Module-1: Introduction
INTRODUCTION
TO FINANCIAL MANAGEMENT
Financial
Management is the functional area of a business firm that addresses the problem
of sourcing resources for an organisation and using them effectively. While
financial accounting is a recording process, financial management is a planning
process. Any kind of business activity depends on the finance. Hence, finance
function is called the ‘lifeblood of the
firm’.
Definitions of Financial Management:
According to Khan
& Jain – “Finance is the art
and science of managing money”
According to Prasanna
Chandra – “The central concern of
financial management is a rational matching of funds to their uses so as to
maximise the wealth of shareholders”
According to Weston
& Brigham – “Financial
Management is an area of financial decision making, harmonising individual
motives and enterprise goals”
According to I M
Pandey – “Financial Management is
that managerial activity which is concerned with the planning and controlling
of the firm’s financial resources”
Scope of Financial Management / Elements of Financial Management /
Finance Decisions:
Functions of Financial Management:
1.
Estimation
of capit al requirements
2.
Determination
of capital composition
3.
Choice
of sources of funds
4.
Investment
of funds
5.
Disposal
of surplus
6.
Management
of cash
7.
Financial
controls
OBJECTIVES OF FINANCIAL MANAGEMENT
1. Profit
Maximisation: One of the primary objectives of financial management is
to maximise the firm’s profits, as profits are the yardsticks in which the
performance of a business is measured. It is also the purpose why a business
firm exists.
2. Wealth
Maximisation: The owner of the business is interested in the firm
earning highest possible profits, so that the value of his investment held in
the form of equity shares enhances and his wealth gets maximised. For the share
price of a company to grow, not only should the firm deliver profits in a given
period, but also create goodwill by hinting a consistent growth in profits in
future as well.
Profit
Maximisation Objective Vs Wealth Maximisation Objective
There is an
ongoing debate over which objective of financial management is superior and
right.
Profit
maximisation
objective is narrow focused, short-term oriented and leads to ignore the side
effects of managerial decisions being biased to show maximum profits at the end
of the period. For instance, social costs of projects may be overlooked or
window dressing practices might be adopted by managers, thus leading to
corporate governance issues.
On the other
hand, wealth maximisation objective focuses to create goodwill for
the firm, thereby avoids any short-term oriented and biased decisions being
taken. At the same time, it does not loosen the focus on profits to be earned.
Hence,
generally accepted objective of financial management is to ‘maximise the shareholders’ wealth’.
Operational Objectives of Financial Management:
-
To
ensure regular and adequate supply of funds to firm
-
To
ensure adequate returns to shareholders
-
To
ensure optimum utilisation of funds
-
To
ensure safety of investment
-
To
plan sound capital structure
CHANGING ROLE OF FINANCE MANAGERS
Traditional
functions of Finance Managers:
Obtaining
Finance, Banking Relationship, Cash Management, Credit Administration, Capital
Budgeting, Financial Accounting, Internal Auditing, Taxation, Management Accounting
and Control
New functions
of Finance Managers:
Investment
Planning, Financial Structuring, Mergers, Acquisitions & Restructuring,
Working Capital Management, Performance Management, Risk Management, Investor
Relations
INTERFACE OF FINANCIAL MANAGEMENT WITH OTHER FUNCTIONAL AREAS
Interface with Accounting
Function:
-
Finance
manager utilises the inputs provided by accounting, like the financial
statements, debtor ledgers, and inventory ledgers in decision making. A finance
manager modifies the data provided by accounting records, like preparation of
cash flow or funds flow statement, ratios etc., and is equip himself for better
decision making
Interface with
Marketing Function:
-
Finance
department is responsible to allocate the adequate finance to the marketing
department to enable firm’s marketing activities.
-
Marketing
function provides data required regarding market conditions for forecasts
required by finance function in evaluating projects and planning capital
sourcing
Interface with
Production Function:
-
Finance
manager arranges for finance required by production department for procuring
raw materials, machinery, wages, operating expenses etc.
-
Production
department assists the finance department in preparing budgets, by providing
cost details and capital equipment specifications
Interface with
Human Resource Function:
-
Finance
department allocates finance towards salary and wages for manpower sourcing
-
Human
Resource department provides forecast of manpower cost requirement to finance
department to prepare labour budgets, arrange for working capital and costs of
recruitment and training
INDIAN
FINANCIAL SYSTEM
Two of the
major functions of finance manager is sourcing and investing funds. A system that facilitates availability of
funds and alternate investment options is a financial system. A financial
system would include three aspects:
Financial Products: Shares, Bonds, Deposits, Derivatives etc.
Financial Markets: Buyers and Sellers of financial products
Financial Institutions: Institutes producing, distributing & servicing
financial products
Financial Markets in India:
Financial Markets in India can be separated into Primary and Secondary
Markets:
Primary Markets
·
Primary
markets are markets where a company raises funds directly from the public by
issuing a shares or bonds. These markets are also known as ‘New Issue Market’
·
Primary
markets are facilitated by financial institutions like underwriters, investment
banks
·
In
India, companies can issue shares or bonds of different varieties after
obtaining due approvals from regulators like SEBI (Securities Exchange Board of
India) and other institutions.
Secondary Markets
·
A
Secondary market is where the investors, who own financial products that they
have purchased from the primary market, sell it.
·
Secondary
markets are facilitated by Stock Exchanges, Brokers and Investment advisors
·
Secondary
markets are regulated strictly by SEBI
·
Stock Market – Shares are freely traded on stock exchanges. The price of a share is
fixed based on the supply and demand conditions and keep changing with changes
in demand. In India, Bombay Stock Exchange (BSE) and National Stock Exchange
(NSE) are the key stock exchanges facilitating secondary market for shares.
·
Debt Market – Bonds and debentures of different kinds are traded. In India, retail
debt trading is yet to fully open up and wholesale (trading by institutions)
trading is facilitated by NSE’s Wholesale Debt Market (NSE-WDM).
·
Commodities Market – Physical products like metals, agriproducts, etc., are
traded in commodities market in larger lots. Prices get discovered based on the
supply-demand dynamics. Most of such trades are done virtually using system
networks, and most often than not actual delivery does not take place. There is
a huge Over-The-Counter (OTC) market where deals are privately executed. In
India, Multi-Commodity Exchange (MCX) is the key exchange facilitating
secondary trading of commodities.
·
Money Market – Financial products, mostly fixed interest bearing securities of less
than one-year tenure are issued and purchased in money market. Banks and
financial institutions are the major users of money market products. Even
though the returns are lower, money markets provide liquidity. Products include
repos, reverse repos, commercial papers, certificate of deposits etc. Reserve
Bank of India (RBI) plays a major role in this market.
·
Forex Market – Foreign currencies are traded against one another by mostly banks and
financial institutions. Foreign investors, exporters and importers buy and sell
foreign exchange for receipts and payment purposes. There is no exchange, as
the trading happens between currencies of any two countries. Hence, forex
markets are mostly OTC. There are national exchanges that facilitate currency
derivative trading, used mostly for risk management purposes.
Sources of Long-term Financing:
A firm may need
financing for a variety of reasons, like, capital asset acquirement, new
machinery purchase, construction of factory or storage building, new product
development etc. Normally, a company’s first choice would be to finance these
through internal sources through its retained earnings. But, when the
requirement is huge and there are other financial benefits, a firm may choose
to raise financing through below sources:
1)
Shares – Shares are issued to owners of the company for long-term financing
needs. They will have a nominal or face value, normally Rs. 10 or Rs. 100. When
they are issued for the first time through a fresh issue (IPO – Initial Public
Offering), they will be issued at their face value, may be with a premium. Post
the IPO, they will be traded in stock exchanges and price gets fixed by market.
The market value of a listed company’s shares bears no relationship to their
face value.
Shares
are the most preferred sources of finance by firms, as shareholders’ liability
is unlimited. Shareholders need to be paid dividends at the option of Board of
Directors, who will do so, when the firm has enough earnings and cash on hand.
Hence, share capital is generally the
lowest risk-bearing source of financing for the company.
2)
Debentures – Debentures are issued by companies as an alternative source of long-term
financing. Debentures are generally referred to as Bonds when traded in secondary market. Similar to stocks, even
debentures will have a face value of Rs. 100 or Rs. 1000 and will have a coupon
rate, which is the rate at which the interest need to be paid by the company
wither annually or half-yearly. Debentures can be redeemable after a maturity
period or can be irredeemable. Some companies issue debentures that can be
convertible into shares after a certain period.
As
debentures need to be paid interest irrespective of company earning profits,
debenture holders are treated as long-term creditors of the company. Therefore,
debt is risky source of financing for the
company.
3)
Term Loans – Loans from Banking and Non-Banking financial institutions are an
important and one of the quick sources of financing for companies. Bank
borrowings can be for short-term in the form of cash credits and overdrafts, or
form medium-term ranging between 1 year to 3 years, or for long-term mostly
funded towards capital projects. These loans can bear a fixed rate of interest
or floating rate of interest. A bank will consider several factors, like the
purpose of the loan, amount of the loan, income sufficiency of the borrower to
repay, duration of the loan and collaterals if any.
4)
Lease Financing – A lease is an agreement between two parties, the lessor and the lessee.
The lessor owns a capital asset, like machinery or building, but allows it to
be used by the lessee. The lessee makes payment under the terms of the lease to
the lessor, for specified period of time. There are two basic forms of lease:
Operating Lease – where
lessor supplies the asset on lease and will be responsible for Maintainence and
at the end of the lease, lessor can either lease the asset to some other lessee
or sell the asset
Finance Lease – where
lessor provides financing to the lessee to buy and use the asset and holds the
ownership title till the full repayment with interest by the lessee of the
lease amount. Also, lessee has to bear the Maintainence.
5)
Hybrid Financing – Hybrid financing instruments are those sources of
finance which possess the features of both equity and debt. Below are few such
instruments:
Preference Shares – Like debt preference shares will also carry a fixed
rate of payment (dividend) and priority towards payment on liquidation before
equity shareholders. Unlike equity shareholders, preference shareholders will
not carry any management voting rights. Like equity shares, preference shares
are also paid dividend out of earnings, and in case of loss preference
shareholders may not get the dividend.
Convertible Debentures – In addition to normal debentures,
these debentures have an option to convert into equity on certain terms and
conditions.
Warrants – Similar to debentures warrants
also have the right to purchase equity shares of the company. They are not debt
or equity till they are exercised. They will be rights or options in the hands
of holders to buy either debenture or equity.
6)
Private Equity - Shares or debentures of a firm that is not listed in
a stock market or available for trading is called private equity. Companies
choose private equity investors mainly because of the flexibility they offer.
Private Equity investors can be of two types:
Venture capital - VC is the capital invested by a venture
capital firm into a new company or project. VC puts money into the firm usually
in return for an equity stake, into a new business and expects to liquidate
once the supernormal profit period of the new business is over. VC assumes a
serious risk of losing their capital.
Angel Investor – When high networth individuals invest in private
equity with a considerable stake, they’re referred to as angel investors. They
are similar to VCs, except that they are individuals, whereas VCs are
institutions.
Sources of Short-term Financing:
Short-term
financing will be required by companies for the purpose of funding towards
working capital or current assets. Major sources of short-term financing are as
below:
1)
Accruals – Outstanding
Wages and Taxes
2)
Trade Credit – Credit
extended by suppliers
3)
Working Capital Loans by Commercial Banks
a. Cash
Credit / Overdraft
b. Loans
c. Purchase
/ Discounting of Bills
d. Letter
of Credit
e. Bank
Guarantee
4)
Public Deposits – Deposits from general public
5)
Inter-corporate Deposits –
Deposits from parent or subsidiary companies
6)
Loans from NBFCs –
Non-Banking Financial Institutions
7)
Rights Debentures – Issue of additional debentures to
existing debenture-holders
8)
Commercial Papers – Short-term unsecured promissory notes
9)
Factoring – Firm sells its accounts receivable to
a factoring agency at a discount
FREQUENTLY
ASKED QUESTIONS
1.i)
What
is financial management? (3 Marks)
1.ii)
Define
financial management and bring out the basic finance functions. (3 Marks)
1.iii)
What
is Financial Management and how is it different from accounting function? (3
Marks)
1.iv)
Mention
any three objectives of Financial Management (3 Marks)
1.v)
State
any three ways by which a company can maximise its wealth? (3 Marks)
1.vi)
What
is wealth maximisation? (3 Marks)
1.vii)
In
what ways the objective of wealth maximisation is superior to profit
maximisation (3 Marks)
1.viii)
Explain
the important sources of short term financing (3 Marks)
1.ix)
What
do you mean by Forex market? (3 Marks)
1.x)
Write
a brief note on (a) Money Market (b) Commodities Market (c) Debt Market (3
Marks)
1.xi)
What
are the differences between primary and secondary market? (3 Marks)
1.xii)
Write
a note on Indian Financial System. (7 Marks)
1.xiii)
Explain
the features, advantages and limitations of debentures as a long term source of
financing. Why do firms prefer debentures to equity shares? (10 Marks)
1.xiv)
Explain
the justification for the goal of maximisation of shareholder’s wealth. (10
Marks)
1.xv)
“Financial
Management is concerned with solution to three major finance decisions a firm
must make”. Explain this statement highlighting the interrelationship amongst
these decisions. (10 Marks)
1.xvi)
Explain
emerging role of finance managers in India? (10 Marks)
1.xvii) Explain briefly the present Indian financial system,
its institutions and markets (10 Marks)
1.xviii) What is the significance of a strong financial system
in a growing economy? Explain in details functions of a financial system. (10
Marks)
