MODULE I: AN OVERVIEW OF FINANCIAL MANAGEMENT R.O. MARAMBA OBJECTIVES: At the end of this topic, the students will be able to: 1. Know and explain the evolution of finance as a recognized field of study. 2. Know and explain the goals and functions of Financial Management: and 3. Research and discuss the recent economic developments establishing their implications to financial management. Definition of Financial Managerment Financial Management is the application of general principles of management to financial possessions of an enterprise. It is also a vital activity in any organization. It is a planning, organizing, controlling and monitoring financial resources with a view to achieve organizational goals and objectives. Goals of Financial Management The objectives of the enterprise and financial management may be identical. One could maintain that the company's top priority is to generate the highest profit for the company. If we accept this answer, the company would evaluate each choice it makes in terms of the revenue that would be flowing in. The greatest option would be the plan that generated the most revenue. While this method may be straightforward and very desirable, it does have some significant flaws or disadvantages. Let us consider the first drawback. Changes in profit may also mean changes in risk. An enterprise with earnings per share (EPS) of say P150/share may be less acceptable if its EPS would be P175/share. BUT deeper consideration of this would lead you to think that intrinsic risk or the risk that goes with those two alternatives increase, Now the second drawback of the maximizing profit approach is that it does not fully take into account the timing when the profit/gain would be received. Consider the matrix below which shows two alternatives as to which one would your firm consider investing into: Nico Corporation's Ordinary Shares Riel Corporation's Ordinary Shares Earnings Per Share Year 2010 Year 2011 Total P 300 P 450 P 750 450 300 750 If the company’s framework of mind is merely maximizing profit, one may say that they can invest in either Nico or Riel Corporation since the yield is the same. However, Riel Corporation is definitely a better choice. Why? Because, Riel Corporation's benefits occur earlier. This means that your company can reinvest the P150/share (P450-P300) difference in earnings a year earlier than if you chose to invest in Nico Corporation. Get it? The last drawback that one may experience using the maximizing the profit approach as the main goal of the company is the accurate measuring of the key ingredient in this approach, which is profit. Why? The reason is because it is practically impossible to accomplish this. You could respond, "Well, we compute income all the time in our accounting courses," which is true, but there are other ways to define profit. There are several accounting and economic definitions of profit. Every definition is open to various interpretations. The issue is complicated by economic phenomena including inflation, deflation, and foreign exchange transaction variables. Although techniques for financial accounting and reporting are constantly changing to address these concerns, numerous issues still persist. Categories Used To Group Financial Management Goals: Maximization of the value of the firm (Valuation Approach) Maximization of Shareholder Wealth Social Responsibility and Ethical Behavior Valuation Approach It is not the intention of the explanation above to minimize the significance of profit. Let's just emphasize how crucial profit maximization is. This is not primordial, though. The true test of performance is not how much income is made, but rather how much the company's owners appreciate that income. What does this mean? This means that the main goal of financial management is to maximize not profit alone, but the maximization of overall value of the firm, thus it is called the Valuation Approach. Therefore, in considering investment proposals or decisions, the financial manager should not only consider profit, he/she must also consider among other things the: Risk attached to the investment proposal or the company's operation. Time design as to when and how the profits will flow into the company. This refers to as to when will the profits flow into the company and furthermore, more when will there be an upsurge or decline of profit (refer to example of Nico and Riel Corporation). The quality and reliability of the profits reported by the firm. Therefore, a wise financial manager should analyze how all of these may affect the company's overall valuation. A decision is acceptable if it maintains the status quo or increases the firm's overall value. Maximization of Shareholders' Wealth Maximizing shareholder wealth is regarded as the company's primary objective. However, this is not a simple task. The market value of the company's stocks is not directly under the control of managers. Even if a firm proves to be stable and profitable, market value of stocks may not always be high. This is particularly true when economic, political, and social factors are causing stock market prices to decline. The main concern of shareholders is not so much with the day-to-day movements of the stock market price, but with the long-term wealth of the shareholders. In the 1950s and 1960s, the focus was on increasing earnings; in the 1970s and 1980s, it was on lowering risks and high current dividend payments. What actions should a financial manager make in order to maximize the value of the company's stock? Does it mean that maximizing profit results to maximizing the company's stock values? We just gave you two hanging questions on the previous paragraph. However, for one to answer the question, we need to consider the company's income or profits vis-avis earnings per share (EPS). We suggest that you review your knowledge of EPS in your acShares outstanding Year-end Net Income Year 2010 100,000 P500,000 Year 2011 200,000 P600,000 counting subjects. To guide us in finding the answer, let us consider the example below. Example: Observe the data of Nico Corporation: You own 100 shares of Nico Corporation. Year Percentage of ownership Share of net income Earnings Per Share 2010 100 shares/100,000 shares=1% 1%xP500,000= P5,000 P500,000/100,000 shares =P5/share 2011 100 shares/200,000 shares=0.5% 0.5%xP600,000= P3,000 P600,000/200,000shs = P3/share Analysis: EPS = Net Income / Shares outstanding Interpretation: We can interpret, based on the data provided and the analysis made, that the company-wide profit increased by P100,000 in 2011. Your share of net income decreased by P2,000. The EPS decreased by P2/share in 2011. Furthermore, you suffered with the other shareholders an earnings dilution despite the increase in total corporate profit. Conclusion: Since profits increase by P100,000, your share of net income decreased by P2,000 and the company's earnings per share diminished by P2/share, we can therefore infer two things. First, that profit maximization does not necessarily mean stock value maximization. Lastly, considering other things being constant, if the company is truly concerned with the welfare of its shareholders, it should focus on EPS rather than on total company profits. Social Responsibility Social responsibility is an issue that needs to be considered. Can one reconcile the need of the firm for wealth maximization and the need of the firm to be socially responsible? Stated differently, can a firm be socially responsible while focusing on maximizing the shareholders' wealth or maximizing the overall value of the firm? In most cases, they can be reconciled. The corporation would be able to attract more capital, help reduce unemployment, and provide services to the community by employing strategies that would maximize wealth and corporate market value. This is not always the case, though. Salary distribution, recruiting procedures, product security, minority training, anti-pollution initiatives, and product pricing may occasionally conflict with maximizing corporate value. Installing costly pollution control equipment is not regarded as profitable. Should businesses stop utilizing these gadgets, then? A resounding NO. It is easy to say no. However, to resolve issues like these, companies belonging to the same industry must do a concerted effort in being socially responsible.Why concerted? Concerted because, if only.one company opts to be socially responsible that “martyr “would not survive. For instance if only Company X opts to acquire the antipollution device which is costly, the price of the products sold by Company X needs to be increased. Company Y and Company Z, both without the anti-pollution device, can sell their products at a lesser price. Company X will be at a disadvantage. However, will companies be willing to voluntarily participate in this concerted effort? Not always. Therefore, a more acceptable solution to this is to allow certain cost-augmenting measures to be compulsory rather than voluntary to guarantee that the burden falls uniformly on all the businesses. Companies X, Y and Z, thus making the cost less burdensome, will now carry relating this to the anti-pollution example, the cost of putting an anti-pollution device. However, who will make this compulsory? Answer - Government agencies. A coordinated effort between the industry and the government can make this solution more feasible. Since they spend a lot on advertising, some businesses that have made the "enlightened" decision to be socially responsible claim that their socially responsible actions and measures may not necessarily be too costly because consumers tend to buy more from companies that practice social responsibility. Functions of Financial Management The functions of financial management are actually the topics we shall cover in this book. Financial management involves the prudent allotment and spreading of company funds to current assets and non-current assets. An effective and efficient financial management entail the creation of a well-balanced blend of financing activities and to formulate the suitable dividend policy that is coherent with the firm's business objectives. Some of these general functions are carried out on a daily basis like cash management, inventory management, credit management, and fund receipt; and disbursement manage-ment. Other activities not done on a daily basis but rather irregularly would include company stock and bond issuance, capital budgeting and creating dividend policies. It is important to note that while daily and irregular activities are managed, the financial manager must be able to balance making income and considering the inherent risks on decisions made. This balancing act between income and risk is referred to as risk-return trade-offs. The financial manager must strike a balance between the highest possible income with the most reasonable amount of risk. This balancing act requires expertise that is gained through studying and experience. All these activities plus the balance of the risk-return trade-off is done to achieve the primordial goal financial management, which is to maximize the shareholders' wealth. Financial Manager's Responsibilities The responsibilities of a financial manager are closely linked with the function of finan-cial management. The particular activities inherent to a financial manager's job would be: 1. Forecasting and Planning. The financial manager does not function alone. He/She must be able to work together with other managers in formulating strategic as well as operative plans necessary to form the company's desired position. 2. Making Crucial Investment & Financing Decisions. Increasing sales or increasing demand for services from companies require investing money for acquisition of property, plant and equipment (PPE), and inventory. The financial manager must help decide on the appropriate amount of PPE to be acquired and determine the sources of funds to finance such acquisitions. 3. Coordinating and Controlling. It is very important for all managers, financial or otherwise, to coordinate with each other. As mentioned in number one, the financial manager works and coordinates with other executives to guarantee efficient operation of the firm. All business decisions made by other executives in the firm have financial implications. For instance, proposals made by marketing managers on improving sales of a product line may entail acquisition of new equipment, which in turn entails cash disbursements. Therefore, marketing managers must carefully take into account how their decisions and actions affect other factors like fund availability, inventory requirements, and plant acquisition, capacity and utility. 4. Trading in Financial markets. It is crucial for financial managers to have their “hands on dealings” with the financial markets. These markets are those involved in the trading of debt and equity securities. Financial managers are often task to trade the equity securities of the firm in the financial market. In doing so, the firm is affected and at the same time affecting other firms. The effect is that investors are either making or losing money in trading. 5. Risk Management. No business entity is ever free from risks. The risk may come in terms of financial risks where prices of commodities, currency exchange rates and interest rates fluctuate; or the risk may even come in terms of natural calamities like floods, fires, and earthquakes. A well-skilled financial manager however, can deter the effects of these risks by availing of the appropriate and adequate insurance for the firm, or by hedging in the derivatives market. In addition to this, ·the financial manager is also accountable for the entity's risk management policies and programs that involve the detection of the risks. Risks that the entity should efficiently hedge itself against. ALTERNATIVE FORMS OF BUSINESS ORGANIZATION There are three basic forms of business organizations. These are: (1) sole proprietor-ships; (2) partnerships; and (3) corporations. Sole Proprietorship. This considered as the oldest, most common, and simplest form of business organization. This is a form of business entity, where there is only one owner, hence the word sole. The customary feature of a sole proprietorship is that the owner is inseparable from the business. One may say that they are the same entity. (Reconcile this with the separate entity concept you have learned in your basic accounting). This type of entity offers a number of benefits. First of which is simplicity in decision making, since only one person makes all the major decisions. Other advantages would be that it is easy and inexpensive to form, subject to few government regulations. An aspect of the “same entity” concept is that taxes on a sole proprietorship are determined at the personal income tax rate of the owner. In other words, a sole proprietorship does not pay taxes separately from the owner. It is not subject to corporate income taxes. However, there are drawbacks to this form of business organization. Due to its very nature, it would be difficult for a single proprietor to come up with a sizable amount of capital. Another aspect of the “same entity” concept is that the owner of a sole proprietorship has complete control over the business, its operations, and is financially and legally responsible for all debts and legal actions against the business. This “same entity” aspect of the sole proprietorship invariably creates another drawback. The proprietor has unlimited personal liability for the payables or financial obligations of the firm. This means that the owner is liable to pay with his personal properties, liabilities not covered by their assets. Lastly, the life of the company is limited to the life of the proprietor. Partnership. This exists when two or more persons combine their resources to conduct business, earn profit, and distribute among themselves the results of their operations. The contract evidencing its existence is called the articles of partnership. The main advantage of a partnership would be its low cost and ease of formation. The disadvantages are similar to a sole proprietorship: unlimited liability, limited life, difficulty of transferring ownership since this would lead to dissolution of the partnership, difficulty of amassing a large amount of capital. As mentioned in the previous paragraph, partnerships are typically unlimited. This would mean that the partners are liable to pay obligations beyond their contributions. Just like a sole proprietorship, a partnership has unlimited liabilities. The partners are obliged to pay the company debts with their personal properties not covered by the investments made by the owners or not covered by the assets of the company. These partnerships are called general or unlimited liability partnerships. Partnership firms are common but not limited to professionals like doctors, lawyers, accountants, architects and other service-oriented professionals. Corporation. This is a legal business entity created by the government. This does not follow the same entity concept. It is considered as separate and distinct from its owners and executives. The contract evidencing the existence of a corporation is called articles of incorporation. The articles of incorporation present the rights and limitations of the entity. This form of business entity has a number of advantages. First of which, is unlimited life. Changes in ownerships or death of owners do not dissolve the corporation. Another advantage is ease of transferability of ownership. Unlike a partnership where the consent of the partners are required for the admission of an incoming partner(s), the corporation transfers ownership through the selling and buying of shares of stocks. Last advantage would be limited liability. Since the owners are separate and distinct from the corporation, the owners are not obliged to pay financial obligations not covered by company assets using their personal properties. Hybrid Forms of Organization Typically, partnerships are considered general or better known as unlimited liability partnerships. This was discussed previously. However, another type of partnership exists, the limited liability partnership (LLP). Under this type, the partnership is composed of at least one general partner and the rest are limited partners. In this scenario, the limited partners do not have control in company operations. As the name indicates, the limited partners are liable only for their investments. This specific characteristic makes the LLP a hybrid because although the firm is a partnership, it has the benefit of a corporation-like firm where the owners are not obliged to pay company debts with their personal properties. AGENCY RELATIONSHIPS Whenever a person or a group of persons (principal) employs another person or group of persons (agency), to render service(s) and at the same time delegates’ decisionmaking authority to the agent, an agency relationship exists. In financial management parlance agency relationships exists between the company's shareholders and managers, and between creditors and owners. Agency Conflicts ' We know for that a shareholder's primary goal is wealth maximization. There could be a conflict of interest if the manager, is also a partial owner of the same firm. The manager's primary goal is to maximize the size of the firm and by doing so he stabilizes job security for himself and for all the employees of the firm, and ultimately, increase his position, status, perquisites and salary, thus the shareholder's primary goal of wealth maximization might be set aside. It can be argued that since there are managers owning a small portion of the corporate share they are hungry for salary increases and perquisites at the cost of shareholders that are not managers. Agency Costs There are means by which managers can be persuaded to maximize the company's stock price or maximize wealth and act for the shareholders' best interest. However, this would entail costs. The costs could come in terms of audit costs, which is geared towards monitoring managerial actions, and restructuring the company that would regulate undesirable managerial actions. The more control measures employed by management gearing towards stockholders' benefits, the higher would be the agency costs. It is therefore crucial, that the amount of costs to be spent in assuring that managerial actions are for the benefit of shareholders, be viewed and assessed just like any other investment decision made by the company. Make sure that agency costs should not exceed the return or yield that the company will gain from implementing the control measures. Control Mechanisms There are a number of ways to encourage managers to perform for the interest of shareholders. Some of them are: 1. Provide Performance-based Incentive Plans. There are ways by which performance based incentives may be given to managers. One way is by providing managers with executive stock options. Under this scenario, managers are given the privilege to acquire the company's share at a fixed price. Performance shares may also be given to managers as incentives. Performance shares are given to managers based on their effectiveness in achieving company goals. The relevant criteria for effective performance could be in terms of achieving high EPS, high return on assets (ROA), or high return on equity (ROE). Another relevant criteria for providing incentives would be the economic value added (EVA). This is another way by which an entity's profitability is measured. EVA is derived by subtracting the cost of all capital (interest expense among other things) from the net income after tax. If the EVA is positive, it can be interpreted that management is adding or making added value for shareholders. In other words the higher management for its shareholders is creating the EVA, the more wealth. If is EVA is negative, it can be interpreted that management is ruining value. 2. Straight Involvement by Shareholders (Institutional). In the late 1990, institutions like, insurance companies, pension funds and mutual funds owned almost half of the shares in the United States. This being so, they developed a significant influence over the entity's operations. They can provide suggestions to management in running the business. During that time, it became a practice that when a shareholder owns stocks of at least one thousand dollars for at least one year, that said shareholder can sponsor a proposal which must be voted at the annual shareholder's meeting, regardless of management's approval. 3. Takeovers. Shareholders in some cases do hostile takeovers. In this situation, managers of firms acquired by the shareholders are terminated. Those managers, who are “lucky” to be retained, lose their independence and autonomy, thus “twisting, “so to speak, the manager's arm to perform measures that would maximize the company's share prices and ultimately maximize the firm's wealth.
