Meaning of Financial Management

Financial Management means planning, organizing, directing and controlling the financial
activities such as procurement and utilization of funds of the enterprise. It means applying
general management principles to financial resources of the enterprise.

Scope/Elements
1. Investment decisions includes investment in fixed assets (called as capital budgeting).
Investment in current assets are also a part of investment decisions called as working
capital decisions.
2. Financial decisions - They relate to the raising of finance from various resources which
will depend upon decision on type of source, period of financing, cost of financing and
the returns thereby.
3. Dividend decision - The finance manager has to take decision with regards to the net
profit distribution. Net profits are generally divided into two:
a. Dividend for shareholders- Dividend and the rate of it has to be decided.
b. Retained profits- Amount of retained profits has to be finalized which will depend
upon expansion and diversification plans of the enterprise.

Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and control of
financial resources of a concern. The objectives can be1. 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.

Functions of Financial Management

1. Estimation of capital requirements: A finance manager has to make estimation with

regards to capital requirements of the company. This will depend upon expected costs and
profits and future programmes and policies of a concern. Estimations have to be made in
an adequate manner which increases earning capacity of enterprise.
2. Determination of capital composition: Once the estimation have been made, the capital
structure have to be decided. This involves short- term and long- term debt equity
analysis. This will depend upon the proportion of equity capital a company is possessing
and additional funds which have to be raised from outside parties.
3. Choice of sources of funds: For additional funds to be procured, a company has many
choices likea. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.
Choice of factor will depend on relative merits and demerits of each source and period of
financing.
4. Investment of funds: The finance manager has to decide to allocate funds into profitable
ventures so that there is safety on investment and regular returns is possible.
5. Disposal of surplus: The net profits decision have to be made by the finance manager.
This can be done in two ways:
a. Dividend declaration - It includes identifying the rate of dividends and other
benefits like bonus.
b. Retained profits - The volume has to be decided which will depend upon
expansional, innovational, diversification plans of the company.
6. Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and salaries,
payment of electricity and water bills, payment to creditors, meeting current liabilities,
maintainance of enough stock, purchase of raw materials, etc.
7. Financial controls: The finance manager has not only to plan, procure and utilize the
funds but he also has to exercise control over finances. This can be done through many
techniques like ratio analysis, financial forecasting, cost and profit control, etc.
The 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
a. Evaluation of new investment in terms of profitability
b. 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. It 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 firms
capital structure. A firm tends to benefit most when the market value of a companys 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. Its the financial managers 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. Firms
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 activities of a firm is one of the most important and complex activities of a firm.
Therefore in order to take care of these activities a financial manager performs all the requisite
financial activities.
A financial manger is a person who takes care of all the important financial functions of an
organization. The person in charge should maintain a far sightedness in order to ensure that the
funds are utilized in the most efficient manner. His actions directly affect the Profitability, growth
and goodwill of the firm.
Following are the main functions of a Financial Manager:

1. Raising of Funds
In order to meet the obligation of the business it is important to have enough cash and
liquidity. A firm can raise funds by the way of equity and debt. It is the responsibility of a
financial manager to decide the ratio between debt and equity. It is important to maintain
a good balance between equity and debt.

2. Allocation of Funds
Once the funds are raised through different channels the next important function is to
allocate the funds. The funds should be allocated in such a manner that they are optimally
used. In order to allocate funds in the best possible manner the following point must be
considered

The size of the firm and its growth capability

Status of assets whether they are long term or short tem

Mode by which the funds are raised.

These financial decisions directly and indirectly influence other managerial activities.
Hence formation of a good asset mix and proper allocation of funds is one of the most
important activity

3. Profit Planning

Profit earning is one of the prime functions of any business organization. Profit earning is
important for survival and sustenance of any organization. Profit planning refers to proper
usage of the profit generated by the firm. Profit arises due to many factors such as
pricing, industry competition, state of the economy, mechanism of demand and supply,
cost and output. A healthy mix of variable and fixed factors of production can lead to an
increase in the profitability of the firm. Fixed costs are incurred by the use of fixed
factors of production such as land and machinery. In order to maintain a tandem it is
important to continuously value the depreciation cost of fixed cost of production. An
opportunity cost must be calculated in order to replace those factors of production which
has gone thrown wear and tear. If this is not noted then these fixed cost can cause huge
fluctuations in profit.

4. Understanding Capital Markets

Shares of a company are traded on stock exchange and there is a continuous sale and
purchase of securities. Hence a clear understanding of capital market is an important
function of a financial manager. When securities are traded on stock market there
involves a huge amount of risk involved. Therefore a financial manger understands and
calculates the risk involved in this trading of shares and debentures. Its on the discretion
of a financial manager as to how distribute the profits. Many investors do not like the
firm to distribute the profits amongst share holders as dividend instead invest in the
business itself to enhance growth. The practices of a financial manager directly impact
the operation in capital market.
Every firm has a predefined goal or an objective. Therefore the most important goal of a
financial manager is to increase the owners economic welfare. Here economics welfare may
refer to maximization of profit or maximization of shareholders wealth. Therefore Shareholders
wealth maximization (SWM) plays a very crucial role as far as financial goals of a firm are
concerned.
Profit is the remuneration paid to the entrepreneur after deduction of all expenses.
Maximization of profit can be defined as maximizing the income of the firm and
minimizing the expenditure. The main responsibility of a firm is to carry out business by
manufacturing goods and services and selling them in the open market. The mechanism of
demand and supply in an open market determine the price of a commodity or a service. A firm
can only make profit if it produces a good or delivers a service at a lower cost than what is
prevailing in the market. The margin between these two prices would only increase if the firm
strives to produce these goods more efficiently and at a lower price without compromising on the
quality.
The demand and supply mechanism plays a very important role in determining the price of a
commodity. A commodity which has a greater demand commands a higher price and hence may
result in greater profits. Competition among other suppliers also effect profits. Manufacturers

tends to move towards production of those goods which guarantee higher profits. Hence there
comes a time when equilibrium is reached and profits are saturated.
According to Adam Smith - business man in order to fulfill their profit motive in turn
benefits the society as well. It is seen that when a firm tends to increase profit it eventually
makes use of its resources in a more effective manner. Profit is regarded as a parameter to
measure firms productivity and efficiency. Firms which tend to earn continuous profit eventually
improvise their products according to the demand of the consumers. Bulk production due to
massive demand leads to economies of scale which eventually reduces the cost of production.
Lower cost of production directly impacts the profit margins. There are two ways to increase the
profit margin due to lower cost. Firstly a firm can produce at lower sot but continue to sell at the
original price, thereby increasing the revenue. Secondly a firm can reduce the final price offered
to the consumer and increase its market thereby superseding its competitors.
Both ways the firm will benefit. The second way would increase its sale and market share while
the first way only tend to increase its revenue. Profit is an important component of any business.
Without profit earning capability it is very difficult to survive in the market. If a firm continues
to earn large amount of profits then only it can manage to serve the society in the long run.
Therefore profit earning capacity by a firm and public motive in some way goes hand in hand.
This eventually also leads to the growth of an economy and increase in National Income due to
increasing purchasing power of the consumer.
Many economists have argued that profit maximization has brought about many
disparities among consumers and manufacturers. In case of perfect competition it may appear
as a legitimate and a reward for efforts but in case of imperfect competition a firms prime
objective should not be profit maximization. In olden times when there was not too much of
competition selling and manufacturing goods were primarily for mutual benefit. Manufacturers
didnt produce to earn profits rather produced for mutual benefit and social welfare. The aim of
the single producer was to retain his position in the market and sustain growth, thereby earning
some profit which would help him in maintaining his position. On the other hand in todays time
the production system is dominant by two tier system of ownership and management. Ownership
aims at maximizing profit and management aims at managing the system of production thereby
indirectly increasing the income of the business.
These services are used by customers who in turn are forced to pay a higher price due to
formation of cartels and monopoly. Not only have the customers suffered but also the employees.
Employees are forced to work more than their capacity. they is made to pay in extra hours so that
production can increase.
Many times manufacturers tend to produce goods which are of no use to the society and create
an artificial demand for the product by rigorous marketing and advertising. They tend to make

the product so tempting by packaging and labeling that its difficult for the consumer to resist.
These happen mainly with products which aim to target kids and teenagers. Ad commercials and
print ads tend to provide with wrong information to artificially hike the expectation of the
product.
In case of oligopoly where the nature of the product is more or less same exploit the customer to
the max. Since they form cartels and manipulate prices by giving very less flexibility to the
consumer to negotiate or choose from the products available. In such a scenario it is the
consumer who becomes prey of these activities. Profit maximization motive is continuously
aiming at increasing the firms revenue and is concentrating less on the social welfare.
Government plays a very important role in curbing this practice of charging extraordinary high
prices at the cost of service or product. In fact a market which experiences a high degree of
competition is likely to exploit the customer in the name of profit maximization, and on the other
hand where the production of a particular product or service is limited there is a possibility to
charge higher prices is greater. There are few things which need a greater clarification as far as
maximization of profit is concerned
Profit maximization objective is a little vague in terms of returns achieved by a firm in
different time period. The time value of money is often ignored when measuring profit.
It leads to uncertainty of returns. Two firms which use same technology and same factors of
production may eventually earn different returns. It is due to the profit margin. It may not be
legitimate if seen from a different stand point.
Finance is a field that deals with the allocation of assets and liabilities over time
under conditions of certainty and uncertainty. Finance also applies and uses the
theories of economics at some level. Finance can also be defined as the science of
money management. A key point in finance is the time value of money, which
states that purchasing power of one unit of currency can vary over time. Finance
aims to price assets based on their risk level and their expected rate of return.
Finance can be broken into three different sub-categories: public finance, corporate
finance and personal finance.

Financial management refers to the efficient and effective management of money (funds) in
such a manner as to accomplish the objectives of the organization. It is the specialized function
directly associated with the top management. The significance of this function is not only seen in
the 'Line' but also in the capacity of 'Staff' in overall administration of a company. It has been
defined differently by different experts in the field.

It includes how to raise the capital, how to allocate it i.e. capital budgeting. Not only about long
term budgeting but also how to allocate the short term resources like current assets. It also deals
with the dividend policies of the share holders.

Definitions of Financial Management

Financial Management is the Operational Activity of a business that is

responsible for obtaining and effectively utilizing the funds necessary for
efficient operation. by Joseph Massie

Business finance deals primarily with rising administering and disbursing

funds by privately owned business units operating in non-financial fields of
industry. by Kuldeep Roy

Financial Management is an area of financial decision making, harmonizing

individual motives and enterprise goals. By Weston and Brigham

Financial management is the area of business management devoted to a

judicious use of capital and a careful selection of sources of capital in order to
enable a business firm to move in the direction of reaching its goals. by
J.F.Bradlery

Financial management is the application of the planning and control function

to the finance function. by K.D. Willson

Financial management may be defined as that area or set of administrative

function in an organization which relate with arrangement of cash and credit
so that organization may have the means to carry out its objective as
satisfactorily as possible . - by Howard & Opton.

Business finance can be broadly defined as the activity concerned with

planning, raising, controlling and administering of funds and in the business.
by H.G Gathman & H.E Dougall

Financial management is a body of business concerned with the efficient and effective use of
either equity capital, borrowed cash or any other business funds as well as taking the right
decision for profit maximization and value addition of an entity.- Kepher Petra; Kisii University.
Objectives of Financial Management:

Financial management is one of the functional areas of business. Therefore, its objectives must
be consistent with the overall objectives of business. The overall objective of financial
management is to provide maximum return to the owners on their investment in the long- term.

This is known as wealth maximisation. Maximisation of owners wealth is possible when the
capital invested initially increases over a period of time. Wealth maximisation means maximising
the market value of investment in shares of the company.
Wealth of shareholders = Number of shares held Market price per share.
In order to maximise wealth, financial management must achieve the following specific
objectives:
(a) To ensure availability of sufficient funds at reasonable cost (liquidity).
(b) To ensure effective utilisation of funds (financial control).
(c) To ensure safety of funds by creating reserves, re-investing profits, etc. (minimisation of
risk).
(d) To ensure adequate return on investment (profitability).
(e) To generate and build-up surplus for expansion and growth (growth).
(f) To minimise cost of capital by developing a sound and economical combination of corporate
securities (economy).
(g) To coordinate the activities of the finance department with the activities of other departments
of the firm (cooperation).
Profit Maximisation:

Very often maximisation of profits is considered to be the main objective of financial

management. Profitability is an operational concept that signifies economic efficiency. Some
writers on finance believe that it leads to efficient allocation of resources and optimum use of
capital.
It is said that profit maximisation is a simple and straightforward objective. It also ensures the
survival and growth of a business firm. But modern authors on financial management have
criticised the goal of profit maximisation.
Ezra Solomon has raised the following objections against the profit maximisation objective:
Objections against the Profit Maximisation Objectives:
(i) The concept is ambiguous or vague. It is amenable to different interpretations, e.g., long run
profits, short run profits, volume of profits, rate of profit, etc.

(ii) It ignores the timing of returns. It is based on the assumption of bigger the better and does not
take into account the time value of money. The value of benefits received today and those
received a year later are not the same.
(iii) It ignores the quality of the expected benefits or the risk involved in prospective earnings
stream. The streams of benefits may have varying degrees of uncertainty. Two projects may have
same total expected earnings but if the earnings of one fluctuate less widely than those of the
other it will be less risky and more preferable. More uncertain or fluctuating the expected
earnings, lower is their quality.
(iv) It does not consider the effect of dividend policy on the market price of the share. The goal
of profit maximisation implies maximising earnings per share which is not necessarily the same
as maximising market-price share. According to Solomon, to the extent payment of dividends
can affect the market price of the stock (or share), the maximisation of earnings per share will
not be a satisfactory objective by itself.
(v) Profit maximisation objective does not take into consideration the social responsibilities of
business. It ignores the interests of workers, consumers, government and the public in general.
The exclusive attention on profit maximisation may misguide managers to the point where they
may endanger the survival of the firm by ignoring research, executive development and other
intangible investments.
Wealth Maximisation:

Prof. Ezra Solomon has advocated wealth maximisation as the goal of financial decision-making.
Wealth maximisation or net present worth maximisation is defined as follows: The gross present
worth of a course of action is equal to the capitalised value of the flow of future expected
benefits, discounted (or as capitalised) at a rate which reflects their certainty or uncertainty.
Wealth or net present worth is the difference between gross present worth and the amount of
capital investment required to achieve the benefits being discussed. Any financial action which
creates wealth or which has a net present worth above zero is a desirable one and should be
undertaken.
Any financial action which does not meet this test should be rejected. If two or more desirable
courses of action are mutually exclusive (i.e., if only one can be undertaken), then the decision
should be to do that which creates most wealth or shows the greatest amount of net present
worth. In short, the operating objective for financial management is to maximise wealth or net
present worth.
Wealth maximisation is more operationally viable and valid criterion because of the
following reasons:

(a) It is a precise and unambiguous concept. The wealth maximisation means maximising the
market value of shares.
(b) It takes into account both the quantity and quality of the expected steam of future benefits.
Adjustments are made for risk (uncertainty of expected returns) and timing (time value of
money) by discounting the cash flows,
(c) As a decision criterion, wealth maximisation involves a comparison of value of cost. It is a
long-term strategy emphasising the use of resources to yield economic values higher than joint
values of inputs.
(d) Wealth maximisation is not in conflict with the other motives like maximisation of sales or
market share. It rather helps in the achievement of these other objectives. In fact, achievement of
wealth maximisation also maximises the achievement of the other objectives. Therefore,
maximisation of wealth is the operating objective by which financial decisions should be guided.
The above description reveals that wealth maximisation is more useful if objective than profit
maximisation. It views profits from the long-term perspective. The true index of the value of a
firm is the market price of its shares as it reflects the influence of all such factors as earnings per
share, timing of earnings, risk involved, etc.
Thus, the wealth maximisation objective implies that the objective of financial management
should be to maximise the market price of the companys shares in the long-term. It is a true
indicator of the companys progress and the shareholders wealth.
However, profit maximisation can be part of a wealth maximisation strategy. Quite often the
two objectives can be pursued simultaneously but the maximisation of profits should never be
permitted to overshadow the broader objectives of wealth maximisation.
The financial management has come a long way by shifting its focus from traditional approach to
modern approach. The modern approach focuses on wealth maximization rather than profit
maximization. This gives a longer term horizon for assessment, making way for sustainable
performance by businesses.

Profit Maximization vs. Wealth Maximization

A myopic person or business is mostly concerned about short term benefits. A short term horizon
can fulfill objective of earning profit but may not help in creating wealth. It is because wealth
creation needs a longer term horizon Therefore, financial management emphasizes on wealth
maximization rather than profit maximization. For a business, it is not necessary that profit
should be the only objective; it may concentrate on various other aspects like increasing sales,
capturing more market share etc, which will take care of profitability. So, we can say that profit
maximization is a subset of wealth and being a subset, it will facilitate wealth creation.
Giving priority to value creation, managers have now shifted from traditional approach to
modern approach of financial management that focuses on wealth maximization.
This leads to better and true evaluation of business. For e.g., under wealth maximization, more
importance is given to cash flows rather than profitability. As it is said that profit is a relative
term, it can be a figure in some currency, it can be in percentage etc. For e.g. a profit of say
$10,000 cannot be judged as good or bad for a business, till it is compared with investment, sales
etc. Similarly, duration of earning the profit is also important i.e. whether it is earned in short
term or long term.
In wealth maximization, major emphasizes is on cash flows rather than profit. So, to evaluate
various alternatives for decision making, cash flows are taken under consideration. For e.g. to
measure the worth of a project, criteria like: present value of its cash inflow present value of
cash outflows (net present value) is taken. This approach considers cash flows rather than
profits into consideration and also use discounting technique to find out worth of a project. Thus,
maximization of wealth approach believes that money has time value.

An obvious question that arises now is that how can we measure wealth. Well, a basic principle
is that ultimately wealth maximization should be discovered in increased net worth or value of
business. So, to measure the same, value of business is said to be a function of two factors
earnings per share and capitalization rate. And it can be measured by adopting following relation:
Value of business = EPS / Capitalization rate
At times, wealth maximization may create conflict, known as agency problem. This describes
conflict between the owners and managers of firm. As, managers are the agents appointed by
owners, a strategic investor or the owner of the firm would be majorly concerned about the
longer term performance of the business that can lead to maximization of shareholders wealth.
Whereas, a manager might focus on taking such decisions that can bring quick result, so that
he/she can get credit for good performance. However, in course of fulfilling the same, a manager
might opt for risky decisions which can put the owners objectives on stake.
Hence, a manager should align his/her objective to broad objective of organization and achieve a
tradeoff between risk and return while making decision; keeping in mind the ultimate goal of
financial management i.e. to maximize the wealth of its current shareholders.
The important role of financial manager in modern business is as follows: 1. Provision Capital:
How to create and implement programs for Provision of capital required by the Company. 2.
Investor relations: the creation and maintenance of a sufficient market for company with the
Securities and maintaining a sufficient connection with the investment Bankers, analysts and
shareholders. 3.Short long-term financing: To the appropriate sources for the company current
loans from commercial banks and other lending institutions. 4. Banking and storage: agreement
with the bank, consider a given depots. 5. Credit and collections: the direct lending and
collection accounts for the company, including oversight of the necessary sales financing
arrangements, such as the payment of time and Leasing plans. 6. Investment: To raise money
from the company as needed and get create and coordinate measures for investments in pension
and other similar trust funds. 7. Insurance: Providing insurance protection as needed. 8. Planning
Control: Develop, coordinate and manage an appropriate plan for monitoring the measures. 9.
Reporting and Interpretation: To compare the information with business plans and standards and
to report and interpret the results of operations for all Levels of management and owners of the
company. 10. Evaluation and Consulting: For all segments management is responsible for policy
or action on any stage Operation of the company in achieving the objectives and effectiveness of
policies, organizational structure and procedures. 11. Tax Administration: the administration of
tax policy and procedures. 12. Government Reporting: monitor or coordinate the preparation of
the reports from government agencies. 13. Asset Protection: Protect company assets through
internal controls, internal audit and the appropriate insurance Cover.
Read more at: http://www.mbaclubindia.com/forum/functions-of-the-financial-manager6245.asp#.VMCuzixr_K8

Financial Concepts:
The Risk/Return
Tradeof
By Investopedia Staf

The risk/return tradeof could easily be

called the "ability-to-sleep-at-night test."
While some people can handle the
equivalent of financial skydiving without
batting an eye, others are terrified to climb
the financial ladder without a secure
harness. Deciding what amount of risk

you can take while remaining comfortable

with your investments is very important.
In the investing world, the dictionary
definition of risk is the chance that an
investment's actual return will be diferent
than expected. Technically, this is
measured in statistics by standard
deviation. Risk means you have the
possibility of losing some, or even all, of
our original investment.
Low levels of uncertainty (low risk) are
associated with low potential returns. High
levels of uncertainty (high risk) are
associated with high potential returns.
The risk/return tradeof is the balance

between the desire for the lowest possible

risk and the highest possible return. This
is demonstrated graphically in the chart
below. A higher standard deviation means
a higher risk and higher possible return.

A common misconception is that higher

risk equals greater return. The risk/return
tradeof tells us that the higher risk gives
us the possibility of higher returns. There
are no guarantees. Just as risk means
higher potential returns, it also means

higher potential losses.

On the lower end of the scale, the riskfree rate of return is represented by the
return on U.S. Government Securities
because their chance of default is next to
nothing. If the risk-free rate is currently
6%, this means, with virtually no risk, we
can earn 6% per year on our money.
The common question arises: who wants
to earn 6% when index funds average
12% per year over the long run? The
answer to this is that even the entire
market (represented by the index fund)
carries risk. The return on index funds is
not 12% every year, but rather -5% one
year, 25% the next year, and so on. An

investor still faces substantially greater

risk and volatility to get an overall return
that is higher than a predictable
government security. We call this
additional return the risk premium, which
in this case is 6% (12% - 6%).
Determining what risk level is most
appropriate for you isn't an easy question
to answer. Risk tolerance difers from
person to person. Your decision will
depend on your goals, income and
personal situation, among other factors.
Types of risk

First let's revise the simple meaning of two words, viz.,

types and risk.

In general and in context of this finance article,

1. Types mean different classes or various forms / kinds of
something or someone.
2. Risk implies the extend to which any chosen action or
an inaction that may lead to a loss or some unwanted
outcome. The notion implies that a choice may have an
influence on the outcome that exists or has existed.
However, in financial management, risk relates to any
material loss attached to the project that may affect the
productivity, tenure, legal issues, etc. of the project.
In finance, different types of risk can be classified under two
main groups, viz.,

1. Systematic risk.
2. Unsystematic risk.

The meaning of systematic and unsystematic risk in finance:

1. Systematic risk is uncontrollable by an organization and
macro in nature.
2. Unsystematic risk is controllable by an organization and
micro in nature.
A. Systematic Risk

Systematic risk is due to the influence of external factors on

an organization. Such factors are normally uncontrollable
from an organization's point of view.
It is a macro in nature as it affects a large number of
organizations operating under a similar stream or same
domain. It cannot be planned by the organization.
The types of systematic risk are depicted and listed below.

1. Interest rate risk,

2. Market risk and
3. Purchasing power or inflationary risk.
Now let's discuss each risk classified under this group.

1. Interest rate risk

Interest-rate risk arises due to variability in the interest rates

from time to time. It particularly affects debt securities as
they carry the fixed rate of interest.
The types of interest-rate risk are depicted and listed below.

1. Price risk and

2. Reinvestment rate risk.
The meaning of price and reinvestment rate risk is as
follows:
1. Price risk arises due to the possibility that the price of
the shares, commodity, investment, etc. may decline or
fall in the future.
2. Reinvestment rate risk results from fact that the interest
or dividend earned from an investment can't be
reinvested with the same rate of return as it was
acquiring earlier.
2. Market risk

Market risk is associated with consistent fluctuations seen in

the trading price of any particular shares or securities. That
is, it arises due to rise or fall in the trading price of listed
shares or securities in the stock market.
The types of market risk are depicted and listed below.

1. Absolute risk,
2. Relative risk,
3. Directional risk,
4. Non-directional risk,
5. Basis risk and
6. Volatility risk.
The meaning of different types of market risk is as follows:
1. Absolute risk is without any content. For e.g., if a coin is
tossed, there is fifty percentage chance of getting a head
and vice-versa.

2. Relative risk is the assessment or evaluation of risk at

different levels of business functions. For e.g. a relativerisk from a foreign exchange fluctuation may be higher if
the maximum sales accounted by an organization are of
export sales.
3. Directional risks are those risks where the loss arises
from an exposure to the particular assets of a market. For
e.g. an investor holding some shares experience a loss
when the market price of those shares falls down.
4. Non-Directional risk arises where the method of trading
is not consistently followed by the trader. For e.g. the
dealer will buy and sell the share simultaneously to
mitigate the risk
5. Basis risk is due to the possibility of loss arising from
imperfectly matched risks. For e.g. the risks which are in
offsetting positions in two related but non-identical
markets.
6. Volatility risk is of a change in the price of securities as
a result of changes in the volatility of a risk-factor. For
e.g. it applies to the portfolios of derivative instruments,
where the volatility of its underlying is a major influence
of prices.

3. Purchasing power or inflationary risk

Purchasing power risk is also known as inflation risk. It is so,

since it emanates (originates) from the fact that it affects a
purchasing power adversely. It is not desirable to invest in
securities during an inflationary period.
The types of power or inflationary risk are depicted and
listed below.

1. Demand inflation risk and

2. Cost inflation risk.
The meaning of demand and cost inflation risk is as follows:
1. Demand inflation risk arises due to increase in price,
which result from an excess of demand over supply. It

occurs when supply fails to cope with the demand and

hence cannot expand anymore. In other words, demand
inflation occurs when production factors are under
maximum utilization.
2. Cost inflation risk arises due to sustained increase in
the prices of goods and services. It is actually caused by
higher production cost. A high cost of production inflates
the final price of finished goods consumed by people.
B. Unsystematic Risk

Unsystematic risk is due to the influence of internal factors

prevailing within an organization. Such factors are normally
controllable from an organization's point of view.
It is a micro in nature as it affects only a particular
organization. It can be planned, so that necessary actions
can be taken by the organization to mitigate (reduce the
effect of) the risk.
The types of unsystematic risk are depicted and listed
below.

1. Business or liquidity risk,

2. Financial or credit risk and
3. Operational risk.
Now let's discuss each risk classified under this group.

1. Business or liquidity risk

Business risk is also known as liquidity risk. It is so, since it

emanates (originates) from the sale and purchase of
securities

affected

changes, etc.

by

business

cycles,

technological

The types of business or liquidity risk are depicted and listed

below.

1. Asset liquidity risk and

2. Funding liquidity risk.
The meaning of asset and funding liquidity risk is as follows:
1. Asset liquidity risk is due to losses arising from an
inability to sell or pledge assets at, or near, their carrying
value when needed. For e.g. assets sold at a lesser
value than their book value.
2. Funding liquidity risk exists for not having an access to
the sufficient-funds to make a payment on time. For e.g.
when commitments made to customers are not fulfilled
as discussed in the SLA (service level agreements).

2. Financial or credit risk

Financial risk is also known as credit risk. It arises due to

change in the capital structure of the organization. The
capital structure mainly comprises of three ways by which
funds are sourced for the projects. These are as follows:
1. Owned funds. For e.g. share capital.
2. Borrowed funds. For e.g. loan funds.
3. Retained earnings. For e.g. reserve and surplus.
The types of financial or credit risk are depicted and listed
below.

1. Exchange rate risk,

2. Recovery rate risk,
3. Credit event risk,
4. Non-Directional risk,

5. Sovereign risk and

6. Settlement risk.
The meaning of types of financial or credit risk is as follows:
1. Exchange rate risk is also called as exposure rate risk.
It is a form of financial risk that arises from a potential
change seen in the exchange rate of one country's
currency in relation to another country's currency and
vice-versa. For e.g. investors or businesses face it either
when they have assets or operations across national
borders, or if they have loans or borrowings in a foreign
currency.
2. Recovery rate risk is an often neglected aspect of a
credit-risk analysis. The recovery rate is normally needed
to be evaluated. For e.g. the expected recovery rate of
the funds tendered (given) as a loan to the customers by
banks, non-banking financial companies (NBFC), etc.
3. Sovereign risk is associated with the government. Here,
a government is unable to meet its loan obligations,
reneging (to break a promise) on loans it guarantees, etc.

4. Settlement risk exists when counterparty does not

deliver a security or its value in cash as per the
agreement of trade or business.
3. Operational risk

Operational risks are the business process risks failing due

to human errors. This risk will change from industry to
industry. It occurs due to breakdowns in the internal
procedures, people, policies and systems.
The types of operational risk are depicted and listed below.

1. Model risk,
2. People risk,
3. Legal risk and
4. Political risk.

The meaning of types of operational risk is as follows:

1. Model risk is involved in using various models to value
financial securities. It is due to probability of loss resulting
from the weaknesses in the financial-model used in
assessing and managing a risk.
2. People risk arises when people do not follow the
organizations procedures, practices and/or rules. That is,
they deviate from their expected behavior.
3. Legal risk arises when parties are not lawfully
competent to enter an agreement among themselves.
Furthermore, this relates to the regulatory-risk, where a
transaction could conflict with a government policy or
particular legislation (law) might be amended in the future
with retrospective effect.
4. Political risk occurs due to changes in government
policies. Such changes may have an unfavorable impact
on an investor. It is especially prevalent in the third-world
countries.
C. Conclusion

Click on this image to get a complete view of the types of

risk in finance.

Following three statements highlight the gist of this article on

risk:
1. Every organization must properly group the types of
risk under two main broad categories viz.,

a.

Systematic risk and

b.

Unsystematic risk.

2. Systematic risk is uncontrollable, and the organization

has to suffer from the same. However, an organization
can reduce its impact, to a certain extent, by properly
planning the risk attached to the project.
3. Unsystematic risk is controllable, and the organization
shall try to mitigate the adverse consequences of the
same by proper and prompt planning.
So these are some basic types of risk seen in the domain of
finance.
CONCEPT OF RETURN AND RISK
There are different motives for investment. The most prominent among all is to earn a return on
investment. However selecting an investment on the basis of return in not enough. The fact is
that most investors invest their funds in more than one security suggest that there are
other factors, besides return, and they must be considered. The investors not only
like return but also dislike risk. So, what is required is: a clear understanding of what risk and
return are and What creates them, and. How can they be measured?

Return:
The return is the basic motivating force and the principal reward in the
investment process. The return may be defined in terms of (i) realized return, i.e., the return
which has been earned, and (ii) expected return, i.e., the return which the investor anticipates to
earn over some future investment period. The expected return is a predicted or estimated return
and may or may not occur. The realized returns in the past allow an investor to estimate cash
inflows in terms of dividends, interest, bonus, capital gains, etc, available to the holder of the
investment. The return can be measured as the total gain or loss to the holder over a
given period of time and may be defined as a percentage return on the initial amount
invested. With reference to investment in equity shares, return is consisting of the
dividends and the capital gain or loss at the time of sale of these shares.
Risk:

Risk in investment analysis means that future returns from an investment are
unpredictable. The concept of risk may be defined as the possibility that the actual
return may not be same as expected. In other words, risk refers to the chance that
the actual outcome (return) from an investment will differ from an expected
outcome. With reference to a firm, risk may be defined as the possibility that the
actual outcome of a financial decision may not be same as estimated. The risk may
be considered as a chance of variation in return.
o f v a r i at i o n s a re c o n s i de re d m o re r i s ky t h an t h o s e w i t h le s s e r
Between equity shares and corporate bonds, the former is riskier than latter. If the
corporate bonds are held till maturity, then the annual interest inflows and maturity
repayment