INTRODUCTION TO FINANCIAL MANAGEMENT Serres After studying this chapter, you should be able to understand : Meaning, definition and evolution of finance and financial management. Nature of financial Management. Significance or importance of financial management. Finance function - approaches and scope. ‘Scope of financial management. Relationship of finance with other business functions. Objectives of financial management-profit maximisation and wealth maximisation, Financial decisions — investment, financing, dividend, and working capital decisions, Inter-relation of financial decisions. Financial management process. Functional areas of financial management. Organisation of the finance function or role of finance manager. © INTRODUCTION In our present day economy, finance is defined as the provision of money at the time when it is Tequired. Every enterprise, whether big, medium or small, needs finance to carry on its operations - —_——i, 12 Introduction to Financial and to achieve its targets. In fact, finance is so indispensable today that it is rightly said to be lifeblood of an enterprise. Without adequate finance, no enterprise can possibly accomplig, is ‘ i ives. ‘The subject of finance has been traditionally classified into two classes : (i) Public Finance , (i) Private Finance. Public finance deals with the requirements, receipts and disbursements of fungg in the government institutions like states, local self-governments and central government. Private finance is concerned with requirements, receipts and disbursements of funds in case of an individuay a profit seeking business organisation and a non-profit organisation. " Thus, private finance can be classified into : (i Personal finance; (ii) Business finance ; and (iii) Finance of non-profit organisations, SE. dt PUBLIC FINANCE PRIVATE FINANCE © GOVERNMENT INSTITUTIONS: ‘© PERSONAL FINANCE © STATE GOVERNMENTS ‘@ BUSINESS FINANCE © LOCAL SELF-GOVERNMENTS ‘© FINANCE OF NON-PROFIT ORGANISTIONS ‘© CENTRAL GOVERNMENT Personal finance deals with the analysis of principles and practices involved in managing one’s ‘own daily need of funds. The study of principles, practices, procedures, and problems concerning financial management of profit making organisations engaged in the field of industry, trade, and commerce is undertaken under the discipline of business finance. The finance of non-profit organisation is concerned with the practices, procedures and problems involved in financial management of charitable, religious, educational, social and other similar organisations. tm MEANING OF BUSINESS FINANCE Literally speaking, the term ‘business finance’ connotes finance of business activities. It is composed of two words (i) business, and (ji) finance Thus, itis essential to understand the meaning of the two words, business and finance, which is the starting point to develop the whole concept and meaning of the term business finance. ‘The word ‘business’ literally means a ‘state of being busy’. All creative human activities relating to the production and distribution of goods and services for satisfying human wants are known as business. It also includes all those activities which indirectly help in production and exchange of goods, such as, transport, insurance, banking and warehousing, etc. Broadly speaking, the term “business’ includes industry, trade and commerce. ’ ‘Wheeler defines business finance as, “That business activity which is concerned with the acquisition and conservation of capital funds in meeting the financial needs and overall objectives of business enterprise.”Introduction to Financial Management 13 ‘According to Guthmann and Dougall, “Business finance can be broadly defined as the activity concemed with the planning, raising, controlling and administering the funds used in the business.” In the words of Prather and Wert, “Business finance deals primarily with raising, administering and cisbursing funds by privately owned business units operating in non-financial fields of industry.” Finance may be defined as the provision of money at the time when it is required. Finance refers to the management of flows of money through an organisation. It concerns with the application of skills in the manipulation, use and control of money. Different authorities have interpreted the term ‘finance’ differently. However, there are three main approaches to finance : (i) The first approach views finance as to providing of funds needed by a business on most suitable terms. This approach confines finance to the raising of funds and to the study of financial institutions and instruments from where funds can be procured. (ii) The second approach relates finance to cash. (iii) The third approach views finance as being concerned with raising of funds and their effective utilisation. Having studied the meaning of the two terms business and finance ; we can develop the meaning of the term ‘business finance’ as an activity or a process which is concerned with acquisition of funds, use of funds and distribution of profits by a business firm. Thus, business finance usually deals with financial planning, acquisition of funds, use and allocation of funds and financial controls. Business finance can further be sub-classified into three categories, viz ; ( sole-proprietory finance, i) partnership firm finance, and (iii) corporation or company finance. Eien oan SOLE-PROPRITORY PARTNERSHIP FIRMS COMPANY OR FINANCE FINANCE CORPORATION FINANCE The above classification of business finance is based upon the three major forms of organisation for a business firm. In sole proprietorship form of organisation, a single individual promotes, finances, controls and manages the business enterprise. He also bears the whole risk of business. A partnership, on the other hand, is an association of two or more persons to carry on as co-owners of a business and to share its profits and losses. It may come into existence either as a result of the expansion of sole-trade business or by an agreement between two or more persons. The liability of the partners is unlimited and they collectively share the risks of the business. A joint stock company or a corporation is an association of many persons who contribute money or money's worth to a ‘common stock and employ it in some trade or business and who share profit and loss arising there“4 from. In the words of Chief Justi fic ice Marshall, “a corporation is an artificial and existing only in contemplation of the law. Being a mere creation of law, it possess’ properties which the charter of its creation confers upon it either incidental t9 sve existence”. Corporation is a legal entity having limited liability, perpetual sui seal. A corporation is regarded as something different from its owners. The a are owned by it rather than its members, and a corporation’s liabilities are th corporation, not the owners or the members. ‘As the present day sama as ees TET ser i y ‘oblems of the form of organisation, there is a need to give is to the finance ae ircomporatet enterprises and that is why, some authorities 3° Fr 2 business finance and corporation finance. Further, the principles of business both smal (propaetry) and large xxpoation forme of busines nT . GEMENT im MEANING AND DEFINITION OF FINANCIAL MANA\ Financial management refers to that part of the management activity which is © rm Pt resources. It deals with finding ‘out various sources for eds of the business. planning and controlling of firm’s financi hn ims, The sources must be suitable and ‘economical for the m of financial i. As a separate "cs for its theoretical issets of the corporation e obligations of the is concerned with the raising funds for the ‘The most appropriate use of such funds also forms a part of f managerial activity, it has a recent origin. ‘This draws heavily on Econo! concepts. management is an area of financial decision-making, In the words of Weston and Brigham, “Financial harmonising individual motives and enterprise goals.” “JF, Bradley defines financial management as, “the area of ‘the business management devoted to a judicious use of capital and @ careful vraction of sources of capital in order tO enable a spending unit to Move in the direction of reacting its goals.” Massie, “Financial management is the operational activity of a business that is nd effectively utilising the funds necessary for efficient operations.” Howard and Upton are of the opinion that fi rent is the application of the planning and nancial managem control functions to the finance function. ‘According to Phillippatus, “Financial management is concerned with the managerial decisions that result n te acquisition and fnancing of short term and long fom credits for the firm.” Ezra Solomon and John J. Pringle are of the opinion that Financial Management is concerned with the effective use of an important economic resource, namely capital fund.” it is clear that financial management is a specialized branch of Janning, obtaining and effectively utilizing the firm's ‘According to J.L. responsible for obtaining a From the above definition, management which is concerned with pI financial resources. = NATURE OF FINANCIAL MANAGEMENT Financial management refers to that of busi ivit ich is t eee maa part usiness activity which is concerned with the Th : nature of financial management is concerned with its functions, objectives, goals and{Introduction to Financial Management 15 seope, which have been discussed as separate topics later in this chapter. However, the main characteristics of financial management are explained as below. 1. Specialised Branch of General Management. Financial management is a specialized branch of general management like production, marketing, human resource etc. It is concerned with planning and controlling of firm’s financial resources. 2, Integral Part of Management. Financial management is an integral part of overall management. It is pervasive throughout the organisation as all activities of a firm need finance. Thus, it occupies the central position in the organisation. Both an Art as well as a Science. Financial management is neither a pure art nor a pure science. It is both a science as well as an art. It has certain well defined principles and uses various methods and techniques like capital budgeting, statistical and mathematical models and computer applications. It is also an art as practiced by the financial managers. It requires gertain skills in decision marking. Growing as a Profession. Financial management has emerged as a_separate discipline of study and is fast growing as a profession. It provides a variety of financial services like planning, acquisition and effective utilization of financial resources for long-term as well as short-term financial needs of a firm. Multidisciplinary Approach. Financial management is multi disciplinary in approach. It depends upon other disciplines like economics, accounting etc. Involves Risk-Return Trade off. Financial management is concerned with investment, financing and dividend decisions of a firm. All these decisions are inter related and involve trade off between risk and return. An efficient financial management has to take decision in relation to its effect on the shareholder's wealth. 7. Focus on Valuation of the Firm. The main focus of financial management is towards maximizing the value of the firm. It includes the maximisation of stockholder’s wealth as well as other financial claimholders such a s debenture holders, preferred stockholders, etc. » - s s 8. Organic Function. Financial management is an organic function that is needed by all organizations whether business or non-business, big or small, sole proprietary or corporate form or organisation. 9. Attainment of Common Objectives of a Firm. Financial management helps in the attainment of common objectives of an enterprise by maximizing the profits and wealth of its stakeholders. 10. Backbone of Commerce and Industry. Financial management is not only an essential function for the survival, growth and expansion of a firm, it is also a backbone of commerce and industry of a nation. m EVOLUTION OF FINANCIAL MANAGEMENT Financial management emerged as a distinct field of study only during the twentieth century. But even before that some references were made to the finance function as a branch of economics_, oo setvodection to Fine Hrsg, ‘The evolution of financial management can be studied under the following, three phases 1. The Traditional Phase 2. The Transitional Phase 3. The Modern Phase © 1. The Traditional Phase Financial management emerged as a distinct field of study only in century as a result of consolidation movement and formation of tare seen pornlas ener In the initial stages of the evolution of financial management, emphasis was placed on the onan” sources and forms of financing the large sized business enterprises. The grave economic receon, 1930's rendered difficulties in raising finance from banks and other financial institutions. Tee, emphasis was laid upon improved methods of planning and control, sound financial structure of the firm and more concern for liquidity. The ways and means of evaluating the credit worthiness of firms were developed. © 2. Transitional Phase The post World War II era necessitated reorganisation of industries and the need for selecting sound financial structure. In the early 50's the emphasis shifted from the profitability to liquidity and from institutional finance to day to day operations of the firm. The techniques of analysing capital investment in the form of ‘capital budgeting’ were also developed. Thus, the scope of financial management widened to include the process of decision-making within the firm. C1 3. The Modern Phase The modern phase began in mid-fifties and the discipline of financial management has now “become more analytical and quantitative. 1960's witnessed phenomenal advances in the theory of ‘portfolio analysis’ by Microwitz, Sharpe, Lintner etc. Capital Asset Pricing Model (CAPM) was developed in 1970's. The CAPM suggested that some of the risks in investments can be neutralised by holding of diversified portfolio of securities. The ‘Option Pricing Theory’ was also developed in the form of the Binomial Model and the Black-Scholes Model during this period. The role of taxation in ersonal and corporate finance was emphasised in 80's. Further, newer avenues of raising finance vith the introduction of new capital market instruments such as PCD’s, FCD’s, PSB’s and CPP’s etc. ere also introduced. Globalisation of markets has witnessed the emergence of ‘Financial ngincering’ which involves the design, development and implementation of innovative financial struments and the formulation of creative optimal solutions to problems in finance. The techniques models, mathematical programming and simulations are presently being used in corporation ance and it has achieved the prime place of importance. We may conclude that financial agement has evolved from a branch of economics to a distinct subject of detailed study of its n. SIGNIFICANCE/IMPORTANCE OF FINANCIAL MANAGEMENT Finance is the life blood and nerve centre of a business, just as circulation of blood is essential in uman_ body for maintaining life, finance is very essential to smooth running of the business. ItIntroduction to Financial Management w has been rightly termed as universal lubricant which keeps the enterprise dynamic, No business, whether big, medium or small can be started without an adequate amount of finance. Right from the very beginning, ie. conceiving an idea to business, finance is needed to promote or establish the business, acquire fixed assets, make investigations such as market surveys, etc., develop product, keep men and machine at work, encourage management to make progress and create values. Even an existing concern may require further finance for making improvements or expanding the business. Thus, the importance of finance cannot be over-emphasised and the subject of business finance has become utmost important both to the academicians and practising managers. The academicians find interest in the subject because the subject is still in its developing stage and the Practising managers are interested in the subject because among the most crucial decisions of a firm are those related to finance. The importance of financial management has arisen because of the fact that present day business activities are predominantly carried on company or corporate form of organisation. ‘The advent of corporate enterprises has resulted into : (i) the increase in size and influence of the business enterprises, (ii) wide distribution of corporate ownership, and (iii) separation of ownership and management. The above three factors have further increased the importance of financial management. As the owners (shareholders) in a corporate enterprise are widely scattered and the management is separated from the ownership, the management has to ensure the maximisation of owner's economic welfare. The success and growth of a firm depends upon adequate return on its investment. The investors or shareholders can be attracted by a firm only by maximisation of their wealth through the application of principles and procedures as laid down by Financial Management. The knowledge of the discipline of Financial Management is important not only to the practising managers, but also to others who deal with a corporate enterprise, such as investors, lenders, bankers, creditors, etc., as there is always a scope for the management to manipulate and ‘window dress’ the financial statements. In the present day capitalistic regime, the size of the business enterprises is increasing resulting into corporate empires empowered with a lot of social and political influence. This makes financial management all the more important. Further, if we refer to corporation finance as the financial management practiced by business firms, the importance of financial management can well be described as the importance of corporation finance. Financial management is applicable to every type of organisation, irrespective of its size, kind or nature. It is as useful to a small concern as to a big unit. A trading concer gets the same utility from its application as a manufacturing unit may expect. This subject is important and useful for all types of ownership organisations. Where there is a use of finance, financial management is helpful. Every management aims to utilise its funds in a best possible and profitable way. So this subject is acquiring a universal applicability.of funds as and when ‘required at the ‘minimum possible cost: a financial planning and: successful promotion of an enterprise; : - ii) | proper use a and allocation of funds ; ee a) taking sound financial decisions; a __ = — _™ improving the profi itability through financial controls ; j - _(¥i) | _ increasing the wealth ofthe investors and the nation and — (vii) | Promoting and mobilising individual and corporate s savings. 7 a FINANCE FUNCTION Finance function is the most important of all business functions. It remains a focus of all Activities. It is not possible to substitute or eliminate this function because the business will close down in the absence of finance. The need for money is continuous. It starts with the setting up of an enterprise and remains at all times. The development and expansion of business rather needs more commitment for funds. The funds will have to be raised from various sources. The sources will be selected in relation to the implications attached with them. The receiving of money is not enough, its utilisation is more important. The money once received will have to be returned also. If its use is proper then its return will be easy otherwise it will create difficulties for repayment. The anagement should have an idea of using the money profitably. It may be easy to raise funds but it * be difficult to repay them. The inflows and outflows of funds should be properly matched. m= APPROACHES TN FCINANSE FCIINGTIONIntroduction to Financial Management 19 The traditional approach to the scope and functions of finance has now been discarded as it suffers from many serious limitations : (i) Itis outsider-looking in approach that completely ignores internal decision making as to the proper utilisation of funds. (ii) ‘The focus of traditional approach was on procurement of long-term funds. Thus, it ignored the important issue of working capital finance and management. (iii) The issue of allocation of funds, which is so important today is completely ignored. (iv) It does not lay focus on day to day financial problems of an organisation. © 2. The Modern Approach : ‘The modern approach views finance function in broader sense. It includes both raising of funds as well as their effective utilisation under the purview of finance. The finance function does not stop only by finding out sources of raising enough funds, their proper utilisation is also to be considered. The cost of raising funds and the returns from their use should be compared. The funds raised should be able to give more returns than the costs involved in procuring them. The utilisation of funds requires decision making. Finance has to be considered as an integral part of overall management. So finance function, according to this approach, covers financial planning, raising of funds, allocation of funds, financial control etc. The new approach is an analytical way of dealing with financial problems of a firm. The techniques of models, mathematical programming, simulations and financial engineering are used in financial management to solve complex problems of present day finance. The moder approach considers the three basic management decisions, ie,, investment decisions, financing decisions and dividend decisions within the scope of finance function. @ AIMS OF FINANCE FUNCTION The primary aim of finance function is to arrange as much funds for the business as are required from time to time. This function has the following aims : 1. Acquiring Sufficient Funds. The main aim of finance function is to assess the financial needs of an enterprise and then finding out suitable sources for raising them. The sources should be commensurate with the needs of the business. If funds are needed for longer periods then long-term sources like share capital, debentures, term loans may be explored. ‘A concern with longer gestation period should rely more on owner's funds instead of interest-bearing securities because profits may not be there for some years. rv . Proper Utilisation of Funds. Though raising of funds is important but their effective utilisation is more important. The funds should be used in such a way that maximum. benefit is derived from them. The returns from their use should be more than their cost. It should be ensured that funds do not remain idle at any point of time. The funds committed to various operations should be effectively utilised. Those projects should be preferred which are beneficial to the business.os” Iniradvation to Fence Maneaeg, 9. Increasing Profitability, The planning, and control of finance Sanction aime at increns, yet true thats generaten money. To Increane profitabyyy Y, profitability of the eon sufficient funds will have to be invested, Hinance function should be 90 planned thay 4” Concern neither nuffers from inadequacy of funds nar wavtes more funds than required. ¢ proper control should also be exerciied no that scarce resources are not frittered away oy nical operations. The cost of acquiring, funds also influences profitability of y., in. If the cont of raining, funds in more, then profitability will go down. Financ, une unit function also requires matching of cont and returns from funds: Maximising Firm‘s Value, Finance function also aims at maximising, the value of the firm It in generally aid that a concern’s value is linked with ity profitability. Even though, profitability influences a firm’s value but it is not all, Besides profits, the type of wources nds, the cost of funds, the condition of money market, the demand for wed for raising products are some other considerations which also influence a firm’s value. m SCOPE OR CONTENT OF FINANCE FUNCTION/FINANCIAL MANAGEMENT The main objective of financial management is to arrange sufficient finances for meeting short- term and long-term needs, These funds are procured at minimum costs so that profitability of the business is maximised, With these things in mind, a Financial Manager will have to concentrate on the following areas of finance function. SCOPE OR CONTENT OF FINANCE FUNCTION/FINANCIAL MANAGEMENT 1. | Estimating Financial Requirements Deciding Capital Structure | Selecting a Source of Finance | Solecting a Pattern of Investment | Proper Cash Managomont | | implementing Financial Controls gt | Proper Use of Surpluses 1, Estimating Financial Requirements. The first task of a financial manager is to estimate short-term and long-term financial requirements of his business. For this purpose, he will prepare a financial plan for present as well as for future. The amount required for purchasing fixed assets as well as needs of funds for working capital will have to be ascertained, The estimations should be based on sound financial principles so that neither there are inadequate nor excess funds with the concern. The inadequacy of funds will adversely affect the day-to-day working of the concern whereas excess funds may tempt a management to indulge in extravagant spending or speculative activities. 2. Deciding Capital Structure. The capital structure refers to the kind and proportion of different securities for raising funds. After deciding about the quantum of funds required it should be decided which type of securities should be raised. It may be wise to finance fixed assets through long-term debts. Even here if gestation period is longer, then shareIntroduction to Financial Management mn » capital may be most suitable. Long-term funds should be employed to finance working capital also, if not wholly then partially. Entirely depending upon overdrafts and cash credits for meeting working capital needs may not be suitable. A decision about various sources for funds should be linked to the cost of raising funds. If cost of raising funds is very high then such sources may not be useful for long. A decision about the kind of securities to be employed and the proportion in which these should be used is an important decision which influences the short-term and long-term financial planning of an enterprise. Selecting a Source of Finance. After preparing a capital structure, an appropriate source of finance is selected. Various sources from which finance may be raised, include : share capital, debentures, financial institutions, commercial banks, public deposits, etc. If finances are needed for short periods then banks, public deposits and financial institutions may be appropriate ; on the other hand, if long-term finances are required then share capital and debentures may be useful. If the concern does not want to tie down assets as securities then public deposits may be a suitable source. If management does not want to dilute ownership then debentures should be issued in preference to shares. The need, purpose, object and cost involved may be the factors influencing the selection of a suitable source of financing. . Selecting a Pattern of Investment. When funds have been procured then a decision about investment pattern is to be taken. The selection of an investment pattern is related to the use of funds. A decision will have to be taken as to which assets are to be purchased ? The funds will have to be spent first on fixed assets and then an appropriate portion will be retained for working capital. Even in various categories of assets, a decision about the type of fixed or other assets will be essential. While selecting a plant and machinery, even different categories of them may be available. The decision-making techniques such as Capital Budgeting, Opportunity Cost Analysis etc. may be applied in making decisions about capital expenditures. While spending on various assets, the principles of safety, profitability and liquidity should not be ignored. A balance should be struck even in these principles. One may not like to invest on a project which may be risky even though there may be more profits. . Proper Cash Management. Cash management is also an important task of finance manager. He has to assess various cash needs at different times and then make arrangements for arranging cash. Cash may be required to (a) purchase raw materials, (b) make payments to creditors, (c) meet wage bills ; (d) meet day-to-day expenses. The usual sources of cash may be : (a) cash sales , (b) collection of debts, (c) short-term arrangements with banks etc. The cash management should be such that neither there is a shortage of it and nor it is idle. Any shortage of cash will damage the creditworthiness of the enterprise. The idle cash with the business will mean that it is not properly used. It will be better if Cash Flow Statement is regularly prepared so that one is able to find out various sources and applications. If cash is spent on avoidable expenses then such spending may be curtailed. A proper idea on sources of cash inflow may also enable to assess the utility of various sources. Some sources may not be providing that much cash which we should have thought. All this information will help in efficient management of cash. . Implementing Financial Controls. An efficient system of financial management necessitates the use of various control devices. Financial control devices generally used are:Ss Introduction to Financial Managemen, @ i e nial pee (b) Budgetary Control, (c) Break Even Analysis., (d) Cost Contro}, aaa (P) Cost and Internal Audit. Return on investment is the best contro} oe a the performance of various financial policies. The higher this percentage, y be the financial performance. The use of various control techniques by the finance manager will help him in evaluating the performance in various areas and take corrective measures whenever needed. 7. Proper Use of Surpluses. The uitlisation of profits or surpluses is also an important factor in financial management. A judicious use of surpluses is essential for expansion ang diversification plans and also. in protecting the interests of shareholders. The ploughing back of profits is the best policy of further financing but it clashes with the interests of for paying dividend and retaining shareholders. A balance should be struck in using funds earnings for financing expansion plans, etc. The market value of shares will also be influenced by the declaration of dividend and expected profitability in future. A finance manager should consider the influence of various factors, such as : (a) rend of earnings of the enterprise, (b) expected earnings in future, (c) market value of shares, (d) need for funds for financing expansion, etc. A judicious policy for distributing surpluses will Pe essential for maintaining proper growth of the unit. 12. m@ RELATIONSHIP OF FINANCE WITH OTHER BUSINESS FUNCTIONS/DISCIPLINES ‘Business function’ means functional activities that an enterprise undertakes in achieving its ied on the basis of its operational activities. desired objectives. These functions may be classifi Pete en deur aU ¥ ¥ ¥ ¥ ¥ RESEARCH AND El PRODUCTION | | DISTRIBUTION] | ACCOUNTING | | PERSONNEL | | pevELOPMENT FUNCTION FUNCTION FUNCTION FUNCTION FUNCTION FUNCTION Finance function of a business is closely related to its other functional areas. Funds will be wasted in the absence of efficient production and in the absence of proper marketing, the firm will not be ible to engage funds judiciously in the business. Most of the important decisions of a business mterprise are taken on the basis of availability of funds. However, finance function in practice should ot limit the general running of the business. Financial policies of a firm should be devised in such a :anner $0 as to match the requirements of other functional areas. ‘The relationship between finance function and other business functions of an enterprise is iscussed below : 1. Purchase Function. Materials required for production of commodities should be procured on onomic terms and should be utilised in efficient manner to achieve maximum productivity. In this sction the finance manager plays a key role in providing finance. In order to minimise cost and vrcise maximum control, various material management techniques such as economic orderintroduction to Financial Management quantity (EOQ), determination of stock level, perpetual inventory system etc, are applied. The task of the finance manager is to arrange the availability of cash when the bills for purchase become due. 2, Productivity Function, Production function occupies the dominant position in business activities and it is a continuous Process. The production cycle depends largely on the marketing function because production is justified when they are resulted in revenues through sales. Production function involves heavy investment in fixed assets and in working capital. Naturally, a tighter control by the finance manager on the investment in productive assets becomes necessary. It must be seen that there is neither over-capitalisation nor under-capitalisation. Cost-benefit criteria should be the prime guide in allocating funds and therefore finance and production manager should work in ‘unison. 3. Distribution Function. As goods produced are meant for sale, distribution function is an important business activity. It is more important because it provides continuous inflow of cash to meet the outflow thereof. So while choosing different distributing channels, media of advertisement and sales promotion devices, the cost benefit criterion should be the guiding factor. If cost reduction in distribution function is effected without compromising efficiency, it will lead to increased benefit to the enterprise in the form of higher profit and to the consumers in the form of lower cost. As every aspect of distributory function involves cash outflow and every distributing activity is aimed at bringing about inflow of cash, both the functions are closely inter-related and hence should be carried out in close unison. 4. Accounting Function. Charles Gastenberg visualises the influence of scientific arrangement of records, with the help of which inflow and outflow of funds can be efficiently managed and stocks and bonds can be efficiently marketed. Moreover, the efficiency of the whole organisation can be greatly improved with correct recording of financial data. All the accounting tools and control devices, necessary for appraisal of finance policy can be correctly formulated if the accounting data are properly recorded. For example, the cost of raising funds, expected returns on the investment of such funds, liquidity position, forecasting of sales, etc. can be effectively carried out if the financial data so recorded are reliable. Hence, the relationship between accounting and finance is intimate and the finance manager has to depend heavily on the accuracy of the accounting data. PRov, FINANCIAL Raw ones ACCOUNTING MANAGEMENT |__ PROVIDE rInanciat |_TO_ spe ciciong cost ACCOUNTING iNFORMATION’| MANAGEMENT | Taye ?}—CecSIONS _| ‘ACCOUNTING a OER v 1. FINANCING “AAW OF PROCESS AND 2. INVESTMENT| ANALYSES DATE RECEIVED IVIDEND. DATA GENERATION _ __| (ACCOUNTING AND FINANCIAL MANAGEMENT RELATIONSHIP) 5. Personnel Function. Personnel function has assumed a prominent place in the domain of business management. No business function can be carried out efficiently unless there is a sound Personnel policy backed up by efficient management of personnel. Success or failure of every_. 114 Introduction to Financial Managemen business activity boil a tess activity boils down to the efficiency of otherwise of the men entrusted with the . function. A sound personnel poli 5 TesPective ie RS policy includes proper wage structure, incentives schemes, promoti os ae tuman resource development and other fringe benefits provided to the employees, jy a ae affect finance. But the finance manager should know that organisation can afford to pay ly what it can bear. It means that expenditure incurred on personnel management and the expected return on such investment through labour productivity should be considered in framing 3 sound personnel policy. Therefore, the relation between the finance and personnel department should be intimate. 6. Research and Development. In the world on research and development is a productive investment growth of the firm. Unless there is a constant endeavour for improvement and sophistication of an existing product and introduction of newer varieties, the firm is bound to be gradually out marketed and out of existence. However, sometimes expenditure on R and D invovles a heavier amount, disproportionate to the financial capacity of the firm. In such a case, it financially cripples the enterprise and the expenditure ultimately ends in fiasco. On the other hand, heavily cutting down ent and diversification of the product. So, there expenditure of R and D blocks the scope of improvem« continuing R and D work and the funds k out by joining efforts of finance manager of innovations and competitiveness, expenditure ‘and R and D itself is an aid to survival ang must be a balance between the amount necessary for available for such a purpose. Usually, this balance is struc and the person at the helm of R & D. 7. Financial Management and Economics. Financial management draws heavily on Economics for ite theoretical concepts. The development of the theory of finance began as an off shoot of the ‘ar with the two areas of economics, ie. economics. A finance manager has to be famili is. Microeconomics deals with the economic decisions of ‘cs looks at the economy as a whole in which a ts of microeconomics help a finance manager in vodels like fixation of prices, cost volume profit analysis, break even analysis, ions, long-term investment decisions called capital budgeting, cash and management decisions etc. A firm is also study of microeconomics and macroeconomi individuals and firms, whereas macroecono! perticular business unit is operating. The concep! developing decision mi inventory management decisis eceivables management models or working capital jnfluenced by the overall performance of the economy as itis dependent upon the money and capital funds. The finance manager should, thus, recognise and markets for the procurement of investible derstand the macroeconomic theories, monetary and fiscal policies and their impact on the economy as a whole and the firm in particular. m OBJECTIVES OF FINANCIAL MANAGEMENT OR GOALS OF BUSINESS FINANCE Financial management is concerned with procurement and use of funds. Its main aim is to use business funds in such a way that the firm’s value / earnings are maximised. There are various alternatives available for using business funds. Each alternative course has to be evaluated in detail. ‘The pros and cons of various decisions have to looked into before making a final selection. The decisions will have to take into consideration the commercial strategy of the business. Financial management provides a framework for selecting a proper course of action and deciding a viable commercial strategy. The main objective of a business is to maximise the owner’s economic welfare.ell {ntroduction to Financial Management 115 ‘This objective can be achieved by : 1, Profit Maximisation, and 2, Wealth Maximisation co 1. Profit Maximisation Profit earning is the main aim of every economic activity. A business being an economic institution must earn profit to cover its costs and provide funds for growth. No business can survive without earning profit. Profit is a measure of efficiency of a business enterprise. Profits also serve as a protection against risks which cannot be ensured. The accumulated profits enable a business to face risks like fall in prices, competition from other units, adverse government policies etc. Thus, profit maximisation is considered as the main objective of business. The following arguments are advanced in favour of profit maximisation as the objective of business: (i) When profit-earning is the aim of business then profit maximisation should be the obvious objective. (ii) Profitability is a barometer for measuring efficiency and economic prosperity of a business enterprise, thus, profit maximisation is justified on the grounds of rationality. (iii) Economic and business conditions do not remain same at all the times. There may be adverse business conditions like recession, depression, severe competition etc. A business will be able to survive under unfavourable situation, only if it has some past earnings to rely upon. Therefore, a business should try to earn more and more when situation is favourable. (iv) Profits are the main sources of finance for the growth of a business. So, a business should aim at maximisation of profits for enabling its growth and development. (0) Profitability is essential for fulfilling social goals also. A firm by pursuing the objective of profit maximisation also maximises socio-economic welfare. However, profit maximisation objective has been criticised on many grounds. A firm pursuing the objective of profit maximisation starts exploiting workers and the consumers. Hence, it is immoral and leads to a number of corrupt practices. Further, it leads to colossal inequalities and lowers human values which are an essential part of an ideal social system. It is also argued that profit maximisation should be the objective in the conditions of perfect competition and in the wake of imperfect competition today, it cannot be the legitimate objective of a firm. The concept of limited liability in the present day business has separated ownership and management. A company is financed by shareholders, creditors and financial institutions and is controlled by professional managers. Workers, customers, government and society are also concerned with it. So, one has to reconcile the conflicting interests of all these parties connected with the firm. Thus, profit ‘maximisation as an objective of financial management has been considered inadequate. Even as an operational criterion for maximising owner's economic welfare, profit maximisation has been rejected because of the following drawbacks :—— Do 146 - @ Ambiguity. The term ‘profit’ is vague and it cannot be precisely defined. It means different things for ciferent people. Should we consider. shor em profits or Long-term profs > Does it mean total profits or earnings per share ? Should we take profits before tax or after tax ? Does it mean operating profit or profit available for shareholders ? Further, it ig Possible that profits may increase but earnings per share decline. For example, if a company hhas presently 10,000 equity shares issued and earns a profit of € 1,00,000 the earnings per share are ® 10. Now, if the company further issues 5,000 shares and makes a total profit of & 1,20,000, the total profits have increased by % 20,000, but the earnings per share will, decline to 88. Even if, we take the meaning of profits as earnings per share and maximise the earnings per share, it does not necessarily mean increase in the market value of shares and the owner's economic welfare. (ii) 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 earnings as equal though they occur in different periods. It ignores the fact that cash received 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 if it is is smaller than the expected higher returns after a long period. Gii)_ Ignores Risk Factor. It does not take into consideration the risk of the prospective earnings stream. Some projects are more risky than others. The earning streams will also be risky in the former than the latter. Two firms may have same expected earnings per share, but if the earning stream of one is more risky then the market value of its shares will be comparatively less. (iv) Dividend Policy. The effect of dividend policy on the market price of shares is also not considered in the objective of profit maximisation. In case, earnings per share is the only objective then an enterprise may not think of paying dividend at all because retaining profits in the business or investing them in the market may satisfy this aim, © 2. Wealth Maximisation Wealth maximisation is the appropriate objective of an enterprise. Financial theory asserts that wealth maximisation is the single substitute for a stockholder’s utility. When the firm maximises the stockholder’s wealth, the individual stockholder can use this wealth to maximise his individual utility. It means that by maximising stockholder’s wealth the firm is operating consistently towards maximising stockholder’s utility. A stockholder’s current wealth in the firm is the product of the number of shares owned, multiplied with the current stock price per share. Stockholder’s current wealth ina firm = (Number of)» ( Curent sock) Symbolically, W,=NP, ” the Given the number of shares that the stockholder owns, the higher the stock price per share Introductio greater \ price. Th serves as doing or Maxims ae- sanducion to Fisncol Manapement a7 er wil be the stockolder’s wealth, Thus, a firm should aim at maximising its current stock ice. This objective helps in increasing the value of shares in the market. The share’s market price es as a performance index or report card of its progress. It also indicates how well management is sing on behalf ofthe shareholder. We can conclude that: refersto Maximum Utility "> Maximum stockholder’s wealth —2!2!2_, Maximumcurrentstock price pershare However, the maximisation of the market price ofthe shares should be in the long run. The long run implies a period which is long enough to reflect the normal market value of the shares imrespective of short-term fluctuations. While pursuing the objective of wealth maximisation, all efforts must be put in for maximising the current present value of any particular course of action. Every financial decision should be based con cost-benefit analysis. If the benefit is more than the cost, the decision will help in maximising the wealth. On the other hand, if cost is more than the benefit the decision will not be serving the purpose of maximising wealth. Implications of Wealth Maximisation. There is a rationale in applying wealth maximising policy as an operating financial management policy. It serves the interests of suppliers of loaned capital, employees, management and society. Besides shareholders, there are short-term and long-term suppliers of funds who have financial interests in the concen. Short-term lenders are primarily interested in liquidity position so that they get their payments in time. The long-term lenders get @ fixed rate of interest from the earnings and also have a priority over shareholders in return of their funds. Wealth maximisation ojbective not only serves shareholder's interests by increasing the value of holdings but ensures security to lenders also. The employees may also try to acquire share of company's wealth through bargaining etc. Their productivity and efficiency is the primary consideration in raising company’s wealth. The survival of management for a longer period will be served if the interests of various groups are served properly. Management is the elected body of shareholders. The shareholders may not like to change a management if itis able to increase the value of their holdings. The efficient allocation of productive resources will be essential for raising the wealth of the company. The economic interest of society are served if various resources are put to economical and efficient use. ‘The following arguments are advanced in favour of wealth maximisation as the goal of financial management : (i) It serves the interests of owners, (shareholders) as well as other stakeholders in the firm, ie. suppliers of loaned capital, employees, creditors and society. (ii) Itis consistent with the objective of owners economic welfare. (ii). The objective of wealth maximisation implies long-run survival and growth of the firm. (iv) It takes into consideration the risk factor and the time value of money as the current present value of any particular course of action is measured. The effect of dividend policy on market price of shares is also considered as the decisions are taken to increase the market value of the shares. (vi) The goal of wealth maximisation leads towards maximising stockholder’s utility or value maximisation of equity shareholders through increase in stock price per share. (v)been criticiseq by = nax wealth” actually do. = sation : firms Criticism of Wealth Maximisat win accounts pave of ™ at the! j certain financial theorists mainly 0" ective is not descriP) socially desirable. warily imise the stockholder, ( Itis a prescriptive idea. THe OF ie jmisation 570" “active is 10 . (ii) ‘The objective of wealth maximisato e objective © nancial claimholders such 3, th yneth ii) There is some controversy to which includ wealth or the wealth of the FO ers, ete auficulties when ownership ang debentureholders, P! Cs may also face ¢ the large corporate form of (iv) The objective of wealth maximisatie” case in most 0 ers (equity shareholders), there management are separated ar as agents of the ne oie and the managerial interes, organisations. When en in terest between shareho oe ppanagerial utility But not py is a possibility for a con 5 ane ‘The managers may act in such a manner which maximi: = ssiaation wealth of stockholders or the firm. ‘pion that wealth maximisation is the moy the opini £ conflicts between the stockholders ” ouak of In spite of all the criticism, we are of the OF een of een th appropriate objective of a firm and the side com's © a managers can be minimised. and debentureholders, firm and society and stockhol: CO Financial Management and Profit Maximisation ; to maximise shareholders’ wealth. This can be done by cial management helps in devising ways and exercising in increasing profitability. The following elements The primary aim of a business is increasing the quantum of profits. Finan: appropriate cost controls which utilimately help are involved in maximising profits. (i) Increase in Revenues. For maximising its profits, a firm will have to increase revenue receipts. Revenues will go up only when sales increase. There should be all out efforts to increase the sales. All possible markets should be exploited so that demand for products increases. This should be followed by increasing production for meeting increased demand. Ina competitive economy, profits can be increased either by raising the price of produces or by increasing the volume of sales. The second alternative will be more appropriate. di) Controlling Costs. Another way of increasing profit is to control or reduce costs. This will increase the margin of profit per unit. The costs may be controlled by controlitg material wastages, increasing labour efficiency, reducing overhead cost by increas production etc. iii) Minimising Risks. A business operates under_a number of uncertainties. Business is do™ with an eye on future which itself is uncertain and i ae certe a 7 risk both business and financial. ain and difficult to predict. There are mary more risks but . ini ut at the same time may help ot fitability. A financial ; Peony Bave to balance the Pros and cons of various decisions element is kept under control.{Introduction to Financial Management m AGENCY PROBLEMS (MANAGER'S VS. SHAREHOLDERS' GOALS) The owners (shareholders) in a large corporate enterprise are widely scattered and the management is separated from the ownership. The operational decision making authority in such a company is vested in the hands of managers who act as agents of the shareholders. Although the duty of the agent (manger) is to act in the best interests of the principal (shareholders), in actual Practice there may be a conflict between the interests of the two. The managers may not always act towards maximising shareholder's wealth but may pursue their own goals such as higher salaries at the cost of shareholders. In the same manner, there may be a conflict between the interests of the shareholders and that of the other stakeholders in the firm, such as suppliers of loaned capital, employees, creditors and society. The managers may act towards reconciling the conflicting interests of various stakeholders at the cost of maximising shareholders’ wealth. This conflict in the managers, generally referred to as agency problem, results into agency costs such as less than maximum value of shareholders’ wealth or increased costs in modifying and integrating the conflicting goals. @ FINANCIAL DECISIONS Financial decisions refer to decisions concerning financial matters of a business firm. There are many kinds of financial management decisions that the firm makes in pursuit of maximising shareholder's wealth, viz., kind of assets to be acquired, pattern of capitalisation, distribution of firm's income etc. We can classify these decisions into three major groups : 1. Investment Decisions. (a) Long-term Investment (Capital Budgeting) Decisions. (b) Short-term (Working Capital) Decisions. 2. Financing Decisions. 3. Dividend Decisions. © 1. Investment Decisions Investment Decision relates to the determination of total amount of assets to be held in the firm, the composition of these assets and the business risk complexions of the firm as perceived by its investors. It is the most important financial decision. Since funds involve cost and are available in a limited quantity, its proper utilisation is very necessary to achieve the goal of wealth maximisation. The investment decisions can be classified under two broad groups : (i) Long-term investment decision and (ii) Short-term investment decision. The long-term investment decision is referred to as the capital budgeting and the short-term investment decision as working capital management. Capital budgeting is the process of making investment decisions in capital expenditure. These are expenditures, the benefits of which are expected to be received over a long period of time exceeding one year. The finance manager has to assess the profitability of various projects before committing the funds. The investment proposals should be evaluated in terms of expected Profitability, costs involved and the risks associated with the projects. The investment decision is important not only for the setting up of new units but also for the expansion of present units,rarodvetion to Fnanetal Management 120 Jopment project cos'® and reallocation of funds, a of permanent assets, research and devel investments made earlier do not fetch resull as anticipated ea7 id, relates to the allocation” of funds as among on the other hand, re the aay tae off ten » likely to yield and Short-term investment decision, cash and equivalents, receivables and invento! decision liquidity and profitability. The reason is that, the more the more profitable an asset, the more illiquid it A working capital management policy is one which ensure mers sound structural health of the organisation sries. Such 4 ‘avestment decision or proper liquidity and a " = id nmitted itself to new investment, it must Once tment decision and com n Once the firm has taken the invest ere ee ay rake ew este decide the best means of financing WET are on BONE Hence, a firm will Be oo woul Saas at pia il needs. jon is not only concerned Pe ow best to ing for new financial fs oe aa Fa ie asets but also concerned Wi the best ove inancing ; ‘ funds which will make opm capital drious sources in the overall jure. The important ake ita! Sof fe firm. The debt-equity ratio shoul ea re peed ape is ising the srofitability of the concern. 8 rs 4 Btiiry ond scpee tupon outsiders. It may help in 11 turn eo equity = will ato hance the risk. The raising of funds through equity will bring permanent funds business but the bar "wil higher rates of earnings. The financial manager has to strike a balance eeility of the concern improves. If the capital stability then the market prices of the shares of more del jsbursement of profits back to investors who that part of profits of a company which is the reward of shareholders for investments made by ‘dend decision is concerned with the quantum of profits to be distributed among shareholders. 4 decision has to be taken whether all the profits are to Pr istrbuted, to retain all the profits. in business or to Keep & part of profits in the business and distribute others among shareholders. The higher rate of dividend may raise the market price of apse and thus, maximise the wealth of shareholders. The firm should also consider the question of ividend stability, stock dividend (bonus shares) and cash dividend. All these decisions have been discussed in detail in separate chapters of this book. 3. Dividend Decision ‘The third major financial d supplied capital to the firm. The term distributed by it among its shareholders. It is thom in the share capital of the company. The divi jecision relates to the di dividend refers to mm INTER-RELATION OF FINANCIAL DECISIONS a We have studied above the three major grouj ial decisions, vi tment tu ips of financial decisions, viz., i isi financing decisions and dividend decisions. Although these are different Kinds aeIntroduction to Financial Management 12 management decisions yet these decisions are inter-related because the underlying objective of all these decisions is the same, i.e. maximisation of shareholders’ wealth. All these decisions influence ‘one another and are inter-dependent. For example, the decision to invest in some proposal cannot be taken in isolation without having necessary finance available for the same. The financing decision in turn is influenced by and also influences the dividend decision. In case the profits are retained for financing of the investment, the profits available for distribution to the shareholders as dividends are reduced. An efficient financial management thus, has to take the optimal joint decision by evaluating each of the decision involved in relation to its effect on shareholder's wealth and by considering the joint impact of these decisions on the market value of the company’s shares. Pi ; eg DIVIDEND > FINANCING DECISION DECISION (INTER-RELATION OF FINANCIAL DECISION) Leu eo euncancaus IS CONCERNED WITH FINANCING DECISION INVESTMENT DECISION DIVIDEND DECISIONS T ANALYSES RISK AND RETURN RELATIONSHIP TRADE OF) TO ACHIEVE THE GOAL OF WEALTH MAXIMISATION lm FACTORS INFLUENCING FINANCIAL DECISIONS There are a number of (both external as well as internal) factors that influence the financial decisions. A list of the important external as well as internal factors influencing the decisions is given below : External Factors : * State of economy * Structure of capital and money markets.vogge marten igs tens The following figure shows the relationship between various financial decisions and the risk-return trade off and market value of the firm. INVESTMENT DECISIONS — CAPITAL BUDGETING — WORKING CAPITAL MANAGEMENT MARKET VALUE OF Beall FINANCING DECISIONS — CAPITAL STRUCTURE DIVIDEND DECISIONS — DIVIDEND POLICY (RISK — RETURN TRADE OFF) Financial decisions of a firm often involve alternative courses of action. A finance manager has to select amongst the various alternatives available to him. For example, while making an-investment decision, he has to decide whether, the firm should go in for a machinery having capacity of 50,000 units or 2,00,000 units. In the same manner the financing decision may involve a choice between a debt equity ratio of 1:1 or 2:1, the dividend decision may be concerned with the quantum of profits to be distributed. The alternative courses of action imply different risk-return relationship as there is positive relationship between the amount of risk assumed and the amount of expected return. A machine with higher capacity may give a higher expected return but involves a higher risk of investment, whereas the machine with lower capacity may have a lower expected return and a lower12 related because the underlying objective of all reholders’ wealth. All these decisions influence the decision to invest in some proposal cannot be available for the same. The financing decision in lend decision. In case the profits are retained for distribution to the shareholders as dividends are sto take the optimal joint decision by evaluating on shareholder's wealth and by considering the the company’s shares. (waz) at o hi = —M———— management decisions yet these decisions is the same, one another and are inter-de taken in isolation without h tum is influenced by and ai financing of the investment, reduced. An efficient financial management thus, na each of the decision involved in relation to its effec joint impact of these decisions on the market value of these decisions are inter 1€. maximisation of shai Pendent. For example, ‘aving necessary finance Iso influences the divid the profits available for DECISION (INTER-RELATION OF FINANCIAL DECISION) Gira TS eis 1S CONCERNED WITH FINANCING DECISION | INVESTMENT DECISION DIVIDEND DECISIONS ANALYSES. i RISK AND RETURN RELATIONSHIP ‘TRADE OF) t TO ACHIEVE THE GOAL OF WEALTH MAXIMISATION = FACTORS INFLUENCING FINANCIAL DECISIONSv * Requirements of investors * Government policy * Taxation policy * Lending policy of financial institutions. Internal Factors : * Nature and size of business ‘* Expected return, cost and risk * Composition of assets Structure of ownership Trend of earnings Age of the firm Liquidity position Working capital requirements Conditions of debt agreements. ancial decisions and the m RISK-RETURN TRADE OFF the relationship between various fir ‘The following figure shows riskeretur trade off and market value of the firm INVESTMENT DECISIONS = CAPITAL BUDGETING WORKING CAPITAL MANAGEMENT Gnas Nn bo aaa FINANCING DECISIONS = CAPITAL STRUCTURE DIVIDEND DECISIONS = DIVIDEND POLICY (RISK - RETURN TRADE OFF) of a firm often involve alternative courses of action. A finance manager has to elect amongst the various alternatives available to him. For example, while making an-investment he has to decide whether, the firm should go in for a machinery having capacity of 50,000 nits or 2,00,000 units. In the same manner the financing decision may involve a choice between a ‘bt equity ratio of 1:1 or 2:1, the dividend decision may be concerned with the quantum of profits to distributed, The alternative courses of action imply different risk-return relationship as there is sitive relationship between the amount of risk assumed and the amount of expected return. A chine with higher capacity may give a higher expected return but involves a higher risk of sstment, whereas the machine with lower capacity may have a lower expected return and a lower — Financial decisions ecision,Introduction to Financial Management 1.23 risk of investment. A higher debt-equity ratio may help in increasing the return on equity but will also enhance the financial risk. The financial manager has to strike a balance between various sources so that the overall profitability of the firm and its market value increases. While making a financial decision, one has to answer the basic questions : What is the expected return ? What is the risk involved ? How would the decision influence the market value of the firm ? @ FINANCIAL MANAGEMENT PROCESS The financial management process begins with the financial planning and decisions. While implementing these decisions, the firm has to acquire certain risk and return characteristics. These characteristics determine the market price of shares and shareholder wealth. The process must include the feedback system to enable it take corrective measures, if required. The figure below depicts the process of financial management : Dae ‘AND CONTROL Laman 2 rinanciapecisions >| TMS RISK AND RETURN || MARKET PRICE ‘SHAREHOLDER Se ewe peogion |_| CHARACTERISTICS OFSHARE >| WEALTH 3. DIVIDEND DECISION CA) Po n= NP (FINANCIAL MANAGEMENT PROCESS) FUNCTIONAL AREAS OF FINANCIAL MANAGEMENT Financial management, at present, is not confined to raising and allocating funds. The study of financial institutions like stock exchange, capital market etc. is also emphasised because they influence underwriting of securities and corporate promotion. Company finance was considered to be the major domain of financial management. The scope of this subject has widened to cover capital structure, dividend policies, profit planning and control, depreciation policies, etc. The techniques of financial analysis like financial statements analysis, funds statements, ratio analysis etc. are also helpful in analysing financial strength of the enterprise. Some of the functional areas covered in financial management are discussed as such : 1. Determining Financial Needs. A finance manager is supposed to meet financial needs of the enterprise. For this purpose, he should determine financial needs of the concern. Funds are needed to meet promotional expenses, fixed and working capital needs. The requirement of fixed assets is related to the type of industry. A manufacturing concern will require more investments in fixed assets than a trading concern. The working capital needs¥ Introduction to Financial Managemen, tions, the higher will be the depend upon the scale of operations, larger the scale of operal f financial needs may jeopardise ¢y, needs for working capital. A wrong assessment of survival of a concern. FUNCTIONAL AREAS OF FANGIAL MANAGEMENT Determining Financial Needs ‘Selecting the Sources of Funds | @ 3. Financial Analysis and Interpretation 4 Cost-Volume-Profit Analysis _ 5. _ | Capital Budgeting ~ 6. | Working Capt Management 7. _ | Profit Planning and Control _ a [Dividend POC gdh, tiie ana TT ee ae 1s. A number of sources may be available for raising funds, _ Financial institutions may be 2. Selecting the Sources of Fund of sour : is of share capital anc el ‘A concern may resort to issue Pi oa na neds may be met bY getting rovide long-term funds. The working capi coh verde faites from commercial banks. A finance manager has to be very careful and cautious in approaching different sources. The terms and conditions of banks may not be favourable to the concern. A small concern may find difficulties in raising funds for want of adequate securities or due to its reputation. The selection of a suitable source of funds will influence the profitability of the concern- This selection should be made with great caution. 3. Financial Analysis and Interpretation. The analysis and interpretation of financial statements is an important task of a finance manager. He is expected to know about the profitability, liquidity position, short-term and long-term financial position of the concern, For this purpose, a number of ratios have to be calculated. The interpretation of various ratios is also essential to reach certain conclusions. Financial analysis and interpretation has of financial management. s. Cost-volume-profit analysis is an important tool of profit planning. It answers questions like, what is the behaviour of cost and volume ? At what point of production a firm will be able to recover its costs ? How much a firm should produce to eam a desired profit ? To understand cost-volume profit relationship, one may be subdivided as : fixed costs, variable should know the behaviour of costs. The costs costs and semi-variable costs. Fixed costs remain constant irrespective of changes in production. An increase or decrease in volume of production will not influence fixed costs Variable costs, on the other hand, vary in direct proportion to change in production. Sem variable costs remain constant for a period and then become variable for a short period. These costs change with the change in output but not in the same proportion become an important area 4. Cost-Volume-Profit Analysis‘twtroduction to Financial Management 145 ” 2 7 The first concern of a finance manager will be to recover all costs. He will aspire to achieve break-even point at the earliest. It is a point of no-profit no-loss. Any production beyond break-even point will bring profits to the concern. The volume of sales, to earn a desired profit, can also be ascertained. This analysis is very helpful in deciding the volume of output or sales. The knowledge of cost-volume profit analysis is essential for taking important decisions about production and profits. Capital Budgeting. Capital budgeting is the process of making investment decisions in capital expenditures. It is an expenditure the benefits of which are expected to be received ‘over a period of time exceeding one year. It is an expenditure incurred for acquiring or improving the fixed assets, the benefits of which are expected to be received over a number of years in future. Capital budgeting decisions are vital to any organisation. An unsound investment decision may prove to be fatal for the very existence of the concern. The crux of capital budgeting is the allocation of available resources to various proposals. The crucial factor which influences the capital budgeting decision is the profitability of the prospective investment. For making correct capital budgeting decisions, the knowledge of its techniques is essential. A number of methods like pay back period method, rate of return method, net present value method, internal rate of return method and profitability index method may be used for making capital budgeting decisions. Working Capital Management. Working capital is the life blood and nerve centre of a business. Just as circulation of blood is essential in the human body for maintaining life, working capital is essential to maintain the smooth running of business. No business can run successfully without an adequate amount of working capital. Working capital refers to that part of the firm's capital which is required for financing short-term or current assets such as cash, receivables and inventories. It is essential to maintain a proper level of these assets. Finance manager is required to determine the quantum of such assets. Cash is required to meet day-to-day needs and purchase inventories etc. The scarcity of cash may adversely affect the reputation of a concern. The receivables management is related to the volume of production and sales. For increasing sales, there may be a need to give more credit facilities. Though sales may go up but the risk of bad debts and cost involved in it may have to be weighted against the benefits. Inventory control is also an important factor in working capital management. The inadequacy of inventory may cause delays or stoppages of work. Excess inventory, on the other hand, may result in blocking of money in stocks, more costs in stock maintaining etc. Proper management of working capital is an important area of financial management. Profit Planning and Control. Profit planning and control is an important responsibility of the financial manager. Profit maximisation is, generally, considered to be an important objective of a business. Profit is also used as a tool for evaluating the performance of management. Profit is determined by the volume of revenue and expenditure. Revenue may accrue from sales, investments in outside securities or income from other sources. The expenditures may include manufacturing costs, trading expenses, office and administrativetatrodecsioo 2 Finenciet eRe expenses, selling and distribution expenses and financial costs. The excess of revenue 4, expenditure determines the amount of profit. Profit planning and control directly infiy,,." the declaration of dividend, creation of surpluses, taxation etc. Break-even analysis. cost-volume-profit relationship are some of the tools used in profit planning and contro, Dividend Policy. Dividend is the reward of the shareholders for investments made, them in the shares of the company. The investors are interested in earning the maxim, return on their investments whereas management wants to retain Profits for Furth ae z be reconciled in the interests wancing. These contradictory aims will have to be refonel Nt Mt of shareholders and the company. The company should distribute @ Feast’ 9” mount q, dividends to its members and retain the rest for its growth ane snd of earnings, sy poly is influenced by a number of factors such as magnitude and & ts alc pole * the company, government's economic po} type of shareholders, future requirements of 't area of financial management becaus, ‘ r «ig an important al taxation policy, etc. Dividend policy is an impo" pany are directly related to it the interests of the shareholders and the needs of the com m@ FUNCTIONS OF A FINANCE MANAGER past has widened the role of a financia, tise of larger-scale units, innovations in The changed business environment in the recent manager. The increasii ace of industrialisation, e inforsation rocessi percents intense competition etc. have increased the need for financial planning ond control. The ‘size and extent of business activities are dependent upon the availability of finances. Financial reporting may be used as a technique fo control. In the present business context, a financial manager is expected to perform the following financial manager has to estimate the financial ill be required for acquiring various assets ? The meeting working capital needs. He functions. 1. Financial Forecasting and Planning. A needs of a business. How much money wi amount will be needed for purchasing fixed assets and has to plan the funds needed in the future. How these funds will be acquired and applied is an important function of a finance manager. 2. Acquisition of Funds. After making financial planning, the next step will be to acquire funds. There are a number of sources available for supplying funds. These sources may be shares, debentures, financial institutions, commercial banks, etc. The selection of an appropriate source is a delicate task. The choice of a wrong source for funds may create difficulties at a later stage. The pros and cons of various sources should be analysed before making a final decision. 3. Investment of Funds. The funds should be used in the best possible way. The cost of acquiring them and the returns should be compared. The channels which generate higher returns should be preferred. The technique of capital budgeting may be helpful in selecting a project. The objective of maximising profits will be achieved only when funds are efficiently used and they do not remain idle at any time. A financial manager has to keep in mind the principles of safety, liquidity and soundness while investing funds.\ Introduction to Financial Management 6. Management of Cash, Receivables and Inventory. Fit 127 4. Helping in Valuation Decisions. A number of mergers and consolidations take place a the present competitive industrial world. A finance manager is supposed to assist management in making valuation etc. For this purpose, he should understand various methods of valuing shares and other assets so that correct values are arrived at. Maintain Proper Liquidity. Every concern is required to maintain some liquidity for meeting day-to-day needs. Cash is the best source for maintaining liquidity. Its required to purchase raw materials, pay workers, meet other expenses, etc. A finance manager is required to determine the need for liquid assets and then arrange liquid assets in such a way that there is no scarcity of funds. nance manager is required to determine the quantum and manage the various components of working capital such as cash, receivables and inventories. On the one hand, he has to ensure sufficient availability of such assets as and when required, and on the other there should be no surplus or idle investment. 7, Disposal of Surplus. A finance manager is also expected to make proper utilisation of surplus funds. He has to make a decision as to how much earnings are to be retained for future expansion and growth and how much to be distributed among, the shareholders. 8. Performance Evaluation and Financial Control. Performance evaluation is regarded as one of the most important function of a finance manager. It acts as the basis of financial control. Periodic comparisons of actual costs, revenues, profits and investments with the budgeted costs, revenues, profits and investments help the finance manager in taking decisions about future actions. im CHANGING SCENARIO OF FINANCIAL MANAGEMENT IN INDIA (RECENT DEVELOPMENTS) Until the opening up of the economy in 1991, the financial environment was highly regulated and thus the scope of financial management was also limited. However, with the opening up of the economy, liberalisation, privatisation and globalisation (LPG) has brought unprecedented change in the economic, trade, finance and industrial scenarios. Thus, the scenario of financial management or the role of financial manager, in India, has widened and undergone a sea change. Some of the important changes that have taken place in Indian Financial management are given as below : 1 2. 3. 4, 5, 6. . Declicensing of industries. Financial sector reforms in the banking, insurance and capital markets. .. Disinvestment in public sector undertakings. Reforms in taxation and company law. 5. Abolition of MRTP Act. . Replacement of Foreign Exchange Regulation Act (FERA) with liberalised Foreign Exchange Management Act (FEMA).{ntroduction to Financial Managemen, 7. Liberalisation of foreign investments. 8. Deregulation of interest rates, 9. Full convertibility of rupee: 10. Introduction of the process of book-building, reverse book building, buy-back of shares ang free pricing of issues. 11. Raising of finance by Indian companies globally through Foreign Currency Convertbje Bonds (FCCBs), Global Depository Receipts (GDRs) and American Depository Receipy, (ADRs). Introduction of derivative instruments such as options a1 capital market. th oriented securities market. Constitution of SEBI to promote a healthy and grow ‘ons and financial restructuring, etc. ent, oF the role of ind future trading in the Indian 12. 13, 14, Increase in the number and size of mergers, acquisiti ‘The above mentioned changes have made the job of financial mana5eltet’ financial manager, more complex and demanding, especially in the following areas (a) Financial planning and control. (b) Financing decisions relating to debt and equity mix. banks and other institutions. (©) Financial negotiations with various (a) Investment decisions (e) Risk management (© Working capital management (@) Financial restructuring, mergers and acquisitions (h) Treasury management () Investor relations (j) Performance evaluation, etc. m_ ORGANISATION OF THE FINANCE FUNCTION The finance function is centralised because of its importance. The financial decisions are crucial for the survival of the concem. Any bad decision on financial aspects will adversely affect the reputation of the concern. ‘The centralisation of finance function will result in certain economies in raising funds, purchasing of fixed assets, etc. In large concerns, for organising finance functions, the Controller and Treasurer are appointed. Financial controller performs the functions of planning and controlling. preparation of annual reports, capital budgeting, profit analysis, cost and inventory management, and accounting and payroll. The main functions of the treasurer include raising of additional funds, cash management, receivables management, audit of accounts, protecting funds and securities and maintaining relations with banks and other financial institutions, etc.y to Financial Management 129 rRanisation of finance function may be diagrammatically shown as below: ‘ BOARD OF DIRECTORS MANAGING DIRECTOR —- : PRESIDENT PRODUCTTON ¥ |VICE PRESIDENT FINANCE| VICE PRESIDENT SALES INANCIAL CONTROLLER TREASURES + + + ¥ 4 “ND ‘ANNUAL UDG PROFIT ACCOUNTING CONTROL REPORTS cing ANALYSIS 'AND PAYROLL. + ¥ T_ t + DITIONAL, CASH on PROTECT FUNDS | | fA Ton AL FUNDS MANAGEMENT| AND SECURITIES) |PANK A FINANCY > Controller Vs. Treasurer > terms ‘controller’ and ‘treasurer’ are used in the United States of America for financial ves in a firm, where various functions of corporate finance /financial management are divided ntrollership functions and treasurership functions. The basic responsibility of the treasurer is ‘ide, manage and protect the firm’s capital whereas the controller has the responsibility to hat the funds are used efficiently. The controller performs the functions of budgeting, control, ting, reporting and interpretation etc. ¢ table below lists some of the important functions of the treasurer and the controller : ‘Treasurer Controller *rovision of capital (both long-term & short-term) | 1. | Accounting Relations with banks & financial institutions 2. | Preparation of financial reports Dash management 3. | Reporting and interpreting Receivables management 4, | Planning and control Protect funds and securities (insurance) 5. | Internal auait investor relations 6. | Tax administration Audit 7._| Economic appraisal & reporting to Govemment owever, it may be noted that many a times the functions of treasurer and controller overlap ‘ach other. Activities of the treasurer are performed by the controller and vice-versa, In India,130 controller financial controller is is generally termed as fina! 1 car and 206 ce pers tod 2 India appoint Hi mpanies EVEN 4PPoint ¢,. designation of treasurer has not become company secretary. A large number of companies 1 troller and treasure’ jal executives: tee two a duties of the treasurer or both of the con chief financial officer (CFO) to supervise the 2 What do you understand 3. ata to nae of france : 4 Wiite a brief nate onthe s00P2 OF babi i financial mana ? 15. ae ming west etree ass PONS 16. 1 tq pny wn ce 7. rite a bret note on rsk-rturn trade Of. 18. Wat do you understand by agency PODITS ? 419, What are the functions of chiel financial managers ? "B. ESSAY TYPE QUESTIONS 1. nat do you mean by bsess ares 7xcus aousapreaces 10 an UAC, with allocating funds to specific assets and obtaining the best m! 2 Finance function is concerned financing in relation tothe overall valuation ofthe frm.” Discuss. 3. What is meant by finance function ? Discuss its objectives. 4. Wats francial management? What major decisions are required to be taken in finance ? 5 Citicaly analyse te functions of Financial Manager ina large scale industrial establishment. 6 (@) What are the responsibiltie ofthe financial manager in a modem business organisation? (b) What are the prominent areas of financial decision making ? mere ix offuction to Financial Manayement 7 131 “Maximisation of profits is regarded as the proper objective of investment decision, but it is not as ‘exclusive as maximising shareholders’ wealth.” Comment. ‘What do you mean by financial management ? What is the scope of finance function in a business enterprise ? Should the goal of financial decision-making be profit-maximisation or wealth- maximisation ? 9. Explain the objectives of financial management. 10. What do you understand by financial decisions ? Discuss the major financial decisions. 11. “Investment, financing and dividend decisions are all inter-related.” Comment. 12. Assuming wealth maximisation to be the objective of the financial management, show how the financing, investment and dividend decisions of a company can help to attain this objective. . Can there be a conflict between shareholder's and manager's financial goals ? How does the wealth maximisation objective resolve the same ? 14. Discuss the changing scenario of financial management in India. 15. “Finance function of a business is closely related to its other functions.” Discuss. How should the finance function of an enterprise be organised ? Discuss. 17. “Finance is the life blood of business.” Explain this statement. 8. gaa