Unit 1

Financial Management

Finance is one of the crucial prerequisites to start any business. Further, a sufficient corpus of funds
and efficient financial management is required throughout a business’s lifetime and even when a
company is sold or wound up. Therefore, funds need to be managed, regulated as per procedures, and
monitored at every step of the business lifecycle.

Any business that manages its finances better experiences exponential growth, and businesses that
mismanage their financial resources and activities usually undergo losses or make lower profits. Let’s
delve deeper into the world of financial management.

Financial Management means planning, organizing, directing and controlling the financial activities
such as procurement and utilization of funds of the enterprise. Financial management has various
elements that require specific attention or we may call it the scope of financial management as well.
Financial management combines organisation, business objectives, task and innovation management
as well as the financial stability and profits of a business, and the list can lead to a convoluted practice.
However, it doesn’t have to be as complicated as it sounds. Most financial management plans will
break them down into four elements commonly recognised in financial management. These four
elements are planning, controlling, organising & directing, and decision making. With a structure and
plan that follows this, a business may find that it isn’t as overwhelming as it seems.
In simple terms, financial management is the business function that deals with investing the available
financial resources in a way that greater business success and return-on-investment (ROI) is achieved.
Financial management professionals plan, organize, and control all transactions in a business. They
focus on sourcing the capital whether it is from the initial investment by the entrepreneur, debt
financing, venture funding, public issue, or any other sources. Financial management professionals are
also responsible for fund allocation in an optimized way to ensure greater financial stability and growth
for the organization.
Scope in Broad Sense
Financial management is an organic function of any business. Any organization needs finances to
obtain physical resources, carry out the production activities and other business operations, pay
compensation to the suppliers, etc. There are many theories around financial management:

1. Some experts believe that financial management is all about providing funds needed by a
business on terms that are most favorable, keeping its objectives in mind. Therefore, this
approach concerns primarily with the procurement of funds which may include instruments,
institutions, and practices to raise funds. It also takes care of the legal and accounting relationship
between an enterprise and its source of funds.

2. Another set of experts believe that finance is all about cash. Since all business transactions
involve cash, directly or indirectly, finance is concerned with everything done by the business.
 3. The third and more widely accepted point of view is that financial management includes the
procurement of funds and their effective utilization. For example, in the case of a manufacturing
company, financial management must ensure that funds are available for installing the production
plant and machinery. Further, it must also ensure that the profits adequately compensate the costs
and risks borne by the business.
In a developed market, most businesses can raise capital easily. However, the real problem is the
efficient utilization of the capital through effective financial planning and control.

Scope in Narrow Sense

1. 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.

2. Financial decisions - They relate to the raising of finance from various resources which will
depend upon decision on type of source, period of financing, cost of financing and the returns
thereby.

3. Dividend decision - The finance manager has to take decision with regards to the net profit
distribution. Net profits are generally divided into two: a. Dividend for shareholders- Dividend and
the rate of it has to be decided. b. Retained profits- Amount of retained profits has to be finalized
which will depend upon expansion and diversification plans of the enterprise.

Evolution and Functions

Financial management emerged as a distinct field of study in the present business scenario. The evolution
of financial management may be divided into three broad phases:

i) The traditional phase

ii) The transitional phase
iii) The modern phase.

Let us discuss these phases in brief:

In the traditional phase the focus of financial management was on certain events which required funds e.g.,
major expansion, merger, reorganization etc. The traditional phase was also characterized by heavy
emphasis on legal and procedural aspects as at that point of time the functioning of companies was
regulated by a plethora of legislation. Another striking characteristic of the traditional phase was that, a
financial management was designed and practiced from the outsiders point of view mainly those of
investment bankers, lenders, regulatory agencies and other outside interests.

During the transitional phase the nature of financial management was the same but more emphasis was laid
on problems faced by finance managers in the areas of fund analysis planning and control.

The modern phase is characterized by the application of economic theories and the application of
quantitative methods of analysis. The distinctive features of the modern phase are:

 Changes in macro economic situation that has broadened the scope of financial management. The
core focus is how on the rational matching of funds to their uses in the light of the decision
criteria.
  The advances in mathematics and statistics have been applied to financial management specially
in the areas of financial modeling, demand forecasting and risk analysis.

Major Functions of Financial Management

Listing down the top 9 financial management functions can help you take a deeper look into the
functions of a financial manager. And, if you are interested, you can opt for financial management
courses and certifications.

1. Financial Planning and Forecasting

Financial management, refers to the procurement of funds and effectively managing and
utilising the same in business, While the term "financial management Planning & forecasting"
refers to the application of management principles to financial resources, in basic terms, it is

 Planning
 Organising
 Directing
 Controlling

2. Cash Management
The primary function of financial manager is to determine the revenue a company will need to
reach its goals. When determining how much capital a company needs, the role of a finance
manager includes estimating the size of the business, predicting profitability, and
understanding company policies. The manager must also know how to measure financial
risk management to secure the business from losses.
3. Determining the Capital Structure
When the capital requirement estimation is complete, one of the other major financial
management functions is deciding on the capital composition. Both long-term and short-term
debt equity research and analysis are involved in this function. It will mostly depend on the
amount of equity capital that a company already has and the additional revenue required from
other sources. The structure must be decided upon after assessing the necessary capital.
4. Funding Sources
Identifying the source of the capital is one of the next financial management functions. In order
to raise capital in exchange for equity, the company may choose to contact investors, take
bank loans, or hold an initial public offering (IPO). The advantages and restrictions of each
funding source are taken into consideration while choosing and ranking them.

5. Forecasting Cash Flows

Estimating the upcoming expenses is part of the cash flow forecasting process. A cash flow
prediction is an essential tool for your company because it will let you know whether you'll have
enough money to run or grow the enterprise. It will also let you know when the company is
losing more money than it is making. The funding sources may be internal or external.
6. Income Distribution
The financial manager functions include making the judgement regarding net revenues. This is
possible in two areas of an organization's financial management functions. First, when a
dividend is declared, the rate of dividends and, if applicable, bonuses are also determined.
7. Investing the Business Capital
Making decisions on how to distribute money to successful ventures is another one of the
functions of financial management. For each investment, the financial manager must be aware
of the financial management risk and projected return. Also, the investment strategies must
be designed to maximise profit potential and minimise capital loss. Financial management
functions are required to invest funds in viable businesses to ensure investment protection and
consistent returns on investment.
8. Financial Command
The finance manager must develop tactics and ways to work on financial control of funds in
addition to developing strategies to raise, allocate, and spend funds. A number of strategies
can be used to accomplish this when it comes to financial management functions, including
ratio analysis, financial forecasting, pricing, cost control, and others.
9. Pricing & Price Control
Many sizable businesses have thorough cost-accounting systems in place to keep track of
expenditures related to financial management functions. Moreover, systems are made to
emphasise statistically significant information on tasks and activities that will be displayed on a
monitor. Financial management functions may offer insight into variations in spending at
various manufacturing levels and the revenue margins required to run the firm successfully.

Types of financial management

Here are two types of financial management:

Strategic financial management

It is a type of financial management that involves managing the finances of a company to meet
its strategic goals. Strategic financial management uses different management techniques and
financial tools to create a strategic plan. This management approach helps identify and
implement strategies that maximise the organisation's market value. Strategic management
helps a manager make decisions related to investments in various assets. Some key features
of strategic financial management are:

 focusing on long-term fund management

 promoting growth and profitability and maximising shareholder's wealth

 utilising financial resources and focusing on the outcome of developed financial

strategies

 making decisions about mergers and acquisitions

  choosing capital investments

Tactical financial management

Tactical financial management involves managing the short-term finances of a company. This
management technique involves informing a company about how to process daily transactions
and comparing actual spending with the budget. Tactical management can help a company
ensure compliance with tax and legal requirements. The primary aim of this financial
management is taking benefit of the market condition. For instance, the tactical approach
provides flexibility to increase equity exposure when the market outlook is healthy. It can help a
company reduce losses and increase profits.

Objectives of Financial Management

For optimal financial decisions, it is essential to define objectives of financial management. These
objectives serve as decision-criterion. Financing is a functional area of business and, therefore, the
objectives of financial management must be in tune with the overall objectives of the business. The main
objectives of business are survival and growth. In order to survive in the business and to grow, a business
must earn sufficient profits. It must also maintain good relations with investors, employees, customers and
other groups of society. Financial management of an organisation may seek to achieve the following
objectives:

 Ensure adequate and regular supply of funds to the business,

 Provide a fair rate of return to the suppliers of capital,
 Ensure efficient utilisation of capital according to the principles of profitability, liquidity and
safety,
 Devise a definite system for internal investment and financing,
 Minimise cost of capital by developing a sound and economical combination of Corporate
securities,
 Co-ordinate the activities of the finance department with the activities of other departments of the
organisation.

Generally, maximization of economic welfare of its owners is accepted as the financial objective of the
firm. But, the question is, how does one maximise the owners’ economic welfare? Financial experts differ
while finding a solution to this problem. There are two well known criteria in this regard:
i) Profit Maximisation
ii) Wealth Maximisation.

Profit Maximization
The process of increasing the profit earning capability of the company is termed to as Profit Maximization.
It is basically a short-term goal and is primarily confined to the accounting analysis of the financial year. It
ignores the risk and avoids the time value of money. It is mainly concerned as to how the company will
survive and grow in the existing competitive business environment. The very objective of every business
enterprise is the welfare of its owners. It can be achieved by the maximisation of profits. Therefore,
according to this criterion, the financial decisions (investment, financing and dividend) of a firm should be
oriented to the maximisation of profits (i.e. select those assets, projects and decisions which are profitable
and reject those which are not profitable). In other words, actions that increase profits are be undertaken
and vice versa. Profit maximisation as an objective of financial management can be justified on the
following grounds:

1) Rational
2) Test of Business Performance
3) Main Source of Inspiration
4) Maximum Social Welfare
5) Basis of Decision-Making

Drawbacks of Profit Maximisation Concept

1) It is vague
2) It ignores time value of money
3) It ignores risks
4) It ignores social responsibility

From the above description, it can be easily concluded that profit maximisation criterion is inappropriate
and unsuitable as an operational objective of financial management. In imperfect competition, the profit
maximisation criterion will certainly encourage concentration of economic power and monopolistic
tendencies. That is why, the objective of wealth maximisation is considered as the appropriate and feasible
objective as against the objective of profit maximisation.

Wealth Maximisation

The ability of a company to increase the value of its stock for the stakeholders is known as Wealth
Maximization. It is a long-term goal and involves various external factors like sales, products, services,
market share, etc. It assumes the risk and recognizes the time value of money. It is mainly concerned with
the long-term growth of the company and hence is concerned more about fetching the maximum chunk of
the market share to attain a leadership position.

The objective of profit maximisation, as discussed above, is not only vague and ambiguous, but it also
ignores the two basic criteria of financial management i.e. (i) risk and (ii) time value of oney. Therefore,
wealth maximisation is taken as the basic objective of financial management, rather than profit
maximisation. It is also known as ‘Value Maximisation’ or ‘Net Present Value Maximisation’. According
to Ezra Soloman of Stanford University, the ultimate objective of financial management should be the
maximisation of wealth. Prof. Irwin Friend has also supported this view.

Superiority of Wealth Maximization

We have discussed the goals or objectives of financial management. Now, the question arises as to the
choice i.e., which should be the goal of financial management in decision –making i.e., profit
maximisation or wealth maximisation. In present day changed circumstances, wealth maximisation is a
better objective because it has the following points in its favour:

It measures income in terms of cash flows, and avoids the ambiguity now associated with accounting
profits as, income from investments is measured on the basis of cash flows rather than on accounting
profits.
It recognises time value of money by discounting the expected income of different years at a certain
discount rate (cost of capital).

It analyses risk and uncertainty so that the best course of action can be selected from different alternatives.

It is not in conflict with other motives like maximisation of sales or market value of shares. It helps rather
in the achievement of all these other objectives. The key difference between Wealth and Profit
Maximization is that Wealth maximization aims at long term objective of the company to increase the
value of the stock by increasing shareholders wealth to attain the leadership position in the market,
whereas, profit maximization aims at increasing the capability of earning profits in the short run for the
survival and growth of the company in the existing competitive market. The difference between both can
be viewed as follow:

TASKS AND RESPONSIBILITIES OF MODERN FINANCIAL

MANAGER
In the modern enterprise, a finance manager occupies a very important position, he being one of the most
dynamic members of corporate managerial team. Now a days, his role is becoming more and more
pervasive and significant in solving complex managerial problems. Earlier, the role of a finance manager
was confined to raising funds from various sources, but due to recent developments taking place in the
socioeconomic and political scenario throughout the world, he is placed in a central position in the
organisation. Finance manager is responsible for shaping the fortunes of the enterprise and is supposed to
involve in the most vital decision of allocation of capital like mergers, acquisitions, etc. A finance
manager, unlike other members of the corporate team cannot be averse to the fast developments, around
him and has to take note of the changes in order to take relevant steps in view of the dynamic changes in
circumstances. Financial activities of a firm are one of the most important and complex activities of a firm.
Therefore in order to take care of these activities, a financial manager needs to perform various financial
activities. The task and responsibilities of finance managers vary from organisation to organisation
depending upon the nature and size of the business, but inspite of these variations the main tasks and
responsibilities of finance manager can be classified as follows:

a) Compliance with policy and procedures laid by the Board of Directors.

b) Compliance with various rules and procedures as laid by law.
c) Information generation for various stakeholders.
d) Effective and efficient utilisation of funds.

The main tasks and responsibilities of a financial manager are discussed below:

1) Financial Planning and Forecasting: Financial manager is also concerned with planning and
forecasting of production, sales and level of inventory.

In addition to this, he has also to plan and forecast the requirement of funds and the sources from which the
funds are to be raised.

2) Financial Management: Fund management is the primary responsibility of the finance manager. Fund
management includes effective and efficient acquisition, allocation and utilisation of funds. The fund
management includes the following:

Acquisition of funds: The finance manager has to ensure that adequate funds are available from
the right sources at the right cost at the right time. The finance manager will have to decide the
mode of raising fund, whether it is to be through the issue of securities or lending from the bank.

Allocation of funds: Once funds are acquired the funds have to be allocated to various projects
and services as per the priority fixed by the Board of Directors.

Utilization of funds: The objective of business finance is to earn profiles, which on a very large
extent depend upon how effectively and efficiently allocated funds are utilized. Proper utilisation
of funds is based on sound investment decisions, proper control and asset management policies
and efficient management of working capital.

3) Disposal of Profits: Finance manager has to decide the quantum of dividend which the company wants
to declare. The amount of dividend will depend upon mainly the future requirement of funds for expansion
and the prevailing tax policy.

4) Maximisation of Shareholder’s Wealth: The objective of any business is to maximize and create
wealth for the investors, which is measured by the price of the share of the company. The price of the share
of any company is a function of its present and expected future earnings. The finance managers should
pursue policies which maximises earnings.
5) Interpretation and Reporting: Interpretation of financial data requires skills. The finance manager
should analyse financial data and find out the reasons for variance from standards and report the same to
the management. He should also assess the likely financial impact of these variances.

6) Legal Obligations: All the companies are governed by specific laws of the land. These laws relate to
payment of taxes, salaries, pension, corporate governance, preparation of accounts etc. The finance
manager should ensure that a true and correct picture of the state of affairs should be reflected in the
statement of accounts. He should also ensure that the tax returns and various
other information should be submitted on time.

Time Value of Money Definition

Time Value of Money (TVM) is a fundamental financial concept, stating that the current value of money is
higher than its future value, given its potential to earn in the years to come. Thus, it suggests that a sum of
money in hand is greater in value than the same sum of money received in the next couple of years.

Also referred to as the present discounted value, TVM is determined by its ability to yield returns in terms
of its future value. A person having the money in hand can invest it for better returns in the future. On the
other hand, the same amount received a year after, it loses its value.

What is the future value of money?

The future value of money is the amount of money you’ll have in the future, assuming you invest a
specific amount of money in an account with a certain interest rate. Investors can use this calculation to
compare different investments, such as a high-yield savings account versus stocks. The math can become
tricky because it’s based on the assumption of stable growth. For accounts with a set interest rate and one,
up-front payment, the formula is simpler, as you can see from the above example.

When we get into compounded annual interest, the formula becomes more complicated because you have
to account for the interest rate applying to the cumulative balance. A practical application of the future
value of money can be using the concept to help decide whether it’s better to put no money down on an
item — such as a car — or to finance part of the purchase.

The same concept applies to increasing retirement contributions as opposed to spending the money today.
So you can calculate how much you can expect to have in retirement and what the true cost of purchasing
that new item is in terms of the money you’re giving up in the future. For example, the future value in 10
years of a $25,000 car today assuming 5 percent compounded annually is $40,722. That car suddenly looks
a lot more expensive.

What is the present value of money?

The same principle works in reverse, allowing you to convert the future value of money into the present
value today. For example, if you received $500 in three years, that’s equivalent to $431.92 today, if you
can receive 5 percent interest annually on it. So if you were presented with the choice to receive $431.92
today or $500 in three years, you might be ambivalent about the choice if you know you can earn 5 percent
on your money over that time period.

The expected return you might receive over time – what experts call the discount rate – has a big impact on
the present value:

A higher discount rate means the present value of a future sum of money is lower.

A lower discount rate means the present value of a future sum of money is higher.

For example, using the $500 example from before, if you could earn 8 percent on your money over that
three-year period, then the present value of that money is just $396.92.

Winners of the lottery may think about present value when they’re deciding whether to take a lump sum
payment today or payments over a longer period. If they can earn more than the discount rate that lottery
officials use to calculate the lump sum payout, it may be worthwhile for winners to take the lump sum and
invest it themselves. So they may opt for the lower total payout.