Meaning of 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.

Scope/Elements

1. Investment decisions 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.
2. 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.
3. 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, allocation and control of
financial resources of a concern. The objectives can be-

1. To ensure regular and adequate supply of funds to the concern.

2. To ensure adequate returns to the shareholders which will depend upon the earning
capacity, market price of the share, expectations of the shareholders.
3. To ensure optimum funds utilization. Once the funds are procured, they should be
utilized in maximum possible way at least cost.
4. To ensure safety on investment, i.e, funds should be invested in safe ventures so that
adequate rate of return can be achieved.
5. 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

1. 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.
2. 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.
 3. Choice of sources of funds: For additional funds to be procured, a company has many
choices like-
a. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. 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.

4. 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.
5. Disposal of surplus: The net profits decision have to be made by the finance manager.
This can be done in two ways:
a. Dividend declaration - It includes identifying the rate of dividends and other
benefits like bonus.
b. Retained profits - The volume has to be decided which will depend upon
expansional, innovational, diversification plans of the company.
6. 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.
7. Financial controls: The finance manager has not only to plan, procure and utilize the
funds but he also has to exercise control over finances. This can be done through many
techniques like ratio analysis, financial forecasting, cost and profit control, etc.

Role of a Financial Manager

Financial activities of a firm is one of the most important and complex activities of a firm.
Therefore in order to take care of these activities a financial manager performs all the requisite
financial activities.

A financial manger is a person who takes care of all the important financial functions of an
organization. The person in charge should maintain a far sightedness in order to ensure that the
funds are utilized in the most efficient manner. His actions directly affect the Profitability,
growth and goodwill of the firm.

Following are the main functions of a Financial Manager:

1. Raising of Funds

In order to meet the obligation of the business it is important to have enough cash and
liquidity. A firm can raise funds by the way of equity and debt. It is the responsibility of a
financial manager to decide the ratio between debt and equity. It is important to maintain
a good balance between equity and debt.
2. Allocation of Funds

Once the funds are raised through different channels the next important function is to
allocate the funds. The funds should be allocated in such a manner that they are optimally
used. In order to allocate funds in the best possible manner the following point must be
considered

 The size of the firm and its growth capability

 Status of assets whether they are long-term or short-term
 Mode by which the funds are raised

These financial decisions directly and indirectly influence other managerial activities.
Hence formation of a good asset mix and proper allocation of funds is one of the most
important activity

3. Profit Planning

Profit earning is one of the prime functions of any business organization. Profit earning is
important for survival and sustenance of any organization. Profit planning refers to
proper usage of the profit generated by the firm.

Profit arises due to many factors such as pricing, industry competition, state of the
economy, mechanism of demand and supply, cost and output. A healthy mix of variable
and fixed factors of production can lead to an increase in the profitability of the firm.

Fixed costs are incurred by the use of fixed factors of production such as land and
machinery. In order to maintain a tandem it is important to continuously value the
depreciation cost of fixed cost of production. An opportunity cost must be calculated in
order to replace those factors of production which has gone thrown wear and tear. If this
is not noted then these fixed cost can cause huge fluctuations in profit.

4. Understanding Capital Markets

Shares of a company are traded on stock exchange and there is a continuous sale and
purchase of securities. Hence a clear understanding of capital market is an important
function of a financial manager. When securities are traded on stock market there
involves a huge amount of risk involved. Therefore a financial manger understands and
calculates the risk involved in this trading of shares and debentures.

Its on the discretion of a financial manager as to how to distribute the profits. Many
investors do not like the firm to distribute the profits amongst share holders as dividend
instead invest in the business itself to enhance growth. The practices of a financial
manager directly impact the operation in capital market.
Capital Budgeting Process

Definition: The Capital Budgeting is one of the crucial decisions of the financial management
that relates to the selection of investments and course of actions that will yield returns in the
future over the lifetime of the project.

Capital Budgeting Process

1. Identification of Potential Investment

Opportunities: The first step in the capital
budgeting process is to explore the investment
opportunities. There is generally a committee
that identifies the expected sales from a
certain course of action, and then the
investment opportunities are identified
keeping these targets as a basis.Before
initiating the search for the potential
investments, there are certain points that need
to be taken care of: monitor the external
environment on a regular basis to know about
the new investment opportunities, define the
corporate strategy based on the analysis of the
firm’s strengths, weaknesses, opportunities and threats, share the corporate strategy and
objectives with the members of capital budgeting process and seek suggestions from the
employees.
2. Assembling of Investment Proposals: Once the investment opportunities are identified, several
proposals are submitted by different departments. Before reaching the capital budgeting process
committee, the proposals are routed through several persons who ensures that the proposals are in
line with the requirements and then classify these according to their categories Viz, Replacement,
Expansion, New product and Obligatory & welfare investments.This categorization is done to
simplify the task of committee members and facilitate quick decision making, budgeting, and
control.
3. Decision Making: At this stage, the executives decide on the investment opportunity on the basis
of the monetary power, each has with respect to the sanction of an investment proposal.For
example, in a company, a plant superintendent, work manager, and the managing director may
okay the investment outlays up to the limit of 15,00,000, and if the outlay exceeds beyond the
limits of the lower level management, then the approval of the board of directors is required.
4. Preparation of Capital Budget and Appropriations: The next step in the capital budgeting process
is to classify the investment outlays into the smaller value and the higher value. The smaller value
investments okayed by, the lower level management, are covered by the blanket appropriations
for the speedy actions.And if the value of an investment outlay is higher then it is included in the
capital budget after the necessary approvals. The purpose of these appropriations is to evaluate
the performance of the investments at the time of the implementation.
5. Implementation: Finally, the investment proposal is put into a concrete project. This may be time-
consuming and may encounter several problems at the time of implementation.For expeditious
processing, the capital budgeting process committee must ensure that the project has been
formulated and the homework in terms of preliminary studies and comprehensive formulation of
the project is done beforehand.
 6. Performance Review: Once the project has been implemented the next step is to compare the
actual performance against the projected performance. The ideal time to compare the
performance of the project is when its operations are stabilized.Through a review, the committee
comes to know about the following: how realistic were the assumptions, was the decision making
efficient, what were the judgmental biases and were the desires of the project sponsors fulfilled.

Thus, the Capital Budgeting, due to its complex behavior comprises a series of steps that should
be strictly followed before finalizing the investments.

Nature / Features of Capital Budgeting Decisions:

1. Long Term Effect: Such decisions have long term effect on future profitability and influence
pace of firms growth. A good decision may bring amazing returns and wrong decision may
endanger very survival of firm. Hence capital budgeting decisions determine future destiny of
firm.

2. High Degree of Risk: Decision is based on estimated return. Changes in taste, fashion,
research and technological advancement leads to greater risk in such decisions.

3. Huge Funds: Large funds are required and sparing huge funds is problem and hence decision
to be taken after proper care .

4. Irreversible Decision: Reverting back from a decision is very difficult as sale of high value
asset would be a problem.

5. Most Difficult Decision: Decision is based on future estimates/uncertainty. Future events are
affected by economic, political and technological changes taking place.

6. Impact on Firms Future Competitive Strengths: These decisions determine future profit or cost
and hence affect the competitive strengths of firm.

7. Impact on Cost Structure: Due to this vital decision, firm commits itself to fixed costs such as
supervision, insurance, rent, interest etc. If investment does not generate anticipated profit, future
profitability would be affected.

Objectives of Capital Budgeting

The following are the objectives of capital budgeting.

1. To find out the profitable capital expenditure.

2. To know whether the replacement of any existing fixed assets gives more return than earlier.

3. To decide whether a specified project is to be selected or not.

4. To find out the quantum of finance required for the capital expenditure.
5. To assess the various sources of finance for capital expenditure.

6. To evaluate the merits of each proposal to decide which project is best.

Features of Capital Budgeting

The features of capital budgeting are briefly explained below:

1. Capital budgeting involves the investment of funds currently for getting benefits in the future.
2. Generally, the future benefits are spread over several years.

3. The long term investment is fixed.

4. The investments made in the project is determining the financial condition of business
organization in future.

5. Each project involves huge amount of funds.

6. Capital expenditure decisions are irreversible.

7. The profitability of the business concern is based on the quantum of investments made in the
project.

Techniques Used in Investment Decision Making

Most commonly used technique in investment decision making are given below:

1. Payback Period Method: It is one of the simplest methods to calculate period within which
entire cost of project would be completely recovered. It is the period within which total cash
inflows from project would be equal to total cash outflow of project. Here, cash inflow means
profit after tax but before depreciation.

Merits of Payback period Method

i. This method of evaluating proposals for capital budgeting is simple and easy to understand, it
has an advantage of making clear that it has no profit on any project until the payback period is
over i.e. until capital invested is recovered. This method is particularly suitable in the case of
industries where risk of technological services is very high.

ii. In case of routine projects also, use of payback period method favours projects that generates
cash inflows in earlier years, thereby eliminating projects bringing cash inflows in later years
that generally are conceived to be risky as this tends to increase with futurity.

iii. By stressing earlier cash inflows, liquidity dimension is also considered in selection criteria.
This is important in situations of liquidity crunch and high cost of capital.
iv. Payback period can be compared to break-even point, the point at which costs are fully
recovered but profits are yet to commence.

v. The risk associated with a project arises due to uncertainty associated with cash inflows. A
shorter payback period means that uncertainty with respect to project is resolved faster.

Limitations of Payback Period

i. It stresses capital recovery rather than profitability. It does not take into account returns from
the project after its payback period.

ii. This method becomes an inadequate measure of evaluating 2 projects where the cash inflows
are uneven.

iii. This method does not give any consideration to time value of money, cash flows occurring at
all points of time are simply added.

iv. Post-payback period profitability is ignored totally.

2. Accounting Rate of Return (Average Rate of Return – ARR): ARR is a financial ratio used in
capital budgeting. The ratio does not take into account the concept of time value of money. ARR
calculates the return, generated from net income of the proposed capital investment. The ARR is
a percentage return. Say, if ARR = 7%, then it means that the project is expected to earn seven
cents out of each dollar invested. If the ARR is equal to or greater than the required rate of
return, the project is acceptable. If it is less than the desired rate, it should be rejected. When
comparing investments, the higher the ARR, the more attractive the investment. Over one-half of
large firms calculate ARR when appraising projects. It is calculated with the help of the
following formula:

ARR=Average Profit / Investment

Merits of ARR
a. It is simple, common sense oriented method.

b. Profits of all years taken into account.

c. It considers actual net profit of the project.

Demerits of ARR
a. Time value of-money is not considered

b. Risk involved in the project is not considered

c. Annual average profits might be same for different projects but accrual of profits might differ
having significant implications on risk and liquidity
d. The ARR has several variants and that it lacks uniform understanding.

3. Net Present Value (NPV) Method: The best method for evaluation of investment proposal is
net present value method or discounted cash flow technique. This method takes into account the
time value of money. The net present value of investment proposal may be defined as sum of the
present values of all cash inflows as reduced by the present values of all cash outflows
associated with the proposal. Each project involves certain investments and commitment of cash
at certain point of time. This is known as cash outflows.
Cash inflows can be calculated by adding depreciation to profit after tax arising out of that
particular project.

Merits of NPV method:

i. NPV method takes into account the time value of money.

ii. The whole stream of cash flows is considered.

iii. NPV can be seen as addition to the wealth of shareholders. The criterion of NPV is thus in
conformity with basic financial objectives.

iv. NPV uses discounted cash flows i.e. expresses cash flows in terms of current rupees. NPV's
of different projects therefore can be compared. It implies that each project can be evaluated
independent of others on its own merits.

Limitations of NPV Method:

i.It involves different calculations.

ii. The application of this method necessitates forecasting cash flows and the discount rate. Thus
accuracy of NPV depends on accurate estimation of these 2 factors that may be quite difficult in
reality.

iii. The ranking of projects depends on the discount rate.