1: Financial Management and the Firm
After completing this chapter, you should be able to: (1) recognize the six steps included in the management process; (2) apply the management process to better manage the financial resources of the small to medium-size firm; and (3) apply the management process to other activities such as being a successful student.
To achieve your learning goals, you should complete the following objectives:
- Understand the need for a concise firm mission statement.
- Learn how to distinguish between the firm’s strategic (long-term) goals and its tactical (short-term) objectives.
- Learn how to choose goals and objectives that will successfully guide financial managers in the financial management process.
- Learn how to identify a firm’s (internal) strengths and weaknesses.
- Learn how to identify a firm’s (external) opportunities and threats.
- Learn how to develop a strategy to reach the firm’s goals and objectives that take advantage of the firm’s strengths and opportunities and minimize the limitations of its weaknesses and threats.
- Learn how to implement and evaluate outcomes of the firm’s strategy for achieving its goals and objectives.
- Learn how to apply the management process to one’s own efforts to succeed in this class.
Introduction to Management
Financial management is about, above all else, management. The verb manage comes from an Italian verb meaning “to handle” as in how a rider handles a horse. The management process can be applied to a wide variety of organizations and resources. In this book, we apply the management process to managing the financial resources of the small business as opposed to larger corporations.
The Management Process
The management process includes six steps: 1) develop the firm’s mission statement; 2) choose the firm’s strategic (long-term) goals and tactical (short-term) objectives; 3) identify the firm’s strengths, weaknesses, opportunities, and threats; 4) develop the firm’s strategy for accomplishing its strategic goals and tactical objectives; 5) implement the firm’s strategy; and 6) evaluate the firm’s performance.
These six steps are illustrated in Figure 1.1 followed by narrative that describes them in more detail. Note that as one moves from one management step to the other, one moves toward the center of the circle in Figure 1.1. And as one moves toward the center of the circle, each activity is constrained by previous management choices.
Figure 1.1. The Managerial Process in Six Steps
Develop the Firm’s Mission Statement
The management process begins with a mission statement. The firm’s mission statement explains why the firm exists and what it values. The mission statement may also establish criteria for selecting activities in which the firm will participate. Mission statements might also describe the firm’s customers, the markets in which it will participate, and the firm’s social responsibilities. Mission statements are often succinct, short, easy to express and remember, clear, and flexible enough to describe the entire range of the firm’s activities. For example, a mission for a vegetable farm may be: “our mission is to provide wholesome and safe vegetables grown in an environmentally healthy and worker-friendly environment.”
Motives play a critical role in the formulation of the firm’s mission statement. Motives spring from physical and socio-emotional needs and the relative importance of these motives will determine how the firm manages its resources to satisfy its needs. Therefore, the relative importance of the financial manager’s motives should be reflected in the mission statement. To illustrate, motives may reflect the need to increase one’s own consumption, to act in accordance with one’s internalized set of values, to earn the good will of others, to increase one’s sense of belonging in one’s community or other organizations, and to improve the well-being of a disadvantaged group. The mission statement needs to guide the firm’s efforts to manage its resources depending on the relative importance of these competing motives.
One word sometimes associated with management is the word “vision.” Vision is the ability to imagine or picture, in one’s mind, something that has not yet been created physically. Therefore, vision is a necessary condition for any kind of physical creation because we must create an event, outcome, or thing in our mind before we can create it physically. An architect must imagine a building and reflect that vision in plans which the builders will follow to create a building. A football coach imagines an offensive play and reflects it in a drawing before it can be executed in a game. A financial manager must imagine a project that will produce valued outcomes before committing time, energy, and other resources to the project. A vision of what the manager wants the firm to achieve is reflected in the firm’s mission statement. A biblical expression highlights the importance of vision: “where there is no vision, the people perish…” (Proverbs 29:18).
Choose the Firm’s Strategic Goals and Tactical Objectives
Strategic goals set the long-term direction of the firm. Strategic goals are consistent with the firm’s mission statement—what it values, why it exists, and what its purpose is. Strategic goals direct the firm’s efforts toward achieving its mission over the long run. Strategic goals also call for tactical objectives, specific actions needed to achieve strategic goals. For example, a strategic goal may be to increase the firm’s revenues by 10%. The objectives consistent with this goal may be to develop new products, to focus on a particular marketing strategy, or to increase the firm’s sales force. The firm’s objectives transform the firm’s strategic goals into an action plan. Tactical objectives describe what short term actions are required if the firm is to reach its long-term goals.
The importance of goals and objectives
There are at least four reasons management requires the firm to choose goals and objectives:
- Firm goals and objectives express what the firm believes is possible and desirable to achieve. By choosing the firm’s goals and objectives, the manager is expressing confidence in what the firm can achieve. By declaring the firm’s goals and objectives, the manager is also declaring its commitment of time, energy, and resources to achieve a desired end. Declaring the firm’s confidence and commitments in the form of its goals and objectives is the first reason for setting strategic goals and tactical objectives.
- As the firm works to achieve its goals and objectives, it faces a multitude of choices, including how best to allocate its limited resources. Goals and objectives guide the firm in its allocation decisions by asking: what choices and resource allocations will best enable the firm to reach its goals and objectives? Therefore, firm goals and objectives provide criteria for making choices, the second reason for setting goals and objectives.
- Most firms include multiple actors with diverse assignments. Goals and objectives provide a means for rallying firm members to support a common cause. Goals and objectives provide a means for seeing one’s individual efforts in the context of the overall goals and objectives of the firm and to identify opportunities for synergism within the firm. Ideally, the firm’s goals and objectives represent a consensus of firm members’ beliefs in what is possible and desirable and how to best achieve them so that all parts of the firm work cooperatively and enthusiastically together. Providing a framework for firm members to work synergistically is the third reason for setting goals and objectives.
- Finally, goals and objectives provide a measure against which the firm can evaluate its performance. It allows the firm to ask and answer questions such as: Where are we? How are we doing? Can we get where we want to be from here? Are we closer to reaching our goals than before? Measuring one’s efforts against a standard is the fourth reason for setting goals and objectives.
The characteristics of good goals and objectives.
Some goals are better than others. The four reasons why we choose goals and objectives help us define the characteristics of good goals and objectives.
- Good goals and objectives are realistic. They identify outcomes that are feasible for the firm to achieve given its environment and resources. It is not helpful to set unrealistic goals and objectives, even if they impress others. Unrealistic goals and objectives may create unrealistic expectations and lead to frustration later because they cannot be achieved. Good goals and objectives can be achieved with the resources available to the firm and the environment in which it exists.
- Good goals and objectives answer the question: “What must the firm do to achieve its mission?” Goals and objectives that are consistent with the firm’s mission statement provide the criteria for the management of the firm’s energy and resources. If the firm goals and objectives fail to provide such criteria, then other goals and objectives should be selected.
- Good goals and objectives reflect a consensus among those tasked with achieving them. People work hard for money. But they work harder when they feel they are part of a team—that their contributions are valued. Thus, good goals and objectives are the product of serious discussions intended to produce a consensus among those involved in reaching them. Therefore, at the end of the day, good goals and objectives provide a focus for synergistic efforts.
- Finally, progress toward the achievement of good goals and objectives can be measured. Thomas S. Monson (1970) taught, “when progress is measured, progress improves. And when progress is measured and reported, the rate of improvement increases.” Measuring the firm’s progress helps guide the firm’s future. If the measures signal that the firm is making adequate progress, then the firm is supported in its efforts to keep doing what it has been doing. If the measures signal that the firm is not making adequate progress, then the firm is supported in its efforts to change directions.
Identify the Firm’s Strengths, Weaknesses, Opportunities, and Threats.
Before developing strategies to accomplish the firm’s goals and objectives, a manager needs to identify and evaluate the internal strengths and weaknesses of the firm. This evaluation should include an assessment of the firm’s ability to survive financially in both the long run and the short run (solvency and liquidity); its profitability; its efficient management of its resources on which its profitability depends; and the risk inherent in its current financial state. External opportunities and threats that impact the firm’s ability to accomplish its objectives also need to be considered. An external opportunity and threat analysis might include evaluating the behavior of close competitors or assessing the condition of the economy and business climate, or the impacts of the business cycle on clients’ incomes and the resulting product demand.
Develop and Evaluate the Firm’s Strategy.
The firm’s strategy is a plan that describes how it intends to achieve its strategic goals and its tactical objectives. Some have claimed that a goal or objective without a plan is only a wish. The firm’s strategy is a plan of action that describes who will do what, when, and how. For each goal or objective, the firm must develop the corresponding strategy to accomplish it. The strategy development process includes collecting data and information about possible choices and likelihoods of possible events. Then, the information must be analyzed to determine the impact of a particular strategy on the firm’s goals and objectives. Based on these analyses, management must select the proper strategy.
Implement the Firm’s Strategy.
Once a strategy is selected, it must be administered throughout the firm. All relevant parts of the business (accounting, purchasing, manufacturing, processing, shipping, sales, administration) must support and take an active role implementing the strategy. There may be changes in the business that are necessary to implement the strategy such as changes in personnel, technology, or financial structure. Implementing the firm’s strategy will require a carefully coordinated effort if the firm’s strategy leads to the firm achieving its goals and objectives.
Evaluate the Firm’s Performance.
Firm managers must continually evaluate the strategies they implemented to reach the firm’s objectives and goals. They must determine if what the firm has achieved is consistent with its mission statement, goals, and objectives within an environment described by the firm’s strengths, weakness, opportunities, and threats. Firm managers must also be prepared to alter strategies in response to changes in technologies, laws, market conditions, and personnel. These changes will make it necessary for the firm to continually reevaluate and make adjustments.
Evaluating the firm’s performance must also include a review of its mission statement, goals, objectives, efforts to implement its strategies, and its strengths, weaknesses, opportunities and threats. Since the firm’s mission statement and strategic goals are oriented toward the long term, they change infrequently. However, the firm’s strategies may change as frequently as its internal strengths and weaknesses and external opportunities and threats change.
The Firm Financial Management Process
The firm’s financial management process involves the acquisition and use of funds to accomplish its financial goals and objectives consistent with its financial mission statement. The firm’s financial management process essentially employs the same six management steps described earlier. The six steps of financial management include: 1) develop the financial mission of the firm; 2) choose the financial goals and objectives of the firm; 3) identify and evaluate the firm’s financial strengths, weaknesses, opportunities and threats; 4) develop financial strategies including evaluating and ranking investment opportunities to achieve financial goals and objectives consistent with the firm’s mission; 5) implement investment strategies by matching the liquidity of funding sources with cash flow generated from investments, by forecasting future funding needs, and by assessing the risk facing the firm; and, 6) evaluate the firm’s financial performance relative to the goals and objectives of the firm. These six steps are described next in more detail.
(1) Develop the Firm’s (Financial) Mission Statement.
While financial management usually plays a role in developing the firm’s overall mission statement, there are other considerations shaping the firm’s mission. As a result, the financial mission of the firm is usually nested within the more general mission of the firm. One financial mission of the firm may be to reach certain financial conditions that allow the firm’s owners to pursue other goals and provide firm owners resources in the future. The firm’s mission statement may lead naturally to important financial goals such as to maximize profit, reduce costs and increase efficiency, manage or increase the firm’s market share, limit the firm’s risk, or maximize the owner’s equity in the firm. However, there may be a distinction between a firm’s financial mission and the firm’s overall mission. In other words, the firm’s financial mission included in the strategic financial management process may be an objective in the firm’s overall strategic management process.
(2) Choose the Firm’s (Financial) Strategic Goals and Tactical Objectives.
The part of the firm’s mission related to financial management must lead to the firm selecting financial goals consistent with the firm’s mission statement and objectives likely to lead to the successful achievement of its strategic goals. The financial objectives may direct how the firm organizes itself and how it manages its tax obligations—subjects discussed in Chapters 2 and 3. However, taxes will also influence the development and implementation of investment strategies—subjects discussed in several chapters of this book.
(3) Identify (Financial) Strengths, Weaknesses, Opportunities and Threats.
The use of coordinated financial statements (CFS) discussed in Chapter 4 can be used to evaluate the firm’s internal strengths and weaknesses. We may need to look outside of the firm to identify external opportunities and threats facing the firm. Financial statements are used to formulate ratios that can be compared to other firms to determine how the firm’s financial condition compares to normal—or average—firms, the subject of Chapter 5. Chapter 6 uses financial statements and ratios to demonstrate that the firm is a system with interconnected parts. As a result, each financial measure (e.g. solvency, profitability, efficiency, liquidity, and leverage) are connected to each other, and a change in one measure will change all the others.
(4) Develop and Evaluate the Firm’s (Financial) Strategy.
Financial managers face an almost limitless set of investment opportunities with a wide variety of characteristics. Some investments will be liquid and easily converted to cash, such as inventories or time deposits. Other investments, such as real estate or production facilities, cannot be easily converted to cash and are considered illiquid. There are investments that provide fairly certain, low risk returns while others will provide uncertain, high risk returns. Some investments are depreciable while others increase in value over time. Firm budget resources for capital or long-term investments and evaluate them using present value (PV) tools. Many of the chapters that follow focus on PV models. Indeed, it may be correct to say that the focus of much of this book is on how to use PV models to evaluate a firm’s financial strategy.
- PV models recognize the time value of money; that a dollar today is different than a dollar received in the future (Chapter 7);
- PV models convert future cash flow to their equivalent value in the present (Chapter 8);
- PV models need to be consistent, must be investments of homogeneous size, term, and tax treatments—comparing apples to apples and oranges to oranges (Chapters 9, 10, and 11);
- PV models are similar in construction to accrual income statements (Chapter 12);
- PV models often evaluate incremental changes in a firm’s portfolio of investments and project the future values of exogenous variables (Chapter 13);
- PV models can be used to find the liquidity of investments since investments like firms differ in their degree of liquidity (Chapter 14);
- Risk is ubiquitous and we must account for it in our PV models (Chapter 15).
Equipped with PV models and knowledge of how to conduct proper comparisons of investments using consistent measures, we are prepared to apply our tools to a wide range of investment problems that employ a variety of PV models. Included is a discussion of loan analysis in Chapter 16, land investments in Chapter 17, leasing options in Chapter 18, and investment in financial assets in Chapter 19. Then Chapter 20 introduces yield curves to help us identify outside-of-the-firm external threats and opportunities. Finally, the last chapter in this book, Chapter 21, ends with a cautionary note—there are relational goods that may be more important than money and should not be ignored.
(5) Implement the Firm’s (Financial) Strategy.
Financial managers often play an important role in managing the implementation of an investment strategy. The implementation stage of financial management may include interacting with capital markets to raise funds required to support a strategy. Managers decide whether to acquire funds internally or borrow from other investors, commercial banks, the Farm Credit System, life insurance companies, or, depending on how the firm is organized, by issuing stocks or bonds.
In the process of obtaining and allocating funds, financial managers interact directly or indirectly with financial markets. This interaction could be simply obtaining a savings or checking account at your local bank. Or it could involve more sophisticated interactions such as raising funds by issuing ownership (equity) claims in your firm in the form of shares of stock.
Another part of implementing the financial strategy of the firm is to interact with various parts of the business and the household. For example, setting inventory policy is both a financial and business management decision and requires input from the production and sales departments of the firm as well as the firm’s financial managers. In addition, financial managers must make trade-offs between risks and expected returns. One tool that can be used to evaluate future returns and risk is the term structure of interest rates, the subject of Chapter 20. There are other kinds of trade-offs as well. One important trade-ff is between commodities and relational goods. We will need both because they each satisfy different needs. This book is mostly about managing commodities, but Chapter 21 reminds us that “money can’t buy love” or relational goods. Therefore, one more thing about management is to account for and manage relational goods.
(6) Evaluate the Firm’s (Financial) Performance.
Finally, financial concepts and information are often used to evaluate a strategy’s performance and to signal investment changes the firm needs to adopt in the future. In this effort, PV models will prove to be particularly helpful.
The relative importance of the six steps included in the management process will differ depending on what is being managed. In the case of financial management, the financial goals, the objectives, the strengths, weaknesses, opportunities, and threats analysis, and the strategies adopted and evaluated will differ from personnel management, for example. Similar to both financial management and other management efforts is their shared responsibility for the firm. What follows is really strategic firm management applied to the financial resources available to the firm.
Our focus on firm financial management. While all six firm financial management processes are important and discussed in this book, we focus on two:
- Assessing the firm’s internal strengths and weakness through the use of coordinated financial statements, ratio analysis, and comparisons with ‘average’ firms; and
- Developing strategies described by after-tax cash flow and evaluating them using PV models.
Of course the other parts of the management process are important, especially implementing strategic financial investment plans and evaluating the firm’s performance. However, a thorough treatment of these topics which should be pursed in other venues.
Trade-offs between Financial Goals and Objectives
The firm’s financial goals and objectives guide the financial manager. There are, of course, a wide range of possible tactical objectives that a firm may adopt to achieve its strategic goals and its mission. However, one maxim should guide the manager’s choice of objectives: “There is no such thing as a free lunch!” Interpreted, this adage reminds us that nearly always, every objective comes at the cost of another objective
For example, consider the objective of maximizing the firm’s profits. Increases in short-term profits may often reduce long-term profits. If the firm desires to reduce its risk, this may require that the firm reduce its profits by investing in less risky–but lower return–investments.
One often-stated firm financial management objective is to maximize the profits of the firm. However, the measure of profits can differ drastically across different accounting practices. For example, cash versus accrual accounting, different depreciation methods, and different inventory accounting methods all lead to different measures of profit. Maximizing profits using one accounting method may not maximize profits using another accounting practice. Furthermore, profits may be difficult to measure when the firm employs unpaid family labor. The real problem is that profits don’t reflect the actual cash flow of the firm.
In addition, the traditional notion of profit ignores the timing of the cash flow received by a firm. Suppose you are given the choice of receiving $1,000 either today or one year from today. Which would you choose? Naturally, you would choose to get the money today because you could invest the money for some positive rate of return and earn more than $1,000 by the end of one year. For instance, suppose you could invest the money in the bank and earn a 5 percent return during the year. At the end of the year you would get back your $1,000 plus $1,000 x (.05) = $50 interest or a total of $1,050. Clearly, the $1,000 today is worth more than the $1,000 one year from today. The notion that dollars at different points in time are not worth the same amounts at a single point in time is known as the time value of money concept. Moreover, it underlies one of the most important financial trade-offs: present profits versus the present value of discounted future after-tax cash flow.
Another trade-off involving the maximize profit objective is that it ignores liquidity. Liquidity can be defined as a firm’s ability to meet unexpected cash demands. These cash demands might be unexpected cash expenses for such things as repairs and overhead expenses, new investment opportunities, or unexpected reductions in revenue. The concept of liquidity is closely related to risk. Liquidity needs are usually met by holding salable assets and/or maintaining the capacity to borrow additional funds. Serious risks may reduce the value of some assets and make liquidation of the assets difficult. Likewise, serious risk may also make it difficult to borrow additional funds.
If you were a firm manager, would your objective be to maximize profits or is some other objective more preferable? In this class, we will argue that traditional profit maximization is not a very desirable objective for a financial manager. We will argue that in most cases, financial decisions should be made so they maximize the value of the firm, which turns out to be the same thing as maximizing the present value of all the future cash generated by the firm. Once again, it is important to note that “cash flow” is much different than “profit.”
This concept of maximizing firm value is easy to defend in large firms where firm ownership is often separate from management. Owners of these firms generally want management to operate the firm in a way that maximizes the value of their investment; however, in smaller firms and households the value maximization principal is often constrained by other considerations such as concerns about quality of life. For example, you would likely be able to increase your personal wealth over time by driving a Chevrolet instead of a Cadillac (you could invest the cost savings), but you may gain enough satisfaction from driving a Cadillac (or a tractor with green paint) that you are willing to accept the lower wealth level. Nevertheless, for most of this course we will assume that financial decisions are made in a manner that is consistent with maximizing value. In cases where a firm does not maximize present value, it is still useful to estimate the present value maximizing decisions as a benchmark in order to understand the cost of alternative decision in terms of wealth loss.
Summary and Conclusions
Like it or not, we are all managers—if not managers of a firm then we are personal managers. We have important management responsibilities for our lives and resources. The management process is a universal process requiring that we first determine our mission and what goals and objectives are consistent with our mission? The goals and objectives we choose must declare what it is that we believe we can and should accomplish and the level of our commitment to reaching our goals and objectives. Finally, we cannot avoid setting goals and objectives because having no goal or objective is a goal or objective—to reach nowhere in particular.
Choosing our goals and objectives is crucial in the management process. We cannot achieve our mission without properly formulated goals and objectives. Goals and objectives lead us to conduct an honest evaluation of our internal strengths and weakness and external threats and opportunities, a process that identifies the resources and constraints likely to contribute to achieving our mission. After formulating our goals and objectives, and after conducting an honest evaluation of our strengths, weaknesses, opportunities and threats, we next decide on a strategy, a plan to follow that will enable us to accomplish our mission. Strategic management requires that we implement our plan, that we take specific actions to ensure we achieve our goal by implementing our strategies. And finally, we evaluate and, if necessary, modify our goals, objectives, and our understanding of our strengths, weaknesses, threats, and opportunities. Then, when we have completed the management process, we repeat it all over again, continually, and not necessarily following the steps in the management process in the same order. We end this chapter by emphasizing this truism: we are all managers, all the time.
Questions
- What does the word management mean?
- Discuss the six steps included in the management process. Should these steps be practiced sequentially? In any order? Or does it depend on the management problem? Defend your answer.
- What features differentiate management and firm financial management?
- Consider mission statements and strategic goals and tactical objectives. Is the following statement: “I want to obtain a college degree.” a mission statement, a goal, or an objective? If it is a tactical objective, what strategic goals and mission statement are consistent with this tactical objective? If it is a strategic goal, what mission statement and tactical objectives are consistent with this strategic goal? Finally, if it is a mission statement, what strategic goals and tactical objectives are consistent with this mission statement?
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Mission statements, strategic goals, and tactical objectives
reflect motives. Several motives may explain one’s desire to
achieve a college degree. One motive for obtaining a college degree
is to increase one’s lifetime earnings. But there are other
motives. To help you connect motives to your personal mission
statement, goal, or objective to obtain a college degree, identify
the relative importance of the five motives described below. To
complete the questionnaire below, assume you have 10 weights (e.g.
pennies) to allocate among the five motives for attending the
university. Distribute the 10 weights (pennies) according to the
relative importance of each motive. Write your answer in the blank
next to each question. There is no right or wrong allocation of
weights among the motives except that the sum must add to 10. Each
motive reflects the relative importance of one’s need to increase
one’s own consumption, to earn internal/external validation, and to
have a sense of belonging.
- I want a college degree so I can increase my lifetime earnings and get a better job.
- I want a college degree so important people in my life will be pleased with my achievements.
- I want a college degree to live up to the expectations I have for myself.
- I want a college degree so I will feel part of groups to which I want to belong.
- I want a college degree so that in the future, I will be better able to help others.
- Develop a management plan for this class, this semester. This should include a brief discussion of each of the six steps in the strategic planning process including a mission statement, strategic goals and objectives, your strengths, weaknesses, opportunities, and threats, your strategies, your plan to implement your strategies, and, lastly, your evaluation process. Discuss what role financial management will play in your strategic planning process.
- Imagine yourself as the financial manager of a small firm. Write a mission statement focused on profit maximization. What other considerations may be ignored if profit maximization were your primary mission? Suppose your mission statement was to “aid the disadvantaged”? Would profit or value maximization be part of your firm’s goals and objectives? Please explain.