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    23 views24 pages

    FM - Introduction To FM - Text Book

    Uploaded by

    SHANMUGHA SHETTY S S

    Copyright:

    © All Rights Reserved
    Download as PDF or read online from Scribd
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    CHAPTER 1 Introduction to Financial Management Ee Financial Management ~ Meaning — Significance of Wealth Maximisation — Criticisms of Wealth ‘Maximisation — Decisions in Financial Management — Organisation of the Finance Function — Finance Manager — Functions of Finance Manager — Traditional Role New Role — Financial Plan — Principles Governing a Financial Plan — Steps in Financial Planning — Meaning of Capitalisation — Cost Theory — Points to Remember — Question Bank Commercial Banks RBI Development Banks Shares, Debentures Preference Shares Public Deposits Financial pote a System Companies ‘Term Loans Farmers Leasing, Service Sector Hire-Purchase Cash Credit Oversiraft Financial Markets SEBI Capital Market ‘Money Market Fig. 1.1: Indian Financial System FINANCE Finance is one of the major elements, which activates the overall growth of the economy. Finance is the lifeblood of economic activity. A well-knit financial system directly contributes to the rowth of the economy. An efficient financial system calls for the effective performance of financial Ssstitutions, financial instruments and financial markets. MANAGEMENT Re In the present day industrial world, management has become universal. With the increase in the complexities of management of business concerns, the importance of ‘management’ has increased csormously. The principles of management are being applied not only for managing business concerns, but also to manage various other service sector ‘institutions like hospitals, educational (1) 2 Financial Management institutions, efe. Hence, management occupies such an important place in the modern world that the welfare of the people and the destiny of the country are very much influenced by it. It is in this context both finance and management functions gained substantial significance in the industry. FINANCIAL MANAGEMENT — MEANING Financial management is the specialised functions directly associated with the top management. The significance of this function is not only seen in the ‘Line’ but also in the capacity of ‘Staff’ in the overall administration of a company. It has been defined differently by different experts in the field. Some of the important definitions are: “Financial management is the operational activity of a business that is responsible for obtaining and ef utilising thé S86 fi ition.” — by Joseph & Massie “Business finance deals primarily with raising administering and disbursing funds by privately owned business units operating in non-financial fields of industry.” — by Prather and Wert “Financial management is an area of financial decision making, harmonizing individual motives and enterprise goals” — by Weston and Brigham “Financial management is the area of business management devoted to a judicious use" of capital and a careful selection of sources of capital in order fo enable a business firm fo move in the direction of reaching its goals” — by LF. Bradlery “Financial management is the application of the planing and control functions to the finance function, - — by Archer & ‘Ambrosio. “Financial management may be defined as that area or set of administrative functions in an organisation which relate with arrangement of cash and credit so that the organisation may have the means to carry out its objective as satisfactorily as possible.” — by Howard & Opton. “Business Finance can be broadly defined as the activity concerned with planning, raising, controlling and administering of funds and in the business. — by E.G. Gathman & H.E. Dougall A ag a aol > 9a ae t the: this: rent. f in 1 the mn. & all and ns to hich d. It et. It d its ol to Introduction to Financial Management BALANCESHEET LIABILITIES AMOUNT ASSETS: AMOUNT < z 1. | Long-term liabilities Capital Expenditure (Fixed Liabilities) 2 1 | (Fixed Assets) ? Short term Liabilities 2. | Revenue Expenditure (Current Liabilities) 2 (Current Assets) 2 Total 2 [ tat 2 Financial management is therefore inextricably linked with general management that one cannot be separated from the other. It is thus an integral part of general management ‘and not merely a staff Sinetion, which is concerned, only with administration of sources of funds. It is eoncemed with the nee of finds as well, and therefore, with the investment decisions that determines the nature of @ frin’s business. How to acquire finance for short-term and long-term assets is an important decision-making area of financial management. Both assets and liabilities should be properly chosen. It has both merits and limitations which financial management will have to reconcile. Moreover, sch selection would also involve a judicious planning and management of inflows and outflows of funds. GENERAL OBJECTIVES GOALS OF FINANCIAL MANAGEMENT SPECIFIC OBJECTIVES Fig. 1.2: Goals of Financial Management ‘The ultiniate objective of the subject financial management is to fulfill the basic desires of the Sams. In the broader concept it has to meet the requirements of not only the shareholders but also the cakeholders, This is achieved through maintaining consistency of growth in the percentage of dividend and market value of shares. Following are some of the important goals/objectives of financial management. Specific Objectives 1. Profit Maximisation: Earning profits by a corporate or a company is a social obligation. Profit i the only means through which an efficiency of organisation can be measured. 'As the business units are exploiting the resources of the country namely, land, Jabour, eapital_and sesources, has an obligation to make use of these resources to achieve profits. It isan economic ccligation to cover the cost of fiinds and offer surplus funds to expansion and growth, Accumulated rofits red f an enterprise. It should serve as the base for all types of décisions. Profit ewpoint may be to maximise value, the financial executive's primary managerial responsibility isto ®, | preserve the continuity of the flow of funds so that no essential decision of the top management is ustrated for the lack of corporate purchasing power. 4. Administrating the Allocation of Funds: Once funds are allocated on various investment spportunites, it is the basie responsibility of the finance manager to watch the performance of each ripee that has been invested. He has to adopt the close supervision and marking of flow of funds. cs will ensure continuous flow of funds as per the requirements of the organisation. This helps the agement to increase efficiency by reducing the cost of operations and eam fair amount of ofits out of these investments. 5, Analysing the Performance of Finance: Once the funds are administered, it is very comfortable for the finance manager to take decisions. Through budgeting, he will be able to compare the actuals with standards, The returns on the investments must be continuous and concistent, The cost of each financial decision and returns of each investment must be analysed. Ssherever deviations are found, necessary steps of strategiés are to be adopted to overcome s1." n events. This helps in achieving ‘Ziquidity’ of a business unit. 40 Financial Management 6. Accounting and Reporting to the Management: Now, the role of the finance manager is changing. The department of finance has gained substantial recognition. He not only acts as line executive but also as staff. He’ has to advise and supply information about the performance of finance to the top management and is also responsible for maintaining up-to-date records of the performance of financial decisions. If need arises, he holds the responsibility to improve the overall functioning of the organisation. The financial manager will have to keep its assets intact, which enable a firm to conduct its business. Asset management has assumed importance in financial management. It is also necessary for the finance manager to ensure that sufficient funds are available for the smooth conduct of business. In this connection, it may be pointed out that the management of funds has both liquidity and profitability aspects. Financial management is concerned with the many responsibilities which ate the main thrust of a business enterprise. Although a business failure may not always be the result of financial failures, financial failures do lead to business failures. Hence accounting and reporting of the performance of finance is an important aspect of financial management. DECISIONS IN FINANCIAL MANAGEMENT ‘The functions of finance involve three important decisions, viz., Investment Decisions, Financing Decisions and Dividend Decisions. All these decisions directly contribute to the corporate goal of wealth maximisation. The subject financial management guides the management to have optimal mix of these decision. The joint contribution of these decision increases the value of the shares. Let us discuss the above decisions separately. 1. Investment Decisions: Investment decisions is referred to the activity of deciding the pattern of investment. It covers both short-term as well as long-term investment, in other words capital assets and the current assets. It is a long range financial decision and deals with allocation of capital. It has to show how the funds can be invested in assets which would yield maximum return to the business concern. This is a risky decision where finance manager has to take maximum care in selecting the areas of investment. As the future is uncertain the returns expected must cover both risks as well as the uncertainties. The variability of each proposals must be examined Costing technique, capital budgeting, CVP analysis has to be adopted before making a final decision on the investment avenues. The popular technique adopted in the industry to evaluate the proposals are ‘Net present value’, The present economic scenario is pressurizing this decision to look more carefully than before. As the competition for Multi-national companies are dominating joint venture, mergers and acquisition are taking place, each addition and deletion of products of the asset must significantly contributes to the concept of increasing the wealth of the organisation. \t is another important decisions where a business concern has to take maximum care in financing different proposals. The appropriate mix of finance with debt to equity directly contributes to the profitability of a business unit. ‘The instrument that are 10 be selected must aim at maximising the returns to the investors and to protect the interest of creditors. The role of finance manger in taking decision with regard to combination of the capital structure is vital. He has an alternative of mobilising the funds through (a) equity, (b) equity plus debt, (c) equity plus debt plus preference shares and (d) equity plus debt plus preference shares plus public deposits with term loan, Each opportunities must be evaluated with its benefits. If a company opts only for Se Sstroduction to Financial Management __ "1 xy it looses its leverage benefits. If it opts for both debt and equity. proper balance must be tained between the two to reduce the financial risk. Supposing, a finance manager would like to = more debt and less equity. This may bring in more dividend to share holders and results in screased price of the share in the market and may lead to wealth maximisation. But the cost of sorrowed funds may increase the risk of the business concern. Most of the earnings will be used on the payment of interest on the borrowed funds which is also called as “Financing Risk”. Hence he should be intelligent and tactful in deciding he ratio between debt to equity. In addition to the responsibility of having proper “Financing Mix”, he should also provide cofficient scope for gaining additional sources of funds for expansion, diversification etc. This can be achieved through issue of preference shares, public deposits and raising term loans. Therefore, capital structure should not be rigid and it should be flexible. 3, Dividend Decision: The ultimate objective of a business concer is to fulfill the desires of equity shares namely (a) High Percentage of dividend and (b) Maximum returns to share holders in the form of capital gain. In addition to these he has to plan for (c) How much cash dividend should be paid to the shareholders? (d) How much profit is to be flown back by capitalisation? (e) Maintenance of stable dividend rate over the period. He should always keep in view the psychology of investors who svish to get a better yield on their investment. Hence sound decision on divided should be taken. While taking such a decision, the finance manager should also care much for retained earnings, which will act as solid component of equity capital. The dividend pay out ratio must be evaluated in the light of the objectives of maximising shareholders’ wealth. Thus the dividend decision has become a vital aspect of financing decision. 4. Current Asset Management: The finance manager should also manage the current assets to have liquidity in the business. Involvement of reduction in dividend. But the finance manager should also equally look after the current financial needs of the firm to maintain optimum production through which he must achieve efficiency and increase the operating cycle to meet the short-term obligations. Hence, it is also termed as ‘Working Capital Management’. It keeps business operations going with the proper management of cash, accounts receivables and inventory. ORGANISATION OF THE FINANCE FUNCTION he organisation structure of finance is as important as any other functional department, Experts feel that finance department has more significance than the other functional department. It is established directly under the control of board of directors. The structure and the size of the finance department differ from one industry to another industry. If the size of the industry is small, owners themselves will have the responsibilities of finance function. If the size of the organisation is big, an independent finance department will be established. It may be in the form of centralised or decentralised authority. If the size of the organisation is very large, an expert committee will assist the board in all the financial matters. (The finance function is controlled by the top management, because the survival and growth of the firm mainly depends upon the sound financial ‘decisions taken by the firm. These are general issues and hence are vested with the top brass. Moreoverthe top management will be in a position to co-ordinate the financial activities with other functional aréas. Fund flow will be smooth because of the sound working of finance functions. This helps in maintaining ‘solvency’ of the firm. Several economies of large-scale operations can be achieved through this finance department. 42 Financial Manageme! ‘The finance functions, although, is controlled by the top management, there will be a separat expert team to look after these activities and this function'will be sub-divided according to the needs. common structure of the finance department cannot be evolved, as the size of the firm and nature of th business vary from firm to firm. However a general organisational structure can be thought of. The finance function can be broadly divided into two parts: 1. Routine matters or day-to-day functional transactions like custody of cash and bank accounts. collection of loans, payments of cash for transactions ete. 2. Special financial functions like + Functional planning and budgeting > Profit analysis + Investment decisions + Financial accounting | + Cost accounting * Internal audit _ The above two functions are looked after by “Treasurer” and the ‘Controller’. Routine matters ‘are looked after by the Treasurer and special matters are managed by the Controller of finance. These two executives are governed by a special committee called Finance Committee. The organisation chart will explain the structure of finance department. The following chart is not rigid and can be altered according to the needs of the individual organisation. ‘The designation used need not be identified es “managers’. The recent trends call for usage of designation as ‘Directors’, ‘President’, or “Vice-President” finance. The usage of “controller” and the ‘treasurer’ designations are very popular in USA. But in the Indian context, the position is slightly different. The role of Treasurer is routine and repetitive in nature. He takes care of opening bank accounts, depositing cash and maintaining day-to-day financial matters. The opportunities for investments are to be explored by the treasurer. Periodical tax administration and insurance related issues are attended by the treasurer. The responsibility of credit collection, preparation of ageing schedule, follow-up of collection and maintaining the inflow of cash will be looked relationship with the banker and financial institutions. He has to fulfil the requirements of periodical payment of interest and the principal. He is also responsible for submitting regular inventory statements, cash and fund flow statements to the banker as per the terms and conditions of the loan agreements. The role of controller is entirely different, he is more responsible than the treasurer. He is in- charge of planning, developing strategies and guiding the management in all financial decisions. Preparations of financial planning, planning for investments, economic appraisal, cost reduction strategies, protection of assets and preparation of Annual report and other important issues are looked after by the controller. He has a role of ‘Staff towards the top management. To conclude both are responsible for smooth running of the organisation and in achieving wealth maximisation, Fil nf troduction to Financial Management 13 f Share holders 1 : Board of directors al Chairman ate al ‘Managing Director General Manager Production Marketing Finance Purchase ° Manager Manager ‘Manager Manager 1 I ‘Asst. Prod. "Asst. Mark. Finance ‘Asst. Prod. Manager Manager Committee Manager ; E I oaelae Supervisor Marketing z [ Supervisors Supeeviss Workers Field Force Workers sol Treasurer Controller a 1. Accounting 6. Cost Accounts : 2. Budgeting 7 nternal Audit 3 Babies ing 3, Financial Planning 8. Profit Planning Bicratc ranae 4, Investment Decisions 9. Protection of Assets Relation with Bankers 5, Economic Appraisal 10. Annual Reports i 6. Insurance Fig. 1.5: Organisation Chart of Finance Department FINANCE MANAGER oo Finance manager is a person who heads the department of finance, He forms important sctivities in connection with each of the general functions of management. He groups activities in such a way that areas of responsibility and accountability are clearly defined. His focus is on eeersity of the firm. The profit centre is a technique by which activities are decentralised for the development of strategic control point. The determination of the nature and extent of staffing is 14 Financial Managem: aided by financial budget programme. Planning involves heavy reliance on financial tools a analysis. Control requires the use of the techniques of financial ratios and standards, Briefly, informed and enlightened use of financial information is necessary for the purpose of co-ordineais the activities of an enterprise. Every business, irrespective of its size, should, therefore, have Financial manager who has to take key decisions on the allocation and use of money by varior departinents. Specifically, the finance manager should anticipate financial needs, acquire financi edie caer allocate funds to various departments of the business. If the financial manage handles each of these tasks well, his firm is on the road to good financial health, Sinee the finana ‘manager isan integral part of the top management, he should shape his decisions and recommendations ‘0 Contribute to the over all progress of the business. It is his primary objective, to maximise the value of the firm to its stockholders. FUNCTIONS OF FINANCE MANAGER The following are some of the important functions of the finance manager. 1. He should anticipate and estimate the total financial requirements of the firm (Preparing sound finayeial plan). 2, He has to select the right sources of funds at right time and at right cost. [Balancing the own capital (EQUITY) and borrowed capital (DEBT) for the best advantage of the firm]. 3. He has to allocate the available funds in the profitable avenues. [Judicious Fund Allocation] 4. He has, to maintain liquidity position of the firm at the peak [Synchronising the finance inflow and outflow for better liquidity], 5 He should analyse financial performance and plan for its growth. {Continuovs financial appraisal activity] a He has to administrate the activities of working capital management, 2 He has to protect the interest of creditors, shareholders and the employees, ' He has to concentrate more on fulfilling the social obligation of a business unit. Estimation of the Financial Management. Selection of the Right sources of funds. Allocation of Funds, Analysis and interpretation of financial performance, Analysis of Cost-Volume-Profits. Capital Budgeting. Working Capital Management. Profit planning and control. Fair returns to the investors. Maintaining liquidity and Wealth Maximisation. eZ0“40zZ0% Fig. 1.6: Functional Areas uf Financial Management Papa meni ‘troduction to Financial Management 18 ang 4. Estimation of the Financial Requirements: The requirement of finance to a business /, at “eoncern in continuous. It is needed in all the stages of business cycle namely, initial growth, iting eration and declining stage. Funds are needed to establish the industry both for meeting capital ve a expenditure and revenue expenditure. Total estimation of funds for these assets are the first assignment ious) eethe subject financial management, Funds are also needed at the growth stage for expansion and to ieiall_ merease the production to meet the demand of consumers. The requirement of finance arises even at ager se stage of saturation. It is needed for diversifying the product, so that, a firm can continuously icial| say on in the saturation stage. If the firm becomes sick, to rejuvenate the activities of such business ions! concern rescheduling, repackage of financial services are needed. Hence, it is the first task of the] Gnance manager. 2, Selection of the Right Sources of Funds: After estimating the total funds of business concern, itis the second important step of the finance manager to select the right type of sources of ds at the right time at right cost, Each financial instrument is associated with different types of costs. Equity has the cost of dividend or expectation of the shareholders, debenture or borrowings sas the cost of interest, preference share has the cost of dividend. Careful selection has to be made ot of the available alternative sources of funds. 3, Allocation of Funds: After mobilising the total funds of a firm, it is the responsibility of ance manager to distribute the funds to capital expenditure and revenue expenditure. The evaluation

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