Fundamentals of Finance and Financial Management

Finance and Financial Management Defined

Depending on its use, the definition of finance may be presented in two different ways. As a verb, finance
would mean “to provide funding,” for example, in the form of a loan or borrowed money with the intent of
collecting the money back after a specified period of time. In this kind of arrangement, the money that was
loaned will earn interest, or the charge for borrowing money, which is usually a percentage of the principal
or the loaned amount over a specified period of time.

Individuals borrow money from other people or from banks when they do not have sufficient funds, for
instance, to support daily needs, short-term projects such as home improvement, or long-term goals like
education. Businesses take out loans from financial institutions for the purchase of new equipment or
construction of additional facilities. More often than not, interest is paid on the amount that was borrowed.

Finance, when used as a noun, is a field in business and economics. From the perspective of an
economist, finance is the allocation of scarce resources which include money. In business, it is the
function or area which is responsible for managing the aspect of the operations that deals with money
matters. It is concerned not only with the allocation of funds but also with the sources of such funds.

The study of finance addresses three basic questions:

1. What types of investments (short term and/or long term) should the firm undertake?

2. What sources of funds (short term and long term) should the firm tap to fund these investments?

3. How can the firm ensure that its cash flows will suffice to support its day-to-day operation.

Financial management, on the other hand, has a broader meaning as it covers the planning, organizing,
leading, and controlling of all financial activities of an organization. Financial management puts emphasis
on managing the funds of an organization in order to create value for the firm by minimizing risks (cost
and expenses) and maximizing returns (sales and profit). It also includes management of funds needed
for day-to-day operations, investment decisions, and financing those investments. The focus of this
module, however, is on finance and financial management as a function in business.

Branches of Finance

The broad field of finance may be divided into two main branches: public and private finance.

Public finance covers management of public funds, national budget, and tools for fiscal policy such as
government expenditure and taxation. Public revenue is generally derived from taxes, while public
expenditure involves allocation of national budget into programs designed to benefit the general public.
An example of public expenditure would be the construction of public roads, public market, and other
infrastructure projects that are intended for public use.

Private finance may be further categorized into personal and corporate finance.

Personal finance, which gained much popularity among the younger generation of income earners,
encompasses everything that pertains to personal financial planning, including coming up with a budget
that matches one’s short- and long-term needs, creating a savings plan for contingencies, and investing
in financial products such as retirement plans and insurance.

Your parents’ practice of budgeting for the needs of your family while at the same time saving for your
college education is a good example of personal finance.

Corporate finance (also known as business finance) is primarily concerned with the management of all
the financial activities of an enterprise or a business organization. The ultimate goal of corporate finance
is to maximize shareholder value through sound financial planning.

A detailed plan for a business organization includes areas of decision that are meant to ensure the
financial well-being of the firm. There is a good chance that one of your relatives or someone from your
neighborhood is a professional who works in a field that is in one way or another related to corporate
finance—a bank employee, a financial analyst, or an accounting staff.

The following are examples of situations that show how corporate finance is practiced in organizations:

1. The accounting supervisor is preparing a cost-and-benefit analysis on whether it is more costly

2. The marketing manager is meeting with the finance officer to discuss the pricing of a new
product before it is launched in the market.
3. The marketing officer is advised that the budget for advertising and promotion is not enough to
include social media advertising.
4. The human resources manager is explaining to the other members of the management team
how hiring additional staff will help with productivity but may also impact cost and profitability.

5. The logistics manager is requesting for a new vehicle that will be used for delivery. However,
the finance officer explains that the benefits of purchasing a new vehicle will not be enough to
justify the amount to be spent.

It is evident from the given examples that finance is not confined to just one department in an
organization. Every cross-functional area or department is somehow connected to functions related to
finance

The study of corporate finance may be categorized into four interrelated areas:

1. Financial markets and institutions – This area covers banks, insurance companies, finance
companies (nonbank institutions that offer both short-term and long-term loans to individuals and
other firms), and other financial intermediaries.

Financial intermediaries are also nonbank financial institutions that offer specialized financial services to
businesses. Common examples of financial intermediaries are companies that offer insurance and mutual
funds. In more progressive countries, such as the United States and the United Kingdom, financial
services corporations offer very specialized services to businesses. For these organizations to thrive in
the financial markets, decision makers need to have an understanding of factors that cause prices of
financial products to rise and fall—government regulations, interest rates, market risks, return on
investments, behavior of investors and other key players, and even the law of supply and demand.

2. Investments – This area focuses on investment options and decisions made by both individual and
corporate investors. Some of the considerations made are the risk-return trade-off, the prices of financial
products (securities), and the financial products to be included in one’s portfolio of investments in order
to maximize return
3. Financial services – This area refers to services offered by organizations whose line of business is to
help individuals and other organizations manage money. These organizations include banks, insurance
companies, brokerage firms, and similar companies that provide professional guidance on decisions
pertaining to how money should be managed in order to achieve certain goals such as purchasing a
home, setting up a retirement fund, investing on new equipment, and maximizing a shareholder’s wealth.

4.
4. Managerial (business) finance – This area will be the core focus of this module. Every organization,
public or private, depends on sound decisions on the following:

 net cash flow (inflow less outflow)

 how to finance the acquisition of assets and other growth plans

 which financing options to access when the supply of cash is deficient

 what to do with the firm’s excess cash

 optimal inventory levels

 working capital management

 how much of the earnings should be paid out to dividend versus how much should be
reinvested in the firm.

 whether to merge with or acquire other firm.

Accounting and Finance

Although finance and accounting are closely related, they are distinct disciplines that have different
focuses. One of the main features of finance is managerial accounting. It involves the preparation of
reports that are intended to aid internal users in decision-making to ensure good or better performance
in the future.

Some of the most common reports prepared in managerial accounting are budget, cost analysis,
inventory analysis, sales and profit projections, and risk-return analysis. Managerial accounting may
rely on the use of historical data provided by financial accounting.

Financial accounting keeps track of all the historical transactions of a business that will be used in
preparing reports intended for use by external parties such as government agencies, investors, and
creditors. Managerial accounting information is vital to the role of the finance manager. For instance, the
sales and profit projections coupled with cost analysis are useful when trying to decide if a particular
product should be launched in the market or if a business unit should be opened. Budgets are used not
only by finance managers but also by other department managers such as in the implementation of
programs and also as a control measure.

Financial Management in Business

Decision makers in a business organization depend largely on financial information gathered, prepared,
and analyzed by finance managers. The key to the effective use of such information is how finance is
applied in other business functions within the organization such as production, marketing, human
resource, procurement, and operations.

Finance managers are involved in planning. They contribute in identifying goals and objectives, setting
targets, and establishing control measures in order to monitor performance. However, it is not just the
finance managers who should possess financial knowledge. In most cases, managers from other
departments are required to have an understanding of how their different functions affect or can be
affected by the overall financial condition of the organization.

Financial information is generated by different departments. At times, other department heads also
prepare financial reports. For instance, the production manager prepares a periodic report on the amount
of rejects as a percentage of total production, or the human resource supervisor monitors the number of
overtime hours. It is up to the person in charge of the Finance Department to gather all these data and put
them together in a format that is clearly and easily understood by decision makers.

Financial information also serves as an effective communication tool across departments. The following
are snippets from conversations between organizational members:

 Human Resources to Accounting: “Ma’am, I would like to know the possible effects of hiring two
additional employees in production on our overall profitability assuming that output will increase
by 30%. Thank you.”

 Accounting to Sales: “My concern is that the sales department is not achieving its sales targets
and at the same time exceeding budget for promotion.”

 One employee to another: “Our manager explained to us that even if we can increase our
sales, it will still not improve the company’s finances if we do not control our operating
expenses.”