PRINCIPLE OF BUSINESS

FINANCE

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 INTRODUCTION
Finance is the life blood of an organization – Warren Buffet

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What is Finance?

 Suppose you want to start up a business. No matter what

the nature of the proposed business is, its size or how it
will be registered, you will have to address some
fundamental questions:
 How much investment is required to set up the business? It
includes preliminary expenditure, land and building, plant
and machinery, and furniture and fixture.
 How will you raise the money? It includes long term
sources like equity and debt.
 How will you finance your day-to-day activities? It includes
your inventory, giving credit to customers, and some cash
to take care of daily operations.
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 All this involves finance.
What is Finance?

 While these are not the only areas of financial decision

making, they are certainly the important ones.
 Financial Management refers to the efficient and effective
utilization of finance (referred to as funds) in such a
manner so as to accomplish the objectives of the
organization.
 It broadly involves two aspects - managing inflow and
outflow of funds.
 As a financial manager you broadly try to pre-pone your
inflows and post-pone your outflows.
 As a finance manager you also need to make a risk –
return trade off in every financial decision because of
agency problems. 4
What is Financial Accounting?

 Financial accounting is basically the backbone of any

financial management system.
 Without proper financial accounting records, finance
managers will not be in a position to take financial
management decisions.
 Financial accounting is basically a process in which
financial transactions are condensed and classified and
recorded and summarized in the books of accounts based
on certain established principles to prepare the Income
statement and Balance sheet.
 Management accounting uses this output to prepare
certain advanced MIS reports (e.g. fund flow statement,
ratio analyses) to aid in financial decision making. 5
Why do we need financial accounting?

 It assists in financial decision making.

 It enables the organization to keep systematic records and
track the assets and liabilities of the organization.
 It prevents chances of error or fraud in the form of
revenue and cost leakages.
 It enables the assessment of liabilities towards direct
(Income tax) and indirect taxes (Excise duty and Sales
tax) and facilitates the filing of returns to tax authorities.
 It ensures transparency to major stakeholders.
 It enables the management to assess the periodical health
of the organization.
 It helps prevent asset liability mismatch (ALM). 6
Financial Accounting Vs Finance

 Users of Information : External – Internal

 Type of Analysis : Whole – Part
 Data Used : Raw Data – Semi finished Data
 Nature of Analysis : Historical – Futuristic
 Unit of Measurement : Quantitative – Qualitative
 Frequency : Medium to Long Term – Short Term
 Nature : Objective – Subjective
 Precision : Very High – Low to Medium
 Legal Compulsion : Very High – Low
 Nature of Content : Low to Medium – Very High
 Level of Management : Low – Medium to High 7
Economics Vs Finance

 The macro economic environment defines the setting

within which a firm operates, and undermines the
conceptual underpinnings for financial decision making.
 The key macro economic variables that influences a firms
objectives are – inflation and interest rates.
 A firms top-lines, bottom-lines, including share prices are
largely influenced by these two factors.
 Other key macro economic factors that influences a firm
are – economic growth rate, tax environment, currency
stability, money supply, supply of skilled man power, govt
policy on land acquisition, etc.
 Without understanding of economics, financial decisions
become irrelevant redundant. 8
Important areas of financial decisions

 Capital Budgeting – The process of analyzing, appraising

and taking decisions with regards to investments in new
projects or businesses or scaling up existing businesses in
the form of increasing existing capacities.
 Working Capital Management – It involves the assessment
of requirement of funds for carrying on the day to day
activities of the businesses, followed by effective
monitoring and control.
 Investment Management – It involves the systematic
allocation of working capital rendered surplus during off
seasons and ploughing back of the same during peak
seasons based on established principles of risk and return
and diversification. 9
Important areas of financial decisions (contd)

 Capital Structure – It involves decisions regarding the

composition or mix of raising of long term funds from
equity shares – preference shares – debentures.
 Dividend Policy – It refers to establishing patterns in
dividend payment decisions of a firm to its equity
shareholders based on its goals and objectives.

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Objectives of finance

 Profit Maximization – The most traditional school of

thought in finance argues that a business entity exists for
the sole purpose of making profits and not charity.
Therefore profit maximization is the main objective of
finance.
 Critique: Profit generally implies the surplus of revenue
over cash. However, profits can also be earned by selling
of fixed assets like land, investments held by a firm or
through other sources like interests and dividends on
investments or commissions.
 Such non-orthodox sources of generating profit does not in
any way enhance the health of the organization as they
are not regular sources nor primary to its business. 11
 Profit is also not well defined and vague.
Objectives of finance (contd)

 Shareholder Wealth Maximization – According to this

school of thought since the equity shareholders provide
seed capital and are the ultimate risk bearers of the firm,
therefore financial decisions should be taken in a manner
that enhances equity share prices as the profits ultimately
belongs to the shareholders.
 Critique: The capital market skeptics argue that the stock
market displays myopic tendencies and are often
incorrectly priced.
 Some argue that other important stakeholders are ignored
like employees, suppliers, customers, etc.
 Most importantly, it ignores the society at large, as a firm
cannot exist in vacuum. 12
Objectives of finance (end)

 Stakeholder Wealth Maximization – According to this

modern school of thought financial decisions should be
taken in a way to ensure not only the equity shareholders,
but all relevant stakeholders are benefitted from it. The
logic is while shareholders provide only the risk capital,
other stakeholders also contribute largely to the success
of any firm.
 Critique: Balancing the interests of all the relevant
stakeholders is not practical. There is no way to determine
the right balance and will be left to individual discretion.
 Further, if a firms social objectives supersedes its business
objectives, it will fail to rival its competitors and ultimately
become sick. 13
What then is the right objective?

 Growth – It primarily refers to the extent the firm has

created or enhanced value over a period of time. Growth
can be measured in terms of sales, profits, earnings per
share, market capitalization, etc. Modern organizations link
growth with market leadership and sustainability.
 The broad objective is to grow at pace that outsmarts its
competitors.
 Growth based on one measure is extremely susceptible to
risk.
 Growth will not only ensure healthy profits but will also
maximize returns to shareholders and also contribute to
the society as a whole through CSR.
 Growth therefore reins supreme over all objectives. 14
How to choose organization form?

 An organization is an artificial person. Therefore, choosing

the type of organizational form is important as it has
serious financial implications, especially from the point of
view of finance, taxation and control.
 Sole Proprietorship – It is a business entity owned by a
single person and is subject to minimal government
regulations. It is simple, very easy to set up and set up
costs are nominal. The owner bears all the profits and
losses of the firm. Owners liabilities are unlimited.
 Such firms have limited ability to raise capital and attract
talent.
 It is relatively easy to transfer the assets and or sell of the
firm. 15
Other issues in selecting organizational form

 Decision Making – In proprietorship firms decision making

is the fastest. In a partnership firm the consent of all the
partners is essential (except for sleeping partners).
Therefore, decision making process slows down. In a
company, since superiors need to ratify decisions, often at
multiple levels; decision making is the slowest.
 Confidentiality – In a proprietorship firm information is
shared with no one, therefore confidentiality is very high.
In case of a partnership firm, confidentiality comes down.
Since company’s need to file their financial details with
RoC and stock exchanges, a lot of information is there in
the public domain.
 Succession Planning – It is the smoothest in case of a 16
company.
Agency problem

 In proprietorship or partnership it is the owners or partners

who also manages the activities of the business entity.
 However, in case of a company there is complete divorce
between ownership (or principal) and management.
 Professional managers are usually appointed to manage
the day to day affairs of the business. There is an implicit
relationship of trust.
 It is expected that the decisions taken by the managers (or
agents) should be well aligned with the dictum of the
owners. However, often there is a conflict between the
two. This is known as agency problem.
 Agency problem needs to minimized through a holistic and
360 degree appraisal of their performance and rewards.17
The finance vertical (contd)

 Entry Level (0 – 5 yrs) : In industry, entry level finance

functions typically involves around managing working
capital, which includes inventory, debtors and cash. In a
bank it could include: credit appraisal, credit monitoring
and control. In an IT or consulting positions it could
include financial or investment analysis.
 Mid Level (5 – 15 yrs): In industry, mid level finance
functions typically involves investment or treasury
management or may be heading a particular division or
even SBU. In such cases projects appraisal or capital
budgeting, including raising long term finance (advisory
capacity) becomes an important function. In a bank it
could include an operations or branch head. In IT industry
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it could be a Sr Consultant.
The finance vertical (end)

 Senior Level (15 – above yrs) : In industry, senior level

finance functions (CFO) typically involves designing of
capital structure and dividend policy. As the CFO is
primarily responsible for RoI he also is final approving
authority for new projects or scaling up existing
businesses.
 In a bank it could include senior positions at regional –
zonal – head office levels, where decisions are taken with
regards to exposures in different industries, base rate
across different lending products and opening of new
branches or ATMs.
 In IT / Consulting industry it could be of Country or
Functional heads, directly reporting to the BoD. 19
End

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