Module-1: Introduction to Financial Management & Financial System

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 FINANCING

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)