Unit 1: Introduction to Financial Management

A] Introduction, Meaning and Importance of Financial Management

Finance is derived from the French word ‘finer’ which means to pay or settle.
Every business organization, whether big or small requires finance throughout its lifetime. Hence, finance is the
lifeblood of modern business. Following are examples of the different needs/uses of Finance:

i. Promoting a company= To register a co., paying necessary charges, fees, obtaining imp. Documents etc.
ii. Buying Fixed Assets= Finance is required to purchase fixed assets such as Plant, Machinery, equipment,
Office, Factory, Furniture etc. which are all essential to run a business.
iii. Working Capital= Finance is required for smooth day-to-day running of business. This is termed as
working capital. It helps in timely payment of wages, salaries, to suppliers for raw.
materials etc.
iv. Pay Taxes/Duties = Various forms of taxes such as Income tax,GST etc. has to be paid to government
on time.
v. Advertising/Promotion Exps= To push the sales and revenue of the business, advertising exps are required
vi. Repay loans/Interest = Finance is required to repay loan instalments along with interest on time to banks,
Financial Institutions
vii. Paying Dividends= Finance is required to pay cash dividends to shareholders.

Role of Finance Managers in Traditional days:

Traditionally, finance managers were concerned only with raising the required funds in a company. This was in
1940’s & 1950’s. However, this approach did not involve decision making, and it also ignored efficient
employment/usage of those funds. This approach laid emphasis on external sources of long-term finance.
Role of Finance Managers in Modern days:
Modern approach came into existence due to the inherent limitations of traditional approach. According to the
modern approach, finance manager is concerned not only with the optimum way of raising funds but also their
proper and efficient usage.

Financial Management is that managerial activity which is concerned with the planning and controlling
of the firm’s financial resources, Such as procurement and utilization of funds of the enterprise. It means
applying general principles of management to financial resources of the enterprise.
Finance is the key to successful business operations. Without proper administration of finance, no
business enterprise can reach its full potentials for growth and success

Importance of Financial Management can be summarized as follows:

i] Organizations: FM is important to all types of organizations namely Business organizations, NGOs,
Govt. undertakings, Public & Pvt Sectors etc.
ii] Shareholders : Shareholders rely on FM to receive optimum dividend and maximize their wealth
iii] Lenders/Creditors: They rely on effective FM for safety of their funds, timely repayment of principle and
interest
iv] Employees: Employees rely on effective FM for getting timely payment of their wages/salary,
bonus, incentives and retirement benefits
v] Customers : Customers rely on FM for getting quality products at reasonable prices
vi] Public: They rely on FM to fund general Public welfare activities as a part of Corporate Social
Responsibility[CSR]
vii] Government : FM ensures timely payment of taxes and other charges
viii] Management : Efficient FM helps management in overall brand/image building, increase in the
market share,optimizing shareholders wealth and profit.
ix] Other Departments:Finance dept. thru efficient management of funds has to ensure that adequate funds
are made available to all departments [Production, marketing etc] for their smooth
functioning.
Thus we can say that :
i] It brings economic growth & development thru investments, financing, dividend, and risk management
decisions which help companies to undertake better projects.
ii] When there is good growth and development of the economy, it will ultimately improve the std. of living of
all the people.
Iii] Improved std. of living will lead to good health and financial stress will reduce.
Iv] It enables the individuals to take better financial decisions, which will reduce poverty, reduce debts ,
increase savings and investments

B] Scope /Functions of Financial Management

Financial Management has a wide scope and includes the following:
i]Anticipation = Estimating financial needs of the co. [i.e. How much finance is required?]
ii] Acquisition= Collecting finance from different sources[Equity ,Debt etc]
iii] Allocation = Using this allocated finance to purchase fixed and current assets for the company
iv]Appropriation = Dividing the profits of the co. among shareholders, debentureholders and also keeping a part
as reserves
v] Assessment = Controls all the financial activities

Following are the main function of FM/Scope Of FM:

i] Procurement/Getting of Funds
-Funds are obtained from different sources & have different features in terms of risk,cost & control.
-From the risk point of view, Equity Capital is the best ,since it has to be repaid only on winding up of the
company. However ,it is the most costly source, since many expenses such as brokerage,underwriting, etc are
involved. Also, equity shareholders expectations in relation to dividend, bonus has to be taken care of.
-Debentures on the other hand are cheaper due to their tax advantage. However, they are riskier to the company
than equity shares due to the requirement of timely payment of interest & redemption of principle on maturity.
-Thus, a Finance Manager should keep the cost of funds at a minimum level & should ensure proper balancing
of risk & control.
-Thus ,the Finance Manager should estimate the Capital Requirements for long-term ,medium term & short
term requirements.
-Once estimation is done, he has to decide about the sources from which these funds are to be obtained ,keeping
in mind the cost, risk & control.
-He should work out a proper mix of these & get funds at minimum cost ,minimum risk & with least dilution of
control of the present owners.

ii] Effective Utilisation of Funds

Funds should not be kept idle. It should be ensured that the funds generate a higher rate of return than the cost
of these funds.
Investment in fixed assets should be done only after employing proper Capital Budgeting techniques. Similarly,
adequate working capital should be maintained so as to avoid the risk if insolvency & problems of liquidity.

iii] Disposal Of Surplus

The surplus profits generated ,can be disposed in 2 ways ,namely, by giving Dividends or Transfer to Reserves.

iv] Management of Cash & Receivables

Cash is required for many purposes such as payment of wages & salaries ,payment of expenses ,payment to
creditors etc . Cash Management decisions should be such as to give maximum liquidity to the firm alongwith
maximum profits.
Accounts Receivable are the money receivable in some future date for Credit Sales/ services given at present.
Extension of credit involves both ,costs & benefits .The decision must be taken to determine the ultimate effect
of credit sales on company’s profitabilty
C] The main objectives/goals of FM :
The most fundamental objective of FM is Wealth Maximization
In general, following are the main objectives of Financial Management which ultimately leads to wealth
maximization in the long run :

i.Proper Utilization of Funds:

The main responsibility of finance managers is to ensure proper utilization of funds which are mobilized thru
different sources. Usage of these funds should lead to Value Addition.

ii. Maximisation of Return on Investment [ROI]:

It is the primary aim of every company to earn a high ROI so that it need not depend on additional funds and at
the same time it can reward its shareholders in terms of dividend and bonus shares.

iii. Ensuring a Sound Capital Structure

Having an optimum capital mix [i.e Proportion of Equity and Debt ] is also a very imp. Goal. Whilst doing so,
various factors should be kept in mind namely cost of each source of funds, Control, risk,

iv.Survival :
The problem of survival arises due to increased competition, change in consumer behaviour , technology
change, labour problems etc. A wrong decision may put the company’s survival itself in danger. This problem
of survival is common to all types of business units ,big or small.

v. Cashflows:
A short term goal of financial management is to ensure availability of adequate cashflows to meet its working
capital such as payment of raw materials, wages,rent etc. An organization with strong cashflows can take
advantage of many opportunities such as cash discounts on instant payments, bulk purchases, offering credit to
customers etc.

vi. Break Even Point:

This is another short term objective of a firm. Every firm must aim at achieving break-even level[i.e level of no
profit no loss] at the earliest , since profit is earned once this level is achieved .

vii. Minimum Profits:

The firm must be able to earn minimum profits in short term so as to cover all its expenses. Profit is the soul of
the business, ‘No Profit No Business’. If profits are not there, people may even withdraw their invested money
and would also discourage future investors.

viii. Good Image for the organization

An efficient Finance department will bring good name, reputation,image and goodwill for the firm in the
market, and this will help survival in short run and also success in long run

ix.Ensure Co-ordination between other activities/departments

Proper co-ordination between company’s activities, departments is also an imp. Objective

D] Qualities of a Successful Finance Manager

The job of a Finance Manager is full of duties and responsibilities. In order to perform his duties successfully ,
he should possess the following qualities :
1.Good Personality :
He should be physically and mentally healthy and strong enough to bear the strain of finance in an
organization
2.Intelligence & Self Confidence
The job of a finance manager involves analytical work.He should be intelligent enough to grasp the
financial problems well and immediately respond and also control the finance.He should also be self confident
to face the challenges involved in his job.
3.Initiative
He should do the job on his own without being asked to
4.Innovative
He should have research and a creative mind. He should be able to bring innovation in financial
management of the organization.
5.Communication Skill
He should understand the problems of his subordinates and communicate instructions to solve them,
thru effective communication skills.
6.Decision Making Skill
His job involves decision making. He has to take various decisions which have financial implications on
the working of the organization. He should be able to judge the situation and take the decision accordingly.
7.Administrative Skill
He should be able to plan, organize, direct, control and coordinate the finance activities. He has to see
that the financial decisions are properly implemented.
8.He should be honest, patient and disciplined
Finance field requires utmost honesty, self discipline to be able to enforce these qualities in the whole
organization. Also ,he should be patient and not take hasty decisions which can have an adverse impact on the
organisation

E] Profit Vs Wealth Maximization

Profit Maximisation:
-To achieve this objective ,various types of Financial decisions may be taken .Sometimes , decision makers
adopt policies giving extraordinary profits in the short –run but may prove to be unhealthy for the growth
,survival & overall interests of the firm.
-In today’s modern world, profit maximization as an ultimate goal /objective is considered Immoral, Unrealistic
& Difficult ,since it ignores social responsibility , & may lead to using unethical methods.
-Profitability as a guide to financial decision making is simple. This is because profit is considered as a test of
economic efficiency,it provides a yardstick by which economic performance can be judged
-It leads to efficient allocation of resources

The Profits are measured as Total accounting Profit available to shareholders.

Advantages of using Profit Maximisation Approach:
i. Profit is a test of economic efficiency
ii. It leads to efficient usage of resources i.e Resources are directed to most profitable projects
iii. It ensures maximum social welfare since leads to higher standard of living, economic growth ,lowers
poverty
Limitations of using Profit Maximisation Approach:
i. Profit is a loose term for eg. Profit before tax or Profit after tax, Operating profit or shareholders
profit etc. It is not clear which profit should be maximised
ii. There is no guidance as to how to compare present and future profits, their timings etc
iii. It undermines future for today’s profit, hence can ignore projects which will be profitable in future

Wealth Maximisation / Value Maximisation :

The wealth/value of the firm is defined as the market price of the Firm’s Share. The maximization of price of
shares in the long-run should be by making efficient decisions which are desirable for the growth of the
company & are valued positively by the investors and not by manipulating the prices in the short-run.
Market Price of shares takes into account present & future EPS, timing ,risk of these earnings ,dividend policy
of the company.
If the share value is to stay high , the company has to reduce its costs & utilize its resources efficiently.
Advantages of using Wealth Maximisation Approach:
i. It is a long term strategy which raises the present value of owner’s investment,that is undertaking
projects that will increase the market value of firm’s securities
ii. Recognises Risk and Uncertainties[Govt securities are risk free , other securities have a risk
premium]Risk premium is the consideration for the risk perceived by the investor for that security.
iii. Considers shareholders return by considering the payment of dividends to their shareholders
iv. It is based on the concept of cashflows, and cashflows are a reality& are exact[unlike profits]
v. It considers time value of money,

Wealth Maximization leads to economic growth ,higher economic output, productivity, employment and higher
wages .Management’s most important mission is to maximize Shareholder’s wealth

Concept Of Economic Value Added [EVA]

-EVA is based on the past performance of the company.
-It determines whether the firm is earning a higher rate of return on all invested funds in comparison to the Cost
of such funds [based on WACC]
-If earnings are greater than costs, management is adding to shareholder’s wealth/value, & if the company’s
WACC is greater than corporate earnings ,shareholder’s wealth is eroded.
-Thus, EVA implies the difference between operating profits after taxes & total cost of funds. Thus, EVA= [Net
operating Profit after tax-(Tot. Capital*WACC)]
-EVA Approach is modified Accounting Approach to find profits after meeting all financial costs
-It reflects true profit position of the company, and is more realistic than traditional accounting approach ,since
firms cannot earn profits without meeting financial costs.
-It is in line with Cost-Benefit Analysis i.e. Financial Benefits should be more than Financial costs in order to
have true profits.
Advantages of EVA:
1.It focuses more on wealth creation than profit maximization
2.According to EVA, business should cover both, operating & capital costs ,hence it is useful to shareholder,
creditors, employees
3.EVA helps in evaluating project performance
4.It focuses on Cashflow ,not just profits
Disadvantages of EVA:
1.It is very tough to compute, since assumptions are required for WACC
2.NOPAT requires adjustment of Non-Cash expenses
3.EVA is calculated on historical data & future predictions are difficult

Concept of Trading on Equity

Trading on equity means using borrowed funds[carrying fixed rate of interest] in the expectation of obtaining a
higher return to the equity shareholders.
Trading on equity is a concept where a firm operates with less proportion of equity shareholder’s funds/equity
capital and more proportion of borrowed funds ,and thus helps in maximising the returns to equity shareholders.
By increasing return to equity shareholders, it helps in Wealth Maximisation
Trading on equity can be successfully used by only those companies which have stable earnings ,or those
companies whose earnings increase every year.
Trading on equity cannot be used by companies with fluctuating earnings, since they will find it difficult to pay
Interest expense in time.
Trading on equity helps in generating higher returns to the shareholders by utilising the benefits of low cost
loans/borrowed funds.[ Low cost since interest is lower and tax benefit can also be availed]
Thus, companies with higher earnings ability than its cost of capital can utilise this concept effectively
Trading on equity is explained with the help of following example:
Situation 1 [No Debt] – Equity Capt =Rs.100,000
Situation 2 [with Debentures] – Equity Capt Rs. 50,000 and 10%Debentures Rs.50,000
NPBIT = 25,000 ; Tax =30%

Solution: Situation 1 Situation 2

NPBIT 25,000 25,000
-Interest ------ (5000) [50,000*10%]
----------- ----------
NPBT 25,000 20,000
-Tax @30% (7500) (6000)
---------- ---------
NPAT 17,500 14,000
[Profit Avail for equity]

Return on Equity= 17500 14000

Prof avail for eq/ Eq Capt -------- ---------
100,000 50,000
=17.5% 28%

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