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FINANCIAL MANAGEMENT

CONCEPTS & METHODS

BY AKONYET PATRICK

CPAK, CPAU, MSC A&F, B.COM, UDBS, ANDRAGOGY, PEDAGOGY

2019 Release i

Contents

FINANCIAL MANAGEMENT

INTRODUCTION

Business concern needs finance to meet their requirements in the economic world. Any kind of business activity depends on the finance. Hence, it is called as lifeblood of business organization. Whether the business concerns are big or small, they need finance to fulfill their business activities. In the modern world, all the activities are concerned with the economic activities and very particular to earning profit through any venture or activities. The entire business activities are directly related with making profit. (According to the economics concept of factors of production, rent given to landlord, wage given to labour, interest given to capital and profit given to shareholders or proprietors), a business concern needs finance to meet all the requirements. Hence finance may be called as capital, investment, fund etc., but each term is having different meanings and unique characters. Increasing the profit is the main aim of any kind of economic activity. MEANING OF FINANCE Finance may be defined as the art and science of managing money. It includes financial service and financial instruments. Finance also is referred as the provision of money at the time when it is needed. Finance function is the procurement of funds and their effective utilization in business concerns. The concept of finance includes capital, funds, money, and amount. But each word is having unique meaning. Studying and understanding the concept of finance become an important part of the business concern. DEFINITION OF FINANCE 1 According to Khan and Jain, “Finance is the art and science of managing money”. 2 Financial Management According to Oxford dictionary, the word ‘finance’ connotes ‘management of money’. Webster’s Ninth New Collegiate Dictionary defines finance as “the Science on study of the management of funds’ and the management of fund as the system that includes the circulation of money, the granting of credit, the making of investments, and the provision of banking facilities. DEFINITION OF BUSINESS FINANCE 1

According to the Wheeler, “Business finance is that business activity which concerns with the acquisition and conversation of capital funds in meeting financial needs and overall objectives of a business enterprise”. According to Guthumann and Dougall, “Business finance can broadly be defined as the activity concerned with planning, raising, controlling, administering of the funds used in the business”. In the words of Parhter and Wert, “Business finance deals primarily with raising, administering and disbursing funds by privately owned business units operating in nonfinancial fields of industry”. Corporate finance is concerned with budgeting, financial forecasting, cash management, credit administration, investment analysis and fund procurement of the business concern and the business concern needs to adopt modern technology and application suitable to the global environment. According to the Encyclopedia of Social Sciences, “Corporate finance deals with the financial problems of corporate enterprises. These problems include the financial aspects of the promotion of new enterprises and their administration during early development, the accounting problems connected with the distinction between capital and income, the administrative questions created by growth and expansion, and finally, the financial adjustments required for the bolstering up or rehabilitation of a corporation which has come into financial difficulties”. TYPES OF FINANCE Finance is one of the important and integral parts of business concerns; hence, it plays a major role in every part of the business activities. Finance can be classified into two major parts: Private Finance and Public Finance; Private Finance includes the Individual, Firms, Business or Corporate Financial activities to meet the requirements. Public Finance is concerns with revenue and disbursement of Government such as Central Government, State Government and Semi-Government Financial matters. DEFINITION OF FINANCIAL MANAGEMENT Financial management is an integral part of overall management. It is concerned with the duties of the financial managers in the business firm. 2

2. Financial Management and Accounting; Accounting records includes the financial information of the business concern. Hence, we can easily understand the relationship between the financial management and accounting. In the olden periods, both financial management and accounting are treated as a same discipline and then it has been merged as Management Accounting because this part is very much helpful to finance manager to take decisions. But nowadays financial management and accounting discipline are separate and interrelated.
3. Financial Management and Mathematics; Modern approaches of the financial management apply large number of mathematical and statistical tools and techniques. They are also called as econometrics. Economic order quantity, discount factor, time value of money, present value of money, cost of capital, capital structure theories, dividend theories, ratio analysis and working capital analysis are used as mathematical and statistical tools and techniques in the field of financial management.
4. Financial Management and Production Management; Production management is the operational part of the business concern, which helps to multiply the money into profit. Profit of the concern depends upon the production performance. Production performance needs finance, because production department requires raw material, machinery, wages, operating expenses etc. These expenditures are decided and estimated by the financial department and the finance manager allocates the appropriate finance to production department. The financial manager must be aware of the operational process and finance required for each process of production activities.
5. Financial Management and Marketing; Produced goods are sold in the market with innovative and modern approaches. For this, the marketing department needs finance to meet their requirements. The financial manager or finance department is responsible to allocate the adequate finance to the marketing department. Hence, marketing and financial management are interrelated and depends on each other.
6. Financial Management and Human Resource; Financial management is also related with human resource department, which provides manpower to all the functional areas of the management. Financial manager should carefully evaluate the requirement of manpower to each department and allocate the finance to the human resource department as wages, salary, remuneration, commission, 4

bonus, pension and other monetary benefits to the human resource department. Hence, financial management is directly related with human resource management. OBJECTIVES OF FINANCIAL MANAGEMENT Effective procurement and efficient use of finance lead to proper utilization of the finance by the business concern. It is the essential part of the financial manager. Hence, the financial manager must determine the basic objectives of the financial management. Objectives of Financial Management may be broadly divided into two parts such as:

1. Profit maximization
2. Wealth maximization. Profit Maximization; The main aim of any kind of economic activity is earning profit. A business concern is also functioning mainly for the purpose of earning profit. Profit is the measuring techniques to understand the business efficiency of the concern. Profit maximization is also the traditional and narrow approach, which aims at, maximizes the profit of the concern. Profit maximization consists of the following important features.
3. Profit maximization is also called as cashing per share maximization. It leads to maximize the business operation for profit maximization.
   2. Ultimate aim of the business concern is earning profit, hence, it considers all the possible ways to increase the profitability of the concern.
   3. Profit is the parameter of measuring the efficiency of the business concern. So it shows the entire position of the business concern.
   4. Profit maximization objectives help to reduce the risk of the business. Favorable Arguments for Profit Maximization The following important points are in support of the profit maximization objectives of the business concern: (i) Main aim is earning profit. 5

(i) Wealth maximization is superior to the profit maximization because the main aim of the business concern under this concept is to improve the value or wealth of the shareholders. (ii) Wealth maximization considers the comparison of the value to cost associated with the business concern. Total value detected from the total cost incurred for the business operation. It provides extract value of the business concern. (iii) Wealth maximization considers both time and risk of the business concern. (iv) Wealth maximization provides efficient allocation of resources. (v) It ensures the economic interest of the society. Unfavorable Arguments for Wealth Maximization (i) Wealth maximization leads to prescriptive idea of the business concern but it may not be suitable to present day business activities. (ii) Wealth maximization is nothing, it is also profit maximization, it is the indirect name of the profit maximization. (iii) Wealth maximization creates ownership-management controversy. (iv) Management alone enjoys certain benefits. (v) The ultimate aim of the wealth maximization objectives is to maximize the profit. (vi) Wealth maximization can be activated only with the help of the profitable position of the business concern. FUNCTIONS OF FINANCE MANAGER Finance function is one of the major parts of business organization, which involves the permanent, and continuous process of the business concern. Finance is one of the interrelated functions which deal with personal function, marketing function, production function and research and development 7

activities of the business concern. At present, every business concern concentrates more on the field of finance because, it is a very emerging part which reflects the entire operational and profit ability position of the concern. Deciding the proper financial function is the essential and ultimate goal of the business organization. Finance manager is one of the important role players in the field of finance function. He must have entire knowledge in the area of accounting, finance, economics and management. His position is highly critical and analytical to solve various problems related to finance. A person who deals in finance related activities may be called finance manager. Finance manager performs the following major functions:  Finance decision,  Investment/capital budgeting decision,  Working capital management,  Dividend decision and,  Corporate social responsibility decision. IMPORTANCE OF FINANCIAL MANAGEMENT Finance is the lifeblood of business organization. It needs to meet the requirement of the business concern. Each and every business concern must maintain adequate amount of finance for their smooth running of the business concern and also maintain the business carefully to achieve the goal of the business concern. The business goal can be achieved only with the help of effective management of finance. We can’t neglect the importance of finance at any time at and at any situation. Some of the importance of the financial management is as follows: Financial Planning Financial management helps to determine the financial requirement of the business concern and leads to take financial planning of the concern. Financial planning is an important part of the business concern, which helps to promotion of an enterprise. Acquisition of Funds : Financial management involves the acquisition of required finance to the business concern. Acquiring needed funds plays a major part of the financial management, which involve possible source of finance at minimum cost. 8

Sole proprietorships own all the assets of the business and the profits generated by it. They also assume complete responsibility for any of its liabilities or debts. In the eyes of the law and the public, you are one in the same with the business. Advantages of a Sole Proprietorship

• Easiest and least expensive form of ownership to organize.
• Sole proprietors are in complete control, and within the parameters of the law, may make decisions as they see fit.
• Profits from the business flow-through directly to the owner’s personal tax return.
• The business is easy to dissolve, if desired. Disadvantages of a Sole Proprietorship
• Sole proprietors have unlimited liability and are legally responsible for all debts against the business. Their business and personal assets are at risk.
• May be at a disadvantage in raising funds and are often limited to using funds from personal savings or consumer loans.
• May have a hard time attracting high-caliber employees, or those that are motivated by the opportunity to own a part of the business.
• Some employee benefits such as owner’s medical insurance premiums are not directly deductible from business income (only partially as an adjustment to income). Partnerships In a Partnership, two or more people share ownership of a single business. Like proprietorships, the law does not distinguish between the business and its owners. The Partners should have a legal agreement that sets forth how decisions will be made, profits will be shared, disputes will be resolved, how future partners will be admitted to the partnership, how partners can be bought out, or what steps will be taken to dissolve the partnership when needed; Yes, its hard to think about a “break-up” when the business is just getting started, but many partnerships split up at crisis times and unless there is a defined process, there will be even greater problems. They also must decide up front how much time and capital each will contribute, etc. Advantages of a Partnership
• Partnerships are relatively easy to establish; however time should be invested in developing the partnership agreement.
• With more than one owner, the ability to raise funds may be increased.
• The profits from the business flow directly through to the partners’ personal tax return.
• Prospective employees may be attracted to the business if given the incentive to become a partner.
• The business usually will benefit from partners who have complementary skills. Disadvantages of a Partnership 10

• Partners are jointly and individually liable for the actions of the other partners.
• Profits must be shared with others.
• Since decisions are shared, disagreements can occur.
• Some employee benefits are not deductible from business income on tax returns.
• The partnership may have a limited life; it may end upon the withdrawal or death of a partner. Types of Partnerships that should be considered:

1. General Partnership Partners divide responsibility for management and liability, as well as the shares of profit or loss according to their internal agreement. Equal shares are assumed unless there is a written agreement that states differently.
2. Limited Partnership and Partnership with limited liability “Limited” means that most of the partners have limited liability (to the extent of their investment) as well as limited input regarding management decision, which generally encourages investors for short term projects, or for investing in capital assets. This form of ownership is not often used for operating retail or service businesses. Forming a limited partnership is more complex and formal than that of a general partnership.
3. Joint Venture Acts like a general partnership, but is clearly for a limited period of time or a single project. If the partners in a joint venture repeat the activity, they will be recognized as an ongoing partnership and will have to file as such, and distribute accumulated partnership assets upon dissolution of the entity. Corporations A Corporation, chartered by the state in which it is headquartered, is considered by law to be a unique entity, separate and apart from those who own it. A Corporation can be taxed; it can be sued; it can enter into contractual agreements. The owners of a corporation are its shareholders. The shareholders elect a board of directors to oversee the major policies and decisions. The corporation has a life of its own and does not dissolve when ownership changes. Advantages of a Corporation

• Shareholders have limited liability for the corporation’s debts or judgments against the corporation.
• Generally, shareholders can only be held accountable for their investment in stock of the company. (Note however, that officers can be held personally liable for their actions, such as the failure to withhold and pay employment taxes.
• Corporations can raise additional funds through the sale of stock.
• A Corporation may deduct the cost of benefits it provides to officers and employees.
• Can elect S Corporation status if certain requirements are met. This election enables company to be taxed similar to a partnership. 11

is being paid by another to do something, whether in formal employment or a negotiated deal such as paying for household jobs or car repairs. The problem arises where the two parties have different interests and asymmetric information (the agent having more information), such that the principal cannot directly ensure that the agent is always acting in its (the principal's) best interests, particularly when activities that are useful to the principal are costly to the agent, and where elements of what the agent does are costly for the principal to observe. Moral hazard and conflict of interest may arise. Indeed, the principal may be sufficiently concerned at the possibility of being exploited by the agent that he chooses not to enter into a transaction at all, when that deal would have actually been in both parties' best interests: a suboptimal outcome that lowers welfare overall. The deviation from the principal's interest by the agent is called "agency costs". Various mechanisms may be used to align the interests of the agent with those of the principal. In employment, employers (principal) may use piece rates/commissions, profit sharing, efficiency wages, performance measurement (including financial statements), the agent posting a bond, or the threat of termination of employment. In terms of game theory, it involves changing the rules of the game so that the self-interested rational choices of the agent coincide with what the principal desires. Even in the limited arena of employment contracts, the difficulty of doing this in practice is reflected in a multitude of compensation mechanisms and supervisory schemes, as well as in critique of such mechanisms as e.g., Deming (1986) expresses in his Seven Deadly Diseases of management. Employment contract In the context of the employment contract, individual contracts form a major method of restructuring incentives, by connecting as closely as is optimal the information available about employee performance, and the compensation for that performance. Because of differences in the quantity and quality of information available about the performance of individual employees, the ability of employees to bear risk, and the ability of employees to manipulate evaluation methods, the structural details of individual contracts vary widely, including such mechanisms as "piece rates, [share] options, discretionary bonuses, promotions, profit sharing, efficiency wages, deferred compensation, and so on. Typically, these mechanisms are used in the context of different types of employment: salesmen often receive some or all of their remuneration as commission, production workers are usually paid an hourly wage, while office workers are typically paid monthly or semimonthly (and if paid overtime, typically at a higher rate than the hourly rate implied by the salary). The way in which these mechanisms are used is different in the two parts of the economy which Doeringer and Piore called the "primary" and "secondary" sectors (see also dual labour market). The secondary sector is characterised by short-term employment relationships, little or no prospect of internal promotion, and the determination of wages primarily by market forces. In terms of occupations, it consists primarily of low or unskilled jobs, whether they are blue-collar (manual- labour), white-collar (e.g., filing clerks), or service jobs (e.g., waiters). These jobs are linked by the fact that they are characterized by "low skill levels, low earnings, easy entry, job impermanence, and low returns to education or experience." In a number of service jobs, such as food service, golf caddying, and valet parking jobs, workers in some countries are paid mostly or entirely with tips. 13

The use of tipping is a strategy on the part of the owners or managers to align the interests of the service workers with those of the owners or managers; the service workers have an incentive to provide good customer service (thus benefiting the company's business), because this makes it more likely that they will get a good tip. The issue of tipping is sometimes discussed in connection with the principal–agent theory. "Examples of principals and agents include bosses and employees ... [and] diners and waiters." "The "principal-agent problem", as it is known in economics, crops up any time agents aren't inclined to do what principals want them to do. To sway them [(agents)], principals have to make it worth the agents' while ... [in the restaurant context,] the better the diner's experience, the bigger the waiter's tip. In the ... language of the economist, the tip serves as a way to reduce what is known as the classic "principal-agent" problem." According to "Videbeck, a researcher at the New Zealand Institute for the Study of Competition and Regulation "in theory, tipping can lead to an efficient match between workers' attitudes to service and the jobs they perform. It is a means to make people work hard. Friendly waiters will go that extra mile, earn their tip, and earn a relatively high income...[On the other hand,] if tipless wages are sufficiently low, then grumpy waiters might actually choose to leave the industry and take jobs that would better suit their personalities."[ As a solution to the principal–agent problem, though, tipping is not perfect. In the hopes of getting a larger tip, a server, for example, may be inclined to give a customer an extra large glass of wine or a second scoop of ice cream. While these larger servings make the customer happy and increase the likelihood of the server getting a good tip, they cut into the profit margin of the restaurant. In addition, a server may dote on generous tippers while ignoring other customers, and in rare cases harangue bad tippers. Non-financial compensation Part of this variation in incentive structures and supervisory mechanisms may be attributable to variation in the level of intrinsic psychological satisfaction to be had from different types of work. Sociologists and psychologists frequently argue that individuals take a certain degree of pride in their work, and that introducing performance-related pay can destroy this "psycho-social compensation", because the exchange relation between employer and employee becomes much more narrowly economic, destroying most or all of the potential for social exchange. Evidence for this is inconclusive—Deci (1971), and Lepper, Greene and Nisbett (1973) find support for this argument; Staw (1989) suggests other interpretations of the findings. Team production On a related note, Drago and Garvey (1997) use Australian survey data to show that when agents are placed on individual pay-for-performance schemes, they are less likely to help their coworkers. This negative effect is particularly important in those jobs that involve strong elements of "team production" (Alchian and Demsetz 1972), where output reflects the contribution of many individuals, and individual contributions cannot be easily identified, and compensation is therefore based largely on the output of the team. In other words, pay-for-performance increases the incentives to free-ride, as there are large positive externalities to the efforts of an individual team member, and low returns to the individual (Holmström 1982, McLaughlin 1994). The negative incentive effects implied are confirmed by some empirical studies, (e.g., Newhouse,

1973. for shared medical practices; costs rise and doctors work fewer hours as more revenue is shared. Leibowitz and Tollison (1980) find that larger law partnerships typically result in worse 14

de-emphasise less relevant but perhaps equally or more important aspects of education; while AT&T’s practice at one time of paying programmers by the number of lines of code written resulted in programs that were longer than necessary—i.e., program efficiency suffering (Prendergast 1999, 21). Following Holmström and Milgrom (1990) and Baker (1992), this has become known as "multi-tasking" (where a subset of relevant tasks is rewarded, non-rewarded tasks suffer relative neglect). Because of this, the more difficult it is to completely specify and measure the variables on which reward is to be conditioned, the less likely that performance- related pay will be used: “in essence, complex jobs will typically not be evaluated through explicit contracts.” (Prendergast 1999, 9). FINANCIAL MATHEMATICS AND VALUATION OF SECURITIES Time value of money: this phrase implies that the value of money is not constant and UGX 100 this year is not the same as UGX 1000 next year. The UGX 100 this year is more valuable than the UGX 100 next year due to the following reasons; Inflation, risk or uncertainty about the future, postponement of consumption. Therefore to compensate for the above factors, the compensation rate is required to induce investors /lenders to part with the money. This is the required rate of return “r”. Example if UGX 100 is invested at the rate of 10% p.a, the value will be UGX 110 That is 100 +100x 10% =100(1+10%) = 100(1+0.1); in the second year 110 will be reinvested and will grow to UGX 121, that is 110 +110x10% = 110(1+10%), but 110 = 100(1+10%) so, 110(1+10) = 100(1+10%) x(1+10%) = 100(1+10%)^2 Not in year 1 the formula is equivalent to 100(1+10%)^1 In general if the amount invested is P and the rate of return is r for n years, the future value (FV) is given by 16

FV = P(1+r)n^ ; the term (1+r)n^ is called the future value factor and the computation of future values in which interest earns interest is called compounding. From the above formula, P =FV/(1+r)n^ and the term 1/(1+r)n^ is the discount factor. Effective interest rate: is the annualized interest rate if compounding is done more than once a year, say “m” times. Effective interest rate = (1+r/m)m^ – 1 and future value after n years FV= (1+r/m)mn Annuity ; an equal sum of money invested over equal interval of time is called annuity. The ordinary annuity has the investment starting after one year and annuity due starts investment immediately. The term annuity ordinarily means ordinary annuity

Future value of annuity FVA = {

( 1 + r ) n − 1

r }^

A

Present value of annuity (PVA)r =

( 1 + r ) n − 1 r ( 1 + r )

n }A or^ A{

1 −( 1 + r ) − n

r }

Present value of annuity due

A {

1 −( 1 + r ) − n

r }

( 1 + r ) Future value of annuity due

A {

( 1 + r ) n − 1

r }

( 1 + r ) Perpetuity : is an annuity forever and its present value is

A

r 17