Financial Management and Analysis

Read and summarize chapter 1 of Financial Management Text book in at least 400 words.

*Answer #13 of the questions at the end of the chapter.

Finance is the application of economic principles and concepts to busi- ness decision-making and problem solving. The field of finance can be considered to comprise three broad categories: financial management, investments, and financial institutions:

■ Financial management. Sometimes called corporate finance or busi- ness finance, this area of finance is concerned primarily with financial decision-making within a business entity. Financial management deci- sions include maintaining cash balances, extending credit, acquiring other firms, borrowing from banks, and issuing stocks and bonds.

■ Investments. This area of finance focuses on the behavior of financial markets and the pricing of securities. An investment manager’s tasks, for example, may include valuing common stocks, selecting securities for a pension fund, or measuring a portfolio’s performance.

■ Financial institutions. This area of finance deals with banks and other firms that specialize in bringing the suppliers of funds together with the users of funds. For example, a manager of a bank may make decisions regarding granting loans, managing cash balances, setting interest rates on loans, and dealing with government regulations.

No matter the particular category of finance, business situations that call for the application of the theories and tools of finance generally involve either investing (using funds) or financing (raising funds).

Managers who work in any of these three areas rely on the same basic knowledge of finance. In this book, we introduce you to this com- mon body of knowledge and show how it is used in financial decision-

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4 FOUNDATIONS

making. Though the emphasis of this book is financial management, the basic principles and tools also apply to the areas of investments and financial institutions. In this introductory chapter, we’ll consider the types of decisions financial managers make, the role of financial analy- sis, the forms of business ownership, and the objective of managers’ decisions. Finally, we will describe the relationship between owners and managers.

FINANCIAL MANAGEMENT

Financial management encompasses many different types of decisions. We can classify these decisions into three groups: investment decisions, financing decisions, and decisions that involve both investing and financing. Investment decisions are concerned with the use of funds— the buying, holding, or selling of all types of assets: Should we buy a new die stamping machine? Should we introduce a new product line? Sell the old production facility? Buy an existing company? Build a ware- house? Keep our cash in the bank?

Financing decisions are concerned with the acquisition of funds to be used for investing and financing day-to-day operations. Should man- agers use the money raised through the firms’ revenues? Should they seek money from outside of the business? A company’s operations and investment can be financed from outside the business by incurring debts, such as though bank loans and the sale of bonds, or by selling owner- ship interests. Because each method of financing obligates the business in different ways, financing decisions are very important.

Many business decisions simultaneously involve both investing and financing. For example, a company may wish to acquire another firm— an investment decision. However, the success of the acquisition may depend on how it is financed: by borrowing cash to meet the purchase price, by selling additional shares of stock, or by exchanging existing shares of stock. If managers decide to borrow money, the borrowed funds must be repaid within a specified period of time. Creditors (those lending the money) generally do not share in the control of profits of the borrowing firm. If, on the other hand, managers decide to raise funds by selling ownership interests, these funds never have to be paid back. However, such a sale dilutes the control of (and profits accruing to) the current owners.

Whether a financial decision involves investing, financing, or both, it also will be concerned with two specific factors: expected return and risk. And throughout your study of finance, you will be concerned with

Introduction to Financial Management and Analysis 5

these factors. Expected return is the difference between potential bene- fits and potential costs. Risk is the degree of uncertainty associated with these expected returns.

What is an agency cost? Give three examples of agency costs.

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