MODULE 1 FINANCIAL MANAGEMENT

FINANCE

Finance is one of the basic requirement for any business. Finance is considered as life blood of a
business. In order to carry out a business operation effectively there should be sufficient finance is
needed. Finance is required at different stages of business, beginning from its formation, expansion
and up to its winding up.

The success of every business depends upon the way in which the required funds are arranged
at the right time, in right quantity from the right sources and at the least cost.

FINANCIAL MANAGEMENT

Financial management simply means the application of management principles into financial
operation.
According to Soloman” Financial management is considered with the efficient use of
economic resources”
“Financial management may be defined as the art and science of managing money”
Financial management is considered with the management decisions that result in the
acquisition and financing of the long term and short term finance of a firm.
SCOPE OF FINANCIAL MANAGEMENT
The scope of financial management is classified in to two categories: -
a) Traditional approach
b) Modern approach

a) Traditional Approach: -
According to this approach, the finance function is restricted to procurement of funds by
corporate enterprise to meet their financial needs.
b) Modern Approach
According to this approach finance function covers both acquisition of funds as well as their
allocation of fund to various uses.(Acquisition plus allocation)
According to this approach financial management is concerned with issue involved in
raising of fund and efficient allocation of fund.
It can be broken down into three major decisions such as: -
1. Investment decision
2. Financial decision
3. Dividend decision
These three decisions are collectively known as finance function.

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Investment decisions: - Investment decisions are decisions related to the selection of assets in which
funds will be invested by a firm. Assets are of two broad groups, (i) long term or fixed assets (ii) Short
term or current assets.

All decisions related to long term or fixed assets are called capital budgeting. All
decisions related to current assets are referred to as working capital decisions.

Financing decisions: Financing decisions refers to deciding on the appropriate ratio of different sources of
finance considering their cost and raising procedures. Finance can raise from different sources. Such sources
are broadly classified into two: - owner’s fund and borrowed funds

Owner’s fund refers to fund raised through issue of shares. Borrowed fund refers to fund raises
through issue of debentures and through loans from financial institutions.
Dividend decisions: -
Dividend decisions are decisions on whether the firm should distribute all profits, or retain
them or distribute a portion and retain the balance.
Answer from answer key provided by University (Previous year question paper) 8 mark qtn
What is financial management? Explain the scope of financial management
a) Estimating financial requirements
b) Deciding capital structure
c) Selecting a source of finance
d) Selecting a pattern of investment
e) Proper cash management
f) Implementing financial control
g) Proper use of surpluses

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 OBJECTIVES OF FINANCIAL MANAGEMENT (EXAM IMPORTANT)
Mainly objectives of financial management broadly classified into two: -
a) Profit maximization
b) Wealth maximization
Profit maximization
According to this approach, the objectives of financial management is profit maximization and
actions that increase profit are under taken and those decrease profits are avoided.
Wealth maximization
The objective of financial management is to maximise the wealth of the shareholders, who are
the owners of the company.
It is the universally accepted objectives of financial management because of it removes the
limitations of profit maximisation objectives. Here, the objectives of financial management is to maximise
the market value of the shares of the firm.

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Financial planning

Financial planning is one of the important functions of financial management. Financial Planning
means deciding in advance the financial activities to be carried on in order to achieve the basic
objective of the firm.

Financial planning means deciding well in advance how much fund is required for a particular
business. Financial planning is the task of deciding in advance how much capital is required and the
pattern of financing.

Features of a Sound Financial Planning (3-mark question) (PEPSI)

1. Simplicity:- Simplicity of financial plan helps the management in procuring the necessary
capital.
2. Foresight:-While preparing the financial plan, the planners should take in to consideration the
present and future requirements of funds to the organization.
3. Flexibility:-The flexibility in the financial plan helps the company to introduce necessary
change according to the changing business situation.
4. Liquidity:- For smooth running of an organization company should have adequate percentage
of current assets should be kept in the form of required cash. While preparing company’s
financial plan, it is necessary to pay proper attention to the liquidity requirements of a firm.
5. Provision for contingencies:- A good financial plan has to provide adequate amount or
provision for future contingencies(changes).
6. Economical: The cost of source of capital collected should be minimum or economical. The
cost of capital raised should not be a burden on the company.
7. Intensive use of capital:- Effective utilization of capital is an important principle of financial
plan. They have to maintain equilibrium of balance in working capital and fixed capital.
8. Period of finance:- Usually long term fund should be raised by the issue of equity shares.
9. Solvency:;Solvency requires that short term and long term payments should be made on dates
when they are due. This will increase the goodwill of enterprise.

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 CAPITALISATION
Capitalization is the valuation of long term capital, which is comprised of
shareholders fund, long term loans and reserves and surplus.
Capitalization refers to the valuation of Permanent investments in the business.
Capitalization involves determination of the value of funds that a firm should raise as its capital.
Capitalization depends upon its earning capacity. The amount of capitalization is fully associated with
the rate of earnings expected by the firm.
There are three possible dimensions or types of capitalization:-
1 Normal capitalization
2. Over capitalization
3. Undercapitalization
1. Normal capitalization:- It means the rate of return justifies the amount of capital invested in the
business. The return almost equal to the amount of capital invested.
2. Over capitalization:-The rate of return of the firm is lower than the normal earnings rate of the
industry. In other words the rate of return does not justify the amount of capital invested.
3.Under capitalization:-The earnings rate of the firm is more than the normal earnings rate of
the industry. The rate of return justifies the the amount of capital invested.

CAPITAL STRUCTURE (VERY IMPORTANT)

Capital structure refers to the kind of securities that make up capitalization.
The capital structure of business can be measured by the ratio of various
kinds of permanent loan and equity capital to total capital.
Capital structure refers to the mix or composition of long term sources
of funds such as debentures, long term debt, preference share capital, equity share capital and
reserves and surplus.
Capital structure of a company consist any of the following forms:-
1) Equity shares
2) Equity shares and Preference shares
3) Equity shares and debentures
4) Equity shares, Preference shares and debentures
5) Equity shares, Preference shares, debentures, long term loans

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 A financial manager should plan an optimum capital structure for his company.
Essential /Features of an Appropriate or Optimal capital structure
1. Maximum return:-The capital structure must give maximum return to the shareholders.
2. Minimum Risk:-The use of borrowed fund increases the level of risk of the company and the
shareholders. It is because interest has to be paid before paying the shareholders. Where less
debt is used, more equity finance will be required which will affect the shareholders in terms
of return.
3. Flexibility:-The capital structure of the firm should be flexible. So that the company can
increase or decrease the proportion of debt and equity.
4. Management Control:-The capital structure should not involve the risk of loss of control of
the company.
5. Solvency:- Capital structure should ensure that the firm does not run the risk of becoming
insolvent. Increased use of borrowed funds may threaten the solvency of the company.

FACTORS DETERMINING/GOVERNING CAPITAL STRUCTURE (8 MARK)

While determining the capital structure, a number of factors should be taken in to consideration. These
factors can be classified in to two :-
a) Internal factors
b) External factors

A) INTERNAL FACTORS
1. Size of Business:-It is very difficult for small companies to raise long term debt. Hence they depend
on share capital and retained earnings. A large company requires large amount of capital. It cannot be
raised from single source. That time company uses different types of securities or sources at
reasonable cost.
2. Nature of Business:-The nature of business, method of operation, type of product etc also affect
the capital structure. This is because the ratio of fixed capital or working capital will vary according
to nature of business.
3.Regularity of Income:-When a company expects high and regular income, they use more debt
capital. When the earnings are uncertain and unpredictable equity shares are issued.
4. Period and Purpose of Financing:-Equity shares are best choice for funds required for permanent
investment(long term). Preference shares and debentures are better for modernization and expansion.
5. Trading on equity (Financial leverage): It is a process of using fixed charge securities along with
equity shares in the capital structure. So as to increase the earnings of the shareholders.

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6. Desire to retain Control:-If the management desires to retain control over the company, it may
raise additional capital through the issue of preferences shares or raising debt instead of issuing equity
shares.

b) EXTERNAL FACTORS
1. Conditions in the Capital market:-Capital market conditions determine the type of securities to
be issued. These also determine the rate of interest on debentures, rate of dividend on preference
shares etc.
During depression, it is better to raise capital through preference shares and
debentures(fixed income bearing securities). During boom period equity shares are better.
2. Attitude of Investors:- Equity shares can be best be issued to investors who are ready to take more
risk. The investors who are cautious care more for security of investment and stability of income they
prefer debentures.
3. Cost of Financing / Cost of capital: The cost of fiancé is one of the important factor influencing
capital structure. The company try to use cheapest source of fiancée to maximize returns. cost of
financing by debentures is cheaper than the financing by issue of equity shares.
4. Legal Requirements:- While setting capital structure financial manager should follow rules and
regulations of Govt.
5. Taxation Policy:-High tax rate directly influences the capital structure decisions. High tax rate
discourages the issue of equity shares and encourages the issue of debentures. This is because the
interest on debentures can be directly charged to profit and loss account for tax calculation.

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 FIXED CAPITAL AND WORKING CAPITAL
Fixed capital is the amount of capital invested in fixed assets.
Eg: Building, Land, Machinary etc.
Fixed capital is the capital needed for the acquisition of assets to be used for a long period. Fixed
capital is required for acquisition of fixed assets that are to be used repeatedly over a long period of
time.
Factors Determining Fixed Capital (GST ND)
(What are the factors considered while using fixed capital)
1. Nature of Business:-Trading concerns require smaller amount of fixed capital than the
industrial manufacturing concerns. Industrial units using complex production process require
more fixed capital.
2. Size of Business:-Larger the size of the business, heavier would be the investment in fixed
capital.
3. Degree of Automation:- Highly mechanized and automated plants require more fixed capital
as compared to the units using labour intensive.
4. Types of manufacturing Process:-Assembling and service industries require less investment
in fixed capital. But analytical and synthetically processing industries require larger fixed
capital.
5. Growth and Expansion Programmes:-The amount of fixed capital required depends upon
the growth and expansion programmes of the firm. If the firm has immediate plans of expansion
and diversification of products, it will require more fixed capital.

WORKING CAPITAL

The amount of capital required for day to day working of a firm is known as working
capital. It is required for the purchase of raw material and for meeting the day to day expenses
on salaries, wages, rent, advertising etc.Working capital is the portion of capital required
for investing in short term or current assets like inventory, bills receivables, sundry debtors,
cash required for meeting expenses like salaries, wages, rent, printing and stationeries etc.
There are two concepts of defining working capital:- Such as
a) Gross working capital
b) Net working capital
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Gross working capital is referred to as the total value of current assets. It is the total investment in
all the current assets like cash, inventories, receivables, prepaid expenses etc.
Net working capital:-Working capital is defined as the excess of current assets over current
liabilities.
Operating Cycle of Working Capital:- Working capital is required because of the time gap
between the sale and their actual realization in cash. This time gap is technically called as
operating cycle. Operating cycle
FACTORS INFLUENCING WORKING CAPITAL
1. Nature of Business:- The manufacturing and trading concerns require more amount
of working capital because they have to invest more in inventories and debtors.
2. Size of the business:-Generally large business concerns are required to maintain
huge inventories. Bigger the size, the larger will be the working capital.
3. Production cycle:-Production cycle time covers the time gap between the
procurement of material and production of goods. The longer the production cycle
the larger will be the requirement of working capital.
4. Terms of Trade:-A concern which purchases on credit and sells on cash will require
less amount of working capital.
5. Seasonal fluctuations:- Certain industries manufacture and sell goods only during
certain seasons. Such concerns require large amount of working capital during the
season.
6. Business Cycle:-In boom period, when the business is prospering, large amount of
working capital is required. It is due to the increased sales, rise in prices, expansion
of the business etc. During depression period demand and sales of goods decline,
that resulting in lower level of inventories and debtors

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 SOURCES OF FINANCE
There are two types of sources of finance required by business enterprises. They are Short term and
Long Term
SHORT TERM SOURCE:-
A company needs short term finance on regular basis to purchase raw materials, pay wages and
salaries and maintain smooth production cycle.
Short term finance means availability of funds for a period of one year or less than one year. The
basic purpose of short term finance is to meet the working capital requirements of the company.
These funds are usually for businesses to run their day-to day operations including payment of wages
to employees, inventory ordering and supplies
THESE ARE THE MAIN SHORT TERM SOURCES OF FINANCE:-
a) Bank over-draft.

If the borrower requires temporary finance, the banker may allow him to overdraw on
his account with or without security.
b) Trade credit
Trade credit refers to the credit extended by the supplier of goods in the normal
course of business. In this case supplier sends goods to the buyer for the payment to be
received in future as per terms of the sales invoice.
c) Cash credit
Cash credit is a financial arrangement through which the commercial banks allow the
borrower to the borrow money up to a certain limit.
d) Loans:
When a bank makes an advance in lump sum against some security, it is known as loan.
In case of loan, a specified amount is sanctioned to the customer.
e) Public deposits
Business firm are raising short-term finance from their member, directors and the
general public. Maximum period allowed in the case of public deposit is 36 month and
a minimum of 6 month.
f. Advances from Customers:
Some business houses get advances from their customers against orders. This is
also known as cash before delivery.

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LONG TERM FINANCE
Long term sources of finance are those that are needed over a longer period of time -
generally over a year. Long term finance may be needed to fund expansion projects.
THESE ARE THE MAIN LONG TERM SOURCES OF FINANCE
1. Equity shares:-Equity shares are one of the most important financial instruments to
raise long term funds. These shares are treated as the base for capital formation of a
company. Equity shares are those shares which are not preference shares.
Equity shares do not carry any preferential right in respect of dividend or repayment
of capital. Dividend is paid on equity shares only after paying a fixed rate of dividend
on preference shares.
2. Preference shares:- Preference share represents that part of share capital of a
company , which carries preferential rights. A fixed dividend is paid on preference
shares before any dividend is paid on equity shares
3. Retained Earnings:- The amount retained in the business is known as retained
earnings. A part of the profit earned every year shall be retained in the business. A
Portion of the profit which is not distributed but is retained and reinvested in the
business is called retained earnings.
4. Long term Loan:- Long term loans are for a specific period at a fixed or variable
interest rate. The interest is payable periodically. They are issued against some
securities.
5. Debentures:- A company can raise money by issuing debentures. Debenture is an
instrument of acknowledgement of debt.
Fixed rate of interest. No profits but must pay. Deductible expense, Redemption, No
Voting rights
6. Venture Capital :- Venture capitalists are groups of (generally very wealthy)
individuals or companies specifically setup to invest in developing companies.
Venture capitalists are on the look out for companies with potential. They are
prepared to offer capital(money) to help the business grow. In return the venture
capitalist gets some stakes in the running of the company as well as a share in the
profits made.

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