FINANCIAL MANAGEMENT - THEORY

T.Y B.COM

SEMESTER - 5

FINANCIAL MANAGEMENT

(FM) - THEORY

UNIT - 1

CHAPTER - 1

 • IMPORTANCE OF FINANCE

 • SCOPE OF FINANCIAL MANAGEMENT

 • THE CORE CONCEPTS OF FINANCIAL MANAGEMENT

 • OBJECTIVES

 • FINANCE FUNCTION

 • ORGANISATION OF FINANCE FUNCTION

IMPORTANCE OF FINANCE:

Finance is considered to be the life blood of the business. A business need funds at every stage viz., at the inception, for inventories, fixed assets, working capital and later on for repayment of liabilities, expansion, development and modernization activities etc. it is hardly possible to think of any business activity without finance. Finance constitute the very base upon which the super structure of a modern corporate enterprise is erected. The corporate enterprises use different sources of funds for their growth. A corporate enterprise could grow and build a sound financial base only if it gets adequate finance and that too at reasonable cost. 

A major function of finance manager is to get funds at the lowest possible cost for the firm. However, the process does not end with the acquisition of the funds but perhaps starts with the intent of making the most judicious use of funds that have been acquired. The management should have clear idea of using the money profitably. The success or failure of any organization depends largely on how efficiently the funds are managed i.e. raised and invested in the business. Inefficient management of funds can lead not only to a loss of profit but also to an ultimate downfall of the concern. Without adequate finance no business can survive and without sound financial management no business can prosperous and grow. An efficient management of funds is therefore necessary for a sound base of financial position of a concern. 

The sound financial position is a prerequisite for survival, growth and for earning maximum return on investment in assets in any company. The importance of financial management is reflected in following areas of finance:

1. 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.

2. 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.

3. 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.

4. 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.

5. 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.

6. 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 profit and higher profitability leads to maximize the wealth of the investors as well as the nation.

7. 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. Nowadays financial management is also popularly known as business finance or corporate finances. The business concern or corporate sectors cannot function without the importance of the financial management.

SCOPE OF FINANCIAL MANAGEMENT : 

Financial management and other areas of management: 

Financial management is one of the important part of overall management, which is directly related with various functional departments like personnel, marketing and production. Financial management covers wide area with multidimensional approaches. The relationship between financial management and other functional areas of management is as follows:

1. Financial Management and Production Department

Profit of the concern depends upon the production performance. Production performance needs finance, because production department requires raw material, machinery, wages, operating expenses etc. These expenditures are decided and estimated by the financial department and the finance manager allocates the appropriate finance to production department. The financial manager must be aware of the operational process and finance required for each process of production activities. The production department may be required to take various decisions like increase in capacity utilization, replacing machinery, improvisations of production facilities etc. All these decisions have financial implications and therefore, should be evaluated in the light of the objective of the maximization of shareholders wealth. So, the financial management has a role to play.

2. Financial Management and Personnel Department

Financial management is also related with Personnel Department, which provides manpower to all the functional areas of the management. The Personnel Department has to work with the finance manager while evaluating different schemes of training programmes, employee’s welfare, incentive schemes, revision of pay scales etc. Financial manager should carefully evaluate the requirement of manpower to each department and allocate the finance to the Personnel Department keeping in view both the employee’s welfare and the interest of the firm. Hence, financial management is directly related with Personnel Department.

3. Financial Management and Marketing

The marketing department is concerned with the ultimate activity of the firm i.e , the selling of goods and services to customers. Produced goods are sold in the market with innovative and modern approaches. For this, the marketing department needs finance to meet their requirements. The financial manager or finance department is responsible to allocate the adequate finance to the marketing department. Hence, marketing and financial management are interrelated and depends on each other.

4. Financial Management and Research and Development

The management requires finance to carry out various activities aimed at developing new products or improving existing product. The organization needs to maintain a separate reserve to finance its research and development activities on regular basis.

THE CORE CONCEPTS OF FINANCIAL MANAGEMENT 

Financial Management is primarily a decision making activity involving investment and financing decisions, which are guided by a set of core concepts and the goal of shareholder’s wealth maximization(Jim McMenamin).

The theory of financial management is based upon following axioms/core concepts:

1) CASH FLOW

This axiom refers to the difference between the accounting profit which is based upon the accounting concepts and conventions, and the cash flows which are based on the movement of cash. In Financial Management, the cash flow is the basic measurement tool. There are two dimensions of cash flows: cash inflows and cash outflows, and cash flow management involves the effective management of both. An organization’s cash flows will arise as a result of:

1) Operative activities; 

2) Investing activities; and 

3) Financing activities. 

Accounting Perspective

                                Rs.

Sales ……...…..   5,00,000

Costs …...…….   4,50,000

                        ------------------

Profit …….......     50,000

 

Financial Management Perspective

                                        Rs.

Cash inflows …….....  4,20,000

Cash outflow .......... 4,50,000

                                 -------------------

Net cash flow ……...   (30,000)

The financial management perspective reveals more clearly the financial condition of the business. It would be the key part of the financial manager’s role, in any organization, to monitor cash flows closely and take appropriate steps to minimize the risk of customer non -payment and insolvency. 

 Cash Inflow = Net Profit + Depreciation +/- other Non-Cash items

 Free Cash Flow = cash flow – (Investment Expenditures + Dividends)

However it is measured or defined, Cash flow generation is the true test of a firm’s performance and is vital for its long-term survival and growth. 

2) RISK AND RETURN

This axiom refers to that no investor will take additional risk unless he expects to be compensated with additional return. The motivation for undertaking an investment decision is the expectation of gaining a satisfactory return – a return which rewards effort and justifies the risk. But the return from an investment, particularly a business investment is not guaranteed. 

The actual return may prove to be more than, less than, or equal to, the return expected before the investment was undertaken. Investment decisions are typically made with imperfect knowledge of the future, and necessarily involve risk; how much risk depends on the nature of investment. 

In the context of financial management, by risk we mean the chance that the actual returns may differ from the expected returns, and in finance a risky investment is one whose potential returns are expected to have a high degree of variation or volatility. Remember that in financial management, returns are measured in terms of expected future cash flows – not profit , and the risk is the degree of volatility surrounding expected future cash flow return. A finance manager cannot avoid the risk altogether nor he can make a decision by considering the return aspect only. Usually, as the return from an investment increases, its risk also increases. In an attempt to increase the return, the finance manager will have to undertake greater degree of risk also. Therefore, a finance manager is often required to tradeoff between the risk and return. A particular combination of risk and return where both are optimized may be known as Risk-Return tradeoff. Every financial decision involves such tradeoff between risk and return. At this level of risk-return, the market price of the share will be maximized. Investment decision will be influenced by the investor’s propensity for risk taking, or the investor’s attitude to risk.

3) THE TIME VALUE OF MONEY 

Not only is the concept of measuring return in terms of cash flows important in financial management, but it is also the timing of cash flow returns which is vitally important. It is the timing of cash flows, as well as their size, which determines their value. You may have heard the expression; ‘A rupee today is worth more than a rupee tomorrow’. Cash flows which are to be received at some time in the future, say, one or two years from now, have less value than the equivalent cash flows to be received today. Cash received today can be reinvested in other investments to generate more cash flows. They could at least be placed in a deposit account to earn interest, thereby increasing their future value. This raises the notion that there is an opportunity cost (see next concept) associated with investment cash flows, because alternative investment opportunities always exist. 

4) OPPORTUNITY COST

To attract finance for its investments plans, a firm must offer potential investor an attractive rate of return, a rate of return which is competitive with the rate an investor could obtain elsewhere on an alternative investment of equal risk. From an investor’s perspective the opportunity cost of investing in a company, say ‘A’, would be the return given up by not investing in another comparable investment for one with a lower expected return. 

The firm’s opportunity cost of capital is the rate of return the firm must pay to investor to induce them to part with their money. Thus, the cost of capital to the firm is the opportunity cost of the next best investment alternative of equal risk available to the investor. This opportunity cost of capital is the rate of return which should be used to test the firm’s investment decisions. In simple terms, potential investments which are expected to earn less than this rate of return should be rejected. Those which are expected to earn an equal or higher rate of return should be accepted. 

5) VALUE 

The process of value creation is the driving force behind financial management and creating wealth for shareholders by increasing the value of their investment in the business is the central goal of financial management. This goal is the focus of all the financial decision. 

When making investment and financial decision, the finance manager clearly cannot assess their impact on shareholders’ value without first analyzing their effect on the firm’s cash flow, their timing and on its risk. 

If value-enhancing investment and financial decisions are made, this will be reflected in an increase in the firm’s value. In the case of a public company, shareholder can expect to see their wealth increase through an increase in the market value of the company’s shares. 

For a public company maximizing shareholder value in essence means maximizing the market value of the firmas reflected in its long-run share price and a shareholder’s wealth at any point in time is measured by the market value of the share hold. The market value of the firm can be defined as;

Total MV of firm = MV of its debt + MV of its equity.

In summary, the concepts of cash flow, the time value of money, risk-return and the 

opportunity cost affect the firms’s value in following ways:

1. Cash Flows : the greater the volume of positive cash flows the firm is expected to generate , the greater will be its value assuming all other factors remain constant.

2. Time value of money : The sooner cash flows are expected to be received; the greater will be their value, all other factors remaining constant.

3. Risk : The more risky or variable cash flows are expected to be, the lower will be the value of the investment again assuming all other factors remain constant.

4. Opportunity cost : The lower the return an investment offers compared to similar investments of equal risk, the lower its value, all other factors remaining unchanged.

OBJECTIVES :

Financial management is concerned with raising of funds and use (investment) of funds. The funds raised by the firm should be used in such a way that the earnings are maximized. This is the main aim of financial management. The another aim of financial management is to maximize the wealth of the shareholders. The wealth of the shareholders can be maximized by increasing the market price of the shares. If the benefit from the investment of the funds in assets is more than the cost, there shall be surplus and this will increase the market price of shares. This rise in market price of shares will maximize the wealth of the shareholders. Higher the market price of shares, the greater will be the wealth of the shareholders. So there are two main objectives of financial management:

1. Profit Maximization and

2. Wealth Maximization

A. Profit Maximization :

Profit earning is the main aim of the business. A business must earn profit to cover its cost. No business can survive without profit. Profit also serves as a protection against risks or adverse conditions. Thus, accumulated profits (or reserves or retained earnings) are very much useful to face the adverse conditions of the business like rise in material prices, increase in wage rates, reduction in selling price due to severe competition with other firms, adverse govt. policies etc. Thus, profit maximization is a main goal of the business. 

The following arguments are in favour of profit maximization: 

1. No business can survive without profit. So, profit is essential for survival of any business.

2. Profitability is a barometer for measuring efficiency of the management and economic prosperity of the business. So, it is justified on the grounds of rationality.

3. The business has to face some adverse conditions like recession, depression, severe competition etc. A business will survive under adverse condition, only if it has some past accumulated profits or reserves or retained earnings. Therefore all firms will try to earn more and retain more when the business is favourable for their future use.

4. Profit is the main source of finance for the expansion, growth and development of the business. So, every business will try to earn more and retain it for its future expansion, growth and development.

5. Profitability is essential for fulfilling social goals also. A firm by maximizing profit will reinvest the same and expand its business. This will create the job opportunities for the people. So, a firm by maximizing profit can satisfy its social responsibility and can also help in increasing the economic welfare of the people.

However, profit maximization objective has been criticized on many grounds.

1. The term ‘Profit’ is vague and it cannot be precisely defined. It means different things for different people. There are different connotations of profit. Profit may be Operating profit or PBIT. It may be PBT or PAT. It may be EPS. If profit maximization is taken to be the objective, the question arises, which of these variants of profit should a firm try to maximize? A loose expression like profit cannot form the basis of operational criterion for financial management.

2. Profit maximization criterion ignores the time value of money. It ignores the fact that cash received today is more valuable than the same amount received after, say one year or two years or three years. While working out profitability of the project, “the bigger the better” principle is adopted. In profit maximization, the decision is based on the total benefits received over the life of the assets and not when they are received. This is the main limitation of this criterion. This is explained in the following table. 

Time-pattern of Benefits (Profit in cash)

Period	Alternative – A (Rs. Lakhs)	Alternative – B (Rs. Lakhs)
1st Year	50	-----
2nd Year	100	100
3rd Year	50	100
Total Rs.	200	200

The above table shows that the total profits of Alternative A and Alternative B are same. If the profit maximization is the decision criterion for the investment in the asset, then both the alternatives would be ranked equally. But the returns from both the alternatives differ in one important respect; Alternative-A provides higher return in earlier years while alternative-B provides larger returns in later years. Out of the two alternatives, Alternative-A, is better than Alternative-B. This is because a basic dictum of financial planning ‘the earlier the better’. The benefits received earlier are more valuable than benefits received later. The reason for superiority of benefits now over benefits later lies in the fact that the former can be reinvested in the business to earn a higher return. This is referred to as time value of money. 

3. The profit maximization ignores uncertainty and risk in earning profits in future. An uncertain and fluctuating return implies risk to the investors. It can be safely assumed that the investors are risk-averters, that is, they want to avoid or at least minimize the risk. They can, therefore, be reasonably expected to have a preference for a return, which is more certain in the sense that it has less fluctuation over the years. The following table will clarify the uncertainty and risk in earning profits. 

Uncertainty about Expected Benefits (Profit / Return)

Period	Alternative – A (Rs. Lakhs)	Alternative – B (Rs. Lakhs)
1st Year	9	0
2nd Year	10	10
3rd Year	11	20
Total Rs.	30	30

It is clear from the above table that the total returns associated with the two Alternatives - A and B are identical (Rs. 30 lakhs) in a normal situation but the range of variation is very wide in case of Alternative - B, while it is narrow in case of Alternative - A. To put it differently, the earnings associated with Alternative - B are more uncertain as they fluctuate widely. Obviously, Alternative-A is better in terms of risk and uncertainty. The profit maximization criterion fails to reveal this. 

B. Wealth Maximization :

Value (or wealth) maximization means the maximization of the net present value (NPV) of investment in assets. The net present value (NPV) of investment in assets is the difference between the present value of stream of future cash inflows (PVCI) and the present value of cash outflow (PVCO) required for investment in the assets. The PVCI and PVCO both are determined by discounting at a rate that reflects both time and uncertainty. If PVCI exceeds PVCO, it will increase the value of the firm. This will increase the market price of the share and thereby wealth of the shareholders. Such investment should be made in the business. The present value maximization criterion is superior than profit maximization criterion because of the following: 

(1) The wealth maximization criterion is based on the concept of cash flows generated from the use of the assets while profit maximization criterion is based on the concept of accounting profit generated from the use of the assets. Cash flow is the precise concept with a definite connotation. Measuring benefits in terms of cash flows avoids the ambiguity associated with accounting profit. This is the first operational feature of the wealth maximization criterion. 

(2) The wealth maximization criterion considers both the uncertainty and risk in earning profits in the future. It also incorporates the time value of money. For incorporating risk and differences in timings in stream of earning profits in future, adjustments are made in the cash flow pattern. The value of stream of future cash flows is converted into present value by discounting them at a capitalization (discount) rate that reflects both time and risk. This discount rate is expressed in terms of percentage. A large discount (capitalization) rate is due higher risk and longer time period in investment while low discount rate is due to lower risk and the shorter time period. Low discount rate shows more certainty and less risk in investment. 

Using this discount rate to determine the present values of cash inflows and outflows, any investment that has positive net preset value (+NPV) i.e. excess of PVCI over PVCO (in case of a single alternative) or highest net present value (in case of mutually exclusive alternatives i.e. only one can be undertaken) should be selected. This will increase the value of the firm and thereby he market price of the shares. The increase in market price of the shares maximizes the wealth of the shareholders. The shareholders wealth can be ascertained as follows : 

Shareholder’s wealth = 

Number of shares owned by the shareholders x Market Price per Share

Given the number of shares that the shareholder owns, the higher the MPS the greater will be the shareholder’s wealth. Thus, the firm should aim at maximizing its current market price.

FINANCE FUNCTION :

Finance function the most important of all business functions. It is not possible to substitute or eliminate this function because the business will close down in the absence of finance. The need for money is continuous. It stars with setting up of the business and remains at all times. The funds are raised from various sources to meet the requirements of the business. The receiving of money is not enough, its utilization is more important. The money once received will have to be returned also. If its use is proper then its return would be possible otherwise it would create difficulties for repayment. The inflows and outflows of funds should be properly matched. In short the function of raising of funds, investing them in assets and distributing returns (dividends) to shareholders are respectively known as financing decision, investment decision and dividend decision. While performing these functions, a firm attempts to balance cash inflows and outflows. This is called liquidity decision and it is also an important finance decision or function. 

(1) Investment Decision : 

The investment decision relates to the selection of assets in which a firm has to invest its funds. The assets which can be acquired by the firm for its use, fall into two broad categories: 

i) Long Lived Assets or Long Term Assets or Fixed Assets. 

ii) Short Lived Assets or Short Term assets or Current Assets. 

The investment of funds in first category of assets is known as capital budgeting while in second category is popularly known as working capital management. 

(A) Capital Budgeting :

Capital budgeting is the process of making investment decisions in capital expenditure. It is most crucial financial decision for a firm. It is related to the purchase of fixed assets whose benefits are likely to be received in future over a long period of time i.e. exceeding one year. The finance manager has to assess the profitability of investment in asset before purchasing it. The investment in asset should be evaluated in terms of expected returns and costs involved in it. If the expected returns are higher than the costs, then it is worth to purchase the asset. The decision for the purchase of fixed assets is important not only for the setting up of new business but also for the expansion of present business, replacement of old assets or present assets which do not fetch result as anticipated earlier.

While evaluating capital budgeting decision an element of risk involved in it should also be considered. The benefits from purchase of fixed assets extent into the future and their accrual is always uncertain. The future profits are estimated under various assumptions of the physical volume of sales and the level of prices. An element of risk in the sense of future profits, is thus, involved in the exercise. The returns from capital budgeting decision, should therefore be evaluated in relation to the risk in earnings associated with it. 

The evaluation of investment in fixed assets implies a certain norms or standard against which the benefits are to be judged. The requisite norm is known as cut-offrate or hurdle rate or required rate or minimum rate of return etc. This standard or cut off rate is the cost of financing the assets i.e. interest cost (on debt fund) or opportunity cost (of reserve). If the benefits or the expected return from the investment in the assets are higher than the cost of capital, the assets may be purchased. So the cut off rate is also another important aspect for investment in assets in capital budgeting decision.

(B) Working Capital Management :

Working capital refers to that part of the firm’s capital which is required for financing short - term assets or current assets such as cash, accounts receivables (debtors) and inventories. It is an important and an integral part of the financial management as short term survival is the pre-requisite for long term success. In working capital management decision, two major aspects of financial management i.e. liquidity and profitability are associated with it. There is a conflict between liquidity and profitability. If a firm does not have sufficient current assets, it may become illiquid and consequently may not be able to pay its current liabilities as and when they become due and this may increase the risk of bankruptcy. If current assets are too large; the liquidity would be very high but due to excess investment in current assets it would reduce profitability of the firm. It is therefore necessary that there should be optimum investment in current assets so that there can be trade off (balance) between liquidity and profitability.

(2) Financing Decision :

Financing decision is the second important function to be performed by the finance manager. Once the firm has taken the investment decision, it must decide the best mix of debt funds and equity funds for financing the assets. The mix of debt fund and equity fund is known as capitalization or capital structure. The finance manger must strive to obtain the optimum capital structure for the firm. The use of more debt affects the risk and return to the shareholders. The more use of debt increases the return to the shareholders due to its low cost as compared equity but it also increases the risk. On the other hand, the use of more equity fund reduces the return to the shareholders and also the financial risk. The finance manager should therefore, decide the best financing mix and trade off the risk and return in investing in assets. When the shareholders’ return is maximized with minimum risk, the market value per share will be maximized and the firm’s capital structure would be optimum. 

(3) Dividend Decision :

Divided decision is the third major financial decision. The financial manager must decide whether the firm should distribute all its earnings, or retain them, or distribute a part of it and retain the balance. Like the debt policy, the dividend policy should also be determined in terms of its impact on the shareholder’s wealth. The optimum dividend policy is one that maximizes the market price of shares. Thus, if shareholders expect the return on their investment in the form of dividend, the finance manager must determine the optimum dividend-payout ratio. The payout ratio is equal to the percentage of dividends to earnings (dividends/PAT*100) available to shareholders. While paying dividends, the finance manager should also consider the questions of dividends stability, bonus shares and cash dividends in practice. Most profitable companies pay cash dividends regularly. Periodically, additional shares, called bonus shares (stock dividends) are also issued to the shareholders in addition to cash dividends.

(4) Liquidity Decision :

Liquidity means ability of a firm to pay its current liabilities as and when they become due. Current liabilities are paid out of realization of current assets. So Current assets should be liquid enough for the payment of current liabilities. If Current assets are illiquid, the firm may go into liquidation. There exists a conflict between liquidity and profitability (discussed in item (B) above of working capital management). If the firm has less investment in current assets, it may become illiquid. On the other hand, if a firm has high current assets, it may have excess liquidity but profitability would be very less. Thus, a trade off (balance) must be strived between liquidity and profitability in managing the current assets. In order to have trade off between these two, there should be optimum investment in current assets.

ORGANISATION OF FINANCE FUNCTION :

Financial decisions are of crucial importance. It is therefore essential to set up an efficient organization for financial management functions.

 

Since finance is a major or critical functional area, the ultimate responsibility for carrying out financial management functions lays with the top management, that is, board of directors or managing director or chief executive or the committee of the board. However, the exact nature of the organization of the financial management functions differ from firm to firm depending upon the factors such as size of the firm, nature of the business, type of financing operations ability of financial officers and so on. 

Similarly the designation of the chief executive of the finance department also differs widely in different firms. In some cases they are known as finance mangers while in others as vice - president (finance) or director (finance) or financial controller and so on. The finance manager reports directly to the top management. Various sections within the financial managed area are headed by managers known as controller and treasurer. 

The job of the chief financial executive does not cover only routine aspects of finance and accounting but as a member of the top management, he is closely associated with the formulation of different policies as well as decision making. Under him are controller and treasurer. The tasks of financial management and allied areas like accounting, taxation etc. are distributed between these two key financial officers. Their functions are described as follows : 

The main functions of the treasurer are related with the financing activities of the firm. 

Included in the range of his functions are :

1. Obtaining finance.

2. Banking Relationship,

3. Investor Relationship,

4. Short-term Financing,

5. Cash Management,

6. Receivables management,

7. Investments

8. Insurance etc.

The functions of the controller are related mainly to accounting and control. The typical functions performed by him include:

1. Financial Accounting,

2. Internal Audit,

3. Taxation,

4. Management Accounting and Control,

5. Budgeting, Planning and Control,

6. Economic Appraisal and so on

The organization chart of the financial management function in a large firm is as follows : 

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