UNIT 1

Introduction to Financial Management

Let’s define financial management as the first part of the introduction to financial management.
For any business, it is important that the finance it procures is invested in a manner that the
returns from the investment are higher than the cost of finance. In a nutshell, financial
management –

 Endeavors to reduce the cost of finance

 Ensures sufficient availability of funds

 Deals with the planning, organizing, and controlling of financial activities like the
procurement and utilization of funds

Some Definitions

“Financial management is the activity concerned with planning, raising, controlling and
administering of funds used in the business.” – Guthman and Dougal

“Financial management is that area of business management devoted to a judicious use of

capital and a careful selection of the source of capital in order to enable a spending unit to move
in the direction of reaching the goals.” – J.F. Brandley

“Financial management is the operational activity of a business that is responsible for obtaining
and effectively utilizing the funds necessary for efficient operations.”- Massie
Scope of Financial Management

To understand the financial management scope, first, it is essential to understand the

approaches that are divided into two sections.

1. Traditional Approach
2. Modern Approach

Approach 1: Traditional Approach to Finance Function

During the 20th century, the traditional approach was also known as corporate finance. This
approach was initiated to procure and manage funds for the company. For studying financial
management, the following three points were used
(i) Institutional sources of finance.
(ii) Issue of financial devices to collect refunds from the capital market.
(iii) Accounting and legal relationship l between the source of finance and business.
In this approach, finance was required not for regular business operations but occasional
events like reorganization, promotion, liquidation, expansion, etc. It was considered essential
to have funds for such events and regarded as one of the crucial functions of a financial
manager.
Though he was not accountable for the effective utilization of funds, however, his
responsibility was to get the required funds from external partners on a fair term. The
traditional approach of finance management stayed until the 5th decade of the 20th
century. The traditional approach only emphasized on the fund’s procurement only by
corporations. Hence, this approach is regarded as narrow and defective.

Limitations of Traditional Approach

 One-sided approach- It is more considerate towards the fund procurement and the
issues related to their administration, however, it pays no attention to the effective
utilization of funds.
 Gives importance to the Financial Problems of Corporations- It only focuses on
the financial problems of corporate enterprises, so it narrows the opportunity of the
finance function.
  Attention to Irregular Events- It provides funds to irregular events like
consolidation, incorporation, reorganization, and mergers, etc. and does not give
attention to everyday business operations.
 More Emphasis on Long Term Funds- It deals with the issues of long-term
financing.

Approach 2: Modern Approach to Finance Function

With technological improvement, increase competition, and the development of strong
corporate, it was important for Management to use the available financial resources in its best
possible way. Therefore, the traditional approach became inefficient in a growing business
environment.
The modern approach had a more comprehensive analytical viewpoint with a focus on the
procurement of funds and its active and optimum use. The fund arrangement is an essential
feature of the entire finance function.
The main elements of this approach are an evaluation of alternative utilisation of funds,
capital budgeting, financial planning, ascertainment of financial standards for the business
success, determination of cost of capital, working capital management, Management of
income, etc. The three critical decisions taken under this approach are.
(i) Investment Decision
(ii) Financing Decision
(iii) Dividend Decision

Features of Modern Approach

The following are the main features of a modern approach.

 More Emphasis on Financial Decisions- This approach is more analytic and less
descriptive as the right decisions for a business can be taken only on the base of
accounting and statistical data.
 Continuous Function- The modern approach is a constant activity where the
financial manager makes different financing decisions unlike the traditional method,
 Broader View- It gives importance not only to optimum use of finance also abut the
fund’s procurement. Similarly, it also incorporates features relating to the cost of
capital, capital budgeting, and financial planning, etc.
 The measure of Performance- Performance of a firm is also affected by the financial
decision taken by the Management or finance manager. Therefore, to maximize
revenue, the modern approach keeps a balance between liquidity and profitability.
The other scope of financial management also includes the acquisition of funds, gathering
funds for the company from different sources, assessment and evaluation of financial plans
and policies, allocation of funds, use of funds to buy fixed and current assets, appropriation of
funds, dividing and distribution of profits, and the anticipation of funds along with estimation
of financial needs of the company.

The scope of financial management is explained in the diagram below:

You can understand the nature of financial management by studying the nature of investment,
financing, and dividend decisions.

Core Financial Management Decisions

In organizations, managers in an effort to minimize the costs of procuring finance and using it in
the most profitable manner, take the following decisions:

Investment Decisions: Managers need to decide on the amount of investment available out of
the existing finance, on a long-term and short-term basis. They are of two types:

 Long-term investment decisions or Capital Budgeting mean committing funds for a long
period of time like fixed assets. These decisions are irreversible and usually include the
ones pertaining to investing in a building and/or land, acquiring new plants/machinery or
replacing the old ones, etc. These decisions determine the financial pursuits and
performance of a business.

 Short-term investment decisions or Working Capital Management means committing

funds for a short period of time like current assets. These involve decisions pertaining to
 the investment of funds in the inventory, cash, bank deposits, and other short-term
investments. They directly affect the liquidity and performance of the business.

Financing Decisions: Managers also make decisions pertaining to raising finance from long-
term sources (called Capital Structure) and short-term sources (called Working Capital). They
are of two types:

 Financial Planning decisions which relate to estimating the sources and application of
funds. It means pre-estimating financial needs of an organization to ensure the availability
of adequate finance. The primary objective of financial planning is to plan and ensure that
the funds are available as and when required.

 Capital Structure decisions which involve identifying sources of funds. They also
involve decisions with respect to choosing external sources like issuing shares, bonds,
borrowing from banks or internal sources like retained earnings for raising funds.

Dividend Decisions: These involve decisions related to the portion of profits that will be
distributed as dividend. Shareholders always demand a higher dividend, while the management
would want to retain profits for business needs. Hence, this is a complex managerial decision

Functions of Financial Management

Here we are going to focus on some of the key important top 10 functions of financial
management notes and will discuss in few lines to understand them.

Liquidity Functions

Looking for adequate liquidity to hold out the business strategies, each financial manager
should perform some primary tasks. Firstly, raising funds, the company gets funding from
various source of funds. At different periods some various source of funds is going to be a lot
more desirable.

Secondly, forecasting cash flows, your day-to-day businesses need to get that the company to
invest their bills easily. This will be mainly one matter of matching funding inflows against
cash outflows. That the firm needs to be capable forecast your sources of funds plus timing to
cash inflows from clients and use them towards suppliers and lenders payments.

Capital Requirement Estimation

 Finance manager or supervisor need to make estimation with regards to funds / capital
requirement of an organization. This particular depends after profits, expected cost, policies,
rules and future programs. Estimations is one of an important functions of financial
management. Estimations have to be made in a sufficient manner through which it can
improve earning potential of a company.

Capital Composition

When the estimation of capital requirement have been completed. Your finance plan with
respect to capital structure need to be determined. This involves long-term as well as short-
term debt equity research and analysis. It will mostly depend after each proportion
concerning equity capital, which a company is actually possessing and additional required
funds that have to be raised from external parties.
Selecting a Sources of Funds
To raise additional funds and to be obtained those funds, the best organization has many
options. For example:

 Issue of debentures as well as shares.

 Loan to be taken from financial institutions or banks.
 Public deposits to be drawn just like at as a type of bonds. Choice of factor are determined
by general demerits and merits concerning each source of funds and at each stage of
company.

Price Control

Many large companies possess comprehensive cost-accounting systems to monitor

expenditure in areas for the company’s functions of financial management. Information are
fed right into a software system every day. In addition, computer systems are also designed to
highlight statistical important facts on tasks and activities to be displayed for a monitor.

Pricing

Some of the relevant decision taken within company include the costs established for the
items, services and products. Each philosophy then approach to pricing rules are important
elements in company’s advertising efforts, brand and then sales.

Determination of the appropriate worth is the best joint decision concerning marketing
manager provides insight to just how varying worth will likely affect demand within the
market and company’s competitive position. Each financial supervisor can supply insight
about changes in expenditures at different levels of manufacturing and the revenue margins
necessary to carry on the business successfully.

Capital Investment
Finance manager is needed in order to choose allocation of funds entering into profitable
ventures to ensure that there is an investment protection as well as a regular returns on
investment is available.

Managing Funds

Funds can be seen as liquid assets of the company. The term funds contains funding held by
your company, cash given by a company, funds borrowed by a company and funds gained by
acquisitions of preferred stocks and equity stocks.

Into the functions of financial management, your financial manager or supervisor acts as one
specialized officer of a company. That the manager is responsible for allocating funds and
tracking the sufficient funds available for a company to perform its business smoothly.

Distribution of Income

The net revenues decision need to be established simply by finance supervisor. This can be
done in two functions of financial management for an organization. Firstly by declaring
dividend, It includes determining their rate of dividends along with bonus if any. Second by
retaining income, the amount maintains to-be determined that upon expansion, innovation or
any diversification plans of an organization.

Financial Control

The finance manager not only need to build strategy to raise funds, allocate funds and make
use of the funds, but he even need to build techniques and methods to work on financial
control of funds. This can be complete thru some techniques just like ratio analysis, financial
forecasting, pricing, cost control and much more.

Objectives of Financial Management

A financial manager is responsible for making the decisions to bring effective financial
management to the organization. His/her decisions should be gainful for the shareholders as
well as the company. So the decisions which increase the value of the share in the market are
considered to be good and fruitful. Increased value of shares fulfills many other objectives
also but it does not means that the manager should use manipulative activities to raise the
prices of the shares. This boom must come with the growth of the organization, with the
increase in profits, and with the satisfaction of all the parties which are directly or indirectly
associated with the firm.

Some of the prime objectives of financial management are as follows:

1. Profit Maximization

A business is set up with the main aim of earning huge profits. Hence, it is the most important
objective of financial management. The finance manager is responsible to achieve optimal
profit in the short run and long run of the business. The manager must be focused on
earning more and more profit. For this purpose, he/she should properly use various methods
and tools available.

1. Profit Maximization:

i. It is only for short term

ii. It emphasis on profit only

iii. It ignores society

iv. It has a narrow scope

v. It is a traditional approach

vi. It ignores the risk factor

vii. It ignores the time value of money

viii. It is secondary objective

ix. It does not consider the effect of earnings per share, dividends paid or any other return to
shareholders on the wealth of the shareholders

2. Wealth Maximization

Shareholders are the actual owners of the company. Hence, the company must focus on
maximizing the value or wealth of shareholders. The finance manager should try to distribute
maximum dividends among the shareholders to keep them happy and to improve the
goodwill of the company in the financial market. The declaration of dividend and payout
policy is decided with the help of financial management. A proper dividend policy related to
the declaration of dividends or retaining the company's profit for future growth and
development is part of dividend decisions. But this is based on the performance of the
company and the amount of profit earned. Better performance means a higher value of shares
in the financial market. In nutshell, the finance manager focuses on maximizing the value of
shareholders.

2. Wealth Maximization:

i. It is for long term

ii. It emphasis on shareholders wealth

iii. It considers society

iv. It has a wider scope

v. It is a modern approach

vi. It considers the risk factor

vii. It considers time value of money

viii. It is primary objective

Comparision Between Wealth Maximization And Profit Maximisation

 Basis Wealth Maximization Profit Maximization

It is defined as the management of

It is defined as the management of
financial resources aimed at increasing
Definition financial resources aimed at
the value of the stakeholders of the
increasing the profit of the company.
company.

Focuses on increasing the value of the

Focuses on increasing the profit of
Focus stakeholders of the company in the
the company in the short term.
long term.

It considers the risks and uncertainty It does not consider the risks and
Risk inherent in the business model of the uncertainty inherent in the business
company. model of the company.

It helps in achieving a larger value of a

It helps in achieving efficiency in the
company’s worth, which may reflect
Usage company’s day-to-day operations to
in the increased market share of the
make the business profitable.
company.

Sources of Long Term Financing

1 – Equity Capital

It represents the interest-free perpetual capital of the company raised by public or private
routes. The company may either raise funds from the market via IPO or opt for a private
investor to take a substantial stake in the company.

 There is a dilution in the ownership, and the controlling stake rest with the largest equity
holder in equity financing.
 The equity holders have no preferential right in the company’s dividend and carry a higher
risk across all the buckets.
 The rate of return expected by the equity shareholders is higher than the debt holders due to
the excessive risk they bear in repayment of their invested capital.

2 – Preference Capital

Preference shareholders carry preferential rights over equity shareholders in terms of

receiving dividends at a fixed rate and getting back invested capital in the company if the
same is wound up.

It is a part of the company’s net worth, thus increasing the creditworthiness and improving
the leverage compared to the peers.

3 – Debentures

Is a loan taken from the public by issuing debenture certificates under the company’s
common seal? Debentures can be placed via public or private placement. Suppose a company
wants to raise money via NCD from the general public. In that case, it takes the debt IPO
route where all the public subscribing to it gets allotted certificates and are creditors of the
company. If a company wants to raise money privately, it may approach the major debt
investors in the market and borrow from them at higher interest rates.

 They are entitled to a fixed interest payment per the agreed-upon terms mentioned in
the term sheet.
 They do not carry voting rights and are secured against the company’s assets.
 In case of any default in debenture interest payment, the debenture holders can sell the
company’s assets and recover their dues.
 They can be redeemable, irredeemable, convertible, and non-convertible.

4 – Term Loans

Banks or financial institutions generally give them for more than one year. They have
mostly secured loans offered by banks against strong collaterals provided by the company in
the form of land and building, machinery, and other fixed assets.

 They are a flexible source of finance provided by the banks to meet the long-term capital
needs of the organization.
 They carry a fixed rate of interest and give the borrower the flexibility to structure the
repayment schedule over the tenure of the loan based upon the company’s cash flows.
 It is faster than the issue of equity or preference shares in the company as there are fewer
regulations to abide by and less complexity.

5 – Retained Earnings

These are the profits that the company has kept aside over time to meet the company’s future
capital needs.

 These are the company’s free reserves, which carry nil cost and are available free of charge
without any interest repayment burden.
 One can safely use it for business expansion and growth without taking additional debt
burden and diluting further equity in the business to an outside investor.
 They form part of the net worth and directly impact the equity share valuation.