FINANCE FUNCTION

Definition:-
The finance function is the process of acquiring and utilising funds of a
business. – by R.C.Osborn
Financing consists of the raising, providing, managing of all the money,
capital or funds of any kind to be used in connection with the business.
-- by Bonneville & Dewey

SCOPE OF FINANCE FUNCTION

According to modern approach, the scope of finance function is
concerned with the following three types of decisions.
Financing Decisions :-
Decisions basically concerned with the process of acquiring funds. May
be from own sources (Equity Capital) or loan sources ( Debt Capital).
These decisions are concerned with answers to the following questions.
• What should be the amount of funds to be raised?
• What should be the mix of equity and debt capital?
Investment Decisions:-

Concerned with utilisation of funds. These decisions relate to the

selection of the assets in which funds should be invested. From the
asset perspective these decisions are—
• Capital Budgetting decisions
• Working Capital Management
Dividend Policy Decisions:-
Related to the decisions regarding proportion of dividends & profits
retained in the business for future expansion.
SIGNIFICANCE OF FINANCE FUNCTION
Other than finance, every business generally operates in the other main
functional areas – Production, Marketing and Personnel. These
functions are closely related to finance function because funds are
required to execute these functions. E.g. to produce good quality of
finished goods, business needs good infrastructural facilities like
building, plant& machinery etc. To regulate the flow of production
inputs like quality raw material, WIP, consumable stores, quality
control equipments, maintenance facilities are required. All these need
investments in terms of fixed capital & working capital which is the
area of finance function.
 To market the finished goods to guarantee regular flow of goods in the
market, it may be required to have good distribution systems which
may call for investment in terms of fixed assets or labour force. All
these activities need the investments to be made either in terms of
fixed capital and/or working capital which is the area of finance
function.
The personnel function deals with the availability of human resource at
proper time, training them properly and fixing their job responsibilities.
All these activities need funds to pay salaries, wages and other
facilities.
Thus, all the functions or activities of the business are ultimately related to
finance. The success of the business depends on how best all these
functions can be co-ordinated with finance function.
 CONCEPT OF FINANCE
• The concept of ‘Finance’ is not a static one but it is more dynamic in
nature. It has changed with times and according to circumstances. The
important approaches could be explained as below.
• According to first approach, the term finance was interpreted to mean
procurement of funds by corporate enterprises to meet their financing
needs.
• According to second approach finance is concerned with cash. As all
the business transactions are expressed in terms of cash, it is
concerned with every activity of the business. This approach is
concerned with all the functional areas of the business i.e. Production,
Marketing, Purchasing, HR administration, R&D.
• The third approach interprets the term finance as being concerned with
procurement of funds and proper application of the funds. This
approach is more balanced and acceptable universally as it gives
equal weightage to procurement and utilisation of funds as well. This
approach is called Managerial Approach to the term finance.
 CORPORATE FINANCE
• Corporation :- Corporations are joint stock companies which are
public limited. Corporations are owned by it’s stockholders who elect a
board of directors. The separation of ownership and management
gives corporations perpetual character.
• Finance function of corporations can broadly be divided into two
categories.
Finance Control Function Treasury Function
• Accounting & Costing 1. Receivables Management
• Annual Reporting 2. Taxes & Insurance
• Internal Auditing 3. Cost Management
• Budgeting 4. Securities
• Statistics & Finance 5. Banking Relations
• Record Keeping 6. Real Estate
7. Dividend Distributions
 OBJECTIVES OF CORPORATE FINANCE
• The two most important objectives of Corporate Finance are –
1. Maximisation of EBIT & EPS
2. Maximisation of the spread between ROA and WACC i.e.EVA
Apart from the above major objectives following objectives which are
consequential to the above are –
• Maximisation of the market capitalisation
• Maximisation of the % ROI.
• Desired growth rate in EPS
• To attract the institutional investors.
ROLE OF A FINANCE EXECUTIVE :-
Finance function may not be a specialized function in small business
organisations. But in large corporate houses it is a specialized task and is
centralised. Usually the Board Of Directors have the authority to take the
financial policy decisions. Within this policy framework, the delegation of
powers is made to the executive committee comprising of CFO, Managing
Director and one or two directors. Only routine financial matters are
delegated to lower level officers.
Reasons for finance function being highly centralised are –
• Financial decisions are the most crucial ones on which survival or failure
of the organisation depends.
• Financial decisions affects the solvency position of the organisation and
a wrong decision in this area may lead to crisis.
• The organisation may gain economies of centralisation in the form of
reduced cost of raising funds, acquisition of fixed assets at the
competitive prices.
DUTIES AND RESPONSIBILITIES OF FINANCE
EXECUTIVE
• Recurring Duties
1. Deciding the Financial needs
2. Raising the funds required
3. Allocation of funds
-- Fixed Asset Management
-- Working Capital Management
4. Allocation of income
5. Control of Funds
6. Evaluation of Performance
7. Corporate Taxation
8. Other Duties like internal audit, statutory & tax audit, safeguarding
securities & assets by properly insuring them.
• Non-recurring Duties
These duties include preparation of financial plan at the time of
company promotion, financial readjustments in times of liquidity
crisis, valuation of the enterprise at the time of merger & acquisition.
Non-recurring Duties in the Field of Finance
1. Business Finance
2. International Finance
3. Public Finance
4. Private Finance
Non-recurring Duties in other fields :-
1. Production
2. Marketing
3. Personnel
Implications of Forms of Business Organisations:-
• Sole Proprietorship
• Partnership
• HUF Businesses
• Co-operatives
• Joint Stock Companies
• Public Sector Enterprises
 FINANCIAL SYSTEM
A financial system consists of different financial assets, financial
intermediaries, financial market, borrowers & investors. An efficient
financial system is of critical importance for the economic development
of any country.
Financial Market :- A financial market may be defined as the market of
financial assets i.e. the market in which financial assets are transacted.
Issue of shares & debentures by a company, issue of mutual fund
units, working capital loans by commercial banks, long term financial
assistance by financial institutions which are undertaken in financial
markets. The financial market in India is divided into three parts-
• Money Market :- It is a market for short term debt transactions. The
formal money market is basically characterized by presence of RBI,
DFHI, Mutual funds, NBFCs, commercial banks, financial institutions
etc. These participants transact in treasury bills, inter-bank call money,
commercial bills of exchange, inter-corporate deposits etc.
• Capital Market :- It is a market for long term financial assets such as
shares, bonds, debentures, mutual fund units.
The subsequent sale or purchase of these securities is undertaken in
secondary market. This market is basically provided by the stock
exchanges.
• Government Securities Market :- It is a market in which the
securities/loans of central government, state government & other
government authorities are traded. These securities, primarily in
the form of government loans, also known as Gilt-edged
securities. The main participants in this market are the commercial
banks, provident funds.
• Financial Assets :-Financial assets represent a financial claim of
the holder over the issuer.
• Financial Intermediaries :- These are financial institutions and
are key players in the financial system. Financial intermediaries
play a role of establishing a link between the debtors and the
creditors in the financial system. They are classified as-
-All India level financial institutions such as IDBI, SIDBI
-State level financial institutions such as MSFC
-Commercial Banks
-Insurance companies
 - The mutual funds
- The NBFC including leasing & hire purchase companies
- The agricultural finance companies including NABARD
- Other institutions such as chit funds
Regulatory Framework :-
Regulatory framework for controlling and supervising the financial
system in India is a complex network of legislations, guidelines,
notifications. The main elements of regulatory framework are-
- The Company Act 1956
- The Securities Contracts (Regulation) Act, 1956
- The Income Tax Act, 1961
- The Banking Regulation Act, 1949
- Numerous Guidelines issued by SEBI and the RBI
- Credit Policy announced by RBI
 SIGNIFICANCE OF FINANCIAL SYSTEM
An efficient financial system regulating the various institutions can lead to
the economic development of the country. The advantages of good
financial system are as follows.
• Enables investors to make their investments to their expectations, which
are constantly changing.
• The process of market evaluation, allocates the available funds for
investment to the most efficient firms who can apply them most
profitably and productively.
• Mobilises the investible surplus and provides expert services in bringing
about the flow of funds into securities of business establishments.
• Acts as a link between those who save and those who are interested
in investing these savings.
• Ensures the transparency of transactions of buying and selling the
securities.
• Guarantees the protection of funds invested by the small investors.
• Keeps a watch over the company management.
• Encourages acceleration in the rate of capital formation and thus acts as
a catalyst in the wealth creation.
•Performs fundamental & technical analysis so as to guide the
stakeholders in order to make informed decisions.

• Provide for listing of different securities showing their market value.

• Provision of ready & continuous market for the purchase and sell of different
securities.
• Provides an environment for speculation over different securities in a market place.
 RATIO ANALYSIS
• Absolute figures in the financial statements, either the profitability
statements or the balance sheet, may not give the qualitative indication
regarding the financial position or performance of an organisation.
A ratio is a relationship expressed in mathematical terms between two
individual or groups of figures connected with each other in some
logical manner.
 CAPITAL BUDGETTING
Capital budgetting includes analysis of various proposals regarding capital
expenditure to evaluate their impact on the financial situation of the
company and to choose the best out of the various alternatives.
 CAPITALISATION
• The financial decision that determines the amount which the firm
should have at it’s disposal for financing fixed assets as well as the
current assets ( portion of which is financed out of long term
sources) is called ‘Capitalisation’.
• Thus capitalisation means total amount of long term funds available
to the company. It cludes capital stock & debts as well.
• Amount of capitalisation of the firm should be equivalent as justified
by it’s profits and by the rate of return for the industry concerned.
THEORIES OF CAPITALISATION
A] Cost Theory :-
Cost theory considers the amount of capitalisation on the basis of cost
of various assets required to set up the organisation. It gives more
stress on current outlays than on the periodic requirements.
The cost theory considers the actual funds but not the earnings
capacity of the assets.
The total capitalisation is sum invested in fixed & current assets and
also funds required to meet promotional & organisational expenses.
 B] EARNINGS THEORY :-
This theory considers the amount of capitalisation on the basis of
expected future earnings. It is worked out in two steps.
I] To decide future earnings –
Estimation of future earnings should be based on following criteria.
• Smaller period of estimation
• Weighted average of the past earnings with more weights to
recent earnings.
• Due adjustments to non-recurring factors.
• Adjustment to known factors in future.
• For new concerns reasonably correct estimation of future sales &
& costs (based on forecast).
• Allowances for contingencies.
II] To determine Capitalisation Rate –
It may be one or combination of the following
• The rate of return requireqd to attract the investors.
• Cost of Capital
• Rate of earnings of similar organisations.
 III] To capitalise the future earnings at the decided rate of capitalisation.
• Earnings theory is ideal as it considers earnings capacity but also has a limitation
as it involves estimation of two variables i.e. future earnings and capitalisation
rate which is critical.
OVERCAPITALISATION
It means an existence of excess capital as compared to the level of business activity
and requirements.
Causes of Overcapitalisation :-
• Assets of the firm purchased during inflationary trends.
• Inadequate provision for depreciation of the assets.
• Heavy expenses during the stage of formation/incorporation.
• Acquisition of intangible assets like goodwill, patents. Trademarks, copyrights,
Designs etc by paying exorbitant price without proportionate earnings.
• In adequate estimation of funds resulting into huge borrowings at high cost.
• Liberal dividend policy seriously affecting retained profits & earnings capacity.
High rates of taxation leading to shortage of funds seriously affecting
earnings capacity of the assets.

• Issue of securities in favourable capital market conditions irrespective

of the fact whether they are really required or not. As a result the ability
of the company increases but not the earnings capacity.
• Lower than prevailing market rate of capitalisation.
Effects of Over Capitalisation
• On Company :- Real value of the business and it’s earnings capacity
reduces with adverse effect on it’s market value.
• On Shareholders:- Shares held are not having proper backing of
tangible assets.
• On Cosumers:- To overcome the situation of overcapitalisation &
improve earnings, the selling prices may be increased.
• On Society at Large :- Increasing selling prices & falling market prices
of shares affects consumers and shareholders as well. This may lead to
liquidation of the firm leading unemployment and loss of industrial
production.
 REMEDIES FOR OVERCAPITALISATION

• To reduce the debts by repaying them out of own earnings.

• To redeem high cost preference shares.
• High cost debenture holders may be persuaded to accept new low cost
debentures debentures.
• Devaluation of face value of shares with consent from shareholders.
UNDERCAPITALISATION
It is excess of real worth of the assets over the aggregate of Capital (shares term
loans & debentures) outstanding.
Causes of Undercapitalisation
• Underestimation of the future earnings.
• Windfall gains especially during the transition period from depression to boom.
• Implementation of modernisation program increasing earnings capacity many
times.
EFFECTS OF UNDERCAPITALISATION

• On Company :-
Increasing EPS may further increase the competition in the business.
Increasing profits will increase the tax liability.
High market price of shares restrict the volume of trades.
More demand of wages from employees.
Customers feeling about the high prices & profitability.
• On Shareholders :-
High dividend income
High market price maximises wealth.
Limited trades of shares on account of high price.
• On Society
Encouragement to new entrepreneurs
Improve industrial production and reduce unemployment
REMEDIES FOR UNDERCAPITALISATION

• Issue of bonus shares.

• Splitting the shares.
CAPITAL STRUCTURE
Capital Structure refers to the mix of sources from which the long term
funds required by a business are raised.
Capital structure is based on the following principles.
Cost Principle :- Ideal capital structure should minimise the cost of
capital and maximise EPS.
Risk Principle :- High risk in financing capital should be avoided.
Control Principle :- Should ensure controlling stake of the promoter
group in the company.
Flexibility Principle :- Capital structure should be able to cater to
additional requirements of capital in future.
Timing Principle :- Capital structure should be able to exploit favourable
market conditions & should minimise the cost of raising.
FACTORS AFFECTING CAPITAL STRUCTURE

• Internal Factors
1. Cost of Capital
2. Risk Factor
3. Control Factor
4. Objects of Capital Structure Planning
• External Factors
1. General Economic Conditions
2. Level of Interest Rates
3. Policy of Lending Institutions
4. Taxation Policy
5. Statutory Restrictions
• General Factors
1. Constitution of Company
2. Characteristics of Company
3. Stability of Earnings
4. Attitude of Management
MANAGEMENT OF PROFITS