INTRODUCTION TO FINANCE

In general, finance is defined as the provision of money at the time

It is required.

Specifically it is defined as procurement of funds and their

effective utilisation.

Financial management is defined as the management of flow of

funds in a firm.

All business decisions have financial implications and therefore

financial management is inevitably related with every aspect of
business operations.
The finance manager has emerged as a professional manager
involved with funds to be raised by the firm, with the allocation of
these funds to different projects and with the measurement of the
result of each allocation.

Major characteristics of modern phase are :

- the firm (i.e., insider) is more important

- rational matching of funds to their uses so as to maximise

the wealth of the current shareholders.

- the approach has become more analytical and quantitative

FINANCIAL DECISIONS IN A FIRM

There are three broad areas of financial decision making – capital
budgeting, capital structure and working capital management.
1. Capital Budgeting :

Means allocation of funds to different long term assets like

investing in lands, machineries, infrastructures, distribution
networks etc.

It also involves investment in any project.

2. Capital Structure :

It involves determining the best mix of debt, equity and hybrid

securities to employ.

Once a firm has decided the investment project it wants to

undertake, it has to figure out ways and means of financing them.
The key issues in capital structure decision are :

- what should be the optimal debt-equity ratio?

- which specific instruments should be employed?

- which capital market should the firm access?

- when should the firm raise finances?

- what price the firm should offer its securities?

Besides these – what should be the optimal dividend payout ratio?

In this case the objective is to minimise the cost of financing

without impairing the ability of the firm to raise finances.
3. Working Capital Management :

It is also referred as short-term financing decisions.

Related to day-to-day financing activities and deals with –

- current assets (inventories, debtors, short term holdings

of marketable securities and cash)

- current liabilities (short-term debt, trade creditors,

accruals and provisions)

The key issues in this case are –

- what should be the optimum level of inventory?

- credit policy of the firm?

 - where should the firm invest its short-term cash surpluses?

- what sources of short-term finance are appropriate for the

firm?

FUNCTIONS OF FINANCE
The functions of finance involve three major decisions a company
must make – the investment decisions, the financing decisions,
and the dividend / share repurchase decisions.

1. The Investment Decisions :

Capital investment is the allocation of capital to investment

proposals whose benefits are to be realized in the future.
The assets which can be acquired fall into two groups –

) long term assets – which yield a return over a period of time

in future.

i) short term assets – those assets which in normal course of

business are convertible into cash
without any loss in value, usually within
a year.

The decisions regarding long term assets are known as capital

budgeting and regarding short term assets as working capital
management.

2. Financing Decisions :

t relates to the choice of the proportion of sources to finance the

selected investment proposals.
Thus, financing decisions covers mainly capital structure
decisions.

3. Dividend Policy Decisions :

The dividend should be analysed in relation to the financing

decision of a firm.

Two alternatives are available in dealing with the profits of the

firm – they can be distributed to the shareholders in the form of
dividends or they can be retained in the business itself.

The final decision will depend upon the preference of the

shareholders and investment opportunities available before the
firm.
CAPITAL BUDGETING
Capital Budgeting decisions are related to the allocation of funds
to fixed or long term assets, which by definition refer to assets
which are in operation, and yield a return, over a period of time,
usually, exceeding one year.

They therefore involve a current outlay or series of outlays of cash

resources in return for an anticipated flow of future benefits.

Thus, capital budgeting evaluates expected future cash flows in

relation to cash put out today.

Importance of Capital Budgeting :

- involvement of heavy funds

- long-term implications
- irreversible decisions
- very difficult decision to make
Kinds of Capital Investment Proposals :

- independent proposal
- dependent proposal
- mutually exclusive proposals

Factors Affecting Capital Budgeting Decisions :

i) The amount of investment –

it accounts for different factors like cost of new
project, installation cost, tax effect, proceeds from
sale of assets etc.

ii) Minimum rate of return on investment –

it is decided on the basis of cost of capital thus it
decides the cut-off point.
 iii) Return expected from investment –
it may depend on either accounting profit or cash
flows.

iv) Ranking of the investment proposals –

when a number of proposals appears to be
acceptable, they will be ranked on certain criteria
and the best one will be selected.

v) Risk and uncertainty –

risk involves situations in which the probabilities of
a particular event occuring are known whereas in
uncertainty , these probabilities are not known.

Capital Budgeting Process :

It is a complex process which may be divided into following

phases -
i) Identification of Potential Investment Opportunities
On the basis of target, external environment, SWOT
analysis, benefits associated with the project can be
estimated and best projects can be identified.

ii) Assembling of Investment Proposals

After scrutinising the projects by different department
it is sent to capital budgeting committee.

iii) Decision Making

A decision is taken after valuing all the pros and
cons of a project.

iv) Preparation of Capital Budget and Appropriations

Smaller projects are often covered by blanket
appropriations for expeditious actions for bigger
projects appropriation order is required.
 v) Implementation
After doing all the cross checks, the project is finally
implemented. For expeditious implementation at a
reasonable cost, the following are helpful – adequate
formulation of project, use of network techniques, use
of principle of responsibility accounting.

vi) Performance Review

Performance is reviewed by comparing actual
performance with projected performance and
necessary action should be taken, if required.

Project Classification :

Projects can be categorised into different categories, like

i) Mandatory Investment
for statutory requirements like pollution control
equipments, fire fitting equipments etc.
ii) Replacement Projects
for replacement of old equipments so that quality and
efficiency should be maintained.

iii) Expansion Projects

to increase capacity or widen the distribution network

iv) Diversification Projects

for producing new products or services or entering
into entirely new geographical areas. It entails large
outlays, substantial risks and considerable
managerial effort and attention.

v) Research and Development Projects

very critical for any company and difficult to analyse.

vi) Miscellaneous Projects

all other projects which requires huge investment.
 Investment Decision Rule

• It should maximise the shareholders’ wealth.

• It should consider all cash flows to determine the true
profitability of the project.
• It should provide for an objective and unambiguous way of
separating good projects from bad projects.
• It should help ranking of projects according to their true
profitability.
• It should recognise the fact that bigger cash flows are
preferable to smaller ones and early cash flows are preferable
to later ones.
• It should help to choose among mutually exclusive projects that
project which maximises the shareholders’ wealth.
• It should be a criterion which is applicable to any conceivable
investment project independent of others.
Investment Criteria / Evaluation Techniques :

It is classified into two broad categories – traditional methods and

time adjusted methods (or discounted cash flow methods).

Investment Criteria

Traditional Method or Time Adjusted Methods or

Non-Discounting Criteria Discounting Criteria

Net Present Modified

Payback Average Value IRR
Period rate of return
Benefit Cost Net Terminal
Discounted Payback Ratio Value
Period Internal Rate Profitability
of Return Index
 Accounting
Concepts and
Conventions
Accounting
Concepts
The term ‘concept’ is used to
connote accounting postulates, that
is necessary assumptions and
conditions upon which accounting
is based.

These are the theories on how and

why certain categories of
transactions should be treated in a
particular manner.
Business
Entity
Concept
• The business and its owner(s)
are two separate entities
The Books Of Accounts
are prepared from the
point of view of the
business

Hence…
Capital (Liability)

Drawings
The Personal Transactions of the
Owner are not recorded.

For Example:
A Car purchased by the owner for
personal use is not Recorded in the
Books Of Account Of the Business.
 Going
Concern
Concept
 It is assumed that the entity is a
going concern, i.e., it will continue
to operate for an indefinitely long
period in future and transactions
are recorded from this point of
view.
 Money
Measurement
Concept
In accounting, a record
is made only of those
transactions or events
which can be measured
and expressed in terms
of money.
Non monetary transactions
are not recorded in
accounting.
Accounting
Period
Concept
For measuring the
financial results of a
business periodically,
the working life of an
undertaking is split into
convenient short periods
called accounting period.
Cost Concept
An asset acquired by a
concern is recorded in the
books of accounts at
historical cost (i.e., at the
price actually paid for
acquiring the asset). The
market price of the asset is
ignored.
 Historical
Cost Of

Market Value
Of
Dual - Aspect
Concept
 For Every
Debit, there is
a Credit
Every transaction should
have a two- sided effect to
the extent of same amount
For Example:
Cash Sales Rs. 10,000
For Example:
Purchased From Ram goods worth Rs. 20,000
and discount received Rs. 2,000.
This Concept has resulted in

THE
ACCOUNTING
EQUATION
Realisation
Concept
Profit is earned when goods
or services are provided
/transferred to customers.
Thus it is incorrect to record
profit when order is
received, or when the
customer pays for the
goods.
Matching
Concept
 The matching principle ensures that
revenues and all their associated
expenses are recorded in the same
accounting period.

The matching principle is the basis on

which the accrual accounting method of
book- keeping is built.
 For Example

Salary paid in 2012-13

relating to 2011-12
Such salary is treated as Expenditure for
2011-12 under Outstanding Salaries
Account, not for the year 2012-13
Accounting
Conventions
Accounting Conventions are the
common practices which are
universally followed in recording
and presenting accounting
information of business. It helps in
comparing accounting data of
different business or of same units
for different periods.
Materiality
 Only those transactions,
important facts and items
are shown which are
useful and material for
the business. The firm
need not record
immaterial and
insignificant items.
Illustration:
Company XYZ Ltd. bought 6 months supplies of
stationary worth $600.

Question:
Should the Company spread the cost of this
stationary for 6 months by expensing off $100
per month to the income statement?

Answer:
Based on this concept, as the amount is so small
or immaterial, it can be expensed off in the next
month instead of tediously expensing it in the
next 6 months.
 Full
Disclosure
Financial Statements
and their notes
should present all
information that is
relevant and
material to the user’s
understanding of the
statements.
Conservatis
m
 Accountant should
always be on side of
safety.
 For
Example

• Making Provision for

Bad and Doubtful
Debts
• Showing
Depreciation on Fixed
Consistency
The accounting practices
and methods should
remain consistent from
one accounting period to
another.

Whatever accounting
practice is followed by the
business enterprise,
should be followed on a
consistent basis from
For Example