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Financial Management 244 Term 3
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Summary of Financial Management 244 work covered in the third term (semester 2). INCLUDES: Chapters 1; 2; 8; 9 EXCLUDES: Most of chapter 3
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Financial Management 244Semester 2
Chapter 1: Introduction to Financial Management
Introduction
All businesses, even though they differ in nature, are guided by the same corporate financial
principles. The financial function of a business is primarily concerned with the flow of capital to and
from a business. More specifically, the financial function deals with 3 decisions that need to be
made: the financing decision (relating to where the business is going to source capital to finance the
activities); the investment decision (which assets and projects the business is going to invest their
finances); and the relationship between the acquisition and application of capital.
Defining Financial Management
Financial Management can be defined as the process of creating value within an organization. This
process consists of planning, organizing directing and controlling financial activities within a
business. Value is created when we see an increase in the wealth of the shareholders within the
organization. It is important to note that financial management consists of much more than just
keeping an eye on the firms’ books. People often confuse financial management with accounting.
Accounting follows a historical perspective, because they report on financial activities that have
already occurred within the financial year. Financial managers, on the other hand, focus on value
creation going forward, meaning that they use the information from the accountants in order to
make future financial decisions, in order to create this value for shareholders.
Links between Financial Management, Accounting and
Economics
Financial managers have to make decisions in an ever-changing economic environment, and
information (such as GDP, inflation, unemployment etc.) has an impact on the decisions that the
financial manager has to make, in order to ensure that value is created. In South Africa, given that
we are an emerging market, we are also more susceptible to adverse developments in global
financial markets, and these developments also need to be taken into consideration to make sure
that financial managers are making correct decisions that will be beneficial to the future of the firm.
Financial Management Decisions
The decisions that need to be made by financial managers can be categorized into 3 main groups:
What should the business should invest in? What assets and projects should be undertaken?
These form part of the capital-budgeting decision
Where will the business get the long-term financing that is required to pay for this business?
This forms part of the capital-structure decision. It answers the question of whether the
business will use debt or equity to finance the new
How will the business manage its day-to-day financial activities? This forms part of the
working-capital management decision.
Capital Budgeting Decision
This is the first main category of decisions taken by financial managers. This decision involves the
acquisition and management of non-current assets (also called capital project/investments). As
financial managers, we should always aim to create value, and only invest in value-adding non-
current assets. In order to determine whether or not a new investment will be value-adding, the
,financial manager needs to determine the net present value of that particular asset. To do this, you
need to determine:
Size: the size of the cash flows relates to, for example, how much initial investment is
required (cash outflow), and how much income this investment is going to make for the
business (cash inflows).
Timing: when will the investment take place and for how long will you receive an income
from it.
Risk: what is the likelihood of receiving that income – are you guaranteed to receive the
income, or is there some risk involved?
Only assets that yield a positive net present value are taken into consideration by the business.
Therefore, all positive NPVs are deemed to be value adding investments, and are thus the assets we
want to invest in. This then means that the cash flows exceed the actual cost that it is going to take
for the business to invest in them.
Capital Structure Decision
The next major category of financial management decisions relates to the capital structure of the
firm. This decision in concerned with the mi of debt and equity that a business uses to fund the
firm’s activities. There are essentially 3 options available to financial managers:
Borrow long-term funds (debt capital) – risk would increase as a result
Use savings of the company from previous years (retained earnings)
Issue more shares – however ownership within the organization will decline
Each of these options will have an effect on the risk and the value of the firm. As a financial manager,
it is important to ask yourself which form of financing is going to be the cheapest, because each
option will have its own costs associated with it. For example, with debt financing, the business will
have increased financing costs. For savings, there are minimal costs associated. For issuing more
shares, there will be a higher dividends amount paid out to all shareholders.
Working Capital Management Decision
The third main category of financial management decisions concerns how to manage working
capital. Working capital refers to your short-term assets and liabilities, and they typically include
inventory, cash, trade receivables, and trade payables. Decisions that need to be made are centered
around how to approach the day0to-dy financial management of the business. Will products be sold
for cash, credit or both? Who will receive credit? How many days will debtors have to pay
outstanding debt? Will expenses be paid in cash or credit? These decisions are important in order to
ensure that the firm is functioning efficiently, and there are sufficient resources available to ensure
that the business remains liquid and profitable within the organization.
Main Categories of Financial Decisions
One way to understand the interaction between these main categories of financial management
decisions is to look at a firm’s statement of financial position. On one side we have a firm’s assets,
and on the other side, the current and non-current liabilities, and the equity. All capital-budgeting
decisions take place on the asset side of the statement of financial position – which current/non-
current assets will the business invest in? The capital structure decision takes place in the equity and
liabilities side. How much debt is the business going to use and how much equity will they use in
order to finance the business? The working capital decision takes place between the current assets
and current liabilities.
The Goals of Financial Management
Financial managers need goals to motivate them when making decisions on behalf of a firm. They
may formulate a number of goals (such as increasing turnover; enhance market share; minimize
, costs; avoid insolvency). There are 3 goals that deserve more in-depth attention, given how
prevalent they are in financial management practice.
1. Profit Maximization: The main aim here is to maximize profits. This will either be done by
increasing revenue or decreasing other operating costs. However, there are 2 main flaws
associated with this goal: accounting profit can be manipulated through malpractice, and
profit maximization ignores the issue of timing and risk associated with generating that
profit.
2. Maximizing the Rate of Return: with this, the ratio of net profit after tax to total assets need
to be maximized. However, this goal has the same risk associated with profit maximization:
it uses accounting values which can be manipulated to calculate the rate of return.
Both of the above-mentioned goals are accounting based and reflect the historical performance of a
firm. If a manager is only going to look at past performance of a firm, the firm will most likely not be
able to grow.
3. Maximizing shareholder: this represents a forward-looking goal that is focused on increasing
the wealth of the shareholders of the firm. At any point in time, the shareholders wealth is
influenced by the number of issued shares and the current share price. As such, the financial
manager is only going to engage in activities that will positively influence the current share
price. The goal of maximizing shareholders wealth also focuses on, and considers both the
risk and the return, which already makes it an improved option over profit maximization and
the maximizing rate of return.
Profit maximization and maximizing the rate of return are seen as short-term goals, while
maximizing shareholders wealth is considered to be both a short-term, and long-term future
orientated goal.
Stakeholders
It is important to note that in addition to meeting the needs of shareholders, financial managers also
need to weigh up the needs of various other stakeholders. Stakeholders include all individuals
and/or organizations that have a stake or an interest in the business. These include shareholders,
but are expanded to, in addition, include employees, customers, suppliers, industry regulators and
also the general public. It is important to also consider the interests of other stakeholders of a
company, not just the shareholder’s interests. This is because stakeholders have been increasingly
affected by the consequences of various corporate scandals, and the business’ operations have an
increasing impact on various other stakeholders. Therefore, in order to in list stakeholder’s support,
it would make sense for a business to then take their interests into consideration as well.
The Corporate Forms of Business in South Africa
*self-study – pages 11 to 14*
The Agency Problem
In a sole proprietorship, the owners are also generally the managers, and so it is assumed that they
will then run the business in such a manner so as to maximize their own wealth. However, we know
that in most publicly listed companies, shares are held by a large number of shareholders, and these
shareholders cannot be involved in the day-to-day management of the business. As a result of this,
managers are appointed. Managers become agents and are obligated to maximize the interests of
those that have appointed them, known as principals. This relationship between the principal and
the agent is referred to as the agency relationship. The agency problem arises when the agent does
not make decisions based on the best interest of the principle. This means that managers make
decisions for the protection of their own best interest instead of focusing on what is best for the
shareholders.
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