INTRODUCTION TO FINANCIAL MANAGEMENT

INTRODUCTION TO FINANCIAL MANAGEMENTMeaning of Financial ManagementFinancial Management can be defined as the management of flow of funds and it deals with financial decision making. It encompasses the procurement of funds in the most economic manner and employment of these funds in the most optimum way to maximize the return for the owner. In simple words, financial management includes any decision made by a business/investor that affects its finances. Definition of Financial ManagementFinancial Management is the activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient operations. Joseph and Massie.Financial Management is concerned with the acquisition, financing and management of assets with some overall goal in mind Van Horne and Wachowicz.J.F. Bradlery :-financial management is the area of business management devoted to a judicious use 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

Three Major DecisionsThe functions of finance in a firm may be divided into three major decisions that the firm must make:

Financing decision

Investment decision

Dividend decisionFinancing DecisionHere the financial manager has to determine the proportion of debt and equity in capital structure.

A capital structure with a reasonable proportion of debt and equity capital is called the Optimal Capital Structure.

The objective is to minimize cost of capital.

It is a long term decisionInvestment DecisionThe investment decision relates to the selection of assets in which funds will be invested by a firm

The assets which can be acquired fall into two broad categories Long term assets (which yield return over a period of time) Capital Budgeting.Capital budgeting refers to selection of an asset or investment proposal or course of action whose benefits are likely to be available in future over the lifetime of the project.

Cont.Short term or current assets (convertible into cash usually within one year) Working Capital ManagementWCM is concerned with the management of current assets & current liabilities The key strategies and considerations in ensuring a trade-off between profitability and liquidity is one of the major dimensions of WCM

Dividend DecisionThe dividend should be analysed in relation to the financing decision of the firm. Two alternatives are available in dealing with the profits of a firm:They can be distributed to the shareholders in the form of the dividends They can be retained in the business itself.The decision as to which course should be followed depends largely on the significant dividend decision, the dividend pay out ratio, i.e. what proportion of net profits should be paid out to the shareholders.

Approaches to Financial ManagementTraditional ApproachThe traditional approach, which was popular in the early stage, limited the role of finance manager to raising of funds needed by the corporate enterprises to meet their financial needs. Looking after the legal and accounting relationship between a corporation and its sources of funds.Finance function was concerned with procuring of funds to finance the expansion or diversification activities and thus the occurrence of finance function was episodic in nature.

Cont.In order to finance business growth, there was an emergence of financial institutionsFinance function was viewed from the point of view of suppliers of funds i.e. lenders, both individuals and institutions. The emphasis was to consider the interest of the outsidersFocus was on the long term resources and only the long term finance was of any concern. Working capital management was virtually non-existent.

Cont.Treatment of different aspects of finance was more of a descriptive nature rather than analyticalFinance was concerned with procuring of funds primarily by issue of securities, so a knowledge of sources of funds, what securities to sell, to whom and by what techniques to sell, was needed

Procurement of funds by corporate enterprises to meet their financing needs

Criticism of Traditional ApproachBuilt around episodic events WCM was ignored.Focus on external funds internal funds were neglected.Procurement of funds was important - effective utilisation of funds was ignored.Emphasis on outsiders - no consideration to internal financing decisionsFocus on corporate enterprises non corporate organisations were left out of the scope of study.

Modern ApproachAccording to modern approach, the term financial management provides a conceptual and analytical framework for financial decision-making. Finance function is concerned with raising funds and their effective utilization both.The new approach views the term financial management in a broader sense. It is viewed as an integral part of over-all management.

Scope of Financial ManagementEstimating financial requirementsDeciding capital structureSelecting source of financeSelecting pattern of investmentCash managementProfit managementEvaluation of financial performanceEnsuring liquidityNegotiation for additional fundsAnalysing trends in stock prices

Functions of Finance ManagerExecutive finance function - Crucial for success of the organisation and high level of caliber is required

Determining allocation of net profitsDeciding about needs and sources of new outside financingCarrying out negotiations for outside fundingEstablishing and controlling cash flows

Functions of Finance ManagerIncidental finance function - Help managers to perform managerial functions and can be performed by lower level personnel as they do not involve much decision making

Record of receipts and payments Maintaining accounts Administrative work associated with managerial functionsPreparation of various financial statementsOrganization structure of finance function

17Functions of TreasurerProvision of financeInvestor relationsBanking and custodyCredit and collectionsInvestments

Functions of ControllerPlanning and controllingReporting and interpretingTax administrationGovernment reportingFinancial appraisalQualities of a Finance ManagerTechnical knowledgeVision and foresightCommunication skillsGood personalityIntelligenceInitiativeConfidenceHuman skillsINTERFACE OF FINANCE FUNCTION WITH OTHER FUNCTIONAL AREASAll business decisions have financial implications, and therefore, FM is inevitably related to almost every aspect of business operations Finance and MarketingFinance and HRFinance and R&DFinance and AccountingFinance and Production

Trading on EquityIt means using borrowed funds carrying a fixed charge in the expectation of obtaining a higher return to the equity shareholders

SourceA LtdB LtdEquity Share Capital10,00,0002,00,0008% Preference Share Capital-3,00,00010% Debentures -5,00,000Total Capital Employed10,00,00010,00,000Net Profit Before Tax 3,20,0003,20,000Assume tax @ 30%Trading on EquityFirm operates with less proportion of equity funds and more proportion of borrowed fundsEvery action that helps in increasing the returns on the owners funds must be undertaken by the finance manager because ultimate objective of FM is wealth maximisation of the shareholders. Shareholders gain by utilising the benefits of low cost borrowed fundsThis can be successfully implemented by only those companies with stability in their earnings or increasing earnings year after yearObjectives of Financial ManagementClear objectives provide a framework for optimum financial decision-making.

There are two widely accepted objectives

Profit MaximisationThose actions should be undertaken that maximise profits and those decrease profits are to be avoidedAll other business goals (social goals can be met only with adequate profits) so it should be maximized.

Criticism - Profit MaximisationProfits in absolute terms is not a proper guide to decision making. It should be expressed either on a per share basis or in relation to investment (PAT or PBT)

It leaves consideration of timing and duration undefined (how to compare profits now with the future profits or streams of profit)

Ignores risk (quality of benefits)

Wealth MaximisationMuch of the theory in corporate finance is based on the assumption that mangers should strive to maximise the value of the firmValue of the firm is equal to the value of its equity and debt claims Normally value of the debt claims remain fairly stableSo maximising value of the firm is equivalent to maximising the value of equityThe focus of FM is on the value to the owners or suppliers of equity capitalWealth MaximisationWealth maximisation implies the maximisation of the market price of sharesEmphasis is on raising present value of the owners investment by implementation of projects that will increase the market value of the firms securitiesRecognises riskRecognises the timing of returns by taking into account the trade-off between the various returns and the associated levels of riskConsiders the shareholders returns by taking into account the payment of dividend to shareholdersCriticism Wealth MaximisationPrices of shares may not reflect the intrinsic value

Firm should pursue product market goals like maximising market share, enhancing customer satisfaction, achieving zero-defect level

Balance between interest of various stakeholders