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INTRODUCTION TO FINANCIAL MANAGEMENTDR: EL ILAM SI MOHAMED

Chapter 1

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Key Concepts and Skills

Know the basic types of financial management decisions and the role of the financial manager

Know the goal of financial managementKnow the financial implications of the different forms of business organization

Understand the conflicts of interest that can arise between owners and managers

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Chapter Outline

Finance: A Quick Look Business Finance and The Financial Manager Forms of Business Organization The Goal of Financial Management The Agency Problem and Control of the

Corporation Financial Markets and the Corporation

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Basic Areas Of Finance

• Corporate finance• Investments• Financial institutions• International finance

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Investments

• Work with financial assets such as stocks and bonds

• Value of financial assets, risk versus return and asset allocation

• Job opportunities• Stockbroker or financial advisor• Portfolio manager• Security analyst

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Financial Institutions

Companies that specialize in financial matters Banks – commercial and investment, credit

unions, savings and loans Insurance companies Brokerage firms

Job opportunities

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International Finance

This is an area of specialization among all of the areas discussed so far

It may allow you to work in other countries or at least travel on a regular basis

Need to be familiar with exchange rates and political risk

Need to understand the customs of other countries and speaking a foreign language fluently is also helpful

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Why Study Finance?

Marketing Budgets, marketing research, marketing financial products

Accounting Dual accounting and finance function, preparation of

financial statements Management

Strategic thinking, job performance and profitability Personal finance

Budgeting, retirement planning, college planning, day-to-day cash flow issues

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Business Finance

Some important questions that are answered using finance What long-term investments should the firm

take on? Where will we get the long-term financing to

pay for the investment? How will we manage the everyday financial

activities of the firm?

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Financial Manager

Financial managers try to answer some or all of these questions

The top financial manager within a firm is usually the Chief Financial Officer (CFO) Treasurer – oversees cash management, credit

management, capital expenditures and financial planning

Controller – oversees taxes, cost accounting, financial accounting and data processing

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Financial Management DecisionsCapital budgeting

What long-term investments or projects should the business take on?

Capital structure How should we pay for our assets? Should we use debt or equity?

Working capital management How do we manage the day-to-day finances of the

firm?

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Forms of Organization

Three major forms in the united states Sole proprietorship Partnership

General Limited

Corporation S-Corp Limited liability company

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Sole Proprietorship

Advantages Easiest to start Least regulated Single owner keeps all

the profits Taxed once as personal

income

Disadvantages Limited to life of owner Equity capital limited

to owner’s personal wealth

Unlimited liability Difficult to sell

ownership interest

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Partnership

Advantages Two or more owners More capital available Relatively easy to start Income taxed once as

personal income

Disadvantages Unlimited liability

General partnership Limited partnership

Partnership dissolves when one partner dies or wishes to sell

Difficult to transfer ownership

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Corporation

Advantages Limited liability Unlimited life Separation of

ownership and management

Transfer of ownership is easy

Easier to raise capital

Disadvantages Separation of

ownership and management

Double taxation (income taxed at the corporate rate and then dividends taxed at personal rate)

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Goal Of Financial ManagementWhat should be the goal of a corporation?

Maximize profit? Minimize costs? Maximize market share? Maximize the current value of the company’s

stock?Does this mean we should do anything and everything to maximize owner wealth?

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The Agency Problem

Agency relationship Principal hires an agent to represent their interest Stockholders (principals) hire managers (agents)

to run the companyAgency problem

Conflict of interest between principal and agentManagement goals and agency costs

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Managing Managers

Managerial compensation Incentives can be used to align management and

stockholder interests The incentives need to be structured carefully to

make sure that they achieve their goalCorporate control

The threat of a takeover may result in better management

Other stakeholders

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Work the Web Example The Internet provides a wealth of

information about individual companies One excellent site is finance.yahoo.com Click on the web surfer to go to the site,

choose a company and see what information you can find!

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Figure 1.2

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Financial Markets

Cash flows to the firmPrimary vs. secondary markets

Dealer vs. auction markets Listed vs. over the counter securities

NYSE NASDAQ

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Quick Quiz

What are the four basic areas of finance? What are the three types of financial management

decisions and what questions are they designed to answer?

What are the three major forms of business organization?

What is the goal of financial management? What are agency problems and why do they exist

within a corporation?

Financial Management

Definitions and conceptsDr: EL ILAM SI MOHAMED

Financial management, sometimes called financial operations or finance, is how an insurance company manages its resources to meet the company’s financial goals, especially the overall goals of solvency and profitability.

Organization of Financial Management

Investment Committee Board of Directors

Audit Committee Board of Directors

Chief Investment Officer

Investment Operations

Chief Financial Officer Financial Operations

TreasurerTreasury

Operations

Controller Accounting and

Financial Reporting

Chief AuditorAudit and

Internal Control

Accounting is a system or set of rules and methods for collecting, recording, analyzing, summarizing, and reporting financial information.

Financial reporting is the process of presenting financial data about a company’s financial position. Operating performance, and flow of funds into and out of the company.

In most of the insurance companies, the controller or comptroller is the head of accounting and financial reporting

Accounting and Financial Operations

The primary responsibilities of the accounting and financial reporting function are to :

Record, track and report on financial transactions Coordinate the budget process and oversee expense analysis Prepare financial statements and reports for external

stakeholders Gather, record ,analyze and distribute financial information to

company mangers

Accounting and Financial Operations

Treasury Operations, manages the cash coming into and out of a company

The treasurer oversees the maintenance and management of records and reports for all of an insurer’s cash transactions

Treasury Operations

Treasuery operations include the following responsibilities: Cash Management-Oversees cash receipts and approves cash

disbursements Bank relations and account administration- Set up bank

accounts, reconciles bank statements Bank reconciliation-Records cash transactions and charges them to

proper accounts Short term credit activities- invests excess cash in very short –

term arrangements and arranges for very short term borrowing as needed

Cash forecasting- Forecasts and tracks the movement of money into and out of the company

Liquidity management- Manages cash on hand to meet contractual obligations by using liquidity

Treasury Operations

Investments are core insurance company operation. Typically, a CIO manages investment operations.

The CIO is responsible for : Making recommendations to the board and implementing board

directives Ensuring investment decisions are in line with investment policy and

regulatory requirements Communicating to the accounting and actuarial areas the current and

expected rates of return on the company’s investments

Investment Operations

By conducting audits of its financial and operational business activities , an insurer can objectively , and compliance with evaluate its operating procedures, management efficiency and compliance with specified rules and regulations

Audit and Internal Control

The ongoing duties of an insurer’s audit committee include: Monitoring internal controls for financial operations Supervising and meeting with internal auditors to discuss their activities

and findings Monitoring organizational activities to improve operating efficiencies Reporting the committee’s activities to the board of directors Reporting the committee’s activities in the annual report to stockholders

and policy owners

Audit and Internal Control

(1) Setting Financial strategy (2) Managing risk (3) Managing the company’s solvency

and profitability (4) Managing capital (5) Managing cash flows (6) Providing financial information to

stakeholders

Responsibilities of Financial Management

Financial strategies may be categorized as : 1) Aggressive 2) Conservative 3) combination of the above two Aggressive : A company that places a strong emphasis on taking risks that could

enhance its profitability. For e.g. investing in relatively high- risk assets, developing many new and unusual products, implementing new distribution systems

Conservative Financial Strategy: An insurer that places a strong emphasis on avoiding risks that could threaten its solvency generally pursues a conservative financial strategy. For e.g. …………….

1) Setting Financial Strategy

Risk is the possibility that an investment might have an unexpected result. Common types of risks: Investment risk- is the possibility that an investor will fail to earn some or all of an expected return

or will lose all or part of the original investment. Some important risks associated with investing are Market Risk : For e.g. real estate investment may lose value if the real estate market as a whole

declines Interest-rate risk: For e.g. if the interest rate increase, bonds tend to lose market value Default-risk: The risk that a borrower will fail to repay the debt Liquidity –risk: for e.g. I the owner of property, such as shopping mall, should suddenly need cash

quickly, the property may have to be sold for a price less than its true value Currency risk: the value of an insurer’s investments in a foreign country fluctuates with the value

of that country’s currency

2) Managing Risks

Operational Risk is a broad category of risks originating from inadequacies in an insurer’s operational areas or from external events affecting an insurer's operational areas. Two major types of operational risks are:

Business process risk- For e.g. inefficient customer service processes might create long TAT Event Risk: For e.g. an earthquake might result in technology failures and an inability to run the

business Product Risk : is the risk that a company’s [products might not sell as well or be as profitable as

expected A) Pricing risk: For e.g. more insured might die than an insurer anticipated when pricing a life

insurance product, so claims will be higher B) Policyholder behavior risk: For e.g. customer ‘s surrender patterns may be higher than an

insurer anticipated

2) Managing Risks

Risk management is the process of systematically identifying, assessing, and minimizing the negative impact of risk.

To minimize the negative impact of these various risk across the organization, most insurers practice Enterprise Risk Management. ERM is a system that identifies and quantifies risks both from potential threats and potential opportunities and manages them.

2) Managing Risks

The dual goals of financial management are to (1) protect solvency (2) increase profitability

Pursuing profitability requires a certain amount of risk taking, whereas protecting solvency involves risk avoidance and stability

Long term profitability enables an insurer to A) Provide funds for investments B) Pay policy dividends C) Pay cash dividends to stockholders and increase the attractiveness of the company’s

stock to investors D) Generate high-quality ratings from insurance rating agencies E) Provide funds to develop products, expand product lines, for company expansion e.t.c

3) Managing Solvency and Profitability

Financial managers attempt to increase the probability that the company will remain financially healthy by using the company’s capital appropriately

Capital= Assets – Liabilities Benefits to an insurer of maintaining the strong capital position include: Greater ability to withstand difficult conditions such as bad economy Greater flexibility in its operations Greater ability to raise capital on favorable terms

4) Managing Capital

Ways to Raise Capital?

Ways to Use Capital?

A cash flow is any movement of cash into or out of an organization A cash inflows include- 1) revenues from product sales 2)

investment income 3) sales of existing assets 4) external financing A Cash outflow includes 1) payments to policy owners and

beneficiaries 2) payment for operating expenses 3) purchase of new assets

The basic goal for managing cash flows is to have enough assets available so that the insurer can pay its obligations as they come due and to invest the remaining assets wisely to earn favorable returns

5) Managing Cash Flows

Insurers provide information to stakeholders in the form of

Financial statements Annual report Annual statements

6) Providing financial information to stakeholders

A financial statement is a summary of a company’s financial condition on a specified date or its performance during a specified period.

Two key financial statements are the income statement and the balance sheet The income statement shows a company’s revenues and expenses during a

defined period, such as one quarter or one year, and shows weather the company experienced a profit or loss during that period.

Revenues are amounts that a company earns from its business operations Expenses are amounts that a company spends to support its business operations The income statement also shows net income, which is calculated by subtracting

expenses from revenues

6) Providing financial information to stakeholders

Balance sheet, which lists the value of an insurer’s assets ,liabilities , and capital and surplus as of a specified date

Annual Report is a financial document that an incorporated business issues to its stakeholders and other interested parties to report the business’s activities and financial performance for the preceding year.

Annual Statement

6) Providing financial information to stakeholders