Introduction

Financial Management is one of the functional areas of management. It is concerned with the management of financial resources of the organization in most optimal manner.

Here are some finance issues to be discussed: 1. From where to raise the most cost effective financial resources needed to carry out the operations and how to manage the risks associated with such financing? 2. Where to invest the money so as to maximize the returns on investments?

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3.How much of the profits to distribute as dividends to

shareholders and how much to retain for future investment needs? OF FINANCIAL MANGEMENT According to Howard & Upton, Financial Management is the application of planning and control functions to the finance function.

DEFINITION

According to Weston & Brigham, Financial Management is an area of financial decision making, harmonizing individual motives and enterprise goals.

Nature & Scope of FM

The scope of FM extends to the decisions that are relevant to optimal utilization of financial resources. FM performs planning, decision making, facilitation and control functions in an organization. The sourcing of finances needed by various departments and its balanced allocation for various activities is done by the finance department.

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There are two main approaches associated with the scope of Financial Management: The Traditional Approach: This approach was popular in the early part of 20th Century. According to this approach, the scope of FM was confined to raising & managing the funds needed by business enterprises to meet their financial needs. It was limited to arrangement of funds from various financial institutions.

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The

Modern Approach: Modern approach viewed FM in a broader sense. According to this approach, finance function is related to procurement of funds as well as their allocation i.e. effective utilization. It aims at acquiring sufficient funds, utilizing them properly, increasing profitability of the concern and maximizing firms value. It considers 3 basic financial decisions Investment decisions, Financing decisions & Dividend decisions.

Financial Objectives
Objectives of FM are considered usually at two levels: At Macro Level & at Micro Level.

At Macro Level the chief objective of FM is to make an intensive & economical use of scarce capital resources.

At Micro Level there are two main Objectives: Wealth Maximization of Shareholders and Profit Maximization.

Finance Functions
An organization can be viewed from two different perspectives Functional & Stakeholders. From the Functional Viewpoint, each organization can be divided into various functional areas such as Marketing, Production, Personnel, Finance etc. The functional division of organizational structure helps establish the relationship of each individual with the organizational goals.

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Like

different functions of an enterprise, there are different Stakeholders associated with business.
They

are equity shareholders, debt holders, employees, suppliers, customers etc.

Functional View of Organization

Production Finance Operations

Business
Marketing

Personnel

Purchase

R&D

Stakeholders View of Organization

Suppliers Shareholders Employees

Business
Regulatory Bodies Society Customers

Financial Decisions
There are 3 types of Financial Decisions:

Investment Decisions

Financing Decisions

Dividend Decisions

Investment Decisions

Investment decisions involve putting the resources in avenues that give a return that is in excess of the cost incurred on procuring such resources.

Basic issues involved are: 1. Evaluation of alternate avenues so as to select the best option, and 2. Implementation & Monitoring of the selected investment option.

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The decision to invest or not is taken into account as per the probable impact of such investments on the wealth of the shareholders.

If the investment option is likely to create or enhance the wealth, it is acceptable, otherwise it is not.

1. 2.

These decisions are referred as:

Capital Budgeting Decisions or Long Term Working Capital Decisions or Short Term

Financing Decisions
Financing decisions relate to the procurement of required amount of funds, as and when needed, at lowest possible cost.

Financing decisions are commonly referred to as Capital Structure Decisions.

They determine the financial risk profile of the business.

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Main issues involved are: 1. Where from to procure the necessary capital? 2. What should be the optimal mix of various sources of capital? And, 3. How much should be the proportion of short term and long term capital?

Financing decisions are concerned with the sources of financing the assets of an organization.

Dividend Decisions

Dividend decisions focuses upon identifying what portion of profit is to be distributed amongst the shareholders as dividends and how much is to be kept for future financing needs of the business as retained earnings.

Roles & Responsibilities of a Finance Manager

Financial Planning: Main responsibility of a finance

manager is to make a sound financial forecast to estimate the short term & long term financial requirements and then to plan for them.

Raising of Necessary Funds: The second main

responsibility is to supply the firm adequate funds for its various operations. This includes decision regarding Capital Structure and selecting appropriate source of finance.

Management of fixed & current assets:

Acquisition of fixed assets like land, building etc. & their management and management of current assets like cash, stock, bank deposits etc. are also the responsibility of finance manager.

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Controlling the use of funds: A business firm is basically a profit earning concern. An effective control on cash inflow and outflow should be maintained and financial check should be followed.

Disposition of Profit: Proper disposition of profit is also an important aspect. Financial manager makes a balance between the dividends, i.e., the expectations of investors and the need of retained earnings for financing expansion plans and growth.

Introduction to Indian Financial System

Financial system is a platform for seekers of fund and suppliers of funds, where savings are converted into investments and investments into savings.

Financial system of a country means a set of financial arrangements by which the savings in the economy are mobilized for investment in productive assets.

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The financial system deals with all types of finance agricultural, industrial, developmental and governmental finance.

The suppliers of funds as well as the users of funds are part of the financial system.

Hence, the financial system is concerned with borrowing and lending of funds.

Components of Financial System

Indian Financial System consists of four components.. Financial 2. Financial 3. Financial 4. Financial
1.

Markets Institutions Services Instruments

Financial Markets
Financial markets refer to the markets for borrowing and lending of funds. These markets provide facilities for buying & selling of financial claims.

Financial Markets

Capital Market

Money Market

Foreign Exchange Market

Govt. Securities Market

Capital Market
A capital market may be defined as the market for lending and borrowing of long term funds.

It is concerned with raising of capital for the purpose of investment.

It is of two types: 1. Primary Market / New Issue Market 2. Secondary Market

Money Market
Money market means the market for lending and borrowing of short term funds. Indian money market consists of two parts 1. Organized Sector 2. Unorganized Sector Organized Sector comprises of the public sector banks, private sector banks and foreign banks. Unorganized Sector consists of indigenous bankers & money lenders who pursue the banking business on traditional lines.

Foreign Exchange Market

In this market, foreign currency is made available to the needy. It comprises of the Reserve Bank of India, authorized dealers in foreign currency, money changers, foreign banks, exporters & importers.

Government Securities Market

The market in which government securities like treasury bills & bonds are purchased & sold is known as the government securities market. Treasury bills are issued for raising short term funds while bonds are issued to raise long term funds. Market for govt. & semi govt. securities is known as guilt edged market.

Financial Institutions
Financial Institutions
Banking Institutions
Central Bank / RBI
Commercial Banks Cooperative Banks Other Banks

Non-Banking Institutions
Venture Capital Funds
Factoring Companies Mutual Funds Investment Companies NBFCs

Banking Institutions
A BANK is an institution which deals in money and credit. It accepts deposits from the public and lends money to the borrowers.
1. 2. 3. 4.

Banking system in India is divided into 4 broad categories:Central Bank Commercial Banks Cooperative Banks Other Banks

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Central Bank: Every country has a central bank

which supervises and regulates the entire banking system. Therefore, it is known as the Bankers bank.

Commercial Banks: These banks perform the

usual banking functions of mobilizing deposits and providing credit.

Cooperative Banks: These banks are organized

on the principles of cooperation to encourage savings among the members.

Other Banks: These banks comprises of

development banks, agricultural banks, indigenous banks etc.

Institutions
These institutions are described under NBFCS. These companies raise deposits from the public by providing them various incentives. They provide loans to small scale industries, traders & self employed persons. NBFCs generally provide unsecured loans and, therefore, charge high rates of interest. So, NBFCs are financial intermediaries engaged in the business of accepting public deposits and giving loans.

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NBFCs are of several types: Loan Companies Leasing Companies Chit Funds Investment Companies

1. 2. 3. 4.

Financial Instruments
Several types of instruments are used by both banking & non banking financial Institutions. There are various financial instruments: 1. Commercial Paper: CP is an unsecured

promissory note issued by a firm to raise funds for a short period, generally varying from a few days to a few months. In India, the maturity period of CP generally varies between 90 days to 180 days. It is a money market instrument and generally purchased by commercial banks, mutual funds and other financial institutions.

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2. Letter of Credit: It is a letter by the importers bank guaranteeing the credit worthiness of the importer. 3. Cheque 4. Travellers Cheque 5. Credit Card

Financial Services

There are various financial services:

1.
2. 3. 4. 5.

Mutual Funds
Investment Trusts Venture Capital Funds Credit Rating Factoring

Sources of Finance
Sources of Finance

Long Term
Equity Shares Preference Shares Debentures/Loans Retained Earnings

Short Term
Trade Credit Commercial Papers

Public Deposits
Bank Overdraft

Equity Capital
It represents ownership capital because equity shareholders collectively own the company.

They enjoy the rewards and bear the risks of ownership.

The maximum amount of capital that a company can raise from the ordinary shareholders is known as Authorised Capital.

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The portion of Authorised Capital offered by the company to the investors is the Issued capital.

That part of issued capital which has been subscribed or accepted by the investors is known as Subscribed Capital.

The actual amount paid up by the shareholders or investors is called the Paid Up Capital.

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Par value / Face value The par value of an equity share is the value stated in the memorandum. The par value of equity shares is generally Re. 1, 2, 5 or 10. Issue Price It is the price at which the equity share is issued. Often, the issue price is higher than the par value. When the issue price exceeds the par value, the difference is referred to as the share premium. E.g. A share can have a par value of 10 but its issue price can be 50. Issue price cannot be lower than the par value as per the law.

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Book Value Book value of an equity share is given by: Paid up equity capital + Reserves & Surplus No. of equity shares Market Value Market value of an equity share is the price at which it is traded in the market. This price can be easily established for a company which is listed on the stock market and actively traded. For a company which is listed on the stock market but traded very infrequently, it is difficult to obtain a reliable market quotation.

Rights & Position of Equity Shareholders

1. Right to Income: Equity shareholders have a residual claim to the income of the firm. The income left after satisfying the claims of all other investors belongs to the equity shareholders. This income is equal to Profit After Tax Preference Dividends.

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Sales - Variable Costs Contribution - Fixed Costs EBIT or Operating Profit - Interest EBT - Tax EAT - Preference Dividend Earnings Available for Equity Shareholders

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2. Right to Control: Equity Shareholders, as owners of the firm, elect the board of directors and enjoy voting rights at the meetings of the company. They have a control over the operation of the firm. 3. Right in Liquidation: They have residual claim over the assets of the firm in the event of liquidation.

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4. Pre Emptive Right: Equity shareholders have a legal right to be offered by the company the first opportunity to purchase additional issue of equity shares. A shareholder owning 2% of the existing issued capital has a pre emptive right to acquire 2% of additional shares to be issued by the company. Pre emptive right protects the existing shareholders from the dilution of their financial interest as a result of additional equity issue.

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E.g. A company has 10,00,000 equity shares with a par value of Rs. 10 & market price of Rs. 20. It plans to issue 5,00,000 additional shares at a price of Rs. 12 per share.

Expected Price of total shares =

= 10,00,000 x 20 + 5,00,000 x 12 15,00,000 = Rs. 17.33

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If a shareholder has 100 shares, his financial situation with respect to the company when he enjoys the pre emptive right and when he does not enjoy the pre emptive right would be shown as below:

Pre emptive right

Value of initial holding = 20 x 100 = 2000 Additional subscription = 12 x 50 = 600 Value of equity after the additional issue = 17.33 x 150 = 2599.5 = 2600 (Approx.)

No pre emptive right

Value of initial holding = 20 x 100 = 2000 Additional subscription = 0 Value of equity after the additional issue = 17.33 x 100 = 1733

Disadvantages of Equity Capital

1. 2. 3. 4.

Advantages of Equity Capital: It is a permanent source of fund. There is no compulsion to pay dividends. Equity Capital has no maturity date. It enhances the creditworthiness of the company.

Disadvantages of Equity Capital: 1. Sale of equity shares to outsiders dilutes the control of existing owners. 2. Cost of equity capital is high.

Preference Capital
Preference Capital is a unique type of long term financing in which it combines some of the features of equity as well as debentures.

It resembles equity in the following ways: 1. Dividend on preference capital is also paid out after tax profit. 2. It is not an obligatory payment for a particular year. It is similar to debentures in several ways: 1. It carries a fixed dividend rate. 2. It does not have voting rights. 3. It has a fixed maturity period.

Features of Preference Capital

Cumulative Dividends Preference Capital has got cumulative dividends as all unpaid dividends are carried forward and then paid. Redeemability It has a fixed maturity after which it must be retired. Fixed Dividend Preference dividend is fixed in nature and is also known as fixed income security. Voting Rights Preference Capital ordinarily does not carry voting rights.

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Convertibility Preference Share Capital may sometimes be converted partly or fully into equity shares or debentures at a certain ratio during a specified period.

Prior Claim on Income / Assets The claim of preference shareholders on the income and assets of the company is prior to the claim of equity shareholders.

Disadvantages of Preference Capital

1. 2. 3.

Advantages of Preference Capital: There is a stable and fixed dividend. No dilution of control. It enhances the creditworthiness of the company. Disadvantages of Preference Capital: Expensive source of financing as compare to debt capital. Though, there is no legal obligation to pay preference dividends, skipping them can adversely effect the image of the company in the market.

1. 2.

Debentures
Debentures are the instruments for raising long term debt.

Debenture holders are the creditors of the company.

Debentures often provide more flexibility than term loans as they offer greater variety of choices with respect to maturity, interest rate, security, repayment and special features.

Features of Debentures
Trustee When a debenture issue is sold to the public / investors, a trustee is appointed. It is usually a bank or a financial institution or an insurance company. The trustee is supposed to ensure that the borrowing firm fulfills its contractual obligations. Maturity and Redemption Debentures have got a fixed maturity period and a redemption value. They get redeemed after a specific period of time.

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Convertibility Debentures may be converted into equity shares at the option of debenture holders. Security Generally, debentures are secured. In case the company fails to pay interest on debentures or repay the principal amount, the debenture holders can recover it from the sale of the assets of the company. Interest Rate Debentures carry a fixed interest rate.

Disadvantages of Debentures
Advantages of Debentures: 1. Interest on debenture is given before tax. 2. No dilution of control. 3. It is a cheaper source of finance than equity and preference shares. 4. Fixed rate of interest.

Disadvantages of Debentures: 1. As the interest on debentures has to be paid every year whether there are profits or not, so it becomes a burden for the company. 2. It increases the financial leverage.

Term Loans
Term loans given by financial institutions and banks are the primary source of long term debt. Term loans, also referred to as term finance, represent a source of debt finance which is generally repayable in less than 10 years. Term loans differ from short term bank loans which are employed to finance short term working capital need and usually they are for less than one year.

Features of Term Loans

Currency Financial institutions and banks give rupee loans as well as foreign currency term loans. They provide rupee term loans directly to business concerns for setting up new projects as well as for expansion, renovation etc. They provide foreign currency term loans for meeting the foreign currency expenditure towards import of plant, machinery and equipment.

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Security Term loans typically represent secured borrowings. Financial institutions or banks take some security while providing loan.

Restrictive Covenants In order to protect their interest, financial institutions generally impose restrictive conditions on the borrowers. The specific set of restrictive covenants depends on the nature of the project and the financial situation of the borrower.

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Interest Rate The interest and principal repayment on term loans are definite obligations that are payable irrespective of the financial situation of the borrower. Financial institutions impose a penalty for defaults.

The principal amount of a term loan is generally repayable over a period of 5 to 10 years.