Financial Management

Unit 1

Unit 1

Financial Management

Structure:
1.1 Introduction
Objectives
1.2 Meaning and Definition of Financial Management
1.3 Goals of Financial Management
Profit maximisation
Wealth maximisation
Wealth maximisation vs. profit maximisation
1.4 Finance Functions
Financing decisions
Investment decisions
Dividend decisions
Liquidity decisions
1.5 Organisation of Finance function
1.6 Interface between Finance and Other Business Functions
Relation between Finance and accounting
Finance and marketing
Finance and production (operations)
Finance and HR
1.7 Summary
1.8 Glossary
1.9 Terminal Questions
1.10 Answers
1.11 Case Study

1.1 Introduction
Financial management of a firm is concerned with procurement and
effective utilisation of funds for the benefit of its shareholders. It embraces
all those managerial activities that are required to procure funds at the least
cost and their effective deployment.
Reliance and Infosys are examples of admired Indian companies that
employ effective financial management skills to their businesses. They have
been rated well by the financial analysts on many crucial aspects that
enabled them to create value for their shareholders. They employ the best
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technology, produce good quality goods or render services at the least cost,
and continuously contribute to the shareholders wealth.
The three core elements of financial management are:
a. Financial planning
Financial planning is done to ensure the availability of capital
investments to acquire the real assets. Real assets are lands, buildings,
plants and equipments. Capital investments are required for establishing
and running the business smoothly.
b. Financial decisions
Decisions need to be taken on the sources from which the funds
required for the capital investments could be obtained.
There are two sources of funds - debt and equity. In what proportion
the funds are to be obtained from these sources is to be decided for
formulating the financing plan.
c. Financial control
Financial control involves managing the costs and expenses of a
business. For example, it includes taking decisions on the routine
aspects of day-to-day management of collecting money which is due
from the firms customers and making payments to the suppliers of
various resources.
In this unit, you will learn about these core elements of financial
management.
Objectives:
After studying this unit, you should be able to:
analyse the meaning of business management
describe the goals of financial management
discuss the functions of finance
explain the interface between finance and other managerial functions of a
firm

1.2 Meaning and Definition of Financial Management

Financial management is the art and science of managing money.
Regulatory and economic environments have undergone drastic changes
due to liberalisation and globalisation of Indian economy. These have
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changed the profile of Indian finance managers. Indian finance managers

have transformed themselves from License Raj managers to well-informed,
dynamic, proactive managers capable of taking decisions of complex
nature.
Traditionally, financial management was considered as a branch of
knowledge that focused on the procurement of funds. Formation, merger
and restructuring of firms and legal and institutional frame work, instruments
of finance occupied the prime place in this traditional approach.
The modern approach transformed the field of study from the traditional,
narrow approach to a dynamic and extensive approach. The core of modern
approach evolved around the procurement of the least cost funds and its
effective utilisation for maximisation of shareholders wealth.
Self Assessment Questions
1. What has changed the profile of Indian finance managers?
2. Finance management is considered as a branch of knowledge with
focus on the __________.

1.3 Goals of Financial Management

Financial management means maximisation of economic welfare of its
shareholders. Maximisation of economic welfare means maximisation of
wealth of its shareholders. Shareholders wealth maximisation is reflected in
the market value of the firms shares. Experts believe that, the goal of
financial management is attained when it maximises the market value of
shares. There are two versions of the goals of financial management of the
firm Profit Maximisation and Wealth Maximisation.
Let us now discuss the goals of financial management in detail.
1.3.1 Profit maximisation
Profit maximisation is based on the cardinal rule of efficiency. Its goal is to
maximise the returns with the best output and price levels. A firms
performance is evaluated in terms of profitability. Profit maximisation is the
traditional and narrow approach, which aims at maximising the profit of the
concern. Allocation of resources and investors perception of the companys
performance can be traced to the goal of profit maximisation. Profit
maximisation has been criticised on many accounts:
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The concept of profit lacks clarity. What does profit mean?

o Is it profit after tax or before tax?
o Is it operating profit or net profit available to shareholders?

In this sense, profit is neither defined precisely nor correctly. It creates

unnecessary conflicts regarding the earning habits of the business
concern. Differences in interpretation of the concept of profit thus expose
the weakness of profit maximisation.

Profit maximisation neither considers the time value of money nor the net
present value of the cash inflow. It does not differentiate between profits
of current year with the profits to be earned in later years.

The concept of profit maximisation fails to consider the fluctuations in

profits earned from year to year. Fluctuations may be attributed to the
business risk of the firm. Risks may be internal or external which will
affect the overall operation of the business concern.

The concept of profit maximisation apprehends to be either accounting

profit or economic normal profit or economic supernormal profit.
Profit maximisation as a concept, even though has the above-mentioned
drawbacks, is still given importance as profits do matter for any kind of
business. Ensuring continued profits ensure maximisation of
shareholders wealth.

Figure 1.1 depicts the two goals of financial management.

Figure 1.1: Goals of Financial Management

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1.3.2 Wealth maximisation

The term wealth means shareholders wealth or the wealth of the persons
those who are involved in the business concern. Wealth maximisation is
also known as value maximisation or net present worth maximisation. This
objective is an universally accepted concept in the field of business.
Wealth maximisation is possible only when the company pursues policies
that would increase the market value of shares of the company. It has been
accepted by the finance managers as it overcomes the limitations of profit
maximisation.
The following arguments are in support of the superiority of wealth
maximisation over profit maximisation:
Wealth maximisation is based on the concept of cash flows. Cash flows
are a reality and not based on any subjective interpretation. On the other
hand, profit maximisation is based on accounting profit and it also
contains many subjective elements.
Wealth maximisation considers time value of money. Time value of
money translates cash flow occurring at different periods into a
comparable value at zero period. In this process, the quality of cash flow
is considered critical in all decisions as it incorporates the risk associated
with the cash flow stream. It finally crystallises into the rate of return that
will motivate investors to part with their hard earned savings. Maximising
the wealth of the shareholders means positive net present value of the
decisions implemented.
Let us now look at some of the key definitions.
Positive net present value can be defined as the excess of present value
of cash inflows of any decision implemented over the present value of
cash out flow.
Time value factor is known as the time preference rate; that is, the sum
of risk free rate and risk premium.
Risk free rate is the rate that an investor can earn on any government
security for the duration under consideration.
Risk premium is the consideration for the risk perceived by the investor
in investing in that asset or security.
Required rate of return is the return that the investors want for making
investment in that sector.
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Caselet:
X Ltd is a listed company engaged in the business of FMCG (Fast
Moving Consumer Goods). Listed implies that the companys shares are
allowed to be traded officially on the portals of the stock exchange. The
Board of Directors of X Ltd took a decision in one of its board meetings to
enter into the business of power generation. When the company
informed the stock exchange at the conclusion of the meeting about the
decision taken, the stock market reacted unfavourably. The result was
that the next days closing of quotation was 30% less than that of the
previous day. Why did the market react unfavourably?
Investors in FMCG company might have thought that the risk profile of
the new business that the company wants to take up is higher compared
to the risk profile of the existing FMCG business of X Ltd, expecting a
higher return. Then, the market value of the companys shares started
declining.
Therefore, the risk profile of the company gets translated into a time
value factor. The time value factor so translated becomes the required
rate of return.
1.3.3 Wealth maximisation vs. profit maximisation
Let us now see how wealth maximisation is superior to profit maximisation.
Wealth maximisation is based on cash flow. It is not based on the
accounting profit as in the case of profit maximisation.

Through the process of discounting, wealth maximisation takes care of

the quality of cash flow. Converting uncertain distant cash flow into
comparable values at base period facilitates better comparison of
projects. The risks that are associated with cash flow are adequately
reflected when present values are taken to arrive at the net present
value of any project.
Corporates play a key role in todays competitive business scenario. In
an organisation, shareholders typically own the company, but the
management of the company rests with the board of directors. Directors
are elected by shareholders. Company management procures funds for
expansion and diversification of capital markets.

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In the liberalised set up, society expects corporates to tap the capital
markets effectively for their capital requirements. Therefore, to keep the
investors happy throughout the performance of value of shares in the
market, management of the company must meet the wealth maximisation
criterion.

When a firm follows wealth maximisation goal, it achieves maximisation

of market value of share. A firm can practise wealth maximisation goal
only when it produces quality goods at low cost. On this account, society
gains because of the societal welfare. Maximisation of wealth demands
on the part of corporates to develop new products or render new
services in the most effective and efficient manner. This helps the
consumers, as it brings to the market the products and services that a
consumer needs.

Another notable feature of the firms that are committed to the

maximisation of wealth is that, to achieve this goal they are forced to
render efficient service to their customers with courtesy. This enhances
consumer welfare and benefit to the society.

From the point of evaluation of performance of listed firms, the most

remarkable measure is that of performance of the company in the share
market. Every corporate action finds its reflection on the market value of
shares of the company. Therefore, shareholders wealth maximisation
could be considered as a superior goal compared to profit maximisation.

Since listing ensures liquidity to the shares held by the investors,

shareholders can reap the benefits arising from the performance of
company only when they sell their shares. Therefore, it is clear that
maximisation of market value of shares will lead to maximisation of the
net wealth of shareholders.

Therefore, we can conclude that maximisation of wealth is probably the

more appropriate goal of financial management in todays context. Though
this cannot be a goal in isolation, it is important to understand that profit
maximisation as a goal, in a way, leads to wealth maximisation.
Self Assessment Questions
3. _______ is based on cash flows.
4. ________ considers time value of money
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1.4 Finance Functions

Finance functions deal with the functions performed by the finance
manager. They are closely related to financial decisions. In the course of
performing these functions, finance manager takes several decisions and
performs various important functions:
Financing decisions
Investment decisions
Liquidity decisions
Dividend decisions
Figure 1.2 depicts the functions of the finance manager.

Figure 1.2: Finance Managers Decisions

Let us now discuss these points in detail.

1.4.1 Financing decisions
Financing decisions relate to the composition of relative proportion of
various sources of finance. The sources could be:
(a) Shareholders Fund: Equity Share Capital, Preference Share Capital,
Accumulated Profits.
(b) Borrowing from outside agencies: Debentures, Loans from Financial
Institutions.
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Financial management weighs the merits and demerits of different sources

of finance while taking financing decision. Irrespective of the choice of
source, be it singular or a combination of both, there is a cost involved. The
cost of equity is the minimum return the shareholders would have received if
they had invested elsewhere. Borrowed funds cost involves interest
payment.
Both types of funds, thus, incur cost, and this is the cost of capital to the
company. Hence, it can be said that the cost of capital is the minimum
return expected by the company.
Financing decisions relate to the acquisition of such funds at the least cost.
In order to calculate the specific cost of each type of capital, recognition
should be given to two dimensions of cost:
Explicit Cost
Implicit Cost
A firm's explicit costs are the actual cash payments it makes to those who
provide resources. Explicit costs are rent paid on land hired, wages paid to
the employees, and interest paid on capital. In addition to this, a firm also
pays insurance premium and taxes and sets aside depreciation charges.
Explicit cost of any source of capital may be defined as the discount rate
that equates the present value of funds received by the firm net of
underwriting costs, with the present value of expected cash outflows. These
outflows may be interest payments, repayment of principal, or dividend. It
can also be stated as the Internal Rate of Return a firm pays for financing.
Implicit costs are the opportunity costs of using resources owned by the firm
or provided by the firm's owners. To the firm, the implicit costs mean the
money payments that self-employed resources could have earned in their
best alternative uses.
Implicit cost is the rate of return associated with the best investment
opportunity for the firm and its shareholders that will be foregone if the
project presently under consideration by the firm was accepted. Opportunity
costs are technically referred to as implicit cost of capital.
Implicit cost is not a visible cost but it may seriously affect the companys
operations, especially when it is exposed to business and financial risk.
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The distinction between implicit and explicit cost is important from the point
of view of the computation of cost of capital.
In India, if a company is unable to pay its debts, creditors of the company
may use legal means to sue the company for winding up and is normally
known as risk of insolvency. A company which employs debt as a means of
financing generally faces this risk especially when its operations are
exposed to high degree of business risk.
In all financing decisions, a firm has to determine the capital structure, i.e.
composition of debt and equity.
Debt is cheap because interest payable on loan is allowed as deduction in
computing taxable income on which the company is liable to pay income tax
to the Government of India.
Whenever funds are to be raised to finance investments, capital structure
decision is involved. A demand for raising funds generates a new capital
structure since a decision has to be made as to the quantity and forms of
financing.
Capital structure refers to the mix of a firms capitalisation (i.e. mix of long
term sources of funds for meeting capital requirement.) Capital structure
decision refers to deciding the forms of financing (which sources to be
tapped), their actual requirements (amount to be funded), and their relative
proportions in total capitalisation.
Normally, a finance manager tries to choose a pattern of capital structure
which minimises the cost of capital and maximises the owners return. We
will learn more on capital structure and related aspects in Unit 7.
Note
The interest rate on loan taken is 12%, tax rate applicable to the company
is 50%, and then when the company pays Rs.12 as interest to the lender,
taxable income of the company will be reduced by Rs.12.
In other words, when the actual cost is 12% with a tax rate of 50%, the
effective cost becomes 6%. Therefore, the debt is cheap. But, every
instalment of debt brings along with it corresponding insolvency risk.
Another thing notable in connection to this is that the firm cannot avoid its
obligation to pay interests and loan instalments to its lenders and
debentures.
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An investor in a companys shares has two objectives for investing:

Income from capital appreciation (capital gains on sale of shares at
market price)
Income from dividends
The ability of the company to offer both these incomes to its shareholders
determines the market price of the companys shares.
The most important goal of financial management is maximisation of net
wealth of the shareholders. Therefore, management of every company
should strive hard to ensure that its shareholders enjoy both dividend
income and capital gains as per the expectation of the market.
Therefore, to declare a dividend of 12%, a company has to earn a pre-tax
profit of 19%. On the other hand, to pay an interest of 12%, the company
has to earn only 8.4%. This leads to the conclusion that for every Rs.100
procured through debt, it costs 8.4%, whereas the same amount procured in
the form of equity (share capital) costs 19%. This confirms the established
theory that equity is costly but debt is cheap and risky source of funds to the
corporate.
Financing decision involves the consideration of managerial control,
flexibility and legal aspects, and regulatory and managerial elements.
Solved Problem 1
Dividend = 12% on paid up value
Tax rate applicable to the company = 30%
Dividend tax = 10%
Compute the profit that the company must earn before tax, when a
company pays Rs.12 on paid up capital of Rs.100 as dividend.
Solution
Since payment of dividend by an Indian company attracts dividend tax, the
company when it pays Rs.12 to shareholders, must pay to the Govt of India
10% of Rs.12 = Rs.1.2 as dividend tax.
Therefore dividend and dividend tax sum up to Rs.12 + Rs.1.2 = Rs.13.2.
Since this is paid out of the post tax profit, in this question, the company
must earn:
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Post tax dividend paid

pretax profitrequired to declare and pay the dividend
1 Tax rate
=

13.2 13.2

Rs.19(approximate)
1 0.3 0.7

1.4.2 Investment decisions

To survive and grow, all organisations have to be innovative. Innovation
demands managerial proactive actions. Proactive organisations
continuously search for innovative ways of performing the activities of the
organisation. Innovation is wider in nature. It could be:
Expanding by entering into new markets.
Adding new products to its product mix.
Performing value added activities to enhance customer satisfaction.
Adopting new technology that would drastically reduce the cost of
production.
Rendering services or mass production at low cost or restructuring the
organisation to improve productivity.
These innovations change the profile of an organisation. These decisions
are strategic because they are risky. However, if executed successfully with
a clear plan of action, investment decisions generate super normal growth to
the organisation.
A firm may become bankrupt if the management fails to execute the
decisions taken. Therefore, such decisions have to be taken after taking into
account all the facts affecting the decisions and their execution.
There are two critical issues to be considered in these decisions. They are:

Evaluation of expected profitability of the new investments.

Rate of return required on the project.

The Rate of Return required by an investor is normally known as the hurdle

rate or the cut off rate or the opportunity cost of capital.
Investments in buildings and machineries are to be conceived and executed
by a firm to enter into any business or to expand its business. The process
involved is called Capital Budgeting. Capital Budgeting decisions demand
considerable time, attention, and energy of the management. They are
strategic in nature as the success or failure of an organisation is directly
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attributable to the execution of Capital Budgeting decisions taken.

Investment decisions are also known as Capital Budgeting decisions and
hence lead to investments in real assets.
The key function of the financial management is the selection of the most
profitable assortment of capital investment. It is also one of the most
important area of decision making for the financial manager because any
action taken by the manager in this area affects the working and the
profitability of the firm in future.
The impact of long-term capital investment decisions is far reaching. It
protects the interests of the shareholders and of the enterprise because it
avoids over-investment and under-investment in fixed assets. By selecting
the most profitable projects, the management facilitates the wealth
maximisation of equity shareholders. We will take a detailed look at Capital
Budgeting in Unit 8.
1.4.3 Dividend decisions
Dividends are payouts to shareholders. Dividends are paid to keep the
shareholders happy. Dividend decision is a major decision made by the
finance manager.
Dividend is that portion of profits of a company which is distributed among
its shareholders according to the resolution passed in the meeting of the
Board of Directors. This may be paid as a fixed percentage on the share
capital contributed by them or at a fixed amount per share. The dividend
decision is always a problem before the top management or the Board of
Directors as they have to decide how much profits should be transferred to
reserve funds to meet any unforeseen contingencies and how much should
be distributed to the shareholders.
Payment of dividend is always desirable since it affects the goodwill of the
concern in the market on the one hand, and on the other, shareholders
invest their funds in the company in a hope of getting a reasonable return.
Retained earnings are the sources of internal finance for financing of
corporates future projects but payment of dividend constitute an outflow of
cash to shareholders. Although both - expansion and payment of dividend are desirable, these two are in conflicting tasks. It is, therefore, one of the
important functions of the financial management to constitute a dividend
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policy which can balance these two contradictory view points and allocate
the reasonable amount of profits after tax between retained earnings and
dividend. All of this is based on formulation of a good dividend policy.
Since the goal of financial management is maximisation of wealth of
shareholders, dividend policy formulation demands the managerial attention
on the impact of its policy on dividend and on the market value of its shares.
Optimum dividend policy requires decision on dividend payment rates so as
to maximise the market value of shares. The payout ratio means what
portion of earnings per share is given to the shareholders in the form of cash
dividend. In the formulation of dividend policy, the management of a
company will have to consider the relevance of its policy on bonus shares.
Dividend policy influences the dividend yield on shares. Dividend yield is an
important determinant of an investors attitude towards the security (stock) in
his portfolio management decisions.
The following issues need adequate consideration in deciding on dividend
policy:
Preferences of shareholders Do they want cash dividend or capital
gains?
Current financial requirements of the company.
Legal constraints on paying dividends.
Striking an optimum balance between desire of shareholders and the
companys funds requirements.
Companies attempt to maintain a stable dividend policy whereby a stable
rate of dividend is maintained. This also ensures that the companys market
value of shares stays higher. The main reasons why a stable dividend is
preferred are:
(a) A regular and stable dividend payment may serve to resolve uncertainty
in the minds of shareholders, and it creates confidence among
shareholders.
(b) Many investors are income conscious and favour a stable dividend.
(c) Other things being in balance, the market price invariably vary with the
rate of dividend declared by the company on its equity shares. The value
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of shares of a company that has a stable dividend policy does not

fluctuate as much, even if the earnings of the company fluctuate now and
then.
(d) A stable dividend policy encourages investments from institutional
investors.
In this way, stability and regularity of dividends not only affects the market
price of shares but also increases the general credit of the company that
pays the company in the long run. Dividend decisions are thus highly
significant.
1.4.4 Liquidity decisions
The liquidity decision is concerned with the management of the current
assets, which is a pre-requisite to long-term success of any business firm.
This is also called as working capital decision. The main objective of the
current assets management is the trade-off between profitability and
liquidity, and there is a conflict between these two concepts. If a firm does
not have adequate working capital, it may become illiquid and consequently
fail to meet its current obligations thus inviting the risk of bankruptcy. On the
contrary, if the current assets are too enormous, the profitability is adversely
affected. Hence, the major objective of the liquidity decision is to ensure a
trade-off between profitability and liquidity. Besides, the funds should be
invested optimally in the individual current assets to avoid inadequacy or
excessive locking up of funds. Thus, the liquidity decision should balance
the basic two ingredients, i.e. working capital management and the efficient
allocation of funds on the individual current assets.
In other terms, liquidity decisions deal with working capital management. It
is concerned with the day-to-day financial operations that involve current
assets and current liabilities.
The important elements of liquidity decisions are:
Formulation of inventory policy
Policies on receivable management
Formulation of cash management strategies
Policies on utilisation of spontaneous finance effectively
We will look at these elements individually, in detail, over the course of this
book.
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1.5 Organisation of finance function

Financial decisions and functions are strategic in character and therefore,
an efficient organisational structure is required to administer the same.
The organisation of finance functions implies the division and classification
of functions relating to finance because financial decisions are of utmost
significance to firms. Finance is like blood that flows throughout the
organisation. In all organisations, CFOs play an important role in ensuring
proper reporting based on the substance of the shareholders of the
company.
Although in case of companies, the main responsibility to perform
finance function rests with the top management. Yet the top management
(Board of Directors), for convenience, can delegate its powers to any
subordinate executive who is known as Director of Finance, Chief Financial
Controller/Officer, Financial Manager, or Vice President of Finance.
Moreover, it is finally the duty of the Board of Directors to perform
the finance functions. There are various reasons behind it to assign the
responsibility to them. Financing decisions are quite important for the
survival of the firm. The growth and expansion of business is always
affected by financing policies. The loan paying capacity of the business
depends upon the financial operations.
For the survival of the firm, there is a need to ensure both long-term and
short-term financial solvency.
Weak functional performance by financial department will weaken
production, marketing, and HR activities of the company. The result would
be the organisation becoming anaemic. Once anaemic, unless crucial and
effective remedial measures are taken up, it will pave way for corporate
bankruptcy. Under the CFO, normally two senior officers manage the
treasurer and controller functions.
Activity 1
List out the functions of Chief Financial Officer that can make or mar the
companys success.
Hint: All the finance functions are to be discussed.

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A Treasurer performs the following functions:

Obtaining finance and utilising funds
Liaison with term lending and other financial institutions
Managing working capital
Managing investment in real assets
A Controller performs the following functions:
Accounting and auditing
Management control systems
Taxation and insurance
Budgeting and performance evaluation
Maintaining assets intact to ensure higher productivity of operating
capital employed in the organisation
In India, CFOs have a legal obligation under various regulatory provisions to
certify the correctness of various financial statements and information
reported to the shareholders in the annual report. Listing norms, regulations
on corporate governance, and other notifications of Government of India
have adequately recognised the role of finance function in the corporate
setup in India.
Self Assessment Questions
5. ________ leads to investment in real assets.
6. ____ relate to the acquisition of funds at the least cost.
7. Formulation of inventory policy is an important element of _______.
8. Obtaining finance is an important function of _________.
9. What are the two critical issues to be considered under investment
decisions?
10. Define rate of return.
11. One of the most important decisions made by a finance manager
dealing with maximisation of shareholders wealth is ________.

1.6 Interface between Finance and Other Business Functions

1.6.1 Relation between Finance and accounting
In the hierarchy of the finance function of an organisation, the controller
reports to the CFO. Accounting is one of the functions that a controller
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discharges. Accounting is a part of Finance. For computation of return on

investment, earnings per share and for various ratios of financial analysis,
the data base will be accounting information. Without a proper accounting
system, an organisation cannot administer the effective function of financial
management.
The purpose of accounting is to report the financial performance of the
business for the period under consideration. All the financial decisions are
futuristic based on cash flow analysis. All the financial decisions consider
quality of cash flow as an important element of decisions. Since financial
decisions are futuristic, they are taken and put into effect under conditions of
uncertainty. Assuming the condition of uncertainty and incorporating the
effect on decision making results in use of various statistical models. In the
selection of the statistical models, element of subjectivity creeps in.
The relationship between finance and accounting has two dimensions:
(a) They are closely associated to the extent that accounting is an
important input in financial decision making
(b) There are definite differences between them
Accounting is a necessary input for the finance function as it generates
information through the financial statements. The data contained in these
financial statements assists the financial managers in assessing the past
performance and providing future directions to the firm and in meeting
certain legal obligations. Thus accounting and finance are functionally
inseparable.
The key differences between finance and accounting related to the
treatment of funds and decision making are discussed below:
(a) Treatment of funds: The measurement of funds in accounting is always
based on the accrual concept, whereas, in case of finance, the
treatment of funds is based on cash flow. That means, here the
revenue is recognised only when cash is actually received or actually
paid.
(b) Decision making: The purpose of accounting is collection and
presentation of financial data. The financial manager uses this data for
financial decision making. It does not mean that accountants never
make decisions or financial managers never collect data. But the
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primary focus of the function of accountants is collection and

presentation of data in financial statements while the financial
manager's major responsibility relates to financial planning, controlling, and decision making. Thus, we can say that the role of finance
begins where accounting ends.
1.6.2 Finance and marketing
Marketing decisions, generally, have financial implications. Pricing, product
promotion and advertisement, choice of product mix, distribution policy,
selections of channels of distribution, deciding on advertisement policy,
remunerating the salesmen, etc. all have financial implications. In fact, the
recent behaviour of rupee against US dollar (appreciation of rupee against
US dollar), affected the cash flow positions of export-oriented textile units,
BPOs and other software companies.
It is generally believed that the currency in which marketing manager
invoices the exports decides the cash flow consequences of the
organisation if the company is mainly dependent on exports. Marketing cost
analysis, a function of finance manager, is the best example of application of
principles of finance on the performance of marketing functions by a
business unit. Formulation of policy on credit management cannot be done
unless the integration of marketing with finance is achieved. Deciding on
credit terms to achieve a particular level of sales has financial implications
because sanctioning liberal credit may result in huge and bad debt. On the
other hand, conservative credit terms may depress the sales.
Relation between inventory and sales:
Co-ordination of stores administration with that of marketing management is
required to ensure customer satisfaction and good will. But investment in
inventory requires the financial clearance because funds are locked in, and
the funds so blocked have opportunity cost of capital.
1.6.3 Finance and production (operations)
Finance and operations management are closely related. Decisions on plant
layout, technology selection, productions or operations, process plant size,
removing imbalance in the flow of input material in the production or
operation process and batch size are all operation management decisions.
Their formulation and execution cannot be done unless they are evaluated
from the financial angle. The capital budgeting decisions are closely related
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to production and operation management. These decisions make or mar a

business unit. Failure to understand the implications of the latest
technological trend on capacity expansions has cost even blue chip
companies.
Many textile units in India became sick because they did not provide
sufficient finance for modernisation of plant and machinery. Inventory
management is crucial to successful operation management. But
management of inventory involves a number of financial variables.
In any manufacturing firm, the Production Manager controls a major part of
the investment in the form of equipment, materials, and men. He should
organise his department in such a way that the equipments under his or her
control are used most productively, the inventory of work-in-process or
unfinished goods, stores and spares are optimised, and the idle time and
work stoppages are minimised. If the production manager can achieve this,
he or she would be holding the cost of output under control and thereby help
in maximising profits. He or she has to appreciate the fact that while the
price at which the output can be sold is largely determined by external
factors such as competition, market, government regulations, etc., the cost
of production is more amenable to his or her control. Similarly, he or she
would have to make decisions regarding make or buy, buy or lease, etc., for
which he or she has to evaluate the financial implications before arriving at a
decision.
1.6.4 Finance and HR
Financial management is also related to human resource department as it
provides manpower to all the functional areas of the management. Financial
manager should carefully evaluate the requirement of manpower to each
department and then allocate the required finance to the human resource
department as wages, salary, remuneration, commission, bonus, pension,
and other monetary benefits to the human resource department.
Attracting and retaining the best manpower in the industry cannot be done
unless they are paid salary at competitive rates. If an organisation
formulates and implements a policy for attracting competent manpower, it
has to pay the most competitive salary packages to them. However, by
attracting competent manpower, capital and productivity of an organisation
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improves. Hence, financial management is closely associated with human

resource management.
Caselet:
Infosys does not have physical assets similar to that of Indian Railways.
But if both were to come to capital market with a public issue of equity,
Infosys would command better investors acceptance than the Indian
Railways. This is because the value of human resource plays an
important role in valuing a firm.
The better the quality of man power in an organisation, the higher the
value of the human capital and consequently the higher the productivity
of the organisation. Indian Software and IT enabled services have been
globally acclaimed only because of the manpower they possess. But it
has a cost factor - the best remuneration to the staff.

1.7 Summary
Let us recapitulate the important concepts discussed in this unit:
Financial Management is concerned with the procurement of the least
cost funds, and its effective utilisation for maximisation of the net wealth
of the firm.

There exists a close relation between the maximisation of net wealth of

shareholders and the maximisation of the net wealth of the company.

The broad areas of decision are Financing decisions, Investment

decisions, Dividend decisions, and Liquidity decisions.

1.8 Glossary
Dividend: Portion of profits of a company which is distributed among its
shareholder.
Explicit costs: The actual cash payments it makes to those who provide
resources.
Financial management: Concerned with procurement and effective
utilisation of funds.
Implicit costs: The opportunity costs of using resources owned by the firm
or provided by the firm's owners.
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Opportunity cost of capital: The Rate of Return required by an investor is

normally known as the hurdle rate or the cut-off rate.
Wealth: Shareholder wealth.

1.9 Terminal Questions

1. What are the goals of financial management?
2. How does a finance manager arrive at an optimal capital structure?
3. Examine the relationship of financial management with other functional
areas of a firm.
4. Examine the relationship between finance and accounting.
5. Examine the relationship between finance and marketing.

1.10 Answers
Self Assessment Questions
1.
2.
3.
4.
5.
6.
7.
8.
9.

Liberalisation and globalisation of Indian economy

Procurement of funds
Wealth maximisation
Wealth maximisation
Investment decisions
Financing decisions
Liquidity decisions
Treasurers
The two critical issues are:
Evaluation of expected profitability of the new investment
Rate of return required on the project
10. Rate of return is normally defined as the hurdle rate or cutoff rate or
opportunity cost of the capital.
11. Dividend decision
Terminal Questions
1. Financial management means maximisation of economic welfare of its
shareholders. The two goals of financial management are 1) profit
maximisation and 2) wealth maximisation. Refer 1.3
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2. Financing decisions relate to the composition of relative proportion of

various sources of finance. Whenever funds are to be raised to finance
investments, capital structure decision is involved. Refer 1.4.1
3. The relationship between financial management and other areas of a
firm can be explained by the. Refer 1.6
4. Accounting is a necessary input for the finance function as it generates
information through the financial statements. Refer 1.6.1
5. Marketing decisions, generally, have financial implications. Refer 1.6.2

1.11 Case Study: Hindustan Unilever Limited

Introduction:
Hindustan Unilever Limited (HUL) is India's largest Fast Moving Consumer
Goods Company with a heritage of over 75 years in India and touches the
lives of two out of three Indians.
With over 35 brands spanning 20 distinct categories such as soaps,
detergents, shampoos, skin care, toothpastes, deodorants, cosmetics, tea,
coffee, packaged foods, ice cream, and water purifiers, the Company is a
part of the everyday life of millions of consumers across India. Its portfolio
includes leading household brands such as Lux, Lifebuoy, Surf Excel, Rin,
Wheel, Fair & Lovely, Ponds, Vaseline, Lakm, Dove, Clinic Plus, Sunsilk,
Pepsodent, Closeup, Axe, Brooke Bond, Bru, Knorr, Kissan, Kwality Walls,
and Pureit.
The Company has over 16,000 employees and has an annual turnover of
around Rs.19,401 crore (financial year 2010 - 2011). HUL is a subsidiary of
Unilever, one of the worlds leading suppliers of fast moving consumer
goods with strong local roots in more than 100 countries across the globe
with annual sales of about 44 billion in 2011. Unilever has about 52%
shareholding in HUL.
Unilever has a long history in sustainability and the use of marketing and
market research to promote behaviour change. In November 2011, for the
first time, it published its own model of effective behaviour change. For
those who are interested, the details of this model can be seen at
http://www.hul.co.in/mediacentre/news/2011/inspiring-sustainableliving.aspx
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History of the Company:

In the summer of 1888, visitors to the Kolkata harbour noticed crates full of
Sunlight soap bars, embossed with the words "Made in England by Lever
Brothers". With it began an era of marketing branded Fast Moving
Consumer Goods (FMCG).
Soon after followed Lifebuoy in 1895, and other famous brands like Pears,
Lux, and Vim. Vanaspati was launched in 1918 and the famous Dalda brand
came to the market in 1937. In 1931, Unilever set up its first Indian
subsidiary, Hindustan Vanaspati Manufacturing Company, followed by Lever
Brothers India Limited (1933) and United Traders Limited (1935). These
three companies merged to form HUL in November 1956; HUL offered 10%
of its equity to the Indian public, being the first among the foreign
subsidiaries to do so. Unilever now holds 52.10% equity in the company.
The rest of the shareholding is distributed among about 360,675 individual
shareholders and financial institutions.
The erstwhile Brooke Bond's presence in India dates back to 1900. By
1903, the company had launched Red Label tea in the country. In 1912,
Brooke Bond & Co. India Limited was formed. Brooke Bond joined the
Unilever fold in 1984 through an international acquisition. The erstwhile
Lipton's links with India were forged in 1898. Unilever acquired Lipton in
1972 and in 1977 Lipton Tea (India) Limited was incorporated.
Pond's (India) Limited had been present in India since 1947. It joined the
Unilever fold through an international acquisition of Chesebrough Pond's
USA in 1986.
Since the very early years, HUL has vigorously responded to the stimulus of
economic growth. The growth process has been accompanied by judicious
diversification, always in line with Indian opinions and aspirations.
The liberalisation of the Indian economy, started in 1991, clearly marked an
inflexion in HULs and the Group's growth curve. Removal of the regulatory
framework allowed the company to explore every single product and
opportunity segment, without any constraints on production capacity.
Simultaneously, deregulation permitted alliances, acquisitions, and mergers.
In one of the most visible and talked about events of India's corporate
history, the erstwhile Tata Oil Mills Company (TOMCO) merged with HUL,
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effective from April 1, 1993. In 1996, HUL and yet another Tata company,
Lakme Limited, formed a 50:50 joint venture, Lakme Unilever Limited, to
market Lakme's market-leading cosmetics and other appropriate products of
both the companies. Subsequently in 1998, Lakme Limited sold its brands to
HUL and divested its 50% stake in the joint venture to the company.
HUL formed a 50:50 joint venture with the US-based Kimberly Clark
Corporation in 1994. Kimberly-Clark Lever Ltd, which markets Huggies
Diapers and Kotex Sanitary Pads. HUL has also set up a subsidiary in
Nepal, Unilever Nepal Limited (UNL), and its factory represents the largest
manufacturing investment in the Himalayan kingdom. The UNL factory
manufactures HULs products like soaps, detergents, and personal products
both for the domestic market and exports to India.
The 1990s also witnessed a string of crucial mergers, acquisitions, and
alliances on the Foods and Beverages front. In 1992, the erstwhile Brooke
Bond acquired Kothari General Foods, with significant interests in Instant
Coffee. In 1993, it acquired the Kissan business from the UB Group and the
Dollops Ice cream business from Cadbury India.
As a measure of backward integration, Tea Estates and Doom Dooma, two
plantation companies of Unilever, were merged with Brooke Bond. Then in
1994, Brooke Bond India and Lipton India merged to form Brooke Bond
Lipton India Limited (BBLIL), enabling greater focus and ensuring synergy in
the traditional Beverages business. 1994 witnessed BBLIL launching the
Wall's range of Frozen Desserts. By the end of the year, the company
entered into a strategic alliance with the Kwality Ice cream Group families
and in 1995 the Milk food 100% Ice cream marketing and distribution rights
too were acquired.
Finally, BBLIL merged with HUL, with effect from January 1, 1996. The
internal restructuring culminated in the merger of Pond's (India) Limited
(PIL) with HUL in 1998. The two companies had significant overlaps in
personal products, speciality chemicals and exports businesses, besides a
common distribution system since 1993 for personal products. The two also
had a common management pool and a technology base. The
amalgamation was done to ensure for the Group, benefits from scale
economies both in domestic and export markets and enable it to fund
investments required for aggressively building new categories.
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In January 2000, in a historic step, the government decided to award 74

percent equity in Modern Foods to HUL, thereby beginning the divestment
of government equity in public sector undertakings (PSU) to private sector
partners. HULs entry into bread is a strategic extension of the company's
wheat business. In 2002, HUL acquired the government's remaining stake in
Modern Foods.
In 2003, HUL acquired the cooked shrimp and pasteurised crabmeat
business of the Amalgam Group of Companies, a leader in value added
marine products exports.
HUL launched a slew of new business initiatives in the early part of 2000s.
Project Shakti was started in 2001. It is a rural initiative that targets small
villages populated by less than 5000 individuals. It is a unique win-win
initiative that catalyses rural affluence even as it benefits business.
Currently, there are over 45,000 Shakti entrepreneurs covering over
100,000 villages across 15 states and reaching to over 3 million homes.
In 2002, HUL made its foray into Ayurvedic health and beauty centre
category with the Ayush product range and Ayush Therapy Centres.
Hindustan Unilever Network, Direct to home business was launched in 2003
and this was followed by the launch of Pureit water purifier in 2004.
In 2007, the Company name was formally changed to Hindustan Unilever
Limited after receiving the approval of share holders during the 74th AGM
on 18 May, 2007. Brooke Bond and Surf Excel breached the Rs 1,000 crore
sales mark the same year followed by Wheel which crossed the Rs.2, 000
crore sales milestone in 2008.
On 17th October, 2008, HUL completed 75 years of corporate existence in
India.
Following are excerpts from the companys Annual Report 2010
2011:
Financial Highlights:
Net Sales: Rs. 19,401 crore
Net Profit: Rs.2, 306 crore
EPS (Basic): Rs.10.58
EVA: Rs.1, 750 crore
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Total expenditure:
1% 5%

6%

Ma teria ls

6%

Advertising Costs
6%

Sta ff Costs
Ca rria ge a nd
Freight

16%
60%

Utilities, Rent,
Repa irs etc.
Deprecia tion
Other

Financial Performance 10 year track record (Rs.

Crores)
Expenditure
P&L
account

2008-09
2001

2002

Gross
Sales*

11,781.30

10,951.61

Other
Income

381.79

384.54

Interest

(7.74)

(9.18)

2003

2004

2005

2006

2007

(15
months)

2009-10

11,096.02 10,888.38 11,975.53 13,035.06 14,715.10 21,649.51 18,220.27

459.83

318.83

304.79

354.51

431.53

(66.76)

(129.98)

(19.19)

(10.73)

(25.50)

589.72

349.64

2010-11

20,305.54
586.04

(25.32)

(6.98)

(0.24)

Profit
1,943.37
Before
Taxation
@

2,197.12

2,244.95 1,505.32 1,604.47 1,861.68 2,146.33

3,025.12

2,707.07

2,730.18

Profit
1,540.95
After
Taxation
@

1,731.32

1,804.34 1,199.28 1,354.51 1,539.67 1,743.12

2,500.71

2,102.68

2,153.25

Earnings
Per
Share of
Re. 1#

7.46

8.04

8.05

5.44

6.40

8.41

8.73

11.46

10.10

10.58

Dividend
Per
Share of
Re. 1#

5.00

5.16

5.50

5.00

5.00

6.00

9.00

7.50

6.50

6.50

* Sales before Excise Duty Charge @ Before Exceptional/Extraordinary items #

Adjusted for bonus

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Balance
Sheet

2001

2002

Unit 1

2003

2004

2005

2006

2007

2008-09
(15
months)

2009-10 2010-11

Fixed Assets 1,320.06

1,322.34

1,369.47 1,517.56

1,483.53

1,511.01 1,708.14

2,078.84

2,436.07 2,468.24

Investments

1,635.93

2,364.74

2,574.93 2,229.56

2,014.20

2,413.93 1,440.80

332.62

1,264.08 1,260.68

Net Deferred
Tax

246.48

269.92

267.44

226.00

Net Current
Assets

(75.04)

(239.83)

(368.81)

(409.30)

3,127.43

3,717.17

3,843.03 3,563.82

220.12

220.12

2,823.57

3,438.75

1,918.60 1,872.59

Share Capital
Reserves &
Surplus
Loan Funds

220.12

220.12

220.14

224.55

212.39

(1,355.31) (1,353.40) (1,833.57)

2,362.56
220.12
2,085.50

2,796.09 1,527.76
220.68

217.74

2,502.81 1,221.49
72.60

88.53

254.83

248.82

209.66

(182.84)

(1,365.45) (1,304.6
6)

2,483.45

2,583.52 2,633.92

217.99
1,843.52

215.95

83.74

58.30

1,704.31 1,471.11

56.94

3,127.43

3,717.17

3,843.03 3,563.82

2,362.56

HUL Share
Price on BSE
(Rs. Per
Share of Re.
1)*

223.65

181.75

204.70

143.50

197.25

216.55

213.90

237.50

238.70

284.60

Market
Capitalisation
(Rs. Crores)

49,231

40,008

45,059

31,587

43,419

47,788

46,575

51,770

52,077

61,459

2,796.09 1,527.76

421.94

218.17

2,365.35 2,417.97

2,483.45

2,583.52 2,633.92

Others

* Based on year-end closing prices quoted in the Bombay Stock Exchange,

adjusted for bonus shares.

Excerpts from the report on Human Resources:

Your Companys Human Resource agenda for the year focused on
strengthening four key areas: building a robust talent pipeline,
enhancing individual and organisational capabilities for future-readiness,
driving greater employee engagement and strengthening employee
relations further through progressive people practices at the shop
floor
In the first half of 2010, a comprehensive Talent and Organisation
Assessment was undertaken to understand their readiness to partner
the business ambition in the medium term and a holistic people strategy
was drawn up, which was the basis of the work done in the key areas
mentioned above. This Human Resource agenda not only looks at the
current needs of the business, but also enhances the Companys
preparedness for the future
The Company participates in a Global People Survey every 2 years,
which is a leading indicator of employee morale and motivation, with
Employee Engagement being one of the key dimensions measured. For
the current year, the employee participation rate for this survey was over
99% (with an employee base of approximately 15000) and your
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Company were ranked among the top performing companies across

Unilever globally in all dimensions. This was on account of a number of
proactive and innovative initiatives to engage our employees, the most
significant being continuous and consistent business linked
engagement, a vision for the future of the business and clarity and
transparency to individuals on their own careers
Discussion Questions:
1. Do you think that HUL has preferred the profit maximisation approach
over the wealth maximisation approach? Justify your answer.
(Hint: Refer to wealth maximisation)
2. How do you think an effective interaction between the HR and finance
department of a firm helps in achieving its goals? You may draw
instances from the case provided above.
(Hint: Refer to Finance & HR))
3. Study the pattern of total expenditure as given in the annual report.
Which core element of financial management is this based on?
(Hint: Refer to Financing decisions)
4. HUL is known for its marketing power. Wide bouquets of brands are
handled under their purview, as we have seen above. What is the
correlation between finance and marketing management? How is their
relationship significant to the achievement of final goals of the company?
(Hint: Refer to Finance and Marketing)
(Source: HUL Annual Report 2010 2011, www.hul.co.in)
References:

Khan, M. Y. and Jain P. K. (2007). Financial Management, Text,

Problems & Cases, 5th Edition, Tata McGraw Hill Company, New Delhi.
Maheshwari, S.N.(2009)., Financial Management Principles & Practice,
13th Edition, Sultan Chand & Sons.
Van Horne, James, C (2002), Principles of Financial Management,
Pearson Education.
Prasanna, Chandra (2007), Financial Management: Theory and Practice,
7th Edition, Tata McGraw Hill.

E-Reference:
HUL Annual Report 2010 2011, www.hul.co.in retrieved on
10/12/ 2011
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