Unit 1 : Introduction to Financial Management

 Concept of Financial Management

 FINANCE Functions
 Objectives of Financial Management
 PROFITABILITY v/s SHAREHOLDERS WEALTH MAXIMIZATION
 Time value of money – Compounding and Discounting

CONCEPT OF FINANCIAL MANAGEMENT :

Financial management in a business means planning and directing the use of the company’s financial
resources -- the cash it generates through its operations and the capital obtained from investors or
lenders. Although a company may have an accounting staff or an outside accounting firm to provide
financial guidance, financial management is one of the most important aspects of the business
owner’s job. Regardless of whether you sell a product or service, operate locally or nationally or sell
to consumers or other businesses, many basic financial practices remain the same. During both slow
and boom times, it’s important to maintain consisting accounting practices. Understanding key
concepts for managing your company’s finances will help you minimize your expenses and maximize
your profits.

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.

The management of financial resources is called financial management. It guides how to find and use
the best investment and financing opportunities in the continuously changing and complex
environments. Financial Management is actually a basic skill that consists of certain concepts and
techniques that are useful not only for business life, but also in our personal life. It is a righteous
statement that “money makes the world go round”. Finance is actually the life blood of an
organization, and mismanagement in finance may easily lead to bankruptcy.

There is an overall corporate strategy that is based on the finance and every project of the company,
like MIS (Management Information System) etc, comes under this corporate financial strategy. So, it
is also important for IT professionals to know the basics of financial management.

Finance is the science that deals with the management of financial resources in the best possible
manners. It is the comprised of further three steps.

 Money and Capital Markets.

 Investment
 Financial Management.

Below are some of the important concepts and techniques that are used in financial
management freely.

1- Financial Statements Analysis:

Financial statement analysis shows the health and performance of the company based upon its
past performance. There are four types of financial statements that are analyzed.
  Profit & Loss Statement/Income Statement:

The income statement shows the operating efficiency and net profit for a given accounting
period.

 Balance Sheet:

The balance sheet is the picture about the financial health of a company at a particular time. It
shows what types of sources are used to acquire different types of assets of the company.

 Statement of Shareholder’s Equity:

This statement shows how much shares a shareholder has in a company as an owner.

 Cash Flow Statements:

Cash flow statements show the inflow and outflow of cash during any given period.

All of these financial statements reflect the accounting results of the firm for a given period of
the time. It describes the effects on assets, profits and dividends over the years. The
management of the company uses these statements to take their financial related decisions and
make financial policies.

2- Investment Decisions & Capital Budgeting:

Investment decisions are important for an organization as there is a large portion of capital
attached to them. In fact the income and success of a business primarily depend upon the
density of its investments, the kinds of assets in which investment is made and the way these
assets to enhance the overall value of the company.

Capital Budgeting is related to the investment in fixed assets. The term “capital” here means
the fixed assets that are utilized in the production process while the term “budget” refers to the
plan that contains details of expected cash inflows and outflows for some future period.
Investment decisions are based on the following concepts and techniques.

 Interest Rate Formulas.

 Time Value of Money.
 Discounted Cash Flows.
 Net Present Value.
 Internal Rate of Return.

3- Risk and Return

Every investor (individual /company) wants to invest his money in an investment that will give
him a maximum return. But on the other side of the investment there is some risk associated
with that investment. The risk and return are interrelated and the selection of investment
portfolio falls under this section. The important theories of this section are below.

 Uncertainty
 Risk
  Portfolio Theory
 Capital Asset Pricing Model

4- Corporate Financing and Capital Structure

The company needs capital to expand its size. The finance department is responsible for the
acquisition of funds for the company. Funds can be acquired from many ways. One way is in
the form of debt and the other one is in the form of equity. The combination of debt and equity
is called the capital structure of the firm. The value of a company can be enhanced through a
proper combination of debt and equity. Capital structure theory contains on the following
concepts.

 Cost of Capital
 Leverage
 Dividend Policy
 Debt Instruments

5- Valuation

Valuation of the company or its assets is significant for financial manager as he is a primarily
concerned to increase the value of the company and its shareholders. Besides this, the creditors
and investors are also concerned with the valuation of the company in order to make their
relevant decisions. Below are some of different factors and techniques that affect the value of
a company.

 Share
 Bond
 Option
 Corporate

6- Inventory Management and Working Capital

Inventory management and capital structure are related to the efficient management of current
assets. The operating efficiency of the firm can be enhanced through effective use of Working
Capital Management and inventory management.

7- International Finance:

As the world is becoming a global village and there are a lot of business opportunities
throughout the different regions of the world. Therefore, there is a strong need of some
international finance for the business community. Here more opportunities are available for the
finance managers regarding their investment and financing areas. So, these opportunities and
related threats always discuss under this area of financial management.

8- Responsibility of Financial Management

In an organization there is a hierarchy of managers at different levels, and each one is

responsible for different functions. In between all these managers, the Chief Financial Officer
(CFO) is responsible for the financial management of the company. He is responsible to report
to the CEO while the treasurer and controller fall under the hierarchy level of CFO.
SCOPE / ELEMENTS OF FINANACIAL MANAGEMENT:
 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.
 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.
 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.

FINANCE FUNCTIONS:
 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.
 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.
 Choice of sources of funds: For additional funds to be procured, a company has many
choices like-

a. 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.
 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.
 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.

 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.
 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.

OBJECTIVES OF FINANCIAL MANAGEMENT :

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

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

2. To ensure adequate returns to the shareholders which will depend upon the earning
capacity, market price of the share, expectations of the shareholders.
3. To ensure optimum funds utilization. Once the funds are procured, they should be
utilized in maximum possible way at least cost.
4. To ensure safety on investment, i.e, funds should be invested in safe ventures so that
adequate rate of return can be achieved.
5. To plan a sound capital structure-There should be sound and fair composition of
capital so that a balance is maintained between debt and equity capital.

Financial management is the responsibility of planning, directing, organizing and controlling a

company’s capital resources. Small business owners typically complete this function because
they are responsible for all company resources. Larger business organizations may have a
financial or accounting manager to handle this business function. Financial management has
several objectives in a business. Most of the objectives serve in a support capacity to provide
business owners with relevant information on the company’s business operations. Support
Accounting

Financial management has an objective to support the company’s accounting department.

Financial managers do not usually complete everyday accounting functions. They typically
review the information from the accounting department and review this information for
accuracy and validity. Corrective measures or suggestions can be made to improve the
company’s accounting information. Accounting information plays an important role in small
business. Business owners often use accounting information to secure external financing from
banks, lenders and investors.

Provide Decision Information

Business owners often require financial or accounting information when making business
decisions. One objective of financial management is to provide business owners and other
individuals with information for making business decisions. Information must be useful,
relevant and accurate. Financial managers are usually an intermediary between the business
owner and other operational managers. This saves the business owner time and effort from
wading through extensive information with no relation to the decision at hand.

Risk Management

Risk management is often a primary objective for financial management functions in larger
business organizations. Risk management ensures companies do not face undue pressure or
risk from various financial situations. Financial rooms can result from business opportunities
providing inadequate financial returns, debt financing with unfavorable loan terms, lack of
available business credit and unstable financial investments. Financial managers often spend
copious amounts of time reviewing their company’s financial activities to ensure the least
amount of risk is absorbed by the company.

Improve Operational Controls

Financial management has a responsibility to improve operational controls and workflow.

Financial managers often review information from several divisions or departments within their
company. The focus of this review process ensures company employees are operating within
standard company guidelines. Financial managers can make suggestions to business owners
for improving the company’s controls and business operations. These suggestions outline
specific objectives for reducing waste, limiting unnecessary expenditures and improving
employee productivity. Each objective can help business owners improve their company’s
overall financial operations.

PROFITABILTITY V/S SHAREHOLDERS WEALTH

MAXIMIZATION:

PROFIT MAXIMIZATION
Profit Maximization is the traditional approach, in this process Companies undergo to
Determine the best Output and price levels in order to maximize its return. The company will
usually adjust influential factors such as production costs, sale price, and output levels as a way
of reaching its profit goal. The overall objective of business enterprises to earn at least
satisfactory returns on the funds invested to sustain in the market for long periods.

WEALTH MAXIMIZATION
Wealth maximization is almost universally accepted and appropriate goal of a firm. According
to wealth maximization, the managers should take decisions that maximize the net present
value of the shareholders or shareholders’ wealth. The wealth maximization principle implies
that the fundamental objective of a firm is to maximize the market value of its shares.

The Following is the comparison table:

PROFIT MAXIMIZATION WEALTH MAXIMIZATION

Profit Maximization is based on the increase Wealth Maximization is based on the cash
of sales and profits of the organization. flows into the organization.
Focused On
Profit Maximization emphasizes on short Wealth Maximization emphasizes on long
term goals. term goals.
Time Value of Money
Profit Maximization ignores the time value Wealth Maximization considers the time
of money. Time value of money refers the value of money. In wealth maximization,
money receivable today is more valuable the future cash flows are discounted at an
 than the money which is going to be suitable discounted rate to represent their
recieved in future. present value.
Risk
Profit Maximization ignore the risk and Wealth Maximization considers the risk and
uncertainity. uncertainty.
Reliability
In the new business environment Profit Wealth maximisation objectives ensures fair
maximisation is regarded as unrealistic, return to the shareholders, reserve funds for
difficult, inappropriate and immoral. growth and expansion, promoting financial
discipline in the management.
Objective
Profit Maximization objective leads to Wealth Maximization provides efficient
exploiting employees and consumers. it also allocation of resource, It ensures the
leads to inequalities and lowers human economic interest of the society.
values.

The essential difference between the maximization of profits and the maximization of wealth
is that the profits focus is on short-term earnings, while the wealth focus is on increasing the
overall value of the business entity over time. These differences are substantial, as noted below:

 Planning duration. Under profit maximization, the immediate increase of profits is

paramount, so management may elect not to pay for discretionary expenses, such as
advertising, research, and maintenance. Under wealth maximization, management
always pays for the discretionary expenditures.
 Risk management. Under profit maximization, management minimizes expenditures,
so it is less likely to pay for hedges that could reduce the organization's risk profile. A
wealth-focused company would work on risk mitigation, so its risk of loss is reduced.
 Pricing strategy. When management wants to maximize profits, it prices products as
high as possible in order to increase margins. A wealth-oriented company could do the
reverse, electing to reduce prices in order to build market share over the long term.
 Capacity planning. A profit-oriented business will spend just enough on its productive
capacity to handle the existing sales level and perhaps the short-term sales forecast. A
wealth-oriented business will spend more heavily on capacity in order to meet its long-
term sales projections.

It should be apparent from the preceding discussion that profit maximization is a strictly short-
term approach to managing a business, which could be damaging over the long term. Wealth
maximization focuses attention on the long term, requiring a larger investment and lower short-
term profits, but with a long-term payoff that increases the value of the business.

TIME VALUE OF MONEY:

Time Value of Money (TVM) is an important concept in financial management. It can be used
to compare investment alternatives and to solve problems involving loans, mortgages, leases,
savings, and annuities.

TVM is based on the concept that a dollar that you have today is worth more than the promise
or expectation that you will receive a dollar in the future. Money that you hold today is worth
more because you can invest it and earn interest. After all, you should receive some
compensation for foregoing spending. For instance, you can invest your dollar for one year at
a 6% annual interest rate and accumulate $1.06 at the end of the year. You can say that the
future value of the dollar is $1.06 given a 6% interest rate and a one-year period. It follows
that the present value of the $1.06 you expect to receive in one year is only $1.

A key concept of TVM is that a single sum of money or a series of equal, evenly-spaced
payments or receipts promised in the future can be converted to an equivalent value
today. Conversely, you can determine the value to which a single sum or a series of future
payments will grow to at some future date.

You can calculate the fifth value if you are given any four of: Interest Rate, Number of Periods,
Payments, Present Value, and Future Value. Each of these factors is very briefly defined in
the right-hand column below. The left column has references to more detailed explanations,
formulas, and examples.
Interest Interest is a charge for borrowing money, usually stated as a
percentage of the amount borrowed over a specific period of
 Simple time. Simple interest is computed only on the original amount
 Compound borrowed. It is the return on that principal for one time period. In
contrast, compound interest is calculated each period on the
original amount borrowed plus all unpaid interest accumulated to
date. Compound interest is always assumed in TVM problems.

Number of Periods Periods are evenly-spaced intervals of time. They are intentionally
not stated in years since each interval must correspond to a
compounding period for a single amount or a payment period for
an annuity.

Payments Payments are a series of equal, evenly-spaced cash flows. In TVM

applications, payments must represent all outflows (negative
amount) or all inflows (positive amount).

Present Value Present Value is an amount today that is equivalent to a future

payment, or series of payments, that has been discounted by an
 Single Amount appropriate interest rate. The future amount can be a single sum
 Annuity that will be received at the end of the last period, as a series of
equally-spaced payments (an annuity), or both. Since money has
time value, the present value of a promised future amount is worth
less the longer you have to wait to receive it.

Future Value Future Value is the amount of money that an investment with a
fixed, compounded interest rate will grow to by some future date.
 Single Amount The investment can be a single sum deposited at the beginning of
 Annuity the first period, a series of equally-spaced payments (an annuity),
or both. Since money has time value, we naturally expect the
future value to be greater than the present value. The difference
between the two depends on the number of compounding periods
involved and the going interest rate.
Loan Amortization A method for repaying a loan in equal installments. Part of each
payment goes toward interest and any remainder is used to reduce
the principal. As the balance of the loan is gradually reduced, a
progressively larger portion of each payment goes toward reducing
principal.

Cash Flow Diagram A cash flow diagram is a picture of a financial problem that shows
all cash inflows and outflows along a time line. It can help you to
visualize a problem and to determine if it can be solved by TVM
methods.

COMPOUNDING AND DISCOUNTING TIME VALUE OF MONEY :

Time Value of Money says that the worth of a unit of money is going to be changed in future.
Put simply, the value of one rupee today will be decreased in future. The whole concept is
about the present value and future value of money. There are two methods used for ascertaining
the worth of money at different points of time, namely, compounding and discounting.
Compounding method is used to know the future value of present money. Conversely,
discounting is a way to compute the present value of future money.

Compounding is helpful to know the future values, of the cash flow, at the end of the particular
period, at a definite rate. Contrary to this, Discounting is used to determine the present value
of the future cash flow, at a certain interest rate.
COMPARISION CHART:
Basis for Compounding Discounting
Comparison
Meaning The method used to determine the The method used to determine the
future value of present investment is present value of future cash flows
known as Compounding. is known as Discounting.
 Concept If we invest some money today, What should be the amount we
what will be the amount we get at a need to invest today, to get a
future date. specific amount in future.
Use of Compound interest rate. Discount rate
Known Present Value Future Value
Factor Future Value Factor or Present Value Factor or
Compounding Factor Discounting Factor
Formula FV = PV (1 + r)^n PV = FV / (1 + r)^n

DEFINING COMPUNDING:

For understanding the concept of compounding, first of all, you need to know about the term
future value. The money you invest today, will grow and earn interest on it, after a certain
period, which will automatically change its value in future. So the worth of the investment in
future is known as its Future Value. Compounding refers to the process of earning interest on
both the principal amount, as well as accrued interest by reinvesting the entire amount to
generate more interest.

Compounding is the method used in finding out the future value of the present investment.
The future value can be computed by applying the compound interest formula which is as
under:

Where n = number of years

R = Rate of return on investment.

DEFINING OF DISCOUNTING:
Discounting is the process of converting the future amount into its Present Value. Now you may
wonder what is the present value? The current value of the given future value is known as Present
Value. The discounting technique helps to ascertain the present value of future cash flows by
applying a discount rate. The following formula is used to know the present value of a future sum:

Where 1,2,3,…..n represents future years

FV = Cash flows generated in different years,
R = Discount Rate
For calculating the present value of single cash flow and annuity the following formula
should be used:

Where R = Discount Rate

n = number of years

KEY DIFFRENCE BETWEEN COMPOUNDING AND DISCOUNTING :

The following are the major differences between compounding and discounting:

1. The method uses to know the future value of a present amount is known as
Compounding. The process of determining the present value of the amount to be
received in the future is known as Discounting.
2. Compounding uses compound interest rates while discount rates are used in
Discounting.
3. Compounding of a present amount means what will we get tomorrow if we invest a
certain sum today. Discounting of future sum means, what should we need to invest
today to get the specified amount tomorrow.
4. The future value factor table is referred to calculate the future value in case of
compounding. Conversely, in discounting, present value can be computed with the
help of a Present value factor table.
5. In compounding, present value amount is already specified. On the other hand, the
future value is given in the case of discounting.

CONCLUSION:
Compounding and Discounting are simply opposite to each other. Compounding converts the
present value into future value and discounting converts the future value into present value. So,
we can say that if we reverse compounding it will become discounting. Compounding Factor
table and Discounting Factor table is taken into consideration for the quick calculation of the
two. In the table, you will find the factors, concerning different rates and periods. The factor is
directly multiplied by the amount to arrive the present or future value.