CHAPTER 1

FINANCIAL MANAGEMENT:
AN OVERVIEW

1
INTRODUCTION

‘ Despite of the variations between

businesses the basic finance issues
they face are essentially the same
‘ The key issues in finance are:
9 Where to raise financial resources from
9 Where to invest the resources
9 How best to manage the production-
distribution function
9 How much of profit to distribute and how
much to retain
Chapter 1
2
Financial Management: An Overview
NATURE AND SCOPE OF FINANCIAL
MANAGEMENT

‘ Financial Management is concerned

with the management of financial
resources Management

Human Resources Finances

Material

Technology Information

HR Finance
Department R& D IT Department
Department Production Department
Department

Chapter 1
3
Financial Management: An Overview
NATURE AND SCOPE OF FINANCIAL
MANAGEMENT

‘Financial management performs

facilitation, reconciliation, and
control functions in an
organization.
‘All the decisions having monetary
implications come under the
purview of financial management.
‘The finance manager is on the top
and not on the tap’.
Chapter 1
4
Financial Management – An Overview
ROLE OF FINANCE FUNCTION

‘Finance is central to all business

activities
‘Finance function reconciles the
conflicting interests of the varied
stakeholders and also the
different functions in an
organization

Chapter 1
5
Financial Management – An Overview
FINANCE DECISIONS FOR
THE FIRM

‘Financial decision-making involves

procurement of funds and their
optimal utilization through
investment, financing, dividend
and working capital decisions

Chapter 1
6
Financial Management – An Overview
INVESTMENT DECISIONS

‘ Investment decisions aim at selecting

the most productive avenues with a
view to maximizing the returns on
investment.
‘ Examples include expansion,
modernization, and replacement of
long-term assets. R&D expenditure
having long-term implications is also
categorized as investment decision
‘ Also referred to as capital budgeting
decisions
Chapter 1
7
Financial Management – An Overview
INVESTMENT DECISIONS

‘ Such decisions are critical for long-

term survival and growth in the
competitive business environment
‘ Decisions are taken in the light of their
impact on the wealth of shareholders
‘ These decisions involve huge capital
outlay, have long-term implications,
and are usually irreversible

Chapter 1
8
Financial Management – An Overview
FINANCING DECISIONS

‘Financing decisions are mainly

concerned with the identification
of potential sources of funds and
tapping of these sources
‘They are vaguely referred to as
capital structure decisions.

Chapter 1
9
Financial Management – An Overview
FINANCING DECISIONS

‘ The main issues involved in such decisions

are:
9 Where from to procure the requisite funds?
9 What should be the optimal mix of various sources
of capital?
9 How much should be the proportion of short-term
and long-term funds?
9 How do the expectations of providers of each
source of capital change with alteration in the
capital mix?
‘ They determine the financial risk profile of
the business
‘ The thrust of financing decisions is on
bringing down the cost of financing keeping
the risk constant
Chapter 1
10
Financial Management – An Overview
FINANCING DECISIONS

‘A right blend of debt–equity

assumes significance as it affects
the risk return profile of the
business.
‘Financing decisions are taken in
the light of their likely impact on
the wealth of the stockholders.

Chapter 1
11
Financial Management – An Overview
DIVIDEND DECISIONS

‘ The dividend decision decides on how

much to distribute as dividends and
how much to plough back for future
financing needs in business.
‘ Such a decision depends on trade off
between future financing needs of the
firm and current consumption
requirements of the shareholders.
‘ Generally firms in sectors with a high-
growth rate follow a policy of high
retention and low payout.
Chapter 1
12
Financial Management – An Overview
DIVIDEND DECISIONS

‘ Determining the payout ratio and the

method of dividend payment are the two
concerns of dividend policy.
‘ The payout ratio is decided in the light of its
likely impact on shareholders’ wealth.
‘ Normally, firms follow a policy of stable
dividends.
‘ Dividend policy is considered as a residue of
investment and financing policy.

Chapter 1
13
Financial Management – An Overview
WORKING CAPITAL DECISIONS

‘Working capital decisions are

related to the management of
current assets.
‘The two key decision points in
working capital management are
level of investment in current
assets and financing of such
assets
Chapter 1
14
Financial Management – An Overview
INTEGRATED VIEW OF FINANCE
DECISION-MAKING

‘ The four key decision areas in finance

are the part of an integrated decision
making framework in finance.
‘ They are directly liked to each other
and reinforce each other.
‘ All the decisions have a common
objective function-shareholders’ wealth
maximization.

Chapter 1
15
Financial Management – An Overview
KEY ISSUES IN FINANCIAL
DECISION-MAKING

Investment • What business to be in?

Decision • What growth rate is appropriate?
• What assets to acquire?
Financing • What mix of debt and equity to be used?
Decision • Can we change value of the firm by changing the capital mix?
• Is there an optimal debt–equity mix?
Dividend • How much of the profit should be distributed as dividends and
Decision how much should be ploughed back
• Can we change value of the firm by changing the amount of
dividend?
• What should be the mode of dividend payment
Working • What level of inventory of goods is ideal?
Capital • What level of credit should be given to the customers?
Decision • What level of cash should be maintained?
• How can the blockage of funds in the current assets be
minimized without compromising profits?

Chapter 1
16
Financial Management – An Overview
INTEGRATED VIEW OF FINANCE
DECISION-MAKING

Owners’ wealth maximization

Goal

Manufacturing, Trading, or Service

Activities

Needed to carry out the activities of the

organization. They are reflected on the asset
side of the balance sheet. Are long-term (fixed
assets) and short-term (current assets) in nature.
Decisions pertaining to their procurement are
Economic Resources alternatively referred to as investing decisions/
capital budgeting decisions and working
capital decisions respectively.

Relate to the liabilities side of te balance sheet.

Concerned with the raising of long-term and
short-term financial resources. Decisions
Financial Resources related to their procurement are referred to as
financing decisions/ capital structure decisions

Chapter 1
17
Financial Management – An Overview
OBJECTIVE FUNCTION IN FINANCE

‘ Multiplicity of functions and

stakeholders often causes the conflict
of interest between them
‘ The goal of wealth maximization is the
widely accepted goal of the business
‘ It reconciles the varied, often
conflicting, interest of the
stakeholders.
‘ It is free from the limitations that other
objectives are faced with
Chapter 1
18
Financial Management – An Overview
AGENCY COSTS AND CORPORATE
GOVERNANCE

‘ The stakeholders in the company form

of business organization are multiple,
their stakes are varied and their
objectives are often conflicting.
‘ Conflicting interest between the varied
stakeholders particularly the
stockholders and the management
causes agency problems

Chapter 1
19
Financial Management – An Overview
AGENCY COSTS AND CORPORATE
GOVERNANCE

‘ To resolve the agency problems monitoring

and control mechanisms become
imperative.
‘ Such mechanisms entail costs that are
termed as agency costs
‘ Agency costs take the form of either
incentives to management like bonuses,
stock options or monitoring and control
costs like audit fees, credit rating fees etc.

Chapter 1
20
Financial Management – An Overview
AGENCY COSTS AND CORPORATE
GOVERNANCE

‘Corporate governance is another

mechanism to protect the interest
of the shareholders
‘Set of rules, processes, and
customs that enable the effective
management of firms in the best
interest of shareholders are
termed as corporate governance.
Chapter 1
21
Financial Management – An Overview
FINANCIAL MANAGEMENT AND
ACCOUNTING

‘Financial management is
intricately related to financial and
management accounting.
‘The accounting information
provides inputs for financial
decision making.
‘Financial decisions in turn get
reflected in the accounting
statements
Chapter 1
22
Financial Management – An Overview
FINANCIAL MANAGEMENT AND
ACCOUNTING

Financial Management

Recording and Financial decisions

reporting of decisions analyzed to facilitate
relating to different future decision-making
finance functions

Performance of the firm Information, tools and

that is reflected in the techniques to facilitate
financial statements financial decisions
used in financial
decisions

Financial Accounting Management Accounting

Chapter 1
23
Financial Management – An Overview
FINANCIAL OBJECTIVES AND
ORGANIZATIONAL STRATEGY

Organizational
Goal

Organizational/Corporate
Strategy

Functional objectives

Functional Strategies

Marketing Finance Production Manpower

Strategy Strategy Strategy Strategy
Chapter 1
24
Financial Management – An Overview