Financial Management

(UNIT – 1)
 Meaning of Finance
The term ‘Finance’ has been defined in various ways by different schools of thought.
Basically, the term finance revolves around the management of money or financial resources
of a business enterprise.

Nature of Finance Function

Salient features of the finance function are as below;
1. Finance function is mostly integrated and centralised in every business organisation.
2. Irrespective of size, nature, legal status, every organisation has a finance function.
3. Finance and its related activities play a very significant role in the long-term growth
and survival of the organisation.
4. Finance functions helps in managerial decision making through analysis and
interpretation of financial data.
5. Finance function is interrelated to other primary functions of business e.g., marketing,
production planning, human resources etc.

Scope of Finance Functions

1. Estimating Financial Requirements: It is of paramount importance for a company
to assess its long-term as well as short-term capital needs in a precise manner. The
projection with regard to capital requirements should be accurate; otherwise the
business may run into trouble either due to shortage of funds or its excess.

2. Deciding Capital Structure: Once the total fund requirement for a business is
assessed, the next step is to decide the capital structure i.e., deciding the ratio of
various components of the total capital. It includes deciding the ratio in which (i)
long-term and short-term funds, (ii) debt-equity mix and (iii) borrowed funds may be
decided carefully by the Finance Department of the company.

3. Selecting Source of Finance: There are a number of sources from where funds can
be raised by a company e.g., issue of equities, debentures, bonds, borrowing from
banks or financial institutions, public deposits etc. This selection may be done with
utmost care.

4. Selecting a Pattern of Investment: Once the funds have been raised, the next
important decision to be taken is the appropriate application of funds. For this various
techniques viz, Capital Budgeting, Opportunity Cost Analysis etc. may be adopted.
The principle of safety, profitability and liquidity should not be ignored while taking
these decisions.

5. Proper Cash Management: Proper cash management is also very necessary for the
smooth functioning of the enterprise. Both excess cash as well as shortage of cash is
harmful for the company. Excess cash will result into idle cash which will lower the
profits of the business. On the other hand, shortage of cash will create problems for
the smooth functioning of the business.
6. Proper Use of Surpluses: Proper use of surplus cash is necessary through investment
these surplus funds at the most suitable place, for example, in share market. To make
effective use of surplus cash it is necessary for the finance manager to understand
capital market properly before taking such decision so that maximum return for the
company may be assured.
 7. Implementing Financial Control: Monitoring of the financial performance of funds
raised and invested by a company in the business is an important function of the
finance department. For this purpose, various analytical tools and techniques e.g.,
Budgetary Control, Cost Control, Internal Audit, Ratio Analysis, Break-even Point
Analysis etc. are available, which should be used and implemented by every
organisation.

.
Sources of Long-term Finance
Various sources of long-term finance are as follows:
 Equity Share Capital
 Preference Share Capital
 Debentures
 Term Loans
 Lease Financing
 Hire Purchase Financing

(A) Equity Share Capital Equity Shares or Ordinary Shares represent the ownership
position in a company. The holders of equity shares, called shareholders, are the legal
owners of the company. Equity shares are the permanent capital. Equity shares may
be issued in three ways:
 Public Issue of Equity: In this type of issue, equity share are directly issued to
the public.
 Private Placement: Private placement involves sale of shares by the company to
a few selected investors, particularly the institutional investors like the Unit Trust
of India (UTI), Life Insurance Corporation of India (LIC), Industrial Development
Bank of India (IDBI) etc.
 Right Issue: A right issue involves selling of ordinary shares to the existing
shareholders of the company.

(B) Preference Share: Preference shares are issued for a limited time period. These
shares have fixed rate of dividend which is generally distributed in each after six
months. Preference shares is often considered to be a hybrid security since it has
many features of both ordinary shares and debentures.

(C) Debentures: A debenture is a long-term promissory note for raising loan capital. It is
a type of loan which is taken by the company from the public. The holders of
debentures are called debenture holders. A fixed interest is paid to debenture holders
each after six months. Interest on debentures is tax deductible. Debentures which are
issued by the Government company, are called Bonds.

(D) Term Loan: Term loans are loan which are obtained directly from the banks and
financial institutions. Term loans are sources of long-term debt. In India, they are
 generally obtained for financing large expansion, modernisation or diversification
projects. Therefore, this method of financing is also called Project Financing.

(E) Lease Financing: Lease is a contract between a lessor (The owner of the asset) and a
lessee (the user of the asset). Under the contract, the owner gives the right to the user
to use the asset over an agreed period of time, for a consideration called the lease
rental. The lessee pays the rental to the lessor. At the end of the lease contract, the
asset reverts to the lessor, who is the legal owner of the asset. As the legal owner, it is
the lessor not lessee, who is entitled to claim depreciation on the leased asset. There
are three types of lease:
 Operating Lease: Short-term, cancellable lease agreements are called Operating
Lease. Examples are: a tourist renting a car, lease contracts for computers, office
equipment, car, trucks etc. An operating Lease may run for 3 – 5 years.
 Financing Lease: Long-term, non-cancellable lease contracts are known as
Financial Lease. Examples are: plant, machinery, land, building, ships, aircrafts
etc. In India, financial leases are very popular with high-cost and high-technology
equipments.
 Sale-and-lease-back: Sale-and-lease-back is a special financial lease
arrangement. Sometimes, a user may sell an asset owned by him to the lessor and
lease it back from him. Thus, in this process user arrange capital for his expenses.

(F) Hire Purchase Financing: In hire purchase financing there are three parties: the
manufacturer, owner of the asset (hiree) and user of the asset (hirer). Sometimes,
manufacturer and hiree may be the same party. A hire purchase agreement between
the hirer and the hiree involves the following three conditions:
 The owner of the asset (hiree) gives the possession of the asset to the hirer with an
understanding that the hirer will pay agreed instalments over a specified period of
time.
 The ownership of the asset will transfer to the hirer on the payment of all
instalments.
 The hirer will have the option to terminate the agreement any time before the
transfer of ownership of the asset.
Thus, for the hirer, the hire purchase agreement is like a cancellable lease with a right
to buy the asset. The hirer is required to show the hired asset on his balance sheet and
is entitled to claim depreciation, although he does not own the asset until full payment
is made.

Financial Management
Financial management is that specialised body of general management which is concerned
with timely procurement of adequate funds for the efficient functioning of the enterprise.
In other words, financial management is that managerial activity which is concerned
with the planning and controlling of the firm’s financial resources. It encompasses the
procurement of funds in the most economic and prudent manner and employment of these
funds in the most optimum way to maximise the return for the real owner i.e., equity
shareholders. It is concerned with overall managerial decision making in general and with the
management of economic resources in particular. All business decisions have financial
implications and therefore financial management is inevitable related to almost every aspect
of business operations.

Nature of Financial Management

The financial management is neither a pure science nor an art. It deals with various methods
and techniques which can be adopted, depending on the situation of business and the purpose
of decision. As a science, it uses various statistical and mathematical models and computer
applications for solving the financial problems relating to the firm. For example, capital
investment appraisal, capital allocation and rationing, optimising capital structure mix,
portfolio management etc. Along with the above, a Financial Manager is required to apply his
analytical skills in decision making. Hence, Financial Management is both a science as well
art.

Significance of Financial Management

1. Finance is the Controlling Function: For all the business operations the finance is
the base. Every business activity such as production, purchase, sale, marketing,
manpower planning etc involves the flow of funds and thus is controlled and
monitored by the finance function. So, planning and implementation of all the
business functions are governed by the function of finance.

2. Aid To Managerial Decision Making: Financial management plays a vital role in

policy and managerial decision making in a firm. Major business decisions and
choices relating to production, marketing, labour, research and development etc. are
based on finance decision.

3. Wealth Maximisation: Objective of financial management is maximising wealth of

equity shareholders who are real owner of the company. To achieve this objective,
finance managers use various techniques e.g., EBIT-EPS Analysis, Leverage, Cost of
Capital, Capital Budgeting etc.

4. Administrative in Nature: Financial management has evolved to be more controlling

and supervising in nature. Financial management is not only concerned with fund
acquisition but also extended to capital allocation, sourcing of funds, project appraisal
etc.
 5. Base for Managerial Functions: Proper management of finance is foremost
importance for all other functions and processes of a business concern. Thus, all other
management functions such as planning, co-ordinating, directing etc. can be
implemented and achieved, if there is proper financial planning and control.

6. Performance Measures: Financial management often deals with those factors which
directly affect the profitability and risk factors of a business concern. So, financial
management usually acts as a measure for determining the performance level of other
functions to stabilise and control profitability and risk factors.

Major Decisions of Financial Managers

A finance manager takes so many decisions time to time. There are three major decisions
which are taken by financial managers which are:
 Investment Decision
 Financing Decision
 Dividend Decision
 Liquidity Decision
1. Investment Decision: Investment decision is relating to investment of funds in assets. A
firm’s investment decisions may be divided in two categories:

a. Capital Budgeting Decision: These decisions are relate to purchase of fixed

assets. Fixed assets are long-term assets hence; these decisions are also known as
long- term decisions. For taking these decisions, all the alternatives are evaluated
on the basis of some pre-determined criteria and the best one is selected.

b. Working Capital Decision: Working capital decisions are short-term decisions.

In other words, these decisions are related to investment in current assets. If the
company invests too much in current assets, it may adversely affect the
profitability due to the cost of funds blocked in current assets. These decisions
affect day-to-day working of the enterprise.

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

performed by the financial manager. Broadly, financial manager must decide when,
where from and how to acquire funds to meet the firm’s investment needs. Funds can be
raised by issuing shares or debentures or any combination of debt-equity. Financial
manager should select that option which can minimise the control and risk of the
company and on the other hand it can maximise the shareholders’ wealth.

3. Dividend Decision: Another major area of decision making by a finance manager is

known as the dividend decisions. The dividend decision is concerned with the quantum
of
 profits to be distributed among shareholders. A decision has to be taken whether all the
profits have to be distributed, to retain all the profits in business or to keep a part of
profits in the business and distribute remaining among shareholders.

4. Liquidity Decision: These decisions deal with proper administration of current assets. It
is desirable for financial managers to maintain proper liquidity in the firm. It is necessary
for effective functioning of the firm. Importance of proper liquidity may be understood
by this fact that non-liquidity is one of the major cause for the insolvency of the firms.
Thus, liquidity decision has become one of the important decisions for financial
managers.

Financial Manager
A financial manager is a person who is responsible to carry out the finance functions. In a
modern enterprise, the financial manager occupies a key position. The role of financial
manager is becoming more pervasive, intensive and significant in solving the complex funds
management problems. The finance manager is now responsible for shaping the fortune of
the enterprise and is involved in the most vital decision of the allocation of capital.

Role of Financial Manager

Major roles of financial manager are:
 Funds Raising
 Funds Allocation.
 Profit Planning
 Understanding Capital Market

1. Funds Raising: Funds raising is a major role of financial manager. The financial
manager is required to provide funds to the company as and when needed. Whatever
the funds are raising from the market, the important thing is that, those funds should
be sufficient as well as at right time otherwise enterprise cannot do their activities in
an efficient manner. When the financial managers are raising funds, he should also try
to maximise shareholders’ wealth.

2. Funds Allocation: Funds allocation is another very important role of financial

manager. Before allocating funds, the financial manager should evaluate all the
available alternatives properly and then should decide the best option. The problem of
funds allocation is as important as the problem of funds rising. Once the proper funds
are acquired, it is the liability of the financial manager to distribute those funds in
such a manner which can help in achieving the objective of wealth maximisation.
 3. Profit Planning: The functions of the financial manager may be broadened to include
profit-planning function. Profit planning refers to the operating decisions in the areas
of pricing, costs, volume of output and the firm’s selection of products lines. The cost
structure of the firm i.e., the mix of fixed and variable costs have a significant
influence on a firm’s profitability. Profit planning helps to anticipate the relationship
among volume, costs and profits and develop action plans to increase the profitability.

4. Understanding Capital Market: Capital market brings investors and firms together.
Hence the financial manager has to deal with capital markets. He should fully
understand the operations of capital markets and the way in which the capital markets
value securities. He should also know how risk is measured and how it can be
minimised. Thus understanding capital market is another important function of
financial manager.

Objectives of Financial Management

There are two approaches regarding objectives of financial management:
 Traditional Approach – Profit Maximisation
 Modern Approach – Wealth Maximisation

1. Traditional Approach – Profit Maximisation: It is universally recognised that the

basic goal of business should be to maximise owner’s economic welfare. In order to
achieve this ultimate goal ‘maximisation of profit’ has been considered a basic
objective of financial management. Various types of financial decisions, to be taken
with a view to maximise the profit of the firm. So, out of different mutually exclusive
options only that one should be selected which will result in maximum increase in
profit.

Arguments in favour of Profit Maximisation Concept:

 The aim of every firm is to earn profit.
 Profitability is a barometer for measuring efficiency and economic prosperity.
 Profits are the main sources of finance for the growth of a business.
 In an adverse market situation, a company can survive only if it has already
earned sufficient profits during favourable market situation.

Arguments against Profit Maximisation Concept or Criticism of Profit

Maximisation Concept: Profit maximisation concept was questioned and criticised
on following grounds:
 a. Vague Concept: The Profit Maximisation is vague and ambiguous. It does not
clarify which profits does its mean. Does it refer to maximisation of short-term
profits or long-term profits; after-tax profits or profits before tax; profits on capital
employed or profits available to shareholders etc.

b. Overlooks Risks: Sometimes this concept also ignores risks. The management,
who follow this concept, may undertake all profitable investment opportunities
regardless of the associated risks.

c. Ignores Time Value of Money: Profit maximisation objective treats all earnings
as equal though they occur in different periods. It ignores the fact that cash
received today worth more than the cash received tomorrow. Thus, this concept
also ignores the time value of money.

2. Modern Approach – Wealth Maximisation: Profit maximisation, on account of the

reason given above, is not considered to be an ideal criterion for making investment
and financial decision. Wealth maximisation goal as decision criteria suggests that
any financial action which creates wealth is desirable and should be accepted. This
concept influence on maximising the wealth of shareholders.

Arguments in Favour of Wealth Maximisation:

 Wealth maximisation is advanced and better to the objective of profit maximisation
because the only objective of the business firm is to enhance the wealth of the
shareholders.
 Wealth maximisation involves the comparison of the value to cost associated with the
company.
 Wealth maximisation takes into concern both time value and risk factors of the firm.
 Wealth maximisation promotes and improves optimum and efficient utilisation of
resources.

Profit Maximisation Vs Wealth maximisation

S. No. Base Profit Maximisation Wealth Maximisation
1 Nature It is concerned with maximising It is concerned with maximising
the profit of the company the wealth of shareholders
2 Rational The rationale behind this The rationale behind this concept
concept is the need for is enhancing shareholders’ wealth
maximum level of accumulated as a courtesy for their investment
profits for growth / expansion/ in the company’s equity and their
diversification and protection continued relationship and loyalty
against unforeseen situations with the company.
like economic recession, natural
disaster, unexpected losses in
future etc.
 3. Time Span This concept pertains to This concept pertains to
comparatively shorter period, comparatively long-term value
i.e., a financial year. Thus, it is creation and augmentation of
concerned with short-term individual shareholder’s wealth.
vision. Thus, it is concerned with long-
term vision.
4. Time Value This concept does not consider This concept considers time value
of Money time value of money. of money.
5. Immediate Management of a company is The immediate beneficiaries of
Beneficiaries the immediate beneficiaries of this concept are shareholders.
this concept. Shareholders are Management of a company is the
the secondary beneficiaries, secondary beneficiary
especially when the
management is separate from
ownership.

Meaning of Risk:
A person making an investment expects to get some return from the investment in the future.
But, as future is uncertain, so future expected return is also uncertain. It is this uncertainty
associated with the returns from an investment that introduces risk into an investment.
We can distinguish between the expected return and the realised return from an
investment. The investor makes the investment decision based on the expected return. But the
actual return may not be same as it was expected at the time of making investment. So, there
may be a variation between expected return and actual return. This possibility of variation of
the actual return from the expected return is termed risk.
Thus, we can say that – “Risk is the potential for variability in returns.” An
investment whose returns are fairly stable is considered to be a low-risk investment, whereas
an investment whose returns fluctuate significantly is considered to be a high-risk investment.

Elements of Risk
OR
Types of Risk and Their Effect of Investment
The elements of risk may broadly be classified into two groups. The first group comprises
factors that are external to a company and affect a large number of securities. These are
mostly uncontrollable in nature. They are called Systematic Risk. The second group includes
those factors which are internal to companies and affect only those particular companies.
These are controllable to a great extent. They are called Unsystematic risk. These Systematic
risk and Unsystematic Risk are the two components of total risk. Thus,

Total Risk = Systematic Risk + Unsystematic Risk

Risk
Systematic Risk Unsystematic Risk

Market Risk Interest Rate Risk Business

Purchasing Power Risk Risk
Financial
Risk
1. Systematic Risk: Systematic risk is also known as uncontrollable and non-
diversifiable. As the society is dynamic, changes occur in the economic, political and
social systems constantly. These changes have an influence on the performance of
companies and thereby on their stock prices. For example, economic and political
instability adversely affects all industries and companies. When an economy moves
into recession, corporate profits will shift downwards and stock prices of most
companies may decline. Thus, the impact of economic, political and social changes is
system-wide and which is referred to as systematic risk. Systematic risk is further
subdivided into interest rate risk, market risk and purchasing power risk.

a. Interest Rate Risk: Interest rate risk is a type of systematic risk that particularly
affects debt securities like bonds and debentures. A bond or debenture normally
has a fixed interest rate. A bond or debenture is normally issued with an interest
rate which is equal to the interest rate prevailing in the market at the time of issue.
But if after some time another company issue debentures which interest rate is
high, then in this condition demand of the previous company debenture will going
on decline because another debenture with high interest rate is available in the
market. The decreasing demand will reduce the market price of the old debenture.

b. Market Risk: Market risk is a type of systematic risk that affects shares. Market
prices of shares move up or down consistently for some time periods. A general
rise in share prices is referred to as a bullish trend, whereas a general fall in share
prices is referred to as a bearish trend. Thus, the stock market is seen to be
volatile. This volatility leads to variations in the returns of investors in shares. The
variation in returns caused by the volatility of the stock market is referred to as the
market risk.

c. Purchasing Power Risk: Another type of systematic risk is the purchasing power
risk. It refers to the variation in investor returns caused by inflation. Inflation
results in lowering of the purchasing power of money. When an investor
purchases a security, he foregoes the opportunity to buy some goods or services.
In other words, he is postponing his consumption. Meanwhile, if there is inflation
in the economy, the prices of goods and services would increase and thereby the
investor actually experiences a decline in the purchasing power of his investments
and the return from the investment.

2. Unsystematic Risk: Unsystematic risk is also referred to as controllable risk.

Unsystematic risk occurs due to managerial inefficiency, technological changes in
production process, availability of raw material, labour problem etc. When variability
of returns occurs because of such firm-specific factors, it is known as unsystematic
risk. The unsystematic risk may be of two types: (a) business risk, and (b) financial
Risk.

a. Business Risk: Every company operates within a particular operating

environment. This operating environment comprises both internal environment
within the firm and external environment outside the firm. The impact of these
operating conditions is reflected in the operating cost of the company. If a company is
bearing a high fixed cost, it will face a more decline in profits due to any slight decline in
sales because fixed cost does not decrease with decreasing sales. Such a firm is said to
face a large business risk.
 b. Financial Risk: Financial risk is a function of financial leverage which is the use
of debt in the capital structure. The presence of debt in the capital structure creates
fixed payments in the form of interest. This fixed interest payment creates more
variability in the earning per share (EPS) available to equity shareholders. So,
slight decline in profits may cause a much more decline in EPS.

What do you mean by Time Value of Money? Explain it.

Ans. The time value of money (TVM) is the concept that money you have now is worth
more than the identical sum in the future due to its potential earning capacity.
• Time
• Value
• Money
Understanding Time Value of Money (TVM)
• The time value of money draws from the idea that rational investors prefer to receive
money today rather than the same amount of money in the future because of money's
potential to grow in value over a given period of time.
• For example, money deposited into a savings account earns a certain interest rate and
is therefore said to be compounding in value.
• Time value of money is based on the idea that people would rather have money today
than in the future.
• Given that money can earn compound interest, it is more valuable in the present rather
than the future.
• The formula for computing time value of money considers the payment now, the
future value, the interest rate, and the time frame.
• The number of compounding periods during each time frame is an important
determinant in the time value of money formula as well.

Time Value of Money Formula

• Depending on the exact situation in question, the time value of money formula may
change slightly. For example, in the case of annuity or perpetuity payments, the
generalized formula has additional or less factors. But in general, the most
fundamental TVM formula takes into account the following variables: FV = Future
value of money
• PV = Present value of money
• i = interest rate
• n = number of compounding periods per year
• t = number of years
• Based on these variables, the formula for TVM is:
• FV = PV x [ 1 + (i / n) ] (n x t)
What is Amortization?

Amortization refers to the process of paying off a debt through scheduled, pre-determined instalments
that include principal and interest. In almost every area where the term amortization is applicable, the
payments are made in the form of principal and interest.

Such usage of the term relates to debt or loans, but it is also used in the process of periodically
lowering the value of intangible assets much like the concept of depreciation.

Example of Amortization

Many examples of amortization in business relate to intellectual property, such as patents and
copyrights. Here’s a typical situation.

 Company ABZ Inc. paid an outside inventor $180,000 for the exclusive rights to a solar panel she
developed.
 ABZ Inc. spent $20,000 to register the patent, transferring the rights from the inventor for 20 years.
 News of the sale caused two other inventors to challenge the application of the patent. ABZ
successfully defended the patent but incurred legal fees of $50,000.

Patent capitalized cost = $250,000 ($180,000 + $20,000 + $50,000)

Useful life = 20 years

$250,000 / 20 = $12,500 annual amortization expense

An annuity is a financial product that provides certain cash flows at equal time intervals. Annuities are
created by financial institutions, primarily life insurance companies, to provide regular income to a
client.
An annuity is a reasonable alternative to some other investments as a source of income since it
provides guaranteed income to an individual. However, annuities are less liquid than investments in
securities because the initially deposited lump sum cannot be withdrawn without penalties.
Types of Annuities
There are several types of annuities that are classified according to frequency and types of payments.
For example, the cash flows of annuities can be paid at different time intervals. The payments can be
made weekly, biweekly, or monthly. The primary types of annuities are:
1. Fixed annuities
Annuities that provide fixed payments. The payments are guaranteed, but the rate of return is usually
minimal.
2. Variable annuities
Annuities that allow an individual to choose a selection of investments that will pay an income based
on the performance of the selected investments. Variable annuities do not guarantee the amount of
income, but the rate of return is generally higher relative to fixed annuities.
3. Life annuities
Life annuities provide fixed payments to their holders until his/her death.
4. Perpetuity
An annuity that provides perpetual cash flows with no end date. Examples of financial instruments
that grant perpetual cash flows to its holder are extremely rare.

PVa = A∑ 1/(1+i)t
t =1