1.

BASICS OF FINANCIAL MANAGEMENT

Q1. ‘Financial Management is the management of funds’. Elaborate
 Finance is called as the science of money. It studies the principles and the methods of obtaining funds,
investments of funds and management of surplus money.
 Finance may be defined as a set of functions in an organization which relate to the management of money so that
the organization may carry out its objectives in an effective and efficient manner.
 In simple words finance is defined as the activity concerned with the planning, raising, controlling and
administering of the fund used in the business.

Scope – ‘Financial Management deals with procurement of funds and effective utilisation of funds in a business.’
 Financial management is that managerial activity which is concerned with the planning and controlling of the
firm's financial resources.
 It is an integrated decision making process concerned with acquiring, financing and managing assets to
accomplish the overall goal of a business organisation.
 Financial managers have a major role in cash management, acquisition of funds and in all aspects of raising and
allocating capital. As far as business organisations are concerned, the objective of financial management is to
maximise the value of business.
 “Financial management comprises the forecasting, planning, organising, directing, co-ordinating and controlling
of all activities relating to acquisition and application of the financial resources of an undertaking in keeping with
its financial objective.”

Procurement Utilization

Owners
Borrowings
Funds Venture ADR, GDR, Current
(Debenture, Fixed Assets
(Share Capital FCCB, ECB Assets
Bonds)
Capital)
Long Term Short Term

Q2. Short Notes on Objectives of Financial Management

a) Profit Maximisation: of the Company

The finance manager has to make his decisions to maximise the profits of the concern. It ensures that a firm utilizes
its available resources most efficiently under conditions of competitive markets.

Advantages Disadvantages / Limitations

Profits are vital for survival of business. The term “Profit” is vague.
Essential for the growth and development of business. Higher the profits, higher the risks involved. It
may ignore the risk or uncertainty element.
Impact on society through payment to factors of Ignores time pattern of return, difficult to sustain
production. in the long run.
Profit-making firms only can pursue social obligations Ignores social and moral obligations of business.

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b) Wealth Maximisation: of the Shareholders
The objective of a firm should be to maximise its value or wealth. Wealth or Value of a firm is represented by the
market price of its shares. This value is a function of two factors:
1) Dividends (profit distributed)
 The expected rate of Earnings Per Share (EPS) of the company; and 2) Increase the Market price per share (cap. gain)
3) Bonus Issue (free of cost)
 The Capitalisation Rate. 4) Rights Issue (below Mkt. price)
5) Buy-back (above Mkt. price)
6) Delist (above Mkt. price)
Value of a Firm = Earnings per Share (EPS)
Capitalization Rate (%)
EPS: Earnings per Share (EPS) depends upon the assessment as to how profitably a company is going to operate in
the future or what it is likely to earn against each of its ordinary shares.
Capitalisation Rate: It is the cumulative result of the assessment of the various shareholders regarding the risk and
other qualitative factors of a company. This rate reflects the liking of the investors for a company. Wealth
maximization is a better objective for a business since it represents both return and risk.

Advantages Disadvantages
i) Emphasizes the long term i) Offers no clear relationship between
ii) Recognises risk or uncertainty financial decisions and share price,
iii) Recognises the timing of returns ii) Can lead to management anxiety and
iv) Considers shareholders' return. frustration.

Q3. ‘There is a conflict between Profit Maximization and Wealth Maximization function’. Discuss
 Basically, profit maximization is a short-term goal. It is usually interpreted to mean the maximization of profits
within a given period of time. A firm may maximize its short-term profits at the expense of its long-term profitability
and still realize this goal. In any company, the management (Board of Directors) is the decision taking authority.
Normally, the basic tendency of any management is to maximize enterprise profits (i.e. profit maximization).
 However, in an organization where there is a significant outside participation (through shareholding, lenders etc.),
the management is under constant supervision of the various stakeholders of the company – employees,
creditors, customers, government, etc. Every entity associated with the company will evaluate the performance of
the management for the fulfilment of its own objective. The success of the enterprise shall depend on satisfaction
of the stakeholders. Shareholder wealth maximization is a long-term goal shareholders are interested in future as
well as present profits.
 Thus, the wealth maximization objective is wider and it covers the interests of the various groups such as owners,
employees, creditors and society, and thus, it may be consistent with the management objective of survival.
Hence, in today’s world, wealth maximization is a better objective.
 Wealth maximization is generally preferred because it considers – (a) wealth for the long-term, (b) risk or
uncertainty, (c) the timing of returns, and (d) the shareholders’ return.

Objects of Financial
Management

1. Wealth Maximization 2. Profit Maximization

of Shareholders of Company

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Q4. Distinguish between profit maximization and wealth maximization.

Sr. Profit Maximization Wealth Maximization
1 Focus on the short term Focus on the long term
2 Profits are vital for survival of business Wealth incudes shareholders' return.
3 Narrow approach (BOD/ shareholders) Broad approach (all stakeholders)
4 Higher the risk, high the profits Risk is considered, but no emphasized upon
5 Ignores the time value of money Recognizes the timing of returns
6 Linked to annual profits Linked to share prices and dividends
7 Profits can be manipulated through Wealth is a real concept and difficult to
window dressing manipulate easily.

Q5. What are the Roles / Functions of a Finance Manager? What are the challenges of Financial Mgr. in 21st century?

1) Change in Technology / online 5) Volatile Forex Mkt.

1. Fund Requirement Estimation: 2) New avenues of raising funds 6) Shareholders' maturity
3) Rising Legal Compliances 7) Economic-Political factors
 The requirements of funds have to be carefully estimated. 4) Complex Taxation policies 8) Issue due to Global markets
9) M & A deals / Valuation
 The purpose of funds (investment in fixed assets or working capital) & timing of funds should be determined.
 This involves the use of techniques like budgetary control and long range planning.
 This calls for forecasting all physical activities of the organisation and translating them into monetary terms.

2. Determining Sources of Finance

 Identify the various sources of finance – long, medium and short term.
 Select the sources of funds which are most suitable for the company. Such choice should be exercised with
great care and caution.

3. Capital Structure / Financial Decisions:

 Decisions regarding capital structure (called financing decisions) should be taken to provide proper balance
between (a) long-term and short-term funds (b) loan funds and own funds.
 Long-term funds are required to (a) finance fixed assets and long-term investments and (b) provide for
permanent needs of working capital. Short Term Funds are required for Working Capital purposes.
 A proper mix of various sources has to be worked out by the Finance Manager.

4. Investment decisions:
 Funds procured should be invested / utilised effectively.
 Long Term Funds should be invested (a) in Fixed Assets / Projects after Capital Budgeting and (b) in
Permanent Working Capital after estimating the requirements carefully.
 Asset management policies should be laid down, for Fixed Assets and Current Assets.

5. Dividend decisions:
 The Finance Manager assists the top management in deciding as to (a) what amount of dividend should be
paid to shareholders and (b) what amount should be retained in the business itself.
 Dividend Decisions depend upon numerous factors like (a) earnings, (b) trend of share market prices, (c)
requirement of funds for future growth, (d) cash flow situation, (e) tax position of shareholders

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6. Cost Control:
Financial Manager is responsible for monitoring and analyzing cost over-runs. He can make recommendations to
the top management for controlling the costs relating to purchases, production, distribution etc.

7. Cost-Volume-Profit (CVP) Analysis / Profit Planning

 In-depth study of fixed costs, variable costs and semi-variable costs is needed
 Ensure that the income / revenues are sufficient to cover the variable costs, i.e. a positive contribution.
 To determine the BEP of the business and take key decisions to improve profitability of the enterprise.

8. Taxation
 Corporate taxation is an important function of the financial management.
 Taxation includes direct taxes such as Income Tax as well as indirect taxes such as Excise, Service Tax, etc.
 Taxation functions include periodical compliances as well as tax management techniques.
 Proper tax planning and management is vital for the wealth maximization function of the enterprise.

9. Cash Management Decisions (Working Capital):

 The Finance Manager has to ensure that all sections/ branches/ factories/ departments and units of the
organisation are supplied with adequate funds (cash), to facilitate smooth flow of business operations.
 He should also ensure that there is no excessive cash (idle funds) in any division at any point of time.
 For this purpose, cash management and cash disbursement/ transfer policies should be laid down.

10. Performance Evaluation / Financial Analysis:

 The Finance Manager has to evaluate financial performance of various units of the organisation. There are
various tools of financial analysis viz. Budgetary Control, Ratio Analysis, Cash Flow and Fund Flow Analysis,
Common Size Statement analysis, Intra-Firm Comparison etc.
 Financial Analysis helps management to assess how effectively funds are utilised & identify improvements

11. Financial negotiations:

The Finance Manager is required to interact and carry out negotiations with financial institutions, banks and public
depositors. Negotiations with outside financiers require specialised skills.

12. Market Impact Analysis:

 The Finance Manager has to keep in touch with stock exchange quotations and behaviour of share prices.
 It involves analysis of trends in stock market and judging their impact of the share price of the Company.

13. Product / Services Pricing:

The Financial Manager can supply important information about cost at varying levels of production and the profit
margins needed to carry on the business successfully. In fact, financial manager analyses information for pricing
decisions and contribute to the formulation of pricing policies jointly with the marketing manager.

14. Corporate Restructuring (M & A deals)

 Corporate restructuring includes external growth through mergers and acquisitions.
 Valuation and financing M & A deals is an important aspect of corporate restructuring. The process of valuing
a firm and its securities is difficult, complex and prone to errors. The financial manager should, therefore, go
through a valuation process very carefully.

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Sources
M&A of Funds Invt.
Deals Decision

Pricing Cost
Decision Control

Stock
Financial
Exch.
Analysis
Mgt. Financing
Decision

Profit Dividend
Planning Decision
Internal
Tax Mgt.
Control

Q6. What are the major decisions of a finance manager Functions of Finance
OR
The major decisions of a finance manager are inter-related. Comment.

A) Investment Decisions
 Investment ordinarily means utilization of money for profits or returns. These decisions determine how scarce
resources in terms of funds available are committed to projects.
 Basically, it implies creating or purchasing physical assets and carrying on business or purchasing shares or
debentures of a company or even acquisition of another company.
 The investment of funds in a project has to be made after careful assessment of the various projects through
capital budgeting exercise as well as financing the working capital requirements.
 Investment decisions are commitments of monetary resources, in expectation of economic returns in future.
Choice is required to be made amongst available resources and avenues for investment.
 Thus, investment decisions have become the most important area in the decision making process. Such
decisions are essentially made after evaluating the different proposals with reference to growth and profitability
projections of the company. The choice helps achieve the long term objectives of the company i.e. survival and
growth, preserving market share of its products and retaining leadership in its production activity.
 Investment decisions include expansion, replacement of assets or modernization etc.

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B) Financing Decisions Borrowed Funds vs Own Funds
 Financing decisions relate to acquiring the optimum finance to meet funds requirement and seeing that fixed and
working capital are effectively managed.
 The financial manager needs to possess a good knowledge of the sources of available funds and their respective
costs, and needs to ensure that the company has a sound capital structure, i.e. a proper balance between equity
(own) capital and debt (borrowing).
 Financing decisions also need a good knowledge of risk evaluation e.g. excessive debt carries higher risk than
equity because of the priority rights of the lenders.

C) Dividend Decisions Profit Payout vs. Profit Retention

 Dividend decisions relate to the determination as to how much and how frequently cash can be paid out of the
profits of an organization as income for its owners / shareholders.
 The dividend decisions thus has two elements – the amount to be paid out and the amount to be retained to
support the growth of the organisation, the latter being also a financing decision; the level and regular growth of
dividends represent a significant factor in determining a profit-making company's market value.
 Theoretically, this decision should depend on whether the company or its shareholders are in the position to
better utilize the funds, and to earn a higher rate of return on funds.
 However, in practice, a number of other factors like the market price of shares, the trend of earning, the tax
position of the shareholders, cash flow position, requirement of funds for future growth, and restrictions under the
Companies Act, etc. play an important role in the determination of dividend policy of business enterprise.

D) Liquidity Decision (Ability to meet current obligations)

 Liquidity can be defined as the ability of a business to meet its short-term obligations.
 It shows the speed (efficiency) with which a business can convert its assets into cash to pay what it owes in the
near future.
 It also focuses attention on the availability of funds. Enhancement of liquidity enable to corporate body to have
more funds from the market.
 A company will need to maintain liquidity for transaction purposes, precautionary measures and for speculative
opportunities.
 Liquidity is assessed through the use of ratio analysis. Liquidity ratios provide an insight into the present cash
solvency of a firm and its ability to remain solvent in the event of calamities. Ratios such as current ratio, quick
ratio, cash ratio etc. show the liquidity position of a company at a given point of time.
 Further, liquidity is affected by the credit policy of the company. The same can be seen through average
collection and payment period. A higher inventory turnover ratio also facilitates faster conversion of stock into
sales and in-turn into cash.
 Liquidity is a vital decision for a business to ensure timely payment of current obligations. A poor liquidity position
may affect the goodwill of a business. The firm may lose lucrative opportunities, affecting its wealth maximization
function.

Investment Financing Dividend Liquidity (W. Cap)

Decision Decision Decision

•Expansion •Debt‐Equity •Payout vs. •Stock

•Modernization •Mix of Own & Retention, i.e. •Debtors
•Diversification Borrow funds re‐invest •Cash Mgt.

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Q7. Factors affecting Decision Criteria

Decision criteria depends upon the objective to be achieved through the decision making process. The main
objectives which a business organisation pursues are maximisation of return and minimization of costs. A fair
decision criterion should consider various proposals and select the best alternative.

A fair decision criterion should follow the following two fundamental principles i.e.
(1) the “Bigger and Better” principle which implies bigger benefits as compared to smaller ones; and
(2) “A Bird in Hand is Better than Two in the Bush” principle, which implies early benefits are better to later benefits.

Further, factors such as urgency of matter, recovery of funds, rate of return and profitability etc. shall be considered.

Q8. Short Notes

a) Profitability

 Profitability is an important tool in financial management for decision-making.

 It is used to measure and compare performance of a business. Profitability can be related to sales or to total
capital employed or to net worth of the company.
 Profit to sales ratio reflects the company’s ability to generate profits per unit of sales. Absence of adequate
profitability ratio on sales reflects the company’s inability to utilise assets effectively.
 From investors point of view profits are compared as percentage to the capital employed in the business.
Another important profitability ratio is Profits on Equity, i.e. PAT in relation to shareholders’ funds. This is an
indicator of profits earned on funds invested by the owners. It is an indicator of actual returns received by them.
 For assessment of profitability as a decision criterion return on investment (ROI) is a frequently used ratio.
Return on Investment: This is an important profitability ratio from the angle of shareholders and reflects on the
ability of management to earn a return on resources put in by the shareholders.
 Inadequacy of profit margin is an evidence of company’s inability to achieve satisfactory results.

b) Costing and Risk

 In financial management, costing relates to the system adopted for assessing cost of capital from various
sources viz., equity and preference shares, debentures, long-term borrowings from financial institutions, etc.
 Equity capital is owner’s money employed in the business whereas borrowed funds are creditors’ funds carrying
an interest obligation and repayment schedule.
 Thus risks are involved if interest is not paid or on account of default in repayment of principal.
 It is ensured that the rate of interest on borrowed funds is usually lower than the returns expected by the
investors or risk-takers in the business. Moreover, interest paid is deductible for tax purposes.
 But if the company is unable to earn sufficient returns, the returns for owners are reduced and risk increases.
Using borrowed funds or fixed cost funds in the capital structure of a company is called financial gearing.
 High financial gearing will increase the earnings per share of a company if earnings before interest and taxes
are rising, as compared to the earnings per share of a company with low or no financial gearing.
 Risk is associated with fixed interest on debt capital. Higher the interest, the greater the chance that it will not be
covered by earnings and so greater the risk. Any internal disturbance or external constraint that may hamper the
company’s production and sales will reduce inflow of funds but fixed interest charges have to be paid.

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c) Value of Firm – Risk and Return

A Financial Manager tries to achieve the proper balance between considerations of ‘risk and return’ associated with
various financial management decisions to maximize the market value of the firm. It is well known that ‘higher the
return, other things being equal, higher the market value, higher the risk and vice versa’. In fact, risk and return go
together. This implies that a decision alternative with high risk tends to promise higher return and reverse is true.

d) Distinguish between Business Risk and Financial Risk

Sr. Business Risk Financial Risk

1 Business risk is associated with the Financial risk is associated with the
variation in operating profits (EBIT) variation in net profits (PAT)

2 Business risk occurs due to excessive Financial risk occurs due to excessive
fixed cost in the company. fixed interest in the company.

3 Higher business risk results in higher Higher financial risk leads to inability to
break-even point pay bank interest (EMIs)

4 Also known as operating risk and Measured by financial leverage

measured by operating leverage

5 Business risk is not affected by the capital Financial risk is due to the debt-equity
structure of company, i.e. debt-equity ratio of a company, i.e. capital structure

6 Result of Investment Decision Result of Financing Decision

e) Financial Management – Art or Science

 Financial Management is a social science as it deals with people. Also, it is applied in practical affairs and solving
business problems. But, there is a wide scope for application of value judgement in financial decisions-making.
 Most practical problems of finance have no fixed answers that can be worked out mathematically or programmed
on a computer. They must be solved by judgement, intuition and experience.
 Theory of financial management is based on certain systematic principles, some of which can be tested in
mathematical equations (as natural science). The use of computers, operations research, statistical techniques
and econometric models find wide application in financial management as tools for solving corporate financial
problems like budgeting, choice of investments, acquisition or mergers etc.
 This takes the financial management nearer to treatment as a subject of real science.
 Hence, knowledge of facts, principles and concepts is necessary for making decisions but personal involvement
of the manager through his intuitive capacities and power of judgement becomes essential.

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f) Financial Distress & Insolvency Root cause is Borrowing i.e. Financial Risk

 Generally, a business should be managed to reduce the risk and maximize the returns of the shareholders.
 Business risk includes variability of demand for its products, their prices, input prices etc.
 Financial risk is due to high proportion of debt in the capital structure requires a high level of interest payments.
If cash inflows are inadequate, the firm will face difficulties in payment of interest and repayment of principal.
 If such a situation continues for a long time, the firm would face pressure from creditors. Reduced sales can
also cause difficulties in carrying out production operations.
 In such a scenario, the firm would face a lot of difficulties – investors would not invest further, creditors and
lenders would recall their loans, market share price would fall heavily etc. Thus, the firm would find itself in a
situation called as ‘financial distress’.
 It may have to sell its values i.e. resort to distress sale. So, when sale proceeds are inadequate to meet outside
liabilities, the firm is said to have become bankrupt or insolvent (after legal proceedings).
 Failure of a firm to meet its current obligations could be temporary and might be corrected.
 When liabilities exceed assets i.e. the net worth becomes negative, bankruptcy / insolvency arises.
 Bankruptcy can be ascertained by comparing current assets and current liabilities, i.e. the ability of the firm to
discharge its short term liabilities.
 Examples of solvency ratios are Debt to Equity ratio, Debt to total Funds Ratios, and Interest coverage ratio.
Trend analysis should be made for the past three to five years to pick up signals of bankruptcy, if any.

g) Economic Value- Added (EVA)

 Economic value added (EVA) is the after tax cash flow generated by a business over and above the cost of the
capital it has deployed to generate that cash flow. EVA represents the real profits versus paper profits.
 EVA stresses on measuring shareholders value. Practically, shareholders provide funds to a firm so that they
gain a return on that capital.
 EVA concept is related to the wealth maximization function, since the ‘value addition’ is the surplus returns
earned by the shareholders. EVA represents the surplus earned after meeting all obligations, i.e. wealth creation.
 There are two key components to EVA. The Net Operating Profit After Tax (NOPAT) and the capital charge,
which is the amount of capital multiplied by its cost of capital.
 The cost of capital is the minimum rate of return on capital required to compensate debt and equity investors for
bearing risk-a-cut-off rate to create value and Capital is the amount of cash invested in the business. In formula
form –
EVA = (Operating Profit) – (The Capital Charge)
EVA = NOPAT - (Cost of Capital x Capital)
 However, to compute EVA, certain adjustments should be made to the NOPAT as well as the capital employed in
business.
 Implementing EVA in a company is a kind of change process which should be given some management effort.
However, if right actions are taken straight from the beginning then implementing EVA should be one of the
easiest change processes that a company goes through. The actions might include e.g. gaining commitment of all
members of the management group through training and discussing, training of the other employees, especially
all the key persons and adopting EVA in all levels of organizations

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h) Financial Sector / Financial System

 Financial Sector plays a vital role in the mobilization and allocation of savings. Financial institutions, instruments
and markets constitute the financial sector and act as mode for the transfer of funds from savers to borrowers.
 The financial sector performs economic functions of intermediary through the following –
o Liability-Asset transformation (i.e., accepting deposits as liability and converting into assets such as loans);
o Size transformation (i.e., providing large loans on the basis of numerous small deposits);
o Risk transformation (i.e., distributing risks through diversification).
 The process of financial intermediation supports increasing capital creation through savings and investments.

 Economic Development Institute of World Bank – key areas of financial system reforms:

 Reforms of structure of financial systems;

 Policies and Regulations to deal with insolvency and illiquidity of financial intermediaries;
 Development of markets for short and long term financial instruments;
 Role of institutional elements in development of financial systems;
 Links between financial sector and real estate sectors.
 Dynamics of financial systems management in terms of stabilization and adjustment, and
 Access to International Markets.

 Salient Features of Financial Sector Reforms in India:

 Policy Framework

o Interest Rate Policy – Regulation of lending rates leads to regulation of the deposit rates. A major effort
is undertaken to simplify the administered structure of interest rates.
o Pre-emption of Deposits – Reduction of Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR)
is the goal of fiscal policy and several steps have already been taken in this direction. Such reduction
increases liquidity in the economy, thereby higher amount available with the banking industry.
o Directed Credit – This includes focused lending by banks towards the priority sector such as agriculture,
small scale industry and the programs for poverty alleviation. Further, banks have been instructed to
have a balanced portfolio to ensure diversification and risk reduction.

 Improvement of Financial Health

Ensuring safety and soundness of the financial system, imparting greater transparency and accountability in
operations and restoring the credibility and confidence in the Indian financial system. Banks have now been
given a clear definition of what constitutes a ‘Non-Performing’ Asset (NPA) and instructions have been
issued that no interest should be charged and taken to income account on any NPA. Banks are required to
make provisions on advances depending on the classification of assets into the four broad groups:
(i) standard assets, (ii) sub-standard assets, (iii) doubtful assets, and (iv) loss assets.

 Institutional Strengthening

A major effort has been made to strengthen the banking system with emphasis on public sector banks.
Certain institution building measures taken such as
(i) recapitalization,
(ii) improving the quality of loan portfolio,
(iii) instilling a greater element of competition and
(iv) strengthening the supervisory process.

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 Financial Sector Regulations

Due to increasing financial sector liberalization and emergence of financial multinationals, financial sector
stability has emerged as a key objective of the Reserve Bank of India (RBI). The focus of RBI’s financial sector
policies is strengthening the health of financial institutions as well as improving efficiency of financial markets.
RBI policies include adoption of international standards in the banking system, strengthening Urban Cooperative
Banks (UCBs) and Non-Banking Financial Companies (NBFCs) and improvement in customer services. The
Reserve Bank undertook several initiatives to improve corporate governance in the banking system.

In August 2007, the Govt. of India constituted a High Level Committee on Financial Sector Reforms, under the
Chairmanship of Mr. Raghuram Rajan. The purpose of this committee was to outline a comprehensive agenda
for the evolution of financial sector indicating especially the priorities and sequencing decisions. The terms of
Reference of the Committee were as under:
o To identify emerging challenges in meeting the financing needs of the Indian economy;
o To examine the performance of various segments of the financial sector and identify changes that will allow it
to meet the needs of the real sector;
o To identify changes in the regulatory and supervisory infrastructure that can better allow the financial sector
to play its role, while ensuring that risk are contained; and
o To identify changes in other areas of economy, including the conduct of monetary and fiscal policy, and the
operation of legal system and the education system that could help financial sector function more effectively.

 Financial Sector Legislative Reforms Commission (FSLRC)

In 2011-12, the Finance Minister announced the formation of FSLRC to harmonize financial sector legislations,
rules and regulations. FSLRC was formed to modernize the legal system and recast these old laws in tune with
the modern requirements of the financial sector. The FSLRC submitted its report in March 2013. The
Commission proposed an Indian Financial Code Bill 2013 to create a Unified Financial Authority (UFA) and
bring about reforms in financial sector regulations. The panel suggested that SEBI, IRDA, PFRDA (Pension
Fund Regulatory and Development Authority) and the Forward Markets Commission (FMC) be merged under
one regulator, the UFA. However, RBI will continue to be the banking regulator.

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