FINANCIAL MANAGEMENT

UNIT 1

Dr. THULASI KRISHNA. K, Ph.D.

Dept. of Management Studies,

MITS, Madanapalle, A.P.

DEFINITION OF FINANCIAL MANAGEMENT

– Managerial activities which deal with planning and

controlling of firms and financial sources.

– Financial management is an area of financial decision making,

harmonsing individual motives and enterprise goals.

- Weston Brigham

Meaning of Finance

Finance is a branch of economics concerned with resource allocation as

well as resource management, acquisition and investment. Simply,

finance deals with matters related to money and the markets.

Finance is often defined simply as the management of money or

funds’ management.

Meaning of Business Finance

According to the Wheeler, “Business finance is that business

activity which concerns with the acquisition and conservation of

capital funds in meeting financial needs and overall objectives of a

business enterprise”.

According to the Guthumann and Dougall, “Business finance can

broadly be defined as the activity concerned with planning, raising,

controlling, administering of the funds used in the business”.

OTHER DEFINITIONS OF FINANCIAL MANAGEMENT

Financial management is an integral part of overall management. It is

concerned with the duties of the financial managers in the business firm.

Solomon defines as, “It is concerned with the efficient use of an

important economic resource namely, capital funds”.

S.C. Kuchal defines it as “Financial Management deals with procurement

of funds and their effective utilization in the business”.

NATURE OF FINANCIAL MANAGEMENT

Financial management refers to that part of management activity, which

is concerned with the planning and controlling of firm’s financial

resources.

Activities of Financial Management

a. Anticipating financial needs

b. Acquiring financial resources

c. Allocating funds in business

EVOLUTION OF FINANCIAL MANAGEMENT

The Evolution of financial management is classified in to two

categories.

- Traditional approach

- Transitional approach

- Modern approach

TRADITIONAL APPROACH (1920-40)

According to this approach, the scope of the finance

function is restricted to “procurement of funds by corporate

enterprise to meet their financial needs.

The term ‘procurement’ refers to raising of funds externally

as well as the inter related aspects of raising funds.

Emphasis was on long-term finance

In traditional approach, the resources could be raised from

the combination of the available sources like internal and

external sources.

LIMITATIONS OF TRADITIONAL APPROACH

This approach is confined to ‘procurement of funds’ only.

It fails to consider an important aspect i.e., allocation of

funds.

Focused only on corporate finance.

It deals with only outsiders i.e., investors, investment

bankers.

The internal decision making was completely ignored in this

approach.

The traditional approach failed to consider the problems

involved in working capital management.

It neglected the issues relating to the allocation and

management of funds and failed to make financial

decisions.

TRANSITIONAL PHASE (1940-50)

Emphasis on working capital management

Capital Budgeting Techniques were developed.

MODERN APPROACH (from 1950)

The modern approach is an analytical way of looking into

financial problems of the firm.

According to this approach, the finance function covers both

acquisition of funds as well as the allocation of funds to

various uses.

Financial management is concerned with the issues

involved in raising of funds and efficient and wise allocation

of funds.

MAIN CONTENTS OF MODERN APPROACH

How large should an enterprise be and how far it

should grow?

In what form should it hold its assets?

How should the funds required be raised?

- Financial management is concerned with finding

answer to the above problems. (Rational matching of

funds to their uses for maximizing shareholders’ wealth)

This phase has seen advancements in capital structure

decisions, cash management models and dividend

policies.

FUNCTIONS OF FINANCE

There are three finance functions

Investment decision

Financing decision

Dividend decision

INVESTMENT DECISION

Investment decision relates to selections of asset in

which funds will be invested by a firm.

The asset that can be acquired by a firm may be long-

term asset and short-term asset.

Decision with regard to long-term assets is called

capital budgeting.

Decision with regard to short-term or current assets is

called working capital management.

Capital Budgeting

Capital budgeting relates to selection of an asset or

investment proposal which would yield benefit in future.

It is concerned with long-term investment decision

making.

It evaluates the investment proposal in terms of risk

associated with it and such evaluation is made against

certain norms or standard. This standard is broadly known

as cost of capital.

Working Capital Management

Working capital management or current asset

management is an important part of investment

decision.

Proper management of working capital ensures firm’s

liquidity and solvency.

A conflict exists between profitability and liquidity while

managing current asset.

Working Capital Management

If a firm does not invest sufficient funds in current

assets it may become illiquid and may not meet its

current obligations.

The financial manager should develop proper techniques

of managing current assets so that neither insufficient nor

unnecessary funds are invested in current assets.

If the current assets are large, the firm would lose its

profitability and liquidity.

Management of Working Capital

The management of working capital has two

aspects.

- Efficient management of individual current

asset such as cash, receivable and inventory.

- Overview of working capital management and

FINANCING DECISION

Financing decision is concerned with the

financing mix or capital structure.

FINANCING DECISION

Determination of the proportion of equity and debt is the

main issue in financing decision.

Once the best combination of debt and equity is determined, the

next step is raising appropriate amount through available sources.

The mix of debt and equity is known as capital structure.

DIVIDEND DECISION

A firm distribute all profits or retain them or distribute a

portion and retain the balance with it.

Which course should be allowed? The decision

depends upon the preference of the shareholders and

investment opportunities available to the firm.

Dividend decision has a strong influence on the

market price of the share.

So the dividend policy is to be determined in

terms of its impact on shareholder’s value.

The optimum dividend policy is one which

maximizes the value of shares and wealth of

the shareholders.

Dividend Decision

The financial manager should determine the optimum

pay out ratio i.e., the proportions of net profit to be paid

out to the shareholders.

The above three decisions are inter related. To have an

optimum financial decision the three should be taken

jointly.

OBJECTIVES OF FINANCIAL MANAGEMENT

The term ‘objective’ refers to a goal or decision

for taking financial decisions.

Profit maximisation

Wealth maximisation

PROFIT MAXIMISATION

The term profit maximisation is deep rooted in

the economic theory.

It is needed when firms pursue the policy of

maximising profits.

Society’s resources are efficiently utilised.

The firm should undertake those actions that

would increase profits and drop those actions

that would decrease profit.

The financial decisions should be oriented to the

maximisation of profits.

Profit provides the yardstick for measuring

performance of firms.

It makes allocation of resources to profitable

and desirable areas.

It also ensures maximum social welfare.

Favourable Arguments for Profit Maximization

The following important points are in support of the profit

maximization objectives of the business concern:

(i) Main aim is earning profit.

(ii) Profit is the parameter of the business operation.

(iii) Profit reduces risk of the business concern.

(iv) Profit is the main source of finance.

(v) Profitability meets the social needs also.

Limitations

The term profit is vague

Ignores Time Value of Money

Ignores the Risk

Ignores Quality, image, technological advancements

etc.

Profit maximisation as an objective is too narrow (It fails to take

into account the social considerations such as the obligations to

various interests of workers, consumers, society, as well as ethical

trade practices).

WEALTH MAXIMISATION

Wealth maximisation or net present value maximisation

provides an appropriate and operationally feasible

decision criterion for financial management decisions.

According to this objective, the managers should take decisions

that maximize the shareholders' wealth. In other words, it is to

make the shareholders as rich as possible.

Shareholders' wealth is maximized when a decision generates net

present value. The net present value is the difference between

present value of the benefits of a project and present value of its

costs.

Using Solomon’s symbols and methods, the net present worth can be calculated as shown below:

W = V – C

Where, W = Net present worth; V = Gross present worth; C = Investment

(equity capital) required to acquire the asset or to purchase the course of

action.

V = E/K

Where, E = Size of future benefits available to the suppliers of the input

capital;

K = The capitalization (discount) rate reflecting the quality (certainty/

uncertainty) and timing of benefit attached to E.

IMPORTANCE OF FINANCIAL MANAGEMENT

(i) Success of Promotion Depends on Financial Administration

(ii) Smooth Running of an Enterprise

(iii) Financial Administration Co-ordinates Various Functional Activities

(iv) Focal Point of Decision Making

(v) Determinant of Business Success

(vi) Measure of Performance

(vii) Determination of fixed assets

(viii) Determination of current assets

(ix) Determination of Capital Structure

NEW ROLE OF FINANCE FUNCTION IN THE CONTEMPORARY SCENARIO

Continuous focus on margins and ensure that the organisation stays

committed to value creation.

Work across the functional divide of the company and exhibit leadership

skills.

Understand what's driving the numbers and provide operation insights,

including a sense of external market issues and internal operating trends,

and become key strategy player.

Aware and use the highly innovative financial instruments.

Know the emergence of capital market as central stage for raising money.

Adding more value to the business through innovations in impacting

human capital.

Must balance the need to cut overhead with the need to create a finance

organisation able to meet long-term goals by designing financial processes,

systems and organisation that can support the business in the future and initiating

cost reductions that further cut organisational fat, but not operational muscle.

Liaison (link) to the financial community, investors and regulators (rating agencies,

investment and commercial bankers and peers), which are valuable information

sources for strategic and tactical decisions.

Assess probable acquisitions, contemplating initial negotiation, carrying out due

diligence, communicating to employees and investors about the horizontal

integration.

Deal with the post-merger integration in the light of people issues.

Deal with the new legislation (New Companies Bill, Limited Liability

Partnership), and regulations merely add more formality and, to an extent,

bureaucracy, to what most already subscribe to as best practices in

financial reporting.

Be one of the undisputed arbiter in matters of financial ethics, with the

backing of legislation and stiff penalties.

Finance managers are central to changes in audit and control practices.

Corporate governance is a key issue that must be continuously monitored

and he/she should not push the limit of the P&L and growth.

Be aware of the proposed changes in financial reporting systems such as

International Financial Reporting Standards (IFRS), Goods and Services

Tax (GST), Direct Tax Code (DTC) and Extensible Business Reporting

Language (XBRL). Adapting and optimising within changing tax reforms

would become imperative for then and their organisations.