Financial Management

Module – I

Introduction
 • Finance – Concept, Types

• Financial Management
– Concept, Related Discipline, Scope,
Objectives

• Functions of Financial Management

What is Finance?
 The word finance was adapted by English speaking
communities to mean “the management of money.”
Finance is a prerequisite for obtaining physical resources.
It is a broad term that describes two related activities: the
study of how money is managed and the actual process of
acquiring needed funds. It encompasses the oversight,
creation and study of money, banking, credit, investments,
assets and liabilities that make up financial systems.
Finance is an art and science of managing various available
resources like money, assets, investments, securities, etc.
The major areas of finance are (1) Financial Services and
(2) Managerial Finance/Corporate Finance/Financial
Management.
Financial Services are connected with the design and delivery of
advice and financial products to individuals, businesses and
governments within the areas of banking and related institutions,
personal financial planning, investments, real estate, insurance
etc.
Financial Management is concerned with the duties of the
financial managers in the business firm. Financial Managers
actively manage the financial affairs of any type of private-
public, profit seeking – non-profit seeking, large – small business
where varied tasks like budgeting, financial forecasting, cash
management, credit, administration, investment analysis, funds
management etc. are in under consideration.
 • According to Khan and Jain, “Finance is the art and
science of managing money”.

• According to Oxford dictionary, the word ‘finance’

connotes ‘management of money’.

• Webster’s Ninth New Collegiate Dictionary defines

finance as “the Science on study of the management
of funds and the management of fund as the system that
includes the circulation of money, the granting of
credit, the making of investments, and the provision of
banking facilities.
• According to the Wheeler, “Business finance is
that business activity which concerns with the
acquisition and conversation of capital funds
in meeting financial needs and overall objectives
of a business enterprise”.

• According to the Guthumann and Dougall,

“Business finance can broadly be defined as
the activity concerned with planning, raising,
controlling, administering of the funds used in
the business”.
Types of Finance
 Finance can be classified into two major parts:
Finance

Private Finance Public Finance

Individual /Personal
Finance Central Government
Partnership/
Private Finance State Government
Business/ Corporate Finance
Corporate Finance related activities
• Planning the Finance
• Raising the Finance
• Investing the Finance
• Monitoring the Finance
Financial Management
 • Financial management is an integral part of overall
management. It is concerned with the duties of the
financial managers in the business firm.
• The term financial management has been defined by
Solomon, “It is concerned with the efficient use of an
important economic resource namely, capital funds”.
• The most popular and acceptable definition of financial
management as given by S.C. Kuchal is that “Financial
Management deals with procurement of funds and their
effective utilization in the business”.
 • Howard and Upton : Financial management “is an
application of general managerial principles to the
area of financial decision-making.
• Weston and Brigham : Financial management “is an
area of financial decision-making, harmonizing
individual motives and enterprise goals”.
• Joshep and Massie : Financial management “is the
operational activity of a business that is responsible
for obtaining and effectively utilizing the funds
necessary for efficient operations.

Thus, Financial Management means planning, organising,

directing and controlling the financial activities such as
procurement and utilisation of funds of the enterprise. It
means applying general management principles to financial
resources of the enterprises.
Financial Management and related disciplines
The Financial Decision Areas like Investment Analysis,
Working Capital Management, Sources and Cost of
Funds, Determination of Capital Structure, Dividend
Policy, analysis of Risks and Returns are related to the
Primary Disciplines i.e. Accounting, Macroeconomics,
Microeconomics and Other Related Disciplines i.e.
Marketing, Production and Quantitative Methods.
 Financial Management and Economics
Macroeconomics
It is concerned with the institutional
structure of banking system, money and
capital markets, financial intermediaries,
monetary, fiscal policies etc.
Financial managers should (i) recognise
and understand how monetary policy
affects the cost and availability of funds,
(ii) know the fiscal policies and their effect
in economy, (iii)be aware of the financial
institution and financing outlets, (iv)
understand the consequences of various
levels of economic activities and changes
in economic policies
Microeconomics
It deals with the economic decisions
of individuals and organisations and
also concerned with defining the
actions that will permit the firms to
achieve success involving (1)
supply-demand relationships and
profit maximisation strategies, (2)
issues related to the mix of
productive factors, ‘optimal’ sales
level and product pricing strategies,
(3) measurement of utility
preference, risk and determination
of value, (4) the rationale of
depreciating asset.

Financial Managers should focus on the Marginal Analysis based on

marginal revenue and marginal cost. They should consider both the financial
environment and the decision theories.
 Financial Management and Accounting
The relationship between finance and accounting has two
dimensions (i) they are closely related to the extent that
accounting is an important input in financial decision making
and (ii) there are key differences in viewpoints between them.
Accounting generates information/data relating to
operations/activities of the firm. The end-product of accounting
constitutes financial statements such as the balance sheet, the
income statement (profit and loss account) and the statement of
changes in financial position/sources and uses of funds
statement/cash flow statement. The information contained in
these statement and reports assists financial managers in
assessing the past performance and future directions of the
firm and in meeting legal obligations such as payment of taxes
and so on.
Generally, two differences between finance and accounting
can be found.
Treatment of Funds
The measurement of funds (income and expenses) in
accounting is based on the Accrual Principle/System. E.g.,
revenue is recognised at the point of sale and not when
collected. Similarly, expenses are recognised when they
are incurred rather than when actually paid. So the
accrual-based accounting data do not reflect fully the
financial circumstances of the firm. A firm may be profitable
in the accounting sense in that it has earned profit (sales –
expenses) but it may not be able to meet current obligations
owing to shortage of liquidity due to uncontrollable
receivables. Such firm may not survive regardless of its
levels of profits.
The viewpoint of finance relating to the treatment of funds is
based on cash flows. The revenues are recognised only
when actually received in cash (i.e. cash inflow) and
expenses are recognised on actual payment (i.e. cash
outflow). This is so because the financial manager is
concerned with maintaining solvency of the firm by
providing the cash flows necessary to satisfy its obligations
and acquiring and financing the assets needed to achieve the
goals of the firm. Thus, cash flow-based returns help
financial managers avoid insolvency and achieve the desired
financial goals.
 Decision Making
Finance and Accounting also differ in respect of their purposes.
The purpose of accounting is collection and presentation of
financial data. It provides consistently developed and easily
interpreted data on past, present and future operations of the
firm. The financial manager uses such data for financial
decision making. It does not mean that accountants never
make decisions or financial managers never collect data.
 Financial Management or Mathematics
Modern approaches of the financial
management applied large number of
mathematical and statistical tools and
techniques. They are also called as
econometrics. Economic order quantity,
discount factor, time value of money, present
value of money, cost of capital, capital
structure theories, dividend theories, ratio
analysis and working capital analysis are used
as mathematical and statistical tools and
techniques in the field of financial
management.
Financial Management and Production Management
Production management is the operational part of the
business concern. Profit of the concern depends
upon the production performance. Production
performance needs finance, because production
department requires raw material, machinery,
wages, operating expenses etc. These expenditures
are decided and estimated by the financial
department and the finance manager allocates the
appropriate finance to production department. The
financial manager must be aware of the
operational process and finance required for each
process of production activities.
 Financial Management and Marketing

Produced goods are sold in the market with

innovative and modern approaches. For this,
the marketing department needs finance to
meet their requirements. The financial
manager or finance department is responsible
to allocate the adequate finance to the
marketing department. Hence, marketing and
financial management are interrelated and
depends on each other.
 Financial Management and Human Resource

Financial management is also related with human

resource department, which provides manpower
to all the functional areas of the management.
Financial manager should carefully evaluate the
requirement of manpower to each department
and allocate the finance to the human resource
department as wages, salary, remuneration,
commission, bonus, pension and other monetary
benefits to the human resource department.
Hence, financial management is directly related
with human resource management.
Scope of Financial Management
Financial management is an analytical way of viewing the
financial problems of a firm -

What is the total volume of funds an enterprise should

commit?
What specific assets should as enterprise acquire?
How should the funds required be financed?

Alternatively

How large should an enterprise be and how fast should it

grow?
In what form should it hold assets?
What should be the composition of its liabilities?
Financial Management, in the modern sense of the
term, can be broken down into three major decisions
as functions of finance

(i) The Investment Decision,

(ii) The Financing Decision and
(iii) The dividend policy decision.
 The Investment Decision

It 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
groups:
(i) Long-term assets which yield a return over a
period of time in future,
(ii)Short-term or current assets, defined as those
assets which in the normal course of business
are convertible into cash without diminution in
value, usually within a year.

The first of these involving the first category of

 Capital Budgeting
Capital Budgeting relates to the 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. The long-
term assets can be either new or old/existing
ones. The first aspect of the capital budgeting
decision relates to the choice of the new asset
out of the alternatives available or the
reallocation of capital when an existing asset
fails to justify the funds committed. Whether an
asset will be accepted or not will depend upon
the relative benefits and returns associated with
 The second element of the capital budgeting
decision is the analysis of risk and uncertainty.
Since the benefits from the investment proposals
extend into the future, their accrual is uncertain.
They have to be estimated under various
assumptions of the physical volume of sale and
the level of prices. An element of risk in the
sense of uncertainty of future benefits is, thus,
involved in the exercise. The returns from capital
budgeting decisions should, therefore, be
evaluated in relation to the risk associated with it.
 In brief, the main elements of capital budgeting
decisions are (i) the long-term assets and their
composition,
(ii) the business risk complexion of the firm and
(iii) the concept and measurement of the cost of
capital
 Working Capital Management

It is concerned with the management of current

assets. It is an important and integral part of
financial management as short-term survival is a
prerequisite for long-term success. One aspect
of working capital management is the trade-
off between profitability and risk (liquidity).

There is a conflict between profitability and

liquidity. If a firm does not have adequate
working capital, that is, it does not invest
 In addition, the individual current assets
should be efficiently managed so that
neither inadequate nor unnecessary funds
are locked up. Thus the management of
working capital has two basic ingredients:

(1)AN OVERVIEW OF WORKING

CAPITAL MANAGEMENT AS A
WHOLE,

(2) EFFICIENT MANAGEMENT OF THE

INDIVIDUAL CURRENT ASSETS SUCH
 Financing Decision
The second major decision involved in financial
management is the financing decision, The
investment decision is broadly concerned with
the asset-mix or the composition of the assets of
a firm. The concern of the financing decision is
with the financing mix or capital structure or
leverage.
The term Capital Structure refers to the proportion
of debt (fixed interest sources of financing) and
equity capital (variable-dividend
securities/source of funds). The financing
decision of a firm relates to the choice of the
proportion of these sources to finance the
. A Capital structure with a reasonable proportion
of debt and equity capital is called the Optimum
Capital Structure.

Thus, one dimension of the financing decision

whether there is optimum capital structure and
in what proportion should funds be raised to
maximise the return to the shareholders?

The second aspect of the financing decision is the

determination of an appropriate capital
structure, given the facts of a particular case.
 Dividend Policy Decision
The third major decision area of financial
management is the decision-relating to the
dividend policy. The dividend decision should be
analysed in relation to the financing decision of a
firm. Two alternatives are available in dealing
with the profits of a firm: (1) they can be
distributed to the shareholders in the form of
dividends or
(2) They can be retained in the business itself.
The decision as to which course should be followed
depends largely on a significant element in the
dividend decision, the dividend pay-out ratio
Objectives of Financial Management
 The Financial Management is generally concerned
with procurement, allocation and control of
financial resources of a concern. The objectives
can be:
• To ensure regular and adequate supply of funds
to the concern.
• To ensure adequate returns to the shareholders
which will depend upon the earning capacity,
market price of the share, expectations of the
shareholders.
• To ensure optimum funds utilisation. Once the
funds are procured, they should be utilised in
Effective procurement and efficient use of finance lead to
proper utilization of the finance by the business concern. It
is the essential part of the financial manager. Hence, the
financial manager must determine the basic objectives of
the financial management.

Objectives of Financial Management may be broadly

divided into two parts such as:

1. Profit maximization

2. Wealth maximization.
 Profit Maximization
The term profit can be used in two senses. As a
owner-oriented concept it refers to the amount
and share of national income which is paid to
the owner of business
i.e.to the equity share holders.

It can also be termed as profitability which

signifies economic efficiency. It refers to the
situation where output exceeds input i.e. the value
created by the use of resources is more than the
Two important issues are related to the value/share
price-maximisation – Economic Value Added
(EVA) and focus on stakeholders.

EVA is equal to after-tax operating profits of a

firm less the cost of funds used to finance
investments.
A positive EVA would increase owner’s
value/wealth. Therefore, only investment with
position positive EVA would be desirable from
the view point of maximising shareholders’
wealth
The computation of the after-tax operating profits
 Merits:
(i) Its relative simplicity and (ii) Its strong link with
the wealth maximisation of the owners.

However, EVA is, in effect, a repackaged and well

marketed application of the NPV technique of
investment decision. But EVA is certainly a useful
tool for operationalising the owners’ value
maximisation goal, particularly with respect to the
investment decision.
 Focus on Stakeholders
The focus on the stakeholders does not, however,
alter the shareholders’ wealth maximisation goal.
It tends to limit the firm’s actions to preserve the
wealth of the stakeholders. The stakeholders
view is considered part of its “social
responsibility” and is expected to provide
maximum long-term benefit to the
shareholders by maintaining positive
stakeholders relationship which would
minimise stakeholder turnover, conflict and
litigation.
In brief a firm can better achieve its goal of
 Therefore, profit maximization consists of the
following important features.
1. Ultimate aim of the business concern is earning
profit, hence, it considers all the possible ways to
increase the profitability of the concern.
2. Profit is the parameter of measuring the
efficiency of the business concern. So it shows
the entire position of the business concern.
3. Profit maximization objectives help to reduce
the risk of the business.
 Favourable Arguments for Profit Maximization
The following important points are in support of the
profit maximization objectives of the business
concern:
(i) Main aim is earning profit.
(ii) Profit is the parameter of the business operation.
(iii) Profit reduces risk of the business concern.
(iv) Profit is the main source of finance.
Drawbacks of Profit Maximization

Ambiguity,

Timing of Benefits

Quality of Benefits
 Ambiguity
The term ‘Profit’ is a vague and ambiguous concept. It
has no precise connotation. It may be short-term,
long-term; total profit, rate of profit; before-tax,
after-tax; return on total capital employed
(measures company’s profitability and the
efficiency with which its capital is employment
i.e. EBIT/Capital Employed) or total assets or
shareholder’s equity and so on. If profit
maximisation is taken to be the objective, then
question may arise, which of these variants of profit
should a firm try to maximise?
 Timing of Benefits
A more important technical objection to profit
maximisation, as a guide to financial decision
making, is that it ignores the differences in the
time pattern of the benefits received over the
Time
working life Alternative A irrespective
of the asset, Alternative B
of when
(Rs. In lakh) (Rs. In lakh)
they were received.
Period I 50 -
PeriodTime
II Pattern 100 of Benefits (Profit)
100
Period III 50 100
Total 200 200
The total profit associated with alternatives A
and B are identical. If the profit maximisation
is the decision criterion, both the alternatives
would be ranked equally.
This is primarily because a basic dictum of
financial planning, the earlier is the better as
benefits received sooner are more valuable
than benefits received later. The reason for the
superiority of benefits now over benefits later
lies in the fact that the former can be
reinvested to earn a return. This is referred
to as time value of money. The profit
maximisation criterion does not consider the
 Quality of Benefits
It ignores the quality aspect of benefits associated
with a financial course of action. The term
quality here refers to the degree if certainty
with which benefit can be expected. As a rule,
the more certain the expected return, the higher is
the quality of the benefits. An uncertain and
fluctuating return implies risk to the investor
when they want to avoid risk or accept a
minimise risk. They can, therefore, be reasonably
expected to have a preference for a return which
is more certain in the sense that it has smaller
variance over the years.
Uncertainty about expected benefit (Profit)
State of Economy Proft (Rs. Crore)
Alt A Alt B
Recession (Period I) 9 0
Normal (Period II) 10 10
Boom (Period III) 11 20
Total 30 30
 The total returns associated with the two
alternatives are identicial in a normal situation
but the range of variatiions is very wide in case
of alternative B, while it is narrow in respect of
alternative A. To put it differently, the earnings
associate with alternative B are more uncertain
(risky) as they fluctuate widely depending on
the state of the economy. Obviously, alternative
A is better in terms of risk and uncertainty. The
profit maximisation criterion fails to reveal this.
 From all these, it can be determined that an
appropriate operational decision criterion for
financial management should (i) be precise
and exact, (ii) be based on the better principle
of financial management i.e. it should
consider both quantity and quality
dimensions of benefits and (iv) recognise the
time value of money.

The alternative to profit maximisation, i.e. wealth

maximisatiion is one such measure.
 Wealth Maximisation
This is also known as value maximisation or net
present worth maximisation. Its operational
features satisfy all the three requirements of a
suitable operational objective of financial course
of action, namely, exactness, quality of benefits
and the time value of money.

The wealth maximisation criteion is based on the

concept of cash flows generated by the decision
rather than accounting profit which is the
basis of the masurenment of benefits in the
case of the profit maximisation criterion.
 In applying the value maximisation criterion, the
term value is used in terms of worth to the owners,
i.e., ordinary shareholders. The capitalisation
(discount) rate i.e. employed is, therefore, the
rate that reflects the time and risk preferences of
the owners or suppliers of capital. A large
capitalisation rate is the result of higher risk and
longer time period.

For the above reason, the net present vale

maximisation is superior to the profit
maximisation as an operational objective.
 Favourable Arguments for Wealth
Maximization
(i) Wealth maximization is superior to the profit
maximization because the main aim of the
business concern under this concept is to
improve the value or wealth of the
shareholders.
(ii) Wealth maximization considers the
comparison of the value to cost associated with
the business concern. Total value detected
from the total cost incurred for the business
operation.
 Unfavourable Arguments for Wealth Maximization

.
(i) Management alone enjoy certain benefits.

(ii) The ultimate aim of the wealth maximization objectives is to

maximize the profit. Wealth maximization can be activated
only with the help of the profitable position of the business
concern.