FINANCIAL MANAGEMENT

UNIT-1

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

Nature, Significance, and Scope of Financial Management

Financial management is an organic function of any business. Any organization needs
finances to obtain physical resources, carry out the production activities and other
business operations, pay compensation to the suppliers, etc.

There are many theories around financial management:

1. Some experts believe that financial management is all about providing funds
needed by a business on terms that are most favorable, keeping its objectives in mind.
Therefore, this approach concerns primarily with the procurement of funds which may
include instruments, institutions, and practices to raise funds. It also takes care of
the legal and accounting relationship between an enterprise and its source of funds.
2. Another set of experts believe that finance is all about cash. Since all business
transactions involve cash, directly or indirectly, finance is concerned with everything
done by the business.
3. The third and more widely accepted point of view is that financial management
includes the procurement of funds and their effective utilization. For example, in the
case of a manufacturing company, financial management must ensure that funds are
available for installing the production plant and machinery. Further, it must also ensure
that the profits adequately compensate the costs and risks borne by the business.

The scope of Financial Mangement

The introduction to financial management also requires you to understand the scope of
financial management. It is important that financial decisions take care of
the shareholders‘ interests.
Further, they are upheld by the maximization of the wealth of the shareholders, which
depends on the increase in net worth, capital invested in the business, and plowed-back
profits for the growth and prosperity of the organization.

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.

OBJECTIVES OF FM

The primary objectives of financial management are:

 Attempting to reduce the cost of finance

 Ensuring sufficient availability of funds
 Also, dealing with the planning, organizing, and controlling of financial activities
like the procurement and utilization of funds.

The objectives of financial management are given below:

1. Profit maximization

Main aim of any kind of economic activity is earning profit. A business concern
is also functioning mainly for the purpose of earning profit. Profit is the
measuring techniques to understand the business efficiency of the concern.

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

2. 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 maximize
shareholder’s value

3. 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.

4. Proper mobilization

Mobilization (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.

5. Proper utilization of finance

Proper utilization of finance is an important objective of financial management.

The finance manager must make optimum utilization 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.

6. 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.
7. 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.

8. 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.

9. Proper coordination

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

10. 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.

11. 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.

12. Financial discipline

Financial management also tries to create a financial discipline. Financial

discipline means:

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

13. 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 minimized.
 14. 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.

15. 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 MANAGER

Financial managers are responsible for the financial health of an organization.

They produce financial reports, direct investment activities, and develop
strategies and plans for the long-term financial goals of their organization.
Financial managers work in many places, including banks and insurance
companies.

Financial managers typically do the following:

 Prepare financial statements, business activity reports, and forecasts

 Monitor financial details to ensure that legal requirements are met

 Supervise employees who do financial reporting and budgeting
 Review company financial reports and seek ways to reduce costs
 Analyze market trends to find opportunities for expansion or for acquiring
other companies
 Help management make financial decisions
FINANCIAL MANAGER RESPONSIBILITIES AND DUTIES

Although the roles and responsibilities of a finance manager vary from one
organisation to another, there are certain tasks that are common across all jobs.

The duties of a finance manager include:

 Daily reporting.
 Analysing targets.
 Meeting with department heads.
 Managing and coordinating monthly reporting, budgeting and reforecast
processes.
 Providing back office services such as accounts payable, collection and
payroll.
 Monitoring cash flow.
 Liaising with accountant teams.

Finance manager responsibilities can also include:

 Providing insights on the financial health of the organisation.

 Ensuring the business meets all its statutory and compliance obligations,
including statutory accounting and tax issues.
 Keeping track of market trends.
 Looking for cost-reduction opportunities.
 Developing relationships with external contacts such as auditors,
solicitors and HM Revenue & Customs.
 Supervising staff.

“A typical day can range from orderly and standard routines and processes
through to involvement in commercial aspects, legal and contract issues and
system/project work,” says Southern, senior financial controller at total jobs.
“One thing for sure, it is always busy and the to-do list is never empty.”

Functions of Financial Manager are discussed below:

1. Estimating the Amount of Capital Required:

This is the foremost function of the financial manager. Business firms require
capital for:

(i) purchase of fixed assets,

(ii) meeting working capital requirements, and
(iii) modernisation and expansion of business.

The financial manager makes estimates of funds required for both short-term
and long-term.

2. Determining Capital Structure:

Once the requirement of capital funds has been determined, a decision regarding
the kind and proportion of various sources of funds has to be taken. For this,
financial manager has to determine the proper mix of equity and debt and short-
term and long-term debt ratio. This is done to achieve minimum cost of capital
and maximise shareholders wealth.

3. Choice of Sources of Funds:

Before the actual procurement of funds, the finance manager has to decide the
sources from which the funds are to be raised. The management can raise
finance from various sources like equity shareholders, preference shareholders,
debenture- holders, banks and other financial institutions, public deposits, etc.

4. Procurement of Funds:
The financial manager takes steps to procure the funds required for the business.
It might require negotiation with creditors and financial institutions, issue of
prospectus, etc. The procurement of funds is dependent not only upon cost of
raising funds but also on other factors like general market conditions, choice of
investors, government policy, etc.

5. Utilisation of Funds:
The funds procured by the financial manager are to be prudently invested in
various assets so as to maximise the return on investment: While taking
investment decisions, management should be guided by three important
principles, viz., safety, profitability, and liquidity.

6. Disposal of Profits or Surplus:

The financial manager has to decide how much to retain for ploughing back and
how much to distribute as dividend to shareholders out of the profits of the
company. The factors which influence these decisions include the trend of
earnings of the company, the trend of the market price of its shares, the
requirements of funds for self- financing the future programmes and so on.

7. Management of Cash:
Management of cash and other current assets is an important task of financial
manager. It involves forecasting the cash inflows and outflows to ensure that
there is neither shortage nor surplus of cash with the firm. Sufficient funds must
be available for purchase of materials, payment of wages and meeting day-to-
day expenses.

8. Financial Control:
Evaluation of financial performance is also an important function of financial
manager. The overall measure of evaluation is Return on Investment (ROI). The
other techniques of financial control and evaluation include budgetary control,
cost control, internal audit, break-even analysis and ratio analysis. The financial
manager must lay emphasis on financial planning as well.

PROFIT MAXIMIZATION Vs WEALTH MAXIMIZATION

The essential difference between the maximization of profits and the
maximization of wealth is that the profits focus is on short-term earnings,
while the wealth focus is on increasing the overall value of the business
entity over time. These differences are substantial, as noted below:
 Planning duration. Under profit maximization, the immediate increase
of profits is paramount, so management may elect not to pay for
discretionary expenses , such as advertising, research, and maintenance.
Under wealth maximization, management always pays for these
discretionary expenditures .
 Risk management . Under profit maximization, management minimizes
expenditures, so it is less likely to pay for hedges that could reduce the
organization's risk profile. A wealth-focused company would work on risk
mitigation, so its risk of loss is reduced.
 Pricing strategy . When management wants to maximize profits, it
prices products as high as possible in order to increase margins. A wealth-
oriented company could do the reverse, electing to reduce prices in order to
build market share over the long term.
 Capacity planning. A profit-oriented business will spend just enough
on its productive capacity to handle the existing sales level and perhaps the
short-term sales forecast . A wealth-oriented business will spend more
heavily on capacity in order to meet its long-term sales projections.
AGENCY COST
An agency cost is a type of internal company expense, which comes from the
actions of an agent acting on behalf of a principal. Agency costs typically arise
in the wake of core inefficiencies, dissatisfactions, and disruptions, such
as conflicts of interest between shareholders and management. The payment of
the agency cost is to the acting agent.
KEY FACTORS
 An agency cost is an internal expense that comes from an agent taking
action on behalf of a principal.
 Core inefficiencies, dissatisfactions, and disruptions contribute to agency
costs.
 Agency costs that include fees associated with managing the needs of
conflicting parties are called agency risk.
 An agent-principal relationship exists between a company's management
(agent) and its shareholders (principal).
#1 – Direct Agency Cost
 Monitoring Costs: When the activities of the management of the

company are aligned to the benefits of the shareholders and these restrict

the activities of the management. The cost of maintaining the board of

directors therefore to a certain extent is also a part of the monitoring

costs. Other examples of the monitoring costs are the employee stock

options plan available for the employees of a company.

 Bonding Costs: Contractual obligations are entered between the

company and the agent. A manager continues to stay with a company

even after it is acquired, who might forego the employment opportunities.

 Residual Losses: In case the monitoring bonding costs are not enough to

diverge the principal and agent interests, additional costs are incurred

which are called the residual costs.

#2 – Indirect Agency Cost
The indirect agency costs are those that refer to the expenses incurred due to the

opportunity lost. For example, there is a project that the management can

undertake but might result in the termination of their jobs. However, the

shareholders of the company are of the opinion that if the company undertakes

the project it will improve the shareholders’ values and if the management

rejects the project it will have to face a huge loss in terms of shareholders’

stake. Since this expense is not directly quantifiable but affects the interests of

the management and shareholders, it becomes a part of the indirect agency

costs.

How to Limit Agency Costs?

The most common method to handle the agency costs involved in a company is

by way of implementing incentive scheme, which can be of two types: financial

and non-financial incentives scheme.

#1 – Financial Incentives Scheme

Financial incentives help the agents by motivating them so that they can act for

the interest of the company and its benefits. The management receives such

incentives when they perform well on a project or achieves the required goals.

Certain examples of the financial incentives scheme are :

  Profit-Sharing Scheme: The management becomes eligible to receive a

certain percentage of the company’s profits as a part of the incentive

scheme.

 Employee Stock Options: A pre-determined number of shares are

available to be bought by the employees at a price which is usually lower

than the market.

#2 – Non-financial Incentives Scheme

This scheme is less prevalent than the financial incentives scheme. These are

less effective to reduce the agency costs when compared to the financial

incentives scheme. Some of the common examples are :

 Non – financial rewards and recognition from peers and colleagues.

 Corporate services and added benefits.

 Better workspace.

 Better or improved opportunities.

 
Benefits
Some of the benefits are as follows:

 They are targeted towards aligning the management and shareholders’

benefits and interests. This means keeping the company in good shape for

both parties.
  Due to the right application of these agency costs, the market value of the

firm remains intact and improves in the eyes of the stakeholders of the

company.

 
Limitations
Some of the limitations are as follows:

 It means the involvement of financial resources which ultimately impacts

the company’s balance sheet.

 Might involve higher or more resources than usual practice in some cases

where both the parties – the principal and agent- are difficult to align with

all incentives or costs involved.

 They might impact the share price of the company’s stock in case a

substantial size of the debt is involved.

TIME VALUE OF MONEY

The time value of money (TVM) is the concept that money you have now is
worth more than the identical sum in the future due to its potential earning
capacity. This core principle of finance holds that provided money can earn
interest, any amount of money is worth more the sooner it is received. TVM is
also sometimes referred to as present discounted value.
The time value of money is the widely accepted conjecture that there is greater
benefit to receiving a sum of money now rather than an identical sum later. It
may be seen as an implication of the later-developed concept of time
preference.
The time value of money is the reason why interest is paid or earned: interest,
whether it is on a bank deposit or debt, compensates the depositor or lender for
the time value of money. Hence, It also underlies investment. Investors are
willing to forgo spending their money now only if they expect a favorable
return on their investment in the future, such that the increased value to be
available later is sufficiently high to offset the preference to spending money
now; see required rate of return.
Time value of money problems involve the net value of cash flows at different
points in time.
This principle allows for the valuation of a likely stream of income in the future,
in such a way that annual incomes are discounted and then added together, thus
providing a lump-sum "present value" of the entire income stream; all of the
standard calculations for time value of money derive from the most basic
algebraic expression for the present value of a future sum, "discounted" to the
present by an amount equal to the time value of money. For example, the future
value sum {\displaystyle FV}FV to be received in one year is discounted at the
rate of interest {\displaystyle r}r to give the present value sum {\displaystyle
PV}PV:

{\displaystyle PV={\frac {FV}{(1+r)}}}PV = \frac{FV}{(1+r)}

Some standard calculations based on the time value of money are:

Present value: The current worth of a future sum of money or stream of cash
flows, given a specified rate of return. Future cash flows are "discounted" at the
discount rate; the higher the discount rate, the lower the present value of the
future cash flows. Determining the appropriate discount rate is the key to
valuing future cash flows properly, whether they be earnings or obligations.[3]
Present value of an annuity: An annuity is a series of equal payments or receipts
that occur at evenly spaced intervals. Leases and rental payments are examples.
The payments or receipts occur at the end of each period for an ordinary annuity
while they occur at the beginning of each period for an annuity due.[4]
Present value of a perpetuity is an infinite and constant stream of identical cash
flows.[5]
Future value: The value of an asset or cash at a specified date in the future,
based on the value of that asset in the present.[6]
Future value of an annuity (FVA): The future value of a stream of payments
(annuity), assuming the payments are invested at a given rate of interest.