Financial
Management
Introduction
Finance?
– Finance can be described as the life blood of business.
– Can the terms ‘money’ and ‘finance’ be used interchangeably?
– Finance may be defined as the art and science of managing
money.
– According to the Wheeler, “Business finance is that business
activity which concerns with the acquisition and conversation
of capital funds in meeting financial needs and overall
objectives of a business enterprise”.
Types of Finance
Finance
Public Finance
Central
Gov
State
Gov
Private Finance
Local
Bodies
Personal
Finance
Social
Finance
Business
Finance
Public Finance
– It deals with the study of principles underlying the acquisition
and utilization of financial resources by central government,
state government and semi governmental bodies.
– It is the management of public exchequer.
– It focuses on fiscal policy, government revenues, taxation,
government expenditure, budget procedures etc.
Private Finance
– It covers the financial planning of individuals, business
organizations and non-profit organizations.
– It includes:
– Personal Finance: planning and management of personal or
family’s financial activities. It includes family budgeting,
banking, insurance, retirement planning etc.
– Social Finance: Financial planning in social enterprises including
charitable organizations, educational and religious institutions.
– Business Finance: Activities concerned with planning, raising,
controlling and administering the funds used in the business.
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market.
Financial Management
– Financial Management is concerned with the procurement of
funds, their effective utilization and the management of
surplus. Thus, it is a managerial activity that covers the
planning and controlling of financial and economic resources of
an organization.
Central issues in Financial
Management
– From where to procure funds? (Financing Decisions)
– Where to invest? ( long term investment decision – Capital
budgeting)
(Short term investment decision – Working
Capital)
- How profit is to be distributed? ( Dividend decisions)
Functions of Financial
Management
– Finance functions can be broadly divided into:
– Executive Finance Function
– Auxiliary Finance Function
Executive Finance Function
i.
Financing Decisions
– Financing decisions are concerned with the procurement of the
required amount of funds at most favorable terms as and when
required.
– It is the decision regarding when, where and how to procure the
required funds at lowest possible cost.
Executive Finance Function
ii. Investing Decisions
– Long term investment decisions or Capital Budgeting may be defined
as the process of long range planning involving the investment of
current funds efficiently in long term assets whose benefit are
expected to receive over a series of future years.
– Decisions regarding expansion, modernization, diversification,
replacement of fixed assets etc. are capital budgeting decisions.
– These decisions shape the character of the business as fixed assets
are the real earning assets
Executive Finance Function
iii. Liquidity Decisions
– It is also known as Working Capital Decisions.
– Working capital refers to the amount required to finance the day to
day operations of the business or short term requirements such as
purchase of raw materials, payment of wages, rent, taxes etc.
– Working Capital Management tries to avoid two dangers – Excessive
working capital and inadequate working capital
– Thus WCM aims at liquidity –profitability trade off.
Executive Finance Function
iv. Dividend Decisions
– Dividend decisions are related to the management of surplus.
Dividend decisions refers to the decision regarding the dividend pay
out ratio and retention ratio.
– These decisions are to be taken scientifically as it directly affects the
shareholders and company.
Auxiliary Finance Function
i.
Supervision of cash receipts and cash disbursements
ii.
Safeguarding cash balances
iii.
Safeguarding important documents – ownership of assets (fixed
and financial)
iv.
Safeguarding documents related to procurement of fund
v.
Maintaining books of accounts as per Companies Act ,2013
vi.
Preparation of financial statements as per Schedule III
vii. Performance Evaluation
viii. Financial Reporting
ix.
Track the behavior of Share Prices continuously
Overview of Financial
Management
FINANCIAL MANAGEMENT
Financial Decisions
Financing
Decisions
Investing
Decisions
Dividend
Decisions
Risk-Return Trade Off
Maximize shareholder wealth
Working
Capital
Decisions
Goals of Financial
Management (objectives)
– Two main goals of Financial Management are:
– Profit Maximization &
– Wealth Maximization
Profit Maximization
– Profit Maximization refers to maximization of profit of the
firm.
– According to this concept, activities that increase the profit
are undertaken and those decreases the profit are avoided.
– Supporters of this concept argue that profit is a criterion
for measuring the economic efficiency of the firm
– Increased economic efficiency leads to efficient utilization
of economic resources as well.
Arguments in favor of Profit
Maximization
– Profitability is the barometer for measuring the economic
efficiency of the business
– Efficient utilization of economic resources
– Social interest is protected as their resources are used most
efficiently
– Profit maximization helps
opportunities internally
firm
to
finance
investment
– Accumulate profits and reserves serve as a cushion during
recession, depression and stiff competition
– High profitability attracts new investors into the firm
– When profits are maximized, shareholders wealth is also
maximized.
Criticisms of Profit
Maximization
1.
Term Profit is vague and Ambiguous
– It is not clear that whether profit is total profit / earnings
per share / profit before tax / profit after tax / short term
profit / long term profit / net income etc.
– No body knows which profit are to be maximized
Criticisms of Profit
Maximization
2. Ignores timing of cash flows
– In profit maximization, profits earned during different
periods are treated alike.
– We know due to inflation and uncertainty, money
received today has more value than money receivable the
next year. So this aspect is ignored.
– Project 1: 1- Rs 1,00,000 ; 2 – Rs 50,000 ; 3 – Rs 50,000
– Project 2 : 1 – Nil; 2 – Nil; 3 – Rs 2,00,000
– Which project is the successful project?
Criticisms of Profit
Maximization
3. Ignores Risk factors
– Risk refers to variability of returns
– Projects with high variability in profits are risker.
– Decisions are mainly made on profits without considering
risk elements which then becomes illogical.
Criticisms of Profit
Maximization
4. Conflicting Interest
– Profit maximization concept completely ignores the
interest of other stakeholders.
– It is considered as immoral as it neglects the social
responsibility of the business
– Overemphasis on profit may reduce the quality of
products
Criticisms of Profit
Maximization
5. Absence of Perfect Competition
– In absence of perfect competition, profit maximization
results in concentration of power in limited hands and
exploitation of societal resources.
– Interest of society can only be preserved in case of perfect
competition.
•
•
•
•
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•
National Institution for Transforming India
1st January 2015
Head Quarters : New Delhi
Chair person : Prime Minister
Vice Chair Person : Rajiv Kumar
CEO : Amitabh Kanth IAS
• Replaced 65 year old Planning Commission (1950)
Wealth Maximization
– Wealth maximization refers to the increase in the market
capitalization of the firm by increasing the market price of
the shares.
– Market capitalization = total no of shares x present share
price
– Wealth Maximization is also known as Net Present Worth
Maximization.
– Net present worth is the difference between present value
of future benefits and the current investment.
Wealth Maximization
– NPW = Present value of future benefits – Initial Investment
– If NPW is positive, it means that wealth of shareholders is
increased which will eventually reflect in the market price.
– Thus financial manager while taking decisions, should
ensure that the decisions should create a positive NPW
Wealth Maximization superiors
to Profit Maximization ?
– Wealth Maximization concept considers the timing of cash
inflows.
– Lets consider an example:
Year
0
1
2
3
Cash Flows
-1000
400
600
200
Discount Factors
@ 10%
Wealth Maximization superiors
to Profit Maximization ?
– Wealth Maximization concept considers the timing of cash
inflows.
– Lets consider an example:
Year
0
1
2
3
Cash Flows
-1000
400
600
200
Discount Factors
@ 10%
Discount Factor = 1 / (1+r)^ n
Wealth Maximization superiors
to Profit Maximization ?
– Wealth Maximization concept considers the timing of cash
inflows.
– Lets consider an example:
Year
0
1
2
3
Cash Flows
-1000
400
600
200
0.9091
0.8264
0.7513
Discount Factors
@ 10%
Discount Factor = 1 / (1+r)^ n
Wealth Maximization superiors
to Profit Maximization ?
– Wealth Maximization concept considers the timing of cash
inflows.
– Lets consider an example:
Year
0
1
2
3
Cash Flows
-1000
400
600
200
Discount Factors
@ 10%
0.9091
0.8264
0.7513
NPV
363.64
495.87
150.26
Wealth Maximization superiors
to Profit Maximization ?
– Wealth Maximization concept considers the timing of cash
inflows.
– Lets consider an example:
Year
0
1
2
3
Cash Flows
-1000
400
600
200
Discount Factors
@ 10%
0.9091
0.8264
0.7513
NPV
363.64
495.87
150.26
Comparison
1,009.77
Positive NPV
9.77
Wealth Maximization superiors
to Profit Maximization ?
– Wealth Maximization concept considers the timing of cash
inflows.
– Wealth Maximization concept considers the risk factor or
the elements of uncertainty in future earnings
– Net present worth is very precise and fee from ambiguity
– In profit maximization concept, the dividend policy was
neglected. The wealth maximization concept considers
dividend decisions as it affects the market price of shares
Wealth Maximization superiors
to Profit Maximization ?
– Wealth maximization concept is very much important for
the long term survival and growth of the company as it
protects the interest of various stakeholders of the
business
– Maximization of wealth indirectly leads to maximization of
profit also
Criticisms of Wealth
Maximization
– It is only a perspective idea and it doesn’t tell how the
wealth can be maximized.
– Wealth maximization ideology is not socially desirable
always.
– Some people argue that wealth maximization is nothing
but profit maximization added with time value of money
and risk factor.
– Conflicts between board of directors and owners as this
concept is sometimes detrimental to the interest of
managers and directors.
– More emphasis to the wealth of shareholders.
• National Bank for Agriculture and Rural Development (NABARD)
• 12 July 1982
• Head Quarters : Mumbai
• Chair person : Govinda Rajulu
• NABARD supervises State Cooperative Banks (StCBs), District
Cooperative Central Banks (DCCBs), and Regional Rural
Banks (RRBs) and conducts statutory inspections of these banks
Profit Maximization v/s
Wealth Maximization
Basis
Wealth Maximization
Profit Maximization
Timing of Cash Inflows
Considered
Ignored
Risk Factors
Considered
Ignored
Ambiguity
Low
High
Dividend Policy
Considered
Ignored
Concept
Broad and Rational
Narrow
Perspective
Economists’ Perspective
Accountants’ Perspective
Discounting Principle
Applicable
Not Applicable
Role of Finance Manager
CFO
Treasurer
Controller
Cash Manager
Credit
Manager
Capital
Budgeting
Manager
Fund Raising
Manager
Portfolio
Manager
Financial
Accounting
Manager
Cost
Accounting
Manager
Tax Manager
Data
Processing
Manager
Internal
Auditor
Role of Financial Manager
– The executive or officer who handles the financial affairs of
a firm is called ‘financial manager’.
– He is involved in the planning, utilization and control of
financial and economic resources of an organization.
– In large business organizations, CFO is appointed as
Director (Finance). Further there may be treasurer who
handles finance and a controller who deals with accounts.
Financial Manager as a
Treasurer
I.
Estimating the Capital Requirements:
It is the duty of financial manager to forecast the amount of
fund required to finance its fixed assets and current assets.
II. Financing Decision
Finance Manager has to decide the capital structure of the
company, the proportion of debt and equity in the total long
term capital of the company
III. Investment Decision
It is he decision regarding the fixed assets management
policy. Finance manager should decide the assets in which the
funds are to be allocated.
Financial Manager as a
Treasurer
IV. Dividend Decisions:
Financial Manager has to take a decision regarding the
proportion of net income to be distribute and retained in the
business.
V. Investor Relations
It is the duty of financial manager to maintain good
relationship with the investment community to enhance the
marketability of shares.
VI. Working Capital Management
There is an inverse relationship between liquidity and
profitability. It is the duty of finance manager to maintain
balance between current assets and current liabilities
Financial Manager as a
Controller
I.
Tax Management
The firm has to use all possible legal ways to reduce its tax
liability. The controller is entrusted with the duties of timely
filing of returns, payment of taxes etc.
II. Financial Accounting
Duty of financial manager includes maintenance of books of
accounts and preparation of financial statements as per
statutory requirements.
III. Internal Auditing
Financial Manager has to establish a good internal auditing
system to eliminate frauds and misappropriations of goods
and cash
Financial Manager as a
Controller
IV. Reporting to Government
Finance Manager has to coordinate the preparation of various
reports to be submitted to corporate affairs, SEBI etc.
V. Finance Control
Finance Manager is also entrusted with the duty of
comparing actual performance and planned performance.
Tools like financial statement analysis, budgetary control etc.
are used for this purpose.
Scope / Evolution /Approaches
of Financial Management
– Traditional Approach
Traditional approach covers the following aspects:
i.
Procurement View: Traditional finance emphasize more
on procurement of funds from financial institutions
(term loans) and capital markets (equity, preference,
debentures etc.)
ii.
Relationship View: Gave more importance to accounting
and legal relationship between supplier of funds and
firm
Scope / Evolution /Approaches
of Financial Management
iii. Maintenance of Records: Finance Managers were
expected to do the lower level functions such as maintenance
of financial records and performance reports.
Iv Limited Role : Finance function was not part of the regular
managerial operations. Finance manager has limited role to
perform as his service was sought only in the events of
merger, consolidations, reorganization of business etc.
Scope / Evolution /Approaches
of Financial Management
Traditional Approach was severly crticised because of
following reasons.
i.
Ignored the allocation aspect: More focused on
procurement of funds. Finance manager was not
allowed to take decisions regarding allocation or
utilization of funds
ii.
Outsider-looking Approach: Outsiders such as banks and
other suppliers of funds got dominance in the financial
decision making process.
iii.
Lack of Scientific Approach: Relationship between risk
and return was completely neglected. Lack of advanced
financial models
Scope / Evolution /Approaches
of Financial Management
Traditional Approach was severly crticised because of
following reasons.
iv. Ignored Working Capital Management: Due to over
emphasis on long term financing, it ignored short term
liquidity management.
v. Ignored Routine functions: Financial Manager has only
limited role to perform as his service was sought only in case
of events like mergers, consolidations etc.
vi. Ignored Cost of Capital: There was no comparison
between return and cost of capital.
Scope / Evolution /Approaches
of Financial Management
– Modern Approach
Modern approach gives importance to both procurement and
allocation of funds.
Modern approach addresses the following questions:
– Financing decisions
– Long term investment decisions
– Short term investment decisions
– Dividend decisions
– Financial Control decisions
Importance of Financial
Management
1.
Financial Planning
Financial management helps to quantify the financial
requirements of a business concern well in advance. It is the duty
of financial manager to ensure that adequate funds are available
for investment. For this, various budgets and estimates are
prepared.
2. Acquisition of Funds
Financial management involves the acquisition of required funds
for allocation into various projects. Proper analysis of various
financing option helps the firm to acquire funds at low cost.
Importance of Financial
Management
3. Efficient Utilization of Fund
Proper utilization leads to improved operational efficiency of the
firm. Increased operational efficiency brings additional profits or
reduces cost. This leads to shareholder value maximization.
4. Scientific Financial Decisions
Finance managers use techniques ranging from ratio analysis to
advanced financial models for making sound decisions. Financial
decisions have its impact on the entire business operations.
Importance of Financial
Management
5. Incresed Profitability
Profitability is primarily a function of the effectiveness of funds
employed in assets. Financial management helps to improve the
profitability position of the firm by using strong control devices
such as budgetary control, ratio analysis and cost volume profit
analysis.
6. Wealth Maximization
If there is no proper financial management system, it will
ultimately lead to lower profitability. Lower profitability is an
indication of inefficient utilization of funds. This reduces market
prices of shares and affect the wealth of investors.
Importance of Financial
Management
7. Smooth Functioning of Business
Working capital management is an integral part of financial
management. It ensures adequate working capital, optimum
inventory and optimum cash balance so that production and sales
processes are not interrupted.
8. Dividend Policy
Financial Management helps the firm to manage the surplus of
the firm to suit the needs of both company and shareholders. An
optimum dividend policy make the investors satisfied.
FM and other disciplines
– Financial Management is not an independent branch of
study. It is an integral part of the overall management. The
relationship between other branches of studies includes:
– Finance and Economics
– Finance and Accounting
– Finance and Taxation
– Finance and Marketing
– Finance and Quantitate Techniques
– Finance and HRM
Finance & Economics
– While considering important financial decisions, economic
analysis is also require.
– Before taking long term investment decisions, the finance
manager should consider general economic conditions,
inflation, banking systems. Fiscal policy of the government
etc.
– All these matters comes under the purview of macro
economics.
– Micro economics – Production theory, cost analysis etc.
Adam Smith
Father of Economics
Finance & Accounting
– Accounting can be viewed as a sub unit of finance as the
accounting department supplies necessary information to
take sound financial decisions.
– Many of the finance functions cannot be performed
without accounting
– For taking dividend decisions – net income of the business
is to be known.
– Finance managers also use cost and management
techniques like break even analysis, budgetary control etc.
Luca Pacioli
Father of Accounting
Finance & Taxation
– Almost all financial decisions involve taxation. Both direct taxes
and indirect taxes have a major impact on financial decisions.
– While considering dividend decision, firm has to consider
Dividend Distribution Tax (DDT)
– Deciding debt equity mix – interest on debt is a tax deductible
item.
– Long term investment decisions – impact of depreciation
cannot be ignored.
James Wilson
Father of Income Tax
Finance & Marketing
– When a firm needs to introduce a new product, its cost
benefit analysis has to be done. This need the help of the
finance department.
– Inventory decisions and receivables management which are
related to marketing department are also executed by the
finance department.
Philip Kotler
Father of Marketing
Finance & Quantitative
Techniques
– One of the basic principle of finance is ‘discounting’.
– Compounding and discounting are treated as mathematics
of finance
– While taking decisions under uncertainty and risk, finance
considerably draws inference from quantitative techniques.
– Techniques used as standard deviation, probability analysis,
simulation method etc.
Finance & HRM
– Human resource represents one of the important assets of
an organization though not disclosed in the balance sheet.
– Firm has to incur a considerable amount for the purpose of
recruitment, training etc.
– To create a sound HR policy, comparison of expenditure
incurred and labour productivity should be done.
– Further finance department also decides the wage
structure, incentives etc.
Elton Mayo
Father of HRM
Inter-relationship between
financial decisions
– Investment decisions are affected by financing decisions?
– Financial manager has to plan the pattern of financing
– Financing decision is related to investment decision?
– How the procured funds are invested, what should be rate
of return.
– Dividend decision to Financing and Investing decisions?
– Company earn profits by investing in profitable projects
– If a company retain the profit that could be used as internal
source of financing
Inter-relationship between
financial decisions
– How working capital decisions are relate to others?
– Raising of funds through long term sources increases the
liquidity
– Payment of dividends affect the liquidity
RISK-RETURN trade off
– Financial management aims at wealth maximization
through maximization of market price of shares.
– These decisions are affected by risk-return characterstics.
– When firm uses debt in the capital structure, the risk of
payment of interest exists.
– However it will increase the returns of shareholders as debt
is a cheaper source of finance.
RISK-RETURN trade off
– When firm distributes its profits among shareholders, it
may increase the market price of shares as shareholders
return increases.
– On other hand, risk of liquidity arises for the company due
to lack of funds.
– Thus wealth maximization is possible only when there is a
trade off between risk and return.
– Risk-return trade off refers to a balance between risk and
return that maximize the value of the firm.
– Meaning of Finance – Types of Finance
– Financial Management – Meaning
– Functions of Financial Management
– Goals of Financial Management
– Difference between Profit Maximization and Wealth Maximization
– Role of Financial Manager
– Scope of Financial Management
– Importance of Financial Management
– Financial Management and other disciplines
– Inter-relationship
– Risk Return tradeoff