CHAPTER ONE

AN OVERVIEW OF FINANCIAL MANAGEMENT

INTRODUCTION

In simple language finance is money. To start any business we need capital. Capital is the
amount of money required to start a business. The finance is required to acquire various fixed
assets and current assets. 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. This course
discusses the meaning of finance, types of finance, need of finances, objectives and functions
of financial management in detail.

1.1. BASIC IDEA OF FINANCIAL MANAGEMENT

Finance is the study of money. Finance means to arrange payment for. It is basically
concerned with the nature, creation, behavior, regulation and problems of money. It focuses
on how the individuals, businessmen, investors, government and financial institutions deal.
We need to understand what money is and does is the foundations of financial knowledge. In
this content it is relevant to study the structure and behavior of financial system and the role
of financial system in the development of economy and the profitability of business
enterprises.

You are aware that no business can be started without finance. Finance is a scarce resource
which is not available freely and it has cost. All the resources that are useful to any business
organization like men, material, machines and money or finance are limited in nature. Since,
they are limited, we cannot waste them. These resources are to be used optimally for
productive purposes. Finance is one of the resources vital for any business organization. It is
scarce, has cost and also alternative uses.

Financial management involves the management of finance function. It is concerned with the
planning, organizing, directing and controlling the financial activities of an enterprise. It
deals mainly with raising funds in the most economic and suitable manner; using these funds
as profitably as possible; planning future operations; and controlling current performance and
future developments through financial accounting, cost accounting, budgeting, statistics and
other means. It is continuously concerned with achieving an adequate rate of return on
investment, as this is necessary for survival and attracting of new capital. Thus, financial
management means the entire range of managerial efforts devoted to the management of
finance – both its sources and uses – of the enterprise.

The importance of financial management cannot be over emphasized. In every organization,

where funds are involved, sound financial management is necessary. It helps in monitoring
the effective deployment of funds in fixed assets and in working capital. As Collins Brooks
has remarked “Bad production management and bad sales management have slay in
hundreds, but fault financial management has slain in thousands.” Hence, it can be said that
sound financial management is indispensable for any organization, whether it is profit
oriented or non-profit oriented. It helps in profit planning, capital spending, measuring costs,
controlling inventories, accounts receivable etc., In addition to the routine problems,
financial management also deals with more complex problems like mergers, acquisitions and
reorganizations.

1.2. BASIC ASSUMPTIONS AND PRINCIPLES OF FINANCIAL

MANAGEMENT

A successful study of financial management requires the need for a conceptual framework or
assumptions, contexts and principles in which financial management theories can be
developed. Therefore, we study financial management under the assumptions of capital
markets, in the context of corporate form of business organizations and under the guidance of
the basic principles that form the financial management.

The major areas of finance are: (1) Financial services and (2) financial management
(managerial finance/ corporate finance. Financial service is concerned with design and
delivery of advice and financial products to individuals, businesses and governments within
the areas of banking and related institutions, personal financial planning, investments, real
estate, and insurance and so on. While, financial management is the management of capital
sources and their uses so as to attain the desired goal and objectives of the firm. It involves

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sourcing of funds, making appropriate investments and promulgating the best mix of
financial resources in relation to the value of the firm.

Basic Assumptions
A. Existence of well developed capital market
Financial management is studied under the assumption that there is capital market and capital
exchange in the business environment concerned with free and competitive interaction and
reasonable costs and prices like any commodity market .This interaction in a well developed
capital market exists between the corporation and financial markets in the following manner.
Initially, the corporation raises capital in the financial markets by selling securities –stocks
and bonds .Secondly, the corporation then invests this in return generating assets-new
projects. Thirdly, the cash flow from those assets is either reinvested in the corporation,
given back to the investors, paid to government in the form of taxes.

B. The Context of Corporate Form of Business Organizations

Financial management is studied in the context of a corporate form of business organization

and its decisions due to the following characteristics and advantages of a corporation.
I. Basic characteristics
 Separate legal existence
 Limited liability
 Ownership possession and transfer through stocks.
 Separation of ownership from management
 Indefinite life time
 Double taxation
 The right to issue shares.
II. Advantages
 Ease of raising capital/ mobilization of huge amount of capital
 Existence of secondary capital markets /resale markets. A secondary market is a
security market in which previously stocks are resold or exchanged while primary
stock markets are markets in which stocks are exchanged when they are first
issued.
 A corporate entity is a self perpetuating entity

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  Corporations have a better chance of growth due to their ability for easy raise of
capital.

Basic principles that form the basis for financial management

1. The risk –return trade-off

In financial decision making, we don’t take additional risk unless we expect to be
compensated with additional return that is, investors demand a high return for taking
additional risks. The risk– return relationship will be a key concept in the valuation of stocks
and bonds and proposal of new projects for acceptance.
2. The time value of money
A dollar received today is worth more than a dollar to be received in the future .The time
value of money is the opportunity cost of passing up the earning potential of a dollar today.
3. Cash –Not profits –is a king
In measuring wealth or value, we will consider cash flows, not accounting profits, because it
is the cash flows, not profits that are actually received by the firm, relevant for decision
making and can be reinvested .Accounting profits on the other hand, appear when they are
earned rather than when the money is actually in hand.
4. Incremental cash flows.
It is only what changes that count. In making business decisions in creating wealth ,we only
consider incremental cash flow which is the difference between the cash flows if the decision
is made versus what they will be if the decision is not made/Relevant cash flow analysis/
5. Efficient capital markets – capital markets are efficient and the prices are right. An
efficient capital market is a market in which the values of all assets and securities at any
instant in time fully reflect all available public information. Such markets characterized by
the existence of a large number of profits –driven individuals acting independently.
6. The Agency problem – Managers won’t work for owners unless it’s in their best interest.
It is the problem resulting from conflicts of interest between the managers (agents of the
stockholders) and the stockholders.
7. Taxes bias business decision- In incremental cash flow analysis, the cash flow to be
considered should be after- tax incremental cash flows to the firm as a whole.

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8. All risks are not equal – Some risks can be diversified away, and some cannot be. Risk
diversification is the process of reducing risk through increasing the alternatives of risk full
investment and other business decisions.
9. Ethical behavior is doing the right thing and ethical dilemmas are everywhere in the
business.

1.3. SCOPE OF FINANCIAL MANAGEMENT

Financial management has undergone significant changes over the years as regards its scope
and coverage. As such the role of finance manager has also undergone fundamental changes
over the years. In order to have a better exposition to these changes, it will be appropriate to
study both the traditional concept and the modern concept of the finance function.

Traditional Concept:

In the beginning of the 20th century/1900, which was the starting point for the scholarly
writings on Corporation Finance, the function of finance was considered to be the task of
providing funds needed by the enterprise on terms that are most favorable to the operations
of the enterprise. The traditional scholars are of the view that the quantum and pattern of
finance requirements and allocation of funds as among different assets, is the concern of non-
financial executives. According to them, the finance manager has to undertake the following
three functions:

i) Arrangement of funds from financial institutions;

ii) Arrangement of funds through financial instruments Viz. shares, bonds, etc
iii) Looking after the legal and accounting relationship between a corporation and its
sources of funds

The traditional concept found its first manifestation, though not systematically, in 1897 in the
book ‘Corporation Finance’ written by Thomas Greene. It was further impetus by Edward
Meade in 1910 in his book, ‘Corporation Finance’. Later, in 1919, Arthur Dewing brought a
classical book on finance entitled “The Financial Policy of Corporation.”

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The traditional concept evolved during 1920s continued to dominate academic thinking
during the forties and through the early fifties. However, in the later fifties the traditional
concept was criticized by many scholars including James C. Van Horne, Pearson Hunt,
Charles W. Gerstenberg and Edmonds Earle Lincoln due to the following reasons:

The emphasis in the traditional concept is on rising of funds, this concept takes into account
only the investor’s point of view and not the finance manager’s view point. The traditional
approach is circumscribed to the episodic financing function as it places overemphasis on
topics like types of securities, promotion, incorporation, liquidation, merger, etc.

The traditional approach places great emphasis on the long-term problems and ignores the
importance of the working capital management. The concept confined financial management
to issues involving procurement of funds. It did not emphasis on allocation of funds. It blind
eye towards the problems of financing non-corporate enterprises has yet been another
criticism.

In the absence of the coverage of these crucial aspects, the traditional concept implied a very
narrow scope for financial management. The modern concept provides a solution to these
shortcomings.

Modern Concept:

The traditional concept outlived its utility due to changed business situations since mid-
1950s. Technological improvements, widened marketing operations, development of a strong
corporate structure, keen and healthy business competition – all made it imperative for the
management to make optimum use of available financial resources for continued survival of
the firm.

The financial experts today are of the view that finance is an integral part of the overall
management rather than mere mobilization of the funds. The finance manager, under this
concept, has to see that the company maintains sufficient funds to carry out the plans. At the
same time, he has also to ensure a wise application of funds in the productive purposes. Thus,
the present day finance manager is required to consider all the financial activities of
planning, organizing, raising, allocating and controlling of funds. In addition, the

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development of a number of decision making and control techniques, and the advent of
computers, facilitated to implement a system of optimum allocation of the firm’s resources.

These environmental changes enlarged the scope of finance function. The concept of
managing a firm as a system emerged and external factors now no longer could be evaluated
in isolation. Decision to arrange funds were to be seen in consonance with their efficient and
effective use. This systems approach to the study of finance is being termed as ‘Financial
Management’. The term ‘Corporation Finance’ which was used in the traditional concept was
replaced by the present term ‘Financial Management.’ The modern approach view the term
financial management in a broad sense and provides a conceptual and analytical framework
for financial decision-making. According to it, the finance function covers both acquisitions
of funds as well as their allocation.

1.4. FUNCTIONS OF FINANCIAL MANAGEMENT

This refers to the special activities or purposes of financial management. The functions of
financial management are planning for acquiring and utilizing funds by a firm as well as
distributing funds to the owners in ways that achieve goal of the firm.

In general, the functions of financial management include three major decisions a firm must
make. These are:

 Investment decisions
 Financing decisions
 Dividend decisions

1.4.1 Investment Decisions

They deal with allocation of the firm’s scarce financial resources among competing uses.
These decisions are concerned with the management of assets by allocating and utilizing
funds within the firm. It deals about forecasting financial requirements for real assets and
acquiring those real assets. Specifically, the investment decisions include:

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  Determining the asset mix or composition: - determining the total amount of the
firm’s finance to be invested in current and fixed assets. This determination can be
depends up on the type and nature of the business.
 Determining the asset type: - determining which specific assets to maintain within
the categories of current and fixed assets.
 Managing the asset structure, i.e., maintaining the composition of current and fixed
assets and the type of specific assets under each category.

The investment decisions of a firm also involve working capital management and capital
budgeting decisions. The former refers to those decisions of a firm affecting its current
assets and short – term liabilities. This decision is known as current assets management also.
The later, on the other hand, involves long – term investment decisions like acquisition,
modification, and replacement of fixed assets. Long-term refers to the time horizon of more
than one year. The long term assets like plants, machines, equipments, land, buildings etc.
The finance manager must concentrate to principles of safety, liquidity and profitability
while investing capital.

Generally, the investment decisions of a firm deal with the left side of the basic accounting
equation: A = L + OE (Assets = Liabilities + Owners’ Equity).

1.4.2 Financing Decisions

The financing decisions deal with the financing of the firm’s investments, i.e., decisions
whether the firm should use equity or debt funds in order to finance its assets. They are also
concerned with determining the most appropriate composition of short – term and long –
term financing. In simple terms, the financing decisions deal with determining the best
financing mix or capital structure of the firm. It deals about financial assets (loans, leases,
shares and bonds).

The financing decisions of a firm are generally concerned with the right side of the basic
accounting equation.

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1.4.3. Dividend Decisions

The dividend decisions address the question how much of the cash a firm generates from
operations should be distributed to owners in the form of dividends and how much should be
retained by the business for further expansion. There are tradeoffs on the dividend policy of a
firm. On the one hand, paying out more dividends will make the firm to be perceived strong
and healthy by investors; on the other hand, it will affect the future growth of the firm. So the
dividend decision of a firm should be analyzed in relation to its financing decisions.

Investmen
t

Retur

Financing Market Value

Decisions
of the firm
Risk

Dividend
Decisions

1.5. GOALS OF FINANCIAL MANAGEMENT

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:

1. Profit maximization

2. Wealth maximization.

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Profit maximization

In the conventional theory of the firm, the principal objective of a business firm is to
maximize profits. Under the assumption of given tastes and technology, price and output of a
given product under perfect competition are determined with the sole objective of
maximization of profit.

Maximization of profit simply refers to the maximization of income of the firm. Under profit
maximization objective, business firm attempt to adopt those investments projects, which
yield profits, and drop all other unprofitable activities.

In maximizing profit, input-output relationship is crucial, either input is minimized to achieve

a given amount of output or the output is maximized with a given amount of input. Thus, this
objective of the firm enhances productivity and improves the efficiency of the firm.

The conventional theory of the firm defends profit maximization objective on the following
grounds;

Only those firms survive in the long-run in a competitive market, which are able to make a
reasonable amount of profit. Once they are able to make profit, they will always try to make
it large as possible. All other objectives are subjected to this primary objective.

Profit maximization assumption is a time-honored objective of a firm and evidence against

this objective is not conclusive or unambiguous

Profit maximization objective has been found extremely accurate in predicting certain aspect
of firm's behavior and trends as such the behavior of most firms are directed with the
objective of profit maximization.

Though not perfect, profit is the most efficient and reliable measure of the efficiency of a
firm

Under the condition of competitive market, profit can be used as a performance evaluation
criterion, and profit maximization leads to efficient allocation of resources

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Wealth Maximization

Wealth refers to the market price of stock. Wealth maximization (shareholders wealth
maximization) is almost universally accepted goal/ objective of a firm. According to this
goal, the manager should take decision that maximizes the shareholders wealth. In other
words, it is to make the shareholders as richer as possible. Shareholders wealth is maximized
when a decision generates net present value. The net present value is the difference between
present value of the benefits of a project and present value of its costs. A decision that has a
positive net present value creates wealth for shareholders and a decision that has a negative
net present value destroys wealth of shareholders. Therefore only those projects which have
positive net present value should be accepted.

Wealth maximization: A superior Decision Criterion

a. Efficient allocation of resources

b. Separation between ownership and management
c. Residual owners
d. Emphasis on cash flow
e. Recognizes time value of money

1.6. CONFLICT OF GOALS BETWEEN MANAGEMENT AND OWNERS AND

AGENCY PROBLEM

As you understand, in a corporate form of business organization owners (stockholders) do

not run the activities of the firm. Rather, the stockholders elect the board of directors, who in
turn assign the management on behalf of the owners. So, basically, managers are agents of
the owners of the corporation and they undertake all activities of the firm on behalf of these
owners. Managers are agents in a corporation to maximize the common stockholders’ well-
being.

However, there is a conflict of goals between managers and owners of a corporation and
mangers may act to maximize their interest instead of maximizing the wealth of owners.
Managers are interested to maximize their personal wealth, job security, life style and fringe
benefits.

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The natural conflict of interest between stockholders and managerial interest create agency
problems. Agency problems are the likelihood that mangers may place their personal goals a
head of corporate goals. Theoretically, agency problems are always there as long as mangers
are agents of owners.

Corporations (owners) are aware of these agency problems and they incur some costs as a
result of agency. These costs are called agency cost and include:

1. Monitoring expenditures – are expenditures incurred by corporations to monitor or

control the activities of managers. A very good example of a monitoring expenditure is fees
paid by corporations to external auditors.

2. Bonding expenditures – are cost incurred to protect dishonesty of mangers and other
employees of a firm. Example: fidelity guarantee insurance premium.

3. Structuring expenditures – expenditures made to make managers fell sense of ownership

to the corporation. These include stock options, performance shares, cash bonus etc.

4. Opportunity costs – unlike the previous three, these costs are not explicit expenditures.
Opportunity costs are assumed by corporations due to hindrances of decisions by them as a
result of their organizational structure and hierarchy.

On top of the above costs assumed by corporations, there are also other ways to motivate
managers to act in the best interest of owners. These ways include making know managers
that they would be fired if they do not act to maximize shareholders wealth and that the
corporation could be overtaken by others if its value is very much lower than other firms.

1.7. CLOSE RELATED FIELDS OF FINANCIAL MANAGEMENT

Though finance had ceded itself from economics, it is not totally an independent field of
study. It is an integral part of the firm’s overall management. Finance heavily draws theories,
concepts, and techniques from related disciplines such as economics, accounting, marketing,
operations, mathematics, statistics, and computer science. Among these disciplines, the field
of finance is closely related to economics and accounting.

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 Finance and Economics: You are aware that the economics has two branches one is
macroeconomics and the other is microeconomics. Financial management has close
relationship with each of these.
Economics, which provides

 Decision-making tools such as pricing theory(supply and demand), risk analysis,

comparative return analysis
 Information on the economic and financial environment in which the company
operates

Macro-economics: The macro-economics is the study of the economy as a whole. It causes

the institutional structure of the banking system, money and capital markets, financial
intermediaries monetary, credit and fiscal policies and economic policies dealing with and
controlling level of activity within an economy. The financial manager is expected to know
how monetary policy affects cost and availability of funds, undertake fiscal policy it’s affect
on economy, aware the financial institutions and their modes of operations to tap financial
sources so on and so forth. In other words financial manager considers: inflation,
unemployment, industrial production, domestic and international competition, foreign trade
statistics, international capital flows, exchange rates, changes in technology, consumer and
investor attitudes, the state of financial markets, changes in government policy etc.

Micro-economics: It deals with the individual firms and will permit the firms to achieve
success. The theories of micro-economics like demand supply relation and pricing strategies,
measurement of utility, preference, risk and determination of value are highly useful to a
finance manager to take decisions to maximize profits.

 Finance and Accounting: There is close relationship between accounting and finance.
Accounting is sub function of finance. The data / information supplied by the accounting
like income statement, balance sheet will serve as basis for decision making in financial
management.
But there are certain key differences between the two.
 Treatment of income: - in financial accounting income measurement is on accrual
basis. Under this method revenues are recognized as earned and expenses as incurred.

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 In finance, however, the cash method is employed to recognize the revenue and
expenses.
 Decision-making: - the primary function of accounting is to gather and present
financial data. Finance, on the other hand, is primarily concerned with financial
planning, controlling and decision-making. The financial manger evaluates the
financial statements provided by the accountant by applying additional data and then
makes decisions accordingly.
 Accounting is highly governed by generally accepted accounting principles.
1.8. FINANCIAL MARKETS AND CORPORATION
Financial Markets

A financial market is a place where the business houses can raise their long and short-term
financial requirements. The development of financial markets indicates the development of
economic system. For mobilization of savings and for rapid capital formation, healthy growth
and development of these markets are crucial. These markets help promotion of investment
activities; encourage entrepreneurship and development of a country.

There are many types of financial markets and hence several ways to classify them. For our
purpose, here we shall consider the following two classifications.

1. Classification on the basis of maturity

This is based on the maturity dates of securities

Money Markets - are financial markets in which securities traded have maturities of one-year
or less. Examples of securities traded here include treasury bills, commercial papers, short
term promissory notes, certificate of deposit, and ban

ker’s acceptance and so on.

Capital Markets - are financial markets in which securities of long-term funds are traded.
Major securities traded in capital markets include bonds, preferred and common stocks.

2. Classification on the basis of the nature of securities

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This is based on whether the securities are new issues or have been outstanding in the market
place.

Primary Markets - are financial marketers in which firms raise capital by issuing new
securities.

Secondary Markets - are financial markets in which existing and already outstanding
securities are traded among investors. Here the issuing corporation does not raise new
finance.

Financial Instruments

There are mainly two kinds of securities namely ownership securities and loan securities.
Further ownership securities are classified into two (a) common stock and (b) preference
stock. These securities or instruments are being traded in capital markets.

Common stock – It is also known as equity shares, who are the real owners of the business
will enjoy the profit or loss suffered by the company. Dividend payment is not compulsory.

Preferential stock – By name these holders have two preferential rights I) to get fixed rate of
dividend at the end of every year irrespective of profits / losses of the company II) to get
back the investment first when the company goes into liquidation.

Bonds – Bondholders are the money suppliers to a business unit entitled for a fixed rate of
interest at the end of each year. Their stake is confined to the interest only.

Financial Institutions

The financial institutions include banks, development banks, investing institutions at national
and international level that provide financial services to the business organizations. These
financial institutions provide long-term, short-term finances and extend under writing,
promotional and merchant banking services.

Corporations are share companies raising their fund from the financial markets both capital
and money primary and secondary. Therefore, financial manager of a corporation should

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know about the operation of financial markets, instruments and institution on the other hand
the financial system as a whole for undertaking investment, financing and dividend decision.

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