THURSDAY, MAY 3, 2007

introduction to the financial management

Financial management is a specialized functional field dealing with the management of finance right
from estimation and procurement till its effective utilization in the business. It is an area looked after
by the finance manager who deals with the following issues:
i). Which new proposals for employing capital should be accepted by the firm ?
ii). How much working capital will be needed to support the firm's operations ?
iii). Where should the firm go to raise long term capital and how much will it cost ?
iv). Should the firm declare dividend on its equity capital and if so, how large a dividend should be
declared ?
v). What steps can be taken to increase the value of firm's equity capital?

The above issues are solved by taking three major decisions (1) Investment decision (2) Financing
decision (3) Dividend decision. As objective of the Financial Management is to maximize the value (i.e.
wealth of shareholders). the firm should strive for an optimal combination of the there interrelated
decisions solved jointly .The decisions to invest in a new capital project, for example, necessities
financing the investment. The financing decisions in turn, influences and is influenced by the dividend
decision. The retained earnings used in internal financing represents dividends foregone by the
shareholders. With a proper conceptual frame work, joint decisions that tend to be optimal can be
reached .

1) Financial management is a process to

Function of fib dividend
g Estimate the requirement of found k
g How to arrange the found k financial
g How to invest or utilised k
2) It is the efficient managment of the financial assets. Its objectives are the maximization of wealth
and profit maximization.

FINANCIAL TOOLS

Financial tools are the techniques that can be employed by the finance manager to solve the problem
properly effectively and efficiently. The following are the financial tools:
1) Ratio analysis
2) Fund flow and cash flow analysis
3) Cash budget
4) ABC analysis
5) EOQ model
6) Ageing schedule
7) Projected financial statements
8) Long - term investment appraisal tools - pay back period, net present value, profitability index
internal rate of return. etc.
9) Cost of capital
10) Leverages
11) Hedging

APPROCHES / MEANING OF F.M.

The basic message behind the statement " Financial Management is concerned with the solutions of the
three major decisions a firm must make the investment decision, the financing decision and the
dividend decision " is self evident.
A firm wants to earn profit because the founders of the firm believe that there is an opportunity to
make profitable investment. This profitable investment need to be financed and profit distributed
amongst those who have contributed the capital. Hence, there is need for decisions such as how to
finance investment ? How to distribute profit among shareholders ?

Modern approach of financial management basically provides a conceptual and analytical framework
for financial decision making. It emphasises on an effective use of fund. According to this approach the
financial management can be broken down into three different decisions:
1) Investment Decisions;
2) Financing Decisions; and
3) Dividend Decisions

1) Investment Decisions : These involve the allocation of resources among various type of assets. what
portion of the firm's fund should be invested in various current assets such as cash. marketable
securities and receivable and what portion in fixed assets, such as inventories and plant and
equipment. The assets mix affects the amount of income the firm can earn.For example, a
manufacturer is in business to earn income with fixed assets such as machinery and not with current
assets. However, placing too high a percentage of its assets in new building or new machinerymay
leave the firm short of cash to meet an unexpected need or exploit sudden opportunity. The firm's
financial manager must invest in fixed assets. but not too much. Besides determining the assets mix
financial manager must also decide what type of fixed and current assets to acquire. All this covers
area pertaining to capital budgeting and working capital management.
2) Financing Decision : It is the next step in financial management for executing the investment
decisions once taken a look at the balance - sheet of a company indicates that it obtains finance from
shareholders ordinary, preference, debentureholders, or long - term loans from the institutions, bank
and other sources. There are variations in the provisions contained in preference shares, debentures,
loans papers etc. Thus financing decisions i.e. the financing mix of capital structure. Efforts are made
to obtain an otimal financing mix for a particular company. This necessitates study of capital structure
as also the short and intermediate term financing plans of the company.

In more advanced companies financing decision today , has become fully - integrated with top -
management policy formulation via capital budgeting, long - range planning , evalution of alternate
uses of funds and establishment of measurable standards of performance in financial terms.
3) Dividend Decisions : The third major decision of financial management is the decision relating to the
dividend policy. 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; they can be retained in the
business. Which courses should be followed - dividend or retention ? One: the dividend pay out ratio
i.e. what proportion of net profits should be paid out to the shareholders. The decision will depend
upon the preference of the shareholders and investment opportunities available within the firm. The
second major aspect of the dividend decision is the factors determining dividend policy of a firm in
practice
All the above decision of finance are inter - related with one another. Any decision undertaken by the
firm in one area has its impact on other areas as well. For example acceptance of an investment
proposal by a firm affects its capital structure and dividend decision as well. So these decision are inter
- related and should be taken jointly so that financial decision is optimal. All the financial decision
have ultimately to achieve the firm's goal of maximisation of shareholders wealth.

Modern Approach to corporate finance in an improvement on the Traditional Approach :

company finance is identified with raising of funds in meeting financial needs and fulfilling the set
objectives of a company. At the outset in the early
years corporate finance was confined to :
1) Arrangement of funds from financial institutions.
2) Mobilising funds through financial institutions.
3) looking after the legal and accounting relationship between corporate unit and its sources of funds.

The traditional approach to corporate finance laid emphasis on the external fund. But the subject or
corporate finance spreads itself wider and wider. In the changed scenario the scope and importance of
corporate finance has been greatly widened. onalNow it not only includes the traditional and
conventional role of taking decision viz, investment, financing and dividend but also covers the area of
reviewing and controlling decision to commit funds to new and on going uses.

The field underwent a number of significant changes - new financial instrument and transactions like
options on future contracts, foreign currency swaps, and interest rate swaps, GDR ( Global Depository
Receipts ), globalisation of capital market, liberalisation measures taken by various government - all
these have emphasised the need for effective and efficient modern approach to corporate finance.

The modern approach to corporate finance lay emphasis that the corporate unit must make the best
and most efficient use of finances available to it. Accordingly the central theme of financial policy is
the wise use of funds and a rational matching of advantage of potential uses against the cost of
alternative potential useu with a desire to reach the set financial goals. It facilitates the key - how
large should an undertaking be, in what form assets should beheld with capital market.

Given the existing legal, poltical and economic environment the modern approach entails a conceptual
framework and is concerned with issues like -
(a) - financial goals or corporate unit;
(b) - adequacy of capita - maintaining minimum levels of capital to support the perceived risks ;
(c) - controls of client's money.
(d) - measuring the performance of the company.
(e) - position of the firm within the group.

Thus it is quit obvious that the modern approach to corporate finance is an extension as well as an
improvement on the traditional approach.

Profitability may not always assure liquidity :

Profitability is the ratio of profit per rupee of sales/ investment. It reflects the firm's ability to
generate profits per unit sales. If sales lack sufficient margin of profit, it is difficult for the business
enterprise to cover its fixed costs, including fixed charges on debt and to earn profit for shareholders.
The net profit margin indicates the firm's ability to generate profits after paying all taxes and
expenses. The ratio reflects the ability of the firm to utilise its assets effectively.

Profitabitity thus is a measure of efficiency and the search for provides an incentive to achieve
efficiency. It also indiean public acceptance of the firm's product and shows that the firm can produce
competitively. In addition it is profits which generate resources for repaying debt incurred to finance
the project and internal financing of expansion.

Liquidity on the other hand may be defined as the firm's ability to meet its short term and current
obligations on the becoming due for payment. It reflects the ability to convert its assets into cash to
pay its dues on schedule and in perquisite for the very survival of a firm. Liquidity is assessed through
the use of ratio analysis. These ratio help analy the present cash solvency of a firm and its ability to
remain solvent in the event of umexpected occurrence.

While short term creditors of the firm as interested in the short term solvency or liquidity of a firm,
liquidity implies the ability to meet the demands of creditors and business. The three motives which
affect the management's attitude towards liquidity are (1) Transaction motive ; the firm must maintain
adequate cash to meet its short term liabilities covering a period of upto one year (2) Precautionary
motive . idle cash must be maintained to meet unexpected demands for funds due to occurrence of
unforescen circumstances ; and (3) Speculative motive ; the management may like to maintain
adequate funds to take advantage of an unexpected bargain / deal when may come its way in the near
future.

While both liquidity and profitability are efficient financial management of a firm, these are basically
contradictory financial decision. Decision taken by the finance manager to increase profitability
generally strain the liquidity position of a firm. For example a firm may opt for debt financing vis -a -
vis equity financing due to the inbuilt tax ( leverage ) advantage. The decision however is likely to
strain the liquidity position of the firm, due to the periodic interest and re - payment obligations.
Equity financing however places no such obligation on the firm, and the decision to pay dividend is
discretionary. With increase in debt component in the capital structure of a firm, the expeuted
profitability goes up . Although endangering liquidity in the process. The financial manager's jb
therefore entails maintaining a balance between liquidity and profitability. While maximising returns
he must ensure maintenance of sale liquidity position for the firm.
Principles of financial Decision Making :
All major business decisions have financial implications. For example , should the firm expand; what
would be the best way to finance an expansion; which proposal would generate more revenue ; which
would result in the greatest long - term benefit and how to produce it ? What price to charge for it ?
Finance scholars and proffessional have developed a body of theory and a set of tools. These are the
principles of financial decision making .

At the outset, there are two basic principles of financial decision making viz .
(1) Time value of money , i.e. value maximisation.
(2) risk / exected return trade off.

(A) Time value of money or value maximisation :

The time value of money refers to the fact that a rupee available for use immediately is more valueble
than a rupee that will become available use only later.

This is the most basic principle in finance. Why a rupee today is worth more than a rupee a year from
now ? For instance, the interest rate today on saving is 9% and the rupee deposited today will grow
total value of Rs 1.09 in one year.

The saver is committing a present value of Re . 1 for a future value of Rs 1.09. The concept of the time
value of money is extremely important for all financial decision.

(B) Risk / expected trade off :

Return is the percentage change in the value of an investment over a period of time. For a risky
investment, the expected return is the planned or anticipated return from the invesment.

These consideration of risk and expected return lead to general principle of great importance.
Investors make a risky investment only if the expected return from the risky investment justify the risk.

Imp note : All the above decision should be taken after considering risk and return relationship.

(1) Cost element - While taking financial decision, cost element should be taken into consideration. It
is the most vital concept and represents a standard for allocating the firm's investible funds in the most
optimum manner.
(2) Risk element - This is another important factor to be considered before arriving at an investment
involves risk, its return is uncertain. Financial decision should be made only when the expected returns
from the risky investment justify the risk.
(3) Liquidity and profitability - Financial managers should made decision which would capable of
generating both liquidity and profitability. Liquidity is very important to meet short - term
requirement. Further it is necessary for ensuring solvency. Profitability is required to meet objectives
of share holders. But there is a tangle between profitability and liquidity. Therefore financial decision
should be made in such a way which have a balanced mixture of liquidity and profitability.
(4) Leverage effects - The financing decision is a significant one as it influences the shareholder's
return and risk. The new financing decision may affect a company's debt - equity mix. The effect of
leverage may be favourable or unfavourable. EPS is the vital concept of company and therefore
financial decisions should be made after analysing leverage affect .
(5) Prevailing environment in the company as well as in the industry - Financial decision should be
made in accordance with the conditions prevailing both in the company as well as in the industry. This
is necessary to meet the challenges of competitiors. In order to derive optimum advantage of the
industry, competitors strategy on various decision like production, pricing should be carefully followed
before making financial decisions.
Besides these factors, suitability and diversification factors also have to be kept in mind.
(6) Diversification
(7) Suilability
Financial management as a science or as an art :
Financial management is science or an art is a debatable issue. In true sense. neither it is pure science
like physics, not it is an art like painting. It lies somewhere between two extremes. It is science
because it is based on theoretical prepositions and procedures adopted in the business enterprises. The
subject matter of the financial management in addition to theoretical propositions includes the body of
rules and regulations. It also takes the help of statistical techniques, econometric models, operational
research and computer technology for solving corporate financial problems.
These problems may be budgeting decisions, choice of investment acquisition or allocation of funds,
locating sources of capital and various other areas In this way the nature of financial management is
nearer to the applied science as it envisages the sue of classified and tested knowledge in solving
business problems.

Despite the use of scientific method in the area of financial management there remains a wide
application of value judgement in financial decision - making. Application of mathematical or computer
based packages provide in many cases no solutions unless human thinking and skills are appiled or
making choice. thus the application of human judgement sills skills become neceesary in many cases,
such judgement is based on experience of a particular financial manager making the decisions. The
application of human judgement in the decision making makes financial management an art along with
its features of science. Thus in this way knowledge of facts, principal and concepts as well as personal
involvement of finance manager along with application of skills in the analysis and decision-making
process the financial management both science as well art.
Globalisation & Liberalisation & Financial Management :
Globalisation means integration of nationanl economy to the world economy. In economic sense
globalisation refers borderless world where there is free flow of money and currencies. ideas and
exertise , postering patnership and allian to serve the customers best financial decision making deals
with financial matter of a corporate enterprise i.e. kind of assests to be acquired , patten captain
structure and distribution of assets and investment
(1) Complicates the task of investment decision : Presently the invetment decision making has become
a complicated and tendious exercise. Corporate units now alongwith national conditions also takes into
account global view i.e. foreign exchange risk exposure, economic, political, legal and tax parameters
while making investment decisions. It demands higher level of expertise from finance executives to
understand the situation and to arrive at optimal investment decision.
(2) Widens the scope raising the funds : Corporate units now have access to foreign market to raise the
resources at competitive rates. Foreign intitutional investors and NRI may also participate in this
process and this help in attaining the least cost capital structure.
(3) Dividend decision have to be taken in the light of global scenario and available portfolio
opportunities, and internal needs of the corporate units.

Liberalisation is a process which is aimed at to create an atmosphere of free competition among

different agent of production and distribution of goods and services, finance and trade both public and
private, demestic and foreign, small and large alike. The major components of liberalisation process
includes changes in industrial policy which amounted to redical transformation of the entire industrial
environment. The major impact of liberalisation on the Indian industry include the following:

1. Optimum utilisation of financial, material and human resources;

2. Effective role of market mechanism in determination of allocation of resources;
3. Boost in trade and commerce;
4. Encouragament of foreign investment and integration of country's economy with global economy;
5. Increase in number of foreign collaborations and transfer of technologies;
6. Capital inflows and improvement in foreign reserve position;
7. Development of infrastructure. 
8.Financial Markets :
It is a market where buyer's and sellers meet to exchange things for money. Financial markets can be
divided into :
(a) Money Market
(b) Capital Market 

Money Market refers to open - market operations in highly marketable instrument like bills of exchange
etc.

Capital market is again can be divided into :

(a) PRIMARY MARKET
(b) SECONDARY MARKET

New issues of shares and debt securities are made in the primary market and existing securities are
traded in the secondary market

Primary market can have following three segment :

(a) PUBLIC ISSUE
(b) RIGHT ISSUE
(c) PRIVATE PLACEMENT

Secondary market again can be divided into three segment :

(a) STOCK EXCHANGE [ 23 stock exchange in India ]
(b) National stock Exchange
(c) Over the counter Exchange of India.

9.GLOBALISSTION OF FINANCIAL MARKET :

With the economic reforms, in the financial sector in India, the financial markets of India have been
integrate with the financial markets in other parts
of would. The financial liberalisation in India has enabled the India companies to source funds from the
inter- national market through EVRO-ISSUES.

International market [Euro Marker] can again be dividend into :

a) INTERNATIONAL MONEY MARKET
b) INTERNATIONAL CAPITAL MARKET

Financial sector reforms and financial management :

Financial sector reform is one of the important component of economic reforms initiated by the
government of india to boost its economy and also to intenrate ot to the world economy. “The reform
objective in our out country in largely to promot adiversified efficient and a competitive financial
system. It aims at raising the following the allocative efficiency of available saving increasing the
return on investments and promoting the accelerated growth and development of the real sector,
Specifi goals of the programme include:

i). to correct and improve the macro-economic policy setting within which banks operate. This involve
monetary control reforms including rationalization of interest rates, redesigning direct credit
programmes, and bringing down the level of resource pre-emptions:
ii). To improve the financial health and condition of banks by recapitalizing banks, restructurning the
weak ones and improving the incetive under which banks function:
iii). To build financial institution and infrastructure relating to supervision . audit technology and leg
framework.
iv). To improve the level of managerial competence and the quality of human resource by reviewing
policies recruitiment , training , placement etc.
v). To improve access to financial saving.
vi). To reduce intermediating costs and distortions in the banking system.
vii). To promote competition through a level playing field and freer entry and exit in the financial
sector.
viii). To develop transparent and efficient capital and money markets.

In India, financial sector reforms are confined to banking and financial institutions.

In recent years, the government of India along with other regulatory bodies have undertaken various
steps to make financial sector more competitive , efficient, transparent and flexible. Some of these
step in this reguard include following:

Reducing in statutory Liquidity ratio, cash reserve ratio and interest rate , SCP,CRR & interest .
Permission to set up banks under private sector .
Floating interest rate on financial assistance by some all India development banks.
Strengthening the supervisory process.
Instilling a greater element of competition.
Introduction of various financial institutions and instruments.
o 
However, the financial sector reforms addressed on the issue like rate of interest and prudential norms