Financial Management

Ratika ChawlaAsst ProfessorKCMT,Bareilly

Definitions

• “Financial management is concerned with the managerial decisions that result in the acquisition and financing of short term and long term credits for the firm”

• “Financial Management deals with procurement of funds and their effective utilization in the business”

In simple words,• Financial Management is the study of all those tools and

techniques which are used for the procurement and investment of funds.

• It also undertakes the ways of disposal of profits.

Financial Management involves two broad aspects:

Procurement of funds:

Identification of sources of Finance Determination of Finance Mix Raising of funds b) Effective Utilization of Funds: . To decide about where to invest the funds in a most effective way.

Scope of Financial Management It can be divided under two approaches:

Traditional approach:

Under this approach the role of finance manager was restricted to only procurement of funds & it includes:

Study & analysis of the institution and other sources of finance which can be used for raising funds

Study and analysis of financial instruments which can be used for raising funds

Analysis of legal and accounting relationship between the business organization and its sources of funds

Limitations of Traditional Approach Limited Scope It ignored working capital financing It ignored routine problems Limited use for only corporate enterprise.

Modern Approach

Modern approach enlarged the scope of financialmanagement & it covers:

What is the total volume of funds an enterprise should invest in?

What specific assets should an enterprise acquire? In what form should the firm hold its assets?

Modern Approach encompasses three major decisions of financial management:

Investment decisions

Financing decisions

Dividend Policy decisions

Functions of Finance Manager

Formulation of Financial objectives

Forecasting and estimating capital requirement

Designing the capital structure

Determining the suitable source of finance

Procurement of funds

Investment of funds

Disposal of profits

Maintaining the proper liquidity

Maintaining relations with outside agencies

Evaluating financial performance

Keeping touch with stock exchange quotations and behavior of share price

Tools & Techniques of Financial Management

Capital budgeting techniques Cost of capital Leverage Cash Management Receivables Management Inventory Management

OBJECTIVE OF FINANCIAL MGMT.

Wealth maximization of Shareholders talks about the value of the company generally expressed in terms of the value of the shares .

Profit Maximization - refers to how much rupee profit the company makes.

Although Profit maximization was the traditional concept, all firms now look at maximizing wealth for their shareholders

Profit Maximization This implies that the finance manager has to make his decisions in manner so that the profits of the concern are maximized.

The operational efficiency of the firm is assessed from the amount of return it generates on the capital employed by it.

Therefore it is very necessary for a firm to direct all its decisions towards the goal of profit maximization.

This can be achieved by increasing sales turnover and minimizing the manufacturing and financial cost

Profit Maximization The process by which a firm determines the price and output levels that

give the maximum profits. It suffers from the following limitations:

Concept of Profit is not clear (It could mean PAT, PBT, EBIT , etc.) Profit in absolute terms cannot be used as an effective tool for

decision making , it has to be expressed in terms of EPS or with respect to investments made

It does not consider the risk factor. It has a short-term focus It ignores the magnitude and the timing of earnings. (Time Value of

Money)

Wealth Maximization Wealth maximization means maximizing the wealth of the shareholders in terms of market value of the share and value of the firm. This involves increasing the Earning per share of the shareholders.

Wealth maximization is regarded as operationally and managerially the better objective because:

Time value of money

The risk or uncertainty of future earning

Effect of dividend policy on the market price of the share

Steps for achieving the objective of wealth maximization

The objectives of financial management are such that they should be beneficial to owners, management, employees & customers. These objectives can be accomplished only by maximizing the Value of the

firm through the following ways:

Increase in profits Reduction in cost Sources of funds Minimize risk Long run value Good track record of dividend payment

“Wealth Maximization is superior criteria than profit maximization”

Profit Maximization Vs Wealth Maximization

Profit Maximization Wealth Maximization

It does take into account time value of money.

It takes into account time value of money

It does not take into consideration the uncertainty of future earnings

It takes into account the risk factor

It does not consider the effect of dividend policy on market price of shares

It takes into account the effect of dividend policy on Market Price of shares.

It does not differentiate between the short term and long term profits

It considers the different strategies for long term and short term profits.

Risk & Return Analysis “ Higher the risk, Higher the gain”

1. RETURN -

Return denotes the benefits which accrue on the investments made by the firm.

There are different approaches to measure the return namely:

Profit approach Income approach Cash flow approach Ratios approach

Risk

“Risk may be defined as the variation of actual outcome from the expected outcome”

Risk = Actual Return – Expected Return

Types of Risk:(1) Systematic Risk: It is also called non diversifiable and

uncontrollable risk. It Includes : Market risk Interest rate risk Purchasing power risk

2. Unsystematic Risk : It is also called diversifiable and controllable risk which effects a particular firm or business. It includes:

(1) Business Risk

(2) Financial Risk

Relationship between Risk and Return Return is directly proportional to the amount of the risk taken

by the firm.

Higher the risk, larger the return of the firm. The relationship between the return and the risk can be explained with the help of following equation:

Rate of return= risk free return+ premium for

risk taking

Importance of time value of money The concept of time value of money helps in arriving at the

comparable values of the different rupee amount arising at different point of time into equivalent values of a particular point of time.

The cash flows arising at different periods of time can be made comparable by using any one of the following two ways:

(1) By compounding the present money to a future date i.e. by finding out the value of the present money.

(2) By discounting the future money to present date i.e. by finding out present value (PV)of future money

Reasons for the time preference of money

Risk factor There is uncertainty about the receipt of money in

future. Preference for present consumption. Investment Opportunities.