FINANCIAL MANAGEMENT

Financial Management

Introduction to Financial Management

 Financial management refers to efficient acquisition, allocation and usage of funds by a

company for its smooth working.
 The main objectives of financial management are to reduce the expenses involved in
procuring funds, to control risk and to achieve effective deployment of funds.

Importance of Financial Management

 The role of financial management is as such that it has a direct impact on all the
financial aspects/activities of a company. Certain aspects affected by financial
management decisions are
1. Size and composition of fixed assets: The amount of money invested in fixed
assets is an outcome of investment decisions. So, if more amount of capital is
decided to be invested in fixed assets, then it will increase the value of the
total share of fixed assets by the amount invested.
2. Amount and composition of current assets: The quantum of current assets and its
constituents like cash, bills receivable, inventory etc. is also influenced by
management decisions. It is also dependent on the amount invested in fixed
assets, decisions about credit and inventory management etc.
3. Amount of long-term and short-term funds to be used: Financial management
determines the quantum of funds to be raised for the short term and long term.
In case a firm requires more liquid assets, then it will prefer to have more
long-term finance even
when their profits will decrease due to payment of more interest in comparison
to short- term debts.
4. Proportion of debt and equity in capital: Financial management also takes
decisions regarding the proportion of debt and/or equity.
5. All items in profit and loss account: All items in the profit and loss account are
affected
by financial management decisions. For example, higher amount of debt will
lead to increase in the expense in the form of interest payment in the future.

Objectives
1. The basic objective of financial management is to maximise the wealth of shareholders.
2. It aims at taking financial decisions which prove beneficial for shareholders. Such
financial decisions are taken wherein the anticipated benefits exceed the cost
incurred. This in turn implies
an improvement in the market value of shares.

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3. An increase in the market value of shares is gainful for shareholders.
4. It focusses on taking those financial decisions which lead to value addition for the
company, so
the price of the equity share rises.
5. As this basic objective gets fulfilled, other objectives such as optimum utilisation
of funds, maintenance of liquidity etc. are also fulfilled automatically.
6. It involves choosing the best alternative which will prove to be beneficial.

Types of Financial Management

Financial management is mainly concerned with the following decisions:

A. Investment Decisions
A firm must decide where to invest the funds such that it can earn maximum returns.
Such decisions are known as investment decisions and can be classified as long-term and
short-term investment decisions.
 Long-term investment decisions:
o It refers to long-term investment decisions such as investment in a new fixed
asset, new machinery or land.
o They are also known as capital budgeting decisions.
It affects a firm’s long-term earning capacity and profitability and also has long-
term implications on the business.
o Moreover, such investment involves a large amount of money, so it is very difficult to
revert such decisions.
o Example: Decision to purchase a new fixed asset, opening a new branch etc.

 Short-term investment decisions

o These decisions are also known as working capital decisions and affect day-to-day
business operations.
o It also affects the liquidity and profitability of a business.
o Example: Decisions related to cash management, inventory management etc.

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Factors Affecting Capital Budgeting Decisions

B. Financial Decisions
 Financing decisions involve decisions with regard to the volume of funds to be raised
from various sources.
 These decisions also include identification of sources of finance.
 There are two main sources of raising funds, namely shareholders’ funds (equity) and
borrowed funds (debt).
 Taking into consideration factors such as cost, risk and profitability, a company must
decide an optimum combination of debt and equity.
 For example, while debt proves to be cheaper than equity, it involves greater financial risk.
 Financial decisions must be taken judiciously as they have an impact on the overall cost
of capital
of the firm and also involves financial risk.
 Generally, a mixture of both debt and equity funds proves to be beneficial for the
company.

Difference between debt and equity as a source of finance

Equity Debt
 Includes equity share capital and retained  Includes funds raised through
earnings debentures, loans and other forms of
 No fixed charges and commitments related debt
to payment of interest and payment of  Fixed interest and repayment
capital
obligations i.e. financial risk is involved

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Factors affecting the Financial Decision
Cost Cost of raising funds is an important factor taken into
consideration while
choosing a source of fund. Generally, the source of fund which is
the cheapest will be chosen.
Risk Risk involved in each source of fund is different. However,
funds with
moderate or low risk are chosen.
Flotation Cost Higher the flotation cost, less attractive is the source of fund.

Cash Flow Position Cash flow position of a company also impacts its decision when
choosing a
source of fund. A company with a strong cash flow position will
invest in debt, whereas a company with a weak cash flow position
will opt for investment in equity.
Fixed Operating Cost Companies having a high fixed operating cost must refrain from
investing in
debt, whereas companies with less financing cost may opt for
investing more in debt. This is because fixed operating costs like a
building or rent require a lot of finance. Hence, the company must
avoid sources of finance which will add more to their expenses.
Control Companies which do not want to dilute the level of control must
Considerations invest in
debt, as investing in equity will result in dilution of
management’s control over the business.
State of capital market The status of the capital market is also a crucial factor in
determining the
choice of the source of fund. In case the market is bullish,
more people invest in equity, whereas when the market is
bearish, it is difficult for companies to issue equity shares.
C. Dividend Decisions
 Dividend decisions involve decisions regarding how the company would distribute
its profit or surplus.
 Dividend is basically a part of profit which is distributed to shareholders.
 The company decides whether to distribute it to equity shareholders in the form of
dividends or to keep it in the form of retained earnings.
 So, the main decision is regarding how much profit is to be distributed and how much is
to be retained in the business.
 This decision is generally taken considering the objective of maximising shareholder’s
strength and also retaining earnings to increase the future earning capacity of the
organisation.
Factors affecting the Dividend Decision
1) Amount of earning  A firm decides the dividends to be paid on the basis of its current
and
past earnings.

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 If the company has higher earnings, then it would be in a
better
position to pay dividends.
 As against this, if a company has low earnings, it would be
able to pay lower dividends.
2) Stable earnings  A company with stable or smooth earnings can pay higher
dividends to shareholders than a company which has unstable
and uneven earnings.
3) Stable  Generally, companies try to stabilise their dividends such that
dividends there is not
much fluctuation in the dividends they distribute.
 They opt for increasing the dividends only when there is a
consistent increase in their earnings.
4) Growth  Companies with higher growth prospects prefer to retain a
prospects greater portion of their earnings for future reinvestment.
 Accordingly, they pay lesser dividends.

5) Cash flow  Payment of dividends implies a cash outflow from the company.
position If a company has less cash (low liquidity), then it will pay less in
the form of dividends. Similarly, if a company has surplus cash
(high liquidity), then it
will pay out more dividends.
6) Preference of  The preference of shareholders must also be considered while
shareholders taking
dividend decisions.
 For instance, if the shareholders prefer that a certain minimum
amount of dividends be paid, then the company is likely to
declare the same.
7) Taxation policy  Taxation policy of the government is an important factor in
taking the dividend decision.
 For instance, if the rate of taxation on payment of dividend by
companies is high, then the company may distribute less by way
of dividends.

8) Stock market  Dividend decisions taken by a company affect the market

reactions price of its
stock.
 If a company declares higher dividends, then it is seen
positively by investors, and its stock price increases.
 On the other hand, a fall in the dividends would have an
adverse effect on the stock price of a company.
9) Contractual  Sometimes, a company may enter a contractual agreement with
constraints the
lenders which restrict or shape their dividend decisions.
 Such agreements must be kept in mind while taking dividend
decisions.
10) Access to  Generally, large companies having greater access to the capital
capital market market
would not depend on retained earnings to finance their future
projects. Hence, they are likely to pay higher dividends.
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11) Legal  Companies mandatorily need to adhere to the rules and policies
constraints of the
Companies Act.
 The dividend decisions must be taken in careful consideration of
these rules and policies.
 Apart from these provisions, if the company enters into a loan
agreement wherein the lender lays certain restrictions on the
payment of dividend in future, then the company will have to
adhere to those restrictions.

Financial Planning

Financial planning involves designing the blueprint of the overall financial operations of a
company such that the right amount of funds are available for various operations at the
right time.

Main Objectives of Financial Planning

1) Identifying the sources from where the funds can be raised and ensuring that the required
funds are available to the firm as and when needed. For this, under financial planning, an
estimation is made regarding the amount of funds which would be required for various
business operations. In addition,
an estimation is made regarding the time at which the funds would be needed.
2) To ensure that there is proper utilisation of funds in the sense that there is neither
surplus nor
inadequate funding by the firm. In other words, it ensures that situations of both excess
or shortage of funds are avoided. This is because while inadequate funds obstruct
operations of the firm, excess fundingofleads
Importance to wasteful
Financial Planningexpenditure by the firm. Thus,
1) proper
Helps financial
in planning ensures optimal
 Forecasts utilisation
things that of funds by the firm.
are to happen
facing  Helps a business to prepare itself to face future situations in
eventual situations a better manner
 Prepares a blueprint depicting alternative situations and
equips management in advance to tackle changed prevailing
scenario
2) Improves  Helps in coordinating various business functions
Coordination  For example, coordinating the functions of the sales,
production and finance departments by providing clear rules,
policies and procedures

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3) Helps in  Ensures reduction of wastes, thereby leading to good

optimum management of funds
utilisation of funds
4) Evaluation  By providing detailed business objectives and depicting all the
of financial plans for varied business segments, it makes it easier
performance to evaluate
segment-wise business performance
5) Helps in avoiding  Helps a company to prepare itself for future shocks and surprises
surprises & shocks

6) Reduces wastage &  Detailed plans of action helps in reducing wastage and avoids
duplicity duplication of efforts

7) Acts as a link  Tries to link the present with the future

 Provides a link between investment and financing decisions

Differences between financial planning and financial management

Financial Planning Financial Management

 It is the process of estimating the  It refers to the efficient acquisition,
amount of allocation
funds which would be required by the and usage of funds of the company.
business and determining the sources
through which
these would be obtained.
 Financial planning aims at ensuring  Financial management aims at
smooth determining the
operations by considering the best investment alternative by
requirement of funds against their considering the relative costs and
availability. benefits.
 It has a narrow scope and is a part of  It has a wider scope.
financial
management.
 The objective is to ensure availability of  The objective is to manage various
funds activities
as and when required and that related to finance.
unnecessary fund raising is avoided. 8