SYBBA – Semester – III

Financial Management

Unit – 1 – Introduction to Financial Management (20%)

Sr.No. Content Page No.

1 02
Introduction to Financial Management
2 02
Meaning and Definition of Financial Management
3 02
Nature of Financial Management
4 03
Relationship of Financial Management with other disciplines
5 05
Evolution of Financial Management
6 06
Traditional Approach vs. Modern Approach
7 Goals of Financial Management 08

8 Functions of Finance 10

9 12
Organization of Financial Function
1. Introduction to Financial Management
We all are aware that in economics, the four factors of production considered are land,
labour, capital and entrepreneur. The term “Capital” can also be referred to as “Finance”. It
represents the money that is required to be brought into finance or fund an activity.
Undoubtedly, money occupies a key position in the capitalistic economies of the modern
age. One of the most important functions of the top management is raise finance at a right
time and in a right quantity and also to use it most effectively. In fact, this function
constitutes the core of financial management.

In financial management, two functions are considered to be of prime importance:

 The procurement or raising of funds and
 The effective utilization of funds

Money is the life blood of modern business. Money is required to purchase expensive
machinery and also for day-to-day expenses on raw materials, labour and operational and
administrative needs of business. Execution of expansion plans and modernization
programmes are not possible without adequate finance. Thus, money can be described as
the life blood of a business organization. In engineering jargon, finance is the oil that
lubricates the huge machinery of the industrial sector.

2. Meaning and Definition of Financial Management

Financial management means raising of adequate funds at the minimum cost and using
them effectively in business. In other words, financial management is concerned with the
financial problems of the business organization. It is concerned with the problems of raising
finance to establish, expand and modernize business unit, the problem of providing fixed
and working capital, the problem of distribution of income etc.
According to Hoagland, “Financial management is concerned mainly with such matters as,
how a business corporation raises its finance and how it makes use of it”.
According to Solomon, “Financial Management is concerned with the efficient use of
important economic resources, namely, capital funds”
According to Phillippatus, “Financial management is concerned with the managerial
decisions of acquisition & financing of long term & short term funds. As such it deals with
the situations that require selection of specific assets, specific liabilities as well as problems
of growth of enterprise. The analysis of decisions is based on the expected inflows & outflow
of funds & their effects upon managerial objectives”.

3. Nature of Financial Management

The nature of financial management includes the following −
1) Estimates capital requirements:
Financial management helps in anticipation of funds by estimating working capital and fixed
capital requirements for carrying business activities. The finance manager prepares a budget
of all expenses and revenues for a particular time period on the basis of which capital
requirements are determined.
2) Decides capital structure:
Deciding optimum capital structure for an organization is a must for attaining efficiency and
earning better profits. Proper balance between debt and equity should be attained, which
minimizes the cost of capital. Financial management decides proper portion of different
securities (common equity, preferred equity and debt).
3) Select source of fund:
Choosing the source of funds is one of the crucial decisions for every organization. There are
various sources available for raising funds like shares, bonds, debentures, venture capital,
financial institutions, retained earnings, owner investment, etc. Every business should
properly analyze different sources of funds available and choose one which is cheapest and
involves minimal risk.
4) Selects investment pattern:
Once funds are procured it is important to allocate them among profitable investment
avenues. The investment proposal should be properly analyzed regarding its safety,
profitability, and liquidity. Before investing any amount in it all risk and return associated
with it should be properly evaluated.
5) Raises shareholders value:
Financial management works towards raising the overall value of shareholders. It aims at
increasing the amount of return to shareholders by reducing the cost of operations and
increasing the profits. The finance manager focuses on raising cheap funds from different
sources and invests them in the most profitable avenues.
6) Management of cash:
Financial management monitors all funds movement in an organization. Finance managers
supervise all cash movements through proper accounting of all cash inflows and outflows.
They ensure that there is no situation like deficiency or surplus of cash in an organization.
7) Apply financial controls:
Implying financial controls in business is a beneficial role played by financial management. It
helps in keeping the company actual cost of operation within the limit and earning the
expected profits. There are various processes involved in this like developing certain
standards for business in advance, comparing the actual cost or performance with pre-
established standards, and taking all required remedial measures.

4. Relationship of Financial Management with other disciplines

There is close relationship of financial management with economics, accounting and other
disciplines.

A) Relationship between Finance and Economics:

There are two important branches of economics – one is macro economics and the other is
micro economics.
Macro Economics and Finance:
The macro economics provides the broad environmental framework within which a business
firm operates. The key macro economic factors affecting financial decisions include growth
rate of GDP, The domestic saving rate, rate of interest, corporate taxes, the rate of inflation
etc. Financial decisions like use of financial leverage, design of capital structure, timing of
issuing share capital, dividend decision etc are influenced by macro economic factors.
It is important for financial managers to understand the macroeconomics specially for:
- Understanding how monetary policy affects the cost & availability of funds.
- Recognizing fiscal policy and its effects on the economy.
- Understanding the various financial institutions.
Micro Economics and Finance:
Micro economics is the economics of a business firm. Principle of marginal analysis, supply
and demand relationship, cost benefit analysis, concept of optimization etc are the
principles of micro economics which are used for decision making at the firm level. Financial
decisions like pricing of the product, optimum level of cash, credit policies etc are made with
the help of principles of micro economics.

B) Relationship between Finance and Accounting:

The relationship between finance and accounting are closely related to the extent that
accounting is an important input in financial decision making. Accounting is concerned
primarily with the recording of the economic transactions in monetary terms. The financial
management is concerned with taking financial decisions on the basis of various information
provided by the accounting disciplines which has three branches: Financial accounting, Cost
accounting and Management accounting.

The relationship between Finance and Accounting can be expressed as follows:

i) Accounting provides relevant information regarding purchases, sales, profit, reserves, cash
and bank, number of shares etc. The firm can ascertain various ratios, fund flow, earning per
share etc. which is useful in financial and investment decisions and planning.
ii) Accounting provides necessary information to finance manager in context to the liquidity
management, inventory management, working capital management etc.
iii) Accounting reveals the divisible profit of the firm. The information about the divisible
profit is very essential and useful for framing the appropriate dividend policy of the firm.
iv) Financial manager can control the financial aspects of the activities of the firm like
purchasing, production, marketing etc. with the help of the information provided by the
accounting.

C) Relationship between Finance and Other Disciplines:

Apart from economics and accounting, finance also draws for its key day-to-day decisions on
supportive disciplines such as marketing, production and personnel.
i) Finance and Production:
The decisions regarding production determine the requirements of fixed and working
capital. Similarly, when changes are effected in the areas of production i.e., when decisions
are taken about expansion of production, diversification or introduction of a new product,
the requirements of finance also change accordingly.
ii) Finance and Marketing:
It is through sales that finished goods are converted into cash and it reduces the working
capital requirement. Sales policy includes price policy, advertisement policy, sales
promotion policy etc. Decisions about all these policies will affect the financial position and
they in turn depend upon financial position. A liberal credit policy will lead to increase in
working capital requirements, while it will also reduce working capital needs by increasing
sales.
iii) Finance and Personnel:
Personnel management and financial management are closely related because money is
required for making regular payment of wages and salaries. If bonus has to be paid at the
end of the year, the financial manager is required to make provision for it.
5. Evolution of Financial Management
There are three phases of evolution of financial management:
A) The Traditional Phase
B) The Transitional Phase
C) The Modern Phase
A) The Traditional Phase (Period up to 1940 approximately):
This approach was very popular in the early part of 20th century.
The main objective of financial management was limited to only raising the required funds
on suitable terms. Therefore, the job of finance manager was revolved around only to
estimate the required funds, selecting suitable securities by considering volume of funds,
selection of bankers and underwriters, etc. In this context, finance manager had to perform
the job of record keeping, preparation of different reports and maintaining cash effectively
during this phase.
During this period, the term corporate finance was used for the financial management
because it put more and more emphasis on the financial problem of the company form of
business organization only.
During this phase, the treatment of different aspects of managing the finance was more of
descriptive nature. Therefore, during this phase, the analytical techniques like cost of
capital, leverage, break even analysis, ratio analysis, fund flow analysis, estimation of
working capital etc. neither developed nor applied. Finance function was considered
particularly from the point of view of funds suppliers. The emphasis was given on the
interest of outsiders. The required funds were procured by the issuance such as equity
shares, preference shares and debt instruments. The heavy emphasis was given to long term
financing, financial instruments, financial institutions, legal aspects of financial events etc.
The traditional phase has been criticized on several points:
1) The traditional phase emphasis on raising of funds only. Hence, the personnel who take
internal financial decisions were ignored. The subject of finance is treated from the angle of
investors, creditors and banks. They are outsiders to the firm and hence this phase is the
outsider looking in approach.
2) The traditional phase concentrates mainly on the financial administration of the joint
stock companies. Since joint stock companies are only one form of business. It ignores the
finance function of the sole proprietors, partnership firms, co-operatives etc.
3) The traditional phase considers the requirements and procurement of finance on such
events during the life time of a company as incorporation, merger etc. Such events do not
occur everyday. Thus this phase ignored day to day financial problems.
4) The traditional phase emphasis on the long term financial requirements only and ignores
the importance of working capital management. The long term requirements of finance
arise only once or twice a year while the short term requirements are to be felt almost every
day.
B) The transitional Phase (After 1940):
During this phase, the scope of finance function widened and more emphasis was given to
the day-to-day (Working Capital) problems of finance which were faced by the finance
managers. The nature of financial management during this phase was similar to that of the
traditional phase.
Thus phase was an extension of traditional phase & continued up to early fifties. The capital
budgeting technique regarding the selection of proper project was developed during this
phase.
C) The Modern Phase (After 1950):
In the modern phase, the scope of financial management has broadened. The status of
finance manager has emerged as a professional manager. The knowledge of securities,
financial markets, financial institutions, and international financial management has been
developed.
Modern phase is concerned with both acquisitions of funds as well as its effective utilization
of the funds. This phase is also concerned with management of earning. This phase covers
both types of financial problems i.e. the problems of long term finance as well as those of
working capital. Here finance function is examined from the view point of insiders &
outsiders both. The theories of efficient capital market, time value of money, dividend
policy, leverage, working capital management etc have been developed during this phase.
Modern approach lays stress on three types of decisions:
(i) Investment decision
(ii) Financing Decision
(iii) Dividend Decision.

6. TRADITIONAL APPROACH VS. MODERN APPROACH

Points Traditional Phase Modern Phase

Period FM emerged as a distinct field of study This phase began in mid-1950s’

at the turn of the 20th century..in 1897

Focus Mainly on certain episodic events like Rational matching of funds to their
formation of company, issuance of uses so as to maximize the wealth of
capital, major expansion, merger, the current shareholders. Concerned
reorganization and liquidation in the with mainly investment, financing and
life cycle of the firm dividend policy decisions

Day-to-day problem Routine working of a company was Day-to-day financial problems also
ignored. Cash management was given received attention
high importance…i.e. paying of
creditors on time

Approach There was heavy emphasis on the The increased use of qualitative
descriptive topics like legal and techniques, which is evident from the
procedural requirement related to various research works, led to a more
raising sources of finance, the analytical approach towards finance
instruments of finance, etc.

Viewpoint Outsider-looking-in Insider-looking-out

The viewpoint of outsiders like The viewpoint of managers within the

bankers, investors was emphasized company also holds importance
while running the affairs of the
company. The insiders i.e. managers’
 viewpoint was totally ignored

Funds requirement Working capital management finds no The total funds requirement is
mention in the literature available estimated instead of just the fixed
from that period. Focus was placed on capital requirement as in the
acquiring long-terms sources of funds traditional phase. Theories of
capitalization were used for this
purpose

Uses of funds The traditional theory dealt with only The amount to be invested in long-
procurement of funds but completely term assets and short-term assets was
misses out on uses of these funds decided taking into consideration
various factors

Sector Confined to issues of only the The problems of non-corporate sector

corporate sectors. There was no which were totally ignored in the
reference of issues affecting the non- traditional approach were given due
corporate sector consideration

Types of companies The manufacturing organization was The service organization or knowledge
the focal point in the traditional based firms e.g. the computer
approach software developers which rely on
human assets rather than physical
capital have begun to command
increased importance in today’s
financial field

Dividend Less mention as compared to modern Several issues related to dividend were
phase addresses e.g. dividend is fully paid;
partly paid and partly retained; and
fully retained in business

Evaluation of Does not find mention The company’s performance was

performance evaluated and problem areas were
identified and resolved by the
management. The management
information system in the field of
finance started to be developed

Liaison with banks / Less as compared to modern phase Since working capital too assumed
financial institutions great importance during this period
the relationship with banks and
financial institutions became all the
more important
7. Goals of Financial Management

The firm has to take investment and financing decisions on continuous basis. To make
optimum and wise decisions, a clear understanding of the objectives is a must. There are
two widely accepted goals as follows:
A. Profit Maximization
B. Wealth Maximization

A) Profit Maximization:
Economists believe for a long time that earning maximum profit is sole aim of any business
organization because that will lead to optimum allocation of resources also. Here as per this
goal, any action leads to increase the firm’s profit are undertaken and action which leads to
decrease profit is avoided. As per this criterion the investment, financing and dividend policy
decisions of a firm should be concentrated on the maximization of the profit. No business
can survive without earning profit. Profit is a measure of efficiency of a business enterprise.
Profits also serve as a protection against risks which cannot be ensured.

Points in favor of profit maximization

1. Profit is a barometer through which the performance of company can be measured.
Higher the profit greater degree of success.
2. Profit ensures maximum welfare to the shareholders, employees & prompts payment to
creditors of company.
3.Profit maximization increases the confidence of management in expansion &
diversification programs of company.
4. Profit maximization attracts the investors to invest their saving in securities.
5. Profit indicates the efficient use of funds.

Points against profit maximization

1. It is vague: Concept of profit is vague. Profit is not a clear term. Is it Gross profit? Net
Profit? Profit before tax? After tax? Earnings per share.
2. It encourages corrupt practices to increase the profits.
3. It ignores risk: - The future benefits may possess different degrees of certainty. The
more certain the expected return, the higher is its value or conversely the more uncertain
is the expected return, the lower is its value. This concept is also totally ignored.
4. It ignores time value of money. The profit maximization objective does not make explicit
distinction between returns received in different time periods. It gives no consideration to
the time value of money, and it values benefits received in different periods of time as the
same.
5. A huge profit invites problems from workers. They demand high salary & benefits.
6. True & fair picture of organization is not reflected through profit maximization.
7. Huge amount of profit attracts Government intervention.

B) Wealth Maximization:
The primary objective of financial management is wealth maximization. The concept of
wealth in the context of wealth maximization objective refers to the shareholders’ wealth as
reflected by the price of their shares in the share market. Therefore, wealth maximization
means maximization of the market price of the equity shares of the company.
When a financial decision is to be taken to invest money in some project, the project must
be so selected that the present value of cash flow received from it exceeds the present
value of cash outflow to be invested. Thus Net Present Value of a course of action is the
difference between the present value of all cash inflows and the present value of all cash
outflows. A course of action means some action taken in which funds are invested e.g. a
new machine is installed to replace manual labour. If the project gives more cash flow than
cash invested, then it can be said that it increases net worth of shareholders. It increases
value of shares of the company.

Advantages of wealth maximization:

1. It is clear: Wealth maximization is clear term. The present value of cash flows is taken into
consideration.
2. Time value of money: It considers the concept of time value of money by discounting the
future cash flows. Here present value of cash inflows and present value of cash outflows are
taken into account.
3. Universally accepted: The concept of wealth maximization is universally accepted
because; it takes care of interest of financial institution, owners, employees & society at
large.
4. Considers risk: it considers risk elements for evaluation. The future cash flows are
discounted by a rate higher or lower depending upon the uncertainty associated with it.
Hence Net Present Value of cash flows with more uncertainty will automatically be reduced.
Discounting is done at the rate higher or lower according to the degree of risk involved.

Criticism of Wealth Maximization:

1. Wealth maximization cannot achieve without profit.
2. It does not render service to society automatically.
3. There is some controversy as to whether the objective is to maximize the stockholders
wealth or the wealth of the firm which includes other financial claimholders such as
debenture holders, preferred stockholders, etc.,
4. The objective of wealth maximization may also face difficulties when ownership and
management are separated as is the case in most of the large corporate form of
organizations.

How Wealth Maximization is superior to profit maximization

However organization gets more benefit from the wealth maximization as compare to profit
maximization and wealth maximization is universally accepted concept if company wanted
to run business for longer time.
In following ways wealth maximization is superior than profit maximization.
1) Term:
Profit is a clear term in wealth maximization. Present value of cash flow is taken into
consideration. Whereas profit is a vague term in profit maximization.
2) Risk :
Wealth Maximization consider element of the risk. Profit maximization ignores risk.
3) Time value of Money :
Wealth maximization considers the time value of money. Whereas Profit maximization
ignores time value of money.
4) Social responsibility:
In wealth maximization, firm tries to increase reputation & thereby increasing wealth. So
firm is conducting social welfare activities & satisfying stakeholder that is society.
5) Leadership position in Industry:
Wealth maximization firm concentrate to increase market share & thereby increasing
reputation so it can be leader in industry. Whereas if objective is profit maximization, firm
will rarely think for increasing market share by reducing profit margin. So it would be
difficult to be a leader in industry.
6) Value :
Wealth maximization goal is the value of an entity expressed in terms of the market value of
its common stock.
Profit maximization measures the value of an entity in terms of the currency profits that it
makes.
7) Management and Shareholders difference:
Shareholders, being the owners of an entity, will focus on the wealth maximization goal.
They are more risk averse and would take the risks for the long-term success of their entity.
They would sacrifice current revenues to reinvest for the future wealth maximization.
Management, on the other hand, highly focuses on the present-day revenues of an entity.
They prefer profit maximization goals that are more concerned with their earnings.

8. Functions of Finance

Main functions of finance are as follows:

1. Investment Decision (Fund Allocation)
2. Financing Decision (Fund Raising)
3. Dividend Decision (Profit planning)
4. Liquidity Decision or Working capital Management

1) Investment Decision:
A firm’s investment decisions involve capital expenditures. They are therefore, referred as
capital budgeting decision. A capital budgeting decision involves the decision of allocation of
capital or commitment of funds to long term assets that would yield benefits (cash flows) in
the future.

Two important aspects of investment decisions are:

(i) evaluation of prospective profitability of the new investment & return associated with it.
(ii) Measurement of a cut – off rate or minimum rate of return against that prospective
return could be compared.

Future benefits of investments are difficult to measure and cannot be predicted with
certainty. Risk in investment arises because of the uncertain returns. Investment proposals
should, therefore, be evaluated in terms of both expected return and risk. Besides the
decision to commit funds in new investment proposals, capital budgeting also involves
replacement decisions, that is, decision of recommitting funds when an asset becomes less
productive or non-profitable.
Major areas covered under investment decisions are:-
(i) Ascertainment of total value of funds, a firm can commit.
(ii) Appraisal and selection of investment proposals using various techniques-NPV, IRR,PI etc.
(iii) Analysis of risk and uncertainty in the investment proposal.
(iv) Buy or lease decisions.
(v) Assets replacement decisions.

2) Financing Decision:
Financing decision means to identify When, Where, How the funds can be acquired to meet
the company’s investment needs.
The central issue before finance manager is to determine the appropriate proportion of
equity and debt. The mix of debt and equity is known as the firm’s capital structure. The
finance manager must strive to obtain the best financing mix or the optimum capital
structure for firm.
The firm’s capital structure is considered optimum when the market value of shares is
maximized.
In sourcing of finance, finance manager should keep in view the cost of respective sources of
funds, the merits and demerits of various sources of finance, impact of taxation etc.
Major areas covered under financing decisions are:
i) Consideration of cost of capital of various sources of finance keeping in view the impact of
taxation.
ii) Optimization of financing mix and maximizes shareholders’ wealth.

3) Dividend Decision:
The financial manager must decide whether the firm should distribute all profits or retain
them or distribute a portion and retain the balance. The proportion of profits distributed as
dividends is called the dividend-payout ratio and the retained portion of profits is known as
the retention ratio.
Finance manager must consider optimum dividend payout ratio while deciding proportion
of dividend. The optimum dividend policy is one that maximizes the market value of the
firm’s shares.
Major areas covered under dividend decisions are:-
- Determining Dividend policies of the firm.
- Considering statutory provisions regarding dividends.
- Consideration of the profitability of firm’s requirement of funds for expansion or
diversification.

4) Liquidity decisions or working capital management:

It is concerned with the management of current assets. It is very important as short term
survival is a must for long term success. If the firm’s investment in current assets is too little,
firm will not be able to meet its short term liabilities and thus invite the risk of insolvency.
However, if the firm’s investment in current assets is too high, the firm will be losing interest
on the extra blockade of funds in current assets. The finance manager must ensure that
funds would be made available when needed.
9. Organization of Finance Functions

In a large sized business unit, a clear and detailed division of finance functions is made. In
the firms wherein officials like treasurers and controllers are appointed, they perform staff
duties in addition to their general duties as the main accounting officials of the organization.
Their staff duties include financial forecasting, financial control and performance evaluation.
In larger organization the treasurers and controllers are accountable to the main finance
officer known as vice president or director of finance.

Functions or duties of Controller:

1. Planning & Budgeting:
To provide accounting data to the management for planning future activities and to
prepare budgets.
2. Accounting:
To formulate accounting and costing policies and to prepare financial statements,
reports.
3. Internal Control:
To develop systems for internal control.
4. Tax Administration:
To establish and administer tax policies and procedures.
 5. Inventory Control :
To take adequate steps to minimize inventory costs.
6. Appraisal And reporting :
To compare actual performance with standards or estimated performance and also
prepare report to submit government agencies.

Functions or duties of Treasurer:

1. Provision of Capital
To take all the steps needed for the procurement of finance required by the
business.
2. Credit Management:
To direct the granting of credit and the collection of receivables of the company.
3. Investors’ relations:
To maintain adequate liaison with financial institutions, bankers and shareholders.
4. Investments:
To invest the company’s funds as required in the business.
5. Banking and custody:
To maintain banking arrangement, have custody of company’s money and securities.
6. Auditing:
To help the internal and external auditors in carrying out their audit activities
effectively.