Finance: an overview
Why study finance?
Many students in this subject do not work in finance nor are they planning to become financial managers. These students often wonder why they need to complete Financial Management as part of their MBA. You might be working in a company (private or public), government agency, sole proprietorship, partnership or a not-for-profit/charitable organisation. You may even be job hunting or going for a promotion. Irrespective of the type of organisation you might be working in (or aspire to be working in), you are somehow impacted by financial decisions.
We all understand the important role that finance plays in our personal lives. Taking out a loan to buy a car or a house involves a major financial decision. Choosing the contribution amount to make to our superannuation or retirement fund is also an important financial decision with long-term implications. In fact, examining and understanding financial issues is necessary to make informed financial decisions in every stage of life.
If you aspire to work for a particular company or go for a promotion, the ability to assess the financial health of the company by interpreting their published annual reports may put you in a position to recommend potential savings or investments, thereby greatly increasing your chances to secure that job or promotion.
As a manager, any forward planning for a business or organisation will require you to read financial records and understand what the numbers really mean so that sound planning decisions can be made. For example, if you are involved in the strategic decision to expand your business by investing some capital expenditure (CapEx), you will probably use a combination of historical numbers and market intelligence to forecast the investment’s expected revenue. You would also be expected to decide how best to allocate the limited resources available to the business between competing options. For instance, if there are two competing projects, e.g. buy new machinery or commission a new conveyor, you will need to prioritise your investment given that capital is scarce. In such situations, an understanding of finance will be important to making sound management decisions.
Read
Section 1.1 ‘Finance: an overview’ on pages 3-5 of the textbook gives you a broad view of the scope of financial management.
If you are interested to learn more about why financial management skills are necessary and about how to develop those skills, read
Knight, R 2017, ‘How to improve your finance skills (Even if you hate numbers)’, Harvard Business Review Digital Articles, pp. 2–6.
How much do you already know about finance?
As a core subject of AIB’s MBA, Financial Management inevitably has students with diverse prior knowledge of, and experiences with, financial management. Some of you are no doubt already experts and will go on to take finance specialisation elective subjects, many of you will have some prior experience (whether personal or work-related), but others of you will be starting from the very beginning (and perhaps a little anxious about the calculations). Wherever you are starting from, be reassured that you are not alone.
Types of business structure
There are three main legal structures upon which all organisations are based.
Sole Proprietorship (sole trader)
This refers to a business owned by an individual, e.g. a self-employed accountant or plumber. The owner keeps all the profits and has unlimited liability for all the business’s debts.
Partnership
This is an association of two or more individuals joining together as co-owners to operate a business for profit, e.g. a legal practice operated by a group of legal practitioners. All partners share the profit or loss of the business and have unlimited liability.
Corporation (limited company)
This is an entity that legally functions separately and apart from its owners. Liability of the owner is limited to the amount of their holding in the company. Companies can be private or public. One of the key advantages of a public company over a private company is that public companies can raise funds from the general public by issuing shares. However, going public or listing a company is not a cheap process. Also, there are many regulatory hurdles and compliance activities that public companies need to be on top of, such as additional reporting to the stock exchange and taxation authorities. This scrutiny can often also take management attention away from day-to-day operations.
Comparing business structures
| Sole Trader | Partnership | Limited Company | |
|---|---|---|---|
| Who owns it? | The individual | The partners | The shareholders |
| Who manages it? | The individual | The partners | The directors |
| Who is liable? | The individual | The partners | The company |
| Who pays tax? | The individual | The partners | The company |
| What type of tax? | Income tax | Income tax | Corporation tax |
In comparing these organisational forms, the following should be considered:
- organisation regulations and costs
- liability of owners
- continuity of the business
- transferability of ownership
- management control
- ease of raising capital
- income taxes.
Read
Section 1.2 ‘Three types of business organisation’ on pages 5-8 of the textbook looks at the advantages and disadvantages of each business structure, and how the finance area fits into company structure. In particular, examine Figure 1.1 How the finance area fits into a corporation (page 8).
Watch
The LinkedIn Learning video Choose a company structure (03:09 minutes) summarises the set up, liability and limitations of business structures.
Barratt, J 2018, Choose a company structure, LinkedIn Learning video, viewed 23 April 2021,
https://www.linkedin.com/learning/banking-for-small-business/choose-a-company-structure?auth=true.
Five basic principles of finance
The logic behind the financial concepts covered in this subject is derived from the following five financial principles.
1. Money has a time value
If you were offered the choice of $1,000 today or $1,000 in one year’s time, which would you choose?
Choosing to receive it today and investing it to generate an amount of more than $1,000 at the end of the year would be the smart choice. In general, we can say that an amount received today is worth more than that same amount received any time in the future. Compound interest is used in the practical application of this principle.
2. There is a risk—return trade-off
The risk—return trade-off will be a frequent consideration throughout this subject. We will not take on additional risk unless we expect to be compensated with an additional return. It assumes that the relationship is linear. Thus, there is a reward for bearing risk and the greater the risk, the greater the potential reward. Of course, we are talking about the expected return, not the actual return.
The relationship between risk and expected return can be illustrated by this diagram:
Source: Figure 1.2, Titman et al. 2019, p.13.
3. Cash flows are the source of value (“Cash is King”)
Cash flows, and not accounting profits, are used for measuring wealth, hence the phrase “Cash is King”. This marks a point of departure between the disciplines of accounting and finance. Dividends paid to shareholders are an example of such cash flows. For future reference, depreciation of an asset is an accounting book entry and not a cash flow. Also, only incremental cash flows should be considered while making choices.
An incremental cash flow is the difference between cash flows if a new project/asset was taken on compared to the cash flows if the project/asset was not taken on. Those of you who have studied economics will recognise that this principle relates to the concept of opportunity cost. In a nutshell, this principle states that it’s only what changes that counts when considering investments in projects/assets.
4. Market prices reflect information
Efficient markets are markets in which the values of all assets and securities (shares, bonds, etc.), at any point in time, fully reflect all available information. Taken to the theoretical limits, the theory suggests that markets respond to changes extremely quickly, i.e. ‘insider trading’ would be impossible.
5. Individuals respond to incentives
In the company structure of a business organisation, the shareholders (the principal) hire managers (the agent) to run the company for them (the agency relationship). The managers must act in the best interests of the shareholders to maximise their value. However, if a conflict of interest arises, there is then the question of whether the managers would pursue their own goals rather than the goals of the shareholders. This conflict is referred to as ‘the agency problem’ in finance. Many corporations address the agency problem through adequate employee compensation schemes.
The ‘individuals respond to incentives’ principle relates to the incentives offered to managers and recognises that a manager will not work for the business owners unless it is in that manager’s best interest to do so. In this context, agency costs represent any cost incurred, such as reduced share price associated with potential conflict between managers and investors, when these two stakeholders are not the same.
Read
Section 1.4 ‘The five basic principles of finance’ on pages 12-15 of the textbook provides more details and examples of these five basic finance principles.
Enhancing value through financial decisions
Maximising value
From a financial management perspective, the goal of the financial manager is to maximise shareholder value. This is different to maximising accounting profit. Accounting profits are not necessarily the same as cash flows. Profit maximisation does not tell us when cash flows are to be received (time value of money), and profit maximisation ignores the uncertainty or risk associated with cash flows.
So, what type of financial decisions do contribute to maximising shareholder value? Three key questions to address are:
1. What long-term investments should the business undertake?
The process of answering this question is known alternatively as capital budgeting, investment appraisal or project evaluation. Although all three titles are encountered in financial literature, ‘capital budgeting’ will be used throughout this subject when referring to this investment process to keep consistent with the textbook.
2. How should the business raise money to fund these investments?
Such decisions are referred to as capital structure decisions and relate to the business’s selected balance between debt (what the business owes) and equity (what the business owns).
3. How can the business best manage its cash flows as they arise in its day-to-day operations?
The related process is termed working capital management and monitors the balance of the business’s current assets (items such as cash and inventory or stock) and its current liabilities (short-term debts).
Watch
In this excerpt (02:17 minutes) of an interview recorded by CNN Business (2014) around the time when Facebook acquired WhatsApp, Mark Zuckerberg justifies the investment decision from the perspective of maximising value.
Read
The section ‘Maximising shareholder wealth’ on page 9 of the textbook gives a further case study on how financial decisions impact shareholder value.
In this HBR article, there is a relevant discussion on how executive management, acting on behalf of shareholders, creates value for organisations. It discusses strategies like acquisitions, investments in the right assets, and other valuable insights around cash distribution back to shareholders. This article offers insight into a practical understanding of the notion of ‘creating shareholders value’.
Ethical considerations
There is a growing awareness that the objective of maximising shareholder wealth does not mean that other stakeholders associated with the business (employees, customers, suppliers, the community and so on) can be ignored. If a business wishes to survive and prosper over the longer term, satisfying the needs of other groups and all stakeholders will also be necessary to maximise the wealth of the owners in the long term. Businesses have a social responsibility to the governments, communities and countries in which they invest and operate, and to the people they employ. Increasingly, businesses are asking themselves if greater consideration of environmental, social and government (ESG) issues are necessary to ensure sustainable value and financial resilience.
Ethical behaviour is a quintessential component of ESG, and its importance is testified to by the numerous cases of business failures due to ethical lapses. Ethical errors are fundamentally different from judgement errors in business; they are related to pursuing actions that are questionable or fraudulent and, as such, must be avoided from the outset.
Watch
In this video (06:47 minutes) AIB alumni, Benjamin Hanley, guides you through a snapshot of 3 key questions in relation to Responsible Investment (RI):
- What is RI?
- What isn’t RI?
- Why does RI matter?
Read
Read more details on ethics and financial decision making in the section titled ‘Ethical considerations in corporate finance’ on pages 9-11 of the textbook.
Summary
This introductory module has provided a broad overview of how finance impacts on various decisions for an organisation. The overarching goal of a finance manager is to increase shareholder value and wealth, but we have learned how questions on ethical practice in the effort to maximise stakeholder value are becoming increasingly tied to sustainability and resilience. In this module, we also learned about different business structures and about 5 foundational finance principles, all of which become the basis of more in-depth discussion and analysis in subsequent modules.