MODULE: 1

INTRODUCTION TO FINANCIAL MANAGEMENT

SESSION DATE: 22.03.2012 Prof. Rakhi R. Shrivastava

a)

Scope of Financial Management

i. ii. iii. iv. v. vi. Why Financial Management? ( Functions of Financial Management) Major Decisions in Financial Management Importance of Financial Management in Business World Risk and Return in Financial Planning Impact of Taxation and Inflation on Business and Role of FM Impact of Depreciation and FM

b)

Objectives of Financial Management

i. ii. iii. Profit Maximization as an objective of FM Wealth Maximization as an objective of FM Value Maximization as an objective of FM

c)

Techniques of Financial Management (An Introduction)

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2.

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Explain the nature of finance and its interaction with other management functions. Review the changing role of the finance manager and his/her position in the management hierarchy. Focus on the Shareholders Wealth Maximization (SWM) principle as an operationally desirable finance decision criterion Discuss agency problems arising from the relationship between shareholders and managers Illustrate the organization of finance function

Finance is the life-blood of business. Without finance neither any business can be started nor successfully run . Finance is needed to promote or establish business, acquire fixed assets, make necessary investigations, develop product keep man and machines at work ,encourage management to make progress and create values.

Financial management is one of the functional areas of management. It refer to that part of the management activity which is concerned with the planning and controlling of firms financial resources. DEFINITION : Financial management is the application of planning and control function of the finance function (Howard and Upton)

1. Selection of investment proposals ,known as the investment decision.

4. Allocation of profit for dividend payment, known as the dividend decision.

2. Determination of working capital requirements, known as the working capital decision.

3. Raising of funds to finance the assets, known as the financing decision.

Accounting is the language of business. Finance uses accounting information together with other information to make decisions that affect the market value of the firm.

There are three primary decision areas in FM that are of concern.

The finance functions rests around three important decisions:

Investment decisions financing decision, and dividend decision.

The scope of financial function covers decisions not only for the acquisition of funds but also their effective use. FM is required in the following areas:
1. 2. 3. 4. 5. 6. 7. 8. Estimating the requirement of funds Decision regarding capital structure Investment Decision Dividend Decision Cash Management Evaluation of Financial Performance Negotiation for Additional Funds Analysing trends in stock market

In other words, the firm decides how much to invest in shortterm and long term assets and how to raise the required

funds.

In making financial decisions, the financial manager should

aim at increasing the wealth of the share holders.

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Investment Decisions

What assets should the company hold? This determines the Right-hand side of the balance sheet. these decision are concerned with the effective utilization of funds in one activity or the other.

The investment decision can be classified under two groups:

(i) Long term investment decision

(ii) Short term investment decision

(Capital budgeting)

(Working capital Management.)

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Those decisions which determine how scarce resources in terms of funds available are committed to the projects. The investment decision of a finance manager cover the following areas:
Ascertainment of total volume of funds, a firm can commit. Appraisal and selection of capital investment proposals Measurement of risk and uncertainty in the investment proposal Prioritization of investment decisions. Funds allocation and its rationing Determination of fixed assets to be acquired. Determination of level of investments in current assets. Buy or lease decisions Asset replacement decisions Restructuring, reorganization, mergers and acquisitions Security analysis and portfolio management.

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Financing decisions
How should the company pay for the investments it makes? This determines the left-hand side of the balance sheet. it is also known as capital structure decision. It involves choosing the best source of raising funds and deciding optimal mix of various sources of finance. A company can not depend upon only one source of finance. hence a varied financial structure is developed. but before using any particular source of capital ,its relative cost of capital, degree of risk and control etc. should be thoroughly examined by the financial manager. The major source of long-term capital are shares and debentures and term loans etc.

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Those decisions which determine that the mix of debt equity chosen to finance investment projects should maximise the value of investment made. The investment decision of a finance manager cover the following areas:

Determination of degree of leverage or gearing and analysis of its impact on the firm and individual shareholders. Determination of financing pattern of long, medium and short-term funds requirement Raising funds through issue of financial instruments like equity shares, preference shares, debentures and bonds. Arrangement of funds from banks and financial institutions Arrangement of funds for working capital requirements Consideration of interest burden on the firm Consideration of debt level changes and its impact on firms bankruptcy Taking advantage of interest and depreciation in reducing the tax liability of the firm Consideration of various modes of improving EPS and MPS of companys shares. Consideration of cost of capital of individual components and weighted average cost of capital

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Those decisions which determine that the mix of debt and equity chosen to finance investment projects should maximise the value of investment made. The investment decision of a finance manager cover the following areas:

Optimization of financing mix to improve return to the equity shareholders and maximizing the wealth of the firm and value of the shareholders. Portfolio management Consideration of over capitalization and undercapitalization on the firms profitability. Consideration of foreign exchange risk exposure of the firm and decisions to hedge the risk. Study the impact of stock market and economic conditions of the country on mode of financing. Maintenance of balance between long term funds and short term funds. Evaluation of alternative uses of funds Setting of budgets and review of performance for control action. Analysis of position and performance of the company through various tools like cash flow statement, funds flow statements, trend analysis and ratio analysis to identify the problem areas and its correction measures.

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Dividend decisions

What should be done with the profits of the business? The dividend decision is concerned with determining how much part of the earning should be distributed among the share holders by way of dividend and how much should be retained in the business for meeting the future needs of funds internally.

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Those decisions which are concerned with the determination of quantum of profits to be distributed to the owners and the frequency of such payment. The level and the regular growth of dividends represent a significant factor in determining a profit making companys market value and value of its shares in the stock market. The dividend decision will affect finance function in two ways:

The amount to be paid out and its influence on share price

The amount of the profit to be retained for internal investments which maximizes the value of the firm and ultimately improves the share value of the firm.

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The finance manager will involve in taking the following dividend decisions:

Determination of dividend and retention policies of the firm. Consideration of impact of levels of dividend and retention of earnings on the market value of the share and the future earnings of the company. Consideration of possible requirement of funds by the firm for expansion and diversification proposals for financing existing business requirements Reconsideration of distribution and retention policies in boom and recession periods. Considering the impact of legal and cash flows constraints on dividend decisions.

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In the words of Ezra Pound,

the function of financial management is to review and control decision to commit and recommit funds to new and ongoing uses. Thus in addition to raising funds, FM is directly concerned with production, marketing and other functions within an enterprise whatever decisions are made about the acquisition or distribution of assets.

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 asset mix, capital mix and profit allocation.

Hence FM is nothing but managerial decision making on:

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The importance of financial management is judged fro the following points:

1. Applicability: The principles of finance is applicable wherever there is cash flow. The cash flows are central element in financial analysis, planning, control and resource allocation decisions. So financial management is equally applicable to:
all forms of business (sole traders, partnerships and companies.) non profit organizations like trusts, societies, government organizations and public sector enterprises.

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Chances of failure:
A firm with latest technology, sophisticated machinery, high caliber marketing and technical experts may fail to succeed unless its finances are managed on sound principles of financial management. The finance function is the primary function which enable the other functions like production, marketing, purchase and personnel to be more effective in achievement of organizational goals and objectives.

Return on Investment:
The Financial management studies the risk and return perception of the owners and the time value of money.

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The important functions of a financial controller in a large business firm consist of the following:
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Provision of capital Investor relations Short term financing Banking and custody Credit and collections Investments Insurance Planning and control Reporting and interpreting Evaluating & consulting
11. Tax administration 12. Government Reporting 13. Protection of assets 14. Economic appraisal 15. Managing funds 16. Measuring of return 17. Cost control 18. Price setting 19. Forecasting profits 20. Forecast cash flows
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Board of Directors

Managing Director/President

Finance Director/Chief
Finance officer

Financial Controller

Internal Auditor

Treasurer

Manager Accounts

Managemen t Accountant

Manager credit

Manager Taxation

Cash Manager

Corporate Finance & Funding Manager

Foreign Exchange manager

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Manager Accounts
Salaries
Financial Accounts Statutory Accounts Debtors Ledger Creditors Ledger

Management Accountant
Cost Accounting Management Accounting Budgeting

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Manager Credit
Credit Assessment
Setting credit limits Monitoring credit Chasing overdue accounts Assessment of duties / taxes

Manager Taxation
Payment of duties and taxes Claiming refunds Tax planning Compliance with tax laws

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Cash Manager
Banking Arrangements

Corporate finance and Funding Manager

Obtaining funds

Foreign Exchange Manager

Buying and selling foreign currencies

Cash Transmission

Interest rate exposure management

Currency exposure management

Banking costs Project finance Cash forecasting, monitoring & control Working capital control

Investing surplus funds

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The projects promising high average profit are accompanies with high risk.

The management should try to minimize risk and maximize profit of the company.

So risk and return go together.

Capital structure decisions assume vital significance in FM due to their influence both on return and risk of shareholders.
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These factors are divided into two parts:

1.

Macro economic factor: These factors are:

(a) the state of economy; ( inflationary and deflationary conditions and (2) the Government Policy ( on Taxation & Depreciation )

2. Micro

economic factor: These economic factors are related to the internal condition of the firm:
(a) Nature and size of the firm (b) Level of risk and stability in earnings (c) Liquidity position (d) Asset structure and pattern of ownership (e) Attitude of the management

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Taxation affects a firm in numerous ways. So the impact of taxation on corporate financial management is as follows:

Corporate taxes on firms profits Reduction in WACC because interest payments are allowable against tax. Dividend will not reduce the tax burden of the firm since it is not a charge on profits. Where a firm incurs overall loss, it can be carried forward to a future profit making year. Where a unit of the firm incurs loss, the loss of loss making unit will reduce the overall tax liability of the firm by set off of losses. Impact of depreciation provision on the reduction of taxable income. Taxation of capital gains and its impact on the profit of the firm. Double taxation of firms earnings like dividend received from other companies and its impact on profit. Kindly read from the book in detail about depreciation, inflation and Taxation.

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The basic objectives of FM centers around:

The procurement funds from various sources like equity share capital, debentures, term loans and working capital finance etc. Effective utilization of funds to maximize the profitability of the firm and the wealth of its owners.

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Allocation of funds (investment decision)

The corporate finance theory centres around three important objectives of finance function:
Distribution of funds (dividend decision) Generation of funds (financing decisions)

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All management decisions should help to accomplish the goal of the firm!

So, What should be the goal of the firm?

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Proper utilization of funds Maximization of Return on Investment (ROI) Survival Break Even Point Minimum Profit Ensure Coordination Good Image for the organization

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Profit Maximization as an objective of FM

What it should be?

Value Maximization as an objective of FM Wealth Maximization as an objective of FM

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Maximization of wealth, According to Prof Solomon Ezra of Stanford university,

the ultimate goal of financial management should be the maximization of the owners wealth. The value of corporate wealth may be interpreted in terms of the value of the companys total assets. The finance should attempt to maximize the value of the enterprise to its shareholders. Value is represented by the market price of the companys common stock.

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Long term Funds

Short Term Funds

used to acquire fixed assets and permanent working capital

used to acquire temporary working capital

Generate net cash inflows from operations Service debt obligations

Generate net cash inflows from operations Retained earnings available for reinvestment Firms wealth maximization

Dividend Distribution

Firms wealth maximization

Firms wealth maximization

Value maximization of equity shareholders through increase in stock market price of share.

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Maximizing Sales /Revenue /Earnings Maximizing Social Wealth Maximizing Profits

Social Acceptability and Recognition

Maximizing Return on sales /on investments

Maximizing Shareholder Value

Maximizing Corporate Wealth

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Production Function Research and Development Function Marketing Function

Human Resource Function

Finance Function

Advertising Function

Customer Care and After sales Service Function Purchase Function

Accounting Function

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The important step of effective financial management is comprehensive analysis of performance results of the company. The major techniques for analysis of financial statements to drive better corporate financial management are as follows:

Comparative statement

Common Size statement

Trend analysis

Ratio analysis

Cash flow analysis

Funds flow analysis

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 After thorough analysis of financial statement, decisions

are taken for fm of next year. So major techniques for financial management are:

Time value of money Capital Budgeting Calculation of cost of capital &WACC. Capital structure Leverage analysis Working capital management

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