basics of fm - module i

8/2/2019 Basics of FM - Module I

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Financial Management

An Introduction


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Contents

Introduction to FM

Scope

Objectives

Functions

Role of Financial Manager

Assignment - Interface of FinancialManagement with other Functional Areas

Key challenges faced by Modern FM

Financial Environment


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FINANCE

Finance is the life-blood of business.Without finance neither any business can be

started nor successfully run . Finance is

needed to promote or establish business,acquire fixed assets, make necessaryinvestigations, develop product keep man

and machines at work, encouragemanagement to make progress and createvalues.


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FINANCIAL MANAGEMENT

Financial management is one the functional

areas of management. It refer to that part of

the management activity which is concerned

with the planning and controlling of firms

financial resources.


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DEFINITION

Financial management is the application of

planning and control function of the finance

function

Howard and Upton


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NATURE AND SCOPE OF

FINANCIAL MANAGEMENT

The nature of financial decisions would be

clear when we try to understand the

operation of a firm. At the very outset, the

promoters makes an appraisal of various

investment proposals and selects one or

more of them , depending upon the net

benefits derived from each as well as on theavailability of funds.


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PROCESS INVOLVED IN

FINANCIAL DECISION

1. Selection of investment proposals ,known as the

investment decision.

2.Determination of working capital

requirements, known as the working capitaldecision.

3. Raising of funds to finance the assets, known

as the financing decision.4. Allocation of profit for dividend payment,

known as the dividend decision.


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Three decision areas in finance:

Investment decisions - What assets should thecompany hold? This determines the left-hand sideof the balance sheet. these decision are concernedwith the effective utilization of funds in one

activity or the other. The investment decision canbe classified under two groups :

(i) Long term investment decision

(ii) Short term investment decision

The former are referred to as the capitalbudgeting and the latter as working capitalmanagement.


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Financing decision

Financing decisions - How should the companypay for the investments it makes? This determinesthe right-hand side of the balance sheet. it is alsoknown as capital structure decision. It involves thechoosing the best source of raising funds and

deciding optimal mix of various source of finance.

A company can not depend upon only one sourceof finance, hence a varied financial structure is

developed. but before using any particular sourceof capital ,its relative cost of capital ,degree of riskand control etc should be thoroughly examined bythe financial manager.

The major source of long-term capital are sharesand debentures.


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DIVIDEND DECISION

Dividend decisions - What should be done

with the profits of the business? The

dividend decision is concerned with

determining how much part of the earning

should be distributed among the share

holders by way of dividend and how much

should be retained in the business formeeting the future needs of funds internally.


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Factors influencing financial

decision

These factors are divided into two parts -

1.Micro economic factor

2.Macro economic factor

Micro economic factor - micro economic factor isrelated to the internal condition of the firm-

(a) Nature and size of the firm

(b) Level of risk and stability in earnings

(c) Liquidity position(d) Asset structure and pattern of ownership

(e) Attitude of the management


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Macro economic factor

These are the Environmental factors-

1. The state of the economy2. Governmental policy


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All management decisions

should help to accomplish thegoal of the firm!

What should be the goal of the firm?


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Objectives of financial management

The objective of financial management are

considered usually at two levels the

Objective of financial management-

1. Maximization of profits

2. Maximization of wealth


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Maximization of profits

Profit earning is the main aim of every

economic activity. Profit maximization

simply means maximizing the income of the

firm . Economist are of the view that profits

can be maximized when the difference of

total revenue over total cost is maximum, or

in other words total revenue is greater thanthe total cost.


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PROFIT PLUS POINTS

Measures business

performance

Ensures timely payments

to Shareholder,

employees, Government,

Creditors Ensures expansion and

diversification

Indicates efficient use of

Funds

PROFIT MINUS

POINTS

Profit is not a clear term

(Long / Short)

Leads to employee and

consumer exploitation

Does not consider Risk

factor and Time value ofMoney

Leads to cut throat

competition

A/c Manipulation

Estimating exact profits is

impractical


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Maximization of wealth

According to prof solomon ezra of stand ford

university , the ultimate goal of financial

management should be the maximization of the

owners wealth. The value of corporate wealth maybe interpreted in terms of the value of the

companys total assets. The finance should

attempt to maximize the value of the enterprise to

its shareholders. Value is represented by themarket price of the companys common stock.


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WEALTH PLUSPOINTS

Clear term as itconsiders presentvalue of cash flows

Considers time value

of money Considers interest of

External Parties

Aims at Dividend and

returns Considers impact of

Risk

WEALTH MINUSPOINTS

It is not descriptive

It differs from oneentity to another


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Other Objectives

Balanced Asset Structure Fixed andCurrent Asset balance

LiquidityCos capacity to meet short term

and long term obligations Planning Funds Cost of Funds to be

minimized

Financial Discipline Scandals, misuse ofFunds


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What about risk? Isnt risk

important as well as profits?

How would the stockholders of a smallbusiness react if they were told that their

manager cancelled all casualty and liabilityinsurance policies so that the money spenton premiums could go to profit instead.

Even though the expectedprofits increased

by this action, it is likely that stockholderswould be dissatisfied because of theincreased risk they would bear.


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The common stockholders are

the owners of the corporation!

Stockholders elect a board of directors whoin turn hire managers to maximize the

stockholders

well being. When stockholders perceive that

management is not doing this, they mightattempt to remove and replace themanagement, but this can be very difficultin a large corporation with manystockholders.


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More likely, when stockholders

are dissatisfied they will simply

sell their stock shares.

This action by stockholders will

cause the market price of thecompanys stock to fall.


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When stock price falls relative

to the rest of the market (orrelative to the rest of the

industry) ...

Management is failing in their job to

increase the welfare (or wealth) of the

stockholders (the owners).


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Conversely, when stock price is

rising relative to the rest of themarket (or industry), ...

Management is accomplishing their goal

of increasing the welfare (or wealth) of

the stockholders (the owners).


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Important focal points in the

study of finance:

Accounting and Finance often focus on

different things

Finance is more focused on market values

rather than book values.

Finance is more focused on cash flows

rather than accounting income.


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Functions

Anticipating Financial needs

Acquiring Financial Resources

Allocating Funds in Business Administering Allocation of Funds

Analyzing Financial Performance

Accounting and reporting to management Maintaining Liquidity

Ensuring Profit and Wealth maximization


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Functions

Day to Day

Cash Custody

Bank Accounts

Loan Collection Payment of Cash for

transactions

Specific Functions

Functional planningand Budgeting

Investment Decisions Cost Accounting

Profit Analysis

Financial Accounting

Internal Audit


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Why is market value more

important than book value?

Book values are often based on dated

values. They consist of the original cost of

the asset from some past time, minusaccumulated depreciation (which may not

represent the actual decline in the assets

value). Maximization of market value of the

stockholders shares is the goal of the firm.


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Why is cash flow more important

than accounting income? Cash flow to stockholders (in the form of

dividends) is the only basis for valuation

of the common stock shares. Since thegoal is to maximize stock price, cash flow

is more directly related than accounting

income.

Accounting methods recognize income at

times other than when cash is actually

received or spent.


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One more reason that cash flow

is important:

When cash is actually received is important,

because it determines when cash can beinvested to earn a return.

[Also: When cash must be paid determines

when we need to start paying interest onmoney borrowed.]


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Examples of when accounting

income is different from cash

flow:

Credit sales are recognized as accounting

income, yet cash has not been received. Depreciation expense is a legitimate

accounting expense when calculatingincome, yet depreciation expense is not acash outlay.

A loan brings cash into a business, but isnot income.


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More examples:

When new capital equipment is purchased,

the entire cost is a cash outflow, but only

the depreciation expense (a portion of the

total cost) is an expense when computing

accounting income.

When dividends are paid, cash is paid out,

though dividends are not included in thecalculation of accounting income.


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Definitions: Operating income vs.

operating cash flow

Operating income = earnings before interest

and taxes (EBIT). This is the total incomethat the company earned by operating

during the period. It is income available to

pay interest to creditors, taxes to thegovernment and dividends to stockholders.


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Operating cash flow:

Operating cash flow

= EBIT + Depreciation - Taxes.

This definition recognizes that depreciation

expense is added in computing EBIT, since

it is not a cash outlay.

It also recognizes that taxes paid is a cash

outlay.


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Importance of Proper Financial Management

FINANCIAL

MANAGEMENT

Make sound

business

decisions

Maximumuse

ofresources

Measure

business

performance

Evaluate newbusiness

opportunities


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Emerging Role / Key Challenges

of Financial Manager

Investment planning

Financial structure

Mergers, acquisitions and restructuring Working capital management

Performance management

Risk management Investor relations


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BEAS Co Ltd, plans for an IPO at Rs.10 per share with anobjective to raise capital to establish itself and has plans toraise Rs. 500,000 but managed to distribute only Rs. 300000 tothe public through banks, finance companies and brokers, out

of the capital limit of Rs. 10,00,000 as per the MOA. Theresponse was moderate and the total number of shareapplications received was Rs. 1,00,000. In response to the firstcall of Rs 5 per share the total funds received was Rs.40,000.

Questions: (1 mark each)

1. What is the price of one share?

2. What is the objective behind the IPO? What does IPO standFor?

3. What is the Value of the First call?

4. Whom did the company approach for the distribution ofshares to the public?

5. Calculate Authorized capital .6. Calculate Issued capital .

7. Calculate subscribed capital .

8. Calculate called up capital .

9. Calculate paid up capital .

10. Calculate the number of shares issued by the company .


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1. What is the price of one share? Rs.10 per share

2. What is the objective behind the IPO? What does IPOstand For? Initial Public offering - with an objective to

raise capital to establish itself3. What is the Value of the First call? Rs 5 per share

4. Whom did the company approach for the distribution ofshares to the public? banks, finance companies& brokers

5. Calculate Authorized capital . 10,00,0006. Calculate Issued capital . Rs. 300000

7. Calculate subscribed capital . Rs. 1,00,000

8. Calculate called up capital . Rs 50,000

9. Calculate paid up capital. Rs.40,00010. Calculate the number of shares issued by the company.

Rs. 300000 / 10 per share = 30,000

basics of fm - module i

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