Financial Management

Financial Management

Introduction to FinanceFinance Functions- Three approaches

I-Provision of money at the time it is wanted.

2- Management of Cash and maintaining the liquidity of funds.3- Procurements of Funds as well as their effective utilization & Financial decision making.

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

Importance of Finance FunctionsFinance function Interrelated with

Production Personnel Marketing

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 and enterprise goal”.

MEANING AND DEFINITION OF FINANCIAL MANAGEMENT (contd..)

• “Financial management is concerned with the efficient use of an important economic resource, namely capital funds” - Solomon Ezra & J. John Pringle.

• “Financial management is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient business operations”- J.L. Massie

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 the growing complexities associated thereto.

FINANCE AND OTHER RELATED DISCIPLINES

Finance and EconomicsThe 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 in financial management is marginal analysis. Most of the financial decisions should be made taken into account the marginal revenue and marginal cost. So, every financial manager must be familiar with the basic concepts of micro economics.

• Macro economics is concerned with the institutional structure of the banking system, money and capital markets, monetary, credit and fiscal policies etc. So, the financial manager must be aware of the broad economic environment and their impact on the decision making areas of the business firm.

Finance and AccountingAccounting and finance are closely related. Accounting is

an important input in financial decision making process. Accounting is concerned with recording of business transactions. It generates information relating to business transactions and reporting them to the concerned parties. The end product of accounting is financial statements namely profit and loss account, balance sheet and the statements of changes in financial position. The information contained in these statements assists the financial managers in evaluating the past performance and future direction of the firm (decisions) in meeting certain obligations like payment of taxes and so on. Thus, accounting and finance are closely related.

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.

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 manager must be familiar with the basic concept of ideas of marketing.

Finance and Quantitative Methods

Financial management and Quantitative methods are closely related such as linear programming, probability, discounting techniques, present value techniques etc. are useful in analyzing complex financial management problems. Thus, the financial manager should be familiar with the tools of quantitative methods. In other way, the quantitative methods are indirectly related to the day-to-day decision making by financial managers.

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 to understand, plan and manage cost, through appropriate tools and techniques including Budgeting and Activity Based Costing.

Finance and Law

A sound knowledge of legal environment, corporate laws, business laws, Import Export guidelines, international laws, 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 money from the capital markets. Similarly, now many Indian corporate are sourcing from international capital markets and get their shares listed in the international exchanges. This calls for sound knowledge of Securities Exchange Commission guidelines, dealing in the listing requirements of various international stock exchanges operating in different countries.

Finance and Taxation

A sound knowledge in taxation, both direct and indirect, is expected of a finance manager, as all financial decisions are likely to have tax implications. Tax planning is an important function of a finance manager. Some of the major business decisions are based on the economics of taxation. A finance manager should be able to assess the tax benefits before committing funds. Present value of the tax shield is the yardstick always applied by a finance manager in investment decisions.

Finance and Treasury Management

Treasury has become an important function and discipline, not only in banks, but in every organization. Every finance manager should be well grounded in treasury operations, which is considered as a profit center. It deals with optimal management of cash flows, judiciously investing surplus cash in the most appropriate investment avenues, anticipating and meeting emerging cash requirements and maximizing the overall returns, it helps in judicial asset liability management. It also includes, wherever necessary, managing the price and exchange rate risk through derivative instruments. In banks, it includes design of new financial products from existing products.

Finance and Banking• Banking has completely undergone a change in today’s

context. The type of financial assistance provided to corporate has become very customized and innovative. During the early and late 80’s, commercial banks mainly used to provide working capital loans based on certain norms and development financial institutions like ICICI, IDBI, and IFCI used to provide long term loans for project finance. But, in today’s context, these distinctions no longer exist. The same bank provides both long term and short term finance, besides a number of innovative corporate and retail banking products, which enable corporate to choose between them and reduce their cost of borrowings. It is imperative for every finance manager to be up-to date on the changes in services & products offered by banking sector including several foreign players in the field..

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 manager’s scope of work & responsibilities

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 through software packages including ERP. The finance manager takes an active part in assessment of various available options, identifying the right one and in the implementation of such packages to suit the requirement

International Finance• Capital markets have become globally integrated. Indian companies

raise equity and debt funds from international markets, in the form of Global Depository Receipts (GDRs), American Depository Receipts (ADRs) or External Commercial Borrowings (ECBs) and a number of hybrid instruments like the convertible bonds, etc., Access to international markets, both debt and equity, has enabled Indian companies to lower the cost of capital.

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

Finance managers are expected to have a thorough knowledge on international sources of finance, merger implications with foreign companies, 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 projected profitability and cash flow estimates. This is an essential aspect of finance manager’s expertise

OBJECTIVES OF FINANCIAL MANAGEMENT

The objectives of Financial Management can be put into two categories:

1.Basic Objectives2.Other objectives

Basic Objectives1.Profit Maximization - Traditional objective.The arguments put in support of Profit 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 profit criterion.

• Profit maximization ensures maximum return to the shareholders, 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 quite essential for the successful functioning of an economy.

Contd….• All business decisions are taken keeping in view the

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

• Profits are the main sources of finance for the growth and efficiency of a business.

• Profits serve as a protection against risks.• Profit is not only an objective, but also a measuring rod or

criterion of efficient, effective and economic utilization of financial 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 and

straightforward statement of the objectives.

Criticisms against profit maximization concept

• Profit maximization is an out-dated objective.• Profit maximization is a vague concept. This concept

does not clarify as to which profits are to be maximized, short-term profits or long-term profits, or the absolute amount of profits or the rate of profits. Again, the term profit itself is vague. It can vary widely depending upon the principles of accounting applied.

• A more important technical objection to the profit maximization, as a guide to financial decision-making, is that it ignores the differences in the time pattern of the benefits received over the working life of the asset, irrespective of when they were received

Contd…• The concept of profit maximization ignores the factors of risk

and uncertainty. That is, the profit maximization concept considers profit maximization as the only objective of a business undertaking, and ignores the factor of risk and uncertainty to which a business unit is exposed. But profit maximization cannot 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 are prepared to accept lower profits in order to have growth in the volume 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 at the cost of social and moral obligations and ethical trade practices is not a good business policy. All these qualitative aspects of business activities are ignored by the concept of profit maximization.

Contd…Again there are several forces, which work against the objective of profit

maximization. They are • Profit maximization involves an element of risk. Higher profits involve

greater risk. So a business would like to have normal or fair profit rather than maximum profit

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

• When a firm maximizes its profits, the workers of the firm would demand 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 more taxes, 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 not

considered in the objective of profit maximization.

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 only vague and ambiguous but it also ignores two important dimensions of financial analysis, namely, risk and time value of money

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 Company’s share.

Steps for Wealth Maximization

• Avoid high levels of risk• Regular dividend• Maintain growth in sales• Maintain price of firm’s equity share• Adopting sound investment policies

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 of discount, while discounting the cash flows or cash benefits from the projects.

• This concept allows dividend policy of the company to have its effect on the market value.

• The objective of wealth maximization also contributes to the maximization of other objectives of financial management

• Wealth maximization objective not only serves the interests of the shareholders by increasing the value of their holdings, but also ensures security to the lenders.

Limitations of Wealth Maximization

• Maximization of wealth is subject to the social responsibilities of the firm. The firm cannot ignore social responsibilities.

• Maximization of wealth is also subject to Govt. restrictions. The various statutory provisions enacted by the Govt. to protect the interests of the society reduce the freedom of a business firm in its efforts to maximize wealth.

• The objective of wealth maximization is not necessarily socially desirable.

Wealth Maximization V/s Profit Maximization

From the above discussion, it is clear that, of the basic objectives of financial management, viz., profit maximization and wealth maximization, the objective of wealth maximization is more appropriate and satisfactory. As Prof. Ezra Solomon has said “Maximization of wealth provides the more useful and meaningful guidance than the maximization of profits for the evaluation of financial action or decision”.The objective of wealth maximization is superior to the objective of profit maximization in the following respects.

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 factor by 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.

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

SCOPE AND FUNCTIONS OF FINANCIAL MANAGEMENT

Financial Management today covers the entire gamut of activities and functions given below. The head of finance is considered to be importantly of the CEO in most organizations and performs a strategic role. The functions of Financial Management can be divided into two groups-

Executive Functions Routine Functions

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

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;

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 financial

markets• Increasing the firm’s competitive financial strength in the

market• Adhering to the requirements of corporate governance• Preparations of various financial statement• Providing top management with information on current and

prospective financial condition of the business as a basis for policy decision on purchases, marketing and pricing.

Routine functions Chart

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

Managerial Finance Functions ( contd…)

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 become more important, complex and demanding. The key challenges are, inter-alia, in the areas specified below

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

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

3. Dividend decisions, issue of Bonus Shares and retention of profits 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).

Emerging Role of Finance Managers (contd…)

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

7. Tax administration and tax planning.8 . Pricing, volume of output, product-mix and

cost- volume-profit analysis (CVP Analysis).9. Cost control.10. Stock Market— Analyse the trends in the

stock market and their impact on the price of Company’s share.

Liquidity V/s Profitability

The Finance Manager always faced with the dilemma of Liquidity V/s Profitability. He has to 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.

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.

Capital Budgeting Decisions

Capital Structure Decisions

Dividend Decisions

Working Capital Decisions

Return

Risk

Market Value ofthe Firm

RISK RETURN TRADE OFF

ORGANISATION OF FINANCE FUNCTIONSince finance is major/critical functional area, the

ultimate responsibility for carrying out financial management functions lies with the top management, ie., board of directors /managing director/chief executive or the committee of the board. However, the exact nature of the organization of the financial management function differs from firm to firm depending upon factors such as size of the firm, nature of business, type of financial operations, ability of financial officers and the financial philosophy, and so on.

ORGANISATION OF FINANCE FUNCTION(Contd..)Similarly, the designation of the chief executive of

the finance department also differs widely in case 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

Organisation of Finance Function

50

Organization for finance functionOrganization for finance function in

a multidivisional company

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 oversees whether funds are correctly applied.

Functions of Treasurer and Controller

• Provision of capital• Maintaining relationship with

banks ,financial institutions and investors

• Arranging short term finance• Credit management• Cash Management• Receivables Management• Cost Control• Protection of funds

• Accounting functions• Preparation of annual report

financial report & interpretation

• Planning & Budgetary control• Statutory audit & internal

audit• Tax Administration• Internal control• Govt. Reporting• Protection of assets• Economic appraisal

Importance of Financial Management

• In every Organization where funds are involved, sound financial management is necessary, sound financial management is essential in both profit and non-profit organizations. The Financial management helps in maintaining the effective development of funds in fixed assets and in working capital. The finance manager assesses the financial position of the company through the working out of the return on capital, debt-equity ratio, cost of the capital from each source etc., comparison of the capital structure with that of similar companies.

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 enough

funds 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.