Summary

Chapter One

Nature and Scope of Financial Management



Learning Objectives :

This first chapter attempts to

Familiarize students with financial
objectives & Goals of a firm.

Develop conceptual frame work of financial
management.

Focus on nature, scope, and functions of
financial management.

Discuss the role of finance manager in
changing economic scenario.


A . Backdrop

Role of Finance Manager 40 years ago

Finance manager was expected to maintain financial
records and prepare reports on companys status and
performance. He was further required to arrange
funds needed by the firm to meet its obligations on
a timely basis.

In other words, his services were required only
when need for funds arose. He had no strategic role
in management of the firm.


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Role of Finance Manager now -

With technological advances in industries and
increased business complexities, there has been a
major expansion in the role. The tightening money
market and despondent state of stock market have
also contributed to this change. His position has
transcended the traditional role of garnering funds
for the business and he has become an integral part
of companys strategic management.

In this capacity, the finance manager actively
participates in all management decisions. He has to
deal with total funds employed in the enterprise.
Further he is now responsible to ensure that funds
collected by him are wisely applied among various
projects. And towards this end he has to evaluate
results of each such application.

As a result, he is now directly concerned with
decisions related to production, marketing and
other activities that involve commitment of funds
to the new or ongoing uses.

To meet global competition from multinational
companies, Indian firms are forming new business
strategy to work on quality, reduce cost, improve
productivity, and maximize corporate value.
Financial manager plays a very effective and
integrated role in financial decisions that are
required to implement this strategy.


B . Financial Objectives of a Firm :

Corporate objectives are expressed in the mission
and vision statements of companies.

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These are written in qualitative terms and are more
ethical and philosophical in character and reflect
top managements values.
Being profit seeking organization the management is
supposed to set profit maximization as its basic
objective.


B.1. Profit maximization objective


This objective is stated in terms of quantum of
profits to be earned, targeted rate of return on
investments or desired profit-to-sales ratio.

This objective is simple to understand, requires
employment of resources where returns are highest,
and permits quick judgment on effectiveness of
financial decisions.

The objective also suffers from certain drawbacks

Firstly, it is vague as one is not clear about what
is profit? Is it total surplus before tax or after
tax? Or it is it a rate of return on sales? or on
capital employed? Or on owners funds?

Profits on a short term basis are not synonymous
with those on long term basis. Each interpretation
has its distinct impact on financial decisions.

Secondly, it ignores Time Value Factor so crucial
to financial decisions. Hence a project returning
Rs. 90,000/- in year and alternative yielding Rs.
15,000/- a year for the next six years will look
equally attractive under this objective!




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Thirdly, it ignores Risk Factor. Two projects can
have equal profitability but different risk
profiles. Risk evaluation is absent in statement of
the profit maximization objective.


B.2. Wealth maximization objective

This objective is clear & it suggests that for a
project to be undertaken, its net present value
(gross present value minus capital investment) must
be positive. While calculating gross present value
stream of earnings expected in future are
discounted at a rate that reflects their
uncertainty. Thus both Time and Risk factors are
covered in decision making process.

Net present worth is arrived using formula
A A A
1 2 n
W = + + . . . - C
(1+K) (1+K)
2
(1+K)
n


Where W = net present worth,
A
1
, A
2
, A
n
= expected stream of benefits
expected to occur over years,
K = discount rate that reflects degree of
risk & timing, and
C = initial capital outlay for the project


This objective is very clear and as stated earlier,
considers time value of money as well as risk &
uncertainty element; and hence superior to profit
maximization objective.

It must be noted that, in short run, if magnitude
of risk is not great, wealth maximization & profit
maximization objectives show no difference.


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B.3. Maximization of Profit Pool

A profit pool is defined as the total profits
earned in an industry at all points along the
industrys value chain. It includes the
disaggregate of processes, the mapping of the value
chain beyond the confines of legal entities, the
adoption of flexible organizational structures and
creation of net worked organizations.

A profit pool concept looks beyond the core
business and spots activities with untapped source
of profit. Low margins on core business are used to
attract customers and high margin ancillary
business is transacted with them to maximize profit
pool.

Increased sales revenue and market share do not
necessarily provide profit pool. A profit pool map
alone answers the question how and where is the
money made in the industry.

For example in automobile industry profit is made
from

making & selling cars
selling used cars
petrol, diesel retail sales
insurance
after sales service
car leasing & finance


Revenue from core activity is more but at lower
margins, and major profit is earned from ancillary
activities where margins and customer royalty are
high.



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C . Financial Goals of a Firm

Major goals of all enterprises are :

Maximize short term and long term profits &
minimize risks by striking a balance between risk &
return.

Ensure effective utilization of resources.

Build sufficient flexibility in financial
operations

Impart liquidity and profitability of the
enterprise.

These Goals need to be defined for achievement
of the objective of wealth maximization.

D . Management vs. Owners

The goal of maximizing owners interest
predominates, other goals of the firm so that
management is allowed to continue and survive in
competitive environment.

In this role the management acts as a satisfier for
owner rather than as a maximizer for the firm.

Towards this end management may accept lower
margins to ensure sustained market share
(satisfier role), rather than aggressively exploit
market potential (maximizer role).

E . Social Objective

As a corporate citizen, modern firm has another
objective to assume social responsibility.
This objective acknowledges the fact that
environment conducive to economic growth, in which
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it operates, is provided to the firm by the
society.

Some argue that social responsibility requires firm
to bear more costs and risks and is, therefore, to
that extent in conflict with its economic goals.

Experience, however, has proved that in the long
term both economic and social objectives are
mutually beneficial.

Thus funds deployed to improve social environment
of workforce housing, schools, hospitals etc.
increase costs immediately. But gains from improved
productivity & reduced turnover, effectively more
than offset them in the long run.


F . Concept of Financial Management

Interpretations of the term Finance

F1 - Finance function involves acquiring funds
on reasonable terms to pay bills and other
obligations of the enterprise promptly. This is
traditional & restrictive view of Finance.

F2 - Finance means cash, and finance manager
must go in details in all activities in production,
marketing, personnel research that involve use of
cash. This is very broad and vague viewpoint.


F3 - Procurement of funds and their wise
application is the modern approach to finance. The
finance manager has to obtain funds on most
economic terms and apply them to projects that
generate maximum wealth.

This is depicted on the diagram below -
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Interpretations of the term Finance- Modern
Approach



Funds Source Funds Application

Internal cash flows Asset Expenditure
from operations a) Current
b) Fixed

External debt or Non-asset Expenditure.
equity from
Individuals a) Labour / Material
Institutions b) Interest Charges
Other firms c)Profit distribution
Government to owners


G . Nature of Financial Management

Financial management is now considered to be an
integral part of overall management as the function
involves, in addition to fund raising, utilization
of funds and monitoring their use. Funds are used
for production, marketing, human resource, research
and all other business activities and hence
financial manager has to fully associate with all
business activities.

Success of strategic business decisions like entry
in new territory, product line, expansion of
capacity, relocation, depends upon their financial
appraisals. As a part of this appraisal, finance
manager has to continuously review all financial
decisions providing dynamic perspective to
financial management.

Various financial functions are intimately
connected with each other. Proportion of fixed
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assets to current assets decides risk complexion,
which in turn influence the terms at which fresh
funds can be raised and methods to be adopted to
finance projects. Dividend decisions affect
financing decisions which are again influenced by
investment decisions.

In other words, except for management of income
which is his prime responsibility, finance manager
has to operate with expertise of other functional
heads of the organization to discharge his
responsibilities effectively.

H . Functions of Financial Management

H.1. Traditional Concept of Finance Function

Determining funds requirements, finding most
economic source for them and timing of acquiring
and disposing funds, was considered as the real
scope of financial management.

Allocation of funds for different assets,
monitoring them to optimize their use, was
considered to be in the scope of non-financial
executives.

This view is criticized by modern scholars on
following grounds,

Just like finance manager is responsible to
acquire funds, he is also responsible to ensure
their proper utilization over the best alternatives
available. Traditional concept ignores the second
responsibility

The old concept focuses on one time jobs of
finance manager like incorporation, consolidation,
recapitalization etc and ignores his responsibility
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in resolving day to day ongoing financial problems
which assume equal importance.

The old concept focuses on corporate finance and
ignores his responsible role in management of non
incorporated firms, partnerships, trading concerns,
etc.

The old approach considers long term finance
important and ignores finance managers skills
required to tackle day to day working capital
funding.

H.2. Modern Concept of Finance Function

It is an integral part of overall management &
not only an advisory function.

In addition to procurement of funds at optimum
cost, it has to ensure beneficial application of
funds for business growth.

It includes planning, raising, allocating &
controlling finances to accomplish broad business
objectives.


H.3. Contents of Modern Finance Function

Are categorizes by modern scholars as

a] Recurring functions
b] Non-recurring, one time or episodic functions.


a] Recurring functions:

Recurring finance function encompasses all such
financial activities as are carried regularly for
the efficient conduct of a firm.
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Recurring Finance Function

Planning for Raising Allocation Allocation Monitoring
Funds of Funds of Funds of Income of uses
Funds


1. Planning for funds : This function seeks to

1. Develop long term financial plan to determine
quantum of funds requirements, its duration and
make up of investments.

2. Synchronize cash inflows with outflows so that
the organization does not have any funds
unutilized.

3. Balance profitability with risk by deploying
all funds and keeping least funds liquid to
meet emergencies.

4. Capitalization reflects decisions regarding
fund requirements. These decisions are taken
after considering company objectives and
strategy, top management philosophy, fiscal &
financial policies of the Government.

5. Capital Structure reflects decisions
regarding forms of financing requirements.
These decisions are based on cardinal
principles of risk, cost, control, flexibility,
and timing.

6. Prepare & use Master Plan , Funds Flow
Statement, Forecast of Working Capital,
Cash Budget etc. These are the tools of the
finance manager.




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2. Raising of funds :

If funds are to be raised through equity
capital, finance has to arrange for prospectus,
appoint agents to handle capital issue, ensure it
is underwritten, and monitor the process until
shares are issued to subscribers.

If funds are to be raised through borrowings
from banks or financial institutions, finance
manager has to prepare a project report, enter into
agreement, schedule the repayments. More expertise
from him is expected when funds are borrowed from
overseas.


3. Allocation of funds :

While allocating funds over different assets,
factors to be considered by the Finance Manager are
competing uses of funds over different projects,
immediate requirements, and management of assets,
profit prospects & overall management plans.

Next management of sundry debtors and inventories
is prime responsibility of finance manager. Sundry
debtors are to be maintained at minimum without
adverse effects on sales. Optimum levels of
inventories are to be maintained to ensure least
funds are blocked but materials are available when
needed.

4. Allocation of income :

Finance Manager has to decide how much of the
income is to be retained within the business for
financing investments or retiring debts & how much
to be distributed to owners.


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5. Monitoring uses of funds :

Long term use for capital investment is monitored
by comparing, on a regular basis, actual results
with those estimated in the project report used for
approval of release of funds. Comparisons enable
corrective action and revisions to balance
expenditure.

Short term use for receivables is monitored by
reviewing credit and collection policies, their
strict implementation, keeping tab on collection
days, controlling ratio of bad debts to sales etc.

Short term use for inventories is monitored by
reviewing inventory norms, implementing them ,
checking slow moving and non moving items in stock,
keeping inventory turnover ratio high without
causing interruptions in production due to lack of
materials.

Finance Manager needs to obtain information, record
it, store and process, analyze and make use of it.
This data allows him to prepare reports to
Management for action.


b] Non-recurring functions.

These functions are infrequent and usually at the
time of start up of the company, or during a major
liquidity crisis when the capital has to be re-
structured. Finance manager has additionally to
handle financial aspects of mergers & acquisitions.

I . Scope of Financial Management

The scope is very wide and starts from inception of
the company to its growth, expansion & eventual
winding up.
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The functions mainly cover decision areas related
to
investment;

financing &

dividends.


Decision areas related to investment :

Long term investment decisions relate to allocation
of funds to projects whose benefits accrue over a
long period.

For internal investment decisions, economic
viability of different projects is studied to
select most profitable alternative

For external investment decisions, firm considers
investing in other company and arranging merger or
acquisition.

Or else it considers portfolio management by
selecting a bundle of securities that provide
maximum yield at minimum risk.


For short term investment decisions finance manager
decides how the funds are distributed over cash or
cash equivalents, receivables and inventories
Here the main issue is trade off between
profitability & liquidity.

Decision areas related to financing :

Optimal financing mix or make up of capitalization
is determined by following factors.

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Sources of funds
Quantum of funds
Cost of funds used today.
Cost of future funds.
How much quantity from each source?
Which instruments to use and when?
Is service of a financial institute to be used?
Are underwriting services to be used?

Decision areas related to dividends :

Both goals of growth & dividends are desired, these
goals are conflicting as higher dividends mean
lesser retained earnings required for growth.

Finance manager balances funds over these purposes
in such a way that wealth is created for
stockholders over a period of time.

J . Cardinal Principles of Financial Management

J .1. Strategic Principle :

All financial decisions be integrated with
overall corporate objectives and strategies.

J .2. Optimization Principle :

Maximum utilization of funds should be the goal
of financial management. This mandates proper
balance between fixed and working capital.


J .3. Risk Return Principle :

Maintain proper balance between risk and
return. Firm flush with cash has no risk, but has
no income from cash lying idle.


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J .4. Marginal Principle :

An enterprise should continue to work until its
marginal income equals its marginal cost.

J .5. Suitability Principle :

Source of fund selected to finance an asset should
match with the character of the asset. Hence short
term financial needs be met with short term sources
such as short term borrowings, overdrafts etc.

J .6. Flexibility Principle :

The financial plan needs to have a built-in
flexibility to meet dynamic business environment.

J .7. Timing Principle :

The finance manager should time his investment and
financing decisions in such a way to seize all
available market opportunities.


J .8. Ploughing Back Principle :

The firm must generate adequate internal cash
surpluses to fund replacement, modernization and
growth of its capacities.


K. Concept of Financial Management in Public Sector

Principles of prudent financial management adopted
in the private sector are equally applicable to the
public sector. Financial management in public
sector has its additional characteristics related
to broad objectives, multiple controls and very
large size of operations.

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The objectives of social gains regarding
development of backward areas, or provision of
employment, creating basic infra-structure by
providing basic raw materials, machineries are in
conflict with the normal financial objective of
profit maximization.

For survival & growth, it has to balance these
diverse objectives with making profit for itself.

The task of financial management assumes greater
significance as the amount of assets, cash &
materials controlled by public sector firms is more
the budgets of an entire big size state. This size
defines the quality & depth of financial control
that needs to be exercised in the public sector.

Financial management in the public sector has to
pay greater attention to the outside economic
environment governed by the economic, fiscal and
industrial policies of the Government.

The finance manager in the public sector has to
establish greater co-ordination with other
departments for efficient use of the funds. Two way
information systems between the finance & other
departments have to be developed for this purpose.

Even though profit generation is not the only goal
for Finance manager in the public sector, he has to
control inventories, increase sales and reduce
costs to maintain overall margins. The Government
and employees expect firms in the public sector to
make profit so that they are not a liability to
former and provides benefits like bonus to the
latter.

Unlike in private sector, finance manager in public
sector is controlled by top management of his own
undertaking as well as authorities in various
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ministries. Multiple reporting is complex as
objectives of internal management do not always
match those of outside agencies.

L . New Paradigms of Financial Management

Both profit and non-profit firms work in a fiercely
competitive environment where vigorous growth is
essential for survival.

This is achieved through product development &
innovation and world class levels in product
quality & cost as well as in network for
distribution and marketing.

One of the critical factors for failures of large
firms, in both public & private sectors, is use of
archaic outmoded tools for their financial
management. These companies could not reap
benefits of favorable economic environment. For
progress & survival, all companies need to follow
the new paradigms of financial management.

New paradigms

Financial management is integral part of
strategic management.

Objectives of financial management must be
tethered to corporate objectives.

Thrust of financial management on value addition
of the organization, stockholders &
stakeholders.

Maximize profit pool and not just profit &
wealth.

Re-engineer finance processes, dig out hidden
costs & eliminate.
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Focus on core activities & source rest to
suppliers.

Adopt zero working capital, just in time, web
based accounting and inventory software.


Evolve new financial instruments like zero coupon
bonds, deep discount bonds, floating rate bonds,
convertible warrants etc to garner funds
efficiently.

Hedge risks arising out of fluctuations in prices
of commodities, shares; interest and foreign
exchange rates.

















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Statements & Financial Analysis
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