Financial Management (10MBA23)-I Chapter

7/31/2019 Financial Management (10MBA23)-I Chapter

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Financial Management

(10MBA23)

Module-1

G.V.M.Sharma

Asso. Prof-Dept. of MBA

PESIT


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Financial Management

Introduction to Finance

Finance Functions- Three approaches

I-Provision of money at the time it iswanted.

2- Management of Cash andmaintaining the liquidity of funds.

3- Procurements of Funds as well astheir effective utilization & Financialdecision making.


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Contd.

In simple terms finance is defined as the activity

concerned with the planning, raising,

controlling and administering of the funds

used in the business. Thus, finance is the

activity concerned with the raising and

administering of funds used in business


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Importance of Finance Functions

Finance function Interrelated with

Production Personnel Marketing


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MEANING AND DEFINITION OF

FINANCIAL MANAGEMENT

Howard and Upton define financial

management as an application of general

management principles to the area of

financial decision-making.

Weston and Brigham define financial

management as an area of financial decision

making, harmonizing individual motives andenterprise goal.


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MEANING AND DEFINITION OF

FINANCIAL MANAGEMENT (contd..)

Financial management is concerned with theefficient use of an important economicresource, namely capital funds - Solomon

Ezra & J. John Pringle. Financial management is the operational

activity of a business that is responsible forobtaining and effectively utilizing the fundsnecessary for efficient business operations-J.L. Massie


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Nature of Financial Management

The nature of financial management refers to

its relationship with related disciplines like

economics and accounting and other subject

matters.

The finance function assumes a lot of

significance in the modern days in view of the

increased size of business operations and thegrowing complexities associated thereto.


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FINANCE AND OTHER RELATED

DISCIPLINES


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Finance and Economics

The relevance of economics to financial management can

be described in two broad areas of economics i.e.,micro economics and macro economics.

The basic principle of micro economics that applies infinancial management is marginal analysis. Most of thefinancial decisions should be made taken into accountthe marginal revenue and marginal cost. So, everyfinancial manager must be familiar with the basicconcepts of micro economics.

Macro economics is concerned with the institutional

structure of the banking system, money and capitalmarkets, monetary, credit and fiscal policies etc. So,the financial manager must be aware of the broadeconomic environment and their impact on thedecision making areas of the business firm.


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Finance and Production

Finance and production are also functionally

related. Any changes in production process

may necessitate additional funds which the

financial managers must evaluate and finance.Thus, the production processes, capacity of

the firm are closely related to finance.


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Finance and Marketing

Marketing and finance are functionally related.

New product development, sales promotion

plans, new channels of distribution,

advertising campaign etc. in the area of

marketing will require additional funds and

have an impact on the expected cash flows of

the business firm. Thus, the financial managermust be familiar with the basic concept of

ideas of marketing.


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Finance and Quantitative Methods

Financial management and Quantitative methodsare closely related such as linear programming,probability, discounting techniques, present value

techniques etc. are useful in analyzing complexfinancial management problems. Thus, thefinancial manager should be familiar with thetools of quantitative methods. In other way, the

quantitative methods are indirectly related to theday-to-day decision making by financialmanagers.


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Finance and Costing

Cost efficiency is a major strategic advantage to

a firm, and will greatly contribute towards its

competitiveness, sustainability and

profitability. A finance manager has tounderstand, plan and manage cost, through

appropriate tools and techniques including

Budgeting and Activity Based Costing.


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Finance and Law

A sound knowledge of legal environment, corporate laws,business laws, Import Export guidelines, internationallaws, trade and patent laws, commercial contracts, etc.are again important for a finance executive in a

globalized business scenario.For example the guidelines of SEBI for raising moneyfrom the capital markets. Similarly, now many Indiancorporate are sourcing from international capitalmarkets and get their shares listed in the international

exchanges. This calls for sound knowledge of SecuritiesExchange Commission guidelines, dealing in the listingrequirements of various international stock exchangesoperating in different countries.


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Finance and Taxation

A sound knowledge in taxation, both direct andindirect, is expected of a finance manager, as allfinancial decisions are likely to have taximplications. Tax planning is an important

function of a finance manager. Some of the majorbusiness decisions are based on the economics oftaxation. A finance manager should be able toassess the tax benefits before committing funds.

Present value of the tax shield is the yardstickalways applied by a finance manager ininvestment decisions.


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Finance and Treasury Management

Treasury has become an important function anddiscipline, not only in banks, but in every organization.Every finance manager should be well grounded intreasury operations, which is considered as a profit

center. It deals with optimal management of cashflows, judiciously investing surplus cash in the mostappropriate investment avenues, anticipating andmeeting emerging cash requirements and maximizingthe overall returns, it helps in judicial asset liability

management. It also includes, wherever necessary,managing the price and exchange rate risk throughderivative instruments. In banks, it includes design ofnew financial products from existing products.


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Finance and Banking

Banking has completely undergone a change in todays

context. The type of financial assistance provided tocorporate has become very customized and innovative.During the early and late 80s, commercial banks mainlyused to provide working capital loans based on certainnorms and development financial institutions like ICICI,IDBI, and IFCI used to provide long term loans for projectfinance. But, in todays context, these distinctions no longerexist. The same bank provides both long term and shortterm finance, besides a number of innovative corporateand retail banking products, which enable corporate tochoose between them and reduce their cost of borrowings.

It is imperative for every finance manager to be up-to dateon the changes in services & products offered by bankingsector including several foreign players in the field..


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Finance and Insurance

Evaluating and determining the commercial

insurance requirements, choice of products

and insurers, analyzing their applicability to

the needs and cost effectiveness, techniques,ensuring appropriate and optimum coverage,

claims handling, etc. fall within the ambit of a

finance managers scope of work &responsibilities


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Finance and Information Technology

Information technology is the order of the day

and is now driving all businesses.. A finance

manager needs to know how to integrate

finance and costing with operations throughsoftware packages including ERP. The finance

manager takes an active part in assessment of

various available options, identifying the rightone and in the implementation of such

packages to suit the requirement


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International Finance

Capital markets have become globally integrated. Indian companiesraise equity and debt funds from international markets, in the formof Global Depository Receipts (GDRs), American DepositoryReceipts (ADRs) or External Commercial Borrowings (ECBs) and anumber of hybrid instruments like the convertible bonds, etc.,Access to international markets, both debt and equity, has enabledIndian companies to lower the cost of capital.

For example, Tata Motors raised debt as less than 1% from theinternational capital markets recently by issuing convertible bonds.

Finance managers are expected to have a thorough knowledge oninternational sources of finance, merger implications with foreigncompanies, acquisitions abroad and international transfer pricing.The implications of exchange rate movements on new project

viability have to be factored in the project cost and projectedprofitability and cash flow estimates. This is an essential aspect offinance managers expertise


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OBJECTIVES OF FINANCIAL

MANAGEMENT

The objectives of Financial Management can be

put into two categories:

1. Basic Objectives

2. Other objectives


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Basic Objectives1.Profit Maximization - Traditional objective.

The arguments put in support ofProfit Maximization are Profit is a prime motive or incentive, which contributes

to better and more efficient performance.

Efficient allocation of scarce resources and their

judicious utilization are based on the basis of profitcriterion.

Profit maximization ensures maximum return to theshareholders, prompt payment to creditors, better

wages and working conditions for labour. Without the objective of profit maximization, there will

be no place for competition in business, which is quiteessential for the successful functioning of an economy.


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Contd. All business decisions are taken keeping in view the

objective of profit maximization. So, profit maximizationhas become a part of decision-making process.

Profits are the main sources of finance for the growth andefficiency of a business.

Profits serve as a protection against risks.

Profit is not only an objective, but also a measuring rod orcriterion of efficient, effective and economic utilization offinancial resources by the management.

Profit maximization is a proper test of the economic

efficiency of a firm. Earning of profits is necessary for fulfilling social goals

The concept of profit maximization is the simple andstraightforward statement of the objectives.


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Contd The concept of profit maximization ignores the factors of risk

and uncertainty. That is, the profit maximization conceptconsiders profit maximization as the only objective of a businessundertaking, and ignores the factor of risk and uncertainty towhich a business unit is exposed. But profit maximizationcannot be the only objective of a business unit, as there is direct

relationship between uncertainty and risk and profit. A business unit is not run solely with the objective of earning

the maximum profits possible. There are firms, which areprepared to accept lower profits in order to have growth in thevolume of sales and to have stability. There are some firms,

which undertake some projects, which may yield lower profits,but contribute to social welfare. Further, profit maximization atthe cost of social and moral obligations and ethical tradepractices is not a good business policy. All these qualitativeaspects of business activities are ignored by the concept ofprofit maximization.


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ContdAgain there are several forces, which work against the objective of profit

maximization. They are

Profit maximization involves an element of risk. Higher profits involvegreater risk. So a business would like to have normal or fair profitrather than maximum profit

Many firms would like to have greater liquidity rather than locking theirfunds in increased production activities to earn maximum profits.

When a firm maximizes its profits, the workers of the firm woulddemand higher wages, more bonus, etc.

When a firm maximizes its profits and exploits the workers, consumers,etc., there is the threat of government interference in the form of moretaxes, strict regulatory measures and even nationalization of the firm.

Profit maximization may lead to exploitation of workers and consumers. Profit maximization leads to social inequality.

The effect of dividend policy on the market price of shares is notconsidered in the objective of profit maximization.


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Contd

To conclude, the profit maximization criterion is

inappropriate and unsuitable as an

operational objective of investment, financing

and dividend decisions of a firm. It is not onlyvague and ambiguous but it also ignores two

important dimensions of financial analysis,

namely, risk and time value of money


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Basic Objectives (contd)

2.Maintenance of Liquid Assets.

3.Wealth Maximization- means maximizing the

NPV . The NPV of a course of action is the

difference between the PV of its benefits and

the PV of its costs. The wealth created by a

company through its action is reflected in the

MV of the Companys share.


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Steps for Wealth Maximization

Avoid high levels of risk

Regular dividend

Maintain growth in sales Maintain price of firms equity share

Adopting sound investment policies


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Advantages of Wealth Maximization The wealth maximization concept considers the time value

of money. This concept takes into account the risk factor. It gives due

weightage to the risk factor by applying different rates ofdiscount, while discounting the cash flows or cash benefitsfrom the projects.

This concept allows dividend policy of the company to haveits effect on the market value.

The objective of wealth maximization also contributes tothe maximization of other objectives of financial

management Wealth maximization objective not only serves the

interests of the shareholders by increasing the value oftheir holdings, but also ensures security to the lenders.


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Limitations of Wealth Maximization

Maximization of wealth is subject to the socialresponsibilities of the firm. The firm cannotignore social responsibilities.

Maximization of wealth is also subject to Govt.

restrictions. The various statutory provisionsenacted by the Govt. to protect the interests ofthe society reduce the freedom of a business firmin its efforts to maximize wealth.

The objective of wealth maximization is notnecessarily socially desirable.


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Wealth Maximization V/s Profit

Maximization

From the above discussion, it is clear that, of the basicobjectives of financial management, viz., profitmaximization and wealth maximization, the objectiveof wealth maximization is more appropriate andsatisfactory. As Prof. Ezra Solomon has saidMaximization of wealth provides the more usefuland meaningful guidance than the maximization ofprofits for the evaluation of financial action ordecision.

The objective of wealth maximization is superior to theobjective of profit maximization in the followingrespects.


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Wealth Maximization V/s Profit

Maximization (contd..)Profit Maximization Wealth Maximization

Profit maximization concept ignores the

time value of money.

But wealth maximization concept

recognizes the time value of money.

The concept of profit maximization

ignores the factors of risk and uncertainty.

On the other hand, wealth maximization

concept takes into account the risk factorby applying different rates of discount,

while discounting the cash flows form

projects

The objective of profit maximization is

concerned with the maximization of

profits.

But the objective of wealth maximization

also contributes to the maximization of

other objectives of financial management

Profit maximization concept is vague, where wealth maximization concept is

very clear and not vague.


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Other objectives

Ensuring a fair return to share holders

Building up of reserves for growth and

expansion

Ensuring maximum operational efficiency and

effective utilization of finances

Ensuring financial discipline in the

organization


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SCOPE AND FUNCTIONS OF FINANCIAL

MANAGEMENT

Financial Management today covers the entiregamut of activities and functions given below.The head of finance is considered to be

importantly of the CEO in most organizationsand performs a strategic role. The functions ofFinancial Management can be divided intotwo groups-

Executive Functions

Routine Functions


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Executive functions

Financial forecasting

Investment decisions

To manage corporate asset structure

The management of income Management of cash

Deciding about new sources of finance

To contact and carry negotiation for new

financing Analysis and appraisal of financial performance

Advising the top management


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Routine functions

Estimating the total requirements of funds for a given period.

Raising funds through various sources, both national and

international, keeping in mind the cost effectiveness;

Investing the funds in both long term as well as short term

capital needs;

Funding day-to-day working capital requirements of business;

Collecting on time from debtors and paying to creditors on

time;

Managing funds and treasury operations;

Ensuring a satisfactory return to all the stake holders;

Paying interest on borrowings;


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Routine functions (contd)

Repaying lenders on due dates Maximizing the wealth of the shareholders over the long

term

Interfacing with the capital markets

Awareness to all the latest developments in the financialmarkets

Increasing the firms competitive financial strength in themarket

Adhering to the requirements of corporate governance

Preparations of various financial statement

Providing top management with information on current andprospective financial condition of the business as a basis forpolicy decision on purchases, marketing and pricing.


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Routine functions Chart


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Managerial Finance Functions

The functions of finance in a firm are divided

into four major decisions. Viz.,

Investment decision

Financing decision

Dividend decision

Liquidity decision


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Managerial Finance Functions

( contd)


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Emerging Role of Finance ManagersReflecting the emerging economic and financial environment in the post

liberalized era, the role/job of financial managers in India has becomemore important, complex and demanding. The key challenges are, inter-alia, in the areas specified below

1. Investment Decisions for obtaining maximum profitabilityafter taking the time value of the money into account.

2. Financing decisions through a balanced capital structure ofDebt-Equity ratio, sources of finance, computations ofEBIT,EPS, interest coverage ratio etc.

3. Dividend decisions, issue of Bonus Shares and retention ofprofits with the objective of maximization of market value

of equity share.4. Best utilization of fixed assets.

5. Efficient working capital management (inventory, debtors,cash, marketable securities and current liabilities).


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Emerging Role of Finance Managers

(contd)

6. Taking the cost of capital, risk, return andcontrol aspects into account.

7. Tax administration and tax planning.

8 . Pricing, volume of output, product-mix andcost- volume-profit analysis (CVP Analysis).

9. Cost control.

10. Stock Market Analyse the trends in thestock market and their impact on the priceof Companys share.


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Liquidity V/s Profitability

The Finance Manager always faced with thedilemma of Liquidity V/s Profitability. He hasto maintain the balance between the two.

Liquidity means that: The firm has adequate cash to pay for its bills

The firm has sufficient cash to make large

purchases The firm has cash reserve to meet

emergencies at all times.


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Liquidity V/s Profitability

Profitability goal on the other hand requires

that, the funds of the firm are so used so as to

yield the highest return.

Liquidity and profitability are very closely

related. When Liquidity increases, profitability

will come down and vice versa.

RISK RETURN TRADE OFF


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Capital Budgeting

Decisions

Capital Structure

Decisions

Dividend

Decisions

Working Capital

Decisions

Return

Risk

Market Value ofthe Firm

RISK RETURN TRADE OFF


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ORGANISATION OF FINANCE FUNCTION

Since finance is major/critical functional area, the

ultimate responsibility for carrying out financialmanagement functions lies with the topmanagement, ie., board of directors /managingdirector/chief executive or the committee of the

board. However, the exact nature of theorganization of the financial managementfunction differs from firm to firm depending uponfactors such as size of the firm, nature ofbusiness, type of financial operations, ability offinancial officers and the financial philosophy,and so on.


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ORGANISATION OF FINANCE FUNCTION(Contd..)

Similarly, the designation of the chief executive of

the finance department also differs widely incase of different firms. In some firms, they are

known as finance managers, while in other cases

as vice-president (finance), director (finance),and financial controller and so on. He reports

directly to the top management. Managers such

as controller and treasure head various sections

within the financial management area


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Organisation of Finance Function

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Organization for finance functionOrganization for finance function in a

multidivisional company


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Role of Treasurer and Controller

Two more officersthe treasurer and the

controllermay be appointed under the

direct supervision of CFO to assist him or her.

The treasurers function is to raise and

manage company funds while the controller

oversees whether funds are correctly applied.

f


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Functions of

Treasurer and Controller

Provision of capital

Maintaining relationship withbanks ,financial institutionsand investors

Arranging short term finance

Credit management

Cash Management

Receivables Management

Cost Control

Protection of funds

Accounting functions

Preparation of annual reportfinancial report &interpretation

Planning & Budgetary control

Statutory audit & internalaudit

Tax Administration

Internal control

Govt. Reporting Protection of assets

Economic appraisal


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Importance of Financial Management

In every Organization where funds are involved,sound financial management is necessary, soundfinancial management is essential in both profitand non-profit organizations. The Financial

management helps in maintaining the effectivedevelopment of funds in fixed assets and inworking capital. The finance manager assessesthe financial position of the company through theworking out of the return on capital, debt-equityratio, cost of the capital from each source etc.,comparison of the capital structure with that ofsimilar companies.

I t f Fi i l


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Importance of Financial

Management(Contd..)

Financial Management also helps in Ascertaining how the company would perform in future.

It helps in indicating whether the firm will generate enoughfunds to meet its various installments due to loans

Redemption of other liabilities. Profit planning

Measuring costs

Controlling inventories

Accounts receivables

Optimizing the output from a given input of funds.


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Think out of Box

h l h k i h l h


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Three people check into a hotel. They payRs.30 to the manager and go to their room.The manager suddenly remembers that the

room rate is Rs.25 and gives Rs.5 to thebellboy to return to the people. On the wayto the room the bellboy reasons that Rs.5would be difficult to share among three

people so he pockets Rs.2 and gives Rs.1 toeach person. Now each person paid Rs.10and got back Rs.1. So they paid Rs.9 each,totaling Rs.27. The bellboy has Rs.2,

totaling Rs.29. Where is the missing Rupee1?


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Financial Management (10MBA23)-I Chapter

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