Financial Management

Unit 1

Unit 1

Financial Management

Structure: 1.1 Introduction Objectives 1.2 Meaning and Definition of Financial Management 1.3 Goals of Financial Management Profit maximisation Wealth maximisation Wealth maximisation vs. profit maximisation 1.4 Finance Functions Financing decisions Investment decisions Dividend decisions Liquidity decisions 1.5 Organisation of Finance function 1.6 Interface between Finance and Other Business Functions Relation between Finance and accounting Finance and marketing Finance and production (operations) Finance and HR 1.7 Summary 1.8 Glossary 1.9 Terminal Questions 1.10 Answers 1.11 Case Study

1.1 Introduction
Financial management of a firm is concerned with procurement and effective utilisation of funds for the benefit of its shareholders. It embraces all those managerial activities that are required to procure funds at the least cost and their effective deployment. Reliance and Infosys are examples of admired Indian companies that employ effective financial management skills to their businesses. They have been rated well by the financial analysts on many crucial aspects that enabled them to create value for their shareholders. They employ the best
Sikkim Manipal University Page No. 1

Financial Management

Unit 1

technology, produce good quality goods or render services at the least cost, and continuously contribute to the shareholders wealth. The three core elements of financial management are: a. Financial planning Financial planning is done to ensure the availability of capital investments to acquire the real assets. Real assets are lands, buildings, plants and equipments. Capital investments are required for establishing and running the business smoothly. b. Financial decisions Decisions need to be taken on the sources from which the funds required for the capital investments could be obtained. There are two sources of funds - debt and equity. In what proportion the funds are to be obtained from these sources is to be decided for formulating the financing plan. c. Financial control Financial control involves managing the costs and expenses of a business. For example, it includes taking decisions on the routine aspects of day-to-day management of collecting money which is due from the firms customers and making payments to the suppliers of various resources. In this unit, you will learn about these core elements of financial management. Objectives: After studying this unit, you should be able to: analyse the meaning of business finance describe the goals of financial management discuss the functions of finance explain the interface between finance and other managerial functions of a firm

1.2 Meaning and Definition of Financial Management

Financial management is the art and science of managing money. Regulatory and economic environments have undergone drastic changes due to liberalisation and globalisation of Indian economy. These have
Sikkim Manipal University Page No. 2

Financial Management

Unit 1

changed the profile of Indian finance managers. Indian finance managers have transformed themselves from License Raj managers to well-informed, dynamic, proactive managers capable of taking decisions of complex nature. Traditionally, financial management was considered as a branch of knowledge that focused on the procurement of funds. Formation, merger and restructuring of firms and legal and institutional frame work, instruments of finance occupied the prime place in this traditional approach. The modern approach transformed the field of study from the traditional, narrow approach to a dynamic and extensive approach. The core of modern approach evolved around the procurement of the least cost funds and its effective utilisation for maximisation of shareholders wealth. Self Assessment Questions 1. What has changed the profile of Indian finance managers? 2. Finance management is considered as a branch of knowledge with focus on the __________.

1.3 Goals of Financial Management

Financial management means maximisation of economic welfare of its shareholders. Maximisation of economic welfare means maximisation of wealth of its shareholders. Shareholders wealth maximisation is reflected in the market value of the firms shares. Experts believe that, the goal of financial management is attained when it maximises the market value of shares. There are two versions of the goals of financial management of the firm Profit Maximisation and Wealth Maximisation. Let us now discuss the goals of financial management in detail. 1.3.1 Profit maximisation Profit maximisation is based on the cardinal rule of efficiency. Its goal is to maximise the returns with the best output and price levels. A firms performance is evaluated in terms of profitability. Profit maximisation is the traditional and narrow approach, which aims at maximising the profit of the concern. Allocation of resources and investors perception of the companys performance can be traced to the goal of profit maximisation. Profit maximisation has been criticised on many accounts:
Sikkim Manipal University Page No. 3

Financial Management

Unit 1

The concept of profit lacks clarity. What does profit mean? o Is it profit after tax or before tax? o Is it operating profit or net profit available to shareholders?

In this sense, profit is neither defined precisely nor correctly. It creates unnecessary conflicts regarding the earning habits of the business concern. Differences in interpretation of the concept of profit thus expose the weakness of profit maximisation. Profit maximisation neither considers the time value of money nor the net present value of the cash inflow. It does not differentiate between profits of current year with the profits to be earned in later years. The concept of profit maximisation fails to consider the fluctuations in profits earned from year to year. Fluctuations may be attributed to the business risk of the firm. Risks may be internal or external which will affect the overall operation of the business concern. The concept of profit maximisation apprehends to be either accounting profit or economic normal profit or economic supernormal profit. Profit maximisation as a concept, even though has the above-mentioned drawbacks, is still given importance as profits do matter for any kind of business. Ensuring continued profits ensure maximisation of shareholders wealth.

Figure 1.1 depicts the two goals of financial management.

Figure 1.1: Goals of Financial Management

Sikkim Manipal University

Page No. 4

Financial Management

Unit 1

1.3.2 Wealth maximisation The term wealth means shareholders wealth or the wealth of the persons those who are involved in the business concern. Wealth maximisation is also known as value maximisation or net present worth maximisation. This objective is an universally accepted concept in the field of business. Wealth maximisation is possible only when the company pursues policies that would increase the market value of shares of the company. It has been accepted by the finance managers as it overcomes the limitations of profit maximisation. The following arguments are in support of the superiority of wealth maximisation over profit maximisation: Wealth maximisation is based on the concept of cash flows. Cash flows are a reality and not based on any subjective interpretation. On the other hand, profit maximisation is based on accounting profit and it also contains many subjective elements. Wealth maximisation considers time value of money. Time value of money translates cash flow occurring at different periods into a comparable value at zero period. In this process, the quality of cash flow is considered critical in all decisions as it incorporates the risk associated with the cash flow stream. It finally crystallises into the rate of return that will motivate investors to part with their hard earned savings. Maximising the wealth of the shareholders means positive net present value of the decisions implemented. Let us now look at some of the key definitions. Positive net present value can be defined as the excess of present value of cash inflows of any decision implemented over the present value of cash out flow. Time value factor is known as the time preference rate; that is, the sum of risk free rate and risk premium. Risk free rate is the rate that an investor can earn on any government security for the duration under consideration. Risk premium is the consideration for the risk perceived by the investor in investing in that asset or security. Required rate of return is the return that the investors want for making investment in that sector.
Sikkim Manipal University Page No. 5

Financial Management

Unit 1

Caselet: X Ltd is a listed company engaged in the business of FMCG (Fast Moving Consumer Goods). Listed implies that the companys shares are allowed to be traded officially on the portals of the stock exchange. The Board of Directors of X Ltd took a decision in one of its board meetings to enter into the business of power generation. When the company informed the stock exchange at the conclusion of the meeting about the decision taken, the stock market reacted unfavourably. The result was that the next days closing of quotation was 30% less than that of the previous day. Why did the market react unfavourably? Investors in FMCG company might have thought that the risk profile of the new business that the company wants to take up is higher compared to the risk profile of the existing FMCG business of X Ltd, expecting a higher return. Then, the market value of the companys shares started declining. Therefore, the risk profile of the company gets translated into a time value factor. The time value factor so translated becomes the required rate of return. 1.3.3 Wealth maximisation vs. profit maximisation Let us now see how wealth maximisation is superior to profit maximisation. Wealth maximisation is based on cash flow. It is not based on the accounting profit as in the case of profit maximisation. Through the process of discounting, wealth maximisation takes care of the quality of cash flow. Converting uncertain distant cash flow into comparable values at base period facilitates better comparison of projects. The risks that are associated with cash flow are adequately reflected when present values are taken to arrive at the net present value of any project. Corporates play a key role in todays competitive business scenario. In an organisation, shareholders typically own the company, but the management of the company rests with the board of directors. Directors are elected by shareholders. Company management procures funds for expansion and diversification of capital markets.

Sikkim Manipal University

Page No. 6

Financial Management

Unit 1

In the liberalised set up, society expects corporates to tap the capital markets effectively for their capital requirements. Therefore, to keep the investors happy throughout the performance of value of shares in the market, management of the company must meet the wealth maximisation criterion. When a firm follows wealth maximisation goal, it achieves maximisation of market value of share. A firm can practise wealth maximisation goal only when it produces quality goods at low cost. On this account, society gains because of the societal welfare. Maximisation of wealth demands on the part of corporates to develop new products or render new services in the most effective and efficient manner. This helps the consumers, as it brings to the market the products and services that a consumer needs. Another notable feature of the firms that are committed to the maximisation of wealth is that, to achieve this goal they are forced to render efficient service to their customers with courtesy. This enhances consumer welfare and benefit to the society. From the point of evaluation of performance of listed firms, the most remarkable measure is that of performance of the company in the share market. Every corporate action finds its reflection on the market value of shares of the company. Therefore, shareholders wealth maximisation could be considered as a superior goal compared to profit maximisation. Since listing ensures liquidity to the shares held by the investors, shareholders can reap the benefits arising from the performance of company only when they sell their shares. Therefore, it is clear that maximisation of market value of shares will lead to maximisation of the net wealth of shareholders.

Therefore, we can conclude that maximisation of wealth is probably the more appropriate goal of financial management in todays context. Though this cannot be a goal in isolation, it is important to understand that profit maximisation as a goal, in a way, leads to wealth maximisation. Self Assessment Questions 3. _______ is based on cash flows. 4. ________ considers time value of money
Sikkim Manipal University Page No. 7

Financial Management

Unit 1

1.4 Finance Functions

Finance functions deal with the functions performed by the finance manager. They are closely related to financial decisions. In the course of performing these functions, finance manager takes several decisions and performs various important functions: Financing decisions Investment decisions Liquidity decisions Dividend decisions Figure 1.2 depicts the functions of the finance manager.

Figure 1.2: Finance Managers Decisions

Let us now discuss these points in detail. 1.4.1 Financing decisions Financing decisions relate to the composition of relative proportion of various sources of finance. The sources could be: (a) Shareholders Fund: Equity Share Capital, Preference Share Capital, Accumulated Profits. (b) Borrowing from outside agencies: Debentures, Loans from Financial Institutions.
Sikkim Manipal University Page No. 8

Financial Management

Unit 1

Financial management weighs the merits and demerits of different sources of finance while taking financing decision. Irrespective of the choice of source, be it singular or a combination of both, there is a cost involved. The cost of equity is the minimum return the shareholders would have received if they had invested elsewhere. Borrowed funds cost involves interest payment. Both types of funds, thus, incur cost, and this is the cost of capital to the company. Hence, it can be said that the cost of capital is the minimum return expected by the company. Financing decisions relate to the acquisition of such funds at the least cost. In order to calculate the specific cost of each type of capital, recognition should be given to two dimensions of cost: Explicit Cost Implicit Cost A firm's explicit costs are the actual cash payments it makes to those who provide resources. Explicit costs are rent paid on land hired, wages paid to the employees, and interest paid on capital. In addition to this, a firm also pays insurance premium and taxes and sets aside depreciation charges. Explicit cost of any source of capital may be defined as the discount rate that equates the present value of funds received by the firm net of underwriting costs, with the present value of expected cash outflows. These outflows may be interest payments, repayment of principal, or dividend. It can also be stated as the Internal Rate of Return a firm pays for financing. Implicit costs are the opportunity costs of using resources owned by the firm or provided by the firm's owners. To the firm, the implicit costs mean the money payments that self-employed resources could have earned in their best alternative uses. Implicit cost is the rate of return associated with the best investment opportunity for the firm and its shareholders that will be foregone if the project presently under consideration by the firm was accepted. Opportunity costs are technically referred to as implicit cost of capital. Implicit cost is not a visible cost but it may seriously affect the companys operations, especially when it is exposed to business and financial risk.
Sikkim Manipal University Page No. 9

Financial Management

Unit 1

The distinction between implicit and explicit cost is important from the point of view of the computation of cost of capital. In India, if a company is unable to pay its debts, creditors of the company may use legal means to sue the company for winding up and is normally known as risk of insolvency. A company which employs debt as a means of financing generally faces this risk especially when its operations are exposed to high degree of business risk. In all financing decisions, a firm has to determine the capital structure, i.e. composition of debt and equity. Debt is cheap because interest payable on loan is allowed as deduction in computing taxable income on which the company is liable to pay income tax to the Government of India. Whenever funds are to be raised to finance investments, capital structure decision is involved. A demand for raising funds generates a new capital structure since a decision has to be made as to the quantity and forms of financing. Capital structure refers to the mix of a firms capitalisation (i.e. mix of long term sources of funds for meeting capital requirement.) Capital structure decision refers to deciding the forms of financing (which sources to be tapped), their actual requirements (amount to be funded), and their relative proportions in total capitalisation. Normally, a finance manager tries to choose a pattern of capital structure which minimises the cost of capital and maximises the owners return. We will learn more on capital structure and related aspects in Unit 7. Caselet The interest rate on loan taken is 12%, tax rate applicable to the company is 50%, and then when the company pays Rs.12 as interest to the lender, taxable income of the company will be reduced by Rs.12. In other words, when the actual cost is 12% with a tax rate of 50%, the effective cost becomes 6%. Therefore, the debt is cheap. But, every instalment of debt brings along with it corresponding insolvency risk. Another thing notable in connection to this is that the firm cannot avoid its obligation to pay interests and loan instalments to its lenders and debentures.
Sikkim Manipal University Page No. 10

Financial Management

Unit 1

An investor in a companys shares has two objectives for investing: Income from capital appreciation (capital gains on sale of shares at market price) Income from dividends The ability of the company to offer both these incomes to its shareholders determines the market price of the companys shares. The most important goal of financial management is maximisation of net wealth of the shareholders. Therefore, management of every company should strive hard to ensure that its shareholders enjoy both dividend income and capital gains as per the expectation of the market. Therefore, to declare a dividend of 12%, a company has to earn a pre-tax profit of 19%. On the other hand, to pay an interest of 12%, the company has to earn only 8.4%. This leads to the conclusion that for every Rs.100 procured through debt, it costs 8.4%, whereas the same amount procured in the form of equity (share capital) costs 19%. This confirms the established theory that equity is costly but debt is cheap and risky source of funds to the corporate. Financing decision involves the consideration of managerial control, flexibility and legal aspects, and regulatory and managerial elements. Solved Problem 1 Dividend = 12% on paid up value Tax rate applicable to the company = 30% Dividend tax = 10% Compute the profit that the company must earn before tax, when a company pays Rs.12 on paid up capital of Rs.100 as dividend. Solution Since payment of dividend by an Indian company attracts dividend tax, the company when it pays Rs.12 to shareholders, must pay to the Govt of India 10% of Rs.12 = Rs.1.2 as dividend tax. Therefore dividend and dividend tax sum up to Rs.12 + Rs.1.2 = Rs.13.2. Since this is paid out of the post tax profit, in this question, the company must earn:
Sikkim Manipal University Page No. 11

Financial Management

Unit 1

Post tax dividend paid Pr etax required to declare and pay the dividend 1 Tax rate 13.2 13.2 = Rs.19 (approximat e) 1 0.3 0.1

1.4.2 Investment decisions To survive and grow, all organisations have to be innovative. Innovation demands managerial proactive actions. Proactive organisations continuously search for innovative ways of performing the activities of the organisation. Innovation is wider in nature. It could be: Expanding by entering into new markets. Adding new products to its product mix. Performing value added activities to enhance customer satisfaction. Adopting new technology that would drastically reduce the cost of production. Rendering services or mass production at low cost or restructuring the organisation to improve productivity. These innovations change the profile of an organisation. These decisions are strategic because they are risky. However, if executed successfully with a clear plan of action, investment decisions generate super normal growth to the organisation. A firm may become bankrupt if the management fails to execute the decisions taken. Therefore, such decisions have to be taken after taking into account all the facts affecting the decisions and their execution. There are two critical issues to be considered in these decisions. They are: Evaluation of expected profitability of the new investments. Rate of return required on the project.

The Rate of Return required by an investor is normally known as the hurdle rate or the cut off rate or the opportunity cost of capital. Investments in buildings and machineries are to be conceived and executed by a firm to enter into any business or to expand its business. The process involved is called Capital Budgeting. Capital Budgeting decisions demand considerable time, attention, and energy of the management. They are strategic in nature as the success or failure of an organisation is directly attributable to the execution of Capital Budgeting decisions taken.
Sikkim Manipal University Page No. 12

Financial Management

Unit 1

Investment decisions are also known as Capital Budgeting decisions and hence lead to investments in real assets. The key function of the financial management is the selection of the most profitable assortment of capital investment. It is also one of the most important area of decision making for the financial manager because any action taken by the manager in this area affects the working and the profitability of the firm in future. The impact of long-term capital investment decisions is far reaching. It protects the interests of the shareholders and of the enterprise because it avoids over-investment and under-investment in fixed assets. By selecting the most profitable projects, the management facilitates the wealth maximisation of equity shareholders. We will take a detailed look at Capital Budgeting in Unit 8. 1.4.3 Dividend decisions Dividends are payouts to shareholders. Dividends are paid to keep the shareholders happy. Dividend decision is a major decision made by the finance manager. Dividend is that portion of profits of a company which is distributed among its shareholders according to the resolution passed in the meeting of the Board of Directors. This may be paid as a fixed percentage on the share capital contributed by them or at a fixed amount per share. The dividend decision is always a problem before the top management or the Board of Directors as they have to decide how much profits should be transferred to reserve funds to meet any unforeseen contingencies and how much should be distributed to the shareholders. Payment of dividend is always desirable since it affects the goodwill of the concern in the market on the one hand, and on the other, shareholders invest their funds in the company in a hope of getting a reasonable return. Retained earnings are the sources of internal finance for financing of corporates future projects but payment of dividend constitute an outflow of cash to shareholders. Although both - expansion and payment of dividend are desirable, these two are in conflicting tasks. It is, therefore, one of the important functions of the financial management to constitute a dividend

Sikkim Manipal University

Page No. 13

Financial Management

Unit 1

policy which can balance these two contradictory view points and allocate the reasonable amount of profits after tax between retained earnings and dividend. All of this is based on formulation of a good dividend policy. Since the goal of financial management is maximisation of wealth of shareholders, dividend policy formulation demands the managerial attention on the impact of its policy on dividend and on the market value of its shares. Optimum dividend policy requires decision on dividend payment rates so as to maximise the market value of shares. The payout ratio means what portion of earnings per share is given to the shareholders in the form of cash dividend. In the formulation of dividend policy, the management of a company will have to consider the relevance of its policy on bonus shares. Dividend policy influences the dividend yield on shares. Dividend yield is an important determinant of an investors attitude towards the security (stock) in his portfolio management decisions. The following issues need adequate consideration in deciding on dividend policy: Preferences of shareholders Do they want cash dividend or capital gains? Current financial requirements of the company. Legal constraints on paying dividends. Striking an optimum balance between desire of shareholders and the companys funds requirements. Companies attempt to maintain a stable dividend policy whereby a stable rate of dividend is maintained. This also ensures that the companys market value of shares stays higher. The main reasons why a stable dividend is preferred are: (a) A regular and stable dividend payment may serve to resolve uncertainty in the minds of shareholders, and it creates confidence among shareholders. (b) Many investors are income conscious and favour a stable dividend. (c) Other things being in balance, the market price invariably vary with the rate of dividend declared by the company on its equity shares. The value of shares of a company that has a stable dividend policy does not
Sikkim Manipal University Page No. 14

Financial Management

Unit 1

fluctuate as much, even if the earnings of the company fluctuate now and then. (d) A stable dividend policy encourages investments from institutional investors. In this way, stability and regularity of dividends not only affects the market price of shares but also increases the general credit of the company that pays the company in the long run. Dividend decisions are thus highly significant. 1.4.4 Liquidity decisions The liquidity decision is concerned with the management of the current assets, which is a pre-requisite to long-term success of any business firm. This is also called as working capital decision. The main objective of the current assets management is the trade-off between profitability and liquidity, and there is a conflict between these two concepts. If a firm does not have adequate working capital, it may become illiquid and consequently fail to meet its current obligations thus inviting the risk of bankruptcy. On the contrary, if the current assets are too enormous, the profitability is adversely affected. Hence, the major objective of the liquidity decision is to ensure a trade-off between profitability and liquidity. Besides, the funds should be invested optimally in the individual current assets to avoid inadequacy or excessive locking up of funds. Thus, the liquidity decision should balance the basic two ingredients, i.e. working capital management and the efficient allocation of funds on the individual current assets. In other terms, liquidity decisions deal with working capital management. It is concerned with the day-to-day financial operations that involve current assets and current liabilities. The important elements of liquidity decisions are: Formulation of inventory policy Policies on receivable management Formulation of cash management strategies Policies on utilisation of spontaneous finance effectively We will look at these elements individually, in detail, over the course of this book.

Sikkim Manipal University

Page No. 15

Financial Management

Unit 1

1.5 Organisation of finance function

Financial decisions and functions are strategic in character and therefore, an efficient organisational structure is required to administer the same. The organisation of finance functions implies the division and classification of functions relating to finance because financial decisions are of utmost significance to firms. Finance is like blood that flows throughout the organisation. In all organisations, CFOs play an important role in ensuring proper reporting based on the substance of the shareholders of the company. Although in case of companies, the main responsibility to perform finance function rests with the top management. Yet the top management (Board of Directors), for convenience, can delegate its powers to any subordinate executive who is known as Director of Finance, Chief Financial Controller/Officer, Financial Manager, or Vice President of Finance. Moreover, it is finally the duty of the Board of Directors to perform the finance functions. There are various reasons behind it to assign the responsibility to them. Financing decisions are quite important for the survival of the firm. The growth and expansion of business is always affected by financing policies. The loan paying capacity of the business depends upon the financial operations. For the survival of the firm, there is a need to ensure both long-term and short-term financial solvency. Weak functional performance by financial department will weaken production, marketing, and HR activities of the company. The result would be the organisation becoming anaemic. Once anaemic, unless crucial and effective remedial measures are taken up, it will pave way for corporate bankruptcy. Under the CFO, normally two senior officers manage the treasurer and controller functions. Activity 1 List out the functions of Chief Financial Officer that can make or mar the companys success. Hint: All the finance functions are to be discussed.

Sikkim Manipal University

Page No. 16

Financial Management

Unit 1

A Treasurer performs the following functions: Obtaining finance and utilising funds Liaison with term lending and other financial institutions Managing working capital Managing investment in real assets A Controller performs the following functions: Accounting and auditing Management control systems Taxation and insurance Budgeting and performance evaluation Maintaining assets intact to ensure higher productivity of operating capital employed in the organisation In India, CFOs have a legal obligation under various regulatory provisions to certify the correctness of various financial statements and information reported to the shareholders in the annual report. Listing norms, regulations on corporate governance, and other notifications of Government of India have adequately recognised the role of finance function in the corporate setup in India. Self Assessment Questions 5. ________ leads to investment in real assets. 6. ____ relate to the acquisition of funds at the least cost. 7. Formulation of inventory policy is an important element of _______. 8. Obtaining finance is an important function of _________. 9. What are the two critical issues to be considered under investment decisions? 10. Define rate of return. 11. One of the most important decisions made by a finance manager dealing with maximisation of shareholders wealth is ________.

1.6 Interface between Finance and Other Business Functions

1.6.1 Relation between Finance and accounting In the hierarchy of the finance function of an organisation, the controller reports to the CFO. Accounting is one of the functions that a controller
Sikkim Manipal University Page No. 17

Financial Management

Unit 1

discharges. Accounting is a part of Finance. For computation of return on investment, earnings per share and for various ratios of financial analysis, the data base will be accounting information. Without a proper accounting system, an organisation cannot administer the effective function of financial management. The purpose of accounting is to report the financial performance of the business for the period under consideration. All the financial decisions are futuristic based on cash flow analysis. All the financial decisions consider quality of cash flow as an important element of decisions. Since financial decisions are futuristic, they are taken and put into effect under conditions of uncertainty. Assuming the condition of uncertainty and incorporating the effect on decision making results in use of various statistical models. In the selection of the statistical models, element of subjectivity creeps in. The relationship between finance and accounting has two dimensions: (a) They are closely associated to the extent that accounting is an important input in financial decision making (b) There are definite differences between them Accounting is a necessary input for the finance function as it generates information through the financial statements. The data contained in these financial statements assists the financial managers in assessing the past performance and providing future directions to the firm and in meeting certain legal obligations. Thus accounting and finance are functionally inseparable. The key differences between finance and accounting related to the treatment of funds and decision making are discussed below: (a) Treatment of funds: The measurement of funds in accounting is always based on the accrual concept, whereas, in case of finance, the treatment of funds is based on cash flow. That means, here the revenue is recognised only when cash is actually received or actually paid. (b) Decision making: The purpose of accounting is collection and presentation of financial data. The financial manager uses this data for financial decision making. It does not mean that accountants never make decisions or financial managers never collect data. But the
Sikkim Manipal University Page No. 18

Financial Management

Unit 1

primary focus of the function of accountants is collection and presentation of data in financial statements while the financial manager's major responsibility relates to financial planning, controlling, and decision making. Thus, we can say that the role of finance begins where accounting ends. 1.6.2 Finance and marketing Marketing decisions, generally, have financial implications. Pricing, product promotion and advertisement, choice of product mix, distribution policy, selections of channels of distribution, deciding on advertisement policy, remunerating the salesmen, etc. all have financial implications. In fact, the recent behaviour of rupee against US dollar (appreciation of rupee against US dollar), affected the cash flow positions of export-oriented textile units, BPOs and other software companies. It is generally believed that the currency in which marketing manager invoices the exports decides the cash flow consequences of the organisation if the company is mainly dependent on exports. Marketing cost analysis, a function of finance manager, is the best example of application of principles of finance on the performance of marketing functions by a business unit. Formulation of policy on credit management cannot be done unless the integration of marketing with finance is achieved. Deciding on credit terms to achieve a particular level of sales has financial implications because sanctioning liberal credit may result in huge and bad debt. On the other hand, conservative credit terms may depress the sales. Relation between inventory and sales: Co-ordination of stores administration with that of marketing management is required to ensure customer satisfaction and good will. But investment in inventory requires the financial clearance because funds are locked in, and the funds so blocked have opportunity cost of capital. 1.6.3 Finance and production (operations) Finance and operations management are closely related. Decisions on plant layout, technology selection, productions or operations, process plant size, removing imbalance in the flow of input material in the production or operation process and batch size are all operation management decisions. Their formulation and execution cannot be done unless they are evaluated from the financial angle. The capital budgeting decisions are closely related
Sikkim Manipal University Page No. 19

Financial Management

Unit 1

to production and operation management. These decisions make or mar a business unit. Failure to understand the implications of the latest technological trend on capacity expansions has cost even blue chip companies. Many textile units in India became sick because they did not provide sufficient finance for modernisation of plant and machinery. Inventory management is crucial to successful operation management. But management of inventory involves a number of financial variables. In any manufacturing firm, the Production Manager controls a major part of the investment in the form of equipment, materials, and men. He should organise his department in such a way that the equipments under his or her control are used most productively, the inventory of work-in-process or unfinished goods, stores and spares are optimised, and the idle time and work stoppages are minimised. If the production manager can achieve this, he or she would be holding the cost of output under control and thereby help in maximising profits. He or she has to appreciate the fact that while the price at which the output can be sold is largely determined by external factors such as competition, market, government regulations, etc., the cost of production is more amenable to his or her control. Similarly, he or she would have to make decisions regarding make or buy, buy or lease, etc., for which he or she has to evaluate the financial implications before arriving at a decision. 1.6.4 Finance and HR Financial management is also related to human resource department as it provides manpower to all the functional areas of the management. Financial manager should carefully evaluate the requirement of manpower to each department and then allocate the required finance to the human resource department as wages, salary, remuneration, commission, bonus, pension, and other monetary benefits to the human resource department. Attracting and retaining the best manpower in the industry cannot be done unless they are paid salary at competitive rates. If an organisation formulates and implements a policy for attracting competent manpower, it has to pay the most competitive salary packages to them. However, by attracting competent manpower, capital and productivity of an organisation
Sikkim Manipal University Page No. 20

Financial Management

Unit 1

improves. Hence, financial management is closely associated with human resource management. Caselet: Infosys does not have physical assets similar to that of Indian Railways. But if both were to come to capital market with a public issue of equity, Infosys would command better investors acceptance than the Indian Railways. This is because the value of human resource plays an important role in valuing a firm. The better the quality of man power in an organisation, the higher the value of the human capital and consequently the higher the productivity of the organisation. Indian Software and IT enabled services have been globally acclaimed only because of the manpower they possess. But it has a cost factor - the best remuneration to the staff.

1.7 Summary
Let us recapitulate the important concepts discussed in this unit: Financial Management is concerned with the procurement of the least cost funds, and its effective utilisation for maximisation of the net wealth of the firm. There exists a close relation between the maximisation of net wealth of shareholders and the maximisation of the net wealth of the company. The broad areas of decision are Financing decisions, Investment decisions, Dividend decisions, and Liquidity decisions.

1.8 Glossary
Dividend: Portion of profits of a company which is distributed among its shareholder. Explicit costs: The actual cash payments it makes to those who provide resources. Financial management: Concerned with procurement and effective utilisation of funds. Implicit costs: The opportunity costs of using resources owned by the firm or provided by the firm's owners.
Sikkim Manipal University Page No. 21

Financial Management

Unit 1

Opportunity cost of capital: The Rate of Return required by an investor is normally known as the hurdle rate or the cut-off rate. Wealth: Shareholder wealth.

1.9 Terminal Questions

1. What are the goals of financial management? 2. How does a finance manager arrive at an optimal capital structure? 3. Examine the relationship of financial management with other functional areas of a firm. 4. Examine the relationship between finance and accounting. 5. Examine the relationship between finance and marketing.

1.10 Answers
Self Assessment Questions Liberalisation and globalisation of Indian economy Procurement of funds Wealth maximisation Wealth maximisation Investment decisions Financing decisions Liquidity decisions Treasurers The two critical issues are: Evaluation of expected profitability of the new investment Rate of return required on the project 10. Rate of return is normally defined as the hurdle rate or cutoff rate or opportunity cost of the capital. 11. Dividend decision Terminal Questions 1. Financial management means maximisation of economic welfare of its shareholders. The two goals of financial management are 1) profit maximisation and 2) wealth maximisation. Refer 1.3
Sikkim Manipal University Page No. 22

1. 2. 3. 4. 5. 6. 7. 8. 9.

Financial Management

Unit 1

2. Financing decisions relate to the composition of relative proportion of various sources of finance. Whenever funds are to be raised to finance investments, capital structure decision is involved. Refer 1.4.1 3. The relationship between financial management and other areas of a firm can be explained by the. Refer 1.6 4. Accounting is a necessary input for the finance function as it generates information through the financial statements. Refer 1.6.1 5. Marketing decisions, generally, have financial implications. Refer 1.6.2

1.11 Case Study: Hindustan Unilever Limited

Introduction: Hindustan Unilever Limited (HUL) is India's largest Fast Moving Consumer Goods Company with a heritage of over 75 years in India and touches the lives of two out of three Indians. With over 35 brands spanning 20 distinct categories such as soaps, detergents, shampoos, skin care, toothpastes, deodorants, cosmetics, tea, coffee, packaged foods, ice cream, and water purifiers, the Company is a part of the everyday life of millions of consumers across India. Its portfolio includes leading household brands such as Lux, Lifebuoy, Surf Excel, Rin, Wheel, Fair & Lovely, Ponds, Vaseline, Lakm, Dove, Clinic Plus, Sunsilk, Pepsodent, Closeup, Axe, Brooke Bond, Bru, Knorr, Kissan, Kwality Walls, and Pureit. The Company has over 16,000 employees and has an annual turnover of around Rs.19,401 crore (financial year 2010 - 2011). HUL is a subsidiary of Unilever, one of the worlds leading suppliers of fast moving consumer goods with strong local roots in more than 100 countries across the globe with annual sales of about 44 billion in 2011. Unilever has about 52% shareholding in HUL. Unilever has a long history in sustainability and the use of marketing and market research to promote behaviour change. In November 2011, for the first time, it published its own model of effective behaviour change. For those who are interested, the details of this model can be seen at http://www.hul.co.in/mediacentre/news/2011/inspiring-sustainableliving.aspx
Sikkim Manipal University Page No. 23

Financial Management

Unit 1

History of the Company: In the summer of 1888, visitors to the Kolkata harbour noticed crates full of Sunlight soap bars, embossed with the words "Made in England by Lever Brothers". With it began an era of marketing branded Fast Moving Consumer Goods (FMCG). Soon after followed Lifebuoy in 1895, and other famous brands like Pears, Lux, and Vim. Vanaspati was launched in 1918 and the famous Dalda brand came to the market in 1937. In 1931, Unilever set up its first Indian subsidiary, Hindustan Vanaspati Manufacturing Company, followed by Lever Brothers India Limited (1933) and United Traders Limited (1935). These three companies merged to form HUL in November 1956; HUL offered 10% of its equity to the Indian public, being the first among the foreign subsidiaries to do so. Unilever now holds 52.10% equity in the company. The rest of the shareholding is distributed among about 360,675 individual shareholders and financial institutions. The erstwhile Brooke Bond's presence in India dates back to 1900. By 1903, the company had launched Red Label tea in the country. In 1912, Brooke Bond & Co. India Limited was formed. Brooke Bond joined the Unilever fold in 1984 through an international acquisition. The erstwhile Lipton's links with India were forged in 1898. Unilever acquired Lipton in 1972 and in 1977 Lipton Tea (India) Limited was incorporated. Pond's (India) Limited had been present in India since 1947. It joined the Unilever fold through an international acquisition of Chesebrough Pond's USA in 1986. Since the very early years, HUL has vigorously responded to the stimulus of economic growth. The growth process has been accompanied by judicious diversification, always in line with Indian opinions and aspirations. The liberalisation of the Indian economy, started in 1991, clearly marked an inflexion in HULs and the Group's growth curve. Removal of the regulatory framework allowed the company to explore every single product and opportunity segment, without any constraints on production capacity. Simultaneously, deregulation permitted alliances, acquisitions, and mergers. In one of the most visible and talked about events of India's corporate history, the erstwhile Tata Oil Mills Company (TOMCO) merged with HUL,
Sikkim Manipal University Page No. 24

Financial Management

Unit 1

effective from April 1, 1993. In 1996, HUL and yet another Tata company, Lakme Limited, formed a 50:50 joint venture, Lakme Unilever Limited, to market Lakme's market-leading cosmetics and other appropriate products of both the companies. Subsequently in 1998, Lakme Limited sold its brands to HUL and divested its 50% stake in the joint venture to the company. HUL formed a 50:50 joint venture with the US-based Kimberly Clark Corporation in 1994. Kimberly-Clark Lever Ltd, which markets Huggies Diapers and Kotex Sanitary Pads. HUL has also set up a subsidiary in Nepal, Unilever Nepal Limited (UNL), and its factory represents the largest manufacturing investment in the Himalayan kingdom. The UNL factory manufactures HULs products like soaps, detergents, and personal products both for the domestic market and exports to India. The 1990s also witnessed a string of crucial mergers, acquisitions, and alliances on the Foods and Beverages front. In 1992, the erstwhile Brooke Bond acquired Kothari General Foods, with significant interests in Instant Coffee. In 1993, it acquired the Kissan business from the UB Group and the Dollops Ice cream business from Cadbury India. As a measure of backward integration, Tea Estates and Doom Dooma, two plantation companies of Unilever, were merged with Brooke Bond. Then in 1994, Brooke Bond India and Lipton India merged to form Brooke Bond Lipton India Limited (BBLIL), enabling greater focus and ensuring synergy in the traditional Beverages business. 1994 witnessed BBLIL launching the Wall's range of Frozen Desserts. By the end of the year, the company entered into a strategic alliance with the Kwality Ice cream Group families and in 1995 the Milk food 100% Ice cream marketing and distribution rights too were acquired. Finally, BBLIL merged with HUL, with effect from January 1, 1996. The internal restructuring culminated in the merger of Pond's (India) Limited (PIL) with HUL in 1998. The two companies had significant overlaps in personal products, speciality chemicals and exports businesses, besides a common distribution system since 1993 for personal products. The two also had a common management pool and a technology base. The amalgamation was done to ensure for the Group, benefits from scale economies both in domestic and export markets and enable it to fund investments required for aggressively building new categories.
Sikkim Manipal University Page No. 25

Financial Management

Unit 1

In January 2000, in a historic step, the government decided to award 74 percent equity in Modern Foods to HUL, thereby beginning the divestment of government equity in public sector undertakings (PSU) to private sector partners. HULs entry into bread is a strategic extension of the company's wheat business. In 2002, HUL acquired the government's remaining stake in Modern Foods. In 2003, HUL acquired the cooked shrimp and pasteurised crabmeat business of the Amalgam Group of Companies, a leader in value added marine products exports. HUL launched a slew of new business initiatives in the early part of 2000s. Project Shakti was started in 2001. It is a rural initiative that targets small villages populated by less than 5000 individuals. It is a unique win-win initiative that catalyses rural affluence even as it benefits business. Currently, there are over 45,000 Shakti entrepreneurs covering over 100,000 villages across 15 states and reaching to over 3 million homes. In 2002, HUL made its foray into Ayurvedic health and beauty centre category with the Ayush product range and Ayush Therapy Centres. Hindustan Unilever Network, Direct to home business was launched in 2003 and this was followed by the launch of Pureit water purifier in 2004. In 2007, the Company name was formally changed to Hindustan Unilever Limited after receiving the approval of share holders during the 74th AGM on 18 May, 2007. Brooke Bond and Surf Excel breached the Rs 1,000 crore sales mark the same year followed by Wheel which crossed the Rs.2, 000 crore sales milestone in 2008. On 17th October, 2008, HUL completed 75 years of corporate existence in India. Following are excerpts from the companys Annual Report 2010 2011: Financial Highlights: Net Sales: Rs. 19,401 crore Net Profit: Rs.2, 306 crore EPS (Basic): Rs.10.58 EVA: Rs.1, 750 crore
Sikkim Manipal University Page No. 26

Financial Management

Unit 1

Total expenditure:
1% 5%

6% 6%

Ma teria ls Advertising Costs

6%

Sta ff Costs Ca rria ge a nd Freight

60%

16%

Utilities, Rent, Repa irs etc. Deprecia tion Other

Financial Performance 10 year track record (Rs. Crores) Expenditure

P&L account 2008-09 2001 2002 2003 2004 2005 2006 2007 (15 months) 2009-10 2010-11

Gross Sales* Other Income Interest

11,781.30

10,951.61 384.54 (9.18) 2,197.12

11,096.02 10,888.38 11,975.53 13,035.06 14,715.10 21,649.51 18,220.27 459.83 (66.76) 318.83 (129.98) 304.79 (19.19) 354.51 (10.73) 431.53 (25.50) 589.72 (25.32) 3,025.12 349.64 (6.98) 2,707.07

20,305.54 586.04 (0.24) 2,730.18

381.79 (7.74)

Profit 1,943.37 Before Taxation @ Profit 1,540.95 After Taxation @ Earnings Per Share of Re. 1# Dividend Per Share of Re. 1# 7.46

2,244.95 1,505.32 1,604.47 1,861.68 2,146.33

1,731.32

1,804.34 1,199.28 1,354.51 1,539.67 1,743.12

2,500.71

2,102.68

2,153.25

8.04

8.05

5.44

6.40

8.41

8.73

11.46

10.10

10.58

5.00

5.16

5.50

5.00

5.00

6.00

9.00

7.50

6.50

6.50

* Sales before Excise Duty Charge @ Before Exceptional/Extraordinary items # Adjusted for bonus

Sikkim Manipal University

Page No. 27

Financial Management

Unit 1

Balance Sheet

2001

2002 1,322.34 2,364.74 269.92 (239.83) 3,717.17 220.12 3,438.75 58.30 3,717.17 181.75

2003

2004

2005 1,483.53 2,014.20 220.14

2006 1,511.01 2,413.93 224.55

2007 1,708.14 1,440.80 212.39

2008-09 (15 months) 2,078.84 332.62 254.83 (182.84) 2,483.45 217.99 1,843.52 421.94 2,483.45 237.50

2009-10 2010-11 2,436.07 2,468.24 1,264.08 1,260.68 248.82 209.66

Fixed Assets 1,320.06 Investments Net Deferred Tax Net Current Assets Share Capital Reserves & Surplus Loan Funds Others HUL Share Price on BSE (Rs. Per Share of Re. 1)* Market Capitalisation (Rs. Crores) 223.65 1,635.93 246.48 (75.04) 3,127.43 220.12 2,823.57 83.74 3,127.43

1,369.47 1,517.56 2,574.93 2,229.56 267.44 (368.81) 226.00 (409.30)

(1,355.31) (1,353.40) (1,833.57) 2,362.56 220.12 2,085.50 56.94 2,362.56 197.25 2,796.09 220.68 2,502.81 72.60 2,796.09 216.55 1,527.76 217.74 1,221.49 88.53 1,527.76 213.90

(1,365.45) (1,304.6 6) 2,583.52 2,633.92 218.17 215.95 2,365.35 2,417.97

3,843.03 3,563.82 220.12 220.12 1,918.60 1,872.59 1,704.31 1,471.11 3,843.03 3,563.82 204.70 143.50

2,583.52 2,633.92 238.70 284.60

49,231

40,008

45,059

31,587

43,419

47,788

46,575

51,770

52,077

61,459

* Based on year-end closing prices quoted in the Bombay Stock Exchange, adjusted for bonus shares.

Excerpts from the report on Human Resources: Your Companys Human Resource agenda for the year focused on strengthening four key areas: building a robust talent pipeline, enhancing individual and organisational capabilities for future-readiness, driving greater employee engagement and strengthening employee relations further through progressive people practices at the shop floor In the first half of 2010, a comprehensive Talent and Organisation Assessment was undertaken to understand their readiness to partner the business ambition in the medium term and a holistic people strategy was drawn up, which was the basis of the work done in the key areas mentioned above. This Human Resource agenda not only looks at the current needs of the business, but also enhances the Companys preparedness for the future The Company participates in a Global People Survey every 2 years, which is a leading indicator of employee morale and motivation, with Employee Engagement being one of the key dimensions measured. For the current year, the employee participation rate for this survey was over 99% (with an employee base of approximately 15000) and your
Sikkim Manipal University Page No. 28

Financial Management

Unit 1

Company were ranked among the top performing companies across Unilever globally in all dimensions. This was on account of a number of proactive and innovative initiatives to engage our employees, the most significant being continuous and consistent business linked engagement, a vision for the future of the business and clarity and transparency to individuals on their own careers Discussion Questions: 1. Do you think that HUL has preferred the profit maximisation approach over the wealth maximisation approach? Justify your answer. (Hint: Refer to wealth maximisation) 2. How do you think an effective interaction between the HR and finance department of a firm helps in achieving its goals? You may draw instances from the case provided above. (Hint: Refer to Finance & HR)) 3. Study the pattern of total expenditure as given in the annual report. Which core element of financial management is this based on? (Hint: Refer to Financing decisions) 4. HUL is known for its marketing power. Wide bouquets of brands are handled under their purview, as we have seen above. What is the correlation between finance and marketing management? How is their relationship significant to the achievement of final goals of the company? (Hint: Refer to Finance and Marketing) (Source: HUL Annual Report 2010 2011, www.hul.co.in) References: Khan, M. Y. and Jain P. K. (2007). Financial Management, Text, Problems & Cases, 5th Edition, Tata McGraw Hill Company, New Delhi. Maheshwari, S.N.(2009)., Financial Management Principles & Practice, 13th Edition, Sultan Chand & Sons. Van Horne, James, C (2002), Principles of Financial Management, Pearson Education. Prasanna, Chandra (2007), Financial Management: Theory and Practice, 7th Edition, Tata McGraw Hill.

E-Reference: HUL Annual Report 2010 2011, www.hul.co.in retrieved on 10/12/ 2011
Sikkim Manipal University Page No. 29