FINANCIAL MANAGEMENT UNIT-I

UNIT – I

INTRODUCTION TO FINANCIAL MANAGEMENT

CONCEPT AND DEFINITIONS:

FINANCIAL MANAGEMENT: is that managerial activity which is concerned with the planning
and controlling of the firm’s financial resources. ---- Wheeler

According to Soloman:

" Financial Management is concerned with the efficient use of important economic resource,
namely capital funds."

According to S.C. Kuchhal,

“Financial management deals with procurement of funds and their effective utilization in the
business.”

Guthmann and Dougall defines business finance as,

“The activity concerned with planning, raising, controlling and administering the funds used in the
business.”
***Nature of Financial Management:

Financial management is applicable to every type of organization, irrespective of the size, kind
or nature. Every organization aims to utilize its resources in a best possible and profitable way.

i) Financial Management is an integral part of overall management. Financial

considerations are involved in all business decisions. Acquisition, maintenance, removal
or replacement of assets, employee compensation, sources and costs of different capital,
production, marketing, finance and personnel decision, almost all decisions for that matter
have financial implications. Therefore, financial management is pervasive throughout the
organisation.

ii) The central focus of financial management is valuation of the firm. Financial decisions
are directed at increasing/ maximization/ optimizing the value of the institution.

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iii) Financial management essentially involves risk-return tradeoff. Decisions on

investment involve choosing of types of assets which generate returns accompanied by
risks. Generally higher the risk returns might be higher and vice versa. So, the financial
manager has to decide the level of risk the firm can assume and satisfy with the
accompanying return. Similarly, cheaper sources of capital have other disadvantages. So
to avail the benefit of the low cost funds, the firm has to put up with certain risks, so, risk-
return trade-off is there throughout.

iv) Financial management affects the survival, growth and vitality of the institution.
Finance is said to be the life blood of institutions. The amount, type, sources, conditions
and cost of finance squarely influence the functioning of the institution.

v) Finance functions, i.e., investment, raising of capital, distribution of profit, are performed
in all firms - business or non-business, big or small, proprietary or corporate undertakings.
Financial management is a concern of every concern including educational institutions.

vi) Financial management is a sub-system of the institutional system which has other
subsystems like academic activities, research wing, etc, In systems arrangement financial
subsystem is to be well-coordinated with others and other subsystems well matched with
the financial sub-system.

vii) Financial management of an institution is influenced by the external legal and

economic environment. The legal constraints on using a particular type of funds or on
investing in a particular type of activity, etc., affect financial decisions of the institution.
Financial management is, therefore, highly influenced/constrained by external
environment.

viii) Financial management is related to other disciplines like accounting, economics,

taxation, operations research, mathematics, statistics etc., It draws heavily from these
disciplines.

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***SCOPE / IMPORTANCE OF FINANCIAL MANAGEMENT:

The scope of financial management is very wide. It can be applied in various areas for decision
making. Financial management is one of the important parts of overall management, which is
directly related with various functional departments like personnel, marketing and production.
Some of the importance of the financial management is as follows:
Financial Planning
Financial management helps to determine the financial requirement of the business concern
and leads to take financial planning of the concern. Financial planning is an important part
of the business concern, which helps to promotion of an enterprise.
Acquisition of Funds
Financial management involves the acquisition of required finance to the business concern.
Acquiring needed funds play a major part of the financial management, which involve
possible source of finance at minimum cost.

Proper Use of Funds

Proper use and allocation of funds leads to improve the operational efficiency of the business
concern. When the finance manager uses the funds properly, they can reduce the cost of
capital and increase the value of the firm.
Financial Decision
Financial management helps to take sound financial decision in the business concern.
Financial decision will affect the entire business operation of the concern. Because there is
a direct relationship with various department functions such as marketing, production
personnel, etc.
Improve Profitability
Profitability of the concern purely depends on the effectiveness and proper utilization of
funds by the business concern. Financial management helps to improve the profitability
position of the concern with the help of strong financial control devices such as budgetary
control, ratio analysis and cost volume profit analysis.
Increase the Value of the Firm
Financial management is very important in the field of increasing the wealth of the investors
and the business concern. Ultimate aim of any business concern will achieve the maximum

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profit and higher profitability leads to maximize the wealth of the investors as well as the
nation.
Promoting Savings
Savings are possible only when the business concern earns higher profitability and
maximizing wealth. Effective financial management helps to promoting and mobilizing
individual and corporate savings.

EVOLUTION OF FINANCE FUNCTION:

Financial management came into existence as a separate field of study from finance function in
the early stages of 20th century. The evolution of financial management can be separated into three
stages:
1. Traditional stage (Finance up to 1940): The traditional stage of financial management
continued till four decades. Some of the important characteristics of this stage are:
i) In this stage, financial management mainly focuses on specific events like formation expansion,
merger and liquidation of the firm.
ii) The techniques and methods used in financial management are mainly illustrated and in an
organized manner.
iii) The essence of financial management was based on principles and policies used in capital
market, equipments of financing and lawful matters of financial events.
iv) Financial management was observed mainly from the prospective of investment bankers,
lenders and others.
2. Transactional stage (After 1940): The transactional stage started in the beginning years of
1940’s and continued till the beginning of 1950’s. The features of this stage were similar to the
traditional stage. But this stage mainly focused on the routine problems of financial managers in
the field of funds analysis, planning and control. In this stage, the essence of financial management
was transferred to working capital management.
3. Modern stage (After 1950): The modern stage started in the middle of 1950’s and observed
tremendous change in the development of financial management with the ideas from economic
theory and implementation of quantitative methods of analysis. Some unique characteristics of
modern stage are:

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i) The main focus of financial management was on proper utilization of funds so that wealth of
current share holders can be maximized.
ii) The techniques and methods used in modern stage of financial management were analytical and
quantitative.
Since the starting of modern stage of financial management many important developments took
place. Some of them are in the fields of capital budgeting, valuation models, dividend policy,
option pricing theory, behavioral finance etc.

**OBJECTIVES OF FINANCIAL MANGEMENT:

The Objectives of Financial Management may be broadly divided into two parts such as:
1. Profit maximization
2. Wealth maximization.

I. Profit maximization : The ultimate aim of the business concern is earning profit, hence, it
considers all the possible ways to increase the profitability of the concern. Main aim of any kind
of economic activity is earning profit. A business concern is also functioning mainly for the
purpose of earning profit. Profit is the measuring techniques to understand the business efficiency
of the concern. Profit maximization is also the traditional and narrow approach, which aims at,
maximizes the profit of the concern.

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II. Wealth maximization: The term wealth means shareholder’s wealth or the wealth of the
persons those who are involved in the business concern. Wealth maximization is also known as
value maximization or net present worth maximization. Wealth maximization is superior to the
profit maximization because the main aim of the business concern under this concept is to improve
the value or wealth of the shareholders.

PROFIT MAXIMISATION Vs WEALTH MAXIMISATION:

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*****ROLE / FUNCTIONS OF FINANCE MANAGER:

Finance manager is one of the important role players in the field of finance function.
He must have entire knowledge in the area of accounting, finance, economics and
management. His position is highly critical and analytical to solve various problems related
to finance. A person who deals finance related activities may be called finance manager.
Finance manager performs the following major functions:

1. Estimating financial requirements:

The first task of a financial manager is to estimate short term and long term financial requirements
of his business. For that, he will prepare a financial plan for present as well as for future. The
amount required for purchasing fixed assets as well as needs for working capital will have to be
ascertained.
2. Deciding capital structure:
Capital structure refers to kind and proportion of different securities for raising funds. After
deciding the quantum of funds required it should be decided which type of securities should be
raised. It may be wise to finance fixed assets through long term debts. Even here if gestation period
is longer than share capital may be the most suitable. Long term funds should be employed to
finance working capital also, if not wholly then partially. Entirely depending on overdrafts and
cash credits for meeting working capital needs may not be suitable. A decision about various
sources for funds should be linked to the cost of raising funds.

3. Selecting a source of finance:

An appropriate source of finance is selected after preparing a capital structure which includes share
capital, debentures, financial institutions, public deposits etc. If finance is needed for short term
periods then banks, public deposits and financial institutions may be the appropriate. On the other
hand, if long term finance is required then share capital and debentures may be the useful.
4. Selecting a pattern of investment:
When funds have been procured then a decision about investment pattern is to be taken. The
selection of an investment pattern is related to the use of funds. A decision will have to be taken

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as to which assets are to be purchased? The funds will have to be spent first on fixed assets and
then an appropriate portion will be retained for working capital and for other requirements.

5. Proper cash management:

Cash management is an important task of finance manager. He has to assess various cash needs at
different times and then make arrangements for arranging cash. Cash may be required to purchase
of raw materials, make payments to creditors, meet wage bills and meet day to day expenses. The
idle cash with the business will mean that it is not properly used.
6. Implementing financial controls:
An efficient system of financial management necessitates the use of various control devices. They
are ROI, break even analysis, cost control, ratio analysis, cost and internal audit. ROI is the best
control device in order to evaluate the performance of various financial policies.
7. Proper use of surpluses:
The utilization of profits or surpluses is also an important factor in financial management. A
judicious use of surpluses is essential for expansion and diversification plans and also in protecting
the interests of share holders. The ploughing back of profits is the best policy of further financing
but it clashes with the interests of share holders. A balance should be struck in using funds for
paying dividend and retaining earnings for financing expansion plans.

8.Forecasting Profits:

The Financial manager is usually responsible for collecting the relevant data to make forecasts of
profit levels in future.

9.Measuring Required Return:

The acceptance or rejection of an investment proposal depends on whether the expected return
from the proposed investment is equal to or more than the required return. An investment project
is accepted if the expected return is equal or more than the required return. Determination of
required rate of return is the responsibility of the financial manager and is a part of the financing
decision.

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10.Managing Assets:

The function of asset management focuses on the decision-making role of the financial manager.
Finance personnel meet with other officers of the firm and participate in making decisions
affecting the current and future utilization of the firm’s resources.

11.Managing Funds:

In the management of funds, the financial manager acts as a specialised staff officer to the Chief
Executive of the company. The manager is responsible for having sufficient funds for the firm to
conduct its business and to pay its bills.

***** FUNCTIONS OF FINANCIAL MANAGEMENT (OR) FINANCE FUNCTIONS /

DECISIONS OF FINANCE MANGER:

The functions of financial management can be divided as:

I. INVESTMENT DECISIONS

II. FINANCING DECISIONS

III. DIVIDEND DECISIONS

IV. LIQUIDITY DECISION

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I. INVESTMENT DECISIONS: Investment decisions also known as “capital budgeting

decision”. Investment Decision relates to the determination or selection of total amount of funds
to be invested in long-term business plans.

Capital budgeting is the process of making investment decisions in capital expenditure. These are
expenditures, the benefits of which are expected to be received over a long period of time
exceeding one year.

The investment decisions can be classified under two broad groups; (i) long-term investment
decision and (ii) Short-term, investment decision. The long-term investment decision is referred
to as the capital budgeting and the short-term investment decision as working capital management.

II.FINANCING DECISIONS: It is also known as “Capital Structure Decisions”.

The financing decisions relate to the proportion or combination of debt and equity mix.

Capital Structure: is the mix of a firm’s permanent long-term financing represented by debt,
preferred stock, and equity.

The raising of more debts will involve fixed interest liability and dependence upon outsiders. It
may help in increasing the return on equity but will also enhance the risk. The raising of funds
through equity will bring permanent funds to the business but the shareholders will expect higher
rates of earnings. The financing decision is not only concerned with how best to finance new asset,
but also concerned with the best overall mix of financing for the firm.

III.DIVIDEND DECISIONS: The term dividend refers to that part of profits of a company which
is distributed by it among its shareholders. It is the reward of shareholders for investments made
by them in the share capital of the company. The dividend decision is concerned with the quantum
of profits to be distributed among shareholders. A decision has to be taken whether ail the profits
are to be distributed, to retain all the profits in business or to keep a part of profits in the business
and distribute others among shareholders. The higher rate of dividend may raise the market price
of shares and thus, maximise the wealth of shareholders. The firm should also consider the
question of dividend stability, stock dividend (bonus shares) and cash dividend.

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IV.LIQUIDITY DECISION: It is the investment decision on current assets affects the firm’s
profitability and liquidity. The term liquidity implies the ability of the firm to meet bills and the
firm’s cash reserves to meet emergencies whereas profitability aims to achieve the goal of higher
returns. Liquidity and profitability are closely related. Obviously, liquidity and profitability goals
conflict in most of the decisions. The finance manager always perceives / faces the task of
balancing liquidity and profitability. Lack of liquidity in extreme situations can lead to the firm’s
insolvency.

Goals (or) mission and objectives of Firm’s:

The mission statement of the firm underline the basic motive behind the objectives or goals of the
firm.

The goals of firm can be divided into:

I. Non-financial goals
II. Financial goals
I.Non-financial goals:
a. Enhancing employee satisfaction and welfare
b. Management satisfaction
c. Social objective
d. Quality product to the customer
e. Quality service to the customer
II.Financial goals:
a. Maximization of profits
b. Maximizing the shareholder’s wealth
c. Maximizing the EPS or Target market share
d. Sustaining and maintaining the business position
e. Maintaining financial liquidity and solvency
Maximization Vs Satisfying in Financial Management:
The maximization of profits is not only important objective, the business organizations have to
maximize and the satisfying the following areas:
• Maximizing the profits

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• Maximizing the shareholder’s wealth

• Maximizing the market value per share
• Maximizing the Earning Per Share
• Maximizing the assets value
Along with the maximization goal the business organizations have to satisfy the following:
• Satisfying the society
• Satisfying the shareholders
• Social welfare
• Customer satisfaction
• Satisfying the employees
• Satisfying the financiers
• Satisfying the government

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