UNIT 1

FINANCIAL MANAGEMENT
Finance Functions- Meaning, Nature, Scope, Objectives Of Financial Management, Profit Vs
Wealth Maximization, Relationship Of Financial Management And Other Areas Of Management.

Prof. T Rama Krishna Rao

Disha College
MEANING OF FINANCIAL MANAGEMENT:
Financial management may be defined as planning, organizing, directing and controlling the financial
activities of an organization. According to Guthman and Dougal, financial management means, “the
activity concerned with the planning, raising, controlling and administering of funds used in the
business.” It is concerned with the procurement and utilization of funds in the proper manner
Financial activities deal with not only the procurement and utilisation of funds but also with the
assessing of needs for funds, raising required finance, capital budgeting, distribution of surplus,
financial controls, etc.
Ezra Solomon has described the nature of financial management as follows: “Financial management
is properly viewed as an integral part of overall management rather than as a staff specially concerned
with funds raising operations.
In this broader view, the central issue of financial policy is the wise use of funds and the central
process involved is a rational matching of the advantage of potential uses against the cost of
alternative potential sources so as to achieve the broad financial goals which an enterprise sets for
itself.
In addition to raising funds, financial management is directly concerned with production, marketing
and other functions within an enterprise whenever decisions are made about the acquisition or
distribution of funds.”
CONCEPT
Financial Management means planning, organizing, directing and controlling the financial activities
such as procurement and utilization of funds of the enterprise. It means applying general management
principles to financial resources of the enterprise.
There are three key elements to the process of financial management:
(1) Financial Planning :-Management need to ensure that enough funding is available at the right
time to meet the needs of the business. In the short term, funding may be needed to invest in
equipment and stocks, pay employees and fund sales made on credit.
In the medium and long term, funding may be required for significant additions to the productive
capacity of the business or to make acquisitions.
(2) Financial Control:-Financial control is a critically important activity to help the business ensure
that the business is meeting its objectives. Financial control addresses questions such as:
• Are assets being used efficiently?
• Are the businesses assets secure?
• Do management act in the best interest of shareholders and in accordance with business rules?
(3) Financial Decision-making :-The key aspects of financial decision-making relate to investment,
financing and dividends:

Prof. T Rama Krishna Rao

Disha College
• Investments must be financed in some way – however there are always financing alternatives that
can be considered. For example it is possible to raise finance from selling new shares, borrowing
from banks or taking credit from suppliers
• A key financing decision is whether profits earned by the business should be retained rather than
distributed to shareholders via dividends. If dividends are too high, the business may be starved of
funding to reinvest in growing revenues and profits further
Definitions
“Financial management is the activity concerned with planning, raising, controlling and administering
of funds used in the business.” – Guthman and Dougal
“Financial management is that area of business management devoted to a judicious use of capital and
a careful selection of the source of capital in order to enable a spending unit to move in the direction
of reaching the goals.” – J.F. Brandley
“Financial management is the operational activity of a business that is responsible for obtaining and
effectively utilizing the funds necessary for efficient operations.”- Massie
Nature or Features or Characteristics of Financial Management
Nature of financial management is concerned with its functions, its goals, trade-off with conflicting
goals, its indispensability, its systems, its relation with other subsystems in the firm, its environment,
its relationship with other disciplines, the procedural aspects and its equation with other divisions
within the organisation.
1. Financial Management is an integral part of overall management. Financial considerations are
involved in all business decisions. So financial management is pervasive throughout the
organisation.
2. The central focus of financial management is valuation of the firm. That is financial decisions
are directed at increasing/maximization/ optimizing the value of the firm.
3. Financial management essentially involves risk-return trade-off Decisions on investment
involve choosing of types of assets which generate returns accompanied by risks. Generally
higher the risk, returns might be higher and vice versa. So, the financial manager has to decide
the level of risk the firm can assume and satisfy with the accompanying return.
4. Financial management affects the survival, growth and vitality of the firm. Finance is said to
be the life blood of business. It is to business, what blood is to us. The amount, type, sources,
conditions and cost of finance squarely influence the functioning of the unit.
5. Finance functions, i.e., investment, rising of capital, distribution of profit, are performed in all
firms - business or non-business, big or small, proprietary or corporate undertakings. Yes,
financial management is a concern of every concern.
6. Financial management is a sub-system of the business system which has other subsystems like
production, marketing, etc. In systems arrangement financial sub-system is to be well-
coordinated with others and other sub-systems well matched with the financial subsystem.

Prof. T Rama Krishna Rao

Disha College
SCOPE AND FUNCTIONS OF FINANCIAL MANAGEMENT:
The scope of financial management includes three groups. First – relating to finance and cash,
second – rising of fund and their administration, third – along with the activities of rising
funds, these are part and parcel of total management, Isra Salomon felt that in view of funds
utilization third group has wider scope.
It can be said that all activities done by a finance officer are under the purview of financial
management. But the activities of these officers change from firm to firm, it become difficult
to say the scope of finance. Financial management plays two main roles, one – participating in
funds utilisation and controlling productivity, two – Identifying the requirements of funds and
selecting the sources for those funds. Liquidity, profitability and management are the
functions of financial management. Let us know very briefly about them.
1. Liquidity: Liquiditycan be ascertained through the three important considerations.
i) Forecasting of cash flow: Cash inflows and outflows should be equalized for the purpose
of liquidity.
ii) Rising of funds: Finance manager should try to identify the requirements and increase of
funds.
iii) Managing the flow of internal funds: Liquidity at higher degree can be maintained by
keeping accounts in many banks. Then there will be no need to depend on external loans.
2. Profitability: While ascertaining the profitability the following aspects should be taken into
consideration:
i) Cost of control: For the purpose of controlling costs, various activities of the firm should be
analyzed through proper cost accounting system,
ii) Pricing: Pricing policy has great importance in deciding sales level in company’s marketing.
Pricing policy should be evolved in such a way that the image of the firm should not be
affected.
iii) Forecasting of future profits: Often estimated profits should be ascertained and assessed to
strengthen the firm and to ascertain the profit levels.
iv) Measuring the cost of capital: Each fund source has different cost of capital. As the profit of
the firm is directly related to cost of capital, each cost of capital should be measured.
3. Management:It is the duty of the financial manager to keep the sources of the assets in
maintaining the business. Asset management plays an important role in financial management.
Besides, the financial manager should see that the required sources are available for smooth running
of the firm without any interruptions.
A business may fail without financial failures. Financial failures also lead to business failure. Because
of this peculiar condition the responsibility of financial management increased. It can be divided into
the management of long run funds and short run funds.
Long run management of funds relates to the development and extensive plans. Short run
management of funds relates to the total business cycle activities. It is also the responsibility of
financial management to coordinate different activities in the business. Thus, for the success of any
firm or organization financial management is said to be a must

OBJECTIVES OF FINANCIAL MANAGEMENT

Prof. T Rama Krishna Rao
Disha College
Following is a brief account of each one of the above objectives of financial management:
(1) Basic Objectives:
(i) Profit-Maximisation: Since time immemorial, the primary objective of financial management has
been held to be profit-maximization. That is to say, that financial management ought to take financial
decisions and implement them in a way so as to lead the enterprise along lines of profit
maximasation. The support for these objectives could be derived from the philosophy, that ‘profit is a
test of economic efficiency’.Though, there could be little controversy over profit maximisation, as the
basic objective of financial management – yet, in the modern times, several authorities on financial
management criticise this objectives, on the following grounds:

 Profit is a vague concept, in that; it is not clear whether profit means – short-run or long-run
profits. Or Profit before tax or profits after tax or Rate of profits or the amount of profits.
 The profit maximisation objective ignores, what financial experts call the time value of
money’. To illustrate, this concept, let us assume that two financial courses of action provide
equal benefits (i.e. profits) over a certain period of time. However, one alternative gives more
profits in earlier years; while the other one gives more profits in later years.
 Based on profit maximization criterion, both alternatives are equally well. However, the first
alternative i.e. the one which gives more profits in earlier years is better; as some part of the
profits received earlier could be reinvested also.
 Modern financial experts call this philosophy, ‘the earlier the better principle’. The second
alternative which gives more profits only in later years is inferior; as the time-value of profits
is more in the case of the first alternative.
 The profit maximization objective ignores the quality of benefits (i.e. profits). The factor
implicit here, is the risk element associated with profits. Quality of benefits (profits) is the
most when risk associated with their occurrence is the least. According to modern financial
experts, less profit with less risk are superior to more profits with more risk.
 Profit-maximisation objective is lop-sided. This objective considers or rather over-emphasizes
only on the interests of owners. Interests of other parties like, workers, consumers, the
Government and the society as a whole are ignored, under this concept of profit-
maximisation.

Prof. T Rama Krishna Rao

Disha College
(ii) Wealth-Maximisation:Discarding the profit-maximisation objective; the real basic objective of
financial management, now-a-days, is considered to be wealth maximisation. Wealth maximisation is
also known as value-maximisation or the net present worth maximisation.
Since wealth of owners is reflected in the market-value of shares; wealth maximisation means the
maximisation of the market price of shares. Accordingly, wealth maximisation is measured, by the
market value of shares.

 According to wealth maximisation objective, financial management must select those

decisions, which create most wealth for the owners. If two or more financial courses of action
are mutually exclusive (i.e. only one can be undertaken at a time); then that decision-which
creates most wealth, must be selected.
 The wealth arising from a financial course of action could be stated as follows:
 Wealth = Gross present worth of a financial course of action minus amount of capital invested
which is required to achieve the benefits i.e. cash flows.
 The wealth maximisation objective is held to be superior to the profit maximisation objective,
because of the following reasons:
 It is based on the concept of cash flows; which is more definite than the concept of profits.
Moreover, management is more interested in immediate cash flows than the profits a large
part of which might be hidden in credit sales- still to be realized.
Through discounting the cash flows arising from a financial course of action over a period of
time at an appropriate discount rate; the wealth maximisation approach considers both- the
time value of money and the quality of benefits.
 Wealth maximisation objective is consistent with the long term profitability of the company.
(2) Operational Objectives:
(i) Timely Availability of Requisite Finances:A very important operational objective of financial
management is to ensure that requisite funds are made available to all the departments, sections or
units of the enterprise at the needed time; so that the operational life of the enterprise goes smoothly.
(ii) Most Effective Utilization of Finances:Throughout the enterprise, the finances must be utilized
most effectively. This is yet, another important operational objective of the financial,
management.Toensure the attainment of this objective, the financial management must:

 Formulate plans for the most effective utilisation of funds, among channels of investment,
which create most wealth for the company.
 Exercise and enforce ‘financial discipline’ to prevent wasteful expenditure, by any
department, or branch or section of the enterprise.
(iii) Safety of Investment:The financial management must primarily look to the safety of investment
i.e. the channels of investment might bring in less returns; but investment must be safe. Loss of
investment, in any one line, might lead to capital depletion; and ultimately tell upon the financial
health of the enterprise.
(iv) Growth of the Enterprise:The financial management must plan for the long-term stability and
growth of the enterprise. The limited finances of the enterprise must be so utilized that not only short
run benefits are available; but the enterprise grows slow and steady, in the long run also.
(3) Social Objectives:

Prof. T Rama Krishna Rao

Disha College
(i) Timely Payment of Interest:The financial management must see to it that interest on bonds,
debentures or other loans of the company is paid in time. This will not only keep the creditors
satisfied with the company adding to its goodwill; but also prevent any untoward consequences of the
non-payment of interest, in time.
(ii) Payment of Reasonable Dividends:An important social objective of financial management is
that shareholders i.e. the equity members of the company must get at least some regular dividends.
This objective is important for two reasons: –

 It helps the company maintain its competitive image, in the market.

 The members on whose funds the company is running profitable operations must be duly
compensated, as a matter of natural justice.
(iii) Timely Payment of Wages:The financial management must make a provision for a timely
payment of wages to workers. This is necessary to keep the labor force satisfied and motivated.
Further, if wages are paid on time; the legal consequences of non-payment of wages, under the ‘
Payment of Wages Act’, need not frighten management.
(iv) Fair-Settlement with Suppliers:The financial management must make it a point to settle
accounts with suppliers and fellow- businessmen in time, in a fair way; otherwise the commercial
reputation of the enterprise will get a setback.
(v) Timely Payment of Taxes:An important objective of financial management would be to make
timely payment of taxes to the Government – so as to avoid legal consequences; and also fulfill its
social obligations towards the State.
(vi) Maintaining Relations with Financiers:The financial management must develop and maintain
friendly relations with financiers i.e. banks, financial institutions and various segments of the money
market and capital market. When good relations are maintained with financiers; they might come to
the rescue of the enterprise, in situations of financial crisis.
(4) Research Objectives:
The successful attainment of various objectives by the financial management requires it to follow a
research approach. It must research into new and better sources of finances; and also into new and
better channels for the investment of finances.
This research objective of financial management requires it to:

 Collect financial data about the progress of its competitive counterparts.

 Make a study of money market and capital market operations, through a study of latest
financial magazines and other literature on financial management.

Prof. T Rama Krishna Rao

Disha College
PROFIT MAXIMISATION AND WEALTH MAXIMISATION
The firm’s investment and financing decision are unavoidable and continuous. In order to make them
rational, the firm must have a goal. Two financial objectives predominate amongst many objectives.
These are:
1. Profit maximization
2. Shareholders’ Wealth Maximization
Profit Maximization refers to the rupee income while wealth maximization refers to the maximization
of the market value of the firm’s shares. Although profit maximization has been traditionally
considered as the main objective of the firm, it has faced criticism. Wealth maximization is regarded
as operationally and managerially the better objective.
1. Profit Maximization
Profit Maximization implies that either a firm produces maximum output for a given input or uses
minimum input for a given level of output. Profit maximization causes the efficient allocation of
resources in competitive market condition and profit is considered as the most important measure of
firm performance. The underlying logic of profit maximization is efficiency.
In a market economy, prices are driven by competitive forces and firms are expected to produce
goods and services desired by society as efficiently as possible. Demand for goods and services leads
price. Goods and services which are in great demand can command higher prices. This leads to higher
profits for the firm. This in turn attracts other firms to produce such goods and services. Competition
grows and intensifies leading to a match in demand and supply. Thus, an equilibrium price is reached.
On the other hand, goods and services not in demand fetches low price which forces producers to stop
producing such goods and services and go for goods and services in demand. This shows that the
price system directs the managerial effort towards more profitable goods and services. Competitive
forces direct price movement and guides the allocation of resources for various productive activities.

Objections to Profit Maximization:

Certain objections have been raised against the goal of profit maximization which strengthen the case
for wealth maximization as the goal of business enterprise. The objections are:
1. Profit cannot be ascertained well in advance to express the probability of return as future is
uncertain. It is not at all possible to maximize what cannot be known. Moreover, the return
profit vague and has not been explained clearly what it means. It may be total profit before tax
and after tax of profitability tax. Profitability rate, again is ambiguous as it may be in relation
to capital employed, share capital, owner’s fund or sales. This vagueness is not present in
wealth maximisation goal as the concept of wealth is very clear. It represents value of benefits
minus the cost of investment.
2. The executive or the decision maker may not have enough confidence in the estimates or
future returns so that he does not attempt further to maximize. It is argued that firm’s goal
cannot be to maximize profits but to attain a certain level or rate of profit holding certain share
of the market or certain level of sales. Firms should try to ‘satisfy’ rather than to ‘maximise’.
3. There must be a balance between expected return and risk. The possibility of higher expected
yields are associated with greater risk to recognize such a balance and wealth maximisation is
brought in to the analysis. In such cases, higher capitalization rate involves. Such combination
Prof. T Rama Krishna Rao
Disha College
 of expected returns with risk variations and related capitalization rate cannot be considered in
the concept of profit maximisation.
4. The goal of maximisation of profits is considered to be a narrow outlook. Evidently when
profit maximisation becomes the basis of financial decision of the concern, it ignores the
interests of the community on the one hand and that of the government, workers and other
concerned persons in the enterprise on the other hand.
5. The criterion of profit maximisation ignores time value factor. It considers the total benefits or
profits in to account while considering a project where as the length of time in earning that
profit is not considered at all. Whereas the wealth maximization concept fully endorses the
time value factor in evaluating cash flows. Keeping the above objection in view, most of the
thinkers on the subject have come to the conclusion that the aim of an enterprise should be
wealth maximisation and not the profit maximisation.
6. To make a distinction between profits and profitability. Maximisation of profits with a view to
maximizing the wealth of share holders is clearly an unreal motive. On the other hand,
profitability maximisation with a view to using resources to yield economic values higher than
the joint values of inputs required is a useful goal. Thus, the proper goal of financial
management is wealth maximisation.
2.’ Wealth Maximization: wealth maximization means maximizing the net present value of a course
of action to shareholders. Net Present Value (NPV) of a course of action is the difference between the
present value of its benefits and the present value of its costs. A financial action that has a positive
NPV creates wealth for shareholders and therefore, is desirable. A financial action resulting in
negative NPV destroys shareholders’ wealth and is, therefore undesirable. Between mutually
exclusive projects, the one with the highest NPV should be adopted.
NPVs of a firm’s projects are additive in nature. That is NPV(A) NPV(B) = NPV(A B)
The objective of Shareholders Wealth Maximization (SWM) considers timing and risk of expected
benefits. Benefits are measured in terms of cash flows. One should understand that in investment and
financing decisions, it is the flow of cash that is important, not the accounting profits. SWM as an
objective of financial management is appropriate and operationally feasible criterion to choose among
the alternative financial actions.
Maximizing the shareholders’ economic welfare is equivalent to maximizing the utility of their
consumption over time. The wealth created by a company through its actions is reflected in the
market value of the company’s shares. Therefore, this principle implies that the fundamental
objective of a firm is to maximize the market value of its shares. The market price, which represents
the value of a company’s shares, reflects shareholders’ perception about the quality of the company’s
financial decisions. Thus, the market price serves as the company’s performance indicator.
In such a case, the financial manager must know or at least assume the factors that influence the
market price of shares. Innumerable factors influence the price of a share and these factors change
frequently. Moreover, the factors vary across companies. Thus, it is challenging for the manager to
determine these factors.

Differences between Profit Maximization and Wealth Maximization:

Prof. T Rama Krishna Rao

Disha College
 1. The process through which the company is capable of increasing is earning capacity is
known as Profit Maximization. On the other hand, the ability of the company in
increasing the value of its stock in the market is known as wealth maximization.
2. Profit maximization is a short term objective of the firm while long term objective is
Wealth Maximization.
3. Profit Maximization ignores risk and uncertainty. Unlike Wealth Maximization, which
considers both.
4. Profit Maximization avoids time value of money, but Wealth Maximization recognizes
it.
5. Profit Maximization is necessary for the survival and growth of the enterprise.
Conversely, Wealth Maximization accelerates the growth rate of the enterprise and
aims at attaining maximum market share of the economy
Relationship between financial management and other functional areas
1. Financial Management and Production Department: The financial management and
the production department are interrelated. The production department of any firm is
concerned with the production cycle, skilled and unskilled labour, storage of finished goods,
capacity utilisation, etc. and the cost of production assumes a substantial portion of the total
cost.The production department has to take various decisions like replacing machinery,
installation of safety devices, etc. and all the decisions have financial implications.
2. Financial Management and Material Department: The financial management and the
material department are also interrelated. Material department covers the areas such as
storage, maintenance and supply of materials and stores, procurement etc.The finance
manager and material manager in a firm may come together while determining Economic
Order Quantity, safety level, storing place requirement, stores personnel requirement, etc.
The costs of all these aspects are to be evaluated so the finance manager may come forward
to help the material manager.
3. Financial Management and Personnel Department: The personnel department is
entrusted with the responsibility of recruitment, training and placement of the staff. This
department is also concerned with the welfare of the employees and their families. This
department works with finance manager to evaluate employees’ welfare, revision of their pay
scale, incentive schemes, etc.
4. FinancialManagement and Marketing Department: The marketing department is
concerned with the selling of goods and services to the customers. It is entrusted with
framing marketing, selling, advertising and other related policies to achieve the sales target.
It is also required to frame policies to maintain and increase the market share, to create a
brand name etc. For all this finance is required, so the finance manager has to play an active
role for interacting with the marketing department

Prof. T Rama Krishna Rao

Disha College
FUNCTIONS OF FINANCIAL MANAGEMENT
Major function
1. Investment Decision: - One of the most important finance functions is to intelligently allocate
capital to long term assets. This activity is also known as capital budgeting. It is important to
allocate capital in those long term assets so as to get maximum yield in future. Following are the
two aspects of investment decision Evaluation of new investment in terms of profitability
Comparison of cut off rate against new investment and prevailing investment.
Since the future is uncertain therefore there are difficulties in calculation of expected return. Along
with uncertainty comes the risk factor which has to be taken into consideration. This risk factor plays
a very significant role in calculating the expected return of the prospective investment. Therefore
while considering investment proposal it is important to take into consideration both expected return
and the risk involved Investment decision not only involves allocating capital to long term assets but
also involves decisions of using funds which are obtained by selling those assets which become less
profitable and less productive. It wise decisions to decompose depreciated assets which are not
adding value and utilize those funds in securing other beneficial assets. An opportunity cost of
capital needs to be calculating while dissolving such assets. The correct cut off rate is calculated by
using this opportunity cost of the required rate of return (RRR)
2.Financial Decision:-Financial decision is yet another important function which a financial manger
must perform. It is important to make wise decisions about when, where and how should a business
acquire funds. Funds can be acquired through many ways and channels. Broadly speaking a correct
ratio of an equity and debt has to be maintained. This mix of equity capital and debt is known as a
firm’s capital structure. A firm tends to benefit most when the market value of a company’s share
maximizes this not only is a sign of growth for the firm but also maximizes shareholders wealth. On
the other hand the use of debt affects the risk and return of a shareholder. It is more risky though it
may increase the return on equity funds. A sound financial structure is said to be one which aims at
maximizing shareholders return with minimum risk. In such a scenario the market value of the firm
will maximize and hence an optimum capital structure would be achieved. Other than equity and
debt there are several other tools which are used in deciding a firm capital structure.
3. Dividend Decision:-Earning profit or a positive return is a common aim of all the businesses. But
the key function a financial manger performs in case of profitability is to decide whether to distribute
all the profits to the shareholder or retain all the profits or distribute part of the profits to the
shareholder and retain the other half in the business. It’s the financial manager’s responsibility to
decide an optimum dividend policy which maximizes the market value of the firm. Hence an
optimum dividend payout ratio is calculated. It is a common practice to pay regular dividends in case
of profitability another way is to issue bonus shares to existing shareholders.
4.Liquidity Decision:-It is very important to maintain a liquidity position of a firm to avoid
insolvency. Firm’s profitability, liquidity and risk all are associated with the investment in current
assets. In order to maintain a tradeoff between profitability and liquidity it is important to invest
sufficient funds in current assets. But since current assets do not earn anything for business therefore
a proper calculation must be done before investing in current assets. Current assets should properly
be valued and disposed of from time to time once they become non profitable. Currents assets must
be used in times of liquidity problems and times of insolvency.

Prof. T Rama Krishna Rao

Disha College
Other functions
1. Estimation of capital requirements: A finance manager has to make estimation with regards to
capital requirements of the company. This will depend upon expected costs and profits and
future programmers and policies of a concern. Estimations have to be made in an adequate
manner which increases earning capacity of enterprise.
2. Determination of capital composition: Once the estimation has been made, the capital structure
have to be decided. This involves short- term and long- term debt equity analysis. This will
depend upon the proportion of equity capital a company is possessing and additional funds which
have to be raised from outside parties.
3. Choice of sources of funds: For additional funds to be procured, a company has many choices
like-
 Issue of shares and debentures
 Loans to be taken from banks and financial institutions
 Public deposits to be drawn like in form of bonds.
 Choice of factor will depend on relative merits and demerits of each source and period of
financing.
4. Investment of funds: The finance manager has to decide to allocate funds into profitable
ventures so that there is safety on investment and regular returns is possible.
5. Disposal of surplus: The net profits decision has to be made by the finance manager. This can
be done in two ways:
6. Dividend declaration - It includes identifying the rate of dividends and other benefits like
bonus.
7. Retained profits - The volume has to be decided which will depend upon expansion,
innovational, diversification plans of the company.
8. Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and salaries, payment
of electricity and water bills, payment to creditors, meeting current liabilities, maintenance of
enough stock, purchase of raw materials, etc.
9. Financial controls: The finance manager has not only to plan, procure and utilize the funds but
he also has to exercise control over finances. This can be done through many techniques like
ratio analysis, financial forecasting, cost and profit control, etc

Prof. T Rama Krishna Rao

Disha College
ROLE OF FINANCE MANAGER
1. Estimating the Amount of Capital Required:This is the foremost function of the financial
manager. Business firms require capital for:
(i) purchase of fixed assets,
(ii) meeting working capital requirements, and
(iii) modernisation and expansion of business.
The financial manager makes estimates of funds required for both short-term and long-term.
2. Determining Capital Structure:Once the requirement of capital funds has been determined, a
decision regarding the kind and proportion of various sources of funds has to be taken. For this,
financial manager has to determine the proper mix of equity and debt and short-term and long-term
debt ratio. This is done to achieve minimum cost of capital and maximise shareholders wealth.
3. Choice of Sources of Funds:Before the actual procurement of funds, the finance manager has to
decide the sources from which the funds are to be raised. The management can raise finance from
various sources like equity shareholders, preference shareholders, debenture- holders, banks and other
financial institutions, public deposits, etc.
4. Procurement of Funds:The financial manager takes steps to procure the funds required for the
business. It might require negotiation with creditors and financial institutions, issue of prospectus, etc.
The procurement of funds is dependent not only upon cost of raising funds but also on other factors
like general market conditions, choice of investors, government policy, etc.
5. Utilisation of Funds:The funds procured by the financial manager are to be prudently invested in
various assets so as to maximise the return on investment: While taking investment decisions,
management should be guided by three important principles, viz., safety, profitability, and liquidity.
6. Disposal of Profits or Surplus:The financial manager has to decide how much to retain for
ploughing back and how much to distribute as dividend to shareholders out of the profits of the
company. The factors which influence these decisions include the trend of earnings of the company,
the trend of the market price of its shares, the requirements of funds for self- financing the future
programmes and so on.
7. Management of Cash:Management of cash and other current assets is an important task of
financial manager. It involves forecasting the cash inflows and outflows to ensure that there is neither
shortage nor surplus of cash with the firm. Sufficient funds must be available for purchase of
materials, payment of wages and meeting day-to-day expenses.
8. Financial Control:Evaluation of financial performance is also an important function of financial
manager. The overall measure of evaluation is Return on Investment (ROI). The other techniques of
financial control and evaluation include budgetary control, cost control, internal audit, break-even
analysis and ratio analysis. The financial manager must lay emphasis on financial planning as well.

Prof. T Rama Krishna Rao

Disha College
CAPITALIZATION
Over and Under Capitalization
The term capitalisation, or the valuation of the capital, includes the capital stock and debt. According
to another view it is a word ordinarily used to refer to the sum of the outstanding stocks and funded
obligations which may represent wholly fictitious values.
The ordinary meaning of capitalisation in the computation appraisal or estimation of present value.
This ‘valuation’ concept underlies the definitions of capitalisation and the emphasis is placed upon
the amount of capital. But the term capitalisation has on thrown its previous concept.
The study of capitalisation involves an analysis of three aspects:
i) amount of capital
ii) composition or form of capital
iii) changes in capitalisation.
Capitalisation may be of 3 types. They are over capitalisation, under capitalisation and fair
capitalisation. Among these three over capitalisation is likely to be of frequent occurrence and
practical interest.
Over Capitalisation:
Many have confused the term ‘over-capitalisation’ with abundance of capital and ‘under-
capitalisation’ with shortage of capital. It becomes necessary to discuss these terms in detail. An
enterprise becomes over-capitalised when its earning capacity does not justify the amount of
capitalisation.
Over-capitalisation has nothing to do with redundance of capital in an enterprise. On the other hand,
there is a greater possibility that the over-capitalised concern will be short of capital. The abstract
reasoning can be explained by applying certain objective tests. These tests require the comparison
between the different values of the equity shares in a corporation. When we speak in terms of over-
capitalisation we always have the interest of equity holders in mind.
There are various standards of valuing corporation or its equity shares:

 Par value:It is not the face value of a share at which it is normally issued, i.e., at premium nor
at discount, it is static and not affected by business oscillations. Thus it fails to reflect the
various business changes.
 Market Value:It is determined by factors of demand and supply in a stock market. It is
dependent on a number of considerations, affecting demand as well as supply side.
 Book Value:It is calculated by dividing the aggregate of the proprietary items – like share
capital, surplus and proprietary reserves – by the number of outstanding shares.
 Real Value:It is found out by dividing the capitalised value of earnings by the number of
outstanding shares. Before the earnings are capitalised, they should be calculated on an
average basis. It may be pointed out at this place that longer the period cover by the study, the
more representative the average will be the period should normally cover all the phase of
business cycle, i.e., good, bad, and indifferent years. Some authors compare the par value of
the share with the market value and if par value is greater than the market value they regard it
as a sign of over-capitalisation.
Prof. T Rama Krishna Rao
Disha College
Causes of over-capitalization:

 Promotion with inflated asset:The promotion of a company may entail the conversion of a
partnership firm or a private company into a public limited company and the transfer of assets
may be at inflated prices which do not bear any relation to the earning capacity of the concern.
Under these circumstances, the book value of the corporation will be more than its real value.
 The incurring of high establishment or promotion expenses (ex: good will, patent rights) is a
potent cause of over-capitalisation. If the earnings later on do not justify the amount of capital
employed, the company will be over-capitalised.
 Inflationary conditions:Boom is a significant factor for making the business enterprises over-
capitalised. The newly started concern during the boom period is likely to be capitalised at a
high figure because of the rise in general price level and payment of high prices for the
property assembled. These newly floated concerns as well as the reorganised and expanded
ones find themselves over-capitalised after the boom conditions subside.
 Shortage of capital:The shortage of capital is also a contributory factor of over-capitalisation,
the inadequacy of capital may be due to faulty drafting of the financial plan. Thus a major part
of the earnings will not be available for the shareholders which will bring down the real value
of the shares.
 Defective depreciation policy:It is not uncommon to find that many concerns are over-
capitalised due to insufficient provision for depreciation/replacement or obsolescence of
assets. The efficiency of the company is adversely affected and it is reflected in its reduced
profit yielding capacity.
 Liberal Dividend Policy:If corporations follow liberal dividend policy by neglecting essential
provisions, they discover themselves to be overcapitalized after a few years when book value
of their shares will be higher than the real value?
 Taxation Policy:Over-capitalisation of an enterprise may also be caused due to excessive
taxation by the Government and also their basis of calculation may leave the corporations with
meagre funds.

Effects of over capitalisation:

 Over-capitalisation affects the company, the shareholders and the society as a whole. The
confidence of Investors in an over-capitalised company is injured on account of its reduced
earning capacity and the market price of the shares which falls consequently. The credit-
standing of a corporation is relatively poor.
 Consequently, the credit-standing of a corporation is relatively poor. Consequently, the
company may be forced to incur unwieldy debts and bear the heavy loss of its goodwill In a
subsequent reorganization. The Shareholders bear the brunt of over capitalization doubly. Not
only is their capital depreciated but the income is also uncertain and mostly irregular. Their
holdings have little value as collateral security.
 An over-capitalised company tries to increase the prices and reduce the quality of products,
and as a result such a company may liquidate. In that case the creditors and the Labourers will
be affected. Thus it leads to the misapplication and wastage of the resources of society.

Corrections for over-capitalisation:

1. Reorganisation of the company by selling shares at a high rate of discount.

Prof. T Rama Krishna Rao

Disha College
 2. Issuing less interested new debentures on premium in place of old debentures.
3. Redeeming preference shares carrying high dividend
4. Reducing the face value (par value) of shares.

UNDER-CAPITALISATION:
under-capitalisation is regarded equivalent to the inadequacy of capital but it should be considered as
the reverse of over-capitalisation i.e. it is a condition when the real value of the corporation is more
than the book value.
The following are the causes for under-capitalization:
1. Underestimation of earnings:Sometimes while drafting the financial plan, the earnings are
anticipated at a lower figure and the capitalisation may be based on that estimate; if the
earnings prove to be higher the concern shall become under-capitalised.
2. Unforeseeable increase in earnings:Many corporations started during depression find
themselves to be under-capitalised in the period of recovery or boom due to unforeseeable
increase in earnings.
3. Conservative dividend policy:By following conservative dividend policy some corporations
create adequate reserves for depreciation, renewals and replacements and plough back the
earnings which increase the real value of the shares of those corporations.
4. High efficiency maintained:By adopting ‘latest techniques of production many companies
improve their efficiency. The profits being dependent on the efficiency of the concern will
increase and, accordingly, the real value of the corporation may exceed its ‘book value’.
Effects of under-capitalization:
1. Causes wide fluctuations in the market value of shares.
2. Provoke the management to create secret reserves.
3. Employees demand high share in the increased prosperity of the company.

Prof. T Rama Krishna Rao

Disha College
 CASE STUDY
Q. 1 A Technology Start-Up Company Headed By An Inexperienced CEO That Needed To
Raise Significant Equity Capital
The Challenge:
The Client needed to raise considerable equity capital to fund the continuation of their product
development and their sales and marketing efforts. Previously, the Client had raised limited capital
from local Angel investors, but now needed to attract sophisticated institutional investors. This was
the first time the CEO had headed a venture-backed start-up company and he needed prudent business
counsel to avoid the typical pitfalls of a young company.
Additionally, the Client’s daily bookkeeping was being handled by an administrative assistant with
little accounting experience. Accounting records were inaccurate and incomplete. The CEO was
understandably concerned that his accounting records would not pass the rigorous due diligence
conducted by the new institutional investors. The Client needed an experienced CFO who had
successfully raised venture capital and who could serve as a trusted advisor to the CEO. He also
needed to make sure the day-to-day was being handled in a professional manner that would give
investors confidence.
The Solution:
At the recommendation of the Client’s attorney, Rankin McKenzie was engaged to both assist the
CEO in raising equity capital and to be responsible for the company’s accounting functions. Rankin-
McKenzie utilized a team-approach to meet the client’s needs. The team consisted of a part-time CFO
who had extensive start-up and capital fundraising experience and a part-time Controller who had
expertise in QuickBooks. The Rankin McKenzie team helped the CEO successfully raise over $7
million in equity capital from a top-tier venture capital firm. Moreover, the team’s careful
management of the company’s books and records made the VC due diligence a painless process. The
CFO served as the CEO’s close confidant to help guide the Client through numerous challenging
growth opportunities.
Q.2 E-Commerce Start-Up Company In Need Of Accounting Expertise

The Challenge:
Sales were beginning to grow rapidly and the company was in need of a clear, concise mechanism for
reconciling sales per the company website to the back gateway and bank.
The Solution:
Rankin McKenzie provided a part-time Controller to the Client in order to establish procedures for
tracking and reconciling sales on a monthly basis. Additionally, numerous financial reports were
developed that have provided management with valuable tools for running the business successfully.
Q. 3Biotech Start-Up Company That Needed To Raise Capital
The Challenge:
The Client needed to raise its first institutional round to complete initial animal studies. The co-
founders completed a draft of a presentable Business Plan, but early investor feedback indicated that
the financial projections were unrealistic and unacceptable. The financial presentation needed to

Prof. T Rama Krishna Rao

Disha College
clearly demonstrate the use of capital and what additional capital requirements would be required
upon successful completion of the animal studies. The Client did not have the experience to undertake
this financial presentation and had limited resources to engage an experienced full-time CFO.
The Solution:
Rankin McKenzie was brought in to meet with the co-founders and review the Business Plan. We
devoted time with the co-founders to understand their Business Plan and then develop a five-year
financial model to show the cash flows required to execute the Business Plan. After several iterations,
a final financial model and summary was incorporated into the revised Business Plan for investors.
After reviewing with previously contacted investors and several new investors that Rankin McKenzie
knew, two investors expressed interest in negotiating a term sheet with the Client. In addition, the
Rankin McKenzie partner assisted the Client by making sure that the existing financial statements
were reliable and understandable. The Client was impressed with our ability to problem-solve in a
time of their need.

Prof. T Rama Krishna Rao

Disha College