Financial

Management
 What is Financial Management ?
The planning, directing, monitoring, organizing,
and controlling of the monetary resources of an
organization.

It is an area of finance dealing with financial

decision business enterprise make and the
tools and analysis used to make this decision.

Financial Management can be defined as:

The management of the finances of a business
organization in order to achieve financial
objectives,
 Role of Financial Management

 Create wealth for the business

 Generate cash, and

 Provide a sufficient return on

investment bearing in mind the risks
that the business is taking and the
resources invested.
 Real And Financial Assets
•Real Assets: Can be Tangible or Intangible
o Tangible real assets are physical assets that
include plant, machinery, office, factory,
furniture and building.
o Intangible real assets include technical know-
how, technological collaborations, patents and
copyrights.
•Financial Assets are (also called securities) financial
papers or instruments such as shares and bonds or
debentures.

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 Equity and Borrowed Funds
• Shares represent ownership rights of their
holders. Shareholders are owners of the
company. Shares can of two types:
oEquity Shares
oPreference Shares
• Loans, Bonds or Debts: represent liability of
the firm towards outsiders. Lenders are not
owners of the company. These provide interest
tax shield.

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 Equity and Preference Shares

•Equity Shares are also known as ordinary shares.

o Do not have fixed rate of dividend.
o There is no legal obligation to pay dividends to
equity shareholders.
•Preference Shares have preference for dividend
payment over ordinary shareholders.
o They get fixed rate of dividends.
o They also have preference of repayment at the
time of liquidation.

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Agency Problems: Managers Versus Shareholders’

Goals
•There is a Principal Agent relationship between
managers and shareholders.

•In theory, Managers should act in the best interests

of shareholders.

•In practice, managers may maximise their own

wealth (in the form of high salaries and perks) at
the cost of shareholders.

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Agency Problems: Managers Versus Shareholders’

Goals
•Managers may perceive their role as reconciling conflicting
objectives of stakeholders. This stakeholders’ view of
managers’ role may compromise with the objective of SWM.

•Managers may avoid taking high investment and financing

risks that may otherwise be needed to maximize shareholders’
wealth. Such “satisfying” behaviour of managers will frustrate
the objective of SWM as a normative guide.

•This conflict is known as Agency problem and it results into

Agency costs.

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EVOLUTION OF FINANCIAL MANAGEMENT

Financial management has emerged as a distinct field of

study only in the early part of this century as a result of
consolidation movement and formation of large enterprises.
Its evolution may be divided into three phases viz.,
 The Traditional phase,
 The Transitional phase and
 Modern phase

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 Traditional approach
According to this approach, the scope of the
finance function is restricted to “procurement of
funds by corporate enterprise to meet their
financial needs.
The term ‘procurement’ refers to raising of funds
externally as well as the inter related aspects of
raising funds.
In traditional approach the resources could be
raised from the combination of the available
sources.
Limitations of traditional
approach
 This approach is confirmed to ‘procurement of funds’
only.
 It fails to consider an important aspects i.e. allocation
of funds.
 It deals with only outside I.e. investors, investment
bankers.
 The traditional approach fails to consider the problems
involved in working capital management.
 The traditional approach neglected the issues relating
to the allocation and management of funds and
failed to make financial decisions.
 Modern approach
 The modern approach is an analytical way of
looking into financial problems of the firm.

 According to this approach, the finance

function covers both acquisition of funds as
well as the allocation of funds to various uses.
 Financial management is concerned with the
issues involved in raising of funds and efficient
and wise allocation of funds.
Main Contents of Modern
approach

 How large should an enterprise be and how far

it should grow?

 In what form should it hold its assets?

 How should the funds required be raised?

- Financial management is concerned with

finding answer to the above problems.
 Sources of Finance
 Capital required for a business can be classified
under two main categories, viz.,

- Fixed Capital, and

- Working Capital.
- every business needs funds for two purposes.
- for its establishment and to carry out its day-to-
day operations.
 Sources of Finance

 Long term funds are required to create production

facilities through purchase of fixed assets such as
- plant,
- machinery,
- land,
- building,
- furniture, etc.
 Sources of Finance
- Investment in these asset represent that part of
firm’s capital which is blocked on permanent or
fixed basis and is called fixed capital.
 Funds are also needed for short-term purposes
for the purchase of raw materials, payment of
wages and other day to day expenses, etc. These
funds are known as working capital
Sources of Finance/Funds
 The financial requirements may be for a long term, medium term or short term.

Financial Requirements

Short-Term Medium-Term Long-Term

Bank Credit Issue of Debentures Issue of shares
Customer advances Issue of Preference shares Issue of Debentures
Trade Credit Bank Loan Ploughing back of
Public deposit / Fixed deposit profits
Loan from
Loans from financial institutions spec.financial
institutions
 ELEMENTS OF FINANCIAL
MANAGEMENT
1. Financial Planning:-
 Management need to ensure that enough funding
is available at the right time to meet the needs of
the business.

 In the short term, funding may be needed to invest

in equipment and shares, pay employees and fund
sales made on credit.

 In the medium and long term, funding may be

required for significant additions to the productive
capacity of the business or to make acquisitions.
 2. Financial Control:-
 Financial control is a critically important activity
to help the business ensure that the business is
meeting its objectives. Financial control
addresses questions such as:

 Are assets being used efficiently?

 Are the businesses assets secure?

 Do management act in the best interest of

shareholders and in accordance with business
rules?
 3. Financial Decision-making:-
 The key aspects of financial decision-making relate
to investment, financing and dividends:

 Investments must be financed in some way –

however there are always financing alternatives
that can be considered. For example it is possible
to raise finance from selling new shares, borrowing
from banks or taking credit from suppliers.

 A key financing decision is whether profits earned

by the business should be retained rather than
distributed to shareholders via dividends. If
dividends are too high, the business may be
starved of funding to reinvest in growing revenues
and profits further.
 OBJECTIVE OF FINANCIAL MANAGEMENT :

Maximization of Profit :
“Profit maximization” is a term which denotes
the maximum profit to be earned by an
organization in a given time period.
The profit- maximization goal implies that the
investment, financing and dividend policy
decision of the enterprise should be oriented
to profit maximization.

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21
Merits of the Profit – Maximization:
 Best Criterion on Decision-Making: The goal of profit –
maximization is regarded as the best criterion of the
decision of making as it provides a yard-stick to judge the
economic performance of the enterprises.
 Efficient allocation of Resources: It leads to efficient
allocation of scarce resources as they tend to be diverted
to those uses which, in terms of profitability, are the most
desirable.
 Optimum Utilization: Optimum utilization of available
resource is possible.
 Maximum Social Welfare
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 Drawbacks of Profit maximisation :

 Time Factor Ignored

 it is Vague
 The Term ‘Maximum’ is also Ambiguous
 It Ignores Time Value
 it Ignores the Risk Factor
 In new business environment profit maximization is regarded
as
 Unrealistic
 Difficult
 Inappropriate
 Immoral.

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 Wealth Maximization
 Maximizes the net present value of a course of action to
shareholders.
 Accounts for the timing and risk of the expected benefits.
 Benefits are measured in terms of cash flows.
 Fundamental objective—maximize the market value of
the firm’s shares.
 Another objective - Ensuring fair return to shareholder,
Building up reserves for growth and expansion, ensuring
financial discipline in the management

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 Maximizing return or EPS
 Ignores timing and risk of the expected benefit.
 Market value is not a function of EPS. Hence maximizing EPS
will not result in highest price for company's shares.
 Maximizing EPS implies that the firm should make no
dividend payment so long as funds can be invested at
positive rate of return—such a policy may not always work.

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Significance of Wealth- Maximization:
The company although it cares more for the economic welfare of
the shareholders, it cannot forget the others who directly or
indirectly work for the overall development of the company. Thus
Wealth- Maximization takes care of
 Lenders or creditors
 Workers or Employees
 Public or Society
 Management or Employer

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 Finance Manager’s Role
•Raising of Funds
•Allocation of Funds
•Profit Planning
•Understanding Capital Markets

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The Role of the Financial
Manager

 There are three finance functions

 Investment decision

 Financing decision

 Dividend decision
 Investment Decision
 Investment decision relates to selections of
asset in which funds will be invested by a firm.
 The asset that can be acquired by a firm may
be long term asset and short term asset.
 Decision with regard to long term assets is
called capital budgeting
 Decision with regard to short term or current
assets is called working capital management
 Capital Budgeting
 Capital budgeting relates to selection of an
asset or investment proposal which would yield
benefit in future. It involves three elements.
 The measurement of the worth of the proposal
 Evaluation of the worth of the investment
proposal against certain norms or standard.
The standard is broadly known as cost of
capital
 Risk-return Trade-off
• Financial decisions of the firm are guided by
the risk-return trade-off.
•The return and risk relationship:
Return = Risk-free rate + Risk premium
•Risk-free rate is a compensation for time and
risk premium for risk.

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 Risk Return Trade-off

Risk and expected return move in tandem; the greater the risk, the greater the
expected return.

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 Financing Decision
 Determination of the proportion of equity and
debt is the main issue in financing decision.
 Financing decision is concerned with the
financing mix or capital structure. The mix of
debt and equity is known as capital structure.
 Once the best combination of debt and equity is
determined, the next step is raising appropriate
amount through available sources.
 Working Capital
Management
 Working capital management or current asset
management is an important part of investment
decision.
 Proper management of working capital ensures
firm’s liquidity and solvency.
 A conflict exists between profitability and
liquidity while managing current asset.
 Working Capital
Management
 If a firm does not invest sufficient funds in
current assets it may become illiquid and may
not meet its current obligations.
 If the current asset are large, the firm would
lose its profitability and liquidity.
 The financial manager should develop proper
techniques of managing current assets so that
neither insufficient nor unnecessary funds are
invested in current assets.
 Dividend Decision
 Dividend decision has a strong influence on the
market price of the share.

 So the dividend policy is to be determined in

terms of its impact on shareholder’s value.

 The optimum dividend policy is one which

maximizes the value of shares and wealth of
the shareholders.
 Dividend Decision
 The financial manager should determine the
optimum pay out ratio I.e. the proportions of net
profit to be paid out to the shareholders.
 The above three decisions are inter related. To
have an optimum financial decision the three
should be taken jointly.
 Organisation of Finance Function

Organization for finance function

Organization for finance function in a multidivisional company

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