Part I: Introduction

Chapter 1: An Overview of Financial Management

Any kind of business activity depends on the finance. Hence, it is called as lifeblood of business
organization. According to the economics concept of factors of production, rent is given to
landlord, wage is given to labor, interest is given to capital and profit is given to shareholders or
proprietors. A business concern needs finance to meet all the requirements. Hence, finance may
be called as capital, investment; fund etc., the purpose of this chapter is to give you an idea of
what financial management is all about.

1.1 Definition of finance

Literally, finance means the money used in day-to-day activities of an individual or a business
for exchange of goods and services. Finance is a distinct area of study that comprises facts,
theories, concepts, principles, techniques and practices related with raising and utilizing of funds
(money) by individuals, businesses, and governments.

Finance is a very wide and dynamic field of study.

• It directly affects the decisions of all individuals and organizations that earn or raise money and
spend or invest it.

• Therefore, it that deals with how, where, by whom, why, and through what money is
transferred among and between individuals, businesses, and governments.

• It is concerned with the processes, institutions, markets, and instruments involved in the
transfer of funds.

 According to Khan and Jain, “Finance is the art and science of managing money”. This
is b/c it requires individual judgment of the person making the financial decision.
 According to Oxford dictionary, the word „finance‟ connotes „management of money‟.

1.1.2. Areas of Finance

Finance, in general, consists of three interrelated areas:

1) Money and capital markets, which deal with securities markets and financial institutions;

2) Investments, which focus on the decision of investors, both individuals and institutions, as
they choose among securities for their investment portfolios; and

3) Financial management or "business finance" which involves the actual management of

business firms.

1|Page
 NOTE: The career opportunities within each field are many and varied, but managers of finance
must have knowledge of all the three areas if they are to perform their jobs well.

FM is the broadest area in finance and the one with greatest number of job opportunities. The
types of jobs encountered in financial management range from decisions regarding plant
expansion to choosing what types of securities to issue to finance the expansion.

It also involves the responsibility for:

 deciding the credit terms under which customers may buy,

 how much inventory the company should carry,
 how much cash to keep on hand,
 whether to acquire other company (merger analysis), and
 How much of the firms earnings to retain in the business versus payout as
dividends.

1.1.3. Types of Finance

Finance

Private Public
finance Finance

Partnershi Business
Individual Finance
p Finance Finance Central State Semi
governme governme governme
nt nt nt

1.1.4. Finance & related fields

The field of finance is closely related to economics and accounting.

A. Finance versus Economics

 Basic Similarities between Finance and Economics

1. Economics is the mother field of finance.

2|Page
2. The economic environment within which a firm operates influences the decisions of a
financial manager. Hence, a financial manager must:

 Understand the interrelationships between the various sectors of the economy.

 Understand such economic variables as a gross domestic product, unemployment,
inflation, interests, and taxes in making financial decisions.
 Also be able to use the structure of decision-making provided by economics.
 They must use economic theories as guidelines for their efficient financial decision
making.
 Basic Differences between Finance and Economics

1) Finance is less concerned with theory than is economics. Finance is basically concerned with
the application of theories and principles.

2) Finance deals with an individual firm; but economics deals with the industry and the overall
level of the economic activity.

B. Finance versus Accounting

 Similarities between Finance and Accounting

a) Accounting provides financial information through financial statements

i.e., accounting is an important input for financial decision-making.

b) Accounting and finance functions generally overlap;

c) In many situations, the accounting and finance activities are within the control of the financial
manager of a firm.

 Basic Differences between Finance and Accounting

i. Treatment of income: In accounting income measurement is on accrual basis. In finance, the

cash method is employed to recognize the revenue and expenses.

ii. Decision-making: The primary function of accounting is to gather and present financial data.
Finance is primarily concerned with financial planning, controlling and decision-making.The
financial manager evaluates the financial statements provided by the accountant by applying
additional data and then makes decisions accordingly.

iii. Accounting is highly governed by GAAP or IFRS.

3|Page
 1.2. Definition of financial management

It is concerned with the duties of the financial managers in the business firm. The most popular
and acceptable definition of Financial Management is it deals with procurement of funds and
their effective utilization in the business. Financial management can also be defined as a decision
making process concerned with planning for raising and utilizing funds in a manner that achieves
the goal of a firm. Financial management is a specified business function or dep‟t that deals with
the management of capital sources and uses of a firm.

We study financial management under the assumptions of capital markets, in the context of
corporate form of business organizations and under the guidance of the basic principles that form
the financial management.

A. Existence of well-developed capital markets; The interaction in a well-developed capital

market exists between the corporation and financial markets in the following manner.

1. Initially, the corporation raises capital in the financial markets by selling securitiesstocks and
bonds.

2. Secondly, the corporation then invests this in return generating assets- new project.

3. Thirdly, the cash flow from those assets is either reinvested in the corporation, given back to
the investors, paid to government in the form of taxes.

B. The context of corporate form of business organizations; financial management is studied

in the context of a corporate form of business organization and its decisions due to the
characteristics and advantages of a corporation.

C. Basic principles that form the basis for financial management

1. The risk –return trade-off 8. Taxes bias business decision

2. The time value of money 9. All risks are not equal

3. Cash- Not profits- is a king 10. Ethical behavior; ethical dilemmas

4. Incremental cash flows

5. The curse of competitive markets

6. Efficient capital markets

7. The Agency problem

1.2.1. Key Activities of the Financial Manager

The primary activities of the financial managers are:

4|Page
1. Performing Financial Analysis:

2. Performing Financial Forecasting:

3. Making Investment Decisions: include credit management, inventory control, cash

management, capital budgeting and other investment activities of a firm.

4. Making Financing Decision: include any activities associated with procurement or acquisition
of funds. Examples include borrowing decisions, decisions to issue shares of common stock and
preferred stock, bonds, and other securities.

1.2.2. Importance of Financial Management

Finance is the lifeblood of business organization The business goal can be achieved only with
the help of effective management of finance. Some of the importance of the financial
management is as follows:

1) Financial Planning:

2) Acquisition of Funds:

3) Proper Use of Funds:

4) Financial Decision:

5) Improve Profitability:

6) Increase the Value of the Firm:

7) Promoting savings:

1.2.3. Approaches to Financial Management

Financial management approach measures the scope of the financial management. Theoretical
points of view, financial management approach may be broadly divided into two major parts.

1) Traditional Approach - /financial management/

It is the initial stage of financial management, which was followed, in the early part of during
the year 1920 to 1950. It is based on the past experience and the traditionally accepted methods.
Its main part is rising of funds for the business concern. It consists of the following important
area

a) Arrangement of funds from lending body.

b) Arrangement of funds through various financial instruments.

5|Page
 c) Finding out the various sources of funds.

2) Modern Approach

It views financial management in a broad sense. Corporate finance is defined much more broadly
to include any business decisions made by a firm that affect its finance. Accordingly, financial
management provides a conceptual and analytical framework for the three major financial
decision making functions of a firm. Accordingly, the scope of managerial finance involves the
solution to investing, financing, and dividend policy problems of a firm.

1.2.4. Functions of financial management

This refers to the special activities or purposes of financial management. The functions of
financial management include three major decisions a firm must make. These are:

A) Investment Decisions: They deal with allocation of the firm‟s scarce financial resources
among competing uses.

Specifically, the investment decisions include:

i. Determining the asset mix or composition

ii. Determining the asset type

iii. Managing the asset structure

The investment decisions of a firm also involve working capital management and capital
budgeting decisions. the investment decisions of a firm deal with the left side of the basic
accounting equation: A = L + OE

B) Financing Decisions:

They deal with the financing of the firm‟s investments, i.e. decisions whether the firm should use
equity or debt funds in order to finance its assets. They are also concerned with determining the
most appropriate composition of short – term and long – term financing. They deal with
determining the best financing mix or capital structure of the firm. The financing decisions of a
firm are generally concerned with the right side of the basic accounting equation i.e., A = L + OE

C) Dividend Decisions:

They address the question how much of the cash a firm generates from operations should be
distributed to owners in the form of dividends and how much should be retained by the business
for further expansion. there are tradeoffs on the dividend policy of a firm. On the one hand,
paying out more dividends will make the firm to be perceived strong and healthy by investors; on
the other hand, it will affect the future growth of the firm. So the dividend decision of a firm
should be analyzed in relation to its financing decisions.2.

6|Page
1.2.5 Objectives of financial management

Objectives of Financial Management may be broadly divided into two parts such as:

1. Profit maximization 2. Wealth maximization

1. Profit Maximization

A business concern is also functioning mainly for the purpose of earning profit. Profit
maximization is also the traditional and narrow approach, which aims at, maximizes the profit of
the concern.

 Profit maximization consists of the following important features.

i. It leads to maximize the business operation for profit maximization.

ii. It considers all the possible ways to increase the profitability of the concern.

iii. Profit is the parameter of measuring the efficiency of the business concern. So it shows the
entire position of the business concern.

iv. Profit maximization objectives help to reduce the risk of the business.

 Limitations of profit maximization

1. Vague:

i. The term “profit” is vague and it does not clarify what exactly it means. It has different
interpretations for different people. Does it mean short-term or long-term; total profit or net
profit; profit before tax or profit after tax; return on capital employed.

ii. Profit maximisation is taken as objective, the question arises which of the about concepts of
profit should an enterprise try the standard of efficiency of financial management.

2. Ignores Time Value of Money:

i. Time value of money refers a money receivable today is more valuable Than money, which is
going to be receivable in future period.

ii. The profit maximization goal does not help in distinguishing between the returns receivable in
different periods.

iii. It gives equal importance to all earnings through the receivable in different periods. Hence, it
ignores time value of money.

3. Ignores Quality of Benefits:

7|Page
i. Quality refers to the degree of certainty with which benefits can be expected.

ii. The more certain expected benefits, the higher are the quality of the benefits and vice versa.

iii. Two firms may have same expected earnings available to shareholders, but if the earnings of
one firm show variations considerably when compared to the other firm, it will be more risky.

Profit maximization objective leads to exploiting employees and consumers. It also leads to
colossal /vast inequalities and lowers human values that are an essential part of ideal social
systems. It assumes perfect competition and in the existence of imperfect competition, it cannot
be a legitimate/lawful/legal objective of any firm. It is suitable for self-financing, private
property and single ownership firms.

A company is financed by shareholders, creditors and financial institutions and managed and
controlled by professional managers. A part from these people, there are some others who are
interested towards company (i.e., employees, government, customers and society).Hence one has
to take into consideration all these parties interests, which is not possible under the objective of
profit maximization. Wealth maximization objective is the alternative of profit maximization.

2. Wealth Maximization

it is also known as value maximization or net present worth maximization. this objective is a
universally accepted concept in the field of business.There are two ways in which the wealth of
shareholders changes.These are:

a) Through changing dividend payments, and

b) Through the change in the market price of common shares

Hence, the change in shareholders' wealth, or change in the value of business firms, may be
calculated as follows:

1. Multiply the dividend per share paid during the period by the number of shares owned.

2. Multiply the change in shares price during the period by the number of shares owned.

3. Add the dividends and the change in the market value of shares, computed in step 1
and 2 above, to obtain the change in the shareholders „wealth during the period.

In order to maximize the wealth of shareholders, a business firm must seek to provide the larges
attainable combination of dividends per share and stock price appreciation.

1.2.6 Agency problem

Managers are agents in a corporation to maximize the common stockholders‟ well-being.Agency

problems are the likelihood that mangers may place their personal goals a head of corporate

8|Page
goals. Managers are interested to maximize their personal wealth, job security, life style and
fringe benefits. Theoretically, agency problems are always there as long as mangers are agents of
owners.

Agency costs include:

1) Monitoring expenditures

Are expenditures incurred by corporations to monitor or control the activities of managers. A

very good example of a monitoring expenditure is fees paid by corporations to external auditors.

2) Bonding expenditures –

Are cost incurred to protect dishonesty of mangers and other employees of a firm. Example:
fidelity guarantee insurance premium.

3) Structuring expenditures

Expenditures made to make managers fell sense of ownership to the corporation. These include
stock options, performance shares, cash bonus etc.

4) Opportunity costs –

Other ways include: making know managers that they would be fired if they do not act to
maximize shareholders wealth, the corporation could be overtaken by others if its value is very
much lower than other firms.

1.3 Financial security, financial institution and financial market

Financial security; The variety of financial securities is limited only by human creativity,
ingenuity, and governmental regulations. At the risk of oversimplification, we can classify most
financial securities by the type of claim and the time until maturity. In addition, some securities
actually are created from packages of other securities. We discuss the key aspects of financial
securities in this section.

Financial securities are simply pieces of paper with contractual provisions that entitle their
owners to specific rights and claims on specific cash flows or values. Debt instruments typically
have specified payments and a specified maturity. The debt matures in less than a year; it is a
money market security. Equity instruments are a claim upon a residual value. In contrast,
derivatives are securities whose values depend on, or are derived from, the values of some other
traded assets.

Financial institution

When raising capital, direct transfers of funds from individuals to businesses are most common
for small businesses or in economies where financial markets and institutions are not well

9|Page
developed. Businesses in developed economies usually find it more efficient to enlist the services
of one or more financial institutions to raise capital. Most financial institutions don‟t compete in
a single line of business but instead provide a wide variety of services and products, both
domestically and globally. The following sections describe the major types of financial
institutions and services

Business organizations are categorized into financial and non-financial business organizations.
Financial business organizations are grouped into depositary institutions (commercial banks,
savings and loan associations, savings banks and credit unions) and non-depository financial
institutions (insurance companies, investment companies and pension funds). Depository
financial institutions derive the bulk of their loanable funds from deposit accounts sold to the
public. While non- depository institutions attract funds by offering legal contracts to protect the
saver against risk (e.g. Insurance companies and pension funds) or sell shares to the public and
invest the proceeds in stocks, bonds, and other securities ( e.g. Investment companies).

Financial Assets

Assets-tangible or intangible tangible- do physically produce goods and services Intangible

assets- don‟t physically produce goods & services but entitle the owner a right for a future cash
flow . Financial Assets fall under intangible assets

Types of Financial Assets: Based on the nature of the cash flow, they can be classified into:

1. Debt Instruments eg bond, saving pass book, CDs (time deposit) etc

2. Equity Instrument eg C/stock

3. Hybrid instrument eg P/stock

4. Derivative instruments eg. Options contract, forward/future contract

1.3 The role and classification of financial market

Financial Markets are a market where financial assets are traded

Financial markets bring together people and organizations needing money with those having
surplus funds.

Role of Financial Markets

a) Transfer of funds

b) Redistribution of risk

c) The price discovery process

10 | P a g e
The interactions of buyers and sellers in a financial market determine the price of the traded
asset. This is called the price discovery process.

d) Liquidity Function • financial market offers liquidity.

• In the absence of financial markets, the owner would be forced to hold a debt instrument until
it matures and an equity instrument until the company is either voluntarily or involuntarily
liquidated.

e) Reducing the cost of transacting

The two costs associated with transacting are search costs and information processing costs.
Search costs represent explicit costs, such as the money spent to advertise one‟s intention to sell
or purchase a financial asset, and implicit costs, such as the value of time spent in locating
counterparty. The presence of some form of organized financial market reduces search costs.
Information costs are associated with assessing the investment merits of a financial asset, that is,
the amount and likelihood of the cash flow expected to be generated from a financial asset.

Classification of financial Markets

There are many different financial markets in a developed economy. Each market deals with a
somewhat different type of instrument, customer, or geographic location. Here are some ways to
classify markets:

1. By type (nature) of financial claim Based on this, financial markets are classified as:

i) Debt market- Debt instruments. Eg. Bond

ii) Equity Market eg stocks

2. By maturity of financial claim Based on this factor, financial markets are classified as:

i) Money market- are the markets for short-term, highly liquid debt securities,. eg Treasury bills,
CDs and

ii) Capital market- are the markets for corporate stocks and debt maturing more than a year in the
future. Long-term financial instruments. Eg. stocks, bonds

3. By seasoning of financial claim

i. Primary market- are the markets in which corporations raise new capital. If Microsoft were to
sell a new issue of common stock to raise capital, this would be a primary market transaction.
The corporation selling the newly created stock receives the proceeds from such a transaction.
The initial public offering (IPO) market is a subset of the primary market.

11 | P a g e
ii. Secondary market - are markets in which existing, already out-standing securities are traded
among investor. Previously issued securities

4. By immediate delivery or future delivery Based on this classification, financial markets could
be:

i) Cash or spot market -immediate and

ii) Derivative market-future delivery

1.4. Forms of Business organization

-proprietorship

12 | P a g e