•Financial ManagementFinancial Management

•An IntroductionAn Introduction

FINANCEFINANCE

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

started nor successfully run . Finance is started nor successfully run . Finance is needed to promote or establish business, needed to promote or establish business, acquire fixed assets, make necessary acquire fixed assets, make necessary investigations, develop product keep man investigations, develop product keep man and machines at work ,encourage and machines at work ,encourage management to make progress and create management to make progress and create values. values.

FINANCIAL MANAGEMENTFINANCIAL MANAGEMENT

Financial management is one the functional Financial management is one the functional area of management. It refer to that part of area of management. It refer to that part of the management activity which is the management activity which is concerned with the planning and controlling concerned with the planning and controlling of firms financial resources.of firms financial resources.

DEFINITIONDEFINITION

““Financial management is the application of Financial management is the application of planning and control function of the finance planning and control function of the finance function” function”

Howard and UptonHoward and Upton

NATURE AND SCOPE OF NATURE AND SCOPE OF FINANCIAL MANAGEMENTFINANCIAL MANAGEMENT

The nature of financial decisions would be The nature of financial decisions would be clear when we try to understand the clear when we try to understand the operation of a firm. At the very outset, the operation of a firm. At the very outset, the promoters makes an appraisal of various promoters makes an appraisal of various investment proposals and selects one or investment proposals and selects one or more of them ,depending upon the net more of them ,depending upon the net benefits derived from each as well as on the benefits derived from each as well as on the availability of funds. availability of funds.

PROCESS INVOLVE IN PROCESS INVOLVE IN FINANCIAL DECISIONFINANCIAL DECISION

1. Selection of investment proposals ,known as the 1. Selection of investment proposals ,known as the investment decision.investment decision.

2. Determination of working capital 2. Determination of working capital requirements, known as the working requirements, known as the working capital capital

decision.decision.

3. Raising of funds to finance the assets, 3. Raising of funds to finance the assets, known known as the financing decision.as the financing decision.

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

•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 information Finance uses accounting information

together with other information to make together with other information to make decisions that affect the market value of the decisions that affect the market value of the firm.firm.

• There are There are threethree primary decision areas that primary decision areas that are of concern.are of concern.

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

Investment decisions - What assets should the Investment decisions - What assets should the company hold? This determines the left-hand side company hold? This determines the left-hand side of the balance sheet. these decision are concerned of the balance sheet. these decision are concerned with the effective utilization of funds in one with the effective utilization of funds in one activity or the other. The investment decision can activity or the other. The investment decision can be classified under two groups-be 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 budgeting The former are referred to as the capital budgeting

and the latter as the capital budgeting and the and the latter as the capital budgeting and the latter as working capital management. latter as working capital management.

Financing decisionFinancing decisionFinancing decisions - How should the company Financing decisions - How should the company pay for the investments it makes? This determines pay for the investments it makes? This determines the right-hand side of the balance sheet. it is also the right-hand side of the balance sheet. it is also known as capital structure decision. It involves the known as capital structure decision. It involves the choosing the best source of raising funds and choosing the best source of raising funds and deciding optimal mix of various source of finance.deciding optimal mix of various source of finance.

A company can not depend upon only one source A company can not depend upon only one source of finance ,hence a varied financial structure is of finance ,hence a varied financial structure is developed. but before using any particular source developed. but before using any particular source of capital ,its relative cost of capital ,degree of risk of capital ,its relative cost of capital ,degree of risk and control etc should be thoroughly examined by and control etc should be thoroughly examined by the financial manager. the major source of long-the financial manager. the major source of long-term capital as shares and debentures. term capital as shares and debentures.

DIVIDEND DECISION DIVIDEND DECISION

Dividend decisions - What should be done Dividend decisions - What should be done with the profits of the business? The with the profits of the business? The dividend decision is concerned with dividend decision is concerned with determining how much part of the earning determining how much part of the earning should be distributed among the share should be distributed among the share holders by way of dividend and how much holders by way of dividend and how much should be retained in the business for should be retained in the business for meeting the future needs of funds internally.meeting the future needs of funds internally.

Factors influencing financial Factors influencing financial decision decision

These factors are divided into two parts-These factors are divided into two parts-1.Micro economic factor1.Micro economic factor2.Macro economic factor2.Macro economic factorMicro economic factor- micro economic factor is Micro economic factor- micro economic factor is related to the internal condition of the firm-related 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

Macro economic factor Macro economic factor

These are the Environmental factor-These are the Environmental factor-

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

2. Governmental policy 2. Governmental policy

•All management decisions All management decisions should help to accomplish the should 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?

Objectives of financial managementObjectives of financial management

The objective of financial management The objective of financial management are considered usually at two levels –at are considered usually at two levels –at macro level and micro level. three primary macro level and micro level. three primary objectives are commonly explained as the objectives are commonly explained as the Objective of financial management-Objective of financial management-

1.1. Maximization of profitsMaximization of profits

2.2. Maximization of returnMaximization of return

3.3. Maximization of wealth Maximization of wealth

Maximization of profitsMaximization of profits

Profit earning is the main aim of every Profit earning is the main aim of every economic activity. Profit maximization economic activity. Profit maximization simply means maximizing the income of simply means maximizing the income of the firm . Economist are of the view that the firm . Economist are of the view that profits can be maximized when the profits can be maximized when the difference of total revenue over total cost is difference of total revenue over total cost is maximum, or in other words total revenue maximum, or in other words total revenue is greater than the total cost. is greater than the total cost.

Maximization of returnMaximization of return

Some authorities on financial management Some authorities on financial management conclude that maximization of return conclude that maximization of return provide a basic guideline by which financial provide a basic guideline by which financial decision should be evaluated . decision should be evaluated .

Maximization of wealthMaximization of wealth

According to prof solomon ezra of stand ford According to prof solomon ezra of stand ford university , the ultimate goal of financial university , the ultimate goal of financial management should be the maximization of the management should be the maximization of the owners wealth. The value of corporate wealth may owners wealth. The value of corporate wealth may be interpreted in terms of the value of the be interpreted in terms of the value of the company’s total assets. The finance should company’s total assets. The finance should attempt to maximize the value of the enterprise to attempt to maximize the value of the enterprise to its shareholders. Value is represented by the its shareholders. Value is represented by the market price of the company’s common stock.market price of the company’s common stock.

•What about risk? Isn’t risk What about risk? Isn’t risk important as well as profits?important as well as profits?

• How would the stockholders of a small How would the stockholders of a small business react if they were told that their business react if they were told that their manager canceled all casualty and liability manager canceled all casualty and liability insurance policies so that the money spent insurance policies so that the money spent on premiums could go to profit instead.on premiums could go to profit instead.

• Even though the Even though the expected expected profits increased profits increased by this action, it is likely that stockholders by this action, it is likely that stockholders would be dissatisfied because of the would be dissatisfied because of the increased risk they would bear.increased risk they would bear.

•The common stockholders are The common stockholders are the owners of the corporation!the owners of the corporation!

• Stockholders elect a board of directors who Stockholders elect a board of directors who in turn hire managers to maximize the in turn hire managers to maximize the stockholdersstockholders’’ well being. well being.

• When stockholders perceive that When stockholders perceive that management is not doing this, they might management is not doing this, they might attempt to remove and replace the attempt to remove and replace the management, but this can be very difficult management, but this can be very difficult in a large corporation with many in a large corporation with many stockholders.stockholders.

•More likely, when stockholders More likely, when stockholders are dissatisfied they will simply are dissatisfied they will simply

sell their stock shares.sell their stock shares.

•This action by stockholders will This action by stockholders will cause the market price of the cause the market price of the

company’s stock to fall.company’s stock to fall.

•When stock price falls relative When stock price falls relative to the rest of the market (or to the rest of the market (or

relative to the rest of the relative to the rest of the industry) ...industry) ...

•Management is failing in their job to Management is failing in their job to increase the welfare (or wealth) of the increase the welfare (or wealth) of the

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

•Conversely, when stock price is Conversely, when stock price is rising relative to the rest of the rising relative to the rest of the

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

•Management is accomplishing their Management is accomplishing their goal of increasing the welfare (or goal of increasing the welfare (or wealth) of the stockholders (the wealth) of the stockholders (the

owners).owners).

•The goal of the firm should be to The goal of the firm should be to maximize the maximize the stock pricestock price!!

• This is equivalent to saying the goal is to This is equivalent to saying the goal is to maximize maximize owners’ wealthowners’ wealth..

• Note that the stock price is affected by Note that the stock price is affected by management’s decisions affecting management’s decisions affecting bothboth risk risk and profit.and profit.

• Stock price can be maintained or increased Stock price can be maintained or increased only when stockholders perceive that they only when stockholders perceive that they are receiving profits that fully compensate are receiving profits that fully compensate them for bearing the risk they perceive.them for bearing the risk they perceive.

•Important focal points in the Important focal points in the study of finance:study of finance:

• Accounting and Finance often focus on Accounting and Finance often focus on different things different things

• Finance is more focused on Finance is more focused on market valuesmarket values rather than book values.rather than book values.

• Finance is more focused on Finance is more focused on cash flowscash flows rather than accounting income.rather than accounting income.

•Why is market value more Why is market value more important than book value?important than book value?

• Book values are often based on dated Book values are often based on dated values. They consist of the original cost of values. They consist of the original cost of the asset from some past time, minus the asset from some past time, minus accumulated depreciation (which may not accumulated depreciation (which may not represent the actual decline in the assets’ represent the actual decline in the assets’ value).value).

• Maximization of market value of the Maximization of market value of the stockholders’ shares is the goal of the firm.stockholders’ shares is the goal of the firm.

Why is cash flow more important Why is cash flow more important than accounting income?than accounting income?

• Cash flow to stockholders (in the form of Cash flow to stockholders (in the form of dividends) is the only basis for valuation of dividends) is the only basis for valuation of the common stock shares. Since the goal is the common stock shares. Since the goal is to maximize stock price, cash flow is more to maximize stock price, cash flow is more directly related than accounting income. directly related than accounting income.

• Accounting methods recognize income at Accounting methods recognize income at times other than when cash is actually times other than when cash is actually received or spent.received or spent.

•One more reason that cash flow One 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 be because it determines when cash can be invested to earn a return.invested to earn a return.

[Also: [Also: WhenWhen cash must be paid determines cash must be paid determines when we need to start paying interest on when we need to start paying interest on money borrowed.]money borrowed.]

•Examples of when accounting Examples of when accounting income is different from cash income is different from cash

flow:flow:• Credit sales are recognized as accounting Credit sales are recognized as accounting

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

accounting expense when calculating accounting expense when calculating income, yet depreciation expense is not a income, yet depreciation expense is not a cash outlay.cash outlay.

• A loan brings cash into a business, but is A loan brings cash into a business, but is not income.not income.

•More examples:More examples:

• When new capital equipment is purchased, When new capital equipment is purchased, the entire cost is a cash outflow, but only the entire cost is a cash outflow, but only the depreciation expense (a portion of the the depreciation expense (a portion of the total cost) is an expense when computing total 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 the though dividends are not included in the calculation of accounting income.calculation of accounting income.

•Definitions: Operating income vs. Definitions: Operating income vs. operating cash flowoperating cash flow

• Operating income = earnings before interest Operating income = earnings before interest and taxes (EBIT). This is the total income and taxes (EBIT). This is the total income that the company earned by operating that the company earned by operating during the period. It is income available to during the period. It is income available to pay interest to creditors, taxes to the pay interest to creditors, taxes to the government, and dividends to stockholders.government, and dividends to stockholders.

•Operating cash flow:Operating cash flow:

• Operating cash flow Operating cash flow = EBIT + Depreciation - Taxes. = EBIT + Depreciation - Taxes. This definition recognizes that depreciation This 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 cash It also recognizes that taxes paid is a cash outlay.outlay.