UNIT 1

FINANCIAL MANAGEMENT

Financial management is management principles and practices applied to finance. General

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

Definition:
1. “Financial management is the activity concerned with planning, raising, controlling and
administering of funds used in the business.”
– Guthman and Dougal
2. “Financial management is that area of business management devoted to a judicious use of
capital and a careful selection of the source of capital in order to enable a spending unit to
move in the direction of reaching the goals.”
– J.F. Brandley
3. “Financial management is the operational activity of a business that is responsible for
obtaining and effectively utilizing the funds necessary for efficient operations.”
–Massie
Considering all these views, financial management may be defined as that part of management
which is concerned mainly with raising funds in the most economic and suitable manner, using
these funds as profitably as possible.

Scope / Approaches of Financial Management

1. Traditional Approach

• It completely ignored decision making as to proper utilization of funds

• The focus of traditional approach was on procurement of long-term funds. Thus, it ignored
the important issue of working capital finance and management.
• The issue & allocation of funds, is completely ignored.
• It does not lay focus on day to day financial problems of an organization.

2. Modern Approach
▪ What specific assets should an enterprise acquire?
▪ In what form should a firm hold its assets?
▪ What should be the composition of liabilities?
▪ What steps should be taken for the company to grow?
OBJECTIVES OF FINANCIAL MANAGEMENT

• Profit Maximization

• Wealth Maximization

• Optimum Funds Utilization

• Ensure safety on Investment

• Sound Capital Structure

Nature or Features or Characteristics of Financial Management

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

1. Financial Management is an integral part of overall management. Financial

considerations are involved in all business decisions. So financial management is pervasive
throughout the organisation.

2. The central focus of financial management is valuation of the firm. That is financial
decisions are directed at increasing/maximization/ optimizing the value of the firm.

3. Financial management essentially involves risk-return trade-off Decisions on investment

involve choosing of types of assets which generate returns accompanied by risks. Generally
higher the risk, returns might be higher and vice versa. So, the financial manager has to
decide the level of risk the firm can assume and satisfy with the accompanying return.

4. Financial management affects the survival, growth and vitality of the firm. Finance is
said to be the life blood of business. It is to business, what blood is to us. The amount, type,
sources, conditions and cost of finance squarely influence the functioning of the unit.
5. Finance functions, i.e., investment, rising of capital, distribution of profit, are performed
in all firms - business or non-business, big or small, proprietary or corporate undertakings.
Yes, financial management is a concern of every concern.

6. Financial management is a sub-system of the business system which has other

subsystems like production, marketing, etc. In systems arrangement financial sub-system
is to be well-coordinated with others and other sub-systems well matched with the financial
subsystem.

Finance Functions (Scope of Financial Management)

The finance function encompasses the activities of raising funds, investing them in assets
and distributing returns earned from assets to shareholders. While doing these activities, a
firm attempts to balance cash inflow and outflow.

It is evident that the finance function involves the four decisions viz., financing decision,
investment decision, dividend decision and liquidity decision. Thus the finance function
includes:

1. Investment decision

2. Financing decision

3. Dividend decision

4. Liquidity decision

1. Investment Decision: The investment decision, also known as capital budgeting, is

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

i. The evaluation of the prospective profitability of new investments, and

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

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

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

2.Financing Decision: Financing decision is the second important function to be

performed by the financial manager. Broadly, he must decide when, from where and how
to acquire funds to meet the firm’s investment needs. The central issue before him or her
is to determine the appropriate proportion of equity and debt. The mix of debt and equity
is known as the firm’s capital structure. The financial manager must strive to obtain the
best financing mix or the optimum capital structure for the firm. The firm’s capital structure
is considered optimum when the market value of shares is maximized.

3. Dividend Decision: Dividend decision is the third major financial decision. The
financial manager must decide whether the firm should distribute all profits, or retain them,
or distribute a portion and return the balance. The proportion of profits distributed as
dividends is called the dividend-payout ratio and the retained portion of profits is known
as the retention ratio. Like the debt policy, the dividend policy should be determined in
terms of its impact on the shareholders’ value. The optimum dividend policy is one that
maximizes the market value of the firm’s shares. Thus, if shareholders are not indifferent
to the firm’s dividend policy, the financial manager must determine the optimum dividend-
payout ratio. Dividends are generally paid in cash. But a firm may issue bonus shares.
Bonus shares are shares issued to the existing shareholders without any charge. The
financial manager should consider the questions of dividend stability, bonus shares and
cash dividends in practice.

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

Profit Maximization & Wealth Mazimization

What is 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 is primarily concerned as to how the company will survive and grow in the existing
competitive business environment.

What is 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 and recognizes the time value of money given the business environment
of the operating entity.

• It is mainly concerned with the long-term growth of the company and hence is concerned
more about fetching the maximum chunk of the market share to attain a leadership position.
 Profit Maximization Wealth Maximization

Profit Maximization is Short Term Wealth Maximization is Long term

objective objective

High Div, Low Reserves & Surplus and Low Div, High Reserves & Surplus and
High Div pay out Low Div pay out

Beneficial for ST investor Beneficial for LT investor

Market Value of Shares decreases Market Value of Shares increases

G/W of such companies decreases G/W of such companies increases

Co will depend on outside sources of Co will be internally strong as such it will

finance not depend on outside sources of finance

No future plans & improper planning Future plans & proper planning
Time Value of Money

The recognition of time value of money in financial decision making is extremely

important. Maximisation of shareholder’s welfare is the basic objective of the financial
management, is superior to profit maximisation because, among other things the former
incorporates the timing of benefit received, while he later ignores it.

This may be due to:

(i) Risk, i.e., uncertainty associated with future receipts or

(ii) Inflation causing the decline in purchasing power of money or

(iii) Reinvestment opportunities for funds received early.

Similarly if the firm borrows funds from a bank or from any other sources, it receives cash
now and commits an obligation to pay interest and return principal sum in future. While
taking decisions on these matters, the financial management must keep the time factor in
mind.

If the timing of cash flows is not considered, the firm may make decisions which may falter
its objective of maximizing the owner’s welfare.

Computing the Time Value of Money

If a sum is invested today, it will earn interest and increase in value over time. The value
that the sum grows to is known as its future value. Computing the future value of a sum is
known as compounding.

The present value of a sum is the amount that would need to be invested today in order to
be worth that sum in the future. Computing the present value of a sum is known
as discounting.

The Future Value of a Sum

The future value of a sum depends on the interest rate and the interval of time over which
the sum is invested. This is shown with the following formula:

FV = PV*(1+r/100 )n

where:

FV = future value of a sum invested for n periods

r = periodic interest rate

PV = present value

n= number of periods until the sum is received

Each period may be a year, a month, a week, etc. The terms in the formula must be
consistent with each other; for example, if it is measured in months, then r must be a
monthly rate of interest.

The Present Value of a Sum

The formula for computing the present value of a sum

is: PV = FV

( 1 + r /100 ) n

Note that the present value is simply the inverse of the future value.