CHAPTER NATURE, PURPOSE AND SCOPE OF FINANCIAL MANAGEMENT Expected Learning Outcomes Alter studying Chepler 1, you should be able to: Describe the nature, goal and basic scope of financial management. 2. Explain briefly the three major types of decisions that the Finance Manager makes. Discuss the importance or significance of financial management. Describe the relationship between Financial Management and Accounting. Describe the relationship between Financial Management and Economics. oooCHAPTER 1 NATURE, E AND SCOPE OF FINANCIAL MANAGEMENT NATURE OF FINANCIAL MANAGEMENT Financial Management, also referred to as managerial finance, corporate finance, and business finance, is a decision making, process concerned with Planning, acquiring and utilizing funds in a manner that achieves the firm's desired goals It is also described as the process for and the analysis of making, financial decisions in the business context. Financial management is part of a larger discipline called FINANCE which is a body of facts, priveiples, and theories relating to reising and using money by individuals, businesses, and governments. This concerns both financial management of profit-oriented business orgenizations particularly the corporate form of business, as well as, ‘oncepts and techniques that are applicable to individuals and to governments. ‘THE GOAL OF FINANCIAL MANAGEMENT Assuming that we confine ourselves to for-profit businesses, the goal of financial ‘management is to make money and add value for the owners. This goal, however, a litle vague and a more precise definition-is needed in order to have an objective basis for making and evaluating financial decisions. The financial ‘manager in a business enterprise must make decision for the owners of the fim. He must actin the owners’ or shareholders” best interest by making, decisions that increase the value of the firm or the value of the stock. ‘The appropriate goa forthe financial manager can thus be stated as follows: ‘The goal of fnanctal management isto maximize the current value per share (of the existing stack ar ownership in a business firm,4 Chapter | ‘The stated goal considers the fact that the sharoholders in a firm ae the residual ‘we mean that they are, ented only to what is left after ‘employees, supplier, creditors and anyone else with a lexitimate claim are paid their die. If-any of these groups go unpaid, the sharcholders or owners get nothing: So, if the shareholders aré-benefiting in the sense that the residual portion is growing, it must be true that everyone else is being benefited too, Because the goal of financiel management is to maximize the value of the share(s), there is a need to learn how to identify investments, arrangements and distribute satisfactory amount of dividends or share in the profits that favorably impact the value of the share(s) Finally, our goal does not imply that the financial manager should take illegal or tunethical actions in the hope of increasing the value of the equity in the firm. The financial manager should best serve the owners of the business by identifying goods and services that add value to the firm because they are desited and valued in the free market place SHARED PROSPERITY: NEW, BROADER GOAL OF BUSINESSES “Shared Prosperity: The Business Groups’ Response to Inequality and the Pandemic” (EXCERPTS) Philippine Inquirer, November 16, 2020 by Rex C. Drillon It ‘Aistorc event inthe annals of Phiippine business happened on Nov: 5, 2020. In that ‘event, 26 of the county's largest business and protessional associations signed @ Covenant for Shared Prosperity. ‘The signatories to this covenant included MAP, MBC, FINEX, PCCI, BAP, AMCHAM, ECCP, ICP, ISA and 16 other assoziatons. They. ae called the Philopine Business Groups or PBGs. Combined, they represent thousands of businesses and an even ‘greater numberof individual member-rofessonals committe to national development. Commitments of the PEGs In the Covenant for Shared Prospety, the PBGs.then pledged and signed the ‘commitments tothe folowing stakeholders 1. Commirments_to_employees: Recruit, tain and develop employees and rmaragers to be best tha they can be imespective of gener, alma mater, ge, ethnicty and religon; prove just compensation and benefis; promote meritocracy and encourage worksite harman,ats: Purpase and Scope of Financial Management 5. 2. Commitment to customers: Provide ork ‘quality products and services that are of Continuing value to customers; " 3. Commitment to suapliers: Treat tho joods, service and funds providers fairly, eticaly and wih respect ax they.'m tn, aw axpected & tot Bait Own ‘suppl in thet supply chain the same way: 4. Commitment to the comrunty: Ge setively involved in the communities whore ‘they operate in, wih particular attention to the needs of the disadvantaged in those communities; Commitment tothe envicmant: Protect and proserve the envionment forthe benet of curent and future generations by erplying environment-endly techrologis in all aspects of business operation: and 6 + Commitment to stockholders Daiver reasonable and just retums to and fait treatment of the controling and nonconrling sharehlders. In forthcoming year, the signatory associations and ther member companies shal issue poly statement tret embody the commitents of these member companies to their respecive six siaeholirs, namely: Employees, Customers, Supple, Community Emironment and Shareholders, They wore advised to adopt he 21 metics on shared prosperty as developed by the Word Econo Forum It has been said thatthe imate end ofthe corporate govemarce advocacy is sharing the prosperity thats, te help companies create wea eticaly end to share that weath ike good stewart, eradeat poverty. Wie all know thatthe uttmate soluton to povety is jobs, jb end more jobs. Corporations can help create more jobs ~ by goveming well because good governance enables. ‘Companies to ea more and gow bigger fase, thereby creating more jobs, ‘When people have bs, they dont go hungry. When poop have jobs, they can afford to {0 to school or send ther chien to schoo. When people have jobs, they dont despair ‘hey can hope, they can dream. Jobs feed the stomach, jobs fed the mind, and jobs feed the spirit.Cpe) Inequality, inclusivity ven before the pandemic, meny in tho lcal business have boon srugling wih how the ayn genera, end Pili Buses, n para, should esd (0 to gota protien of inequality and inst, As this were nt enough, the COVID-19 pandemic ‘came and has shaken the very oundtions of the global society and economy with the Prippines being one ofthe werst it In tho county, hundreds of thousands had been afected and thousands have died Because of COVID-A8, Just as bad, if not worse, tens of thousands of businesses, partcualy mieo, small and medium enterprises, have closed down, mllons have lost thor obs and the economy received terible beating, contacting by 16.5 percent in he second quart lone. {tis sale to assume that proportionately, our county is not very far, if not worse, from the {erie global problem of inequality. Our poverty incidence, for on. is among the highest inthe region. The role ofthe Finance Function can not be overemphasized in attaining ‘hose stratogic objectives because all of these goals will require decisions on proper sourcing and allocation of funds. Financial Management and Public Responsibility Finance is a very challenging and rewarding fed. Finencial managers are given the responsibilty to plan the future growth and direction ofa firm which can greatly affect he community in which ti based. The decisions reached by @ financial manager uate represent a blend of theoretical, technical and judgmental matters that must reflect the concems of society. ‘The primary goal for managers of publy owned companies implies that decisions should te made fo maxinize the lng-nn value ofthe frm’ equiy share. At the same tne, managers know that this does not mean maxinize shareholder value “at all costs" Managers have the obligation to behave ethically and they must follow the lw and other soclety-imposed constraints. Financial managers have certain cigations to those who entrust them with the running of the fim. They must have a clear sense of ethics and must avoid pay offs or other forms of ‘personal gain, Managers should not engage in practices that can damage the image of te fm but should partculate as much as possible in social acts to demonstrate tat they are cogrizant ofthe importance of the community and those who buy their products or services.Natwre. Purpose and: ee of Finance Menagement 7 uncial manager 5 Tequiements wih proitmaking MUS nse social and. enviromental produce the most effe Site is the image of the firm, Lease Sion college education fre Sew calle Sependets of ill maximize the firm's wealth, as well fetus {9 the business concer. Briefly, the tational vic Monagement looks into the following functions that a fnancie! ‘business firm will perform: 1. Procurement of short-term as well 45 longterm finds from financial institutions 2. Mobilization of funds 1 through financial instruments such as equity shares, preference shares, debentures, bonds, notes, and so forth Compliance with legal and regulatory provisions relating to funds Procurement, use and distribution as well as coordination ofthe finance function with the accounting function With modem business situation increasing in, complexity, the role of Finance Manager which iil i jus confined to acustion of finds, expanded o judicious and efficient use of funds avilable othe fim, Keeping im view the objectives of the firms and expectations of the providers of funds.3 Chapin) Moré recently though, with the globalization and liberalization of world economy, tremendous reforms in financial sector evolved in order to promote more diversified, efficient and competitive financel system in the country. The financial reforms’ coupled with the diffusion of information technology have brought intense competition, mergers, takeovers, cost management, quality improvement, financial discipline and so forth Globalization has caused to integrate the national economy with the global economy and. has created a new financial environment which brings new opportunities and challenges to the business enterprises. This development has ‘also led to total reformation of the finance function and its responsibilities i organization, Financial management has assumed a much greater significance and the role of the finance managers has been given a fresh perspective, In view of modern approach, the Finance Manager is expected 10 enly2s the business frm and determine the total Funds requirments ofthe fim, the asets or resources to be acquired, the best pattem of financing the assets and how best to Satisfy the investors” expected return on their investment. ‘TYPES OF FINANCIAL DECISIONS ‘The three major types of decisions that the Finance Manager of a modem business firm will be involved in are: 1. Investment decisions 2, Financing decisions 3. Dividend dec im to maxiniize the shareholders’ wealth through All these decisions. ‘maximization of the firm's wealth,FINANCING DECISIONS Financing decisions assert that the mix of debt and equity chosen to fiance investment should maximize the value of investnents made. ‘The finance devsions should consider the cost of finance available in different forms and the risks attached to it. The principle of financial leverage ce trading ‘onthe equity shouldbe considered when selecting the dett-equity mix or capital structore decision. If the ens of capital ofeach component is reduced, the overall ‘weighted average cost of capital and minithization of risks in financing will ad to the profitability ofthe organization and create wealth othe owner. DIvieNo Decisions ‘The dividend decision is concerned with the determination of quantum of profits 1 be distributed to the owners, the fequency of such payments and the amounts to be retained by the fim. ‘The dividend distribution polices and retention of profits will have ultimate effect on the firm's wealth. The bosines firm shuld retain its profits inthe form Of appropriations or reserves for financing is future prowth and expansion Schemes. If the fie, however, adopts a very conservative dividend payments Policy, the fitm's share prices in the market could be adversely affected. An ‘optimal dividend distribution policy therefore will lead to the maximization of sharcholcers' wealth To summarize, the basic objectve'of the investment, financing and dividend decision isto maimize the firm's wealth. f the firm enjoys the stability nd Aarowth, ts share prices in the market will improve and will lead to capital Appreciation of shareholders’ investmeat and ultimately maxi shareholders’ wealth$0 chapeer) SIGNIFICANCE OF FINANCIAL MANAGEMENT ‘The importance of financial management is known for the following aspects: BROAD APPLICABILITY ‘Any organization whether motivated with earning profit or not having cash flow requires to be viewed from the angle of financial discipline. The principles of finance are applicable wherever there is cash flow. The concept of cash flow is ‘one of the central elements of financial analysis, planning, control, and resource allocation decisions. Cath flow is important because the financial health of the firm depends on its ability to generate sufficient amounts of cash to pay its ‘employees, suppliers, creditors, and owners. Financial management is equally applicable to all. forms of business like sole traders, partnerships, and corporations. It is also applicable to nonprofit ‘organizations like trust, societies, government organizations, public sectors, and 0 forth. [REDUCTION OF CHANCES OF FAILURE A firm having latest technology, sophisticated machinery, high caliber marketing and technical experts, and so forth may still fail unless its finances are managed ‘on sound principles of financial management. The strength of business lies in its financial discipline. Therefore, finance function is treated as primordial which enables the other functions like production, marketing, purchase, and personnel to be effective in the achievement of organizational goal and objectives, MEASUREMENT OF RETURN ON INVESTMENT Anybody who invests his money will expect to eam a reasonable return on investment. The owners of business try to maximize their wealth. Financi ‘management studies the rsk-return perception of the owners and the time value ‘of money. It considers the amount of cash flows expected to be generated for the benefit of owners, the timing of these cash flows and the risk attached to these ‘cash flows. The greater the time and risk associated with the expected cash flow, the greater is the rate of return required by the owners,12 Parzen ant Scope of Financil Management 11, RELATIONSHIP BETWEEN RECOUNTING AND eee RINANCIAL MANAGEMENT, FINANCIAL MANAGEMENT AND ACCOUNTING Just as marketing and production are majrfunetions in an enterprise, finance t00 isan independent specialized funtion and is well knit with other functions. Financial management is separa management area. in many organizations counting and finance fnctions are inrtwined andthe finance func sc considered 4s part of the functions ofthe accountant. Financial management however, something, more than an at of scouring and. bookhee ‘Accounting, function discharges the fanction of systematic. recording, of transactions relating to the fem’s actives in the books of accounts and summarizing the save for presemation ia the Mancilsiatmens such a8 the Statement of Comprehorsve Income, the Statement of Financial Poston, the ‘Siatement of Changes in Sharehalders' Equity and the Cath flow Statement. Financial statements help managers to make business decisions involving the best use of cash, the attainment of efficient operations, the optimal allocation of funds famong assets, and the effective Financing of invesunent and operations. The interpretation of financial statements is achieved partly by using financial ratios, ‘ro forma and cash flow statement. ‘The finance manager will make use ofthe accountng information in the analysis ‘nd review ofthe Firm's business postion indecision making. In dition tothe ‘analysis of financial information available from the books of accounts and ‘records ofthe firm, a finance manager uses the other methods and techniques ike capital budgeting techniques, statistical ard mathematical models, and computer applications in decision making to maximize the value of the firms wealth and value ofthe owner's wealth. In view ofthe above, fnanco function is considered ‘distinct and separate function rather than simply an extension of accourting function, It should be pointed out that the managers of «firm are supplied with more detailed statistical information than appears in published financial statements ‘These data are especially important in developing cash flow concepts for evaluating the relative meis of different investment projects.$2 Chapter mine incremental eash flows (an ‘This information permits managers to dee merwtas com approach that Tooks atthe net retusa given project generates in comparison ‘with allemative investmenis), thus enabling them to make more accurate assessments of the profitabiltes of specific investments. It is the responsibilty fof managers to direct their accountants to prepare infernal statements that include this information so that they can make the best invesiment decisions possible, Finacial management is the Key fntion and many firms prefer to centralize the fincton tokecp constant corte onthe finances ofthe frm. Any ineTciney a financial management wil be conluded witha disastrous situation. But as fae the routine maters are concerned, the finance funtion could be decentralised ‘with adoption of responsibilty acounting. concept It advantageous ecentalize accounting fanction to speedup te processing of information, Bix since the accounting information wood in making financial deisiona rors onto shouldbe exercised n processing of accurate and eile information to the needs of the Firm. The centralization or decentralization accounting ass finance factions mainly depends on the atte ofthe fp level management FINANCIAL MANAGEMENT AND ECONOMICS Financial managers can make better decisions if they apply these basic economic principles. For example, economic theory teaches us to seek the best allocation of, Fesources. To this end, financial managers are given the responsibility to find the best and least expensive sources of funds and to invest these funds into the best and most efficient mix of assets. In doing so, they try to find the mix of available ‘resources that will achieve the highest return at the least risk within the confines of an expected change in the economic climate. Goed financial management has & sound grasp of the way economic and financial principles impact the profitability of the fiem, Financial managers do a better job when they understand how to respond «effectively to changes in supply, demand, and prices (firm-related micro factors). a well as no more general and overall economic factors (macro factors) Leaning to deal with these factors provides important tools for effective financial planning, ‘The finance manager must_be familiar with the microeconomic and ‘macroeconomic environment aspects of business._ Mates Pepe nd eo Prat Meapenen 13 When making inverment deo, fuana TREE SDN femand n pceeotta es f Understanding the nature of these fcr. help ree dvanageous operating dco has beso ina ty stares bondoc ser fe The sale of products a profit depends hea analyze and intrpret supply and demand seal accomplish this, statstieal technique in sales eke plac, the best managers develop and adopt reliable, workable 5 that forecast demard and pinpoin when dietional changes ‘Microeconomics deals with the economic decisions of individuals and fis. It focuses on the optimal operating sregies tased on the eoouomic. daa of individuals and firs. The coneept of mierdecanomis helps the nance manager in decisions ike pricing, taxation, determination of capacity and operating levels, break-even analysis, volumecost-profe analysis, capital structure, decisions, dividend distibution decisions, profitable productmix decisions. fation of levels of inventory, setting the optimum eash balance, pricing of waranty and ‘Options, interest ate structure, prsert velue of esh flows and so forth, ‘Macroeconomics looks athe economy 38 whole in which paicalar business concer is operating. Macroeconomics provies insight into polices by whieh economic activity i controlled. The suceess ofthe busines firm is influenced by the overall performance af the economy ard i dependent upon the money nd pital markets, since the invest fonds ae to be procured fom the finan markets. A frm ie operating within the institutional framework, which operates ‘on the macrosconomie theories.BBA Chopter 1 = The governments fiscal and monetary policies will influence the strategie financial planning ofthe enterprise. The finance manager should also Iook inns the other macroeconomic factors like rate of infation, rel intrest rates, level et seonomic asivity, trade cycles, market competition both from new entamts ang substitutes, intemational business conditions, foreign exchange rates, bargun} Power of buyers, unionization of labor, demestic savings rate, depth of finan markets, avabily of finds in capital markets, growth rate of egonon, govemments foreign policy, financial intermediation, banking system, an forth, The concep of Financial management are equally applicable to both private fect undertakings end publi sector enterprises, but the rules, proces wy ec Guntailty of financial decision are more rigid in PSES as they ae fianees py the government cut of tes collected frm the pubic. The majority oft puis Sector industries are budget financed by the government and are subjects i rect regulation as regarding funding and pring policies, The public sector accountng information system is also euite dens om that adopted by the private sector because of the need to prepare cae information as per requirement of the Commission on Audit and ver dene sr0up of interested parties.Finan 138 REVIEW QUESTIONS AND PROBLEMS Questions What is the purpose of financial management? Describe the kings of ‘sctvities that financial management deals with ‘What isthe difference in perspective between finance and accounting? Explain the shareholder welts maxiizaton goal ofthe frm and how it ‘can be measured. Make an argument for why itis « better goal ian maximizing profit. "Name and describe a many corporate stakeholder a you can, ‘What conflicts of intrest can aise between managers end stockholders? ‘What are the thrce types of financial management decisions? For each {ype of decision, give an example of a business transaction that would be relevant, ‘What gost should always motivate the action of a firm's financit manager? ‘What do financial managers try to maximize, and whats their second objective? In tying to achieve optimum profits, whet may a firm, ignore? State the kinds of assurances tht investors and creditors seek fom & firm, ‘What environmental considerations prevent the firm fom achieving the best results in terms of cost control and profitability? Explain what this . What are some of the miero- and macro-seonomics factors that influence the decisions ofa finn?Chee 1 sccouning statements help the manager monitor a fms 13, Wa tee Sia ca he tance sect cll he fry about say fd financial structure? 14, What are some of the nonfinancial aspects of the manager's role in society, such as responsibility toward workers, crestment of monitorie, and dealing with gender problems? 15, Besides maximizing the wealth of the firm, what are some of the other goals of financial management? Multiple Choice Questions |. What isthe primary goa! of financial management? a. Increase earnings b. Maximizing cashflow Maximizing shareholders’ wealth Minimizing risk ofthe firm 2. Proper return management means that 2. the firm should take as few risks as possible, consistent with the objectives of the firm, an appropriate trade- Off between risk and return should be determined. ‘c. _the firm should ear highest return possible. 4. the firm should value future profits more highly than current profits, 3. Which ofthe following is not a major afea of concern and emphasis in moder financial management? a. Inflation and its effect on profits b, Stable short-term interest rates ©. Changing international environment 4. Increased reliance on debt 4, Which of the following is not a major area of concer and emphasis inmedem financial management? 8, Marginal analysis b. Risk-retum trade-off © Commodity trading 4. Changing financial institutions.Nate Purpose end Scope of Financia 13D 5. ‘auings may te ppp because ic lu cosider te tiniog of the bene Ineo earnings ay be sesmpanied Wy anacceplably higher Yea reer dae eer, : 1 © amings af subjective: they can be defined in a vey Sch 5 scouting or econo arings 4. Aloft gen chocs, 6. Allof the following se fanatins ofthe financial manager except ‘Analyzing and planning the company’s performance . Anticipating the company's Financial neds Assigning the market price ofthe company's tock. 4. “Allocating the funds Ge most profiable ase, 7. Which fe flowing statement ial? 1 The racing destin ils the res of allcting fonds for invest im competing et 1 The teamer would be eonible fr aves such as managing Cashlace, ranting “nto artomers and managing te poet Stioing ow ert: ‘The opin! capital src isthe best conbion of long-term desoniys 4. Wit meer © dtersine the appropri ickret nde to mimi the mart value of the mfr sharcolar