FINANCIAL MANAGEMENT

Meaning of Financial Management

Financial Management means 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 of the enterprise.

Scope/Elements

1. Investment decisions includes investment in fixed assets (called as capital budgeting). Investment in current assets are also a part of investment decisions called as working capital decisions.
2. Financial decisions - They relate to the raising of finance from various resources which will depend upon decision on type of source, period of financing, cost of financing and the returns thereby.
3. Dividend decision - The finance manager has to take decision with regards to the net profit distribution. Net profits are generally divided into two:
4. 1. Dividend for shareholders- Dividend and the rate of it has to be decided.
   2. Retained profits- Amount of retained profits has to be finalized which will depend upon expansion and diversification plans of the enterprise.
   
   

   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-

   1. To ensure regular and adequate supply of funds to the concern.
   2. To ensure adequate returns to the shareholders which will depend upon the earning capacity, market price of the share, expectations of the shareholders.
   3. To ensure optimum funds utilization. Once the funds are procured, they should be utilized in maximum possible way at least cost.
   4. To ensure safety on investment, i.e, funds should be invested in safe ventures so that adequate rate of return can be achieved.
   5. To plan a sound capital structure-There should be sound and fair composition of capital so that a balance is maintained between debt and equity capital.

   
   

   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 programmes 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 have been made, the capital structure have 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-
      1. Issue of shares and debentures
      2. Loans to be taken from banks and financial institutions
      3. 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 have to be made by the finance manager. This can be done in two ways:
      1. Dividend declaration - It includes identifying the rate of dividends and other benefits like bonus.
      2. 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, maintainance 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.

   Financial Planning - Definition, Objectives and Importance

   Definition of Financial Planning

   Financial Planning is the process of estimating the capital required and determining it’s competition. It is the process of framing financial policies in relation to procurement, investment and administration of funds of an enterprise.

   Objectives of Financial Planning

   Financial Planning has got many objectives to look forward to:

   1. Determining capital requirements- This will depend upon factors like cost of current and fixed assets, promotional expenses and long- range planning. Capital requirements have to be looked with both aspects: short- term and long- term requirements.
   2. Determining capital structure- The capital structure is the composition of capital, i.e., the relative kind and proportion of capital required in the business. This includes decisions of debt- equity ratio- both short-term and long- term.
   3. Framing financial policies with regards to cash control, lending, borrowings, etc.
   4. A finance manager ensures that the scarce financial resources are maximally utilized in the best possible manner at least cost in order to get maximum returns on investment.

   Importance of Financial Planning

   Financial Planning is process of framing objectives, policies, procedures, programmes and budgets regarding the financial activities of a concern. This ensures effective and adequate financial and investment policies. The importance can be outlined as-

   1. Adequate funds have to be ensured.
   2. Financial Planning helps in ensuring a reasonable balance between outflow and inflow of funds so that stability is maintained.
   3. Financial Planning ensures that the suppliers of funds are easily investing in companies which exercise financial planning.
   4. Financial Planning helps in making growth and expansion programmes which helps in long-run survival of the company.
   5. Financial Planning reduces uncertainties with regards to changing market trends which can be faced easily through enough funds.
   6. Financial Planning helps in reducing the uncertainties which can be a hindrance to growth of the company. This helps in ensuring stability an d profitability in concern.

   Finance Functions

   The following explanation will help in understanding each finance function in detail

   Investment Decision

   One of the most important finance functions is to intelligently allocate capital to long term assets. This activity is also known as capital budgeting. It is important to allocate capital in those long term assets so as to get maximum yield in future. Following are the two aspects of investment decision

   1. Evaluation of new investment in terms of profitability
   2. Comparison of cut off rate against new investment and prevailing investment.

   Since the future is uncertain therefore there are difficulties in calculation of expected return. Along with uncertainty comes the risk factor which has to be taken into consideration. This risk factor plays a very significant role in calculating the expected return of the prospective investment. Therefore while considering investment proposal it is important to take into consideration both expected return and the risk involved.

   Investment decision not only involves allocating capital to long term assets but also involves decisions of using funds which are obtained by selling those assets which become less profitable and less productive. It wise decisions to decompose depreciated assets which are not adding value and utilize those funds in securing other beneficial assets. An opportunity cost of capital needs to be calculating while dissolving such assets. The correct cut off rate is calculated by using this opportunity cost of the required rate of return (RRR)

   Financial Decision

   Financial decision is yet another important function which a financial manger must perform. It is important to make wise decisions about when, where and how should a business acquire funds. Funds can be acquired through many ways and channels. Broadly speaking a correct ratio of an equity and debt has to be maintained. This mix of equity capital and debt is known as a firm’s capital structure. A firm tends to benefit most when the market value of a company’s share maximizes this not only is a sign of growth for the firm but also maximizes shareholders wealth. On the other hand the use of debt affects the risk and return of a shareholder. It is more risky though it may increase the return on equity funds. A sound financial structure is said to be one which aims at maximizing shareholders return with minimum risk. In such a scenario the market value of the firm will maximize and hence an optimum capital structure would be achieved. Other than equity and debt there are several other tools which are used in deciding a firm capital structure.

   Dividend Decision

   Earning profit or a positive return is a common aim of all the businesses. But the key function a financial manger performs in case of profitability is to decide whether to distribute all the profits to the shareholder or retain all the profits or distribute part of the profits to the shareholder and retain the other half in the business. It’s the financial manager’s responsibility to decide a optimum dividend policy which maximizes the market value of the firm. Hence an optimum dividend payout ratio is calculated. It is a common practice to pay regular dividends in case of profitability Another way is to issue bonus shares to existing shareholders.

   Liquidity Decision

   It is very important to maintain a liquidity position of a firm to avoid insolvency. Firm’s profitability, liquidity and risk all are associated with the investment in current assets. In order to maintain a tradeoff between profitability and liquidity it is important to invest sufficient funds in current assets. But since current assets do not earn anything for business therefore a proper calculation must be done before investing in current assets. Current assets should properly be valued and disposed of from time to time once they become non profitable. Currents assets must be used in times of liquidity problems and times of insolvency.

   Role of a Financial Manager

   
   

   Financial activities of a firm is one of the most important and complex activities of a firm. Therefore in order to take care of these activities a financial manager performs all the requisite financial activities.

   A financial manger 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
         • Status of assets whether they are long term or short tem
         • 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 cost can cause huge fluctuations in profit.

         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 manger understands and calculates the risk involved in this trading of shares and debentures. Its on the discretion of a financial manager as to how distribute the profits. Many investors do not like the firm to distribute the profits amongst share holders as dividend instead invest in the business itself to enhance growth. The practices of a financial manager directly impact the operation in capital market.

   Capital Structure - Meaning and Factors Determining Capital Structure

   Meaning of Capital Structure Capital Structure is referred to as the ratio of different kinds of securities raised by a firm as long-term finance. The capital structure involves two decisions- Type of securities to be issued are equity shares, preference shares and long term borrowings (Debentures). Relative ratio of securities can be determined by process of capital gearing. On this basis, the companies are divided into two- Highly geared companies - Those companies whose proportion of equity capitalization is small. Low geared companies - Those companies whose equity capital dominates total capitalization.

   For instance - There are two companies A and B. Total capitalization amounts to be USD 200,000 in each case. The ratio of equity capital to total capitalization in company A is USD 50,000, while in company B, ratio of equity capital is USD 150,000 to total capitalization, i.e, in Company A, proportion is 25% and in company B, proportion is 75%. In such cases, company A is considered to be a highly geared company and company B is low geared company.

   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 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 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 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 tend 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.