Lecture Notes

On
FINANCE AND RELATED DISCIPLINES
MBA – 2nd sem
BBA – 2nd sem
Subject – Financial Management
By : Dr Monisha Gupta

Department of Management, NGB (DU)

FINANCE AND RELATED DISCIPLINES
Financial Management is not an independent area, but an integral part of overall management. As a
subject too, Financial Management had been a branch of Economics till 1890. Later, it has evolved into a
separate discipline. It draws heavily on Economics to explain its theoretical concepts, even today. The
subject is of immense interest to academicians and practicing managers. Academicians take interest as
there are several controversies and no unanimous opinion is, still, found. Again, the subject is a matter
of great challenge to practicing managers as business affords a lot of scope to expand, with ever-
growing competition. Every decision-making process involves finance, demanding new innovative
products and techniques to use them to the utmost advantage of the firm. Finance managers often do
feel in real life why this subsequent thinking did not come to them earlier, to solve their problems.
Threat to survive sharpens the thinking process.

Finance and Economics

Economics has two broad areas, viz. Macroeconomics and Microeconomics.
Macroeconomics is concerned with overall institutional and international environment in which the
firm must operate. In other words, macroeconomics is the environment in which an industry operates,
which is not controllable by any individual firm. They are the external factors, which are beyond the
control of the company. They relate primarily to

• State of the economy

• Government policy

When we analyze our problems from the viewpoint of the whole economy, it is a macro economics.
Institutional environment encompasses banking system, capital markets, financial intermediaries, credit
policies of The Reserve Bank of India, structure and growth of financial system, monetary and economic
policies of the government, which vary periodically. Their awareness and adoption to change for the
firm is vital. Business firms operate in the macroeconomic environment. Unless the finance managers
understand the implications of the policy and assess the impact they make to the business, and change
accordingly, business firms cannot survive, let alone grow. Finance managers have to understand the
broad economic environment in which their firms work. To be successful, they cannot afford to function
in isolation. They should recognize the impact of each decision, be it monetary or credit policy, in terms
of their relative cost and availability of funds. For example, when the economy faces slump, it is not
advisable to go for expansion activities. Similarly, when the economy experiences an uptrend, firm can
opt for trading on equity for financing as larger profits are assured to most of the firms. That policy helps
the firm to increase earnings per share. Finance managers have to update their knowledge and make
detailed analysis in respect of matters affecting the company to apprise the management for the timely
changes to be introduced.

Microeconomics is firm’s specific environment and also controllable. Microeconomic factors deal with
the internal conditions of the firm. A few important factors are as under:
1. Nature and Size of Enterprise: Firms differ in activities and their size. Their capital structure and
methods of financing also depend on their size. A manufacturing firm or public utility organization would
require more fixed assets, so their capital structure is large. Small firms can obtain their fixed assets
even on lease. But, large firms would construct their own building and assemble their own plants. Unlike
big firms, small firms do not enjoy goodwill in the capital market and are largely dependent on internal
finances.

2. Level of Risk and Stability in Earnings: Risk influences the financial decisions of the firm. Greater the
risk, firm has to retain more profits, rather than adopting a liberal dividend policy. Firms that enjoy
stable earnings prefer fixed-cost capital, such as preference shares and debentures as they can pay the
fixed amount of interest, without difficulty, from their earnings. Where stable earnings do not exist,
financing is done through equity as there is no commitment to pay fixed and regular dividend.

3. Liquidity Position: Dividend, normally, is paid out of cash. Firms with a sound liquidity position can
adopt liberal dividend policy. If there is illiquidity in the firm, it affects nature of financing and dividend
decisions.

4. Pattern of Ownership: In a closely-held company, ownership lies in a few hands. It is easier to

convince them that a conservative dividend policy is good to them, if the policy is in the interests of the
company. Where there are many shareholders, their wishes matter the most in decision-making. Their
preferences cannot be ignored, while designing dividend policy.

5. Attitude of Management: Though listed last, importance of attitude of management is not the least.
If the firm is conservative, greater importance is given to liquidity, rather than the profitability. More
investment is made in current assets. The finance manager tries to tread a beaten path, preferring to
avoid fixed obligations for raising additional capital, even if debt capital is advantageous. On the other
hand, finance manager in an aggressive firm stresses profitability, sacrificing importance of liquidity.
Additional capital is raised by debt, accepting the risk of debt to take advantage of the debt.
Alternatively, preference may be given to conduct the business with lesser current assets.

Finance and Accounting

Much of the modern business is not possible without accounting information. It is an accepted fact that
business is finance oriented. It is the process of using money to make money. Accounting generates
information/data related to activities/operations of a firm, dealing in goods or services. Necessary input
is provided by accounting for finance function. Accounting is a source of most information, which
management uses for decision-making. Management is heavily dependent on accounting for operating
facts.

Finance is closely related to accounting. Accounting is the data collection process, dealing with accurate
reporting, while finance is a managerial or decision-making process. Accounting provides the input for
finance. Finance is wide, while accounting is its part. Finance is referred to with greater respect than
accounting. In many organizations, finance is entrusted only to those who enjoy the trust of the top
management. End products of accounting—profit and loss account, balance sheet, sources and
application of funds statement and cash flow statement—assist finance managers in assessing the past
performance and understanding the future directions of the firm.

There are two key differences between accounting and finance. One relates to treatment of funds and
the other relates to decision-making.

Treatment of Funds: Accrual system of accounting is the backbone of accounting, which forms the basis
for determination of operating results. Revenue is recognized at the point of sale, irrespective of its
realization of sale proceeds. In other words, collection of cash has no significance. Similarly, expenses
are recognized when they are incurred, not at the time of payment. Payment of expense is not relevant
at all. A firm may be quite profitable in the accounting sense, but, still, struggling, even, to make small
cash payments due to liquidity problems. In fact, such a book profit firm cannot survive very long.
Solvency is always a challenge, if it is not the focus of the firm. For treatment of funds, finance is based
on cash flows. Funds mean inflow and outflow of cash. Sales, when actually realized, are inflows and
expenses when paid are outflows. Here, the importance is on solvency, i.e. ability to maintain cash
obligations as and when they fall due for payment. Insolvency situation is avoided. The goal of the firm is
to maintain the necessary cash flows, to meet its obligations and finance the assets needed for the firm.

Decision-making: Accounting and finance differ in their purpose. The purpose of accounting is collection
and presentation of data. The data so made available is used by the finance manager for decision-
making. It does not mean that accountants never make decisions and finance managers never collect
data. Their focus is different. Accountants collect accurate data and finance managers plan, control and
make decisions. In a way, finance begins where accounting ends.

Finance and Other Related Disciplines

Finance also draws support from other related disciplines, such as production, marketing and
quantitative methods. Finance is a service function to meet the needs of production and marketing. If
the firm decides to produce and sell more, capital expenditure projects may be needed, for which
finance manager has to arrange funds. Such a decision also would have impact on the projected cash
flows. In those areas, production and finance managers need to work closely for optimum investment in
plant and machinery. Finance is becoming a complex area and so tools of analysis developed in the
quantitative methods area are helpful in analyzing the complex financial management problems.