Financial Management

Chapter 01
Introduction to FM
By: Muhibullah Zamani
Email: [Link]@[Link]
Facebook: Muhibullah Zamani
YouTube: Smart Finance Academy
WhatsApp: 0093744542178
Course Outline:
1- Introduction
2- Financial markets
3- Time Value of Money
4- Afghanistan’s taxation system
5- Risk and Return
6- Valuation of Securities
7- Financial Statements Analysis
Course Outline Chapter 1:
1- Definitions
2- Functions
3- Objectives
4- Corporate governance
5- The value creation process
Topics Outcome
Students will be able to:
Explain the role of finance manager.
Describe the functions of financial management.
 References
Chapter 01 of Fundamentals of Financial Management by James [Link]
Horne, 13th Edition.
Chapter 1 of F9_Financial management, ACCA.
Chapter 1&2 of Business finance theory and Practice 8th edition by Eddie
McLaney (Pearson Education).
What is Financial Management all about?
 What is Financial
Management?
“Planning, raising, controlling, and administering the funds used in the
business.”
Planning how money will be used
Raising funds (equity, debt, etc.)
Investing in profitable projects
Controlling and monitoring financial performance
Managing risks related to money

Make simulator account and start trading in stock exchange market

[Link]
. Functions of Financial Management

A-Executive Finance
Functions

B-Incidental Finance
Functions
A-Executive Finance Functions
(Key Activities of a Finance Manager)
1. Forecasting Financial Requirements
To estimate, how much fund is required to acquire fixed assets and to meet the working
capital requirements.

Working capital:
FIXED ASSETS:
Working capital = total of current assets – total of current liabilities
Land and building 100000 Working capital = 400000 – 300000
Plant and machinery 50000 Working capital = 100000
Vehicles 60000
Furniture and fixture 40000 Total capital required = fixed assets + working capital
Tools and equipment.. 50000 Total capital required = 300000 + 100000
Total value 300000 Total capital required = 400000

HOW??? Budgeting
2. Acquiring Necessary Capital and making Optimum Capital Structure
how the finance is mobilized and where it will be available.
Where to raise the amount of 400000? Individual Contributions
Board Contributions
Corporate Contributions
Foundation Contributions
Sources of fund: Donated Professional Services
Equity share Donated Use of Facilities
Preference share What are the various Gifts In Kind - Goods
Debt: sources of fund? Donated Securities
Unrestricted Grants
Bond Program Service Fees
Bank Loan Membership Dues
Loan From Friends Etc. Interest
Total capital = Debit + Equity Dividends
Total capital = 30% + 70% Unrealized Gain(Loss)
= 40% + 60% Realized Gain(Loss)
= 50% + 50%
= 0% + 100%
3. Investment Decision/ Utilization of fund

Proper allocation of fund…Priorities Consider: principles of safety, liquidity and

Maximum common benefits profitability
Stakeholders satisfaction Apply: capital budgeting techniques:

Payback period method

Net present value method
Profitability index method
Internal rate of return
Projects Net terminal value method
Accounting rate of return
Post payback profitability method
cont.…
4- Management of income or dividend decision:
How much to pay dividend to shareholders, how much to distributes as
bonus to employees, and how much to retain for the future out of the profit
earned after tax.

Suppose net profit is $ 100000

Dividend 50000
Retained earning 30000
Repayment of loan 15000
Bonus to employees 5000
5- Liquidity/cash decision:
Liquidity decision is concerned with the management of current
assets(working capital management).
If current asset is more, then, liquidity is more which cause to less
usage because of idle funds.
If current asset is less, then liquidity is less, which cause to deficit
funding because of shortage of fund.
If current asset is proper, then, liquidity is optimum which cause
optimum usage as a result of proper use of fund.

Cashflow forecasting and

HOW??? Monitoring
6- Analysis of financial Position/Performance :
To analyze, check and appraise financial position/ performance and then
set necessary guidelines for future. Please
Comparative/Horizontal Analysis visit
Common Size/Vertical Analysis
Trend Analysis
Ratio Analysis
Cash Flow Analysis [Link]
Cost Volume Profit Analysis
Fund Flow Analysis
What Then? Action Planning
B-Incidental Finance Functions:
These are functions of routine nature.
Record keeping and reporting.
Preparation of financial statements.
Preparation of Payroll.
Preparation of Bank Reconciliation Statement.
Preparation of tax return forms or tax related activities.
Managing cash balance.
Safeguarding the valuable papers, securities, insurance policies etc.
 Objective of financial management

• Shareholder wealth maximization

• Procurement and Utilization of funds
• Maintain the liquidity of the firm
• Social responsibilities
 Corporate Governance

• Corporate governance refers to the system by which corporations are

managed and controlled.
• It encompasses the relationships among a company’s shareholders, board
of directors and senior management.
• These relationships provide the framework within which corporate
objectives are set and performance is monitored.
 The Value Creation Process

• Value is created when a firm earns returns greater than its cost of capital.
• The process involves:
• Identifying opportunities to invest in positive net present value (NPV) projects.
• Financing those opportunities at an optimal cost.
• Managing operations efficiently to achieve superior returns.
• Returning value to shareholders through dividends or share buybacks.
• Tools like EVA (Economic Value Added) measure value creation beyond
accounting profits.
Thank You
 Conflict of Interest and Agency Cost
Agency theory  Principal vs the agent

Conflict of goals Agency Problem:

How to manage the A) Direct Cost: Agency Cost:

Agency Problem?
B) Indirect Cost:

1- Internal control(code of conduct policy,

whistle blowing policy.
2- Reward schemes
– Economic Value Added (EVA) Short
– Revenue Growth Scenarios
- Minimum profit levels
 Regulatory
Framework

Financial Corporate
Statements Governance

International National Ownership vs Purpose and

Standards & Standards & Control Objectives
Regulation Regulation
 The Tools of Financial Management
There are many tools, not necessarily financial, which managers can use to help achieve good
practice in financial management.
• Planning What Do You Think?
Tools: Strategic plan, Operational plan, budgets, work plans, cashflow forecast,
feasibility study…etc.
• Organising
Tools: Constitution, organisation charts, flow diagrams, job descriptions, Chart of Accounts,
Finance Manual, budgets…etc..
• Controlling
Tools: Budgets, delegated authority, procurement procedure, reconciliation, internal
and external audit, fixed assets register, vehicle policy, insurance...etc.
• Monitoring
Tools: Evaluation reports, budget monitoring reports, Cashflow reports, financial
statements, project reports, donor reports, audit reports, …etc.
Importance of Financial Management
• Being accountable to the donors and other stakeholders :
• Securing future: Help org. prepare themselves for long-term financial
sustainability.
• Eliminating fraud and theft:
• Making productive decisions: to make effective and efficient use of resources
• Achieving objectives and fulfil commitments to stakeholders:
• Enhancing credibility: Gain the respect and confidence of funding agencies,
partners and beneficiaries
• Strengthening fundraising efforts: Give the org. the advantage in competition
for increasingly scarce resources
 Scope of Financial Management
• Developing and managing Budget, forecasting income and expenses, allocating
resources and tracking variances.
• Long term Financial planning, analyzing funding sources, diversifying income streams.
• Generating timely and accurate financial reports to provide transparency and
accountability.
• Cash Flow Management
• Internal Control: Fraud, Misuse, Corruption and via regular audit, and supporting
documents.
• Maintaining effective communication with donors, partners and other stakeholders.
Who is Responsible for Financial Management?

DISCUSSION
 Stakeholder objectives and conflicts
Stakeholder vs shareholder views
Sustainability  Page 32
Internal: Fundamentals of
Company employees Financial Management
James C. Van Horne
Company managers/directors John M. Wachowicz, Jr 13th Edition

External: Connected:
The government Equity investors (ordinary shareholders)
The community at large Customers
Pressure groups Suppliers
Regulators. Finance providers (debt holders/bankers)
Competitors
Additional question – Stakeholder conflicts
Suggest the potential conflicts in objectives which could arise between the
following groups of stakeholders in a company.

ACCA F9
Page
67
 The role of management and goal congruence
Agency theory:
Agency theory is often used to describe the relationships between the
various interested parties in a firm and can help to explain the various
duties and conflicts that occur:
Agency relationships occur when one party, the principal, employs another
party, the agent, to perform a task on their behalf. In particular, directors
(agents) act on behalf of shareholders (principals).
Agency Problem:
This conflict of goals between a firm’s managers and shareholders is often
referred to as the agency problem.
Agency Cost:
Agency costs occur when a company's management or "agent" places his own
personal financial interests above those of the shareholder or "principal.
Agency costs can be either:
A) Direct Cost:
The costs incurred if the agent uses to company's resources for his own benefit.
B) Indirect Cost:
The cost of techniques that principals use to prevent the agent from prioritizing
his interests over the shareholders. Cases page
48
 Scenario 1:
Remuneration: The UK recession in 2008 – 2009 led to many companies
reporting sharply reduced profits and laying off staff or cutting levels of
employee pay. At the same time many directors were awarded large
increases in pay or large bonuses. The greatest media attention focused
on the companies who received government assistance as part of a bail-
out package but continued to reward their top executives highly.
 Scenario 2:
Empire building
The high level of corporate takeover activity in the 1980s led to many
chief executives believing that building as large a group as possible was a
valid aim in itself, an objective described as empire building. Executives
gained prestige from successful bids and from being in charge of large
conglomerates, but the returns to shareholders were often disappointing.
 Scenario 3:
Creative accounting
The directors are responsible for selecting the accounting policies to be used by their
company, subject to accounting standards and the opinion of the auditors. Despite the
constraints upon them, the directors are still free to use creative accounting techniques
to flatter their published accounts and perhaps artificially boost the share price.
Examples of such techniques are:
Capitalizing expenses on the balance sheet (e.G. Development expenditure,
advertising expenditure)
Not depreciating noncurrent assets
Maximizing the value of intangibles on the balance sheet (e.G. Putting a value to
brands)
Recognizing revenue on long-term contracts at the earliest possible time
Other forms of off-balance-sheet financing.
 Scenario 4:
Takeover bids
Boards of directors often spend considerable amounts of time and
money attempting to defend their companies against takeover bids, even
when it appears that the takeover would be in the best interests of the
target company’s shareholders. These directors are accused of trying to
protect their own jobs, fearing that they will be retired if their company is
taken over.
Directors of public companies must now comply with the City Code on
Takeovers and Mergers during a bid period.
[Link]
 Scenario 5:
Unethical activities
Unethical activities might not be prohibited by the Companies Acts or
stock exchange regulations, but are believed by many to be undesirable
to society as a whole. Examples are trading with countries ruled by
dictatorships, testing products on animals, emitting pollution or carrying
out espionage against competitors. The importance of good business
ethics and corporate social responsibility (CSR) has been recognised in
recent years and it is hoped that further progress is being made in the
new millennium.
Although directors are supposed to be acting in the interests of the
shareholders of their company, they stand accused in recent years of
having made decisions on the basis of their own self-interest.
 Scenario 6:
Two years ago, Seattle Co. (based in the United States) established a
subsidiary in Singapore so that it could expand its business there. It hired
a manager in Singapore to manage the subsidiary. During the last two
years, the sales generated by the subsidiary have not grown. Even so, the
manager hired several employees to do the work that he was assigned.
The managers of the parent company in the United States have not
closely monitored the subsidiary because it is so far away and because
they trusted the manager there. Now they realize that there is an agency
problem.
The subsidiary is experiencing losses every quarter, so its management
must be more closely monitored.
How to reduce the problems caused by agency
relationships
Remuneration
Packages

Common types of reward schemes include:

• Remuneration linked to:
– Minimum profit levels
– Economic Value Added (EVA)
– Revenue Growth
• Executive Share Option Schemes (ESOP).
Remuneration linked to minimum profit levels
This scheme would be easy to set up and monitor.

Disadvantages:
• The scheme may lead to managers taking decisions that would
result in profits being earned in the short-term at the expense
of long-term profitability.
• It could also lead to managers underachieving, i.e. relaxing as
soon as the minimum is achieved.
• The scheme might also tempt managers to use creative
accounting to boost the profit figure.
Remuneration linked to economic value added (EVA):
• EVA assesses the performance of a company and its management
through the idea that a business is only profitable when it creates wealth
and returns for shareholders, thus requiring performance above a
company's cost of capital.
• EVA as a performance indicator is very useful. The calculation shows how
and where a company created wealth, through the inclusion of
balance sheet items. This forces managers to be aware of assets and
expenses when making managerial decisions.
• However, the EVA calculation relies heavily on the amount of
invested capital and is best used for asset-rich companies that are stable
or mature. Companies with intangible assets, such as technology
businesses, may not be good candidates for an EVA evaluation.
The formula for calculating EVA is:
EVA = NOPAT - (Invested Capital * WACC)
Where:
NOPAT = Net operating profit after taxes
Invested capital = Debt + capital leases + shareholders' equity
WACC = Weighted average cost of capital
Remuneration linked to revenue growth:
Growth of the business and higher production levels can lead to
economies of scale which in turn can help the business compete
more successfully on price.
However, revenue growth could be achieved at the expense of
profitability, e.g. by reducing selling prices or by selecting high
revenue product lines which may not necessarily be the most
profitable. Maximising revenue is therefore unlikely to maximise
shareholder wealth.
An executive share option scheme (ESOP):
When an executive is awarded share options, the theory is that it is in their
interests for the share price to rise, so they will do whatever possible to
improve the share price. Their interests will be best served by working
towards a goal that is also in the interests of the shareholders.
However, efficient managers may be penalised at times when share prices
in general are falling.
There are several criticisms of ESOPs:
• When directors exercise their share options, they tend to sell the shares
almost immediately to cash in on their profit. Unless they are awarded
more share options, their interest in the share price therefore ends when
the option exercise date has passed.
• If the share price falls when options have been awarded, and the options
go ‘underwater’ and have no value, they cannot act as an incentive.
• If a company issues large quantities of share options, there could be some
risk of excessive dilution of the equity interests of the existing
shareholders.
• Directors may distort reported profits (creative accounting) to protect the
share price and the value of their share options.
Managers are currently awarded bonuses if there is growth in
reported earnings per share (EPS):
Advantages
• Goal congruence – managers will work to achieve growth in EPS,
which will make shareholders feel that their wealth is increasing.
• The figure is difficult (but not impossible!) to manipulate from
one period to another as it will be audited.
Disadvantages:
• There is little incentive for managers to control working capital and cash
flow – a pressing problem. Growth may be at the expense of liquidity and
ultimately compromise the firm’s future survival.
• Managers may gain bonuses simply because of the products concerned
rather than their own efforts. A target growth in EPS would be better.
• Long-term shareholder value and EPS are not well correlated.
• There is only one measure that focuses on final effects rather than
operational causes.
Sarbanes-Oxley Act (SOX) of 2002
It requires firms to implement an internal reporting process that can be easily monitored
by executives and the board of directors. Some of the common methods used by MNCs
to improve their internal control process are:
■ establishing a centralized database of information,
■ ensuring that all data are reported consistently among subsidiaries,
■ implementing a system that automatically checks data for unusual discrepancies
relative to norms,
■ speeding the process by which all departments and subsidiaries access needed
data, and
■ making executives more accountable for financial statements by personally verifying
their accuracy.
Internet Facilitates Management Control
The Internet is making it easier for the parent to monitor the actions and
performance of its foreign subsidiaries.
EXAMPLE Recall the example of Seattle Co., which has a subsidiary in
Singapore. The Internet allows the foreign subsidiary to e-mail updated
information in a standardized format that reduces language problems and
also to send images of financial reports and product designs. The parent
can then easily track the inventory, sales, expenses, and earnings of each
subsidiary on a weekly or monthly basis. Thus, using the Internet can
reduce agency costs due to international aspects of an MNC’s business.
Measuring achievement of corporate objectives
It is necessary for managers, shareholders and other stakeholders to have
ways of measuring the progress of the company towards its objectives. This
is commonly done via ratio analysis.
Ratio analysis compares and quantifies relationships between financial
variables.
Ratio analysis can be grouped into four main categories:
• Profitability and return
• Debt and gearing
• Liquidity
• Investor