A Blog for Management Students- Financial Management

 Financial Management 

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Introduction to Financial Management:- 

Financial management means planning, organising, directing and controlling the financial activities such as procurement and utilisation of funds of the enterprise. 

" Financial management is concerned with the efficient use of an important economic resources Viz., Capital Funds.                                                                                             - Ezra Solamn

Finance is the art & science of managing 'money'. 

Finance is the life blood of Business. 

Financial management is mainly concerned with the proper management of funds.

“Financial management is the activity concerned with planning, raising, controlling and administering of funds used in the business.” – Guthman and Dougal

“Financial management is that area of business management devoted to a judicious use of capital and a careful selection of the source of capital in order to enable a spending unit to move in the direction of reaching the goals.” – J.F. Brandley

“Financial management is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient operations.”- Massie

 

Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and control of financial resources of a concern. The objectives can be-

1. To ensure regular and adequate supply of funds to the concern.

2. To ensure adequate returns to the shareholders which will depend upon the earning capacity, market price of the share, expectations of the shareholders.

3. To ensure optimum funds utilization. Once the funds are procured, they should be utilized in maximum possible way at least cost.

4. To ensure safety on investment, i.e, funds should be invested in safe ventures so that adequate rate of return can be achieved.

5. To plan a sound capital structure-There should be sound and fair composition of capital so that a balance is maintained between debt and equity capital.

Goals of Financial Management:- The firm's investment and financing decisions are unavoidable and continuous. In order to make them rationally, the firm must have a goal.

It is generally agreed in theory that the finanical goal of the firm should be shareholder wealth maximisation  as reflected in the market value of the firm's shares.

(1) Profit Maximisation :- Maximisation of profit is very often considered as the main objective of a business enterprise. The objective of financial management is the same as the objective of a company which is to earn profit.

The shareholder's the owner of the business, invest their funds in the business with the hope of getting higher dividend on their investment. Moreover, the profitability of the business is an indicator of the sound health of the organisation, because it safeguards the economic interests of various social groups which are directly or indirectly connected with the company e.g., shareholders, creditors and employees.  

(2) Wealth Maximisation :-  The wealth maximisation (also known as value maximisation) or Net Present Worth Maximisation) is also universally accepted criterion for financial decision making. The value of an asset should be viewed in terms of benefits it can produce over the cost of capital investment.

The value of a firm is represented by the market price of the company's stock. The market price of a firm's stock represents the assessment of all market participants as to what the value of the particular firm is.

Finance Functions:-

he following explanation will help in understanding each finance function in detail

Investment Decision

One of the most important finance functions is to intelligently allocate capital to long term assets. This activity is also known as capital budgeting. It is important to allocate capital in those long term assets so as to get maximum yield in future. Following are the two aspects of investment decision

1. Evaluation of new investment in terms of profitability
2. Comparison of cut off rate against new investment and prevailing investment.

Since the future is uncertain therefore there are difficulties in calculation of expected return. Along with uncertainty comes the risk factor which has to be taken into consideration. This risk factor plays a very significant role in calculating the expected return of the prospective investment. Therefore while considering investment proposal it is important to take into consideration both expected return and the risk involved.

Investment decision not only involves allocating capital to long term assets but also involves decisions of using funds which are obtained by selling those assets which become less profitable and less productive. Finanacial manager has to take wise decisions to decompose depreciated assets which are not adding value and utilize those funds in securing other beneficial assets. An opportunity cost of capital needs to be calculating while dissolving such assets. The correct cut off rate is calculated by using this opportunity cost of the required rate of return (RRR).

Financial Decision

Financial decision is yet another important function which a financial manger must perform. It is important to make wise decisions about when, where and how should a business acquire funds. Funds can be acquired through many ways and channels. Broadly speaking a correct ratio of an equity and debt has to be maintained. This mix of equity capital and debt is known as a firm’s capital structure.

A firm tends to benefit most when the market value of a company’s share maximizes this not only is a sign of growth for the firm but also maximizes shareholders wealth. On the other hand the use of debt affects the risk and return of a shareholder. It is more risky though it may increase the return on equity funds.

A sound financial structure is said to be one which aims at maximizing shareholders return with minimum risk. In such a scenario the market value of the firm will maximize and hence an optimum capital structure would be achieved. Other than equity and debt there are several other tools which are used in deciding a firm capital structure.

Dividend Decision

Earning profit or a positive return is a common aim of all the businesses. But the key function a financial manger performs in case of profitability is to decide whether to distribute all the profits to the shareholder or retain all the profits or distribute part of the profits to the shareholder and retain the other half in the business.

It’s the financial manager’s responsibility to decide a optimum dividend policy which maximizes the market value of the firm. Hence an optimum dividend payout ratio is calculated. It is a common practice to pay regular dividends in case of profitability Another way is to issue bonus shares to existing shareholders.

Liquidity Decision

It is very important to maintain a liquidity position of a firm to avoid insolvency. Firm’s profitability, liquidity and risk all are associated with the investment in current assets. In order to maintain a tradeoff between profitability and liquidity it is important to invest sufficient funds in current assets. But since current assets do not earn anything for business therefore a proper calculation must be done before investing in current assets.

Current assets should properly be valued and disposed of from time to time once they become non profitable. Currents assets must be used in times of liquidity problems and times of insolvency.

Financial Planning:- Financial Planning is the process of estimating the capital required and determining it’s competition. It is the process of framing financial policies in relation to procurement, investment and administration of funds of an enterprise.

Objectives of Financial Planning

Financial Planning has got many objectives to look forward to:

1. Determining capital requirements- This will depend upon factors like cost of current and fixed assets, promotional expenses and long- range planning. Capital requirements have to be looked with both aspects: short- term and long- term requirements.

2. Determining capital structure- The capital structure is the composition of capital, i.e., the relative kind and proportion of capital required in the business. This includes decisions of debt- equity ratio- both short-term and long- term.

3. Framing financial policies with regards to cash control, lending, borrowings, etc.

4. A finance manager ensures that the scarce financial resources are maximally utilized in the best possible manner at least cost in order to get maximum returns on investment.

Importance of Financial Planning

Financial Planning is process of framing objectives, policies, procedures, programmes and budgets regarding the financial activities of a concern. This ensures effective and adequate financial and investment policies. The importance can be outlined as-

1. Adequate funds have to be ensured.

2. Financial Planning helps in ensuring a reasonable balance between outflow and inflow of funds so that stability is maintained.

3. Financial Planning ensures that the suppliers of funds are easily investing in companies which exercise financial planning.

4. Financial Planning helps in making growth and expansion programmes which helps in long-run survival of the company.

5. Financial Planning reduces uncertainties with regards to changing market trends which can be faced easily through enough funds.

6. Financial Planning helps in reducing the uncertainties which can be a hindrance to growth of the company. This helps in ensuring stability an d profitability in concern.

Unit II 

Capital Budgeting :- Capital Budgeting decision is considered most important and most critical decision for finance manager. It involves decisions related to long-term investments of capital nature. The returns from such investments are scattered over a number of years. Since it requires huge amount of funds, it is considered irreversible.

Some examples of capital budgeting decisions are Purchase of new plant and machinery, replacement of old plant and machinery, expansion and diversification decision, research and development projects etc.

According to Charles T. Horngren:

“Capital Budgeting is long-term planning for making and financing proposed capital outlays.”

According to L.J. Gitman:

“Capital Budgeting refers to the total process of generating, evaluating, selecting and following up on capital expenditure alternatives.”

The process of Capital Budgeting:- 

The process of capital budgeting involves following steps

1. Project Generation: In the first step, projects for investments are identified. This projects may be undertaken to increase revenue or to reducing cost. for this, proposals for expanding production capacity, proposals for replacement of plant etc. could be undertaken.
2. Project Evaluation: In this step, costs and benefits from such projects are evaluated. Projects are judged on the basis of profitability and returns it offers to the firm.
3. Project Selection: The projects generated and evaluated are then screened at various levels of management. After screening, the top management may decide whether to select or reject the proposal.
4. Project Execution: A project is executed after final selection is made by the management. Required funds are allocated to execute the project.
5. Follow-up: Executed projects are then followed-up. Actual performance of the project is compared with the expected performance and deviations are found out. With the help of which future decisions are taken.

Capital Budgeting:- The decision of investing funds in the long term assets is known as Capital Budgeting. Thus, Capital Budgeting is the process of selecting the asset or an investment proposal that will yield returns over a long period.

The first step involved in Capital Budgeting is to select the asset, whether existing or new on the basis of benefits that will be derived from it in the future.

The next step is to analyze the proposal’s uncertainty and risk involved in it. Since the benefits are to be accrued in the future, the uncertainty is high with respect to its returns. Finally, the minimum rate of return is to be set against which the performance of the long-term project can be evaluated.

Working Capital Management:- The working capital management deals with the management of current assets that are highly liquid in nature.

The investment decision in short-term assets is crucial for an organization as a short term survival is necessary for the long-term success. Through working capital management, a firm tries to maintain a trade-off between the profitability and the liquidity.

In case a firm has an inadequate working capital i.e. less funds invested in the short term assets, then the firm may not be able to pay off its current liabilities and may result in bankruptcy. Or in case the firm has more current assets than required, it can have an adverse effect on the profitability of the firm.

Thus, a firm must have an optimum working capital that is necessary for the smooth functioning of its day to day operations.

Techniques of Capital Budgeting:-

Capital budgeting techniques are the methods to evaluate an investment proposal in order to help the company decide upon the desirability of such a proposal. These techniques are categorized into two heads : traditional methods and discounted cash flow methods. 

Traditional Methods:- Traditional methods determine the desirability of an investment project based on its useful life and expected returns. Furthermore, these methods do not take into account the concept of time value of money. 

Pay Back Period Method:- Payback period refers to the number of years it takes to recover the initial cost of an investment. Therefore, it is a measure of liquidity for a firm. Thus, if an entity has liquidity issues, in such a case, shorter a project’s payback period, better it is for the firm. 

Therefore,

Payback period = Full years until recovery + (unrecovered cost at the beginning of the last year)/

Cash flow during the last year:- Here, full years until recovery is nothing but the payback that occurs when cumulative net cash flow equals to zero. Cumulative net cash flow is the running total of cash flows at the end of each time period. 

Average Rate of Return Method (ARR):- Under ARR method, the profitability of an investment proposal can be determined by dividing average income after taxes by average investment, which is average book value after depreciation. 

Thus, ARR = Average Net Income After Taxes/Average Investment x 100

Where, Average Income After Taxes = Total Income After Taxes/Total Number of Years

Average Investment = Total Investment/2

Based on this method,  a company can select those projects that have ARR higher than the minimum rate established by the company. And, it can reject the projects having ARR less than the expected rate of return. 

Discounted Cash Flow Methods:- As mentioned above, traditional methods do not take into the account time value of money. Rather, these methods take into consideration present and future flow of incomes. However, the DCF method accounts for the concept that a rupee earned today is worth more than a rupee earned tomorrow. This means that DCF methods take into account both profitability and time value of money. 

Net Present Value Method (NPV):- NPV is the sum of the present values of all the expected incremental cash flows of a project discounted at a required rate of return less than the present value of the cost of the investment. 

In other words, NPV is the difference between the present value of cash inflows of a project and the initial cost of the project. As per this technique, the projects whose NPV is positive or above zero shall be selected. 

If a project’s NPV is less than zero or negative, the same must be rejected. Further, if there is more than one project with positive NPV, then the project with the highest NPV shall be selected. 

NPV = CF1/(1 + k)1 + ……….. CFn/ (1 + k)n + CF0

where CF0 = Initial Investment Outlay (Negative Cash flow)

           CFt = after tax cash flow at time t

                k = required rate of return

Internal Rate of Return (IRR):- Internal Rate of Return refers to the discount rate that makes the present value of expected after-tax cash inflows equal to the initial cost of the project. 

In other words, IRR is the discount rate that makes present values of a project’s estimated cash inflows equal to the present value of the project’s estimated cash outflows. 

If IRR is greater than the required rate of return for the project, then accept the project. And if IRR is less than the required rate of return, then reject the project. 

PV (inflows) = PV (outflows)

NPV = 0 = CF0 + CF1/(1 + IRR)1 + ……….. CFn / (1 + IRR)n + CF0

Profitability Index:- Profitability Index is the present value of a project’s future cash flows divided by initial cash outlay. Thus, it si closely related to NPV. NPV is the difference between the present value of future cash flows and the initial cash outlay. 

Whereas, PI is the ratio of the present value of future cash flows and initial cash outlay. 

 PI = PV of future cash flows/CF0 = 1 + NPV/CF0

Thus, if the NPV of a project is positive, PI will be greater than 1. If NPV is negative, PI will be less than 1. Therefore, based on this, if PI is greater than 1, accept the project otherwise reject.