FINANCIAL

MANAGEMENT
 COURSE TITLE: FINANCIAL
MANAGEMENT

COURSE CODE: BFS C305

SEMESTER: III

CLASS/DIV: SY BBA(FS) B

SUBJECT TEACHER: ASST. PROF. MS.

LIZIA V. GOMES
 COURSE OBJECTIVE

To acquaint the students with financial

management tools & techniques in financial
decision making.
FINANCIAL MANAGEMENT
 Meaning of Finance

Finance is life blood of business.

Finance is a simple task of providing the necessary funds

(money) required by the business of entities like
companies, firms, individuals and others on the terms that
are most favourable to achieve their economic objectives.

The term finance should be understood in two perspectives

- finance as a resource and finance as a discipline.
 Finance, as a resource, refers to monetary means of financing
assets of an entity. Finance as a discipline or subject of study,
describes how individuals , governments and corporate
organizations manage the flows of money through an
organization.

In other words, finance tells how to make decisions about the

collection and allocation of resources in organizations.
 UNIT I: FINANCIAL MANAGEMENT

Meaning & definition of financial management

The word Financial means procuring sources of money supply

and allocation of these resources on the basis of forecasting
monetary requirements of the business.

The word management refers to planning , organization , co-

ordination and control of human activities and physical
resources for achieving the objectives of an enterprise .

Thus, financial management is the part of business management

which is concerned with planning and controlling of firms
financial resources i.e. management of finance function.
 It relates mainly with the control of current performance
acquisition of funds ,profitable use of these funds ,planning for
future activities and employs economically most suitable
methods such as financial accounting, cost accounting,
budgeting, statistics and so on.

Financial management is concerned with three activities:

a) Anticipating financial needs- which means estimate funds
required for investment in fixed and current assets or long term
and short trem assets.
b) Acquiring financial resources- once the required amount of
capital is anticipated the next task is acquiring financial
resources.
c) Allocating funds in business- means allocation of available
funds among the best plans of assets, which will maximise
shareholders wealth.
 Actionable Investment
Cash
report decision
flow

Monitoring Financial management Analysis

Scenario
Key Profitability planning
drivers
Financial management is the ways & means of managing money.
i.e. the determination, acquisition, allocation & utilisation of
financial resources usually with the aim of achieving some
particular goals or objectives.

To conclude, financial management is a functional area of business

management.

Joseph L. Massie has stated that, Financial management is the

operational activity of a business that is responsible for
obtaining & effectively utilizing the funds necessary for
effective operations.
 Nature or characteristics of financial management
Modern approach of finance function has made the role of financial
management very significant in the field of business
management. The responsibility of finance function is
acquisition & rational utilisation of funds.

It has become a continuous business function rather than episodic

function. Based on this approach, the main characteristics of
financial management or finance function can be identified as
follows:

Essential part of business management

The concept of financial management is broad based with the result
that it has become vital & integral part of overall management.
Each activity of business is linked with finance.
For instance, the responsibility for technical advice about plant,
machines, tools, raw materials, fuel etc. lies with the production
manager. But, final decision in this regard can not be taken till
the finance manager gives green signal about all its financial
aspects.

Continuous administrative function

In traditional approach, financial management was mainly confined
to raising of funds needed.
It was a episodic business activity. The modern approach places
greater emphasis on judicious & rational use of funds raised.
This aspect has made financial management a continuous
administrative function. The finance manager of a large business
enterprise performs the functions of capital budgeting &
management of working capital which is a continuous headache
for him.
 Scientific & analytical
At present, the financial management has become less descriptive
& more scientific & analytical in nature.
In the present era, while taking financial decisions, modern
mathematical & statistical methods are used for financial
analysis & evaluation of different alternatives.
That is why, Cohen & Robbins have treated financial management
both science as well as an art & said, managing firms finance
is both an art & a science.
It requires not only a feel for the situation & an analytical skill, but
also a thorough knowledge of the techniques & tools of
financial analysis & the knowledge to apply them & interpret
the results.
 Centralised nature
The FM or finance function is basically of centralised nature in all
functional areas of management, because the objectives of the
business can be achieved more effectively by centralization of
finance function. As such, decentralization of finance function
is not desirable like other functions (production, marketing,
personnel) of the enterprise.

Hence Jack O. Vance ha said, functional areas such as marketing

& production are decentralized in the modern industrial
concerns, but financial co-ordination & control are achieved
through centralization.
 Different from accounting function
Most of the persons regard accounting & finance as the same thing
due to common use of accounting terminology & financial
records, but it is not true.
Finance function is different from accounting function.
Accounting is basically involved with data accumulation while
finance is primarily involved with data analysis for use in
decision-making.

Wide scope
The scope of FM is very wide & complex. Now, the scope of FM
is not confined only to raise capital for meeting long-term
requirements of the enterprise but acquisition of funds for short-
term & long-term needs of the enterprise, proper allocation of
funds & their optimal utilisation are also within its scope.
moreover., it is also responsible for accounting, capital
budgeting, audit, cost control, cash & credit control & other
routine function.

Applicable to all types of organisations

FM is applicable to all types of manufacturing & service
organisations, whatever may be their size, nature, ownership &
control.
It is wrong to say that FM can be applied only to those
organisations whose basic aim is to earn profit.
Raymond Chambers have aptly said, the term FM may be
applied to any kind of undertaking or organisation regardless
of its aims or constitution.
 Scope or functions of financial management (refer to FM by
M.R. Agrawal)
Functions of financial
Functions of financial
management
management

Primary or executive Subsidiary Incidental or routine

Primary or executive Subsidiary Incidental or routine

# Financial planning # Liquidity function

# Financial planning # Liquidity function
# Financial control # Profitability function
# Financial control # Profitability function
# Acquisition of funds # Evaluation of financial
# Acquisition of funds # Evaluation of financial
performance
performance
# Allocation of funds
# Allocation of funds # Co-ordination with other
# Distribution of income # Co-ordination
departmentswith other
# Distribution of income departments
# Clerical or routine
# Clerical
nature or routine
required for the
nature required for the
execution of decision
execution
taking by the of decision
executives
taking by the executives
Financial planning this is primarily a decision-making function.
First of all a financial manager has to formulate a sound financial
plan for the enterprise, whether, it is new or old.
Planning is the formulation of enterprise goals or objectives, the
selection among alternative course of action & the initiation of
policies & programmes to achieve the objectives.
Financial plan is essential for the organisation & operation of an
enterprise & involves the following three basic steps:
Determining financial objectives
Formulating financial policies
Making adjustments & re-adjustments

Financial control - is required for the successful execution of

objectives, policies & programmes established under the financial
plan. It is the important function of financial management.
In exercising control, necessary directions are given to the
subordinate staff for achieving the objectives.

There are two steps in controlling:

Developing stds. of performance and
Comparing actual performance with these stds.
For proper control, finance manager can also establish a system of
reports.
A system of report involves:
Obtaining information, recording information, storing information,
processing the information & use of information.
Acquisition of funds the main function of FM is to ensure
adequate supply of funds from the right source at the right cost &
at the right to time to the firm to meet its funding needs.
The funds can be raised from various sources.
From which source funds should be raised depends upon its cost of
capital, nature of cost & duration of funds.

Allocation of funds allocation means the effective distribution of

the acquired funds to projects & services in accordance with the
stated plans & agreed priorities.
The technique of capital budgeting is useful in proper allocation of
funds among fixed or long-term assets.
Investments in current or short-term assets are made keeping in
view the profitability & liquidity.
When sufficient funds are not invested in current assets, there is
possibility of illiquidity of the company.
On the other hand, if sufficient funds are invested in current assets,
the profitability would be affected as idle assets would not earn
anything. Therefore, sound techniques of current assets
management should be adopted.

Distribution of income rational distribution of profits is also an

important function of FM.
Net after tax can be distributed among shareholders as a return on
their investments or retained in the business for expansion or
distributed among employees as bonus.
The decision regarding distribution of income should be based on
the effects on shareholders wealth.
Liquidity function co-ordinate cash flows required for
meeting day to day needs.

Profitability function tries to maximise the profits of the

enterprise so that the value of the firm may increase & the
shareholders may get the maximum return.
Required to keep the firm in existence.
F manager uses various techniques profit planning, price fixation
of g/s, cost of capital, cost control etc.

Evaluation of financial performance it is the responsibility of

the fm to analyse the performance & report the result to BODs.
F evaluation = current yrs. Performance is compared with the
progress of previous yr. & conclusion are drawn.
This helps to point the errors & bring change in the future policies.
Co-ordination with other departments the success of an
enterprise depends on the co-ordination with the activities of
different departments.
Finance function affects each activity of the business, therefore
there should be proper co-ordination between the finance
department & other departments of the enterprise.
It is the duty of the finance manager to maintain uniformity in
decisions taken by the different departments of the enterprise.
This will help in achieving the objectives of the firm.

The executive finance functions discussed above are inter-related.

Therefore, a change in the decision with regard to one of the
functions is likely to affect change in the decision of some all or
all others.
Incidental or routine functions are those functions of clerical
or routine nature which are necessary for the execution of
decisions taken by the executives.
Maintenance of accounts & preparation of reports
Compliance with governmental regulations
Administration of internal audit etc.

The routine finance functions are performed by people at lower

level. The involvement of chief financial executive in incidental
functions is limited only to the following acts:
Setting up rules of procedure
Establishing standards for carrying out the functions effectively
Revising the performance, whether the instructions are being
followed properly or not.
 Scope of finance
Firms create manufacturing capacities for production of goods;
some provide services to customers.
They sell their goods & services to earn profit.
They raise funds to acquire manufacturing & other facilities.
Thus, the three most important activities of a business firm are:

Production
Marketing
Finance

A firm secures whatever capital it needs & employs it (finance

activity) in activities, which generate returns on invested capital
(production & marketing activities).
1.Public Finance: Like business organizations, governments(local,
state or federal) raise and spend large sum of money, but unlike
business organizations, they pursue non-profit goals. To deal
with governmental financial matters, a separate and specialized
field of finance has emerged as public finance.

2. Securities And Investment Analysis: This area is of interest to

individuals and institutional investors. It covers mainly
measurement of risk and return on investment in securities.

3. Institutional Finance: Institutional finance deals with issues of

capital formation and the organizations that perform the
financing function of the economy. Therefore, it mainly studies
saving and capital formation and institutions involved in this
process such as banks, insurance companies, provident and
pension funds, etc.
4. International Finance: International finance studies economic
transactions among nations, corporations and individually &
internationally. It is concerned with flows of money across
international boundaries.

5. Financial Management: Business firms face problems dealing

with acquisition of funds and optimum methods of employing
the funds. Thus, financial management studies financial
problems in individual firms, seeks low-cost funds and seeks
profitable business activities.
 Financial goals / goals / objectives of financial management

1) Profit maximisation
The basic objective of every business is the welfare of its
owners. It can be achieved by maximisation of profits.
Profit is the positive and fruitful difference between revenues
and expenses of business enterprise over a period of time.
Select those assets, projects & decisions which are profitable
& reject those which are not profitable.
Actions that increase profits be undertaken and those that
decrease profits be ignored/avoided.
The overall objective of business enterprise is to earn atleast
satisfactory returns on the funds invested, consistent with
maintaining sound financial position.
Profit maximisation as an objective of FM can be justified on the
following grounds:

Rational : profit is the device which transforms the selfishness

of mankind into channels of useful service.
A rational human being performs an economic activity with the
objective of utility maximisation. Since, utility can easily be
measured in terms of profits, therefore, the objective of profit
maximisation seems rational.

Test of business performance : business has all along been

considered as an economic institution & thus a common
measurement of its efficiency is profit.
The profit earned by any business enterprise is the result of its
production, marketing & managerial efficiency. It is the ultimate
test of business performance.
 Main source of inspiration : it is the profit which inspires persons
or group of persons to be more efficient than others by hard labour
& competition.
If the attraction of profit is over, there will be no place of competition.
In such a situation, the speed of development & progress will be at
standstill.

Maximum social welfare : it ensures maximum social welfare by

providing maximum dividend to shareholders, timely payment to
creditors, more wages & other benefits to workers, better quality
products at cheaper rate to consumers, more employment to society
& maximum return to the owners.

Basis of decision-making : all strategic & tactical decisions in a

business are taken keeping in view the profit earning objective.
This is the only criterion for rational decisions. It is the risk
premium that covers the cost of staying in business.
 Ignores time value of money : profit maximisation criterion
does not make any distinction between the profits earned during
different time periods.
Equal weight is assigned to earnings of different years which is
virtually wrong. The value of a rupee received today will not be
equal to the value of a rupee to be received after one or two
years, but certainly it will be more.
Thus, it makes no difference between the profits of today & the
profits earned after a certain period, say a year or so.

Ignores risks : PM objective overlooks risks involved in

prospective earnings. It considers only the volume of profit
without giving any weightage to risk or uncertainty.
 Limitations or criticisms of profit maximisation
It is argued that profit maximisation may not maximise the
economic welfare of the owners. It is also criticised on the
following grounds:
It is immoral : it leads to a number of corrupt practices. Further,
it leads to social inequalities & degrades human values which
are an indispensible part of an ideal social system.

It is vague : the term profit is vague & has ambiguous concept.

It is amenable to different interpretations for different people.
There are various types of profits i) short-term profit & long-term
profit, ii) profit before tax & profit after tax, iii) gross profit,
operating profit & net profit, iv) profit per share & total profit.
If profit maximization is taken to be the only objective, the
question arises, which of these types of profit should a firm try
to maximise.
 Ignores social responsibility : PM objective does not take into
consideration the social responsibilities of business.
It ignores the interest of workers, consumers, government & the
public in general. The exclusive attention on PM may also
endanger the survival of the firm by ignoring research,
executive development & other intangible investments.

From the above description, it can easily be concluded that-PM

criterion is inappropriate & unsuitable as an operational
objective of FM.
In imperfect competition, the PM criterion will certainly
encourage concentration of economic power & monopolistic
tendencies.
That is why, the objective of wealth maximisation is considered as
the appropriate & feasible objective as against the objective of
PM.
For example: the firm A earned profits of Rs. 90,000, Rs. 1,00,000
& Rs. 1,10,000 in three successive years, while the firm B
earned no profits in the first year, earned profit of Rs. 3,10,000
in the second year & incurred loss of Rs. 10,000 in the third
year.

For both the firms, the volume of profits during the three years is
Rs. 300,000.

But, it is clear that there is no risk in investing money in firm A &

it is very risky to invest in firm B.

The objective of PM does not reveal this fact.

It is suitable for self financing, private property and single owner
firms and for a company.

Under the new business environment, the objective of profit

maximisation is considered immoral, unrealistic, difficult and
inappropriate.
2) Wealth maximization
The objective of PM, ignores the two basic criteria of financial
management i.e. i) risk, & ii) time value of money.
Therefore, WM is taken as the basic objective of FM, rather than
PM. It is also known as Value Maximization or Net Present
Value Maximization.
Wealth maximization means to maximise the net present value (or
wealth) of a course of action.
Finance theory rests on the proposition that the goal of a firm
should be to maximise shareholders wealth.
Shareholders wealth maximisation (SWM) means maximizing
the NPV of a course of action to shareholders.
NPV is the difference between the present value of its benefits
and the present value of its costs.
 A financial action which has a positive NPV creates wealth.
Financial action resulting in negative NPV should be rejected.
Among a number of desirable projects the one with the highest
NPV should be accepted. Wealth will be maximised if NPV
criterion is followed in making financial decisions.
This principle implies that the fundamental objective of the
firm is to maximise market value of its shares. The wealth
maximisation objective is consistent with the objective of
maximizing the wealth of the owners (shareholders) by
increasing the value of the firm.
Market price acts as a firms performance indicator.
The value of the firm is represented by the market price of a
companys shares.
It takes into account the present & prospective future earnings
per share (EPS), the timings & the risk of this earnings, the
dividend policy of the firm & many other factors.
 Therefore, for the purpose of maximisation of wealth, the basic
objective of a company should be to maximise the market value
of its shares, because the value of the enterprise to the
shareholders increases when there is an increase in the market
price of the shares.

To maximise the wealth to the shareholders or market value

of shares, a firm must:
Increase the market share (growth) by new products & process
developments & by improving the quality of the products.
Manage customers properly.
Enhance employee capabilities & information system.
Avoid high levels of risk, when projects with positive or
maximise NPV are accepted, the value of the firm is maximized.
 Strike a balance between debt & equity in financing.
Maintain a satisfactory dividend policy consistently.

Market price of its shares as it reflects the influence of all the

factors such as EPS , timing of earnings, risk involved etc.
Merits/superiority of wealth maximisation:
Measures income in terms of cash flows
Recognizes time value of money
Analyses risk and uncertainty
Not in conflict with other motives
Quite often the two objectives can be pursued simultaneously but
the maximisation of profits should never be permitted to over
shadow the broader objective of wealth maximisation.
 Finance functions
Finance function is the process acquiring & utilizing funds by a
business. The main function of finance is the procurement of
necessary funds for the business.
There has been a gradual change in the nature of finance function.
In the changing scenario of modern business management of
LPG (Liberalisation, Privatisation, Globalisation) the finance
function has much widened.
Along with the procurement of funds, the effective utilisation &
control of funds obtained is also included in the finance
function.
To understand finance function properly, it is essential to
understand the following two approaches of finance function:
Traditional approach; &
Modern approach
 Financial Management

Financing
Financing Investment
Investment Dividend
Dividend
Decisions
Decisions Decisions
Decisions Decisions
Decisions

Capital Working
Structure Capital
Current Assets
Decisions Financing Capital Expenditure Or
(Long-term (Short-term Decisions Working Capital Management
Sources) Sources)

Cost of Capital Finance

Cost of Capital Finance
Functions
Functions
 Financing decisions
when, from where and how to acquire funds to meet the firms
investment needs.
Mix of debt and equity is known as the capital structure of the
firm.
when the shareholders return is maximized with given risk, the
market value per share will be maximized and the firms capital
structure will be considered optimum.

In financing decisions, a financial manager has to decide about

the amount of capital required; proportion of debt & equity
capital (capital structure) & selection of the sources of funds.
The amount of capital required is ascertained by forecasting the
investment in fixed, current & intangible assets.
 Capital structure is determined by the proportion of debt &
equity capital in the total capital invested.
The financial manager has to maintain the optimal capital
structure or the best financing mix for the company.
After determining the combination of debt & equity, the finance
manager should raise required funds from the best available
sources.
Selection of a particular source of funds depends upon the cost
of financing; nature of cost (fixed or variable) & period of
raising funds.
The finance manager is not responsible only for funds required
at the time of commencement of the business but he has to
manage additional funds required for development, expansion,
amalgamation & merger plans of the enterprise.
 Investment decisions
Investment decisions pertain to the allocation of funds raised
with a view to acquire assets.

These assets are of two types i.e. fixed & current assets.
Decisions regarding investment in fixed or long-term assets are
based on the costs & benefits or returns arising from these
assets. These are called capital budgeting decisions.

Decisions regarding investment in current or short-term assets

are taken keeping in view the profitability & liquidity.

When sufficient funds are not invested in current assets, there is

apprehension of illiquidity of the company.
 On the other hand, if sufficient funds are invested in current
assets, the profitability would be affected as idle assets would
not earn anything. Therefore, the finance manager should
workout a strategy to obtain a trade-off between liquidity &
profitability. For this, he should adopt sound techniques of
current assets management.

Thus, a firms investment decision involves capital

expenditures.

Capital budgeting decision involves decision of allocation of

capital or commitment of funds to long term assets that would
yield benefits in the future.
 Dividend decisions
Dividend decisions pertains to allocation of income & is very
important function of financial manager.

The term dividend refers to that part of profits of a company

which is distributed by it among its shareholders. It is the reward
to shareholders for investment made by them in the share capital
of the company.

Hence, the financial manager has to decide about the portion of

net profits that should be retained in the business & the portion
of net profits which should be distributed to shareholders in the
form of cash dividend.
 The higher rate of dividend may raise the market price of the
shares & thus maximise the wealth of shareholders. Therefore,
dividend policy should be such that it has positive impact on the
wealth of the shareholders.

Hence, the Finance manager must decide whether the firm

should distribute all profits as dividends or retain them, or
distribute a portion and retain the balance.

Dividend payout ratio

Retention ratio
 Approaches of finance function

Traditional approach of finance function

o The traditional approach of FM has limited the role of the
finance manager in the initial stages.
o According to this approach, the main function of finance was
confined to the procurement of funds.
o Finance manager was called upon, in particular only when his
speciality was required to raise funds during major events such
as promotion, reorganization, expansion etc.
o In this approach, emphasis was laid on the study of raising
capital, institutional sources & current practices of finance.
 Features of traditional approach are as follows:
Raising funds: the main function of finance was to procure &
manage required funds from various sources for achieving the
predetermined objectives of the enterprise. This necessitated for
the finance manager to establish contacts with various institutions.

Episodic function: finance function was not related to day-to-day

operations of the enterprise, but it was concerned with procurement
of funds to finance promotion, expansion or diversification of
activities. Thus, the occurrence of finance function was episodic in
nature.

Outsider-looking-in approach: the function of finance was to lay

more emphasis on the guidance of the investors rather than the
internal management of the enterprise. Therefore, it is also known
as outsider-looking-in approach.
 Long-term financing: this approach emphasises more upon
sources & problems of long-term financing. It does not take into
consideration the problems of working capital management or
short term financing.

Descriptive nature: the treatment of different aspects of

finance was more of a descriptive nature rather than analytical.
In fact, thee was no analytical financial decision-making as
such.

Thus, according to this traditional approach, the scope of FM or

finance function was confined to raising of funds from external
sources. This has limited role of financial manager.
 Criticisms of traditional approach:
o Outsiders point of view: the emphasis, in the traditional approach,
was on raising of funds & their administration. The subject matter of
finance function was evaluated from the point of view of suppliers
of funds such as bankers, investors & so on, i.e. the outsiders.
It implies that no attention was paid to the views of those who had to
take internal financial decisions. Thus, it was an outsider-looking-
in approach where internal decision-making i.e. insider-looking-in
was completely ignored.

o Ignores routine problems: this approach stresses upon the episodic

events occurring during the life of the enterprise. The subject matter
of finance function of corporate enterprises confined to the financial
problems faced during promotion, expansion or diversification,
merger, reorganization etc. As a result, the day-to-day financial
problems of the business enterprises were not considered at all.
o Ignores non-corporate enterprises: it emphasises upon the
financial problems of corporate enterprises. This has confined
the scope of financial management to a segment of the industrial
enterprises. Non-corporate individual enterprises such as sole
trade, partnership firms were outside of its scope.

o Ignores working capital financing: finance is required by an

enterprise to meet its long-term as well as short-term
obligations. But this approach places more emphasis on the
long-term financing of an enterprise & ignores the importance of
current assets or working capital management.

o Conceptual omissions: this approach has also been criticised on

conceptual & analytical grounds. It neglects the judicious
allocation of funds to different assets & the question of optimal
combination of sources of finance.
Thus, it omits discussion on two important matters i.e. (i) financing
mix & (ii) the relationship between cost of capital & valuation of
the firm.

The traditional approach ignored what Solomon has described as the

central issues of the financial management. These issues are as
under:
Should an enterprise commit capital funds to certain purposes?
Do the expected returns meet financial standards of performance?
How should these standards be set & what is the cost of capital
funds to the enterprise?
How does the cost vary with the mixture of financing methods
used?
The traditional approach of finance function has completely failed in
answering these questions, but the modern approach, which is
being discussed , answers all these questions.
 Modern approach of finance function

Its scope is wider since it covers conceptual and analytical

framework for financial decision making.

Economic and environmental factors made it essential to work

for an effective and efficient utilization of resources including
the financial resources of an enterprise.

At the same time , several management tools and techniques of

decision making were also developed and these facilitated the
optimum allocation of resources of an enterprise.
 The main contents of the new approach are:
a) What is the total volume of funds an enterprise should commit?
b) What specific assets an enterprise should acquire?
c) How should the required funds be financed?

These three questions are related to 3 decisions of financial

management.

Increased use of information technology and globalization of

business are two trends that provide companies with new
opportunities to reduce risks and also lead to increased
competition . So, shareholders value maximization should be
well focused.
 According to this modern approach, finance function means
activities relating to planning, procurement, control &
administration of funds used in the business.

As such, finance is not considered to be confined up to the time

of promotion & reorganisation, but it is considered to be related
to all problems of managerial finance.

The activities like:

(i) Determination of capital requirements of the firm;
(ii) Procurement of necessary funds so that optimal capital
structure can be decided;
(iii) Allocation of funds among different assets; &
(iv) Financial control for the effective utilisation of funds are
covered under the purview of modern approach.
 Thus, function of finance is not only to procure funds but their
effective utilisation too.

This requires the financial manager to take three important

decisions i.e. financing decision, investment decision &
dividend decision.

These three decisions of financial management are inter-related

whose net result would be the optimum utilisation of funds.
Hence, the combined result of these financial decisions is called
finance function.

This new approach with broadened view, incorporates all the

financial activities of an enterprise.
 In this new approach, the objectives of an enterprise can be
achieved by proper financial planning, raising capital
economically, rational investment & effective use of funds.

The newer, broader approach aims at formulating rational

policies for the optimal use, procurement & allocation of
funds.
 INTERRELATION AMONG FINANCIAL DECISIONS

Investment decision determines the profitable investment

avenue, financing decision determines the pattern of financing
the capital required for investment, and together impact the
surpluses generated by an organization to be distributed as
dividends.

1.Interrelation between Investment and Financing Decisions:

Under the investment decision financial manager will decide
what type of asset or project should be selected.

The selection of a particular asset or project will help determine

the amount of funds required to finance the project or asset.
2. Interrelation between Financing and Dividend Decisions :
Financing decision influences and is influenced by dividend
decision, since retention of profits for financing selected assets or
projects reduces the profit available to ordinary shareholders,
thereby reducing dividend payout ratio.

If the dividend decision is 100 per cent payout ratio then the
finance manager has to be depend completely on outside sources to
raise the required funds .So dividends decision influences the
financing decision.

3.Interrelation between Dividend and Investment Decision :

Dividend decision and investment decision are interrelated
because retention of profits for financing the selected asset
depends on the rate of return on proposed investment and the
opportunity cost of retained profits.
 Role of Financial Manager / Role of Finance Manager

A financial manager is a person who is responsible, in a

significant way, to carry out the finance functions.
In a modern enterprise, the financial manager occupies a key
position.
He or she is one of the members of the top management team,
& his or her role, day-by-day, is becoming more pervasive,
intensive & significant in solving the complex funds
management problems.
The financial manager is now responsible for shaping the
fortunes of the enterprise, & is involved in the most vital
decision of the allocation of capital.
In the new role, he or she needs to have a broader & far-sighted
outlook, & must ensure that the funds of the enterprise are
utilised in the most efficient manner.
 About three decades ago, he or she was not considered an
important person, as far as the top management decision-making
was concerned.
He or she became an important management person only with
the advent of the modern approach to the financial management.

The main functions or role of a financial manager are as

follows:
Fund raising
o The traditional approach dominated the scope of financial
management & limited the role of the financial manager simply
to funds raising.
o It was during the major events, such as promotion,
reorganisation, expansion or diversification in the firm that the
financial manager was called upon to raise funds.
o In the day-to-day activities, his or her only significant duty was
to see that the firm had enough cash to meet its obligations.

o The notable feature of the traditional view of financial

management was the assumption that the financial manager had
no concern with the decision of allocating the firms funds.

o These decisions were assumed as given, & he or she was

required to raise the needed funds from a combination of various
sources.

o The traditional approach has been criticised because it failed to

consider the day-to-day managerial problems relating to finance
of the firm.
o The traditional approach of looking at the role of the financial
manager lacked a conceptual framework for making financial
decisions, misplaced emphasis on raising of funds, & neglected
the real issues relating to the allocation & management of funds.

Funds allocation
o The emphasis shifted from the episodic financing to the financial
management, from raising of funds to efficient & effective use of
funds.

o The new approach is embedded in sound conceptual & analytical

theories.

o In modern enterprise, the basic finance function is to decide about

the expenditure decisions & to determine the demand for capital
for these expenditures.
o In other words, the financial manager, in his or her new role, is
concerned with the efficient allocation of funds.

o The allocation of funds is not a new problem, however. It did

exist in the past, but it was not considered important enough in
achieving the firms long run objectives.

o In his or her new role of using funds wisely, the financial

manager must find a rational for answering the following three
questions:
How large should an enterprise be, & how fast should it grow?
In what form should it hold its assets?
How should the funds required be raised?
o The questions stated above relate to three broad decision-making
areas of financial management: investment (including both long-
term & short-term assets), financing & dividend.

o The modern financial manager has to help make these

decisions in the most rational way. They have to be made in such
a way that the funds of the firm are used optimally.

Profit planning
o The functions of the financial manager may be broadened to
include profit-planning function.

o Profit planning refers to the operating decisions in the areas of

pricing, costs, volume of output & the firms selection of
product lines.
o Profit planning is therefore, a prerequisite for optimising
investment & financing decisions.
o The cost structure of the firm, i.e., the mix of fixed & variable
costs has a significant influence on a firms profitability.
o Fixed costs remain constant while variable costs change in direct
proportion to volume changes.
o Because of the fixed costs, profits fluctuate at a higher degree
than the fluctuations in sales.
o The change in profits due to the change in sales is referred to as
operating leverage.
o Profit planning helps to anticipate the relationships between
volume, costs & profits & develop action plans to face
unexpected surprises.
 Understanding capital markets
o Capital markets bring investors (lenders) & firms (borrowers)
together. Hence the financial manager has to deal with capital
markets.

o He or she should fully understand the operations of capital

markets & the way in which the capital markets value securities.

o He or she should also know how risk is measured & how to

cope with it in investment & financing decisions.

o For example: if a firm uses excessive debt to finance its growth,

investors may perceive it as risky.
o The value of the firms share may, therefore, decline. Similarly,
investors may not like the decision of a highly profitable,
growing firm to distribute dividend.

o They may like the firm to reinvest profits in attractive

opportunities that would enhance their prospects for making high
capital gains in the future.

o Investments also involve risk & return. It is through their

operations in capital markets that investors continuously evaluate
the actions of the financial manager.
 ORGANIZATION OF FINANCE FUNCTION

Board Of Directors
Board Of Directors

Managing Director

Vice president Vice president

Vice president
Operations Vice president
Vice president Sales
Operations Vice president Sales
Finance
Finance

Treasurer Controller
Treasurer Controller
 Organization of financial management means the division and
the classification of various functions which are to be
performed by the finance department.

A sound structure defines who is who, who reports to whom

and functions and responsibilities of each individuals.

The structure of the organization of financial management

vary from firm to firm depending on factors like the size of the
firm, nature of business transactions; type of financing
operations; capabilities of financial executives etc.
 The reason for placing the financial functions in the hands of top
management may be attributed to the following factors:
First, financial decisions are crucial for the survival of the firm
Second, the financial actions determine the solvency of the firm
Third, centralization of the finance functions can result in a
number of economies to the firm.
CFO (Chief Financial Officer) is a member of the top
management ,and he or she is closely associated with the
formulation of policies and making decisions for the firm.

The treasurer and controller, if a company has these executives,

would operate under CFOs supervision.

He or she must guide them and others in the effective working

of the finance department.
ROLE OF TREASURER
The treasurer is responsible for providing & managing funds, his
functions include:
Raising of additional funds,
Cash management,
Receivables management,
Audit of accounts,
Protecting funds & securities, &
Maintaining relations with banks & other financial institutions,
etc.

FINANCIAL PLANNING AND FORECASTING

 FUNDS MANAGEMENT
Acquisitions of Funds
Allocation of Funds
Utilization of Funds

LEGAL OBLIGATIONS

FINANCIAL INFORMATION AND PROFESSIONAL

ADVISE

FINANCIAL PUBLIC RELATIONS

(for the detail note please refer to FM by M.R. Agrawal)
ROLE OF CONTROLLER
Financial controller is responsible for management & control of
assets & performs the functions of:
oPlanning & controlling,
oPreparation of annual reports,
oCapital budgeting,
oProfit analysis,
oCost & inventory management &
oaccounting & pay-roll.

Line officer
He plans and directs all activities of the finance department as line
officer and supervises the functions of his subordinate staff and sub-
departments.
 Functional head
He performs all acts such as acquisition, proper allocation and
efficient utilization of funds, financial planning, accounting,
budgeting, cost of capital, cash and credit management etc.

Specialist of Finance
He advises and helps the higher management or board of directors
in investment, financial and dividend decisions.

Representative of government
Acts as a representative of the government as he is responsible
for determining all types of taxes and depositing them in
government treasuries.
TIME VALUE OF MONEY

Most of the financial decisions such as investment decision

financing decision, and dividend decision involves cash flows
(inflow and outflow ) occurring in the different time periods.

A rupee which is received today is more valuable than a rupee

receivable in future.

The amount that is received in earlier period can be reinvested

and it can earn an additional amount.

Money loses its value over time which makes it more desirable
to have it now rather than later.
 Time value of money is a concept that recognizes the relevant
worth of future cash flows arising as a result of financial
decisions by considering the opportunity cost funds.

Time value of money concept attempts to incorporate the above

considerations into financial decisions by facilitating an
objective evaluation of cash flows from different time periods by
converting them into present value or future value equivalent.

An individuals time preference for money/reasons for time

value of money / importance of time value of money:
1) Risk & uncertainty
2) Current Consumption
3) Possibility of Investment Opportunity
4) Inflation
We live under risk or uncertainty. As an individual is not certain
about future cash receipts, he or she prefers receiving cash now.

Most people have subjective preference for present consumption

over future consumption of goods & services either because of
the urgency of their present wants or because of the risk of not
being in a position to enjoy future consumption that may be
caused by illness or death, or because of inflation.

As money is the means by which individuals acquire most goods

& services, they prefer to have money now.
Further, most individuals prefer present cash to future cash
because of the available investment opportunities to which they
can put present cash to earn additional cash.
For example: an individual who is offered Rs 100 now or Rs 100
one year from now would prefer Rs 100 now as he could earn on
it an interest of, say, Rs 5 by putting it in the savings account in
a bank for one year.

His total cash flow in one year from now will be Rs 105. thus, if he
wishes to increase his cash resources, the opportunity to earn
interest would lead him to prefer Rs 100 now, not Rs 100 after
one year.
VALUATION CONCEPT
The time value of money establishes that there is a preference of
having money at present than a future point of time.

That a person will have to pay in future more for a rupee

received today.

A person may accept less today, for a rupee to be received in the

future.

Thus, the inverse of compounding process is termed as

discounting.
SIMPLE INTEREST

Simple interest is the interest paid (earned) on the original

amount,or principal borrowed (lent).
Simple amount is a function of three components such as
principal amount borrowed or lent,interest per annum and the
number of years for which the interest rate is calculated.

Si = P0(I)(n)
where Si = simple interest
I = interest rate per annum
P0 = Principal amount at year 0
n = number of years for which interest is
calculated
 Simple interest is the interest that is calculated only on the
original amount (principal), & thus, no compounding of interest
takes place.
COMPOUND INTEREST

In simple interest there is no opportunity to earn interest on

interest whereas in compounding interest each interest
payment is (reinvested )having the opportunity to earn interest
on interest.
A) Compound Value of Single Amount
Compound value or Future value account on an account can
be calculated by the following formula.
CV = P0(1+I)n
where CV = Compound Value
I = Interest per annum
P = Principal amount
n = Number of years for which
compound is done
B) Compound value for series of cash flows

Compound interest is the interest that is received on the original

amount (principal) as well as on any interest earned but not
withdrawn during earlier periods.
PRESENT VALUE

In the present value we know the present value of a sum

that is receivable in the future.

The present value of a future cash inflow or outflow is the

amount of current cash that is of equivalent value to the
present value.

The process of determining present value of a future

cash flows (inflow or outflow ) is called discounting.
FUTURE VALUE

Future value of a single cash flow

Suppose your father gave you Rs 100 o your eighteenth birthday.

You deposited this amount in a bank at 10 per cent rate of
interest for one year. How much future sum would you receive
after one year? You would receive Rs 110:

Future sum = principal + interest

 Time Value of Money says that the worth of a unit of money is
going to be changed in future.
Put simply, the value of one rupee today will be decreased in
future. The whole concept is about the present value and future
value of money.
There are two methods used for ascertaining the worth of
money at different points of time, namely, compounding and
discounting.
Compounding method is used to know the future value of
present money. Conversely, discounting is a way to compute
the present value of future money.
Compounding is helpful to know the future values, of the cash
flow, at the end of the particular period, at a definite rate.
Contrary to this, Discounting is used to determine the present
value of the future cash flow, at a certain interest rate.
 Compounding is the process of calculating future values
of cash flows & discounting is the process of calculating
present values of cash flows.
 WHY SHOULD MONEY HAVE TIME VALUE?

Money can be employed productively to generate real returns.

Example: Rs 100/ invested in raw material & labour results in goods
worth Rs 105/.
Investment earned a rate of return of 5%.

In a inflationary period a rupee today has a higher purchasing

power than a rupee in the future.

Future is characterised by uncertainty - individuals prefer current

consumption to future consumption.

The manner in which the above three determinants combine to

determine the rate of interest can be symbolically represented as
follows:
 Nominal or market rate of interest = rate of interest on returns +
expected rate of inflation + risk premium to compensate for
uncertainty.

Time value of money (TVM) can be taken care with two

methods: compounding & discounting.
DEFINITION OF COMPOUNDING
For understanding the concept of compounding, first of all, you
need to know about the term future value.
The money you invest today, will grow and earn interest on it,
after a certain period, which will automatically change its value
in future. So the worth of the investment in future is known as
its Future Value.
Compounding refers to the process of earning interest on both
the principal amount, as well as accrued interest by reinvesting
the entire amount to generate more interest.
Compounding is the method used in finding out the future value
of the present investment.
DEFINITION OF DISCOUNTING
Discounting is the process of converting the future amount into
its Present Value.
Now you may wonder what is the present value? The current
value of the given future value is known as Present Value.
The discounting technique helps to ascertain the present value
of future cash flows by applying a discount rate.
Difference Between Compounding and Discounting
The following are the major differences between compounding
and discounting:
The method uses to know the future value of a present amount is
known as Compounding. The process of determining the present
value of the amount to be received in the future is known as
Discounting.
Compounding uses compound interest rates while discount rates are
used in Discounting.
Compounding of a present amount means what will we get
tomorrow if we invest a certain sum today. Discounting of future
sum means, what should we need to invest today to get the
specified amount tomorrow.
The future value factor table is referred to calculate the future value
in case of compounding. Conversely, in discounting, present value
can be computed with the help of a present value factor table.
In compounding, present value amount is already specified. On the
other hand, the future value is given in the case of discounting.
 Formula to calculate compounding FV = PV (1 + r)^n
Formula to calculate discounting PV = FV / (1 + r)^n

Conclusion
Compounding and Discounting are simply opposite to each
other.
Compounding converts the present value into future value and
discounting converts the future value into present value.
So, we can say that if we reverse compounding it will become
discounting.