UNIT I

Introduction to Financial
Management
 What is Finance?
• Finance is the study of how people and businesses
evaluate investments and raise capital to fund them.

• Elements of finance
1. What long-term investments should the firm undertake?
(capital budgeting decisions – how to spend the money?)
2. How should the firm fund these investments? (capital structure
decisions -- How to get the money?)
3. How can the firm best manage its cash flows as they arise in
its day-to-day operations? (working capital management decisions –
how to manage cash (liquid) money?)
 Scope of Finance Function

• Base for any business activity

• Interrelationship between finance, production,
marketing, sales, personnel, maintenance, stores,
research and development functions .

Production Marketing

Finance
 Concept of Financial Management

• According to Joseph and Massie- “Financial

Management is the operational activity of a business
that is responsible for obtaining and effectively
utilising the funds necessary for efficient operations.”
 Meaning of Financial Management

Financial Management is concerned with the

acquisition and efficient use of financial resources by
a business enterprise to achieve its overall objective
of wealth maximisation
 4 major functions of finance
manager
• What long-term investments should the firm take on?
(Investment Decisions or Capital Budgeting)
• From where do we acquire the long-term financing to pay
for the investment?( Financing Decisions or Capital
Structure)
• How will we manage the everyday financial activities of the
firm?( Working capital management Decisions)
• How much profit is to be distributed and how much to
retain?( Dividend Decisions)
PRINCIPLES OF FINANCIAL MANAGEMENT
 PRINCIPLES OF FINANCIAL MANAGEMENT
1. Cash Flow Concept
It is based on the management of inflows and outflows of cash. It ignores
non cash items like amortization of preliminary expenses, depreciation. It
uses all cash received and cash expenses in order to find out the returns on its
investments. It considers profits and it is more comprehensive than the
accounting concept of profits.
2. Time Value of Money
Financial management uses compounding and discounting techniques-to
study the receipts and payments of cash at different points of time by brining
it to some common denominator.
3. Risk and Return
All financial decisions taken by the financial manager is based on the concepts
of risk and return. The degree of risk is calculated to find out the choice of
investments. There are definite statistical techniques used in financial
management to take decisions.
 PRINCIPLES OF FINANCIAL MANAGEMENT
4. Incremental Cash Flow
Financial management analyzes the benefits and the expenses on
the new project to find out what would be the additional
expenses relating to the new project. It is able to find out the
amount of additional working capital that will be required for a
new project.

5. Wealth Maximization
Financial management creates value for the shareholders of the
company. It is used to find out the earnings per share of a
shareholder. Within this parameter it has to make the firm
commercially viable, look into the profitability of the concern for
the satisfaction of the shareholders wealth. Hence, profit
maximization is a narrow concept, wealth maximization is the
comprehensive perspective of financial management.
 SCOPE OF FINANCIAL MANAGEMENT
1. Traditional Scope of Financial Management
2. Modern scope of FM
 Traditional Scope of Financial Management
• To organize funds from different sources like banks, investment
companies and financial institutions.
• To use financial instruments in the form of shares, debentures,
bonds, fixed deposits for company's requirements.
• To settle the organization of funds through proper
administration, preparation of reports, legal advise and proper
accounting records.
• Traditional Financial Management was known as Corporation
Finance and was called the outsider looking approach.
 Modern Financial Management Scope / Functions
1. To take financial decisions. (Investment, Financing and Dividend
Decision).
2. Managing the flow of funds (To match inflows and outflows of
cash).
3. To make a profitable venture (To see that losses are minimized).
4. To create value for wealth management of share holders (To
invest and finance carefully).
5. To balance conflicting goals for firm. (Liquidity Vs Profitability,
Profit Maximization Vs Wealth Maximization, Risk and Return).
6. To manage different groups of people. (Shareholders,
management, investors, government, customer and suppliers).
7. To take up social responsibility. (To maintain fair practices like
safety in working conditions, providing fair wages to employees
and looking after community interests).
 ROLE OF A FINANCIAL MANAGER IN
MODERN FINANCIAL MANAGEMENT

1. Decision Making
The financial manager has to take decisions regarding the following:
• To procure funds for the organizations keeping in mind that there should
be a minimum cost of procurement.
• To invest the funds procured in different assets with the maximum
profitability.
• To distribute the profits of the firm to the owners / shareholders of the
firm as a return of their capital invested.

2. Financial Planning and Control

• The financial manager has to plan the resources of the firm so that there is
no shortage of funds or excess funds . He must take certain measures to
adopt a control in the organization to avoid wastage of resources.
ROLE OF A FINANCIAL MANAGER IN
MODERN FINANCIAL MANAGEMENT

3. Selecting a Proper Capital Structure

• The financial manager should take into consideration the amount
of debt required in a firm and have a balanced capital structure of
equity and debt to take the advantage of financial, leverage and
owner's capital.

4. Planning Fixed Assets

• The financial manager has the role of procuring fixed assets. The
selection procedure of the assets should be according to the
techniques of financial management. The right selection of fixed
assets will be helpful in a corporate organization for long term
decisions.
ROLE OF A FINANCIAL MANAGER IN
MODERN FINANCIAL MANAGEMENT

5. Working Capital Management Decisions

• The financial manager has to prepare policies relating to the purchase and
sale of current assets and the management of working capital requirements
of the firm. He has to manage the cash requirements of the firm, make a
policy for receivables and discounts. involving sales management. He has to
plan and control the inventory to make working capital efficient.

6. Resolving Conflict Decisions

• A financial manager has to resolve 'agency' conflicts between owners,
management and creditors of the firm.

7. Liquidity and Profitability Decision

• In order to run the organization efficiently a financial manager must
balance between maximum profitability and liquid cash in the organization.
8. Risk and Return Decisions
• A financial manager should not take extreme risky steps in order to maximize profits.
He should take decisions carefully to run the organization with high returns but
minimum risk. He should take the level of risk that a firm will be able to handle and
not face the problem of financial distress.

9. Constraints Relating to Government, Law and Society

• The financial manager has to work in the organization bearing certain important
government rules and regulations, the legal framework and social and environment
responsibilities of the organization.

10. Principles of Financial Management

• The role of the financial manager is to work in accordance with the principles of
modern financial management. He must apply the rules relating to cash flow analysis, time
value of money, incremental cash flow analysis and wealth maximization principles.

11. Techniques of Financial Management

• Financial manager has to apply the techniques of financial management for analyzing
projects, designing capital structure, managing cash and inventory and purchasing assets
of the company.
OBJECTIVES OF FINANCIAL MANAGEMENT

Two Major Objectives of Financial

Management:

1. Profit Maximization
2. Wealth Maximization
 Profit Maximization
• Profit maximization is an accounting term. A firm incurs
revenue expenses and receives revenue returns during a
year. If its revenue is higher than its expenses it makes a
profit and this profit judges the efficiency level of an
organization.
• All organizations apply this method for providing to the
third parties the picture of the firm. This aspect is like the
older concept of financial management.
• Profit maximization helps an organization to find out
whether it is able to cover its costs or not. However, it has
some benefits and limitations:
 Benefits of Profit Maximization
1. It acts as a barometer to an organization to find out
whether the firm is running efficiently as a
commercial enterprise or it is unable to meet its
expenses.
2. It provides information about the company to people
who would like to invest in it. A profitable company
becomes an attractive investment.
3. If a firm is profitable then the company can decide to
expand or diversify its business.
 Limitations of Profit Maximization
1. Profit maximization does not study the concept of
time value of money.
2. It concentrates towards providing a rosy picture to
the third parties and public but it is not concerned
with decision making for internal efficiency.
3. It does not have techniques or theories through
which it is able to analyze risks of a firm.
4. It focuses on profit and does not take any steps
towards maximizing the wealth of the shareholders.
 Limitations of Profit Maximization

5. It makes quantitative calculations but does not consider

the qualitative aspects of an organization for example;
it does not take any steps towards responsibilities and
ethics for society.
6. Profitability is based on accounting concept. It does not
give a clear picture because it does not take inflows and
outflows of cash for calculation. It includes
depreciation and this is not a true indication of the
cash flows in an organization.
7. Profit maximization must be used with wealth
maximization to support the modern scope of
financial management.
 Wealth Maximization
• Wealth maximization is based on the principles of the financial
management. It is superior to profit maximization. It takes into
consideration time value of money, cash flows, risk and return
and considers only incremental cash flows of the organization.
Its main objective is to create and manage wealth of the
shareholders to maximize it while organizing it.
• The wealth of the shareholders can be maximized by taking
investment, financing and dividend decisions carefully. This
means that the techniques of financial management should be
applied the get maximum benefit. Wealth can be maximized
when the present value of the share can be calculated through
time value management and by using the cash flow technique in
finding out the present value and future values of the share.
 Wealth Maximization
• Wealth can be maximized by analyzing the features of
risk and finding out the amount of return. This
provides an understanding to the market value of the
share. Therefore it measures the concepts of risk and
uncertainty.
• Wealth maximization also considers qualitative aspects.
It considers the requirements of different groups of
people in the organization. It identifies the requirements
of shareholders, employees, management, government,
customers, agents and suppliers. It resolves agency
problems and costs attached to any conflicts arising out
of their interaction.
 Benefits of Wealth Maximization
1. Maximization of shareholders wealth analyzes the present
value of the share and the future values through the
application of financial management principles.
2. It applies time value of management through compounding
and discounting techniques for single and multiple cash flows
for a future period or finding out the present value of a share.
It also provides an understanding of multiple compound
periods, annuities and annuities due.
3. It applies the cash flow concept which is according to the
principles of financial management. It considers cash items
only and in this way it is able to calculate the correct resources
of the organization
 Benefits of Wealth Maximization
4. It applies qualitative analysis to the problems of different
groups of people in and organization. Therefore, it covers the
quantitative techniques and also qualitative aspects in an
organization.
5. Wealth maximization is a concept which is applied only with
ethical and moral values such as fair wages, minimum wage
regulations, prohibition of child labour, creating friendly
environment, pollution control etc.
6. Wealth maximization is clear, not ambiguous and has proper
techniques of analysis for calculation of the valuation of
shares, dividends, present and future values of a share. This
reflects in the market value of the share.
Difference between Profit Maximization and
Wealth Maximization
FINANCIAL MANAGEMENT AND OTHER AREAS OF
STUDY
1. Financial Management and Financial Accounting
Accounting is a resource or an input to financial management
decisions. Financial management and financial accounting are
complimentary to each other. The accounting tools are an input
to financial decision-making. Financial accounting uses financial
statements like balance sheet, profit and loss account; fund flow
and cash flow statements to project the profitability of the firm.
Financial management uses the information to make decisions
relating to investment, financing and dividends to reach the goal
of wealth maximization.
2. Financial Management and Economics
Financial management branched out from the subject of economics and is
complementary to macro and microeconomics. Both finance and economics
make an analysis of money and capital markets, financial intermediaries,
banking system, monetary credit and fiscal policy . Financial Management
takes the information relating to the financial environment and prepares
policies for firms and take financial decisions within the ambit of the
monetary and fiscal policies in an economy. Changes in economic policy have
to be applied by the financial manager while taking decisions. Microeconomics
consists of concepts and theories relating to supply and demand, price,
profitability and profit maximization strategies. Financial decisions have to
continuously evaluate price of a product, sales revenue and financing decisions
of a firm.
3. Financial Management and Marketing Management Financial
management and marketing management are inter-related in a firm. All
marketing decisions are based on financial implications. Good credit and
discount policies for customers, sales, credit, revenue, advertisement budgets,
brands, patents are part of the activities of a financial manager as it affects the
liquidity position of a firm .
4. Financial Management and Human Resources Management
Human resource management is complementary and in some ways
dependent on a financial manager to take decision regarding recruitment and
placement of manpower as there are financial implications affecting the
liquidity of a firm. People should be hired only after calculating the costs to
the company as well as the benefits occurring after hiring certain people. A
balance will have to be maintained as liquidity and profitability as well as the
well being of the shareholder considered
5. Financial Management and Production Management The
Production department in an organization is given the
responsibility of procuring material, machineries, spares and
consumables and inventory. The financial manager has to take
financial decisions and make financial policies after finding out
their implications on decision-making areas- like capacity
utilization, replacement of machines, installation of safety
systems and ease in production capacity to enhance sales. The
policies of a financial manager has a direct implication on the
company/ firm as a whole because excess inventory will cause
'carrying costs’ whereas reduce inventory will have implication of
'cost of not carrying' affecting the production of the firm.
 LIQUIDITY VS PROFITABILITY

Liquidity and profitability in a firm are conflicting goals

that a financial manger has to balance. Liquidity means
that a firm is able to make its payments timely.
Profitability will enable a firm informed whether its
business is sustainable and will continue to function. If
a firm is profitable, it will continue its operations if it
has cash to pay for its obligations. Therefore, Liquidity
and profitability move in a circle with risk and return
 Liquidity may be achieved by the following:
i) Managing Flow of Funds: Adequate cash in the company
for making payments.
'ii) Matching Cash Flows: A firm forecasting its future cash
inflows with its cash outflows.
'iii} Sourcing of Funds: To identify resources within the
organization and the possibility of raising funds as
required on an immediate basis for making payments.
IV) Cash Reserves: To identify internal reserves to meet
contingencies of the firm.
 Profitability can be attained in the following
manner:

(i) High Risk High Profitability: To increase

profitability by using leverage(Debt).
(ii) Forecasting Future Profit: To evaluate expected
profits by forecasting them.
(iii) Measure Cost of Capital: To find out the cost of
each source of capital as it is linked to
profitability.
(iv) Cost Control Measure: To control each
department by proper maintenance of records
and making effective policies.
 Balancing Liquidity and Profitability
• Cash does not have any return and if a firm increases its liquidity it will reduce its profitability. On
the contrary if all the funds are invested then there will be no liquidity and this will also reduce
profitability. In many situations a financial manager faces the challenge of balancing the conflicting
goals of profitability and liquidity.
• Where an investment is profitable but the funds are locked for long periods of time, the financial
manager may consider this situation as risky because funds are locked up. He has to cope with the
dilemma of his choice between profitability and liquidity. High profitability is possible by taking
risks and since debt is cheaper than equity having high debt in the firm. However, high risk is good
during boom period but does not have any stability. A financial manager has to visualize the
overall corporate goal and have a balance between liquidity and profitability to achieve continuity
in business operations.
• Liquidity is having enough money in the form of cash and near cash assets for meeting a firm's
financial obligations or converting its assets easily into cash but profitability is a measure of the
amount by which a company's revenue exceed its expenditures. Profitability is finally essential to
run a business. Borrowings of a firm may increase its profitability but it will also increase the
financial risk. Borrowings have to, be made by analyzing the strengths of the firm and its ability to
return the loan and also give a good return to the shareholders. Liquidity and profitability are
conflicting goals. They will have to be continuously balanced by a financial manager to optimize
the value of the shares of a shareholder. Therefore, a risk return trade off is desired to balance
liquidity and profitability.
 METHODS I TECHNIQUES OF FINANCIAL
1. Capital Budgeting
MANAGEMENT
The techniques in capital budgeting provide an analysis for selection of a single
project as well as for taking mutually exclusive decisions through different
traditional and modern discounting methods of payback period, average rate
of return, net present value, profitability index and internal rate of return.
2. Cost of Capital
Decisions relating to sources of capital and costs relating to different sources
of funds can be taken by applying the tools a method of determining cost of
capital and optimum capital structure of a firm.
3. Operating and Financial Leverage
Leverages provide an assessment of the commercial viability and financial
viability of a concern. By applying these techniques a firm can avoid financial
distress situation.
 METHODS I TECHNIQUES OF FINANCIAL MANAGEMENT

4. Working Capital
Modern financial management provides models, theories, concepts and
practical applications for management of cash, procurement of optimum
inventory and effective management of current assets.

5. Fund Flow and Cash Flow Analysis

This technique provides to a financial manager the basis for finding out the
sources of funds and their utilization. The projected analysis of funds and
cash assist a firm in future working capital requirements of a firm.

6. Dividend Decisions
Dividend models provide a basic understanding to the corporate policy,
amount, form and time of dividend payment.

7. Economic Value Added (EVA)

A financial manager has the important function to create economic value to
the organization. EVA will provide the company after tax profits from
operations by deducting the cost of capital employed to produce those profits.
Tools/Methods of FM