CHAPTER 1 : FINANCIAL MANAGEMENT 06 HOURS

Meaning – Finance Function – Aims and Scope of Finance Function – Financial Management -
Financial Decisions – Objectives of Financial Management – Financial Planning – Principles of
Sound Financial Planning – Factors Affecting Financial Planning

Chapter -1
What is Financial Management?
Meaning

Financial management means:

• To collect finance for the company at a low cost and

• To use this collected finance for earning maximum profits.

Thus, financial management means to plan and control the finance of the company. It is done to achieve
the objectives of the company.

Definition of Financial Management

According to Dr. S. N. Maheshwari,

"Financial management is concerned with raising financial resources and their effective utilisation towards
achieving the organisational goals."

According to Richard A. Brealey,

"Financial management is the process of putting the available funds to the best advantage from the long
term point of view of business objectives."

CONCEPT OF FINANCIAL MANAGEMENT

As already discussed, the general meaning of finance refers to providing funds, as and when needed.
However, as management function, the term ‘Financial Management’ has a distinct meaning.

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Financial management deals with the study of procuring funds and its effective and judicious utilisation, in
terms of the overall objectives of the firm, and expectations of the providers of funds. The basic objective
is to maximise the value of the firm. The purpose is to achieve maximisation of share value to the owners
i.e. equity shareholders. The term financial management has been defined, differently, by various authors.
Some of the authoritative definitions are given below:

1. “Financial Management is concerned with the efficient use of an important economic resource, namely,
Capital Funds” —Solomon

2. “Financial Management is concerned with the managerial decisions that result in the acquisition and
financing of short-term and long-term credits for the firm”

—Phillioppatus

3. “Business finance is that business activity which is concerned with the conservation and acquisition of
capital funds in meeting financial needs and overall objectives of a business enterprise” —Wheeler

4. “Financial Management deals with procurement of funds and their effective utilisation in the business”
—S.C. Kuchhal

The definition provided by Kuchhal is most acceptable as it focuses, clearly, the Basic requirements of
financial management. From his definition, two basic aspects emerge:

(A) Procurement of funds.

(B) Effective and judicious utilisation of funds.

Financial management has become so important that it has given birth to Financial Management as a
separate subject.

SCOPE OF FINANCIAL MANAGEMENT

Financial management is concerned with optimum utilisation of resources. Resources are limited,
particularly in developing countries like India. So, the focus, everywhere, is to take maximum benefit, in
the form of output, from the limited inputs.

Financial management is needed in every type of organisation, be it public or private sector. Equally, its
importance exists in both profit oriented and non-profit organisations. In fact, need of financial management
is more in loss-making organisations to turn them to profitable enterprises. Study reveals many
organisations have sustained losses, due to absence of professional financial management.

Financial management has undergone significant changes, over the years in its scope and coverage.
Financial management has a wide scope.

According to Dr. S. C. Saxena, the scope of financial management includes the following five 'A's.

1. Anticipation : Financial management estimates the financial needs of the company. That is, it finds
out how much finance is required by the company.

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 2. Acquisition : It collects finance for the company from different sources.
3. Allocation : It uses this collected finance to purchase fixed and current assets for the company.
4. Appropriation : It divides the company's profits among the shareholders, debenture holders, etc.
It keeps a part of the profits as reserves.
5. Assessment : It also controls all the financial activities of the company. Financial management is
the most important functional area of management. All other functional areas such as production
management, marketing management, personnel management, etc. depends on Financial
management. Efficient financial management is required for survival, growth and success of the
company or firm.

Approaches:
Broadly, it has two approaches:

Traditional Approach-Procurement of Funds

Modern Approach-Effective Utilisation of Funds

Traditional approach is the initial stage of financial management, which was followed, in the early part
of during the year 1920 to 1950. This approach is based on the past experience and the traditionally accepted
methods. Main part of the traditional approach is rising of funds for the business concern.

Traditional approach consists of the following important areas:

• Arrangement of funds from lending body.

• Arrangement of funds through various financial instruments.
• Finding out the various sources of funds.

Modern Approach

After the 1950's, a number of economic and environmental factors, such as the technological innovations,
industrialization, intense competition, interference of government, growth of population, necessitated
efficient and effective utilisation of financial resources.
In this context, the optimum allocation of the firm's resources is the order of the day to the management.
Then the emphasis shifted from episodic financing to the managerial financial problems, from raising of
funds to efficient and effective use of funds. Thus, the broader view of the modern approach of the finance
function is the wise use of funds.
Since the financial decisions have a great impact on all other business activities, the financial manager
should be concerned about deter-mining the size and nature of the technology, setting the direction and
growth of the business, shaping the profitability, amount of risk taking, selecting the asset mix,
determination of optimum capital structure, etc.
The new approach is thus an analytical way of viewing the financial problems of a firm.

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According to the new approach, the financial management is concerned with the solution of the major areas
relating to the financial operations of a firm, viz., investment, and financing and dividend decisions.
The modern financial manager has to take financial decisions in the most rational way. These decisions
have to be made in such a way that the funds of the firm are used optimally.
These decisions are referred to as managerial finance functions since they require special care with
extraordinary administrative ability, management skills and decision - making techniques, etc.

FINANCE FUNCTION– IMPORTANCE

In general, the term “Finance” is understood as provision of funds as and when needed. Finance is

the essential requirement –sine qua non– of every organisation.

1. Required Everywhere: All activities, be it production, marketing, human resources development,

purchases and even research and development, depend on the adequate and timely availability of
finance both for commencement and their smooth continuation to completion. Finance is regarded
as the life-blood of every business enterprise.

2. Efficient Utilisation More Important: Finance function is the most important function of all
business activities. The efficient management of business enterprise is closely linked with the
efficient management of its finances. The need of finance starts with the setting up of business. Its
growth and expansion require more funds. The funds have to be raised from various sources. The
sources have to be selected keeping in relation to the implications, in particular, risk attached.
Raising of money, alone, is not important. Terms and conditions while raising money are more
important. Cost of funds is an important element. Its utilisation is rather more important. If funds
are utilised properly, repayment would be possible and easier, too. Care has to be exercised tomatch
the inflow and outflow of funds. Needless to say, profitability of any firm is dependent on its cost
as well as its efficient utilisation.

AIMS OF FINANCE FUNCTION

The following are the aims of finance function:

1. Acquiring Sufficient and Suitable Funds: The primary aim of finance function is to assess the needs
of the enterprise, properly, and procure funds, in time. Time is also an important element in meeting the
needs of the organisation. If the funds are not available as and when required, the firm may become sick or,
at least, the profitability of the firm would be, definitely, affected.

It is necessary that the funds should be, reasonably, adequate to the demands of the firm. The funds should
be raised from different sources, commensurate to the nature of business and risk profile of the organisation.
When the nature of business is such that the production does not commence, immediately, and requires
long gestation period, it is necessary to have the long-term sources like share capital, debentures and long

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term loan etc. A concern with longer gestation period does not have profits for some years. So, the firm
should rely more on the permanent capital like share capital to avoid interest burden on the borrowing
component.

2. Proper Utilisation of Funds: Raising funds is important, more than that is its proper utilisation. If proper
utilisation of funds were not made, there would be no revenue generation. Benefits should always exceed
cost of funds so that the organisation can be profitable. Beneficial projects only are to be undertaken. So, it
is all the more necessary that careful planning and cost-benefit analysis should be made before the
actualcommencement of projects.

3. Increasing Profitability: Profitability is necessary for every organisation. The planningand control
functions of finance aim at increasing profitability of the firm. To achieve profitability, the cost of funds
should be low. Idle funds do not yield any return, but incur cost. So, the organisation should avoid idle
funds. Finance function also requires matching of cost and returns of funds. If funds are used efficiently,
profitability gets a boost.

4. Maximising Firm’s Value: The ultimate aim of finance function is maximising the value of the firm,
which is reflected in wealth maximisation of shareholders. The market value of the equity shares is an
indicator of the wealth maximisation.

FUNCTIONS OF FINANCE
Finance function is the most important function of a business. Finance is, closely, connected with
production, marketing and other activities. In the absence of finance, all these activities come to a halt. In
fact, only with finance, a business activity can be commenced, continued and expanded. Finance exists
everywhere, be it production, marketing, human resource development or undertaking research activity.
Understanding the universality and importance of finance, finance manager is associated, in modern
business, in all activities as no activity can exist without funds. Financial Decisions or Finance Functions
are closely inter-connected. All decisions mostly involve finance. When a decision involves finance, it is a
financial decision in a business firm. In all the following financial areas of decision-making, the role of
finance manager is vital. We can classify the finance functions or financial decisions into the following
groups:

1. Investment Decision or Long-term Asset mix decision

2. Finance Decision or Capital mix decision

3. Dividend Decision or Profit allocation decision

1) Investment decision: It refers to the selection of the assets in which investment is to be made by the
company. Investment can be made in Long term fixed assets and short term current assets. Thus Investment
decision is divided in two parts :

(a) Long term Investment decisions: Such decisions are also called Capital Budgeting decisions. It relates
to the investment in long term fixed assets. As such decisions affects the growth of the firm, it involves

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huge fund to be blocked for a long period, and such decisions are irreversible in nature, they should be
taken carefully after making a comparative study of various alternatives available.

(b) Short term Investment decision (Working capital decision): It refers to investment in short term
assets such as cash, inventory, debtors etc. Finance manager has to ensure that enough working capital is
available to meet the day to day requirements. It should also ensure that unnecessarily high reserve of
working capital should not be retains as it decreases the profitability. Thus profitability and Liquidity are
to be compared and appropriate amount kept as working capital.

2. Financing decision: There are various sources of obtaining long term finance such as Equity shares,
preference shares, term loans, Debentures etc. For taking financing decision and deciding the capital
structure various factors are to be considered and an analysis of cost and benefit is made.

3. Dividend decision: It refers to the decision related to the distribution of profit. The finance manager has
to decide as to how much amount of profit is to be distributed as Dividend and how much to be retained in
the business. If too much retained earnings are maintained, it dissatisfies the shareholders as they receive
less dividend. Similarly if a liberal dividend policy is followed, though the shareholders are satisfies, but
the firm does not have enough reserve for future growth, expression, meeting contingency etc.

Objectives of Financial Management

The main objectives of financial management are:-

Profit maximization : The main objective of financial management is profit maximization. The finance
manager tries to earn maximum profits for the company in the short-term and the long-term. He cannot
guarantee profits in the long term because of business uncertainties. However, a company can earn
maximum profits even in the long-term, if:-

The Finance manager takes proper financial decisions.

He uses the finance of the company properly.

Wealth maximization : Wealth maximization (shareholders' value maximization) is also a main objective
of financial management. Wealth maximization means to earn maximum wealth for the shareholders. So,
the finance manager tries to give a maximum dividend to the shareholders. He also tries to increase the
market value of the shares. The market value of the shares is directly related to the performance of the
company. Better the performance, higher is the market value of shares and vice-versa. So, the finance
manager must try to maximise shareholder's value.

Proper estimation of total financial requirements : Proper estimation of total financial requirements is a
very important objective of financial management. The finance manager must estimate the total financial
requirements of the company. He must find out how much finance is required to start and run the company.
He must find out the fixed capital and working capital requirements of the company. His estimation must
be correct. If not, there will be shortage or surplus of finance. Estimating the financial requirements is a
very difficult job. The finance manager must consider many factors, such as the type of technology used by
company, number of employees employed, scale of operations, legal requirements, etc.

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Proper mobilisation : Mobilisation (collection) of finance is an important objective of financial
management. After estimating the financial requirements, the finance manager must decide about the
sources of finance. He can collect finance from many sources such as shares, debentures, bank loans, etc.
There must be a proper balance between owned finance and borrowed finance. The company must borrow
money at a low rate of interest.

Proper utilisation of finance : Proper utilisation of finance is an important objective of financial

management. The finance manager must make optimum utilisation of finance. He must use the finance
profitable. He must not waste the finance of the company. He must not invest the company's finance in
unprofitable projects. He must not block the company's finance in inventories. He must have a short credit
period.

Maintaining proper cash flow : Maintaining proper cash flow is a short-term objective of financial
management. The company must have a proper cash flow to pay the day-to-day expenses such as purchase
of raw materials, payment of wages and salaries, rent, electricity bills, etc. If the company has a good cash
flow, it can take advantage of many opportunities such as getting cash discounts on purchases, large-scale
purchasing, giving credit to customers, etc. A healthy cash flow improves the chances of survival and
success of the company.

Survival of company : Survival is the most important objective of financial management. The company
must survive in this competitive business world. The finance manager must be very careful while making
financial decisions. One wrong decision can make the company sick, and it will close down.

Creating reserves : One of the objectives of financial management is to create reserves. The company must
not distribute the full profit as a dividend to the shareholders. It must keep a part of it profit as reserves.
Reserves can be used for future growth and expansion. It can also be used to face contingencies in the
future.

Proper coordination : Financial management must try to have proper coordination between the finance
department and other departments of the company.

Create goodwill : Financial management must try to create goodwill for the company. It must improve the
image and reputation of the company. Goodwill helps the company to survive in the short-term and succeed
in the long-term. It also helps the company during bad times.

Increase efficiency : Financial management also tries to increase the efficiency of all the departments of
the company. Proper distribution of finance to all the departments will increase the efficiency of the entire
company.

Financial discipline : Financial management also tries to create a financial discipline. Financial discipline
means:-

a. To invest finance only in productive areas. This will bring high returns (profits) to the company.
b. To avoid wastage and misuse of finance.

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Reduce cost of capital : Financial management tries to reduce the cost of capital. That is, it tries to borrow
money at a low rate of interest. The finance manager must plan the capital structure in such a way that the
cost of capital it minimised.

Reduce operating risks : Financial management also tries to reduce the operating risks. There are many
risks and uncertainties in a business. The finance manager must take steps to reduce these risks. He must
avoid high-risk projects. He must also take proper insurance.

Prepare capital structure : Financial management also prepares the capital structure. It decides the ratio
between owned finance and borrowed finance. It brings a proper balance between the different sources of.
capital. This balance is necessary for liquidity, economy, flexibility and stability.

Financial Planning - Definition, Objectives and Importance

Definition of Financial Planning
Financial Planning is the process of estimating the capital required and determining it’s competition. It is
the process of framing financial policies in relation to procurement, investment and administration of funds
of an enterprise.

Objectives of Financial Planning

Financial Planning has got many objectives to look forward to:

a. Determining capital requirements- This will depend upon factors like cost of current and fixed
assets, promotional expenses and long- range planning. Capital requirements have to be looked
with both aspects: short- term and long- term requirements.
b. Determining capital structure- The capital structure is the composition of capital, i.e., the relative
kind and proportion of capital required in the business. This includes decisions of debt- equity ratio-
both short-term and long- term.
c. Framing financial policies- with regards to cash control, lending, borrowings, etc.
d. A finance manager ensures that the scarce financial resources are maximally utilized in the best
possible manner at least cost in order to get maximum returns on investment.

Importance of Financial Planning

Financial Planning is process of framing objectives, policies, procedures, programmes and budgets
regarding the financial activities of a concern. This ensures effective and adequate financial and investment
policies. The importance can be outlined as-

1. Adequate funds have to be ensured.

2. Financial Planning helps in ensuring a reasonable balance between outflow and inflow of
funds so that stability is maintained.
3. Financial Planning ensures that the suppliers of funds are easily investing in companies which
exercise financial planning.
4. Financial Planning helps in making growth and expansion programmes which helps in long-
run survival of the company.
5. Financial Planning reduces uncertainties with regards to changing market trends which can
be faced easily through enough funds.

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 6. Financial Planning helps in reducing the uncertainties which can be a hindrance to growth
of the company. This helps in ensuring stability an d profitability in concern.

Canons Basic Principles of Financial Planning

Canons are the basic (fundamental) principles (rules or standards) laid down by an authoritative entity
(either by an authoritative individual or institution, etc.) on something (may be either a concept or theory
or procedure or practice, etc.) with an intention to refine, improve, standardize and optimise its mode of
operation.

Financial Planning tells us how to prepare a financial or capital plan.

Long-term corporate objectives : The financial plan must consider the long-term objectives of the
company. The amount of capital received, the sources of funds and the application (use) of funds must be
decided only after considering the objectives of the company.

Simple : A financial plan must not be complex. It must be simple to understand and easy to use. The capital
structure must be simple. It must include a limited number of securities. If not, the investors will not invest
their money in the company.

Realistic : A financial plan must be realistic and practical. It must show the exact financial requirements of
the company. If not, there will be surplus or shortage of capital. The company must be able to collect
(acquire) the finance without any difficulty. The finance which is collected must be fully utilised.

Flexible : A financial plan must be flexible. It must not be rigid. The company must be able to change the
financial plan according to the circumstances. The company may have surplus finance or shortage of
finance. It must be able to return the surplus finance to the investors. Similarly, in case of shortage, it must
be able to collect more finance from the investors.

Economical : A financial plan must be economical. The cost of collecting finance must be low. The rate of
interest and dividend must be low. There must be a proper balance between owned and borrowed finance.
In the beginning, the company must use more owned finance i.e. equity shares. However, later, it must use
borrowed finance, i.e. loans, debentures, etc.

Liquidity : A financial plan must have liquidity. That is, the company must have sufficient cash to meet its
day-to-day requirements. The company must have a proper cash reserve. The cash reserve must not be too
high nor too low. If it is high then the company will have surplus cash. If it is too low then the company
will have a shortage of cash. Surplus cash and shortage of cash are both harmful to the company.

Provisions for contingencies : Contingencies are events, which may or may not happen in the future. They
are unforeseen or unexpected expenses. A financial plan must make provisions for contingencies. However,
unnecessary provisions must not be made. Proper judgement is required for making provisions for
contingencies.

Appealing to investors : A financial plan must be appealing to the investors. There are many types of
investors. Some investors give importance to security while others give importance to profitability. The
financial plan must be attractive to all types of investors.

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Effective and optimum use of funds : A financial plan must make the effective and optimum use of the
financial resources, i.e. funds. The finance collected by the company must not be wasted. They must be
properly used to meet the fixed capital and working capital needs of the company. Proper use of finance
results in high profits.

Balance of owned and borrowed capital : There must be a balance between owned finance and borrowed
finance. If not, the company will face many problems.

Safety to investors : A financial plan must offer safety to the investors' money. If not, the investors will
not invest their money in the company.

Timings of collecting finance : A financial plan must give importance to the timing of collecting finance.
During a boom period, the company must collect finance from equity shares. During a depression, it must
use borrowed finance.

Controlled by few shareholders : A financial plan must see that the company is controlled by few
shareholders.

Long-term vision : A financial plan must be prepared with proper vision and foresight. It must be prepared
for a long term. The long-term financial needs must be considered while preparing the finance plan. In
future, the company will grow. When it grows, it will require finance. All this must be considered while
preparing the financial plan.

Balanced capitalisation : A financial plan must have balanced capitalization. It must avoid over-
capitalization and under-capitalization.

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