BBAIIYEAR IIISEMESTER Financial Management I

Unit1.Financial Management–An Overview

1. Finance–Meaning & Definition
2. Financial Management-Meaning & Definition
3. Financial Decisions –Investment Decision, Financial Decision, and
Dividend Decision.
4. Goals of Financial Management Profit Maximization, Wealth Maximization, Merits
and Demerits.
5. Controller vs Treasurer, Risk-return trade-off

1.1Finance-Meaning and definition

Meaning

What is finance? What are the firm's financial activities? How are they related
to the firm's other activities?

Financial management is a long term decision making process which involves

lot of planning, allocation of funds, discipline and much more. Nobody can
everthinktostartabusinessoracompanywithoutfinancialknowledgeandmanageme
ntstrategies.Financelinksitselfdirectlytoseveralfunctionaldepartmentslikemarketi
ng, production and personnel.

Business concern needs finance to meet their requirements in the economic

world. Any kind of business activity depends on the finance. Hence, it is called
as lifeblood of business organization. Whether the business concerns are big or
small, they need finance to fulfill their business activities.

Definition

According to Khan and Jain, “Finance is the Art and Science of managing
money.”

According to Oxford dictionary, the word ‘Finance’ connotes ‘management of

money’.
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1.2FINANCIALMANAGEMENT

Meaning of Financial Management:

Financial Management is that specialized function of general management
which is related to the procurement of finance and its effective utilization for
the achievement of common goal of the organization. It includes each and every
aspect of financial activity in the business. Financial Management has been
defined differently by different scholars A few of the definitions are be given
below:-

"Financial Management is an area of financial decision making

harmonizingindividualmotivesandenterprisegoals.”-WestonandBrigam.

“Financial Management is the application of the planning and cool functions to

the finance function.’’ –Howard and Upton.

From the above definitions, it is clear that financial management is that

specialized activity which is responsible for obtaining and effectively utilizing
the funds for the efficient functioning of the business and, therefore, it includes
financial planning, financial administration and financial control.

 Financial management entails planning for the future of a person or a

business enterprise to ensure a positive cash flow.
 It includes the administration and maintenance of financial assets.
 Besides, financial management covers the process of identifying and
managing risks.
 The primary concern of financial management is the assessment rather
than the techniques of financial quantification.
 A financial manager looks at the available data to judge the performance
of enterprises.
 Some experts refer to financial management as the science of money
management.
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1.3Financial Decisions
What is Financial Decision?
The decisions regarding the financial matters of any organization are known as
Financial Decisions. In simple terms, it refers to the decision regarding the
investment of the funds of the business in various assets.
Financial management focuses on providing solutions to three significant
problems concerned with the firm’s financial operations corresponding to the
three questions of investment, financing, and dividend decision.
In financial terms, financial decisions refer to finding the best solutions to
financial or investment problems from various alternatives.

Kinds of Financial Decisions

The management of an organization takes several financial decisions to
maximize its profits. The finance function deals with three main kinds of
decisions are:
 Financing decisions
 Investment decisions
 Dividend decisions

1. Financing Decision
Financing decisions are concerned with the determination of financial sources,
the amount to be obtained from each source, and the value of each source of
finance from various long-term sources. The short-term sources come under
working-capital management.
Financing decisions are concerned with the identification of various accessible
sources. A firm obtains its main sources of funds from its shareholders or by
borrowing funds. The shareholders’ funds refer to the equity capital and the
retained earnings. The finance raised through debentures or any other form of
debt is known as a borrowed fund.
Based on the basic characteristics of each source of funds, the firm determines
the proportions of funds raised through them. Whether the firm earns a profit or
not, it is bound to pay the interest on the borrowed funds.
Similarly, the repayment of the borrowed funds has to be done at a
predetermined time. The risk of default on payment is known as a financial risk
that has to be taken care of by a firm that probably has insufficient shareholders
to make these fixed payments.
On the other hand, the funds of the shareholders have no pressure concerning
the payment of returns or there payment of capital.
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2. Investment Decision
As resources are scarce, a firm has a lot more use of resources than them being
present. Thus, a firm has to decide where to invest these resources to earn the
highest possible returns for its investors. Therefore, the investment decisions reveal
how the firm’s funds are invested in different assets.
Investment decisions are of two types- short-term and long-term. A long-term
investment decision is also known as a Capital Budgeting decision. Short-term
investment decisions deal with the decisions about the levels of cash, inventory, and
receivables. They are also known as Working-capital decisions.

3. Dividend Decision
The decision that every financial manager has to undertake is concerned with the
distribution of dividends. This is known as a dividend decision.
The part of the profit that is distributed among the shareholders is known as a
dividend. A dividend decision is concerned with how much of the profit earned by
the company (after paying taxes) is to be given to the shareholders and how much of
it is to be reserved by the business.
While dividends consist of current income, reinvestment through retained earnings
expands the scope of the firm's future earnings.
The financing decision of the firm is also affected by the extent of retained earnings.
Since the funds are not needed by the firm to the same degree as reinvested retained
earnings, the ultimate goal of expanding the shareholders' funds should be taken
into consideration when deciding on dividends.

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1.4 Goals of Financial Management

1. Profit Maximization

2. Wealth Maximization

1. Profit Maximization:
The main aim of any economic activity is to earn a profit. A business concern
primarily functions for the purpose of earning a profit. No business can survive
without earning a profit. Profit is a measure of the efficiency of a business enterprise,
and it also serves as protection against risks. Accumulated profits enable a business
to face risks such as rising prices, competition from other business units, and
adverse government policies. Thus, profit maximization is considered the main
objective of a business unit.

Merits of Profit Maximization:

1. Profit is an indicator through which the performance of a business unit can be
measured.
2. Profit ensures the maximum welfare of employees, shareholders, and prompt
payments to creditors of a company.
3. Profit maximization increases the confidence of management in expansion and
diversification programs of a company.
4. Profit maximization attracts investors to invest their savings in the securities of a
company.

Demerits of Profit Maximization:

1. Profit is not a clear term; profit may be before tax or after tax.
2. Profit maximization encourages wrong practices to increase the profit of a
business.
3. Profit maximization does not consider the impact of the time value of money.
4. Profit maximization does not consider the element of risk.
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2. Wealth Maximization:
- Wealth maximization only occurs in the long term.
The term "wealth" refers to the "shareholders' wealth" or the "wealth of the
individuals involved in the business concern," including shareholders, owners,
creditors, employees, banks, government workers, etc. Wealth maximization is
also known as value maximization or net present value maximization.
The current wealth of stockholders in the firm is equal to the number of shares
owned multiplied by the current price per share. [SW = Number of shares
owned X Current price per share.] For example, in the case of Reliance
Industries Ltd., [100 X Rs.2,517.80 (26/06/23)] = Rs.2,51,780.
Note: To understand the concept, you can compare the financial data and share
prices of Reliance Industries Ltd. and Reliance Communications.

Net Present Value is the difference between Cash inflow and Cash outflow.
[NPV= Cash inflow – Cash outflow]

Final action – (+ve) NPV -- Creates Wealth -- Accepted/Desirable

Final action – (-ve) NPV -- Destroys Wealth -- Rejected/Undesirable
SWM – Fundamental objective of a firm is to maximize the market value of its shares.

IF A COMPANY IS MAXIMIZING ITS WEALTH, IT WILL REFLECT ON THE

MARKET VALUE OF ITS SHARES.

Merits of Wealth Maximization:

1. It considers the concept of time value of money.
2. The concept of wealth maximization is universally accepted because it takes care
of the interests of financial institutions, employees, society, owners, etc.
SWM– -+ve guides
3. Wealth maximization Createthe management
NtPresentValueisthedifferencebet
Final Destro Accepte in framing a strong dividend policy
Rejected/
to give maximum NP toysWeal
weenCashinflowandCashoutflow.
actio ve
return sWealt d/Desira
the equityUndesira
shareholders.
n V
NP h
th ble
4. The concept of wealth maximization considers the impact of risk factors.
V
Demerits of Wealth Maximization:
1. The objective of wealth maximization is not descriptive.
2. The objective of wealth maximization is not necessarily socially desirable.
3. The concept of increasing the wealth of the shareholders differs from one
company to another.
4. The objective of wealth maximization faces difficulties when ownership and
management are separated.
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1.5 Controller and Treasurer, Risk-return Trade-off

 Organization Chart of the Financial Management:

The Chief Finance Executive works directly under the President or the
Managing Director of the company. Besides routine network, the person in
charge keeps the Board of Directors informed about all phases of business
activity, including economic, social, and political developments affecting the
business behavior. He also furnishes information about the financial status of
the company by reviewing it from time to time. The Chief Finance Executive
may have many officers under him to carry out his function. Broadly, his
functions are divided into two types:
1. Treasury function
2. Control functions.
Organization of the Financial Management Function

1. Treasurer and Roles of Treasurer:

The main role of the Treasurer is to refer to the financial officer and look at the
task of financing and its related activities. Treasury always deals with liquid
assets, and so the main role of the Treasurer is to look at the cash and its other
liquid assets.

Some important tasks of the Treasurer are as follows:

- Formulating the whole capital structure of the organization in accordance with
the goals of the organization and implementing it within the organization.
- Managing the amount of liquid assets and all types of cash.
- Acting as a cashier.
- Playing the role of an authority signatory on payment cheques, including the
authority to approve such cheques.
- Managing the overall credit function of the firm.
• He also has the authority to utilize the surplus cash of the company whenever
there is any type of short-term beneficial investment.
• He also makes the company's policies according to decisions on trade
discounts and vendor payment.
• He also maintains relationships with bankers and vendors.

All of the above-mentioned functions of the Treasurer are implemented with the
help of a cash manager, finance manager, and credit manager.
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2. CONTROLLER and Roles of Controller:

As we have already seen that the Treasurer deals with liquid assets, the
Controller of the organization has to record the transactions of these liquid
assets. It is the combined and effective working of both departments that gives
rise to an effective system of internal controls. The Controller is a financial
officer responsible for accounting and control.

He performs the following functions:

• Records all the transactions in the general ledger, the accounts receivables, and
the accounts payables, sub-ledger, transactions with respect to fixed assets such
as depreciation, inventory control, etc.
• Looks into the aspects of taxes and insurance.
• Keeps track of the company's short-term investments by recording and
reconciling the transactions with those of the brokerage firms.
• Carefully looks into the regulatory aspects and implementation of the
company's policy on trade discounts and receivables aging.
• Acts as the planning director.
• Keeps a record of the attendance of the employees, their movement timings to
facilitate in preparing the payroll.
• Reports information to the management.

The office bearers who assist the Controller in accomplishing the above tasks
are tax manager, data processing manager, cost accounting manager, and
accounting manager. Thus, the functions of financial accounting, internal audit,
taxation, management accounting, control, budget planning, and control are
accomplished in this manner.

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 Risk-return trade-off:
Risk-return trade-off means that with an increase in the potential return, the risk
also increases. Every individual invests in the stock market by following a
strategy to achieve short-term or long-term investment goals. Earning profits
comes with a set of risks, which every investor has to factor into their strategy. As
per most investors, risk exposure directly affects the profit potential for every
investment instrument. They believe that with higher risk comes opportunities for
higher profits. Let us understand what the risk-return trade-off is.

What is the risk-return trade-off?

The risk-return trade-off meaning describes the investment mindset of investors

for the risk exposure included in their investment strategy. The risk and return
trade-off states that when investing in equities and mutual funds, the risk exposure
and potential profits move in tandem; the higher the risk, the higher the returns.
For example, equities offer the highest potential returns for investors but come
with the highest level of risk.

An ideal risk-return trade-off depends on numerous factors such as set goals, risk
tolerance, investment duration, and the potential to replace lost funds. If investors
want to make high profits in less time, they can follow the risk-return trade-off
mindset and invest in volatile assets that regularly fluctuate in price.

Understanding risk-return trade-off:

Every investment instrument comes with a certain level of risk, where investors
can lose the capital amount owing to various negative factors. However, the level
of risk depends on the investment duration, the instrument's volatility, and risk
tolerance.
Risk-return trade-off is a term used in capital markets by investors who believe
that an investment instrument is likely to provide higher returns if it contains a
high level of risk. As per the trade-off concept, investing with low levels of risk
can provide stable but not high returns.

Investment duration also plays an important role in allowing investors to utilize

the risk-return trade-off. Ideally, investing for the long term allows them to
potentially lower the risk. However, if one wants to make high profits in the short
term, the risk factor is higher with the possibility of higher returns.
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