INTRODUCTION TO FINANCIAL MANAGEMENT:Corporate Financing & Capital Structure,

OBJECTIVES OF FINANCIAL MANAGEMENT, FINANCIAL ASSETS AND FINANCIAL MARKETS:Real Assets, Bond >>

Financial Management MGT201

Lesson 01

INTRODUCTION TO FINANCIAL MANAGEMENT

Learning objectives:

The purpose of this lecture is to provide you with an overview of financial management. After

finishing this lecture, you would be able to have a better understanding of the following.

· Definition of financial management

· Significance of financial management for non-finance students and professionals

· Important concepts and areas in financial management

· The position of financial managers in organizational hierarchy and their respective work

domains.

· Different business legal entities, their advantages and limitations.

· The external and internal business environments and their relevance to financial management.

· Different types of financial and real assets markets.

What is FM?

FM is the management of financial resources how to best find and use investments and

financing opportunities in an ever-changing and increasingly complex environment.

Why should CS majors study FM?

First of all, financial management is a core life skill; almost every one needs to understand some

concepts of finance to manage his/her business & personal finances.

It is generally and quite rightfully said, "Money makes the world go round". Finance is like a

life-blood for a company. Even the best of the companies and CEOs go out of the business because of

poor financial management policies.

Management Information Systems (MIS) and Information Technology (IT) are just a part of the

overall corporate strategy which runs on finances, the major resource. So the computer sciences

professionals need to have an understanding of the financial concepts to understand and contribute to

the overall corporate strategy.

Financial Engineering is an upcoming field that requires people with CS, math/science, and

finance background. Financial engineering is the application of engineering methods to finance. One

important area of study is the design, analysis, and construction of financial contracts to meet the needs

of enterprises. This field is experiencing an increased demand for professionals, especially those who

are trained in both the underlying mathematics/computer technologies and finance.

Definitions

Finance:

Finance is the science of managing financial resources in an optimal pattern i.e. the best use of

available financial sources. Finance consists of three interrelated areas:

1) Money & Capital markets, which deals with securities markets & financial institutions.

2) Investments, which focuses on the decisions of both individual and institutional investors as

they choose assets for their investment portfolios.

3) Financial Management, or business finance which involves the actual management of firms.

Major Areas & Concepts of Financial Management

Following are some of the important areas and concepts of financial management, which would

be discussed in detail in the lectures to come.

Analysis of Financial Statements:

Analysis of financial statement is one of the most common techniques of financial analysis, in

which the financial performance and financial health of a company are analyzed based on its past

performance.`

The following financial statements are used in the analysis process.

· Profit & Loss Statement or Income Statement

Income statement reflects the operating efficiency or profitability of a company as a result

of its operations along with the net profit available to the shareholders for a given year

(usually one accounting period). This statement provides the analyst with some insight into

the financial performance of the company.

· Balance Sheet

Balance Sheet is a snap-shot of an organization's financial health at a particular time. It

shows what assets are owned by the business and the sources of acquiring these assets.

Financial Management MGT201

Statement of Shareholders' equity

Statement of shareholders' equity provides the share of the owners in the business.

· Statement of Cash Flows

Statement of cash flows explicitly reflects the cash movement (inflows and outflows)

during the operations in an accounting period.

Taken together, these statements give an accounting picture of the firm's operations and

financial position. Financial statements report what has actually happened to the assets, earnings,

and dividends over the years. The analysis of the information contained in these statements help

management of the organization to evaluate the performance and activities of the concern; it also

helps the investors and creditors to have an idea of the profitability potential and creditworthiness of

the business.

Investment Decisions & Capital Budgeting:

Investment decisions are the most critical as they usually involve huge sums of money and

these decisions are likely to bring prosperity or doom to a business. A company's future income

depends on how much investment is made, in what type of assets, and how these assets add to the

overall value of the company.

Capital budgeting is a term strictly related to investment in fixed assets; here, the term

capital refers to the fixed assets that are used in production, while budget is a plan which details

projected cash inflows and outflows over some future period. The following concepts and

techniques are employed while analyzing investment decisions.

Interest rate formulas

Time Value of Money

Discounted Cash Flows

Net Present Value

Internal Rate of Return

Risk & Return:

Investors, individual or institutional, invest their money with the expectations of earning a

return on their investment. While investors wish and attempt to earn maximum return, they are

constrained by risk. How the risks and returns are related and how do investors make a choice of

their portfolios is important for investment decision making. Following concepts and theories would

be discussed while discussing the risk-return choices of the investor:

Uncertainty

Risk

Portfolio Theory

Capital Asset Pricing Model

Corporate Financing & Capital Structure:

When a firm plans to expand, it needs capital or funds. Acquisition of funds is considered to

be a primary responsibility of a finance department in an organization. There are numerous ways to

acquire funds, i.e., finances can be raised in the form of debt or equity. The proportion of debt and

equity constitutes the capital structure of the firm. Financial experts attempt to find a combination of

debt and equity that could increase the overall value of the company, i.e., they try to find the

optimal capital structure. The following concepts would be used to understand how an optimal

capital structure could be attained.

Cost of Capital

Leverage

Dividend Policy

Debt Instruments

Valuation:

Asset or company valuation is important not only for financial managers, but also for

creditors and investors. It is important to know the value of the company or its assets to make

Financial Management MGT201

important financing and investment choices. Different valuation techniques and factors that

influence the value of a company or its financial instruments would be discussed in this section.

Bond

Option

Corporate

Working Capital & Inventory Management:

Working capital and inventory management pertains to the effective management of current

assets. As we will see, an optimal and effective utilization of working capital and inventory

increases the operating efficiency of the firm.

International Finance & Foreign Exchange:

With the increasing importance of international trade and global markets, the role of

international finance has increased manifold. In a global environment, the finance managers have

more choices pertaining to investing and financing than ever before. However, it is important to

understand the implications of working in a global environment, since fluctuations in the currency

rates can convert a good financing or investment decision into a bad one. This section of the course

would discuss the international financial environment and the financial implications of working in a

global environment.

Organizational Structure

(Who does the FM work?)

Chief Executive Officer (CEO)

Chief Financial Officer (CFO)

Treasurer

Controller

Accounts

Cash & Investment

Capital Budgeting

Audit

Capital Structure

Inventory

Business Legal Entities

· Sole Proprietorship :

It is an unincorporated business owned by one individual. Going into a business as a sole

proprietor is simple one merely has to begin business operations. Proprietorship consists of 80%of

the total number of businesses worldwide.

Advantages:

It is easily & inexpensively formed.

ii.

It is subject to few government regulations.

iii.

The business pays no corporate income tax; only personal income tax is paid by the

proprietor.

Financial Management MGT201

Limitations:

It is difficult for a proprietorship to obtain large sums of capital.

ii.

The proprietor has unlimited personal liability for the business debts, which can

result in losses hat exceed the money invested by him in the business.

iii.

The life of the business organized as proprietorship is limited to the life of the

individual who created it.

Partnership:

A partnership exists whenever two or more persons associate to conduct a non-corporate

business. It could be registered or unregistered.

Advantages:

Low cost involved

ii.

Ease of formation.

Limitations:

Unlimited Liability.

ii.

Limited life of the organization.

iii.

Difficulty of transferring ownership.

iv.

Difficulty of raising large amounts of capital.

Corporation:

A corporation is a limited company and a separate legal entity registered by the government. It

is separate & distinct from its owners & managers. It Can be Private Limited (Pvt. Ltd.) or Public

Limited (which may be listed on Stock Exchange). The businesses in the form of corporations control

80% of global sales of products and services.

Advantages:

i- Unlimited life:

A corporation can continue even after the death of its original owners.

ii- Easy transferability of ownership interest:

Ownership interests can be divided into shares of stock, which in turn can be transferred far

more easily than can proprietorship & partnership interests.

iii- Limited Liability:

The liability of the shareholders is limited up to the extent of nominal value of shares held by

them. Creditors and banks cannot confiscate personal properties of director & shareholders in case of its

bankruptcy.

Limitations:

Double Taxation:

Corporate earnings may be subject to double taxation the earnings of the

corporation are taxed at corporate level, and then any earnings paid out as

dividends are taxed again as income to the stockholders.

ii.

Legal Formalities:

Setting up a corporation, and filing many official documents, is more complex

and time consuming than for a proprietor ship or a partnership

Hybrids (Mixed):

Hybrid organizations are specialized types of partnerships, which combine the

limited liability advantage of a corporation with the tax advantages of a

partnership.

S-Type Corporation:

S- Type corporations are Limited Liability Corporations without double

taxation. In a regular corporation, the company itself is taxed on business

profits. In addition, the owners pay individual income tax on money that they

draw from the corporation as salaries, bonuses, or dividends. In contrast, in an

Financial Management MGT201

S corporation, all business profits "pass through" to the owners, who report

them on their personal tax returns (as in sole proprietorships, partnerships, and

Limited Liability Companies). The S corporation itself does not pay any

income tax, although a co-owned S corporation must file an informational tax

return like a partnership or Limited Liability Companies to tell the tax

authorities what each shareholder's portion of the corporate income is.

LLP:

Limited Liability Partnership (LLP) is also a form of partnership with allows

limited liability to the owners and avoids double taxation. These organizations

are similar in many ways to the S Corporations; however, LLPs offer more

flexibility and benefits to the owners.

PC:

Personal Corporations (PC) or Professional Corporations are generally formed

by professionals to protect them against litigations. Professionals like doctors,

lawyers and accountants prefer to register their business as Professional

Corporations.

Balance Sheet An FM Perspective

Financial Management MGT201

Internal and External Business Environment

Internal Business Environment:

Internal environment of business normally consists of the following.

Finance

ii.

Marketing

iii.

Human Resources

iv.

Operations (Production, Manufacturing)

Technology

vi.

Other Functions (Logistics, Communications)

External Business Environment:

The following business environment factors outside an organization have a profound effect on

the functions and operations of an organization.

Customers

ii.

Suppliers

iii.

Competitors

iv.

Government/Legal Agencies & Regulations

Macro Economy/Markets:

vi.

Technological Revolution

An analysis which is used in a business is called SWOT Analysis. SWOT is an acronym where

S stands for Strengths

W stands for Weaknesses

O stands for Opportunities

T stands for Threats

Strengths and weaknesses are within an organization, i.e., they pertain to the internal

environment of the organization.

Opportunities and threats, on the other hand, pertain to the external environment, i.e., outside

the organization.

Financial Management MGT201

Financial Markets

Capital Markets:

These are the markets for the long term debt & corporate stocks.

Stock Exchange:

A stock exchange is a place where the listed shares, Term finance certificates (TFC)

and national investment trust units (NIT) are exchanged and traded between buyers and

sellers.

Long term bonds:

Long term government & corporate bonds are also traded in capital markets.

Money Markets

Money market generally is a market where there is buying and selling of short term liquid

debt instruments. (Short term means one year or less). Liquid means something which is

easily en-cashable; an instrument that can be easily exchanged for cash. Following financial

instruments are traded in money markets.

Short term Bonds

Government of Pakistan: Federal Investment Bonds (FIB), Treasury-Bills (T-

Bills)

Private Sector: Corporate Bonds, Debentures

Call Money, Inter-bank short-term and overnight lending & borrowing

Loans, Leases, Insurance policies, Certificate of Deposits (CD's)

Badlah (money lending against shares), Road-side money lenders

Real Assets or Physical Asset Markets

Following are the active markets of real and physical assets in Pakistan

Cotton Exchange, Gold Market, Kapra Market

Property (land, house, apartment, warehouse)

Computer hardware, Used Cars, Wheat, Sugar, Vegetables, etc.

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