Financial Management:

UNIT I
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 of Financial Management

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.

2. 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.
3. 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.

4 Financial controls: The finance manager has not only to plan, procure and utilize the
funds but he also has to exercise control over finances.

Finance Functions

The following explanation will help in understanding each finance function in detail
Investment Decision

One of the most important finance functions is to intelligently allocate capital to long term assets.
This activity is also known as capital budgeting.

It is important to allocate capital in those long term assets so as to get maximum yield in
future. Following are the two aspects of investment decision

a. Evaluation of new investment in terms of profitability

b. Comparison of cut off rate against new investment and prevailing investment.

Since the future is uncertain therefore there are difficulties in calculation of expected return.

Along with uncertainty comes the risk factor which has to be taken into consideration. This risk
factor plays a very significant role in calculating the expected return of the prospective
investment.

Therefore while considering investment proposal it is important to take into consideration both
expected return and the risk involved.

Investment decision not only involves allocating capital to long term assets but also involves
decisions of using funds which are obtained by selling those assets which become less profitable
and less productive.

It is a wise decision to decompose depreciated assets which are not adding value and utilize those
funds in securing other beneficial assets.

An opportunity cost of capital needs to be calculating while dissolving such assets. The correct
cut off rate is calculated by using this opportunity cost of the required rate of return (RRR)

Financial Decision

Financial decision is yet another important function which a financial manger must perform. It is
important to make wise decisions about when, where and how should a business acquire funds.

Funds can be acquired through many ways and channels. Broadly speaking a correct ratio of an
equity and debt has to be maintained. This mix of equity capital and debt is known as a firm’s
capital structure.

A firm tends to benefit most when the market value of a company’s share maximizes this not
only is a sign of growth for the firm but also maximizes shareholders wealth. On the other hand
the use of debt affects the risk and return of a shareholder. It is more risky though it may increase
the return on equity funds.

A sound financial structure is said to be one which aims at maximizing shareholders return
with minimum risk. In such a scenario the market value of the firm will maximize and hence an
optimum capital structure would be achieved.
Other than equity and debt there are several other tools which are used in deciding a firm capital
structure.

Dividend Decision

Earning profit or a positive return is a common aim of all the businesses. But the key function a
financial manger performs in case of profitability is to decide whether to distribute all the profits
to the shareholder or retain all the profits or distribute part of the profits to the shareholder and
retain the other half in the business.

It’s the financial manager’s responsibility to decide a optimum dividend policy which maximizes
the market value of the firm. Hence an optimum dividend payout ratio is calculated.

It is a common practice to pay regular dividends in case of profitability. Another way is to issue
bonus shares to existing shareholders.

Liquidity Decision

It is very important to maintain a liquidity position of a firm to avoid insolvency. Firm’s

profitability, liquidity and risk all are associated with the investment in current assets.

In order to maintain a tradeoff between profitability and liquidity it is important to invest

sufficient funds in current assets. But since current assets do not earn anything for business
therefore a proper calculation must be done before investing in current assets.

Current assets should properly be valued and disposed of from time to time once they become
non profitable. Currents assets must be used in times of liquidity problems and times of
insolvency.

Role of a Financial Manager

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/Her 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

1. The size of the firm and its growth capability

2. Status of assets whether they are long-term or short-term
3. 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.

Short-term sources of short term funds.

Short-term sources: Funds which are required for a period not exceeding one year are called
short-term sources. The major sources of short term funds are:
1. Indigenous Bankers
2. Trade Credit
3.Installment Credit
4. Advances
5. Factoring
6. Accrued Expenses
7. Deferred Incomes
8. Commercial Paper
9. Commercial Banks
10. Public Deposits.

.1 Indigenous Bankers: Private money-leaders and other country bankers used to be the only
sources of finance prior to the establishment of commercial banks. They used to charge very high
rates of interest and exploited the customers to the largest extent possible.

2 Trade Credit: Trade credit refers to the credit extended by the suppliers of goods in the normal
course of business. As present day commerce is built upon credit, the trade credit arrangement of
a firm with its suppliers is an important source of short-term finance. The creditworthiness of a
firm and the confidence of its suppliers are the main basis of securing trade credit.
The main advantages of trade credit as a source of short-term finance include:
(i) It is easy and convenient method of finance.
(ii) It is flexible as the credit increases with the growth of the firm.
(iii) It is informal and spontaneous source of finance.
(iv) The biggest disadvantage of this method of finance is charging of higher
prices by the suppliers and loss of cash discount.

3. Installment Credit: This is another method by which the assets are purchased and the
possession of goods is taken immediately but the payment is made in Installment over a pre-
determined period of time. Generally, interest is charged on the unpaid price or it may be adjusted
in the price.

4. Advances: Some business houses get advances from their customers and agents against orders
and this source is a short-term source of finance for them. It is a cheap source of finance and in
order to minimise their investment in working capital, some firms having long production cycle,
especially the firms manufacturing industrial products prefer to take advance from their
customers.
5. Factoring: Another method of raising short-term finance is through account receivable credit
offered by commercial banks and factors. A commercial bank may provide finance by
discounting the bills or invoices of its customers. Thus, a firm gets immediate payment for
sales made on credit.
 6. Accrued Expenses: Accrued expenses are the expenses which have been incurred but not yet
due and hence not yet paid also. These simply represent a liability that a firm has to pay for the
services already received by it. The most important items of accruals are wages and salaries,
interest, and taxes.
7. Deferred Incomes: Deferred incomes are incomes received in advance before supplying goods
or services. They represent funds received by a firm for which it has to supply goods or services
in future. These funds increase the liquidity of a firm and constitute an important source of short-
term finance.8Commercial Paper: 8 Commercial paper represents unsecured promissory notes
issued by firms to raise short-term funds. It is an important money market instrument in
advanced countries like U.S.A. In India, the Reserve Bank of India introduced commercial paper
in the Indian money market on the recommendations of the Working Group on Money Market
(Vaghul Committee).
9 Commercial Banks: Commercial banks are the most important source of short-term
capital. The major portion of working capital loans are provided by commercial banks. They
provide a wide variety of loans tailored to meet the specific requirements of a concern. The
different forms in which the banks normally provide loans and advances are as follows: (a) Loans
(b) Cash Credits (c) Overdrafts, and (d) Purchasing and discounting of bills
10 Acceptance of fixed deposits from the public by all type of manufacturing and non-bank
financial companies in the private sector has been a unique feature of Indian financial system. The
importance of such deposits in financing of Indian industries was recognised as early as in 1931
by the Indian Central Banking Enquiry Committee. Since January 1967, the Government of India
has tried to restrict the growth of company deposits through various measures. The primary
objective of exercising control over public deposits has been to regulate the growth of deposits
outside the banking sector as well as to provide some protection to the investors in such deposits.
But, in spite of the restrictive measures, public deposits with the nonbanking corporate sector
have become a significant part of corporate financing.

Long Term Sources of Finance

Let us explain the long term sources of finance . They are further divided into 2 categories i.e..
internal long-term sources of finance and external long-term sources of finance. Let us
understand this in more detail below:

External Long Term Sources of Finance

You can check below some of the external long term sources of finance which might be a good
option for your business or your organization.

Equity Share Capital

It is the main sources of finance, which any organization would look before beginning the
business. Equity share capital is the best alternative when looking for permanent sources of
capital. It expresses the ownership rights of an organization. A public company may
raise assets or funds from promoters, investors or individuals by issuing common equity shares
of a company.
 These shareholders / investors are paid dividends just when there are distributable earnings. The
risk of value investors is restricted up to the worth of the shares face value.

Preference Share Capital

Those individuals who are more keen towards payment of dividends at regular intervals rather
than appreciation of capital value. In case of liquidation, preference shareholders are paid
initially and then equity shareholders are been paid. Long term sources of funds from preference
shares are raised by offering public issue of shares.

It does not require any security as well as they do not have ownership privilege in an
organization. It has a few attributes of debt capital as well as some of equity capital. There are
different types of preference share capital issued by a company as a long term sources of finance,
they are:

 Convertible Preference Shares.

 Non-convertible Preference Shares.

 Non-participating Preference Shares.

 Participating Preference Shares.

 Non-participating Preference Shares.

 Redeemable Preference Shares.

 Irredeemable Preference Shares.

 Cumulative Preference Shares.

 Non-cumulative Preference Shares.

Loans from Financial Institutions

When the firm either takes loan / finance from banks or from non-banking financial institutions
which are repayable following 3, 5 or under 10 years then it is represented as long term sources
of finance.

Financial Institutions give long-term loans for financial needs to private as well as public firms.
For the most part company’s get long-term sources of finance by raising term loans. Below are
some of the financial institutions that provides such types of term loans, they are: Nationalized
Commercial Banks.

 Development Banks.

 Government Financial Institutions.

 Other Investment Organizations.

Debentures
A debenture is a debt record of declaration with a typical seal of an organization. It contains
terms and conditions of debt repayment, rate of interest payments, redemption / maturity of debt
and more and the information related to security offered by an organization. There are various
different types of debentures issued by a company for long term sources of finance, they are:

 Secured or Mortgage Debenture.

 Simple or Naked Debentures.

 Bearer Debentures.

 Convertible Debentures.

 Non-Convertible Debentures.

 Redeemable Debentures.

 Registered Debentures.

 Irredeemable Debentures.

 Right Debentures

Internal Long Term Sources of Finance

Below are some of the internal long term sources of finance which you can think of when you
are looking around for sources of financing options.

Retained Earnings
That income which the organization has accumulated throughout the years and in this manner, it
tends to be known as reserve funds of the organization. These undistributed profits kept as a
reserve fund are then utilized by the organization at specific point for specified purpose. For
example: business expansion, investing in research of new products, diversification programmes
etc. In spite of the fact, it is one of the essential methods for long term sources of finance mostly
for improvement, development or expansion of an organization.