Financial Management

Dr. Saurabh Pratap

IIIT DM JABALPUR
Introduction
 Financial Management means
 planning,

 organizing,

 directing and controlling the financial activities

 i.e procurement and utilization of funds of the enterprise. It means
applying general management principles to financial resources of the
enterprise.
Scope and Elements
 Investment decisions includes investment in fixed assets (called
as capital budgeting). Investment in current assets are also a
part of investment decisions called as working capital
decisions.
 Financial decisions - They relate to the raising of finance from
various resources which will depend upon decision on type of
source, period of financing, cost of financing and the returns
thereby.
 Dividend decision - The finance manager has to take decision
with regards to the net profit distribution. Net profits are
generally divided into two:
 Dividend for shareholders- Dividend and the rate of it has to be
decided.
 Retained profits- Amount of retained profits has to be finalized
Objectives
The financial management is generally concerned with procurement,
allocation and control of financial resources of a concern.
 To ensure regular and adequate supply of funds to the concern.
 To ensure adequate returns to the shareholders which will depend
upon the earning capacity, market price of the share, expectations of
the shareholders.
 To ensure optimum funds utilization. Once the funds are procured,
they should be utilized in maximum possible way at least cost.
 To ensure safety on investment,
 i.e, funds should be invested in safe ventures so that adequate rate of
return can be achieved.
 To plan a sound capital structure-There should be sound and fair
composition of capital so that a balance is maintained between debt
and equity capital.
Top 3 Types of Financial Decisions
Type # 1. Investment Decisions:
 determination of total amount of assets to be held in the
firm, the composition of these assets and the business
risk complexions of the firm as perceived by its investors.
It is the most important financial decision.

 funds involve cost and are available in a limited quantity,

its proper utilization is very necessary to achieve the goal
of wealth maximization.
Classification:
 Long-term investment decision
 Short-term investment decision and
 The long-term investment decision is referred to as the
capital budgeting and the short-term investment decision
as working capital management.

 The investment proposals should be evaluated in terms of

expected profitability, costs involved and the risks
associated with the projects.

 The investment decision is important not only for the

setting up of new units but also for the expansion of
present units, replacement of permanent assets, research
and development project costs, and reallocation of funds
 Short-term investment decision, on the other hand,
relates to the allocation of funds as among cash and
equivalents, receivables and inventories. Such a decision is
influenced by tradeoff between liquidity and profitability

 The reason is that, the more liquid the asset, the less it is
likely to yield and the more profitable an asset, the more
illiquid it is

 A sound short-term investment decision or working

capital management policy is one which ensures higher
profitability, proper liquidity and sound structural health
of the organization
Type # 2. Financing Decisions:
 Once the firm has taken the investment decision and
committed itself to new investment, it must decide the
best means of financing these commitments. Since, firms
regularly make new investments; the needs for financing
and financial decisions are ongoing

 a firm will be continuously planning for new financial

needs. The financing decision is not only concerned with
how best to finance new assets, but also concerned with
the best overall mix of financing for the firm.
 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 financial manager has to
strike a balance between various sources so that the
overall profitability of the concern improves
Type # 3. Dividend Decision:
 third major financial decision relates to the disbursement
of profits back to investors who supplied capital to the
firm. 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
 all 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, maximize the wealth of shareholders.
 The firm should also consider the question of dividend stability,
stock dividend (bonus shares) and cash dividend
What is capital budgeting?
 Capital budgeting is a process used by companies for
evaluating and ranking potential expenditures or
investments that are significant in amount.

 The large expenditures could include the purchase of new

equipment, rebuilding existing equipment, purchasing
delivery vehicles, constructing additions to buildings, etc.
The large amounts spent for these types of projects are
known as capital expenditures.
 Capital budgeting usually involves the calculation of each
project's future accounting profit by period, the cash flow
by period, the present value of the cash flows after
considering the time value of money, the number of years
it takes for a project's cash flow to pay back the initial
cash investment, an assessment of risk, and other factors.

 Capital budgeting is a tool for maximizing a company's

future profits since most companies are able to manage
only a limited number of large projects at any one time.
Capital Structure
 “Capital structure is essentially concerned with how the
firm decides to divide its cash flows into two broad
components, a fixed component that is earmarked to
meet the obligations toward debt capital and a residual
component that belongs to equity shareholders”
The importance of designing a proper
capital structure
 Value Maximization

 Cost Minimization

 Increase in Share Price

 Investment Opportunity

 Growth of the Country

Patterns of Capital Structure:
 Equity Shares and Debentures (i.e. long term debt
including Bonds etc.),
 Equity Shares and Preference Shares,
 Equity Shares, Preference Shares and Debentures (i.e. long
term debt including Bonds etc.).

However, irrespective of the pattern of the capital structure,

a firm must try to maximize the earnings per share for the
equity shareholders and also the value of the firm.
Working capital management
 Working capital management involves the relationship
between a firm's short-term assets and its short-term
liabilities. The goal of working capital management is to
ensure that a firm is able to continue its operations and
that it has sufficient ability to satisfy both maturing short-
term debt and upcoming operational expenses. The
management of working capital involves managing
inventories, accounts receivable and payable, and cash.
Why Firms Hold Cash
The finance profession recognizes the three primary
reasons offered by economist John Maynard Keynes to
explain why firms hold cash.
 Speculation
reason for holding cash as creating the ability for a firm to
take advantage of special opportunities that if acted upon
quickly will favor the firm.
An example of this would be purchasing extra inventory at
a discount that is greater than the carrying costs of holding
the inventory
 Precaution
Holding cash as a precaution serves as an emergency fund for a
firm. If expected cash inflows are not received as expected cash
held on a precautionary basis could be used to satisfy short-term
obligations that the cash inflow may have been bench marked for

 Transaction
Firms are in existence to create products or provide services.
The providing of services and creating of products results in the
need for cash inflows and outflows. Firms hold cash in order to
satisfy the cash inflow and cash outflow needs that they have
Float
 Float is defined as the difference between the book
balance and the bank balance of an account.
 For example, assume that you go to the bank and open a
checking account with $500. You receive no interest on the
$500 and pay no fee to have the account.
 Now assume that you receive your water bill in the mail and that it
is for $100. You write a check for $100 and mail it to the water
company. At the time you write the $100 check you also record the
payment in your bank register. Your bank register reflects the book
value of the checking account. The check will literally be "in the mail"
for a few days before it is received by the water company and may
go several more days before the water company cashes it.
 The time between the moment you write the check and the time
the bank cashes the check there is a difference in your book balance
and the balance the bank lists for your checking account. That
difference is float. This float can be managed. If you know that the
bank will not learn about your check for five days, you could take
the $100 and invest it in a savings account at the bank for the five
days and then place it back into your checking account "just in time"
to cover the $100 check.
Ways to Manage Cash
 Firms can manage cash in virtually all areas of operations
that involve the use of cash. The goal is to receive cash as
soon as possible while at the same time waiting to pay
out cash as long as possible. Below are several examples
of how firms are able to do this.
 Policy For Cash Being Held: Here a firm already is holding
the cash so the goal is to maximize the benefits from holding it
and wait to pay out the cash being held until the last possible
moment
 Assume that rather than investing $500 in a checking account
that does not pay any interest, you invest that $500 in liquid
investments. Further assume that the bank believes you to be a
low credit risk and allows you to maintain a balance of $0 in
your checking account.
  This allows you to write a $100 check to the water company
and then transfer funds from your investment to the checking
account in a "just in time" (JIT) fashion. By employing this JIT
system you are able to draw interest on the entire $500 up
until you need the $100 to pay the water company. Firms often
have policies similar to this one to allow them to maximize idle
cash.
 Sales: The goal for cash management here is to shorten
the amount of time before the cash is received. Firms that
make sales on credit are able to decrease the amount of
time that their customers wait until they pay the firm by
offering discounts.
  For example, credit sales are often made with terms such as 3/10 net
60. The first part of the sales term "3/10" means that if the customer
pays for the sale within 10 days they will receive a 3% discount on
the sale. The remainder of the sales term, "net 60," means that the
bill is due within 60 days. By offering an inducement, the 3% discount
in this case, firms are able to cause their customers to pay off their
bills early. This results in the firm receiving the cash earlier.

 Inventory: The goal here is to put off the payment of cash for
as long as possible and to manage the cash being held. By using
a JIT inventory system, a firm is able to avoid paying for the
inventory until it is needed while also avoiding carrying costs
on the inventory. JIT is a system where raw materials are
purchased and received just in time, as they are needed in the
production lines of a firm.
Goal of Financial Management
 Assuming that we restrict ourselves to for-profit
businesses, the goal of financial management is to make
money or add value for the owners. This goal is a little
vague, of course, so we examine some different ways of
formulating it to come up with a more precise definition.
Such a definition is important because it leads to an
objective basis for making and evaluating financial
decisions.
The possible financial goals with some ideas like the following:
 Survive.
 Avoid financial distress and bankruptcy.
 Beat the competition.
 Maximize sales or market share.
 Minimize costs.
 Maximize profits.
 Maintain steady earnings growth.
Profit Maximization
 Managerial economics allows firms to compute the price
of a product that would maximize profits.

 To do this, they need total revenue and total cost.

TR= P*Q
P is commodity price
Q is quantity dispatched/sell
 Total revenue is illustrated as an upward-sloping straight
line. Because your firm is a price taker in perfect
competition, the slope of the total revenue function is a
constant and corresponds to the market-determined
price.
Total cost has two components
— total fixed cost and total
variable cost. Total fixed cost is a
constant, so even if your firm
Total Profit
shuts down and produces zero
units of output, it still incurs
total fixed cost. In the
illustration, total fixed cost
corresponds to the point where
the total cost curve intersects
the vertical axis at TFC.
 Total profit is maximized at the output level where the
difference between total revenue and total cost is greatest. In
the illustration, this occurs at the output level q0. At the
output level q0, total revenue equals TR0, total cost
equals TC0, and total profit is the difference between
them.
 Economists use the terms profit and economic
profit interchangeably and it is defined as:

cost associated with production, including the opportunity cost of your time and financial
investment. Therefore, if economic profit equals zero, you stay in business. Zero economic
profit means you’re receiving exactly as much income in this situation as you will in your
next best alternative.
PRICE ELASTICITY OF DEMAND
 Mastering managerial economics involves calculating
values, with the ultimate goal of determining how to
maximize profit. The usefulness of the price elasticity of
demand depends upon calculating a specific value that
measures how responsive quantity demanded is to a price
change.

The symbol η represents the price elasticity of demand.

Q0 = initial quantity demanded that exists when the price equals P0.
Q1 = the new quantity demanded that exists when the price changes to P1.
 the price elasticity of demand will always be a negative
number. Price and quantity demanded always move in
opposite directions, hence the price elasticity of demand is
always negative.
 Example:
HOW TO DETERMINE PRICE: FIND ECONOMIC
EQUILIBRIUM BETWEEN SUPPLY AND DEMAND

 Business executives face an economic dilemma

in determining price: Customers want low prices, and
executives want high prices. Markets resolve this dilemma
by reaching a compromise price.
 The compromise price is the one that makes quantity
demanded equal to quantity supplied. At that price, every
customer who is willing and able to buy the good can do
so. And every business executive who wants to sell the
good at that price can sell it.
Wealth maximization
 Concept of increasing the value of a business in order to
increase the value of the shares held by stockholders.
 The concept requires a company's management team to
continually search for the highest possible returns on
funds invested in the business, while mitigating any
associated risk of loss.
 This calls for a detailed analysis of the cash flows
associated with each prospective investment, as well as
constant attention to the strategic direction of the
organization.
 The most direct evidence of wealth maximization is
changes in the price of a company's shares.
 For example, if a company spends funds to develop valuable
new intellectual property, the investment community is likely to
recognize the future positive cash flows associated with this
new property by bidding up the price of the company's shares.
Similar reactions may occur if a business reports continuing
increases in cash flow or profits.
  The concept of wealth maximization has been criticized,
since it tends to drive a company to take actions that are
not always in the best interests of its stakeholders,
 A company may minimize its investment in safety equipment in
order to save cash, thereby putting workers at risk.
 A company may continually pit suppliers against each other in
the unmitigated pursuit of the lowest possible parts prices,
resulting in some suppliers going out of business.
 A company may only invest minimal amounts in pollution
controls, resulting in environmental damage to the surrounding
area.
Because of these types of issues, senior management may find it necessary to back away from the sole
pursuit of wealth maximization, and instead pay attention to other issues, as well. The result is likely to be a
modest reduction in shareholder wealth.
Financial Statement: Balance Sheet
 A balance sheet is a statement of the financial condition of a business at a specific
time

 The balance sheet shows what is owned by a business, what is owed, and the
owner’s equity (or net worth) of the business

 By comparing past balance sheets with the present balance sheet, the growth or
decline of assets, liabilities and net worth can be determined

 The balance sheet is often called a net worth statement. The net worth is the value
that would be left if all of the business’s debt obligation were paid in full

 Assets may include cash on hand, bank accounts, accounts receivable, feed supplies,
livestock, equipment, buildings, land and other items
 Although each asset may not be completely paid for, its full

value is listed. The unpaid accounts, notes and mortgages are

listed as liabilities

 In many farm businesses, there is no sharp distinction between

business and family assets and liabilities

 The relationship of assets, liabilities and net worth is expressed as follows:
 Assets – Liabilities = Net Worth (Equity)
 Assets = Liabilities + Net Worth (Equity)

 A current asset is cash or other assets that can be quickly converted into
cash in the normal business processes within 1 year.
Uses of the Balance Sheet
 Lenders use the balance sheet to evaluate the financial position of most
loan applicants
 The balance sheet statement also can be extremely useful to the owner of
the business because it indicates the business’s net worth
 Comparing balance sheets over time shows how much the business net
worth is growing or decreasing.
 A balance sheet can be used by the owner of a business to support a
request for borrowed funds
 The balance sheet gives information on how best to meet liabilities.
 Comparing total current assets to total non-current helps determine
whether too much or too little capital is tied up in permanent investments
 A balance sheet provides the information for making these comparisons