CHAPTER ONE

AN OVERVIEW OF FINANCIAL MANAGEMENT (FM)

Finance is the application of economic principles and concepts to business decision-making and
problem solving. The field of finance can be considered to comprise three broad categories:
financial management, investments, and financial institutions:
 Financial management. Sometimes called corporate finance or business finance, this
area of finance is concerned primarily with financial decision-making within a business
entity. Financial management decisions include maintaining cash balances, extending
credit, acquiring other firms, borrowing from banks, and issuing stocks and bonds.
 Investments. This area of finance focuses on the behavior of financial markets and the
pricing of securities. An investment manager’s tasks, for example, may include valuing
common stocks, selecting securities for a pension fund, or measuring a portfolio’s
performance.
 Financial institutions. This area of finance deals with banks and other firms that
specialize in bringing the suppliers of funds together with the users of funds. For
example, a manager of a bank may make decisions regarding granting loans, managing
cash balances, setting interest rates on loans, and dealing with government regulations.
No matter the particular category of finance, business situations that call for the application of
the theories and tools of finance generally involve either investing (using funds) or financing
(raising funds). Managers who work in any of these three areas rely on the same basic
knowledge of finance.
AN OVERVIEW OF THE FINANCIAL ENVIRONMENT

Finance people must understand not only the internal environment, but also the financial
environment and markets within which the firm operates. They need to know where capital
required is raised, where the financial instruments are traded, and how stock prices are
determined.
1. Financial Institutions
Financial institutions are financial intermediaries, which are specialized financial firms that
facilitate the transfer of funds from savers to demanders’ of capital. They accept savings from
customers and lend this money to other customers or they invest it. In many instances, they pay
savers interest on deposited funds. The key participants in financial transactions of financial

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institutions are individuals, businesses, and government. By accepting the savings from these
parties, financial institutions transfer again to individuals, business firms, and governments.
Since financial institutions are generally large, they gain economies of scale in the transfer of
money between savers and demanders. By pooling risks, they help individual savers to diversify
their risk.

2. Financial Instruments

Financial instruments are written and formal documents of transferring funds between and
among individuals, businesses, and governments. They include loans and borrowing contracts,
promissory notes, commercial papers, treasury bills, bonds, and stocks.
3. Financial Markets
Financial markets are markets in which financial instruments are bought and sold by suppliers
and demanders of funds. They, unlike financial institutions, are places in which suppliers and
demanders of funds meet directly to transact business.
MEANING OF FINANCIAL MANAGEMENT

 Financial management is one major area of study under finance. It deals with decisions
made by a business firm that affect its finances.
 Financial management is sometimes called corporate finance, business finance, and
managerial finance.
 Financial management can also be defined as a decision making process concerned with
planning for raising, and utilizing funds in a manner that achieves the goal of a firm.
 Financial management encompasses many different types of decisions. We can classify
these decisions into three groups:
 investment decisions,
 financing decisions, and
 decisions that involve both investing and financing.
 Investment decisions are concerned with the use of funds the buying, holding, or selling
of all types of assets: Should we buy a new die stamping machine? Should we introduce a
new product line? Sell the old production facility? Buy an existing company? Build a
warehouse? Keep our cash in the bank?
 Financing decisions are concerned with the acquisition of funds to be used for investing
and financing day-to-day operations. Should managers use the money raised through the

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 firms’ revenues? Should they seek money from outside of the business? A company’s
operations and investment can be financed from outside the business by incurring debts;
such as though bank loans and the sale of bonds, or by selling ownership interests.
Because each method of financing obligates the business in different ways, financing
decisions are very important.
 Many business decisions simultaneously involve both investing and financing. For
example, a company may wish to acquire another firm an investment decision. However,
the success of the acquisition may depend on how it is financed: by borrowing cash to
meet the purchase price, by selling additional shares of stock, or by exchanging existing
shares of stock. If managers decide to borrow money, the borrowed funds must be repaid
within a specified period. Creditors (those lending the money) generally do not share in
the control of profits of the borrowing firm. If, on the other hand, managers decide to
raise funds by selling ownership interests, these funds never have to be paid back.
However, such a sale dilutes the control of (and profits accruing to) the current owners.
Whether a financial decision involves investing, financing, or both, it also will be concerned with
two specific factors: expected return and risk. In addition, throughout your study of finance, you
will be concerned with these factors. Expected return is the difference between potential
benefits and potential costs. Risk is the degree of uncertainty associated with these expected
returns.
Scholars Definition of FM

1. The term financial management has been defined by Solomon, “It is concerned with the
efficient use of an important economic resource namely, capital funds”.
2. The most popular and acceptable definition of financial management as given by
S.C.Kuchalis that “Financial Management deals with procurement of funds and their
effective utilization in the business”.
3. Howard and Upton: Financial management “as an application of general managerial
principles to the area of financial decision-making.
4. Weston and Brigham: Financial management “is an area of financial decision-making,
harmonizing individual motives and enterprise goals”.
5. Joshep and Massie: Financial management “is the operational activity of a business that
is responsible for obtaining and effectively utilizing the funds necessary for efficient
operations.

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Thus, Financial Management is mainly concerned with the effective funds management in the
business. In simple words, Financial Management as practiced by business firms can be called as
Corporation Finance or Business Finance.
Basic assumptions and principles of financial management
Traditional Approach
In the beginning of the present century, which was the starting point for the scholarly writings on
Corporation Finance, the function of finance was considered to be the task of providing funds
needed by the enterprise on terms that are most favorable to the operations of the enterprise. The
traditional scholars are of the view that the quantum and pattern of finance requirements and
allocation of funds as among different assets, is the concern of non-financial executives.
According to them, the finance manager has to undertake the following three functions:
arrangement of funds from financial institutions;
arrangement of funds through financial instruments Viz. shares, bonds, etc
looking after the legal and accounting relationship between a corporation and its sources
of funds.
Modern Approach
This systems approach to the study of finance is being termed as ‘Financial Management’. The
term ‘Corporation Finance’ that was used in the traditional concept was replaced by the present
term ‘Financial Management.’ The modern approach view the term financial management in a
broad sense and provides a conceptual and analytical framework for financial decision-making.
According to it, the finance function covers both acquisitions of funds as well as their allocation.
Principles of financial management
There are 10 basic principles in financial management
1. Organize your finance 6. Understand risk
2. Spend less than you earn 7. Diversification is not just for
3. Put your money to work investment
4. Limit debt to income producing asset 8. Maximize your employment benefit
5. Continuously educated your self 9. Pay attention to taxes
10. Plan for the unexpected

THE SCOPE OF FINANCIAL MANAGEMENT

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Financial management is one of the important parts of overall management, which is directly
related with various functional departments like personnel, marketing and production. Financial
management covers wide area with multidimensional approaches. In general, financial
management covers:

 investing decision,
 financing decision and
 Dividend policymaking decision.

FINANCIAL MANAGEMENT DECISIONS OR FUNCTION OF FINANCIAL

MANAGEMENT
i) Investment (Asset-Mix) Decisions: the investment decisions relates to the selection of assets
in which funds will be invested by the firm. The assets may long term assets which yield return
in the future over longer periods; and short-term assets which are coverable into cash at normal
operation of the business without decrease in value, usually within a year. When the investment
is made on long-term assets, it is considered as capital budgeting while the other is working
capital.

Capital budgeting decision is concerned with long-term assets and their compositions.
Measurement of investment proposals is the major exercise of capital budgeting decision. It
evaluates the business risk composition of the firm where risk and uncertainty of a certain project
proposal is evaluated against a certain established standards. Moreover, it is concerned with
judgment of the benefit of the firm with concept of the cost of capital.

Working capital management is concerned with the management of current assets. It is an

important and integral part of financial management as a short-term survival is the prerequisite
for the long-term success.

ii) Financing (Capital-Mix) Decisions: It is emphasized when, where and how to acquire funds
to meet the firm’s investment needs. The central issue, therefore, is to determine the proportion
of equity and debt. The mix of debt and equity is known as the firm’s capital structure. The
financial manager must strive to obtain the best financing mix or the optimum capital structure
for the firm. The firm’s capital structure is considered to be optimum when the market value of
shares is maximized. The use of debt affects the return and risk of shareholders; it may increase
the return on equity funds but it always increases risk. A proper balance will have to be struck
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between return and risk. When the shareholder’s return is maximized with minimum risk, the
market value per share will be maximized and the firm’s capital structure would be considered
optimum. Once the financial manager is able to determine the best combination of debt and
equity, he/she must raise the appropriate amount through the best available sources.

iii) Dividend or Profit Allocation Decisions: Dividend decision is the third major financial
decision. The emphasis is whether the firm should distribute all profits, or retain them, or
distribute a portion and retain the balance. Like the debt-equity policy, the dividend policy
should be determined in terms of its impact on the shareholders’ value. The optimum dividend
policy is one that maximized the market value of firm’s shares. Thus, if shareholders are not
indifferent to the firm’s dividend policy, the financial manager must determine the optimum
dividend-payout ratio. The financial manager should also consider the questions of dividend
stability, bonus share and cash dividends in practice.
FUNCTIONS OF FINANCE MANAGER
Finance function is one of the major parts of business organization, which involves the
permanent and continuous process of the business concern. Finance is one of the interrelated
functions, which deal with personal function, marketing function, production function, research,
and development activities of the business concern. At present, every business concern
concentrates more on the field of finance because, it is a very emerging part which reflects the
entire operational and profit ability position of the concern. Deciding the proper financial
function is the essential and ultimate goal of the business organization.
Finance manager is one of the important role players in the field of finance function. He must
have entire knowledge in the area of accounting, finance, economics and management. His
position is highly critical and analytical to solve various problems related to finance. A person
who deals finance related activities might be called finance manager. Finance manager performs
the following major functions:
1. Forecasting Financial Requirements
It is the primary function of the Finance Manager. He is responsible to estimate the financial
requirement of the business concern. He should estimate, how much finances required to acquire
fixed assets and forecast the amount needed to meet the working capital requirements in future.

2. Acquiring Necessary Capital

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After deciding the financial requirement, the finance manager should concentrate how the
finance is mobilized and where it will be available. It is also highly critical in nature.
3. Investment Decision
The finance manager must carefully select best investment alternatives and consider the
reasonable and stable return from the investment. He must be well versed in the field of capital
budgeting techniques to determine the effective utilization of investment. The finance manager
must concentrate to principles of safety, liquidity and profitability while investing capital.
4. Cash Management
Present day’s cash management plays a major role in the area of finance because proper cash
management is not only essential for effective utilization of cash but it also helps to meet the
short-term liquidity position of the concern.
5. Interrelation with Other Departments
Finance manager deals with various functional departments such as marketing, production,
personnel, system, research, development, etc. Finance manager should have sound knowledge
not only in finance related area but also well versed in other areas. He must maintain a good
relationship with all the functional departments of the business organization.
THE OBJECTIVE OF FINANCIAL MANAGEMENT

The primary objective of FM is the maximization of the economic wellbeing, or wealth, of the
owners. The secondary objective is profit maximization for a firm. Whenever a decision is to be
made, management should choose the alternative that most increases the wealth of the owners of
the business.

The Measure of Owner’s Economic Well-Being

The price of a share of stock at any time, or its market value, represents the price that buyers in
a free market are willing to pay for it. The market value of shareholders’ equity is the value of
all owners’ interest in the corporation. It is calculated as the product of the market value of one
share of stock and the number of shares of stock outstanding:
Market value of shareholders’ equity = Market value of a share of stock
* Number of shares of stock outstanding

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Financial Management and the Maximization of Owners’ Wealth
Financial managers are charged with the responsibility of making decisions that maximize
owners’ wealth. For a corporation, that responsibility translates into maximizing the value of
shareholders’ equity. If the market for stocks is efficient, the value of a share of stock in a
corporation should reflect investors’ expectations regarding the future prospects of the
corporation. The value of a stock will change as investors’ expectations about the future change.
For financial managers’ decisions to add value, the present value of the benefits resulting from
decisions must outweigh the associated costs, where costs include the costs of capital.
I. profit maximization
If the owners ‘objective is always to maximize profits, the financial managers takes only those
actions that are expected to make a major contribution to the firm’s overall profits. Profit
maximization is the main aim of financial management, because any kinds of economic activity
are earning profits. However, profit maximization has the following drawback:
a. It is vague i.e. it is not precise objective.
b. It ignores

a) The time value of money

b) Risk
c) Cash flows available to stock holders

II Maximize shareholders’ wealth

Financial managers in a corporation make decisions for the stockholders of the firm. A good
financial manager is, therefore, one that acts in the stockholders’ best interests (seeking to gain
financially) by making decisions, that increases the value of stock. Thus, the goal of the financial
management is to maximize the current value per share of the existing stock. This goal avoids
the problem of profit maximization, no short run versus long run issues, just maximize current
stock value.
The firm’s stock price is dependent on the following factors:
 Projected earning s per share
 Riskiness of the projected earnings
 Timings of the earnings streams
 The firm’s use of debt financing
 The firm’s dividend policy.

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 The other goal of Financial management and its classification
Earning or Increasing Profits Controlling risks
 Maximize sales or market share  Survive
 Minimize costs  Avoid financial distress and
 Maximize profits bankruptcy
 Maintain steady earnings  Beat the competition
growth

IMPORTANCE OF FINANCIAL MANAGEMENT

Finance is the lifeblood of any business organization. It needs to meet the requirement of the
business concern. Every busine-1ss concern must maintain adequate amount of finance for their
smooth running of the business concern and maintain the business carefully to achieve the goal
of the business concern. The business goal can be achieved only with the help of effective
management of finance. We cannot neglect the importance of finance at any time at and at any
situation. Some of the importance of the financial management is as follows:
1. Financial Planning
Financial management helps to determine the financial requirement of the business concern and
leads to take financial planning of the concern. Financial planning is an important part of the
business concern, which helps to promotion of an enterprise.
2. Acquisition of Funds
Financial management involves the acquisition of required finance to the business concern.
Acquiring needed funds play a major part of the financial management, which involve possible
source of finance at minimum cost.
3. Proper Use of Funds
Proper use and allocation of funds leads to improve the operational efficiency of the business
concern. When the finance manager uses the funds properly, they can reduce the cost of capital
and increase the value of the firm.
4. Financial Decision
Financial management helps to take sound financial decision in the business concern. Financial
decision will affect the entire business operation of the concern. Because there is, a direct
relationship with various department functions such as marketing, production personnel, etc.

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 5. Improve Profitability
Profitability of the concern purely depends on the effectiveness and proper utilization of funds by
the business concern. Financial management helps to improve the profitability position of the
concern with the help of strong financial control devices such as budgetary control, ratio analysis
and cost volume profit analysis.
6. Increase the Value of the Firm
Financial management is very important in the field of increasing the wealth of the investors and
the business concern. Ultimate aim of any business concern will achieve the maximum profit and
higher profitability leads to maximize the wealth of the investors as well as the nation.
7. Promoting Savings
Savings are possible only when the business concern earns higher profitability and maximizing
wealth. Effective financial management helps to promoting and mobilizing individual and
corporate savings. Nowadays financial management is also popularly known as business finance
or corporate finances. The business concern or corporate sectors cannot function without the
importance of the financial management.
THE AGENCY RELATIONSHIP

If you are the sole owner of a business, then you make the decisions that affect your own well-
being. However, what if you are a financial manager of a business and you are not the sole
owner? In this case, you are making decisions for owners other than yourself; you, the financial
manager, are an agent. An agent is a person who acts for—and exerts powers of— another
person or group of persons. The person (or group of persons) the agent represents is referred to
as the principal. The relationship between the agent and his or her principal is an agency
relationship.
There is an agency relationship between the managers and the shareholders of corporations.
Problems with the Agency Relationship
In an agency relationship, the agent is charged with the responsibility of acting for the principal.
Is it possible the agent will not act in the best interest of the principal, but instead act in his or her
own self-interest? Yes—because the agent has his or her own objective of maximizing personal
wealth.

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Conflict of goals between management and owners and agency problem
There is a conflict of goals between managers and owners of a corporation and mangers may act
to maximize their interest instead of maximizing the wealth of owners. Managers are interested
to maximize their personal wealth, job security, life style and fringe benefits.
The natural conflict of interest between stockholders and managerial interest create agency
problems. Agency problems are the likelihood that mangers may place their personal goals a
head of corporate goals. Theoretically, agency problems are analyzed there as long as mangers
are agents of owners. Corporations (owners) are aware of these agency problems and they incur
some costs because of agency. These costs are called agency cost and include:
1. Monitoring expenditures– are expenditures incurred by corporations to monitor or control
the activities of managers. A very good example of a monitoring expenditure is fees paid by
corporations to external auditors.
2. Bonding expenditures – are cost incurred to protect dishonesty of mangers and other
employees of a firm. Example: fidelity guarantee insurance premium.
3. Structuring expenditures – expenditures made to make managers fell sense of ownership to
the corporation. These include stock options, performance shares, cash bonus etc.
4. Opportunity costs – unlike the previous three, these costs are not explicit expenditures.
Opportunity costs are assumed by corporations due to hindrances of decisions by them as a result
of their organizational structure and hierarchy.
CLOSE RELATED FIELD OF FINANCIAL MANAGEMENT
1. Financial Management and Economics
Economic concepts like micro and macroeconomics are directly applied with the financial
management approaches. Investment decisions, micro and macro environmental factors are
closely associated with the functions of financial manager.
Financial management also uses the economic equations like money value discount factor,
economic order quantity etc. Financial economics is one of the emerging area, which provides
immense opportunities to finance, and economical areas.
2. Financial Management and Accounting
Accounting records includes the financial information of the business concern.
Hence, we can easily understand the relationship between the financial management and
accounting. In the olden periods, both financial management and accounting are treated as a
same discipline and then it has been merged as Management Accounting because this part is very

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much helpful to finance manager to take decisions. Now a day’s financial management and
accounting discipline are separate and interrelated.
3. Financial Management or Mathematics
Modern approaches of the financial management applied large number of mathematical and
statistical tools and techniques. They are also called as econometrics. Economic order quantity,
discount factor, time value of money, present value of money, cost of capital, capital structure
theories, dividend theories, ratio analysis and working capital analysis are used as mathematical
and statistical tools and techniques in the field of financial management.
4. Financial Management and Production Management
Production management is the operational part of the business concern, which helps to multiple
the money into profit. Profit of the concern depends upon the production performance.
Production performance needs finance, because production department requires raw material,
machinery, wages, operating expenses etc. These expenditures are decided and estimated by the
financial department and the finance manager allocates the appropriate finance to production
department.
The financial manager must be aware of the operational process and finance required for each
process of production activities.
5. Financial Management and Marketing
Produced goods are sold in the market with innovative and modern approaches. For this, the
marketing department needs finance to meet their requirements. The financial manager or
finance department is responsible to allocate the adequate finance to the marketing department.
Hence, marketing and financial management are interrelated and depends on each other.
6. Financial Management and Human Resource
Financial management is also related with human resource department, which provides labor to
all the functional areas of the management. Financial manager should carefully evaluate the
requirement of labor to each department and allocate the finance to the human resource
department as wages, salary, remuneration, commission, bonus, pension and other monetary
benefits to the human resource department. Hence, financial management is directly related with
human resource management.

FINANCIAL MARKETS AND INSTITUTIONS

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Classification of Financial Markets
1. Based on maturity of the assets;

 Money Markets: is market where transactions in short-term (of maturities

of one year or less) debt instruments or marketable securities take place.
They are characterized by high degree of safety and liquidity and low
interest rates. Assets traded in these markets involve treasury bills,
Certificates of deposits, commercial papers, etc.
 Capital Markets: are markets where long-term financial securities, of
maturity exceeding one year (bonds and stocks), are traded.

2. Based on the issuance-status of the assets:

Primary Markets: are those in which securities are initially issued. A primary market is
the only market in which the issuer (government or corporations) is actually receives the
proceeds from the sale of the securities.
Secondary Market: are those in which pre owned securities are sold. A secondary
market can be viewed as a “used” or “pre owned” security market

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