FINANCIAL MANAGEMENT

UNIT - I
 Unit - I

● Financial objective
● Sreholder value maximization v/s profit maximization
● Growth in EPS & total shareholder return
● Possible conflict between shareholder objectives and balancing them
● Linkage of financial objective with corporate strategy
● Financial & other objectives of a not for profit organization
● Economic environment of the business
 Finance and Financial Management

Finance

It is defined as the management of money and includes activities such as investing, borrowing, lending,

budgeting, saving, and forecasting.

Financial Management

Financial Management means planning, organizing, directing and controlling the financial activities such as

procurement and utilization of funds of the enterprise. It means applying general management principles to

financial resources of the enterprise.

 EVOLUTION OF FINANCE
It may be divided into three broad categories, i.e., traditional
phase, transitional phase and modern phase.
1.The Traditional Phase (Up to 1940)
Initially finance was a part of economic activities and business owners were more
concerned with the operational activities.
Characteristics of this phase were :
● finance function was episodic in nature.
● funds were arranged mainly from financial institutions orthrough shares/
debentures.
● the outsider’s point of view was dominant
EVOLUTION OF FINANCE

2.Transitional Phase (1940 – 1950)

● The nature of financial management was similar totraditional phase but greater
emphasis was placed on day-to-dayactivities.
● Funds analysis and control on a regular basis, rather than on a casual basis.
3.The Modern Phase (After 1950)
Started since mid 1950’s.
● Rapid growth of business and competition increases the importance of finance
not only for episodic events but also for day-to-day activities.
What is Financial Management?

• Financial management is all about monitoring, controlling, protecting, and

reporting on a company's financial resources.
• It concern with use of both long and short term financial resources.
• Efficiently using the financial resources and ensuring companies goals
and objectives are met
Why Financial Management?

• Create wealth
• Generate income
• Adequate return on investment
Role of Financial Management:
• Control
• Decision-making
• Coordination
• Resource allocation
• Motivating employees
Financial Objectives:

Before taking financial decisions, we have to determine the financial

objectives.
Objectives can be divided into:
Primary Objectives – Reason for existing
Secondary objectives – Support primary objectives
Financial Constrains
Ability of managers often constrained by stakeholders
Scope/Elements of Financial Management
Investment decisions
● It includes investment in fixed assets (called as capital budgeting). Investment in current
assets are also a part of investment decisions called as working capital decisions.
Financial decisions
● They relate to the raising of finance from various resources which will depend upon decision
on type of source, period of financing, cost of financing and the returns thereby.
Dividend decision
● The finance manager has to take decision with regards to the net profit distribution. Net
profits are generally divided into two:
a) Dividend for shareholders- Dividend and the rate of it has to be decided.
b) Retained profits- Amount of retained profits has to be finalized which will depend upon
expansion and diversification plans of the enterprise
Objectives of Financial Management
The financial management is generally concerned with procurement (purchasing),
allocation and control of financial resources of a concern. The objectives can be:
● To ensure regular and adequate supply of funds to the concern.
● To ensure adequate returns to the shareholders which will depend upon the
earning capacity, market price of the share, expectations of the shareholders.
● To ensure optimum funds utilization. Once the funds are procured, they should
be utilized in maximum possible way at least cost.
● To ensure safety on investment, i.e, funds should be invested in safe ventures so
that adequate rate of return can be achieved.
● To plan a sound capital structure-There should be sound and fair composition
of capital so that a balance is maintained between debt and equity capital.
Functions of Financial Management

Estimation of capital requirements:

● A finance manager has to make estimation with regards to capital requirements of the
company. This will depend upon expected costs and profits and future programmes and
policies of a concern.
● Estimations have to be made in an adequate manner which increases earning capacity of
enterprise.
Determination of capital composition:
● Once the estimation have been made, the capital structure have to be decided.
● This involves short-term and long-term debt equity analysis. This will depend upon the
proportion of equity capital a company is possessing and additional funds which have to
be raised from outside parties.
Functions of Financial Management Continue…

Choice of sources of funds:

For additional funds to be procured, a company has many choices like-
● Issue of shares and debentures
● Loans to be taken from banks and financial institutions
● Public deposits to be drawn like in form of bonds.
Choice of factor will depend on relative merits and demerits of each source and
period of financing.
Investment of funds:
● The finance manager has to decide to allocate funds into profitable ventures so
that there is safety on investment and regular returns is possible.
Functions of Financial Management Continue…

Disposal of surplus:
The net profits decision have to be made by the finance manager. This can be done in two ways:
1. Dividend declaration - It includes identifying the rate of dividends and other benefits like bonus.
2. Retained profits - The volume has to be decided which will depend upon expansional, innovational,
diversification plans of the company.
Management of cash:
● Finance manager has to make decisions with regards to cash management.
● Cash is required for many purposes like payment of wages and salaries, payment of electricity and
water bills, payment to creditors, meeting current liabilities, maintainance of enough stock, purchase of
raw materials, etc.
Financial controls:
● The finance manager has not only to plan, procure and utilize the funds but he also has to exercise
control over finances.
 PROFIT MAXIMIZATION
• In financial management we assume that the objective of the business is
to
maximize shareholder wealth.
• This is not necessarily the same as maximizing profit.
• Firms often find that share prices bear little relationship to reported
profit
figures (e.g. biotechnology companies and other 'new economy' ventures).
POTENTIAL ISSUES

Long-
run
Cash versus
short-
run
issues

Quality (risk)
of
earnings
 FINANCIAL OBJECTIVES – WEALTH
MAXIMIZATION
• If strategy is developed in response to the need to achieve objectives, it
is
obviously important to be clear about what those objectives are.
• Most companies are owned by shareholders and originally set up to make
money for those shareholders.
• The primary objective of most companies is thus to maximize shareholder
wealth. (This could involve increasing the share price and/or dividend pay-
out.)
 MAXIMIZING Vs SATISFICING
• Maximizing – seeking the maximum level of returns, even though this
might
involve exposure to risk and much higher management workloads.
• Satisficing – finding a merely adequate outcome, holding returns at
a satisfactory level, avoiding risky ventures and reducing workloads.
 OBJECTIVE SETTING FOR NOT FOR
PROFIT ORGANIZATIONS (NFPs)
• The primary objective of not for profit organizations is not to make
money but to benefit groups of people.

• As with any organization, NFPs will use mixture of financial and

non financial objectives.
REASONS FOR IMPORTANCE OF NON
FINANCIAL OBJECTIVES IN NFPs

Multiple
and Key
objectives
conflictin
are very
g
difficult
objectives
to
are more
quantify
common
FACTORS INFLUENCING OBJECTIVE
SETTING IN NFPs
Wide range
of
stakeholders

Longer-term High level of interest

planning horizon &
Macro Economic from stakeholder
Influences groups

Funding often Degree of

involvement from
provided
funding bodies and
as a series of advances sponsors

Little or no financial
input from the ultimate
recipients
MEASURING THE ACHIEVEMENT OF
OBJECTIVES IN NFPs
Financial
Objectives
of NFPs

Spend Raise large

funds sum of
effectively money
MACRO ENVIRONMENT POLICIES AND
BUSINESS DECISIONS
POTENTIAL FOR CONFLICT
CORE MACRO ECONOMIC POLICIES
 BUSINESS
COSTS
• Macroeconomic policy may influence the costs of the business sector.
• Not only will the demand for goods and services be affected by macro
economic policy, it also has important implications for the costs and
revenues of businesses. Three important areas may be identified:
a. Exchange Rates
b. Taxation
c. Interest Rates
 MONETARY POLICIES
• Monetary policy is concerned with influencing the overall
monetary
conditions in the economy in particular:
• the volume of money in circulation - the money supply
• the price of money - interest rates.
 CHOICE OF TARGETS
• A fundamental problem of monetary policy concerns the choice
ofvariable
to operate on.
• The ultimate objective of monetary policy is to influence some important
variable in the economy at the level of demand, the rate of inflation, the
exchange rate for the currency etc.
• However monetary policy has to do this by targeting some intermediate
variable which, it is believed, influences, in some predictable way, the ultimate
object of the policy.
 STOCK OF MONEY VS RATE
OF INTEREST
• (a)The volume of money in circulation: The stock of money in the economy is believed
to
have important effects on the volume of expenditure in the economy. This in turn may
influence the level of output in the economy or the level of prices.

• (b)The price of money: The price of money is the rate of interest. If governments wish to
influence the amount of money held in the economy or the demand for credit, they may
attempt to influence the level of interest rates.
 STOCK OF MONEY VS RATE
OF INTEREST
• The monetary authorities may be able to control either the supply of money
in the economy or the level of interest rates but cannot do both
simultaneously.
• In practice, attempts by governments to control the economy by controlling
the money supply have failed and have been abandoned. However, growth in
the money supply is monitored, because excessive growth could be
destabilizing.
MEASUREMENT OF MONEY SUPPLY

Money
Supply
Measurement

Narrow Broad
Measure Measure

Domestic Currency
Notes and Coins in Money held by Operational Notes and Coins in deposits held by
Circulation with Balances held by
banks Circulation with private sector at banks
the public Commercial banks
and building public and building
societies
 EFFECTS OF INTEREST RATES
• The problem for the monetary authorities is that controlling the level of
interest rates is rather easier than controlling the overall stock of money but
the effects of doing so are less certain.

PROBLEM WITH INTEREST RATES

Discourage Expenditure Raise Cost of

Increase Lower
and Spending Credit
Change in AD
Interest Rate
Increase Expenditure Lower Cost of Higher
Decrease
and Spending Credit AD
MONETARY POLICY IN INDIA
 QUANTITATIVE TOOLS
• Cash Reserve Ratio (CRR)– as the name suggests, banks have to keep this
proportion as cash with the RBI. Bank cannot lend it to anyone. Bank earns
no interest rate or profit on this. Bank cannot lend it to anyone.
• Statutory Liquidity Ratio (SLR)- As the name indicates banks have to set
aside this much money into liquid assets such as gold or RBI approved
securities mostly government securities. Banks earn interest on securities but
as yield on govt securities is much lower banks earn that much less interest.
 QUANTITATIVE TOOLS
• Open market operations (OMO)– As the name indicates this refers to
operations conducted by the RBI in open market i.e. RBI does not directly
ask banks to do anything. In this policy, RBI buys and sells government
securities in the open market to control money supply.
• Bank rate– When banks borrow long term funds from RBI. They’ve to pay
this much interest rate to RBI.
 QUANTITATIVE TOOLS
• Open market operations (OMO)– As the name indicates this refers to
operations conducted by the RBI in open market i.e. RBI does not directly
ask banks to do anything. In this policy, RBI buys and sells government
securities in the open market to control money supply.
• Bank rate– When banks borrow long term funds from RBI. They’ve to pay
this much interest rate to RBI.
 LIQUIDITY ADJUSTMENT FACILITY
• The Liquidity Adjustment Facility (LAF) is an indirect instrument
for
monetary control.
• It controls the flow of money through repo rates and reverse repo rates.
• The repo rate is actually the rate at which commercial banks and
other
institutes obtain short-term loans from the Central Bank.
• The reverse repo rate is the rate at which the RBI parks its funds with the
commercial banks for short time periods.
 MORAL
SUASION
• This is an informal method of monetary control.
• The RBI is the Central Bank of the country and thus enjoys a
supervisory position in the banking system.
• If there is a need it can urge the banks to exercise credit control at times
to
maintain the balance of funds in the market.
• This method is actually quite effective since banks tend to follow the
policies set by the RBI.
 SELECTIVE CREDIT CONTROL
• Under this method, the central influence the credit growth in
country
through following techniques:
• Specifying the margin requirements and differential rate of interests
• Regulating the credit for consumer durables.
 MARGINAL STANDING FACILITY
• Under SF, the scheduled commercial banks can borrow additional amount of
overnight money from the Reserve Bank by dipping into their Statutory
Liquidity Ratio (SLR) portfolio up to a limit at a penal rate of interest.
• This provides a safety valve against unanticipated liquidity shocks to
the
banking system
 INTEREST RATE SMOOTHING
• Interest rate smoothing is the policy of some central banks to move official
interest rates in a sequence of relatively small steps in the same direction,
rather than waiting until making a single larger change.
• This is usually for the following reasons:
• economic (e.g. to avoid instability and the need for reversals in policy) and
• political (e.g. higher rates are broken to the electorate gently).
IMPACT OF MONETARY POLICY ON
BUSINESS DECISION MAKING
Availability
of Finance

Business Cost of
Decision Finance
s
Monetar
y Policy
Impact
Level Level of
Consume
of r
inflatio Demand
n Level of
Exchang
e Rates
 IMPACT OF MONETARY POLICY ON
BUSINESS CASH FLOWS AND PROFITS
• Demand-pull inflation might occur
when excess aggregate monetary
demand in the economy and hence
demand for particular goods and
services enable companies to raise
prices and expand profit margins.
 IMPACT OF MONETARY POLICY ON
BUSINESS CASH FLOWS AND PROFITS
• Cost-push inflation will occur when there
are increases in production costs
independent of the state of demand, e.g.
rising raw material costs or rising labor
costs.
• The initial effect is to reduce profit
margins and the extent to which these can
be restored depends on the ability of
companies to pass on cost increases as
price increases for customers
 FISCAL
POLICY
• Fiscal policy is the manipulation of the government budget in order to influence the level
of
aggregate demand and therefore the level of activity in the economy. It covers:
• government spending
• taxation
• government borrowing
which are linked as
follows:
Public expenditure = taxes
raised + government
PROBLEMS OF FISCAL
POLICY
Problem
s

Incentive Effects
Crowding out
of Taxation
 CROWDING OUT
• It is suggested that fiscal policy can lead to 'financial crowding out', whereby
government
borrowing leads to a fall in private investment.
• This occurs because increased borrowing leads to higher interest rates by creating a
greater
demand for money and loanable funds and hence a higher 'price'.
• The private sector, which is sensitive to interest rates, will then reduce investment due to
a
lower rate of return. This is the investment that is crowded out.
• The weakening of fixed investment and other interest-sensitive expenditure counteracts
the
economy boosting benefits of government spending.
• More importantly, a fall in fixed investment by business can hurt long-term
economic
 CROWDING OUT

• Doubts exist over the likely size of any crowding out effect of government
borrowing on other borrowers but a very large PSBR may well lead to a fall
in private investment.

• However, when the economy is depressed, and there is not much new private
sector investment, government spending programs could help to give a
boost to the economy.
 PRIMARY MARKETS
• Primary markets provide a focal point for borrowers and lenders to meet.
• The forces of supply and demand should ensure that funds find their way
to their most productive usage.
• Primary markets deal in new issues of loanable funds.
• They raise new finance for the deficit units.
 SECONDARY MARKETS
• Secondary markets allow holders of financial claims (surplus units)to
realize
their investments before the maturity date by selling them to other investors.
• They therefore increase the willingness of surplus units to invest their funds.
• A well-developed secondary market should also reduce the price volatility of
securities, as regular trading in 'second-hand' securities should ensure
smoother price changes.
• This should further encourage investors to supply funds.
 CAPITAL MARKETS
• Capital markets deal in longer-term finance, mainly via a stock
exchange.
• The major types of securities dealt on capital markets are as follows:
• public sector and foreign stocks
• company securities
• Eurobonds.
 MONEY MARKETS
• Money markets deal in short-term funds and transactions are conducted
by
phone or telex.
• It is not one single market but a number of closely-connected markets.
 WORKING CAPITAL
• Working capital is the difference between current assets and
current
liabilities.
• If we break down the components of working capital we will found
working capital as follows:
Working Capital = Current Assets – Current Liabilities
 CURRENT ASSETS
An asset is classified as current when:
• It is expected to be realised or intends to be sold or consumed in
normal operating cycle of the entity;
• The asset is held primarily for the purpose of trading;
• It is expected to be realised within twelve months after the reporting period;
• It is non- restricted cash or cash equivalent.
 CURRENT LIABILITIES
A liability is classified as current when:
• It is expected to be settled in normal operating cycle of the entity.
• The liability is held primarily for the purpose of trading
• It is expected to be settled within twelve months after the reporting
period
CONCEPT OF WORKING CAPITAL

Workin
g
Capital

Valu Time
e

Gross Net Permanent Fluctuating

 WORKING CAPITAL BASED ON
VALUE
• From the value point of view, Working Capital can be defined as Gross
Working
Capital or Net Working Capital.
• Gross working capital refers to the firm’s investment in current assets.
• Net working capital refers to the difference between current assets and
current
liabilities.
• A positive working capital indicates the company’s ability to pay its short-
term
liabilities.
• On the other hand a negative working capital shows inability of an entity to meet
its
short-term liabilities.
 WORKING CAPITAL BASED ON TIME
• From the point of view of time, working capital can be divided into two
categories
viz., Permanent and Fluctuating (temporary).
• Permanent working capital refers to the base working capital, which is the minimum
level of investment in the current assets that is carried by the entity at all times to
carry its day to day activities.
• Temporary working capital refers to that part of total working capital, which is
required by an entity in addition to the permanent working capital. It is also called
variable working capital which is used to finance the short term working capital
requirements which arises due to fluctuation in sales volume.
DETERMINATION OF WORKING
CAPITAL
WORKING CAPITAL FINANCING
POLICIES
 CURRENT ASSETS TO FIXED ASSETS
RATIO
• The level of the current assets can be measured by creating a
relationship
between current assets and fixed assets.
• Dividing current assets by fixed assets gives current assets/fixed assets ratio.
• Assuming a constant level of fixed assets, a higher current assets/fixed assets
ratio indicates a conservative current assets policy and a lower current
assets/fixed assets ratio means an aggressive current assets policy
assuming all factors to be constant.
 CURRENT ASSETS TO FIXED ASSETS
RATIO
• A conservative policy implies greater liquidity and lower risk whereas
an
aggressive policy indicates higher risk and poor liquidity.
• Moderate current assets policy will fall in the middle of conservative
and aggressive policies.
• The current assets policy of most of the firms may fall between these
two extreme policies.
THANK YOU