CHAPTER 1 INTRODUCTION TO FINANCE

MEANING OF FINANCE

Finance is defined as the provision of money at the time when it is required. Every enterprise, whether big, medium,
small, needs finance to carry on its operations and to achieve its target. In fact, finance is so indispensable today that it
is rightly said to be the blood of an enterprise. Without adequate finance, no enterprise can possibly accomplish its
objectives.

Finance is the application of economic principles to decision-making that involves the allocation of money under
conditions of uncertainty. In other words, in finance we worry about money and we worry about the future. Investors
allocate their funds among financial assets in order to accomplish their objectives, and businesses and governments
raise funds by issuing claims against themselves and then use those funds for operations.

Finance provides the framework for making decisions as to how to get funds and what we should do with them once
we have them. It is the financial system that provides the platform by which funds are transferred from those entities
that have funds to those entities that need funds.

In effect,

Finance is

analytical - uses
uses accounting study of how to
statistics, based on
information as global in raise money and
probability and economic
basis for decision perspective invest in
mathematics to principles
making productively
solve problems

Definitions of Business Finance

 According to Wheeler, “Business finance is that business activity which concerns with the acquisition and
conversion of capital funds in meeting financial needs and overall objectives of a business enterprise”.

 According to Guthumann and Dougall, “Business finance can broadly be defined as the activity concerned with
planning, raising, controlling, administering of the funds used in the business”.

 In the words of Parhter and Wert, “Business finance deals primarily with raising, administering and disbursing
funds by privately owned business units operating in nonfinancial fields of industry”.

IMPORTANCE OF CORPORATE FINANCE

1. Helps in decision making:

Most of the important decisions of business enterprise are determined on the basis of availability of funds. It is
difficult to perform any function of business enterprise independently without finance. Every decision in the
business is needed to be taken keeping in view of it’s impact on profitability. There may be number of alternatives
but the management is required to select the best one which will enhance profitability. Business organisation can
give green signal to the project only when it is financially viable. Thus corporate finance plays significant role in
decision making process.

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2. Helps in Research and Development:
Research and Development must be undertaken for the growth and expansion of business. Detailed technical work
is essential for the execution of projects. Research and Development is lengthy process and therefore funds have to
be made available through-out the research work. This would require continuous financial support. Many a time,
Company has to upgrade its old product or develop new product to attract the consumers. For this company has to
conduct survey, market analysis, etc. which again requires financial support.

3. Important for Economic Growth

Through corporate finance, a company is able to undertake productive activities that contribute to a country’s GDP,
generates employment and ultimately increases per capita income. The economic growth and development can
happen only if corporate sector is sound and robust, for which sufficient finance is essential element.

4. Promotes expansion and diversification:

Modern machines and modern techniques are required for expansion and diversification. Corporate finance
provides money to purchase modern machines and technologies. Therefore, finance becomes mandatory for
expansion and diversification of a company.

5. Managing Risk:
Company has to manage several risks, such as sudden fall in sales, loss due to natural calamity, loss due to strikes,
etc. Company needs financial aid to manage such risks. In the corporate scenario, risks can be classified into two
types – business risk and financial risk.

Business Risk Financial Risk

Business risk is associated with the variation in Financial risk is associated with the variation in net
operating profits (EBIT) profits (PAT)
Business risk occurs due to excessive fixed cost in the Financial risk occurs due to excessive fixed interest in
company. the company
Higher business risk results in higher break-even point Higher financial risk leads to inability to pay bank
interest (EMIs)
Also known as operating risk and measured by Measured by financial leverage
operating leverage
Business risk is not affected by the capital structure of Financial risk is due to the debt-equity ratio of a
company, i.e. debt-equity company, i.e. capital structure
Result of Investment Decision Result of Financing Decision

6. Replace old assets:

Assets such as plant and machinery become old and outdated over the years. They have to be replaced by new assets.
Finance is required to purchase new assets.

7. Payment of dividend and interest:

Finance is needed to pay dividend to shareholders, interest to creditors, banks, etc.

8. Payment of taxes / fees:

Company has to pay taxes to Government such as Income Tax, Goods and Service Tax (GST) and fees to Registrar
of Companies on various occasions.

FINANCIAL MANAGEMENT – MEANING

➢ Financial management is that managerial activity which is concerned with the planning and controlling of the
firm's financial resources.
➢ It is an integrated decision-making process concerned with acquiring, financing and managing assets to accomplish
the overall goal of a business organisation.
➢ Financial managers have a major role in cash management, acquisition of funds and in all aspects of raising and
allocating capital. As far as business organisations are concerned, the objective of financial management is to
maximise the value of business.
➢ “Financial management comprises the forecasting, planning, organising, directing, co-ordinating and controlling
of all activities relating to acquisition and application of the financial resources of an undertaking in keeping with
its financial objective.”

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Definitions of Financial Management
 “It is concerned with the efficient use of an important economic resource namely, capital funds”. – Solomon.

 Financial management “as an application of general managerial principles to the area of financial decision-making.
– Howard and Upton.

 Financial management “is an area of financial decision-making, harmonizing individual motives and enterprise
goals”. – Weston and Brigham

 Financial management “is the operational activity of a business that is responsible for obtaining and effectively
utilizing the funds necessary for efficient operations. – Joseph and Massie

Thus, financial management is broadly concerned with raising of funds, creating value to the assets of the business
enterprise by efficient allocation of funds. It is the study of integration of the flow of funds in the most optimal manner
to maximize the returns of a firm by taking proper decisions in utilizing the funds. In other words, raising of funds
should involve minimum cost and to bring maximum returns.

OBJECTIVES OF FINANCIAL MANAGEMENT

Financial management has dual objectives, viz

a) Profit Maximization
The finance manager has to make his decisions to maximize the profits of the concern. It ensures that a firm utilizes
its available resources most efficiently under conditions of competitive markets.

Advantages:
- Profits are vital for survival of business.
- Essential for the growth and development of business.
- Impact on society through payment to factors of production.
- Profit-making firms only can pursue social obligations

Disadvantages:
- The term “Profit” is vague.
- Higher the profits, higher the risks involved. It may ignore the risk or uncertainty element.
- Ignores time pattern of return, difficult to sustain in the long run.
- Ignores social and moral obligations of business.

b) Wealth Maximization
The objective of a firm should be to maximise its value or wealth. Wealth or Value of a firm is represented by the
market price of its shares. This value is a function of two factors.

Advantages:
- Emphasizes the long term
- Recognizes risk or uncertainty
- Recognizes the timing of returns
- Considers shareholders' return.

Disadvantages:
- Offers no clear relationship between financial decisions and share price,
- Can lead to management anxiety and frustration.

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There is a conflict between profit maximization and wealth maximization.
 Basically, profit maximization is a short-term goal. It is usually interpreted to mean the maximization of profits
within a given period of time. A firm may maximize its short-term profits at the expense of its long-term
profitability and still realize this goal. In any company, the management (Board of Directors) is the decision taking
authority. Normally, the basic tendency of any management is to maximize enterprise profits (i.e. profit
maximization).

 However, in an organization where there is a significant outside participation (through shareholding, lenders etc.),
the management is under constant supervision of the various stakeholders of the company – employees, creditors,
customers, government, etc. Every entity associated with the company will evaluate the performance of the
management for the fulfilment of its own objective. The success of the enterprise shall depend on satisfaction of
the stakeholders. Shareholder wealth maximization is a long-term goal shareholders are interested in future as well
as present profits.

 Thus, the wealth maximization objective is wider and it covers the interests of the various groups such as owners,
employees, creditors and society, and thus, it may be consistent with the management objective of survival. Hence,
in today’s world, wealth maximization is a better objective.

 Wealth maximization is generally preferred because it considers – (a) wealth for the long-term, (b) risk or
uncertainty, (c) the timing of returns, and (d) the shareholders’ return

Distinction between Profit Maximization and Wealth Maximization

Profit Maximization Wealth Maximization

Focus on the short term Focus on the long term
Profits are vital for survival of business Wealth incudes shareholders' return.
Narrow approach (BOD/ shareholders) Broad approach (all stakeholders)
Higher the risk, high the profits Risk is considered, but no emphasized upon
Ignores the time value of money Recognizes the timing of returns
Linked to annual profits Linked to share prices and dividends
Profits can be manipulated through window dressing Wealth is a real concept and difficult to manipulate
easily.

FUNCTIONS OF FINANCE MANAGER

1. Fund Requirement Estimation

 The requirements of funds have to be carefully estimated.
 The purpose of funds (investment in fixed assets or working capital) & timing of funds should be determined.
 This involves the use of techniques like budgetary control and long-range planning.
 This calls for forecasting all physical activities of the organisation and translating them into monetary terms.

2. Determining Sources of Finance

 Identify the various sources of finance – long, medium and short term.
 Select the sources of funds which are most suitable for the company. Such choice should be exercised with great
care and caution.

3. Capital Structure / Finance Decisions

 Decisions regarding capital structure (called financing decisions) should be taken to provide proper balance
between (a) long-term and short-term funds (b) loan funds and own funds.
 Long-term funds are required to (a) finance fixed assets and long-term investments and (b) provide for
permanent needs of working capital. Short Term Funds are required for Working Capital purposes.
 A proper mix of various sources has to be worked out by the Finance Manager.

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 4. Investment Decisions
 Funds procured should be invested / utilised effectively.
 Long Term Funds should be invested (a) in Fixed Assets / Projects after Capital Budgeting and (b) in Permanent
Working Capital after estimating the requirements carefully.
 Asset management policies should be laid down, for Fixed Assets and Current Assets.

5. Dividend Decisions
 The Finance Manager assists the top management in deciding as to (a) what amount of dividend should be paid
to shareholders and (b) what amount should be retained in the business itself.
 Dividend Decisions depend upon numerous factors like (a) earnings, (b) trend of share market prices, (c)
requirement of funds for future growth, (d) cash flow situation, (e) tax position of shareholders

6. Cost Control
 Financial Manager is responsible for monitoring and analyzing cost over-runs. He can make recommendations
to the top management for controlling the costs relating to purchases, production, distribution etc.

7. Cost-Volume-Profit Analysis / Profit Planning

 In-depth study of fixed costs, variable costs and semi-variable costs is needed
 Ensure that the income / revenues are sufficient to cover the variable costs, i.e. a positive contribution.
 To determine the BEP of the business and take key decisions to improve profitability of the enterprise.

8. Taxation
 Corporate taxation is an important function of the financial management.
 Taxation includes direct taxes such as Income Tax as well as indirect taxes such as GST, etc.
 Taxation functions include periodical compliances as well as tax management techniques.
 Proper tax planning and management is vital for the wealth maximization function of the enterprise.

9. Cash Management Decisions

 The Finance Manager has to ensure that all sections/ branches/ factories/ departments and units of the
organisation are supplied with adequate funds (cash), to facilitate smooth flow of business operations.
 He should also ensure that there is no excessive cash (idle funds) in any division at any point of time.
 For this purpose, cash management and cash disbursement/ transfer policies should be laid down.

10. Performance Evaluation

 The Finance Manager has to evaluate financial performance of various units of the organisation. There are
various tools of financial analysis viz. Budgetary Control, Ratio Analysis, Cash Flow and Fund Flow Analysis,
Common Size Statement analysis, Intra-Firm Comparison etc.
 Financial Analysis helps management to assess how effectively funds are utilised & identify improvements.

11. Financial Negotiations

The Finance Manager is required to interact and carry out negotiations with financial institutions, banks and public
depositors. Negotiations with outside financiers require specialised skills.

12. Market Impact Analysis

 The Finance Manager has to keep in touch with stock exchange quotations and behaviour of share prices.
 It involves analysis of trends in stock market and judging their impact of the share price of the Company.

13. Product Services / Pricing

The Financial Manager can supply important information about cost at varying levels of production and the profit
margins needed to carry on the business successfully. In fact, financial manager analyses information for pricing
decisions and contribute to the formulation of pricing policies jointly with the marketing manager.

14. Corporate Restructuring

Corporate restructuring includes external growth through mergers and acquisitions. Valuation and financing M &
A deals is an important aspect of corporate restructuring. The process of valuing a firm and its securities is difficult,
complex and prone to errors. The financial manager should, therefore, go through a valuation process very carefully.

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SCOPE OF FINANCIAL MANAGEMENT

Scope of
Financial
Management

Investing Financing Dividend

Decisions Decisions Decisions

Fixed Working Debt- Retention

Capital Capital Equity Ratio vs
Decision Decision Ratio Payout Ratio

INVESTMENT DECISIONS

➢ Investment ordinarily means utilization of money for profits or returns. These decisions determine how scarce
resources in terms of funds available are committed to projects.
➢ Basically, it is dividend in two parts – Investment in Fixed Capital & Investment in Working Capital.

Fixed Capital Decision

- Fixed Capital Decision implies creating or purchasing physical assets and carrying on business or purchasing
shares or debentures of a company or even acquisition of another company.
- The investment of funds in a project has to be made after careful assessment of the various projects through capital
budgeting exercise as well as financing the working capital requirements.
- Fixed capital decisions are commitments of monetary resources, in expectation of economic returns in future.
- Choice is required to be made amongst available resources and avenues for investment.
- Thus, fixed capital decisions have become the most important area in the decision-making process. Such decisions
are essentially made after evaluating the different proposals with reference to growth and profitability projections
of the company. The choice helps achieve the long-term objectives of the company i.e. survival and growth,
preserving market share of its products and retaining leadership in its production activity.
- These decisions include expansion, replacement of assets or modernization etc.

Working Capital Decisions

- These decisions are also called as liquidity decisions.
- Liquidity can be defined as the ability of a business to meet its short-term obligations.
- It shows the speed (efficiency) with which a business can convert its assets into cash to pay what it owes in the
near future.
- It also focuses attention on the availability of funds. Enhancement of liquidity enable to corporate body to have
more funds from the market.
- A company will need to maintain liquidity for transaction purposes, precautionary measures and for speculative
opportunities.
- Liquidity is assessed through the use of ratio analysis. Liquidity ratios provide an insight into the present cash
solvency of a firm and its ability to remain solvent in the event of calamities. Ratios such as current ratio, quick
ratio, cash ratio etc. show the liquidity position of a company at a given point of time.
- Further, liquidity is affected by the credit policy of the company. The same can be seen through average collection
and payment period. A higher inventory turnover ratio also facilitates faster conversion of stock into sales and in-
turn into cash.

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Factors Affecting Fixed Capital Decisions:

1. Nature of business:
Manufacturing industries and public utilities have to invest huge amount of funds to acquire fixed assets. While
Trading business or those in service sector may not need huge investments in fixed assets.

2. Size of business:
Where a business firm is set up to carry-on large-scale operations, its fixed capital requirements are likely to be high.
It is because most of their production processes are based on automatic machines and equipment.

3. Extent of lease or rent

If entrepreneur decides to acquire assets on lease or on rental basis, less amount of funds for fixed assets will be
needed for the business. A new and emerging business model called ‘Asset Light Model’ is practiced by many
organizations.

Asset light model is a business model where businesses now instead of purchasing the land enter into a contract
with the land owner, where they share a certain percentage of profit arising out of the business done on the land.
This helps in saving a huge cost of land to the business. Although there are many asset-light models, some of the
most common are outsourcing, asset sharing, licensing in, and licensing out. Asset-light models can deliver a better
return on assets, lower profit volatility, greater flexibility, and higher cost savings than asset-heavy models.

Examples of Asset Light Models:

4. Arrangement of sub-contract:
If the business wants to sub-contract some processes of production to others, limited assets are required to carry out
the production. It would minimise fixed capital requirement of business. This is called as outsourcing.

5. Acquisition of old assets:

If old equipment and plants are available at low prices, then it would reduce the need for investment in fixed assets.
The business might decide to invest in second hand assets if they are satisfied about the quality.

6. Government Subsidies:
With the view to foster industrial growth at regional level, the government may provide land and building, materials
at concessional rates. Plants and equipment may also be made available on instalment basis. Such facilities will
reduce the requirement of fixed assets.

7. Trend in economy:
If economic boom is expected, investment in fixed assets rise as companies expect a good business. This is not so
when a slowdown or recession is expected.

8. Consumer preference:
Industries providing goods and services which are in good demand, will require large amount of fixed capital. For
example – Mobile phone manufactures as well as mobile network providers.

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9. Competitive factor:
This factor is prime element in decision making regarding fixed capital requirements. If one of the competitor’s shifts
to automation, the other companies in the same line of activity, will be compelled to follow that competitor. This is
especially true if the firm is operating in ‘oligopoly’ market where actions of one competitor have a significant impact
on the other competitor as number of sellers are few.

Factors Affecting Working Capital Decisions

1. Nature of Business (manufacturing vs. service or construction vs. hospitality)

A company that sells primarily on cash basis have less working capital pressures. Manufacturing companies need
much more inventories and receivables as compared to service industry.

2. Size of Business (small, medium or large)

The amount of working capital needed largely depends on the size of the business. Sometimes small firms have
higher liquidity pressure due to high overhead costs, less favourable credit terms, higher interest rates.

3. Credit Policy (credit granted to customers vs. credit received from suppliers)
Where the credit granted to customers is more as compared to credit received from supplies, there is working
capital pressures and vice versa. Purchases may be on a cash basis, but the manufacturing cycle may be longer and
sales terms maybe generous, causing a wide gap between cash payments and cash receipt and putting heavy
pressure on the firm.

4. Production policy (as per customer order or general market supply)

Companies producing on bulk basis require additional working capital needs due to higher inventories and
receivables. Made-to-order policies can be better managed and liquidity pressures are less.

5. Level of Competition (discounts, schemes, higher inventories etc.)

A high degree of competition puts more pressure to stock, receivables as well as liquidity. Effort to satisfy
customers’ demands and to grant more generous credit terms, thereby causing stress on cash flows.

6. Availability of Raw Material (bulk purchases vs. regular purchases)

7. Seasonal products (air-conditioners, crackers, sweaters etc.)

Companies having strong seasonal movements face working capital problems. The level of uncertainty also add to
the management troubles. In such cases, flexible arrangements are preferable to protect against unforeseen
contingencies.

8. High Taxes and Duties (higher cash outflows in the form of taxes)

9. Age of Business (Life Cycle – introduction, growth, maturity, decline)

As a company expands, larger amounts of working capital are required to avoid interruptions in production. In
maturity phase, there are less pressures due to easy credit and goodwill.

10. Inflationary Conditions (higher cost of goods and services)

11. Level of Technology (automatic vs. manual labour)

12. Economic & Business Cycles (boom, recession, slow-down, depression)

The recurring movements of the economic and business cycles influence working capital changes. As business goes
down, companies tend to postpone capital investments. Also, reduced sales volumes decrease receivables and
modify inventory purchases. However, in a boom period, companies concentrate on higher production and credit
items. During boom, a company faces higher pressure on liquidity.

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13. Goodwill of the company (better bargaining power)

14. New product or service launch (higher promotion costs)

15. Dividend policy (payout vs. retention)

A higher dividend payout may affect the working capital, since there is considerable cash outflows.

16. Interest rates (floating rates affect cash flows)

17. Foreign currency rate fluctuations (exports vs. imports)

18. Operating Cycle

FINANCING DECISION

➢ Financing decisions relate to acquiring the optimum finance to meet funds requirement and seeing that fixed and
working capital are effectively managed.
➢ The financial manager needs to possess a good knowledge of the sources of available funds and their respective
costs, and needs to ensure that the company has a sound capital structure, i.e. a proper balance between equity
(own) capital and debt (borrowing).
➢ Financing decisions also need a good knowledge of risk evaluation e.g. excessive debt carries higher risk than
equity because of the priority rights of the lenders.

DIVIDEND DECISIONS

➢ Dividend decisions relate to the determination as to how much and how frequently cash can be paid out of the
profits of an organization as income for its owners / shareholders.
➢ The dividend decision thus has two elements – the amount to be paid out and the amount to be retained to support
the growth of the organisation, the latter being also a financing decision; the level and regular growth of dividends
represent a significant factor in determining a profit-making company's market value.
➢ Theoretically, this decision should depend on whether the company or its shareholders are in the position to better
utilize the funds, and to earn a higher rate of return on funds.
➢ However, in practice, a number of other factors like the market price of shares, the trend of earning, the tax position
of the shareholders, cash flow position, requirement of funds for future growth, and restrictions under the
Companies Act, etc. play an important role in the determination of dividend policy of business enterprise.

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FACTORS AFFECTING DIVIDEND DECISION

External Factors Internal Factors

State of Economy Financial Needs of Company
Legal Restrictions Desire of Shareholders
Capital Markets Stability of Earnings
Contractual Restrictions Liquidity Position
Taxation Policy Desire for Control
Uncertainty in Markets Age of Company

External Factors

1. General state of Economy

In case of uncertain economic and business conditions, the management may like to retain the whole or part of the
firm’s earnings to build up reserves to absorb shocks in future. Similarly, in periods of recession, the management
may withhold dividend payment to retain large part of earnings to preserve the firm’s liquidity position. Also, in
periods of prosperity the management may retain profits due to availability of large profitable opportunities.

2. State of Capital Market

In case firm has an easy access to the capital market (long term sources) to raise funds, it can follow a liberal dividend
policy. Otherwise, it is likely to adopt more conservative dividend policy. Thus, after payment of dividends (cash
outflow), if the firm can easily raise funds from the market, a higher payout shall be preferred.

3. Legal Restrictions
The management has to take into account all the legal restrictions before taking the dividend decision otherwise it
may be declared as ultra-vires. For example – rules relating to ‘Transfer to Reserves’ etc.

4. Contractual Restrictions
Generally, lending financial institutions put restrictions on dividend payments to protect their interest. There may
be a clause in loan agreement restricting dividend payment until certain amount is repaid etc. Such contractual
restrictions affect the dividend payout of a company.

5. Taxation Policy
Dividend decisions also depend on prevailing corporate income tax rates and taxation policy relating to payment of
dividends. For example – In India there used to be Dividend Distribution Tax where a company declaring dividend
shall pay a certain percentage to the Govt. as tax.

6. Uncertainty in Markets
Where there is high degree of uncertainty in the market, a company avoid huge dividend payment. In such uncertain
times, companies prefer to retain profits for future contingencies.

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Internal Factors

7. Financial Needs of the Company

The financial needs of the company may force them to retain larger profits within the business. This need for funds
contradicts with shareholders’ expectation to receive large dividends. However, a management may give more
importance to future financial needs and growth of a company, rather than desire of shareholders.

8. Desire of the shareholders

Technically, shareholders are the owners of a company and therefore their desire cannot be ignored while deciding
the dividend policy. Shareholders expect two forms of returns on their investment viz. dividend and capital gain. In
most cases, shareholders prefer dividends as it reflects company’s strength, reduces future uncertainty and investors’
current need income.

9. Stability of Earnings
A company having stable income/profits can afford to have higher dividend pay-out ratio as compared to a
company which does not enjoy such stability in its earnings. Companies with cyclical or fluctuating profits prefer to
retain majority of its earnings to meet future uncertainties.

10. Liquidity Position

As per Companies Act, 2013 dividend shall be paid in cash only. Thus, liquidity position of a company definitely
influences the dividend policy. Hence, the management always considers the cash position and overall liquidity
position of a company before and after dividend payment.

11. Desire of Control

Dividend policy is also influenced by the management’s desire to keep control over the company. Higher pay-out
may require raising additional funds through equity route. However, such additional equity issue dilutes the control.
In case of strong desire for control, a management will not pay substantial dividends and prefer a lower dividend
pay-out ratio. However, where management is already having strong control due to substantial shareholding, the
firm may offer a high dividend pay-out ratio.

12. Age of the Company

Generally, a new company prefers to retain majority of its earnings for future investments and growth
opportunities. An established company may distribute dividends for its shareholders.

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