MEANING & DEFINITION OF FINANCIAL MANAGEMENT

Financial Management is that managerial activity which is concerned with the planning and
controlling of the firm’s financial resources. It encompasses the procurement of the funds in the
most economic and prudent manner and employment of these funds in the most optimum way to
maximize the return for the owner. It is concerned with overall managerial decision making in
general and with the management of economic resources in particular. All business decisions
have financial implications and therefore financial management is inevitably related to almost
every aspect of business operations.
Financial Management has been defined differently by different authors. Some definitions of
Financial Management are as follow:

• J.F. Bradley, “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.”

• J.L. Massie, “Financial Management is the operational activity of a business that is

responsible for obtaining and effectively utilizing the funds necessary for efficient
operations.”

• J.F. Weston & E.F. Brigham, “Financial Management is an act of financial decision
making, harmonizing individual motives and enterprise goals.”

• Howard & Upton, “Financial Management may be defined as that area or set of
administrative functions in an organization which relate with arrangement of cash and
credit so that the organization may have the means to carry out its objective as
satisfactorily as possible.”

Hence, Financial Management is that specialized function of general management which is

concerned with the timely procurement of adequate funds and their effective utilization for the
efficient functioning of the business enterprise. Financial Management therefore includes
financial planning, procurement of finance, investment of funds and financial control.

The Financial Management is neither a pure science nor an art. It deals with various methods and
techniques which can be adopted, depending on the situation of business and the purpose of
decision. As a science, it uses various statistical and mathematical models and computer
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applications for solving the financial problems relating to the firm. For Example- Capital
investment appraisal, capital allocation and rationing, optimizing capital structure mix, portfolio
management etc. Along with the above, a Finance Manager is required to apply his analytical
skills in decision making. Hence, Financial Management is both a science as well as an art.

SCOPE OF FINANCIAL MANAGEMENT

The scope of financial management is determined from the stages of development of the study.
Financial management developed as a separate subject from economics in the year 1920. Its
scope has enlarged to make it an integrated and complete subject for every organization. Since
1950 it has assumed an important status. The scope of financial management is usually discussed
in these two phases and called traditional scope and modern scope of financial management.

TRADITIONAL SCOPE OF FINANCIAL MANAGEMENT

Traditionally financial management was used by corporate organizations mainly for the purpose
of finding the sources of funds and the methodologies of raising them from such sources and
utilizing them for the organizations requirements. It also incorporated the legal and accounting
requirements relating to sources and uses of funds.

Traditionally Financial Management was known as Corporation Finance and was called the
outsider looking approach .Its emphasis was centered on the following three issues:

• To organize funds from different sources like banks, investment companies and financial
institutions.

• To use financial instruments in the form of shares, debentures, bonds, fixed deposits for
company’s requirements.

• To settle the organization of funds through proper administration, preparation of reports,

legal advice and proper accounting records.

The traditional financial management had the following limitation:

1. External Decisions and not Internal Decision Making

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 Financial management emphasized the role of those who supplied funds to the corporate
organization. It was focused on outsiders like financial institutions, investment bankers and
banks. Therefore, it did not consider the role of the ‘inside’ or decision relating to internal
problems of the organization.

2. Long term Decisions and not Day to Day Decision Making

Traditional financial management focused on the long term capital planning. However, a
company cannot run on commercial activities without planning for its day to day working
capital. While investment decisions were given full consideration, working capital
management was not given any importance. In fact, it was completely ignored.

3. Procurement and not Allocation of Funds

The main interest of rendering financial management services was in procuring funds for
the business requirements of the firm. The question of how to use the funds and what
techniques should be used to allocate the funds was not considered.

These limitations made financial management an incomplete subject to run an organization

effectively and its role was confined to profit making and duplicating some of the work of
accountants rather making it an independent identity to solve the problems of acquisition and
allocation of funds. With the development of financial management it has become a complete
study of all the requirements of a corporate organization. It has also developed into an insider
looking approach taking care of not only the requirements from the suppliers point of view but
also the requisites of internal decision making and management.

MODERN FINANCIAL MANAGEMENT SCOPE/ FUNCTIONS

The modern scope of Financial Management has enlarged to include the following aspects of
an organization:

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 • To take financial decisions. (Investment, Financing and Dividend decisions).

• Managing the flow of funds (To match inflows and outflows of cash).

• To make a profitable venture (To see that losses are minimized).

• To create value for wealth management of share holders (To invest and finance
carefully).

• To balance conflicting goals for firm (Liquidity Vs Profitability, Profit Maximization Vs

Wealth Maximization, Risk and Return).

• To manage different groups of people (Shareholders, management, investors,

government, customers and suppliers).

• To take up social responsibility (To maintain fair practices like safety in working
conditions, providing fair wages to employees and looking after community interests).

Modern Financial Management is a concept of overall management of a company. Its scope is

broadly divided into three important decisions which may also be called the functions of
financial management/financial manager. These are investment decisions, financing decisions
and dividend decisions. It covers the areas of sourcing of funds, financial analysis, attaining an
optimum capital structure, profit planning and control, project planning and evaluation and
corporate taxation. It takes care of internal and external management of funds and covers the
requirements of different groups of people such as shareholders, management, investors,
government, customers and suppliers.

1. Investment Decision Making

A firm is required to take decisions relating to acquisition of long term assets and current assets.
Capital investment proposals require heavy investment. Therefore, there is the need for
evaluating them through techniques adopted in financial management. The long term decisions
will affect a firm for many future years. Once a volume of funds has been invested it is
important that the assets are used for the requirements of the firm. If allocated incorrectly the
firm will have long term repercussions in its internal management. The scope of financial

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management extends to taking decisions carefully for capital investment also called “capital
budgeting”.

2. Financing Decisions

A financial manager has to procure funds from different sources. He has to decide the quantum
of funds and the type of source that he should use for the firm. There is a cost attached to every
source of fund and hence balance has to be maintained between debt and equity. Debt as a
source is considered to be cheaper than equity as a resource but it is of high risk and the firm
should be able to repay its interest on taking debt. Financing decisions are taken through an
analysis of leverages to get the benefit of the funds. The scope of financial management
therefore extends to an analysis of operating leverage and financial leverage, earnings per share
of shareholders, the relationship of earnings before interests and taxes and earnings per share
and capital structure relationship. These decisions will help the company in finding out whether
it is able to cover its costs and decisions relating to new projects or expansions of their
operations.

3. Dividend Decisions Making

The scope of financial management also extends to the provision of providing dividends to
shareholders. A company cannot pay all its profits as dividends to shareholders. If it does so, the
company will not be able to fund new projects. Dividend decision making pertains to an
analysis of the right amount of dividend to be distributed to shareholders. It has to take care of
the legal restrictions and accounting processes before giving a dividend. The correct decisions
have to be taken regarding the percentage of reserves before distribution of dividends.
Therefore, financial management within its scope considers investment decision, financing
decision and dividend decision. Thus, it covers all the internal aspects of a firm.

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4. Solving Agency Problems

Financial management has an impact on different kinds of people associated internally and
externally with the organization. It covers the interest of both insiders and outsiders. Many types
of conflicts can arise while managing a firm. In normal pattern financial decisions have to be
taken to satisfy the requirements of shareholders, employees, customers, debt holders, suppliers
of the firm, general public, government and management. The problem that can arise is called
the agency problem or the conflict in decisions that satisfy the different groups of people.

The shareholders would be interested in maximizing their earnings but the creditors would be
interested in receiving a high rate of interest. The employees would be interested in high
perquisites. The management would be concerned about their own interests of profitability in
the firm. The financial manager has to take care that the needs of each of the groups is satisfied.
If there are any conflicts and costs arise out of the agency problem, financial management helps
in solving personal goals to make the working environment friendlier.

Other groups of people that are important for the organization are government, customers,
dealers and general public. All these groups of people are within the working scope of a
financial manager. He has to deal with all these groups of people and come to viable solutions to
make the organization profitable.

5. Balancing Profitability And Liquidity

Conflicts in goals have to be solved as they are within the ambit of the scope of financial
management. A firm has to balance its conflicts between being profitable and liquid. When
profitability increases a financial manager may have the problem of low liquidity as all the
funds may be used to make the profitable. Similarly, if there is too much availability of funds
but the firm does not make use of them then a cost will be attached to it. Hence the scope of
financial management is to balance conflicts in profitability and liquidity.

6. Profit And Wealth Maximization

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Modern financial management considers wealth maximization as a comprehensive term but the
financial manager has to make profits to make a commercial organization viable. He must try to
see that decisions relating to investment, financing and dividends are taken carefully so that the
earning per share of the shareholders increase. However, if profitability is low, earnings will not
increase. Therefore, in a sense profit maximization is incomplete but wealth maximization is a
complete concept and is superior to profit maximization as it works under the principles of
financial management.

7. Risk and Return

High return brings about high risk but an organization has to consider several factors before
undertaking high risk because it can make loss if decisions are not taken properly. Therefore,
the scope of financial management is to invest cautiously through proper calculations by
applying techniques through matching of risk with return. A financial manager must calculate
the risks attached to an investment and its effects on the organization.

Every decision that a financial manager takes will have the dimension of both risk and return.
The degree of risk in each decision will be different. A decision cannot be risk free because
market risks cannot be completely eliminated. There are two important risks. These are called
systematic and unsystematic risk. The unsystematic portion of the risk can be reduced till it
becomes nil if proper controls are scheduled but market risks depend on factors beyond the
control of individual. A combination of risk and return which gives optimum results to a firm is
called ‘risk return trade off’.

8. Social Responsibility

The scope of modern financial management now extends to ethics and social responsibility.
Although the functions of financial manager are primarily towards making an organization to
source and use funds effectively, it has an added responsibility of being fair to the people within
and outside the organization. Every organization should be engaged in providing fair wages to
employees and fair dealings with the community.

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 OBJECTIVES OF FINANCIAL MANAGEMENT

The objectives of financial management should have the characteristics of clear, unambiguous
and well defined goals. Its decisions should relate to the fact that a firm/ company will have a
long term existence. Profit is a test of economic efficiency of an organization. Financial
management deals with efficient sourcing and utilizing funds but it goes beyond maximization
of profits. It believes in not only the quantity of profits for efficiency in a firm but also the
benefits of quality. It therefore has qualitative and quantitative benefits in a firm.

Profit Maximization is a narrow objective of financial management but Wealth

Maximization can be called the comprehensive term that covers the objectives of financial
management and is superior to profit maximization.

The objectives of financial management are discussed by first understanding the concepts of
profit maximization and wealth maximization. Since profit maximization concept has certain
limitations and is narrow in approach. Wealth maximization is considered to be the ultimate
goal of financial management.

1.1PROFIT MAXIMIZATION
Profit maximization is an accounting term. A firm incurs revenue expenses and receives
revenue returns during a year. At the end of the year a statement is prepared to find out the
checks and balances of the year. If its revenue is higher than its expenses it makes a profit
and this profit judges the efficiency level of an organization. All organizations apply this
method for providing to the third parties the picture of the firm. This aspect is like the
older concept of financial management. In the modern day world there are more
complexities in an organization. Profit maximization helps an organization to find out
whether it is able to cover its costs or not. However, it has some benefits and limitations:

Benefits of Profit Maximization:

Profit maximization is useful in an organization for the attainment of the following

benefits:

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 1. It acts as a barometer to an organization to find out whether the firm is running
efficiently as a commercial enterprise or it is unable to meet its expenses.

2. It provides information about the company to people who would like to invest in it. A
profitable company becomes an attractive investment.

3. If a firm is profitable then the company can decide to expand or diversify its business.

Limitations of Profit Maximization:

Profit maximization has the following limitations:

1. Profit maximization does not study the concept of time value of money.

2. It concentrates towards providing a rosy picture to the third parties and public but it is
not concerned with decision making for internal efficiency.

3. It does not have techniques or theories through which it is able to analyze risks of a
firm.

4. It focuses on profit and does not take any steps towards maximizing the wealth of the
shareholders.

5. It makes quantitative calculations but does not consider the qualitative aspects of an
organization. For example, it does not take steps towards responsibilities and ethics for
society.

6. Profitability is based on accounting concept. It does not give a clear picture because it
does not take inflows and outflows of cash for calculation. It includes depreciation and
this is not a true indication of the cash flows in an organization.

7. Profit maximization must be used with wealth maximization to support the modern
scope of financial management.

1.2WEALTH MAXIMIZATION

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Wealth maximization is based on the principles of the financial management. It is superior
to profit maximization. It takes into consideration time value of money, cash flows, risk
and return and considers only incremental cash flows of the organization. Its main
objective is to create and manage wealth of the shareholders to maximize it while
organizing it.

The wealth of the shareholders can be maximized by taking investment, financing and
dividend decisions carefully. This means that the techniques of financial management
should be applied to get maximum benefit. Wealth can be maximized when the present
value of the share can be calculated through time value management and by using the cash
flows technique in finding out the present value and future values of the share.

Wealth can be maximized by analyzing the features of risk and finding out the amount of
return. This provides an understanding to the market value of the share. Therefore, it
measures the concepts of risk and uncertainty.

Wealth maximization also considers qualitative aspects. It considers the requirements of

different groups of people in the organization. It identifies the requirements of
shareholders, employees, management, government, customers, agents and suppliers. It
resolves agency problems and costs attached to any conflicts arising out of their
interaction.

Modern financial management also applies ethical and social responsibility issues while
maximizing the wealth of the shareholders.

Benefits Of Wealth Maximization:

Benefits of wealth maximization can be summarized as follows:

1. Maximization of shareholders wealth analyses the present value of the share and the
future values through the application of financial management principle.

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 2. It applies time value of management through compounding and discounting
techniques for single and multiple cash flow for a future period or finding out the
present value of a share. It also provides an understanding of multiple compound
periods, annuities and annuities due.

3. It applies the cash flow concept which is according to the principles of financial
management. It considers cash items only and in this way it is able to calculate the
correct resources of the organization.

4. It applies qualitative analysis to the problems of different groups of people in and

organization. Therefore, it covers the qualitative techniques and also qualitative
aspects in an organization.

5. Wealth maximization is a concept which is applied only with ethical and moral values
such as fair wages, minimum wage regulation, prohibition of child labour, creating
friendly environment, pollution control etc.

6. Wealth maximization is clear, not ambiguous and has proper techniques of analysis
for calculation of the valuation of share, dividend, present and future values of a share.
This reflects in the market value of the share.

PROFIT MAXIMIZATION vs WEALTH MAXIMIZATION

S.No. Basis of Difference Profit Maximization Wealth Maximization

1. Nature It judges the performance of an It judges not only the firm’s
organization through the performance but also the
calculation of profits and losses. earnings per share of the
shareholders.
2. Applicability of Time It ignores time value of money for It considers time value of
Value of Money finding out the performance of a money for finding out the
Concept company present value and future
value of shares.
3. Consideration It considers accounting profit but It takes into account cash
does not take cash flow analysis. flow analysis which is based
on the principles of financial
management.
4. Risk – Return It considers return but does not It analyzes both risk and
Relationship analyze risks attached to it. return according to the
techniques of financial
management.
5. Basis of Decision It takes decisions on the basis of It takes investment financial
Making quantitative analysis. and dividend decisions on
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 the basis of quantitative and
qualitative aspects.
6. Cash and Non – Cash It takes cash and non – cash items It takes only cash items as
items for finding out the performance of according to the principles
the company. of the financial
management. Non – cash
items do not give the correct
picture of cash flows in an
organization.
7. Social and Legal It does not make any analysis on It analyzes social and legal
Aspects the qualitative aspects of an aspects of running an
organization. enterprise and considers
quantitative and qualitative
aspects.

RELATIONSHIP OF FINANCIAL MANAGEMENT AND OTHER

AREA OF MANAGEMENT
Financial management is closely related to other subjects. An insight of its relationship
with other subjects is as follows:

 Financial Management and Financial Accounting:

Accounting is a resource or an input to financial management decisions. Financial

management and financial accounting are complimentary to each other. The accounting
tools are an input to financial decision – making. Financial accounting uses financial
statements like balance sheet, profit and loss account; fund flow and cash flow statements
to project the profitability of the firm. Financial management uses the information to make
decisions relating to investment, financing and dividends to reach the goal of wealth
maximization.

The modern concept in which financial management has developed brings about the fact
that both financial management and financial accounting resemble each other. They are
complementary, yet two different areas of study. It is often stated that the accounting
manager is responsible for providing information to the finance manager for decision
making in a corporate organization.

 Financial Management and Economics:

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Financial management branched out from the subject of economics and is complementary
to macro and micro economics. Both finance and economics make an analysis of money
and capital markets, financial intermediaries, banking system, monetary credit and fiscal
policy. Financial management takes the information relating to the financial environment
and prepares policies for firms and takes financial decisions within the ambit of the
monetary and fiscal policies in an economy. Changes in economic policy have to be
applied by the financial manager whole taking decisions.

Micro economics consists of concepts and theories relating to supply and demand, price,
profitability and profit maximization strategies. Financial decisions have to continuously
evaluate price of a product, sales revenue and financing decisions of a firm.

 Financial Management And Marketing Management:

Financial management and marketing management are inter – related in a firm/company.

All marketing decisions are based on financial implications. Good credit and discount
polices for customers, sales, credit, revenue, advertisement budgets, brands, patents are
part of the activities of a financial manager as it affects the liquidity position of a firm.

 Financial Management And Human Resource Management:

Human resource management is complementary and in some ways dependent on a

financial manager to take decision regarding recruitment and placement of manpower as
there are financial implications affecting the liquidity of a firm. People should be hired
only after calculating the costs to the company as well as the benefits occurring after
hiring certain people. A balance will have to be maintained as liquidity and profitability as
well as the well being of the shareholder will be considered.

 Financial Management And Production Management:

The production department in an organization is given the responsibility of procuring

material, machineries, spares and consumables and inventory. The financial manger has to
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 take financial decisions and make financial policies after finding out their implications on
decision-making areas like capacity utilization, replacement of machines, installation of
safety systems and increase in production capacity to enhance sales. The policies of
financial manager has a direct implication on the company/firm as a whole because excess
inventory will cause ‘carrying costs’ whereas reduce inventory will have implication of
‘cost of not carrying’ affecting the production of the firm.

Financial management has thus become useful for obtaining funds as well as for their
efficient allocation. It is related and complementary to financial accounting, economics,
marketing, human resources and production management. The financial manager balances
liquidity with profitability after which he approves of an activity of expenditure. An
‘insider looking approach’ is used with the goal of wealth maximization of the
shareholder. The financial manager has thus a high status in an organization.

LIQUIDITY VS. PROFITABILITY

Liquidity and profitability in a firm are conflicting goals that a financial manager has to
balance. Liquidity means that a firm is able to make its payments timely. Profitability will
enable a firm to be informed whether its business is sustainable and will continue to
function. If a firm is profitable, it will continue its operations if it has cash to pay for its
obligations. Therefore, liquidity and profitability move in a circle with risk and return.

Liquidity may be achieved by the following:

(i) Managing Flow of Funds: Adequate cash in the company for making payments.

(ii) Matching Cash Flows: A firm forecasting its future cash inflows with its cash
outflows.

(iii) Sourcing of Funds: To identify resources within the organization and the
possibility of raising funds as required on an immediate basis for making
payments.

(iv) Cash Reserves: To identify internal reserves to meet contingencies of the firm.

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Profitability can be attained in the following manner:

(i) High Risk High Profitability: To increase profitability by using leverage.

(ii) Forecasting Future Profit: To evaluate expected profits by forecasting them.

(iii) Measure Cost of Capital: To find out the cost of each source of capital as it is
linked to profitability.

(iv) Cost Control Measure: To control each department by proper maintenance of

records and making effective policies.

(v) Pricing: A good pricing system of the products of the organization will help in
bringing about profitability in a firm.

METHODS / TECHIQUES OF FINANCIAL MANAGEMENT

Modern financial management covers tools and techniques of evaluation in the following
areas:

1. Capital Budgeting: The techniques in capital budgeting provide an analysis for

selection of a single project as well as for taking mutually exclusive decisions through
different traditional and modern discounting methods of payback period, average rate of
return, net present value, profitability index and internal rate of return.

2. Cost of Capital: Decisions relating to sources of capital and costs relating to different
sources of funds can be taken by applying the tools a method of determining cost of
capital and optimum capital structure of a firm.

3. Operating and Financial Leverage: Leverages provide an assessment of the

commercial viability and financial viability of a concern. By applying these techniques a
firm can avoid financial distress situation.

4. Working Capital: Modern financial management provides models, theories, concepts

and practical applications for management of cash, procurement of optimum inventory
and effective management of current assets.
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5. Fund Flow and Cash Flow Analysis: This technique provides to a financial manager
the basis for finding out the sources of funds and their utilization. The projected analysis
of funds and cash assists a firm in future working capital requirements of a firm.

6. Dividend Decisions: Dividend models provide a basic understanding to the corporate

policy, amount, form and time of dividend payment.

7. Economic Value Added (EVA): A financial manager has the important function to
create economic value to the organization. EVA will provide the company after tax
profits from operations by deducting the cost of capital employed to produce those
profits. EVA brings about financial discipline and maximizes the wealth of the firm by
taking correct decision.

S.No. Type of Decision Tools/Methods

1. Investment Decisions Capital Budgeting – Payback, Average
Rate Of Return, Net Present Value,
Internal Rate Of Return, Profitability
Index.

Working Capital Management, ABC

Analysis, Inventory Pricing, Aging
Schedule, Cash Management Models,
Concentration Banking, EOQ Model,
Liquidity vs. Profitability, Receivables
And Discount Management.

2. Financing Decisions Operating and Financial Leverage,

Trading on Equity, Cost Of Capital.

3. Dividend decisions Dividend Policy, Models, Forms,

Payment.

4. Performance Evaluation Decisions Ratio Analysis, Cash Flow, Fund Flow

Analysis, Budgetary Control, EVA.

ORGANIZATION OF FINANCE FUNCTION

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Financial management is important and inter – related with the other departments of a firm. It
prepares financial policies for all the departments of the firm. The organization structure of a
firm shows that all large firms have voice presidents in different fields directly below the
president of accompany. Amongst the vice presidents of different departments there is also a
position especially for a vice president in the area of finance. The financial function assumes
important due to its work of both a controller and a treasurer. The company prepares policies,
evaluates and reviews tax planning and management, cost accounting management, credit
administrating, investments and banking through its “financial controller” functions.

The ‘Treasury’ function is engaged with financing planning and fund raising, cash
management, credit management and foreign exchange management. Its function consists of
providing a good cash balance and matching of cash inflows and cash outflows to meet
liquidity requirements of the firm. It is able to control conflict situations such as agency
problems. It also involves public relation and interaction of the firm with capital market and
financial markets.

The primary concern of the financial departments is the creation of wealth for its shareholders.
Apart from the shareholders the financial managers have to take a decision to satisfy various
groups of people. Financial decision-making is also under the constraints of responsibility
towards government, legal and environmental aspects and responsibilities towards society.

BOARD OF DIRECTORS

PRESIDENT

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 Vice-President Vice-President Vice-President
Marketing Finance Production

Chief Chief
Finance Finance
Manager Manager
(Controlle (Treasurer)

Tax Financial Capital Cash

Manager Accounting Expenditur Manager
Manager e Manager

Cost Data Credit Portfolio

Accounting Processing Collection Manager
Manager Manager Manager

Appraisal or Appraisal
Reporting or
Reporting

The financial manager has to be closely connected with the borrowers of the firm. It covers
individuals and organizations providing funds to the company. The finance function manager
has to be responsible towards such borrowers. Financial policies and decisions have to be taken
to favor the customers and suppliers of the firm to enhance the reputation and value of the firm.

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 Financial decision-making thus affects shareholder, government agencies, customers, creditors
and debtors of the firm and the general public. The finance director is responsible for taking
decisions to suit the requirements of all these groups of people and institutions.

The finance function also covers functional areas such as marketing, human resources and
production. Each financial manager has a role to play and the reports to the vice- president of
finance. The managers perform the specific treasury and controlling functions. Each manager
looks after one of these functions. The ultimate authority is that of the finance vice-president
and reports to the president and other functional vice-presidents regarding policies and controls
of that functional department. The financial policies are continuously reviewed and evaluated.
They work according to the principles of financial management.

**********************

SOURCES OF FINANCE

CLASSIFICATION OF SOURCES OF FINANCE

The different sources of finance that are required by a company can be classified into long term,
medium term and short term funds. The short term requirements are usually due to the non
synchronization of cash inflows with outflows. Short term sources of funds are useful for
investment in current assets. Such requirements range from a period of one day to a maximum of
one year. The sources of short term financing are trade credit, factoring and forfeiting, bill
discounting, overdrafts and cash credits from banks and borrowing against receivables. The firm
can also get short term funds from customers as advances on purchases, and through the use of
credit cards. Long term requirements are for acquisition of long term fixed assets. Long term
sources of funds are needed for a period of 5 to 25 years for investments when a company takes a
decision to start a new venture or expand its present business. The sources of long term finance

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are from internal resources like retained earnings and external sources are from equity capital,
debentures, bonds, preference shares, term loans and innovative instruments.

A company also needs medium term finance for a period of 1 to 5 years. Medium term finance is
needed by a company to make permanent additions to their working capital or to buy fixed
assets. Repayment of loan taken by the company for such an intermediate period is done by
liquidating the assets is financed or through profits or cash flow it generates from its operations.
The sources of medium term finance are leasing and hire purchase as well as fixed deposits from
public and directors of the company and medium term loans from banks.

The classification of sources of funds can be summarized as follow:

SOURCES OF FINANCE

LONG TERM MEDIUM TERM SHORT TERM

SOURCES SOURCES SOURCES

a) Equity Share Capital a) Medium Term a) Cash Credit

Loans
b) Redeemable Preference b) Overdraft
Share b) Deferred Credit
c) Bill Discounting
c) Debentures/Bonds c) Public Fixed
Deposit d) Commercial Paper
d) Long Term Loans
d) Leasing & Hire e) Export Credit
e) Seed Capital Purchase f) Trade Credit
f) Retained Earnings

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 FACTORS AFFECTING THE CHOICE OF A SOURCE OF FINANCE
Funds for financing company’s requirements should be analyzed before the company looks for
sources of funds. Factors to be considered while taking funds for a company’s requirements are
as follow:

1) RISK
The objective of financial management is to maximize the wealth of the shareholders. To fulfill
this objective the financial manager should consider the risk and return of all the loans taken on
behalf of the company for short term, medium term and long term requirements. Every source of
funding is a loan be it short or long and has the various kinds of risks attached to it. If the
company requires a higher return it has to be prepared for higher risks. Higher risks may
temporarily bring about a good return but in the long run it is a potential threat to the
shareholders and to the existence of a company so the risks and return trade off must be
considered. Market risk is not controllable as it depends on factors external to the company.
Internal risks can be controlled through good management policies. To emphasize, risk and
return dimension cannot be ignored, the amount of funding required should be carefully analyzed
before the company actually decides on taking it.

2) RETURN ON FUNDS:
When funds are sourced from the market the financial manager must remember his obligations
towards the shareholders. He should assess the level of expectation of return of the shareholders.
He must see the effect of new finance in the company with respect to the expected profitability of
the company. Interest will have to be paid on the borrowed capital. This may have the effect of
increasing or decreasing profitability. Only when the financial manager feels that the return
brought about will be good from taking a loan he should take it.

3) COST OF FINANCING:
There are several costs attached to funding an enterprise. The cost of serving the finance through
interest payments is a major cost and needs analysis before committing the company to it. There
is a cost of excess funding as well as if the funds were less than the firm’s requirements. The cost

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of illiquidity in the event of not using the funds increases the cost to the company. If a company
does not use the funds that it has scored and cannot return it, the funds become illiquid.

4) DEGREE OF CONTROL:
Type of funds must be analyzed carefully to see that the control of the shareholder is not diluted
by taking loans. The increase in the numbers of creditors will reduced the power of the
shareholders as they have to return the money to their creditors in addition to paying them
interest. The capital structure of the company should be balanced and there should not be a very
high level of debt on it. A ratio of 2:1 is acceptable as debt reduces cost because of deduction in
taxation.

MAJOR SOURCES OF FINANCE TAPPED BY THE

COMPANY

I) SECURITY FINANCING
Security financing is a method of getting external source of financing for the company. The
important securities which help in raising funds for a company are as follow:

• EQUITY SHARES: Equity Shares are called ownership shares because the
holder of the shares participates in earnings of the company by receiving dividends from it.
The ownership rights are exercised through voting in important decision making areas of the
company. Equity shares are called high risk securities because its return varies with the
profitability of a company. Dividend is declared by the company only after making a
provision for reserves, depreciation and taxation. However, equity shares have the benefit of
being traded in a secondary market if its shares are listed on the stock markets.

• PREFERENCE SHARES: Preference shares have ownership rights in the company.

They have a right to receive dividends of the company. They have a preferential right receive
dividends before the equity shareholders of the company. Preference shares do not have
voting shares and they have fixed dividends. Although preference shares resemble equity
shares they have certain special features. They can be issued as cumulative or non-

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 cumulative shares, redeemable or irredeemable, participating and non-participating,
convertible and non-convertible shares.

• DEBENTURES/BONDS: Debentures and Bonds are debt securities they have the
same features. They have a specified rate of interest and a date of maturity. They are both a
form of sourcing finance for long term purposes.

II) LOAN FINANCING

Long term loans are taken by the industrial organization at the time of starting a new business for
expanding their business activities. These loans are of period between 5 years to 10 years. In
India such loans were being disbursed to industry by financial institutions like Industrial
Development Bank of India (IDBI), Industrial Credit and Investment Corporation of India
(ICICI) and Industrial Financial Corporation of India (IFCI). These institutions were specially
setup to provide financial support and facility to industry for development. Commercial banks
since 1991 after India’s new economic reforms have emerged into institutions providing long
term loans in addition to their services to provide loans only for working capital requirements to
industries.

ADVANTAGES DISADVANTAGES
1) Term loans taken by industry from 1) Term loans have restrictions on the working
financial institutions are attractive because of the company.
they have a low rate of interest and have a
low financial burden on the resources of the
company.

2) It has the advantage of a moratorium
period. Thereby, the company does not have
to pay in the beginning years of taking a
loan.
3) Interest charges are tax deductible.
2) Some covenants are negative and the
functioning of the company become difficult
because permission has to be taken from the
lender for every small change it wants to
incorporate.
3) Flexibility in working is reduced and the
company has to work according to the rules and
regulations framed by the lender until the loan is
returned.

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III) PROJECT FINANCING
Project financing refers to managing and financing the economic activities of large
infrastructural projects. High cost with large volume of funds such as power stations, fertilizer
plants, satellites, oil, gas and hotel projects are some infrastructure related project. Special
techniques are required to manage its finances. The financial techniques which had been applied
to oil and gas are now being used for financing other large projects. The two most important
aspects in project financing of these industries are risk and cash flow analysis.

Project finance is a series of techniques for assessing risks and calculations of cash flows
generated by a project. It is a method of risk sharing by the owner or sponsors and lenders of the
company. Project finance is risk management and risk sharing approach so that the owner or
sponsors exposure is limited. Banks and equity investors can get a greater spread over their cost
of funds or returns, enhancing their overall yield on portfolios. In this manner developing
countries can develop many projects. If government and private players become partners, then
government can use funds belonging to other than their own for developing projects with limited
liability for any shortfalls of cash required for payments of debt and equity holders.

ADVANTAGES DISADVANTAGES
1) It provides the company’s owners to 1) The projects consists of a large volume
finance large projects beyond the financial of funds and are subject to risks. These add to
ability of the company. the cost of the project and are subject to losses.

2) The sponsor’s accounts do not have 2) Project finance requires good management
the impact of the project finance because it is
from the lenders and the sponsors. It requires
a separate entity. risk management and cash flow analysis.
3) The high leverage used by project 3) Project finance requires many expenses like
financing benefits the equity holders. government guarantees, paying royalties,
raising debt.
4) Sponsors, customers, suppliers and 4) Project financing requires surrender of all or
government share the risk of the project and part of the interest to another company in
therefore projects of large magnitude can be exchange for finance and reduced net profits
started for the development of the company. and interest of these sponsors.

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IV) LOAN SYNDICATION
Loan syndication is a service provided by merchant bankers for financing a project or for
working capital requirements of a company. The financial institutions like IFCI, IDBI, ICICI,
Life Insurance Corporation of India, Unit Trust of India and General Insurance Companies and
State financial institutions like SFC’s and SDC’s are suppliers of finance for loan syndication.
The merchant bankers undertake the service of loan procurement and raising of loans from India
and abroad. They prepare the loan application forms and follow up the loan procedure with
financial institutions and banks.

ADVANTAGES DISADVANTAGES
1) The company does not have to 1) Merchant bankers provide services that are
identify potential sources of finance for fee based. This is an additional burden on the
taking loans; merchant bankers take up the resources of the company besides the interest
work for a fee. charges that they have to pay to the financial
2) Merchant bankers have preliminary institutions and banks.
discussions with the financial institutions for
the benefit of both the parties. The company
can rely on their trusted merchant bankers to
get them the best deals.
3) Merchant bankers draw up the loan
deed and also get the amount disbursed
quickly.

V) BOOK BUILDING
New Issue Market and stock market are complementary to each other as they are inter-linked
through the functions that they perform. New Issue Market/Primary Market performs the
function of providing an environment for the sale and purchase of new issues; whereas stock
market has the function of trading the securities after the new securities are allotted and then
listed with it.

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Book building is the term which is used in the context of the sale of a new security offered for
the first time in the New Issue Market before the trading of this share begins in the stock market.
This is a new concept in India and is one of the developments in the financial market to bring
about a fair and just system of issuing shares through openness and public demand.

Book building is a process of offering shares to public in the new issue market through public
demand by bidding for the shares. Based on these bids price is discovered. A price band is given
and the public is asked to bid for the price within that band. The preferred price settles the
pricing of the issue. Book building facility was developed in the initial public offer to bring about
the flexibility of price and quantity, which would be decided on the basis of demand.

The bidding process is to be open for 5 days. The retail bidder has the option to bid at cut off
price, they are allowed to revise their bids and the bidding demand is displayed at the closing
time each day. The syndicate members can bid at any price.

VI) DEPOSITORY OR PAPERLESS TRADING

Dematerialization of securities for electronic trading of shares is one of the major steps for
improving and modernizing the stock market and enhancing the level of investor’s protection. It
is expected that it would eliminate bad deliveries and forgery of shares and expedite the transfer
of shares. Long-term benefits are expected to accrue to the market through the removal of
physical securities.

The stock market in India was computerized and trading was made online. The Depository Act
was passed in 1996 for trading online in shares that were dematerialized and transfer of security
through electronic book entry to help in reducing settlement risks and infrastructure bottlenecks.
The dematerialized securities do not have any identification numbers or distinctive numbers.

Dematerialization takes place in India through a multiple depository system. In India, there are
two depository services. The National Securities Depository Ltd. (NSDL) was set up in
November 1996. Another depository called the Central Depository Service Ltd. (CDSL) was also
set up for the purpose of transferring dematerialized shares. Trading of new Initial public offers
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was to be in dematerialized form upon the listing of the shares. Dematerialized form of trading is
done only in shares. Debt instruments however, are not transferable by endorsement delivery.

ADVANTAGES
1) Transactions carried out through the depository system eliminate risks, as it does not
have physical certificates. The problems regarding bad deliveries or fake certificates are
avoided.

2) The transfer of securities is done electronically. As soon as the transaction is carried out
securities are transferred immediately.
3) There is no stamp duty on transfer of securities because there is no physical transfer of
certificate.

VII) FACTORING
Factoring is a financial service for financing credit sales in which receivables are sold by a
company to a specialized financial intermediary called ‘factor’. The factor provides several
services to the company that draws up an agreement, for managing its receivables. These
services pertain specially to protection of the company from credit risks. In addition the factor
also manages the finances of the company, maintains its accounts and collects its debts. For this
service the factor charges a fee or a commission for taking the responsibility of realizing the
receivables from the customers. Factoring involves 3 parties in the agreement. These are the
seller, the buyer and the factor.

While factoring is a financial intermediary for credit sales within the country. Forfeiting is
financing of receivables that arise out of international trade. Banks and financial institutions
purchase trade bills or promissory notes through discounting and cover the risk of non payment
at the time of collection of dues. The purchaser becomes responsible for the risk. He pays cash to
the seller on discounting of the bills.

VIII)VENTURE CAPITAL

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Venture capital finance is a private equity investment fund through which funds are borrowed by
investors who have the technical know how. The venture capitalists make an agreement whereby
they support the project and fund it, in return for momentary gains, shareholding and acquisition
rights in the business financed by them. This service has the advantage of merging of technical
ability with financial strength with part ownership of an enterprise coupled with capital gains.

The first venture capital fund in India was established by Industrial Finance Corporation of India
(IFCI) in 1975. It was called the Risk Capital Foundation (RCF). Venture Capital funds in India
are of four different types. These are the sponsored venture capital funds by development
financial institutions, the state level sponsored development financial institutions, funds
promoted by public sector banks and the private venture capital funds.

IX) CREDIT RATING

Credit rating is a service provided by a credit rating agency for evaluating a security and rating it
by grading it according to its quality. In India, credit rating had its inception in 1987 with the
incorporation of the first service company named Credit Rating Information Services of India
Limited (CRISIL). There are four rating agencies in India. These are CRISIL (Credit Rating
Information Services of India), ICRA (Investment Information and Credit Rating Agency of
India), CARE (Credit Analysis and Research Ltd.) and Duff and Phelps. These rating agencies
are registered and regulated by SEBI. CRISIL has about 42% market share and CARE 36%.

ADVANTAGES
1) The information provided by rating
agencies is like a ready reference for
investors. They do not have to look into the
books of account of the company.
DISADVANTAGES
1) Credit rating depends on the factors analyzed
by a credit rating company. It has no liability
because it is making its own estimation of the
company.

2) Merchant bankers, brokers, traders, 2) Rating by the credit rating agency is after
loan providing agencies make their own taking the external and internal factors of the
estimates of the company before dealing company bit its rating is made specifically for a
with it. The creditability of the company is debt instrument and not a business house.
reinforced by information provided by well
known credit rating agencies.
3) The company whose credit rating
has been done by an agency is repute is
ranked as a safe option and its debt

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securities are preferred by investors.

X) COMMERICAL PAPER (CP)

A commercial paper is an unsecured, short term negotiable instrument with affixed maturity. It is
used for raising short term debt. It is an obligation of the issuer. It is an unsecured promissory
note. It does not have any collateral and it si issued for a period between 7 days and three
months. In India, commercial papers are popularly used between 91 to 180 days. It is a promise
by the borrowing company to return the loan on the specified date of payment.

Commercial paper no doubt is a very important alternate source to bank financing for short term
requirements. It is not tied to any specific trade transaction and very little paper work is involved.
A corporate organization can directly issue commercial papers to investors. This direct dealing
between a company and an investor is called a ‘direct paper’. This is called ‘dealer paper’. The
dealer buys at a lower price and sells at a higher price and gets a commission. In India, this is a
relatively new instrument. It was introduced in 1990 with the objective of providing short term
borrowing. A company is allowed to issue commercial papers. Individuals, non-residents
Indians, banks, companies and registered organizations can invest in commercial papers. Non-
residents Indians cannot transfer or repatriate the commercial papers issued to them. They are
issued at a discount on the face value and their rate is determined through the interplay of market
process of demand and supply. Reserve Bank of India regulates the commercial papers in India.

ADVANTAGES DISADVANTAGES
1) The commercial paper is made 1) Commercial paper does not have any
without pledging any assets. It is a promise collateral. It depends on the credit worthiness of
based on reputation of the company. the company.

2) The guarantee in the agreement is 2) Commercial paper is not as reliable a source

based on credit worthiness, earning capacity
and liquidity of the company.
3) A commercial paper is a very useful
instrument for short term requirements as no
documentation is required.
4) The commercial paper can be
designed between the issuer and the acceptor
and according to their needs the maturity
period can be fixed.
5) It is not necessary to have any trading
as a bank. A buyer of a commercial paper has
no obligation towards anyone.
3) Commercial paper cannot be liquidated
before the maturity date.
4) There is no flexibility after the commercial
paper has been designed and signed.
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transaction between the parties entering into
an agreement and making a commercial
paper.

XI) CERTIFICATE OF DEPOSIT (CDs)

A certificate of deposit is a securitized short term deposit issued by the banks at high interest
rates during the period of low liquidity. The liquidity gap is met by banks by issuing CDs for
short term periods of time. Since the interest rate is attractive CDs are kept till maturity. CDs are
becoming popular because since 2004 there has been a reduction on their stamp duty, withdrawal
of tax deduction at source, opportunity for trading in the stock market and requirement of closure
of deposits only at maturity. In India, CDs are being issued by banks either directly or through
dealers. A CD is negotiable short term instrument in bearer form. They are a part of bank
deposits and are issued for 90 days but the maturity period can vary according to the
requirements of corporate organizations. The minimum issue of CDs to single investor is Rs. 10
lakhs and can be further issued in multiple of Rs. 5 lakhs. They can issue at a discount on the
face value and they are transferable after a lock in period of 30 days from the time of issue. The
CDs market is larger than the CPs market. The rate of CDs is determined by the market. They are
used for interim requirements and for financing current transactions.

ADVANTAGES DISADVANTAGES
1) Certificate of Deposits is financed by 1) Certificate of deposits is a high cost of
banks. It is a formal financing method and it has financing as banks charge a high rate of
a structured form which is filled in by the bank. interest.

2) It provides liquidity through funding to 2) Certificate of deposits is an expensive

small, medium and large companies during a instrument as they have stamp duties levied
period when finance is difficult to get from other on it.
market sources.
3) The maturity date of the instrument can
be designed for a particular investor depending
on his requirement for funds. This gives
flexibility to the instrument
4) CDs have the facility of being traded in
the stock exchange.

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XII) GLOBAL DEPOSITORY RECEIPTS (GDRs)
GDRs are an instrument for raising equity capital by organizations which are in Asian countries.
They are placed in USA, Europe and Asia. They have a low cost and help in bringing liquidity. A
company usually raises capital simultaneously from two countries. For example, the GDR may
be issued in India and simultaneously placed in USA and Europe through one security. The
issuer deals with a single depository bank which facilitates the secondary and inter-market
trading amongst investors which are situated in different countries. It is a fungible instrument and
the issuer does not have any exchange risk. He can freely use the foreign exchange collected
from this issue. Government of India allowed Indian companies to mobilize funds from foreign
markets through Euro issues of global depository receipts and foreign currency convertible
bonds. Companies with a good track record can issue GDRs for developing infrastructure
projects in power, telecommunications and petroleum and in construction and development of
roads, airports and ports in India.

FEATURES OF GDRs

Some of the features of Global Depository Receipts are as follows:

1) Financial Instrument: It is a financial instrument in the form of a depository recipts.

It has been created by a depository bank outside the Indian boundary. It deals with a fixed
number of equity shares of a company.

2) Trading: It is listed and traded in a foreign market.

3) Custodian Bank: The shares are issued in Indian currency in the Indian market with
an Indian bank as its custodian.

4) Price: The prices of the Global Depository Recipts are quoted in U.S. Dollars.

5) Voting Rights: The Global Depository Receipts do not have any voting rights in the
issuing company.
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6) Conversion: The instrument gives the right of conversion to the holder from GDRs to
equity shares of the company. It also has the right and option to convert the equity shares
into GDRs.

7) Shareholders: The issuing company has to deal with the depository bank which is its
only customer. It does not have to deal with multiple shareholders.

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