Financial Management Notes: Introduction to Financial Management

Unit – I: Introduction to Financial Management

Meaning and Definitions of Financial Management/Business Finance/ Finance Functions

Financial management is management principles and practices applied to finance. General management functions include planning, execution and control. Financial decision making includes decisions as to size of investment, sources of capital, extent of use of different sources of capital and extent of retention of profit or dividend payout ratio. Financial management, is therefore, planning, execution and control of investment of money resources, raising of such resources and retention of profit/payment of dividend.

Howard and Upton define financial management as "that administrative area or set of administrative functions in an organisation which have to do with the management of the flow of cash so that the organisation will have the means to carry out its objectives as satisfactorily as possible and at the same time meets its obligations as they become due.”

According to Guthamann and Dougall,” Business finance can be broadly defined as the activity concerned with the planning, raising, controlling and administering the funds used in the business.”

Bonneville and Dewey interpret that financing consists in the raising, providing and managing all the money, capital or funds of any kind to be used in connection with the business.

Osbon defines financial management as the "process of acquiring and utilizing funds by a business”.

Considering all these views, financial management may be defined as that part of management which is concerned mainly with raising funds in the most economic and suitable manner, using these funds as profitably as possible.

Nature or Features or Characteristics of Financial Management

Nature of financial management is concerned with its functions, its goals, trade-off with conflicting goals, its indispensability, its systems, its relation with other subsystems in the firm, its environment, its relationship with other disciplines, the procedural aspects and its equation with other divisions within the organisation.

MEANING OF FINANCE FUNCTION

Finance function is the most important of all business functions. It means a focus of all activities. It is not possible to substitute or eliminate this function because the business will close down in the absence of finance. The need for money is continuous. It starts with the setting up of an enterprise and remains at all times. The development and expansion of business rather needs more commitment for funds. The funds will have to be raised from various sources. The sources will be selected in relation to the implications attached with them. The receiving of money is not enough, its utilization is more important. The money once received will have to be returned also. It its use is proper then its return will be easy otherwise it will create difficulties for repayment. The management should have an idea of using the money profitably. It may be easy to raise funds but it may be difficult to repay them. The inflows and outflows of funds should be properly matched.

APPROACHES TO FINANCE FUNCTION: A number of approaches are associated with finance function but for the sake of convenience, various approaches are divided into two broad categories:

1. The Traditional Approach: The traditional approach to the finance function relates to the initial stages of its evolution during 1920s and 1930s when the term ‘corporation finance’ was used to describe what is known in the academic world today as the ‘financial management’. According to this approach, the scope, of finance function was confined to only procurement of funds needed by a business on most suitable terms. The utilization of funds was considered beyond the purview of finance function. It was felt that decisions regarding the application of funds are taken somewhere else in the organization. However, institutions and instruments for raising funds were considered to be a part of finance function. The scope of the finance function thus, revolved around the study of rapidly growing capital market institutions, instruments and practices involved in raising of external funds.

The traditional approach to the scope and functions of finance has now been discarded as it suffers from many serious limitations:

2. The Modern Approach: The modern approach views finance function in broader sense. It includes both raising of funds as well as their effective utilization under the purview of finance. The finance function does not stop only by finding out sources of raising enough funds, their proper utilization is also to be considered. The cost of raising funds and the returns from their use should be compared. The funds raised should be able to give more returns than the costs involved in procuring them. The utilization of funds requires decision making. Finance has to be considered as an integral part of overall management. So finance functions, according to this approach, covers financial planning, raising of funds, allocation of funds, financial control etc. The new approach is an analytical way of dealing with financial problems of a firm. The techniques of models, mathematical programming, simulation and financial engineering are used in financial management to solve complex problems of present day finance. The modern approach considers the three basic management decisions i.e., investment decisions, financing decisions and dividend decisions within the scope of finance function.

Finance Functions (Scope of Financial Management)/ Types of Decisions to be taken under financial management

The finance function encompasses the activities of raising funds, investing them in assets and distributing returns earned from assets to shareholders. While doing these activities, a firm attempts to balance cash inflow and outflow. It is evident that the finance function involves the four decisions viz., financing decision, investment decision, dividend decision and liquidity decision. Thus the finance function includes:

1. Investment Decision: The investment decision, also known as capital budgeting, is concerned with the selection of an investment proposal/ proposals and the investment of funds in the selected proposal. A capital budgeting decision involves the decision of allocation of funds to long-term assets that would yield cash flows in the future. Two important aspects of investment decisions are:

(a) The evaluation of the prospective profitability of new investments, and

(b) The measurement of a cut-off rate against that the prospective return of new investments could be compared.

Future benefits of investments are difficult to measure and cannot be predicted with certainty. Risk in investment arises because of the uncertain returns. Investment proposals should, therefore, be evaluated in terms of both expected return and risk. Besides the decision to commit funds in new investment proposals, capital budgeting also involves replacement decision, that is decision of recommitting funds when an asset become less productive or non-profitable. The computation of the risk-adjusted return and the required rate of return, selection of the project on these bases, form the subject-matter of the investment decision.

Long-term investment decisions may be both internal and external. In the former, the finance manager has to determine which capital expenditure projects have to be undertaken, the amount of funds to be committed and the ways in which the funds are to be allocated among different investment outlets. In the latter case, the finance manager is concerned with the investment of funds outside the business for merger with, or acquisition of, another firm.

2. Financing Decision: Financing decision is the second important function to be performed by the financial manager. Broadly, he or she must decide when, from where and how to acquire funds to meet the firm’s investment needs. The central issue before him or her is to determine the appropriate 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 his or her firm. The firm’s capital structure is considered 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 as well. The change in the shareholders’ return caused by the change in the profit is called the financial leverage. A proper balance will have to be struck between return and risk. When the shareholders’ return is maximized with given 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 or she must raise the appropriate amount through the best available sources. In practice, a firm considers many other factors such as control, flexibility, loan covenants, legal aspects etc. in deciding its capital structure. 

3. Dividend Decision: Dividend decision is the third major financial decision. The financial manager must decide whether the firm should distribute all profits, or retain them, or distribute a portion and return the balance. The proportion of profits distributed as dividends is called the dividend-payout ratio and the retained portion of profits is known as the retention ratio. Like the debt policy, the dividend policy should be determined in terms of its impact on the shareholders’ value. The optimum dividend policy is one that maximizes the market value of the 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. Dividends are generally paid in cash. But a firm may issue bonus shares. Bonus shares are shares issued to the existing shareholders without any charge. The financial manager should consider the questions of dividend stability, bonus shares and cash dividends in practice. 

4. Liquidity Decision: Investment in current assets affects the firm’s profitability and liquidity. Current assets should be managed efficiently for safeguarding the firm against the risk of illiquidity. Lack of liquidity in extreme situations can lead to the firm’s insolvency. A conflict exists between profitability and liquidity while managing current assets. If the firm does not invest sufficient funds in current assets, it may become illiquid and therefore, risky. But if the firm invests heavily in the current assets, then it would lose interest as idle current assets would not earn anything. Thus, a proper trade-off must be achieved between profitability and liquidity. The profitability-liquidity trade-off requires that the financial manager should develop sound techniques of managing current assets and make sure that funds would be made available when needed. 

Objectives of Financial Management

The firm’s investment and financing decision are unavoidable and continuous. In order to make them rational, the firm must have a goal. Two financial objectives predominate amongst many objectives. These are:

1. Profit maximization

2. Shareholders’ Wealth Maximization (SWM)

Profit maximization refers to the rupee income while wealth maximization refers to the maximization of the market value of the firm’s shares. Although profit maximization has been traditionally considered as the main objective of the firm, it has faced criticism. Wealth maximization is regarded as operationally and managerially the better objective. 

1. Profit maximization: Profit maximization implies that either a firm produces maximum output for a given input or uses minimum input for a given level of output. Profit maximization causes the efficient allocation of resources in competitive market condition and profit is considered as the most important measure of firm performance. The underlying logic of profit maximization is efficiency.

In a market economy, prices are driven by competitive forces and firms are expected to produce goods and services desired by society as efficiently as possible. Demand for goods and services leads price. Goods and services which are in great demand can command higher prices. This leads to higher profits for the firm. This in turn attracts other firms to produce such goods and services. Competition grows and intensifies leading to a match in demand and supply. Thus, an equilibrium price is reached. On the other hand, goods and services not in demand fetches low price which forces producers to stop producing such goods and services and go for goods and services in demand. This shows that the price system directs the managerial effort towards more profitable goods and services. Competitive forces direct price movement and guides the allocation of resources for various productive activities. 

Objections to Profit Maximization:

Certain objections have been raised against the goal of profit maximization which strengthens the case for wealth maximization as the goal of business enterprise. The objections are:

(a) Profit cannot be ascertained well in advance to express the probability of return as future is uncertain. It is not at all possible to maximize what cannot be known. Moreover, the return profit vague and has not been explained clearly what it means. It may be total profit before tax and after tax of profitability tax. Profitability rate, again is ambiguous as it may be in relation to capital employed, share capital, owner’s fund or sales. This vagueness is not present in wealth maximisation goal as the concept of wealth is very clear. It represents value of benefits minus the cost of investment.

(b) The executive or the decision maker may not have enough confidence in the estimates of future returns so that he does not attempt further to maximize. It is argued that firm’s goal cannot be to maximize profits but to attain a certain level or rate of profit holding certain share of the market or certain level of sales. Firms should try to ‘satisfy’ rather than to ‘maximise’.

(c)There must be a balance between expected return and risk. The possibility of higher expected yields are associated with greater risk to recognize such a balance and wealth maximisation is brought in to the analysis. In such cases, higher capitalization rate involves. Such combination of expected returns with risk variations and related capitalization rate cannot be considered in the concept of profit maximisation.

(d) The goal of maximisation of profits is considered to be a narrow outlook. Evidently when profit maximisation becomes the basis of financial decision of the concern, it ignores the interests of the community on the one hand and that of the government, workers and other concerned persons in the enterprise on the other hand.

(e) The criterion of profit maximisation ignores time value factor. It considers the total benefits or profits in to account while considering a project where as the length of time in earning that profit is not considered at all. Whereas the wealth maximization concept fully endorses the time value factor in evaluating cash flows. Keeping the above objection in view, most of the thinkers on the subject have come to the conclusion that the aim of an enterprise should be wealth maximisation and not the profit maximisation.

(f) To make a distinction between profits and profitability. Maximisation of profits with a view to maximizing the wealth of share holders is clearly an unreal motive. On the other hand, profitability maximisation with a view to using resources to yield economic values higher than the joint values of inputs required is a useful goal. Thus, the proper goal of financial management is wealth maximisation.

2. Shareholders’ Wealth Maximization: Shareholders’ wealth maximization means maximizing the net present value of a course of action to shareholders. Net Present Value (NPV) of a course of action is the difference between the present value of its benefits and the present value of its costs. A financial action that has a positive NPV creates wealth for shareholders and therefore, is desirable. A financial action resulting in negative NPV destroys shareholders’ wealth and is, therefore undesirable. Between mutually exclusive projects, the one with the highest NPV should be adopted. NPVs of a firm’s projects are additive in nature. That is

NPV(A) + NPV(B) = NPV(A+B)

The objective of Shareholders Wealth Maximization (SWM) considers timing and risk of expected benefits. Benefits are measured in terms of cash flows. One should understand that in investment and financing decisions, it is the flow of cash that is important, not the accounting profits. SWM as an objective of financial management is appropriate and operationally feasible criterion to choose among the alternative financial actions. 

Maximizing the shareholders’ economic welfare is equivalent to maximizing the utility of their consumption over time. The wealth created by a company through its actions is reflected in the market value of the company’s shares. Therefore, this principle implies that the fundamental objective of a firm is to maximize the market value of its shares. The market price, which represents the value of a company’s shares, reflects shareholders’ perception about the quality of the company’s financial decisions. Thus, the market price serves as the company’s performance indicator.

In such a case, the financial manager must know or at least assume the factors that influence the market price of shares. Innumerable factors influence the price of a share and these factors change frequently. Moreover, the factors vary across companies. Thus, it is challenging for the manager to determine these factors. 

WEALTH MAXIMIZATION AS PRIMARY OBJECTIVE OF FINANCIAL MANAGEMENT

The primary objective of financial management is wealth maximization. The concept of wealth in the context of wealth maximization objective refers to the shareholders’ wealth as reflected by the price of their shares in the share market. Therefore, wealth maximization means maximization of the market price of the equity shares of the company. However, this maximization of the price of company’s equity shares should be in the long run by making efficient decisions which are desirable for the growth of a company and are valued positively by the investors at large and not by manipulating the share prices in the short run. The long run implies a period which is long enough to reflect the normal market price of the shares irrespective of short-term fluctuations. The long run price of an equity share is a function of two basic factors:

The financial manager must identify those avenues of investment; modes of financing, ways of handling various components of working capital which ultimately will lead to an increase in the price of equity share. If shareholders are gaining, it implies that all other claimants are also gaining because the equity share holders are paid only after the claims of all other claimants (such as creditors, employees, lenders) have been duly paid.

The following arguments are advanced in favour of wealth maximization as the goal of financial management:

Criticism of Wealth Maximization: The wealth maximization objective has been criticized by certain financial theorists mainly on following accounts:

Differences between profit maximization and wealth maximization are:

Need of Business Finance

Business finance is required for the establishment and existence of every business organization. Finance is required not only to start the business but also to operate it, it expand for modernize its operations and to secure stable growth. The importance of business finance arises basically to bridge the time gap. Manufacturers require business finance to bridge the time gap between the purchase of raw material and other supplies for production and recovery of sales. Traders require finance to bridge the time gap between the purchase of goods and recovery of sales. The need for business finance arises for the following purposes:

Finance is said to be life blood of business. It is required not only at the time of setting up of business but at every stage during the existence of business. It must be available at the time when it is needed. It must also be adequate for the purpose for which it is needed. Thus, finance is required to bring a business into existence, to keep it alive and to see it growing. Men, materials, machinery and managers can be brought together and engaged in business when adequate finance is available. Many business firms are known to have failed mainly due to shortage of finance. The importance of finance has increased in modern times for two reasons viz., (i) the business activities are now undertaken on a much larger scale than in the past, and (ii) the manufacturing process has become more complex than it used to be. With the growth in size and volume of business and with the increasing complexity of production and trade there is growing need for finance.

Significance of financial management in the present day business world

The scope and significance of financial management can be discussed from the following angles:

1) Importance to Organizations

2) Importance to all Stake holders

a) Share holders: Share holders are interested in getting optimum dividend and maximizing their wealth which is basic objective of financial management.

b) Investors / creditors: these stake holders are interested in safety of their funds, timely repayment of the principal amount as well as interest on the same. All these aspect are to be ensured by the person managing funds/ finance.

c) Employees: They are interested in getting timely payment of their salary/ wages, bonus, incentives and their retirement benefits which are possible only if funds are managed properly and organization is working in profit.

d) Customers: They are interested in quality products at reasonable rates which is possible only through efficient management of organization including management of funds.

e) Public: Public at large is interested in general public welfare activities under corporate social responsibility and this aspect is possible only when organization earns adequate profit.

f) Government: Govt is interested in timely payment of taxes and other revenues from business world where again efficient finance manager has a definite role to play.

g) Management: Management is interested in overall image building, increase in the market share, optimizing share holders wealth and profit and all these aspect greatly depends upon efficient management of financial resources.

3) Importance to other departments of an organization

A large size company, besides finance dept., has many departments like

All these departments look for availability of adequate funds so that they could manage their individual responsibilities in an efficient manner. Lot of funds are required in production/manufacturing dept for ongoing / completing the production process as well as maintaining adequate stock to make available goods for the marketing dept for sale. Hence, finance department through efficient management of funds has to ensure that adequate funds are made available to all department and these departments at no stage starve for want of funds. Hence, efficient financial management is of utmost importance to all other department of the organization.

Role and Functions of Finance Manager

In the modern enterprise, a finance manager occupies a key position, he being one of the dynamic member of corporate managerial team. His role, is becoming more and more pervasive and significant in solving complex managerial problems. Traditionally, the role of a finance manager was confined to raising funds from a number of sources, but due to recent developments in the socio-economic and political scenario throughout the world, he is placed in a central position in the organisation. He is responsible for shaping the fortunes of the enterprise and is involved in the most vital decision of allocation of capital like mergers, acquisitions, etc. A finance manager, as other members of the corporate team cannot be averse to the fast developments, around him and has to take note of the changes in order to take relevant steps in view of the dynamic changes in circumstances.

The nature of job of an accountant and finance manager is different, an accountant's job is primarily to record the business transactions, prepare financial statements showing results of the organisation for a given period and its financial condition at a given point of time. He is to record various happenings in monetary terms to ensure that assets, liabilities, incomes and expenses are properly grouped, classified and disclosed in the financial statements. Accountant is not concerned with management of funds that is a specialised task and in modern times a complex one. The finance manager or controller has a task entirely different from that of an accountant, he is to manage funds. Some of the important decisions as regards finance are as follows:

Financial Forecasting uses a set of techniques to determine the amount of additional financing a company will, or may, require in the future. It can also be a useful approach for assessing a new venture's profitability. Methods employed include, but are not limited to, assumptions, expectations, scenarios, sales percentage, and in addition there are more mathematical analytic methodologies, such as financial ratio based or regression analysis based forecasting. The concept explains the structured methodology that allows organisations to evaluate future financial needs. It also reviews how this technique is used to assess the amount of cash the company requires if a project develops more quickly or slowly than expected.

Sweat equity shares

Sweat equity shares refers to equity shares given to the company’s employees on favourable terms, in recognition of their work. It is one of the modes of making share based payments to employees of the company. The issue of sweat equity allows the company to retain the employees by rewarding them for their services. Sweat equity rewards the beneficiaries by giving them incentives in lieu of their contribution towards the development of the company. Further, it enables greater employee stake and interest in the growth of an organization as it encourages the employees to contribute more towards the company in which they feel they have a stake.