Chapter 1

Overview of financial management

1.1. Introduction

In simple language finance is money. To start any business we need capital. Capital is
the amount of money required to start a business. The mobilization of finance is an
important task for an entrepreneur therefore; finance is one of the significant factors
which determine the nature and size of any enterprise. This is to be noted that
identification of sources of finance from time to time to finance the assets of an
enterprise is critical as it avoids the financial hardships of an enterprise. The finance is
required to acquire various fixed assets and current assets. This course discusses the
meaning of finance, types of finance, need of finances, objectives, and functions of
financial management in detail.
1.2. Meaning of Finance
Finance is the study of money. Finance is the science of managing financial resources
i.e. the best use of available financial sources. It is basically concerned with the nature,
creation, behavior, regulation and problems of money. It focuses on how the individuals,
businessmen, investors, government and financial institutions deal. We need to
understand what money is and does is the foundations of financial knowledge. In this
content it is relevant to study the structure and behavior of financial system and the role
of financial system in the development of economy and the profitability of business
enterprises.
1.3. Classification of Finance
The finance is classified into three categories
 Personal finance: - This deals with the mobilization of funds from own sources.
Here funds may imply cash and non-cash items also.
 Public finance: - This kind of finance deals with the mobilization or administration
of public funds. It includes the aspects relating to make safe the funds by the

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 government from public through various methods viz. taxes, borrowings from
public and foreign markets.
 Business finance: - Financial management actually concerned with business
finance. Business finance is pertaining to the mobilization of funds by various
business enterprises. Business finance is a broad term includes both commerce and
industry. It applies to all the financial activities of trade and auxiliaries of trade such
as banking, insurances, trade agencies, service organizations, and the manufacturing
enterprises.
The following are the basic forms of organizations
 Sole proprietorship
 Partnership
 Corporation
 Co-operative

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In olden days the individual as a sole trader used to bring in his capital and manage
with the help of family members. This system has suffered with certain constraints
like limited resources, lack of expertise etc. Later, partnership form come into
existences to overcome some of the defects of sole trading. The partners used to
contribute in the form of money, assets, expertise; management etc. and profits will
be shared on agreed terms.

With the growth of industrialization, many business establishments have preferred

to set up corporate form of organization to overcome the major defects of sole
trading and partnership form of organization. In case of corporate form of
organization the finances are raised through shares, bonds, banks, financial
institutions, suppliers etc. We do come across another form of organization i.e. co-
operatives. The co-operatives raise funds through the members, government and
financial institutions.
1.4. Definition of Financial Management
Financial management is defined as the management of capital resources and uses
of such sources to attain the desired objective of a firm. Capital resources of a
business firm is obtained from two sources, i.e. resource owned and sacrificed by
the firm (internal fund) and resource borrowed and invested (external funds) by the
firm.
1.5. Growths and Evolution of Financial management

Finance becomes a separate area of study around 1900 for the first time. Since that
time, duties and responsibilities of financial managers have undergone continuous
changes. There are two main reasons for such an ongoing change in the functions
of finance.
i. The dynamic growth and increasing diversity of international economy and

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 ii. The time to time development of new analytical tools those have been adopted
by financial managers.
These developments of the finance function can be categorized in three distinct
phases;
1. The traditional phase 1900-1930’s:- finance was relatively new as a separate
business management function. The functions of financial management were
limited to some routine activities like, rising funds and safeguarding of assets
and ensuring that the firm had enough cash to meet its obligation.
2. The transitional phase 1930-1950’s:- financial management becomes a
separate business function. It became a decision oriented function and uses
analytical tools such as quantitative and computerized techniques, economical
and managerial accounting.
3. The modern phase since 1950’s:- the continues rapid change and
development of world business ensures that the finance function will not only
continue to develop but also have to accelerated its pace of development to
keep up with the complex problems and opportunities that the business
managers are facing.
1.6. The Objective of Financial Management

The financial manager uses the overall company's goal of shareholders' wealth
maximization which is reflected through the increased dividend per share and the
appreciations of the prices of shares in formulating financial policies and
evaluating alternative course of operation. In order to do so, this overall goal of
wealth maximization needs to be related to take the following specific objectives
of financial management into account. These are:

1) Financial management aims at determining how large the business firm

should be and how fast should it grow.

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 2) Financial management aims at determining the best percentage composition
of the firm's assets (asset portfolio decision, or decisions related to capital
uses).
3) Financial management also aims at determining the best percentage
composition of the firm's combined liabilities and equity decisions related
to capital sources).

1) Determining the Size and Growth Rate:

The size of the business firm is measured by the value of its total assets. If the
book values are used the size of the firm is equal to the total assets as indicated in
the balance sheet. When this method of size determination is used, the growth rate
of the business firm is measured by the yearly percentage change in the book
values of all the items in the assets section of the balance sheet.

As the student of financial management, you should be able to understand that

business firm that is large and growing fast and larger doesn't necessarily produce
increasing earnings.

2) Determining Assets Composition (Portfolio):

As indicated earlier, assets represent investments or uses of capital that the

business firm makes in seeking to earn a rate of return for its owners. The most
common asset categories are cash, inventories, and fixed assets. However,
financial institutions, such as banks and insurance companies, have somewhat
different asset categories. They may list loans and advances and negotiable
securities as assets. The percentage composition of the assets of the firm is
computed as ratio of the book value of each asset to total book values of all assets.
The choice of the percentage composition of assets item affects the level of
business risk. The asset structure decision relate to what products and services the
business firm should produce. The financial manager is directly involved in

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decisions related to the assets structure that makes business firm more successful in
a way it will maximize the wealth of shareholders. The wealth maximizing assets
structure can be described in either of the following ways:

1) The asset structure that yields the largest profits for a given level of
exposures to business risk, or
2) The asset structure that minimizes exposure to business risk that is
needed to generate the desired profits.
In both of the cases (i.e. 1 and 2), the financial manager should recognize that the
asset structure of the business firm is the major determinant of the overall risk-
return profile of the firm.

3) Determining the Composition of Liabilities and Equity

As it was stated, liabilities and equity are the sources of capital of the business
firms. They are the financing sources that business firms use to make investment
in various types of assets. The most common financing sources are accounts and
notes payable, accruals for items such as taxes, wages, loans and debt securities of
various maturity dates, common stocks, preferred stocks and retained earnings.
Here again, banks and insurance companies might secure funds from liability
accounts such as time deposits, demand deposit, and saving deposits. As it was
done for the percentage composition of assets, the liability and equity percentage
composition of the business firm is measured by dividing the book value of each
liability of equity item by the total book values of all liabilities and equity. The
mix of liabilities and equity of the business is what is known as the capital
structure.

When the business firm finances its investment by using debt capital, the business
firm and its shareholders face added risks along with the possibility of added
returns. The added risk is the possibility that the firm may face difficulty to repay

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its debts as they mature. Stock prices react to the manner of financing of business
firm, as well as, to the subsequent ability or inability of the firm to manage its
capital structure. The added returns come from the ability of the firm to earn the
rate of return higher than the interests and related financing costs of using
liabilities. The added returns may be paid as dividends and/or reinvested in the
firm to generate more profits. This in effect would maximize the wealth of
shareholders of the business firm.

1.7. Goals of Organizations

The financial objective of the firm is the maximization of owns economic welfare.
Wealth may be expressed as the amount of money which someone would pay now
for that stream of future profits, or expected cash flow. However, there is a
disagreement as to how the economic welfare of owners can be maximized. The
well-known and widely discussed criteria which are put forth for this purpose are;
a) profit maximization and b) wealth maximization
A. Profit maximization – increasing the birr income of the firm
Profit is the difference between cost and revenue. Traditionally, the business has
been considered as an economic institution. As such, it has developed a common
and unique measurement of efficiency, viz. profit. It is possible to assume profit
maximization as a natural business objective.
The appropriateness of this objective is justified on any of the following counts;
i. A human being performing any economic activity rationally aims as utility
maximization. It is argued that utility can be easily measured in terms of
profits.
ii. Profit maximization ensures economic natural selection and in the altimeter end,
only profit maximizer’s survive.
iii. The firm by pursuing its objective of profit maximization also maximizes social
economic welfares.

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However, the profit maximization objective has been criticized in recent years. It
fails to provide an operational feasible measure for ranking alternative courses of
action in terms of their economic efficiency.
It suffers the following three limitations.
1. It doesn’t account of the time value of money. It doesn’t make a distinction
between returns receiver in different time period. It gives no consideration to
the values benefits received today and benefits after a year or more as the
same.
2. It doesn't take account of risk and uncertainty. Risk can be defined the degree
of uncertainty about future net return. Two firms may have same total expected
earnings, but if the earnings of one firm risky the future stream of benefit may
be lead to loss.
3. It is ambiguous. The precise meaning of profit maximization objective is
unclear. Doesn’t it mean short term profit or long term profit? Does it profit
before tax or after tax?
For these reason value/wealth maximization has replaced profit maximization as
the operational criteria for financial management decision, by measuring benefits
in terms of cash flow. By discounting those cash flows over time, using the
concept of compound interest, we can take account of both risk and time value of
money.

B. Wealth maximization- maximizing the net present value of the course of

action
Wealth can be expressed as the amount of money which someone would pay now
for the expected cash flow. The benefit of investment or financing decision can be
measured in terms of the stream of future expected cash flows generated by the
decision.

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Value maximization decision criterion involves a comparison of value to cost.
Actions that has a discounted value, reflecting both time and risk, that exceeds its
cost can be said to create value. Such actions increase the value of the firm and
should be accepted. In the case of mutually exclusive alternatives, when only one
is to be chose, the alternative with the greatest net present value should be selected.

In the wealth maximization, the emphasis is on increasing value and not

necessarily profit. When we talk about value we talk about the market value of the
organization. Market values are determined by the future expected cash flow that
will be generated over the life of the business. In the profit maximization the
emphasis is on profit, especially the quantity of earnings.
Generally, value maximization is talking about the values of the company
generally expressed in the value of the stock. Profit maximization refers to how
much dollar profit the company makes.
1.8. Financial Markets Institutions
Financial market is a place where the business families can raise their long and
short-term financial requirements. The development of financial markets indicates
the development of economic system. For mobilization of savings and for rapid
capital formation, healthy growth and development of these markets are crucial.
These markets help promotion of investment activities; encourage entrepreneurship
and development of a country. The financial markets are broadly divided as
1. Capital market: Capital market is a financial market in which long-term debt
and equity instruments (maturity of one year or greater) are traded. Defined as
a place where all buyers and sellers of capital funds as well as the entire
mechanism for facilitating and effecting long term funds. It provides the long-
term funds that are needed for investment purpose. Thus, the capital markets

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 are concerned with long-term finance. This also includes the institutions,
facilities and arrangements for the borrowing and lending of long-term funds.
Further the capital markets are divided into two categories one is primary market
other one is secondary market.
i. Primary market – In the primary market only new securities are issued
to the public. It is a place where borrowers exchange financial securities
for long-term funds. It facilitates the formation of capital. The securities
may be issued directly to the individuals, institutions, through the
underwriters etc.
ii. Secondary market – is a financial market in which securities that has
been previously issued (and are those secondhand) can be sold.
2. Money Market
Money market is a financial market in which only short term debt instruments
(maturity of less than one year) are traded. It handles transactions in short-term
government obligations, banker’s acceptances and commodity papers. In money
market funds can be borrowed for short period varying from a day to a year. It is a
place where the lending and borrowing of short-term funds are arranged and it
comprises short-term credit instruments and individuals who participate in the
lending and borrowing business.
Financial Instruments
There are mainly two kinds of securities namely ownership securities and loan
securities. Further ownership securities are classified into two (a) common stock
and (b) preference stock. These securities or instruments are being traded in capital
markets.
 Common stock – It is also known as equity shares, who are the real owners
of the business will enjoy the profit or loss suffered by the company.

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 Preferential stock – By name these holders have two preferential rights I)
to get fixed rate of dividend at the end of every year irrespective of profits /
losses of the company II) to get back the investment first when the company
goes into liquidation.
 Bonds – Bondholders are the money suppliers to a business unit entitled for
a fixed rate of interest at the end of each year. Their stake is confined to the
interest only.

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