UNIT ONE

CORE CONCEPTS
OF FINANCIAL
MANAGEMENT

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 UNIT ONE

CHAPTER ONE
INTRODUCTION

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 Lesson 1
Chapter 1
Introduction
Unit 1
Core concepts in financial management
After reading this lesson you will be able to understand the following: -
>Concept of ‘Finance’ under different approaches.
>Significance of ‘Finance’.
>Nature of financial management.
>Relationship between finance and other important functions of the organization.
>Role of a Finance Manager in an organization.
>New challenges faced by the finance manager.

A very warm welcome to all my students in Third Trimester of PGPACM course at NICMAR,
Hyderabad Campus. I will be teaching you FINANCIAL MANAGEMENT; I must tell you
that I find this subject as the most interesting subject and all my efforts will be to make it very
interesting for you as well. Let’s discuss

Almost every firm, government agency, and organization has one or more financial managers
who oversee the preparation of financial reports, direct investment activities, and implement cash
management strategies. As computers are increasingly used to record and organize data, many
financial managers are spending more time developing strategies and implementing the long-
term goals of their organization.

The duties of financial managers vary with their specific titles, which include controller,
treasurer or finance officer, credit manager, cash manager, and risk and insurance manager.
Controllers direct the preparation of financial reports that summarize and forecast the
organization’s financial position, such as income statements, balance sheets, and analyses of
future earnings or expenses. Regulatory authorities also in charge of preparing special reports
require controllers. Often, controllers oversee the accounting, audit, and budget departments.
Treasurers and finance officers direct the organization’s financial goals, objectives, and budgets.
They oversee the investment of funds and manage associated risks, supervise cash management
activities, execute capital-raising strategies to support a firm’s expansion, and deal with mergers
and acquisitions. Credit managers oversee the firm’s issuance of credit. They establish credit-
rating criteria, determine credit ceilings, and monitor the collections of past-due accounts.
Managers specializing in international finance develop financial and accounting systems for the
banking transactions of multinational organizations.

Cash managers monitor and control the flow of cash receipts and disbursements to meet the
business and investment needs of the firm. For example, cash flow projections are needed to
determine whether loans must be obtained to meet cash requirements or whether surplus cash
should be invested in interest-bearing instruments. Risk and insurance managers oversee
programs to minimize risks and losses that might arise from financial transactions and business
operations undertaken by the institution. They also manage the organization’s insurance budget.

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Financial institutions, such as commercial banks, savings and loan associations, credit unions,
and mortgage and finance companies, employ additional financial managers who oversee various
functions, such as lending, trusts, mortgages, and investments, or programs, including sales,
operations, or electronic financial services. These managers may be required to solicit business,
authorize loans, and direct the investment of funds, always adhering to Federal and State laws
and regulations.

Branch managers of financial institutions administer and manage all of the functions of a branch
office, which may include hiring personnel, approving loans and lines of credit, establishing a
rapport with the community to attract business, and assisting customers with account problems.
Financial managers who work for financial institutions must keep abreast of the rapidly growing
array of financial services and products. In addition to the general duties described above, all
financial managers perform tasks unique to their organization or industry. For example,
government financial managers must be experts on the government appropriations and budgeting
processes, whereas healthcare financial managers must be knowledgeable about issues
surrounding healthcare financing. Moreover, financial managers must be aware of special tax
laws and regulations that affect their industry.

Financial managers play an increasingly important role in mergers and consolidations, and in
global expansion and related financing. These areas require extensive, specialized knowledge on
the part of the financial manager to reduce risks and maximize profit. Financial managers
increasingly are hired on a temporary basis to advise senior managers on these and other matters.
In fact, some small firms contract out all accounting and financial functions to companies that
provide these services.

The role of the financial manager, particularly in business, is changing in response to

technological advances that have significantly reduced the amount of time it takes to produce
financial reports. Financial managers now perform more data analysis and use it to offer senior
managers ideas on how to maximize profits. They often work on teams, acting as business
advisors to top management. Financial managers need to keep abreast of the latest computer
technology in order to increase the efficiency of their firm’s financial operations.

We all have heard about the term finance, let us discuss on what does it mean and why do you
as a student of PGPACM want to study it?
Finance can be defined as the art and science of managing money. Virtually all individuals and
organizations earn or raise money and spend or invest money. Finance is concerned with the
process, institutions, markets, and instruments involved in the transfer of money among and
between individuals, businesses, and governments.

Why study finance?

An understanding of the concepts, techniques, and practices presented in this course will fully
acquaint you with the financial manager's activities. Because most business decisions are
measured in financial terms, the financial manager plays a key role in the operation of the firm.
People in all areas of responsibility accounting, information systems, management, marketing,
and operations- need a basic understanding of the managerial finance function. All managers in

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the firm, regardless of their job descriptions, work with financial personnel to justify personnel
requirements, negotiate operating budgets, deal with financial performance appraisals, and sell
proposals based at least in part on their financial' merits. Clearly, those managers who understand
the financial decision- making process will be better able to address financial concerns, and will
therefore more often get the resources they need to accomplish their own goals.

To make informed decisions about where to get and put money in order to maximize value in
both personal and business decisions.

I know you want to ask the following question: -

If I have no intention of becoming a financial manger, why do I need to understand
financial management?
One good reason is “to prepare yourself for the workplace of the future”. More and more
businesses are reducing management jobs and squeezing together the various layers of the
corporate pyramid. This is being done to reduce costs and boost productivity. As a result, the
responsibilities of the remaining management positions are being broadened. The successful
manager will need to be much more of a team player that has the knowledge and ability to move
not just vertically within an organization but horizontally as well. Developing cross-functional
capabilities will be the rule, not the exception. Thus, a mastery of basic financial management
skills is key ingredient that will be required in the work place of your not too distant future.

Finance is the study of money management, the acquiring of funds (cash) and the directing of
these funds to meet particular objectives. Good financial management helps businesses to
maximize returns while simultaneously minimizing risks.

Hardly anybody wants to work in a field where there is no room for experience, creativity,
judgment and a pinch of luck but study of finance is not so. There are many reasons that the
manager’s job is challenging and interesting. Here are four important ones.
-Securities Markets
-Understanding Values
-Time and uncertainty
-Understanding People.
I. Securities Markets include Money Markets and Capital Markets.

Money Markets includes:

*Markets for short-term claims with original maturity of one year or less.
*High-grade securities with little or no risk of default.
*Examples:
1. Treasury Bills.
2. Commercial Paper.
3. Certificates of Deposit.

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Capital markets include:
* Market for long-term securities with original maturity of more than one year.
*Securities may be of considerable risk.
*Example:
1.Stocks
2.Corporate bonds 3.Government bonds

Primary Markets
A primary market is a market for newly created securities. The proceeds from the sale of
securities in primary markets go to the issuing entity. A security can trade only once in the
primary market.

Secondary Markets
A secondary market is a market for previously issued securities. The issuing firm is not directly
affected by transactions in the secondary markets. A security can trade an unlimited number of
times in secondary markets. The volume of trade in secondary markets is such higher than in
primary markets.

Investment Bankers
An investment banker specializes in marketing new securities in the primary market. Examples
of Investment bankers are: Merrill Lynch, Sigma Manufactures Merchant Bank, etc.

Brokers and Dealers

These generally participate in the secondary markets. A broker helps investors in buying or
selling securities. A broker charges commissions, but never takes title to the security. A dealer
buys securities from sellers, and sells them to buyers.

Financial Intermediaries
These are institutions that assist in the financing of firms. Example include; commercial banks
and pension funds. These institutions invest in securities of other firms, but they are themselves
financed by other financial claims. On the other hand, it is a sort of indirect financing in which
savers deposit funds with the banks and financial institutions rather than directly buying bonds or
shares and the financial institutions, in turn lend the money to ultimate borrowers. The
Commercial Banks, Financial Institutions, Finance and Investment Companies, Insurance
Companies, Unit Trust, Pension Funds etc., are examples of financial intermediaries.

II. Understanding Value

Understanding how capital markets work amounts to understanding how financial assets are
valued. This is a subject on which there has been remarkable progress over the past 10 to 20
years. New theories have been developed to explain the prices of bonds and stocks. And, when
put to the test, these theories have worked well. I, therefore, would like to give more stress in this
area because the implication of this is applying in almost all parts of the corporate finance.

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III. Time and Uncertainty
The financial manager cannot avoid coping with time and uncertainty. Firms often have the
opportunity to invest in assets which cannot pay their way in the short run and which expose the
firm and its stockholders to considerable risk. The investment, if undertaken, may have to be
financed by debt, which cannot be fully repaid for many years. The firm cannot walk away from
such choices- someone has to decide whether the opportunity is worth more than it costs and
whether the additional debt burden can be safely borne.

IV. Understanding People

The financial manager needs the opinions and cooperation of many people. For instance, many
new investment ideas come from plant managers. The financial manager wants these ideas to be
presented fairly; therefore, the proposers should have no personal incentives to be either
overconfident or overcautious. Take another example. In some firms the plant manager needs
permissions from the head office to buy a company car but not to lease it, and the line of least
resistance may be to lease the car. In other firms the plant manager needs permission from the
head office to buy or lease, and the line of least resistance may be to travel everywhere by cab.
The financial manager has to be aware of these effects and has to devise procedures that will
avoid as far as possible any conflicts of interest.

These are not the only reasons that financial management is interesting and also challenging.

Concept of Finance
Different finance scholars have interpreted the term ‘finance’ in real world variably. More
significantly, as noted at the very outset of this chapter, the concept of finance has changed
markedly with change in times and circumstances. For convenience of analysis different
viewpoints on finance can be categorized into following three major groups:
F.1. The first category incorporates the views of all those who contend that finance concerns with
acquiring funds on reasonable terms and conditions to pay bills promptly. This approach
covers study of financial institutions and instruments from which funds can be secured, the types
and duration of obligations to be issued, the timing of the borrowing or sale of stocks, the
amounts required, urgency of the need and cost. The approach has the virtue of shedding light on
the very heart of finance function. However, the approach is too restrictive. It lays stress on only
one aspect of finance. The traditional scholars hold this approach of finance
F.2. The second approach holds that finance is concerned with cash. Since almost all business
transactions are expressed ultimately in terms of cash, every activity within the enterprise is the
primary concern of a finance manager. Thus, according to this approach, finance manager is
required to go into details of every functional area of business activity, be it concerned with
purchasing, production, marketing, personnel, administration, research or other associated
activities. Obviously, such a definition is too broad to be meaningful.
F.3. A third approach to finance, held by modern scholars, looks at finance as being concerned
with procurement of funds and wise application of these funds. Protagonists of this approach
opine that responsibility of a finance manager is not only limited to acquisition of adequate cash
to satisfy business requirements but extends beyond this to optimal utilisation of funds. Since
money involves cost, the central task of a finance manager while allocating resources is to match
the benefits of potential uses against the cost of alternative sources so as to maximise value of

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the enterprise. This is the managerial approach of finance which is also known as problem-
centered approach, since it emphasizes that finance manager in his endeavor to maximise value
of the enterprise has to deal with vital problems of the enterprise, viz., what capital expenditures
should the enterprise make? What volume of the funds should the enterprise invest? How should
the desired funds be obtained?

Let us move on to financial management, you all being students of management know the
meaning of management. So let us discuss financial management now.

Nature of Financial Management

Financial management is an integral part of overall management and not merely a staff function.
It is not only confined to fund raising operations but extends beyond it to cover utilisation of
funds and monitoring its uses. These functions influence the operations of other crucial
functional areas of the firm such as production, marketing and human resources. Hence,
decisions in regard to financial matters must be taken after giving thoughtful consideration to
interests of various business activities. Finance manager has to see things as a part of a whole
and make financial decisions within the framework of overall corporate objectives and policies.
The financial management of a firm affect its very survival because the survival of the firm
depends on strategic decisions made in such important matters such as product development,
market development, entry in new product line, retrenchment of a product, expansion of the
plant, change in location, etc. In all these matters assessment of financial implications is
inescapable.

Another striking feature of financial management that explains its generic nature is the
imperativeness of the continuous review of the financial decisions. As a matter of fact, financial
decision-making is a continuous decision-making process, which goes on throughout the
corporate life. Since a firm has to operate in an environment that is dynamic, it has, therefore, to
interact constantly with various environmental forces in addition to changing conditions of the
firm and adapt and adjust its objectives and strategies including financial policies and strategies.
A one-time financial plan not subjected to periodic review and modifications in the context of
changed conditions will be a fiasco because conditions may change to such an extent that the
plan is no longer relevant and acts as a hindrance rather than help. Financial planning should,
therefore, not be static. It has to be continuously adapted to changing conditions.

As you all are MBA students it is essential for you to know the interface between finance and
other functions let us discuss. You all are studying other management subjects also let us relate
those with finance.

Interface between finance and other functions

Till now you might have understood about the pervasive nature of finance. Let us discuss in
greater detail the reasons why knowledge of the financial implications of their decisions is
important for the non-finance managers. One common factor among all managers is that they use
resources and since resources are obtained in exchange for money, they are in effect making the
investment decision and in the process of ensuring that the investment is effectively utilized they
are also performing the control function.

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Marketing-Finance Interface
There are many decisions, which the Marketing Manager takes which have a significant impact
on the profitability impact on the profitability of the firm. For example, he should have a clear
understanding of the impact the credit extended to the customers is going to have on the profits
of the company. Otherwise in his eagerness to meet the sales targets he is liable to extend liberal
terms of credit, which is likely to put the profit plans out of gear. Similarly, he should weigh the
benefits of keeping a large inventory of finished goods in anticipation of sales against the costs
of maintaining that inventory. Other key decisions of the Marketing Manager, which have
financial implications, are:
>Pricing
>Product promotion and advertisement
>Choice of product mix
>Distribution policy.

Production-Finance Interface
As we all know in any manufacturing firm, the Production Manager controls a major part of the
investment in the form of equipment, materials and men. He should so organize his department
that the equipments under his control are used most productively, the inventory of work-in-
process or unfinished goods and stores and spares is optimized and the idle time and work
stoppages are minimized. If the production manager can achieve this, he would be holding the
cost of the output under control and thereby help in maximizing profits. He has to appreciate the
fact that whereas the price at which the output can be sold is largely determined by factors
external to the firm like competition, government regulations, etc. the cost of production is more
amenable to his control. Similarly, he would have to make decisions regarding make or buy, buy
or lease etc. for which he has to evaluate the financial implications before arriving at a decision.

Top Management-Finance Interface

The top management, which is interested in ensuring that the firm's long-term goals are met,
finds it convenient to use the financial statements as a means for keeping itself informed of the
overall effectiveness of the organization. We have so far briefly reviewed the interface of finance
with the non-finance functional disciplines like production, marketing etc. Besides these, the
finance function also has a strong linkage with the functions of the top management. Strategic
planning and management control are two important functions of the top management. Finance
function provides the basic inputs needed for undertaking these activities.

Economics - Finance Interface

The field of finance is closely related to economics. Financial managers must understand the
economic framework and be alert to the consequences of varying levels of economic activity and
changes in economic policy. They must also be able to use economic theories as guidelines for
efficient business operation. The primary economic principle used in managerial finance is
marginal analysis, the principle that financial decisions should be made and actions taken only
when the added benefits exceed the added costs. Nearly all-financial decisions ultimately come
down to an assessment of their marginal benefits and marginal costs.
Accounting - Finance Interface

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The firm's finance (treasurer) and accounting (controller) activities are typically within the
control of the financial vice president (CFO). These functions are closely related and generally
overlap; indeed, managerial finance and accounting are often not easily distinguishable. In small
firms the controller often carries out the finance function, and in large firms many accountants
are closely involved in various finance activities. However, there are two basic differences
between finance and accounting; one relates to the emphasis on cash flows and the other to
decision making. complex and diverse responsibilities.

We all know it very well that environment keeps changing and thus brings in new challenges
every time, let us discuss on the new challenges been faced by manager.

Managers are presently facing some new challenges as indicated below:

>TREASURY OPERATIONS: Short-term fund management must be more sophisticated.
Finance managers could make speculative gains by anticipating interest rate movements.
>FOREIGN EXCHANGE: Finance Managers will have to weigh the costs and benefits of
playing with foreign exchange particularly now that the Indian economy is going global and the
future value of the rupee visa a vis foreign currency has become difficult to predict.
>FINANCIAL STRUCTURING: An optimum mix between debt and equity will be essential.
Firms will have to tailor financial instruments to suit their and investors' needs. Pricing of new
issues is an important task in the Finance Manager’s portfolio now.
>MAINTAINING SHARE PRICES: In the premium equity era, firms must ensure that share
prices stay healthy. Finance managers will have to devise appropriate dividend and bonus
policies.
>ENSURING MANAGEMENT CONTROL: Equity issues at premium means managements
may lose control if they are unable to take up their share entitlements. Strategies to prevent this
are vital.

Prepared by:
Dr. Sarbesh Mishra
NICMAR’s CISC, NAC Campus
Hyderabad – 500 084.
E.mail – sarbesh@in.com
Website: http://www.scribd.com/people/view/1074251

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