FINANCIAL MANAGEMENT

Meaning of Financial Management

Financial Management is a field of finance that deals with financial decisions that business
enterprises make and the tools used to make those decisions. The decisions are based on
planning, organizing, directing and controlling the financial activities such as procurement and
utilization of funds of the enterprise. It means applying general management principles to
financial resources (e.g., stocks, bonds etc.) of the enterprise.

The scope/Elements of Financial Management:

The scope of financial management basically provides a conceptual and analytical framework for
financial decision making.

There are four main financial decisions- Capital Budgeting or Long-term Investment decision
(Application of funds), Capital Structure or Financing decision (Procurement of funds), Dividend
decision (Distribution of funds) and Working Capital Management Decision in order to
accomplish goal of the firm viz., to maximize shareholder’s (owner’s) wealth.

Sometimes all the above four decisions are classified into three decisions as follows:

i. Investment decision – which involves capital budgeting decision (long term investment
decision) and working capital management.

ii. Capital structure

iii. Dividend decision

i. Capital Budgeting Decision:

The process of planning and managing a firm’s long-term investments is called capital
budgeting. In capital budgeting, the financial manager tries to identify profitable investment
opportunities, i.e., assets for which value of the cash flow generated by asset exceeds the cost of

1|Page
that asset. Evaluating the size, timing, and risk of future cash flows (both cash inflows &
outflows) is the essence of capital budgeting.

A finance manager has to find answers to questions such as:

i. What should be the size of firm?

ii. In which assets / projects funds should be invested?

iii. Investments in which assets / projects should be reduced or discontinued?

Capital budgeting decisions determine the fixed assets composition of a firm’s Balance Sheet.
Capital budgeting decision gives rise to operating risk or business risk of a firm.

ii. Capital Structure Decision:

A firm’s capital structure or financing decision is concerned with obtaining funds to meet firm’s
long term investment requirements. It refers to the specific mixture of long-term debt and equity,
which the firm uses to finance its assets. The finance manager has to decide exactly how much
funds to raise, from which sources to raise and when to raise.

Different feasible combinations of raising required funds must be carefully evaluated and an
optimal combination of different sources of funds should be selected. The optimal capital
structure is one which minimizes overall cost of capital and maximizes firm’s value. Capital
structure decision gives rise to financial risk of a firm.

iii. Dividend Decision:

Dividend decision involves two issues-whether to distribute dividends and how much of profits
to distribute as dividends. A finance manager has to decide what percentage of after-tax profit is
to be retained in the business to meet future investment requirements and what proportion has to
be distributed as dividend among shareholders. Should the firm retain all profits or distribute all
profits or retain a portion and distribute the balance?

2|Page
Proportion of profits distributed as dividend is called dividend pay-out ratio and the proportion of
profits retained in the business is retention ratio. Finance manager here is concerned with
determining the optimal dividend pay-out ratio which maximizes shareholder’s wealth. However,
the actual decision is affected by availability of profitable investment opportunities, firm’s
financial needs, shareholder’s expectations, legal constraints, liquidity position of the firm and
other factors.

iv. Working Capital Management Decision:

Working capital management is concerned with management of a firm’s short-term or current

assets, such as inventory, cash, receivables and short-term or current liabilities, such as creditors,
bills payable. Assets and Liabilities which mature within the operating cycle of business or
within one year are termed as current assets and current liabilities respectively.

Working capital management involves following issues:

(1) What are the possible sources of raising short term funds?

(2) In what proportion should the funds be raised from different short-term sources?

(3) What should be the optimum levels of cash and inventory?

(4) What should be the firm’s credit policy while selling to customers?

Inter-Relationships between Financial Decisions:

All the four financial management decisions explained above are not independent but related
with each other’s. Capital budgeting decision requires calculation of present values of cost and
benefits for which we need some appropriate discount rate. Cost of capital which is the result of
capital structure decision of a firm is generally used as the discount rate in capital budgeting
decision.

Hence investment and financing decisions are interrelated. When operating risk of a business is
high due to huge investment in long term assets (i.e., capital budgeting decision) then companies

3|Page
should have low debt capital and less financial risk. Dividend decision depends upon the
operating profitability of a firm which in turn depends on the capital budgeting decision.

Sometimes firms use retained earnings for financing their investment projects and if some
amount of profit is left, that amount is distributed as dividend. Hence there is a relationship
between dividends and capital budgeting on one hand and dividends and financing decision on
the other.

Functions of Financial Management

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 programs 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-
a. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. 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.

4|Page
 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.
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.

Role of a Financial Manager

A financial manager is a person who takes care of all the important financial functions of an
organization. The person in charge should maintain a far sightedness in order to ensure that the
funds are utilized in the most efficient manner. His actions directly affect the Profitability,
growth and goodwill of the firm.

Following are the main functions of a Financial Manager:

1. Raising of Funds

In order to meet the obligation of the business it is important to have enough cash and
liquidity. A firm can raise funds by the way of equity and debt. It is the responsibility of a
financial manager to decide the ratio between debt and equity. It is important to maintain
a good balance between equity and debt.

2. Allocation of Funds

Once the funds are raised through different channels the next important function is to
allocate the funds. The funds should be allocated in such a manner that they are optimally
used. In order to allocate funds in the best possible manner the following point must be
considered

▪ The size of the firm and its growth capability

5|Page
 ▪ Status of assets whether they are long-term or short-term
▪ Mode by which the funds are raised

These financial decisions directly and indirectly influence other managerial activities.
Hence formation of a good asset mix and proper allocation of funds is one of the most
important activity.

3. Profit Planning

Profit earning is one of the prime functions of any business organization. Profit earning is
important for survival and sustenance of any organization. Profit planning refers to
proper usage of the profit generated by the firm.

Profit arises due to many factors such as pricing, industry competition, state of the
economy, mechanism of demand and supply, cost and output. A healthy mix of variable
and fixed factors of production can lead to an increase in the profitability of the firm.

Fixed costs are incurred by the use of fixed factors of production such as land and
machinery. In order to maintain a tandem it is important to continuously value the
depreciation cost of fixed cost of production. An opportunity cost must be calculated in
order to replace those factors of production which has gone thrown wear and tear. If this
is not noted then these fixed costs can cause huge fluctuations in profit.

4. Understanding Capital Markets

Shares of a company are traded on stock exchange and there is a continuous sale and
purchase of securities. Hence a clear understanding of capital market is an important
function of a financial manager. When securities are traded on stock market there
involves a huge amount of risk involved. Therefore, a financial manager understands and
calculates the risk involved in this trading of shares and debentures.

It is on the discretion of a financial manager as to how to distribute the profits. Many

investors do not like the firm to distribute the profits amongst shareholders as dividend

6|Page
 instead invest in the business itself to enhance growth. The practices of a financial
manager directly impact the operation in capital market.

Capital Structure

What is Capital Structure?

A company’s capital structure represents the proportion of debt and equity used by the business
to fund its operations and growth. Debt refers to an amount of money borrowed from one party
by another on the condition that it is repaid at a later date. Equity is the ownership interest in the
business and includes common stock, preferred stock and retained earnings. All these items can
be found on a company’s balance sheet and can be used to calculate the capital structure.

Capital Structure Explained

A company purchases assets using capital. This capital is usually in the form of debt or equity.
There are different types of debt and equity capital available to a company in order to raise cash
and finance its operations. Below outlines common items found in debt and equity:

Debt

• Current portion of long-term debt

• Commercial paper
• Notes payable (often used in the United States to denote commercial paper)
• Leases
• Long term debt

All of these items are liabilities and are the present legal obligations of a company as a result of
its borrowing activities or other fiscal obligations.

Equity

• Common stock
• Share premium

7|Page
 • Retained earnings
• Other comprehensive income (sometimes called ‘reserves under IFRS’)

These items represent the shareholders’ investment in the company. Note these amounts are
recorded at the amount invested at the time and not the current market value.

Key Learning Points

• Capital structure is the proportion of debt and equity a business uses to finance its
operations and growth
• Equity is the ownership interest in the business
• Debt is a type of liability and refers to an amount of money owed from one party to
another on the condition that it is repaid at a later date (usually with interest)
• Leverage ratios help assess how levered a company is in proportion to its total capital
• The proportion of equity or debt that makes up a company’s capital structure is heavily
influenced by its stage in its lifecycle
• Enterprise value is the value of the operational business and is unaffected by capital
structure changes

QN 1: Explain both the short-term and long-term avenues of debt financing an

entrepreneur should explore to undertake a project.

Factors Determining Capital Structure

1. Trading on Equity- The word “equity” denotes the ownership of the company. Trading
on equity means taking advantage of equity share capital to borrowed funds on
reasonable basis. It refers to additional profits that equity shareholders earn because of
issuance of debentures and preference shares. It is based on the thought that if the rate of
dividend on preference capital and the rate of interest on borrowed capital is lower than
the general rate of company’s earnings, equity shareholders are at advantage which
means a company should go for a judicious blend of preference shares, equity shares as

8|Page
 well as debentures. Trading on equity becomes more important when expectations of
shareholders are high.
2. Degree of control- In a company, it is the directors who are so called elected
representatives of equity shareholders. These members have got maximum voting rights
in a concern as compared to the preference shareholders and debenture holders.
Preference shareholders have reasonably less voting rights while debenture holders have
no voting rights. If the company’s management policies are such that they want to retain
their voting rights in their hands, the capital structure consists of debenture holders and
loans rather than equity shares.
3. Flexibility of financial plan- In an enterprise, the capital structure should be such that
there is both contractions as well as relaxation in plans. Debentures and loans can be
refunded back as the time requires. While equity capital cannot be refunded at any point
which provides rigidity to plans. Therefore, in order to make the capital structure
possible, the company should go for issue of debentures and other loans.
4. Choice of investors- The company’s policy generally is to have different categories of
investors for securities. Therefore, a capital structure should give enough choice to all
kind of investors to invest. Bold and adventurous investors generally go for equity shares
and loans and debentures are generally raised keeping into mind conscious investors.
5. Capital market condition- In the lifetime of the company, the market price of the shares
has got an important influence. During the depression period, the company’s capital
structure generally consists of debentures and loans. While in period of boons and
inflation, the company’s capital should consist of share capital generally equity shares.
6. Period of financing- When company wants to raise finance for short period, it goes for
loans from banks and other institutions; while for long period it goes for issue of shares
and debentures.
7. Cost of financing- In a capital structure, the company has to look to the factor of cost
when securities are raised. It is seen that debentures at the time of profit earning of
company prove to be a cheaper source of finance as compared to equity shares where
equity shareholders demand an extra share in profits.
8. Stability of sales- An established business which has a growing market and high sales
turnover, the company is in position to meet fixed commitments. Interest on debentures

9|Page
 has to be paid regardless of profit. Therefore, when sales are high, thereby the profits are
high and company is in better position to meet such fixed commitments like interest on
debentures and dividends on preference shares. If company is having unstable sales, then
the company is not in position to meet fixed obligations. So, equity capital proves to be
safe in such cases.
9. Sizes of a company- Small size business firms capital structure generally consists of
loans from banks and retained profits. While on the other hand, big companies having
goodwill, stability and an established profit can easily go for issuance of shares and
debentures as well as loans and borrowings from financial institutions. The bigger the
size, the wider is total capitalization.

Financial Goal - Profit vs Wealth

Every firm has a predefined goal or an objective. Therefore, the most important goal of a
financial manager is to increase the owner’s economic welfare. Here economics welfare may
refer to maximization of profit or maximization of shareholders wealth. Therefore, Shareholders’
wealth maximization (SWM) plays a very crucial role as far as financial goals of a firm are
concerned.

Profit is the remuneration paid to the entrepreneur after deduction of all expenses.
Maximization of profit can be defined as maximizing the income of the firm and
minimizing the expenditure. The main responsibility of a firm is to carry out business by
manufacturing goods and services and selling them in the open market. The mechanism of
demand and supply in an open market determine the price of a commodity or a service. A firm
can only make profit if it produces a good or delivers a service at a lower cost than what is
prevailing in the market. The margin between these two prices would only increase if the firm
strives to produce these goods more efficiently and at a lower price without compromising on the
quality.

The demand and supply mechanism plays a very important role in determining the price of a
commodity. A commodity which has a greater demand commands a higher price and hence may
result in greater profits. Competition among other suppliers also effect profits. Manufacturers

10 | P a g e
tends to move towards production of those goods which guarantee higher profits. Hence there
comes a time when equilibrium is reached and profits are saturated.

According to Adam Smith - business man in order to fulfill their profit motive in turn
benefits the society as well. It is seen that when a firm tends to increase profit it eventually
makes use of its resources in a more effective manner. Profit is regarded as a parameter to
measure firm’s productivity and efficiency. Firms which tend to earn continuous profit
eventually improvise their products according to the demand of the consumers. Bulk production
due to massive demand leads to economies of scale which eventually reduces the cost of
production. Lower cost of production directly impacts the profit margins. There are two ways to
increase the profit margin due to lower cost. Firstly, a firm can produce at lower sot but continue
to sell at the original price, thereby increasing the revenue. Secondly a firm can reduce the final
price offered to the consumer and increase its market thereby superseding its competitors.

Both ways the firm will benefit. The second way would increase its sale and market share while
the first way only tends to increase its revenue. Profit is an important component of any business.
Without profit earning capability it is very difficult to survive in the market. If a firm continues
to earn large amount of profits, then only it can manage to serve the society in the long run.
Therefore, profit earning capacity by a firm and public motive in some way goes hand in hand.
This eventually also leads to the growth of an economy and increase in National Income due to
increasing purchasing power of the consumer.

Profit Maximization Criticisms

Many economists have argued that profit maximization has brought about many
disparities among consumers and manufacturers. In case of perfect competition, it may
appear as a legitimate and a reward for efforts but in case of imperfect competition a firm’s
prime objective should not be profit maximization.

In olden times when there was not too much of competition selling and manufacturing goods
were primarily for mutual benefit. Manufacturers didn’t produce to earn profits rather produced
for mutual benefit and social welfare. The aim of the single producer was to retain his position in
the market and sustain growth, thereby earning some profit which would help him in maintaining

11 | P a g e
his position. On the other hand, in today’s time the production system is dominant by two tier
system of ownership and management. Ownership aims at maximizing profit and management
aims at managing the system of production thereby indirectly increasing the income of the
business.

These services are used by customers who in turn are forced to pay a higher price due to
formation of cartels and monopoly. Not only have the customers suffered but also the employees.
Employees are forced to work more than their capacity. they are made to pay in extra hours so
that production can increase.

Many times, manufacturers tend to produce goods which are of no use to the society and create
an artificial demand for the product by rigorous marketing and advertising. They tend to make
the product so tempting by packaging and labeling that it’s difficult for the consumer to resist.
These happen mainly with products which aim to target kids and teenagers. Ad commercials and
print ads tend to provide with wrong information to artificially hike the expectation of the
product.

In case of oligopoly where the nature of the product is more or less same exploit the customer to
the max. Since they form cartels and manipulate prices by giving very less flexibility to the
consumer to negotiate or choose from the products available. In such a scenario it is the
consumer who becomes prey of these activities. Profit maximization motive is continuously
aiming at increasing the firm’s revenue and is concentrating less on the social welfare.

Government plays a very important role in curbing this practice of charging extraordinarily high
prices at the cost of service or product. In fact, a market which experiences a high degree of
competition is likely to exploit the customer in the name of profit maximization, and on the other
hand where the production of a particular product or service is limited there is a possibility to
charge higher prices is greater. There are few things which need a greater clarification as far as
maximization of profit is concerned

Profit maximization objective is a little vague in terms of returns achieved by a firm in

different time period. The time value of money is often ignored when measuring profit.

12 | P a g e
It leads to uncertainty of returns. Two firms which use same technology and same factors of
production may eventually earn different returns. It is due to the profit margin. It may not be
legitimate if seen from a different stand point.

13 | P a g e