Financial Management

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1 Different forms business organization Financial Management Sole proprietorship Partnership Cooperative society Company Private limited Vs Public limited company Private co min- two and max fifty, Pub Ltd min- Seven no maximum limit Invites the public to subscribe to its shares Permits free transfer of shares Public Limited companies can be identified Inc. USA LTD and PLC in UK GmbH AG in Germany Meaning and Definition 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. FM is concerned with planning and controlling of the firm s financial resources. FM is considered as the science of money management. There are two aspects of financial management: 1) Procurement of funds a) Equity b) Debentures c) Funding from commercial banks d) International funding 2) Effective utilization of funds a) Utilization of fixed assets b) Utilization of working capital Financial decision in a firm Capital budgeting Capital structure Working capital management (debt and equity) 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. 1

2 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 have 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 likea. 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 has to 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 have 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 has to be decided which will depend upon expansional, innovational, diversification plans of the company. 6. Management of cash: Finance manager has to 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, maintainance 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 has to exercise control over finances. This can be done through many techniques like ratio analysis, financial forecasting, cost and profit control, etc. 2

3 Goals of Objectives of Financial Management 1. Profit Maximisation This is the traditional objective of financial management. The objective is to make more and more profit. The financial manager has to make a decision as to maximize the profits of the concern. But this can t be the sole of objective of the concern because of the following reasons. a) The term profit is vague b) Profit maximization has to be attempted with a realization of risk involved. c) This doesn t take into account the time pattern of return d) Profit maximization as an objective is too narrow. 2. Wealth / Value maximization Shareholders wealth is represented by the market value of equity, also known as market capitalization. Market value of equity = h h And this value should be increased. This is a function of following elements: a) Increase in profits b) Reduction in cost c) Source of funds d) Minimum risks e) Long term value Advantages of Wealth Maximization 1. Wealth maximization is a clear term. Here, the present value of cash flow is taken into consideration. The net effect of investment and benefits can be measured clearly. (Quantitatively) 2)It considers the concept of time value of money. The present values of cash inflows and outflows helps the management to achieve the overall objectives of a company. 3)The concept of wealth maximization is universally accepted, because, it takes care of interests of financial institution, owners, employees and society at large. 4) Wealth maximization guide the management in framing consistent strong dividend policy, to earn maximum returns to the equity holders. 5) The concept of wealth maximization considers the impact of risk factor, while calculating the Net Present Value at a particular discount rate, adjustment is made to cover the risk that is associated with the investments. Criticisms of Wealth Maximization The concept of wealth maximization is being criticized on the following grounds: The objective of wealth maximization is not descriptive. The concept of increasing the wealth of the stockholders differs from one business entity to another. It also leads to confusion in, 3

4 and misinterpretation of financial policy because different yardsticks may be used by different interests in a company. As corporations have grown bigger and more powerful, their influence has become more pervasive; they have created an imbalance which is widely believed to have been instrumental in generating a movement to promote more socially conscious business behaviour. Academicians and corporate officers alike have urged the advisability of more socially conscious business management. Financial management will then have to rise equal to the acceptance of social responsibility of business. Financial management should not only maintain the financial health of a business, but should also help to produce a rate of earning which will reward the owners adequately for the use of the capital they have provided. To the creditors, the management must ensure administration, which will keep the business liquid and solvent. Moreover, financial management will have to ensure that expectations raised by the corporation are fulfilled with a proper use of several tools at is disposal. In other words, it should ensure an effective management of finance so that it may bear the desired fruits for the organization. If it is properly supported and nurtured by efficient activities at all stages, it will positively ensure desired results. Financial management should take into account the enterprise s legal obligations to its employees. It should try to have a healthy concern which can maintain regular employment under favourable working conditions. However, a good financial management alone cannot guarantee that a business will succeed. But it is a necessary condition for business success, though not the only one. It may, however, be described as a pre-requisite of a successful business. In other words, there are various other factors which may support or frustrate financial management by supportive or non- supportive policies. Wealth maximization is as important objective as profit maximization. The operating objective for Financial Management is to maximize wealth or the net present worth of a firm. Wealth maximization is an objective which has to be achieved by those who supply loan capital, employees, society and management. The objective finds its place in these segments of the corporate sector, although the immediate objectives of Financial Management may be to maintain liquidity and improve profitability. The wealth of owners of a firm is maximized by raising the price of the common stock. This is achieved when the management of a firm operates efficiently and makes optimal decisions in areas of capital investments, financing, dividends and current assets management. If this is done, the aggregate value of the common stock will be maximized. There are other goal like: Achieving a higher growth rate 4

5 Attaining a larger market share Gaining leadership in the market in terms of products and technology Promoting employee welfare Increasing customer satisfaction Improving community life, supporting education and research, solving societal problems etc. Though all goals are important, the primary goal is always wealth maximisation as it is critical for the very existence of the business enterprise. If is goal is not met, public/institutions would lose confidence in the enterprise and will not invest further in the company. Functions of finance Finance function is the most important function of a business. Finance is, closely, connected with production, marketing and other activities. In the absence of finance, all these activities come to a halt. In fact, only with finance, a business activity can be commenced, continued and expanded. Finance exists everywhere, be it production, marketing, human resource development or undertaking research activity. Understanding the universality and importance of finance, finance manager is associated, in modern business, in all activities as no activity can exist without funds. Financial Decisions or Finance Functions are closely inter-connected. All decisions mostly involve finance. When a decision involves finance, it is a financial decision in a business firm. In all the following financial areas of decision-making, the role of finance manager is vital. We can classify the finance functions or financial decisions into four major groups: (A) Investment Decision or Long-term Asset mix decision (B) Finance Decision or Capital mix decision (C) Liquidity Decision or Short-term asset mix decision (D) Dividend Decision or Profit allocation decision (A) Investment Decision Investment decisions relate to selection of assets in which funds are to be invested by the firm. Investment alternatives are numerous. Resources are scarce and limited. They have to be rationed and discretely used. Investment decisions allocate and ration the resources among the competing investment alternatives or opportunities. The effort is to find out the projects, which are acceptable. Investment decisions relate to the total amount of assets to be held and their composition in the form of fixed and current assets. Both the factors influence the risk the organisation is exposed to. The more important aspect is how the investors perceive the risk. The investment decisions result in purchase of assets. Assets can be classified, under two broad categories: (i) Long-term investment decisions Long-term assets (ii) Short-term investment decisions Short-term assets Long-term Investment Decisions: The long-term capital decisions are referred to as capital budgeting decisions, which relate to fixed assets. The fixed assets are long term, in nature. Basically, fixed assets create earnings to the firm. They give benefit in future. It is difficult to measure the benefits as future is uncertain. 5

6 The investment decision is important not only for setting up new units but also for expansion of existing units. Decisions related to them are, generally, irreversible. Often, reversal of decisions results in substantial loss. When a brand new car is sold, even after a day of its purchase, still, buyer treats the vehicle as a second-hand car. The transaction, invariably, results in heavy loss for a short period of owning. So, the finance manager has to evaluate profitability of every investment proposal, carefully, before funds are committed to them. Short-term Investment Decisions: The short-term investment decisions are, generally, referred as working capital management. The finance manger has to allocate among cash and cash equivalents, receivables and inventories. Though these current assets do not, directly, contribute to the earnings, their existence is necessary for proper, efficient and optimum utilisation of fixed assets. (B) Finance Decision Once investment decision is made, the next step is how to raise finance for the concerned investment. Finance decision is concerned with the mix or composition of the sources of raising the funds required by the firm. In other words, it is related to the pattern of financing. In finance decision, the finance manager is required to determine the proportion of equity and debt, which is known as capital structure. There are two main sources of funds, shareholders funds (variable in the form of dividend) and borrowed funds (fixed interest bearing). These sources have their own peculiar characteristics. The key distinction lies in the fixed commitment. Borrowed funds are to be paid interest, irrespective of the profitability of the firm. Interest has to be paid, even if the firm incurs loss and this permanent obligation is not there with the funds raised from the shareholders. The borrowed funds are relatively cheaper compared to shareholders funds, however they carry risk. This risk is known as financial risk i.e. Risk of insolvency due to non-payment of interest or non-repayment of borrowed capital. On the other hand, the shareholders funds are permanent source to the firm. The shareholders funds could be from equity shareholders or preference shareholders. Equity share capital is not repayable and does not have fixed commitment in the form of dividend. However, preference share capital has a fixed commitment, in the form of dividend and is redeemable, if they are redeemable preference shares. Barring a few exceptions, every firm tries to employ both borrowed funds and shareholders funds to finance its activities. The employment of these funds, in combination, is known as financial leverage. Financial leverage provides profitability, but carries risk. Without risk, there is no return. This is the case in every walk of life! When the return on capital employed (equity and borrowed funds) is greater than the rate of interest paid on the debt, shareholders return get magnified or increased. In period of inflation, this would be advantageous while it is a disadvantage or curse in times of recession. Example: Total investment: Rs. 1,00,000 Return 15%. Composition of investment: Equity Rs. 60,000 6

7 7% interest Rs. 40,000 Return on 15% Rs. 15,000 Interest on Debt Rs. 2,800 7% on Rs.40,000 Earnings available to Equity shareholders Rs. 12,200 Return on equity (ignoring tax) is 20%, which is at the expense of debt as they get 7% interest only. In the normal course, equity would get a return of 15%. But they are enjoying 20% due to financing by a combination of debt and equity. The finance manager follows that combination of raising funds which is optimal mix of debt and equity. The optimal mix minimises the risk and maximises the wealth of shareholders. (C) Liquidity Decision Liquidity decision is concerned with the management of current assets. Basically, this is working Capital Management. Working Capital Management is concerned with the management of current assets. It is concerned with short-term survival. Short term-survival is a prerequisite for long-term survival. When more funds are tied up in current assets, the firm would enjoy greater liquidity. In consequence, the firm would not experience any difficulty in making payment of debts, as and when they fall due. With excess liquidity, there would be no default in payments. So, there would be no threat of insolvency for failure of payments. However, funds have economic cost. Idle current assets do not earn anything. Higher liquidity is at the cost of profitability. Profitability would suffer with more idle funds. Investment in current assets affects the profitability, liquidity and risk. A proper balance must be maintained between liquidity and profitability of the firm. This is the key area where finance manager has to play significant role. The strategy is in ensuring a trade-off between liquidity and profitability. This is, indeed, a balancing act and continuous process. It is a continuous process as the conditions and requirements of business change, time to time. In accordance with the requirements of the firm, the liquidity has to vary and in consequence, the profitability changes. This is the major dimension of liquidity decision working capital management. Working capital management is day to day problem to the finance manager. His skills of financial management are put to test, daily. (D) Dividend Decision Dividend decision is concerned with the amount of profits to be distributed and retained in the firm. Dividend: The term dividend relates to the portion of profit, which is distributed to shareholders of the company. It is a reward or compensation to them for their investment made in the firm. The dividend can be declared from the current profits or accumulated profits. Which course should be followed dividend or retention? Normally, companies distribute certain amount in the form of dividend, in a stable manner, to meet the expectations of shareholders and balance is retained within the organisation for expansion. If dividend is not 7

8 distributed, there would be great dissatisfaction to the shareholders. Non-declaration of dividend affects the market price of equity shares, severely. One significant element in the dividend decision is, therefore, the dividend payout ratio i.e. what proportion of dividend is to be paid to the shareholders. The dividend decision depends on the preference of the equity shareholders and investment opportunities, available within the firm. A higher rate of dividend, beyond the market expectations, increases the market price of shares. However, it leaves a small amount in the form of retained earnings for expansion. The business that reinvests less will tend to grow slower. The other alternative is to raise funds in the market for expansion. It is not a desirable decision to retain all the profits for expansion, without distributing any amount in the form of dividend. There is no ready-made answer, how much is to be distributed and what portion is to be retained. Retention of profit is related to Reinvestment opportunities available to the firm. Alternative rate of return available to equity shareholders, if they invest themselves. 8

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