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Chapter No 1

Financial Management is that managerial activity which is
concerned with the planning and controlling of the firm's
financial resources. It was a branch of economics till 1890
and as a separate discipline, it is of recent origin.
Finance may be defined as the provision of money at the
time when it is required.
Finance refers to the management of flows of money
through an organization. It concerns with the application of
skills in the manipulation, use and control of money.

Definition and Meaning of

Financial Management
According to F.W.Paish, Finance may be defined as the position of
money at the time it is wanted.
According to the John J Hampton, The term finance can be defined
as the management of flows of money through an organization,
whether it will be a corporation, school, bank or government agency.
According to Weston & Brigham, Financial management is an area
of financial decision making harmonizing individual motives and
enterprise goals.



Evolution of Financial
Traditional Phase: In the traditional phase the focus of financial
management was on certain events which required funds e.g. major
expansion, merger, reorganization etc. It is also characterized by a heavy
emphasis on legal and procedural aspects as at that point of time the
functioning of companies was regulated by a plethora of legislation.
Transitional Phase: 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.
Modern Phase: The modern phase is characterized by the application of
economic theories and the application of quantitative methods of analysis.

Objectives of Finance
The management of finance is to achieve financial objectives. The
following are the main objectives of finance

To create wealth for business

To generate cash
To provide adequate return of investment (bearing in mind the risk of
business and the resources invested)
To ensure that sufficient fund is provided at right time to meet the needs
of the Business

Scope of Finance
What is finance? What are a firm's financial activities? How are they related to the
firm's other activities? Firms create manufacturing capacities for production of
some provide services to customers. They sell their goods or services to earn profit.
They raise funds to acquire manufacturing and other facilities. Thus, the three most
important activities of a business firm are:
A firm secures whatever capital it needs and employs it (finance activity) in
activities, which generate returns on invested capital (production and marketing

Functions of Financial Management

The functions of raising funds, investing them in
assets and distributing returns earned from assets
to shareholders are respectively know as
financing decision, investment decision and
dividend decision.
Functions of Financial Management

Investment Decision
Finance Decision
Dividend Decision
Liquidity Decision

Long-term financial decisions:

Long-term asset-mix or investment decision
Capital-mix or financing decision
Profit allocation or dividend decision

Short-term financial decisions:

Short-term asset-mix or liquidity decision

Investment Decisions: A firm's investment decisions involve

capital expenditures. They are therefore referred as capital
budgeting decisions. There is a broad agreement that the
correct cut-off rate or the required rate of return on
investments is the opportunity cost of capital. The opportunity
cost of capital is the expected rate of return that an investor
could earn by investing his or her money in financial assets of
equivalent risk.
Financing Decisions: A financing decision is the second
important function to be performed by the financial manager.
He or she must decide when, where from and how to acquire
funds to meet the firm's investment needs. The mix of debt
and equity is known as the firm's capital structure. The
financial manager must strive to obtain the best financing mix
or the optimum capital structure for his or her firm.

Dividend Decisions: A dividend decision is the third major financial

decision. The financial manager must decide whether the firm should
distribute all profits or retain them or distribute a portion and retain the
balance. The proportion of profits distributed as divided is called the dividendpayout ratio and the retained portion of profits is known as the retention ratio.
Liquidity Decision: Investment in current assets affects the firm's
profitability and liquidity. Management of current assets that affects a firm
liquidity is yet another important finance function. A proper trade-off must be
achieved between profitability and liquidity. The profitability-liquidity tradeoff requires that the financial manger should develop sound techniques of
managing current assets

Role of Financial Management in the Organization

Finance and Management Functions: There exists an inseparable

relationship between finance on the one hand and production, marketing and
other functions on the other. Almost all business activities directly or
indirectly, involve the acquisition and use of
funds. For example, recruitment and promotion of employees in production
is clearly a responsibility of the production department; but it requires
payment of wages and salaries and other benefits and thus, involves finance.
Real and Financial Assets: A firm requires real assets to carry on its
business. Tangible real assets are physical assets that include plant,
machinery, office, factory, furniture and building. Intangible real assets
include technical know-how, technological collaborations, patents and
copyrights. Financial assets, also called securities, are financial papers or
instruments such as shares and bonds or debentures. Firms issue securities to
investors in the primary capital markets to raise necessary funds. The
securities issued by the firms are traded bought and sold by investors in
the secondary capital markets, referred to as stock exchanges.

Equity and Borrowed Funds:

There are two types of funds that a firm can raise: equity funds
(simply called equity) and borrowed funds (called debt). A firm
sells shares to acquire equity funds. Shares represent ownership
rights of their holders. Buyers of shares are called shareholders (or
stockholders) and they are legal owners of the firm whose shares
they hold. Shareholders invest their money in the shares of a
company in the expectation of a return on their invested capital.
The return consists of dividend and capital gain. Shareholders
make capital gains (or losses) by selling their shares

The main functions of the

financial manager :

Funds Raising
Funds Allocation
Profit Planning
Understanding Capital Markets

Agency Theory

and Meckling developed a

theory of the firm based on agency

Agency Theory is a branch of economics

relating to the behavior of principals and
their agents.

Agency Theory

must provide incentives so that

management acts in the principals best
interests and then monitor results.

Incentives include, stock options, perquisites,

and bonuses.

Social Responsibility
Wealth maximization does not preclude the
firm from being socially responsible.
Assume we view the firm as producing both
private and social goods.
Then shareholder wealth maximization
remains the appropriate goal in governing the

Corporate Governance
Corporate governance: represents the system
by which corporations are managed and
Includes shareholders, board of directors,
and senior management.
Then shareholder wealth maximization
remains the appropriate goal in governing the

Board of Directors
Typical responsibilities:

Set company-wide policy;

Advise the CEO and other senior executives;
Hire, fire, and set the compensation of the CEO;
Review and approve strategy, significant investments, and
acquisitions; and
Oversee operating plans, capital budgets, and financial reports to
common shareholders.

CEO/Chairman roles commonly same person in US, but

separate in Britain (US moving this direction).

Sarbanes-Oxley Act of 2002

Sarbanes-Oxley Act of 2002 (SOX): addresses corporate
governance, auditing and accounting, executive compensation,
and enhanced and timely disclosure of corporate information
Imposes new penalties for violations of securities laws
Established the Public Company Accounting Oversight
Board (PCAOB) to adopt auditing, quality control, ethics,
disclosure standards for public companies and their
auditors, and policing authority
Generally increasing the standards for corporate

Organization of the Financial

Management Function
Board of Directors
(Chief Executive Officer)
Vice President

VP of

Vice President

Organization of the Financial

Management Function

VP of Finance


Capital Budgeting
Cash Management
Credit Management
Dividend Disbursement
Fin Analysis/Planning
Pension Management
Insurance/Risk Mngmt
Tax Analysis/Planning

Cost Accounting
Cost Management
Data Processing
General Ledger
Government Reporting
Internal Control
Preparing Fin Stmts
Preparing Budgets
Preparing Forecasts