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 enterprise. It means applying general management principles to
financial resources of the enterprise.
Scope 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 has 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 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 has 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 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 and salaries, payment of electricity and water bills, payment to
creditors, meeting current liabilities, maintenance 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 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
Relationship with Economics
Relationship with Accounting
Relationship with
Mathematics, Statistics and QT
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.
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)
= PV X (1 + r)n
Compound Interest = FV – Principal
PV = FV / (1 + r)n
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)n
Present Value Factor (PVF)
= 1/ (1 + r)n
PVF < 0 (PVF will always
be less than 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)n
Compound Value Factor (CVF)
= (1 + r)n
CVF > 1 (CVF will always
be more than One)
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