UNIT 1 FINANCIAL MANAGEMENT: BASICS

UNIT 1 FINANCIAL MANAGEMENT: BASICS

UNIT 1 FINANCIAL MANAGEMENT: BASICS Financial Management: Structure 1.0 Introduction 1.1 Unit Objectives 1.2 Importance of Finance 1.3 Meaning of Business Finance 1.4 Meaning of Financial Management 1.5 Objectives of Financial Management 1.6 Scope of Financial Management 1.7 Liquidity Vs. Profitability 1.7.1 Time Value of Money 1.8 Importance of Financial Management 1.9 Summary 1.10 Key Terms 1.11 Answers to Check Your Progress 1.12 Questions and Exercises 1.13 Further Reading 1.0 INTRODUCTION Finance has widely been termed as the master key providing access to all resources required for running business activities. Hence, efficient management of business enterprises is closely linked with efficient management of their finances. A finance manager has, therefore, an important role to perform in a business firm. He has not only to raise the resources at the lowest cost but also to channelize them properly for their optimum utilization and maximization of shareholders wealth. This unit focuses on these various aspects of financial management. 1.1 UNIT OBJECTIVES Meaning and importance of business finance Meaning and objectives of financial management Scope of financial management Dilemma of the finance manager to maintain a balance between liquidity and profitability Different methods of financial management Organization of finance function Importance of financial management Meaning of certain key terms Material 5

Financial Management: 1.2 IMPORTANCE OF FINANCE Finance is regarded as the lifeblood of a business enterprise. This is because in the modern money-oriented economy finance is one of the basic foundations of all kinds of economic activities. It is the master key which provides access to all the sources for being employed in manufacturing and merchandising activities. It has rightly been said that business needs money to make more money. However, it is also true that money begets more money only when it is properly managed. Hence, efficient management of every business enterprise is closely linked with efficient management of its finances. 1.3 MEANING OF BUSINESS FINANCE In general, finance may be defined as the provision of money at the time of its requirement. However, as a management function it has a special meaning. Finance function may be defined as the efficient procurement of funds and their effective utilization. Some of the authoritative definitions are as follows: Business finance is that business activity which is concerned with the acquisition and conservation of capital funds in meeting financial needs and overall objectives of a business enterprise. 1 Business finance can broadly be defined as the activity concerned with planning, raising, controlling and administering of the funds used in the business. 2 1.4 MEANING OF FINANCIAL MANAGEMENT From the various definitions of the term of business finance given above, it can be concluded that the term business finance mainly involves raising of funds and their effective utilization keeping in view the overall objectives of the firm. This requires great caution and wisdom on the part of management. The management makes use of various financial techniques, devices, etc., for administering the financial affairs of the firm in the most effective and efficient way. Financial management, therefore, means the entire gamut of managerial efforts devoted to the management of finance both its sources and uses of the enterprise. According to Soloman, Financial management is concerned with the efficient use of an important economic resource, namely, Capital Funds. Phillippatus has given a more elaborate definition of the term financial management. According to him Financial management is concerned with the management decisions that result in the acquisition and financing of long-term and short-term credits for the firm. As such it deals with the situations that require selection of specific assets (or combination of liabilities) as well as the problem of size and growth of an enterprise. The analysis of these decisions is based on the expected inflows and outflows of funds and their effects upon managerial objectives. Thus, financial management is mainly concerned with the proper management of funds. The finance manager must see that the funds are procured in a manner that the risk, cost and control considerations are properly balanced in a given situation and there is optimum utilization of funds. 1. Wheeler, Business An Introductory Analysis, p. 368. 6 Material 2. Guthman & Sougall, Corporate Financial Policy, p. 1.

1.5 OBJECTIVES OF FINANCIAL MANAGEMENT The objectives of Financial Management can be put into two categories: 1. Basic Objectives 2. Other Objectives Basic Objectives Traditionally the basic objectives of Financial Management have been (i) maintenance of liquid assets and (ii) maximization of profitability of the firm. However, these days there is a greater emphasis on (iii) shareholders wealth maximization rather than on profit maximization. All these aspects are being discussed below: (i) Maintenance of Liquid Assets Financial management aims at maintenance of adequate liquid assets with the firm to meet its obligations at all times. It may be noted that investment in liquid assets has to be adequate neither too low nor too excessive. The finance manager, as discussed later, has to maintain a balance between liquidity and profitability. There is an inverse relationship between the two. The more liquid the assets, the less profitable they are and vice versa. (ii) Profit Maximization A business firm is a profit-seeking organization. Hence, profit maximization is an important objective of financial management. However, the concept of profit maximization has come under severe criticism in recent times on account of the following reasons: It Is Vague: It does not clarify which profits does it mean, whether short-term or long-term. Profits in the short-term may be quite different from those in the long run. For example, if a firm continues to run its business without having adequate maintenance of its machinery, the firm s profits in the short run may increase because of savings in expenditure. However, in the long run the firm may suffer since the machine may have to be replaced or machine may require a heavy expenditure on its repairs because of its improper upkeep from year to year. Moreover, it is also not clear whether profit maximization means maximizing absolute profits or simply the rate of return. It Ignores Timing: The concept of profit maximization does not help in making a choice between projects giving different benefits spread over a period of time. The concept ignores the fact that a rupee recovered today is much more valuable than a rupee received tomorrow. For example, if there are two projects A and B each requiring equal investment, project A gives a 20 per cent return for three years, while project B gives a return of 17 per cent for five years. In order to decide which project should be preferred, it is not only enough to see the rate of return, but also the present value of the cash flows available from both the projects. In case of project A, the rate of return is higher as compared to project B. However, it will stop giving returns after three years and hence it will be more profitable than project B, only when the firm has adequate investment opportunities. In case the firm does not have such opportunities, project B may be more beneficial. It Overlooks Quality Aspect of Future Activities: Business is not run solely with the objective of earning higher possible profits. Some firms place a high value on the growth of sales. They are willing to accept lower profits to gain stability provided by a large volume of sales. Other firms use a part of their profits to make Financial Management: Material 7

Financial Management: Check Your Progress 1. State whether each of the following statements is True or False: (i) The role of the finance manager involves both acquisition and efficient allocation of funds. (ii) Efficient management of every business is closely linked with efficient management of its finances. (iii) The most important objective of financial management is maximization of profits. (iv) A finance manager s concern must be to maintain liquidity rather than profitability. (v) Profit maximization is not considered to be an ideal criterion for making investment and financial decisions. 8 Material contribution for socially productive purposes. Moreover, profit maximization at the cost of social or moral obligations is a short-sighted policy even as a pragmatic approach. (iii) Maximization of Wealth Profit maximization, on account of the reasons given above, is not considered to be an ideal criterion for making investment and financial decisions. Professor Ezra Soloman has suggested the adoption of wealth maximization as the best criterion for financial decision-making. He has described the concept of wealth maximization as follows: The gross present worth of a course of action is equal to the capitalized value of the flow of future expected benefits, discounted (or capitalized) at the rate which reflects their certainty or uncertainty. Wealth or net present worth is the difference between gross present worth and the amount of capital investment required to achieve the benefits. Any financial action which creates wealth or which has a net present worth above zero is a desirable one and should be undertaken. Any financial action which does not meet this test should be rejected. If two or more desirable courses of action are mutually exclusive (i.e., if only one can be undertaken), then the decision should be to do that which creates most wealth or shows the greatest amount of net present worth. In short, the operating objective for financial management is to maximize wealth or net present worth. Wealth maximization is, therefore, considered to be the main objective of financial management. This objective is also consistent with the objective of maximizing the economic welfare of the shareholders of a company. The value of a company s shares depends largely on its net worth, which itself depends on the earning per share (E.P.S.). The finance manager should, therefore, follow a policy which increases the earning per share in the long run. Other Objectives The following are the other objectives of financial management: (i) Ensuring a fair return to shareholders. (ii) Building up reserves for growth and expansion. (iii) Ensuring maximum operational efficiency by efficient and effective utilization of finances. (iv) Ensuring financial discipline in the organization. 1.6 SCOPE OF FINANCIAL MANAGEMENT Financial management is concerned with both acquisition of funds as well as their allocation. The central issue of financial policy is the wise use of funds and the central process involved is a rational matching of advantages of potential uses against the cost of alternative potential uses so as to achieve the broad financial goals which an enterprise sets for itself. 3 Financial Management is an analytical way of looking at the financial problems of a firm. The main contents of the problem are as follows: 4 (i) What is the total volume of funds an enterprise should commit? (ii) What specific assets should an enterprise acquire? 3. Soloman, op. cit., p. 5. 4. Ibid, p. 8.

(iii) How should the funds required be financed? The above questions relate to four broad decision areas of financial management, viz., funds requirement decision, financing decision, investment decision and dividend decision. These decisions, which can also be termed as functions outlining the scope of financial management, are being discussed below: Funds Requirement Decision This is the most important function performed or decision taken by the finance manager. A careful estimate has to be made about the total funds required by the enterprise taking into account both the fixed and working capital requirements. This is done by forecasting the physical activities of the enterprise. This aspect has been discussed in detail later in the book while explaining the concept of Capitalization. Financing Decision Provision of funds required at the proper time is one of the primary tasks of the finance manager. Every business activity requires funds and hence every financial manager is confronted with this problem. He has to identify the sources from which the funds can be raised, the amount that can be raised from each source and the cost and other consequences involved. A proper balance has to be kept between the fixed and non-fixed cost-bearing securities. This aspect has been discussed in detail while explaining the concept of Capital Structure later in this book. Investment Decision This comprises decisions relating to investment in both capital and current assets. The finance manager has to evaluate different capital investment proposals and select the best keeping in view the overall objective of the enterprise. This would involve fixing the criteria for evaluating different investment proposals, fixing priorities, committing funds for them, etc. This aspect is being explained in detail in the unit on Capital Budgeting later in this book. The investment in current assets will depend on the credit and inventory policies pursued by the enterprise. The credit policy is determined keeping in view the need of growth in sales and the availability of finance. Similarly, the inventory policy will be set up taking into account the requirements of production, the market trend of the price of raw materials and the availability of funds. This aspect has been explained in detail later in the unit on Working Capital Management. Dividend Decision The establishment of dividend policy is another important function of the finance manager. The dividend decision involves the determination of the percentage of profits earned by the enterprise which is to be paid to its shareholders. Theoretically, this decision should depend on whether the company of the shareholders can make a more profitable use of the funds. However, in practice a number of other factors like the market price of shares, the trend of earnings, the tax position of the shareholders, etc., play an important role in the determination of dividend policy of a business enterprise. This aspect also has been discussed in detail later in the unit on Dividend Policy. Apart from the above main functions, following subsidiary functions are also performed by the finance manager: To Ensure Supply of Funds to All Parts of the Organization: It is also the finance manager s function to ensure that funds are available to every part of the organization as and when it needs them so as to help in smooth operations of the activities of the organization. Financial Management: Material 9

Financial Management: Evaluation of the Financial Performance: The financial performance of the various units of the organization is to be evaluated from time to time to detect any fault in the financial policy and take the remedial action at appropriate time, if necessary. To Negotiate with Bankers, Financial Institutions and other Suppliers of Credit: Bankers, financial institutions and other suppliers of credit are the different sources of funds. It is necessary for the company to negotiate with them so as to obtain the funds at the most favourable terms. To Keep Track of Stock Exchange Quotations and Behaviour of Stock Market Prices: Stock exchange quotations are the barometers of the economy as a whole. By keeping an eye on the stock market, the finance manager is in a position to plan the policy of the business enterprise with regard to finance more effectively. Thus, we see that Financial Management has emerged as an area of study that encompasses a variety of analytical tools and vigorous analysis. It has changed from an area which was primarily concerned with procurement of funds to one that includes the management of assets, the allocation of capital and the valuation of firm. With the changing environment the scope of financial management will also change, to accept the challenge of a new environment. 1.7 LIQUIDITY VS. PROFITABILITY 10 Material The finance manager is always faced with the dilemma of liquidity vs. profitability. He has to strike a balance between the two. Liquidity means that : (a) the firm has adequate cash to pay for its bills, (b) the firm has sufficient cash to make unexpected large purchases and, above all, (c) the firm has cash reserve to meet emergencies, at all times. The profitability goal, on the other hand, requires that the funds of the firm are so used as to yield the highest return. Liquidity and profitability are very closely related. When one increases, the other decreases. Apparently, liquidity and profitability goals conflict in most of the decisions which the finance manager takes. For example, if higher inventories are kept in anticipation of increase in prices of raw materials, the profitability goal is approached but the liquidity of the firm is endangered. Similarly, the firm by following a liberal credit policy may be in a position to push up its sales but its liquidity will decrease. There is also a direct relationship between higher risk and higher return. Higher risk, on the one hand, endangers the liquidity of the firm; higher return, on the other hand, increases its profitability. A company may increase its profitability by having a very high debt-equity ratio. However, when the company raises funds from outside sources, it is committed to make the payment of interest, etc., at a fixed time and in fixed amounts and hence to that extent its liquidity is reduced. Thus, in every area of financial management, the finance manager is to choose between risk and return and generally he chooses in-between the two. He should forecast cash flows and analyse the various sources of funds. Forecasting of cash flows and managing the flow of internal funds are the functions which lead to liquidity. Cost control and forecasting future profits are the functions of the finance manager which lead to profitability. An efficient finance manager fixes that level of operation

where both return and risk are optimized. Such a level is termed as risk-return tradeoff and every financial decision involves this trade-off. At this level the market value of the company s shares would be the maximum. The interrelationship between market value, financial decisions and risk-return trade-off is depicted in the following chart. Financial Management: Figure 1.1. Relationship between Market Value, Financial Decisions and Risk-Return Trade-off 1.7.1 Time Value of Money Money has a time value because of the following reasons: (i) Individuals generally prefer current consumption...more information regarding this topic has been given in Unit-2. 1.8 IMPORTANCE OF FINANCIAL MANAGEMENT The importance of financial management cannot be overemphasized. In every organization, where funds are involved, sound financial management is necessary. As Collins Brooks has remarked, Bad production management and bad sales management have slain in hundreds, but faulty financial management has slain in thousands. The finance manager must realize that when a firm makes a major decision, the effect of the action will be felt throughout the enterprise. For example, an increase in plant and equipment expenditure will affect the firm s cash position, its borrowing capability and its dividend distribution. Sound financial management is essential in both profit and non-profit organizations. Financial management helps in monitoring the effective deployment of funds in fixed assets and in working capital. The finance manager estimates the total requirement of funds, both in the short period and the long period. The finance manager assesses the financial position of the company through working out of the return of capital, debt-equity ratio, cost of the capital from each source, etc., and comparison of the capital structure with that of similar companies. Material 11

Financial Management: Financial management also helps in ascertaining how the company would perform in the future. It helps in indicating whether the firm will generate enough funds to meet its various obligations like repayment of the various instalments due on loans and redemption of other liabilities. Sound financial management is indispensable for any organization. It helps in profit planning, capital spending, measuring costs, controlling inventories, accounts receivable, etc. Financial management essentially helps in optimizing the output from a given input of funds. 1.9 SUMMARY The finance function is basically concerned with efficient procurement of funds and their effective utilization. Maximization of wealth of the shareholders is the basic goal of a finance manager. The finance manager has to manage a firm s resources in such a manner so that he is in a position to strike a balance between the risk and the return. 1.10 KEY TERMS Business Finance: The activity concerned with planning, raising, controlling and administering the funds used in the business. Risk-return trade-off: It refers to that level of operation where both return and risk are optimized. 1.11 ANSWERS TO CHECK YOUR PROGRESS 1. (i) True (ii) True (iii) False (iv) False (v) True 1.12 QUESTIONS AND EXERCISES Short-Answer Questions 1. Give the meaning of Business Finance. 2. Enumerate the financial tools used by the finance manager to perform his job. 3. Explain the relationship between Risk and Return. 4. State the importance of financial management. Long-Answer Questions 12 Material 1. Profit maximization is the basic goal of a finance manager. Do you agree? Discuss. 2. In what way do you think the role of the finance manager has undergone a change in the recent past?

3. How are the concepts of liquidity and profitability different? Which of these two should the finance manager strive for? Financial Management: 1.13 FURTHER READING Maheshwari, S.N. Elements of Financial Management. New Delhi: Sultan Chand & Sons, 2008. Maheshwari, S.N. Financial Management Principles and Practice. New Delhi: Sultan Chand & Sons, 2007. Material 13

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