9.1 Management of Financial Resources
9.1 Management of Financial Resources
9.1 Management of Financial Resources
FINANCIAL MANAGEMENT
LEARNING OUTCOMES
FINANCIAL MANAGEMENT
1.1 INTRODUCTION
We will like to explain Financial Management by giving a very simple scenario. For
the purpose of starting any new business/venture, an entrepreneur goes through
the following stages of decision making:-
Stage 1 Stage 2 Stage 3 Stage 4
While deciding how much to take from each source, the entrepreneur would keep
in mind the cost of capital for each source (Interest/Dividend etc.). As an
entrepreneur he would like to keep the cost of capital low.
Thus, financial management is concerned with efficient acquisition (financing) and
allocation (investment in assets, working capital etc.) of funds with an objective to
make profit (dividend) for owners. In other words, focus of financial management
is to address three major financial decision areas namely, investment, financing
and dividend decisions.
Any business enterprise requiring money and the 3 key questions being enquired
into
1. Where to get the money from? (Financing Decision)
2. Where to invest the money? (Investment Decision)
3. How much to distribute amongst shareholders to keep them satisfied?
(Dividend Decision)
enterprise. The analysis of these decisions is based on the expected inflows and
outflows of funds and their effect on managerial objectives.
There are two basic aspects of financial management viz., procurement of funds and
an effective use of these funds to achieve business objectives.
Funds procured from different sources have different characteristics in terms of risk,
cost and control. The cost of funds should be at the minimum level for that a proper
balancing of risk and control factors must be carried out.
Another key consideration in choosing the source of new business finance is to strike
a balance between equity and debt to ensure the funding structure suits the business.
Let us discuss some of the sources of funds:
(a) Equity: The funds raised by the issue of equity shares are the best from the risk
point of view for the firm, since there is no question of repayment of equity capital
except when the firm is under liquidation. From the cost point of view, however,
equity capital is usually the most expensive source of funds. This is because the
dividend expectations of shareholders are normally higher than prevalent
interest rate and also because dividends are an appropriation of profit, not
allowed as an expense under the Income Tax Act. Also the issue of new shares
to public may dilute the control of the existing shareholders.
(c) Funding from Banks: Commercial Banks play an important role in funding of the
business enterprises. Apart from supporting businesses in their routine activities
(deposits, payments etc.) they play an important role in meeting the long term
and short term needs of a business enterprise. Different lending services
provided by Commercial Banks are depicted as follows:-
1.6 FINANCIAL MANAGEMENT
(d) International Funding: Funding today is not limited to domestic market. With
liberalization and globalization a business enterprise has options to raise capital
from International markets also. Foreign Direct Investment (FDI) and Foreign
Institutional Investors (FII) are two major routes for raising funds from foreign
sources besides ADR’s (American depository receipts) and GDR’s (Global
depository receipts). Obviously, the mechanism of procurement of funds has to
be modified in the light of the requirements of foreign investors.
1.2.2 Effective Utilisation of Funds
The finance manager is also responsible for effective utilisation of funds. He has to
point out situations where the funds are being kept idle or where proper use of funds
is not being made. All the funds are procured at a certain cost and after entailing a
certain amount of risk. If these funds are not utilised in the manner so that they
generate an income higher than the cost of procuring them, there is no point in running
the business. Hence, it is crucial to employ the funds properly and profitably. Some of
the aspects of funds utilization are:-
(a) Utilization for Fixed Assets: The funds are to be invested in the manner so that
the company can produce at its optimum level without endangering its financial
solvency. For this, the finance manager would be required to possess sound
knowledge of techniques of capital budgeting.
Capital budgeting (or investment appraisal) is the planning process used to
determine whether a firm's long term investments such as new machinery,
replacement machinery, new plants, new products, and research development
projects would provide the desired return (profit).
(b) Utilization for Working Capital: The finance manager must also keep in view the
need for adequate working capital and ensure that while the firms enjoy an
optimum level of working capital they do not keep too much funds blocked in
inventories, book debts, cash etc.
liquidation, etc. Also, when taking financial decisions in the organisation, the needs of
outsiders (investment bankers, people who lend money to the business and other such
people) to the business was kept in mind.
The Transitional Phase: During this phase, the day-to-day problems that financial
managers faced were given importance. The general problems related to funds
analysis, planning and control were given more attention in this phase.
The Modern Phase: Modern phase is still going on. The scope of financial
management has greatly increased now. It is important to carry out financial analysis
for a company. This analysis helps in decision making. During this phase, many
theories have been developed regarding efficient markets, capital budgeting, option
pricing, valuation models and also in several other important fields in financial
management.
The finance functions are divided into long term and short term
functions/decisions
Long term Finance Function Decisions.
(a) Investment decisions (I): These decisions relate to the selection of assets in
which funds will be invested by a firm. Funds procured from different sources
have to be invested in various kinds of assets. Long term funds are used in a
project for various fixed assets and also for current assets. The investment of
funds in a project has to be made after careful assessment of the various projects
through capital budgeting. A part of long term funds is also to be kept for
financing the working capital requirements. Asset management policies are to
be laid down regarding various items of current assets. The inventory policy
would be determined by the production manager and the finance manager
keeping in view the requirement of production and the future price estimates of
raw materials and the availability of funds.
(b) Financing decisions (F): These decisions relate to acquiring the optimum finance
to meet financial objectives and seeing that fixed and working capital are
1.8 FINANCIAL MANAGEMENT
All three types of decisions are interrelated, the first two pertaining to any kind of
organisation while the third relates only to profit-making organisations, thus it can be
seen that financial management is of vital importance at every level of business
activity, from a sole trader to the largest multinational corporation.
Short- term Finance Decisions/Function.
Working capital Management (WCM): Generally short term decision are
reduced to management of current asset and current liability (i.e., working
capital Management)
SCOPE AND OBJECTIVES OF FINANCIAL MANAGEMENT 1.9
The scope of financial management has undergone changes over the years. Until the
middle of this century, its scope was limited to procurement of funds under major
events in the life of the enterprise such as promotion, expansion, merger, etc. In the
modern times, the financial management includes besides procurement of funds, the
three different kinds of decisions as well namely investment, financing and dividend.
All the three types of decisions would be dealt in detail during the course of this
chapter.
The given figure depicts the overview of the scope and functions of financial
management. It also gives the interrelation between the market value, financial
decisions and risk return trade off. The finance manager, in a bid to maximize
shareholders’ wealth, should strive to maximize returns in relation to the given risk; he
should seek courses of actions that avoid unnecessary risks. To ensure maximum
return, funds flowing in and out of the firm should be constantly monitored to assure
that they are safeguarded and properly utilized.
It is important that benefits measured by the finance manager are in terms of cash
flow. Finance manager should emphasis on Cash flow for investment or financing
decisions not on Accounting profit. The shareholder value maximization model holds
that the primary goal of the firm is to maximize its market value and implies that
business decisions should seek to increase the net present value of the economic
profits of the firm. So for measuring and maximising shareholders wealth finance
manager should follow:
Cash Flow approach not Accounting Profit
Cost benefit analysis
Application of time value of money.
How do we measure the value/wealth of a firm?
According to Van Horne, “Value of a firm is represented by the market price of the
company's common stock. The market price of a firm's stock represents the focal
judgment of all market participants as to what the value of the particular firm is. It takes
into account present and prospective future earnings per share, the timing and risk of
these earnings, the dividend policy of the firm and many other factors that bear upon
the market price of the stock. The market price serves as a performance index or report
card of the firm's progress. It indicates how well management is doing on behalf of
stockholders.”
SCOPE AND OBJECTIVES OF FINANCIAL MANAGEMENT 1.13
Value of a firm (V) = Number of Shares (N) × Market price of shares (MP)
Or
V = Value of equity (Ve ) + Value of debt (Vd )
Why Wealth Maximization Works? Before we answer this question it is important to first
understand and know what other goals a business enterprise may have. Some of the
other goals a business enterprise may follow are:-
Achieving a higher growth rate
Attaining a larger market share
Gaining leadership in the market in terms of products and technology
Promoting employee welfare
Increasing customer satisfaction
Improving community life, supporting education and research, solving societal
problems, etc.
FINANCIAL MANAGEMENT
Though, the above goals are important but the primary goal remains to be wealth
maximization, as it is critical for the very existence of the business enterprise. If this
goal is not met, public/institutions would lose confidence in the enterprise and will not
invest further in the growth of the organization. If the growth of the organization is
restricted than the other goals like community welfare will not get fulfilled.
Every entity associated with the company will evaluate the performance of the
management from the fulfilment of its own objective. The survival of the management
will be threatened if the objective of any of the entities remains unfulfilled.
The wealth maximization objective is generally in accord with the interests of the
various groups such as owners, employees, creditors and society, and thus, it may be
consistent with the management objective of survival.
The table below highlights some of the advantages and disadvantages of both profit
maximization and wealth maximization goals:-
To sum it up, the finance executive of an organisation plays an important role in the
company’s goals, policies, and financial success. His responsibilities include:
(a) Financial analysis and planning: Determining the proper amount of funds to
employ in the firm, i.e. designating the size of the firm and its rate of growth.
(b) Investment decisions:The efficient allocation of funds to specific assets.
(c) Financing and capital structure decisions: Raising funds on favourable terms
as possible i.e. determining the composition of liabilities.
(d) Management of financial resources (such as working capital).
(e) Risk management: Protecting assets.
The figure below shows how the finance function in a large organization may be
organized.
SCOPE AND OBJECTIVES OF FINANCIAL MANAGEMENT 1.17
Treatment of Funds
In accounting, the measurement of funds is based on the accrual principle i.e. revenue
is recognised at the point of sale and not when collected and expenses are recognised
when they are incurred rather than when actually paid. The accrual based accounting
data do not reflect fully the financial conditions of the organisation. An organisation
which has earned profit (sales less expenses) may said to be profitable in the
accounting sense but it may not be able to meet its current obligations due to shortage
of liquidity as a result of say, uncollectible receivables. Such an organisation will not
survive regardless of its levels of profits. Whereas, the treatment of funds in financial
management is based on cash flows. The revenues are recognised only when cash is
actually received (i.e. cash inflow) and expenses are recognised on actual payment
(i.e. cash outflow). This is so because the finance manager is concerned with
maintaining solvency of the organisation by providing the cash flows necessary to
satisfy its obligations and acquiring and financing the assets needed to achieve the
goals of the organisation. Thus, cash flow based returns help financial managers to
avoid insolvency and achieve desired financial goals.
Decision – making
The purpose of accounting is to collect and present financial data of the past, present
and future operations of the organization. The financial manager uses these data for
financial decision making. It is not that the financial managers cannot collect data or
accountants cannot make decisions, but the chief focus of an accountant is to collect
data and present the data while the financial manager’s primary responsibility relates
to financial planning, controlling and decision making. Thus, in a way it can be stated
that financial management begins where accounting ends.
1.11.2 Financial Management and Other Related Disciplines
For its day to day decision making process, financial management also draws on other
related disciplines such as marketing, production and quantitative methods apart from
accounting. For instance, financial managers should consider the impact of new
product development and promotion plans made in marketing area since their plans
will require capital outlays and have an impact on the projected cash flows. Likewise,
changes in the production process may require capital expenditures which the financial
managers must evaluate and finance. Finally, the tools and techniques of analysis
developed in the quantitative methods discipline are helpful in analyzing complex
financial management problems.
FINANCIAL MANAGEMENT
lender and equity investors. The agency problem of debt lender would be addressed
by imposing negative covenants i.e. the managers cannot borrow beyond a point. This
is one of the most important concepts of modern day finance and the application of
this would be applied in the Credit Risk Management of Bank, Fund Raising, Valuing
distressed companies.
Agency problem between the managers and shareholders can be addressed if the
interests of
the managers are aligned to the interests of the share- holders. It is easier said than
done.
However, following efforts have been made to address these issues:
Managerial compensation is linked to profit of the company to some extent and also
with the long term objectives of the company.
Employee is also designed to address the issue with the underlying assumption that
maximisation of the stock price is the objective of the investors.
Effecting monitoring can be done.
SUMMARY
Financial Management is concerned with efficient acquisition (financing) and
allocation (investment in assets, working capital etc) of funds.
In the modern times, the financial management includes besides procurement
of funds, the three different kinds of decisions as well namely investment,
financing and dividend.
Out of the two objectives, profit maximization and wealth maximization, in
today’s real world situations which is uncertain and multi-period in nature,
wealth maximization is a better objective.
Today the role of chief financial officer, or CFO, is no longer confined to
accounting, financial reporting and risk management. It’s about being a
strategic business partner of the chief executive officer.
The relationship between financial management and accounting are closely
related to the extent that accounting is an important input in financial decision
making.
Managers may work against the interest of the shareholders and try to fulfill
their own objectives. This is known as agency problem.