Financial Management Function

Investment Decisions Financing Decisions

Fixed Assets Current Assets Equity Debt

Land
Cash A/P
Buildings Preferred Stocks
Marketable Sec. N/P
Equipment Common Stocks
A/R Accruals
Furniture Retained Earnings
Inventories Long Term Debt
Vehicles
Planning to provide funds in appropriate quantities, at appropriate times, and at
acceptable costs, for the purpose of investing those funds to achieve the
maximum possible return, in addition to assuming financial control over the uses
and sources of funds.
Maximize Shareholder Wealth Maximize Profits

Market Value of share Earnings per share (EPS)

Does profit maximization lead to the highest possible share price?
Timing:
Because the firm can earn a return on funds it receives, the receipt of funds sooner
rather than later is preferred. In our example, even though the total earnings from
Rotor are smaller than those from Valve, Rotor provides much greater earnings per
share in the first year. It’s possible that by investing in Rotor, Neptune Manufacturing
can reinvest the earnings that it receives in year 1 to generate higher profits overall
than if it had invested in project Valve. If the rate of return that Neptune can earn on
reinvested earnings is high enough, project Rotor may be preferred even though it does
not alone maximize total profits.
Cash Flows:
Profits do not necessarily result in cash flows available to the stockholders. There is
no guarantee that the board of directors will increase dividends when profits increase.
In addition, the accounting assumptions and techniques that a firm adopts can
sometimes allow a firm to show a positive profit even when its cash outflows exceed its
cash inflows. Furthermore, higher earnings do not necessarily translate into a higher
stock price. Only when earnings increases are accompanied by increased future cash
flows is a higher stock price expected.
Cash Flows:
For example, a firm with a high-quality product sold in a very competitive market
could increase its earnings by significantly reducing its equipment maintenance
expenditures. The firm’s expenses would be reduced, thereby increasing its profits. If
the reduced maintenance results in lower product quality, however, the firm may impair
its competitive position, and its stock price could drop as many well-informed investors
sell the stock in anticipation of lower future cash flows. In this case, the earnings
increase was accompanied by lower future cash flows and therefore a lower stock price.
Risk:
Profit maximization also fails to account for risk, the chance that actual outcomes
may differ from those expected. A basic premise in managerial finance is that a trade-
off exists between return (cash flow) and risk. Return and risk are, in fact, the key
determinants of share price, which represents the wealth of the owners in the firm.
Cash flow and risk affect share price differently: Holding risk fixed, higher cash flow is
generally associated with a higher share price. In contrast, holding cash flow fixed,
higher risk tends to result in a lower share price because the stockholders do not like
risk. In general, stockholders are risk averse, which means that they are only willing to
bear risk if they expect compensation for doing so. In other words, investors expect to
earn higher returns on riskier investments, and they will accept lower returns on
relatively safe investments.
 Emphasis on Cash Flows

Accrual Basis Cash Basis

In preparation of financial
statements, recognizes
Recognizes revenues and
revenue at the time of sale
expenses only with respect
(whether payment has been
to actual inflows and
received or not) and
outflows of cash.
recognizes expenses when
they are incurred.
 Decision Making

Financial managers evaluate

Accountants devote most
of their attention to the
collection and presentation
of financial data.
the accounting statements,
develop additional data, and
make decisions on the basis
of their assessment of the
associated returns and risks.
Accounting System

Financial Statements
 Financial Management System

Financial Statements Investment Decisions

Financing Decisions