FINANCIAL MANAGEMENT: Theories

SCOPE
AND
ROLE
OF
FINANCIAL
MANAGEMENT
Financial Management is the process of
planning decisions in order to maximize wealth.
Financial Managers have a vital role in cash
management and in all aspects of raising and
allocating
financial
capital,
taking
into
consideration the trade-off between risk and
return.
Financial Functions involve record keeping,
performance evaluation, variance analysis,
budgeting, and utilization of resources.
Goals of the business enterprise (1)
Shareholders wealth maximization, (2) Profit
maximization,
(3)
Managerial
reward
maximization, (4) Behavioral goals, and (5)
Social responsibility.
Primary goal of the business maximize the
wealth of shareholders/ maximizing the price of
share capital.
Profit maximization is a short-term goal at
the expense of its long-term goal. Main
objective is to have large profits.
Shareholder wealth maximization is a long
term goal since shareholders are interested in
future as well as present profits. Main objective
is to have the highest market value of share
capital.
Considerations of wealth maximization
(1) wealth for the long term, (2) risk or
uncertainty, (3) timing of returns, (4)
shareholders return.
PROFIT
SHAREHOLDER
MAXIMIZATION
WEALTH
MAXIMIZATION
Short term
Long term
Ignores risk or
Recognizes risk or
uncertainty
uncertainty
Ignores timing of
Recognizes the timing
returns
of returns
Requires immediate
Considers
resources
shareholders return
Easy to calculate
profits
Easy to determine the
Offers unclear
link between financial
relationship between
decision and profits
financial decisions
and share price
Can lead to
management anxiety
Can lead to creative
accounting practices

If Product A has more projected retained

earnings but more risky, the decision is not
straightforward.
Risk-return is the integral to the theory of
finance.
Risk refers to the variability of expected
returns. Typical forms are economic risk,
political uncertainties, and industry problem.
Risk analysis is a process of measuring and
analysing the risk associated with financial and
investment decision.
Return is the reward of investing
Financial accounting records the financial
history of the business and involves the
preparation of reports for use by external
parties.
Managerial accounting provides financial
data to be used in making decisions about the
future of the enterprise.
Accounting information is used by financial
managers to make decisions regarding the
receipt and use of funds to meet corporate
objectives and for the purpose of forecasting.
Responsibilities of a Financial Manager
(1) Financial analysis and planning, (2) Making
investment decisions, (3) Making financing and
capital structure decisions, (4) Managing
financial resources, and (5) Managing risks.
Financial manager affects shareholders
maximization through (1) EPS, (2) Timing,
duration, and risk of earnings, (3) Dividend
policy, and (4) Manner of financing.
Controller is primarily on the internal nature
and includes record keeping, tracking, and
controlling the financial effects of prior and
current operations. They assure that funds are
used efficiently.
Treasurer is primarily external and more on
decision making.
Controller
Treasurer
Concentrates on
Emphasizes the cash
profitability
flow
Budgeting,
Managing cash,
Interpreting financial
insuring assets,
data, preparing taxes,
investing funds,
appraising results and
obtain financing,
making
appraising credit and
recommendations,
collecting funds,
managing and
investing funds,
protecting assets,
investor relations

payroll, etc.
Chief Financial Officer (VP for
Finance) is involved with financial
policy making and planning. He
supervises all phases of financial
activity.
Accounting is a necessary sub function
of finance.
Managerial
accounting
involves
break-even point analysis and variance
analysis.
Break-even point analysis is useful in
deciding whether to introduce a product
line.
Variance analysis is used to compare
actual revenue/cost to its standard for
performance valuation.
Financial market is the constitution of
creation and transfer of financial assets
and liabilities.
Financial markets are composed of (1)
money markets, and (2) capital markets.
Money markets are short term. Examples are
treasury
bills,
commercial
paper,
and
negotiable certificates of deposit issued by
government,
business
and
financial
institutions.
Capital markets are long term. One example
is the PSE.
Philippine Stock Exchange handles the
share capital of many large corporations.
Over-the-counter is a term used to denote all
buying and selling that do not occur on an
organized stock exchange.
Bangko Sentral ng Pilipinas is the central
bank of the country. Main objective is to
maintain price stability conducive to a
balanced and sustainable economic growth.
Agency relationships: between shareholders
and
managers,
and/or
creditors
and
shareholders.
Agency problem exist when a manager owns
less than 100 percent of the ownership.
Agency costs are the costs associated with
the agency problem, such as reduced capital
price.
Used to ensure that managers act in the
best interests of the shareholders: (1)
severance contracts, (2) share options, and (3)
threat of takeover.
To reduce the value of debt outstanding
result from creditors versus shareholders

SEC mandates
sweeping
changes.

UNDERSTANDING FINANCIAL STATEMENTS

Financial decisions are typically based on
data generated from the accounting system.
Reports generated by the accounting
system: Balance sheet, Income statement,
and statement of cash flows.
Balance sheet tells you the financial condition
of the organization time to time. Snapshot if
compared to a movie.
Income statement measures the operating
performance for a specified period of time.
Motion picture if will be compared.
Statement of cash flows provides the
inflows and outflows of cash.
Revenue does not necessarily mean receipt of
cash, and expense not automatically implies a
cash payment. Net income and Net cash flow
are different.
Classified Financial Statements is an
organization in a fashion. Every major revenue
and expense function is listed separately to
facilitate analysis.

Four major functions of CFS: Revenue, cost

of goods sold, operating expenses, and other
revenue or expenses.
Revenue comprises the gross income. Cost of
goods sold is the cost of the merchandise or
service sold. Selling expense are costs
incurred in obtaining the sale of goods.
General and administrative expenses are
cost running the business as a whole. Other
revenue covers incidental sources of revenue
and expense that are nonoperating in nature.
Investing Activities
- Receipts from sales
of equity and debt
securities of other
companies (In)
- Amounts received
from the sale of plant
assets (In)
- Payments to buy
equity
or
debt
securities (Out)
- Payments to buy
plant assets (Out)
Financing Activities

Operating Activities

- Paying off debt (Out)

- Repurchase of share
capital
Issuing
Dividend
payments
- Cash sales (In)
- Cash/Equity Receipts
(In)
- Cash paid for raw
material
or
merchandise (Out)
- Payment to suppliers
(Out)
Payments
on
accounts
payable
(Out)
- Wages (Out(

Current profitability is only one important

factor in predicting corporate success.
Comparative Financial Statement covers
profitability, sales. Dividends, etc.
Four types of Audit opinion: Unqualified
opinion, a qualified opinion, a disclaimer of
opinion, and an adverse opinion.
Unqualified opinion CPA is satisfied that
the financial statements are presented fairly.
Qualified opinion if the company has
placed a scope limitation on CPAs work.

Disclaimer of opinion when severe scope

limitation exists.
Adverse opinion the financial statements
are misleading.
ANALYZING FINANCIAL STATEMENTS
Short-term creditor vendor or supplier
Long-term creditor bank or bondholder
Management is concerned with all the
questions raised by creditors and investors.
Investors are those who are interested in the
current and future level of return and risk.
Horizontal analysis concentrates on trends in
the accounts. It is typically presented in
comparative financial statements. It helps to
pinpoint areas of wide difference that require
investigation.
Common-size statement/Vertical analysis
is one that reveals each item in percentage
terms.
The results of ration analysis allow us to:
appraise the position of business, identify
trouble spots, and make forecasts.
Security and Exchange Commission does
not provide ratios.
BAP Credit Bureau is where Philippine
banking and financial institutions depend.
Credit Information Corporation provides
access to reliable standardized information on
credit history.
Liquidity is the ratio showing the firms ability
to satisfy maturing short-term debt.
Asset utilization ratios reflect the way in
which a business enterprise uses its assets to
obtain revenue and profit.
Solvency is the ability to satisfy long-term
debt as it becomes due.
Financial Leverage is the size of debt in the
business enterprises capital structure.
Debt-equity ratio reveals if the business
enterprise has a great amount of debt in its
capital structure.
Gross Profit Margin is the percentage of
each peso remaining on the business
enterprise has paid for goods acquired.
Profit Margin shows earnings generated from
revenue and is a key indicator of operating
performance.
Return on Investment allows you to evaluate
the profit you will earn if you invest in the
business.

Return on Total Assets shows whether

management is efficient in using available
resources to get profit.
Inventory ratios are useful when a buildup in
inventory exists.
Return on Equity reflects the rate of return
earned on the shareholders investment.
Earnings per Share is the ration most widely
watched by investors.
Price/Earnings Ratio is also called as
earnings multiple, reflects the business
enterprises relationship to its shareholders.
Book value per share shows how investors
feel about the business.
Price/Book Value ratio shows the market
value of the business enterprise in comparison
to its historical accounting value. An enterprise
with old assets may have a high ratio.
Dividend ratios help you determine the
current income from an investment.
Operating cycle is the number of days it
takes to convert inventory and receivables to
cash.
Lower payouts are a sign of a possible
deterioration in a business enterprises
financial health.

Interest Earned (Interest Coverage)=

DebtEquity Ratio=

Debt Ratio=

EBIT
Interest Expense

Total Liabilities
Total Shareholders' Equity

Total Liabilities
Total Assets

Total Assets Turnover=

OperatingCycle=

Net Sales
Total Assets

Average Collection Period

Average Age of Inventory

Accounts Collection Period=

Inventory Ratios=

365 days
AR turnover

Cost of goods sold

Average Inventory

Formulas:

Profit Margin=

NOPAT
Net sale s

Average Age of Inventory=

365
Inventory turnover

Net Workingcapital=Cur . AssetsCur . Liabilities Return on Assets= Earningsavailable

Total assets
Current Ratio =

Current Assets
Current Liabilities

Acid test ratio=

Cash+ Marketable Securities

Current Liabilities

Accounts R eceivable Turnover=

Dividend Yield=

Dividends per share

Market price per share

Dividend Payout=

Dividends per share

Earnings per share

Net Credit Sales

Ave . Accounts Receivable
LEVERAGE AND CAPITAL STRUCTURE

Gross Profit Margin=

Gross Profit
Net Sales

Leverage is the portion of a business

enterprises fixed costs that represent a risk to
the firm.
Operating costs measure operating risk.

Financial costs measure financial risk.

FACT: The HIGHER the FINANCIAL LEVERAGE,
the HIGHER the FINANCIAL RISK and therefore
result to HIGH COST OF CAPITAL.
Contribution Margin (CM) is the excess of
sales over the variable costs.
Unit Contribution Margin (UCM) is the
excess of the unit selling price over the unit
variable cost.
Sale
(Variable Costs)
Contribution Margin
(Fixed Costs)
Net Income
FACT: The LOWER the BREAK-EVEN POINT, the
HIGHER the PROFITS and the LESS the
OPERATING RISK.
Break-even Analysis determine the financial
crossover point at which revenues exactly
match costs.

Operating BreakE ven Point=

( EBIT I )( 1T ) PD ( EBIT I ) ( 1T )PD

=
Plan 1' s OS
Plan 2' s OS
Analysis of cash flow is the second tool of
capital structure.
Coverage ratio is the third tool.

Interest Earned =

Q( PVC)
Q ( PVC )FC

Fact: All TYPES OF LEVERAGE are two-edged

swords. The change in sales, the higher change
will be in the EBIT.

Financial BreakEven Point=IE+

Dividends
(1Tax)

Dividends
Financial Leverage=IE+
(1Tax)
Total Leverage=OL x FL
Capital Structure is the mix of long-term
funding sources used by the business
enterprise. Its primary objective is to MAXIMIZE
THE MARKET VALUE.
Optimal Capital Structure minimizes the
overall cost of capital.

EBIT
Interest

DebtService Coverage=

FC
PVC

Cash Break-even Point is the deduction of

depreciation from the fixed costs, and getting
the break-even point.

Operating Leverage=

EBIT-EPS Analysis is a practical tool that

enables financial managers to evaluate
alternative financing plans by investigating
their effect in EPS for a range of EBIT sales.

EBIT
Principal Payments
Interest +
1Tax

The order of raising funds: Retained

Earnings -> Debt -> Equity.
Expensive equity (From the highest):
Common stock -> Retained Earnings ->
Preferred Stock
Fact: If the management found an excellent
investment and needs additional funding, the
firm should FINANCE WITH DEBT if the firm is
undervalued.

FINANCIAL
BUDGETING

FORECASTING

AND

Financial forecasting serves as a basis for

budgeting and for estimating future financing
requirements.
Internal financing refers to cash flow
generated by the business enterprises normal
operating activities.
External financing refers to capital provided
by parties outside the business enterprise,
such as investors and banks.
Percent-of-sales method is the most widely
used method for projecting the business
enterprises financing needs. It is simple and
inexpensive to use. It assumes that the
business enterprise is operating at full capacity.

Budget represents a business enterprises

annual financial plan. It is a tool for both
planning and control.
Comprehensive
budget
is
a
formal
statement of managements expectations. It
consists of the pro forma income statement,
pro forma balance sheet, and cash budget.
Sales forecast gives the expected level of
sales for the business enterprises goods or
services throughout some future period.
Sales budget is the starting point in preparing
the master budget.
Direct material budget shows how much
material will be required and how much must
be
purchased
to
meet
production
requirements.

Factory overhead budget provides a

schedule of all manufacturing costs other than
direct materials and labor.
Ending inventory budget provides the
information required for the construction of
budgeted financial statements.
Selling
and
administrative
expense
budget shows the operating expenses
incurred in selling the products.
Cash budget shows the expected inflow and
outflow of cash.
Budgeted Income statement summarizes
projections for the various components of
revenue and expenses for the budgeting
period.