Introduction to Financial Management

Learning objectives
After studying this chapter you should be able to understand:

 Meaning and definition of financial management

 Aspects of financial management
 Financial decisions in a firm
 Risk and return trade off
 Importance of financial management
 Objectives of financial management
 Principles of finance
 Assessing corporate performance
 Stakeholders objectives
 Forms of business organization

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Financial Management – Meaning and Definition

Financial Management is that managerial activity which is concerned with

planning and controlling of the firm’s financial resources. Acquiring, financing and
managing assets to accomplish the overall goal of the business enterprise i.e.
maximize shareholders wealth.

Suppose you are planning to start your own business then you will have to
address following questions:

1. What capital investment should you make? i.e. Investment in real estate,
machineries, R&D programs, IT infrastructure etc. (Capital budgeting)
2. How you will raise money to pay for this proposed capital investment? i.e.
what will be your own capital contribution? How much you will borrow from
friends or banks or financial institutions meaning what will be the mix of
equity and debt in your financial plan? (Capital structure)
3. How will you handle day-to-day financial activities like collecting your
receivables and paying your supplier etc. (Working capital management)

All companies face these basic problems of capital budgeting, capital structure,
working capital management and financial controls.
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Financial Management – Meaning and Definition

Different viewpoints on finance

1. Finance is concerned with acquiring funds on reasonable terms and
conditions to payment of bills and settlement of business obligations
promptly. Study of financial institutions and instruments from which funds
can be recurred. Type of duration, terms and conditions – duration, type of
obligation, urgency of need and cost. (Traditional approach)

2. Finance is concerned with cash. All business transactions need cash. Each and
every activity within the enterprise is a primary concern of finance manager
and it covers wider activities of business. Definition is too broad to be convey
precise meaning.

3. Finance is concern with procurement of funds and wise application of these

funds. Finance is not only limited to acquisition of funds but extends beyond
this to optimal use of funds. Finance Manager is concerned with allocation of
funds to maximize the value to the enterprise. Example – Capital expenditure
in which market? What volume of funds to be invested?, How can enterprise
maximize profitability?
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Procurement and Utilization of Funds

• Owner’s funds
• Debentures and bonds
• Banks loans (short term and log term loans), cash
Procurement credit, Bill purchase and discounting, Bank
of Funds Guarantee and LC
• Hire purchase and leasing arrangements
• Venture capital

• Utilization for fixed assets

• Utilization for working capital
Utilization of • Non-asset expenditure Labour
Funds • Interest and debt service charges
• Distribution of profits to owners

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Aspects of Financial Management

M/S ABC is a well–known company in computer training, software development,

Information systems, consultancy etc. and is undertaking a modernization cum
Expansion scheme which calls for additional capital investment.

M/S ABC Company Limited

Procurement of funds INR (Mio) Utlization of funds INR (Mio)

Public issue of equity shares 1,804 Buildings 985

Term Loans - ICICI 130 Computers and accessories 941
Leasing - ICICI 125 Plant and machinery 116
Other loans 75 Infrastructure 454
Deferred payment gurantee 99 Repayment of loans 283
Internal accruals 1,345 Increase in working capital 799
3,578 3,578

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Financial Decisions in a firm

Capital Capital Working Capital

Budgeting structure Management

Define the business Which capital Day-today financial

you wanted to be in market should firm activities that deals
– Capital Allocation access? with CA and CL

Strategic planning. Options of equity, Optimal level of

Costs and benefits preference shares or inventories, credit
spread over years debenture issue period, cash on hand

Plans to invest in Optimal capital How to invest

long-lived assets Debt-equity mix temporary cash
surpluses?

Plans to invest in Dividend pay out. What should be the

long-lived assets Should firm buyback sources of short term
its own shares? finances?
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Capital Budgeting Decision – factors to be considered

Internal investment:

1. Long term v/s short term investment projects

2. Benefits of Long term investment projects accrue in the long run
3. What capital expenditure projects firm should take?
4. What volume of funds should be committed?
5. How funds should be allocated amongst different investment outlets?
6. Many alternative investment proposals are on hand but due to paucity of
resources firm cannot undertake all of these projects at a time.
7. Selection of investment proposal based on maximum profit objective
8. Selection of project based on economic viability – expected returns, cost
involved and risk associated with project

External investment:
1. Merger or acquisition of another firm
2. Evaluate efficacy of merger
3. Portfolio management
4. Current earnings and future growth rate, dividend, market value, book value
and net current assets.
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Capital structure Decision – factors to be considered

1. From what sources are funds available?

2. Cost of funds presently used v/s expected cost of future financing

3. What sources should be tapped and to what extend?

4. What instruments should be employed to raise funds and at what time?

5. Should company approach financial institutions for securing funds? If yes, on

what terms and conditions?

6. Optimal mix of borrowed and owned funds

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Working capital Decision – factors to be considered

1. How to allocate cash and cash equivalents, receivables and inventories?

2. Trade of between liquidity and profitability – higher the relative share of

liquid assets, lesser will be the possibility of cash drains, other things being
equal, profitability in such case will be lower.

3. Smaller portion of funds is held in liquid form, risk of insolvency will be high
but profitability will be high

4. Trade of between profitability v/s liquidity – decision depends upon risk

preference of the management

5. Preferences are influenced by goal of maximizing shareholder’s wealth.

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Financial Decision in a firm

Other factors that influence financial decisions:

1. Efficient market theory – analysis of how price change over time in

speculative markets

2. Portfolio theory – formation of optimal portfolio of securities

3. Capital asses pricing theory – Determination of asset prices under condition

of uncertainty

4. Option pricing theory – determination of prices of contingent claims

5. Agency theory – analysis of incentive conflicts in contractual relations

6. Behavioural finance – assumes people are rational, considers social and

emotional factors.

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Financial Decisions in a firm – Risk and return trade off

Capital
Budgeting
Decisions
Returns

Capital structure Market value of

Decisions the firm

Risk

Working capital
Decisions

 A large plat may have higher expected return but also high risk exposure
 Higher debt-equity ratio compared to lower debt-equity ratio may save
taxes but expose to greater risk
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Importance of Financial Management

The importance of Financial Management cannot be over emphasized. It is the

key to successful business operations. Without proper administration of finance
no organization can reach its full potential for growth and success.

Financial management is all about planning investment, funding investment,

monitoring expenses against budget, and managing gains from investments.
Financial management means management of all matters related to
organization's finances.

Good financial management can be seen in some of the tasks:

1. Optimal investment in fixed assets
2. Ensuring optimal working capital for meeting the day-to-day business needs.
3. Setting sales revenue targets that will deliver growth
4. Increasing gross margins by setting correct and competitive product price
5. Cost saving by finding most cost efficient ways of running day-to-day business
operations.
6. Proper tax planning

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Objectives of Financial Management

Two main objectives of financial management:

1. Profit maximization
2. Wealth / value maximization

1. Profit maximization:
- Traditionally argued that primary objective of a company is to earn profits
- Each alternative to be evaluated whether or not it gives maximum profits
- Vague: Profit conveys different meaning to different people (Short term profits
or long term profits, absolute number of rate of profits)
- Direct relation between risk and profits: Finance manager cannot accept
highly risky propositions even if it gives high profits. Risk is very important
consideration and has to be balanced with profit objective.
- Time pattern of return is not taken into account: Proposal A may give higher
profits as compared to proposal B. If returns of A begins to flow say 10 years
later and that of B is 5 years. Proposal B is preferred even though profits are
low but return flow is more early and quick.
- Its too narrow: fail to take into account social considerations and obligation
towards workers, consumers and society as well as ethical trade practices.
Profit maximization at the cots of social and moral obligations is a short
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Objectives of Financial Management

2. Wealth / value maximization:

- Most widely recognized for performance evaluation of business firm.
- Maximize its market value and implies that business decisions should seek to
increase the net present value of the economic profits of the firm.
- Any financial decision that creates wealth or which has a net present value
above Zero is desirable one and should be accepted and one which does not
satisfy this test should be rejected.
- It considers time value of money hence when used as decisional criterion
serves as very useful guidelines in taking investment decision.

- Does not offer clear relation between financial decision and share price

Project outflow INR 100 Mio

Project Inflow INR 108 Mio
Net present value of project INR 8 Mio
[Project is accepted]

 Discounting factor @10% where discounted project inflow is INR 98 Mio

[Project is accepted]
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Objectives of Financial Management

3. Other objectives

- Achieving higher growth rate

- Achieving larger market share

- Gaining market leadership in terms of products and technology

- Promoting employee welfare

- Improving community life, supporting education and research, solving social

problems, etc.

Primary goal remains to be wealth maximization as it is very critical for the very
existence and survival of any business / firm. If this goal is not met then public
institutions may loose confidence in enterprise and will not invest further in the
growth of the organization.

If growth of the organization is restricted then other goals like community welfare
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Fundamental principles of finance

Cash alone matters:

Investors: Investors provide initial cash Business

 Shareholders Required to finance business Proposal
 Lenders

Proposal generates cash

returns to investors

 Difference between present value of future benefits and initial outlay

represents the net present value of “NPV” of the project.
 Net Present value = Present value of future benefits
Less: Initial outlay
 It is applicable for new investment, acquisition of another company, or
restructuring of existing company operations
 Discount rate reflects theClassification:
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Assessing corporate performance

 Increase in market capitalization over 12 months

 Increase in revenues over one accounting period

 Increase in EBIT over one accounting period

 Return on net worth

 Compound annual growth in EPS over past three years

 Price-earnings ratio

 Market capitalization

 Sales for the latest financial year

 PAT for latest financial year

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Stakeholders interest

The major groups interested in business operations are:

Management viewpoint– This classification assumes that “management group”

is different from “owner group”. This group is interested in operational controls,
COGS, analysis of contribution, GM, Operating expenses, and working capital.

Owners’ viewpoint – This group is interested in returns. Net profit to net worth,
net profits available to equity shareholders, EPS, cash flow per share and
dividend per share.

Lenders’ evaluation – This group is interested in liquidity. Current and quick

ratios, Total debts to total assets, Total debts to net worth, long term debts to
total assets, long term debts to net worth, Earnings before interest and taxes to
interest etc.

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Forms of Organizations

Sole Partnership Companies

Proprietorship Firm Private & Public Ltd
Easy and inexpensive Easy and inexpensive Distinct legal entity,
set up, few Govt. set up, relatively free separate from its owners,
regulations from Govt. regulations shareholders, Limited
Liability, Unlimited life
Life of the firm is Expertise, experience
limited to the life of of the partners is Liability of shareholders of
the owner useful to firm’ the company is limited to
the share capital subscribed
Unlimited personal Distinct legal and tax
liabilities entity To be registered with ROC,
double taxation

Limitations on raising Governed by Indian Separation of ownership

funds from outside, partnership Act, 1932. and management creates
may hamper growth agency problems.

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