Introduction to Financial

Management
Introduction
• Finance is the life blood of any business
firm. The goal of business firm is to
maximise the wealth of the owners in a
company.
• Wealth of the owners in a company is
represented in the market value of the equity
shares.
• Financial Management is primarily
concerned with the process of procuring and
judicious use of financial resources to
maximise the wealth of equity shareholders.
 Meaning of Financial Management:
• Financial Management is the efficient and effective
management of funds in such a manner to accomplish the
objective of an organisation.
• In other words, it is the planning, organising, controlling and
monitoring of the financial resources of an organisation.
Definition:
“Financial Management is the art of raising and spending
money” (P.G.Hastings)
“ Financial Management is the application of the planning
and control functions to the finance function” (Archer and
Abrosio)
Nature and characteristics of Financial Management
1. Management of fund: Financial Management is an art and
science of management of fund or money. It deals with
problems of fund in an organisation.
2. Financial Planning and control: Financial Management is
concerned with planning and control of finance
3. Focus on decision making: In Financial Management,
the focus is on financial decision making. It gives analysis
of data which facilitates decision making.
4. Determinant of business success: Financial Management
plays an important role in the success of an organisation.
5. Centralised in nature: Financial Management is
centralised in nature. In finance function,
decentralisation is not practicable.
6. Continuous administrative function: It is a
continuous administrative function. It is related with
the procurement of fund, utilisation of fund, allocation
of the excess of returns over investments, etc.
7. Multidisciplinary: Accountancy, Economics, Marketing
Management, Quantitative Techniques, etc have an
impact on Financial Management.
 Importance of Financial Management.
Financial function is interlinked with other functions such as
production, marketing, personnel, etc. Therefore, proper
management of money is quite essential. The importance of
financial management is explained under the following heads:
1. Preparation of sound financial plan: Sound financial plan
is very necessary for the success of a business enterprise. If
the financial plan fails to provide adequate capital to meet the
requirements of fixed and fluctuating capital, the business
cannot be carried out smoothly. In the absence of a financial
management, it is not possible to prepare a sound financial
plan.
2. Smooth running of the business: Finance is required
at each stage of business like incorporation, development,
growth, etc. For the smooth running of the business,
proper administration of finance is necessary. This is
facilitated only if there is an efficient financial
management.
3. Controlling and Co-ordination of functional
activities: Financial Management occupies a central
place in the business organisation. It controls and
co-ordinates all other activities in the enterprise like
marketing, production, etc. If financial management is
defective, all other departments will become defective.
4. Decision making: Decision making is the process of
selecting the best course of action from among different
course of actions. Various financial tools are available for
evaluating alternatives and for choosing the best
alternatives. Some of the important financial
management tools include capital budgeting, variance
analysis, cost-profit volume analysis and financial
statement analysis.
5. Providing solutions to financial problems: Efficient
financial management helps the top management by
providing solutions to the various financial problems
faced by it.
6. Determinant of business success: Financial Managers
play a very important role in the success of a business.
They advise the top management in solving various
financial problems. They present relevant information
regarding financial position and operating results before
the top management. This enables the top executives to
evaluate the progress of the business and to make
necessary changes in the policies of the firm.
Objectives or Goals of Financial Management
• There are various parties interested in an organisation
(known as stakeholders).
• They are shareholders, management, employees,
consumers and society at large.
• It is required to safeguard the interest of all these parties.
• The objectives of financial management may be broadly
classified into two:
1. Financial Objectives
2. Other objectives.
1. Financial Objectives

Financial objectives
include
A.Profit maximisation,
B. Wealth maximisation
A. Profit Maximisation:
Profit maximisation is generally regarded as the main
objective of business enterprises and hence the objective
of Financial Management is also maximisation of profit.
Profit of the firm becomes the income of the owner.
Maximisation of profit ensured the self interests of the
owners and managers. Both decide the actions of the firm
and ensure that these are carried out.
• Profit maximisation is justified on the following grounds:
i. Profit is the standard for measuring the success or
efficiency of every business enterprises.
ii. Profit is essential for survival
iii. Social welfare is achieved through profit maximisation
iv. Maximisation of profit means maximum return to
shareholders
v. Maximisation of profit enables to set aside sufficient
funds for future expansion
vi. Profit attracts investors to invest their savings in
securities.
Profit maximisation as objective of FM is criticised on the
following grounds:
i. The concept of profit maximisation is vague and narrow
ii. It ignores the risk factor as well as timing factor
iii. It may allow decisions to be taken at the cost of long run
stability and profitability of the concern.
iv. It emphasizes short run profitability and short term
projects
v. It may cause to decrease in share price.
vi. The profit is only one of the many objectives of a modern
firm
vii. It fails to consider the social responsibility of business.
viii.It leads to exploitation of workers and consumers.
B. Wealth Maximisation
• The ultimate goal of the financial management is
maximisation of owners’ wealth.
• Wealth maximisation means maximising the net present
value (wealth) of a course of action. The net present value of
a course of action is the difference between the present
value of its benefits and present value of its costs.
• A financial action which has a positive net present value
creates wealth and therefore is desirable.
• The most direct evidence of wealth maximisation is changes
in the price of a company’s share.
• Wealth maximisation is justified on the following grounds:
i. It takes into consideration long run survival and growth of
the firm
ii. It is consistent with the object of owner economic welfare.
iii. It considers risk and time value of money.
iv. It suggests the regular and consistent dividend payments to
shareholders.
v. It considers all future cash flows, dividends and earning per
share.
vi. Maximisation of firm’s wealth is reflected in the market
price of share
vii. The shareholders always prefer wealth maximisation rather
than maximisation of inflow of profits.
viii.It is considered superior to profit maximisation.
• The wealth maximisation objective is criticised on the
following grounds:
i. It ignores the wealth maximisation of society since
society’s resources are used to the advantage of a
particular firm. The society’s resource should be
optimally allocated, it should result in capital formation
and growth of the economy.
ii. It is difficult to incorporate in the financial statements
iii. It focuses on shareholders’ wealth maximisation. It
does not take into consideration the welfare of other
stakeholders
2.Other objectives
i. To enhance employees’ satisfaction and welfare:
Employees (including managers) are the backbones of
any business. Hence, an important goal of Financial
Management is to enhance employee satisfaction and
welfare. This is achieved by giving good remuneration,
healthy and safe working condition, good pension
schemes, etc.
ii. To promote wellbeing of society: A company is an
integral part of the society. It is rooted deep into the
society. As such, in return for the privileges and rights
granted to it by the society, the business should be
made responsible to promote wellbeing of the society.
3. To provide quality services/products to customers:
It is the responsibility of business to render quality
services/products to customers.
4. Sales maximisation: The interest of the company are
best served by of sales revenue. It brings with it the
benefits of growth, market share and status. The size of
the firm and prestige are more closely identified with
sales revenue than with profit.
Responsibilities of Financial Management(Financial Manager)

1. Financial Planning
2. Raising necessary funds
3. Controlling the use of funds
4. Appropriation of profits
5. Other responsibilities:
• To owners
• To employees
• To customers/suppliers
• Legal obligations
• Wealth maximisation
Responsibilities of Financial Management(Financial Manager)

1. Financial Planning: The main responsibility of the

Financial Management is to forecast the needs and
identify the source and then to plan for them
2. Raising necessary funds: Another responsibility is to
raise the funds for the operation of the business. A cost
benefit analysis of various sources must be made.
3. Controlling the use of funds: Financial Management is
responsible for proper utilisation of funds. Fund must
be utilised effectively to earn maximum profit.
Unnecessary expenditure should be curtailed.
4. Appropriation of profits: It is an important responsibility of
Financial Management to advise the top executive as to how
much of the profit should be retained in the business and
how much to be used for distribution of dividend.
5.Other responsibilities:
To owners: Financial Management should not only maintain
financial health of the Company but also help the owners in
getting a satisfactory rate of return.
To employees: The Financial Management should try to
make successful going concern capable of providing regular
employment at satisfactory remuneration under favourable
working condition.
To customers/suppliers: It is the responsibility of Financial
Management to ensure provision of funds for regular supply
of products to customers. It is also responsible to make
timely payment to suppliers of raw material, etc. to the
company.
Legal obligations: Financial management is responsible for
complying various laws, rules, etc applicable to the company.
Scope of Financial Management
Financial Management provides a conceptual and
analytical framework for financial decision making. The
approach to the scope of Financial Management is divided
into 2 broad categories:
1. Traditional approach
2. Modern approach
1.Traditional approach
The traditional approach to the scope of financial management
covered three inter-related aspects of raising and
administering funds from outside. They are:
a) Financial institutions and capital markets
b) Financial instruments
c) Procedural and legal aspects of raising finance
Thus, traditional view of Financial Management looks into the
following functions, that a Financial Manager of a business
firm will perform:
• Arrangement of short term and long term funds from
financial institutions and capital markets
• Mobilisation of funds through financial instruments like
equity shares, preference shares, etc
• Orientation of finance function with the Accounting
function and compliance of legal provisions.
 2.Modern approach
• According to the modern approach, the finance function
covers both acquisition of funds as well their allocations.
• According to the modern approach, the Finance Manager is
expected to analyse the firm and to determine the following:
• Total fund requirement of the firm
• Assets to be acquired, and
• Pattern of financing the assets.
Hence, Financial Management covers three broad areas
(financial decisions):
i) Investment decisions,
ii) Financing decisions and
iii) Dividend decisions.
i. Investment decisions
• Investment decisions relates to the selection of assets in
which funds will be invested by a firm.
• The assets which can be acquired are of two types-Fixed
assets(Long term assets) (assets which yield return over a
period of time) and currents assets (short term assets)
(assets can be converted into cash within a short period).
• The financing decision making with regard to long term
asset is called capital budgeting and that with reference
to short term assets is called working capital
management (trade off between liquidity and
profitability) .
ii) Financing decision
• This is concerned with financing mix or capital structure
or leverage.
• It relates to the choice of the proportion of different
sources to finance the investment requirements.
• There must be proper balance between equity and debt.
• A capital structure with a reasonable proportion of debt
and equity capital is called the optimum capital
structure.
iii) Dividend decision
• Dividend decisions concerned with the determination of
quantum of profits to be distributed to the owners and the
frequency of such payments.
• The dividend decision will effect in two ways
• (a) the amount to be paid out and its influence on share
price, and
• (b) the amount of profit to be retained for internal
investment which maximise the value of firm and ultimately
improves the share value of the firm.
• The dividend distribution policy and retention of profits will
have ultimate effect on the firms wealth.
 Mathematics of finance.
• Financial Mathematics (Mathematics of finance) is the
application of mathematical methods to financial problems.
• It deals with problem of investing money.
• It is also known as quantitative finance, financial
engineering, mathematical finance, and computational
finance.
• It draws on tools from probability, statistics, and economic
theory.
• Interest factor is one of the crucial concepts of mathematics
of finance.
 Concept of Time Value of Money (TMV)
• The concept of time value of money is that value of money
received today is different from the value of money received
after a certain period in future.
• One of the essential feature of a sound appraisal method for
capital expenditure proposals is the consideration of the time
value of money.
• A project and many other financial problems involve cash flows
occurring at different points of time. For evaluating such cash
flows an explicit consideration of time value of money is
required.
• Amount of different period can be comparable meaningfully
only when interest factor is introduced.
• This concept is known as the concept of Time Value of Money
(TVM)
• The concept of Time Value of Money is
considered to be the axiom (fundamental
assumption) of financial management.
• Time value of money is to be considered at all
times when financial management decisions
are taken.
Time value of money principle is based on the
following reasons
1. Inflation: In an inflationary economy, the money received today has
more purchasing power than money to be received in future. In other
words, under inflationary conditions, the value of money, expressed in
terms of its purchasing power declines.
2. Risk and uncertainty: Future is uncertain and riskier than present. ₹1
now is certain whereas ₹1 receivable tomorrow is less certain. This ‘bird
in hand’ principle is extremely important in investment appraisal.
3. Preference for immediate consumption: Many individuals have strong
preference for immediate rather than delayed consumption. The promise
of a bowl of rice next week counts for little to the starving man.
4. Investment opportunities: Money (eg: Rs 100) received today is
preferable because it could be invested over the next year at (say) 10%
interest rate to produce Rs 110 at the end of one year. i.e. Money
received earlier can be invested earlier and earn more interest.
 Techniques of Time Value of Money
• The value of money can be assessed either on a given future date or at the
present date.
• If value is calculated as on a future date, it is called future value of money.
The process of calculating future value of present money is called
compounding.
• If it is calculated at present date, it is called present value of money. The
process of calculating present value of future money is called discounting.
 Compounding Techniques
These are used to find out the future value (FV) of present
money. In this technique, the interest earned on the initial
principal amount becomes a part of principal at the end of the
compounding period.
The compounding technique may be explained with reference
to:
a)The Future Value(FV) of a single present cash flow
b) The Future Value of a series of cash flows.
The Future Value(FV) of a single present cash flow

In order to calculate the future value of a single amount, the following

formula is used.
A= P(1+r)n
Where A is the Future Value
P is the Principal at the beginning of the period
r is the rate of interest
n is the number of years for which compounding is done
Use Table III (compound sum of one rupee) for compounding.

For a given period, higher the interest rate, the greater will be the
Future Value
For a given rate of interest rate, the greater the time period, the higher
will be the Future value.
 Multiple compounding periods.
• If the compounding is half yearly, interest is paid twice a year but at
half the annual rate. Hence annual rate of interest is to be divided by
2 and the number of years is to be multiplied by 2.
• Similarly, in the case of quarterly compounding, interest rate is ¼ th of
the annual rate and the number of years is to be multiplied by 4.
• The formula to calculate the compounded value is :

Where m is the number of times for which compounding is to be done

in a year
Doubling Period
• Doubling period is the length of period in which an amount becomes
double at a given rate of interest.
• Compound value table (Table III) can be used to calculate the
doubling period.
• Rule of 72 can also be used to determine the doubling period.
• According to the Rule of 72, the doubling period is calculated as
follows:
Effective rate of interest
The effective rate of interest is the annually compounded rate of interest
that is equivalent to an annual interest rate compounded more than once
per year(quarterly, half yearly, etc)

r= Nominal rate of interest

m= number of compounding in a year.
EIR is useful in financial decision making, particularly in investment decisions
where different optional opportunities have different compounding
intervals.
Future value of a series of equal cash flows or
annuity of cash flow
• A decision may result in the occurrence of cash flows of the same
amount every year for a number of years consecutively.
• Ex:₹2000 each year for 4 years. This is referred to as annuity of
deposit of Rs 2000 for 4 years
• Annuity is a series of equal annual cash flow.
• In other words, annuity is a finite series of equal cash flows made at
regular intervals.
Formula for finding future value of annuity
(if payments are made at the end of the year)

A= Annuity
r= Rate of Interest
n= Duration of the annuity
Compound value of annuity due
A series of payments deposited at the beginning of the year is called
annuity due.
The formulae for calculating the annuity due is as follows.

Where A is the annuity, r is the rate of interest and n is the number of

years
 Discounting or Present Value Technique.
• In the case of compounding technique we calculate the future
value of present money.
• In the case of discounting technique we calculate the present
value of a future sum. It is the reverse of compounding
• The discounting technique to find out the present value may be
explained in terms of:
(i) The present value a single future amount
(ii) The present value of a series of future cash flows.
Present Value of single future sum
• The present value of a future sum will be worth less than the future
sum.
• The present value of Rs 110 receivable next year is less than
Rs 110. At a discounting rate of 10%, it is Rs 100.
• Similarly, the present value of Rs 100 receivable next year is Rs 90.90
at a discounting rate of 10%.
• Similarly, the present value of Re 1 receivable next year is Rs 0.9090 at
a discounting rate of 10%.
• Similarly the present value of Rs 121 receivable at the end of second
year is equal to Rs 100 today at a discounting rate 10%
Present values of a series of future cash flows
• In a business situation, returns are spread over a future period. Cash flows
may be uniform or changing at periodical intervals. In both situations, the
following formula may be used to calculate the PV:

• P1, P2, P3,..= Cash flows after period 1,2,3, etc.

• r is discounting rate
• n is number of years.
 Practical Applications of the concept of Time value of money
• Concept of time value of money helps in arriving at certain
decisions. The following are some of the applications of the concept
of time value of money.
Qn
• An investor deposits Rs 50,000 and expects to receive Rs 80,000.
The deposit pays 10% interest compounded yearly. How many
years should the amount deposited to arrive at Rs 80,000?
• FV=PV(1+r)n
• 80000=50000(1+r)n
• 80000/50000= (1+r)n
• (1+r)n =1.6
• Look up the Table III (compound value interest factor of a lump
sum amount)to find out 1.6 at 10% rate of interest. This
corresponds to 5 years. Hence, the investor should aim at
depositing the money for 5 years.
Risk and Return
• A finance manager has to take various types of financial decisions
from time to time. Every financial decision has two aspects-risk and
return. The value of investment is determined by risk and return.
• Risk
• Risk simply refers to chance of loss. In other words, risk is the
probability of failure to accomplish an objective.
• In the context of financial management, the term risk refers to the
variability of actual return on an investment from the expected
return. It is the probability of losing some or all of the money we put
into an investment. In short, risk is a situation where the outcome is
uncertain.
 Type of Risk
• Risk can be broadly classified into two
1. Systematic Risk
2. Unsystematic Risk
1 Systematic Risk: Systematic risk refers to the risk inherent to the
entire market. This is un-diversifiable risk, i.e. It cannot be
reduced through diversification. Sources of systematic risk could
be macroeconomic factors such as inflation, changes in interest
rate, fluctuations in currency rates, recession, etc. Thus,
systematic risk covers those factors which are external to a
particular company. An individual company cannot control
systematic risk.
Unsystematic Risk :
It is the risk that is inherent in a specific company or industry such as
labour strike, change in management, change in demand for the product,
etc. It covers those factors which are internal to companies/industries.
These are controllable to a great extent.
This includes business risk and financial risk.
Business Risk is the variability in the actual earnings of a firm from its
expected earnings.
Financial risk arises due to presence of debt in the capital structure of a
firm. A firm having higher debt content in its capital structure is
considered to be more riskier.
By investing in a range of companies and industries, unsystematic risk can
be drastically reduced through diversification. Synonyms include
diversifiable risk, non-systematic risk, residual risk and specific risk.
Attitudes towards risk
Decision makers’ attitude may vary widely.
Some investors are risk prefers. They prefer to take risk for more
returns.
Some investors are risk averse. They would not like to take much
risk. But they would not avoid risk completely. They attempt to
manage risk.
Some investors are risk neutral. They have neither preference nor
aversion towards risk.
Return
• Return simply refers to benefits accrued on the original
investment made in an asset or investment.
Measurement of Return:
There are four approaches to measure the return.
1. Profit Approach
2. Income Approach
3. Cash Flow Approach
4. Ratio Approach
1. Profit Approach: Under this approach, return is measured on the basis
of profit earned by the business on its investment
2. Income Approach: Under this approach, the return is measured on the
basis of income. Income is the profit arrived as per accounting
procedures and techniques. Income can be calculated in the following
three major ways- Earning Before Interest and Tax(EBIT), Profit Before
Tax(PBT) and Profit After Tax(PAT)
3. Cash Flow Approach: Under this approach cash flows of the firm are
used to assess its performance. Cash flows are calculated from
accounting profit. For calculating cash flows, non-cash items
(depreciation, etc) are added back to profit.
4. Ratio Approach: According to this approach, some ratios are
calculated to measure the return. Eg: Return on capital employed,
return on total assets, etc.
Relationship between Risk and Return
• Risk and return are positively correlated. It means that a high
return is normally associated with a high risk and low return with
low risk.
• In other words, return is directly proportional to the amount of
the risk taken by the firm.
• The relationship between the risk and return can be explained
with the help of the following equation
• Return= Risk free return + Risk Premium
• Risk free return is a compensation or reward for the time.
• Risk premium mean premium for risk.
Relationship between Risk and Return
30

25

20

Return15

10

Risk
Risk return trade off
• At the time of taking financial decision, the finance manager has
to weigh both risk and return. A proper balance between risk
and return should be maintained by the finance manager to
maximise the market value of shares. A particular combination
where both risk and return are optimised is known as risk-
return trade off. At this level, the market price of shares will be
maximised.