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

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.

Relationship between FA CA AND MA

Financial Accounting vs. Cost Accounting vs. Management Accounting

Financial Accounting gives out information about the enterprise’s financial activities and
situation. It makes use of the past or historical data. All the transactions and statements are
recorded and presented in terms of money mostly. Persons who make use of these financial
statements are outsiders like banks, shareholders, creditors, government authorities
etc. Financial statements are usually presented once in a year and there is a certain format for
their presentation. It is mandatory for the companies to follow the rules and policies framed
under GAAP (Generally Accepted Accounting Principles). It indicates whether the company is
running in loss or profit.

Cost Accounting helps in the determination of the cost of the product, how to control it and in
making decisions. It makes use of both past and present data for ascertainment of product cost.
There is no specific format for the preparation of cost accounting statements. It is used by the
internal management of the company and usually the cost accountant prepares this to ascertain
the cost of a particular product taking into account the cost of materials, labor and different
overheads. No certain periodicity is needed for the preparation of these statements and they are
needed as and when required by the management. This makes use of certain rules and regulations
while computing the cost of different products in different industries.

Unlike the above two accounting, Management Accounting deals with both quantitative and qualitative
aspects. This involves the preparation of budgets, forecasts to make viable and valuable future decisions
by the management. Many decisions are taken based on the projected figures of the future. There is no
question of rules and regulations to be followed while preparing these statements but the management
can set their own principles. Like cost accounting, in management accounting also there is no specific
time span for its statement and report preparation. It makes use of both cost and financial statements
as well to analyze the data.

Definition: Financial statements are a collection of reports about an organization's financial results,
financial condition, and cash flows.

Definition of Financial Planning

Financial Planning is the process of estimating the capital required and determining it’s
competition. It is the process of framing financial policies in relation to procurement, investment
and administration of funds of an enterprise.

Financial Management and Control is a comprehensive system of internal controls put in place by and
under the responsibility of budget user heads, which, by way of managing risks, provides reasonable
assurance that budget and other resources will be used in a regular, ethical, economical, effective and
efficient manner . towards the achievement of objectives. This means that they will be used in keeping
with laws and other regulations, safeguarding the assets and resources against loss, abuse and damage.

Leverage is the use of various financial instruments or borrowed capital, such as margin, to increase the
potential return of an investment. 2. The amount of debt used to finance a firm's assets. A firm with
significantly more debt than equity is considered to be highly leveraged.

Types of leverages

1. Operating Leverage:

Operating leverage is concerned with the investment activities of the firm. It relates to the
incurrence of fixed operating costs in the firm’s income stream. The operating cost of a firm is
classified into three types: Fixed cost, variable cost and semi-variable or semi-fixed cost. Fixed
cost is a contractual cost and is a function of time. So it does not change with the change in sales
and is paid regardless of the sales volume.

Variable costs vary directly with the sales revenue. If no sales are made variable costs will be nil.
Semi-variable or semi-fixed costs vary partly with sales and remain partly fixed. These change
over a range of sales and then remain fixed.

Calculate the degree of operating leverage from the following data:

Sales: 1, 50,000 units at Rs 4 per unit.

Variable cost per unit Rs 2.

Fixed cost Rs 1, 50,000.

Interest charges Rs 25,000.

2. Financial Leverage:

Financial leverage is mainly related to the mix of debt and equity in the capital structure of a
firm. It exists due to the existence of fixed financial charges that do not depend on the operating
profits of the firm. Various sources from which funds are used in financing of a business can be
categorized into funds having fixed financial charges and funds with no fixed financial charges.
Debentures, bonds, long-term loans and preference shares are included in the first category and
equity shares are included in the second category.

Example 5.2:

Calculate the degree of financial leverage from the following information: Capital structure:
10,000, Equity Shares of Rs 10 each Rs 1, 00,000.

5,000, 11 % Preference Shares of Rs 10 each Rs 50,000.

9% Debentures of Rs 100 each Rs 50,000.

The EBIT of the company is Rs 50,000 and corporate tax rate is 45%.
 3. Combined Leverage:

A firm incurs total fixed charges in the form of fixed operating cost and fixed financial charges.
Operating leverage is concerned with operating risk and is expressed quantitatively by DOL.
Financial leverage is associated with financial risk and is expressed quantitatively by DFL. Both
the leverages are concerned with fixed charges. If we combine these two we will get the total risk
of a firm that is associated with total leverage or combined leverage of the firm. Combined
leverage is mainly related with the risk of not being able to cover total fixed charges.

DCL can be computed in the following manner:

Example 5.3:

X Limited has given the following information:

4. Working Capital Leverage:

Investment in working capital has a significant impact on the profitability and risk of a business.
A decrease in investment in current assets will lead to an increase in the profitability of the firm
and vice versa. This is due to the fact that current assets are less profitable in comparison to fixed
assets. Decrease in investment in current assets also increases the volume of risk. Risk and
returns are directly related.

Therefore as risk increases, profitability of firm tends to increase. Thus Working Capital
Leverage (WCL) may be defined as the ability of the firm to magnify the effects of change in
current assets— assuming current liabilities remain constant—on firm’s Return on Investment
(ROI).

Hence WCL may be computed as:

Example 5.4:
From the information given below, compute the working capital leverage.

Total assets: Rs 15, 00,000

Current assets: Rs 5, 00,000

Increase in current assets: Rs 1, 00,000.

Operating cycle is the number of days a company takes in realizing its inventories in cash. ... Operating
cycle is a measure of the operating efficiency and working capital management of a company. A short
operating cycle is good as it tells that the company's cash is tied up for a shorter period.

Determinants of working capita

. Nature of business:

It is an important factor for determining the amount of working capital needed by various
companies. The trading or manufacturing concerns will require more amount of working capital
along-with their fixed investment of stock, raw materials and finished product .Public utilities
and railway companies with huge fixed investment usually have the lowest needs for current
assets, partly because of cash, nature of their business and partly due to their selling a service

instead of a commodity.

2. Length of period of manufacture:

The average length of the period of manufacture, i.e., the time which elapses between the
commencement and end of the manufacturing process is an important factor in determining the
amount of the working capital. If it takes less time to make the finished product, the working
capital required will be less.
3. Volume of business:

Generally, the size of the company has a direct relation with the working capital needs. Big
concerns have to keep higher working capital for investment in current assets and for paying
current liabilities.

4. Use of Manual Labour or Mechanisation:

In labour intensive industries, larger working capital will be required than in the highly
mechanized ones. The latter will have a large proportion of fixed capital. It may be remembered,
however, that to some extent the decision to use manual labour or machinery lies with the
management. Therefore, it is possible in most cases to reduce the requirements of working
capital and increase investments in fixed assets and vice versa.

5. Need to keep large stocks of raw materials of finished goods:

The manufacturing concerns generally have to carry stocks of raw materials and other stores and
also finished goods. The larger the stocks (whether of raw materials or finished goods) more will
be the needs of working capital.

6. Seasonal Variations:

There are some industries which either produce goods or make sales only seasonally. For
example, the sugar industry produces practically all the sugar between December and April and
the woollen textile industry makes its sales generally during winter.

In both these cases the needs of working capital will be very large, during few months {i.e.,
season). The working capital requirements will gradually decrease as and when the sales are
made.

7. Requirements of Cash:

The need to have cash in hand to meet various requirements e.g., payment of salaries, rents, rates
etc., has an effect on the working capital. The more the cash requirements the higher will be
working capital needs of the company and vice versa.

The cost of capital is used to evaluate new projects of a company, as it is the minimum return
that investors expect for providing capital to the company.

http://w w w .investopedia.com/te
What is 'Cost Of Equity'

The cost of equity is the return a company requires to decide if an investment meets capital
return requirements; it is often used as a capital budgeting threshold for required rate of return. A
firm's cost of equity represents the compensation the market demands in exchange for owning
the asset and bearing the risk of ownership.

In finance, the cost of equity is the return (often expressed as a rate of return) a firm theoretically pays
to its equity investors, i.e., shareholders, to compensate for the risk they undertake by investing their
capital. Firms need to acquire capital from others to operate and grow.

the cost of preference share capital is apparently the dividend which is committed and paid by the
company. This cost is not relevant for project evaluation because this is not the cost at which further
capital can be obtained. To find out the cost of acquiring the marginal cost, we will be finding the yield
on the preference share based on the current market value of the preference share.

The cost of retained earnings is slightly less than the cost of common stock, as it excludes
transaction costs and taxes associated with dividends.

Retained earnings refers to the portion of net income (or loss) that is retained by a company
rather than distributed to its owners as dividends.

The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average
to all its security holders to finance its assets. The WACC is commonly referred to as the firm's cost of
capital.

Capital Structure is referred to as the ratio of different kinds of securities raised by a firm as long-term
finance. The capital structure involves two decisions-

Composition and sources of long term funds in financial management

It is the mix of different sources of long-term sources such as equity shares, preference shares,
debentures, long-term loans and retained earnings. The term capital structure refers to the relationship
between the various long-term source financing such as equity capital, preference share capital and
debt capital.

Factors etermining funds requirements

1) Nature of Business:

Need of fixed capital depends upon the nature of business. Usually, nature of business is of two
kinds: Manufacturing Business and Trading Business. In case of manufacturing business, large
investment is made in land, building, machinery, etc. Thus, there is a need for large amount of fixed
capital. On the contrary, in case of trading business in which finished goods are bought and sold, less
amount of fixed capital is needed.
(2) Scale of Operations:

Larger the spread of business activities, greater is the need for fixed capital. If a manufacturing
enterprise is operating on a small scale, it will require less amount of fixed capital. On the other
hand, a large-scale manufacturing enterprise will need relatively more amount of fixed capital.

(3) Choice of Technique:

Those manufacturing enterprises which make use of modern and automatic machines need large
amount of fixed capital. On the other hand, those enterprises in which production is carried out
mainly through manual labour need for fixed capital is very little.

(4) Technology Up gradation:

There are some businesses where fixed asset is used and which does require immediate change.
These days computer technology is undergoing rapid changes. Therefore, those companies
whose business is computer based need more fixed capital.

(5) Growth Prospects:

There are two types of organisations from the point of view of growth: (i) Such organisations,
which have no possibility of growth. They do not need additional fixed capital in future, (ii) Such
organisations which have more possibilities of growth. They need more additional fixed capital.
Such organisations make a choice of the sources of finance well in advance so that in case of
need additional finance can be made available.

(6) Diversification:

Diversification means running business in more products then merely one product. Those
organisations which wish to adopt diversification certainly need more fixed capital. For example,
if a textile manufacturing company starts the business of paper manufacturing, it shall have to
invest heavily in land, building, machinery, etc. Therefore, it will require more additional fixed
capital.

Financial Management Information Systems accumulate and analyze financial data in order to make
good financial management decisions in running the business. ... Financial planning and forecasting are
facilitated if used in conjunction with a Decision Support System (DSS)

Capital budgeting, or investment appraisal, is the planning process used to determine whether an
organization's long term investments such as new machinery, replacement of machinery, new plants,
new products, and research development projects are worth the funding of cash through the firm's
capitalization structure

The payback period ignores the time value of money, unlike other methods of capital budgeting, such as
net present value, internal rate of return or discounted cash flow.
Net Present Value (NPV) is the difference between the present value of cash inflows and the present
value of cash outflows. NPV is used in capital budgeting to analyze the profitability of a projected
investment or project.

Accounting rate of return, also known as the Average rate of return, or ARR is a financial ratio used in
capital budgeting. The ratio does not take into account the concept of time value of money. ARR
calculates the return, generated from net income of the proposed capital investment. The ARR is a
percentage return.

Internal rate of return (IRR) is the interest rate at which the net present value of all the cash flows (both
positive and negative) from a project or investment equal zero. Internal rate of return is used to
evaluate the attractiveness of a project or investment.