Financial

Management

Chapter I :

An Overview of
Financial Management
FINANCE?
Finance is defined as the management of money
and includes activities like investing, borrowing,
lending, budgeting, saving, and forecasting. There
are three main types of finance: (1) personal,
(2) corporate, and (3) public/government.
 An Overview of Financial Management
In the modern world virtually every organization, public
and private, runs on money.
The most common application of the term ‘finance’
involves raising money to acquire assets.

Companies finance assets when they raise money to

acquire those assets. They do that by borrowing, selling
stock, or using money they have earned.

Financial management means the management and

control of money and money-related operations within a
business.
 DEFINITION

Meaning: Financial management is that

administrative area or set of administrative
functions which relate to the management of
finance, both its sources and uses/application.

Definition: “Financial management is an

application of general managerial principles to
the area of financial decision making” – Howard
and Upton.
 NATURE OF FINANCIAL MANAGEMENT

• Part of overall management .

• Closely related with other disciplines .
• Continuous process .
• Different from accounting .
• Helpful in decision making .
• Wider scope .
• Both science and Art
 Scope of the financial management

• To understand the scope of the financial management,

we must examine the traditional as well as the modern
approach of the financial management.
• The traditional approach to the financial management is
restricted to raising to funds from various sources and
completion of the legal formalities required to do the
same.
• The modern approach to the financial management says
that there are three important functions which are
expected to be performed by the financial management.
•How much amount of funds will be
required by the firm?

•How to raise the amount required by the

firm?

•How to invest the amount raised so that

the objectives of the financial management
as well as the firm will be achieved?
A. The Investment Decision
 It is concerned with the effective utilization of
funds in one activity or the other.
 This comprises decisions relating to investment in
both capital and current assets.
 The finance manger has to evaluate different
capital investment proposals and select the best
keeping in view the overall objective of the
enterprise.
Factors Affecting Investment Decision

•Cash flow of the venture

•Profits
•Investment Criteria
B. The Financing Decision

This determines as to how the total funds required by the

firm will be made available through the issue of different
type of securities.

A company cannot depend upon only one source of

capital.

Hence, before using any particular source of capital, the

relative cost of capital, degree of risk control etc. have to
be carefully examined by the finance manager.
 Factors Affecting Financing Decision

•Cost
•Risk
•Cash flow position
•Control
•Condition of the market
C. The Dividend Decision

Dividend decision helps the management in the

declaration and payment of dividend to the
shareholders.

It decides how much of the earnings should be

distributed among the shareholders and how
much should be retained in the business for
future expansion.
 Factors Affecting Dividend Decision

•Earnings
•Dependability in Earnings
•Balancing Dividends
•Development Opportunity
 OBJECTIVES

https://youtu.be/zym8t71QHZo
 Roles of the Financial Manager
I. Traditional Approach:
Financial manager was called upon to raise funds during the major
events such as promotion, reorganization, expansion etc.

His only significant duty was to see that the firm had enough cash
to meet its obligations.
He is required to raise the needed funds from the combination of
various resources such as:
Arrangement of funds from financial institutions
Arrangement of funds from financial instruments such as shares,
bonds etc…
Looking after the legal and accounting relationship between a
corporation and its sources of funds
Criticism of Traditional Approach
•It treated the subject of finance from the view
point of suppliers of funds and ignored the view
point of management of funds i.e, uses/application
of funds.
•The approach focused attention only on the
financial problems of corporate enterprises. Non-
corporate industrial organizations remained
outside its scope.
•The problems relating to short term working
capital financing were ignored.
•It did not emphasize on allocation of funds.
II. Modern Approach
According to modern concept, financial
management is concerned with both
acquisitions of funds and their allocation.
The four broad decision areas of financial
management are:
•Funds required decision
•Financing decision
•Investment decision
•Dividend decision
Besides his traditional function of raising money,
financial manager will be determining the size and
technology, setting the pace and direction of
growth and shaping the profitability and risk
complexion of the firm by selecting the best asset
mix and by obtaining the optimum financing mix.

The finance manager has to look after profit

planning which means operating decisions in the
areas of pricing, volume of output and the firms
selection of product lines.
Profit planning is a prerequisite for optimizing
investment and financing decisions.
 The Relationship Between Finance and Other
Disciplines
A. Financial Management and Cost Accounting
 The finance manager is concerned with proper
utilization of funds and he is rightly concerned
with operational costs of the firm.

 For this purpose the information's supplied by

the cost accounting department is used by him
to keep costs under control.
B. Financial Management and Marketing
 In determining the appropriate price for the
products, the finance manager has to take a joint
decision with marketing manager.
 The marketing manager provides information as
to how different prices will affect the demand
for the company's products in the market.

 While the finance manager supply's information

about costs, change in cost at different levels of
production and the profit margins required to
carry on the business.
C. Financial Management and Production
The acquisition of assets and their effective
utilization affects the firms finances. Hence, he
has to take a joint decision regarding current and
future utilization of the firms assets with
production manager.
D. Financial Management and Personnel Management
The recruitment, training and replacement of staff
are all the functions of the personnel department.
However all these require finance and therefore it
is a joint decision of both.
Functions of Financial Management

Executive functions

Routine functions

https://youtu.be/NUlUvqUGU9A
A) EXECUTIVE FUNCTIONS
i) Financial Forecasting:
 He has to see that an adequate supply of cash is on hand
at the proper time for smooth flow of firms activities.

 Since both cash inflows and outflows are closely related

to the volume of sales, it requires financial forecasting.

 Thus the estimation of the prospective inflow and

outflow of cash in the next year is necessary to maintain
the liquidity in the funds.
ii) Investment decisions
It is the most important aspect of executive
functions of financial manager.
In this, the allocation of capital to various
investment proposals is made in order of
their profitability.

Each investment decision necessarily

involves risk and a financial help in
evaluating the various proposals under
uncertainty with the process of capital
budgeting.
iii) Management policy
The formulation of sound asset management
policies is an essential requirement to successful
financial management.

The fixed and current assets of the firm must be

changed efficiently to ensure success.

The financial manager is charged with varying

degrees of operating responsibility over existing
assets.
He is more concerned with the management of
current assets than with fixed assets.
iv) Management of income
It includes the allocation of net earnings among
shareholders.
He tries to get an optimal dividend payout ratio that
maximize shareholders worth in the long run.

v) Management of cash
Estimating and controlling cash flow is also an important
function of financial management.
All cash must be managed for the benefit of the owners.
He should try for two things:
a. To choose the best among the alternatives uses of
funds and
b. To ascertain the best use that shareholders could find
outside the company.
vi) Assessment of attitude
Assessing the capital markets attitude towards the
company and its shares.
vii) Decision about new sources of finance
A business firm is always in need of funds. So he
is on the basis of forecast of the volume of
operations, should decide upon needs and prepare
the detailed financial plan for the procurement of
funds – both short term and long term.
He is to evaluate the prospective cost of funds as
against the anticipated profit from the use of these
funds by the operating units to which they are to be
allocated.
viii) Contract and carry negotiations for new financing
He has to decide upon the needs and finding out a
suitable source first.

Then he has to contact the sources and carry on the

negotiations to finalize the terms and conditions of the
contract.

ix) Analyze and appraisal of financial performance

To carry out finance functions smoothly proper analyses
like checking and appraisal of financial performance are
very essential.
For this purpose various financial statements are
prepared, analyzed and then the necessary
guidelines are set for future.

x) Advising the top management

It is an expert duty of financial manager to

advise the top management in respect of financial
matters, to suggest various alternative solutions
for any financial difficulty and to make steady
efforts to increase the profitability of capital
invested in the firm.
B) INCIDENT (OR) ROUTINE FUNCTIONS
a. Record keeping and reporting
b. Preparation of various financial statements
c. Cash planning and supervision
d. Credit management
e. Custody and safeguarding the different financial
securities and the like.

f. Providing the top management with necessary and

accurate information on current an prospective
financial conditions of the business as a basis for
policy decisions on purchases, marketing and pricing.
Risk and Return Relationship in Financial Management
The trade-off between risk and return is a key element of effective financial
decision making.

This includes both decisions by individuals (and financial institutions) to invest

in financial assets, such as common stocks, bonds, and other securities, and
decisions by a firm’s managers to invest in physical assets, such as new plants
and equipment.

The relationship between risk and required rate of return can be expressed as
follows:

Required rate of return = Risk-free rate of return + Risk premium

• Risk-free rate of return, rf , refers to the return available on a
security with no risk of default. In the case of debt securities, no
default risk means that promised interest and principal payments are
guaranteed to be made.

• Short-term U.S. government securities, such as Treasury bills, are

generally considered to be risk-free investments. The risk-free rate
of return, rf , is equal to the sum of a real rate of return and an
expected inflation premium:

rf= Real rate of return + Expected inflation premium

Risk Premium

The risk premium assigned by an investor to a given

security in determining the required rate of return is a
function of several different risk elements. These risk
elements (and premiums) include

• Maturity risk premium

• Default risk premium

• Seniority risk premium

• Marketability risk premium

•
Why do organization retain the
earnings rather than distributing
them?
Because of
• legal constraints
• shareholders choice
• development opportunity for the organization