UNIT 1 FINANCIAL MANAGEMENT: AN OVERVIEW Structure 1.0. Objectives 1.1 Introduction 1.2 Evolution of Financial Management 1.3 Nature of Financial Management 1.4. Finance and other related Disciplines 1.5 Objectives of Financial Management 1.6 Risk and Retum trade-off 1.7. Role of Finance Manager 1.8 Let Us Sum Up 19 Key Words 1.10. Self-Assessment Questions 1.0 | OBJECTIVES After studying this unit, you should be able to: * comprehend the evolution of financial management; * understand the nature and scope of financial management; * discuss the relationship of finance with other diseiplines; * understand the objectives of financial management; # assess the functions of finance manager; and + explain the concept of risk and return trade off. 1.1. INTRODUCTION The main objective of any business organization is to generate profits, be it a manufacturing organization or a service organization. Any business or for that matter any activity requires financial resources at any point of time. Financial resources for any organization needs to be planned, directed, monitored, organized and controlled for its optimum utilization. This is where the role of finance manager comes into picture. Now the question arises as to what is financial management? If we have to explain it we can break it into Finance’ and ‘Management’, When we combine these two words. it becomes financial management. Finance + Management = Financial Management.Introduction to Financial Management We can say that when the financial resources are combined with the management functions, it becomes financial management. In this unit we are going to learn the evolution of financial management, its nature and scope, objectives, risk-retum trade off and role of a finance manager. 1.2. EVOLUTION OF FINANCIAL MANAGEMENT Before we discuss the evolution of financial management, it is important to understand the difference between money and finance. What is Money? It is a physical form which is in terms of a nation's currency. But with the digitization of money, digital currency has also been introduced and such money is not in a physical form. However, we will consider money in its conventional form. Money is used to buy something be it by an individual or by an organization or by a nation, It can be used to buy: © assets © groceries * clothes © other items Difference between Money and Finance Let us now understand the basic difference between Money and Finance. Suppose you have 210,000 you spend on your daily needs like groceries, vegetables, clothes ete. In this case you call it Money. Now, you also have 10,000 as savings and you want it to invest it say in term deposit. In this, case it becomes Finance, We ean therefore say that when currency is in hand and is spent without giving returns it is known as 'Money' and when it is invested in some kind of assets with the expectation that there will be some retum associated with it then it is known as ‘Finance’ Therefore, the whole concept of finance is management of money with proper decision-making. This management of finances is known as Financial Management, Let us now see how financial management evolved as a discipline. In the early 1990's financial management emerged as a distinct field and became a separate discipline from accounting. The need for separate discipline was felt due to the complex situations arising out of fast industrialization and increase in competitiveness. To understand the evolution of financial management, it can be divided into three phases. These are: 1. Traditional Phase 2. Transitional Phase 3. Modern Phase1, Traditional Phase (1900-1940): In earlier times ance basically meant of trying to procure funds through different ways and means. The funds were procured through different sources of financing (this we will learn in Unit 3) like loans, shares, debentures ete. It basically involved estimating the needs of the organization and accordingly arranging for the funds, The focus was more on long term sources and to the accounting aspects. This phase lasted for about four decades. Over the years this concept has taken a backseat as it does not involve the decision making process. The concept of financial management evolved over the years and led to the transitional phase. 2, Transitional Phase (1940-1950) : It was similar to the traditional phase. In this phase the importance was given to day to day problems and focus ‘was on the planning, analyzing and controlling part. Slowly the emphasis on the decision-making started during this phase. This led to the evolution of modem phase. 3. Modern Phase (1960 to present) : This phase is an extension of traditional phase where the procured funds are put to optimum utilization, This phase focuses more on shareholders’ wealth ‘maximization. This approach is more logical and rational as it involves decision making on part of the financial manager. These three phases have led to the advent of two approaches which are: Traditional Approach Modern Approach Traditional approach focuses on procurement of funds only whereas modem approach focuses on procurement of funds along with its optimum utilization. 1.3|_| NATURE OF FINANCIAL MANAGEMENT Finance is the lifeline of any business organization. The procurement of funds and its efficient use is very important for any organization, Any organization has to decide why, what, where, how and when of finances. It should focus on: © Why the funds are required? What sources can be used to procure funds? Where from the funds will be procured? * How will the funds be distributed for optimum utilization? * When should the organization plan for getting more funds? The finance functions involve the answers to the above questions. Therefore, we can say that the key elements of financial management are: L. Planning 2. Allocation of resources Managing the resources Financ Management: An ‘OverviewIntroduction to Financial Management 4. Control Ithas been defined by different writers as follows: * As per Ezra Soloman — “Financial Management is concemed with efficient use of an important economic resource namely capital funds. It is the study of the problems involved in the use and acquisition of funds” * According to Weston and Brigham — “Financial Management is an area of financial decision making, harmonizing individual motives and enterprise goals”. ‘© Phillippatun has given a more amplified meaning of financial management. According to him, “Financial Management is concemed with managerial decisions that result in the acquisition and financing of short and long-term credits for the organizations”, Financial Management therefore can be defined as a management decision that results in the procurement of funds with its optimum utilization. The nature of financial management involves the following functions 1. Investment Decision Financing Decision 3. Dividend Decision Investment Decision: This function of the financial management involves appropriate selection of assets where the investment will be done. This can be done under two broad heads: © Long-term assets * Short-term or Current assets Long term assets yield retum over a period of time in future whereas short term assets are usually converted into cash within a year. Therefore, we can say that ‘© investment in long-term assets is known as capital budgeting * management of short-term assets is known as working capital management Both these concepts you will be studying in further units, Financing Decision: The investment decision is considered with proper asset mix whereas financing decision deals with identification of sources of finance determining the financing mix. Determining financing mix is also known as capital structure. It refers to the proportion of debt while procuring funds. There should be a balance between owners’ funds and outsiders’ funds and long-term funds and short-term funds. The firm has to make use of the external and internal funds and employment of these resources in various combinations is called leverage analysis. Financing decision involves the following two aspects:* capital structure theory Financial " Management: An capital structure decision ‘Overview Dividend Decision: The third function of financial management is related to the dividend policy. In this case the dividend is to be analyzed related to the financing decisions of the firm. There are two options available with the firm: © tore in the profits * to distribute the profits in form of dividend to the shareholders The appropriate decision is to be taken by the firm keeping in mind the following aspects: + dividend payout ratio * preference of shareholders # investment opportunities to the firm 1.4 FINANCE AND OTHER RELATED DISCIPLINES Finance can be divided into two broad categories. These are: © Public Finance © Private Finance Public Finance deals with the matters related to the government. It can be Central or State government or governmental institutions, This deals within the funds which are raised through taxes ete. The main objective of public finance is to deal with social or economic objectives than trying to eam profits. Private Finance on the other hand involves personal finance, business finance or finances of the bodies other than governmental institutions, Let us now discuss financial management in relation to other disciplines. There are basically two disciplines viz Economies and Accounting which are closely related to financial management. In fact it can be said that financial ‘management actually emerged from these two disciplines. Financial Management and Economics: Economics can be divided into macroeconomics and microeconomics. Macroeconomics is the broader concept and deals with the overall environment of the nation or the globe where an industry operates. There are extemal factors like economy of the nation, government policies ete. which are beyond the control of any organization. When we relate macroeconomics with financial management, the banking system, capital markets, financial intermediaries, RBI, monetary, fiscal and economic policies etc. come into the picture. On the other hand microeconomics is the organ ment which is controllable in nature. This includes the nature and size of the 9Introduction to Financial Management 10 organization, liquidity position, pattern and ownership of the organization ete, These aspects when studied in detail show that how Financial Management is closely relate to economics. Financial Management and Accounting: As discussed earlier the traditional approach of financial management basically targets the accounting aspect of the firm. With the evolution of financial management, the other aspects like decision making came into picture. It is said where the accounting ends, financial management begins. This clearly shows the close association of financial management and accounting. Let us take an example to understand this, We know that accounting deals with data collection and reporting whereas finance deals with reading these data, analyzing it and finally making a decision. Example: A firm 'X' has the following transactions in a year: Sales 4 = 10,00,000 Cost of Sales - = 7,00,000 Opening & Closing Stock — - Nil Collection from Sales = % 2,00,000 Payments to Suppliers : % 6,00,000 Let us now see the accounting view and financial view of the same Accounting View Financial View (Profit & Loss Account) (Cash Flow Statement) (Amount in 2) (Amount in %) Sales - 10,00,000 Cash inflows - 2,00,000 Less Costs - 7,00,000 Less: eash outflow + — 6,00,000 Net Profit - 3,00,000 *Net cash outflow - — 4,00,000 (*here net cash outflow is more than the inflow i.e. negative) This is how the relationship between the two is seen. Check Your Progress A 1) List the phases in evolution of financial management, 2) What are the different kinds of finance functions? 3) How is Financial Management related to: i) Economics ii) Accounting1.5 | OBJECTIVES OF FINANCIAL MANAGEMENT The objectives of financial management provide a framework for making optimum decisions. There are two objectives of financial management which are as follows: i) Profit Maximization ii) Wealth Maximization ‘The objectives are means to reach to a goal of a business, Let us discuss these. Profit Maximization: In general terms it means maximizing the income of the firm. When we discuss this concept it is quite vague as it does not clearly spell out the following: a) What are the profits? b) What is the absolute value of earnings per share? ©) Does the profits have return on investment? 4) Are the profits calculated before tax or after tax? Initially this objective was the main aim of the firm and there are many arguments in favour of this, In case a firm adopts the concept of profit, maximization then the returns are achieved at a later stage which may not be ‘good for the financial health of the firm, In present times profit maximization is also not socially responsible decision on part of the firm. Let us see some pros and cons of this approach PROS CONS * Resources utilized efficiently [Vague and ambiguous * Measure of firms’ performance |e — Ignores time pattern of profits ‘+ Serves the interest of the society | * — Ignores risk and time value of, wc effres mone} * Test of economic efficiency y © Ignores quality aspect of, benefits © Unrealistic * Ignores socially responsible behaviour In profit maximization ‘the bigger the better’ concept is adopted, Let us understand this through table 1.1 and 1.2 respectively. Financ Management: An ‘Overview MlIntroduction to Financial Management 12 Table 1.1 : Time-Pattern of Profits Time Period Option A (@ in lakh) Option B (in lakh) 1 100 = 0 200 200 mw 100 200 Total 400 400 As visible in table 1.1 total profits associated with option A and B are the same. If the firm considers profit maximization criteria, then both options are equally good as at the end of the day both earn same amount of profits. But as you can see the two options are not the same as the earnings vary during different time periods. This shows that the time pattern of the benefits received from certain investment is ignored. Let us now see another case. Table 1.2 : Uncertainty about expected profits Profit (@ in Lakh) Economic view Option A Option B (Time Period) Recession 10 - Normal Is 20 Boom 20 25 Total 45 45 As you can see in the table 1.2 the total retums are again identical but the outlook of profit maximization is quite narrow as it ignores the risk factor or uncertainty associated with either of the options. It also ignores time value of money. The alternate to this concept is Wealth Maximization. Wealth Maximization: This approach tries to overcome the limitations of profit maximization. This is the ultimate goal of the financial management. In operational terms it means maximization of profit, maximization of retum on capital employed, growth in earning per share or market value of a share or dividends, optimum level of leverage and minimization of cost of capital This is universally accepted in the modem approach to financial management. We can say that this approach takes into consideration the risk, appropriateness and the time value of money. This concept refers to the wealth of the shareholders as shown by the price of their shares in the market. So it means maximization of the market price of the shares of the firm. The net present worth of the firm can be calculated as follows:Financ Where Aj, Az......An = Stream of cash flows expected to occur from a Management: An course of action over a period of time; Overview W = Net present worth K_ = appropriate discount rate to measure risk and timing C = initialoutlay to acquire an asset Therefore, we can say that wealth maximization concept is: * unambiguous © measures risk # considers time value of money * socially responsible This objective guides three functions of financial management ie. investment, financing and dividend, Thus, wealth maximization of shareholders is the main objective and profit maximization can be considered as part of wealth maximization objective. ‘One thing is to be noted here that if the time period is short and the risk is negligible than profit maximization and wealth maximization are almost the same. 1.6 RISK AND RETURN TRADE-OFF There are two main determinants of the prices of a security. These are: © Risk © Retum Its said greater the risk, greater the retum, so risk and return go together In financial management it is very important for the financial manager to understand this concept, This is a guiding factor for decision making. Risk is the measure of uncertainty and can be defined as expected returns from an investment. Let us understand this through an example. Suppose Ms. A invests % 10,000 in a fixed deposit which gives a return of say 6% annually for 3 years.. This means that Ms. A will eam % 600 annually as a fixed amount of interest till the fixed deposit matures. Now say Ms. A has invested the same amount in share of a firm X which will give her dividend. In this case the dividend varies so it becomes variable. Ms. ‘A will get higher returns if the dividends increase. Though in this case the risk is high because there are chances that in certain cases the firm may not perform well and earn profits and Ms. A may not get dividend, However, the higher the risk, the higher is the return, Returns defined as the gain (or loss) expected over a given period of time by the decision maker. A finance manager has to consider the risk to have greater retum so s/he has to ‘trade off between risk and return’,Introduction to Financial Management 14 Risk and Return Trade-Off : Let us understand this concept with the following example: Assumptions: 1) Expes sh flows 2) No taxes ed earnings ~ exp Suppose Ms. A has & 1,00,000 out of which % 20,000 is borrowed at the rate of 5%. She wants to open a small cyber cafe. The total operating cost annually is € 100,000 and sales are € 110,000. The financing and operating position of Ms. A is as follows: Debt & 20,000 — Interest & 1,000 1) Financing — Risk and Return Own Funds % 80,000 - Income & 9,000 [Operating costs & 1,00,000 2) Operating — Risk and Retum Cash Sales & 1,10,000 At the end of the year Ms. A has @ 110,000 and reinvests & 1,00,000 in the business, pays interest of 71,000 and keeps the income of & 9,000 with her. Here you may note that the return is the product of two factors: a) Ms. A here earns 2 10,000, b) = 10,000 have been divided between creditor and Ms. A, the owner which affected the owners’ return. Based on the return on total Ms. A eared 10% (% 10,000/1,00,000) and eared a rate of return of % (9,000/80,000) which is the outcome of operating and financing activities. The rate of return from operations is usually determined by margins and tum over. The margin can be increased by a) increasing sales which should be more than operating expense or b) decreasing operating expenses than sales. ‘A tumover can be increased by increasing sales more than operating assets or reducing operating assets relatively more than sales. Thus there should be a balance between making greater profit for owner against variability of returns, 1.7__ ROLE OF FINANCE MANAGER A finance manager has a challenging role to play. His/her functions can be divided into: 1) Major Functions 2) Other Functions Functions of Finance Manager MAJOR FUNCTIONS, OTHER FUNCTIONS Estimation of Capital Maintaining Optimum level of requirements inventory & receivablesProcuring the required funds _ | Evaluation of investment Allocation of funds Financial negotiations ‘Management of current assets | Track of share prices Financial Control The role of a finance manager is very crucial as s/he has to take into consideration all the finance functions viz. investment decision, financial decisions and dividend decisions. The major function of the financial manager is to see to those finance functions and assess the capital requirements of the firm and then allocate the funds appropriately for the optimum utilization of funds. As part of the minor functions s/he has to keep an eye on the external forces so as to take appropriate decisions. The finance manager has to: find the ways and means to procure funds; * take appropriate investment decisions; © perform financial forecasting; + maintain the liquidity position of the organization; + analyze the financial health of the organization; * prepare the budgets for the functional areas of the organization; + manage the payments and receivables; * frame an appropriate credit policy of the firm; * take decisions related to depreciation and replacemer * take decisions related to the associated risks of the funds, In all finance manager has to analyze, interpret and forecast the funding requirements of the organization, ‘A finance manager while performing her/his duties comes acro: challenges. These challenges can be: many * creating value for shareholders as shareholders have become more aware * understanding the psychology of investors both individual as well as institutional; * managing market risk; * being smart which implies that s/he possesses effective interpersonal and communication skills and overall knowledge of the organization. All these challenges have made the job of a finance manager quite challenging. Check Your Progress B 1) Mention the functions of a finance manager 2) What is wealth maximization? Financ Management: An ‘Overview 15Introduction to Financial Management 16 1.8 | LET US SUM UP We now know that financial management is a combination of ‘Finance! and "Management’, It deals with acquiring funds and allocating them wisely for optimum utilization, The evolution of financial management can be divided into three phases (i) traditional phase; (ii) transitional phase; and (iii) modern phase. The nature of financial management involves three functions (i) investment; (ii) financing; and (iii) dividends. The basic goal of financial management is shareholder’s wealth maximization as it considers the time value of money and the risks associated with it. We have discussed the risk and return trade-off and the finance manager has to trade-off between risk and return, The role of a financial manager is to: 1. Estimate the amount of capital required; 2. Determine the capital structure; 3. Choose sources of finance; 4. Procure funds; 5. Allocate funds; 6. Utilize funds; 7. Manage cash; 8, Financial control; and 9, Check the external factor etc. We can therefore say that financial management is the lifeline of any organization. 1.9 KEY WORDS Financial Management: It is the acquisition, financing and management of funds Profit Maximization: Maximizing firm's profits Wealth Maximization: Maximizing shareholders’ wealth Risk: Measures of uncertainty Return: Expected income or loss over a period of time 1.10 SELF -ASSESSMENT QUESTIONS 1) Distinguish between 'Money' and 'Finance’. 2) What is Financial Management? 3) How has Financial Management evolved as a discipline? 4) Discuss the two objectives of Financial Management? 5) Explain the concept of 'Risk' and ‘Return’, 6) Discuss the role of a Financial Manager. NOTE: These questions will help you to understand the unit better. Try to answer them but do not submit the answers to the University. These questions are for practice only.