Hey guys, I am Derek, welcome to my channel. In this video, I'm gonna make a short introduction to financial management. The first question is, what is finance?
Finance can be defined as the art and science of managing money. Art is like dancing, singing and drawing, something which is based on feeling. But science is more about facts and figures, you have to do experiment, come out with theories to explain what you believe. So, finance is basically a mix of art and science of managing money. The key word here is managing money.
That's what we call financial management. Financial management is a very important aspect for companies. It is because financial management is about maintenance and creation of economic value or wealth.
What is wealth? Let's take an example. Let's say, the market value of Company A is $100 billion. Investors of Company A altogether invested $30 billion. So taking $100 billion minus $30 billion, you will get $70 billion.
This amount of money is what we call, wealth created for investors. Shareholders only paid $30 billion to buy the shares, but the company created extra $70 billion for the shareholders. Of course, this is going to be a good sign for investors, as the value of the company has increased. For finance, it has two broad topics. Personal finance and corporate finance.
Personal finance is about managing your own money. This is the process of planning and managing your personal financial resources to achieve your short-term and long-term financial goals. These goals may include buying a house or a car, saving money for your child's education, saving for retirement, and so on.
Personal finance involves creating a budget, saving for emergencies and future expenses, paying off debt, and investing for your future. It's about making smart choices with your money so that you can live the life you want today and have peace of mind for tomorrow. It would answer the questions such as how much you spend, how much you save, and how you invest your savings. In short, this is about doing individual financial planning.
But for corporate finance, it is more on how to manage company's money. Corporate financial management is the process of making strategic decisions about how to allocate a company's financial resources in order to achieve its goals and objectives. It is like a game of chess, where each move you make with your financial resources, like cash, investments, and credit, is a strategic decision that can lead to a win or a loss. So, it is about making smart decisions with the firm's money. in order to reach the firm's long-term goals and stay competitive in the market.
It would answer the questions such as how firms raise money from investors, how firms invest money to earn a profit, whether to reinvest profits in the business or distribute them back to investors. Alright, another question, is finance the same as accounting? The answer can be yes and no. Yes, because some functions of accounting and finance are closely related and overlapping.
No, because they have some distinct differences in terms of their focus, responsibilities, and goals. Accounting people are the controllers, while finance people are basically the treasurers. Finance people always focus on how to invest and how to make more money for the company.
They're just like the accelerator of a car. To make a car move, you have to press on the accelerator. The harder you press, the faster the car can move. But at the same time, you need to have a break.
This is the function of accounting, which we call them the controllers. When finance people are moving too fast, investing too much money in too many projects, accounting people, the break, will slow them down for safety purpose. One thing to take note, only in big corporations we will have two separate accounting and finance departments. But in smaller firms, generally the financial manager will perform both accounting and finance functions.
Another aspect, accounting is focused on recording and reporting financial transactions, while finance is focused on managing and allocating financial resources. Accounting involves the preparation of financial statements, such as the balance sheet, income statement, and cash flow statement. However, finance managers are using the information prepared by accounting department to make business decisions, such as investing in new projects, or to pay off the outstanding debt of the company. On the other hand, accounting is focused on the past and present, while finance is focused on the future.
Accounting deals with historical financial data and provides information about what has happened in the past. However, finance uses that information to make predictions about what will happen in the future and to make decisions about how to allocate resources. In terms of information recording method, accounting applies accrual method while finance recognizes cash method.
How to differentiate these two methods? Let's take an example. Company A experienced the following activity last year.
Company sales was $100,000, with one car sold, but customer has not made the payment yet, that's why it is 100% still uncollected. The cost of the car is $80,000. The company has already paid in full amount under supplier terms.
If you were to prepare an income statement, under accounting record, which is using the accrual method, you would recognize a sales of $100,000, costs of $80,000. So, the company made a profit of $20,000. But under finance record, which is using the cash method, since you had not received cash from the customer, you would recognize a sales of $0. But you'd already paid the supplier, so there would be a cost of $80,000.
Eventually, the company made a net loss of $80,000 for selling the car. A loss position could happen when company recognized the cash flows of the transaction. This example shows us the difference between accounting and finance records.
Next, we will talk about the goals of a company. It is about what target a company wants to achieve. The first one, profit maximization. Profit maximization refers to how much dollar profit the company makes.
How to make the most profits from the business. Some companies may focus on cutting costs and increasing prices in the short term to boost profits. Such method is a short-term approach, mostly concerned about short-term benefits only.
But in the long term, this strategy may lead to a decrease in customer loyalty, lower sales, and a decrease in overall profits. Another problem with profit maximization is that it ignores the timing of returns, magnitude of returns, and risk. When will you receive the money, how much money will you receive, and how much is the risk?
These questions are not answered if companies only focus on profits. Third, fulfilling objective of earning profit may not help in creating wealth in the long run. Profit should not be the only target of a company.
Rather, company should look at how to create wealth. Wealth means value. In fact, Company should focus more on creating value for the company.
Lastly, it does not consider the social responsibility. If the goal of a company is just to make profit, it may not make donation, it may not care about air pollution. But nowadays, social responsibility is very important for company to survive in the long run.
Another goal of a company is about shareholder wealth maximization. It focuses on maximizing the value of a company. When we say the value of a company, it means the value of the stock or share.
So, it is a long-term approach, mostly concerned about the value of financial assets. Financial assets include bonds, shares, and so on. Next, it considers the timing of returns, magnitude of returns, and risk.
It will answer the following questions, like, when will you receive the money? How much money will you receive and how much is the risk? These are the important criteria of doing a business. How to increase the value of a company? For examples, company may invest in new projects or it may think of how to improve the quality of the products, not to cut the cost but to control the cost by improving the production process.
Probably the old way of production is to take 10 steps to manufacture a product. But if you can come out with a better way of production, reduce the process to five steps only, then you can control the cost and create value. Another good example is Google. Initially Google offered its Gmail service for free as it tried to grab the market share.
This strategy has helped increase the value, that is the share price of Google. In short, shareholder wealth means the share price or the firm's value. Maximizing shareholder wealth means maximizing the share price and also maximizing the firm's value.
In fact, some companies focus on profit, whilst some companies focus on value. Profit versus value, which one is more important to company? Well, profit is a subset of value, which means that profit is only a small part of the value.
As shown in the graph, under value, we have profit, quality, branding, market share, R&D and culture of company. These are the factors that contribute to the value of a company. That's why, profit is not everything.
Profit is just a small part of the value. In other words, creating value will help create profit. But, making profit does not necessarily create value for a company.
Another goal of a company is a stakeholder view. Stakeholders include all groups of individuals who have a direct economic link to the firm such as employees, customers, suppliers, creditors, community, environment, and so on. Companies should not only take care of the shareholders, but also others.
In the process of making profit, companies should avoid actions that could harm the interest of their stakeholders. Taking care of the stakeholders is not to maximize but to preserve stakeholder well-being. For example, to donate money to the community, to build schools or hospitals, to prevent pollution of environment, to take good care of the employees.
These are some examples of taking care of the stakeholders. Such a view is considered to be socially responsible. We usually call this as Corporate Social Responsibility.
More and more companies are contributing in CSR, which they believe that CSR would improve the financial performance of the company. Alright, that's all for this video. Thanks for watching.
See you in the next one. Bye.