INTRODUCTION TO FINANCIAL

MANAGEMENT

Meaning of Financial Management

Financial Management can be defined as the management

of flow of funds and it deals with financial decision

making.
It encompasses the procurement of funds in the most

economic manner and employment of these funds in the

most optimum way to maximize the return for the owner.
In simple words, financial management includes any

decision made by a business/investor that affects its

finances.

Definition of Financial Management

Financial Management is the activity of a business that is

responsible for obtaining and effectively utilizing the

funds necessary for efficient operations. Joseph and
Massie.
Financial Management is concerned with the acquisition,
financing and management of assets with some overall
goal in mind Van Horne and Wachowicz.
J.F. Bradlery :-financial management is the area of
business management devoted to a judicious use of capital
and a careful selection of sources of capital in order to
enable a business firm to move in the direction of reaching
its goals

Three Major Decisions

The functions of finance in a firm may be divided into

three major decisions that the firm must make:

Financing decision
Investment decision
Dividend decision

Financing Decision
Here the financial manager has to determine the

proportion of debt and equity in capital structure.

A capital structure with a reasonable proportion of debt

and equity capital is called the Optimal Capital

Structure.
The objective is to minimize cost of capital.
It is a long term decision

Investment Decision
The investment decision relates to the selection of assets in

which funds will be invested by a firm

The assets which can be acquired fall into two broad

categories
Long term assets (which yield return over a period of
time) Capital Budgeting.
Capital budgeting refers to selection of an asset or
investment proposal or course of action whose benefits
are likely to be available in future over the lifetime of the
project.

Cont.
Short term or current assets (convertible into cash

usually within one year) Working Capital

Management
WCM is concerned with the management of current
assets & current liabilities
The key strategies and considerations in ensuring a
trade-off between profitability and liquidity is one of
the major dimensions of WCM

Dividend Decision
The dividend should be analysed in relation to the
financing decision of the firm.
Two alternatives are available in dealing with the
profits of a firm:
They can be distributed to the shareholders in the
form of the dividends
They can be retained in the business itself.
The decision as to which course should be followed
depends largely on the significant dividend decision,
the dividend pay out ratio, i.e. what proportion of
net profits should be paid out to the shareholders.

Approaches to Financial Management

Traditional Approach
The traditional approach, which was popular in the early

stage, limited the role of finance manager to raising of

funds needed by the corporate enterprises to meet their
financial needs.
Looking after the legal and accounting relationship
between a corporation and its sources of funds.
Finance function was concerned with procuring of funds
to finance the expansion or diversification activities and
thus the occurrence of finance function was episodic in
nature.

Cont.
In order to finance business growth, there was an

emergence of financial institutions

Finance function was viewed from the point of view of
suppliers of funds i.e. lenders, both individuals and
institutions. The emphasis was to consider the interest
of the outsiders
Focus was on the long term resources and only the
long term finance was of any concern. Working capital
management was virtually non-existent.

Cont.
Treatment of different aspects of finance was more of a

descriptive nature rather than analytical

Finance was concerned with procuring of funds
primarily by issue of securities, so a knowledge of
sources of funds, what securities to sell, to whom and
by what techniques to sell, was needed

Procurement of funds by corporate enterprises to meet

their financing needs

Criticism of Traditional Approach

1.
2.
3.
4.
5.

Built around episodic events WCM was ignored.

Focus on external funds internal funds were
neglected.
Procurement of funds was important - effective
utilisation of funds was ignored.
Emphasis on outsiders - no consideration to internal
financing decisions
Focus on corporate enterprises non corporate
organisations were left out of the scope of study.

Modern Approach
According to modern approach, the term financial

management provides a conceptual and analytical

framework for financial decision-making.
Finance function is concerned with raising funds and their
effective utilization both.
The new approach views the term financial management
in a broader sense. It is viewed as an integral part of overall management.

Scope of Financial Management

Estimating financial requirements
Deciding capital structure
Selecting source of finance
Selecting pattern of investment
Cash management
Profit management
Evaluation of financial performance
Ensuring liquidity
Negotiation for additional funds
Analysing trends in stock prices

Functions of Finance Manager

Executive finance function - Crucial for success of

the organisation and high level of caliber is required

Determining allocation of net profits
Deciding about needs and sources of new outside

financing
Carrying out negotiations for outside funding
Establishing and controlling cash flows

Functions of Finance Manager

Incidental finance function - Help managers to

perform managerial functions and can be performed by

lower level personnel as they do not involve much
decision making
Record of receipts and payments
Maintaining accounts
Administrative work associated with managerial

functions
Preparation of various financial statements

Organization structure of
finance function

Functions of Treasurer
Provision of finance
Investor relations
Banking and custody
Credit and collections
Investments

Functions of Controller
Planning and controlling
Reporting and interpreting
Tax administration
Government reporting
Financial appraisal

Qualities of a Finance Manager

Technical knowledge
Vision and foresight
Communication skills
Good personality
Intelligence
Initiative
Confidence
Human skills

INTERFACE OF FINANCE FUNCTION WITH

OTHER FUNCTIONAL AREAS
All business decisions have financial implications, and

therefore, FM is inevitably related to almost every aspect of

business operations
Finance and Marketing
Finance and HR
Finance and R&D
Finance and Accounting
Finance and Production

Trading on Equity
It means using borrowed funds carrying a fixed charge

in the expectation of obtaining a higher return to the

equity shareholders
Source

A Ltd

B Ltd

Equity Share Capital

10,00,000

2,00,000

8% Preference Share Capital

3,00,000

10% Debentures

5,00,000

Total Capital Employed

10,00,000

10,00,000

Net Profit Before Tax

3,20,000

3,20,000

Assume tax @ 30%

Trading on Equity
Firm operates with less proportion of equity funds and

more proportion of borrowed funds

Every action that helps in increasing the returns on the
owners funds must be undertaken by the finance
manager because ultimate objective of FM is wealth
maximisation of the shareholders.
Shareholders gain by utilising the benefits of low cost
borrowed funds
This can be successfully implemented by only those
companies with stability in their earnings or increasing
earnings year after year

Objectives of Financial Management

Clear objectives provide a framework for optimum

financial decision-making.
There are two widely accepted objectives
Profit Maximisation
Those actions should be undertaken that maximise

profits and those decrease profits are to be avoided

All other business goals (social goals can be met only
with adequate profits) so it should be maximized.

Criticism - Profit Maximisation

Profits in absolute terms is not a proper guide to

decision making. It should be expressed either on a per

share basis or in relation to investment (PAT or PBT)
It leaves consideration of timing and duration

undefined (how to compare profits now with the future

profits or streams of profit)
Ignores risk (quality of benefits)

Wealth Maximisation
Much of the theory in corporate finance is based on

the assumption that mangers should strive to maximise

the value of the firm
Value of the firm is equal to the value of its equity and
debt claims
Normally value of the debt claims remain fairly stable
So maximising value of the firm is equivalent to
maximising the value of equity
The focus of FM is on the value to the owners or
suppliers of equity capital

Wealth Maximisation
Wealth maximisation implies the maximisation of the

market price of shares

Emphasis is on raising present value of the owners
investment by implementation of projects that will
increase the market value of the firms securities
Recognises risk
Recognises the timing of returns by taking into account
the trade-off between the various returns and the
associated levels of risk
Considers the shareholders returns by taking into account
the payment of dividend to shareholders

Criticism Wealth Maximisation

Prices of shares may not reflect the intrinsic value
Firm should pursue product market goals like

maximising market share, enhancing customer

satisfaction, achieving zero-defect level
Balance between interest of various stakeholders