MODULE 1
AN INTRODUCTION TO FINANCIAL MANAGEMENT,
ACCOUNTING AND CONTROL
Financial Management, defined
-
Concerned with maintenance and creation of economic value or wealth.
-
Concerned with proper specifications of the financial goals of the firm as well as the
measurement of performance relative to the achievement of this objective.
-
Responsible in allocating funds to current and fixed assets; to obtain the best mix of
financing alternatives and to develop an appropriate dividend policy within the
context of the firm’s objectives.
Accounting, defined
-
It is an art of recording, classifying and analyzing business transactions and events.
The person in charge of accounting is known as an accountant and this individual is
typically required to follow a set of rules and regulations such as the Generally
Accepted Accounting Principles.
Accounting allows a company to analyze the
financial performance of the business and look at its statistics such as net profit.
Control, defined
-
is one of the managerial functions like planning, organizing, staffing and directing. It
is an important function because it helps to check the errors and to take the corrective
action so that deviation from standards are minimized and stated goals of the
organization
are
achieved
in
desired
manner.
According to modern concepts, control is a foreseeing action whereas earlier concept
of control was used only when errors were detected. Control in management means
setting standards, measuring actual performance and taking corrective action. Thus,
control comprises these three main activities.
The Firm and its Environment
The firm is viewed as an organization set up to perform a specific economic goal or
mission. In undertaking this mission, the firm should be able to do two things: (1) meet and
adjust to the demands of the environment, and (2) choose a set and corresponding policies and
programs to meet these demands. Figure 1 suggests a framework for looking at the firm and its
environment.
On one hand, the firm consists of two groups –stockholders or owners and management.
The stockholders provide the capital funds which are employed by the firm in its productive
economic activities. As owners of the firm, they may delegate the actual day-to-day control of
the firm to a second group of individuals called managers. This act of delegation, however, is
accompanied by the assignment of responsibility, in the form of corporate goals set by
stockholders for its management. The setting of corporate goals is the owners’ primary means of
communicating their preferences to the managers. Based on these goals, management chooses
and implements policies and programs which will achieve these objectives. Thus, the role of
management is one of execution of policies.
The other half of Figure 1 shows that the firm cannot be separated from various sectors of
society. There are several influences which are immediately recognizable, namely:
1.) The preference of stockholders and the goals they set for the firm will partly depend
on alternative uses and returns for capital invested in the firm. Thus, there are is a
market for investor capital and the firm should be able to deliver to its stockholders
the benefits which would have been derived if the funds were invested in this outside
market. The same reasoning applies if the firm avails of loan funds from creditors.
E.g. banks and financial institutions.
2.) The firm exists within a legal or political and economic framework. Its objectives
and implementing policies/programs should not be inconsistent with society’s
prevailing legal norms and values. This indicates that the firm should produce some
direct or indirect benefits to society. Otherwise, it becomes an irrelevant institution
and should be legislated out of existence.
3.) Management should not act as if it is accountable only to its stockholders and not to
society.
At the very least, the presence of alternative opportunities in the
management labor market may influence managers to do a better job in order to
increase their “market value”.
4.) The firm’s choice of operating plans – projects and product-service mix will - be done
in face of a competitive market, except when the firm operates as a monopoly.
‘
Figure 1
The Firm and its Environment
Firm
Society/Environment
Stockholders/Growers
(Preferences and
Opportunities)
Outside Market for
Capital
The Setting of
Objectives/Goals for
the Firm
Management
(Preferences and
Opportunities)
Political and
Economic
Environment
Outside Market for
Managers
The Choice of Policies
and Programs to
Achieve Stated
Corporate Objectives
Implementation of
Policies/Programs
Outside Market for
Goods and Services
with Other Firms
The Potential Conflict between the Owner and Management Goals
The evolution of many Philippine companies begins with the lone entrepreneur with a
business idea.
From a one-man operation, this entrepreneur begins to identify bigger
opportunities and expand his business interests. Then comes the point when his own personal
resources alone are not sufficient to sustain growth. At this time, the entrepreneur brings in
partners with capital and/or banks with loan funds. Nevertheless, he may continue to retain
controlling capital interest and to manage the firm himself. We can say that to this stage, the
firm remains entrepreneurial in character. Finally, there comes a time when his business units
and resources have grown far beyond his physical capability to control the firm. As a result, he
may just sit in several Boards of Director and yield the day to day management to professional
managers. At this point, the firm shifts from an entrepreneurial to a professionally-managed
firm.
The crucial difference between entrepreneurial firms and professionally-managed firms,
following the framework in Figure 1, lies in the non-identity of the interests of the owners and of
the managers in the latter type of the firm. Many theories or models of the firm suggest that
while the goals of owners may have been set rationally given the capital markets, there is an
inherent divergence in managerial goals along the following possible lines:
1. Managers may “overspend” on salaries and pre-requisites (e.g. company cars,
representation, plush officers) because these also have the effect of increased personal
consumption. On the other hand, stockholders would only want to spend these prerequisites to the extent that they benefit the company. For example, representation
expenses should be allowed only if they increase future sales of the company.
Beyond this level, (e.g., if “too frequent” or if non-client guests are included), the
management can only derive personal satisfaction from the expense without
contributing to the profit goals of the stockholder.
2. Managers may engage in “shrinking” behavior, preferring leisure over any further
exertion to achieve exceed the stockholders’ goals. This hypothesis is related to the
concept of “sacrificing” behavior. Here, the manager may decide not to exert effort
to exploit all opportunities for the stockholders, preferring instead to achieve the goal
assigned to him with the minimum effort.
3. Managers may supplant the stated goals of the stockholders with some of their own.
For example, management might attempt to expand sales and market share with little
attention to the effects on the goals of stockholders for short run earnings. Managers
might derive personal satisfaction from being the head of the billion=peso company
or of the biggest nationwide branch network.
4. Managers may engage in outright manipulation and misrepresentation of corporate
performance in order to show attainment of owners’ goals. A well-known case was
that of a softdrink company in the late 1970s which showed that management can
sometimes succeed in showing fictitious profits over an extended period.
These theories of the firm and of managerial behavior are based on two crucial but often
unstated premises. First, the assumption is that the “Theory X” version of individual behavior is
valid, i.e., that man prefers less work to more and is driven by economic reasons or self-interest
alone. Second, managerial decisions which adversely affect stockholder goals are possible and
could remain undetected over time because the uncertainty in the environment effectively
“disguises” the impact of the manager’s decisions and the owners are therefore unable to closely
investigate the manager’s actions.
Goals of the Firm
The preferable goal of the firm should be maximization of shareholders’ wealth, by
which we mean maximization of the price of the existing common stock. Not only will this goal
be in the best interest of the shareholders, but it will also provide the most benefits to the society.
In microeconomics, profit maximization is frequently given as a goal of the firm. Profit
maximization stresses the efficient use of capital resources, but it is not specific with respect to
the time frame over which profits are to be measured. A financial manager could easily increase
current profits by eliminating research and development expenditures and cutting down on
routine maintenance.
Some of the corporate goals include the following:
1. Maximize corporate profits
2. Maximize the wealth of the stockholders as reflected in the market price of the
company’s stock
3. Maximize profits or shareholders’ wealth subject to the satisfaction of such other goals as
target market share, customer service and minimum acceptable risk of bankruptcy
4. Maximize profits or shareholders’ wealth while playing in active role as a participant in
society’s current concerns
5. Maximize the value of the firm to its present stockholders.
Traditionally, the concept of profit maximization carries a definite appeal due to its
simplicity and its consistency with classical views of economic efficiency.
Operationally,
however, “profit “is not quite easy to define. There are several interpretations like: (a) net
income from accounting reports; (b) earnings per share and (c) return on investment.
A corporate goal stated in terms of total profits has the advantage of being specific and
understandable to management.
Furthermore, a total profit objective
readily translates to
operational plans and budgets to guide day-to-day management activities. The problem to total
profit alone lies in its inability to simultaneously reflect changes in the capital position of the
company. For example, total profits of the company may have increased during the year but this
might be due to the investment of new shareholders’ capital on marginally profitable projects.
New capital may be placed in a savings account with minimal interest rates and this would
increase net income.
Financial Policy, Planning and Control Functions
Once a company has selected its specific financial goals, management must proceed to
develop operating policies, strategies and mechanisms to achieve those goals.
Due to the
complexity of the finance activity in the typical business firm, it is not a simple task to categorize
the various finance-related functions.
We adopt an approach focusing on the organizational hierarchy for finance in our
classification of the finance function into three types, namely: (a.) financial policy and strategy;
(b.) financial management and control and (c.) financial planning.
Generalizations, of course, are complicated by the fact that these functions are
interrelated in practice and certain decisions (e.g. project selection) involve all three types of
functions. Nevertheless, it will be easier to recognize the nature of the finance functions in
practice if our presentation an organizational motive. Financial policy and strategy formulation
is normally a top level management prerogative. It covers investment and financing decisions
with long-term implications on the overall risk, profitability and growth of the company. The
financial management and control function is essentially a middle management level activity.
Once strategies and policies have been set, middle managers’ role is to ensure that operational
and day-to-day decisions are consistent with the chosen overall direction. Financial planning is
primarily a staff function, providing the necessary informational and analytical support to both
financial policy and control decisions.
Some specific finance policies, decisions and planning roles follow:
A. Financial Policy and Strategy
1. Investment Policy
Choice of product lines and capital projects
2. Capital Structure Policy
a. Working Capital Policy: balancing short-term VS long-term assets and
liabilities
b. Leverage Policy: balancing long-term financing, i.e. debt VS equity
3. Growth Strategy
a. Whether growth should be pursued using internally generated funds or
through mergers and consolidation
b. Whether to integrate toward raw materials production and marketing
(“vertical
integration”
or
toward
diverse
products/services
(“conglomerate” or “horizontal” integration)
4. Dividend Policy
Whether to follow a systematic pattern or earnings retention or dividend
distribution
B. Financial Management and Control
1. Project Management
Assure that long-term projects are implemented according to planned
investment outlays and to yield forecasted cash returns
2. Working Capital Management
a. Cash Management
a.1. Provides for adequate cash balance for day-to-day operating
needs
a.2. Maximize return on idle cash through investment in
marketable securities
a.3. Institute proper control for cash
b. Accounts Receivable Management
b.1. Optimize the accounts receivable investment through
an evaluation of the trade-off between lost sales
opportunity and bad debts
b.2. Institute sound credit evaluation and collection
procedures
c. Inventory Management
c.1. Determine inventory levels by optimizing the trade-off
between inventory carrying cost, ordering cost and lost
sales opportunity
c.2. Institute sound inventory control procedures
3. Management of Fund Sources
a. Identify possible sources of short-term and long-term funds
b. Negotiate and monitor credit facilities with financial institutions
4. Dividends Policy Implementations
a. Determine dividend amounts and form
b. Schedule dividend payments
C. Financial Planning
1. Financial Forecasting
a. Cash Budgeting: forecast of cash needs and sources
b. Profit planning: forecast of revenues and expenditures
c. Balance Sheet forecasting: anticipating
future assets, liabilities and
networth position of the firm
2. Financial Analysis
a. Capital budgeting techniques: evaluation of long-term investment
b. Operating leverage analysis: cost-volume profit
3. Financial Performance Evaluation
a. Financial ratios as overall indicators of performance
b. Market-wide financial indicators
A schematic presentation of the listing of finance functions, decisions and organizational levels
is shown in Figure 2.
Table 1
Major Finance Functions Classified by Organization and Decision Type
ORGANIZATION
DECISIONS
LEVEL AND GOAL
Investment
Top Management
1. Investment Policy
(Policy and Strategy)
2. Growth Strategy
Financing
1. Capital
Structure
Policy
2. Dividends Policy
Operating Management
(Control)
1. Project Management
2. Working Capital
1. Management
of
Fund Sources
2. Administration
of
Dividends Policy
Financial Planning Staff
(Technical Support)
1. Financial Forecasting and Budgeting
2. Financial Analysis
3. Financial Performance and Evaluation
At this point, we direct our attention to how the unique Philippine business environment
and its characteristics can influence the goals and functions of finance.
Activity 1
Do you have an email address? Kindly send it to me (ceecyn39@yahoo.com) so that you can be
a member of the clsu_financialmanagement@yahoogroups.com where I am the moderator.
Kindly answer the following questions without necessarily copying the text above and
send your answer to my email address.
1. What is Financial Management?
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2. What is Accounting?
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3. What is Controlling function?
________________________________________________________________________
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4. Discuss the relationship that exists between the Firm and its Environment. Discuss this
in the viewpoint of Financial Management.
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5. What are the financial goals of the firm?
________________________________________________________________________
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6. Differentiate the three types of the financial functions.
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