Subject: Financial Management

Chapter: One

Chapter No. 1 Introduction to Financial Management

Contents Finance function as different from Accounts function Objectives of Financial Management short-term and long-term Financial system and mar ets in !ndia "overnment of !ndia# Ministry of Finance at the helm# statutes# statutory authorities# financial intermediaries# other financial institutions# agents $ho operate in the mar ets etc% &rief introduction to 'Financial !nstruments(

At the end of the chapter the student will be able to Map the differences bet$een Finance and Accounts functions in an organisation and e)plain the integration of these functions *in the short-term and long-term objectives of Financial Management to profitability and $ealth ma)imi+ation respectively ,ra$ the Financial system in !ndia and ,ifferentiate one financial instrument from another

Introduction
Financial Management is an integral part of Business Management. Finance is one of the key functions in an organisation. The other key functions in an organisation are: Production Human Resources Marketing Each of the abo e function has got sub!di isions " for e#ample Production has maintenance$ %dministration has purchases etc. Finance deals &ith financial resources. Financial management as a corollary &ould deal &ith management of financial resources and related areas.

Some of the ke finance functions are!

Financial planning and estimation of finance re'uired for the organisation Mobilisation of financial resources re'uired as abo e Ensuring that the funds are a ailable in ade'uate 'uantity at appropriate time and at an affordable cost Management of cash in the organisation through cash flo& statement Management of in estment outside the business enterprise in other organisations Management of risk in dealing &ith foreign e#change for imports and e#ports Note! "he abo#e list is not e$hausti#e.

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Subject: Financial Management

Chapter: One -et us e#amine briefly the abo e functions &ith some e#amples.

Financial planning and estimation of finance re'uired for the organisation

%ny acti ity in a business enterprise re'uires planning for proper e#ecution in time. Finance is re'uired for any acti ity at least in the beginning and hence financial planning is the prime function of .Finance/. This in ol es detailed study of any acti ity from understanding the total funds re'uirement for that acti ity$ &hen the funds &ill be re'uired and ho& much funds &ill be re'uired at different stages. For a ne& enterprise the entire resources ha e to come from outside 0e#ternally12 for an e#isting enterprise$ a part of the resources at least &ill be a ailable from the profits made in the past and retained in business after declaring di idend. E#ample 3o. 4: 5e re'uire Rs. 677 lacs for an acti ity. -et us see ho& it affects an e#isting enterprise. -et us assume the profits a ailable to be Rs. 87 lacs. Then &e re'uire further resources of Rs. 497 lacs only. This is the difference bet&een an e#isting enterprise and a ne& one. Financial planning &ill take this into account.

Mobilisation of financial resources

Ha ing ascertained in the abo e e#ample that &e re'uire Rs. 677 lacs for a set acti ity$ for a ne& enterprise &e re'uire the entire amount to be mobilised. For an e#isting enterprise &ith a ailable profits of Rs. 87 lacs$ &e re'uire only Rs. 497 lacs. The Financial manager &ill then assess all the alternati e resources a ailable to him 0for details please refer to ,hapter no. 91 keeping in mind the follo&ing parameters: %de'uacy 0a ailability in ade'uate 'uantity1 Timely 0a ailability in time1 and %t an affordable cost

%de'uate supply in time etc.

This has been e#plained this in the abo e point. For reinforcement the student:s attention is dra&n to one of the ob(ecti es of financial management at least in the short run$ the ob(ecti e of ma#imising profits of the organisation. The profits so ma#imised in turn enhance the Earning Per ;hare 0EP; " for formula please refer to ,hapter no. <1.

Management of cash in the organisation

This in ol es the follo&ing steps: %scertaining the a erage cash re'uirement by looking at the past figures and for a ne& enterprise$ estimating this figure. Preparing the cash flo& statement for a gi en period$ taking all the cash inflo&s and cash outflo&s during the period to determine &hether there is a surplus or deficit at the end of the period %rranging for funds from outside especially through a bank &ith &hom the enterprise has loan facilities in case of deficit in the cash flo& statement2 if on the contrary$ the cash flo& statement re eals a surplus$ dealing &ith this surplus in a suitable manner 0For further details$ please refer to chapter no. = on .&orking capital management/1

Management of in estment outside the organisation

* er a period of time the enterprise rein ests a part of the profits for future gro&th of the organisation in business. The Finance manager can in est such funds outside the business in other enterprises also pro ided the parent enterprise does not re'uire them immediately. ;hort!term surplus as re ealed by the ,ash flo& statement is also in ested for short duration. Thus in estment outside one:s o&n business becomes the responsibility of the Finance Manager

Management of risk in foreign e#change etc.

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Subject: Financial Management

Chapter: One % business enterprise may re'uire imports and do e#ports also. 5hene er this is done the in oice is in foreign currency. >n imports the business enterprise re'uires foreign e#change &hile in e#ports it gets foreign e#change. There is a risk in ol ed &hile doing imports or e#ports. The risk is that the e#change rate of the foreign currency in terms of >ndian Rupees can keep changing. 5e &ill e#plain this through an e#ample. E#ample no. 6 5e ha e a ); ?ollar bill for 4777 recei able after a month. Presently the e#change rate is 4 ); ?ollar @ Rs.9A.6B. By the time the money is recei ed after a month$ in case the rate is less than Rs. 9A.6B$ &e &ill lose money. *n the contrary if the e#change rate is more than Rs. 9A.6B &e &ill gain. E#actly opposite &ill be the effect in the case of imports. The importer &ill pay less if the e#change rate decreases and more if the e#change rate increases. There are &ays and means of minimising the risk of foreign e#change. Finance manager is e#pected to take care of such risks.

%ifference between finance function and accounts function

Finance and accounts functions may be integrated in an organisation. This means that one department handles both. >n most of the small and medium siCe units in >ndia$ the functions &ill be integrated. % business enterprise &ill re'uire a full!fledged finance department only &hen the functions listed abo e are predominant functions impacting business in a big &ay. >f the finance functions are not predominant functions$ %ccounts department looks after Finance also. ,onstant re'uirement of funds$ surplus for in estment etc$ could be some of the factors influencing the need for a full!fledged Finance department.

Accounts function
,ore accounts ha e to take care of the follo&ing areas: Maintaining accounts on a regular basis for all items of income$ e#penditure$ assets and liabilities ,onforming to Denerally %ccepted %ccounting Practices 0D%%P " >ndia1$ %ccounting principles$ +arious %ccounting standards of the >nstitute of ,hartered %ccountants of >ndia 0>,%>1$ Re'uirements under the ,ompanies: %ct like follo&ing .%ccrual system of accounting/ 0as opposed to cash system of accounting1$ Re'uirements under The >ncome Ta# %ct &hile maintaining the %ccounts of the limited company Finalisation of accounts at the end of the accounting period 0financial year1 and preparation of final accounts in the formats prescribed in the ,ompanies: %ct " ;chedule +> after claiming depreciation as per pro isions of ,ompanies: %ct " ;chedule E>+ ,onforming to pro isions relating to %d ance Ta# payment in four instalments " first instalment by 4BF8$ second instalment by 4BF<$ third instalment by 4BF46 and the last instalment by 4BFG. ,onforming to pro isions relating to statutory audit of accounts under the ,ompanies: %ct Preparation of re enue and capital budgets Management >nformation ;ystem 0M>;1 relating to %ccounts and Finance 3ote: Further details on the abo e are not gi en here as they are outside the scope of te#tbook on .Financial Management/. %s the students can see$ most of them are self!e#planatory.

Short&term and long&term ob'ecti#es of Financial Management Short&term ob'ecti#e

The short!term ob(ecti e of Financial Management is to procure financial resources at an affordable cost thereby increasing the return to the shareholders in the form of Earnings Per ;hare 0EP;1. EP; comprises t&o elements namely ?i idend per share 0?P;1 and Retained Earnings per share 0REP; or Reser es per share1. This ob(ecti e is often times referred to as .profit ma#imisation/. This is kno&n as the short!term ob(ecti e as it is done on a continuous$ year!to!year basis. *ne or more of the follo&ing measures can achie e this: Monitoring of costs on a continuous basis through budgets ;uitable cost reduction techni'ues &here er the costs are high Minimisation of cost of borro&ed capital from outside through financial discipline Proper mi# of e'uity and debt 0kno&n as financial le erage " for further details please refer to ,hapter no. B " *perating and financial le erages
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Subject: Financial Management

Chapter: One ,ontrol o er li'uidity a ailable in the organisation so as to minimise the cost of carrying too much cash 4 etc.

(ong&term ob'ecti#e
The long!term ob(ecti e of financial management is to increase the &ealth of the shareholders. The term .&ealth/ refers to arious business assets of the enterprise that are free of debt. This means that this &ealth belongs to the e'uity shareholders. >t is often reflected in the .book alue/ of the share as reflected in the balance sheet. The formula for book alue is: E'uity share capital H Reser es and ;urplus 3umber of e'uity shares issued This can be e#plained through an e#ample. E#ample no. G E'uity share capital @ Rs. 477 lacs 0paid up capital1 Reser es and surplus @ Rs. 677 lacs 3umber of shares @ 47 lacs &ith the Face +alue being Rs.47F! Then the book alue of the share &ould be @ Rs. 477 lacs H Rs. 677 lacs @ Rs. G7F!. 47 lacs shares This means that at the starting point the book alue &as Rs.47F! and this has gone up to Rs. G7F! due to the prudent policy of the management of retaining profits &ithin the organisation. Thus the short!term ob(ecti e also is a contributory factor to realising the long!term ob(ecti e of &ealth ma#imisation. ;ome of the measures through &hich &e achie e the long!term ob(ecti e are: ;trategic financial management decisions relating to e#pansion$ take o er of another business$ financial re!restructuring through financial re!engineering 0e#ample " s&ap a costly loan for a cheaper loan pro ided the credibility of the firm is 'uite high1$ (oint enture etc. Thus &hile profitability reflects the operating efficiency &ealth ma#imisation reflects the managerial)entrepreneurial efficiency. To sum up$ both short!term ob(ecti e and long!term ob(ecti e need to be put in place for sustained gro&th of a business enterprise. To an e#tent at least$ the long!term ob(ecti e is dependent upon the short!term ob(ecti e of profit ma#imisation.

Financial s stem in India

>n order to understand financial management better$ &e need to understand the .Financial ;ystem/ that e#ists in >ndia. %ny country needs a system to regulate$ super ise$ monitor and control the players$ intermediaries$ the in estors etc. &ho take part in the financial markets in the system. Further an efficient system alone can ensure that the national ob(ecti e on .Economy/ of the country is met by aligning the de elopments in the system &ith the national priorities. %n e#ample of the national priority deciding the de elopment in the financial markets is " .infrastructure de elopment and need for longer duration financial resources/ and de elopment of .deep discounted bonds/ to meet this re'uirement. 0For further details please refer to ,hapter no. 9 " Financial sources1

Constituents of the Indian Financial S stem

The Do ernment of >ndia$ Ministry of Finance$ heads the >ndian financial system. The ministry in turn is bifurcated into arious departments like the ?epartment of Economic %ffairs$ the ?epartment of ,ompany %ffairs etc. The >ndian financial system consists of: The financial markets The statutes go erning the arious segments of the financial markets

Carrying too much liquidity involves cost. This cost is referred to as opportunity cost. It simply means that by carrying too much liquidity the business enterprise has foregone an opportunity of getting a return on such amount that it !ill have got by employing the funds in business. "n the contrary carrying too little cash is also ris#y as the enterprise may not be able to fulfil its obligations to creditors etc. in time. Pun(ab Technical )ni ersity$ *nline +irtual ,ampus $

Subject: Financial Management

Chapter: One The statutory authorities responsible for regulating$ super ising$ monitoring and controlling the markets and its components The financial intermediaries ;pecial organisations %gents operating in different segments of the financial markets and Financial instrumentsFsecurities issued in the markets to raise resources

The financial markets

The financial markets consist of: Money markets " ma#imum duration of 46 months ,apital markets " Minimum duration 46 months and ma#imum duration could be e en 67!6B years Foreign e#change markets >nsurance market Banking and Mutual funds The money markets and capital markets in turn do ha e .Primary market/ and .;econdary market/. Primary market means issue of financial instruments by companies and others that &ant to raise financial resources from the market. ;econdary market refers to that market &herein the financial instruments issued in the Primary market change hands from one in estor to another for financial consideration.

;egments of money markets:

,all money market e#clusi ely for banks to be borro&ers " inter!bank operations for a ery short period. *ne day to fourteen days. Fourteen day borro&ing is in the notice money market that is also a part of the ,all Money Market. *nly scheduled commercial banks are permitted to be borro&ers in this market. 5hile some banks &ill be borro&ers$ some others &ill be lenders. There is no specific market place. ?eals are done o er the phone. ,ommercial paper issued by companies and Public ;ector )ndertakings as part of &orking capital re'uirement. This is a promissory note issued by companies re'uiring short!term funds 0say from 4B days to 4A7 days or si# months1. Ma#imum period is t&el e months. The si#!month commercial paper can be e#tended for a further period of si# months$ making a total of 46 months. ,ommercial bills discounted by banks and 3on!banking Financial >nstitutions. These are short!term bills usually not e#ceeding <7!467 days co ering commercial transactions in the pri ate sector. Treasury bills issued by Do ernment of >ndia through the RB> for meeting budgetary deficits. These are for fi#ed maturity periods of <4 days and G89 days.

;egments of money markets

The Reser e Bank of >ndia controls the money markets in >ndia. >t is kno&n as money market regulator.

Primary market
Primary market in the money market is &herein the >nstitutions re'uiring funds issue securities like treasury bills and get finance and there is no specific market place e#cepting in the case of treasury bills. RB> conducts auction of treasury bills after due notice in national dailies and hence this can be construed as the .market place/.

;econdary market
The secondary market is pro ided by ?iscount and Finance House of >ndia -imited 0?FH>1 a subsidiary of RB>. >t pro ides a t&o!&ay 'uotation$ one for purchasing money market instruments and another for selling money market instruments. For
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Subject: Financial Management

Chapter: One e#ample$ a holder of Treasury bill of Do ernment of >ndia can sell it to ?FH> and anyone &ants to purchase treasury bills$ he can approach ?FH> &ho can sell it to him. There is no secondary market for call money or notice money market.

;egments of capital markets:

D*> bonds +arious state go ernment bonds Bonds issued by Public ;ector undertakings like BHE- etc. Bonds issued by pri ate sector companies$ banks and financial institutions ?ebentures issued by pri ate sector companies E'uity share capital issued by pri ate sector companies Preference share capital issued by pri ate sector companies

>n the case of public issues by pri ate sector companies$ banks$ financial institutions and mutual funds$ ;ecurities E#change Board of >ndia 0;EB>1 is the controlling authority. >t is referred to as the capital market regulator. Ho&e er ;EB> does not control Do ernment bonds or securities issued by Public ;ector )ndertakings. D*> bonds and state go ernment bonds are handled and controlled by RB>. Public sector undertaking like Bharat Hea y Electricals -imited 0BHE-1 come directly under D*> " M*F.

Primary market
There is no specific market place for this. This again$ like in the case of money market$ facilitates issue of securities by those &ho re'uire funds in the medium to long!term. The public issue process is super ised and controlled by the lead merchant bankerFbankers in the case of all public issues. Primary market ends &ith the listing of securities on stock e#changes by the Registrar to the >ssue. ?etails of operators in the primary market ha e been gi en under .%gents operating in financial markets/.

;econdary market
The secondary market begins &ith the listing of securities on the stock e#changes by the Registrar to the issue. >t has a market place in the form of stock e#changes. >ts operations are through share brokers &ho are registered &ith respecti e stock e#changes. The stock e#changes in turn are controlled and regulated by ;EB>. ?etails of operators in the secondary market ha e also been gi en under .%gents operating in the financial markets/.

;tatutes go erning the arious segments of the financial markets and the statutory authorities
;tatute means an %ct passed either by the Parliament or ;tate legislature. Money market " 3o specific statute " controlled by RB> ,apital market " ;ecurities ,ontracts Regulations %ct and Rules as &ell as ;EB> regulations for the arious operators in the ,apital market " controlled by ;EB>. Mutual Funds also come under the Regulations of ;EB>. >nsurance " >nsurance Regulatory and ?e elopment %ct 0>R?%1 " controlled by the >nsurance Regulatory and ?e elopment %uthority coming under D*>$ Ministry of Finance Banking " Banking Regulations %ct controlled by RB> 3on!banking Financial ,ompanies 03BF,s " e#ample Iotak Mahindra Finance ,ompany -imited1 " 3on!Banking Financial ,ompanies %ct of RB> Functioning of limited companies registered in >ndia " The ,ompanies: %ct " controlled by the ,ompany -a& Board 6 0,-B1 coming under D*>$ Ministry of Finance. The principal officer is kno&n as .The Registrar of ,ompanies/ 0R*,1. Foreign E#change market " Foreign E#change Management %ct and E#change ,ontrol Regulations %ct both coming under the RB> ;ome segments of the financial markets like the >ndian companies accessing international markets come directly under the D*>$ Ministry of Finance

Company &a! 'oard is primarily responsible for conduct of the affairs of limited companies registered in India under the Companies( )ct. The difference in roles of C&' and *+'I is that the latter is mainly concerned !ith issue of securities in the capital mar#et protecting the interests of various #inds of investors. *+'I is not controlling The Companies( )ct !hile C&' is not controlling the *C,). They play complementary roles. Pun(ab Technical )ni ersity$ *nline +irtual ,ampus -

Subject: Financial Management

Chapter: One

The financial intermediaries

% financial intermediary means an institution like a bank mobilising resources from sa ing units in the economy and deploying these resources by gi ing loans to or by in estment in users of these financial resources for creating economic &ealth. Banking companies Financial >nstitutions 0F>s1 Mutual Funds 0MFs1 3on!banking Financial ,ompanies 03BF,s1

;pecial organisations
These come under one of the financial market regulators or directly under D*> " Ministry of Finance %ll!>ndia Financial >nstitutions " D*> " M*F ,entral Board of ?irect Ta#es " ,B?T " D*> " M*F ;tock E#changes " ;EB> 3ational Bank for %griculture and Rural ?e elopment 03%B%R?1 " RB> >nstitute of ,hartered %ccountants of >ndia 0>,%>1 " D*> " M*F >nstitute of ,ost and 5orks %ccountants of >ndia 0>,5%1 " D*> " M*F >nstitute of ,ompany ;ecretaries of >ndia 0>,;>1 " D*> " M*F >nstitute of ,hartered Financial %nalysts of >ndia 0>,F%>1 " D*> " M*F Foreign >n estment Promotion Board 0F>PB1 " D*> ! M*F

%gents operating in different segments of the financial markets The agents operating in the capital market are more. Hence &e e#amine them briefly here. >n respect of other segments of the financial markets from a study of the abo e it &ill be clear to the students as to &ho the operators are in the respecti e segments. Primary market: Merchant bankerG 0the principal operator1 ;hare brokers &ho under&rite9 besides marketing the issue Bankers to the issue &ho collect the share application money along &ith the share application forms %d ertisement companies and publicity companies Printers for printing the stationery re'uired for the issue Registrars to the >ssue &ho take the responsibility of issuing the securities to successful in estors 0in case the issue collects more money than the issue siCe1$ refund e#cess money together &ith interest and getting the securities listed on a ;tock E#change ;econdary market:
G

;tock E#changes " controlled and regulated by ;EB>

.erchant ban#er controls the /rimary mar#et and is fully responsible for the issue of public securities li#e equity shares debentures bonds etc. the capital mar#et instruments. 0e is the principal operator and controls and monitors all the other operators in the capital mar#et. 0e is fully accountable to *+'I for the smooth conduct of the operations in the capital mar#ets. 0e has to ensure 1112 conformity !ith *C,) rules and regulations as !ell as *+'I rules and regulations.
9

3nder!riting in the capital mar#et means giving an underta#ing to invest money in securities issued to public should the issue fail to collect the required amounts as per *+'I rules and regulations. 3nder!riting as such does not involve any funds and hence is referred to as fee based activity. 0o!ever once the issue fails to collect the required amount the under!riter is e4pected to ma#e good the deficit amount to the e4tent underta#en by him. Pun(ab Technical )ni ersity$ *nline +irtual ,ampus 5

Subject: Financial Management

Chapter: One

;hare brokers " controlled by respecti e stock e#changes ?epositories " 3ational le el special organisations coming under the national stock e#changes and assume responsibility for collating details of o&nership of shares issued by a limited company.
B

?epository participants " Retail le el operators &ho maintain Electronic ;hare %ccounts of arious o&ners of securities Financial instruments
%lready referred to under financial markets abo e. For further details$ please refer to chapter on financial sources

*uestions for reinforcement of learning

4. 5ith the help of details gi en under >ndian Financial ;ystem$ dra& the map of >ndian Financial system$ starting from Do ernment of >ndia " Ministry of Finance. %lso isit &ebsite " &&&.nic.in to kno& more about the functioning of Do ernment of >ndia " Ministry of Finance$ its different departments and their functions etc. 5hat is the difference bet&een a share broker and a depository participantJ >s there a statute controlling the money markets in >ndiaJ 5ho pro ides the secondary market in the money markets segmentJ 5hat are the instruments in the money market and capital marketJ 5hat do you understand by the term .under&riting/ in the capital marketJ ,an you name some 3BF,s operating in >ndiaJ Try to bifurcate the banking sector in >ndia into different segments like pri ate sector$ public$ co!operati e and commercial banks. Further bifurcate the pri ate sector banks into banks of >ndian origin and foreign banks. ?oes >,>,> still e#ist as a Financial >nstitutionJ >f not$ &hyJ

6. G. 9. B. 8. =. A.

)t present !e have t!o depositories operating at the national level 6 7ational *ecurities 8epositories &imited 97*8& 6 o!ned by the 7ational *toc# +4change: and Central 8epository *ervices &imited 9C8*& 6 o!ned by the 'ombay *toc# +4change:. )s per capital mar#et regulations in the secondary mar#et the securities can be sold only in the demat or electronic form and not in the physical form. )ccordingly under the national level depositories depository participants operate at the retail level. They maintain the individual demat accounts on behalf of the shareholders and investors of other securities. These demat accounts are often referred to as +lectronic *hare )ccounts. The 8/s transfer the data from the retail level to the national level depositories !ho in turn collate information about o!nership of securities and submit data to the signatory companies !ith !hom they have signed contracts. Pun(ab Technical )ni ersity$ *nline +irtual ,ampus ;