Module I Financial Management- An Introduction
Financial Management: Meaning, Scope, Objectives of Financial Management, Profit Vs Wealth
Maximization, Financial Management and other Areas of Management, Liquidity Vs Profitability, Methods
of Financial Management, Organization of Finance Functions, Sources of Financing: Classification of
Sources of Finance, Security Financing Loan, Financing Project, Financing Loan, Syndication- Book
Building. New Financial Institutions and Instruments: Depositories, Factoring, Venture Capital, Credit
Rating, Commercial Paper, Certificate of Deposit.
Financial Management: Financial management is the operational activity of a business that is responsible
for obtaining and effectively utilising the funds necessary for efficient operations. Financial management is
the process of planning funds, organizing available funds and controlling financial activities to achieve the
goal of an organization. It includes three important decisions which are investment decisions, financing
decision and dividend decision for a specified period of time. Investment decision includes working capital
decision and capital budgeting decision. Financing decision involves identifying sources of financing,
determining the duration and cost of financing and managing investment return.
Financial management is concerned with three key activities namely:
• Anticipating financial needs
• Acquiring financial resources
• Allocating funds in business
Scope/Elements
1. Investment decisions includes investment in fixed assets (called as capital budgeting). Investment in
current assets is 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:
• Dividend for shareholders- Dividend and the rate of it has to be decided.
• 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
1. The financial management is generally concerned with procurement, allocation and control of financial
resources of a concern. The objectives can be1. 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.
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Module I Financial Management- An Introduction
Functions of Financial Management
Estimate
Required
Capital
Monitering Determine
Financial Capital
Activities Structure
Functions of
Financial
Management
Eveluate
Distribute
and Select
Profit &
Sources of
Surplus
Funds
Allocate
and Control
Funds
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 has been made, the capital structure has 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 like:
• Issue of shares and debentures.
• Loans to be taken from banks and financial institutions.
• 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 has 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, maintenance of enough stock, purchase of raw materials, etc.
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Module I Financial Management- An Introduction
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.
Importance of Financial Management:
The importance of financial management is vital to an organization. It is a pathway to attain goals and
objectives. The financial manager measures organizational efficiency through proper allocation, acquisition,
and management. It improves operational efficiency by providing a timely supply of fund. The following
noticeable importance is found from financial management:
• Provides guidance in financial planning
• Assist in acquiring funds from different sources
• Helps in investing the appropriate amount of funds
• Increase organizational efficiency
• Reduces delay production
• Cut down financial costs
• Reduces cost of fund
• Ensures proper use of fund
• Helps business firm to take financial decisions
• Makes a guideline of earning maximum profits incurring minimum cost
• Increase shareholder’s wealth
• Control the financial aspects of the business
• Provide information through financial reporting
• Makes the employees aware of saving funds.
Traditional approach to financial management
Traditionally, financial management was considered as a branch of knowledge with focus on the procurement
of funds. Instruments of financing, formation, merger and restructuring of firms, legal and institutional frame
work involved therein occupied the prime place in this approach.
Modern approach to financial management
Modern phase has shown the commendable development with combination of ideas from economic and
statistics that led the financial management more analytical and quantitative. The key work area of this
approach is rational matching of funds to their uses, which leads to the maximisation of shareholders' wealth.
Financial management "is the operational activity of a business that is responsible for obtaining and
Effectively utilising the funds necessary for efficient operations".
Profit V/s Wealth Maximization
Profit Maximization Objective (Traditional Approach): The traditional approach of financial
management was all about profit maximization. Earlier the main objective of companies was only to
make more and more profits. This approach of financial management had many limitations:
Limitations of Profit Maximization Objective:
• The term ‘profit’ is vague.
• The term ‘maximum’ is ambiguous.
• The time factor is ignored.
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Module I Financial Management- An Introduction
• It does not consider the time value of money.
• It ignores the risk factor.
• Business may have several other objectives other than profit maximization. Companies
may have goals like: a larger market share, high sales, greater stability and so on. The
traditional approach did not take into account these aspects.
• Social Responsibility is one of the most important objectives of many firms. Big companies
make an effort towards giving back something to the society. They use a certain amount
of the profits earned for social causes. It seems that the traditional approach did not
consider this point.
Wealth Maximization Objective (Modern Approach): Modern Approach is about the idea of wealth
maximization that removes all the limitations of the profit maximization objective. Wealth maximization
involves increasing the Earning per share of the shareholders and to maximize the net present worth. Wealth
means net present worth which is the difference between gross present worth of some decision or course of
action (capitalized value of the expected cash benefits) and the investment required to achieve these benefits
(original cost).
The Wealth Maximization approach is concerned with the amount of cash flow generated by a course of
action rather than the profits. Any course of action that has net present worth above zero creates wealth should
be selected. The goals of financial management may be such that they should be beneficial to owners,
management, employees and customers. These goals may be achieved only by maximizing the value of the
firm.
Elements of Wealth Maximization:
The elements involved in wealth maximization of a firm are as follows:
1. Increase in Profits: A firm should increase its revenues in order to maximize its value. For this
purpose, the volume of sales or any other activities should be stepped up. It is a normal practice for a
firm to formulate and implement all possible plans of expansion and take every opportunity to
maximize its profits. In theory, profits are maximized when a firm is in equilibrium. At this stage, the
average cost is minimum and the marginal cost and marginal revenue are equal. A word of caution,
however, should be sounded here. An increase in sales will not necessarily result in a rise in profits
unless there is a market for increased supply of goods and unless overhead costs are properly
controlled.
2. Reduction in Cost: Capital and equity funds are factor inputs in production. A firm has to make every
effort to reduce cost of capital and launch economy drive in all its operations.
3. Sources of Funds: A firm has to make a judicious choice of funds so that they maximize its value.
The sources of funds are not risk-free. A firm will have to assess risks involved in each source of
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Module I Financial Management- An Introduction
funds. While issuing equity stock, it will have to increase ownership funds into the corporation. While
issuing debentures and preferred stock, it will have to accept fixed and recurring obligations. The
advantages of leverage, too, will have to be weighed properly.
4. Minimum Risks: Different types of risks confront a firm. "No risk, no gain" - is a common adage.
However, in the world of business uncertainties, a corporate manager will have to calculate business
risks, financial risks or any other risk that may work to the disadvantage of the firm before embarking
on any particular course of action. While keeping the goal of maximization of the value of the firm,
the management will have to consider the interest of pure or equity stockholders as the central focus
of financial policies.
5. Long-run Value: The goal of financial management should be to maximize long run value of the
firm. It may be worthwhile for a firm to maximize profits by pricing its products high, or by pushing
an inferior quality into the market, or by ignoring interests of employees, or, to be precise, by resorting
to cheap and "get-rich- quick" methods. Such tactics, however, are bound to affect the prospects of a
firm rather adversely over a period of time. For permanent progress and sound reputation, it will have
to adopt an approach which is consistent with the goals of financial management in the long-run.
Advantages of Wealth Maximization:
• 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 (i.e. quantitatively).
• It considers the concept of time value of money. The present values of cash inflows and outflows help
the management to achieve the overall objectives of a company.
• The concept of wealth maximization is universally accepted, because, it takes care of interests of
financial institution, owners, employees and society at large.
• Wealth maximization guides the management in framing consistent strong dividend policy, to earn
maximum returns to the equity holders.
• 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.
Limitations of Wealth Maximization: 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 and misinterpretation of financial policy because different yardsticks may be used by different
interests in a company.
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Difference between Profit Maximization and Wealth Maximization
Aspect Profit Maximization Wealth Maximization
Primary Goal Maximize short-term profits Maximize long-term shareholder wealth
Time Horizon Short-term focus Long-term focus
Measurement of
Focuses on immediate profits Considers overall financial well-being
Success
Takes into account future income and
Emphasis Primarily on current income
capital gains
Risk Tolerance May prioritize riskier strategies Tends to be more risk-averse
May lead to decisions that sacrifice long- Focuses on sustainable growth and value
Decision Making
term sustainability for short-term gains creation
Stakeholder May not prioritize the interests of all Considers the interests of shareholders,
Consideration stakeholders employees, and other stakeholders
Flexibility in May not be flexible in adapting to Adapts strategies to achieve long-term
Strategy changing market conditions success
Accounting Often relies on accounting profits and Considers economic value added (EVA)
Methods short-term financial metrics and total shareholder return (TSR)
Use of Financial May focus on metrics like Return on Considers metrics like Price-to-Earnings
Ratios Investment (ROI) and Net Profit Margin (P/E) ratio and Price-to-Book (P/B) ratio
Approach to Risk May involve risk-taking for immediate Emphasizes risk mitigation and
Management gains sustainability
Impact on
May lead to short-termism and a negative Generally, promotes responsible and
Corporate
public perception ethical business practices
Reputation
Liquidity Vs Profitability
Liquidity
Liquidity means the debt-repaying capacity of an undertaking. It refers to the firm’s ability to meet the claims
of suppliers of goods, services and capital. According to Archer and D’Ambrosio, liquidity means cash and
cash availability, and it is from current operations and previous accumulations that cash is available, to take
care of the claims of both the short-term suppliers of capital and the long-term ones. It has two dimensions;
the short-term and the long-term liquidity.
Short-term liquidity implies the capacity of the undertaking, to repay the short-term debt, which means the
same as the ability of the firm in meeting the currently maturing obligations form out of the current assets.
The purpose of the short-term analysis is to derive a picture of the capacity of the firm to meet its short-term
obligations out of its short-term resources, that is, to estimate the risk of supplying short-term capital to the
firm.
Long-term liquidity refers to the ability of the firm to retire long-term debt and interest and other long-run
obligations. When relationships are established along these lines, it is assumed that in the long-run assets could
be liquidated to meet the financial claims of the firm. Quite often the expression ‘liquidity’ is used to mean
short-term liquidity of the companies.
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Types of Liquidity
1. Market Liquidity: Market liquidity refers to the ability of a financial instrument, such as a stock or bond,
to be bought or sold in the market without causing a significant impact on its price. It is characterized by the
ease with which assets can be converted into cash. A liquid market typically has a high volume of trading
activity and narrow bid-ask spreads.
Components:
• Bid-Ask Spread: The difference between the highest price a buyer is willing to pay (bid) and the
lowest price a seller is willing to accept (ask). A smaller spread indicates higher liquidity.
• Trading Volume: The total number of shares or contracts traded within a specific time period. Higher
trading volumes often indicate more liquid markets.
Significance:
• Market liquidity is crucial for price stability and efficient market functioning.
• It ensures that buyers and sellers can transact without significant delays or price fluctuations.
• Higher liquidity is generally associated with lower transaction costs.
2. Asset Liquidity: Asset liquidity pertains to the ease with which a particular asset, such as stocks, bonds, or
real estate, can be quickly bought or sold in the market without causing a substantial change in its price. Highly
liquid assets can be converted into cash with minimal impact on their value.
Examples of Liquid Assets:
• Cash or Cash Equivalents: Includes currency, money market instruments, and short-term
government securities.
• Marketable Securities: Stocks and bonds that can be readily traded in the secondary market.
Significance:
• Investors value liquidity as it provides flexibility to adjust portfolios quickly.
• Liquid assets are often considered less risky because they can be easily converted to cash in case of
need.
• Central to risk management strategies and investment decision-making.
3. Funding Liquidity: Funding liquidity refers to an entity's ability to meet its short-term financial obligations
and access sources of funding. It is crucial for businesses, financial institutions, and individuals to have access
to credit or funding when needed.
Factors Affecting Funding Liquidity:
• Credit Lines: Agreements that allow entities to borrow a certain amount within a specified period.
• Borrowing Costs: The interest rates and fees associated with obtaining funds.
• Availability of Credit: The willingness of lenders to provide funds.
Significance:
• Adequate funding liquidity is essential for the day-to-day operations of businesses and financial
institutions.
• Lack of funding liquidity can lead to financial distress and, in extreme cases, insolvency.
• Central banks and regulators monitor and intervene to ensure the stability of funding markets.
In summary, these three types of liquidity are interconnected and crucial for the efficient functioning of
financial markets and the overall stability of the economy. Investors, institutions, and policymakers closely
monitor and manage these aspects to ensure a well-functioning financial system.
Determinants of Liquidity:
• The size of the market in terms of the number of buyers and sellers influences liquidity.
• Lower transaction costs, including brokerage fees and taxes, contribute to higher liquidity.
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• The transparency and availability of information about assets enhance liquidity.
• Regulations affecting trading and market-making activities can impact liquidity.
• Economic stability and growth contribute to overall market liquidity.
• Positive market sentiment and investor confidence foster liquidity.
• The presence of market makers who facilitate buying and selling can enhance liquidity.
Effect of Liquidity
Liquidity has significant effects on businesses, influencing their financial health, operational
flexibility, and overall sustainability. Here are some key effects of liquidity on businesses:
• Working Capital Management: Adequate liquidity is essential for effective working capital
management. Businesses need cash to cover day-to-day operational expenses, pay suppliers,
and manage short-term liabilities.
Lack of liquidity can lead to disruptions in the supply chain, delayed payments, and strained
relationships with suppliers and creditors.
• Operational Flexibility: Liquid businesses have the flexibility to seize opportunities and
navigate challenges. They can invest in new projects, take advantage of discounts from
suppliers, or weather unexpected economic downturns.
Insufficient liquidity may constrain a business's ability to adapt to changing market
conditions, making it more vulnerable to external shocks.
• Debt Servicing and Financial Obligations: Liquidity is crucial for servicing debt
obligations, including interest payments and principal repayments. Businesses with ample
liquidity can meet their debt obligations without resorting to additional borrowing.
Inadequate liquidity may lead to financial distress, affecting a company's creditworthiness
and potentially leading to default.
• Investment and Growth: Liquidity provides the financial resources necessary for
investment in new projects, expansion, and innovation.
Businesses with strong liquidity positions can pursue growth opportunities, while those
facing liquidity constraints may need to delay or scale back their expansion plans.
• Risk Management: Liquidity acts as a buffer against unexpected events and uncertainties. It
allows businesses to manage risks effectively by having the resources to handle emergencies
or unforeseen challenges.
Insufficient liquidity can leave a business exposed to financial risks, reducing its ability to
withstand economic downturns or industry-specific challenges.
• Shareholder Confidence: Maintaining liquidity instils confidence among shareholders and
investors. They are more likely to invest in or hold shares of a company that can demonstrate
its ability to manage cash flow and meet financial obligations.
A lack of liquidity may erode investor confidence, leading to a decline in the company's stock
value and potential shareholder dissatisfaction.
• Credit Rating and Access to Capital: Liquidity is a key factor considered by credit rating
agencies. A strong liquidity position enhances a company's creditworthiness, potentially
lowering borrowing costs and improving access to capital. Poor liquidity may result in a
downgrade of a company's credit rating, making it more challenging and costly to raise funds
through debt issuance.
• Market Perception: Businesses with ample liquidity often enjoy positive perceptions in the
market. Conversely, a perceived lack of liquidity may lead to negative sentiment among
customers, suppliers, and other stakeholders. Market perception can impact a company's
relationships and its ability to attract and retain customers, suppliers, and talented employees.
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Profitability: Profitability is a key financial metric that assesses a company's ability to generate earnings
and ultimately achieve a return on investment. It is a crucial aspect of financial performance and reflects the
efficiency and effectiveness of a business in using its resources to generate a surplus after covering all relevant
expenses. Profitability is typically measured using various financial ratios and metrics.
The profitability of an industry has obviously a direct bearing on its growth. This is principally due to the
psychological incentives and the financial resources that the profitability provides. High profitability makes
possible to plough back substantial resources, helps to raise equity capital in the investment market; and make
it possible to raise loans. Thus, it is business confidence in the level of profitability which is the primary
determinant of the decision to invest. Despite the vilification of profit by forces on the extreme left, a mixed
economy will not undertake productive investment in plant and machinery unless management in reasonably
assured of earning a rate of return at least commensurate with the risks involved.
Types of Profitability Measures:
• Gross Profit Margin: This measure represents the percentage of revenue that exceeds the cost of
goods sold (COGS). It indicates how well a company is managing its production costs.
(Gross Profit / Revenue) x 100
Operating Profit Margin: Also known as EBIT (Earnings Before Interest and Taxes) margin, it reflects a
company's profitability from its core operations, excluding interest and taxes.
(Operating Profit / Revenue) x 100
Net Profit Margin: This measures the percentage of revenue that remains as net profit after all expenses,
including taxes and interest, have been deducted.
(Net Profit / Revenue) x 100
Return on Assets (ROA): ROA assesses how efficiently a company utilizes its assets to generate profits. It is
expressed as a percentage.
(Net Income / Average Total Assets)
Return on Equity (ROE): ROE evaluates the return generated on shareholders' equity, indicating how well
a company uses shareholder funds to generate profits.
(Net Income / Average Shareholders' Equity)
Earnings Per Share (EPS): EPS measures the profit attributable to each outstanding share of common stock.
(Net Income - Dividends on Preferred Stock) / Average Outstanding Shares
Determinants of Profitability:
• Operational Efficiency: Streamlined and efficient operations can lead to lower production costs,
higher gross margins, and improved overall profitability.
• Cost Management: Effective cost control and management practices help reduce expenses,
contributing to higher profitability margins.
• Revenue Growth: Increasing sales and expanding the customer base can positively impact
profitability, especially if the growth is accompanied by effective cost management.
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• Market Competition: The level of competition in the industry influences pricing power and,
consequently, profitability. Intense competition may pressure prices and margins.
• Economic Conditions: The overall economic environment, including factors like inflation and interest
rates, can affect a company's profitability.
• Financial Leverage: The use of debt can amplify returns, but it also introduces interest expenses. The
optimal capital structure can impact profitability.
• Industry Dynamics: The nature of the industry, market trends, and technological advancements can
influence a company's profitability.
Effects of Profitability on Business:
• Financial Health: Profitability is a key indicator of a company's financial health. Consistent profits
allow businesses to reinvest, pay debts, and withstand economic downturns.
• Investor Confidence: Profitable companies tend to attract investors, leading to increased market
capitalization and a positive perception in the financial markets.
• Dividend Payments: Profitability enables companies to distribute dividends to shareholders,
rewarding investors and potentially attracting new ones.
• Operational Investments: Profitable businesses have the financial capacity to invest in research and
development, new technologies, and other operational improvements.
• Creditworthiness: Profitability positively influences a company's creditworthiness, making it easier
to access financing and negotiate favourable borrowing terms.
• Employee Morale and Retention: Profitable companies can offer competitive salaries, benefits, and
job security, contributing to higher employee morale and retention.
• Competitive Positioning: A strong profitability position allows a company to reinvest in its
operations, innovate, and maintain a competitive edge within its industry.
Difference Between Liquidity and Profitability
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Methods of Financial Management:
1. Budgeting: Budgeting is the process of creating a comprehensive plan that outlines expected income and
expenses over a specific period, typically a fiscal year.
Importance:
• Resource Allocation: Budgets help allocate financial resources efficiently, ensuring that funds are
directed toward the most critical activities and projects.
• Goal Setting: They set financial goals and benchmarks, providing a roadmap for achieving
organizational objectives.
• Performance Evaluation: Budgets serve as a standard for measuring actual performance against
planned targets, facilitating performance evaluation and adjustments.
2. Financial Planning: Financial planning involves outlining the organization's financial goals and
developing strategies to achieve them, taking into account factors like revenue growth, cost control, and risk
management.
Importance:
• Strategic Alignment: Financial planning aligns financial activities with the organization's overall
strategic objectives, ensuring a cohesive approach to achieving long-term goals.
• Risk Mitigation: By anticipating future financial challenges and uncertainties, financial planning
helps in developing strategies to mitigate potential risks.
• Resource Optimization: It aids in optimizing the use of financial resources by prioritizing initiatives
that contribute most to the organization's success.
3. Cash Flow Management: Cash flow management involves monitoring and optimizing the inflow and
outflow of cash to ensure there is enough liquidity to cover operational needs.
Importance:
• Operational Stability: Effective cash flow management ensures that the organization has enough
liquidity to cover day-to-day operational expenses, preventing disruptions.
• Debt Servicing: It helps in timely payment of debts and obligations, avoiding penalties and
maintaining a good credit standing.
• Strategic Decision Support: Cash flow insights aid in making strategic decisions, such as when to
invest, expand, or cut costs.
4. Capital Structure Management: Capital structure management involves deciding on the mix of debt and
equity financing used to fund the organization's activities.
Importance:
• Cost of Capital: An optimal capital structure influences the cost of capital, minimizing it and
maximizing returns to shareholders.
• Financial Flexibility: It provides financial flexibility by determining the right balance between debt
and equity, considering the organization's risk tolerance and profitability.
• Leverage and Risk Management: Managing the capital structure helps control financial risk, as
excessive debt can increase financial vulnerability.
5. Risk Management: Risk management involves identifying, assessing, and mitigating financial risks such
as market risk, credit risk, and operational risk.
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Importance:
• Protection from Losses: Effective risk management safeguards the organization from potential
financial losses due to unforeseen events.
• Enhanced Decision-Making: A thorough understanding of risks allows for informed decision-making
and strategic planning.
• Compliance and Reputation: Managing risks ensures compliance with regulations, maintaining the
organization's reputation and stakeholder trust.
6. Investment Decisions: Investment decisions involve evaluating potential projects or assets for acquisition,
using methods like Net Present Value (NPV) and Internal Rate of Return (IRR).
Importance:
• Growth Opportunities: Smart investment decisions contribute to the organization's growth and
expansion.
• Resource Allocation: It aids in allocating resources to projects with the highest potential return on
investment.
• Competitive Advantage: Strategic investments can provide a competitive advantage by enhancing
capabilities or entering new markets.
7. Cost Control: Cost control involves managing and monitoring expenses to ensure they align with budgetary
constraints.
Importance:
• Profitability Improvement: Efficient cost control contributes to improved profitability by preventing
unnecessary expenditures.
• Operational Efficiency: It helps streamline operations and eliminate inefficiencies, leading to better
resource utilization.
• Competitive Positioning: Controlling costs can lead to competitive pricing, enhancing the
organization's position in the market.
8. Financial Reporting and Analysis: Financial reporting involves preparing and presenting financial
statements, while financial analysis includes assessing financial performance using ratios, trend analysis, and
other tools.
Importance:
• Stakeholder Transparency: Financial reporting provides transparency to stakeholders, including
investors, regulators, and employees.
• Decision Support: Financial analysis informs decision-making by providing insights into financial
health, efficiency, and areas for improvement.
• Investor Confidence: Accurate and transparent financial reporting enhances investor confidence and
trust in the organization.
9. Dividend Policy: Dividend policy determines how profits are distributed to shareholders as dividends or
retained for reinvestment.
Importance:
• Shareholder Value: A well-defined dividend policy contributes to shareholder value by providing
returns on investment.
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• Capital Structure Impact: Dividend policies can influence the capital structure and financial health
of the organization.
• Investor Relations: Clear communication of dividend policies enhances investor relations and
satisfaction.
10. Financial Control: Financial control involves monitoring actual financial performance against the budget,
identifying variances, and taking corrective actions.
Importance:
• Performance Evaluation: Financial control allows for continuous performance evaluation and
adjustments to ensure financial goals are met.
• Resource Optimization: It helps in optimizing resource allocation by identifying areas where costs
can be controlled or reallocated.
• Strategic Alignment: Financial control ensures that financial activities align with the organization's
strategic objectives and priorities.
These methods collectively form a comprehensive framework for managing financial resources, ensuring the
organization's financial stability, growth, and overall success.
Organization of Finance Function
Finance, being an important portfolio, the finance functions is entrusted to top management. The Board of
Directors, who are at the helm of affairs, normally constitutes a „Finance Committee‟ to review and formulate
financial policies. Two more officers, namely „treasurer‟ and „controller‟ – may be appointed under the direct
supervision of CFO to assist him/her. In larger companies with modern management, there may be Vice-
President or Director of finance, usually with both controller and treasurer. The organization of finance
function is portrayed below:
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The terms ‘controller’ and ‘treasurer’ are in fact used in USA. This pattern is not popular in Indian corporate
sector. Practically, the controller / financial controller in India carried out the functions of a Chief Accountant
or Finance Officer of an organization. Financial controller who has been a person of executive rank does not
control the finance, but monitors whether funds so augmented are properly utilized. The function of the
treasurer of an organization is to raise funds and manage funds. The treasures functions include forecasting
the financial requirements, administering the flow of cash, managing credit, flotation of securities, maintaining
relations with financial institutions and protecting funds and securities. The controller’s functions include
providing information to formulate accounting and costing policies, preparation of financial reports, direction
of internal auditing, budgeting, inventory control payment of taxes, etc.
DUTIES AND RESPONSIBILITIES OF FINANCIAL MANAGER (OR) FUNCTIONS OF
FINANCIAL MANAGER (OR) ROLE OF FINANCIAL MANAGER.
Finance manager is an integral part of corporate management of an organization. With his profession
experience, expertise knowledge and competence, he has to play a key role in optimal utilization of financial
resources of the organization. With the growth in the size of the organization, degree of specialization of
finance function increases. In large undertakings, the finance manager is a top management executive who
participants in various decision-making functions.
A) Determining financial needs: One of the most important functions of the financial manager is to ensure
the availability of adequate financing, financial needs have to be assessed for different purposes. Money may
be required for initial promotional expenses, fixed capital and working capital needs. Promotional expenditure
includes expenditure incurred in the process of company formation.
B) Determining sources of funds: The financial manager has to choose source of funds. He may issue
different types of securities and debenture, may borrow form a number of finance institutional and the public.
The financial manager must definitely know what he is doing, workout strategies to ensure good financial
health of the firm.
C) Financial analysis: It is the evaluation & interpretation of a firm’s financial position and operation and
involves a comparison and interpretation of accounting data. The financial manager has to interpret different
statements.
D) Optimal capital structure: The financial manager has to establish an optimum capital structure and ensure
the maximum rate of return on investment and the liabilities carrying – fixed charges have to be defined.
E) Cost –volume profit analysis: This is popularly known as the CVP relationship for this purpose are fixed
cost, variable cost and semi-variable cost have to be analysed.
F) Profit planning and control: Profit planning and control have assumed great importance in the financial
activities of modern business. Profit planning ensures the attainment of stability and growth. The break-even
analysis and cost volume profit it analysis are important tools in profit planning and control of the firms.
G) Fixed assets management: A firm’s fixed assets are land, building, machinery and equipment, furniture
and such intangibles as patents, copy rights and goodwill. These fixed assets are justified to the extent of the
utility or their production capacity.
H) Capital budgeting: It refers to the long-term planning for (1) investment in projects and fixed assets and
(2) methods of financing the approved projects. It includes the methods of mobilization of long-terms funds
and their deployments in profitable projects. Capital budgeting is considered as the process of making
investment decisions on capital expenditure.
I) Dividend policies: The dividend policy of a firm determines the magnitude of the earnings distributed to
shareholders. The net operating profit or profit after tax (PAT) has to be intelligently apportioned between
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divided payments, and investments. The dividend policy determines the amount of dividend payment to be
made to the shareholders, the date of payments of dividends and the effect of the dividend policy on the value
of the firm.
J) Acquisition and mergers: A merger is a transaction where two firms agree to integrate their operations on
a relatively equal basis because they have resources and capabilities that together may create a stronger
competitive advantage. Two or more companies combine to form either a new company or one of the
combining companies survives, which is generally the acquirer.
Classification of Sources of Finance
The sources of finance are classified based on period as long, medium and short-term finance. As per the
ownership and control it is classified as Owned funds and borrowed funds. Depending upon the source of
generating this ternal. Each of these sources is further classified funds and borrowed funds. Depending upon
the source of generating this fund it is either internal or external. Each of these sources is further classified as:
A] LONG TERM FINANCE: Financing means providing money for investment in the form of fixed assets
and also in the form of working capital needed for day-to-day operations
(I)EXTERNAL SOURCES:
1. Owned capital (Preference and Equity Capital)
2. Debentures
3. Public Deposits
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4. Lease Financing
5. Hire Purchase
6. Institutional Assistance
7. Government subsidies
8. Mortgage Bonds
9. Venture Capital
(II) INTERNAL SOURCES:
1. Retained earnings
2.Provision for Depreciation
EXTERNAL SOURCES:
1. Preference Shares: Preference shares have two preferential rights. One at the time of payment of dividend
and second repayment of capital at the time of liquidation of the company.
Advantages
• No voting rights and normally has no control over the policies.
• Finance through preference shares is less costly as compared to the equity shares.
• The dividend rate is fixed, providing a constant rate of income to the investors. They do not present a
major control or ownership problem if the dividend amount is being paid to them. In certain specific
cases preference shareholders have voting rights, but they do not pose any major control problem for
the promoters.
• The other advantage of preference shares is that of cumulative dividends. Cumulative preference
shares carry accumulated unpaid dividends year to year till the company can pay all the dividends
including the arrears at a stated rate.
• It helps to maintain the status quo in the control of the equity stock and reduce the cost of capital as
the preferred stock carries lower rate of dividends as compared to other debt securities, like debentures
which usually carry higher rates of interest.
• The preference shareholders may have a right to share the surplus profits by way of additional dividend
and the right to share in the surplus assets in the event of winding-up after all kinds of capital have
been repaid.
• The company does not face liquidation or any other legal proceedings, if it fails to pay preference
dividends, as there is no such legal compulsion to pay preference dividends.
Disadvantages
• Compared to equity capital it is a very expensive source of financing.
• The preference shareholders do not have voting rights, so there is no direct control over the
management of the company. They get only a fixed rate of dividend, even if the company enjoys more
profits.
• The cumulative preference shares become a permanent burden so far as the payment of dividend is
concerned. The company is under an obligation to pay the dividends for the unprofitable periods also.
• In case, if the company earns returns less than the cost of preference share capital, it may result in
decrease in earnings per share (EPS) for the equity shareholders.
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• For tax calculation dividend on preference shares is not a deductible expense, but interest is a
deductible expense.
• Though there is no legal obligation to pay preference dividends, skipping them can adversely affect
the image of the firm in the capital market.
2. Equity Shares: The equity shares are the main sources of finance and the owners of the company contribute
it. It is the source of permanent capital since it does not have a maturity date. The holders of equity shares
have a control over the working of the company. These shares are issued without creating any charge over the
assets of the company.
Advantages
• The equity shares are not repayable to the shareholders and thus it is a permanent capital for the
company unless the company opts to return it through buying its own shares.
• The debt capacity of a company depends on its equity including reserves. Hence, raising of capital
through equity enhances the company’s debt capacity.
• The company has no legal obligation to service the equity by paying a certain rate of dividend, unlike
the debt for which interest is payable. Therefore, the firm can conserve the cash when it faces the
shortages and pay when its earnings are adequate to do so.
Disadvantages
• Among the alternative sources of capital, the equity capital cost is high, because of higher risk, flotation
costs, non-deductibility of dividend for tax purposes, etc.
• Investors perceive the equity shares as highly risky due to residual claim on assets, uncertainty of
dividend and capital gains. Therefore, the company should offer higher returns to attract equity capital.
• Addition to equity capital may not raise profits immediately, but will dilute the earnings per share,
adversely affect the value of the company.
• In raising of capital by offering equity shares will reduce the power of promoters control, unless they
contribute proportionately, or opt for non-voting shares which are costlier than ordinary equity shares.
3. Debentures: Debentures are certificates issued by the company acknowledging the debt due by to its
holders with or without a charge on the assets of the company. A fixed interest has to be paid regularly till the
principal has been fully repaid by the company. The debentures are instruments for raising debt finance and
the debenture holders are the creditors of the company. Debt provides the capital to a company with fixed cost
liability (Interest to be paid annually/semi-annually). The debenture holders get interest paid as the payment
of interest is an obligation on the company. But they do not have voting rights which equity shareholders have.
They have claim over the assets of the company before the equity holders. The obligations of the company
issuing debentures include establishing a Trustee through a trust deed. The trustee, usually a bank or financial
institution is supposed to ensure that the company fulfils its contractual obligations. Secondly, debentures are
backed by mortgages/charges on the immovable properties of the companies. These debentures are redeemable
in nature with maturity of more than 18 months, for which the company must create a Debenture Redemption
Reserve.
Advantages
• It is one of the long-term sources of finance having a maturity period longer than the other sources of
finance.
• The debenture holders are only creditors of the company and hence they cannot interfere with the
company affairs as they do not have voting rights.
• Further, the debenture holders are entitled to interest at a fixed rate, which is usually lower than other
sources of long-term finance.
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• The cost of debentures is usually low, as the interest payments on debentures are tax deductible
expenses. Thus, it helps to reduce the tax burden of the company.
• In case of liquidation of the company, the debenture holders have priority over equity shareholders in
the distribution of available funds of the company.
Disadvantages
• The interest on debentures is payable even if the company is unable to earn profit and hence, it may
not be suitable to those companies whose earnings fluctuate considerably.
• Secured debentures restrict the company from raising further finance through debentures, as the assets
are already mortgaged to the debenture holders.
• The debenture holders can initiate the legal proceedings against the company, if it defaults on its
interest payment or principal when they become due.
4. Institutional Assistance: The Government has set up certain special financial corporation with the object
of stimulating industrial development in the country. These include IFC, SFC, ICICI, IDBI etc.
5. Public Deposits: Public deposits are the another important source for the firms. Companies prefer public
deposits because, these deposits carry lower rate of interest
6. Lease Finance: Lease financing involves the acquisition of the economic use of an asset through a
contractual commitment to make periodic payments called lease rentals to the person who owns the asset.
Thus this is a mode of financing to acquire the use of assets.
Advantages
• If the capital asset is needed for a short period say a year or two, leasing is a very convenient and
appropriate method of acquiring. It dispenses with the formalities and expenses incurred in purchasing
the asset and selling it soon after the need is over.
• In case of owning an asset, the firm bears the risk of the asset becoming obsolete. In the present age
of technological innovations, risks in owning an asset with outdated and old technology cannot be
ignored. Leasing provides a shield against all these hazards by shifting the risk of obsolescence of
equipment to the lessor.
• Under operating or full-service lease, the lessee avails of the maintenance and other services provided
by the lessor, who is well equipped, qualified, and experienced to provide such services efficiently. Of
course, the lessee pays for such services in the form of higher rentals.
• Many leasing companies specialise in leasing a few types of equipment, machines, or vehicles only.
They can easily bargain with the suppliers/manufacturers, etc., and acquire the assets at better prices
and can economise in other administrative expenses also. The lessee may get a concession in lease rent
based on the economies derived by the lessor.
• When an asset is acquired on lease basis, lease rentals are shown as an expense in the firm’s profit and
loss account. Neither the leased asset nor the liability under the lease agreement is shown in the Balance
Sheet. Hence the debt-equity ratio remains unaffected as compared to a firm which buys the asset with
borrowed funds.
Disadvantages:
• The lessee undertakes to pay to lessor regularly lease rental, as consideration for the use of the goods.
So, the cost of this is higher as compared to other sources.
• The goods must be returned to the lessor exactly in the same form, after the lease period is over. The
lessee cannot make any considerable changes to the asset or property as he is not the owner.
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• The lessor, after handing over possession of the leased asset, remains owner of the asset throughout
the lease period and even thereafter.
• After the lease period is over, the lessee will not get the ownership over the leased asset, though quite
a good amount is paid over the years in the form of lease rentals to the lessor.
7. Hire Purchase: Assets involving huge amounts if other sources of long-term finance are too costly may be
acquired through hire purchase. Hire purchase is another method of acquiring a capital asset for use, without
paying its price immediately. Under hire purchase arrangement goods are let on hire. The hirer (user) is
allowed to pay the purchase price in instalments and enjoys an option to purchase the goods after all the
instalments have been paid. Thus, the ownership in the asset is passed on to the hirer on payment of the last
instalment. The amount and number of instalments is fixed at the time of delivering the asset to the hirer. If
the hirer makes default in making payment of any instalment, the seller is entitled to recover the asset from
the hirer. The hirer may, on his own also, return the asset to the hiree without any commitment to pay the
remaining instalments. Thus, the property in the asset remains vested in the seller (hiree) till the right of
purchase is exercised by the hirer after making payment of all the instalments.
8. Government Assistance: The government provides finance to companies in cash grants and other forms
of direct assistance, as part of its policy of helping to develop the national economy, especially in high
technology industries and in areas of high unemployment. Government subsidies and concessions are other
modes of financing long-term requirement. Subject to the government regulations, subsidies and concessions
are granted to business enterprises.
9. Mortgage Bonds: It is a written promise given by the company to the investor to repay a specified sum of
money at a specified rate of interest at a specified time
10. Venture capital: Venture capital is the Money provided by investors to startup firms and small businesses
with perceived long-term growth potential. This is a very important source of funding for startups that do not
have access to capital markets. It typically entails high risk for the investor, but it has the potential for above-
average returns. Venture capital is usually in the form of equity or quasi-equity instruments in a new company
set-up to commercialise a novel idea. It is investment at the early-stage in case of high-growth projects, which
have high-risk with the potential high returns over a period ranging from three to seven years. The risk factor
being high, the probability of failure is also high.
The venture capital investment is “hands-on” investment, where the investor mentors and advises the
promoters of the business in which the investment has been made. The venture capitalist is an investor, who
guides the project through its different stages of growth by identifying avoidable pitfalls and directs the
business along with the possible avenues of growth. The returns to the venture capitalist are from the handful
of the projects, which succeed. The venture capitalist is a partner, who brings more money to the project. Many
projects, which find it difficult to raise funds from banks and other financial institutions, approach venture
capitalists for assistance.
The venture capitalists conduct a preliminary project appraisal, which includes verification of whether it is in
their investment of the business. Further, venture capital organization provides value addition in the form of
management advice and contribution of overall strategy. The relatively high risk will normally be compensated
by the possibility of high return in the form of capital gains in the medium term. The main features that
distinguish venture capital from other sources of capital market are as follows:
i) Venture capital is a form of equity capital for relatively new companies, which find it too premature to
approach the capital market to raise funds. However, the basic objective of a venture capital fund is to earn
capital gain, which usually will be higher than interest at the time of exit.
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ii) The transfer of existing shares from other shareholders cannot be considered as venture capital investment.
The funding should be for new project or for rapid growth of the business, with cash transferring from the
fund to the company.
iii) All the projects financed by the venture capitalists will not be successful. However, some of the ventures
yield very high return to more than compensate for the losses on others. Thus, the venture capital firms, fund
both early and later stage financing requirements of a firm, balancing between risk and profitability. This is
an ideal source of capital for promoters having very good technical and management skills, with limited
financial resources
INTERNAL SOURCES
Retained Earnings: A company out of its profits, a certain percentage is retained that amount is reinvested
into the business for its development. This is also known ploughing back of profits. The companies can raise
funds from internal sources, through the retained earnings, which are ploughing back of profits for future
expansion or diversification activities.
Advantages:
• This is the lowest cost of fund and does not involve any flotation cost as required for raising funds
while issuing different types of securities.
• If the company uses retained earnings, it is not under any obligation for payment of dividend or interest
on retained earnings.
• As there is no implicit cost of retained earnings, the value of share will increase.
• These funds being internally generated, there is a greater degree of operational freedom and flexibility.
Disadvantages:
• Excessive use of retained earnings may lead to monopolistic attitude of the company.
• If retained earnings are used more it may lead to over capitalization, which is symbolic for inefficient
working of an organization.
• By manipulating the value of shares in the stock market the management can misuse the retained
earnings.
• This source of funds is uncertain, as the profits of the business are not certain.
2. Provision for depreciation: Depreciation means decrease in the value of the asset due to wear and tear, lapse of time
and accident. Provision for depreciation considered as one of the sources of financing to business.
B] SHORT TERM SOURCES
The sources of short-term funds used for financing variable part of working capital mainly include the
following:
1. Loans from Commercial Banks: Small-scale enterprises can raise loans from the commercial banks with
or without security. This method of financing does not require any legal formality except that of creating a
mortgage on the assets. Loan can be paid in lump sum or in parts
2. Public Deposits: Often companies find it easy and convenient to raise short- term funds by inviting
shareholders, employees and the general public to deposit their savings with the company. It is a simple
method of raising funds from public for which the company has only to advertise and inform the public that
it is authorised by the Companies Act 1956, to accept public deposits.
3. Trade Credit: Just as the companies sell goods on credit, they also buy raw materials, components and
other goods on credit from their suppliers. Thus, outstanding amounts payable to the suppliers i.e., trade
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creditors for credit purchases are regarded as sources of finance. Generally, suppliers grant credit to their
clients for a period of 3 to 6 months. Thus, they provide, in a way, short term finance to the purchasing
company.
4. Discounting Bills of Exchange: When goods are sold on credit, bills of exchange are generally drawn for
acceptance by the buyers of goods. The bills are generally drawn for a period of 3 to 6 months. In practice,
the writer of the bill, instead of holding the bill till the date of maturity, prefers to discount them with
commercial banks on payment of a charge known as discount.
5. Factoring: The Factoring is essentially a management service designed to help firms better manage their
receivables. It is in fact, a way of off-loading a firm’s receivables and credit management on to someone else
- in this case, the Factoring Agency or the Factor. Factoring involves an outright sale of the receivables of a
firm to another firm specialising in the management of trade credit, called the Factor. Under a typical factoring
arrangement, a Factor collects the accounts on the due dates, effects payments to its client firm on these days
and assumes the credit risks associated with the collection of the accounts. For rendering these services, the
Factor charges a fee which is usually expressed as a percentage of the total value of the receivables factored.
Thus, factoring is an alternative to in-house management of receivables. Depending upon the inherent
requirements of the clients, the terms of Factoring contract vary, but broadly speaking Factoring service can
be classified as:
a) Non-recourse Factoring: In Non-recourse factoring, the Factor assumes the risk of the debts going “bad”.
The Factor cannot call upon its client firm whose debts it has purchased to make good the loss in case of
default in payment by the counter party. However, the Factor can insist on payment from its client if a part of
the receivables turns bad for any reason other than financial insolvency.
b) Recourse Factoring: In recourse factoring, the Factoring firm can insist upon the firm whose receivables
were purchased to make good any of the receivables that prove to be bad and unrealisable. However, the risk
of bad debt is not transferred to the factor.
Advantages
• Under the Factoring arrangement the client receives pre-payment upto 80-90 percent of the invoice
value immediately and the balance amount after the maturity period. This helps the client to improve
cash flow position which helps to have better flexibility in managing working capital funds in an
efficient and effective manner.
• It reduces administrative cost and time, as a result of this, the company can spare substantial time for
improving the quality of production and tapping new business opportunities.
• When without recourse factoring arrangement is made, the client can eliminate the losses on account
of bad debts. This will help in concentrating more production and sales. Thus, it will result in increase
in sales, increase in business and increase in profit.
• The client can avail advisory services from the Factor by virtue of his expertise and experience in the
areas of Finance and marketing. This will help them to improve efficiency and productivity of its
organization.
Disadvantages
• Image of the company may suffer as engaging a Factoring Agency is not considered a good sign of
efficient management.
• Factoring may not be of much use where companies or agents have one-time sales with the customers.
• Factoring increases cost of finance and thus cost of running the business.
• If the client has cheaper meant of finance and credit (where goods are sold against advance payment),
Factoring may not be useful.
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6. Bank Overdraft: Over-draft is a facility extended by the banks to their current account holders for a short
period generally a week. A current account holder is allowed to withdraw from its current deposit account up
to a certain limit over the balance with the bank. The interest is charged only on the amount actually
overdrawn. The overdraft facility is also granted against securities.
7. Cash Credit: Cash credit is an arrangement whereby the commercial banks allow borrowing money up to
a specified-limit known as „cash credit limit. The cash credit facility is allowed against the security. The cash
credit limit can be revised from time to time according to the value of securities. The money so drawn can be
repaid as and when possible. The interest is charged on the actual amount drawn during the period rather on
limit sanctioned. Arranging overdraft and cash credit with the commercial banks has become a common
method adopted by companies for meeting their short- term financial, or say, working capital requirements.
8. Advances from Customers: One way of raising funds for short-term requirement is to demand for advance
from one’s own customers. Examples of advances from the customers are advance paid at the time of booking
a car, a telephone connection, a flat, etc. This has become an increasingly popular source of short-term finance
among the small business enterprises mainly due to two reasons. The enterprises do not pay any interest on
advances from their customers. Thus, advances from customers become one of the cheapest sources of raising
funds for meeting working capital requirements of companies.
9. Accrual Accounts: Generally, there is a certain amount of time gap between incomes is earned and is
actually received or expenditure becomes due and is actually paid. Salaries, wages and taxes, for example,
become due at the end of the month but are usually paid in the first week of the next month. Thus, the
outstanding salaries and wages as expenses for a week helps the enterprise in meeting their working capital
requirements. This source of raising funds does not involve any cost.
10. Bills Discounting: The bill discounting is an important source of financing trade and business. Under this
form of financing, seller of the goods draws a bill of exchange on the buyer (who accepts and returns the same
to the drawer). Subsequently the seller of the goods discounts the bill of exchange with bank or finance
company and avail the finance accordingly. Only those bills which arise out of genuine trade transactions are
considered by the banks and finance companies for discounting purpose. Parties to a Bill of Exchange are as
follows:
i) The drawer draws the bill and ensures that the bill is accepted and paid according to its tenor. The drawer
promises to compensate the holder or any endorser of the bill if it is dishonoured.
ii) The drawee is a person on whom the bill is drawn, and the drawee assumes legal obligation to pay the bill,
as it shows assent by signing across the bill for payment at maturity.
iii) The payee is a person to whom or to whose order the bill is payable.
iv) The endorser could be the payee or any endorsee who signs the bill on negotiation. If the bill is negotiated
to several persons who signs it in turn becomes an endorser. The endorser is liable as a party to the bill. If the
bill of exchange is not endorsed, then drawer and payee will be the same person.
Advantages
• Banks usually discount bills at a rate lower than the rate charged for cash credit. In view of this, drawer
of the bill can reduce its cost of funds by raising the funds through discounting of bills with banks.
• Bills seem to have certainty of payment on due dates, and this helps to have efficient working capital
management for the drawer. It also leads to greater financial discipline as bills are discounted only
against genuine trade transactions as compared with bank overdraft facilities.
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• The banker is having no risk in lending, as providing finance against bill, the bank can ensure safety
of funds lent. A bill is a legal negotiable instrument with the signatures of two concerned parties,
enforcement of a claim is easier.
• With recourse to two party’s bankers face a lower credit risk. In other words, if the acceptor of the bill
fails to make payment on the due date the bank can claim the whole amount from the drawer of the
bill.
• As a security, the value of a bill is not subject to fluctuations which are found in case of values of
tangible goods and financial securities. The amount payable on account of a bill is fixed and the
acceptor is liable for the whole amount.
Disadvantages
• Financial institutions charge a fee, which becomes a cost to the company. Thus, the profit margin of
the company may decrease.
• Bill discounting does not provide any facility or assistance to recover the unpaid bills.
Commercial Paper: Companies with good credit rating can raise money directly from the market by issuing
commercial papers. It is an unsecured instrument through which high net worth corporates borrow funds from
any person, corporate or unincorporated body. It is issued in the form of usance promissory note, which is
freely transferable by endorsement and delivery. Its minimum period of maturity should be 15 days and
maximum period is less than a year, it is issued at a discount to face value. 208 The commercial papers are
unsecured notes but negotiable and hence liquid. Instruments like commercial papers enable both lenders and
borrowers to move out of the relationship in a short period of time. Since lender and borrower meet directly,
the cost of commercial paper borrowing will be lesser than working capital loan. Many banks and cash rich
companies participate in commercial papers, which are issued by high-quality companies. Since they are
liquid, even banks are willing to invest money in commercial papers.
Credit Rating: Credit rating is an evaluation of the creditworthiness of an individual, company, or government
entity. Credit rating agencies assess the ability and willingness of the entity to fulfil its financial obligations,
such as repaying borrowed money or servicing interest on debt.
Key Points:
1. Credit Rating Agencies: Independent organizations, known as credit rating agencies, assign credit
ratings. Examples of prominent agencies include Moody's, Standard & Poor's (S&P), and Fitch
Ratings.
2. Credit Ratings Scale: Credit ratings are typically assigned using letter grades or a numerical scale.
The higher the credit rating, the lower the perceived credit risk. Common grades include AAA or Aaa
(highest), AA or Aa, A, BBB or Baa, and so on.
3. Factors Considered: Credit rating agencies consider various factors, including financial performance,
debt levels, industry conditions, and economic factors, to determine creditworthiness.
4. Credit Impact: A higher credit rating generally allows entities to borrow at lower interest rates since
lenders view them as less risky. Conversely, lower credit ratings may result in higher borrowing costs.
5. Investor Guidance: Investors, lenders, and institutions use credit ratings to assess the risk associated
with investing in a particular entity's debt instruments, such as bonds.
6. Rating Changes: Credit ratings are subject to periodic reviews and may be upgraded, downgraded, or
reaffirmed based on changes in the entity's financial condition or the overall economic environment.
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Certificate of Deposit (CD): A Certificate of Deposit (CD) is a financial instrument offered by banks and
financial institutions that allows individuals to deposit money for a specified period at a fixed interest rate.
CDs are considered time deposits because the funds are held for a predetermined maturity period, during
which the depositor agrees not to withdraw the funds.
Key Points:
1. Maturity Period: CDs have a fixed maturity period, ranging from a few months to several years. The
depositor agrees to keep the funds on deposit until the maturity date.
2. Fixed Interest Rate: The interest rate on a CD is predetermined and remains constant throughout the
term. This fixed rate provides certainty about the return on investment.
3. Liquidity Restrictions: Unlike regular savings accounts, early withdrawal from a CD may result in
penalties. However, some CDs may have features that allow for early withdrawal with a penalty or
under certain conditions.
4. Low Risk: CDs are considered low-risk investments because they are typically issued by banks and
are insured by government agencies, such as the Federal Deposit Insurance Corporation (FDIC) in the
United States.
5. Interest Payments: Interest earned on a CD is usually paid at the end of the maturity period. However,
some CDs may offer periodic interest payments.
6. Varieties of CDs: Various types of CDs exist, including traditional fixed-rate CDs, variable-rate CDs,
and special types like callable CDs, which allow the issuing bank to recall the CD before maturity.
7. Purpose: CDs are often used by individuals and institutions as a conservative investment option to
preserve capital and earn a predictable return.
8. Marketability: CDs are not traded on secondary markets like stocks or bonds. However, they can be
sold on the secondary market through brokers if the holder wishes to liquidate the investment before
maturity.
Security Financing Loan: A Security Financing Loan (SFL) is a type of financial arrangement where a
borrower obtains a loan by using securities, such as stocks, bonds, or other investment instruments, as
collateral. In this context, the borrower pledges their securities to a lender in exchange for a loan. The loan
amount is typically a percentage of the market value of the pledged securities.
Key features of a Security Financing Loan include:
1. Collateral: The borrower provides securities as collateral for the loan. These securities serve as a
guarantee for the lender in case the borrower is unable to repay the loan.
2. Loan-to-Value (LTV) Ratio: The loan amount is determined based on a percentage of the market
value of the pledged securities. This ratio is known as the Loan-to-Value (LTV) ratio. Lenders often
have their own policies regarding the acceptable LTV ratio.
3. Interest Rates: The interest rates on Security Financing Loans can vary and may be fixed or variable.
The rates are influenced by factors such as market conditions, the creditworthiness of the borrower,
and the type of securities being pledged.
4. Purpose: Borrowers may use Security Financing Loans for various purposes, including meeting short-
term liquidity needs, making investments, or taking advantage of other financial opportunities.
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5. Risks and Rewards: While Security Financing Loans provide a source of liquidity, they come with
risks. If the value of the pledged securities decreases significantly, the borrower may face a margin
call, requiring them to either repay part of the loan or provide additional collateral.
6. Margin Calls: In the context of Security Financing Loans, a margin call occurs when the value of the
collateral falls below a certain level (the maintenance margin). In such cases, the borrower may need
to either repay a portion of the loan or provide additional collateral to bring the loan-to-value ratio
back within acceptable limits.
7. Liquidation of Collateral: If the borrower fails to meet a margin call or repay the loan as agreed, the
lender may have the right to liquidate the pledged securities to recover the outstanding amount.
8. Regulation: Security Financing Loans are subject to regulatory frameworks that may vary by
jurisdiction. Financial institutions offering such loans are often regulated, and borrowers need to
comply with legal requirements.
Security Financing Loans are commonly used by investors, traders, and individuals who want to leverage their
investment portfolios or obtain short-term financing while holding securities. It's important for borrowers to
carefully consider the terms and risks associated with these loans and to be aware of the potential consequences
of a decline in the value of the pledged securities.
25 Dr. Khushnuma Bano