Chapter 1

Financial Management
An Overview
 BASIS FOR
ACCOUNTING FINANCE
COMPARISON
Meaning Accounting is an art of recording and Finance is the science of management
reporting of the monetary transactions of funds of a business
of a business.

Accrual Accrual Concept is applied in Accrual Concept is not applied in

Concept Accounting. Finance.

Branches Financial Accounting, Management Private Finance, Public Finance,

accounting, Cost accounting, Tax Corporate Finance etc.
Accounting etc.

Career Accounting professionals can become Finance professionals can become an

accountants, auditors, tax consultant, investment banker, financial analyst,
etc. finance consultant, etc.

Division Accounting is a part of finance. Finance is not a part of accounting.

Objective To provide information regarding the To study the capital market and funds
solvency status of the company to the of business for making future strategies.
readers of the financial statement.

Tools Income Statement, Balance Sheet, Risk Analysis, Capital Budgeting, Ratio
Cash flow Statement etc. Analysis, Leverage, Working Capital
Management etc.
 Financial Management
Financial Management is concerned with the raising of the funds,
allocation of funds and utilization of funds

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”

Financial Management is a regular practice in a business

environment. It entails the process of planning, organizing, monitoring
and also controlling the financial resources of an organization.
Scope of Financial Management

Traditional Scope of Financial Management

External Decisions and not Internal Decision Making

Long term Decisions and not Day to Day Decision Making
Procurement and not Allocation of Funds

Modern Scope of Financial Management

1. Investment Decisions Making

2. Financing Decisions Making
3. Dividend Decisions Making
4. Liquidity Decision Making
5. Balancing Profitability and Liquidity Decision
6. Risk and Return
Scope of Financial Management

The scope of financial management can be broken down

into four major decisions as functions of finance:

(1) Investment Decision

The investment decision relates to the selection of

assets in which funds will be invested by a firm. The
assets which can be acquired fall into two broad groups:
(1) long-term assets (Capital Budgeting)
(2) Short-term or current assets (Working Capital
Management)
(1) Capital Budgeting Capital budgeting is probably
the most crucial financial decision of a firm. It relates
to the selection of an asset or investment proposal
or course of action whose benefits are likely to be
available in future over the lifetime of the project.
(2) Working Capital Management Working capital
management is concerned with the management of
current assets. It is an important and integral part of
financial management as short-term survival is a
prerequisite for long-term success.
(2) Financing Decision  

The second major decision involved in financial management is the

financing decision. The investment decision is broadly concerned with the
asset-mix or the composition of the assets of a firm. The concern of the
financing decision is with the financing-mix or capital structure or leverage.
There are two aspects of the financing decision.

First, the theory of capital structure which shows the theoretical

relationship between the employment of debt and the return to the
shareholders. The second aspect of the financing decision is the
determination of an appropriate capital structure, given the facts of a
particular case. Thus, the financing decision covers two interrelated
aspects: (1) the capital structure theory, and (2) the capital structure
decision.
(3) Dividend Policy Decision  
The dividend decision should be analysed in relation to the
financing decision of a firm. Two alternatives are available
in dealing with the profits of a firm:
(i) they can be distributed to the shareholders in the form of
dividends or
(ii) they can be retained in the business itself. The decision
as to which course should be followed depends largely on a
significant element in the dividend decision, the dividend-
pay out ratio, that is, what proportion of net profits should
be paid out to the shareholders.
(4) Liquidity decision

Current assets management that affects a firm’s liquidity is yet another

important finances function, in addition to the management of long-term
assets. Current assets should be managed efficiently for safeguarding the
firm against the dangers of illiquidity and insolvency. Investment in current
assets affects the firm’s profitability, liquidity and risk.

A conflict exists between profitability and liquidity while managing current

assets. If the firm does not invest sufficient funds in current assets, it may
become illiquid. But it would lose profitability, as idle current assets would
not earn anything. Thus, a proper trade-off must be achieved between
profitability and liquidity.
 PROCESS INVOLVE IN
FINANCIAL DECISION
1. Selection of investment proposals, known as the
investment decision.

2. Determination of working capital requirements, known as

the working capital decision.

3. Raising of funds to finance the assets, known as the

financing decision.

4. Allocation of profit for dividend payment, known as the

dividend decision.
 Factors influencing financial
decision
These factors are divided into two parts-
1.Micro economic factor
2.Macro economic factor

Micro economic factor- micro economic factor is

related to the internal condition of the firm-
(a) Nature and size of the firm
(b) Level of risk and stability in earnings
(c) Liquidity position
(d) Asset structure and pattern of ownership
(e) Attitude of the management
 Determining Financial Needs

Determining Sources of Funds

Financial Analysis

Optimal Capital Structure

Cost Volume Profit Analysis

FUNCTIONS OF FINANCIAL Profit Planning and Control

MANAGEMENT or FINANCIAL Fixed Assets Management
MANAGER
Capital Budgeting

Corporate Taxation
Working Capital Management

Dividend Policies

Acquisitions and Mergers

•All management decisions
should help to accomplish
the goal of the firm!
•What should be the goal of the
firm?
 Objectives of financial
management
The objective of financial management are
considered usually at two levels –at macro
and micro level.
It is used in the sense of a goal or Decision
Criterion for the Three decisions involved in
Financial Management
1. Maximization of profits
2. Maximization of return
3. Maximization of wealth
 Maximization of profits
Profit earning is the main aim of every
economic activity. Profit maximization
simply means maximizing the income of the
firm . Economist are of the view that profits
can be maximized when the difference of
total revenue over total cost is maximum, or
in other words total revenue is greater than
the total cost.
Goals or Objectives of Financial Management

Profit Maximization

n Maximizing the Rupee Income of Firm

• Resources are efficiently utilized

• Profit is considered as the most appropriate

measure of firm performance
• Serves interest of society also
Objections to Profit Maximization
• It is Vague
• It Ignores the Timing of Returns
• It Ignores Risk
• It may tempt to make such decisions which may in the
long run prove disastrous.
• Its emphasis is generally on short run projects.
•It overlook Quality Aspect.
• It is a narrow concept.
• Ignores Social Responsibility Objective of business.
•Maximising profits after taxes does not necessarily
serve the best interest of the owner.
Ex: A company has 10,000 shares outstanding,
profit after tax of Rs. 50,000 and EPS of Rs. 5. If
company sells 10,000 additional shares at Rs. 50
per share and invest the proceeds at 5% after taxes
than what will be the impact on profits and EPS.
Timing of Benefits  

A more important technical objection to profit maximisation,

as a guide to financial decision making, is that it ignores the
differences in the time pattern of the benefits received over
the working life of the asset, irrespective of when they were
received.

Table 1: Time-Pattern of Benefits (Profits)

  Time Alternative A Alternative B (Rs in

lakh)

Period I 50 —
Period II 100 100
Period III 50 100
Quality of Benefits

Probably the most important technical limitation of profit

maximisation as an operational objective, is that it ignores the
quality aspect of benefits associated with a financial course of
action. The term quality here refers to the degree of certainty with
which benefits can be expected.

Uncertainty About Expected Benefits (Profits)

 State of Economy
Profit (Rs crore)

Alternative A Alternative B

Recession (Period I)
Normal (Period II) 9 0
Boom (Period III) 10 10
11 20
In new business environment profit maximization is
regarded as:
Unrealistic
Difficult
Inappropriate
Immoral.
 Maximization of wealth
According to prof solomon ezra of stand ford
university , the ultimate goal of financial
management should be the maximization of the
owners wealth. The value of corporate wealth
may be interpreted in terms of the value of the
company’s total assets. The finance should
attempt to maximize the value of the enterprise to
its shareholders. Value is represented by the
market price of the company’s common stock.
 •What about risk? Isn’t risk
important as well as profits?
• How would the stockholders of a small
business react if they were told that their
manager cancelled all casualty and liability
insurance policies so that the money spent
on premiums could go to profit instead.
• Even though the expected profits increased
by this action, it is likely that stockholders
would be dissatisfied because of the
increased risk they would bear.
•The common stockholders are
the owners of the corporation!
• Stockholders elect a board of directors
who in turn hire managers to maximize
the stockholders’ well being.
• When stockholders perceive that
management is not doing this, they might
attempt to remove and replace the
management, but this can be very
difficult in a large corporation with many
stockholders.
 •More likely, when
stockholders are dissatisfied
they will simply sell their
stock shares.
•This action by stockholders will
cause the market price of the
company’s stock to fall.
 •When stock price falls
relative to the rest of the
market (or relative to the rest
of the industry) ...

•Management is failing in their job

to increase the welfare (or wealth)
of the stockholders (the owners).
•The goal of the firm should be
to maximize the stock price!
• This is equivalent to saying the goal is to
maximize owners’ wealth.
• The stock price is affected by
management’s decisions affecting both
risk and profit.
• Stock price can be maintained or
increased only when stockholders
perceive that they are receiving profits
that fully compensate them for bearing
the risk they perceive.
Shareholders’ Wealth Maximization

 Maximizes the net present value of a course of action to

shareholders.
 Accounts for the timing and risk of the expected benefits.

 Benefits are measured in terms of cash flows.

 Fundamental objective—maximize the market value of the

firm’s shares.
This goal for the maximum present value is generally
justified on the following grounds:
(i) It is consistent with the object of maximising owners
economic welfare.
(ii) It focuses on the long run picture
(iii) It considers risk.
(iv) It recognizes the value of regular dividend payments.
(v) It takes into account time value of money.
(vi) It maintains market price of its shares.
(vii) It seeks growth in sales and earnings.
 Goal Objective Advantages Disadvantages

Profit Large amount of 1.Easy to calculate 1. Emphasizes on the

maximization profits profits short term
2.Easy to determine the 2. Ignores risk or
link between financial uncertainty
decisions and profits 3. Ignores the timing of
returns
4. Requires immediate
returns

Shareholder Highest market 1.Emphasizes on the 1.Offers no clear

wealth value of common long term relationship between
maximization stock 2.Recognizes risk or financial decisions and
uncertainty stock price
3.Recognizes the timing 2.Can lead to
of returns management anxiety and
4.Considers return frustration
 Financial Decision Primary Disciplines
Areas
• Accounting
• Economics
1. Investment analysis
Support • Cost Accounting
2. Working capital management
• Taxation
3. Sources and cost of funds
• Corporate Finance
4. Determination of capital
structure • International Finance
Support
5. Dividend policy Other Related Disciplines
• Marketing
• Production
Resulting in
• Quantitative methods
• Law
Shareholder wealth maximization • Banking
• Insurance
Impact of Other Disciplines on
Financial Management • Information Technology
Profitability
Profit can be simply referred to as the difference between
total incomes less total expenses for business.  Profit
maximization is among the top priorities of any company. Profit
is categorized into various groups according to the components
considered to arrive at each profit amount. A number of ratios
are calculated using the respective profit figures to allow
comparisons with prior periods and other similar companies and
to facilitate financial decision-making.
Liquidity
Liquidity describes the degree to which
an asset or security can be quickly bought or sold in the
market without affecting the asset’s price. This is also the
availability of cash and cash equivalents in a company. Cash
equivalents include treasury bills, commercial paper and other
short-term marketable securities. Liquidity is just as important
as profitability, sometimes even more important in the short-
term. This is because the company needs cash to run day to
day business operations.
 Profitability vs. Liquidity
Profitability is the ability of a company
to generate profits which is calculated
as difference between revenue and
expense done by the company
A profitable company may not have
enough liquidity because most of the
funds of the company are invested into
projects.
Time
Profitability is more important in long-
term as a company which is profitable
can go bankrupt in the short term if it
does not have liquidity.
Ratios
Key ratios include GP margin, OP
margin, NP margin and ROCE.
 
Liquidity is the ability of a company to
convert assets into cash at any point
of time.
A company which has lot of cash or
liquidity may not be profitable because
of lack of opportunities for putting idle
cash.
Liquidity is more important in short-
term because a company which has
liquidity but is not profitable cannot go
bankrupt in the short term.
Key ratios are current ratio, quick ratio
and cash debt coverage ratio.
Profitability vs. Liquidity
The difference between profitability and liquidity is simply the
availability of profits vs. availability of cash. Profit is the principle
measure to assess the stability of a company and is the priority
interest of shareholders. While profit is the most important, this
does not necessarily mean that the business operation is
sustainable. Further, a profitable company may not have enough
liquidity because most of the funds in the company are invested
into projects, and a company which has a lot of cash or liquidity
may not be profitable because it has not utilized excess funds
effectively. Thus, the success depends on the better management
of both profit and cash.
Profitability Liquidity Trade off
Hence as one can see from the above that profitability
and liquidity are not same and the company has to
maintain a fine balance between the two because if
company focuses on too much profitability then it
runs the risk of not able to pay its creditors,
employees and other parties whereas on the other
hand if company focuses on liquidity and then it runs
the risk of going into loss.
 Financial Management and
Other Area of Study
• Financial Management and Financial Accounting (Accounting tools
are input to financial decision-making)

• Financial Management and Economics (Analysis of Macro and

Micro Environment)

• Financial Management and Marketing Management (Marketing

decisions are based on financial implications)

• Financial Management and Human Resource Management

• Financial Management and Production Management