UNIT-1 INTRODUCTION OF FINANCIAL MANAGEMENT

 MEANING OF FINANCIAL MANAGEMENT

Financial Management means planning, organizing, directing and controlling the

financial activities such as procurement and utilization of funds of the enterprise in an
efficient manner.

 EVOLUTION/PHASES/APPROACHES OF FM

Financial management approach may be broadly divided into two major parts.

 Traditional Approach & Modern Approach

(1) Traditional Phase (From 1901 to 1940)

This approach was developed around twentieth century almost from 1901 to 1940.
Under this approach, financial management was considered as ‘Corporation Finance’.
Under this approach, the financial management was used to procure the funds for the
corporation.

The following three things were used to be studied for the procurement of
finances:
(i) Institutional sources of finance.
(ii) Issue of financial instruments to collect necessary funds from the capital market.
(iii) Legal and accounting relationship between the business and source of finance.

According to this approach, finance was needed not for routine matters but for sporadic
events like promotion, reorganisation, expansion, liquidation, etc. Managing funds for
these events was considered an important function of financial manager. The financial
manager was not concerned with internal financing rather he was supposed to maintain
relationship with outside parties and financing institutions.

According to traditional approach, he was not responsible for the efficient use of funds.
His duty was to get necessary funds on fair terms from the outside parties. The
traditional approach of the finance function continued till the fifth decade of the 20th
century.

Limitations of Traditional Phase:

(i) One Sided/ outsider-looking Approach:

This approach gives more attention to procurement of funds but ignores the efficient
utilisation of funds. This approach attaches more significance to the viewpoint of outside
parties (Banks, financial institutions, investors) who provide funds to the business but
ignores the internal parties who take financing decisions. It is, therefore, termed as
outsider-looking approach.

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(ii) More Emphasis on the Financial Problems of Corporations:
This approach focused attention only on the financial problems of corporate enterprises
but non-corporate enterprises, e.g., sole trade and partnership firms, remained outside
its scope. It has, thus, narrowed the scope of finance function.

(iii) More Importance to Irregular Events:

This approach considers the finance section to provide funds on sporadic events like
incorporation, mergers, consolidation, reorganisation, etc. and ignores the day to day
financial problems of business enterprise.

(iv) More Emphasis on Long Term Funds:

This approach gives more importance to the problems of long-term financing. Working
capital financing decisions are kept outside the scope of finance function. It ignores the
importance of working capital.

(2) Modern Phase

With technological improvement, increase competition, and the development of strong
corporate, it was important for Management to use the available financial resources in
its best possible way. Therefore, the traditional approach became inefficient in a growing
business environment.
The modern approach has started around 1950. It had a more comprehensive analytical
viewpoint with a focus on the procurement of funds and its active and optimum use. The
fund arrangement is an essential feature of the entire finance function.
The main element of this approach are an evaluation of alternative utilization of funds,
capital budgeting, financial planning, ascertainment of financial standards for the
business success, determination of cost of capital, working capital management,
Management of income, etc. The three critical decisions taken under this approach are.
The modern approach views finance function in broader sense. It includes both rising 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 functions, according to
this approach, covers financial planning, rising of funds, allocation of funds, financial
control etc.

The modern approach considers the three basic management decisions, i.e., investment
decisions, financing decisions and dividend decisions within the scope of finance
function.

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 Characteristics/features of Modern Approach:

(i) More Emphasis on Financial Decisions: As compared to the traditional approach,

modern approach is less descriptive and more analytical. Due to increasing size of
business and competition, business management can’t afford to take decisions based on
intuition. Right decisions can be taken only on the basis of statistical and accounting
data. Such decisions are less risky.

(ii) Financial Management as an Important Component of Business Management:

Under the traditional approach of finance function, financial manager was not
considered to be significant in decision making. But now, he is considered an important
part of business and he affects the important decisions of business.

(iii) Continuous Function: Under traditional approach, financial management was used
to arrange funds for sporadic events only but under the modern approach, financial
management is a continuous activity and a financial manager has to take various
routine financing decisions also.

(iv) Broader View: The modern approach to finance function expresses broader view as
it gives much importance to the optimum use of finance along with the procurement of
funds. Besides this, it also includes aspects relating to financial planning, capital
budgeting, cost of capital, etc.

(v) Measure of Performance: Financial decisions also affect the performance of

business. If the financial decisions add to the value of firm, they will be considered good.
To maximise the value of firm, a proper balance between profitability and liquidity is
must. Modern approach to finance function explains that the maintenance of this
balance in profitability and liquidity is the main function of financial management.

Traditional Approach Modern Approach

Narrowly defined concept of FM Comparatively a wide concept

Only concerned with raising long Concerns both raising as well as use
term funds of funds

Era before 1950 Era after 1950

Applicable only to large joint stock

companies Applicable to all the business entities

Long as well as short term decisions

Only long term decisions were taken are taken

Both, inside as well as outside

Outside looking approach orientation.

It is a descriptive approach It is an analytical approach

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 FUNCTIONS OF FINANCE/SCOPE OF FINANCIAL MANAGEMENT

(1) Investment Decision

One of the most important finance functions is to intelligently allocate capital to long
term assets. This activity is also known as capital budgeting.

Investment decisions includes investment in fixed assets (called as capital budgeting).

Investments in current assets are also a part of investment decisions called as working
capital decisions.

It is important to allocate capital in those long term assets so as to get maximum yield in
future. Following are the two aspects of investment decision

a. Evaluation of new investment in terms of profitability

b. Comparison of cut off rate against new investment and prevailing investment.

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

 Long-term investment decisions or Capital Budgeting means committing funds for

a long period of time like fixed assets. These decisions are irreversible and usually
include the ones pertaining to investing in a building and/or land, acquiring new
plants/machinery or replacing the old ones, etc. These decisions determine the
financial pursuits and performance of a business.

 Short-term investment decisions or Working Capital Management means

committing funds for a short period of time like current assets. These involve
decisions pertaining to the investment of funds in the inventory, cash, bank deposits,
and other short-term investments. They directly affect the liquidity and performance
of the business.

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(2) Financial Decision
Financial decision is yet another important function which a financial manger must
perform. It is important to make wise decisions about when, where and how should a
business acquire funds. Managers also make decisions pertaining to raising finance from
long-term sources (called Capital Structure) and short-term sources (called Working
Capital). They are of two types:

 Financial Planning decisions which relate to estimating the sources and application
of funds. It means pre-estimating financial needs of an organization to ensure the
availability of adequate finance. The primary objective of financial planning is to plan
and ensure that the funds are available as and when required.

 Capital Structure decisions which involve identifying sources of funds. They also
involve decisions with respect to choosing external sources like issuing shares,
bonds, borrowing from banks or internal sources like retained earnings for raising
funds.

(3) Dividend Decision

Earning profit or a positive return is a common aim of all the businesses. But the key
function a financial manger performs in case of profitability is to decide whether to
distribute all the profits to the shareholder or retain all the profits or distribute part of
the profits to the shareholder and retain the other half in the business.

These involve decisions related to the portion of profits that will be distributed as dividend.
Shareholders always demand a higher dividend, while the management would want to
retain profits for business needs. Hence, this is a complex managerial decision

 FUNCTIONS/ROLE OF A FINANCIAL MANAGER:

1. Estimates the capital requirements of business:

A financial manager firstly has to make the estimation with regards to overall capital
requirements of the business. This will depend on several determinants like probable
costs and expected profits and upcoming programs and policies of the company.
Predictions have to be made in an adequate and concern manner which increases the
earning capacity of business and which ensures proper use of financial resources.
Thus financial management functions guide a financial manager to estimate
organizational capital requirements.

2. Ascertains capital composition:

Once the estimation of capital requirement has been made with the best effort, the
capital structure of the enterprise has to be decided. This involves the analysis of short-
term and long- term debt equity. This will depend on the proportion of possessed equity
capital a company and other additional funds which have to be raised from outside
parties through borrowing.

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3. Raising of Funds

In order to meet the obligation of the business it is important to have enough cash and
liquidity. A firm can raise funds by the way of equity and debt. It is the responsibility of
a financial manager to decide the ratio between debt and equity. It is important to
maintain a good balance between equity and debt. A financial manager needs to evaluate
different sources of funds. A company has many choices for raising additional funds to
be procured in the business like loans to be taken from banks and other financial
institutions, issue of company shares and debentures, public deposits to be drawn like
in form of bonds. Choice of a factor depends on the relative advantages and
disadvantages of each source and financing period.

4. Allocation of Funds

Once the funds are raised through different channels the next important function is to
allocate the funds. The funds should be allocated in such a manner that they are
optimally used. In order to allocate funds in the best possible manner the following point
must be considered

 The size of the firm and its growth capability

 Status of assets whether they are long-term or short-term
 Mode by which the funds are raised

These financial decisions directly and indirectly influence other managerial activities.
Hence formation of a good asset mix and proper allocation of funds is one of the most
important activity. The finance manager has to decide how to allocate the total amount
of funds into profitable ventures. He has to make sure that there is safety on investment
and positive regular returns are possible. The capital should be invested in a wisely
manner so that there is less possibility of losing funds or experience loses. For that, the
manager can use different investment tools like portfolio analysis, net present value,
internal rate of return, an average rate of return and so on.

5. Profit Planning

Profit earning is one of the prime functions of any business organization. Profit earning
is important for survival and sustenance of any organization. Profit planning refers to
proper usage of the profit generated by the firm.

Profit arises due to many factors such as pricing, industry competition, state of the
economy, mechanism of demand and supply, cost and output. A healthy mix of variable
and fixed factors of production can lead to an increase in the profitability of the firm.

Fixed costs are incurred by the use of fixed factors of production such as land and
machinery. In order to maintain a tandem it is important to continuously value the
depreciation cost of fixed cost of production. An opportunity cost must be calculated in
order to replace those factors of production which has gone thrown wear and tear. If this
is not noted then these fixed cost can cause huge fluctuations in profit.
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6. Understanding Capital Markets

Shares of a company are traded on stock exchange and there is a continuous sale and
purchase of securities. Hence a clear understanding of capital market is an important
function of a financial manager. When securities are traded on stock market there
involves a huge amount of risk involved. Therefore a financial manger understands and
calculates the risk involved in this trading of shares and debentures.

Its on the discretion of a financial manager as to how to distribute the profits. Many
investors do not like the firm to distribute the profits amongst share holders as dividend
instead invest in the business itself to enhance growth. The practices of a financial
manager directly impact the operation in capital market.

7. Disposal of surplus:
Financial manager calculates profits of business at the end of an accounting period.
Then the net profits decision has to be taken by the finance manager of the company.
This decision can be made in two ways. He can declare a dividend to the shareholders of
a company where the ordinary shareholders will get the profits in the form of money or
share or retain profits for some purposes like expansion, diversification or innovation of
the business.

8. Manages of cash flow:

Finance manager of a company has to make decisions regarding cash management.
Cash is required for several purposes like payment of wages and salaries to the workers,
payment to the creditors, payment of electricity and water bills, meeting current
liabilities of the business, cost of maintenance of having enough stock, purchase of raw
materials for daily production etc.

9. Controls Finances:
The functions of a finance manager are not only to do a financial plan, procure fund and
utilize the funds but he also has to control the finances involving in the business. This
function can be done by many techniques like ratio analysis, forecasting of financials,
cost analysis and control and profit distribution techniques etc.

10. Decisions regarding acquisitions and mergers:

A business organization can either be expanded through acquiring other business or by
entering into the business by mergers with other firms. While acquisition decision
denotes a process of purchasing new or existing companies, the merger is a process
where two or more companies join together in the formation of a new business. During
such decision, a financial manager has to deal with many complex valuations of
securities of each company.

11. Tax Planning and protection of Assets:

It is the duty of a financial manager to lessen the tax liability of the business. This task
should be performed wisely. It is very important that a finance executive properly
examines various schemes and invest accordingly. He should also protect the assets
engaged in the business to ensure the best use of the resources.
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 OBJECTIVES/GOALS OF FINANCIAL MANAGEMENT

There are main two primary objectives of financial management

1. Maximization of profits and

2. Maximization of Shareholders’ wealth

1. Maximization of profits

Main aim of any kind of economic activity is earning profit. A business concern is
also functioning mainly for the purpose of earning profit. Profit is the measuring
techniques to understand the business efficiency of the concern. The finance
manager tries to earn maximum profits for the company in the short-term and
the long-term. He cannot guarantee profits in the long term because of business
uncertainties.

 Important features
 Profit maximization is also called as cashing per share maximization. It leads to
maximize the business operation for profit maximization.

 Ultimate aim of the business concern is earning profit, hence, it considers all the
possible ways to increase the profitability of the concern.

 Profit is the parameter of measuring the efficiency of the business concern. So it

shows the entire position of the business concern.

 Profit maximization objectives help to reduce the risk of the business.

 Favorable Arguments for Profit Maximization

 Main aim is earning profit.

 Profit is the parameter of the business operation.

 Profit reduces risk of the business concern.

 Profit is the main source of finance.

 Profitability meets the social needs also.

 Unfavorable Arguments for Profit Maximization

 Profit maximization leads to exploiting workers and consumers.

 Profit maximization creates immoral practices such as corrupt practice, unfair

trade practice, etc.

 Profit maximization objectives leads to inequalities among the sake holders such
as customers, suppliers, public shareholders, etc.
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  Drawbacks/Limitations of profit maximization criterion

1) Vague concept: Profit in the short run is quite different from profits in the long run.
In this objective, profit is not defined precisely or correctly. In other words, maximizing
profits does not mean neglecting the long-term picture in favour of short-term
considerations.

2) Ignores the time value of money: Profit maximization strategy ignores the
differences in the time pattern of the benefits received from investment proposals or
courses of action, because money received today has a higher value than money received
next year. It does not take into account the time value of money. The value of benefits
received today and those received a year later are not the same.

3) Ignores risk: Profit maximization does not consider risk. The shareholders of the firm
may expect to receive higher returns from investment of higher risk. This criterion fails
to consider the shareholders wish, to receive a portion of the firm’s returns in the form of
regular dividends. In the absence of any preference for dividends, the firm can maximize
profits from period to period by reinvesting all earnings, using them to acquire new
assets that will boost future profits. But the non-payment of dividends usually leads to
decline in the market value of the firm’s share.

4) Ignores other important areas: Profit maximisation objective does not take into
consideration the social responsibilities of business. It ignores the interests of workers,
consumers, government and the public in general. The exclusive attention on profit
maximisation may misguide managers to the point where they may endanger the
survival of the firm by ignoring research, executive development and other intangible
investments.

2. Maximization of Shareholders’ wealth

Wealth maximization is also known as value maximization or net present worth

maximization. Wealth maximization (shareholders’ value maximization) is also a main
objective of financial management.

Wealth maximization means to earn maximum wealth for the shareholders. So, the
finance manager tries to give a maximum dividend to the shareholders. He also tries to
increase the market value of the shares. The market value of the shares is directly
related to the performance of the company. Better the performance, higher is the market
value of shares and vice-versa. So, the finance manager must try to maximize
shareholder’s value.

 Favourable Arguments for Wealth Maximization

 Wealth maximization is superior to the profit maximization because this concept is
to improve the value or wealth of the shareholders.
 Wealth maximization considers the comparison of the value to cost associated with
the business concern. Total value detected from the total cost incurred for the
business operation. It provides extract value of the business concern.
 Wealth maximization considers both time and risk of the business concern.
 Wealth maximization provides efficient allocation of resources.
 It ensures the economic interest of the society.
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 Unfavorable Arguments for Wealth Maximization
 Wealth maximization leads to prescriptive idea of the business concern but it may
not be suitable to present day business activities.
 Wealth maximization is nothing, it is also profit maximization, it is the indirect
name of the profit maximization.
 Wealth maximization creates ownership-management controversy.
 Management alone enjoy certain benefits.
 The ultimate aim of the wealth maximization objectives is to maximize the profit.
 Wealth maximization can be activated only with the help of the profitable position of
the business concern.

 RELATIONSHIP BETWEEN FINANCIAL MANAGEMENT AND OTHER DISCIPLINES

1. Financial management and Accounting

The relationship between finance and accounting is quite close. Accounting is
basically concerned with collecting, presenting and processing necessary financial
data, whereas finance is concerned with decision-making. The financial manager,
as per the requirements, recasts the statements prepared by accountants,
generates additional data, and makes decisions on subsequent analysis.

2. Financial management and Economics

The relationship between corporate finance and economics can be viewed from two
basic aspects of economics macroeconomics and microeconomics.

Macroeconomics is concerned with broad aspects of an economy such as output,

employment and income. Every business firm operates within the economy. It is
imperative for financial managers to understand the broad economic framework.
He must also be alert about the consequences of varying levels of economic
activities, and recognize and understand the effect of monetary policy on the cost
and availability of funds. The financial managers should evaluate various
financing and investment alternatives in a macroeconomic framework.

Microeconomics is concerned with the economic issues relating to individual firms

operating within the economy. It deals with the economic problems related to
individual firms. Many principles associated to microeconomics such as demand
and supply analysis, profit maximization strategies, pricing theories have practical
application in finance. In this sense, finance is regarded as applied
microeconomics. The principle of marginal analysis technique of microeconomics
is widely used in finance for decision making.

3. Financial Management and Production: The financial management and the

production department are interrelated. The production department of any firm is
concerned with the production cycle, skilled and unskilled labour, storage of
finished goods, capacity utilisation, etc. and the cost of production assumes a
substantial portion of the total cost. The production department has to take
various decisions like replacing machinery, installation of safety devices, etc. and
all the decisions have financial implications.
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 4. Financial Management and Material Department: The financial management
and the material department are also interrelated. Material department covers the
areas such as storage, maintenance and supply of materials and stores,
procurement etc.
The finance manager and material manager in a firm may come together while
determining Economic Order Quantity, safety level, storing place requirement,
stores personnel requirement, etc. The costs of all these aspects are to be
evaluated so the finance manager may come forward to help the material manager.

5. Financial Management and Personnel: Financial management is also related

with human resource department, which provides manpower to all the functional
areas of the management. Financial manager should carefully evaluate the
requirement of manpower to each department and allocate the finance to the
human resource department as wages, salary, remuneration, commission, bonus,
pension and other monetary benefits to the human resource department. Hence,
financial management is directly related with human resource management.

6. Financial Management and Marketing: The marketing department is concerned

with the selling of goods and services to the customers. It is entrusted with
framing marketing, selling, advertising and other related policies to achieve the
sales target. It is also required to frame policies to maintain and increase the
market share, to create a brand name etc. For all this finance is required, so the
finance manager has to play an active role for interacting with the marketing
department.

7. Financial Management and Mathematics: Modern approaches of the financial

management applied large number of mathematical and statistical tools and
techniques. They are also called as econometrics. Economic order quantity,
discount factor, time value of money, present value of money, cost of capital,
capital structure theories, dividend theories, ratio analysis and working capital
analysis are used as mathematical and statistical tools and techniques in the field
of financial management.

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  Time Value of Money:
The value of money received today is different from the value of money received after
some time in the future. The TVM is the concept according to which a sum of money
owned in the present has a greater value than the value of the same sum received at a
moment in the future.

 Why do people prefer money toady than tomorrow? (Reasons)

1. Inflation: Under inflationary conditions the value of money, expressed in terms of its
purchasing power over goods and services, declines. When there is monetary inflation,
the value of currency decreases over time. The greater the inflation, the greater the
difference in value between a rupee today and a rupee tomorrow.

2. Risk: Re. 1 now is certain, whereas Re. 1 receivable tomorrow is less certain. This
‘bird-in-the-hand’ principle is extremely important in investment appraisal. An
individual is not certain about future cash receipt so he wants money today.

3. Personal Consumption Preference: Many individuals have a strong preference for

immediate rather than delayed consumption. The promise of a bowl of rice next week
counts for little to the starving man.

4. Investment Opportunities: Money like any other desirable commodity, has a price,
given the choice of Rs. 100 now or the same amount in one year’s time, it is always
preferable to take the Rs. 100 now because it could be invested over the next year at
(say) 18% interest rate to produce Rs. 118 at the end of one year.

 PRESENT VALUE

Present value describes how much a future sum of money is worth today.

FVN
PV =
(1 + r)N

Here FVN is a future value at the end of relevant period N,

PV is a present value,
r represents an interest rate earned per period
N is a number of years

 FUTURE VALUE
Future value of money is the value of money held presently at some given future time at
given rate of interest.
Future value = value of money at present + interest

FVN = PV × (1 + r)N

 ANNUITY

Annuity is a series of equal amount of cash flows for a specified number of years.

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