Financial Management : An Introduction Finance is the life blood and‘nerve centre of a business, just as circulation ‘of. Iéad is essential in the human body-for maintaining, life, finance‘is-a very essential - th running of the business. Without finance neither any ‘pusiness'can be tarted nor successfully run. Hence, efficient managem at of every business enterprise 5 closely linked with efficient management of its finances.” PREC afi EVOLUTION. OF FINANCE ASA DISCIPLINE ~ ~ Finance has emerged as a distinct area of study during séeond half of the wentieth century. But even before that some direct or indireét references to finance function were made,on a casual basis. Broadly speaking there are three overlapping phases of evolution of finance fiinction : the traditional phase, the transitional phase, ~ and the modern phase. 2 iS on 1. The Traditional Phase (Finance up, to 1940) : Initially finance was a part of economics and no separate attention was paid to finance. Business owners were more concerned with, operational activities, In the traditional phase, the finance manager ‘was concerned with record keeping, preparing different. report, and managing cash. I lar only when his speciality was required sa need felt for the funds. : or the. smoo! ‘A finance manager was called upon in particu! to.locate new sources of funds whenever ‘there was «The traditional phase can be summarized-as follows : (j) Finance function was concerned with procuring of funds to finance the fication activities ,and: thus the occurrence’ of finance expansion or diversi in nature? Finance function was not a part of regular function was episodic managerial operations: (ii: In order to finance business growth, there was an emergence of institutional financing and institutional banking giving risc;to finance industry- (iii) Finance function was viewed particularly from the point of view of supplier ~ of funds ie., the lenders, both individuals and institutions. So the emphasis ‘was to consider the interest of the outsiders, The internal decision making process and the persons jnvolved in thé process were of lesser importance. (iv) The focus of attention was on the long-term resources ‘and only the long-term’ finance was of any coneera, The concept of working capital and its management was virtually non-existent. 3 * (v) The treatment of different aspects of finance was more of a descriptive nature co ae ree there were: no analytical’ financial decisionnance was concerned with procuring of fang. such as equity shares, preference’ shar knowledge of the sources of funds-vha what;techniques to sell, was needed, The Transitional phase : The transitional Phase began = sand continued through the early 1950s. Though the mature of f° the uring this phase was similar to‘that of the traditional Phage 2anci «:*placed:on the day-to-day problems faced: by finance Manager rear, alysis, planning and control. These problems, however, ‘analytical frame works,: eit __3:The Modern Phase : The modern phase began in wi ‘of corporation finance or financial Management has nowy become month quantitative. The focus shifted’ from the ‘outsider’s View of the fie the “insider's viet, ind financial: decisi ite se studies, of corporate’ finance, 4 28 The modétn phase of the evolution of fi 8 an ee and dey t SCcUrities to 5 e ion-making Occupied. * fan © Plage nance function can be sum The scope has widened to inchide analytical decision, making, ‘ Sted guaction mH : 1 Of View of the 4! those who aré taking decisions in the firm; Seat i). The, knowledge of the secutities, financial market necessary and the scope of financé m: being nearly descriptive into analytic S_and institutig fanager’s function hag expanded; pital budgeting, Capital stricture option pricing theory, arbitrage Pricing. theory, working, capital management, financial modeli ‘ny more exciting developments are in the. offing challenging ficld. 1 FINANCE FUNCTION z erm ‘procurement? the funds externally Was used in a broad s This approach towards finance Was criticised on various grounds. (A) Itis too narrow and Testrictive in nature, Procurement of the funds 8% One of functions of finan »(B) It considers the financ it ignores the financial concerns,‘Financial’ Management :-An Introduction--\ ~~ ye 13 (©) 1k. considers-only. the -basie and: non: ie problems relating to the __. business. Day-to-day financial problems of a normal company do not receive > aniy attention. (D) It concentrates only on long hee Anette tetera ns that the vorking capital.” management was out of purview of:finance function. (2) The second approach holds that finance, is ‘concerned ‘with Gash:iThis approach to finance-function is too, wide to be meaningful, as almost every business transaction involves cash. Hunt. and ; William, Donaldson. have followed the same approach. ‘This, approach has too much widened the scope of finance as it;requires the finance. manager to go, into details of every business activity, be, concerned with purchasing, production, marketing, personnel “administration, research. or other associated activities. But, this approach is also not satisfactory. _ (3) The third approach which is more balanced one and hence the acceptable one to the modern scholars, interprets the term finance as being concerned with procirement of funds and wise application of funds. This approach is supposed to be more acceptable as it gives equal weightage to both procurement of funds as well as utilisation of the funds.-This approach is called the managerial approach to’ the term finance. ‘The modern scholars on the subject-as J.F: Bradley, Soloman Ezra. Howard & Upton, Weston & Brigham,’ Archer & Ambrosio, Guthman & Dougal, Van Horne, J.L. Massie, etc., have used the. term in the same sense. According to them, finance function is not. only. concerned with the procurement of funds but also’ with, the effective utilization of funds for the attainment of the organisational objectives as satisfactorly as possible. Th the light of the above discussion, it will be wwrthutile to notesome of ‘the definitions of the finance function given by some modern scholars. According to R. C. Osborn, “The finance function is the process of acquiring and utilising funds of a business.” ‘According to Bonneville and: Dewey, “Financing ‘consists’ of the “raising, providing, managing of all: the money, capital or funds of any kind to-be used in connection with the business.” According to Prather arid Wert, “Business finance deals primarily with raising,” administering and disbursing funds by privately. owned business, units operating in non-financial ficlds of industry.” APPROACHES TO FINANCE FUNCTION ‘Approaches to finance function’ can be divided into ‘two following broad categories, viz., (i) Traditional Approach; and (ji) Modern Approach. a (@ Traditional Approach : The traditional apprdach, which was popular in the early part of twentieth, century, limited the role of financial management to raising and administering of funds needed by the corporate enterprises to mect their financial needs. It broadly covered the following three aspect x (i), Arrangement of funds from financial institutions. (ii) Arrangement of funds through financial instruments, viz., shares, bonds, etc.financial planning, control etc, The new approach is an an: (:0F 2 firm. The. techniques. of model financial engineering are uscd in fin » allocation of funds nalytical way of dealing with lb ls,, mathematical Programming, simulations ; ancial management to solve complex proble 9 , finan Financial prob © Procurement of the funds in the mast‘ée : _ of these funds in the, most optimum way to maximise the return for the owmet concerned with. overall: managerial decision making in general. and with) management of economic resources in Particular. All business decisions tevin ., implications and therefore financial Management is inevitably related to ey i ~ aspect of business operations, Finacial anagemient has been defined differe different authors. Some definitions of ¥ cial Management are as tele LF Bradley, “Financial Management is the arca of business management to a judicious use of capital and careful selection of sources of capital enable a business firm to move in the direction'of reaching its goals ordet+ An Introduction a5 Financial Management JL. Massie, “Financial Management is the operational activity of'a business that is responsible for’ obtaining and effectively utilising the ‘funds necessary. for efficient operations.” LF Weston & EE. Brigham, “Financial Management is an act tof financial decision making, harmonising individual motives and enterprise goals.” : Howard & Upton, “Financial Management may be defined as that area or set of adi tive functions in an organisation which relate with arrangement of cash and credit so that thc organisation. may have the means to carry out its objective as satisfactorily as Des Conclu: : It is clear from the above definitions that Financial “Management is that speci aa function of general management which is concerned with the timely procurement of adcquatc’ funds and their effective utilisation for the efficient functioning of the business enterprise. Financial Management, therefore’ includes financial planning, procurement of finance, irivestment of funds and financial control. - NATURE OF FINANCIAL MANAGEMENT The Financial Management is neither. a pure science nor an art. It deals with various methods and techniques which can be.adopted, depending on the situation of business and the purpose of decision. As a science, it uses various statistical and mathematical models and computer applications for solving the financial problems relating to the firm. For example-capital investment appraisal, capital allocation and rationing, optimising capital structure mix, portfolio management etc. Along with the above, a Finance Manager is required to apply his analytical skills in decision making. Hence, Financial Management is both a science as.well,as.an art: OBJECTIVES OF FINANCIAL. MANAGEMENT From the discussion we have made so far, it becomes clear that a firm has to take the following three major decisions : Whore to invest funds and what amount? i.c., the Investment decisions; (ii) Where to raise funds and what amount? i.c., the Financing decisions; (iii). How much to pay by way of dividends? the Dividend Policy decisions. The. investment and the financial policies depend on the above decisions. It should be remembered that a clear understanding of the objectives which are sought to be attained is necessary'in order to make wise decisions. No doubt, the objective provides a framework for optimum financial decision-making. It is generally accepted that the financial objective of the firm is to maxmise the owncr’s economic. welfare. For this purpose, two well-established and widely-discusscd criteria are presented: (a) Profit Maximisation ad (b) Wealth Maximisation: (a) Goal of Profit Maximisation : It is universally recognised that the basic goal of business should be to maximise owner's economic welfare. In order to achieve this: : ultimate goal ‘maximisation of profit’ has been considered a basic objective of financial management. Various types of financial decisions, to’be taken with a view to maximize the profit of the firm. So, out of different mutually exchisive options only that one should: be selected which will result. in maximum increase -in profit. The following arguments are usually put forward in favour of profit maximisation as the objective of busines 4 i@) When profit-carning is the-aim “be the obvious objective, i) Profitability is a barometer “of-a business enterprise, th of rationality. Gil) Beoriomié and business conditions do ot remain same at all Bi may be “adverse business’ conditions’ like recession, dent times Tye £ Gompetition: ete. A. business will be able to surge ; {Pression He some tc. C ive and situation, only if it has some past earnings to Tely upon. ‘Therefore VOU : i fore, a bys of business then profi, ci ‘ LEH Vite sation « : ni Sh, iciency and CConomic pS Sation is justifieg on the O° © Brain for measuring effi us; profit ‘maximi ance for the growth o} fa busi ion of profits for cnabling eoSeSS. busincss'should aim at maximisati feet a ae Hng its development. ee : () Profitability is essential for fulfilling social goals also. objective ‘of profit maximisation also maximises Socio-economic Welfay Profit: maximisation is widely: preferred, ‘but, infact, the Concept hac v= questioned ‘and ‘ctiticised on-the following grounds + S been, “1. Vague Concept : The” profit maximization as “an ambiguous. It does not clarify which profits does it mean: of short‘term profit or‘long-term Profit j:after tax profit or from the point’ of view of total funds’ employea- ot’ fro shareholders only etc? : 2. Ignores time value of money : Profit maximisation objective ignores the time value of money and does not consider the magnitude and timing of earnings. It treats all ernings‘as equal though they occur in different periods. It ignores the fact that cash reccived today is more important than the same amount of cash received after, say, three years. The stockholders may prefer a regular return from investment even, iFitis smaller than the expected higher returns after a long period, a ( erlooks Risk : The profit maximization does not take into account the amount of risk which the ..firm undertakes in attempting to increase the profits: With Profit maximization as the objective, the management may undertake all profitable _investmient_ opportunities regardless of the‘associated risk. “As ‘stich,’ profit’ maximaization can’t be a prime objective of the’ financial management. The objective’has to be one’having more broad base, which is more precise, which considers risk factor and time value ‘of money and which ee consideration to social ‘and ethical: clémeits also; The alternative is in the form of wealth maximization as the objective of the financial mangement. i (b) Goal of Wealth Maximisation : Profit maximisation, on account of the reat given above, is not considered to be an ideal criterion for making investment 9 i financial decisions. According to Prof. Solomon Ezra, the ultimate goal of the Ha a management should be the maximisation of the owner’s wealth. According bape maximisation ‘of profit is half ‘and unreal motive. ‘The proper goal o! mie management is wealth maximisation of equity shareholders as it is expressly a va the with'the relationship of profitability ‘and ‘the’ volume ‘of capital being use wypes enterprise. As already mentioned, corporate managements have to take thre 4 A firm by pu, Suing ty tax profit: m the point of view ofFinacial Management : An Introduction lof decisions, ie, investment decisions; financing. decisions, aid dividend decisions. ‘These. crucial ‘decisions not only influence one another, but: also jointly affect the ‘value of the firm. It is, therefore, desirable that such decisions must be taken in such a manner so-as to’ maximise the value or worth of the:firm. This objective can also be stated as maximization of value: : Sue as ‘The value of -an-asset. is judged ‘not in. terms-of-its “cost but.in terms: of the benefit it produces, Similarly the value of a course of action is judged in terms of the benefits it produces less the*cost of undertaking it. The. benefits can be'measured in terms of stream of future expected cash flows, but they must take into consideration not only their, magnitude but also the extent of uncertainty. . ‘ Thus, wealth maximization goal as decision criteria suggests that any. financial action which ‘creates ‘wealth or which has discounted stream. of future., benefits exceeding its cost, is desirable’ and should be accepted and that which does not satisfy, this test should be rejected. eae Ra ae : The goal of wealth maximization is supposed to be superior to the goal of profit maximization due to following reasons : ‘ (1) It uses the concept of future expected cash flows rather than the ambiguous term of profits. As stich ‘measurement of benefits in terms of ‘cash flows avoids ambiguity. (2) It considers time value of money. It recongnises that the cash flows generated earlier are more valuable than those generated later. That_is-why ‘while ‘computing value of total benefits, the cash flows’are discounted at a certain discounting rate. At the same time, it recongnises the concept of. risk also, by making necessary adjustments in discounting rate. As such, cash flows of a project involving higher risk are discounted at a higher’ discounting rate and vice versa. 5 ‘Thus, the discounting rate used to discount future cash flows reflects the concepts of both time and risk: . + Duc to the above reasons, the wealth maximization is considered to be superior to profit maximization as_an objective or goal of financial management, However, it should be noted that wealth maximization goal is only an extension “of profit | maximazation goal. If the time period is too short and risk clement is minimum, both wealth maximization and profit maximization will mean the same thing: SCOPE OF FINANCE FUNCTION ‘The scope of the term finance function, as considered by the modern approach, : can be said to be concerned with the following three types of decisions = | @) Financing Decisions, (b) Investment Decisions, (c) Dividend Policy Decisions. (a) Financing Decisions : These decisions are. basically concerned with .the J process of acquiring the funds. Any business activity is basically concerned with raising | othe funds, whenever required, employing these funds for manufacturing and selling || the products in the market and:carning the profits out of the same. Thus, obtaining the funds for their deployment in the business is the starting point of-ariy business activity, Further, the funds required by the business may be raised cither by own sources (Equity Capital) or by outside sources (Debt Capital), The financing decisions are basically concerned with the answers to the questions like. 17 | 4e raised? =>: ; Decisions -:: The second arca'with which Of the funds raised and requi, Tana = = Swati py, ke (2): What should be.the amount of the funds that shoutg be raig ©@) What shoutd be the mix of; equity and deby capital. in wines amount of funds should bi Ls Hee “() Investment Which the 0") cee FWireg deals is the utilisation aipetiod of time, CS ae da -, @i):Current Assets : These are those pi course of business and are’capable of gettin eae peRouend tes sina » ‘The investment decisions with respect to first king ‘Capital Budgeting’. ‘The investm assets are in the form of @ Capital Budgeting : re beries Which are createg gy Mg convered ino cash sua ha A In t id of assets are ent decisions with respect to the se in the for ‘Working Capital Management’. mae ccond king: ¢ The investment decisions related to this area are basically concerned answers, to, the questions like : B > = ¥y @): How assets or projects or Proposals shoulll be chosen t, ¥ vin ? Are there any techniques available to. sclect sucl , Proposal ? : ; : ©) How the decisions regarding choice of assets or :/be made under situation of risk and ui with | ‘© make the investi h assets or Projects Projects or proposals shoula incertainty ? : assets, it may adversely affect s current assets. The decision: management attempt to ensure the balance between thes on one hand and Profitability on another, 4 » (C) Dividend Decisions : Another major ‘area 'of decision’ making by a finance manager is known as the dividend decisions, The dividend decision is concerned with the quantum of profits to’ be distributed among sharcholders, A decision has to be taken whether all the Profits are.t6 be: distributed, to retain all the profits in business or to keep a part of profits in the business and distribute others among sharcholders.: Dividend decisions depend ‘o n many factors;*such as the age of the company, the ‘nature of its business, its =Present financial: funds in future, Ownership pattern Policies, expectations of the sharchol S regarding working capital Se two principles of liquidity ders about capital appreciation or bonus share!Financial, Management : An Introduction 10. be 12, a fee Np een 19 | Examination Questions ‘Long Answer Questions he ‘salient features of What is meant by Financial Management? What are Financial Manjagement? 3 What is Business Finance. ?. Explain the traditional and ‘modern approaches of. Finance Functions of business; (Kumaun, 1999, 2000: & 2002) 3 Explain Financial Management and discuss its objectives and scope. What is finance function? Explain i brief the different approaches (concepis) to finance functions, - "Define Financial Mariagement.’ Discuss the nature and scope of Financial Management. “Finance is the life blood of industry.” Elucidate this statement. with suitable illustrations. (Kumaun, 2005) ‘What do you mean by Finance Function ? Discuss fully the functions and ‘responsibilities of a Finance Manager: 5 What do you understand by ‘Finance Function’ ? What are the functions which are performed by a Finance Manager. ? (Kumaun 2001 & 2004) What do you understand by financial decisions? Discuss the major financial - decisions. “Financial Management is ‘basically concerned with the raising and utilisation of funds for the most effective management of a business enterprise.” Examine this statement. (Kumaun, 2003) “The goal of profit. maximisation does not provide’ an’ operationally “useful criterion for measuring the ‘success of business operations.’ Explain the above statement in the context of the basic-objective of Financial‘ Management. “The basic rationale for the objective of wealth maximisation'is that it reflects the most efficient use of society’s economic resources and. thus leads to’ a maximisation of society's economic wealth”. (Ezra Solomon): Critically comment on the above statement. “Sound Financial Management is a key to progress for corporations.” Elaborate. Short Answer Questions What is meant by Financial Management? Si. Define Financial Management. : Discuss the main features of Financial Management. i State the objectives of Financial Management, q What do you mean by Finance Function? What is traditional approach of finance function? Explain modern approach of finance function. What are the responsibilities of finance manager? Distinguish between Traditional and Modern Approach of finance function.‘State whether the following statements are ‘True’, oF ‘Falser ; 1... Main objective. of financial management is maximisation of Profit 2." Investment decisions is a part of financial decisions. 7 3 “Finacial Management’ and ‘Managerial Finance’ aré' synonym tern; True) Traditional approach confines finance function only to raising of fing, (Ue) §.- Teaditonally:the role of finance manager was restricted ts. rig) efficient: allocation of funds, Nebr ta SCAUsition 6. “Business Finance is useful only for.big enterprises. ~ (False) 7. A. finance manager's concern must be. to -maintain liquidity rath, {Pals profitability, er than # > Fill in the Blanks : ° alse) 1. Dividend decisions is a part of = 2. Main. objective ‘of financial management: is 3. “Traditional approach confines finance function only to .. 4." Financial Management is a =. process, : Aas aa decisions, 2. maximisation of seal, 3. raising’ of funds Select the'correct:option from. the following : “Basic ‘objective of Financial Management is : * “ (a) Maximisation of Sales * (b) Maximisation of Wealth «(© Maximisation of Profit” .--~. (d) None of these 2. “According to traditional approach, the job of a finance manager ig = -(@) Raising. of funds, j (b), Management of Cash stati (c) Raising of. funds and their effective:utilisation (d) None of. these ‘ merge 3. Financial, decisions involve : aiaba ¢ (a) Investment, financing and dividend decisions ) (b) Investment, financing and sales decisions (c):None of these ; 4. As per modern approach to finance function the following decisions are taken: (a) Investment Decision” (b) Financing Decision (c) Dividend Decision (d) All of the above W).. "5. “Financial Management is an area of financial decision ‘making harmonising individual motives and enterprise goal.” This definition is given by : (a) JF. Bradley Spe (b) Weston and Brigham (c) JL. Massie <= (@) None of these » 6. In his traditional role the finance manager is responsible for : (a) arrangement and efficient utilisation of funds “4(b) arrangement of financial resources ‘(© acquiring capital assets for the organisation, ‘40has to play. Planning is the key to the finance manager's success, No business whether small or large, can be successful until and unless it has prepared sound financial plan. operations. By’ adopting the rational financial planning, business enterprises. are relieved of the problems posed by surplus or deficit financing. MEANING AND DEFINITION OF FINANCIAL PLANNING y There have been different view ‘points regarding the concept of financial plan. According to one view point, financial plan'means estimation of. total quantum of funds.needed for the proposed venture while another view point holds(financial plan to mean capital structure) Both these view points may be considered to be narrow in’: approach. According to the modern view point, financial plan covers the following aspects : of * (a) What types of assets ‘will be required to run the business and how-much capital will be required for them ? (b) When arid how much capital will be required’? (c) From which sources the required capital should be raised ? It can be seen from above that preparation of-financial plan is a function ‘of promotion. It is normally performed by the top management and is rarely decentralised | or delegated. The financial plan should take into consideration not only the present conditions but future and probable developments also. : Some of the definitions of financial planning are as follows : 1, Financial Plan is the act of deciding in advance the quantum of capital requirements and its forms” RM Shrivastava 2. “Financial Planning pertains only to the function. of finance and includes the determination. of the firm’s financial objectives, financial policies and financial procedures.” —Walker & Baughan 3. The financial plan of d corporation has a two-fold aspect, it refers not only o the capital structure of the corporation but also tothe financial policies which the corporation has.adopted or intends to adopt.” —Bouneville Conclusion. : Financial planning is primarily a statement estimating the amount of capital and determining its composition. It states : ‘ (i) The quantum of. finance, i.c., the amount needed for implementing the business plans, (ii) The patterns of financing, i.c., the form and proportion of various corporate securities to be issued to raise the required amount. (iii), The policies to be pursued for the floatation of various corporate securities, particularly regarding the time of their floatation. STEPS IN FINANCIAL PLANNING Financial Planning involves the following steps : ; 1. Determination of Financial Objectives : The financial objectives of a company should be clearly determined. The financial objectives of a firm can be divided into short-term objectives as well as long-term objectives. The main purpose of financial planning should be to utilise financial resources in the best possible manner. _ Financial Planning : Planning is one of the most important and basic function which any management , Infact, effective, and sound financial planning is the key to successful business” q Y). vest lon of in achieving its primary objectives. The SUCh poligs h Policiog y es. The. fin stration and distribution of hau Poli ee in 8 funds om act 2s guide to the fir 4 concern’ deal. with ‘procurement; adm in.a best possible way.. ne es 3. Formulating Financial Procedures : ‘The next step in the proces” = planning is to develop procedures that aid in the achievement of the fe 5°! Siang objectives. The procedures are. formed to ensure consistency into smal: E°%s and delegation’ of authority and responsibilty to subordinate officials 1a io" tiv’ -aseigned frianeal activities and appraisal of financial performance ofsgeet®r™m itt 4. Providing’ for: Flexibility :: The financial planning should ‘shake pany) Alexibily in objectives, policies and procedures s0 as to adjust according tag? Ses get " a é. economic situations. t nBtiig ESTIMATING FINANCIAL REQUIREMENTS x Before ‘raising capital, it is essential to make estimates for’ long: * short-term financial needs. In the absence of correct estimates the busines o™ ad: - cither from inadequate or from excess capital. If there is a shortage of font) euler will continue to struggle for existence. On the other hand, if capital is in eS tet needs then it will remain idle and may reduce earnings in comparison to inectss of, So, the estimates should be such that all financial needs are Properly satisfic ee ‘ finances required for'a business can be broadly classified into two main cates; t® (i) Fixed Capital Requirements;-and = * Boiss (i) Working Capital Requirements. ; : > (@ Estimate of Finance For Fixed Capital Requirements : Fixed capital ig funds required for the acquisition of those assets that-are to be used over and oy. for.a long period. In brief, it is required for ‘acquisition of the following -assatg (a) Tangible assets such as land, buildings, plant and-machinery, furniture fittings; etc, ee 3 i y (b) Intangible assets such-as goodwill, patents, copy rights, promotion Costs, et Ti-should be noted that the fixed capital cannot be withdrawn from the busines: without disturbing the normal working of the undertaking. It is, therefore, necessary | that sufficient’ finds to be ‘raised for acquisition. of fixed assets. ‘These ‘funds aie’ required ‘not’ énly while establishing a now enterprise ‘but also for expanding: diversifying and maintaining intact the existing enterprise. ue “The assesiment of fixed capital requirements for a business can be made by preparing a’list of the fixed assets needed by the business. Having compiled a list of the fixed assets required for the business, it will not be diffficult to ascertain the total funds required for purchase of fixed assets. The price of land can be found out from: the property agents, the-information regarding the estimated cost of construction of building can be obtained from the building contractors, the suppliers of machines can be asked to give quotations for the plant and equipments to be installed. Similarly, the amounts to be paid for patents, trade marks, ‘goodwill, etc., can also be ascertained: ‘-(ii) Estimation of Working: Capital Requirements : ‘The term working capita! refers to capital required’ for’ day-to-day operations’ of a business enterprise Particularly to complete the. operating cycle. To avoid the shortage of working capital at once, an estimate of working capital requirements should be made in advance ° that arrangements can be made to procure adequate working capital. The working capital should be determined by ‘estimating the investment in current asscts bee money expected from current liabilities,’The following factors should be taken 1%, consideration while making an estimate of working Capital requirements: _ Total costs incurred ‘on’ material, wages'and overheads.2 Finandial, Planning ; 23. 2 The length of time for which raw materials ate to remain-in'stores before they are issued ‘for: production; E Stier 3 The time taken for conversion of raw material into finished goods,” *"” 4. te length of sales cycle during which finished goods‘are’to'be kept waiting ~ lor sales. *-" pe ah aya! a e% 5. The average period of credit ‘allowed'to customers! © = 273) ?-2 6. The amount of cash required to pay day-to-day’ expenses of thé b 7. The average amount of cash requiréd to make advance payments,’ 8 The average credit period expected to be-allowed by suppliers.’ -” 9 ‘Time'lag in payment of wages ‘and other expenses. 4 s From the total amount blocked in current ‘assets estimated on the’ basis of the first seven items given above, the total of the curreit liabilities, ic, the last two items is deducted to find out the’ requirements of working capital. a IMPORTANCE OF FINANCIAL PLANNING... OR NEED FOR FINANCIAL PLANNING The success of business largely depends on sound financial planning as the expansion. and development programmes of a corporation, its profitability, earning capacity and solvency largely hinges upon sound financial, planning. The significance of financial planning is evident from the following points : 0, 1, Successful Promotion of the Business : Effective financial planning ensures the successful promotion of the business. Successful promotion of the business is only possible if a well thought out flexible financial plan is-drafted in anticipation:of the establishment of the. business. : 2. Efficient Operation of the business : All business. operations require funds. Successful operation. of business.is necessarily. dependent on adequate and. timely availability of finance. Availability of finance is closely linked with financial planning. 3. Maintaining Adequate Liquidity : In, case of efficient financial planning, the firm is capable of maintaining adequate liquid funds to meet its obligations. of, the creditors. Availability of adequate liquid funds also prevents the firm from the situation ~ of oyer-trading.and strengthens its repayment capacity, 4, Expansion and Development of Business : Efficient financial planning avoids financial difficulties in the future expansion and development of the business. 5. Changing Price Level ‘ The modern business operates in a dynamic economic world where price levels keep on changing fastly. This renders the replacement cost of the firm’s assets much higher than its acquisition cost. Therefore, replacement of obsolete assets is only possible through efficient financial planning, 6. Adequate Return-on Capital-Employed : Sound financial planning leads to the effective utilisation of capital by avoiding both the situations of under-capitalisation and over-capitalisation which are harmful to the financial interests:of a corporation. Thus, efficient financial planning leads to higher return on capital employed by the firm. 7. Optimal. Capital Structure at Minimum Cost : Efficient financial:planning also leads to the optimal capital structure of the firm at minimum cost. CHARACTERISTICS ‘OF A SOUND FINANCIAL PLAN 7 OR 8! PRINCIPLES GOVERNING A FINANCIAL PLAN The financial plan should be prepared keeping in view:the following principles :< industrial concern’: - - i implicit iS. i all and is free ‘Com complications and suspicious. There shou derstand securities as they arc likely to ercate complications in the financial pian °°, 0 ng in the mind of the potential investors about their. nature’ and profitely contyat simplicity of financial plan helps the management in procuring the nev it: 2. Objectivity : Financial planning should be, done by keeping in vie. capi - ‘objectives’ of the: company. : W the overt -3. Foresight :, The formulation. of financial plan depends upon th | capital which in its turn depends upon the scope. of operations of the bred + such, the scope of the business operations both present and future should Dusines : as accurately as: possible. : © estima ©. 4, Flexibility : The financial plan should not be rigid. The financial pi be laid down in such a way that it can be modified or adjusted if it es necessary in the light of changing business environments. i expedic ._ 5. Liquidity’ The financial plans should provide for adequate liquidity ¢g <4 the business to. absorb the shocks of its normal operations. Proper for, © enable) future payments will be helpful in planning liquidity. casti 6. Profitability : The financial plan should be profitable in terms of coy, °risk. AS such it should’ strike ‘proper balance between own capital and boss ®t! ~aptal. Too high a comport of borrowed capital may be profitable in terme ot but at the’ same time it may be too risky. The financial plan should be hoes cai in the'sense that the debt capacity of:the company should not be exceeded. Simla while deciding about issuing the securities, it should be kept in mind that contro not go out of hands. '* Seu t 7, Contingencies : The financial plan should be laid down isi such a'way that “is adaptable to meet the contingencies as and when they arisc. The business can nei! ‘have favourable conditions always. Contingencies should be anticipated in advan “and should be provided for. This does not mean that ‘excess capital should be ‘epl “idle at all the times, but it only means that the contingencies should be proper © forecasted. — He a “<3 Intensive use of funds : The financial plan has to be formulated to ensur - that the funds donot remain unused and at the same time there is no lack of fun “This is so because wasteful utilisation of capital as well as inadequacy of capital b may prove to be dangerous for the company. i sett os FACTORS TO BE CONSIDERED IN DRAFTING A FINANCIAL. PLAN: * OR i! iy FACTORS AFFECTING THE, FINANCIAL PLAN i : Financial planning is affected by’a number of factors which should be seriot iy taken’ into consideration while formulating a financial plan. Following : are’ important factors which should be kept in mind while drafting a financial plan’ yf 4 1, Nature of Industry : The nature of industry directly affects the fina ‘| ‘ planning of an enterprise. Capital-intensive industries require lazge amount of capil where: as labour-intensive ‘industriés require : relatively’ small amount ’ of- cl ‘Similarly, other factors such as—stability and regularity in earnings of the indus ~Yariation in demand of goods manufactured, possibilities of future development, also affect the quantum of capital and sources of finance of company. It is obs¢hy) that industries having stability ‘and regularity in earning can easily procure can from’ the' market’ : able to! ‘}Financial: Planning bay 1. Standing of the Concern The standing.of a.concern will influence a decision. about financial plan. The goodwill of the concern, credit rating in the market, past . Performance, attitude of thé management’ are ‘some of the factors which will be considered in ‘formulating a financial plan: TUS inthe crepe ge 3. Amount of Risk : The risk involved in the business should also, be discussed while planning the sources of funds. The business having: moré risks should issue - ownership securities only while enterprises with stable earnings expectation‘can take advantage of trading on:equity. Site 4. Appraisal of Alternative Sources. of Finance: The -financial plan of an | ‘ enterprise also-depends upon the availability of the alternative ‘sources’of finance at the time of need. The pros. and cons of all available sources should be’ properly discussed for taking a final decision on the sources. 5. Plans for the Future Expansion : The future plan of a-concern'should also be considered while formulating a financial plan. The plans for expansion. and diversification in near future will require: a flexible financial plan; The-sources of funds should be such which will facilitate required funds without any difficulty. * 6. Attitude of Management : The financial plan is also affected by the attitude of the management of the industrial tnit. If the existing owners and-management want to retain the control of ‘business in their-hands, they would not like to°issue equity shares in large quantity. If they'do so, they would purchase:a majority of such shares themselves. They would prefer debt capital even for. expansion or diversificantion programmes in future. Ploughing back of profits is always preferred sin such business enterprises. 7. General Economic Conditions : The prevailing economic conditions at the national level and international level will influence a decision about financial plan. These conditions should be considered before taking any decision about sources of funds. A favourable economic environment will help in raising funds without any difficulty’ On the other hand, uncertain economic conditions may make it difficult for even a reputed concern to raise sufficient funds, : : 8. Government Control : Government policies, financial controls and other statutory rules and regulations should also be considered while formulating a financial plan. ‘ LIMITATIONS OF FINANCIAL PLANNING. Some of the limitations of financial planning are discussed as follows : 1. Errors of Forecasting : Financial plan is based upon forecasts which may not be estimated accurately. If forecasting is wrong, the financial plan would be uneffective. Thus, ‘a financial plan should be periodically reviewed and necessary changes must be made in accordance with the changing economic and business environment, 2. Problem of Co-ordination: : Absence: of co-ordination among the various functions of business and indecisiveness on the part of the management may make the financial plan ineffective. 3. Rapid Changes : Changes in economic conditions and government policies also exert adverse influence on the effectiveness of a financial plan. 4, Attitude of Financial Manager : Many times, in practice, there is reluctance ot inability on the part of management to change the financial plan, once it is made. Firstly it may be due to the fact that the plans like capital: expenditure involves commitment of huge funds made well in advance and it may not be possible to change it radically. Secondly, management may be psychologically against the change.Examination Questions 2+ Long Answer Questions _ Define Financial Planning and write a note on the need of Figg fe ; : ‘nancial py.’ ‘:What-do you understand by financial i ig Ruma “ 1 planning? i umaun, yet * financial planning for successful business operator eet the import What are the chief characteristics of a some n factors influencing financial planning.” . What considerations would you keep in mind while drafting an industrial concern? Are there some limitations of reese 1 phat do you understand by a financial planning? Explain Tac Hh R, financial plang Emu 29 a a 19 t financial ‘ae % Blaniingy 2 t lors ae ‘ue : : eter Financial Planning is the key to successful bu 2 zaetoe siness ‘operation on this statement discussing the importance of a Perations, financial plan, C°™%me pe a ct B. Explain the main characteristics of a. sound financial pista Agra, 199 2: ae : Seiad ad BRA, ‘Financial Planning is the. key to successful business operations = discuss the basie-characteristics of a financial plan of a joint sc : : jo aay company Discuss the sendniae fcc RAs Agra, 1995 ; types and factors determining financial planning: : - BRA. i Short Answer Questions Ae What is financial planning? ioe as What are the-chief characteristics of-a sound financial plan? + Explain the factors determining financial planning, Are there some limitations of ‘financial planning’? How can you'assess financial requirements of an enterprise? 5 a Objective Questions : State whether the following statements are.‘True’-or ‘False’ : > Agra, 19. Financial planning depends upon future estimations. dr Financial planning is concerned with procurement and not with use of fun i PB { : (Fal Financial planning and financial plan are the same thing. (Fal Financial planning is not an important. and essential financial process. (Al Success of a business depends upon its sound financial planning. i Financial planning may be short-term, medium-term, or long-term. & Longer the manufacturing period, the-greater.is the requirement of wot! capital. : The best time of floatation of company’s securities is the boom period: (a a Fill in the Blanks : Financial planning depends upon: Financial planning is the key to. Ans.,(1) future, (2) successful’! ik stimations. usiness operations.Capitalisation Capitalisation is onc of the-most important constituents of fin: term “Capitalisation” has been derived from the word capital and in it refers'to the total amount of capital employed in a business: | The term capitalisation has been used differently in different contexts. Broad Interpretation ‘of Capitalisation : : Many authors regard Capitalisations as synonymous with financial planning. Broadly speaking, the term ‘Capitalisation’ refers to the process of determining the plan of financing, It includes not merely the determination of the quantity of finance required for a company but also the decision about the quality of financing, In this sense, capitalisation includes : : (i) Estimating the total amount of capital to be raised; (ii) Determining the type of securities to’be issued: and Gii) Determining the composition’ or proportion of the various securities to be issued. ancial plan; The common practice Narrow Interpretation of Capitalisation : In its narrow sense, the term Capitalisation’ is used in its quantitative sense and Tefers to the process of determining the quantum’ of funds that a firm needs to run its business. According to the scholars holding this view, thé decisions regarding the form or composition of capital fall under the term “Capital Structure”, Valuation Concept of Capitalisation : In this sense ‘Capitalisation’ refers to an activity or process of determining the required capital for a ‘business concern, Valuation concept may differ for a newly-promoted concern and already established concern, * s ; In ‘the case of newly promotéd concern, capitalisation signifies that amount of capital which is sufficient enough to cover the cost and expenses incurred right from the establishment to work-operations. In the case of already established concern, capitalisation refers to the present valuation of total capital employed/invested. 4 DEFINITION OF CAPITALISATION Definitions Based on Traditional Approach of Capitalisation : 1. “Capitalisation means the total accounting value’ of all the capital regularly employed in the business”. —Gestenberg 2. “Capitalisation of a corporation comprises the ownership capital and the borrowed capital as represented by long-term indebtedness.” » =Lillion Doris Definition Based on Modern Approach : Though the narrower interpretation of capitalisation is more popular because of its being very specific in the meaning, the modern thinkers consider that even short-term creditors should be included :in capitalisation. In the words of Walker and Bauighn, “Capitalisation: refers only to long-term debt and capital stock; and short-term creditors do not constitute suppliers of capital is crroncous. In reality, total capital is furnished by short-term creditors and long-term creditors.” ‘NEED OF. CAPITALISATION The need of capitalisation ariscs not only at the time of ; ~ promotion of a company but may also arise as a going concern oan °o*POra during the life time of.a corporation: Generally, the problem of e°tPPOMot under. the following conditions.: zs Capitalisation 1. At the time of promotion/incorporation of a company. 2.-At the time of expansion of an existing company. 3 “s°3.°At the’ time of amalgamation and’absorption of ‘two ‘or ‘m 4. At the time of ré-organisation’ of capital of a company, _ Whatever may be the situation, this problem will always come § capital will be needed for implomentation of the plan'and deciding thie” Ba capitalisation.» na ‘ i “ 8 this is ea, Theories of Capitalisation: © « i ae as -There arc two important -theories which act as guidelines for deter, amount of capitalisation. Nah, ay "4. Cost Theory of Capitalisation : Cost. theory of capitalisation ¢ amount of capitalisation on the basis of cost of various assets required to 5 = organisation. It gives more stress on current outlays than on the requirement are necessary to accomodate the investment on a'going concern basis. The pa need the funds to invest in fixed and current assets and also to’ meet, promant and organizational expenses. The total sum required for all these purposes giver amount of capitalisation. The. cost theory of capitalisation seems to be ideal if considers, the actual funds to. acquire various, assets, but it does not contides earnings capacity of, these asscts. If the amount of capitalisation arrived at on basis includes the. cost.of assets acquired at inflated costs or the cost of idle an obsolete assets, the, earnings are bound to be low which will not be able to favourable return on the cost of assets and this will result into over capitalisation’ ©" 2, Earning Theory of Capitalisation : This theory is based on the fact that it amount of capitalisation’ is correlated with the amount of earnings. Earnings theo of capitalisation considers he amount of capitalisation on the basis of expected futut earnings of the company,,by capitalising the future earnings .at the approprial capitalisation rate. : i : It is obvious that the -above theory has two basic elements : (i) Estimated « expected earnings (income), and (ii) Current rate of Capitalisation (normal rate ¢ return). = ce : i Thuis, for determining the amount of capitalisation, it is necessary to take th following steps : pe : eH * (a). To Decide Future Earnings : Estimations of future earnings is comparativel easier in'the case of existing concerns as there can be some basis of past data,,02 can estimate the income-on the basis of average profits (incomes) of past few yout Of. course, appropriate adjustments for extra-ordinary/non-recurring income a expenses have to be made. In case of a newly set-up concern estimations of ; earnings can be done by analysing the carning capacity of the similar concerns: a can make estimates about sales; operating expenses, revenues, etc. of newly prom” concern. s it (b) To Determine Capitalisation Rate : This's, the most tricky and delicate ands entirely a subjective concept. The concept of capitalisation rate may '@ of:the:following forms : fells mt OFC Company ‘mining tl «gy onsideZ Capitalisation. - 33 (i) It is the rate of return that ig i reed to attract investors to the particular organisation, (ii) It is the cost of capital. (iii) It is the rate of earnings of the similar organizations in the same. indust (©) To Capitalise the Future Earnings ‘at the Decided Rate.of Capitalisation : _ Expected Income x 100° * Amount of Capitalisation = Ger nag of Capitalisation For example, the expected earnings of A Ltd: is Rs. 50,000 and current rate of Capitalisation is" 10%, then “the ‘amount of * Capitalisation” would be 50,000 x 100 3907 = Rs. 500,000. Earnings theory of capitalisation seems to be logical because it correlates the value of a firm or the amount of capitalisation directly with its earning capacity. However, this theory can only be applied when the firm’s expected income and capitalisation rate can precisely be estimated. In real life, it is very difficult to estimate correctly the future earnings as well as to determine the capitalisation rate. EARNING THEORY. VS. COST THEORY “Both of the above theories. have their own limitations. As such, in’ case: of established concerns, earning theory may be useful, whereas new concerns may prefer cost theory to decide the amount of Capitalisation. 5 STAGES OF CAPITALISATION : (A) Over-Capitalisation : When a company has consistently been unable to earn the -prevailing rate of. return on. its capital employed, the situation is termed as over-capitalisation. In simple words, over capitalisation means existence of excess capital as compared to the level. of activity and PERE, Some important definitions of over-capitalisation are as follows : 1. “When a business is unable to earn a fair rate of rotate Ou is outstanding sees, it is over capitalised.” — Bonneville and Dewey 2, “A corporation is-said to be over-capitalised when its earnings are not large enough to yield a fair return on the amount of stocks and bonds that have been issued or when the amount of securities outstanding exceeds the current value of assets.” —Gestenberg 3. “When a company has consistently been unable to earn the prevailing rate of return on its outstanding securities (considering the earnings of similar companies in the same industry and the degree of risk involved) it is said to. over-capitalised.”. =H. Gillbert 4. “Whenever the aggregate of the par-values of stocks and bonds outstanding exceeds the true value of fixed assets, the corporation was said to be éver-capitalised,”” —Hoagland HOW OVER.CAPITALISATION CAN BE IDENTIFIED ? Or TEST. OF OVER-CAPITALISATION One can gain knowledge about over-capitalisation by using any one of the following parameters : (i) Actual Rate of Earnings < Current Rate of Earnings.Real value of the Business’ <'Bodk'vaiue of the Buy, ~ (ii) Real value. of the Shares <"Book value’ of the Shareg ‘sigs +). In other words, any of the above relationshi of over-capitalisation. --Pelanaton of oft terms Use Capital Eee X 100 Rate of earnings of con same line of busine: normal rate of return, 3. Book Value of ihe Business = Total Assets — Outside Average Profit Current Raté of Reta * 100 = _ Book Value of the Business No. of Equity Shares ‘Real Value of thé Bustnsg “No. of Equity Shares ee CAUSES, oF’ ‘OVER CAPITALISATION T™Panies SS activity. 1 a Lani eof EE: 2 Over- estimation of averay ie annual ear ¥ Sometimés, while Sie a new company. i promoters over-estimate the financial requirenients, ‘and as a result, they re ‘capital thar what is actually needed, resulting in‘ over-capitalisation, ‘4; High Promotion Expenses : Incurring high promotional expensés, exces preliminary expenses etc, may lead 'to over- capitalisation. * . Liberal Dividend Policy : The company might have followed ‘the ‘leni dividend | policy: witout bothering much about building up the reserves: As a the retained profits of the company may be adversely affected. Inadequate Depreciation : ‘Adequate provision might not have been depreciato on'the. assets. As such, the real value of the asscts is less, than the b bea aloe of the assets: Formation’ of the Company. during: Inflationary Period : If a compat) 4 floated under. the conditions of inflation, it-requires a large fund for acquiring # d necessary asscts. But when. depression sets in, naturally, the prices ee the assets f which ultimately leads to over-capitalisation. - oft 8. Taxation Policy : High rates of taxation may leave little in the hands q “management to provide for: depreciation, replacements; and dividends. “adversely affect eatnings capacity and thus leads to over-capitalisation- .. EFFECTS OR EVILS OF OVER-CAPITALISATION Over-capitalisation:affects not only.the company and its shareholde' the society asa whole. The evil effects of over-capitalisation are discuss”! ders but