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Financial ManagementFinancial Management

An IntroductionAn Introduction

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FINANCEFINANCE

Finance is the lifeFinance is the life--blood of business.blood of business.Without finance neither any business can beWithout finance neither any business can be

started nor successfully run . Finance isstarted nor successfully run . Finance isneeded to promote or establish business,needed to promote or establish business,acquire fixed assets, make necessaryacquire fixed assets, make necessaryinvestigations, develop product keep maninvestigations, develop product keep man

and machines at work ,encourageand machines at work ,encouragemanagement to make progress and createmanagement to make progress and createvalues.values.

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FINANCIAL MANAGEMENTFINANCIAL MANAGEMENT

Financial management is one the functionalFinancial management is one the functional

area of management. It refer to that part ofarea of management. It refer to that part of

the management activity which is concernedthe management activity which is concernedwith the planning and controlling of firmswith the planning and controlling of firms

financial resources.financial resources.

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DEFINITIONDEFINITION

Financial management is the application ofFinancial management is the application of

planning and control function of the financeplanning and control function of the finance

functionfunctionHoward and UptonHoward and Upton

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NATURE AND SCOPE OFNATURE AND SCOPE OF

FINANCIAL MANAGEMENTFINANCIAL MANAGEMENTThe nature of financial decisions would beThe nature of financial decisions would be

clear when we try to understand theclear when we try to understand the

operation of a firm. At the very outset, theoperation of a firm. At the very outset, thepromoters makes an appraisal of variouspromoters makes an appraisal of various

investment proposals and selects one orinvestment proposals and selects one or

more of them ,depending upon the netmore of them ,depending upon the net

benefits derived from each as well as on thebenefits derived from each as well as on theavailability of funds.availability of funds.

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PROCESS INVOLVE INPROCESS INVOLVE IN

FINANCIALD

ECISIONFINANCIALD

ECISION1. Selection of investment proposals ,known as the1. Selection of investment proposals ,known as the

investment decision.investment decision.

2. Determination of working capital2. Determination of working capital

requirements, known as the workingrequirements, known as the working capitalcapital

decision.decision.

3. Raising of funds to finance the assets,3. Raising of funds to finance the assets, knownknown

as the financing decision.as the financing decision.4. Allocation of profit for dividend4. Allocation of profit for dividend payment,payment,

known as the dividend decision.known as the dividend decision.

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What is Finance Anyway?What is Finance Anyway?

What is this course all about?What is this course all about?

Accounting is the language of business.Accounting is the language of business.

Finance uses accounting informationFinance uses accounting informationtogether with other information to maketogether with other information to make

decisions that affect the market value of thedecisions that affect the market value of the

firm.firm.

There areThere are threethreeprimary decision areas thatprimary decision areas that

are of concern.are of concern.

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Three decision areas in finance:Three decision areas in finance:

Investment decisionsInvestment decisions -- What assets should theWhat assets should thecompany hold? This determines the leftcompany hold? This determines the left--hand sidehand sideof the balance sheet. these decision are concernedof the balance sheet. these decision are concernedwith the effective utilization of funds in onewith the effective utilization of funds in oneactivity or the other. The investment decision canactivity or the other. The investment decision canbe classified under two groupsbe classified under two groups--

(i) Long term investment decision(i) Long term investment decision

(ii) Short term investment decision(ii) Short term investment decision

The former are referred to as the capital budgetingThe former are referred to as the capital budgetingand the latter as the capital budgeting and the latterand the latter as the capital budgeting and the latteras working capital management.as working capital management.

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Financing decisionFinancing decisionFinancing decisionsFinancing decisions -- How should the companyHow should the companypay for the investments it makes? This determinespay for the investments it makes? This determinesthe rightthe right--hand side of the balance sheet. it is alsohand side of the balance sheet. it is alsoknown as capital structure decision. It involves theknown as capital structure decision. It involves thechoosing the best source of raising funds andchoosing the best source of raising funds anddeciding optimal mix of various source of finance.deciding optimal mix of various source of finance.

A company can not depend upon only one sourceA company can not depend upon only one sourceof finance ,hence a varied financial structure isof finance ,hence a varied financial structure isdeveloped. but before using any particular sourcedeveloped. but before using any particular source

of capital ,its relative cost of capital ,degree of riskof capital ,its relative cost of capital ,degree of riskand control etc should be thoroughly examined byand control etc should be thoroughly examined bythe financial manager. the major source of longthe financial manager. the major source of long--term capital as shares and debentures.term capital as shares and debentures.

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DIVIDENDDECISIONDIVIDENDDECISION

Dividend decisionsDividend decisions -- What should be doneWhat should be done

with the profits of the business? Thewith the profits of the business? The

dividend decision is concerned withdividend decision is concerned withdetermining how much part of the earningdetermining how much part of the earning

should be distributed among the shareshould be distributed among the share

holders by way of dividend and how muchholders by way of dividend and how much

should be retained in the business forshould be retained in the business formeeting the future needs of funds internally.meeting the future needs of funds internally.

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Factors influencing financialFactors influencing financial

decisiondecisionThese factors are divided into two partsThese factors are divided into two parts--

1.Micro economic factor1.Micro economic factor

2.Macro economic factor2.Macro economic factor

Micro economic factorMicro economic factor-- micro economic factor ismicro economic factor isrelated to the internal condition of the firmrelated to the internal condition of the firm--

(a) Nature and size of the firm(a) Nature and size of the firm

(b) Level of risk and stability in earnings(b) Level of risk and stability in earnings

(c) Liquidity position(c) Liquidity position(d) Asset structure and pattern of ownership(d) Asset structure and pattern of ownership

(e) Attitude of the management(e) Attitude of the management

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Macro economic factorMacro economic factor

These are the Environmental factorThese are the Environmental factor--

1. The state of the economy1. The state of the economy

2. Governmental policy2. Governmental policy

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All management decisionsAll management decisions

should help to accomplish theshould help to accomplish the

goal of the firm!goal of the firm!

What should be the goal of the firm?What should be the goal of the firm?

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Objectives of financial managementObjectives of financial management

The objective of financial management areThe objective of financial management are

considered usually at two levelsconsidered usually at two levels at macroat macro

level and micro level. three primarylevel and micro level. three primaryobjectives are commonly explained as theobjectives are commonly explained as the

Objective of financial managementObjective of financial management--

1.1. Maximization of profitsMaximization of profits

2.2. Maximization of returnMaximization of return

3.3. Maximization of wealthMaximization of wealth

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Maximization of profitsMaximization of profits

Profit earning is the main aim of everyProfit earning is the main aim of every

economic activity. Profit maximizationeconomic activity. Profit maximization

simply means maximizing the income of thesimply means maximizing the income of thefirm . Economist are of the view that profitsfirm . Economist are of the view that profits

can be maximized when the difference ofcan be maximized when the difference of

total revenue over total cost is maximum, ortotal revenue over total cost is maximum, or

in other words total revenue is greater thanin other words total revenue is greater thanthe total cost.the total cost.

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Maximization of returnMaximization of return

Some authorities on financial managementSome authorities on financial management

conclude that maximization of returnconclude that maximization of return

provide a basic guideline by which financialprovide a basic guideline by which financialdecision should be evaluated .decision should be evaluated .

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Maximization of wealthMaximization of wealth

According to prof solomon ezra of stand fordAccording to prof solomon ezra of stand ford

university , the ultimate goal of financialuniversity , the ultimate goal of financial

management should be the maximization of themanagement should be the maximization of the

owners wealth. The value of corporate wealth mayowners wealth. The value of corporate wealth maybe interpreted in terms of the value of thebe interpreted in terms of the value of the

companys total assets. The finance shouldcompanys total assets. The finance should

attempt to maximize the value of the enterprise toattempt to maximize the value of the enterprise to

its shareholders. Value is represented by theits shareholders. Value is represented by themarket price of the companys common stock.market price of the companys common stock.

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What about risk? Isnt riskWhat about risk? Isnt risk

important as well as profits?important as well as profits? How would the stockholders of a smallHow would the stockholders of a small

business react if they were told that theirbusiness react if they were told that their

manager canceled all casualty and liabilitymanager canceled all casualty and liabilityinsurance policies so that the money spentinsurance policies so that the money spenton premiums could go to profit instead.on premiums could go to profit instead.

Even though theEven though the expectedexpectedprofits increasedprofits increasedby this action, it is likely that stockholdersby this action, it is likely that stockholderswould be dissatisfied because of thewould be dissatisfied because of theincreased risk they would bear.increased risk they would bear.

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The common stockholders areThe common stockholders are

the owners of the corporation!the owners of the corporation! Stockholders elect a board of directors whoStockholders elect a board of directors who

in turn hire managers to maximize thein turn hire managers to maximize the

stockholdersstockholderswell being.well being. When stockholders perceive thatWhen stockholders perceive that

management is not doing this, they mightmanagement is not doing this, they mightattempt to remove and replace theattempt to remove and replace themanagement, but this can be very difficultmanagement, but this can be very difficultin a large corporation with manyin a large corporation with manystockholders.stockholders.

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More likely, when stockholdersMore likely, when stockholders

are dissatisfied they will simplyare dissatisfied they will simply

sell their stock shares.sell their stock shares.

This action by stockholders willThis action by stockholders will

cause the market price of thecause the market price of the

companys stock to fall.companys stock to fall.

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When stock price falls relativeWhen stock price falls relative

to the rest of the market (orto the rest of the market (orrelative to the rest of therelative to the rest of the

industry) ...industry) ...

Management is failing in their job toManagement is failing in their job to

increase the welfare (or wealth) of theincrease the welfare (or wealth) of the

stockholders (the owners).stockholders (the owners).

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Conversely, when stock price isConversely, when stock price is

rising relative to the rest of therising relative to the rest of the

market (or industry), ...market (or industry), ...

Management is accomplishing theirManagement is accomplishing their

goal of increasing the welfare (orgoal of increasing the welfare (or

wealth) of the stockholders (thewealth) of the stockholders (theowners).owners).

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The goal of the firm should be toThe goal of the firm should be to

maximize themaximize the stock pricestock price!! This is equivalent to saying the goal is toThis is equivalent to saying the goal is to

maximizemaximize owners wealthowners wealth..

Note that the stock price is affected byNote that the stock price is affected bymanagements decisions affectingmanagements decisions affecting bothboth riskriskand profit.and profit.

Stock price can be maintained or increasedStock price can be maintained or increasedonly when stockholders perceive that theyonly when stockholders perceive that theyare receiving profits that fully compensateare receiving profits that fully compensatethem for bearing the risk they perceive.them for bearing the risk they perceive.

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Important focal points in theImportant focal points in the

study of finance:study of finance:

Accounting and Finance often focus onAccounting and Finance often focus on

different thingsdifferent things Finance is more focused onFinance is more focused on market valuesmarket values

rather than book values.rather than book values.

Finance is more focused onFinance is more focused on cash flowscash flows

rather than accounting income.rather than accounting income.

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Why is market value moreWhy is market value more

important than book value?important than book value?

Book values are often based on datedBook values are often based on dated

values. They consist of the original cost ofvalues. They consist of the original cost of

the asset from some past time, minusthe asset from some past time, minus

accumulated depreciation (which may notaccumulated depreciation (which may not

represent the actual decline in the assetsrepresent the actual decline in the assets

value).value). Maximization of market value of theMaximization of market value of the

stockholders shares is the goal of the firm.stockholders shares is the goal of the firm.

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Why is cash flow more importantWhy is cash flow more important

than accounting income?than accounting income?

Cash flow to stockholders (in the form ofCash flow to stockholders (in the form of

dividends) is the only basis for valuation ofdividends) is the only basis for valuation ofthe common stock shares. Since the goal isthe common stock shares. Since the goal is

to maximize stock price, cash flow is moreto maximize stock price, cash flow is more

directly related than accounting income.directly related than accounting income. Accounting methods recognize income atAccounting methods recognize income at

times other than when cash is actuallytimes other than when cash is actually

received or spent.received or spent.

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One more reason that cash flowOne more reason that cash flow

is important:is important:

WhenWhen cash is actually received is important,cash is actually received is important,

because it determines when cash can bebecause it determines when cash can be

invested to earn a return.invested to earn a return.

[Also:[Also: WhenWhen cash must be paid determinescash must be paid determines

when we need to start paying interest onwhen we need to start paying interest onmoney borrowed.]money borrowed.]

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Examples of when accountingExamples of when accounting

income is different from cashincome is different from cashflow:flow:

Credit sales are recognized as accountingCredit sales are recognized as accounting

income, yet cash has not been received.income, yet cash has not been received. Depreciation expense is a legitimateDepreciation expense is a legitimate

accounting expense when calculatingaccounting expense when calculating

income, yet depreciation expense is not aincome, yet depreciation expense is not acash outlay.cash outlay.

A loan brings cash into a business, but isA loan brings cash into a business, but isnot income.not income.

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More examples:More examples:

When new capital equipment is purchased,When new capital equipment is purchased,

the entire cost is a cash outflow, but onlythe entire cost is a cash outflow, but only

the depreciation expense (a portion of thethe depreciation expense (a portion of the

total cost) is an expense when computingtotal cost) is an expense when computing

accounting income.accounting income.

When dividends are paid, cash is paid out,When dividends are paid, cash is paid out,

though dividends are not included in thethough dividends are not included in the

calculation of accounting income.calculation of accounting income.

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Definitions: Operating income vs.Definitions: Operating income vs.

operating cash flowoperating cash flow

Operating income = earnings before interestOperating income = earnings before interest

and taxes (EBIT). This is the total incomeand taxes (EBIT). This is the total incomethat the company earned by operatingthat the company earned by operating

during the period. It is income available toduring the period. It is income available to

pay interest to creditors, taxes to thepay interest to creditors, taxes to thegovernment, and dividends to stockholders.government, and dividends to stockholders.

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Operating cash flow:Operating cash flow:

Operating cash flowOperating cash flow

= EBIT + Depreciation= EBIT + Depreciation -- Taxes.Taxes.

This definition recognizes that depreciationThis definition recognizes that depreciation

expense is subtracted in computing EBIT,expense is subtracted in computing EBIT,

though it is not a cash outlay.though it is not a cash outlay.

It also recognizes that taxes paid is a cashIt also recognizes that taxes paid is a cash

outlay.outlay.