Chapter 1

Introduction of Financial Management

1. 1 Introduction
Financial management is that managerial activity which is concern with the
planning and controlling of the firm’s financial resources. Thought it was a branch
of economics till 1890, as a separate activity or discipline it is of recent origin. Still, it
has no unique body of knowledge of its own, and draws heavily on economics for its
theoretical concepts even today.

The subject of financial management is of immense interest to both academicians

and practicing managers. It is of great interest to academicians because the subject
is still developing, and there are still certain areas where controversies exist for
which no unanimous solutions have been reached as yet. Practicing managers are
interested in this subject because among the most crucial decisions of the firm are
those which relate to finance, and an understanding of the theory of financial
management provides them with conceptual and analytical insights to make those
decisions skillfully.

Financial management can be looked upon as study of relations between raising of

finance and development of finance.

1.2 Introduction to Finance

Suppose you are planning to start your own business. No matter what, the nature of
your proposed business is and how it is organized, you will have to address the
following questions:

1. What capital investment should you make? That is, what kind of real
estate, machineries, and equipment should you purchase?
2. Where will you raise money to pay for the proposed capital investments?
That is, what will be the mix of equity and dept in your financing plan?
3. How will you handle the day-to-day financial activities like collecting
your receivables and paying your suppliers?
All business activities require acquisition and use of funds for running the business
unit commercially i.e. generating revenues over total cost incurred. Without funds
no business activity can take a final shape in practice.

Thus all business activities require;

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 1. Funds to formulate business plans,
2. Funds to implement these plans,
3. Funds to generate future growth, and
4. Funds to generate more funds.
Funds like other inputs of the organizations have to be procured at a cost. Funds
can be procured from various sources like Shareholders, debt holders/creditors
financial institutions, banks etc. Funds required for running the business are raised
through a combination of direct revenue from sales, loans from banks, sales of
securities and bonds, etc. All such activities which relate to acquisition and use of
funds are together terms as fund management/money management.

Finance is all about managing ‘BUSINESS MONEY’ i.e. the ‘money’ employed
commercially to generate surplus for the business. In other words finance is an art,
science of using, managing controlling the business funds.

1.3 Scope of finance

What is finance? What are a firm’s financial activities? How are they related to the
firm’s other activities? Firms create manufacturing capacities for productions of
goods; some provide services to customers. They sell their goods or services to earn
profit. They raise funds to acquire manufacturing and other facilities. Thus, the
three most important activities of a business firm are:

⇒ Production
⇒ Marketing
⇒ Finance
A firm secures whatever capital it needs and employs it (finance activities) in
activities which generate returns on invested capital (production and marking
activities).

a. Real and Financial Assets

A firm requires real assets to carry on its business. Real assets can be tangible or
intangible. Plant, machinery, office, factory, furniture building are example of
tangible real assets, which technical know-how, technological collaborations,
parents and copyrights are copyrights are intangible real assets. The firm sells
financial assets or securities, such as shares and bonds or debentures, to investors in
capital markets to raise necessary funds. Financial assets also include lease
obligations and borrowing from banks, financial institutions and others sources.

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Funds applied to assets by the firm are called capital expenditure or investment.
The firm expects to receive return on investment and distribute return as dividends
to investors.

b. Equity and borrowed Funds

There are two types of funds that firm can raise: equity funds and borrowed funds.
A firm sells shares to acquire funds. Shares represent ownership rights of their
holders. Buyers of shares are called shareholders, and they are legal owners of the
firm whose shares they hold. Shareholders invest their money in the shares of a
company in the expectations of a return on their invested capital. The return on the
shareholders’ capital consists of dividend and capital gain, shareholders make
capital gains by selling their shares.

Shareholders can be of two types: ordinary (or common) and preference. Preference
shareholders receive dividend at a fixed rate, and they have a priority over ordinary
shareholders. The dividend rate of ordinary shareholders is not fixed, and it can
vary from year to year depending on the decision of the board of directors. The
payment of dividend to shareholders is not a legal obligations; it depends on the
discretion of the board of directors. Since ordinary shareholders receive dividend
(or re-payment of invested capital, only when the company is wound up) after
meeting the obligations of others, they are generally called owners of residue.
Dividends paid by a company are not deductions charges for calculating corporate
income taxes.

Equity funds can also be obtained by a company by retaining a portion of earnings

available for shareholders. This method of acquiring funds internally is called
earnings retention. Retained earnings are undistributed profits of equity capital;
they are, therefore, rightfully a part of the equity capital. The retention of earnings
can be considered as a form of raising new capital. If a company distributes all
earning to shareholders, then, it can reacquire new capital from the same sources
(existing shareholders) by issuing new shares called a rights issue. Also, a public of
shares may be made to attract new shareholders.

Another important source of securing capital is creditors or lenders. Lenders are

not the owners of the company. They make money available to the firm on a lending
basis and retain title to the funds lent. The return on loans or borrowed funds is
called interest. Loans are furnished for a specified period at a fixed rate of interest.
Payment of interest is a legal obligation. The amount of interest is allowed to be

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treated as expense corporate income taxes. Thus the payment of interest on
borrowing provides tax shield to a firm. The firm may borrow funds from a large
number of sources, such as banks, financial institutions, public or by issuing bonds
or debentures. A bond or a debenture is a certificate acknowledging the money lent
by a bondholder to the company. It states the amount, the rate of interest and the
maturity of the bond or debenture.

c. Finance and Other Management Functions

There exists an inseparable relationship between finance on the one hand and
production, marketing and other functions on the other. Almost all kinds of
business activities, directly or indirectly, involve the acquisitions and use of funds.

1.4 Finance Functions

Although it may be difficult to separate the finance functions from production,
marketing and other functions, yet the function themselves can be readily identified.
The functions of raising funds, investing them in assets and distributing returns
earned from assets to shareholders are respectively known as financing, investment
and dividend decisions. While performing these functions, a firm attempts to
balance cash inflows and outflows. This is called liquidity decisions, and we may add
it to the list of important finance decisions or functions.

Broadly managing funds involve the following functions:

1. Financing decision (or capital-mix decision): These relate to procuring funds

from outside the business organizations. Funds should be procured at a
nominal cost and it should be effectively utilized to give maximum value. The
different sources of obtaining funds from the basis of organization’s capital
structure. The mix of different sources of funds at which the overall cost of
capital remains minimum is the optimum capital structure of the firm.
FINANCIAL DECISION IN A FIRM

There are three broad areas of financial decision making:-

1. Capital Budgeting – the first and perhaps the most important decision
that any firm has to make is to define the business or businesses that is
wants to be in. This decision has a significant bearing on how capital is
allocated in the firm. Once the managers of a firm choose the business or
businesses they want to be in, they have to develop a plan to invest in
building, machineries, equipment, research and development, godowns,

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 showrooms, distribution network, information infrastructure, brands,
and other long-lived assets. This is the capital budgeting process. The unit
of analysis in capital budgeting is an investment project. Considerable
managerial time, attention, and energy is developed to identify, evaluate,
and implement investment projects. When you look at an investment
project from the financial point of view, you should focus in the
magnitude, timing, and riskness of cash flows associated with it. In
addition, consider the options embedded in the investment project.
2. Capital Structure – once a firm has the investment project it wants to
undertake, it has to figure out ways and means of financing them. While
the unit of analyzing in the capital structure decision is the firm as a
whole and not the individual investment project. The key issue in capital
structure decision are- what is the optimal dept-equity ratio for the firm?
Which specific instrument of equity and dept finance should the firm
employ? Which capital markets should the firm access? When should the
firm raise finances? At what price should the firm offer its securities? An
allied issue is the dividend of the firm. What is the optimal dividend
payout ratio for the firm? Should the buy back its own shares? Capital
structure and dividend decisions should be guided by considerations of
cost and flexibility, in the main. The objective should be to minimize the
cost of financing without impairing the ability of the firm to raise finance
required for value creating investment project.
3. Working Capital Management (WCM) – Working capital management
also referred to as short-term financial management, refers to the day-to-
day financial, activities that deal with current assets ( inventories, short-
term holdings of market securities, and cash) and current liabilities
(Short-term dept, trade creditors, accruals, and provisions). The key
issues in WCM are: what is the optimal level of inventory for the
operations of the firm? Should the firm grant credit to its customers and,
if so, on what terms? How much cash should the firm carry on hand?
Where should the firm invest its temporary cash surpluses? What sources
of short-term finance are appropriate for the firm?

2. Investment decisions (or long-term assets-mix decision): These are long term
profitable decisions of the firm which enhance the value of the firm. Also
known as capital budgeting/expenditure decisions, these require huge
investments and related benefits arise in future. As future uncertain hence

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 the risk factor is high in investment decisions. Risks return tradeoff of
investment decisions directly affects the firm’s value in the market place.
These decisions thus help in buying and managing all assets of the firm.
Various techniques are adopted for the appraisal of various investment
decisions. These help to formulate acceptance criterion, or required rate of
return for the investment decisions. Efficient management of existing and
new investments is of paramount important as it brings as overall change in
the value of the firm which may be positive or negative. Positive change in
the value of the firm signifies a high rating by the investors.
3. Liquidity decisions (or short-term asset-mix decisions): These relate to
managing current assets of the firm in order to minimize ‘idle cash’ and
reduce the burden of unnecessary cost of financing the surplus cash.
4. Dividend decision (or profit allocation decision): These relate to rewarding
the owners of the firm i.e. Shareholders for investing their money with the
firm over of time. These rewards are given to the shareholders from the
operating profits the firm has earned, after meeting out all the related cost
and expenses.
5. Decisions Regarding Reporting, Monitoring and Controlling of Funds: These
functions enable efficient and effective financial decision making, leading to
optimum utilizations of financial resources to maximize the financial returns
to the organizations.
Thus all financial functions and related decision making determine the character
of the firm, its operating profits ( profits are lifeblood of every sector of industry
and commerce), business and financial risk, cash positions, expected return, and
overall value of the firm in the market. However financial functions and related
decision making have to be performed in line with the overall objective of the
firm.

Financial Procedures and Systems: For the effective execution of the functions,
certain other functions have to be routinely performed. The financial manager
concern procedures systems and involve a lot of paper work and time. They do not
require specialized skills of finance. Some of the important routine finance functions
are:-

1. Supervision of cash receipts and payments and safeguarding of cash

balance,
2. Custody and safeguarding of securities, insurance policies and other
valuable papers,

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 3. taking care of the mechanical details of new outside financing,
4. Record keeping and reporting.
The finance manager in the modern enterprises is mainly involved in the managerial
finance functions; the routine finance functions are carried out by executives at
lower levels. Financial manager’s involvement in the routine functions is confined
up of rules procedures, selecting forms to be used, establish standards for the
employment of competent personal and to check up the performance to see that the
rules observed and that the forms are properly used.

The involvement of the financial manager in the managerial financial functions is

recent. About two or three decades ago, the scope of finance functions or role of
financial manager was limited to routine activities.

1.5 Role of Finance Manager

How the scope of finance function has widened or the role of the finance manager
has changed is discussed in the following section.

A financial manager is a person who is responsible in a significant way to carry out

the finance functions. It should be noted at the outset that, in a modern enterprise,
the financial manager occupies a key position. He or she is one of the members of
the top management team, and his or her role, day-by-day, is becoming more
enveloping, intensive and significant in solving the complex management problems.
Now his or her functions are neither limited to that of a score-keeper maintaining
records, preparing report and raising funds when needed, nor is he or she a staff
officer-in a passive role of an advisor. The finance manager is now responsible for
shaping fortunes of the enterprise, and is involved in the most vital decision of the
allocation of capital. In his or her new role, he or she needs to have a broader and
far-sighted outlook, and must ensure that the funds of the enterprise are utilized in
the most efficient manner. He or she must realize that his or her actions have far-
reaching consequences for the firm because they influence the size, profitability,
growth, risk and survival of the firm, and as a consequence, affect the overall value
of the firm. The financial manager, therefore, must have a clear understanding and
a strong grasp of the nature and scope of the finance functions.

The financial manager has not always been in the dynamic role of decision-making.
Till recently, he or she was considered to be an unimportant person, as the top
management decision-making was concerned. He or she became an important

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management person only with the advent of the modern or contemporary approach
to the financial management.

a. Raising of Funds

The traditional approach dominated the scope of financial management and limited
the role of the financial manager simply to raising of funds. It was during the major
events, such as promotion, reorganization, expansion or diversification in the firm
that the financial manager was called upon to raise funds. In his or her day-to-day
activities, his or her significant duty was to see that the firm had enough cash to
meet its obligations.

b. Allocation of Funds

In a modern enterprise, the basic finance function is to decide about the expenditure
decisions and to determine the demand for capital for expenditures. In other words,
the financial manager, in his or her role, is concerned with the efficient allocations
of funds. The allocation of funds is not a new problem, however. It did exist in the
past, but was not considered important enough in achieving the firm’s long run
objectives.

In his or her new role of using funds wisely, the financial manager must find a
rationale for answering the following three questions:

How large should an enterprise be, and how fast should it grow?

In what form should it hold its assets?

How should the funds required be raised?
c. Profit Planning

The functions of the financial manager may be broadened to include profit planning
functions. The term profit planning refers to the operating decisions in the area of
pricing, cost, and volume of output and the firm’s selection of product line. Profit
planning is, therefore, a pre-requisite for optimizing investment and financing
decisions. The cost structure of the firm, i.e. the mix of fixed and variables costs has
a significant influence on a firm’s profitability. Profit planning helps to anticipate
the relationships between volume, costs and profit and develop action plans to face
unexpected surprises.

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d. Understanding Capital markets

The financial manager has to deal with capital markets where the firm’s securities
are traded. He or she should fully understand the operations of capital markets and
the way in which securities are valued. He or she also know how risk is measured in
capital markets and how to cope with it as investment and financing decisions often
involve considerable risk.

The finance manager manages the existing assets of the firm and invests in the new
real assets. He or she makes investment decisions to buy real assets. Real assets
produce real cash flow to increase the value of existing shareholders and to attract the
potential investors. All decisions of the finance manager whether it be financing
decisions or investment decision, cannot be separated from the financial market where
the firm operates. Further every decision has to be taken in the light of risk return
tradeoff. Any opportunity which costs more than its benefits should not be accepted by
the finance manager.

Gone are the days when finance manager had to accomplish only the clerical, routine
transaction recording like preparing accurate accounting and financial statements,
paying expenses, receiving revenues and collection.

Today organizations have become large more complex. Finance now involves a
broader horizon where problem identification and decision making related to overall
management has gained prime important. New millennium finance manager is
concerned with all business activities that involve funds directly or indirectly.

ORGANIZATION
FINANCIAL MARKET

Financial Finance
Manage Existing investors &
Operations
potential investors
of the firm

CASH

CASH

Fig. Role of financial manager

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1.6 Principles of Financial Management (Goal of F.M)

The firm’s investment and financing decisions are unavoidable and continuous. In
order to make them rationally, the firm must have a goal. It is generally agreed in
theory that the financial goal of the firm should be the maximization of owners’
economics welfare. Owners’ economics welfare could be maximized by maximizing
the shareholders’ wealth as reflected in the market value of shares.

a. Profit Maximization

It means maximizing the rupees (or any other currency) income of firms. Firm
produce goods and services. They may function in a market economy, or in a
government-controlled economy. In a market economics, prices of goods and
services are determined in competitive markets. Firms in a market economy are
expected to produce goods and services desired by society as efficiently as possible.

Price system is the most important organ of a market economy indicating what
goods and services society wants. Goods and services in great demand commend
higher prices. This results in higher profit for firms; more of such goods and
services are produced. Higher profit opportunities attract other firms to produce
such goods and services. Ultimately, with intensifying competition an equilibrium
price is reached at which demand and supply match. In the case goods and services
which are not required by society, the price and profit fall. Such goods and services
are dropped out by producers in favour of more profitable opportunities. Price
system directs managerial efforts towards more profitable goods and services.
Prices are determined by the demand and supply conditions as well as the
competitive forces, and they guide the allocation of resources for various productive
activities.

b. Maximizing Profit After Taxes (PAT)

Here, from the above maximizing profit means maximizing PAT, in the sense of net
profit as reported in the profit and loss account (i.e. income statement) of the firm.
It can easily be realized that maximizing this figure will not maximize the economics
welfare of the owners. It is possible for a firm to increase PAT by selling additional
equity shares and investing the proceeds in low-yielding assets, such as the
government bonds. PAT would go up but earning per shares would go down.

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Note:-

Gross Profit (GP) = Sales - Cost of Sales

Operating Profit (OP) = Gross Profit (GP) – Selling Administrative and

General Expenses

Profit before Tax (PBT) = Operating Profit (OP) – Non-Operating Expenses

Profit after tax (PAT) or Net Profit or Net Income or Net Earning = Profit

before Tax (PBT) – Income Tax

c. Maximizing Earning Per Share (EPS)

If we adopt maximizing earning per share as the financial objective of the firm, this
is will not ensure the maximization of owners’ economics welfare. It is ignoring
timing and risk of the expected benefits. Apart from these problems, maximization
of earning has certain deficiencies as a financial objective. Maximizing of EPS
implies that the firm should make no dividend payments so long as funds can be
invested internally at any positive rate of return, however small. Such a dividend
may not always be to the shareholders’ advantage.

d. Shareholders’ Wealth Maximization (SWM)

The objective of SWM is an appropriate and operationally feasible criterion to

choose among the alternatives financial actions. It provides unambiguous measure
of what financial management should seeks to maximize in making investment and
financing decisions on behalf of owner (Shareholders). SWM means maximizing the
net present value (NPV) of a course of action to shareholders. The NPV of a course
of action is the difference between the present value of its benefits and present value
of its cost.

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