FIN2603
NOTES
, Chapter 1 - The financial goal of the firm
The financial goal of the firm:
The goal of the firm is to maximise shareholders’ wealth and not maximise
profit
Diversification means not placing all your money in a single investment –
but spreading it over various investments
The short-term goal of the firm should be to ensure the:
o Profitability – firms ability to generate revenues that will exceed
total costs by using the firm’s assets for productive purposes
o Liquidity – the firm’s ability to satisfy its short-term obligations as
they become due
o Solvency – the extent to which a firm’s assets exceed its liabilities;
differs from liquidity in that liquidity pertains to the settlement of
short-term liabilities, while solvency pertains to the excess of total
assets over total liabilities
Profit maximisation is not consistent with wealth maximisation,
because of:
o The timing of earnings per share
o Earnings that do not represent cash flows available to shareholders
o A failure to consider risk
Financial management and accounting:
Many people regard financial management and accounting in the business
environment as the same thing - however, there is a difference
o Handling of funds and decision making are the two reasons why
financial management and accounting are considered different
fields
1. Handling of funds:
The primary functions of an accountant are to develop and provide data
for measuring the performance of the firm, to assess its financial position
and to see to the payment of taxes
o Accrual principle – a principle whereby revenues are recognised at
the point of sale and expenses when they are incurred
The financial manager’s role differs in the way in which he/she views
the funds of the firm
o The financial manager is more concerned with maintaining a firm’s
liquidity and solvency by providing the cash flows necessary to
satisfy its obligations
2. Decision making:
The accountant devotes the majority of his/her attention to the collection
and presentation of historical financial data
Whereas the financial manager evaluates the accountant’s financial
statements, processes and additional data, and makes decisions based on
sub- sequent analyses
1
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,Functions of a financial manager:
Making investment decisions
Making financing decisions
Ensuring profitability (revenue exceeds expenses)
Ensuring solvency (assets exceed liabilities)
Ensuring positive cash flow (cash inflow exceeds cash outflow)
The fundamental principles of financial management:
Financial management is based on the following principles:
1. The cost-benefit principle:
The cost-benefit principle can be used by means of the following steps:
Obtain clarity about the objectives to be attained
Identify alternative ways in which the objective can be achieved
Calculate the cost and benefits of each of the alternatives
Determine the effectiveness of each alternative
Decide on a criterion or standard to be used to measure acceptability
Make a decision about the course of action
2. The risk-return principle:
A trade-off between risk and return
The greater the risk, the greater the required rate of return
The return should exceed the risk
3. The time value of money:
A concept used to evaluate any financial decision involving differences in
the timing of cash inflows and outflows
The time value of money is a matter of interest that may be earned if
money is available today and invested, or the opportunity cost if an
amount will only be received in the future
Money markets - the financial markets for short-term borrowing and
lending; provide short-term liquidity with securities such as treasury bills,
commercial paper and bankers’ acceptances
Capital market - a market place where companies and governments can
raise long-term funds; a market in which money is lent for periods of
longer than a year
Financial institution - an organisation that acts as a channel between
savers and borrowers of funds (Two main types of financial institutions are
banks that pay interest on deposits from the interest earned on the loans,
and insurance companies and mutual funds that collect funds by selling
their policies or shares to the public and provide returns in the form of
periodic benefits and profit pay-outs)
Spread - the difference between the rate charged and the rate paid
(Financial institutions need to invest or lend out their available funds at a
rate that exceeds the rate they are paying to their depositors)
2
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, Agency problem - the cost incurred by the owners of a business when
using an agent (management); associated with problems such as the
disparity between management and shareholder’s objectives
Chapter 2 – Understanding financial statements
Financial statements must provide a fair presentation of the financial
performance and financial position of the firm
Income statement – measures the financial performance during a
certain period
Balance sheet – indicates the financial position at a specific point in time
Cash flow statement – indicates what cash flows were generated
Who uses financial statements:
Shareholders – to assess the worth of their business
Management – to help plan and control activities
Labour unions – for a basis to negotiate wages
Investment analysts – who are investing in the firm
Credit bureaux – needed to issue credit ratings
The state – in terms of taxes
Key generally accepted accounting principles (GAAP):
The financial statements must be generated according to generally accepted
accounting principles (GAAP) to be reliable, understandable and relatively
consistent between reporting periods
Accounting entity
Money measurement
Conservatism
Consistency concept
Materiality
Historic cost
The double-entry system
The going-concern concept – assurance of the firms continuity
Accounting period
The realisation principle – income must have been earned and realised
The accrual principle - a principle whereby revenues are recognised at
the point of sale and expenses when they are incurred
Classification of financial information:
A logical classification of the vast amount of financial information
generated in a firm requires a system of accounts
The accountant may use either a computerised system (for example,
AccPac, Pastel, Baan or SAP) or a manual system
Regardless of the system used, it must provide for five types of accounts,
namely:
o Assets account
3
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NOTES
, Chapter 1 - The financial goal of the firm
The financial goal of the firm:
The goal of the firm is to maximise shareholders’ wealth and not maximise
profit
Diversification means not placing all your money in a single investment –
but spreading it over various investments
The short-term goal of the firm should be to ensure the:
o Profitability – firms ability to generate revenues that will exceed
total costs by using the firm’s assets for productive purposes
o Liquidity – the firm’s ability to satisfy its short-term obligations as
they become due
o Solvency – the extent to which a firm’s assets exceed its liabilities;
differs from liquidity in that liquidity pertains to the settlement of
short-term liabilities, while solvency pertains to the excess of total
assets over total liabilities
Profit maximisation is not consistent with wealth maximisation,
because of:
o The timing of earnings per share
o Earnings that do not represent cash flows available to shareholders
o A failure to consider risk
Financial management and accounting:
Many people regard financial management and accounting in the business
environment as the same thing - however, there is a difference
o Handling of funds and decision making are the two reasons why
financial management and accounting are considered different
fields
1. Handling of funds:
The primary functions of an accountant are to develop and provide data
for measuring the performance of the firm, to assess its financial position
and to see to the payment of taxes
o Accrual principle – a principle whereby revenues are recognised at
the point of sale and expenses when they are incurred
The financial manager’s role differs in the way in which he/she views
the funds of the firm
o The financial manager is more concerned with maintaining a firm’s
liquidity and solvency by providing the cash flows necessary to
satisfy its obligations
2. Decision making:
The accountant devotes the majority of his/her attention to the collection
and presentation of historical financial data
Whereas the financial manager evaluates the accountant’s financial
statements, processes and additional data, and makes decisions based on
sub- sequent analyses
1
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,Functions of a financial manager:
Making investment decisions
Making financing decisions
Ensuring profitability (revenue exceeds expenses)
Ensuring solvency (assets exceed liabilities)
Ensuring positive cash flow (cash inflow exceeds cash outflow)
The fundamental principles of financial management:
Financial management is based on the following principles:
1. The cost-benefit principle:
The cost-benefit principle can be used by means of the following steps:
Obtain clarity about the objectives to be attained
Identify alternative ways in which the objective can be achieved
Calculate the cost and benefits of each of the alternatives
Determine the effectiveness of each alternative
Decide on a criterion or standard to be used to measure acceptability
Make a decision about the course of action
2. The risk-return principle:
A trade-off between risk and return
The greater the risk, the greater the required rate of return
The return should exceed the risk
3. The time value of money:
A concept used to evaluate any financial decision involving differences in
the timing of cash inflows and outflows
The time value of money is a matter of interest that may be earned if
money is available today and invested, or the opportunity cost if an
amount will only be received in the future
Money markets - the financial markets for short-term borrowing and
lending; provide short-term liquidity with securities such as treasury bills,
commercial paper and bankers’ acceptances
Capital market - a market place where companies and governments can
raise long-term funds; a market in which money is lent for periods of
longer than a year
Financial institution - an organisation that acts as a channel between
savers and borrowers of funds (Two main types of financial institutions are
banks that pay interest on deposits from the interest earned on the loans,
and insurance companies and mutual funds that collect funds by selling
their policies or shares to the public and provide returns in the form of
periodic benefits and profit pay-outs)
Spread - the difference between the rate charged and the rate paid
(Financial institutions need to invest or lend out their available funds at a
rate that exceeds the rate they are paying to their depositors)
2
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, Agency problem - the cost incurred by the owners of a business when
using an agent (management); associated with problems such as the
disparity between management and shareholder’s objectives
Chapter 2 – Understanding financial statements
Financial statements must provide a fair presentation of the financial
performance and financial position of the firm
Income statement – measures the financial performance during a
certain period
Balance sheet – indicates the financial position at a specific point in time
Cash flow statement – indicates what cash flows were generated
Who uses financial statements:
Shareholders – to assess the worth of their business
Management – to help plan and control activities
Labour unions – for a basis to negotiate wages
Investment analysts – who are investing in the firm
Credit bureaux – needed to issue credit ratings
The state – in terms of taxes
Key generally accepted accounting principles (GAAP):
The financial statements must be generated according to generally accepted
accounting principles (GAAP) to be reliable, understandable and relatively
consistent between reporting periods
Accounting entity
Money measurement
Conservatism
Consistency concept
Materiality
Historic cost
The double-entry system
The going-concern concept – assurance of the firms continuity
Accounting period
The realisation principle – income must have been earned and realised
The accrual principle - a principle whereby revenues are recognised at
the point of sale and expenses when they are incurred
Classification of financial information:
A logical classification of the vast amount of financial information
generated in a firm requires a system of accounts
The accountant may use either a computerised system (for example,
AccPac, Pastel, Baan or SAP) or a manual system
Regardless of the system used, it must provide for five types of accounts,
namely:
o Assets account
3
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