Introduction to Financial Management

 

Financial Management

Meaning of Financial Management

Financial Management means planning, organizing, directing and controlling the Financial activities such as procurement and utilization of funds of the business. it means applying general management principles to financial resources of the business.

Scope of Financial Management

1.     Investment Decisions – This 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 Decisions – The finance manager must 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 must be decided.

b.     Retained Profits – Amount of retained profits must be finalized which will depend upon expansion and diversification plans of the business.

Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and control of Financial resources of a concern. The objective 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 shares, 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.     Ton ensure safety of investments, 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 must 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 must be made in an adequate manner which increases earning capacity of the business.

2.     Determination of Capital composition: Once the estimation has been made, the capital structure has to be decided. This involves Short-Term and Long-Term debt equity analysis. This will depend upon the proportion of quity capital a company is possessing and additional funds which must 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 must 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 must 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 must be decided which will depend upon expansional, innovational, diversification plans of the company.

 

6.     Management of cash: Finance manager must make decisions with regards to cash management. Cash is required for many purposes like payment of wages & salaries, payment of electricity and water bills, payment to creditors, meeting current liabilities, maintenance of enough stock, purchases of raw materials, etc.

7.     Financial controls: The Finance manager has not only to plan, procure and utilize the funds but he also must exercise control over finances. This can be done through many techniques like ratio analysis, financial forecasting, cost and profit control, etc.

Wealth Maximization V/s Profit Maximization

 

The key difference between Wealth and Profit Maximization is that Wealth maximization is the long term objective of the company to increase the value of the stock of the company thereby increasing shareholders wealth to attain the leadership position in the market, whereas, profit maximization is to increase the capability of earning profits in the short run to make the company survive and grow in the existing competitive market.

Difference Between Wealth & Profit Maximization

Wealth Maximization consists of a set of activities that manage the financial resources intending to increase the value of the stakeholders, whereas, Profit Maximization consists of the activities that manage the financial resources intending to increase the Profitability of the Company.

What is Wealth Maximization?

The ability of a company to increase the value of its stock for all the stakeholders is referred to as Wealth Maximization. It is a long-term goal and involves multiple external factors like sales, products, services, market share, etc. It assumes the risk and recognizes the time value of money given the business environment of the operating entity. It is mainly concerned with the long-term growth of the company and hence is concerned more about fetching the maximum chunk of the market share to attain a leadership position.

What is Profit Maximization?

The process of increasing the profit earning capability of the company is referred to as Profit Maximization. It is mainly a short-term goal and is primarily restricted to the accounting analysis of the financial year. It ignores the risk and avoids the time value of money. It is primarily concerned as to how the company will survive and grow in the existing competitive business environment.

Changing Role of Finance Manager

In the wake of fierce global competitiveness, path breaking technological advancement, increasing regulatory requirements, changes in business models, growing internalization of business and sensitivity of financial market, Indian business to survive and thrive and compete globally will have to redefine the role of their finance managers so that their focus is less on traditional finance jobs like transaction processing, budgeting and capital raising and instead more on strategy making and managing risk and ensure greater transparency in corporate reporting.

Today’s finance managers are expected not only to confine themselves to financial planning, capital raising, managing assets and monitoring with new perspectives, new approaches and new skills but also to assume the role of strategic partner and participate actively in the front – end of strategic thinking, building and reviewing business portfolio, managing risk and act as an agent among various constituencies within and outside the organization.

The basic functions of a Finance Manager are as follows –

1.      Estimating the Capital Requirements

2.      Financing or Capital Structure Decisions

3.      Utilization of Funds or Investment Decisions

4.      Disposal of Surplus or Dividend Decisions

5.      Management of Cash

6.      Financial Control

 

Relationship with Other Management Areas

1.      Relationship with Economics

2.      Relationship with Accounting

3.      Relationship with Mathematics, Statistics and QT

4.      Relationship with Other Disciplines (Marketing/ Production/ Personnel ….)

 

Agency Problem

 

In modern organization there is separation of ownership and management. The management acts on behalf of owners and is their agent. Consequently, management should act in such manner so as to maximize wealth of their principals. However, this may not happen because owners and management have different interests. Due to these reasons’ management may behave in a manner which is inconsistent with the interest of owners. These behavioural problems on the part of management lead to agency problems.

 

Organization of Finance Function

 

Mainly the finance function is divided in 2 broad areas – Controller and Treasurer

Controller (Manager -Accounts) is concerned primarily with planning accounting and control activities.

The Treasurer (Manager – Finance) is responsible mainly for financing, management of cash & receivables and investment activities.

Time Value of Money

The money which is receivable at present has more value than the money receivable in the future. The relationship that exists between the value of money receivable at present and the value of money receivable at future is referred as “Time Value of Money”.

From the above it is clear that the money at present is always more value then the same amount of money in future, that is due to Time Value of Money.

Interest:

Interest is an amount that accrues on the money borrowed / lent at present for a particular period. Interest can also be understood as the rent paid on the money or the price of using the money.

The rate at which the accrues is called as Interest Rate. Interest Rate is usually stated for a year, i.e. *% p.a., 13% p.a., etc.

 

Types of Interest

There are two types of Interest -

1. Simple Interest

2. Compound Interest

 

Simple Interest

SI is the Interest which accrues only on the principal amount of loan. That means that the interest is charged only on the original amount of money borrowed / lent. 

Simple Interest = Amount(P) X Rate of Interest(r) X Time Period (t)

                                 SI = Prt

Formula to calculate Future Value & Principal (Simple Interest Basis)

Future Value of Money (FV) = P + Prt or P (1 + rt)

Principal (P) =    FV/ (1+rt)

Compound Interest

Compound Interest is the Interest which accrues not only on the principal amount but also on the amount of Interest due. In simple words compound interest charges Interest on Interest.

Formula to calculate Future Value & Principal (Compound Interest Basis)

Future Value of Money (FV) = P X (1 + r)^t

Compound Interest (CI) = FV – Principal

Principal (P) = FV / (1 + r)^t 

Present Value

Present value is the concept that states an amount of money today is worth more than that same amount in the future. In other words, money received in the future is not worth as much as an equal amount received today. Receiving Rs.1,000 today is worth more than Rs. 1,000 five years from now.

Present value is the current value of the future sum of money, at a specified rate of return. The future cash flows would be discounted. The higher the discount rate, the lower is the present value of the future cash flows. 

In Simple words, PV is the difference between Future Value (FV) and Interest for the period. It is the FV of money discounted at a given rate of interest.

PV = FV / (1 + r)^t

Present Value Factor (PVF) = 1/ (1 + r)^t

PVF < 0 (PVF will always be less then Zero)

Future Value

Future value is what a sum of money invested today will become over time, at a given rate of interest.

FV is the sum of the Present Value of Money and the Interest accrued on it over a period of time at a rate of Interest.

FV = PV (1 + r)^t

Compound Value Factor (CVF) = (1 + r)^t

CVF > 1 (CVF will always be more than One)