Chapter 1: Introduction to Financial Management

1.1 The Difference between Accounting and Finance

Accounting is a record-keeping system, which has been invented to reflect the financial
operation of a firm. The record can be used periodically to produce financial statements such
as Balance Sheet (SOFP), Income Statement and Cash Flow Statement. These statements
reflect the firm’s standing and performance.

Finance consists of three important aspects:

i. Money and capital markets.
ii. Investment – decisions of individuals and financial institutions as they choose
securities for their investment portfolios.
iii. Financial management / business finance – the actual management of the firm.

Although account and finance do not involves the same aspects, they are closely related. To have
a good financial management, many accounting information are required such as financial
statement and financial ratio analysis.
Source: OUM, Introductory Finance BDPW3103

1.2 Financial Management

Financial Management refers to how we manage money to get maximum return from
investments. It is concerned with the acquisition, financing and management of assets with some
overall goals in mind. A good financial planning and management will increase the value of a
firm. (no of the shares x share price, 1 million shares x Rm10)
OUM, Introductory Finance BDPW3103
Profit Maximization vs Wealth Maximization

Profit maximization profit = revenue –expense= 1000-300 =700 1000-100=900

 Short term in nature
 Profit maximization, major emphasizes is on profit.
 Mostly concerned about short term benefits.
 A short term horizon can fulfil objective of earning profit but may not help in creating
wealth for the shareholders.

Wealth maximization - maximizing the value of the firm through maximizing the price of the
firm’s common stock.
 Long term in nature
 Concentrate on various other aspects like increasing sales, developing goodwill, customer
service, and corporate responsibility for the purpose of capturing more market share
which will take care of profitability.
 priority to value creation

1
  Leads to better and true evaluation of business e.g., under wealth maximization, more
importance is given to cash flows rather than profitability.

The objectives of the Firm / Goals of the Corporation

The most important goal of most corporations is:

Maximizing Shareholder wealth

The firm’s stock price is dependent on the following factors:-

 Cash Flow
 The expectation that the firm will generate cash in future.
 Financial managers concentrate on increasing cash inflows and decreasing
cash outflows.
 The higher the expected cash inflows and the lower the expected cash
outflows, the higher the firm’s stock price will be.

 Timing of cash flow

 Refers to when the firms expect to receive cash and when they expect to
pay out cash.
 The sooner the cash inflows and the later the cash outflows, the higher the
firm’s stock price will be.

 Risk of expected cash flows.

 The less certain owners and investors are about a firm’s expected future
cash flows, the lower they will value the company.
 As risk increased, stock prices goes down and vice versa.

2
 Financial management and its three major roles:

Financial management is concerned with the acquisition, financing, and management of assets

with some overall goal in mind. Thus, the decision function of financial management can be

broken down into three major areas: the investment, financing, and asset management decision.

1. Investment decision.
This is an investment or capital budgeting decision that concerns the left-hand side of the balance
sheet. A determination of the total amount of assets needed to be held by a firm.
Investment decision includes:
 Those that create revenues and profits
 Those that save money.
Examples of investment decisions include:
 Investment in physical / tangible assets, like plant, equipment.
 Investment in financial assets, like bonds, marketable securities.
 New and more efficient distribution system.
 How much and what inventory to maintain.
 Whether and how much credit to grant to customers (working capital decisions)
 Acquisition of other companies

2. Financing decision.
This is a financing decision which will determine the capital structure of the firm. It concerns the
right-hand side of the balance sheet. Financing decisions determine the mix and type of liabilities
(short-term vs long-term financing) found on the firm’s balance sheet.

3
Examples of long-term financing:
 common stock
 long-term debt, like bonds
 preferred stock
Examples of short-term financing:
 trade credit
 short-term bank loans
 commercial paper

4
 Dividend decision is part of financing decision which involves the decision to pay out earnings
or to retain them for reinvestment in the firm. The financial manager must determine the optimal
dividend policy that strikes a balance between current dividends and future growth which
maximizes the price of the stock.

3. Asset management decision.

Once assets have been acquired and appropriate financing provided, these assets must be
efficiently managed. Asset management decisions involved ways of managing assets in order to
achieve the goal of the firm. Normally, financial managers are more concerned with the
management of current assets, such as the determination of proper level of liquidity and working
capital also the management of longer term assets and liabilities such as long term debt vs equity

1.3 The Financial Manager’s Responsibilities

i. Forecasting and planning. The financial manager must interact with other executives as they
look ahead and lay the plans which will shape the firms’ future position.

ii. Major Investment and financing decisions. A successful firm usually has rapid growth in
sales, which requires investments in plant, equipment and inventory. The financial manager
must help determine the optimal rate of sales growth, and he or she must help decide on the
specific assets to acquire and the best way to finance these investments. For example, should
the firm finance with debt or equity, and if debt is used, should it be long term or short term.

Investment in plant, equipment and inventory is important for a successful firm because the sales
of the company grow very fast

A fast growing company usually has sales which grow in a rapid pace, which requires the
company to equipment, plant and inventory

iii. Coordination and control. The financial manager

iv. must interact with other executives to insure that the firm is operated as efficiently as possible.
All business decisions have financial implications, and all managers-financial and otherwise
need to take this into account. For example marketing decision affect sales growth, which in
turn influences investment requirement. Thus, marketing decision makers must take account
of how their actions affect such factors as the availability of funds, inventory policies and plant
capacity utilization.

v. Dealing with the capital market. The financial manager must deal wit the money and capital
markets. All firms affect and are affected by the general financial markets where funds are
raised, where the firm’s securities are traded, and where its investors are either rewarded or
penalized.

5
In summary, financial mangers make decisions regarding which assets their firms should acquire,
how those assets should be financed, and how the firm should manage its existing resources. If
these responsibilities are performed optimally, financial managers

1.4 Cash Accounting and Accruals Accounting

 Accruals Concept – Revenues and costs are recognized as they are earned or incurred, not as
money is received or paid.

 Cash Accounting – It is a system of accounting for costs and income on the basis of
payments and cash receipts.

Finance vs Accounting View (cash flow vs profit)

Techniques in finance generally use cash flows (cash accounting), whereas accounting generally
stresses profits (accruals concept).
Example:

Suppose that Midland Company is in the business of refining and trading gold. At the end of the
year, it sold 2500 ounces of gold for RM1 million. The company had acquired the gold for
RM900,000 at the beginning of the year. The company paid cash for the gold when it was
purchased. Unfortunately, it has yet to collect from the customer to whom the gold was sold.

Based on accruals concept Based on cash accounting

Sales RM1,000,000 Cash inflows RM 0

Cost of Sales 900,000 Cash outflows (900,000)
Profit 100,000 Net cash flows (900,000)

By generally accepted accounting The perspective of corporate finance is

principles, the sale is recorded even different. It is interested in whether cash
though the customer has yet to pay. flows are being created by the operation of
Midland seems to be profitable. Midland.

6
Tutorial: Chapter 1 Introduction to Financial Management QUESTIONS

1. Discuss the difference between profit maximization and wealth maximization.

2. Identify responsibilities for a financial manager in an organization.

3. Explain the difference between accounting and finance.

4. Differentiate cash accounting and accrual accounting

5. Discuss the roles of financial manager.

6. Discuss the factors which affect a firm’s stock price

7
Tutorial 1: Overview of Financial Management ANSWER

1. Discuss the difference between profit maximization and wealth maximization.

Profit maximization
 Short term in nature
 Profit maximization, major emphasizes is on profit.
 Mostly concerned about short term benefits.
 A short term horizon can fulfil objective of earning profit but may not help in creating
wealth.

Shareholder Wealth maximization

 Long term in nature
 Concentrate on various other aspects like increasing sales, developing goodwill, customer
service, and corporate responsibility for the purpose of capturing more market share
which will take care of profitability.
 priority to value creation
 Leads to better and true evaluation of business e.g., under wealth maximization, more
importance is given to cash flows rather than profitability.

2. Identify responsibilities for a financial manager in an organization.

a. Forecasting and planning. The financial manager must interact with other executives
as they look ahead and lay the plans which will shape the firms’ future position.
b. Major Investment and financing decisions. A successful firm usually has rapid growth
in sales, which requires investments in plant, equipment and inventory. The financial
manager must help determine the optimal rate of sales growth, and he or she must help
decide on the specific assets to acquire and the best way to finance these investments.
For example, should the firm finance with debt or equity, and if debt is used, should it be
long term or short term.
c. Coordination and control. The financial manager must interact with other executives to
insure that the firm is operated as efficiently as possible. All business decisions have
financial implications, and all managers-financial and otherwise need to take this into
account. For example marketing decision affect sales growth, which in turn influences
investment requirement. Thus, marketing decision makers must take account of how

8
 their actions affect such factors as the availability of funds, inventory policies and plant
capacity utilization.
d. Dealing with the financial market. The financial manager must deal with the money
and capital markets. All firms affect and are affected by the general financial markets
where funds are raised, where the firm’s securities are traded, and where its investors are
either rewarded or penalized.

3. Explain the difference between accounting and finance.

Accounting is a record-keeping system, which has been invented to reflect the financial
operation of a firm. The record can be used periodically to produce financial statements such
as Balance Sheet, Income Statement and Cash Flow Statement. These statements reflect the
firm’s standing and performance.

Finance consists of three important aspects:

i. Money and capital markets.
ii. Investment – decisions of individuals and financial institutions as they choose
securities for their investment portfolios.
iii. Financial management / business finance – the actual management of the firm.

4. Differentiate cash accounting and accrual accounting

Accruals Concept – Revenues and costs are recognized as they are earned or incurred, not
as money is received or paid.

Cash Accounting – It is a system of accounting for costs and income on the basis of
payments and cash receipts.

5. Discuss the roles of financial manager.

Investment decision.
This is an investment or capital budgeting decision that concerns the left-hand side of the
balance sheet. A determination of the total amount of assets needed to be held by a firm.
Investment decision includes:
 Those that create revenues and profits
 Those that save money.
Examples of investment decisions include:
 Investment in physical / tangible assets, like plant, equipment.
 Investment in financial assets, like bonds, marketable securities.
 New and more efficient distribution system.
 How much and what inventory to maintain.
 Whether and how much credit to grant to customers (working capital decisions)
 Acquisition of other companies

9
Financing decision.
This is a financing decision which will determine the capital structure of the firm. It
concerns the right-hand side of the balance sheet. Financing decisions determine the mix
and type of liabilities (short-term vs long-term financing) found on the firm’s balance
sheet.

10
 Examples of long-term financing:
 common stock
 long-term debt, like bonds
 preferred stock
Examples of short-term financing:
 trade credit
 short-term bank loans
 commercial paper

Dividend decision is part of financing decision which involves the decision to pay out
earnings or to retain them for reinvestment in the firm. The financial manager must
determine the optimal dividend policy that strikes a balance between current dividends
and future growth which maximizes the price of the stock.

Asset management decision.

Once assets have been acquired and appropriate financing provided, these assets must
be efficiently managed. Asset management decisions involved ways of managing
assets in order to achieve the goal of the firm. Normally, financial managers are more
concerned with the management of current assets, such as the determination of proper
level of liquidity and working capital also the management of longer term assets and
liabilities such as long term debt vs equity

6. Discuss the factors which affect a firm’s stock price

The firm’s stock price is dependent on the following factors:-

 Cash Flow
 The expectation that the firm will generate cash in future.
 Financial managers concentrate on increasing cash inflows and
decreasing cash outflows.
 The higher the expected cash inflows and the lower the expected cash
outflows, the higher the firm’s stock price will be.

 Timing of cash flow

 Refers to when the firms expect to receive cash and when they
expect to pay out cash.
 The sooner the cash inflows and the later the cash outflows, the
higher the firm’s stock price will be.

 Risk of expected cash flows.

 The less certain owners and investors are about a firm’s expected
future cash flows, the lower they will value the company.
 As risk increased, stock prices goes down and vice versa.