Meaning of Financial Management:-

Financial Management is such a managerial process, which is concerned with

the planning and control of Financial resources. It is being studied as a separate
subject in 20th century. Till now it was used as a part of economics. Now, its
scope has undergone some basic changes from time to time. In present time, it
analyses all financial problems of a business. Financial Manager estimates the
requirements of funds, plans the different sources of funds and performs
functions of collection of funds and its effective utilisation.

Finance is such a powerful source that it performs an important role to operate

and coordinate the various economic activities of business. Finance is of two
types:-

(1) Public finance.

(2) Private finance.

1. Public Finance:-

Means government finance under which principles and practices relating to the
procurement and management of funds for central government, state
government and local bodies are covered.

2. Private Finance:-

means procurement and management of funds by individuals and private

institutions. Under it we observe as to how individuals and private institution
procure funds and utilise it.

Scope:-

What is finance? What are a firm’s financial activities? How are they related?
Firm create manufacturing capacities for production of goods, some provide
services to customers. They sell goods or services to earn profit and raise funds
to acquire manufacturing and other facilities. Thus, the 3 most important activities
of business firm are:-

(1) Production
(2) Marketing
(3) Finance.
A firm secures whatever capital it needs and employs it (finance activity) in
activities, which generate returns on, invested capital (production and marketing
activities.)

Real and financial Assets:-

A firm acquire real assets to carry on its business. Real assets can be
tangible or intangible. Plant, machinery, factory, furniture etc. are examples of
tangible real assets, while technical know-how, patents, copy rights are examples
of intangible real assets.
 The firm sells financial assets or securities such as shares and bonds or
debentures, to investors in capital market to raise necessary funds. Financial
assets also include borrowings from banks, finance institutions and other
sources.

Funds applied to assets by the firm are called capital expenditure or

investment. The firm expects to receive return on investment and distribute return
as dividends to investors.

EQUITY AND BORROWED FUNDS:-

There are two types of funds that a firm can raise:- Equity funds and
borrowed funds.

A firm sells shares to acquire equity funds. Shares represent ownership

rights of their holders. Buyers of shares are called share holders and they are
legal owners of the firm whose share they hold share holders invest their money
shares of a company in expectation of return on their invested capital. The return
on shares holder’s capital consists of dividend and capital gain by selling their
shares.

Another important source of securing capital is creditors or lenders.

Lenders are not the owners of the company. They make money available to firm
on a lending basis and retain title to the funds lent. The return on loans or
borrowed funds is called interest. Loans are furnished for a specified period at a
fixed rate of interest. Payment of interest is a legal obligation. The amount of
interest is allowed to be treated as expense for computing corporate income
taxes. Thus the payment of interest on borrowings provides tax shied to a firm.
The firm may borrow funds from a large number of sources, such as banks,
financial institutions, public or by issuing bonds or debentures. A bond or
debenture is a certificate acknowledging the money lent by a bond holder to the
company. It states the amount, the rate interest and maturity of bonds or
dentures.

Finance Functions:-

(a) Financing decisions

(b) Investment decisions
(C) Dividend policy decision
(d) Liquidity Decision

(a) Financing Decisions:- are decisions regarding process of raising the funds.
This function of finance is concerned with providing answers to various questions
like -

» What should be amount of funds to be raised.

» What are the various sources available to organisation for raisaing the
required amount of funds? For this purpose, the organisation can go for
internal & external sources.
 » What should be proportion in which internal & external sources should be
used by organisation?

» If organisation, wants to raise funds from different sources, it is required

to comply with various legal & procedural formalities.

» What kinds of changes have taken place recently affecting capital market
in the country?

(b) Investment decisions:- are decisions regarding application of funds raised

by organisation. These relate to selection of the assets in which funds should be
invested.

The assets in which funds can be invested are of 2 types

1. Fixed assets:- are the assets which bring returns to organisation over a
longer span of time. The investment decisions in these types of assets are
“capital budgeting decisions.” Such decisions include

1 How fixed assets should be selected to make investment ? What are various
methods available to evaluate investment proposals in fixed assets?

2 How decisions regarding investment in fixed assets should be made in situation

of risk & uncertainity?

2. Current assets:- are assets which get generated during course of

operations & are capable of getting converted in form of cash with in a
short period of one year. Such decisions include

(1) What is meaning of Working Capital management & its objectives?

(2) Why need for working capital orises?

(3) What are factors affecting requirements of working capital?

(4) How to quantity requirements of working capital?

(5) What are sources available for financing the requirement of working capital?

(c ) Dividend Policy Decisions:- Such decisions include

(1) What are forms in which dividend can be paid to share holders?

(2) What are legal & procedural formalities to be completed while paying dividend
different forms?

(d) Liquidity Decisions:- Current assets should be managed efficiently for safe
guarding firm against of liquidity & insolvency. In order to ensure that neither
insufficient nor unnecessary funds are invested in current assets, the financial
manager should develop sound technique of managing current assets.
OBJECTIVES OF FINANCIAL MANAGEMENT:-

It is the duty of management to clarify the objectives of business so that

the departmental objectives could be determined accordingly. Financial
objectives of a firm provide a concrete framework within which optimum financial
decisions can be made. The main objective of any firm should be to maximise
the economic welfare of its shareholders. Accordingly, there are 2 approaches in
this regard.

(A) Profit maximisation Approach.

(B) Wealth maximisation Approach.

(A) PROFIT MAXIMISATION APPROACH:-

According to this approach, a firm should undertake all those activities

which add to its profits and eliminate all others which reduce its profits. This
objectives highlights the fact that all decisions:- financing, dividend and
investment, should result in profit maximisation. Following arguments are given in
favour of profit maximisation approach:-

(i) Profit is a yardstick of efficiency on the basis of which economic

efficiency of a business can be evaluated.
(ii) It helps in efficient allocation and utilisation of scarce means because
only such resources are applied which maximise the profits.
(iii) The rate of return on capital employed is considered as the best
measurement of the profits.
(iv) Profit acts as motivator which helps the business organisation to be
more efficient through hard work.
(v) By maximising profits, social & economics welfare is also maximised.

However this approach has been criticised on various counts:-

(1) Ambiguity:-

Profit can be expressed in various forms i.e it can be short term or long
term or it can be profit before tax or after tax or it can be gross profit or net profit.
Now the question arises, which profits can be maximised under profit
maximisation approach.

(2) Time Value of Money

This approach is also criticised because it ignores time value of money i.e.
under this approach income of different years get equal weight. But, in fact, the
value of rupee today will be greater as compared to the value of rupee receivable
after one year. In the same manner, the value of income received in the first year
will be greater from that which will be received in later year e.g. the profits of 2
different projects are:-
Example:-

YEAR PROJECT1 PROJECT2

1 5,000 -
2 10,000 10,000
3 5,000 10,000

Both the projects have a total earnings of Rs 20,000 in 3 years and

according to this approach both will be considered equally profitable. But Project
1 has greater profits in the initial years of the project & therefore, is more
profitable in terms of value of income. The profits earned in initial years can be
reinvested and more profits can be earned.

(3) Risk Factor:-

This approach ignores risk factor. The certainity or uncertainity of income

receivable in future can be high or less. High uncertainity increases risk and less
uncertainity reduces risk. Less income with more certainity is considered better
as compared to high income with greater uncertainity.

Thus, this approach was more significant for sole trader & partnership
firms because at that time when personal capital invested in business, they
wanted to increase their assets by maximising profits. Companies are now
managed by professional managers and capital is provided by shareholders,
debenture holders, financial institutions etc. one of the major responsibilities of
business management is to co-ordinate the conflicting interest of all these
parties. In such a situation profit maximisation approach does not appear proper
and practicable for financial decisions.

B Wealth Maximisation Approach

Value Maximisation Approach or Maximum net present worth.

According to this approach , financial management should take such

decision’s which increase net present value of the firm and should not undertake
any activity which decrease net present value. This approach eliminates all the 3
basic criticisms of the profit maximization approach.

As the value of an asset is considered from view point of profit accruing

from it, in the same manner the evaluation of an activity depends on the profits
arising from it. Therefore, all 3 main decisions of financial manager-financing
decision, investment decision dividend decision affect net present value of the
firm. The greater the amount of net present value, the greater will be value of firm
and more it will be in the interest of share holders. When the value of firm
increases, the market price of equity shares also increase. Thus to maximize net
present worth means to maximize the market price of shares. Net present worth
can be calculated with the help of following equation.

A1 A2 An -c
W= + + --------------------- +
(1+k) (1+k)2 (1+k)n
 n At
= ∑ -C
t=1 (1+k)t

Where W = Net present worth.

A, A2--- An= Stream of expected cash benefits from a course of action

over a period of time.

K = Discount rate to measure risk & timing.

C= Initial outlay to acquire that asset

If W is positive, the decision should be taken & vice versa.

If W is Zero, it would mean that it does not add or reduce the present value of the
asset.

This approach is considered good for the companies in present situation.

This approach gives due consideration to the time value of expected income
receivable over different period of time. Under this approach, risk and uncertainty
is analyzed with the help of interest rate. If uncertainty & time period are greater,
higher rate of interest will be used to calculate present value of expected future
cash benefits where as the interest rate will be lower for the projects with low risk
& uncertainty. Besides, this approach uses cash flows instead of accounting
profits which removes ambiguity associated the term profit.

On the basis of above explanation, we can conclude that wealth

maximization approach is better to profit maximisation approach to establish
mutual relation among the various data. It is possible only through statistics.
Cash and inventory management, forecast of financial needs, credit policy
decision all are based on the advanced techniques of statistics.

Finance is also related to law. Any decision regarding financial policy

should be in line with the laws of the country.

Time Value of Money:-

The evaluation of capital expenditure proposals involves the comparison

between cash outflows & cash inflows. The pecularity of evaluation of capital
expenditure proposals is that it involves the decision to be taken today where as
the flow of funds, either outflow or inflow, may be spread over a number of years.
It goes without saying that for a meaningful comparison between cash outflows
and cash inflows, both the variables should be on comparable basis. As such,
the question which arises is “that is the value of flows arising in future the same
in terms of today.”

For Example:- if a proposal involves cash inflow of Rs 10,000 after one year, is
the value of this cash inflow really Rs 10,000 as on today when capital
expenditure proposal is to be evaluated.? The ideal reply to this question is ‘no’.
The value of Rs 10000 received after one year is less than Rs 10,000 if received
today. The reasons for this can be stated as below:-

(i) There is always an element of uncertainety attached with the future cash
flows.

(ii) The purchasing power of cash inflows received after the year may be less
than that of equivalent sum if received today.

(iii) There may be investment opportunities available if the amount is received

today which cannot be exploited if equivalent sum is received after one year.

Time Value of money:

Example:- If Mr. X is given the option that he can receive an amount of Rs 10000
either on today or after one year, he will most obviously select the first option
why? Because, if he receives Rs 10000 today he can always invest the same say
in fixed deposit with the bank carrying interest of say 10% p.a As such, if choice
is given to him, he will like to receive Rs 10000 today or Rs 11000 (i.e. Rs 10000
plus interest @ 10% p.a. on Rs 10000) after one year. If he has jto receive Rs
10,000) only after one year, the real value of same in terms of today is not Rs
10000 but something less than that. This concept is called time value of money.