Unit 1

Financial Management
INTRODUCTION

In our present day economy, finance is defined as the provision of money at the time when it is
required. Every enterprise, whether big, medium or small, needs finance to carry on its
operations and to achieve its targets. In fact, finance is so indispensable today that it is rightly
said to be the lifeblood of an enterprise. Without adequate finance, no enterprise can possibly
accomplish its objectives. Finance is called “The science of money”. It studies the principles and
the methods of obtaining, control of money from those who have saved it, and of administering it
by those into whose control it passes. It is the process of conversion of accumulated funds to
productive use.

Meaning of Financial Management:

Financial Management is the science of money management .It is that managerial activity which
is concerned with planning and controlling of the firm’s financial resources. In other words it is
concerned with acquiring, financing and managing assets to accomplish the overall goal of a
business enterprise.
It is the planning, organising, directing and controlling of the procurement and utilization of
funds and safe disposal of profits to the end that individual, organizational and social objectives
are accomplished.

Definition of Financial Management

Financial Management deals with procurement of funds and their effective utilisation in the
business -S.C. Kuchal

Financial Management is concerned with the efficient use of an important economic resource
viz., Capital Funds -Solomon

Financial Management is the operational activity of a business that is responsible for obtaining
and effectively utilizing the funds necessary for efficient operations - Joseph and Massie

Financial management “as an application of general managerial principles to the area of financial
decision-making. -Howard and Upton

Financial management “is an area of financial decision-making, harmonizing individual motives

and enterprise goals”. -Weston and Brigham
Nature/Feature/ Characteristics of Financial Management
1. Indispensable organ of Business Management- Finance is an essential and indispensable
part of any organization. It is difficult for organizations, whether profit-making or otherwise,
to sustain themselves for long without proper finances. Not just that, the efficient
management of these financial resources is essential to be sustainable and viable in the long-
run. So, financial management is considered as an indispensable or inseperable organ of
business management.

2. Continuous Process- Financial management is that managerial activity which is

concerned with the planning and controlling of a firm's financial resources. It is a
permanent and continuous process for every business concern. Financial management is a
never ending process as planning related to finance is done by every business
organization regularly. It continues as long as the business operates throughout its life.

3. Different from Accounting Function- Accounting restricts up to reporting and

summarizing of financial transactions for the external and internal users whereas
financial management is about planning, directing, monitoring, organizing and
controlling of the monetary resources of an organization to achieve the objective.
Financial Management also helps the management in decision making process.

4. Coordination with other departments- There must be a proper understanding and

corporation among the various departments. The finance department must understand and
agree with other departments within the company for the business to function smoothly.

5. Decision making for top level management- Financial management deals with various
financial decisions, particularly the things relating to financing, dividends, and
investments. Financial Management is a process which helps the top level management to
take various decisions relating to its operations.

Objectives of Financial Management

Effective procurement and efficient use of finance lead to proper utilization of the finance by the
business concern. It is the essential part of the financial manager. Hence, the financial manager
must determine the basic objectives of the financial management. Objectives of Financial
Management may be broadly divided into two parts such as:

1. Profit maximization

2. Wealth maximization.

Profit Maximization
Main aim of any kind of economic activity is earning profit. A business concern is also
functioning mainly for the purpose of earning profit. Profit is the measuring techniques to
understand the business efficiency of the concern. Profit maximization is also the traditional and
narrow approach, which aims at, maximizes the profit of the concern. Profit maximization
consists of the following important features.

1. Profit maximization is also called as cashing per share maximization. It leads to maximize the
business operation for profit maximization.

2. Ultimate aim of the business concern is earning profit, hence, it considers all the possible ways
to increase the profitability of the concern.

3. Profit is the parameter of measuring the efficiency of the business concern. So it shows the
entire position of the business concern.

4. Profit maximization objectives help to reduce the risk of the business.

Favourable Arguments for Profit Maximization

The following important points are in support of the profit maximization objectives of the
business concern:

(i) Main aim is earning profit.

(ii) Profit is the parameter of the business operation.

(iii) Profit reduces risk of the business concern.

(iv) Profit is the main source of finance.

(v) Profitability meets the social needs also.

Unfavourable Arguments for Profit Maximization

The following important points are against the objectives of profit maximization:

(i) Profit maximization leads to exploiting workers and consumers.

(ii) Profit maximization creates immoral practices such as corrupt practice, unfair trade practice,
etc.

(iii) Profit maximization objectives leads to inequalities among the stake holders such as
customers, suppliers, public shareholders, etc.

Drawbacks of Profit Maximization

Profit maximization objective consists of certain drawback also:

(i) It is vague: In this objective, profit is not defined precisely or correctly. It creates some
unnecessary opinion regarding earning habits of the business concern.

(ii) It ignores the time value of money: Profit maximization does not consider the time value of
money or the net present value of the cash inflow. It leads certain differences between the actual
cash inflow and net present cash flow during a particular period.

(iii) It ignores risk: Profit maximization does not consider risk of the business concern. Risks
may be internal or external which will affect the overall operation of the business concern.

Wealth Maximization

Wealth maximization is one of the modern approaches, which involves latest innovations and
improvements in the field of the business concern. The term wealth means shareholder wealth or
the wealth of the persons those who are involved in the business concern.

Wealth maximization is also known as value maximization or net present worth maximization.
This objective is a universally accepted concept in the field of business. Wealth Maximisation
means maximising the wealth of the shareholders. A shareholder holds share in the
company/business and his wealth will improve only when the share price in the market increases.
Maximisation of wealth shareholders i.e. Maximisation of value of share ( market value of share)
is the aim of wealth maximisation.

Favourable Arguments for Wealth Maximization

(i) Wealth maximization is superior to the profit maximization because the main aim of the
business concern under this concept is to improve the value or wealth of the shareholders.

(ii) Wealth maximization considers the comparison of the value to cost associated with the
business concern. Total value detected from the total cost incurred for the business operation. It
provides extract value of the business concern.

(iii) Wealth maximization considers both time and risk of the business concern.

(iv) Wealth maximization provides efficient allocation of resources.

(v) It ensures the economic interest of the society.

Unfavourable Arguments for Wealth Maximization

(i) Wealth maximization leads to prescriptive idea of the business concern but it may not be
suitable to present day business activities.

(ii) Wealth maximization is nothing, it is also profit maximization, it is the indirect name of the
profit maximization.
(iii) Wealth maximization creates ownership-management controversy.

(iv) Management alone enjoy certain benefits.

(v) The ultimate aim of the wealth maximization objectives is to maximize the profit.

(vi) Wealth maximization can be activated only with the help of the profitable position of the
business concern.

Difference between Profit Maximisation and Wealth Maximisation

Importance of Financial Management

1. Financial Planning- Financial management helps to determine the financial requirement of
the business concern and leads to take financial planning of the concern. Financial planning is an
important part of the business concern, which helps to promotion of an enterprise.

2. Acquisition of Funds- Financial management involves the acquisition of required finance to

the business concern. Acquiring needed funds play a major part of the financial management,
which involve possible source of finance at minimum cost.
3. Proper Use of Funds- Proper use and allocation of funds leads to improve the operational
efficiency of the business concern. When the finance manager uses the funds properly, they can
reduce the cost of capital and increase the value of the firm.

4. Financial Decision- Financial management helps to take sound financial decision in the
business concern. Financial decision will affect the entire business operation of the concern.
Because there is a direct relationship with various department functions such as marketing,
production personnel, etc.

5. Improve Profitability- Profitability of the concern purely depends on the effectiveness and
proper utilization of funds by the business concern. Financial management helps to improve the
profitability position of the concern with the help of strong financial control devices such as
budgetary control, ratio analysis and cost volume profit analysis.

6. Increase the Value of the Firm- Financial management is very important in the field of
increasing the wealth of the investors and the business concern. Ultimate aim of any business
concern will achieve the maximum profit and higher profitability leads to maximize the wealth
of the investors as well as the nation.

7. Promoting Savings- Savings are possible only when the business concern earns higher
profitability and maximizing wealth. Effective financial management helps to promoting and
mobilizing individual and corporate savings.

Nowadays financial management is also popularly known as business finance or corporate

finances. The business concern or corporate sectors cannot function without the importance of
the financial management.

Who is a Finance Manager?

Finance Manager is a person who heads the department of finance. He performs important
activities in connection with each of the general functions of management. His focus is on
profitability of the firm.

Finance Manager is a person who manages the activities pertaining to financial activities and is
accountable for an organisation.

Role/ Functions of Finance Manager

The following are the functions which the finance manager has to conduct:

1. Estimation of the financial requirements- The first task of a finance manager is to estimate
the short-term and long-term financial requirements of his business. For this purpose, he will
prepare a financial plan for present as well as for future. The amount required for purchasing
fixed assets as well as funds for working capital will have to be ascertained.
2. Selection of the right sources of funds- A financial manager needs to evaluate different
sources of funds. A company has many choices for raising additional funds to be procured in the
business like loans to be taken from banks and other financial institutions, issue of company
shares and debentures, public deposits to be drawn like in form of bonds. Choice of a factor
depends on the relative advantages and disadvantages of each source and financing period.

3. Allocation of Funds- The finance manager has to decide how to allocate the total amount of
funds into profitable ventures. He has to make sure that there is safety on investment and positive
regular returns are possible. The capital should be invested in a wisely manner so that there is
less possibility of losing funds or experience loses. For that, the manager can use different
investment tools like portfolio analysis, net present value, internal rate of return, an average rate
of return and so on.

4. Analysis and interpretation of financial performance- The financial manager has to

interpret different financial statements. He has to use a large number of ratios to analyze the
financial status and activities of his firm. He is required to measure its liquidity, determine its
profitability, and assess overall performance in financial terms.This is often a challenging task,
because he must understand the importance of each one of the aspects of the firm, and he should
be crystal clear in his mind about the purposes for which liquidity, profitability and performance
are to be measured.

5. Working Capital Management- Working capital refers to that part of firm’s capital which is
required for financing short term or current assets such as cash, receivables and inventories. It is
essential to maintain proper level of these assets. Financial manager is required to determine the
quantum of such assets.

6. Profit Planning and Control- It is one of the primary functions of any business
organizations. Profit earning is essential for the survival and livelihood of any organization.
Profits emerge due to various factors such as pricing, industry competition, state of the economy,
mechanism of demand and supply, cost and output. The functions of a finance manager are not
only to do a financial plan, procure fund and utilize the funds but he also has to control the
finances involving in the business. This function can be done by many techniques like ratio
analysis, forecasting of financials, cost analysis and control and profit distribution techniques etc.

7. Disposal of Surplus- The surplus and the profit of the organization should be disposed off
properly so that the surplus is not misutilised or kept idle at any time. The finance manager needs
to check on the surplus frequently and utilize it properly.

8. Proper cash management- Finance manager of a company has to make decisions regarding
cash management. Cash is required for several purposes like payment of wages and salaries to
the workers, payment to the creditors, payment of electricity and water bills, meeting current
liabilities of the business, cost of maintenance of having enough stock, purchase of raw materials
for daily production etc.

Finance Management Decisions:

Financial Decisions refer to the decisions concerning financial matters of a business concern.
There are many kinds of financial management decisions that the firm makes in pursuit of
maximising shareholder’s wealth.

Major Decisions:

1. Investment Decision- The investment decision refers to the selection of assets in which the
funds will be invested by a firm. The assets which can be acquired fall into two broad groups:

i. Long Term assets which will yield a return over a period of time in future;
ii. Short Term or current assets defined as those assets which in the normal course of business are
convertible into cash usually within a year.
Accordingly, the asset selection decision of a firm is of two types. The first of these involving
the first category of assets is popularly known as capital budgeting. The aspect of financial
decision making with reference to current assets or short term assets is popularly known as
working capital management.

2. Financing Decisions- The major decision involved in financial management is the financing
decision. The investment decision is broadly concerned with the asset mix or the composition of
the assets of a firm. The concern of the financing decision is with the financing-mix or capital
structure. The term capital structure refers to the proportion of debt and equity capital. The
financing decision of a firm relates to the choice of the proportion of these sources to finance the
investment requirements.

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. The dividend decisions relates to taking decisions relating to
whether the profits of the firm can be distributed to the shareholders in the form of dividend and
if it is distributed as dividend then what should be the proportion in which the profits should be
distributed.

Time Value of Money

It is a well-known fact that time is precious. Every business has started to make a profit. A small
amount available today is crucial than the lump sum due in the future. This indicates that time
decides the value of money. Therefore, the time value of money is defined as the money that is
present with any individual currently. The money that is available at the moment will allow
businesses to invest it for expansion, to pay salaries for its employees, to purchase raw materials,
etc. The money which is due for the future is only on papers and does not add any value in the
present. Time value of money is commonly identified as TVM by finance professionals. It is
called a present discounted value as well.

For example, if an individual is given an option to receive Rs. 500 today or to receive the same
amount after one year, he will definitely choose to receive the amount today because the value of
that money is going to be decreased to less than Rs. 500 in future. This preference for current
money as against future money is known as the time value of money or simply TVM

PARAMETERS OF TVM

The following are the certain parameters or reasons for time value of money:

1. Inflation – In an inflationary economy, today’s rupee has more purchasing power to buy,
rather than the same amount of money can buy at a later date. It reduces the purchasing power of
money as it raises the cost of goods or services. The same amount of money can purchase lesser
goods in the future.

2. Opportunity cost – It is the loss associated with the investment and the profit linked with
them because of the obligation of money in another investment within the fixed time duration.
Most of the individuals prefer present cash to future cash because of the available investment
opportunities to which they can put present cash to earn additional cash.

3. Risk – It relates to the risk involved in investment to be undertaken by each investor while
investing. There is always an uncertainty about the future money so investors should be sure
about the risk that the investment is having and the investor need to take.

Methods for ascertaining the worth of money

There are two different concepts for valuing the worth or the value of money:-

1. Compounding method or Technique- Compounding method is used to know the future

value of present money. A Future Value means that a given quantity of money today is worth
more than what will be received at some point of time in future. In other words, the method used
to determine the future value of present investment is known as compounding.

In simple terms, if we invest some money today, compounding method will help to calculate the
amount that will be received at a future date.

2. Discounting Method or Technique- Conversely, discounting is a way to compute the present

value of future money. In other words, the method used to determine the present value of future
cash flows is known as discounting. In simple terms, discounting method helps in calculating the
amount that need to be invested today to get a specific amount in future.