Financial management involves studying how to manage organisations or individual funds, activities that financial management involve include organisation day to day operations, decision making on which projects to finance, deciding on how to raise capital, capital budgeting, deciding on the amount of capital to retain and the amount to pay back, deciding on which accounting method to use in determining fixed assets depreciation, strategy formulation and implementation and finally risk management.
The founder of a firm can loose control of the firm if the firm is transformed into a limited partnership organisation, in limited partnership the owners of the firm will hire a manager to manage the firm but will not participate in day to day operations management and decision making. To ensure that this doesn’t happen the owner may decide to retain the firm as a general partnership or sole proprietorship organisation.
The owner of a firm may also loose control of a firm whereby the manager may not act in line with the interest of the investor, the agency theory states that agency problem may arise whereby there is a conflict of interest between the manager and the investor. To resolve this problem control can be retained by allowing managers to own part of the firm or by hiring monitors such as analysts, a CEO and auditors
The wealth maximisation goal of a firm can be defined as a goal that aims at increasing the value of a company, the firm therefore should undertake activities that are generally accepted such as producing products that are demanded by consumers, producing these products in an efficient way in such a way that the organisation realises growth. This goal can be measured by determine the present and future cash flows and the present value of these cash flows.
The wealth maximisation goal is better than the profit maximisation goal because the profit maximisation goal ignore time; profits are reported after every financial year while cash flows can be determined at any time, this goal is also better in that its measurement using cash flows and present value indicates the difference in risks of projects while profit maximisation goal measurement ignores risk. Finally the wealth maximisation goal reflects return on equity while profit maximisation goal does not.
An auditor is in a better position to monitor the firm, this is because this is an outside monitor and therefore may not be biased, and another reason is because auditors are hired by the owners of the firm and therefore will act in the interest of the owner and not the managers. A CEO may be the weakest monitor given that the individual will require to be paid, he or she will be an inside monitor and the agency problem may also arise between the CEO and the owners
of the firm.
The accounting method used in asset depreciation affects the balance sheet, there are various methods used in calculating depreciation and they include the straight line method, this method will indicate low depreciation expenses in the first useful years of an asset, this result into a higher income reported increasing both taxes paid and shareholder income.
On the other hand if the accelerated depreciation method is used the depreciation expenses are deducted in the first useful years of an asset are higher, this results into lower income whereby lower income means that tax paid and share holder returns will be relatively lower. Therefore the depreciation method used will affect the value of net profits and net value of assets in the balance sheet
The book value and market value of a firm will differ, this is because according to GAAP the values of items in the books of accounts are historical costs, for example the book value of a fixed asset will be the value that the value paid by a firm, for this reason the value of fixed assets in the market and the book value of the fixed assets will differ. Another reason is that book value of share holders’ equity will be the amount invested by the investor, and on the other
hand market value of share holders’ equity in a firm will be dictated by expected future cash flows and present value. Therefore this results into a difference in the book value of the firm and the market value of the firm.
This statement indicates revenue and expenses of an organisation, this statement affects the reporting of expenses and revenue on the balance sheet whereby the value of net income calculated using this statement is added to assets. Accrued expenses and account payable values are also added to current liabilities in the balance sheet, finally the income statement indicates tax, earnings and dividends per share which are indicated in the balance sheet.
Cash flows are more important than accounting profits dues to various reasons, when the free cash flow is determined and the value is negative then this means that the firm is facing management problems, this may also indicate that the firm is investing heavily to support growth. When the value is positive this indicates that there are funds available that can be distributed to investors.
For this reason cash flow indicates the growth in wealth of investors and provides a better understanding of changes in investment, operation and financing activities. Profits on the other hand only indicate the net income gained by the firm ignoring time and risks involved in investment activities.
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