Chapter 01 {Final Energy Financial Management}.Doc

8/14/2019 Chapter 01 {Final Energy Financial Management}.Doc

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Chapter 1

Introduction of Financial Management

1. 1 Introduction

Financial management is that managerial activity which is concern with theplanning and controlling of the firms financial resources. Thought it was a branchof economics till 1890, as a separate activity or discipline it is of recent origin. Still, ithas no unique body of knowledge of its own, and draws heavily on economics for itstheoretical concepts even today.

The subject of financial management is of immense interest to both academiciansand practicing managers. It is of great interest to academicians because the subjectis still developing, and there are still certain areas where controversies exist for

which no unanimous solutions have been reached as yet. Practicing managers areinterested in this subject because among the most crucial decisions of the firm arethose which relate to finance, and an understanding of the theory of financialmanagement provides them with conceptual and analytical insights to make thosedecisions skillfully.

Financial management can be looked upon as study of relations between raising of finance and development of finance.

1.2 Introduction to Finance

Suppose you are planning to start your own business. No matter what, the nature of your proposed business is and how it is organized, you will have to address thefollowing questions:

1. What capital investment should you make? That is, what kind of realestate, machineries, and equipment should you purchase?

2. Where will you raise money to pay for the proposed capital investments?That is, what will be the mix of equity and dept in your financing plan?

3. How will you handle the day-to-day financial activities like collectingyour receivables and paying your suppliers?

All business activities require acquisition and use of funds for running the businessunit commercially i.e. generating revenues over total cost incurred. Without fundsno business activity can take a final shape in practice.

Thus all business activities require;


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1. Funds to formulate business plans,2. Funds to implement these plans,3. Funds to generate future growth, and4. Funds to generate more funds.

Funds like other inputs of the organizations have to be procured at a cost. Fundscan be procured from various sources like Shareholders, debt holders/creditorsfinancial institutions, banks etc. Funds required for running the business are raisedthrough a combination of direct revenue from sales, loans from banks, sales of securities and bonds, etc. All such activities which relate to acquisition and use of funds are together terms as fund management/money management.

Finance is all about managing BUSINESS MONEY i.e. the money employed commercially to generate surplus for the business. In other words finance is an art, science of using, managing controlling the business funds.

1.3 Scope of finance

What is finance? What are a firms financial activities? How are they related to thefirms other activities? Firms create manufacturing capacities for productions of goods; some provide services to customers. They sell their goods or services to earnprofit. They raise funds to acquire manufacturing and other facilities. Thus, thethree most important activities of a business firm are:

Production Marketing Finance

A firm secures whatever capital it needs and employs it (finance activities) inactivities which generate returns on invested capital (production and markingactivities).

a. Real and Financial Assets

A firm requires real assets to carry on its business. Real assets can be tangible or

intangible. Plant, machinery, office, factory, furniture building are example of tangible real assets, which technical know-how, technological collaborations,parents and copyrights are copyrights are intangible real assets. The firm sellsfinancial assets or securities, such as shares and bonds or debentures, to investors incapital markets to raise necessary funds. Financial assets also include leaseobligations and borrowing from banks, financial institutions and others sources.


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Funds applied to assets by the firm are called capital expenditure or investment.The firm expects to receive return on investment and distribute return as dividendsto investors.

b. Equity and borrowed Funds

There are two types of funds that firm can raise: equity funds and borrowed funds.A firm sells shares to acquire funds. Shares represent ownership rights of theirholders. Buyers of shares are called shareholders, and they are legal owners of thefirm whose shares they hold. Shareholders invest their money in the shares of acompany in the expectations of a return on their invested capital. The return on theshareholders capital consists of dividend and capital gain, shareholders makecapital gains by selling their shares.

Shareholders can be of two types: ordinary (or common) and preference. Preferenceshareholders receive dividend at a fixed rate, and they have a priority over ordinaryshareholders. The dividend rate of ordinary shareholders is not fixed, and it canvary from year to year depending on the decision of the board of directors. Thepayment of dividend to shareholders is not a legal obligations; it depends on thediscretion of the board of directors. Since ordinary shareholders receive dividend(or re-payment of invested capital, only when the company is wound up) aftermeeting the obligations of others, they are generally called owners of residue.Dividends paid by a company are not deductions charges for calculating corporate

income taxes.

Equity funds can also be obtained by a company by retaining a portion of earningsavailable for shareholders. This method of acquiring funds internally is calledearnings retention. Retained earnings are undistributed profits of equity capital;they are, therefore, rightfully a part of the equity capital. The retention of earningscan be considered as a form of raising new capital. If a company distributes allearning to shareholders, then, it can reacquire new capital from the same sources(existing shareholders) by issuing new shares called a rights issue. Also, a public of shares may be made to attract new shareholders.

Another important source of securing capital is creditors or lenders. Lenders arenot the owners of the company. They make money available to the firm on a lendingbasis and retain title to the funds lent. The return on loans or borrowed funds iscalled interest. Loans are furnished for a specified period at a fixed rate of interest.Payment of interest is a legal obligation. The amount of interest is allowed to be


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treated as expense corporate income taxes. Thus the payment of interest onborrowing provides tax shield to a firm. The firm may borrow funds from a largenumber of sources, such as banks, financial institutions, public or by issuing bondsor debentures. A bond or a debenture is a certificate acknowledging the money lent

by a bondholder to the company. It states the amount, the rate of interest and thematurity of the bond or debenture.

c. Finance and Other Management Functions

There exists an inseparable relationship between finance on the one hand andproduction, marketing and other functions on the other. Almost all kinds of business activities, directly or indirectly, involve the acquisitions and use of funds.

1.4 Finance FunctionsAlthough it may be difficult to separate the finance functions from production,marketing and other functions, yet the function themselves can be readily identified.The functions of raising funds, investing them in assets and distributing returnsearned from assets to shareholders are respectively known as financing, investmentand dividend decisions. While performing these functions, a firm attempts tobalance cash inflows and outflows. This is called liquidity decisions, and we may addit to the list of important finance decisions or functions.

Broadly managing funds involve the following functions:

1. Financing decision (or capital-mix decision): These relate to procuring fundsfrom outside the business organizations. Funds should be procured at anominal cost and it should be effectively utilized to give maximum value. Thedifferent sources of obtaining funds from the basis of organizations capitalstructure. The mix of different sources of funds at which the overall cost of capital remains minimum is the optimum capital structure of the firm.

FINANCIAL DECISION IN A FIRM

There are three broad areas of financial decision making:-

1. Capital Budgeting the first and perhaps the most important decisionthat any firm has to make is to define the business or businesses that iswants to be in. This decision has a significant bearing on how capital isallocated in the firm. Once the managers of a firm choose the business orbusinesses they want to be in, they have to develop a plan to invest inbuilding, machineries, equipment, research and development, godowns,


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showrooms, distribution network, information infrastructure, brands,and other long-lived assets. This is the capital budgeting process. The unitof analysis in capital budgeting is an investment project. Considerablemanagerial time, attention, and energy is developed to identify, evaluate,

and implement investment projects. When you look at an investmentproject from the financial point of view, you should focus in themagnitude, timing, and riskness of cash flows associated with it. Inaddition, consider the options embedded in the investment project.

2. Capital Structure once a firm has the investment project it wants toundertake, it has to figure out ways and means of financing them. Whilethe unit of analyzing in the capital structure decision is the firm as awhole and not the individual investment project. The key issue in capitalstructure decision are- what is the optimal dept-equity ratio for the firm?

Which specific instrument of equity and dept finance should the firmemploy? Which capital markets should the firm access? When should thefirm raise finances? At what price should the firm offer its securities? Anallied issue is the dividend of the firm. What is the optimal dividendpayout ratio for the firm? Should the buy back its own shares? Capitalstructure and dividend decisions should be guided by considerations of cost and flexibility, in the main. The objective should be to minimize thecost of financing without impairing the ability of the firm to raise financerequired for value creating investment project.

3. Working Capital Management (WCM) Working capital managementalso referred to as short-term financial management, refers to the day-to-day financial, activities that deal with current assets ( inventories, short-term holdings of market securities, and cash) and current liabilities(Short-term dept, trade creditors, accruals, and provisions). The keyissues in WCM are: what is the optimal level of inventory for theoperations of the firm? Should the firm grant credit to its customers and,if so, on what terms? How much cash should the firm carry on hand?Where should the firm invest its temporary cash surpluses? What sources

of short-term finance are appropriate for the firm?

2. Investment decisions (or long-term assets-mix decision): These are long termprofitable decisions of the firm which enhance the value of the firm. Alsoknown as capital budgeting/expenditure decisions, these require hugeinvestments and related benefits arise in future. As future uncertain hence


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the risk factor is high in investment decisions. Risks return tradeoff of investment decisions directly affects the firms value in the market place.These decisions thus help in buying and managing all assets of the firm.Various techniques are adopted for the appraisal of various investment

decisions. These help to formulate acceptance criterion, or required rate of return for the investment decisions. Efficient management of existing andnew investments is of paramount important as it brings as overall change inthe value of the firm which may be positive or negative. Positive change inthe value of the firm signifies a high rating by the investors.

3. Liquidity decisions (or short-term asset-mix decisions): These relate tomanaging current assets of the firm in order to minimize idle cash andreduce the burden of unnecessary cost of financing the surplus cash.

4. Dividend decision (or profit allocation decision): These relate to rewarding

the owners of the firm i.e. Shareholders for investing their money with thefirm over of time. These rewards are given to the shareholders from theoperating profits the firm has earned, after meeting out all the related costand expenses.

5. Decisions Regarding Reporting, Monitoring and Controlling of Funds: Thesefunctions enable efficient and effective financial decision making, leading tooptimum utilizations of financial resources to maximize the financial returnsto the organizations.

Thus all financial functions and related decision making determine the character

of the firm, its operating profits ( profits are lifeblood of every sector of industryand commerce), business and financial risk, cash positions, expected return, andoverall value of the firm in the market. However financial functions and relateddecision making have to be performed in line with the overall objective of thefirm.

Financial Procedures and Systems: For the effective execution of the functions,certain other functions have to be routinely performed. The financial managerconcern procedures systems and involve a lot of paper work and time. They do not

require specialized skills of finance. Some of the important routine finance functionsare:-

1. Supervision of cash receipts and payments and safeguarding of cashbalance,

2. Custody and safeguarding of securities, insurance policies and othervaluable papers,


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3. taking care of the mechanical details of new outside financing,4. Record keeping and reporting.

The finance manager in the modern enterprises is mainly involved in the managerialfinance functions; the routine finance functions are carried out by executives at

lower levels. Financial managers involvement in the routine functions is confinedup of rules procedures, selecting forms to be used, establish standards for theemployment of competent personal and to check up the performance to see that therules observed and that the forms are properly used.

The involvement of the financial manager in the managerial financial functions isrecent. About two or three decades ago, the scope of finance functions or role of financial manager was limited to routine activities.

1.5 Role of Finance Manager

How the scope of finance function has widened or the role of the finance managerhas changed is discussed in the following section.

A financial manager is a person who is responsible in a significant way to carry outthe finance functions. It should be noted at the outset that, in a modern enterprise,the financial manager occupies a key position. He or she is one of the members of the top management team, and his or her role, day-by-day, is becoming moreenveloping, intensive and significant in solving the complex management problems.Now his or her functions are neither limited to that of a score-keeper maintainingrecords, preparing report and raising funds when needed, nor is he or she a staff officer-in a passive role of an advisor. The finance manager is now responsible forshaping fortunes of the enterprise, and is involved in the most vital decision of theallocation of capital. In his or her new role, he or she needs to have a broader andfar-sighted outlook, and must ensure that the funds of the enterprise are utilized inthe most efficient manner. He or she must realize that his or her actions have far-reaching consequences for the firm because they influence the size, profitability,growth, risk and survival of the firm, and as a consequence, affect the overall value

of the firm. The financial manager, therefore, must have a clear understanding anda strong grasp of the nature and scope of the finance functions.

The financial manager has not always been in the dynamic role of decision-making.Till recently, he or she was considered to be an unimportant person, as the topmanagement decision-making was concerned. He or she became an important


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d. Understanding Capital markets

The financial manager has to deal with capital markets where the firms securitiesare traded. He or she should fully understand the operations of capital markets andthe way in which securities are valued. He or she also know how risk is measured incapital markets and how to cope with it as investment and financing decisions ofteninvolve considerable risk.

The finance manager manages the existing assets of the firm and invests in the new real assets. He or she makes investment decisions to buy real assets. Real assets produce real cash flow to increase the value of existing shareholders and to attract the potential investors. All decisions of the finance manager whether it be financing decisions or investment decision, cannot be separated from the financial market where the firm operates. Further every decision has to be taken in the light of risk return

tradeoff. Any opportunity which costs more than its benefits should not be accepted by the finance manager.

Gone are the days when finance manager had to accomplish only the clerical, routine transaction recording like preparing accurate accounting and financial statements, paying expenses, receiving revenues and collection.

Today organizations have become large more complex. Finance now involves a broader horizon where problem identification and decision making related to overall management has gained prime important. New millennium finance manager is concerned with all business activities that involve funds directly or indirectly.

Fig. Role of financial manager

ORGANIZATION

Financial

Operationsof the firm

FinanceManage

FINANCIAL MARKET

Existing investors &potential investors

CASH

CASH


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1.6 Principles of Financial Management (Goal of F.M)

The firms investment and financing decisions are unavoidable and continuous. Inorder to make them rationally, the firm must have a goal. It is generally agreed intheory that the financial goal of the firm should be the maximization of ownerseconomics welfare. Owners economics welfare could be maximized by maximizingthe shareholders wealth as reflected in the market value of shares.

a. Profit Maximization

It means maximizing the rupees (or any other currency) income of firms. Firmproduce goods and services. They may function in a market economy, or in agovernment-controlled economy. In a market economics, prices of goods andservices are determined in competitive markets. Firms in a market economy are

expected to produce goods and services desired by society as efficiently as possible.

Price system is the most important organ of a market economy indicating whatgoods and services society wants. Goods and services in great demand commendhigher prices. This results in higher profit for firms; more of such goods andservices are produced. Higher profit opportunities attract other firms to producesuch goods and services. Ultimately, with intensifying competition an equilibriumprice is reached at which demand and supply match. In the case goods and serviceswhich are not required by society, the price and profit fall. Such goods and servicesare dropped out by producers in favour of more profitable opportunities. Pricesystem directs managerial efforts towards more profitable goods and services.Prices are determined by the demand and supply conditions as well as thecompetitive forces, and they guide the allocation of resources for various productiveactivities.

b. Maximizing Profit After Taxes (PAT)

Here, from the above maximizing profit means maximizing PAT, in the sense of netprofit as reported in the profit and loss account (i.e. income statement) of the firm.

It can easily be realized that maximizing this figure will not maximize the economicswelfare of the owners. It is possible for a firm to increase PAT by selling additionalequity shares and investing the proceeds in low-yielding assets, such as thegovernment bonds. PAT would go up but earning per shares would go down.


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Note:-

Gross Profit (GP) = Sales - Cost of Sales

Operating Profit (OP) = Gross Profit (GP) Selling Administrative and

General Expenses

Profit before Tax (PBT) = Operating Profit (OP) Non-Operating Expenses

Profit after tax (PAT) or Net Profit or Net Income or Net Earning = Profit

before Tax (PBT) Income Tax

c. Maximizing Earning Per Share (EPS)

If we adopt maximizing earning per share as the financial objective of the firm, thisis will not ensure the maximization of owners economics welfare. It is ignoringtiming and risk of the expected benefits. Apart from these problems, maximizationof earning has certain deficiencies as a financial objective. Maximizing of EPSimplies that the firm should make no dividend payments so long as funds can beinvested internally at any positive rate of return, however small. Such a dividendmay not always be to the shareholders advantage.

d. Shareholders Wealth Maximization (SWM)

The objective of SWM is an appropriate and operationally feasible criterion tochoose among the alternatives financial actions. It provides unambiguous measureof what financial management should seeks to maximize in making investment andfinancing decisions on behalf of owner (Shareholders). SWM means maximizing thenet present value (NPV) of a course of action to shareholders. The NPV of a courseof action is the difference between the present value of its benefits and present valueof its cost.

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Chapter 01 {Final Energy Financial Management}.Doc