Unit 1: Introduction To Business Financial Management

Introduction

In a modern economy, everyone probably experiences financial decision-making on a daily basis. The frequency and number of financial transactions and complexity of decisions of course may change from person to person.

Throughout the first chapter of this book, you will be introduced to basic terms and key elements of business financial management. You will also understand the types of decisions that financial managers face everyday. You will realize main themes to be considered in all aspects of financial management. The purpose of this chapter is to give core information to ground in a more complex world of comprehensive financial decision-making.

Financial Environment Of A Company

The environment of a company contains a number of different elements, such as institutional elements, economic system, business system, financial system, etc., interacting with, and being nested in each other.

Members of these elements are called as interest groups, or stakeholders. Main stakeholders are owners, employees, suppliers, lenders, customers, and the community.

Five core components of a financial system are ultimate borrowers, ultimate lenders, financial intermediaries, financial instruments, and legal and administrative rules.

A financial company can be described as a company with a main business activity in financial areas.

Financial intermediary is an institution in a financial system that acts as a middleman between borrowers and lenders.

A non-financial company can be described as a company with a main business activity of producing goods and/services in areas other than finance.

The Cycle of Money

Money in a financial system simultaneously flows in many various directions. The movement of money from lenders to borrowers, and back from borrowers (users of funds) to lenders (savers of funds) in a financial system is called the cycle of money. The economic idea of cycling money is making both lenders and borrowers better off, by creating a win-win situation.

Security is a kind of negotiable paper, showing claims on future cash flows of the issuer of the security.

Supply and demand for loanable funds theory of interest argues that interest rate presents the equilibrium in the market, where demand for and supply of loanable funds meet. Liquidity preference theory of interest argues that interest rate presents the equilibrium in the market, where demand for and supply of money meet.

Liquidity refers to convenience of Money.

The Cyle of Money Within a Company

Production value tells how much effort is required in order to produce goods and services.

Customer value tells how much a customer thinks a product is worth.

Companies, as legal entities, are assumed to survive perpetually.

Profit is, in simple terms, the difference between revenues and expenses. We can find profit information at the bottom line of income statement of a company, as “net income”. In accounting terms, net income is the net increase in the owners’ equity that results from a company’s operations.

This relationship between value creation and profit generation fits well with one of the basic assumptions in business theories, which is the infinite lifetime of a company.

A Financial Manager

Financial performance is a subjective measure of how well a firm can use assets from its primary mode of business and generate revenues. This term is also used as a general measure of a firm’s overall financial health over a given period of time, and can be used to compare similar firms across the same industry or to compare industries or sectors in aggregation.

The financial manager is responsible for the financial operations of the company. At the same time, we can expect that it is usually not a one man’s job to make all financial decisions. Financial manager’s all management tasks about treasury and control need planning, organizing, leading, implementing, and control.

Cost-benefit analysis is a technique used in decisionmaking that takes into account the estimated costs to be incurred by a proposed decision and the estimated benefits likely to arise from it.

Financial managers are assumed to serve best interests of shareholders of companies that they are working for.

Investing Decisions

Investing decisions are concerned with allocating company’s limited resources to the best short-term and long-term investment alternative. Investing decisions also include strategic decisions such as mergers and acquisitions and foreign direct investments.

Assets are items of value owned by a company. A real asset is a physical asset whose value is coming from its substance and properties, while financial assets are nonphysical assets whose value comes contractual claim. Tangible asset is an asset with a physical substance. Intangible asset is an identifiable non-monetary asset without physical substance.

Current assets are assets that a company expects to convert to cash or use within one year. Non-current (fixed) assets are assets that a company expects to convert to cash or use later or longer than one year. Capital expenditures (Capex) are expenditures made to buy new fixed assets or to increase the value of company’s existing fixed assets. Capital budgeting is a process of making long-term decisions on investment projects.

Financing Decisions

It is important to know that companies cannot make all of their investments with existing funds. They are always in search of funds at a minimum cost in order to partly or fully finance their investments in short, medium, and long term. They have two alternatives for financing:

1. debt financing
2. equity financing.

Maturity of short-term financing is less than one year, whereas maturity of medium-term financing may be 1 monts to 3 years, and maturity of long-term financing is longer. If a company issues a debt-based security, then it will be debt financing. If it issues an equity-based security, then it will be equity financing. Capital structure (financial structure) refers to a company’s mixture of debt financing and equity financing maintained by the firm.

Dividend Decisions

Financial managers should decide on how much of their profits to pay out to shareholders in the form of dividends, and how much to retain to finance company’s future investments and growth. Dividend is the distribution of part of the profits of a company to its shareholders.

Legal Forms Of Business Organization

Business organizations can be in any of these two forms in general, a proprietorship (a sole proprietorship and a partnership), and a corporation. If one person owns a business, it is a sole proprietorship. This one person carries all risks and gains all returns. If two or more people own a business, it is a partnership.

Unlimited liability refers to a situation where shareholders are liable for all of company debts with all of the company assets and their personal assets.

Limited liability refers to a situation where shareholders are liable for all of company debts with only all of the company assets but not with their personal assets.

Overview Of Key Financial Concepts

In daily life, terms such as “money”, “fund” and “cash” are usually used synanimously.

Finance means money in very broad terms. Cash refers to immediate spendable funds such as currencies and coins. Cash equivalent is a short-term (less than three months) investment such as treasury bills. Fund refers to money, which is preserved for a specific objective whether in the form of cash, credit, cheque, or other resources. The main difference between cash and fund is that cash is a shortterm asset, whereas fund is a short-term or long-term liability for a company.

Three broad subdivisions of finance as an academic field of study are:

1. business financial management,
2. financial markets and intermediaries,
3. investments.

Business financial management covers subjects related to decisionmakings of company managers, trying to maximize shareholder wealth at given external circumstances at local, regional, international, and global levels of geographical dispersion.

Basic Financial Statements

Financial statements are outputs of accounting system, which tell about key financial information of a company for a period of time, or at a certain point of time. Exhibit 1.1(page:13) provides a quick overview of basic financial statements;

1. balance sheet,
2. income statement,
3. cash flows statement.

Differentiation of Profit, Cash Flow, and Free Cash Flow

Profit is an accounting term, which shows the difference between sales revenues, and costs and expenses. It can be seen on the income statement as net income.

Cash flow refers to an inflow or outflow of cash related to operating activities, investing activities, or financing activities.

Free cash flow is the total of cash flow to creditors and cash flow to stockholders, consisting of the following: operating cash flow, capital spending, and changes in net working capital.

Risk and Return Trade off

Risk refers in general to the magnitude and likelihood of unanticipated changes that have an impact on a firm’s cash flows, value or profitability. Uncertainty refers to a prerequisite condition for risk to exist, but uncertainty can also refer to the possibility that something completely unforeseen can happen. When we measure risk in finance, we consider both downside risk and upside risk. Individuals who like carrying risk have a risk-seeking attitude, those who dislike carrying risk have a risk-averse attitude, and those who neither like nor dislike carrying risk have a risk-neutral attitude.

Time Value of Money

The concept of time value of money suggests that people prefer cash sooner than later. There are three explanations behind this way of thinking:

1. reinvestment opportunities,
2. uncertainty of future,
3. effects of inflation.

Time value of money concept calls for a need for using interest rate as a tool to allow lending and borrowing of cash in the economy.

Shareholder Wealth Maximization As The Main Objective

Maximizing wealth can be so broad in a sense that shareholders can increase their wealth in many ways, such as increasing sales revenue, decreasing costs, increasing profits, improving cash flows, increasing efficiency, growing business, entering into new markets, increasing competitive strength, etc. Shareholder value can be expressed using three concepts:

1. book value,
2. market value, and
3. intrinsic value.

Book value tells the worth of a company based on its financial statements.

Market value is the price that buyers and sellers trade company shares in an open market place.

Intrinsic value is the estimated value, which is calculated by present value of future cash flows that company expects to generate. If we base our understanding of shareholder value on intrinsic value, then the shareholder value would be value of expected future cash flows adjusted for time and risk. (Trotta, R. J., 2003, p.18-27).

Main objective of a company is assumed to be maximizing shareholder wealth.

Agency Problems And Corporate Governance

Agency problems refer to potential conflicting interests between shareholders and managers resulted from separation of ownership and control. “Agency theory” which is widely known in the business literature suggests that there would be a possible conflict, between owners and managers, which in turn cost company as a result of poor decisions in general terms. Risk-averse behaviors, preference of low-return investments, inefficient use of company assets, and unnecessary spending appear to be the examples of poor decisions. Agency cost is a qualitative type of cost, not a quantitative type of cost, and it is not reflected in financial statements as a cost item. Corporate governance is the system of rules, practices and processes by which a company is managed.

Corporate governance is the dominant concept in the Turkish Commercial Code. The corporate governance approach of the Turkish Commercial Code is based on four pillars that have universal characteristics within the context of corporate governance. (1) full transparency, (2) fairness, (3) accountability, (4) responsibility.” (PwC Turkey, 2011, p.9).

Business Ethics

Another very relevant subject in financial decision-making is ethical behavior in companies, which has always been one of the main concerns of societies. It is also a concern of companies because it affects their most important prize, reputation. Social, environmental and health effects of products and services are the most common issues.

Business ethics refers to a company’s attitude and conduct toward its employees, customers, community, and stockholders.

Corporate transparency refers to equity market’s ability to observe a corporation’s operations.

Corporate accountability refers to stakeholders’ ability to hold corporations to account for their operations.

Together with transparency and accountability at a company level, companies are expected to foster a corporate climate where unethical behavior is not permitted at an individual level. There are certain things companies do to improve moral behavior in their organizations.