CHAPTER ONE

AN OVER VIEW OF FINANCIAL MANAGEMENT

1. Introduction
Dear student! You may understand that business today is based on financial undertaking
and knowledge of financial information reveals how a company operates and the policies it
uses, so you can properly interpret its financial statements and better understand
management’s investment and financing decisions. Financial information also provides
feedback; it shows how well you have done your activity and helps to identify problems.
Therefore, it is very important that all managers including you have a working knowledge of
financial management and its implications for businesses.

Dear learner! Have you ever think what finance is? I think it is a common term that you may
hear it many times from different corners. Different people may define it differently. The most
common definition is:
Finance can be defined as “the art and science of managing money”. Finance is concerned with
the process, institutions, markets, and investments involved in the transfer of money among and
between individuals, businesses and governments.

The major areas/classes of finance can be summarized by reviewing the career opportunities in
finance. These opportunities can, for convenience, be divided into two broad parts:
1. Financial services and
2. Managerial finance/corporate finance/ financial management

1. Financial Service: is the area of finance concerned with design and delivery of a device
and financial products to individuals, business and governments.
The career opportunities available in financial service include

 Banking and related institutions

  Personal financial planning,
 Investments
 Real estates
 Insurance

2. Managerial Finance: is concerned with duties of the financial managers in the business
firm. Financial manager’s activity manages the financial affairs of many types of business-
Financial and non-financial, private and public, large and small, profit seeking and not -for
-profit. They perform such varied tasks as budgeting, financial forecasting, cash
management, credit administration, investment analysis and fund procurement.
Alternative classification of finance
Finance is also classified as
i. Public finance and
ii. Private finance

i. Public finance: Deals with the requirement, receipt and disbursement of fund in the
government institutions like state, local self governments and central governments.

ii. Private finance: is concerned with requirements, receipts and disbursements of fund
incase of individual, a profit seeking business organization and non profit
organizations.

Financial Management and Related Disciplines

Financial management, as an integral part of over all management, it is not a totally independent
area. It draws heavily on related disciplines and fields of study, such as economics, accounting,
marketing, production and quantitative methods. Although these disciplines are interrelated,
there are key differences among them. In this section we discuss these relationships.
A. Finance and Economics
The relevance of economics to financial management can be described in the light of the two
broad areas of economics: macroeconomics and microeconomics.
Macroeconomics is concerned with the overall institutional environment in which the firm
operates. It looks at the economy as a whole. Macroeconomics is concerned with the institutional
structure of the banking system, money and capital markets, financial intermediaries, monetary,
credit and fiscal policies and economic polices dealing with, and controlling level of, activity
with in an economy. Since business firms operate in the macroeconomic environment, it is
important for financial environment. Specifically, they should:
1. Recognize and understand how monetary policy affects the cost and the
availability of funds.
2. Be versed in fiscal policy and its effects on the economy
3. Be ware of the various financial institutions/financing outlets:
4. Understand the consequences of various levels of economic activity and charges
in economic policy for their decision environment and so on.
Microeconomics deals with the economic decisions of individuals and organizations. It concerns
itself with the determination of optional operating strategies. In other words, the theories of
microeconomics provide for effective operations of business firms. They are concerned with
defining actions that will permit the firms to achieve success. The concepts and theories of
microeconomics relevant to financial management are, for instance, those involving
1) Supply and demand relationship and profit maximization strategies
2) Issues related to the mix of productive factor, “optimal” sales level and product
pricing strategies.
3) Measurement of utility preference, risk and the determination of value and
4) The rational of depreciating assets.

In addition, the primary principle that applies in financial management is marginal analysis. It
suggests that financial decisions should be made on the basis of comparison of marginal revenue
and managerial cost. Such decisions will lead to an increase in profits of the firm. It is therefore,
important that financial managers must be familiar with basic microeconomics.
Thus, knowledge of economics is necessary for a financial manager to understand both the
financial environment and the decision theories, which underline contemporary financial
management. The financial manager should be familiar with these two areas of economics:
Macroeconomics and microeconomics. Macroeconomics provides the financial manager with in
sight in to policies by which economic activity is controlled. Operating with in that institutional
framework, the financial manager draws on microeconomic theories that may help in the
operation of the firms and profit maximization. A basic knowledge of economics is, therefore,
necessary to understand both the environment and the decision techniques of financial
management.
B. Finance and Accounting
The relationship between finance and accounting, conceptually speaking, has two dimensions.

i) They are closely related to the extent that accounting is an important input in
financial decision making and
ii) There are key differences in viewpoints between them.
Accounting function is a necessary input into the finance function. That is, accounting is a sub
function of finance. Accounting generates information/data relating to operation/activities of the
firm. The end product of accounting constitutes financial statements such as the balance sheet,
the income statement (profit and loss account) and the statement of changes in financial
Position/sources and uses of funds statement/cash flow statement. The information contained in
these statement and reports assists future directions of the firm and in meeting legal obligations,
such as payment of taxes and so on. Thus accounting and finance are functionally closely
related.
Generally, financial management and accounting are often not easily distinguishable. In small
firms the controller often carries out the finance function and in large firms many accountants are
intimately involved in various finance activities.
But there are key difference between finance and accounting. The first difference relates to the
treatment of funds, while the second relates to decision-making

i. Treatment of Funds
The viewpoint of accounting relating to the funds of the firm is different from that of finance.
The measurement of funds (income and expense) in accounting is based on the accrual
principle/system. For instance, revenue is recognized at the point of sale and not when collected.
Similarly expenses are recognized when they are incurred rather than when actually paid. The
accrual based accounting data do not reflect fully the financial circumstances of the firm. A firm
may be a quite profitable in the accounting sense in that it has earned profit (sales less expense)
but it may not be able to meet current obligations owing to shortage of liquidity due to
uncollectible receivables, for instance. Such a firm will not survive regardless of its levels of
profits.

The view point of finance relating to the treatment of funds is based on cash flows. The revenues
are recognized only when actually received in cash (i.e cash inflow) and expenses are recognized
on actual payment (i.e. cash outflow). This so the financial manager is concerned with
maintaining solvency of the firm by providing the cash flows necessary to satisfy its obligations
and acquiring and financing the assets needed to achieve the goals of the firm. Thus, cash flow-
based returns help financial managers avoid insolvency and achieve the desired financial goals.
For Example
Assume that total sales of a trader during the year amounted to Br.10, 000.00 while the cost of
sales was Br.8, 000.00. At the end of the year, it has yet to collect Br.8, 000.00. From the
customers, the accounting view and financial view of the firm’s performance during the year are
given below.

Accounting View Financial View

(Income Statement) (Cash flow statement)
Sales……………………Br.10,000 Cash inflow……………..Br.2,000.00
Less: costs…………..8,000 Less: cash outflow…8,000.00
Net Profit …………………2,000 Net cash outflow ……….6,000.00

Obviously, the firm is quite profitable in accounting sense; it is a financial failure in terms of
actual cash flows resulting from uncollected receivable. Regardless of its profits, the firm would
not survive due to inadequate cash inflows to meet its obligations.

ii) Decision Making

Finance and accounting also differ in respect of their purpose. The purpose of accounting is
collection and presentation of financial data. It provides consistently developed and easily
interpreted data on the past, present and future operations of the firm. The financial manager uses
such data for financial decision-making. It does not mean that accountants never make decisions
or financial manager never collect data. But the primary focus of the functions of accountants is
on collection and presentation of data while the financial manager’s major responsibility relates
to financial planning, controlling and decision-making. Thus, in a sense, finance begins where
accounting ends.
C. Finance and other Related Disciplines
Apart from economics and accounting, finance also draws – for its day to day decisions-on
supporting disciplines such a marketing, production and quantitative methods. For instance,
financial managers should considers the impact of new product development and promotion
plans made in marketing area since their plans will require capital out lays and have an impact on
the projected cash flows. Similarly, Changes in the production process may necessitate capital
expenditures, which the financial manager must evaluate, and finance. And, finally, the tools of
analysis developed in the quantitative method area are helpful in analyzing complex financial
management problems. The marketing, production and quantitative methods are, thus, only
indirectly related to day to day decision making by financial mangers and are supportive in
nature while economics and accounting are the primary disciplines on which the financial
manager draws substantially.
Scope of Financial Management
A number of approaches are associated with finance function but for the sake of convenience,
various approaches are divided in to two broad categories:
1. The traditional approach
2. The modern approach
1. The traditional approach
The traditional approach to the finance functions relates the initial stage of its evaluation during
1920s and 1930s when the term “corporation finance” was used to describe what is known the
academic world today as financial management. According to this approach the scope of
financial function was conferred to only procurement of finds needed by a business most suitable
terms. The utilization of finds was considered beyond the preview of finance function. It was felt
that decisions regarding the application of funds are taken some were else in the organization.
The scope of the finance functions, thus, evolved around the study of rapidly growing capital
markets institutions, instruments and practices involved in rising of external funds.
Limitations of Traditional approach
The traditional approach to the scope and functions of finance has now been discarded as suffers
from many serious limitations.
a) It is outside – looking in approach that completely ignores
internal decision-making as to the proper utilization of funds.
b) The focus of traditional approach was on procurement of long-
term funds. Thus it, ignored the important issue of working capital finance
and management
c) The issue of allocation of funds, which is so important today is
completely ignored
d) It does not lay focus on day-to-day financial problems of an
organization.
2. The modern approach
The modern approach views the term financial management in a broad sense and provides a
conceptual and analytical framework for financial decision-making. According to it, the finance
function covers both acquisitions of funds as well as their allocation. Thus, apart from the issues
involved in acquiring external funds, the main concern of financial management is the efficient
and wise allocation of funds to various uses. Defined in a broad sense, it is viewed as an integral
part of overall management.
The new approach is an analytical way of viewing the financial problems of a firm. The main
contents of this approach are:
 What is the total volume of funds an enterprise should commit?
 What specific assets should an enterprise acquire?
 How should the funds required be financed?
The three questions posed above cover between them the major financial problems of a firm.
According to the new approach it is concerned with the situation of three major problems
relating to the financial operations of a firm, corresponding to the three question of investment,
financial and dividend decision. Thus, financial management in the modern sense of the firm can
be broken down in to three major decisions areas as functions of finance:
i) The investment decision,
ii) The finance decision, and
iii) The dividend policy decision.
 i) Investment DecisionThe investment decision relates to the selection of assets in
which funds will be invested by a firm. The assets which can be acquired fall into two
broad groups:
a) Long term assets which yield a return over a period of time in future.
b) Short term or current assets defined as those assets, which in the normal course of business
are convertible into cash without dimension in value, usually with in a year. The management of
these involving the first category of asset is popularly known in financial literature as capital
budgeting. The aspect of financial decision-making with reference to current assets or short-
term assets is popularly termed as working capital management.
Capital Budgeting- is probably the most crucial financial decision of a firm. It relates to the
selection of an asset or investment proposal or course of action whose benefits are likely to be
available in the future over the lifetime of the project.
Working capital Management- is concerned with the management of current assets. It is an
important and integral part of financial management as short-term survival is a prerequisite for
long term success. One aspect of working capital management is the trade off between
profitability and risk (liquidity). There is a conflict between profitability and liquidity. If a firm
does not have adequate working capital, that is, it does not invest sufficient funds in current
assets, it may become illiquid and consequently may not have the ability to meet its current
obligations and thus, invite the risk of bankruptcy. If the current assets are too large, profitability
is adversely affected. The key strategies and considerations in ensuring a trade off between
profitability and liquidity is one major dimension of working capital management.

In addition, the individual current assets should be efficiency managed so that neither inadequate
nor unnecessary funds are locked up. Thus, the management of working capital has two basic
ingredients:
1) An overview of working capital management as a whole, and
2) Efficient management of the individual current assets such as cash, receivables and
inventory.

ii) Financing decision

The second major decision involved in financial management is the financing decision. The
investment decision is broadly concerned with the asset mix or the composition of the assets of a
firm. The concern of the financing decision is with the financing – mix of capital structure or
leverage. The term capital structure refers to the proportion of debt (fixed interest source of
financing) and equity capital (variable dividend securities/source of fund). The financing
decision of a firm relates to the choice of the proportion of these sources to finance the
investment requirements. There are two aspects of the financing decision. First, the theory of
capital structure, which shows the theoretical relation ship between the employment of debt and
the return to the shareholders. The use of debt implies a higher return to the shareholders as also
the financial risk. A proper balance between debt and equity to ensure a trade off between risk
and a return to the shareholders is necessary. A capital structure with a reasonable proportion of
debt and equity capital called optimum capital structure is necessary for a firm. Thus, one
dimension of financing decision is whether there is an optimum capital structure and in what
proportion should fund be raised to an appropriate capital structure given the facts of a particular
case. Thus, the financing decision covers two interrelated aspects: that is capital structure theory,
and the capital structure decision.
iii) Dividend Policy Decision
The third major decision area of financial management is the decision relating to the dividend
policy. The dividend decision should be analyzed in relation to the financing decision of a firm.
Two alternatives are available in dealing with the profits of a firm, which is they can be
distributed to the share holders in the form of dividends or they can be retained in the business
itself. The decision as to which course should be followed depends largely on a significant
element in the dividend decision, the dividend-pay out ratio, that is, what proportion of net
profits should be paid out to the share holders. The final decision will depend up on the
preference of the shareholders and investment opportunities available with in the firm. The
second major aspect of the dividend decision is the factor determining dividend policy of firm in
practice-retention of the cash for future expansion purposes.
To conclude the traditional approach to the functions of financial management had a very narrow
perception and was devoid of an integrated conceptual and analytical framework. It had rightly
been described in the academic literature. The modern approach to the scope of financial
management has broadened its scope which involves the solution of three major decisions,
namely, investment, financing and dividend. These are interrelated and should be Jointly taken
so that financial decision making is optimal. The conceptual framework for optimum financial
decision is the objective of financial management. In other words to ensure an optimum decision
in respect of these three areas, they should be related to the objectives of financial management.
Key activities of the Financial Management
The primary activities of a financial management are:
i) Performing financial analysis and planning
ii) Making investment decision and
iii) Making financing decisions.
i) Performing financial analysis and planning
The concern of financial analysis and planning is with:
a) Transforming financial data into a form that can be used to monitor financial
condition,
b) Evaluating the need for increased (reduced) productive capacity and
c) Determining the additional/reduced financing required, although this activity
relies heavily on accurate base financial statement, its underlying objective is to
assess cash flows and develop plans to ensure adequate cash flow to support
achievement of the firm’s goals.
ii) Making investment decision
Investment decision determines both the mix and the type of assets held by a firm. The mix
refers to the amount of current assets and fixed assets. Consistent with the mix the financial
manager must determine and maintain certain optimal levels of each type of current assets. He
should also decide the best-fixed assets to acquire and when existing fixed assets need to modify,
replace/liquidate. The success of a firm in achieving its goals depends on these decisions.
iii) Making financing decisions
Financing decision involves two major areas: first, the most appropriate mix of short- term and
long- term financing: second, the best individual short- term or long -term sources of financing
at a given period of time. Many of these decisions are dictated by necessity, but some require an
in a depth analysis of the available financing alternatives, their cost and their long-term
implications.
1.5. Objectives of Financial Management
The term goal or objective refers to an explicit operational guide of decision criterion to be used
by financial managers by which to judge the financial decision making of a firm which is
investment, financing and dividend decision. To make wise decisions a clear understanding of
the objective which is sough to be achieved is necessary. The objectives provide a framework for
optimum financial decision-making. In other words, they are concerned with designing method
of operating the internal investment and financing of a firm. There are two widely discussed
approaches:
i) Profit maximization approach
ii) Wealth maximization approach
It should be noted at the outset that the term “objective” it used in the sense of goal or decision
criterion for the three decisions involved in financial management. It implies that what relevant
is not the overall objective or goal of a business but an operationally useful criterion which to
judge a specific set of mutually interrelated business decision namely investment, financing and
dividend policy.
1) Profit Maximization Decision Criteria
According to this approach, actions that increase profits should be undertaken and those decrease
profits are to be avoided. In specific operational term, as applicable to financial management, the
profit maximization criterion implies that the investment, financial and dividend policy decision
of a firm should be oriented to the maximization of profit. .
Profitability refers to a situation where output exceeds input-used in this sense profit
maximization would imply that a firm should be guided in financial decision making by test,
select assets, projects and decisions which are profitable and reject those which are not.

a) Advantage of Profit Maximization

The rational behind profitability maximizations, as a guide to financial decision-making is
simply profit is a test of economic efficiency. It provides the yardstick by which economic
performance can be judged. Moreover, it leads to efficient allocation of resources, as resources
tend directed to uses, which in terms of profitability are the most desirable. Finally, it ensures
maximum social welfare, financial management.
b) Limitation of profit maximization
The profit maximization criterion has, however been questioned and criticized on many group.
The main technical flows of this criterion are ambiguity, timing of benefits, and quality of
benefit.
i) Ambiguity: One practical difficulty with profit maximization criterion for financial
decision-making is that the term profit is a vague and ambiguous concept. It is
amenable to different interpretations by different people. To illustrate, it may be short
term or long term; it may be total profit or rate of profit, it may before or after tax: It
may be return on total capital, employed or total assets or shareholders equity and so
on. If profit maximization is taken to the objective, the question arises, which of the
variants of profit cannot from the basis of operational criterion for financial
management.
ii) Timing of Benefits
Amore important technical objection to profit maximization, as a guide to financial decision
making, is that it ignored the difference in the time pattern of the benefits received from
investment proposal or courses of action. While working out profitability, the bigger the better,
on the total, benefits received over the working live of the asset, irrespective of when they were
received is considered.\

Time-Pattern of Benefits (profits)

Alternative A(000) Alternative B(000)
Period I 50 -
Period II 100 -
Period III 50 200
Total 200 200

It can be seen from the table that the total profits associated with alternative, A and B, are
identical. If the profit maximization is the decision criterion, both the alternatives would be
ranked equally. But the returns from both the alternatives differ in one important respect, while
alternative A provides higher returns in earlier years, the returns from alternative B are large in
later years. As a result, the two alternative courses of action are not strictly identical. This is
primarily because a basic dictum of financial planning is the earlier the better as benefit received
latter. The reason for the superiority of benefits now over benefits latter lies in the fact that the
former can be reinvested to earn a return. This is referred to as time value of money. The profit
maximization criterion does not consider the distinction between returns received in different
time periods and treats all benefits irrespective of the timing, as equally valuable. This is not true
in actual practice as benefits in later years may associate with risks. The assumption of equal
value is inconsistent with the real world situation.
iii) Quality of Benefits
Probably the most important technical limitation of profit maximization, as an operational
objective, is that it ignores the quality aspect of benefits associated with a financial course of
action. The term quality here refers to the degree of certainty with which benefits can be
expected. As a rule, the more certain the expected return, the higher is the quality of the benefits.
Conversely, the more uncertain/fluctuating is the expected benefits; the lower is the quality of
the benefits. An uncertain and fluctuating return implies risk to the investors. It can be safely
assumed that the investors are risk averters that are they want to avoid or at least minimize risk.
They can therefore, be reasonably expected to have a preference for a return which more certain
in the sense that it has smaller variance over the year.
The problem of uncertainty renders profit maximization unsuitable as an operational criterion for
financial management as it considers only the size of benefits and gives no weight to the degree
of uncertainty of the future benefits. This is illustrated below

Uncertainty about Expected Benefits (Profits) in Birr.

Profit (000)
Alternative A Alternative B
State of Economy
Recession (period I) 9 0
Normal (period II) 10 10
Boom (period III) 11 20
Total 30 30

It is clear from the table that the total profit associated with the two alternatives are identical in a
normal situation but the range of variation is very wide is case of alternative B, while it is narrow
in respect of alternative A. To put it differently, the earnings associated with alternative B are
more uncertain (risky) as they fluctuate widely depending on the state of economy. Obviously,
alternative A is better in terms of risk and uncertainty. The profit maximization criterion fails to
reveal.
To conclude, the profit maximizations criterion is inappropriate as an operational objective of
investment, financing and dividend decision of a firm. It is not only vague and ambiguous but it
also ignores two important dimensions of financial analysis, namely risk, and time value of
money. It follows from the above that an appropriate operational decision criterion for financial
management should:
i) Be precise and exact
ii) Be based on” the bigger the better” principle,
iii) Consider both quantity and quality dimensions of benefits, and
iv) Recognize the time value of money.
The advantage of this decision criterion is, it is simple to interpret, compute and understand.
1. Wealth Maximization Decision Criterion
This is known as value maximization or net present worth maximization. In current academic
literature value maximization is almost universally accepted as an appropriate operational
decision criterion for financial management decision as it removes the technical limitations,
which characterize the earlier profit maximization criterion. Its operational features satisfy all the
three requirements of a suitable operational objective of financial courses of action, namely,
exactness, equality of benefits and the time value of money.

Advantages of Wealth Maximization

Precise Estimation of Benefits: The value of an asset should be viewed in terms of the benefits
it can produce. A significant element in computing the value of a financial course of actions is
the precise estimation of the benefits associated with it. The wealth maximization criterion is
based on the concept of cash flow generated by the decision rather than on the accounting profits
which the basis of the measurement of benefits in the case of the profit maximization criterion.
Cash flow is a precise concept with a definite connotation. Measuring benefits in terms of cash
flows avoids the ambiguity associated with accounting profits. This is the first operational
feature of the net present worth maximization criterion.
Considers Risk and Time Value of Money: The second important feature of the wealth
maximization criterion is that it considers both the quantity and quality dimensions of benefits.
At the same time, it also incorporates the time value of money. The value of a stream of cash
flows with value maximization criterion is calculated by discounting this element back to the
present at a capitalization rate that reflects both the time and risk. In applying the value
maximization criterion, the term value is used in terms of worth to the owners that is ordinary
shareholders. The capitalization (discount) rate that is employed is ,therefore, the note that
reflects the time and risk preferences of the owners of suppliers of capital. A large capitalization
rate is the result of higher risk and longer time period. Thus, a stream of cash flows that is quite
certain might be associated with a rate of 5 percent, while a very risk stream may carry 15
percent discount rate.
For the above reason, the net present value maximization is superior to the profit maximization
as an operational objective. As decision criterion, it involves a comparison of value to cost. An
action that has discounted value reflecting both time and risk that exceeds its cost can be said to
create value. Such actions should be undertaken, conversely, actions, with less value than cost,
reduce wealth and should be rejected.
In the case of mutually exclusive alternatives when only one has to be chosen, the alternative
with the greatest net present value should be selected.
The operational objective of financial management is the maximization of wealth. Alternatively,
we can be expressed symbolically by a short cut method. Net present value (worth) or wealth is
NPV = A1/ (1+k) 2 + A2/ (1+k) 2 …… An/ (1+k) n _
Co
Where A1, A2 … An represent the stream of cash flows expected to occur from a course of
action over a period of time.
K= is the appropriate discount rate to measure risk and timing; and
C= is the initial outlay to acquire that assets.
NPV = met present value = wealth
It can, thus, be seen that in the value maximization decision criterion the time value of money
and handling of the risk as measured by the uncertain of the expected benefits is an integral part
of the exercise. It is moreover a precise and unambiguous concept and therefore, an appropriate
and operationally feasible decision criterion for financial management decision.
Summary
 Financial management/corporate finance/managerial finance are concerned with the duties of the
finance manager in business firm. He performs such varied task as budgeting, financial
forecasting, cash management, credit administration, and investment analysis and fund
procurement. The recent trends towards globalization of business activity have created new
demands and opportunities in managerial finance.
 Finance is closely related to both macroeconomics and microeconomics. Macroeconomics
provides an understanding of the institutional structure in which the flow of finance takes place.
Microeconomics provides various profit maximization strategies based on the theory of the firm.
A financial manager uses these to run the firm efficiently and effectively. Similarly, he depends
on accounting as a source of information data relating to the past present and future financial
position of the firm. Despite this interdependence, finance and accounting differ in that the
former is concerned with cash flows, while the latter provides accrual based information and the
focus of finance in on the decision making but accounting concentrates on collection of data
 The financial management function covers decision-making in three inter related areas namely
investment including working capital management, finance and dividend policy. The three key
activities of the financial manager are:
 Performing financial analysis
 Making investment decisions
 Making financing decisions

 The goal of the financial managers is to maximize the

owners/shareholders wealth as reflected in share prices rather than
profit/EPS maximization because the latter ignores the timing of returns,
does not directly consider cash flows and ignores risk