Corporation:
Strengths Weaknesses
Strengths Weaknesses Strengths Weaknesses
Owner receives all Owner has unlimited liability
Can raise more funds than Owners have unlimited Owners have limited liability, Taxes are generally higher
profits (and sustains all in that total wealth can be
sole  proprietorships liability  and may have to which guarantees that they because corporate income is
losses) taken to satisfy debts
cover debts of other cannot lose more than they taxed, and dividends paid to
Income included and Limited fund-raising power
partners invested owners are also taxed at a
taxed on proprietor’s tends to inhibit growth
Borrowing power enhanced Partnership is dissolved maximum 15% rate
personal tax return
by more owners when a partner dies Can achieve large size via sale of More expensive to organize than
Low organizational Proprietor must be jack-of-
More available brain power ownership (stock) other business forms
costs alltrades •
and managerial skill Ownership (stock) is readily Subject to greater government
Independence Difficult to give employees
transferable regulation
longrun career opportunities
Income included and taxed Difficult to liquidate or managers Has better access to Lacks secrecy because regulations
Secrecy lacks continuity when on partner’s personal tax transfer partnership financing require firms to disclose financial
proprietor dies return results
Ease of dissolution
Can hire professional
Long life of firm
Career opportunities in managerial finance:
=-Financial Analyst =-Capital Expenditure Manager =-Project Finance Manager
=-Cash Manager =-Credit Analyst/Manager =-Pension Fund Manager =-Foreign Exchange Manager
The Managerial Finance Function:
Organization of the finance function: Is dependent upon the size of the organization.
In large organizations the CFO is assisted by the:
Treasurer: responsible for the firm’s financial activities. Controller: responsible for the firm’s accounting activities.

Closely related to and often overlaps with two allied fields: =-Economics =-Accounting
Two key differences between accounting and finance: =-Emphasis on cash flows =-Decision making
Emphasis on cash flows:
Finance Managers: Focus is on cash flow and maintaining solvency. [Accounts are prepared on a cash basis]
Accounting Managers: Focus is on financial statement preparation and paying taxes. [Accounts are prepared on an accruals
basis]
Decision making:
Financial Managers: evaluate the accounting data and make decisions based on assessment of the associated risk and returns.
Accountants: focused on the collection and presentation of financial data.
Goal Of The Firm:
Profit maximization: taking only those actions that are expected to make a major contribution to the firm’s overall profit.
Doesn’t take into consideration: =-Timing of returns =-Cash flows available to shareholders =-Risk
Maximizing shareholder wealth: The goal of the firm, its managers and employees *********Measured by share price
Challenges posed by wealth maximization goal:
Stakeholders: preservation of positive stakeholder relationships often associated with “social responsibility”.
Corporate Governance: ethical and responsible governance to ensure sustainability.
Ethics: Maintaining high ethical standards both legally and morally.
Agency Issue: Management’s personal goals being placed before corporate goals.
Minimizing the agency problem:=- Market forces =-Agency costs
**Incentive plans: such as share options **Performance plans: such as performance shares and cash bonuses
The Managerial Finance Function: Relationship to Economics:
 The field of finance is actually an outgrowth of economics.
 In fact, finance is sometimes referred to as financial economics.
 Financial managers must understand the economic framework within which they operate in order to react or
anticipate to changes in conditions.
 The primary economic principal used by financial managers is marginal cost-benefit analysis which says that financial
decisions should be implemented only when added benefits exceed added costs.
The Managerial Finance Function: Relationship to Accounting:
• The firm’s finance (treasurer) and accounting (controller) functions are closely-related and overlapping.
• In smaller firms, the financial manager generally performs both functions.
 • One major difference in perspective and emphasis between finance and accounting is that accountants generally use
the accrual method while in finance, the focus is on cash flows.
• The significance of this difference can be illustrated using the following simple example.
• Finance and accounting also differ with respect to decision-making.
• While accounting is primarily concerned with the presentation of financial data, the financial manager is primarily
concerned with analyzing and interpreting this information for decision-making purposes.
• The financial manager uses this data as a vital tool for making decisions about the financial aspects of the firm.

Financial Institutions & Markets

Firms that require funds from external sources can obtain them in three ways:
=-through a bank or other financial institution =-through financial markets =-through private placements