SELECT COLLEGE

POSTGRADUATE PROGRAM

Financial Management
Chapter one : Introduction

By :- Shewayirga Assalf (MBA)

April 2024
1. 1 What Is Finance?
 To have a good understanding of financial management,
you need to understand first what finance is?
 Literally, finance means the money used in day-to-day
activities of an individual or a business for exchange of
goods and services.
 Finance is a distinct area of study that comprises facts,
theories, concepts, principles, techniques and practices
related with raising and utilizing of funds (money) by
individuals, businesses, and governments.
 It is a very wide and dynamic field of study
 It directly affects the decisions of all individuals and
organizations that earn or raise money and spend or invest
it.
 It also an area of study that deals with how, where, by
whom, why, and through what money is transferred among
and between individuals, businesses, and governments.
Finance cont…..
 Itis concerned with the processes, institutions,
markets, and instruments involved in the transfer
of funds.
 In addition to principles and techniques, finance
requires individual judgment of the person making
the financial decision
 Finance can also be defined as the art and science
of managing money.
1.2 MAJOR AREAS OF FINANCE
 There are several ways to summarize the major
areas of finance. One way is to review the career
opportunities under it. Another way is based on the
differences in the objectives of different
organizations.
 Major Areas of Finance CONT…
 For the sake of simplifying our discussion, we summarize
the major fields of finance based on career opportunities in
finance.
 The career opportunities again can be divided into different
categories.
 These opportunities can be categorized into two broad
areas.
i) Financial Services
ii) Financial Management
i) Financial Services
 This is a part of finance which involves personal career
opportunities as a loan officer, financial planner,
stockbroker, real estate agent, and insurance broker
 It is generally concerned with the design, development,
and delivery of these financial services to individuals,
business organizations, and governments.
Major Areas of Finance CONT…
ii) Financial Management
 It is concerned with the financial decisions of a
business firm
 This firm can be large or small, private or public,
financial or non-financial, profit – seeking or not-
for-profit.
 It involves specific financial functions of the firm
 1.3 CLASSIFICATION OF FINANCE
 The finance is classified into three categories
 Personal finance
 Public finance
 Business finance
 Personal finance: -This deals with the mobilization of funds from
own sources. Here funds may imply cash and non-cash items also.
 Public finance: - This kind of finance deals with the mobilization
or administration of public funds. It includes the aspects relating
to the securing the funds by the government from public through
various methods viz. taxes, borrowings from public and foreign
markets.
 Business finance: - Financial management actually concerned
with business finance. Business finance is pertaining to the
mobilization of funds by various business enterprises. Business
finance is a broad term includes both commerce and industry. It
applies to all the financial activities of trade and auxiliaries of
trade such as banking, insurances, mercantile agencies, service
organizations, and the manufacturing enterprises.
1.4 Sources of Finance CONT…
 The finance required for any organization could be
primarily divided into two one is ling-run finance to
acquire the fixed assets that are useful to the business
organization over a period of time i.e. more than a year,
usually we call fixed capital.
 The other one is short-term finance which is required to
keep running the fixed assets or to made them finance
which is required to keep running the fixed assets or to
make them working. This is called the working
capital.
 Long-term sources – The important long-term sources
are common stock, preference stock bonds, loans from
financial institutions and foreign capital.
 Short-term sources – The short-term sources are bank
loans, public deposits trade credits provisions and
current liabilities.
 Sources of Finance CONT….
 The requirements of above nature could be financed either
through external sources or internal sources if it is an
existing company.
 External – These are the funds drawn from outsiders.
Among them the prominent are discussed below.
 Share Capital – This is the primary source of finance to a
corporate form of organization. It is the sale of equity or
common stock and preference stock to the public. Which
serves as a permanent capital to an organization. These
holders will get dividend in return for their
investment.
 Common stock – The holders of these shares are owners
of the company. They are the risk takers. They get dividend
when the company earns profits, otherwise they do not get
any dividend. Whatever profit is left after meeting all the
expenses belongs to them. In the event of closure of the
company they are the last people to get their claim.
Sources of Finance CONT….
What is Equity?
 In finance and accounting, equity is the value
attributable to the owners of a business.
The book value of equity is calculated as the
difference between assets and liabilities on the
company’s balance sheet, while the market
value of equity is based on the current share
price (if public) or a value that is determined by
investors or valuation professionals. The
account can also be called
shareholders/owners/stockholders equity or net
worth.
 There are generally two types of equity:
Book value
Market value
Sources of Finance CONT….
 Equity …..
 Example in Excel
 Let’s look at an example of two different
approaches in Excel. The first is the accounting
approach, which determines the book value,
and the second is the finance approach, which
estimates the market value.
Equity ……
#1 Book value of equity
 In accounting, equity is always listed at its book value.
 It is the value that accountants determine by
preparing financial statements and the balance sheet
equation that assets = liabilities + equity.
 The equation is rearranged to be equity = assets –
liabilities.
 The value of a company’s assets is the sum of each
current and non-current assets on the balance sheet.
 The main accounts include cash, accounts receivable,
inventory, prepaid expenses, fixed assets, property
plant and equipment (PP&E), goodwill, intellectual
property, and intangible assets.
 The value of liabilities is the sum of each current and
non-current liability on the balance sheet. Common
accounts include lines of credit, accounts payable,
short-term debt, deferred revenue, long-term debt,
capital leases, and any fixed financial commitment
Equity….
#2 Market value of equity
 In finance, equity is typically expressed as a market
value, which may be materially higher or lower than the
book value. The reason for this difference is that
accounting statements are backward looking (all results
are from the past) while financial analysts look forward
into the future to forecast what they believe financial
performance will be.
 If a company is publicly traded, the market value of its
equity will be easy to calculate, it’s simply the latest
share price multiplied by the total number of shares
outstanding.
 If a company is private, it’s much harder to determine
its market value. If the company needs to be formally
valued, it will often hire professionals such as
investment bankers, accounting firms (valuations
group), or boutique valuation firms to perform a
thorough analysis.
Sources of Finance CONT….
 Preference stock – Preference shares carry two
preferential rights one is to get a fixed dividend at
the end of each year irrespective of the profits, other
one is to get back the original investment first when
the company goes into liquidation.
 Change par bonds – Another source of finance to a
company is issue of bonds/ debentures. These holders
are eligible to get fixed interest at the end of each
year. The holders of these bonds do not wish to take
any risk public deposits. The term is also mentioned
while issuing bonds.
 Public deposits – This is another mode of finance
where the company will advertise and accept deposits
for specified period at a fixed rate of interest.
Sources of Finance CONT…
 Borrowings – The companies may borrow funds from
banks, financial institutions etc for their requirements
at the interest chargeable by the lender institution.
 Foreign capital – The concept of liberalization is
attracting many foreign companies to participate in
the domestic companies. It can be either in the form of
direct participation in the capital or collaboration in a
project in the equity of the company and also provide
loans some time.
 Trade credits – The common means of short-term
external finance is trade credits Normally, every
company gets its raw material and other supplies
 It is an arrangement to buy goods or services on
account ,that is without making immediate cash
payment
 Sources of Finance CONT…
2.Internal Sources – This is applicable for only those
companies which are in existence. By virtue of their
existence, they are in a advantageous position to
generate some of the finance internally.
 Retained earnings – These are the funds that are
retained out of the profits for meeting future
contingencies. It can be either to meet the uncertainty
or future growth and expansion of business.
 The company would be free to utilize this source. The
retained profits enable a company to withstand
seasonal reactions and business fluctuations. The large
accumulated savings facilitate a stable dividend policy
and enhance the credit standing of the company.
However, the quantum of retained earnings depend on
the volume of the profits made by the company.
Sources of Finance CONT…
• Provisions – Generally companies, in order to
meet the legal and other obligations, create some
funds for future use. These are known as
provisions. They include depreciation, taxation,
dividends and various current and non-current
liabilities. The amount set apart in these form
would be required to be paid only on certain
dates. Till then the company can use them for its
own purpose. For instance, taxes payable to the
government are used in the business until these
are paid on due date. Therefore, though for a
short-while provisions would serve as a good
source of internal finance.
 1.5 Meaning of Financial
 Management
It is one major area of study under finance.
 It deals with decisions made by a business firm that affect its
finances
 Sometimes called corporate finance, business finance, and
managerial finance. These terms are used interchangeably in
this material.
 It can also be defined as a decision making process concerned
with planning for raising, and utilizing funds in a manner that
achieves the goal of a firm
 FM means planning, organizing, directing and controlling the
financial activities such as procurement and utilization of
funds of the enterprise.
 It means applying general management principles to financial
resources of the enterprise.
 The study of methods which help us plan, raise and use
firms’ financial resources of an organization in an efficient
and effective manner to achieve corporate objectives.
1.6 Objectives of Financial Management

 The FM is generally concerned with procurement, allocation

& control of financial resources of a concern. The objectives
can be-
 To ensure regular and adequate supply of funds to the
concern.
 To ensure adequate returns to the shareholders which
will depend upon the earning capacity, market price of the
share, expectations of the shareholders.
 To ensure optimum funds utilization. Once the funds are
procured, they should be utilized in maximum possible way
ensure safety on investment, i.e, funds should be invested
in safe ventures so that adequate rate of return can be
achieved east cost.
 To plan a sound capital structure-There should be sound
and fair composition of capital so that a balance is
maintained between debt and equity capital. 19
1.7 Functions of Financial Management

1. Estimation of capital requirements:

 A finance manager has to make estimation with regards
to capital requirements of the company.
 This will depend upon expected costs and profits and
future programmed and policies of a concern.
 Estimations have to be made in an adequate manner
which increases earning capacity of enterprise.
2. Determination of capital composition:
 Once the estimation have been made, the capital
structure have to be decided.
 This involves short- term and long- term debt equity
analysis.
 This will depend upon the proportion of equity capital
a company is possessing and additional funds which
have to be raised from outside parties. 20
Functions of Financial Management…
3. Choice of sources of funds: For additional
funds to be procured, a company has many
choices like-
◦ Issue of shares and debentures
◦ Loans to be taken from banks and financial
institutions
◦ Public deposits to be drawn like in form of bonds.
 Choice of factor will depend on relative merits
and demerits of each source and period of
financing.
4. Investment of funds: The finance manager has
to decide to allocate funds into profitable ventures
so that there is safety on investment and regular
returns is possible.
21
Functions of Financial Management…
5. Disposal of surplus:
 The net profits decision have to be made by the finance
manager.
 This can be done in two ways:

A. Dividend declaration - It includes identifying the rate of

dividends and other benefits like bonus.
B. Retained profits - The volume has to be decided which
will depend upon expansion, innovational, diversification
plans of the company.
6. Management of cash:
 Finance manager has to make decisions with regards to
cash management.
 Cash is required for many purposes like payment of wages
and salaries, payment of electricity and water bills, payment
to creditors, meeting current liabilities, maintenance of
enough stock, purchase of raw materials, etc.
22
1.8 finance and related fields
1 Finance versus Economics
 Finance and economics are closely related in many
aspects
 Economics is the mother field of finance
 The economic environment within which a firm
operates influences the decisions of a financial
manger.
A financial manger must understand the
interrelationships between the various sectors of
the economy
 He must also understand such economic variables
as a gross domestic product, unemployment,
inflation, interests, and taxes in making financial
decisions.
 1 Finance versus Economics….

Basic Differences between Finance and Economics

 Finance is less concerned with theory than is
economics.
 Finance is basically concerned with the application of
theories and principles.
 Finance deals with an individual firm;
 But economics deals with the industry and the overall
level of the economic activity.
2 . F i n a n c e Ve r s u s A c c o u n t i n g
 Accounting provides financial information through
financial statements.
 Therefore, these two fields are closely linked as
accounting is an important input for financial decision-
making.
 Besides, the accounting and finance functions generally
overlap; and usually it is difficult to distinguish them.
Basic Differences Between Finance and Accounting

 Treatment of income: - in accounting income

measurement is on accrual basis. Under this method
revenues are recognized as earned and expenses as
incurred. In finance, however, the cash method is
employed to recognize the revenue and expenses.
 Decision-making: - the primary function of
accounting is to gather and present financial data.
Finance, on the other hand, is primarily concerned
with financial planning, controlling and decision-
making. The financial manger evaluates the
financial statements provided by the accountant by
applying additional data and then makes decisions
accordingly.
 Accounting is highly governed by generally accepted
accounting principles.
Accounting Versus Financial
Management
 Accounting concerns the measurement, in financial
(dollar) terms, of events that reflect the resources,
operations, and financing of an organization.
 Financial management provides the theory, concepts, and
tools necessary to help managers make better financial
decisions.

? Are the two disciplines independent?

1.9 The Role of Finance
 The primary role of finance within any business is to plan
for, acquire, and utilize resources to maximize the
efficiency (and hence value) of the organization.
The Role of Finance CONT…
 Finance activities include:
Planning and budgeting
Financial reporting
Capital investment decisions
Financing decisions
Working capital management
Contract management
Financial risk management
The finance activities listed on the previous slide can
be summarized by the four C’s:
Cost minimization
Cash sufficiency
Capital access
Control
 1.10 The functions of financial management

 The functions of financial management are planning

for acquiring and utilizing funds by a firm as well as
distributing funds to the owners in ways that achieve
goal of the firm.
 In general, the functions of financial management
include three major decisions a firm must make.
These are:
 Investment decisions
 Financing decisions
 Dividend decisions
1 Investment Decisions
 They deal with allocation of the firm’s scarce financial
resources among competing uses.
 These decisions are concerned with the management of
assets by allocating and utilizing funds within the firm.
1 Investment Decisions CONT….
Specifically, the investment decisions include:
 Determining the asset mix or composition: -
determining the total amount of the firm’s
finance to be invested in current and fixed assets.
 Determining the asset type: - determining
which specific assets to maintain within the
categories of current and fixed assets.
 Managing the asset structure, i.e.,
maintaining the composition of current and fixed
assets and the type of specific assets under each
category.
1 Investment Decisions CONT….
 The investment decisions of a firm also involve working
capital management and capital budgeting decisions.
The former refers to those decisions of a firm affecting
its current assets and short – term liabilities. The later,
on the other hand, involves long – term investment
decisions like acquisition, modification, and
replacement of fixed assets.
 Generally, the investment decisions of a firm deal
with the left side of the basic accounting
equation: A = L + OE (Assets = Liabilities + Owners’
Equity).
2 Financing Decisions
 The financing decisions deal with the financing of the
firm’s investments, i.e., decisions whether the firm
should use equity or debt funds in order to finance its
assets
 2 Financing Decisions CONT…
 They are also concerned with determining the most appropriate
composition of short – term and long – term financing.
 In simple terms, the financing decisions deal with
determining the best financing mix or capital structure of
the firm.
 The financing decisions of a firm are generally concerned with
the right side of the basic accounting equation.
3 Dividend Decisions
 The dividend decisions address the question how much of the
cash a firm generates from operations should be distributed to
owners in the form of dividends and how much should be
retained by the business for further expansion.
 There are trade offs on the dividend policy of a firm.
 On the one hand, paying out more dividends will make the firm
to be perceived strong and healthy by investors ; on the other
hand, it will affect the future growth of the firm.
 So the dividend decision of a firm should be analyzed in relation
to its financing decisions.
1.11What is Business?

 According to well-known professors William Pride,

Robert Hughes, and Jack Kapoor, business is 'the
organized effort of individuals to produce and
sell, for a profit, that satisfy society's needs.‘
 A business, then, is an organization which seeks
to make a profit through individuals working
toward common goals.
 The goals of the business will vary based on the
type of business and the business strategy being
used.
 Regardless of the preferred strategy, businesses
must provide a service, product, or good that
meets a need of society in some way.
32
Business……
characteristics
There are three key characteristics
that must be met to have a business.
1. Businesses must be the result of
individuals working together in an
organized way.
2. Businesses must satisfy a societal need.
3. Businesses must seek to make a profit.

33
1.12 Forms of Business organization

1. A sole proprietorship
is a business that has a single owner who is
responsible for making decisions for the company.
2. A partnership
consists of two or more individuals who share the
responsibility of running the company.
3. A corporation
 is one of the most recognizable business structures
and has a separate identity from the owners of the
company.
 One or more owners may participate as
shareholders of a corporation.
34
 Forms of Business organization…
4. Cooperative
 isoperated solely for the benefit of those who
own it and use its services.
 This implies that the business distributes its
generated earnings to its members, also
called user-owners.
 The company's members typically vote to
elect a board of directors to make any
necessary managerial decisions.
Sole Proprietorship
Advantages:
◦ Ease of formation
◦ Subject to few regulations
◦ No corporate income taxes
Disadvantages:
◦ Limited life
◦ Unlimited liability
◦ Difficult to raise capital
Partnership
A partnership has roughly the
same advantages and
disadvantages as a sole
proprietorship.
Corporation

Advantages:
◦ Unlimited life
◦ Easy transfer of ownership
◦ Limited liability
◦ Ease of raising capital
Disadvantages:
◦ Double taxation
◦ Cost of set-up and report filing
Goals of the Corporation
The primary goal is shareholder
wealth maximization, which
translates to maximizing stock
price.
◦ Do firms have any responsibilities to
society at large?
◦ Is stock price maximization good or bad
for society?
◦ Should firms behave ethically?
The d/c b/n the three forms of
business
Formation
 A sole proprietorship or a partnership may be
formed without filing any formal paperwork.
 The creators of a corporation, however, must file
a document known as the articles of
incorporation.
Liability
 The owner(s) of a sole proprietorship or a
partnership may be held liable for any business
activity and/or obligation.
 Corporate shareholders, however, usually are
liable only for the amount they invested.
40
The d/c b/n the three forms of business…
Record Keeping
 Corporations are required to keep strict records of meetings and
other similar administrative activities,
while
 a sole proprietorship or a partnership typically is not required to
do so.
Size
 A sole proprietorship can have only a single owner,

but
a partnership or a corporation may have any number of owners.
Taxes
 The owner of a sole proprietorship is required only to report the
business’ earnings on tax return,
while
 a corporation or a partnership must file a separate return for the
business. 41
 1.13Business Organizations in
Ethiopia
1. Sole proprietorship
2. Partnerships ( 1960 Commercial code, Art.
212)
◦ Ordinary Partnership
◦ Joint Venture
◦ General partnership
◦ Limited partnership
3. Companies (1960 Commercial code, Art.
212)
◦ Private Limited Companies (PLCs)
◦ Share Companies
4. Cooperatives (Unions)
5. Public Enterprises
THANKS
!!!