Chapter one

Introduction to Financial Management

Let’s define financial management as the first part of the introduction to
financial management. For any business, it is important that the finance
it procures is invested in a manner that the returns from the investment
are higher than the cost of finance. In a nutshell, financial management
–

 Endeavors to reduce the cost of finance

 Ensures sufficient availability of funds
 Deals with the planning, organizing, and controlling of financial
activities like the procurement and utilization of funds

Some 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

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Nature, Significance, and Scope of Financial
Management
Financial management is an organic function of any business. Any
organization needs finances to obtain physical resources, carry out the
production activities and other business operations, pay compensation
to the suppliers, etc. There are many theories around financial
management:

1. Some experts believe that financial management is all about

providing funds needed by a business on terms that are most
favorable, keeping its objectives in mind. Therefore, this approach
concerns primarily with the procurement of funds which may include
instruments, institutions, and practices to raise funds. It also takes
care of the legal and accounting relationship between an enterprise
and its source of funds.
2. Another set of experts believe that finance is all about cash. Since
all business transactions involve cash, directly or indirectly, finance is
concerned with everything done by the business.
3. The third and more widely accepted point of view is that financial
management includes the procurement of funds and their effective
utilization. For example, in the case of a manufacturing company,
financial management must ensure that funds are available for
installing the production plant and machinery. Further, it must also
ensure that the profits adequately compensate the costs and risks
borne by the business.
In a developed market, most businesses can raise capital easily.
However, the real problem is the efficient utilization of the capital
through effective financial planning and control.

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The scope of Financial Management

The introduction to financial management also requires you to

understand the scope of financial management. It is important that
financial decisions take care of the shareholders‘ interests.

Further, they are upheld by the maximization of the wealth of

the shareholders, which depends on the increase in net worth, capital
invested in the business, and plowed-back profits for the growth and
prosperity of the organization.

The scope of financial management is explained in the diagram below:

You can understand the nature of financial management by studying the

nature of investment, financing, and dividend decisions.

Core Financial Management Decisions

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In organizations, managers in an effort to minimize the costs of
procuring finance and using it in the most profitable manner, take the
following decisions:

Investment Decisions: Managers need to decide on the amount of

investment available out of the existing finance, on a long-term and
short-term basis. They are of two types:

 Long-term investment decisions or Capital Budgeting mean

committing funds for a long period of time like fixed assets. These
decisions are irreversible and usually include the ones pertaining to
investing in a building and/or land, acquiring new plants/machinery
or replacing the old ones, etc. These decisions determine the financial
pursuits and performance of a business.
 Short-term investment decisions or Working Capital Management
means committing funds for a short period of time like current assets.
These involve decisions pertaining to the investment of funds in
the inventory, cash, bank deposits, and other short-term investments.
They directly affect the liquidity and performance of the business.
Financing Decisions: Managers also make decisions pertaining to
raising finance from long-term sources (called Capital Structure) and
short-term sources (called Working Capital). They are of two types:

 Financial Planning decisions which relate to estimating the

sources and application of funds. It means pre-estimating financial
needs of an organization to ensure the availability of adequate
finance. The primary objective of financial planning is to plan and
ensure that the funds are available as and when required.
 Capital Structure decisions which involve identifying sources of
funds. They also involve decisions with respect to choosing external
sources like issuing shares, bonds, borrowing from banks or internal
sources like retained earnings for raising funds.
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Dividend Decisions: These involve decisions related to the portion of
profits that will be distributed as dividend. Shareholders always demand
a higher dividend, while the management would want to retain profits
for business needs. Hence, this is a complex managerial decision.

Goals of Financial Management

Profit Maximization:

Profit maximization is a stated goal of financial management. It is the

excess of revenue over expenses. Profit maximization is, therefore,
maximizing revenue given the expenses, or minimizing expenses given the
revenue, or a simultaneous maximization of revenue and minimization of
expenses. Revenue maximization is possible through pricing and scale
strategies.

By increasing the selling price one may achieve revenue maximization,

assuming demand does not fall by a commensurate scale. By increasing
the quantity sold by exploiting the price-elasticity of the demand factor,
revenue can maximize. Expenses minimization depends on the variability
of costs with volume, cost consciousness, and market conditions for
inputs. So, a mix of factors calls for profit maximization.

Financial Management Objectives;

This  objective of financial management  is a favored one for the following

reasons:

 Profit is a measure of business success. The higher the profit greater

is the degree of success.
 Profit is a measure of performance. Performance efficiency indicates
by the quantum of profit.

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  Profit-making is essential for the growth and survival of any
undertaking. Only profit-making businesses can think of tomorrow
and beyond. It can only think of renewal and replacement of its
equipment and can go for modernization and diversification. Profit
is an engine doing away with the odds threatening the survival of
the business.
 Profit-making is the basic purpose of business. It accepts by society.
A losing concern is a social burden. The sick business undertakings
cause a heavy burden to all concerned, we know. So, the profit
criterion brings to light operational inefficiency. You cannot conceal
your inefficiency if profit makes the criterion of efficiency.
 Profit-making is not a sin. The profit motive is a socially desirable
goal, as long as your means are good.

However, profit maximization is not very much favored. Certain limitations

point out. First, the concept of profit is vague.

Concepts of Profit;

There are several concepts of profit like gross profit, profit before tax,
profit after tax, net profit, divisible profit, and so on. So the reference to
the profit has to be clear. Second, profit maximization in the long run or
the short run is to state clearly.

Long-run or short-run profit orientations differ in nature, emphasis, and

strategies. Third, profit maximization does not consider the scale factors.
The size of the business and level of profit has to be related. Otherwise,
no sensible interpretation of performance or efficiency is possible. Fourth,
profit has to be related to the time factor. Inflation eats up money value. A
rupee today is worthier than tomorrow and the day after. The time value
of money does not consider in profit maximization.

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Profitability Maximization:

Profit as an absolute figure conveys less and conceals more. It must be

related to either sales, capacity utilization, production, or capital invested.
Profit when expressed about the above size or scale factors it acquires
greater meaning. When so expressed, the relative profit knows as
profitability. Profit per rupee sales, profit per unit production, profit per
rupee investment, etc., are more specific. Hence, the superiority of this
goal to the profit-maximization goal.

Further profit per rupee investment or return on investment, (ROI) is a

comprehensive measure. ROI = Return or Profit / Average Capital
invested.

Profit divided by sales measures the profit per rupee of sales and sales
divided by investment measures the number of times the capital turns
over. The former is an index of profit-earning capacity and the latter is an
index of activeness of the business. Maximization of profitability (ROI) is
possible through either the former or the latter or both.

The favorable scores of this objective are the same as those of the profit
maximization objective. The unfavorable scores of this objective again are
the same as those of the profit maximization objective except one aspect.
Profit maximization goal does not relate profit to any base. But
profitability maximization relates profit to sales and/or investment. Hence
it is a relative measure. So it is better than profit maximization goal on this
score. But as other limitations continue, this objective to gets only a
‘qualified’ report as to its desirability.

EPS Maximization:

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Maximization Earnings Per Share (EPS) involves maximizing earnings after
tax gave the number of outstanding equity shares. This goal is similar to
profitability maximization in respect of merits and demands. It is very
specific both as to the type of profit and the base to which it compares.
One disadvantage is that EPS maximization may lead to value depletion
too because the effect of dividend policy on value totally discards.

Liquidity Maximization:

Liquidity refers to the ability of a business to honor its short-term

liabilities as and when these become due. This ability depends on the ratio
of current assets to current liabilities, the maturity patterns of currents
assets and ‘the current liabilities, the composition of current assets, the
quality of non-cash current assets; the relations with the short-term
creditors; the relations with bankers and the like.

A higher current ratio, a perfect match between the maturity of current

assets and current liabilities, a well-balanced composition of current
assets, healthy and ‘moving‘ current assets, i.e., those that can convert into
liquid assets with much ease and no loss, understanding creditors and
ready to help bankers would help to maintain a high-liquidity level for a
business. All these are not easy to obtain and these involve costs and
risks.

How far is it a good goal? It is a good goal, though not a wholesome one.
Every business has to generate sufficient liquidity to meet its day-to-day
obligations. Last, the business would suffer. A liquidity-rich business can
exploit some rare opportunities like buying inventory in large quantity
when the price is lower, lend to the call money borrowers when the
interest rate is high, retire short-term creditors taking advantage of cash
discounts, and so on. So many benefits accrue. But, high liquidity might
result in idle cash resources and this should avoid. Yes, excess liquidity
and profitability move in the opposite directions, they are conflicting goals
and have to balance.
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Solvency Maximization:

Solvency is long run liquidity. Liquidity is short-run solvency. The business

has to pursue the goal of solvency maximization. Solvency is the capacity
of the business to meet all its long-term liabilities. The earning capacity of
the business, the ratio of profit before interest and tax to interest, the
ratio of cash flow to debt amortization, the equity-debt ratio and the
proprietary ratio influence the solvency of a business. Higher the above
ratios greater is the solvency and vice-versa.

Is this a significant goal? Yes, Solvency is a guarantee for continued

operation, which in turn is necessary for survival, growth, and
expansion. Borrowed capital is a significant source of finance. Its cost is
less; it gives tax leverage; So, equity earnings increase, so market
valuation increases. So, wealth maximization enables through the
borrowed capital. But to use borrowed capital, solvency management is
essential. You have to decide the extent to which you can use debt capital
and ensure that the cost of debt capital is minimum.

Higher dependence and higher cost (higher than the ROI) would spell
doom to the business. If the cost is less, (cost is the post-tax interest rate),
and your earnings are stable, a higher debt may not be difficult for
service. Solvency maximization is increasing your ability to service
increasing debt and does not mean using less debt capital. Increasing the
debt serviceability would require generating more and stable cash flows
through the operations of the business. Ultimately, the nature of
investments and business ventures influence solvency.

Minimization of Risk:

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So far, maximization financial goals were dealt with. Now, if we turn the
coin, the minimization goals come to light. Minimization of risk is one of
the goals. Risk refers to fluctuation, instability, or variations in what we
cherish to obtain. Variations in sales, profit, capacity utilization, liquidity,
solvency, market value, and the like refer to risk. Business risk and
financial risk are prominent among different risks. Business risk refers to
variation in profitability while financial risk refers to variation in debt-
servicing capacity.

The business risk, alternatively, refers to variations in expected returns.

Greater the variations, the greater the business risk. Risk minimization
also does not mean taking any risk at all. It means minimizing risk given
the return and given the risk of maximizing return. Risk reduction is
possible by going in for a mix of risk-free and risky investments. A
portfolio of investments with risky and risk-free investments could help
reducing business risk. So, diversification of investments, as against
concentration, helps in reducing business risk.

Financial risks;

Financial risk arises when you depend more on a high-geared capital

structure and your cash flows and profits before interest and tax (PBIT)
vary. To minimize financial risk, the quantum of debt capital limit to the
serviceable level, which depends on the minimum level of PBIT and the
cash flow. Of course, debt payment scheduling and rescheduling may help
in financial risk reduction and the creditor must be agreeing to such
schedules/reschedules. Here; too, a portfolio of debt capital can be
thought of to reduce risk.

Minimization of Cost of Capital:

Minimization of cost of capital is a laudable goal of financial management.

Capital is a scarce resource, a price has to pay to obtain the same. The

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minimum return expected by equity investors, the interest payable to
debt capital providers, the discount for prompt payment of dues, etc., are
the costs of different forms of capital. The different sources of capital –
equity, preference share capital, long-term debt, short-term debt, and
retained earnings, have different costs. In theory, equity is the costliest
source. Preference share capital and retained earnings cost less than
equity. The debt capital costs less, besides there is the tax advantage.

So, to minimize the cost you have to use more debt and less of other
forms of capital. Using more debt to reduce cost is however is beset with
some problems, viz., you take heavy financial risk, create the charge on
assets, and so on. Some even argue, that more debt means more risk of
insolvency and bankruptcy cost arises. So, debt capital has, besides the
actual cost, another dimension of cost – the hidden cost. So, minimizing
the cost of capital means minimizing the total of actual and hidden costs.

This is a good goal. Minimization of capital cost increases the value of the
firm. If the overall cost of capital is less, the firm can take up even
marginal projects and make good returns and serve society as well. But, it
should avoid the temptation to fritter away scarce capital. Capital should
direct into productive and profitable avenues only.

Minimization of Dilution of Control:

Control on the business affairs is, generally, the prerogative of the equity
shareholders. As the Board holds substantial equity it wants to preserve
its hold on the affairs of the business. The non-controlling shareholders
too, in their financial pursuit, want no dilution of their enjoyment of fruits
of equity ownership. A dilation takes place when you increase the capital
base. By seeking debt capital control dilation minimize. Also, by a rights
issue of equity dilation of control can minimize.

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It is evident, minimization of dilution of control is essentially a financing
-mix decision and the latter’s relevance and significance had been already
dealt with. But you cannot minimize dilution beyond a point, for providers
of debt capital, directly or indirectly, affect business decisions. The
convertibility clause is a shot in the arm for those creditors. Yes,
controlling power has to be distributed.

Wealth Maximization:

Wealth maximization means maximization of the net worth of the

business, i.e. the market valuation of a business. In other words,
increasing the market valuation of equity share is what is pursued here.
This objective is considered to be superior and wholesome. The pros and
cons of this goal are analyzed below.

Taking the positive side of this goal, we may mention that this objective
takes into account the time value of money. The basic valuation model
followed discounts the future earnings, i.e. the cash flows, at the firm’s
cost of capital or the expected return. The discounted cash inflow and
outflow are matched and the investment or project is taken up only when
the former exceeds the latter.

The term cash flow used here is capable of only one interpretation, unlike
the term profit. Cash inflow refers to profit after interest and tax but
before depreciation. Otherwise put, profit after tax and interest as
increased by depreciation. Cash outflow is the investment. The salvage
value of an investment, at its present value, can be reduced from
investment or added to inflow. So, the cash flow concept used in wealth
maximization is a very clear concept.

Other things;

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This goal considers the risk factor in the financial decision, while the
earlier two goals of financial management are silent as though risk factor
is absent. The not only risk is there and it is increasing the level of return
generally. So, by ignoring risk, you cannot maximize profit forever wealth
maximization objective give credence to the whole scheme of financial
evaluation by incorporating risk factor in the evaluation. This
incorporation is done through enhanced discounting rate if need be.

The cash flows for normal-risk projects are discounted at the firm’s cost of
capital, whereas risky projects are discounted at a higher than the cost of
the capital rate so that the discounted cash inflows are deflated, and the
chance of taking up the project is reduced. Cash flows – inflows and
outflows are matched. So, one is related to the other: i.e. there is the
relativity criterion too. So, wealth maximization goal comes clear off all the
limitations all the goals mentioned above. Hence, wealth maximization
goal is considered a superior goal. This is accepted by all participants in
the business system.

Maximization of Economic Value Added:

A modern concept of financial management goal is emerging now, called

as maximization of economic value added (EVA). EVA = NGPAT – INTE,
where, EVA is economic value added, NGPAT is net generating profit after
tax but before interest and dividend and INTE is the cost of combined
capital. INTE = Interest paid on debt capital plus fair remuneration on
equity. EVA is simply put the excess of profit overall expenses, including
expenses towards fair remuneration paid/payable on equity fund.

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