WHAT IS FINANCE AND FINANCIAL MANAGEMENT:

Finance is one of the crucial prerequisites to start any In simple terms, financial management
is the business function that deals with investing the available financial resources in a way
that greater business success and return-on-investment (ROI) is achieved. Financial
management professionals plan, organize, and control all transactions in a business. They
focus on sourcing the capital whether it is from the initial investment by the entrepreneur,
debt financing, venture funding, public issue, or any other sources.
According to B.O.Wheeler: “Financial Management includes those business activities that
are concerned with acquisition and conservation of capital funds in meeting the financial
needs and overall objectives of a business enterprise.”
The financial management of an organization determines the objectives, formulates the
policies, lays out the procedures, implements the programmes, and allocates the budgets
related to all financial activities of a business. Through a streamlined financial management
practice, it is possible to ensure that there are sufficient funds available for the company at
any stage of its operations. The importance of financial management can be assessed by
taking a look at its core mandate:

 Availability of sufficient funds

 Maintaining a balance between income and expenses to ensure financial stability
 Ensuring efficient and high ROI
 Creating and executing business growth and expansion plans
 Safeguarding the organization against market

TRADITIONAL VS MODERN APPROACH OF FINANCIAL MANAGEMENT:

Traditional Approach:

According to this approach, the scope of the finance function is restricted to “procurement of
funds by corporate enterprise to meet their financial needs. The term ‘procurement’ refers to
raising of funds externally as well as the inter related aspects of raising funds. It is only
concerned with raising of long term sources of finance. The internal decision making is
completely ignored in this approach. The traditional approach fails to consider the problems
involved in working capital management. The traditional approach neglected the issues
relating to the allocation and management of funds and failed to make financial decisions.

 Ignored Day-to-day Problems:

The traditional approach gives much importance to funds raising for episodic events that are
stated in the above discussion. Put in simple words the approach is confined to the financial
problems arising in the course of episodic events.
 Outsider–looking–in Approach:
This approach equated the function with the issues involved in raising and administering
funds. Thus, the subject of finance moved around the suppliers of funds (investors, financial
institutions (banks), etc.) who are outsiders. It indicates that the approach was outsider-
looking-in approach and ignored insider-looking-out approach, since it completely ignored
internal decision-making.
  Ignored Working Capital Financing:
The approach gave over emphasis on long-term financing problems. It implies that it ignored
working capital finance, which is in the purview of the finance function.
 Ignored Allocation of Capital:
The main function of this approach is procurement of funds from outside. It did not consider
the function of allocation of capital, which is the important one.

Modern Approach:

The modern approach is an analytical way of looking into financial problems of the firm.
According to this approach, the finance function covers both acquisition of funds as well as
the allocation of funds to various uses. Financial management is concerned with the issues
involved in raising of funds and efficient and wise allocation of funds. Modern approach was
started during mid-1950s. Its scope is wider since it covers conceptual and analytical
framework for financial decision-making.

OBJECTIVES OF FINANCIAL MANAGEMENT

Profit Maximization:
The process of increasing the profit earning capability of the company is referred to as Profit
Maximization. It is mainly a short-term goal and is primarily restricted to the accounting
analysis of the financial year. It ignores the risk and avoids the time value of money. It
primarily concerns the company’s survival and growth in the existing competitive business
environment.

Profit is the basic building block of a company to accrue capital in the shareholder’s equity.
Profit maximization helps the company survive against all the odds of the business and
requires some short-term perspective to achieve the same. Though the company can ignore
the risk factor in the short term, it cannot do the same in the long term as shareholders have
invested their money in the company with expectations of getting high returns on their
investment. It emphasizes on the fact that payment of dividend doesn’t affect the market
prices of the shares.

Wealth Maximization:
The ability of a company to increase the value of its stock for all the stakeholders is referred
to as Wealth Maximization. It is a long-term goal and involves multiple external factors like
sales, products, services, market share, etc. It assumes the risk. It recognizes the time value of
money given the business environment of the operating entity. It is mainly concerned with
the company’s long-term growth and hence is concerned more about fetching the maximum
chunk of the market share to attain a leadership position.

Wealth Maximization considers the interest concerning shareholders, creditors or lenders,

employees, and other stakeholders. Hence, it ensures building up reserves for future growth
and expansion, maintaining the market price of the company’s share, and recognizing
the value of regular dividends being relevant to ascertain the market prices of the shares. So,
a company can make any number of decisions for maximizing profit, but when it comes to
decisions concerning shareholders, then Wealth Maximization is the way to go.
Note: Time Value of Management
The time value of money (TVM) is the concept that a sum of money is worth more now than
the same sum will be at a future date due to its earnings potential in the interim. The time
value of money is a core principle of finance. A sum of money in the hand has greater value
than the same sum to be paid in the future.
Financial Management is based on 6 axioms:
1. Time Value of Money
2. Tax Laws
3. Cash Flow and Accounting Profit
4. Efficient Capital Market
5. Risk-Return Trade off.
6. Incremental Cash Flow.
DECISIONS IN FINANCIAL MANAGEMENT:

Financing Decision (Acquisition)

Financial decision is important to make wise decisions about when, where and how should a
business acquire fund. Because a firm tends to profit most when the market estimation of an
organization’s share expands and this is not only a sign of development for the firm but also it
boosts investor’s wealth. Consequently, this relates to the composition of various securities in
the capital structure of the company.

Factors affecting Financing Decisions

 Cost: Financing decisions are all about allocation of funds and cost-cutting. The
cost of raising funds from various sources differ a lot. The most cost-efficient
source should be selected.

 Risk: The dangers of starting a venture with the funds from various sources differ.
Larger risk is linked with the funds which are borrowed, than the equity funds.
This risk assessment is one of the main aspects of financing decisions.

 Cash flow position: Cash flow is the regular day-to-day earnings of the company.
Good or bad cash flow position gives confidence or discourages the investors to
invest funds in the company.

 Control: In the situation where existing investors need to hold control of the
business then finance can be raised through borrowing money, however, when
they are prepared for diluting control of the business, equity can be utilized for
raising funds. How much control to give up is one of the main financing
decisions.
  Condition of the market: The condition of the market matter a lot for the financing
decisions. During boom period issue of equity is in majority but during a
depression, a firm will have to use debt. These decisions are an important part of
financing decisions.

Investment Decision (Allocation)

These are also known as Capital Budgeting Decisions. A company’s assets and resources are
rare and must be put to their utmost utilization. A firm should pick where to invest in order to
gain the highest conceivable returns. This decision relates to the careful selection of assets in
which funds will be invested by the firms. The firm puts its funds in procuring fixed assets and
current assets. When choice with respect to a fixed asset is taken it is known as capital budgeting
cision.

Factors Affecting Investment Decision

 Cash flow of the venture: When an organization starts a venture it invests a huge
capital at the start. Even so, the organization expects at least some form of income
to meet everyday day-to-day expenses. Therefore, there must be some regular
cash flow within the venture to help it sustain.

 Profits: The basic criteria for starting any venture is to generate income but
moreover profits. The most critical criteria in choosing the venture are the rate of
return it will bring for the organization in the nature of profit for, e.g., if venture A
is getting 10% return and venture В is getting 15% return then one must prefer
project B.

 Investment Criteria: Different Capital Budgeting procedures are accessible to

a business that can be utilized to assess different investment propositions. Above
all, these are based on calculations with regards to the amount of investment,
interest rates, cash flows and rate of returns associated with propositions. These
procedures are applied to the investment proposals to choose the best proposal.

Dividend Decision (Apportionment)

Dividends decisions relate to the distribution of profits earned by the organization. The major
alternatives are whether to retain the earnings profit or to distribute to the shareholders.

Factors Affecting Dividend Decisions

 Earnings: Returns to investors are paid out of the present and past income.
Consequently, earning is a noteworthy determinant of the dividend.
  Dependability in Earnings: An organization having higher and stable earnings can
announce higher dividend than an organization with lower income.

 Balancing Dividends: For the most part, organizations attempt to balance out
dividends per share. A consistent dividend is given every year. A change is made,
if the organization’s income potential has gone up and not only the income of the
present year.

 Development Opportunity: Organizations having great development openings if

they hold more cash out of their income to fund their required investment. The
dividend announced in growing organizations is smaller than that in the non-
development companies.

FIXED VS WORKING CAPITAL REQUIREMENT:

The distinction between fixed and working capital may be clearly identified:
 The part of an organization’s total capital that is invested in long-term assets is known
as fixed capital. Working capital is the money needed to run a business on a daily
basis.
 Fixed capital investments are durable products that will stay in the firm for longer
than one accounting period. The company’s working capital, on the other hand, is
made up of short-term assets and liabilities.
 Fixed capital is generally illiquid since it cannot be quickly converted to cash.
Working capital investments, on the other hand, may be converted into cash quickly.
 Fixed capital is used to acquire non-current assets for the firm, whereas working
capital is used for short-term finance.
 The entity’s strategic objectives, which include long-term business planning, are
supported by fixed capital. Working capital, on the other hand, is used for a variety of
purposes.
CAPITAL STRUCTURE:
Capital Structure can be described as the arrangement of capital by using different sources of
long term funds which consists of two broad types, equity and debt. The different types of
funds that are raised by a firm include preference shares, equity shares, retained earnings,
long-term loans etc. These funds are raised for running the business. Optimal capital structure
is referred to as the perfect mix of debt and equity financing that helps in maximising the
value of a company in the market while at the same time minimises its cost of capital.

Capital structure is vital for a firm as it determines the overall stability of a firm. Here are
some of the other factors that highlight the importance of capital structure

1. A firm having a sound capital structure has a higher chance of increasing the market
price of the shares and securities that it possesses. It will lead to a higher valuation in
the market.
2. A good capital structure ensures that the available funds are used effectively. It
prevents over or under capitalisation.
3. It helps the company in increasing its profits in the form of higher returns to
stakeholders.
4. A proper capital structure helps in maximising shareholder’s capital while minimising
the overall cost of the capital.
5. A good capital structure provides firms with the flexibility of increasing or decreasing
the debt capital as per the situation.
CAPITAL BUDGETING

Capital budgeting is the art of deciding how to spend your company’s money wisely. Basically,
it is the process of evaluating potential long-term investment opportunities to determine which
ones will generate the most profit for a business. It involves analyzing future cash flows,
considering the time value of money, and assessing risks. Ultimately, the goal is to choose
investments that will help the business grow and thrive.
Capital budgeting helps businesses prioritize investments and allocate financial resources more
effectively, reducing the risk of investing in unprofitable projects and maximizing returns.
Overall, capital budgeting is an essential tool for businesses to achieve long-term growth and
success.

 Informs long-term investment decisions

 Reduces risk of unprofitable investments
 Maximizes profits by aligning with business goals
 Prioritizes investments and allocates resources efficiently
 Provides a framework for evaluating opportunities
 Promotes long-term growth and success
 Enables planning and budgeting for future investments

The traditional methods or non-discounted methods include: Payback period and Accounting
rate of return method. The discounted cash flow method includes the NPV method,
profitability index method and IRR.

 Payback Period Method:

As the name suggests, this method refers to the period in which the proposal will generate
cash to recover the initial investment made. It purely emphasizes on the cash inflows,
economic life of the project and the investment made in the project, with no consideration to
time value of money. Through this method selection of a proposal is based on the earning
capacity of the project. With simple calculations, selection or rejection of the project can be
done, with results that will help gauge the risks involved. However, as the method is based on
thumb rule, it does not consider the importance of time value of money and so the relevant
dimensions of profitability.
Payback period = Cash outlay (investment) / Annual cash inflow

 Accounting Rate of Return Method (ARR):

This method helps to overcome the disadvantages of the payback period method. The rate of
return is expressed as a percentage of the earnings of the investment in a particular project. It
works on the criteria that any project having ARR higher than the minimum rate established
by the management will be considered and those below the predetermined rate are rejected.
This method takes into account the entire economic life of a project providing a better means
of comparison. It also ensures compensation of expected profitability of projects through the
concept of net earnings. However, this method also ignores time value of money and doesn’t
consider the length of life of the projects. Also it is not consistent with the firm’s objective of
maximizing the market value of shares.
ARR= Average income/Average Investment

 Discounted cash flow method:

The discounted cash flow technique calculates the cash inflow and outflow through the life of
an asset. These are then discounted through a discounting factor. The discounted cash inflows
and outflows are then compared. This technique takes into account the interest factor and the
return after the payback period.

 Net present Value (NPV) Method:

This is one of the widely used methods for evaluating capital investment proposals. In this
technique the cash inflow that is expected at different periods of time is discounted at a
particular rate. The present values of the cash inflow are compared to the original investment.
If the difference between them is positive (+) then it is accepted or otherwise rejected. This
method considers the time value of money and is consistent with the objective of maximizing
profits for the owners. However, understanding the concept of cost of capital is not an easy
task.

 Profitability Index (PI):

It is the ratio of the present value of future cash benefits, at the required rate of return to the
initial cash outflow of the investment. It may be gross or net, net being simply gross minus
one.
SOURCES OF FINANCE

The long-term sources fulfill the financial requirements of an enterprise for a period
exceeding 5 years. Such financing is generally required for the acquisition of fixed assets
such as equipment, plant, etc.
Where the funds are required for a period of more than one year but less than five
years, medium-term sources of finance are used.
Short-term funds are those which are required for a period not exceeding one year.

Owner’s funds means funds that are provided by the owners of an enterprise, which may be
a sole trader or partners or shareholders of a company. Apart from capital, it also includes
profits reinvested in the business.
‘Borrowed funds’ on the other hand, refer to the funds raised through loans or borrowings.
8.4.1 Retained Earnings
A company generally does not distribute all its earnings amongst the shareholders as
dividends. A portion of the net earnings may be retained in the business for use in the future.
This is known as retained earnings. It is a source of internal financing or self-financing or
‘plowing back of profits’. The profit available for plowing back in an organization depends
on many factors like net profits, dividend policy, and age of the organization.

8.4.2 Trade Credit

Trade credit is the credit extended by one trader to another for the purchase of goods and
services. Trade credit facilitates the purchase of supplies without immediate payment. Such
credit appears in the records of the buyer of goods as ‘sundry creditors’ or ‘accounts payable’.
Trade credit is commonly used by business organisations as a source of shortterm financing.
It is granted to those customers who have reasonable amount of financial standing and
goodwill. The volume and period of credit extended depends on factors such as reputation of
the purchasing firm, financial position of the seller, volume of purchases, past record of
payment and degree of competition in the market. Terms of trade credit may vary from one
industry to another and from one person to another. A firm may also offer different credit
terms to different customers.

8.4.3 Factoring
Factoring is a financial service under which the ‘factor’ renders various services which
includes: (a) Discounting of bills (with or without recourse) and collection of the client’s
debts. Under this, the receivables on account of sale of goods or services are sold to the factor
at a certain discount. The factor becomes responsible for all credit control and debt collection
from the buyer and provides protection against any bad debt losses to the firm. There are two
methods of factoring — recourse and non-recourse. Under recourse factoring, the client is not
protected against the risk of bad debts. On the other hand, the factor assumes the entire credit
risk under nonrecourse factoring i.e., full amount of invoice is paid to the client in the event
of the debt becoming bad. (b) Providing information about credit worthiness of prospective
client’s etc., Factors hold large amounts of information about the trading histories of the
firms. This can be valuable to those who are using factoring services and can thereby avoid
doing business with customers having poor payment record. Factors may also offer relevant
consultancy services in the areas of finance, marketing, etc. The factor charges fees for the
services rendered. Factoring appeared on the Indian financial scene only in the early nineties
as a result of RBI initiatives. The organisations that provides such services include SBI
Factors and Commercial Services Ltd., Canbank Factors Ltd., Foremost Factors Ltd., State
Bank of India, Canara Bank, Punjab National Bank, Allahabad Bank. In addition, many
nonbanking finance companies and other agencies provide factoring service.
8.4.4 Lease Financing
A lease is a contractual agreement whereby one party i.e., the owner of an asset grants the
other party the right to use the asset in return for a periodic payment. In other words it is a
renting of an asset for some specified period. The owner of the assets is called the ‘lessor’
while the party that uses the assets is known as the ‘lessee’ (see Box A). The lessee pays a
fixed periodic amount called lease rental to the lessor for the use of the asset. The terms and
conditions regulating the lease arrangements are given in the lease contract. At the end of the
lease period, the asset goes back to the lessor. Lease finance provides an important means of
modernisation and diversification to the firm. Such type of financing is more prevalent in the
acquisition of such assets as computers and electronic equipment which become obsolete
quicker because of the fast changing technological developments. While making the leasing
decision, the cost of leasing an asset must be compared with the cost of owning the same.

8.4.5 Public Deposits

The deposits that are raised by organisations directly from the public are known as public
deposits. Rates of interest offered on public deposits are usually higher than that offered on
bank deposits. Any person who is interested in depositing money in an organization can do so
by filling up a prescribed form. The organization in return issues a deposit receipt as an
acknowledgment of the debt. Public deposits can take care of both medium and short-term
financial requirements o f a business. The deposits are beneficial to both the depositor as well
as to the organization. While the depositors get higher interest rates than that offered by
banks, the cost of deposits to the company is less than the cost of borrowings from banks.
Companies generally invite public deposits for a period up to three years. The acceptance of
public deposits is regulated by the Reserve Bank of India.

8.4.6 Equity Shares

Equity shares is the most important source of raising long-term capital for a company. Equity
shares represent the ownership of a company and thus the capital raised by the issue of such
shares is known as ownership capital or owner’s funds. Equity share capital is a prerequisite
to the creation of a company. Equity shareholders do not get a fixed dividend but are paid on
the basis of earnings by the company. They are referred to as ‘residual owners’ since they
receive what Rationalised 2023-24 184 BUSINESS STUDIES is left after all other claims on
the company’s income and assets have been settled. They enjoy the reward as well as bear the
risk of ownership. Their liability, however, is limited to the extent of capital contributed by
them in the company. Further, through their right to vote, these shareholders have a right to
participate in the management of the company.
8.4.7 Preference Shares
The capital raised by issue of preference shares is called preference share capital. The
preference shareholders enjoy a preferential position over equity shareholders in two ways:
(i) receiving a fixed rate of dividend, out of the net profits of the company, before any
dividend is declared for equity shareholders; and (ii) receiving their capital after the claims of
the company’s creditors have been settled, at the time of liquidation. In other words, as
compared to the equity shareholders, the preference shareholders have a preferential claim
over dividend and repayment of capital. Preference shares resemble debentures as they bear
fixed rate of return. Also as the dividend is payable only at the discretion of the directors and
only out of profit after tax, to that extent, these resemble equity shares. Thus, preference
shares have some characteristics of both equity shares and debentures. Preference
shareholders generally do not enjoy any voting rights. A company can issue different types of
preference shares

8.4.8 Debentures
Debentures are an important instrument for raising long term debt capital. A company can
raise funds through issue of debentures, which bear a fixed rate of interest. The debenture
issued by a company is an acknowledgment that the company Rationalised 2023-24 186
BUSINESS STUDIES has borrowed a certain amount of money, which it promises to repay
at a future date. Debenture holders are, therefore, termed as creditors of the company.
Debenture holders are paid a fixed stated amount of interest at specified intervals say six
months or one year. Public issue of debentures requires that the issue be rated by a credit
rating agency like CRISIL (Credit Rating and Information Services of India Ltd.) on aspects
like track record of the company, its profitability, debt servicing capacity, credit worthiness
and the perceived risk of lending. A company can issue different types of debentures (see Box
C and D). Issue of Zero Interest Debentures (ZID) which do not carry any explicit rate of
interest has also become popular in recent years. The difference between the face value of the
debenture and its purchase price is the return to the investor.

International Instruments:
Global Depository Receipts: A GDR is a negotiable instrument or an instrument that can be
traded freely in various foreign capital markets. These are issued by Indian companies to raise
funds from abroad and can also be traded on foreign stock exchanges.
American Depository Receipts: This instrument is issued by American companies and can be
traded in American markets. It can be issued to only citizens of America and can only be
traded in US stock exchanges.
Indian Depository Receipts: IDRs are issued to Indian residents only and can be traded on
Indian Stock Exchange. It is denominated in Indian Rupees. It is issued by an Indian
Depository to enable foreign companies to raise funds from Indian Capital Markets. Standard
Chartered PLC was the first company to issue IDRs.