FINANCIAL MANAGEMENT AND ANALYSIS

Finance is the application of economic principles and concepts to business 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 business finance, this area of finance is concerned primarily with financial decision-making within a business entity. Financial management decisions 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 common body of knowledge and show how it is used in financial decision-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 analysis, 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 warehouse?

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 managers 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 ownership 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 these factors. Expected return is the difference between potential benefits and potential costs. Risk is the degree of uncertainty associated with these expected returns.

Financial Analysis

Financial analysis is a tool of financial management. It consists of the evaluation of the financial condition and operating performance of a business firm, an industry, or even the economy, and the forecasting of its future condition and performance. It is, in other words, a means for examining risk and expected return. Data for financial analysis may come from other areas within the firm, such as marketing and production departments, from the firm’s own accounting data, or from financial information vendors such as Bloomberg Financial Markets, Moody’s Investors Service, Standard & Poor’s Corporation, Fitch Ratings, and Value Line, as well as from government publications, such as the Federal Reserve Bulletin. Financial publications such as Business Week, Forbes, Fortune, and the Wall Street Journal also publish financial data (concerning individual firms) and economic data (concerning industries, markets, and economies), much of which is now also available on the Internet.

Within the firm, financial analysis may be used not only to evaluate the performance of the firm, but also its divisions or departments and its product lines. Analyses may be performed both periodically and as needed, not only to ensure informed investing and financing decisions, but also as an aid in implementing personnel policies and rewards systems.

Outside the firm, financial analysis may be used to determine the creditworthiness of a new customer, to evaluate the ability of a supplier to hold to the conditions of a long-term contract, and to evaluate the market performance of competitors.

Firms and investors that do not have the expertise, the time, or the resources to perform financial analysis on their own may purchase analyses from companies that specialize in providing this service. Such companies can provide reports ranging from detailed written analyses to simple creditworthiness ratings for businesses. 

As an example, Dun & Bradstreet, a financial services firm, evaluates the creditworthiness of many firms, from small local businesses to major corporations. As another example, three companies—Moody’s Investors Service, Standard & Poor’s, and Fitch—evaluate the credit quality of debt obligations issued by corporations and express these views in the form of a rating that is published in the reports available from these three organizations.