Chapter 1 : Overview
Prepared by
Md. Hafizur Rahman Khan
Senior Lecturer
Department of Business Administration
Leading University, Sylhet.
Updated on January 07, 2017
Finance: Finance is the art and science of managing money. It deals with
collecting the funds, managing the funds and ensuring their best uses.
Financial Management/ Managerial Finance: Managerial finance is
concerned with the duties of the financial manager working in a organization.
Financial managers administer the financial affairs of all types of organization—
private and public, large and small, profit seeking and not for profit.
Financial Manager: Financial manager is someone who makes financial
decisions and ensures the best use of money in an organization.
Classification of Finance
Finance can be classified into three categories:
A. Public Finance : Public finance is the study of government
revenue and expenditure and the adjustment of these to achieve desirable
effects in the economy. It studies government activities and how the government
finance those activities.
B. Personal Finance: It refers to all financial decisions and activities of an
individual, such as budgeting, insurance, consumption, savings, investment
etc.
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C. Business Finance: It is the study of money within the business firm. It deals
with collecting the funds, managing the funds and ensuring their best use in
the business firm. It can be two types:
1) SME Finance: The financial activities related to running small and
medium sized enterprises is called SME finance.
2) Corporate Finance: The financial activities related to running a
corporation is called corporate finance.
Why Study Finance?
People in all areas—accounting, information systems, management, marketing,
operations, and so forth—need a basic awareness of finance. If someone is not
planning to major in finance, he still need to understand how financial managers
think to improve his chance of success in his chosen business career. Managers in the
firm, regardless of their job descriptions, usually have to provide financial justification
for the resources they need to do their job. Whether they are hiring new workers,
negotiating an advertising budget, or upgrading the technology used in a
manufacturing process, understanding the financial aspects of his actions will help
him gain the resources he needs to be successful.
Scope of Finance / Functions of Finance / Key Decisions of
Financial Manager :
The financial manager is usually concerned with three basic types of decisions, such
as:
Investment Decision (use of money)
Financing Decision (collecting money)
Dividend Decision (Profit distribution)
A) Investment Decision
The first major decision in financial management is investment decision. Investment
decision relates to investment in various assets which fall into two broad groups:
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Long-term assets which yield a return over a longer period of time ( more
than one year) in future
Short-term or current assets defined as those assets which are convertible
into cash within a year.
Decision relating to a firm's long term assets is called capital budgeting decision and
decision relating to a firm's short-term assets is known as working capital
management.
Capital Budgeting: The process of planning and managing a firm’s long-term
investments is called capital budgeting. It is the process of analyzing and
selecting investment projects whose returns are expected to extend beyond one
year. For example, Bata Shoes is deciding to open another show room would be
an important capital budgeting decision.
Working Capital Management/ Liquidity Decision: Working Capital means
investment in current assets. Working capital management concerns the
administration of the firm’s current assets along with the financing (current
liabilities) needed to support current assets. These involve managing the
relationship between a firm's short-term assets and its short-term liabilities. The
management of working capital involves managing inventories, accounts
receivable, accounts payable, and cash. The goal of working capital management
is to ensure that the firm is able to continue its day to day operations and that it
has sufficient cash flow to satisfy both maturing short-term debt.
B) Financing Decision
The second major decision involved in financial management is the financing decision
which are associated with collecting the fund or determing the sources of fund.
Capital Structure: A firm’s capital structure is the specific mixture of debt and
equity capital that the firm uses to finance its operations or to meet up its
investment requrement. The financial manager has two concerns in this area.
First, how much should the firm borrow? That is, what mixture of debt and
equity is best? Second, what are the least expensive sources of funds for the
firm?
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Cost of Capital: The cost of capital is the cost of collecting funds
( debt or equity). It is used to evaluate new projects of a company as it is the
minimum return that investors expect for providing capital to the company,
thus setting a benchmark that a new project has to meet. For an investment to
be worthwhile, the expected return on capital should be greater than the cost of
capital.
C) Dividend Decision
The third major decision area of financial management is the dividend decision
relating to the dividend policy. Profit can be distributed to the shareholders in the form
of dividends or they can be reinvested in the business. Dividend is the part of profit
which is distributed to the owners and retained earnings is the undistributed profit
that is retained in the business for reinvestement purpose.
Career Opportunities in Finance
Financial Analyst: Prepares the firm’s financial plans and budgets. Other
duties include financial forecasting, performing financial comparisons, and
working closely with accounting.
Capital Expenditures Manager: Evaluates and recommends proposed long-
term investments.
Project Finance Manager: Arranges financing for approved long-term
investments.
Cash Manager: Maintains the firm’s daily cash balances. Frequently manages
the firm’s cash collection and disbursement activities.
Credit Manager: Administers the firm’s credit policy by evaluating credit
applications, extending credit, and monitoring and collecting accounts
receivable.
Pension Fund Manager: Manages the employees’ pension fund.
Foreign Exchange Manager: Manages the firm’s exposure to fluctuations in
exchange rates who engage in international business.
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Reletionship between Accounting & Finance
The main purpose of accounting is collection and presentation of financial data. The
finalcial manager uses such data for financial decison making Accounting function is
a necessary input into the finance function. The end product of accounting constitutes
financial statement such as the balance sheet, the income statement etc. The
information contained in these statement assists financial manager in assessing in the
past performance and future directions of the firm and in meeting legal obligations,
such as payment of taxes. Thus, accounting and finance are functionally closely
related. Moreover the finance (treasurer) and accounting (controller) activities are
typically within the control of the vice-president /director (finance) and chief financial
officer (CFO).
Difference between Finance & Accounting
Finance differs from accounting from treatment of fund perspective.
The viewpoint of accounting relating to the treatment of funds is different from
that of finance. The measurement of funds (income and expenses) in accounting
is based on the Accrual method. For example, revenue is recognized at the
point of sale and not when collected. Similarly expenses are recognized when
they are incurred, rather than when they are actually paid.
The measurement of funds (income and expenses) in finance is based on the
cashflow method. The revenues are recognized only when actually received in
cash and expenses are recognized when actually paid in cash .
Reletionship between Finance and Economics
Sometimes finance is called as one of the branch of Economics because finance assits
in money managing which ensures the best fullfillment of humen needs. Finance is
closely related with two main brances of economics-macroeconomics and
microeconomics. Macroeconomics provides an understanding of the world economic
structure in which the flow of finance takes place. Microeconomics provides various
profit maximization strategies based on the theory of the firm. A financial manger uses
these to run the firm effectively and efficiently.
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Organization of Finance Functions
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Stakeholders: They represent all the parties who have a stake in of the
company. They include stockholders, creditors, employees, suppliers, and local
and international communities.
Stockholders: They represent the owners of a corporation, whose ownership, is
evidenced by either common stock or preferred stock.
Board of Directors: They are the group elected by the firm’s stockholders and
having ultimate authority to guide corporate affairs.
President / Chief Executive Officer (CEO): He is responsible for managing
day-to-day operations and carrying out the policies established by the board.
The CEO is required to report periodically to the firm’s directors.
Chief Financial Officer (CFO): The Function of CFO covers routine aspects of
finance and accounting. Under him are treasurer and controller.
o The treasurer is commonly responsible for handling financial activities,
such as financial planning and fund raising, making capital expenditure
decisions, managing cash, credit activities, pension fund and foreign
exchange.
o The controller typically handles the accounting activities, such as
corporate accounting, tax management, financial accounting, and cost
accounting.
Goal of the Business Firm: Profit vs Wealth Maximization
Wealth means collection of assets owned by a business or household. Among profit
and wealth maximization, wealth maximization should be the main goal of the
business firm.
Profit maximization is basically a short-term goal. But stockholder wealth
maximization is a long-term goal. Profit maximization can be achieved in the short
term at the expense of the long-term goal( wealth maximization). For example: a costly
investment may experience losses in the short term but yield substantial profits in the
long term. Also, a firm that wants to show a short-term profit may cancel major
repairs or replacement which may hurt its long-term profitability. So wealth
maximization should be the main goal of the business firm.
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Agency Conflict
Agent: Agent are individual authorized by another person called principal
(owners or shareholders), to act on the latter’s behalf.
Agency Conflict / Problems: A conflict arising when managers place personal
goals ahead of corporate goals. For examples, owners mainly concerned about
the longer term performance of the business that can lead to maximization of
shareholder’s wealth. Whereas, a manager might focus on taking such
decisions that can bring quick result, so that he can get credit for good
performance. It creates conflict between the owners and managers of firm which
is known as agency conflict/problem.
Agency Costs: Cost that arises to minimize the agency problem is called agency
cost.
Agency theory: A theory that explains the relationship between principals and
agents in business and it is also concerned with resolving agency problems.
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