Chapter - 1

Nature of Financial
Management
What is financial management?
 Scope of Finance
• Production-It generates return on capital
invested.

• Marketing-It generates return on capital

invested.

• Finance- It secures whatever capital it

needs and employs in activities

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 Finance Functions
• Investment or Long Term Asset Mix
Decision
• Financing or Capital Mix Decision
• Dividend or Profit Allocation Decision
• Liquidity or Short Term Asset Mix Decision

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 Investment Decision
● Here, financial managers need to determine the
investment amount available out of existing finance.
● They make such decisions on the basis of long-term and
short-term needs.
● Long-term investment decisions are also known as
capital budgeting, where organizations commit to funds
for long periods (for example, fixed assets).
● Short-term investment decisions are also known as
working capital management, where businesses commit
to funds for short periods. It includes decisions
regarding investing funds in inventory, banks and
others.
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 Financing Decision
● Financing decisions are concerned with the amount of
finance to be raised from various sources.

● It can be both long-term sources (capital structure) or

short-term sources (working capital).

● Here, managers need to pre-estimate financial needs

and ensure the availability of adequate finance. The
core objective is to ensure that funds are available as
and when needed.

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 Dividend Decision
• Such decisions are concerned with how much of
the profits earned by an organization should be
distributed and how much should be retained.

• Typically, when funds are distributed among

shareholders, it’s known as dividends.

• When funds are saved for future investments

and contingencies, it’s known as retained
earnings.
• Such decisions are complex and require deep
insights and critical thinking. 7
 Liquidity Decision
The liquidity decision is concerned with the management of the current assets,
which is a pre-requisite to long-term success of any business firm. This is also
called as working capital decision.
The main objective of the current assets management is the trade-off between
profitability and liquidity, and there is a conflict between these two concepts.
If a firm does not have adequate working capital, it may become illiquid and
consequently fail to meet its current obligations thus inviting the risk of
bankruptcy.
On the contrary, if the current assets are too enormous, the profitability is
adversely affected. Hence, the major objective of the liquidity decision is to
ensure a trade-off between profitability and liquidity.
Besides, the funds should be invested optimally in the individual current assets
to avoid inadequacy or excessive locking up of funds. Thus, the liquidity decision
should balance the basic two ingredients, i.e. working capital management and
the efficient allocation of funds on the individual current assets.
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 Who is a financial manager?
Financial managers are responsible for the financial health of an organization.

They create financial reports, direct investment activities, and develop plans

for the long-term financial goals of their organization.

Duties

● Prepare financial statements, business activity reports, and forecasts

● Monitor financial details to ensure that legal requirements are met
● Supervise employees who do financial reporting and budgeting
● Review financial reports and seek ways to reduce costs
● Analyze market trends to maximize profits and find expansion
opportunities
● Help management make financial decisions
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 Finance Manager’s Role
• Raising of Funds
• Allocation of Funds
• Profit Planning
• Understanding Capital Markets

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 Raising of funds
1. In order to meet the obligation of the business it is
important to have enough cash and liquidity.

2. A firm can raise funds by the way of equity and debt. It is

the responsibility of a financial manager to decide the
ratio between debt and equity.

3. It is important to maintain a good balance between equity

and debt.

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 Allocation of fund
Once the funds are raised through different channels the next
important function is to allocate the funds. The funds should be
allocated in such a manner that they are optimally used. In order to
allocate funds in the best possible manner the following point must
be considered
● The size of the firm and its growth capability
● Status of assets whether they are long-term or short-term
● Mode by which the funds are raised

These financial decisions directly and indirectly influence other

managerial activities. Hence formation of a good asset mix and
proper allocation of funds is one of the most important activity
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 Profit Planning
Profit earning is one of the prime functions of any business organization. Profit
planning refers to proper usage of the profit generated by the firm.

Profit arises due to many factors such as pricing, industry competition, state of
the economy, mechanism of demand and supply, cost and output. A healthy mix
of variable and fixed factors of production can lead to an increase in the
profitability of the firm.

Fixed costs are incurred by the use of fixed factors of production such as land and
machinery. In order to maintain a tandem it is important to continuously value
the depreciation cost of fixed cost of production. An opportunity cost must be
calculated in order to replace those factors of production which has gone thrown
wear and tear. If this is not noted then these fixed cost can cause huge
fluctuations in profit. 13
 Understanding Capital Market
• Shares of a company are traded on stock exchange and there is a continuous
sale and purchase of securities. Hence a clear understanding of capital
market is an important function of a financial manager.
• When securities are traded on stock market there involves a huge amount
of risk involved. Therefore a financial manger understands and calculates
the risk involved in this trading of shares and debentures.
• Its on the discretion of a financial manager as to how to distribute the
profits. Many investors do not like the firm to distribute the profits amongst
share holders as dividend instead invest in the business itself to enhance
growth.
• The practices of a financial manager directly impact the operation in capital
market.
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 Financial Goals
• Profit maximization (profit after tax)
• Maximizing Earnings per Share
• Shareholder’s Wealth Maximization

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 Profit Maximization
• Maximizing the Rupee Income of Firm
– Resources are efficiently utilized
– Appropriate measure of firm performance
– Serves interest of society also

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Objections to Profit Maximization
• It is Vague
• It Ignores the Timing of Returns
• It Ignores Risk
• Assumes Perfect Competition
• In new business environment profit
maximization is regarded as
– Unrealistic
– Difficult
– Inappropriate
– Immoral.

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 Maximizing EPS
• Ignores timing and risk of the expected
benefit
• Market value is not a function of EPS. Hence
maximizing EPS will not result in highest
price for company's shares
• Maximizing EPS implies that the firm should
make no dividend payment so long as funds
can be invested at positive rate of return—
such a policy may not always work
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 Shareholders’ Wealth Maximization
• Maximizes the net present value of a
course of action to shareholders.
• Accounts for the timing and risk of the
expected benefits.
• Benefits are measured in terms of cash
flows.
• Fundamental objective—maximize the
market value of the firm’s shares.

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 Risk-return Trade-off
• Risk and expected return move in tandem;
the greater the risk, the greater the
expected return.
• Financial decisions of the firm are guided by
the risk-return trade-off.
• The return and risk relationship:
Return = Risk-free rate +
Risk premium
• Risk-free rate is a compensation for time and
risk premium for risk.
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Managers Versus Shareholders’ Goals
• A company has stakeholders such as employees, debt-holders,
consumers, suppliers, government and society.
• Managers may perceive their role as reconciling conflicting
objectives of stakeholders. This stakeholders’ view of managers’
role may compromise with the objective of SWM.
• Managers may pursue their own personal goals at the cost of
shareholders, or may play safe and create satisfactory wealth
for shareholders than the maximum.
• Managers may avoid taking high investment and financing risks
that may otherwise be needed to maximize shareholders’
wealth. Such “satisfying” behaviour of managers will frustrate
the objective of SWM as a normative guide.

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 Financial Goals and Firm’s Mission and
Objectives
• Firms’ primary objective is maximizing the welfare of
owners, but, in operational terms, they focus on the
satisfaction of its customers through the production
of goods and services needed by them
• Firms state their vision, mission and values in broad
terms
• Wealth maximization is more appropriately a
decision criterion, rather than an objective or a goal.
• Goals or objectives are missions or basic purposes of
a firm’s existence
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 Financial Goals and Firm’s Mission and
Objectives
• The shareholders’ wealth maximization is the
second-level criterion ensuring that the
decision meets the minimum standard of the
economic performance.
• In the final decision-making, the judgement
of management plays the crucial role. The
wealth maximization criterion would simply
indicate whether an action is economically
viable or not.

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Organisation of the Finance Functions
• Reason for placing the finance functions in
the hands of top management
– Financial decisions are crucial for the survival of the
firm.
– The financial actions determine solvency of the firm
– Centralisation of the finance functions can result in a
number of economies to the firm.

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Status and Duties of Finance Executives
• The exact organisation structure for
financial management will differ across
firms.
• The financial officer may be known as the
financial manager in some organisations,
while in others as the vice-president of
finance or the director of finance or the
financial controller.

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Role of Treasurer and Controller
• Two more officers—the treasurer and the
controller—may be appointed under the
direct supervision of CFO to assist him or
her.
• The treasurer’s function is to raise and
manage company funds while the
controller overseas whether funds are
correctly applied.

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 Function of Controller
● A controller is in charge of the company’s accountants.
● They are the highest in the food chain, as far as
accounting goes.
● A financial controller is in charge of supervising the
preparation of financial reports and presenting them to
management. In some governmental organizations, a
controller is also known as a financial comptroller.
● A controller reports to the chief financial officer (if the
company has one), formulates policies for the
company and oversees the audit, budget and
accounting departments in their company.
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● The primary responsibility of the financial controller
is producing and presenting timely reports.
● These reports form the basis of the management’s
decisions and economic predictions.
● They are also tasked with explaining to the
management what the various items of the
financial statements mean and, in some ways,
offering advice following the reports that they
present.
● They will be the ones who are directly presenting
compliance documents and filing tax returns.

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 Function of Treasurer
● The treasurer is the person who helps the company grow its
revenue.
● He or she builds and nurtures relationships with banks and
investment companies so that they know where the best place is
to invest the company’s money.
● Because treasurers are involved in growing the company’s
investments, they will manage relationships with shareholders.
● They do this by effectively communicating the company’s goals
and plans for achieving its fiscal targets.
● The treasurer, being the person best suited to explain the
company’s financial position, is tasked with communicating with
potential and current investors. It is up to the treasurer to explain
how the company is doing financially and how it plans to remain
profitable and beneficial to its investment.
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● The treasurer ensures that the company’s resources
are invested in the most profitable ventures by forming
and maintaining healthy relationships with investment
banks.

● Just like the controller, treasurers should have a

degree in finance, accounting, economics, or a
business-related course.

● They need to be excellent communicators, seeing as

they will constantly be interacting with people in the
banking and corporate sectors.
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