Functions of finance. Investment decision Financing decision Dividend decision Liquidity decision

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1 Functions of finance Investment decision Financing decision Dividend decision Liquidity decision

2 Relationship to accounting Accounting and finance are both forms of managing the money of the business, but they are used for two very different purposes. One of the ways to distinguish between the two is to realize that accounting is part of finance, and that finance has a much broader scope than accounting.

3 Definition Purpose Goal Tools Determination of funds Accounting Preparation of accounting records Measuring, preparation, analyzing, and interpretation of financial statements. To collect and present financial information. To see how the company is performing, to monitor day to day accounting operations, and for taxation. Balance sheets, profit and loss ledgers, positional declarations, and cash flow statements. Revenue is acknowledged at the point of sale and not when it was collected. Expenses are acknowledged when they are incurred than when they are Finance Efficient and productive management of assets and liabilities based on existing information Decision making regarding working capital issues such as level of inventory, cash holding, credit levels, financial strategy, managing and controlling cash flow. To forecast the future performance of the business. Performance reports, ratio analysis, risk analysis, estimating break evens, returns on investment, etc. Revenues are acknowledged during the actual receipt in cash as in cash flow and the expenses are acknowledged when the actual payment is

4 Investment decision Capital budgeting decision allocation of funds to long-term investments that would yield positive cash flows in future Evaluation of prospective profitability of new investments Evaluation of size, timing and risk of cash flows Measurement of a cut-off rate for acceptance/rejection

5 Financing decision Where from, when and how to acquire funds for investment needs? Capital structure is the specific mixture of long-term debt and equity the firm uses to finance its operations (financing mix) At what price should the firm offer its securities? What proportion of debt and equity? Which specific instruments of debt and equity should the firm employ (effect on return and risk) Financial leverage change in shareholders return caused by change in profits

6 Dividend decision Relating to distribution of profits as dividends or decision to plough them back into the business Dividend payout ratio Retention ratio Optimum dividend policy maximizes market value of firm s shares Cash dividend, bonus shares

7 Liquidity decision Concerned with management of current assets (working capital management) Profitability-liquidity trade-off What is the optimal level of inventory for firm s operations? Should credit be offered and what are the terms of credit? How much cash to carry on hand? Where to invest the temporary cash surplus? What sources of short term credit are appropriate for the firm?

8 The Goal of Financial Management Profit maximization vs. Shareholders wealth maximization The wealth maximization goal focuses on a longer term horizon. It gives priority to the creation of value since it is a function of all long-term yields to the stakeholders. Profit maximization is short-term horizon.

9 Emphasis on Time and Revenue Wealth maximization goal highly focuses on cash flow over time. It focuses on the present values of inflows and outflows. One of its components is that money has time value and, therefore, can sacrifice today's profits for tomorrow's super profits and future success. Profit maximization considers today's revenues. It does not deliberate on the element's time or risk in the profits.

10 Management vs. Shareholders Shareholders, being the owners of an entity, will focus on the wealth maximization goal. They would sacrifice current revenues to reinvest for the future wealth maximization. Management, on the other hand, highly focuses on the present-day revenues of an entity. They prefer profit maximization goals that are more concerned with their earnings.

11 Value Wealth maximization goal is the value of an entity expressed in terms of the market value of its common stock, i.e., the current trading market price per share times the number of common shares outstanding. Profit maximization measures the value of an entity in terms of the currency profits that it makes.

Aims of Financial Financial Management:

Aims of Financial Financial Management: CHAPTER 9 Financial Management Introduction Business Finance = Money or funds available for a business for its operations (that is, for some specific purpose) is called finance. It is indispensable for