Chapter 1
Gitman defines finance as “The art and science of managing money’’. Financial management is therefore a subject that looks at the institutions, markets and instruments that deal with the transfer of money among and between individuals, businesses and governments. The following diagram shows this arrangement.
Individuals Individuals
Corporations Financial intermediaries Corporations
Governments Governments
Parties with Parties in need of
Funds Funds (demanders
of finance)
Buy financial Create attractive
Instruments Financial instruments
Thereby making that mobilize excess
Finance available Funds
To financial
Intermediaries
Channel funds to individuals
Corporations and governments
In the form of loans and other
Instruments.
To appreciate the scope of financial management one has to look at the functions performed by the financial manager in an organization. The functions performed by the financial manager can be best understood by focusing on the decisions that the financial manager makes in the organization.
The financial manager makes a number of important decisions but these have to be looked at in the context of the financial objectives that the firm would be striving to achieve. It is therefore important to look at the possible financial goals that can be pursued by an organization as this will help one to understand why a particular alternative (decision) would have been chosen by the decision maker.
Possible financial goals pursued by firms.
There are a number of financial goals that can be pursued by firms either individually or collectively. These are summarized as follows:
Survival
Sometimes severe economic or market shocks may necessitate survival to become the overriding objective. Should this be the case management focus on short-term issues to ensure survival of the concern, paying little attention to long-term survival of the organization. Should this be the case management can postpone the organization’s investment programme.
Maximizing sales
This is alternatively known as maximizing market share. A firm may want to command a high market share. This is because a high market share can be seen as rewarding. The rewards may be in the form of improved profitability or increased survival chances. If this is the case decision like price reduction or relaxation of credit terms can be made.
Growth
Growth, as an objective pursued by the firm is hardly admitted openly, but it is a financial goal that is sometimes pursued. Size is seen as an end in itself. This way managers can earn higher salaries, get huge expense accounts, cars and other perks. Growth can be achieved either internally or externally. Internal growth will generally take the form of expanded operations for a given concern while external growth is achieved through merging or take-over.
Maximizing shareholder wealth
This is the financial goal, which is assumed in financial management. A proxy, that is the firm’s current share price, can measure achievement of this goal. If the firm’s current share price is maximized then it can be argued that the goal of shareholder wealth maximization would have been achieved.
Maximization of profit
This is a much more popular financial objective that can be pursued by the firm. The firm will try to maximize its reported profits. This is a much more acceptable financial goal but others would want to argue that profit maximization should not be the firm’s purpose.
Although profit maximization is a popular objective, it is not the preferred financial objective from the financial management point of view. This is because the financial objective has a number of problems.
Problems with profit maximization
The following problems associated with profit maximization should always be borne in mind should an organization be pursuing this objective.
Basis of computation
Profit maximization is based on accrual or matching concepts unlike shareholder wealth maximization, which is based on cash flows. Profits can be padded through the use of cosmetic accounting. The following arrangements indicate how profits can be manipulated to give a picture, which may apparently be non-existent. An organization may under-provide for depreciation, adopt misleading stock valuations or carry dangerous stock levels, all in an attempt to manipulate reported profit.
Objective’s orientation
Profit maximization leads to the adoption of short-term objectives as it has a short-term orientation. The organization, in an attempt to improve reported profit, may cut discretionary spending like Research and Development expenditure. Wealth maximization favours long-term objectives, which is consistent with the assumed goal of wealth maximization.
Time value concerns
Profit maximization places too much emphasis on the highest profit irrespective of the time value of money aspect. Wealth maximization takes into account the various times at which the benefits (cash flows) accrue and the eventual effect of the benefits on the firm’s share price.
Risk
Wealth maximization, unlike profit maximization, carefully weighs and adjusts for the risk inherent in projects since shareholders expect higher returns on investments with larger inherent risks.
Maintaining a balance between dividends and retention of earnings
Wealth maximization strikes a balance between regular dividend distribution and retained earnings since both decisions influence the share price, which in turn reflects the shareholder’s wealth.
Having looked at the possible financial goals of the firm, the functions performed by the financial manager can now be looked at. It is hoped that the decisions that are eventually made by the financial manager can be understood in their proper context if one has an appreciation of the financial objective that the firm would be striving to achieve.
Functions performed by a financial manager
There are a number of important generic functions that are performed by the financial manager and these are now discussed in the paragraphs that follow.
- Financial analysis and planning
It is the responsibility of the financial manager to establish how well the firm would have performed. He will therefore examine the organization’s financial statements (Balance Sheet and Income Statement), to evaluate the performance of the organization. Following this evaluation a number of important planning decisions can then be made. These include the addition or reduction in planned capacity and the determination of additional funding or reduction of funding that may be necessary. The financial manager primarily uses financial ratio analysis and trend analysis to come up with an informed position on how well the firm would have performed.
- Making investment decisions
This particular function can also be looked at as managing the firm’s asset structure. It is the responsibility of the financial manager to decide on the mix and type of assets to be acquired by the firm. These are real assets like vehicles and plant or financial assets like shares. The financial manager must also make decisions relating to modification, replacement or liquidation of fixed assets. The financial manager uses appraisal techniques like net present value analysis, payback method, internal rate of return, accounting rate of return or profitability index to identify capital projects that can best enhance shareholder value.
- Making financing decisions
Financing decisions relate to the firm’s capital structure hence this decision is often referred to as managing the firm’s capital structure or financial structure. Having identified the assets to be acquired by the firm, an appropriate mode of finance has to be established. The financial manager must decide the best mix of financing that is both short-term and long-term for assets to be acquired by the firm or the financing needed for projects to be undertaken. There is a considerable body of knowledge that the financial manager can draw from to establish an optimal mix of financing that will maximize shareholder wealth. This will be looked at in detail under the capital structure decision.
- Working capital management
This is sometimes referred to as treasury management. All organizations need working capital. Working capital refers to the firm’s current assets and current liabilities. The financial manager must ensure that the firm has sufficient working capital to continue operations so as to avoid costly interruptions in the firm’s production operations.
- Risk management
Risk is the probability that an outcome will not turn out as expected. Firms are more concerned with adverse outcomes (downside risk). It is the responsibility of the financial manager to manage or reduce the risk to which the organization is exposed. A notable type of risk that is worrisome to most organizations is exchange risk. This is a type of risk that organizations engaged in external trade have to face. With exchange risk the amount to be received in the home currency is not certain. It is the financial manager’s function to manage and reduce this exchange risk. The financial manager’s task is complicated if the organization he works for deals in primary commodities. In this case the prices of the primary commodities are not stable and in addition there will be exchange risk. All this requires the skills of the financial manager.
To summarize, the following diagram can capture the primary role of the financial manager:
Capital Market Operating Assets
- Equity - Non current assets
- Debt - Current assets
Searching for Financial manager Searching for
Financing Investment
Opportunities Financial decisions opportunities
Money Market Financial Assets
The primary role of the financial manager
When discussing the investment decision it is important to appreciate the difference between Investment and speculation.
Investment
Investment is the purchase by an individual or institutional investor of a financial or real asset that provides a return proportional to the risk assumed over some future investment period.
Primary differences between investment and speculation
There are basically four different approaches that can be adopted to differentiate investment from speculation.
1. Holding period
The holding period is the period over which the investor intends to hold the investment. Usually speculation is for short periods of time for example one week to a few months. An investment is continuous for a series of a number of years for example 3 years over a long period of time. Emphasis in speculation because of the shorter holding period is on capital gains rather than dividend or interest income.
2. Expected return
Return represents the total annual income and capital gains as a percentage of the beginning investment.
Return = P1 – P0 + D1 * 100
P0 1
Where P1 =Price at the end of period 1.
P0 = Price at the beginning of period 1.
D1 = Dividend received at end of period 1.
The expected return from a single speculative security purchase is much greater than the expected return from the purchase of an investment security. Investors earn a much lower annual return over a longer period of time than speculators.
3. Risk assumed
Speculators assume higher levels of risk than investors. This is because speculators expect higher returns and higher returns can only be expected if one is prepared to assume higher levels of risk.
4. Degree of information available
Speculators look for opportunities where information available for analysis tends to be quite limited.
Investment approaches
There are three approaches that can be adopted when one is contemplating an investment transaction.
The fundamental approach
This approach assumes that a rigorous analysis of each company will result in the identification and selection of undervalued shares. These shares will be identified after an economic analysis, industry and company analysis would have been undertaken. The shares identified will be bought and held as long as they promise a high return. They are sold if the investor believes they have become overpriced. Usually the shares are held for relatively long periods of time. This is a buy and hold approach that is followed by the majority of institutional investors.
The technical approach
The approach emphasizes that the behaviour of the price of a share and the volume of trading determines the future price of the share. It centers on the plotting of the price movement of the share and drawing inferences from the price movement. The technician then selects a few shares and trades in them. The emphasis is on capital gains in the short term.
Modern portfolio theory (MPT)
The approach assumes that the market is efficient and information is available about the market and individual shares. New information is quickly transferred to the market place and a new price established. Since the market is efficient and share prices of one moment are independent from prices in the next moment, it is impossible to predict future prices. Information is known to all, and no one on average can do much better than the market. Investors buy and hold on to their shares.
The financial environment
The financial manager operates in an environment characterized by financial institutions and financial markets.
Financial institutions
Financial institutions are intermediaries that channel the savings of individuals, businesses and governments into loans and investments. Examples of financial institutions in Zimbabwe include commercial banks like Kingdom bank, Standard Chartered or Barclays bank. There are also savings banks like the People’s Own Savings Bank (POSB), credit unions like the Zimta Co-operative Credit Union (ZCCU), life insurance companies like Zimnat and pension funds like the NRZ pension fund or the mining industry pension fund (MIFP).
Financial markets
Financial markets provide a forum in which suppliers of funds and those in need of funds can transact business directly. Financial markets can take the following forms:
- Primary market
This is a financial market in which securities (shares) are initially issued. It is a financial market for new issues.
- Secondary market
This is a financial market in which pre-owned securities are subsequently traded.
- The money market
The money market is a financial market for short- term sources of finance and financial instruments. Short -term financial instruments are instruments having an original maturity of one year or less. The following are examples of short-term financial instruments.
-Treasury bills: These are government of Zimbabwe 90 day treasury bills. They are issued when the government wishes to raise short-term financing.
-Grain bills: These are issued on behalf of the Grain Marketing Board to raise finance to pay for the produce delivered to the GMB.
-RBZ financial bills: These are short- term bill issued by the RBZ to raise finance for central government or to achieve monetary objectives of the central bank.
- Agro bills: They are short-term financial instruments issued to raise short-term financing for the new farmers. This financing is used as seasonal finance to pay for land preparation, acquisition of inputs and other working capital requirements.
-Petrozim bills: These are issued on behalf of NOCZIM to raise finance to procure fuel.
-Megawatt bills: These are issued on behalf of the Zimbabwe electricity supply authority either to raise financing for the rural electrification programme or to retire ZESA debt and pay for electricity imports.
-Tobacco bills: They are bill issued on behalf of the Tobacco Marketing board to promote the production of tobacco.
-NCDS: Negotiable certificate of deposits are short-term financial instruments issued by banks. The certificates can be negotiated to other investors.
It is important to note that financial institutions participate in both the money market and the capital market as suppliers and demanders of finance.
Participants in the money market
There are a number of institutions that participate in the money market either as suppliers or demanders of short-term finance. The following are examples of institutions that participate in the money market:
-Commercial banks: These are institutions that accept demand (cheque) and time (savings) deposits.
-Merchant banks: Merchant banks are bankers to corporations providing investment and short to medium term loans to corporations.
-Discount houses: They are financial institutions involved in buying and discounting money market instruments.
-Building societies: These are institutions involved in the mobilization of savings deposits to provide mortgage finance.
Functions of the money market
The money market performs four main functions. These are explained in the paragraphs that follow.
1. Provision of short-term capital
The money market provides short-term capital to companies, financial institutions, governments and other organizations requiring short-term finance.
2. Provision of a market
The money market provides a market for short-term investors to invest funds in short-term financial instruments that are low risk and highly liquid.
3. Acting as a barometer of liquidity
The money market acts as a barometer of liquidity within the economy. The Reserve bank can increase or curb liquidity by adopting strategies that operate via the money market for example open market operations (OMO).
4. Determining interest rates
The money market also acts as the main determinant of interest rates in the economy. The demand and supply of funds in the money market determines the interest rates in the economy for example APDS for ZIMRA. Interest rates firm because of excessive demand for cash. After the APDS the interest rates ease.
- The capital market
This is a financial market for long-term finance and financial instruments. These will be financial instruments having an original maturity of more than one year. Examples of these financial instruments include debentures, preference shares, ordinary shares and agro-bonds (instruments to provide finance for infrastructural development for the new farmers.
Functions of financial markets