1.

1 Introduction Management of funds is one of the most important functions of any organisation, be it a profit oriented organisation or social organisation like CRY. In this Chapter, we shall try to understand the basic concepts of financial management i.e. management of money matters. In our day-to-day life also we face many finance related problems which we try to solve on our own judgement or with the help of friends and relatives examples of such problems can be 1. Mr A is willing to buy a car but is not sure from which bank he shall take loan. 2. Ms X is having Rs 5 lakhs that she is willing to invest profitably and without much risk. If we analyse carefully we can elaborate the problems as follows 1. Which bank offers the cheapest interest rates? What will be the repayment period ? What will be the instalment per month? How much instalment Mr A can afford, considering his all other expenses? and so on 2. Whether to invest in government securities, Provident fund, Mutual funds, Debentures, Shares, gold or real estate ? To put it simply we can say that Mr A is facing a problem about procurement of funds whereas Ms X is facing problem as to investment of funds. Financial Management provides guidelines , tools and methods of solving the problems of procurement of funds and problems of investment of funds and is helpful for every organisation as well as individual. Finance may be defined as the art and science of managing money. The major areas of finance are: (1) financial services and (2) managerial finance/corporate finance/financial management. While financial services is concerned with the design and delivery of advice and financial products to individuals, businesses and governments within the areas of banking and related institutions, personal financial planning, investments, real estate, insurance and so on, financial management is concerned with the duties of the financial managers in the business firm. Financial managers actively manage the financial affairs of any type of business, namely, financial and non-financial, private and public, large and small, profit-seeking and not-for-profit. They perform such varied tasks as budgeting, financial forecasting, cash management, credit administration, investment analysis, funds management and so on. In recent years, the changing regulatory and economic environments coupled with the globalisation of business activities have increased, the complexity as well as the importance of the financial managers' duties. As a result, the financial management function has become more demanding and complex.

1.2 Meaning of Financial management Various authors have defined the term financial management differently. The most acceptable definition of financial management deals with procurement of funds and their effective utilisation. There are, thus, two basic aspects of financial management procurement of funds and their effective utilisation. 1.2.1 Procurement of funds Procurement of funds or raising the funds is complex problem as funds can be obtained from indefinite sources, each having different characteristic in terms of risk, cost and control. E.g - let us evaluate some sources of funds (For detailed discussion of sources of funds refer following topics - cost of capital and sources of funds)

R I S K

Risk High Cost Low (Bank loan)

Cost High Risk Low (Equity shares)

COST Again Control risk is least for bank loan where as it is highest for Equity shares. One more constraint for procurement of funds is availability of funds e.g for a small business house only availability may be bank loan and the business may not be able to raise funds from public by way of equity shares. Procurement of funds inter alia includes Identification of sources of finance Determination of finance mix from such sources Raising of funds Allocation of profits between dividends and retention of profits i.e internal fund generation In the current global scenario it is not enough to scout for available ways of raising finance but resource mobilisation has to be undertaken through innovative financial products which understand the business as well as investors needs an example can be convertible debentures which gets converted from debentures to equity shares after a predefined date. 1.2.2 Utilisation of Funds - A finance manager is also responsible for effective utilisation of funds. He is responsible to ensure that the funds are not kept idle and are invested properly. Utilisation of funds can be directly linked with the procurement of funds, if the funds are not utilised to generate income higher than the cost of procuring it then there is no point in running the business, say, for example if a bank is offering 5% interest on deposits then the banker must ensure that the amount of deposit is utilised to generate an income which is higher than 5%. The funds have to be so invested that the company can optimise its profitability without harming its solvency and liquidity. The finance manager has to invest in fixed assets and current assets in a right proportion so as to reap maximum yield. Utilisation of funds inter alia includes Identification of area of investments Determination of finance mix for the utilisation Assessing the risk level of the investment Maximising the return on such investment In present day scenario utilisation of funds can be done in indefinite ways making the job of finance manager more complicated and demanding. Following chart indicates the decisionmaking options available to a finance manager for utilisation of its funds.

R I S K

Risk High Returns high (Equity market)

Risk Low Return Low (Government Security) RETURN

1.3 Importance of Financial Management The importance of finance manager cannot be over-emphasised. There is an ordinary belief that a finance manager is needed only in private organisations. However, sound finance manager is essential in all organisations whether profit or non profit where funds are involved. Financial management is so essential as he plays a crucial role in making best use of resources. Commercial history is full of examples where firms have been liquidated not because their technology was obsolete or it lacked demand for its products but because of financial mismanagement, a recent example of ENRON INC can be very elaborative about this point. Financial management essentially optimises the output from the given input of funds. It attempts to use the funds in most productive manner. In underdeveloped countries like India where resources are scare and demands on funds are many, the need for finance manager is enormous. Finance management can be very effective in case of non-profit making organisations as which hardly pay proper attention to financial management. Very frequently we read about such organisations closing down because of lack of finance, in fact, many times, it is not lack of finance but it is lack of proper financial management. Many times these organisations keep their funds idle which has cost. Though motive of such organisations is not to make profits but it can certainly cut down its costs in order to have sound financial position. An example - Following extract is taken from board report of a company emphasising the turnaround in companys financial position achieved due to sound financial management Better cash management and control over capital employed and working capital has helped the company in reducing its loans from Rs 580 crores to Rs 200 crores resulting into interest saving of approx Rs 30 crores, this has improved profit position of the company substantially. We hope to continue with similar performance in current year by undertaking further cost cutting and strict control over cash flows. 1.4 Objectives of Financial Management A basic understanding of objectives of financial management would help us in appreciating how a finance manager makes his decisions. Decisions can be made only when objectives are clear. Following are the fundamental objectives of finance manger 1.4.1 Profit Maximisation It cannot, however, be the sole objective of the company, but it is certainly one of the most important objectives. If a company is run with sole object of profit making then it can create certain problems like i. Profit maximisation has to be attempted with a realisation of risks involved. Risk and profit is directly relates and motive of profit maximisation may lead to risk

ii.

iii.

maximisation also. A finance manager with sole objective of profit maximisation may end up taking excessive risk, which may lead to failure of organisation. In practice, risk is given almost equal importance as that of profit and profit is maximised only till it reaches the acceptable risk level. Profit maximisation may or may not take into account the time pattern of return i.e even if Project A is having more profit than Project B, project A may start giving return at the end of year 5 and Project B at the end of year 1. In such scenario finance manager has to consider both the things time and profit and not only profit. Profit maximisation is a very narrow object and does not take into consideration social aspects, which can be very harmful to the society.

1.4.2 Wealth Maximisation The policy of profit maximisation is considered as short-term policy as it may give exorbitant benefits in short term but may end up affecting growth and survival of the company in the long run. Thus a company may start buying inferior raw materials in order to maximise profit, which it may actually get for some period, but will end up losing its goodwill and may have to close down. Hence, it is commonly agreed that the objective of a firm is to maximise its value or wealth. According to Van Horne Value is represented by the market price of the companys common stock The market price of a firms stock represents the focal judgement of all market participants as to what the market value of the particular firm is. It takes into consideration present and expected future earnings per share, the timing and the risk associated to the earning, companys dividend policy etc.. The market price serves as performance indicator of the firm; it indicates how well management is doing on behalf of the stockholders. Though market value of the firm depends upon various factors, it normally depends upon two Factors a. The likely rate of earnings per share of the company (EPS) b. The Capitalisation rate Let us see one example. If for a company A ltd the market expectation of returns is 25% and its Earnings per share is Rs 5 (EPS = Earnings available to equity share holders/ no of equity shares outstanding) then the market price per share will be 5/25*100 = Rs 20 per share. If we calculate in reverse way we can see that the return on every Rs 20 invested the shareholder will be getting Rs 5 i.e 25% which is as per his expectations. The expected return varies form company to company and industry to industry (which is 25% for A ltd), the logic for expected returns is simple - more the risk more will be the expected returns. The finance manager has to ensure that his decisions are such that the market value of the shares of the company is maximum in the long run. It is, therefore, duty of the finance manager to optimise the earning of the company so that its value is maximum. Wealth maximisation can thus be considered a better objective as it considers both risk and return of the company. It must be clearly understood that financial decision-making is related to the objective of business and objective of business over shadows the objective of wealth maximisation. To support the statement the following example can be taken suppose a Public sector under taking, which is in business of steel pipes, is planning to undertake a research and development programme on fertility of baron lands for public welfare, then the finance manager cannot deny funds stating that this is wastage of funds and it wouldnt maximise the companys wealth. 1.5 Functions of Finance Manager

The main function of finance manager revolves around procurement of funds and its effective utilisation. Thus all the decisions concerning management of funds are subject matter of finance function. This function involves a number of important decisions; some of these have been listed below 1.5.1 Estimating the requirements of funds - In any business requirement of funds have to be carefully estimated. Certain funds are required for long term purposes i.e investment in fixed assets etc. Not only a careful estimation of such funds is required but also estimation of timing of its requirement is essential. Finance Manager also has to estimate the requirement of the working capital and how much funding will be required for funding its current assets. Forecasting these requirements require budgetary controls and techniques. To forecast the funds requirement all the physical activities of the organisation has to be forecasted like sales, requirement of fixaed assets, debtors etc. 1.5.2 Decision regarding the capital structure After estimating the quantum of funds required the finance manager has to plan for the sources from where the funds should and can be raised. An optimum mix of the various sources has to be worked out for this purpose. As discussed earlier each source of finance has different cost, risk and control risk, a finance manager has to take into consideration all these factors and find out an optimum capital structure which will be best for the organisation. Finance manager has to maintain a proper proportion of outside borrowings and own funds. Again as every other decision this decision should also aim at wealth maximisation, which can be achieved by keeping the cost of capital (borrowed from outside as well as own funds) minimum. This is a golden rule of capital structure theories that lesser the cost of capital higher will be the market value of the business. 1.5.3 Investment decision Funds procured should be invested in various kinds of assets. Long term loans / funds should be invested in Fixed assets and short term funds should be invested in current assets. The investment in any asset should be made after through examination of all the options, the technique for examining various capital projects is termed as capital budgeting. One thing a finance manager should always keep in mind is that money should never be kept idle as idle money always has a cost. 1.5.4 Dividend decision The finance manager is concerned with the decision to the decision to declare and pay the dividends periodically, so that the equity investors get return on their investments. He has to help the top management in identifying how much amount can be distributed as dividends, keeping in mind organisations cash needs, expansion plans etc.. There are many other factors on which this decision depends like trend of earnings, the trend of market price of the shares, the tax implications etc. 1.5.5 Supply of funds to all departments and cash management Though not a primary function, cash management and funds allocation is an important function of a finance manager. It is more than likely in any organisation that one branch or department is having excess cash and other may be having a shortage, this may hamper companys day to day functioning as adequate funds is a necessity for smooth running of any business. Finance manager should ensure that cash is not kept idle as it may cost the organisation heavily. 1.5.6 Evaluating financial performances Finance manager is always required to do the job of performance evaluator of the company. He has to supply top management information with financial analysis. Analysis of financial performance helps the management in seeing how the funds have been utilised in various divisions and what can be done to improve it.

1.5.7 Financial negotiations A major responsibility of finance manager is to negotiate with bankers, financial institutions providing loans, debenture investors etc. Negotiation for finance is considered as a specialised job and involves lots of expertise. 1.5.8 Maintaining the share price of the company stability in market price of the shares is extremely essential for every organisation as it maintains the companys goodwill amongst the investors. It is responsibility of Finance manager to see that the prices of shares do not fluctuate extremely. 1.6 Financial management and organisational structure The chief financial executive (his designation may vary from company to company) works directly under the president or Managing director of the company. Besides routine work, he keeps the Board of directors informed about all the phases of business activity, including economic, social and political developments affecting the business behaviour. He also furnishes information about the financial status of the company by analysing it from time to time. The chief financial executive may have many officers under him to carry out his functions. Broadly, his functions are divided into two channels A. Treasury functions B. Control functions The above statement is elaborated in the following chart
Board of directors

Managing director / President

VP (Marketing)

V.P. (Finance)

V.P (Prodn.)

Treasurer

Credit Management

Cash Management

Banking

Portfolio management

Controller

Financial Accounting

Taxes

Internal audit

Budgeting

MIS

&

Cost accounting

1.6.1 Relationship of finance manager with other managers Finance function can never be an independent function and is closely related with other management functions like production, marketing, personnel etc. well take a close look at how these functions are co related, in order to understand position of finance manger in the organisation. Finance is blood of an organisation. It is the common thread which binds all the organisational functions as each function when carried out creates financial implications. The interface between finance and other functions can be described as follows Production Finance Production Function necessitates a large investment. Productive uses of resources ensure a cost advantage for the firm. Optimum investment in inventories improves profit margins. Many parameters of the production function having effect on production cost or possible to be controlled through internal management, thus improving profits. One of the important decisions taken by Finance Production departments together is the make or buy decision. In current scenario this decision has lead to heavy outsourcing to low cost countries. Marketing Finance Many aspects of marketing management have direct financial impact. How much inventory shall be hold so that prompt delivery can be guaranteed to the customer, has a direct impact on inventory holding cost of the company. Similarly credit period granted to customers by the marketing department directly affects the liquidity position of the company. Marketing campaigns and advertisements have huge cost and should always co-related with the revenue which it generates. Personnel Finance In the globalised competitive scenario business firms are moving to leaner and flat organisations. Investments in human resource development are also bound to increase. Restructuring of remuneration structure, Voluntary retirement schemes, stock options etc. have become major financial decisions in the areas of human resources management. Finance may be defined as the art and science of managing money. The major areas of finance are: (1) financial services and (2) managerial finance/corporate finance/financial management. While financial services is concerned with the design and delivery of advice and financial products to individuals, businesses and governments within the areas of banking and related institutions, personal financial planning, investments, real estate, insurance and so on, financial management is concerned with the duties of the financial managers in the business firm. Financial managers actively manage the financial affairs of any type of business, namely, financial and non-financial, private and public, large and small, profit-seeking and not-for-profit. They perform such varied tasks as budgeting, financial forecasting, cash management, credit administration, investment analysis, funds management and so on. In recent years, the changing regulatory and economic environments coupled with the globalisation of business activities have increased, the complexity as well as the importance of the financial managers' duties. As a result, the financial management function has become more demanding and complex.