CHAPTER ONE

AN OVERVIEW OF FINANCIAL MANAGEMENT

1.1. Introduction
To have a good understanding of financial management, you need to understand first what
finance is. Literally, finance means the money used in day-to-day activities of an individual or a
business for exchange of goods and services. But here our focus rather should be to consider
finance as a separate and distinct field of study like accounting, economics, mathematics, history,
geography etc..
1.1.1. What is Finance?
Finance is a distinct area of study that comprises facts, theories, concepts, principles, techniques
and practices related with raising and utilizing of funds (money) by individuals, businesses, and
governments.
According to Khan and Jain, “Finance is the art and science of managing money”.
Finance is a very wide and dynamic field of study. It directly affects the decisions of all
individuals and organizations that earn or raise money and spend or invest it. Therefore, finance
is also an area of study that deals with how, where, by whom, why, and through what money is
transferred among and between individuals, businesses, and governments. It is concerned with
the processes, institutions, markets, and instruments involved in the transfer of funds.
In addition to principles and techniques, finance requires individual judgment of the person
making the financial decision. Hence, finance can also be defined as the art and science of
managing money.
1.1.2 Classification of Finance
Finance is one of the important and integral part of business concerns, hence, it plays a major role
in every part of the business activities. It is used in all the area of the activities under the different
names. Finance can be classified into two major parts:
Private Finance deals with meeting the financial requirements of Individual, Firms, Business or
Corporate Financial in order to finance their activities.
Public Finance which concerns with collection of revenue and disbursement of Government such
as Central Government, State Government and Semi-Government Financial matters.
1.1.3 Evolution of Finance and Financial Management
Finance emerged as a field separate and distinct from economics around 1900. The first major
focus of financial management during its early years of development was the meanness how large
corporations of the time could raise capital. This was a period when the establishment of very
large companies like the Rockefeller oil and Morgan steel was marked.
The economic depression of the 1930s made financial management to shift to topics like
preservation of capital, maintenance of liquidity, reorganization of financially troubled
companies, and the bankruptcy process.
Until 1950s, the study of financial management had been descriptive or definitional in nature. But
in the mid 1950s, more analytical, decision – oriented approach began to evolve. These include
capital budgeting, cash and inventory management, capital structure formulation, and allocation
of income as dividends and retained earnings.

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Starting the late 1960s, the primary focus of financial management has been on the relationships
between risk and return of a firm’s financial decision. That is financial management has focused
on the maximization of earnings (return) for a given level of risk; or minimization of risk for a
given level of return.
1.1.4 Sources of Finance
Sources of finance mean the ways for mobilizing various terms of finance to the industrial
concern. Sources of finance state that, how the companies are mobilizing finance for their
requirements. The companies belong to the existing or the new which need sum amount of
finance to meet the long-term and short-term requirements such as purchasing of fixed assets,
construction of office building, purchase of raw materials and day-to-day expenses.
Sources of finance may be classified under various categories according to the following
important heads:
1. Based on the Period
Sources of Finance may be classified under various categories based on the period.
Long-term sources: Finance may be mobilized by long-term or short-term. When the finance
mobilized with large amount and the repayable over the period will be more than five years, it
may be considered as long-term sources. Share capital, issue of debenture, long-term loans from
financial institutions and commercial banks come under this kind of source of finance. Long-term
source of finance needs to meet the capital expenditure of the firms such as purchase of fixed
assets, land and buildings, etc.
Long-term sources of finance include: equity shares, preference shares, debenture, long-term loans
and fixed deposits
Short-term sources: Apart from the long-term source of finance, firms can generate finance with
the help of short-term sources like loans and advances from commercial banks, moneylenders, etc.
Short-term source of finance needs to meet the operational expenditure of the business concern.
Short-term source of finance include: bank credit, customer advances, trade credit, factoring,
public deposits and money market instruments
2. Based on Ownership
Sources of Finance may be classified under various categories based on the period:
An ownership source of finance includes; Shares capital, earnings, Retained earnings and
Surplus and Profits
Borrowed capital include; Debenture, Bonds, Public deposits and Loans from Bank and Financial
Institutions.
1.2. The nature and scope of financial management
Financial management is an integral part of overall management. It is concerned with the duties
of the financial managers in the business firm. The term financial management has been defined
by Solomon, “It is concerned with the efficient use of an important economic resource namely,
capital funds”. The most popular and acceptable definition of financial management as given by
S.C. Kuchal is that “Financial Management deals with procurement of funds and their effective
utilization in the business”.
Howard and Upton: Financial management “as an application of general managerial principles to
the area of financial decision-making.

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Weston and Brigham: Financial management “is an area of financial decision-making,
harmonizing individual motives and enterprise goals”.
Joshep and Massie: Financial management “is the operational activity of a business that is
responsible for obtaining and effectively utilizing the funds necessary for efficient operations.
Thus, Financial Management is mainly concerned with the effective funds management in the
business. In simple words, Financial Management as practiced by business firms can be called as
Corporation Finance or Business Finance.
Scope of Financial Management
Financial management is one of the important parts of overall management, which is directly
related with various functional departments like personnel, marketing and production. Financial
management covers wide area with multidimensional approaches. The following are the
important scope of financial management.
1) Financial Management and Economics
Economic concepts like micro and macroeconomics are directly applied with the financial
management approaches. Investment decisions, micro and macro environmental factors are
closely associated with the functions of financial manager. Financial management also uses the
economic equations like money value discount factor, economic order quantity etc. Financial
economics is one of the emerging area, which provides immense opportunities to finance, and
economical areas.
2) Financial Management and Accounting
Accounting records includes the financial information of the business concern. Hence, we can
easily understand the relationship between the financial management and accounting. In the
olden periods, both financial management and accounting are treated as a same discipline and
then it has been merged as Management Accounting because this part is very much helpful to
finance manager to take decisions. But nowadays financial management and accounting discipline
are separate and interrelated.
3) Financial Management or 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.
4) Financial Management and Production Management
Production management is the operational part of the business concern, which helps to multiply
the money into profit. Profit of the concern depends upon the production performance.
Production performance needs finance, because production department requires raw material,
machinery, wages, operating expenses etc. These expenditures are decided and estimated by the
financial department and the finance manager allocates the appropriate finance to production
department. The financial manager must be aware of the operational process and finance required
for each process of production activities.
5) Financial Management and Marketing
Produced goods are sold in the market with innovative and modern approaches. For this, the
marketing department needs finance to meet their requirements. The financial manager or
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finance department is responsible to allocate the adequate finance to the marketing department.
Hence, marketing and financial management are interrelated and depends on each other.
6) Financial Management and Human Resource
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.

1.3. Functions of Financial Management

The modern approach to the financial management is concerned with the solution of major
problems like investment financing and dividend decisions of the financial operations of a
business enterprise. Thus, the functions of financial management can be broadly classified into
three major decisions, namely:
(a) Investment decisions,
(b) Financing decisions,
(c) Dividend decisions.
The functions of financial management are briefly discussed as under:
1.3.1. Investment Decision
The investment decision is concerned with the selection of assets in which funds will be invested
by a firm. The assets of a business firm include long term assets (fixed assets) and short term
assets (current assets). Long term assets will yield a return over a period of time in future whereas
short term assets are those assets which are easily convertible into cash within an accounting
period i.e. a year. The long term investment decision is known as capital budgeting and the short
term investment decision are identified as working capital management.
Capital Budgeting may be defined as long – term planning for making and financing proposed
capital outlay. In other words Capital Budgeting means the long-range planning of allocation of
funds among the various investment proposals. Another important element of capital budgeting
decision is the analysis of risk and uncertainty. Since, the return on the investment proposals can
be derived for a longer time in future, the capital budgeting decision should be evaluated in
relation to the risk associated with it.
Two important aspects of capital budgeting decision are:
a. The evaluation of the prospective profitability of new investments.
b. The measurement of cut-off rate against that the prospective return of new investment
could be compared.
Risk in investment arises because of the uncertain return. So that, investment proposal should be
evaluated both in terms of expected return and risk. In addition, investment decision needs
replacement decisions.
The opportunity cost of capital is the Expected Rate of Return that an investor could earn by
investment his/her money in financial assets of equivalent risk.
On the other hand, the financial manager is also responsible for the efficient management of
current assets i.e. working capital management. Working capital constitutes an integral part of
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financial management. The financial manager has to determine the degree of liquidity that a firm
should possess. There is a conflict between profitability and liquidity of a firm.
Working capital management refers to a trade – off between liquidity (Risk) and profitability.
Insufficiency of funds in current assets results liquidity and possessing of excessive funds in
current assets reduces profits. Hence, the finance manager must achieve a proper trade – off
between liquidity and profitability. In order to achieve this objective, the financial manager must
equip himself with sound techniques of managing the current assets like cash, receivables and
inventories etc.
1.3.2. Financing Decision
The second important function is financing decision. The financing decision is concerned with
capital – mix, financing – mix or capital structure of a firm. The term capital structure refers to the
proportion of debt capital and equity share capital. Financing decision of a firm relates to the
financing – mix. This must be decided taking into account the cost of capital, risk and return to the
shareholders. Employment of debt capital implies a higher return to the share holders and also the
financial risk. There is a conflict between return and risk in the financing decisions of a firm. So,
the financial manager has to bring a trade – off between risk and return by maintaining a proper
balance between debt capital and equity share capital.
On the other hand, it is also the responsibility of the financial manager to determine an
appropriate capital structure.
1.3.3. Dividend Decision
The third major function is the dividend policy decision. Dividend policy decisions are concerned
with the distribution of profits of a firm to the shareholders. How much of the profits should be
paid as dividend? i.e. dividend pay-out ratio. The decision will depend upon the preferences of
the shareholder, investment opportunities available within the firm and the opportunities for
future expansion of the firm. The dividend payout ratio is to be determined in the light of the
objectives of maximizing the market value of the share. The dividend decisions must be analyzed
in relation to the financing decisions of the firm to determine the portion of retained earnings as a
means of direct financing for the future expansions of the firm.
1. Capital Budgeting
1. INVESTMENT
DECISIONS 2. Working Capital MGT
1. Cost of Capital
FINANCIAL 2. Capital Structure
2. FINANCING
MANAGEMENT DECISIONS 3. Leverages
3. DIVIDEND 1. Dividend Policy
DECISIONS 2. Retained Earnings
1.5 Goals/ Objectives Of Financial Management
The very objective of Financial Management is to maximize the wealth of the shareholders by
maximizing the value of the firm. This prime objective of Financial Management is reflected in the
EPS (Earning per Share) and the market price of its shares.
The earlier objective of profit maximization is now replaced by wealth maximization. Since profit
maximization is a limited one it cannot be the sole objective of a firm. The term profit is a vague
phenomenon and if given undue importance problems may arise whereas wealth maximization

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on the other hand overcomes the drawbacks of profit maximization. Thus the objective of
Financial Management is to trade off between risk and return. The objective of
Financial Management is to make efficient use of economic resources mainly capital.
The functions of Financial Management involves acquiring funds for meeting short term and long
term requirements of the firm, deployment of funds, control over the use of funds and to trade-off
between risk and return.
Effective procurement and efficient use of finance lead to proper utilization of the finance by the
business concern. It is the essential part of the financial manager. Hence, the financial manager
must determine the basic objectives of the financial management. Objectives of Financial
Management may be broadly divided into two parts such as:
I. Profit maximization II. Wealth maximization.
1.5.1 Profit Maximization
Its 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. Profit maximization is also the traditional and
narrow approach, which aims at, maximizes the profit of the concern. Profit maximization
consists of the following important features.
1. Profit maximization is also called as cashing per share maximization. It leads to maximize the
business operation for profit maximization.
2. Ultimate aim of the business concern is earning profit, hence; it considers all the possible ways
to increase the profitability of the concern.
3. Profit is the parameter of measuring the efficiency of the business concern. So it shows the
entire position of the business concern.
4. Profit maximization objectives help to reduce the risk of the business.
Favorable Arguments for Profit Maximization
The following important points are in support of the profit maximization objectives of the
business concern:
(i) Main aim is earning profit.
(ii) Profit is the parameter of the business operation.
(iii) Profit reduces risk of the business concern.
(iv) Profit is the main source of finance.
(v) Profitability meets the social needs also.
Unfavorable Arguments for Profit Maximization
The following important points are against the objectives of profit maximization:
(i) Profit maximization leads to exploiting workers and consumers.
(ii) Profit maximization creates immoral practices such as corrupt practice, unfair trade
practice, etc.
(iii) Profit maximization objectives leads to inequalities among the stake holders such as
customers, suppliers, public shareholders, etc.
Drawbacks of Profit Maximization
Profit maximization objective consists of certain drawback also:
(i) It is vague: In this objective, profit is not defined precisely or correctly. It creates some
unnecessary opinion regarding earning habits of the business concern.
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 (ii) It ignores the time value of money: Profit maximization does not consider the time value
of money or the net present value of the cash inflow. It leads certain differences
between the actual cash inflow and net present cash flow during a particular period.
(iii) It ignores risk: Profit maximization does not consider risk of the business concern.
Risks may be internal or external which will affect the overall operation of the business
concern.
1.5.2 Wealth Maximization
Wealth maximization is one of the modern approaches, which involves latest innovations and
improvements in the field of the business concern. The term wealth means shareholder wealth or
the wealth of the persons those who are involved in the business concern. Wealth maximization is
also known as value maximization or net present worth maximization. This objective is
universally accepted concept in the field of business.
Favorable Arguments for Wealth Maximization
(i) Wealth maximization is superior to the profit maximization because the main aim of the
business concern under this concept is to improve the value or wealth of the shareholders.
(ii) 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.
(iii) Wealth maximization considers both time and risk of the business concern.
(iv) Wealth maximization provides efficient allocation of resources.
(v) It ensures the economic interest of the society.
Unfavorable Arguments for Wealth Maximization
(i) Wealth maximization leads to prescriptive idea of the business concern but it may not be
suitable to present day business activities.
(ii) Wealth maximization is nothing, it is also profit maximization, it is the indirect name of the
profit maximization.
(iii) Wealth maximization creates ownership-management controversy.
(iv) Management alone enjoys certain benefits.
(v) The ultimate aim of the wealth maximization objectives is to maximize the profit.
(vi) Wealth maximization can be activated only with the help of the profitable position of the
business concern.
1.6 Agency Problems
It has long been recognized that managers may have personal goals that compete with
shareholder wealth maximization. Managers are empowered by the owners of the firm, the
shareholders, to make decisions and that creates a potential conflict of interest known as agency
theory. An agency relationship arises whenever one or more individuals, called principals, hire
another individual or organization, called an agent, to perform some service and delegate
decision-making authority to that agent. In financial management, the primary agency
relationships are those between (1) stockholders and managers and (2) managers and debt
holders.
Jensen and Meckling were the first to develop a comprehensive theory of the firm under agency
arrangements. They showed that the principals, in our case the shareholders, can assure
themselves that the agents (management) will make optimal decisions only if appropriate
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incentives are given and only if the agents are monitored. Incentives include stock options,
bonuses, and perquisites (“perks,” such as company automobiles and expensive offices), and
these must be directly related to how close management decisions come to the interests of the
shareholders. Monitoring is done by bonding the agent, systematically reviewing management
perquisites, auditing financial statements, and limiting management decisions. These monitoring
activities necessarily involve costs, an inevitable result of the separation of ownership and control
of a corporation. The less the ownership percentage of the managers, the less the likelihood that
they will behave in a manner consistent with maximizing shareholder wealth and the greater the
need for outside shareholders to monitor their activities.
Some people suggest that the primary monitoring of managers comes not from the owners but
from the managerial labor market. They argue that efficient capital markets provide signals about
the value of a company’s securities, and thus about the performance of its managers. Managers
with good performance records should have an easier time finding other employment (if they
need to) than managers with poor performance records. Thus, if the managerial labor market is
competitive both within and outside the firm, it will tend to discipline managers. In that situation,
the signals given by changes in the total market value of the firm’s securities become very
important.
Shareholders versus Managers
The agency problem arises when a manager owns less than 100% of the company’s ownership. As
a result of the separation between the managers and owners, managers may make decisions that
are not in line with the goal of maximizing stockholder wealth. For example, they may work less
eagerly and benefit themselves in terms of salary and perks. The costs associated with the agency
problem, such as a reduced stock price and various “perks,” are called agency costs. Thus, to
mitigate agency problems, the following measures should be taken.
(1) Golden parachutes or severance/division of contracts; (2) performance-based stock option
plans/give ownership rights through stock options to managers; (3) the threat of takeover (4)
Offering of attractive monetary and non-monetary incentives to manager; (5) Close monitoring by
shareholders may help to reduce Agency costs.
Creditors versus Shareholders
Conflicts develop if
(1) Managers, acting in the interest of shareholders, take on projects with greater risk than
creditors anticipated and
(2) Raise the debt level higher than was expected. These actions tend to reduce the value of
the debt outstanding.