FINANCIAL MANAGEMENT UNIT - I FOUNDATIONS OF FINANCE CHAPTER –I Financial Management : An Overview Meaning Financial management is dynamic, in the making of day- to- day financial decisions in a business of any size. The old concept of finance as treasurer-ship has broadened to include the new, meaningful concept of controllership. While the treasurer keeps track of the money, the controller’s duties extend to planning analysis and the improvement of every phase of the company’s operations, which are measured with a financial yardstick. Financial management is thus an integrated and composite subject. It welds together much of the material that is found in Accounting, Economics, Mathematics, Systems analysis and Behavioral sciences, and uses other disciplines as its tool. For a long time, finance has been considered as a rather sterile function concerned with a certain necessary recording of activities alone. financial management makes a significant contribution to the management revolution that is taking place. Financial management’s central role is concerned with the same objectives as those of the management; with the way in
Transcript
FINANCIAL MANAGEMENT
UNIT - I
FOUNDATIONS OF FINANCE
CHAPTER –I Financial Management : An Overview
Meaning
Financial management is dynamic, in the making of day- to-day financial
decisions in a business of any size. The old concept of finance as treasurer-ship
has broadened to include the new, meaningful concept of controllership. While
the treasurer keeps track of the money, the controller’s duties extend to planning
analysis and the improvement of every phase of the company’s operations,
which are measured with a financial yardstick.
Financial management is thus an integrated and composite subject. It welds
together much of the material that is found in Accounting, Economics,
Mathematics, Systems analysis and Behavioral sciences, and uses other
disciplines as its tool. For a long time, finance has been considered as a rather
sterile function concerned with a certain necessary recording of activities alone.
financial management makes a significant contribution to the management
revolution that is taking place.
Financial management’s central role is concerned with the same objectives as
those of the management; with the way in which the resources of the business
are employed and how the business is financed. Financial management has
been divided into three main areas - decisions on the capital structure; allocation
of available funds to specific uses and analysis and appraisal of problems.
Financial management includes planning or finance, cash budgets and source of
finance.
Definitions
"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 is an area of financial decision-making, harmonizing
individual motives and enterprise goals". -Weston and Brigham.
"Financial management is the area of business management devoted to a
judicious used of capital and a careful selection of sources of capital in order to
enable a business firm to move in the direction of reaching its goals".-
J.F.Bradlery.
Objective of Financial Management
Profit maximization should serve as the basic criterion for decisions arrived at by
financial managers of privately owned and controlled firms. Different alternatives
are available to a business enterprise in the process of decisions- making. Each
alternative has its own implications. Different courses of actions have to be
evaluated on the basis of some analytical framework and for this purpose,
commercial strategies of an enterprise have to be taken into consideration. The
availability of funds depend upon the kind of commercial strategies adopted by a
firm during a particular period of time. Various different theories of financial
management provides an analytical framework for an evaluation of courses of
action.
Maximization of profits is often considered to be a goal or an alternative goal of a
firm. However, this is somewhat narrow in concept than the goal of maximizing
the value of the firm because of the following reasons:
(a) The maximization of profits, as reflected in the earnings per share, is not an
adequate goal in the first place because it does not take into consideration time
value of money.
(b) The concept of maximization of earnings per share does not include the risk
of streams of alternative earnings. A project may have an earning steam that will
attain the goal of maximum earnings per share; but when compared with the risk
involved in it, it may be totally unacceptable to a stockholder, who is generally
hostile to risk-bearing activities.
(c) This concept of maximization of earnings per share does not take into
account the impact of dividend policy upon market price or value of the firm.
Theoretically, a firm would never pay a dividend if the objective is to maximize
earnings per share. Rather, it would reinvest all its earnings so as to generate
greater earnings in the future.
Financial management techniques, are applicable to decisions of individuals,
nonprofit organizations and of business firms. Also, it is applicable to different
situations in different organizations.
Financial managers are interested in providing answers to the following
questions:
1. Given a firm’s market position, the market demand for its products, its
productive capacity and investment opportunities, what specific assets
should it purchase? This Indirectly emphasizes the approach to capital
budgeting.
2. Given a firm’s market position and investment opportunities, what is the
total volume of funds that it should commit? This indirectly emphasizes the
composition of a firm’s assets.
3. Given a firm’s market position and investment opportunities, how should it
acquire the funds which are necessary for the implementation of its
investment decisions? This underscores the approach to capital financing.
PROFIT MAXIMIZATION Vs WEALTH MAXIMIZATION
Although in general profit maximization is the prime goal of financial
management, there are arguments against the same. The following table
presents points in favour as well as against profit maximization.
Wealth Maximization: The goals of financial management may be such that
they should be beneficial to owners, management, employees and customers.
These goals may be achieved only by maximizing the value of the firm.
Increase in Profits: A firm should increase its revenues in order to maximize its
value. For this purpose, the volume of sales or any other activities should be
stepped up. It is a normal practice for a firm to formulate and implement all
possible plans of expansion and take every opportunity to maximize its profits. In
theory, profits are maximized when a firm is in equilibrium. At this stage, the
average cost is minimum and the marginal cost and marginal revenue are equal.
A word of caution, however, should be sounded here. An increase in sales will
not necessarily result in a rise in profits unless there is a market for increased
supply of goods and unless overhead costs are properly controlled.
Reduction in Cost: Capital and equity funds are factor inputs in production. A
firm has to make every effort to reduce cost of capital and launch economy drive
in all its operations.
Sources of Funds: A firm has to make a judicious choice of funds so that they
maximize its value. The sources of funds are not risk-free. A firm will have to
assess risks involved in each source of funds. While issuing equity stock, it will
have to increase ownership funds into the corporation. While issuing debentures
and preferred stock, it will have to accept fixed and recurring obligauons. The
advantages of leverage, too, will have to be weighed properly.
Minimum Risks: Different types of risks confront a firm. "No risk, no gain" - is a
common adage. However, in the world of business uncertainties, a corporate
manager will have to calculate business risks, financial risks or any other risk that
may work to the disadvantage of the firm before embarking on any particular
course of action. While keeping the goal of maximization of the value of the firm,
the management will have to consider the interest of pure or equity stockholders
as the central focus of financial policies.
Long-run Value: The goal of financial management should be to maximize long
run value of the firm. It may be worthwhile for a firm to maximize profits by pricing
its products high, or by pushing an inferior quality into the market, or by ignoring
interests of employees, or, to be precise, by resorting to cheap and "get-rich-
quick" methods. Such tactics, however, are bound to affect the prospects of a
firm rather adversely over a period of time. For permanent progress and sound
reputation, it will have to adopt an approach which is consistent with the goals of
financial management in the long-run.
Advantages of Wealth Maximization
Wealth maximization is a clear term. Here, the present value of cash flow is
taken into consideration. The net effect of investment and benefits can be
measured clearly. (Quantitatively)
It considers the concept of time value of money. The present values of cash
inflows and outflows helps the management to achieve the overall objectives of a
company.
The concept of wealth maximization is universally accepted, because, it takes
care of interests of financial institution, owners, employees and society at large.
Wealth maximization guide the management in framing consistent strong
dividend policy, to earn maximum returns to the equity holders.
The concept of wealth maximization considers the impact of risk factor, while
calculating the Net Present Value at a particular discount rate, adjustment is
made to cover the risk that is associated with the investments.
Criticisms of Wealth Maximization
The objective of wealth maximization is not descriptive. The concept of
increasing the wealth of the stockholders differs from one business entity to
another. It also leads to confusion in, and misinterpretation of financial policy
because different yardsticks may be used by different interests in a company.
As corporations have grown bigger and more powerful, their influence has
become more pervasive; they have created an imbalance which is widely
believed to have been instrumental in generating a movement to promote more
socially conscious business behaviour. Academicians and corporate officers alike
have urged the advisability of more socially conscious business management.
Financial management will then have to rise equal to the acceptance of social
responsibility of business.
Financial management should not only maintain the financial health of a
business,but should also help to produce a rate of earning which will reward the
owners adequately for the use of the capital they have provided. To the creditors,
the management must ensure administration, which will keep the business liquid
and solvent.
Wealth maximization is as important objective as profit maximization. The
operating objective for Financial Management is to maximize wealth or the net
present worth of a firm. Wealth maximization is an objective which has to be
achieved by those who supply loan capital, employees, society and
management. The objective finds its place in these segments of the corporate
sector, although the immediate objectives of Financial Management may be to
maintain liquidity and improve profitability.
The wealth of owners of a firm is maximized by raising the price of the common
stock. This is achieved when the management of a firm operates efficiently and
makes optimal decisions in areas of capital investments, financing, dividends and
current assets management. If this is done, the aggregate value of the common
stock will be maximized.
Scope and Functions of Financial Management
Financial Management plays two significant roles:
To participate in the process of putting funds to work within the business and
to control their productivity; and
To identify the need for funds and select sources from which they may be
obtained.
The functions of financial management may be classified on the basis of liquidity,
profitability and management.
(1) Liquidity: Liquidity is ascertained on the basis of three important
considerations:
(a) Forecasting cash flows, that is, matching the inflows against cash outflows;
(b) Raising funds, that is, financial management will have to ascertain the
sources from which funds may be raised and the time when these funds are
needed;
(c) Managing the flow of internal funds, that is, keeping its accounts, with a
number of banks to ensure a high degree of liquidity with minimum external
borrowing.
(2) Profitability: While ascertaining profitability, the following factors are taken
into account:
(a) Cost Control: Expenditure in the different operational areas of an enterprise
can be analysed with the help of an appropriate cost accounting system to
enable the financial manager to bring costs under control.
(b) Pricing: Pricing is of great significance in the company’s marketing effort,
image and sales level. The formulation of pricing policies should lead to
profitability, keeping, of course, the image of the organization intact.
(c) Forecasting Future Profits: Expected profits are determined and evaluated.
Profit levels have to be forecasted from time to time in order to strengthen the
organization.
(d) Measuring Cost of Capital: Each source of funds has a different cost of capital
which must be measured because cost of capital is linked with profitability of an
enterprise.
(3) Management: The financial manager will have to keep assets intact, for
assets are resources which enable a firm to conduct its business. Asset
management has assumed an important role in financial management. It is also
necessary for the financial manager to ensure that sufficient funds are available
for smooth conduct of the business. In this connection, it may be pointed out that
management of funds has both liquidity and profitability aspects. Financial
management is concerned with the many responsibilities which are thrust on it by
a business enterprise. Although a business failure may not always be the result
of financial failures, financial failures do positively lead to business failures. The
responsibility of financial management is enhanced because of this peculiar
situation.
Financial Management and Accounting
It is of greater managerial interest to think of financial management as something
of which accounting is a part, which is concerned mainly with the raising of funds,
in the most economic and suitable manner; using the funds as profitably as
possible (for a given risk level); planning future operations and controlling current
performance and future developments through financial accounting, cost
accounting, budgeting, statistics and other means.
Effective planning and direction depends on adequate accounting information available to
a management on the financial condition of an enterprise. This includes:
Decisions which affect external, legal and financial relationships of funds; decisions on methods of financing, fixed and working capital in general
Financial structure, credit policy, payment of dividends, creation of reserves
Decisions which are mainly internal and refer to the deployment of funds on different projects
Quasi-financial decisions which arise from marketing; personnel, production or any other discipline and other problems which have financial aspects
Decisions for which accounting records and reports are widely used.
Accounting is a tool for handling only the financial aspects of business
operations. It is geared to the financial ends of a business only because these
are measurable on the scale of money values. The distinction between financial
management and management accounting is a semantic one, but the gap
between the two is rapidly closing. Financial management, however, has the
broader meaning of planning and control of all activities by financial means, while
management accounting originally meant the internal management of finance in
industry. The accountant devotes his attention to the collection and presentation
of financial data. The financial officer evaluates the accountant’s statements,
develops additional data and arrives at decisions based on his analysis.
Evolution of Financial Management
The main stream of academic writing and teaching followed the scope and
pattern suggested by the narrower and by now traditional definition of the finance
function. Financial management, as it was then more generally called, emerged
as a separate branch of economics. The traditional approach to the entire subject
of finance was from the point of view of the investment banker rather than that of
the financial decision-maker in an enterprise. The traditional treatment placed
altogether too much emphasis on corporation finance and too little on the
financing problems of non-corporate enterprises.
The sequence of treatment was built too closely around the episodic phases during the life
cycle of a hypothetical corporation in which external financial relations happened to be
dominant. Matters like promotion, incorporation, merger, consolidation, recapitalization
and reorganization left too little room for problems of a normal growing company.
Finally, it placed heavy emphasis on long-term financial instruments and problems and
corresponding lack of emphasis on problems of working capital management. The basic
contents of the traditional approach may now be summarised.
The emphasis in the traditional approach is on raising of funds
The traditional approach circumscribes episodic financial function
The traditional approach places great emphasis on long-term problems
It pays hardly any attention to financing problems of non-corporate enterprises.
It is difficult to say at what stage the traditional approach was replaced by
modern approach. It is clear, however, that Ezra Solomon, Thomas L. Rein,
Edward S. Meade and Arthur Stone Dewing among others were profoundly
impressed by subjects like promotion, securities, floatations, reorganization,
consolidations, liquidation, etc. Their works laid emphasis on these topics. They
did not consider routine managerial problems relating to financing of a firm,
problems of profit planning and control, budgeting, finance and cost control, and
working capital management which constitute the crux of the financial problems
of modern financial management.
The central issue of financial policies is a wise use of funds and the central
process involved is a rational matching of advantages of potential uses against
the caution of advantages of potential uses against the caution of alternative
potential sources so as to achieve broad financial goals which an enterprise sets
for itself. The new or modern approach is an analytical way of looking at the
financial problems of a firm. Financial problems are a vital and an integral part of
overall management. In this connection, Ezra Solomon observes: If the scope of
financial management is re-defined to cover decisions about both the use and
the acquisition of funds, it is clear that the principal content of the subject should
be concerned with how financial management should make judgements about
whether an enterprise should hold, reduce, or increase its investments in all
forms of assets that require company funds.
Functional Areas of Financial Management
It would indeed be an extremely difficult task to delineate functions of modern
financial management. The subject management has been stretched to such a
limit that a finance manager today has to be conversant with a large variety of
subjects, while the traditional finance manager concerned him with such
macroeconomic areas of finance as long-term financing, short-term financing,
study of financial institutions, capital market (more particularly, the stock
exchange), promotion, planning of corporations, underwriting of securities, and
so on. A lot of literature on the subject of Financial Management seems to be
devoted to these and similar matters. These areas, to be precise, belong to
corporation finance. Modern Financial Management should hence forward
concentrate on micro- economic areas with which a business enterprise has to
deal during its day-to-day operations.
A Large number of empirical studies on the subject have already been conducted
on different portfolios of Financial Management, some of which have been
tested, while others, which were not tested, were rejected by corporate decision-
makers. For example, capital structure and, more particularly, the cost of different
sources of funds, dividend policies, depreciation policies, retention of surpluses,
liquidity, profit planning and control - these are among the subjects which have
captured the attention of different schools of thoughts from time to time. The
functional areas of financial management is elaborated below.
Determining Financial Needs: One of the most important functions of the
financial manager is to ensure availability of adequate funds. Financial needs
have to be assessed for different purposes. Money may be required for initial
promotional expenses, fixed capital and working capital needs. Promotional
expenditure includes expenditure incurred in the process of company formation.
Fixed assets needs depend upon the nature of the business enterprise - whether
It is a manufacturing, non-manufacturing or merchandising enterprise. Current
asset needs depend upon the size of the working capital required by an
enterprise.
Figure: 1 Functional areas of financial management
Determining the Sources of Funds: The financial manager has to choose the
various sources of funds. He may issue different types of securities. He may
borrow from a number of financial institutions and the public. When a firm is new
and small and little known in financial circles, the financial manager faces a great
challenge in raising funds. Even when he has a choice in selecting sources of
funds, he should exercise it with great care and caution. A firm is committed to
the lenders of finance and has to meet various terms and conditions on which
they offer credit. To be precise, the financial manager must definitely know what
he is doing.
Financial Analysis: It is the evaluation and interpretation of a firm’s financial
position and operations, and involves the comparison and interpretation of
accounting data. The financial manager has to interpret different statements. He
has to use a large number of ratios to analyse the financial status and activities
of his firm. He is required to measure its liquidity, determine its profitability and
assets and overall performance in financial terms. This is often a challenging
task, because he must understand the importance of each one of these aspects
to the firm and he should be crystal clear in his mind about the purposes for
which liquidity, profitability and performance are to be measured.
Optimal Capital Structure: The financial manager has to establish an optimum
capital structure and ensure the maximum rate of return on investment. The ratio
between equity and other liabilities carrying fixed charges has to be defined. In
the process, he has to consider the operating and financial leverages of his firm.
The operating leverage exists because of operating expenses, while financial
leverage exists because of the amount of debt involved in a firm’s capital
structure. The financial manager should have adequate knowledge of different
empirical studies on the optimum capital structure and find out whether, and to
what extent, he can apply their findings to the advantage of the firm.
Cost-Volume-Profit Analysis: This is popularly known as the ‘CVP relationship’.
For this purpose, fixed costs, variable costs and semi-variable costs have to be
analysed. Fixed costs are more or less constant for varying sales volumes.
Variable costs vary according to sales volume. Semi-variable costs are either
fixed or variable in the short run. The finance manager has to ensure that the
income for the firm will cover its variable costs, for there is no point in being in
business, if this is not accomplished. Moreover, a firm will have to generate an
adequate income to cover its fixed costs as well. The finance manager has to
find out the break- even-point (i.e), the point at which total costs are matched by
total sales or total revenue. He has to try to shift the activity of the firm as far as
possible from the break-ever point to ensure company’s survival against
seasonal fluctuations.
Profit Planning and Control: Profit planning and control have assumed great
importance in the financial activities of modern business. Economists have long
before considered the importance of profit maximization in influencing business
decisions. Profit planning ensures attainment of stability and growth. In view of
the fact that earnings are the most important measure of corporate performance,
the profit test is constantly used to gauge success of a firm’s activities.
Profit planning is an important responsibility of the finance manager. Profit is the
surplus which accrues to a firm after its total expenses are deducted from its total
revenue. It is necessary to determine profits properly, for they measure the
economic viability of a business. The first element in profit is revenue or income.
This revenue may be from sales or it may be operating revenue, investment
income or income from other sources. The second element in profit calculation is
expenditure. This expenditure may include manufacturing costs, trading costs,
selling costs, general administrative costs and finance costs.
Profit planning and control is a dual function which enables management to
determine costs it has incurred, and revenues it has earned, during a particular
period, and provides shareholders and potential investors with information about
the earning strength of the corporation. It should be remembered that though the
measurement of profit is not the only step in the process of evaluating the
success or failure of a company, it is nevertheless important and needs careful
assessment and recognition of its relationship to the company’s progress. Profit
planning and control are very important. In actual practice, they are directly
related to taxation. Moreover, they lay the foundation for policies, which
determine dividends, and retention of profits and surpluses of the company. Profit
planning and control are inescapable responsibilities of the management. The
break-even analysis and the CVP relationship are important tools of profit
planning and control.
Fixed Assets Management: A firm’s fixed assets include tangibles such as land,
building, machinery and equipment, furniture and also intangibles such as
patents, copyrights, goodwill, and so on. The acquisition of fixed assets involves
capital expenditure decisions and long-term commitments of funds. These fixed
assets are justified to the extent of their utility and/or their productive capacity.
Because of this long-term commitment of funds, decisions governing their
purchase, replacement, etc., should be taken with great care and caution. Often,
these fixed assets are financed by issuing stock, debentures, long-term
borrowings and deposits from public. When it is not worthwhile to purchase fixed
assets, the financial manager may lease them and use assets on a rental basis.
To facilitate replacement of fixed assets, appropriate depreciation on fixed assets
has to be formulated. It is because of these facts that management decisions on
the acquisition of fixed assets are vital. If they are ill-designed, they may lead to
over-capitalisation. Moreover, in view of the fact that fixed assets are maintained
over a long period of time, these assets are exposed to changes in their value,
and these changes may adversely affect the position of a firm.
Project Planning and Evaluation: A substantial portion of the initial capital is
sunk in long-term assets of a firm. The error of judgment in project planning and
evaluation should be minimized. Decisions are taken on the basis of feasibility
and project reports, containing analysis of economic, commercial, technical,
financial and organizational viabilities. Essentiality of a project is ensured by
technical analysis. The economic and commercial analysis study demand
position for the product. The economy of size, choice of technology and
availability of factors favouring a particular industrial site are all considerations
which merit attention in technical analysis. Financial analysis is perhaps the most
important and includes forecasting of cash in-flows and total outlay which will
keep down cost of capital and maximize the rate of return on investment. The
organizational and manpower analysis ensures that a firm will have the requisite
manpower to run the project. In this connection, it should be remembered that a
project is exposed to different types of uncertainties and risks. It is, therefore,
necessary for a firm to gauge the sensitivity of the project to the world of
uncertainties and risks and its capacity to withstand them. It would be
unjustifiable to accept even the most profitable project if it is likely to be the
riskiest.
Capital Budgeting: Capital budgeting decisions are most crucial; for they have
long-term implications. They relate to judicious allocation of capital. Current funds
have to be invested in long-term activities in anticipation of an expected flow of
future benefits spread over a long period of time. Capital budgeting forecasts
returns on proposed long-term investments and compares profitability of different
investments and their cost of capital. It results in capital expenditure investments.
The various proposal assets ranked on the basis of such criteria as urgency,
liquidity, profitability and risk sensitivity. The financial analyser should be
thoroughly familiar with such financial techniques as pay back, internal rate of
return, discounted cash flow and net present value among others because risk
increases when investment is stretched over a long period of time. The financial
analyst should be able to blend risk with returns so as to get current evaluation of
potential investments.
Working Capital Management: Working capital is rightly an adjunct of fixed
capital investment. It is a financial lubricant which keeps business operations
going. It is the life-blood of a firm. Cash, accounts receivable and inventory are
the important components of working capital, which is rotating in its nature. Cash
is the central reservoir of a firm that ensures liquidity. Accounts receivables and
inventory form the principal of production and sales; they also represent liquid
funds in the ultimate analysis. The financial manager should weigh the
advantage of customer trade credit, such as increase in volume of sales, against
limitations of costs and risks involved therein. He should match inventory trends
with level of sales. The uncertainties of inventory planning should be dealt within
a rational manner. There are several costs and risks which are related to
inventory management. The risks are there when inventory is inadequate or in
excess of requirements. The former may hold up production, while the latter
would result in an unjustified locking up of funds and increase the cost of capital.
Inventory management entails decisions about the timing and size of purchases
purely on a cost basis. The financial manager should determine the economic
order quantities after considering the relationships of different cost elements
involved in purchases. Firms cannot avoid making investments in inventory
because production and deliveries involve time lags and discontinuities.
Moreover, the demand for sales may vary substantially. In the circumstances,
safety levels of stocks should be maintained. Inventory management thus
includes purchase management and material management as well as financial
management. Its close association with financial management primarily arises
out of the fact that it is a simple cash asset.
Dividend Policies: Dividend policies constitute a crucial area of minancial
management. While owners are interested in getting the highest dividend from a
corporation, the board of directors may be interested in maintaining its financial
health by retaining the surplus to be used when contingencies arise. A firm may
try to improve its internal financing so that it may avail itself of benefits of future
expansion. However, the interests of a firm and its stockholders are
complementary, f or the ginancial management is interested in maximising the
value of the firm, and the real interest of stockholders always lies in the
maximisation of this value of the firm; and this is the ultimate goal of financial
management. The dividend policy of a firm depends on a number of financial
considerations, the most critical among them being profitability. Thus, there are
different dividend policy patters which a firm may choose to adopt, depending
upon their suitability for the firm and its stockholders.
Acquisitions and Mergers: Firms may expand externally through co-operative
arrangements, by acquiring other concerns or by entering into mergers.
Acquisitions consist of either the purchase or lease of a smaller firm by a bigger
organization. Mergers may be accomplished with a minimum cash outlay, though
these involve major problems of valuation and control. The process of valuing a
firm and its securities is difficult, complex and prone to errors. The financial
manager should, therefore, go through the valuation process very carefully. The
most difficult interest to value in a corporation is that of the equity stockholder
because he is the residual owner.
Corporate Taxation: Corporate taxation is an important function of the financial
management, for the former has a serious impact on the financial planning of a
firm. Since the corporation is a separate legal entity, it is subject to an income-
tax structure which is distinct from that which is applied to personal income.
The traditional notion that the finance function is simply a process of ‘managing
cash and capital’ or planning and controlling profits, fails to cover the scope of
modern financial management. Today’s finance manager is engaged in such
activities for the construction of models as to direct the search for new
information, set performance standards, rationalise operating rules, and establish
operating control. It is, in brief, an all-encompassing function. Its objective is first
to select the items of financial information which are relevant to a particular
problem, and second, to fit these items into a coherent picture of the problem in
relation to the firm’s aims and financial resources. The final objective of financial
management is to suggest alternative solutions to problems. However, in actual
practice, the modern executive, who is buried in a maze of seemingly endless
statistics and voluminous reports, is constantly struggling to gain real financial
control, The financial controller is often behaviorally more concerned with
expenditure than with profits. He tends to become a person who wants to keep
his financial resources intact, spends nothing, and completely avoids undertaking
risk. Infact, the management of finance should have the optimal use of funds as
its focal point. The auditing approach should give place to a decision-making
approach. The new demands on the finance manager call for a basic
transformation in his approach because he plays a crucial role in the future
success of the organisation. And this is a challenge which he has to face.
An analysis of financial data with the help of scientific tools and techniques to
improve performance of an undertaking (and to achieve better operating results
and better quality of products) is essential n0wdays a day. It is necessary to take
a fresh look at finance management in most Indian industries. The management
of capital in Indian industries is generally anchored to traditional legacies and
practices. This is true for both private and public sectors.
The modern tools of management, including capital management, performance
budgeting, cost control, organizational development and R & D, have not yet
become popular with the captains of our industry. There is an absence of data on
the marginal efficiency of capital, input-output analysis, technical co-efficient,
etc., which render current evaluation of issues somewhat difficult. The
preponderance of proprietary, partnership and private companies has made
industrial units something like closed shops. The management of these sectors is
rested in family complexes about which there is no adequate information.
Moreover, social obligations, growth potents, technical feasibility of financial
planning and flow, and physical productivity - these need a better re-orientation
and gearing up of capital management practices. The vagaries of government
policy on dividend payments and tax rates and limits on share capital floatation
have resulted in a low and uncertain supply of funds to the equity market. As a
consequence, business houses are forced to look for their borrowings elsewhere
as the only reliable method of finance, even when the cost of these borrowing is
relatively high. The present behaviour of financial management is a result of
government policy, in an uncertain capital market.
Financial Decisions
Financial decisions are the decisions relating to financial matters of a corporate
entity. Financial requirement, Investment, Financing and Dividend Decisions are
the most important areas of financial management, which facilitate a business
firm to achieve wealth maximisation.
Funds Requirement Decision: Financial requirement decision is one of the
most important decisions of finance manager. This decision is considered with
estimation of the total funds required by a business unit. The total amount of
capital and revenue expenditure of a company facilitates the financial manager in
finding the total funds requirement. Capital expenditure consists of acquiring
fixed assets. Revenue expenditure consists of maintaining the day-to-day
activities of a business unit. Hence the total of this expenditure helps the finance
manager in determining the total funds requirement.
Investment Decision: Investment decision is concerned with allocation of funds
to both capital and current assets. Capital assets are financed through long-term
funds and current assets are financed through short-term funds. The financial
manager has to carefully allocate the available funds to recover not only the cost
of funds but also must earn sufficient returns on the investments. Capital
budgeting, CVP analysis are the techniques generally used fir the process of
investment decisions.
Financing Decisions: Financing decision is concerned with identification of
various sources of funds. Funds are available through primary market, financial
institution and through the commercial banks. Cost associated with each of the
instrument or source is different. The overall cost of that capital composition must
be kept at minimum proper debt. Equity ratio should be maintained to maximize
the returns to the shareholders. This decision will be made by considering the
different factors. viz., inflation, size of the organisation, government policies, etc.
Dividend Decisions: Regular and assured percentage of dividend and capital
gains are the basic desires of equity shareholders. The overall objective of a
corporation is to fulfill the desires of the shareholders and attain wealth
maximization in the long run. This decision has been considered as the
barometer through which a business firm’s performance is measured. The
suppliers of materials, bankers, creditors, shareholders and the government will
measure and understand the soundness of the company through dividend
decisions. Therefore, dividend decision has been considered as another
Money has time value. A rupee today is more valuable than a rupee a year hence. Why?
There are several reasons:
Individuals, in general, prefer current consumption to future consumption.
Capital can be employed productively to generate positive returns. An investment of one rupee today would grow to (1+r) a year hence (r is the rate of return earned on the investment).
In an inflationary period, a rupee today represents a greater real purchasing power than a rupee a year hence.
Reasons for time value of money
Many financial problems involve cash flows occurring at different points of time. For
evaluating such cash flows an explicit consideration of time value of money is required.
This chapter, discussing the methods for dealing with time value of money, is divided
into four sections as follows:
Future value of a single cash flow
Future value of an annuityPresent value of a single cash flowPresent value of an annuity
