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 marets in !ndia "overnment of !ndia# Ministry of Finance at the helm# statutes#
statutory authorities# financial intermediaries# other financial institutions# agents $ho operate in the marets etc%
&rief introduction to 'Financial !nstruments(
At the end of the chapter the student will be able to
Map the differences bet$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 aboe function has got sub!diisions " 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 aboe
Ensuring that the funds are aailable in ade'uate 'uantity at appropriate time and at an affordable cost
Management of cash in the organisation through cash flo& statement
Management of inestment 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$hausti#e.
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Subject: Financial Management
Chapter: One
-et us e#amine briefly the aboe functions &ith some e#amples.
Financial planning and estimation of finance re'uired for the organisation
%ny actiity in a business enterprise re'uires planning for proper e#ecution in time. Finance is re'uired for any actiity at least in
the beginning and hence financial planning is the prime function of .Finance/. This inoles detailed study of any actiity from
understanding the total funds re'uirement for that actiity$ &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 hae to come from outside 0e#ternally12 for an e#isting enterprise$ a
part of the resources at least &ill be aailable from the profits made in the past and retained in business after declaring diidend.
E#ample 3o. 4:
5e re'uire Rs. 677 lacs for an actiity. -et us see ho& it affects an e#isting enterprise. -et us assume the profits aailable 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
Haing ascertained in the aboe e#ample that &e re'uire Rs. 677 lacs for a set actiity$ for a ne& enterprise &e re'uire the entire
amount to be mobilised. For an e#isting enterprise &ith aailable profits of Rs. 87 lacs$ &e re'uire only Rs. 497 lacs. The
Financial manager &ill then assess all the alternatie resources aailable to him 0for details please refer to ,hapter no. 91 keeping
in mind the follo&ing parameters:
%de'uacy 0aailability in ade'uate 'uantity1
Timely 0aailability in time1 and
%t an affordable cost
%de'uate supply in time etc.
This has been e#plained this in the aboe point. For reinforcement the student:s attention is dra&n to one of the ob(ecties of
financial management at least in the short run$ the ob(ectie 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 inoles the follo&ing steps:
%scertaining the aerage cash re'uirement by looking at the past figures and for a ne& enterprise$ estimating this
figure.
Preparing the cash flo& statement for a gien 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 reeals 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 inestment outside the organisation
*er a period of time the enterprise reinests a part of the profits for future gro&th of the organisation in business. The Finance
manager can inest such funds outside the business in other enterprises also proided the parent enterprise does not re'uire them
immediately. ;hort!term surplus as reealed by the ,ash flo& statement is also inested for short duration. Thus inestment
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. 5heneer this is done the inoice 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 inoled &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 hae a ); ?ollar bill for 4777 receiable after a month. Presently the e#change rate is 4 ); ?ollar @ Rs.9A.6B. By the time
the money is receied 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 aboe 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 inestment etc$ could be some of the factors influencing the need for a full!fledged Finance department.
Accounts function
,ore accounts hae 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 proisions of ,ompanies:
%ct " ;chedule E>+
,onforming to proisions relating to %dance 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 proisions relating to statutory audit of accounts under the ,ompanies: %ct
Preparation of reenue and capital budgets
Management >nformation ;ystem 0M>;1 relating to %ccounts and Finance
3ote: Further details on the aboe are not gien 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(ectie 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 ?iidend per share
0?P;1 and Retained Earnings per share 0REP; or Reseres per share1. This ob(ectie is often times referred to as .profit
ma#imisation/. This is kno&n as the short!term ob(ectie as it is done on a continuous$ year!to!year basis. *ne or more of the
follo&ing measures can achiee this:
Monitoring of costs on a continuous basis through budgets
;uitable cost reduction techni'ues &hereer 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 leerage " for further details please refer to ,hapter no. B "
*perating and financial leerages
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Subject: Financial Management
Chapter: One
,ontrol oer li'uidity aailable 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(ectie 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 Reseres 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
Reseres 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(ectie also is a contributory factor to realising
the long!term ob(ectie of &ealth ma#imisation.
;ome of the measures through &hich &e achiee the long!term ob(ectie are:
;trategic financial management decisions relating to e#pansion$ take oer of another business$ financial re!restructuring
through financial re!engineering 0e#ample " s&ap a costly loan for a cheaper loan proided 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(ectie and long!term ob(ectie need to be put in place for sustained gro&th of a business
enterprise. To an e#tent at least$ the long!term ob(ectie is dependent upon the short!term ob(ectie of profit ma#imisation.
Financial sstem 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$ superise$ monitor and control the players$ intermediaries$ the inestors etc. &ho take part in
the financial markets in the system. Further an efficient system alone can ensure that the national ob(ectie on .Economy/ of the
country is met by aligning the deelopments in the system &ith the national priorities. %n e#ample of the national priority
deciding the deelopment in the financial markets is " .infrastructure deelopment and need for longer duration financial
resources/ and deelopment 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 Sstem
The Doernment 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 goerning the arious segments of the financial markets
4
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 )niersity$ *nline +irtual ,ampus $
Subject: Financial Management
Chapter: One
The statutory authorities responsible for regulating$ superising$ 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 een 67!6B years
Foreign e#change markets
>nsurance market
Banking and
Mutual funds
The money markets and capital markets in turn do hae .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 inestor to another for
financial consideration.
;egments of money markets: ,all money market e#clusiely 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 oer the
phone.
;egments of money markets ,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&ele 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 coering commercial transactions in
the priate sector.
Treasury bills issued by Doernment of >ndia through the RB> for meeting
budgetary deficits. These are for fi#ed maturity periods of <4 days and G89 days.
The Resere 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 proided by ?iscount and Finance House of >ndia -imited 0?FH>1 a subsidiary of RB>. >t proides a
t&o!&ay 'uotation$ one for purchasing money market instruments and another for selling money market instruments. For
Pun(ab Technical )niersity$ *nline +irtual ,ampus %
Subject: Financial Management
Chapter: One
e#ample$ a holder of Treasury bill of Doernment 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 goernment bonds
Bonds issued by Public ;ector undertakings like BHE- etc.
Bonds issued by priate sector companies$ banks and financial institutions
?ebentures issued by priate sector companies
E'uity share capital issued by priate sector companies
Preference share capital issued by priate sector companies
>n the case of public issues by priate 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&eer ;EB> does not control
Doernment bonds or securities issued by Public ;ector )ndertakings. D*> bonds and state goernment bonds are handled and
controlled by RB>. Public sector undertaking like Bharat Heay 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 superised 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 hae been gien 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 respectie stock
e#changes. The stock e#changes in turn are controlled and regulated by ;EB>. ?etails of operators in the secondary market hae
also been gien under .%gents operating in the financial markets/.
;tatutes goerning 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 ?eelopment %ct 0>R?%1 " controlled by the >nsurance Regulatory and ?eelopment
%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
6
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 )niersity$ *nline +irtual ,ampus -
Subject: Financial Management
Chapter: One
The financial intermediaries
% financial intermediary means an institution like a bank mobilising resources from saing units in the economy and deploying
these resources by giing loans to or by inestment 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 ?eelopment 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 >nestment 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 aboe it &ill be clear to the students as to &ho the operators
are in the respectie segments.
Primary market: Merchant banker
G
0the principal operator1
;hare brokers &ho under&rite
9
besides marketing the issue
Bankers to the issue &ho collect the share application money along &ith the share application
forms
%dertisement 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 inestors
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: ;tock E#changes " controlled and regulated by ;EB>
G
.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.
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Subject: Financial Management
Chapter: One
;hare brokers " controlled by respectie stock e#changes
B
?epositories " 3ational leel 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.
?epository participants " Retail leel operators &ho maintain Electronic ;hare %ccounts
of arious o&ners of securities
Financial instruments
%lready referred to under financial markets aboe. For further details$ please refer to chapter on financial sources
*uestions for reinforcement of learning
4. 5ith the help of details gien under >ndian Financial ;ystem$ dra& the map of >ndian Financial system$ starting from
Doernment of >ndia " Ministry of Finance. %lso isit &ebsite " &&&.nic.in to kno& more about the functioning of
Doernment of >ndia " Ministry of Finance$ its different departments and their functions etc.
6. 5hat is the difference bet&een a share broker and a depository participantJ
G. >s there a statute controlling the money markets in >ndiaJ 5ho proides the secondary market in the money markets
segmentJ
9. 5hat are the instruments in the money market and capital marketJ
B. 5hat do you understand by the term .under&riting/ in the capital marketJ
8. ,an you name some 3BF,s operating in >ndiaJ
=. Try to bifurcate the banking sector in >ndia into different segments like priate sector$ public$ co!operatie and
commercial banks. Further bifurcate the priate sector banks into banks of >ndian origin and foreign banks.
A. ?oes >,>,> still e#ist as a Financial >nstitutionJ >f not$ &hyJ
B
)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.
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