FINANCIAL MANAGEMENT

Module - I Finance functions, recording - Definition and scope of finance functions - Profit maximization Vs wealth maximization goal. Organisation of finance function.

Kenneth Midgley and Ronald Burns state. "Financing is the process of organizing the flow of funds so that a business can carry out its objectives in the most efficient manner and meet its obligations as they fall due." Financial Management is an area of financial decision making harmonizing individual motives and enterprise goals.-Weston and Brigam. Financial Management is the application of the planning and control functions to the finance function.- Howard and Upton. Financial Management is the operational activity of a business that is responsible for obtaining and effectively, utilizing the funds necessary for efficient operations.- Joseph and Massie. From the above definitions of the term finance, it can be concluded that the term business finance mainly involves rising of funds and their effective utilization keeping in view the over all objectives of the firm. The management makes use of the various financial techniques, devices etc for administering the financial affairs of the firm in the most effective and efficient way. FINANCE AND RELATED DISCIPLINES. Financial management -an integral part of over all management is not a totally independent area. It draws heavily on related disciplines and fields of study, such as Economics, Accounting, Marketing, Production, and Quantitative Methods. FINANCIAL MANAGEMENT AND ECONOMICS. The relevance of economics to Financial Management can be described in the lights of the two broad areas of economics, -macro economics, and micro economics. Macro economics is concerned with the over all institutional environment in which the Company operates. It looks at the Economy as a whole. It is concerned with the institutional structure of the banking system, money and capital markets, financial intermediaries, monetary credit, and fiscal policies. Since the business operates in the macro economic environment, it is important for financial managers to 1

A business is an activity which is carried on with the intention of earning profits. If the operations of a typical manufacturing organization are considered, it involves the purchasing of raw material, processing the same with the help of various factors of production like labour and machinery, manufacturing the final product and marketing and selling the finished product in the market to earn the profits. Thus production, marketing and business financing are the key operational areas in case of any business organization, out of which finance is the most crucial one. This is so as the functions of production and marketing are related with the function of finance. If the decisions relating to money and funds fail, it may result into the failure of the business organization as a whole. Hence, it is utmost important to take the proper financial decisions and that too at a proper point of time. Finance is the life-blood of modern business economy. We cannot imagine a business without finance in the modern world. It is the basis of all economic activities, no matter; the business is big or small. The problem of finance and that of financial management is to be dealt within every organisation. The problem of finance is equally important to government, semigovernments and private bodies, and to profit and nonprofit organisations. Definition. Financial management is that managerial activity which is concerned with planning and controlling of firms financial resources. According to Paul. G. Hasings, 'Finance' is the management of the monetary affairs of a company. It includes determining what has to be paid for raising the money on the best terms available and devoting the available resources to best uses."

understand the broad economic environment. Micro economics deals with the economic decisions of individuals and organizations. It concerns itself with the determination of optimal operating strategies. A financial manger uses these to run the firm efficiently and effectively. FINANCIAL MANAGEMENT AND ACCOUNTING. Accounting function is a necessary input in to the finance function. ie. accounting is a sub function of finance. Accounting generates information about a firm. The end products of accounting constitute financial statements such as Balance Sheet, P&L Account and the statement of changes in financial position. The information contained in this reports and statements assist financial managers in assessing the past performance and taking future decisions of the firm and in meeting the legal obligations such as payment of Taxes and so on. Thus accounting and finance are functionally closely related. FINANCE AND OTHER RELATED DISCIPLINES. Apart from economics and accounting, finance also draws considerably for its key day today decisionson supportive disciplines such as Marketing, Production, and Quantitative methods. For instance financial managers should consider the impact of new product development and promotion plans made in the marketing area since their plans will require Capital or Fund out flows and have an impact on the projected cash flows. Similarly changes in the production process may necessitate capital expenditure which the financial managers must evaluate and finance. And finally the tools of analysis developed in the quantitative techniques are helpful in analyzing complex financial management problems. Thus the marketing, production and quantitative techniques are only indirectly related to day to day decision making by financial managers and are supportive in nature , while Economics and Accounting are primary disciplines on which the financial managers draws substantially.

SCOPE OF FINANCIAL MANAGEMENT. The approach to the scope and functions of financial management is divided in to two broad categories. Traditional Approach and Modem Approach. TRADITIONAL APPROACH. The traditional approach to the scope of financial management refers to the subject matter, in academic literature in the initial stages of its development, as a separate branch of academic study. The term 'Corporation Finance' was used to describe what is known as Financial management. As the name suggests, the concern of 'Corporation Finance' was with the financing of Corporate enterprises. In other words the scope of finance function was treated by the traditional approach in the narrow sense of procurement of fund by corporate enterprises to meet their financing needs. So the field of study included, 1. Institutional arrangements in the form of financial institutions which comprise the organization of Capital Market. 2. Financial instruments through which Funds are raised from the capital market. & 3. The Legal and Accounting relationship between a firm and its sources of funds. The traditional approach was criticized in the following grounds. 1. The approach equated finance function with raising and administering of funds only. The limitation was that internal decision-making was completely ignored. 2. The focus was on financing problems of Corporate enterprises (i.e. Companies). Non corporate organizations lay outside its scope. 3. The approach laid over emphasis on the problems of long term financing. Hence day to day financial problems and working capital management of a business did not receive any attention. MODERN APPROACH. The modern approach views the term 'Financial management' in a broad sense and provides a conceptual and analytical frame work for financial decision making. 2

According to it Finance function covers both acquisitions of funds as well as their allocations. Thus the Financial Management, in the modern sense of the term, can be broken down in to 3 major decisions as functions of Finance. 1. The investment Decision 2. The Financing Decision 3. The Dividend Policy Decision. FINANCE FUNCTIONS. 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 in to two broad categories. A. Long Term or Fixed Assets, which yield a return over a period of time in future. B. Short term or Current Assets which in the normal course of business are convertible in to cash usually within a year. The aspects of financial decision making with reference to long term assets is popularly known as Capital Budgeting and financial decision making with reference to current assets is popularly termed as Working Capital Management. CAPITAL BUDGETING. Capital Budgeting is probably the most crucial financial decisions for 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 life time of the project. The first aspect of capital budgeting decision relates to the choice of the new asset out of the alternatives available or the reallocation of capital, when an existing asset fails to justify the funds committed. Whether an asset will be accepted or rejected will depend upon the relative benefits and returns associatedwith it. The measurement of worth of the investment proposal is, there for, a major element in Capital budgeting decisions. The second element of Capital Budgeting decision is the analysis of risk and uncertainty. Since the benefits from the investment proposals extend in to the future,

there accrual is uncertain. They have to be estimated under various assumptions of the physical volume of sales and the level of prices. An element of risk in the sense of 'uncertainty of future benefits' is thus involved in the capital budgeting. The returns from capital budgeting decisions should, there fore, be evaluated in relation to the risk associated with it. WORKING CAPITAL MANAGEMENT. Working capital management is concerned with the management of current asset. One aspect of working capital management is the trade off between profitability and risk. There is a conflict between profitability and liquidity. If a firm does not have adequate working capital, it may become illiquid and consequently may not have the ability to meet its current obligations. If current assets are too large, profitability is adversely affected. The key strategies and considerations in ensuring a trade oil' between profitability and liquidity is one of the major dimensions of working capital management. In addition, the individual current asset should be efficiently managed so that neither in adequate nor unnecessary funds are locked up. 2. FINANCING DECISIONS. The second major decision involved in financial management is the financing decision. The concern of the financing decision is with the Financing Mix or Capital Structure or Leverage. The term capital structure refers to the proportion of debt (i.e., fixed interest source of financing) and equity capital (or variable dividend security). The financing decision of a firm relates to the choice of the proportion of these sources to finance the investment requirements. A capital structure with a reasonable proportion of debt and equity capital is called optimum capital structure. 3. DIVIDEND POLICY DECISION. The third major decision of financial management is the decision relating to dividend policy . Two alternatives are available in dealing with the profits of the firm. They can be distributed to the share holders in the form of dividends or they can be retained in the business itself. The final decision will depend upon the preference of the share holders and the investment opportunities available within the firm. 3

The optimum dividend policy is one which maximizes the market value of the Co's shares. Most profitable Co's pay cash dividend regularly. Periodically additional shares, called Bonus shares, are also issued to the existing share holders in addition to the cash dividend.

financial manager helps the management to take different decision on the result of the evaluation of the financial performances. 6. Risk Management Happening of risks means facing different losses. Finance manager is very serious on risk and its management. He plays important role to find new and new ways to control risk of company. Like other parts of management, he estimates all his risks, he organize the employees who are responsible to control risk.He also calculates risk adjusted NPV. He meets all risk controlling organisations like insurance companies, rating agencies at pervasive level. Financial managers play an increasingly important role in mergers and consolidations, and in global expansion and related financing. These areas require extensive, specialized knowledge on the part of the financial manager to reduce risks and maximize profit.

FUNCTIONS OF FINANCE MANAGER

The finance manager occupies an important position in the organisational structure. Earlier his role was just confined to raising of funds from a number of sources. Today his functions are multidimensional. The functions performed by today's finance managers are as below:1. Forecasting the financial requirement: A financial manager has to make an estimate and forecast accordingly the financial requirements of the firm. 2. ACCOUNTING AND CONTROL- The financial manager arranges for the maintenance of financial records. He controls the financial activities of the enterprise. He identifies deviations from planned and efficient financial activities. 3.FORECASTING AND LONG-RUN PLANNINGThe finance manager forecasts costs and technological changes. He studies the market conditions and forecasts the funds needed for investment. He calculated the estimated returns on proposed investment project and forecasts about the demand for the products of the enterprise. 4. CASH MANAGEMENT- The financial manager arranges for cash management of the enterprise. Through cash management, he ensures the supply of funds to the different dept. of the enterprise. The financial manager arranges for the adequate supply of cash to all sections of the enterprise for its smooth flow of operations. 5. EVALUATION OF FINANCIAL PERFORMANCE- The financial manager evaluates the financial performance for the analysis of financial performance of the enterprise. The financial manager constantly reviews the financial performance to assess the financial health of the business enterprise. The

Changing scenario of Financial Management in India. Modern financial management has come a long way from traditional corporatefinance. As the economy is opening up and global resources are being tapped, theopportunities available to a finance manager haveno limits. Financial management is passing through an era of experimentation andexcitement as a large part 6f finance activities are carried out today. A few instancesof these are mentioned as below:Interest rate freed from regulation treasury operation therefore have to bemore sophisticated as interest rates are fluctuating. The rupee has become fully convertible. Optimum debt equity mix is possible. Maintaining share prices is crucial. The dividend policies and bonus policies formed by finance managers have a direct bearing on the share prices. Share buy backs and reverse hook building. Raising resources globally through ADRS/GDRS Risk Management due to introduction of option and future trading. Free pricing and book building for IPOs, seasoned equity offering. Treasury management. 4

OBJECTIVES MANAGEMENT.

OF

FINANCIAL

Financial management is concerned with the efficient use of capital funds. It evaluates how funds are procured and used. Financial management covers decision making in three inter related areas namely Investment, Financing and Dividend policy. The financial manager has to take these decisions with reference to the objectives of the firm. The objectives provide a frame work for optimal financial decision making. There are two widely discussed approaches in this regard. 1. Profit Maximization Approach 2. Wealth Maximization Approach. PROFIT MAXIMISATION APPROACH. According to this approach, actions that increase profits should be undertaken and that decrease profits should be avoided. Profits maximization approach implies that the functions of financial management/ Decisions taken by financial mangers (i.e. the investment, financing, and dividend policy decisions) should be oriented towards maximization of profits or Rupee income of the firm. Or the Company should select those assets, projects, and decisions which are profitable and reject those which are not. In the Economic theory, the behaviour of a Company is analyzed in terms of profit maximization. While maximizing profits, a firm either produces maximum output for a minimum input, or uses minimum input for a given out put. So the underlying logic of profit maximization is efficiency. Profit is a test of economic efficiency and it provides a yard stick by which economic performance can be judged. The profit maximization criterion has however been criticized on several grounds. The main technical flaws are ambiguity, timing of benefits and quality of benefits. 1. AMBIGUITY. One practical difficulty with profit maximization criterion for financial decision making is that, the term profit is a vague and ambiguous concept. It is amenable to different interpretations by different people. It is not clear in what sense the term profit has

been used. It may be total profit before tax or after tax or profitability rate. Rate of profitability may again be in relation to Share capital; owner's funds, total capital employed or sales. Furthermore, the word profit does not speak anything about the short-term and long-term profits. Profits in the short-run may not be the same as those in the long run. A firm can maximise its short term profit by avoiding current expenditures on maintenance of a machine. But owing to this neglect, the machine being put to use may no longer be capable of operation after sometime with the result that the firm will have to make huge investment outlay to replace the machine. Thus, profit maximisation suffers in the long run for the sake of maximizing short-term profit. Obviously a loose expression like profit can't form the basis of operational criterion for financial management. 2. TIMING OF BENEFIT A more important technical objection to profit maximization is that it ignores the differences in the time pattern of the benefits received. The profit maximization criterion does not consider the distinction between returns received in different time periods and treats all benefits irrespective of the timings, as equally valuable. This is not true in actual practice as benefits in early years should be valued more highly than equivalent benefits in later years. The assumption of equal value is in consistent with the real world situation. 3. QUALITY OF BENEFITS. Profit maximization ignores the quality aspect of benefits associated with a financial course of action. The term quality refers to the degree of certainty with which benefits can be expected. As a rule, the more certain the expected return, the higher is the quality of the benefits. An uncertain and fluctuating return implies risk to the investors. To conclude the profit maximization criterion is unsuitable and in appropriate as an operational objective of investment, financing and dividend decision of a firm. It is not only vague and ambiguous, but it also ignores risk and time value of money.

WEALTH MAXIMIZATION APPROACH. This is also known as value maximization or Net Present Worth maximization. It removes the technical limitations of profit maximization criterion. (i.e. ambiguity, timing of benefit and quality of benefit.) Wealth maximization means maximizing the Net Present Value (or wealth) of a course of action. The Net present value of a course of action is the difference between the present value of its benefits and the present value of its costs. A financial action which has a positive Net Present Value creates wealth and there fore it is desirable. A financial action resulting in negative NPV should be rejected. Between a number of desirable mutually exclusive projects, the one with the highest NPV should be adopted. In large concerns, for organizing finance function, the controller and treasurer are appointed. Financial controller perform functions of planning and controlling, preparation of annual reports, capital budgeting, profit analysis, cost and inventory management, and accounting and payroll. The main functions of the treasurer includes raising of additional funds, cash management, receivables management, audit of accounts, protecting funds and securities and maintaining relations with banks and other financial institutions etc.

The objective of wealth maximisation takes care of the questions of the timing and risk of expected benefits. These problems are handled by selecting an appropriate rate for discounting the expected flow of future benefits. It should be remembered that the benefits are measured in terms of cash flows. In investment and financing decisions it is flow of cash which is important, not the accounting profits. The Wealth created by a Company through its actions is reflected in the market value of companies' shares. The value of the companies share is represented by the market price, which in turn, is a reflection of the firm's financial decisions. The market price of theT The finance function is centralized because of its share serves as the performance indicator. importance. The financial decisions are crucial for the survival of the concern. Any bad decision on financial Organisation of Finance Function aspects will adversely affect the reputation of the concern. The organisation of finance function implies the division and classification of functions relating to finance because financial decisions are of utmost significance to firms. Therefore, to perform the functions of finance, we need a sound and efficient organisation.Although in case of companies, the main responsibility to perform finance function rests with the top management yet the top management (Board of Directors) for convenience can delegate its powers to any subordinate executive which is known as Director Finance, Chief Financial Controller, Financial Manager or Vice President of Finance. Besides it is finally the duty of Board of Directors to perform the finance functions. 6