Scope and Objectives of Financial Management

IPCC Paper 3B: Financial Management Chapter 1 Prof. C.P. Gupta

Learning Objectives

1 • Understanding about Financial Management

2 • Understanding the objectives, scope and the how the financial

management has evolved overtime

3 • Objective – Profit Maximization Vs. Value Maximization

4 • To understand the role of a CFO and the challenges faced by

him.

5 • Appreciating Relation between Financial Management,

Accounting, and others.

What this man does???

What is the most Important work of a CFO?

CFO

To understand that …

We have to discuss… • Balance Sheet

Balance Sheet

Let’s have a look at the BALANCE SHEET

Particulars 2011 2012 Particulars 2011 2012EQUITY AND LIABILITIES: ASSETS

SHAREHOLDER'S FUNDS NON-CURRENT ASSETS Share Capital 4,277.76 4,277.76 FIXED ASSETS:Reserves and Surplus 93,226.67 1,08,678.97 Tangible assets 18,481.67 21,567.82

97,504.43 1,12,956.73 Producing Properties 43,575.66 46,376.83 Intangible assets 157.88 112.33

NON-CURRENT LIABILITIES Capital Work-in-Progress 13,976.90 18,298.06 Defered tax liabilities (Net) 9,950.39 11,197.87 Exploratory/Development Wells in Progress 7,747.21 8,581.23 Other long term liabilities 582.46 561.99 83,939.32 94,936.26 Long term provisions 20,823.51 21,313.06

31,356.37 33,072.92 Non current investments 5,182.75 4,364.34 Long- term loans and advances 23,993.85 25,449.81

CURRENT LIABILITIES Deposits under Site Restoration Fund Scheme 8,115.51 9,182.57 Short-term borrowings - 4,500.00 Other non-current assets 862.43 1,210.21 Trade payables 5,225.30 5,261.24 Other current liabilities 13,005.53 13,694.12 CURRENT ASSETSShort term provisions 925.78 2,242.59 Current investments 0.05 851.91

19,156.61 25,697.95 Inventories 4,118.98 5,165.44 Trade receivables 3,994.68 6,194.82 Cash and Cash Equivalents 14,481.09 20,124.57 Short-term loans and advances 2,673.39 3,123.71 Other current assets 655.37 1,123.98

25,923.55 36,584.41

TOTAL 1,48,017.41 1,71,727.61 TOTAL 1,48,017.41 1,71,727.61

BALANCE SHEET OF OIL AND NATURAL GAS CORPORATION LIMITED AS AT 31ST MARCH…(Rs. in Crores)

READ & THINK!!!

What determines BALANCE SHEET Structure?

Have you ever wondered what decisions of a firm determine the

structure of a balance sheet?

Particulars 2011 2012 Particulars 2011 2012EQUITY AND LIABILITIES: ASSETS

SHAREHOLDER'S FUNDS NON-CURRENT ASSETS Share Capital 4,277.76 4,277.76 FIXED ASSETS:Reserves and Surplus 93,226.67 1,08,678.97 Tangible assets 18,481.67 21,567.82

97,504.43 1,12,956.73 Producing Properties 43,575.66 46,376.83 Intangible assets 157.88 112.33

NON-CURRENT LIABILITIES Capital Work-in-Progress 13,976.90 18,298.06 Defered tax liabilities (Net) 9,950.39 11,197.87 Exploratory/Development Wells in Progress 7,747.21 8,581.23 Other long term liabilities 582.46 561.99 83,939.32 94,936.26 Long term provisions 20,823.51 21,313.06

31,356.37 33,072.92 Non current investments 5,182.75 4,364.34 Long- term loans and advances 23,993.85 25,449.81

CURRENT LIABILITIES Deposits under Site Restoration Fund Scheme 8,115.51 9,182.57 Short-term borrowings - 4,500.00 Other non-current assets 862.43 1,210.21 Trade payables 5,225.30 5,261.24 Other current liabilities 13,005.53 13,694.12 CURRENT ASSETSShort term provisions 925.78 2,242.59 Current investments 0.05 851.91

19,156.61 25,697.95 Inventories 4,118.98 5,165.44 Trade receivables 3,994.68 6,194.82 Cash and Cash Equivalents 14,481.09 20,124.57 Short-term loans and advances 2,673.39 3,123.71 Other current assets 655.37 1,123.98

25,923.55 36,584.41

TOTAL 1,48,017.41 1,71,727.61 TOTAL 1,48,017.41 1,71,727.61

BALANCE SHEET OF OIL AND NATURAL GAS CORPORATION LIMITED AS AT 31ST MARCH…(Rs. in Crores)

READ & THINK!!!

Do not you wonder…????

Who is responsible to make decisions that determine assets side and the liabilities side of a

balance sheet??

Functions of a CFO

This Man!!!

“What is the basic function of a Finance Manager in a business firm?”

PUT IN SIMPLE WORDS:

What is Function of a CFO in a company?

Manage the Balance Sheet of the Company.

How should a finance manager manage the Balance Sheet of a Company is a subject matter of FINANCIAL MANAGEMENT!!!

Financial Management ...

…understanding the basics!

Financial Management…???

The theory of Financial Management or Corporate Finance is the theory of financial decision making by business firms.

It can be described as the study of the decisions that every firm has to make related to financial matters.

It is that managerial activity which is concerned with the planning and controlling of the firm’s financial resources.

It can be viewed as proper management of flows of funds in a firm.

To be more precise…

“Financial Management is concerned with the managerial decisions that result in the acquisition and financing of short term and long-term credits for the firm.”

Main Task of Finance Manager

To be precise- the main task of Financial Management is to…

Manage flows of funds/cash through out the organization to enhance the value of a firm.

Therefore, the main challenge before Financial Management is…

Challenges of Financial

Management

Procurement of Funds

Utilization of Funds

Procurement of Funds…Sources

Sources of

Funds

Equity

Debt

Hire-Purchase

and Leasing

Angel Financing

Venture Capital

Commercial Banks

Utilization of Funds…Application

Utilization of Funds

Fixed Assets

Investment Current Assets

Focus/ Nature of Financial Management

It focuses basically on corporate – that is, the vehicle to achieve objectives of an entity. It is assumed to be Joint Stock Company; and hence, it is sometimes is known as CORPORATE FINANCE. • Implication of it is - all managerial decisions will be assumed to be

made by the MANAGEMENT which is an agent of shareholders.

It is all-pervasive managerial function in a firm. It has to be integrated with Production, Marketing and Personnel functions of the management. • Implication of it is - financial decision-making should be integrated

with other managerial functions.

Focus / Nature of Financial Management … (Cont.)

It is all decision-making; nothing except decision-making. • Implication of it is Implication of it is - one

has to make best possible decisions and for that use all that is needed and this makes it a multi-dimensional subject.

What is expected from a Finance Manager?

To provide necessary funds so that no productive and beneficial activity should be sacrificed for want of funds.

To ensure that scarce funds of the firm should be optimally utilized.

To plan and control in a coordinated manner so that the requirements of all the departments could be met effectively.

What is expected from a finance manager? (continued…)

Do not act as a bull-dog but as a watch-dog.

Do not act as a strict controller and auditor but as a facilitator and motivator..

Do not allow the funds of a firm to remain unutilised.

What is expected from a finance manager? (continued…)

Do not let anyone in the firm to waste funds.

Do not let anyone to commit any fraud on funds.

Do not let the system to be rigid enough so as to sacrifice profitable activities/opportunities of the firm.

Role of a CFO

Finance

Accounting

Audit

Treasurer

Controller

Finance Manager

Basic nature of Financial Management as a Course of study

It is a decision-making course – that is to say, each topic in it is concerned with a managerial decision problem.

All decision problems dealt in it are having finance (money or funds) as an important dimension.

Its approach to decision-making is quantitative in nature. That’s to say, it make use of numbers heavily.

It is primarily normative in nature.

• Decision-making • Quantitative Methods of decision making • Behaviour of financial and economic variables • Impact of financial variables on the performance of a firm • Impact of environmental variables on financial variables of a

firm

To understand it properly, one should be comfortable with the following:

To take better financial decisions, one must be aware of necessary legal, economic and financial environment.

Basic nature of Financial Management (continuation…)

Evolution of Financial Management …

Three distinct phases in the evolution of Financial Management:

The Traditional Phase

The Transitional Phase

The Modern Phase

The Evolution of Financial Management

• Descriptive 1 • Fund Raising 2 • Institutional 3 • Profit/Return 4 • Operational 5

Analytical

Fund Investing

Markets

Risk

Strategic

Importance of Financial Management …

At the end, it is to ensure a sound BALANCE SHEET of a company!!!!!

What ‘blood’ is to our body, similarly, funds are to a company! Therefore, the most important task of Financial Management is to manage ‘the blood’ of a company – it’s lifeline!

While managing the funds of a company …

The Finance Manager is supposed to take some important decisions which are known as FINANCIAL DECISIONS.

MAIN DECISIONS made by a CFO

Investment Decisions: Long-term Decisions

Financing Decisions:

Capital Structure Decisions

Dividend Decisions:

Profit Distribution Decisions

Liquidity Decisions:

Working Capital or Short-term Decisions

While taking all these decisions, what is the ultimate corporate

goal attempted to be achieved?

What is the ultimate Corporate Goal?

Financial Management - Objectives

Profit Maximisation

Profit after tax (PAT) Maximisation

Earning per share (EPS) Maximisation

Sales Maximisation

Market Share Maximisation

Firm’s Wealth Maximisation

Shareholders’ Wealth/Value Maximisation

Profit Maximisation … An Objective • This objective has the

following advantage: For any business firm, the natural objective is Profit Maximisation and as such can be pursued to guide

financial decisions of a finance manager.

1. • It is a well understood objective.

2 • It achieves sustainability for a firm as without profits, none can sustain itself for long.

3. • Profit is also considered as a yardstick of efficiency.

4. • In a free and competitive market, profit is the best driving and motivating force behind all

economic decisions.

5 • The theory of ‘Invisible Hand’ that ensures optimum allocation of resources for a society in

a free and competitive market also depends upon the objective of Profit Maximisation.

6 • It is an objective that is compatible with society’s objective as well as firm’s objective.

Disadvantages of Profit Maximisation – as an objective

Profit is a vague term as it means so many things to different people that finance manager fails to appreciate which profit should be maximised.

Should it be profit to all stakeholders or profit to only owners; before tax or after tax; short-term profits or long-term profits; total profits or per share profits; operating profit or net profit; Accounting

profit or Economic profit; and profit reported to shareholders or profit reported to tax authorities?

It works perfectly well when markets are perfectly competitive and free.

But, in real life, markets are full of a number of imperfections and as a consequence, profit can not be used as a yardstick of efficiency and hence, can not guide various economic decisions to ensure

best utilisation of resources for the firm as well as for the society.

Disadvantages of Profit Maximisation – as an objective

This objective ignores risk and uncertainty attached with profit.

If a firm is earning huge profits at a very high

degree of risk, then it may be dangerous for the very existence of the firm in the

periods to come? For instance, should a finance manager divert funds to speculative activities and maximise the profits of a

firm?

It ignores the time value of money

As it does not make a distinction between profits received in future and at present. Also, it ignores

the timings when the costs are incurred and when the

profits are earned.

Profit Maximization objective concentrates only on the profitability

aspects of various decisions

but ignores the financing decisions that are involved in them. As such, it fails to ignore the costs and the

risks involved in financing decisions that are

important.

Other Objectives...

Profit after tax (PAT) Maximisation

Earning per share (EPS) Maximisation • These two are having more or less same disadvantages as the objective of Profit Maximization has.

Sales Maximisation

Market Share Maximisation

………………??????????

Firm’s Wealth Maximisation

This objective also means to maximize the STAKEHOLDERS’ WEALTH.

According to it, the finance manager should decided the things in such a manner that the wealth that would be claimed by all the stakeholders - creditors, lenders, employees, society, shareholders, etc. - should be maximum. • ...Å ….????? • ...y….?????

Shareholders’ Wealth/ Value Maximisation

Creation of shareholders’ Value in fact takes care of PROFIT, SUCCESSFUL MARKETING STRATEGIES, HAPPY CREDITORS and LENDERS.

Ensuring balances among the objectives of the various stakeholders is not a practical objective to be achieved.

Since managers are accountable to the shareholders and they employ them, managers should work for the maximum benefits of the shareholders.

Shareholders’ value consists of dividend payments and the market value of shares. They both are accurately observable in case of listed companies.

Shareholders’ Wealth/ Value Maximisation(continued…)

If we assume that stock markets are efficient then the valuation of the shares reflects the fundamentals and risk involved of a company. Thus, market provides a suitable measure to judge the performance and hence, an objective worth pursuing.

Also, the market takes into account the long-term view to determine the share prices.

This objective takes care of the time value of money.

This objective provides an objective and well defined quantitative yardstick for evaluating financial decisions.

Basic Axioms of Financial Management

Money has time value/opportunity cost.

Every financial decision involves a trade-off between RISK and RETURN.

Financial markets are EFFICIENT.

Accounting Profit is not relevant for financial decisions. Profits based on Cash Flows are more relevant for Financial Decision-Making.

Options have a VALUE.

Incremental/differential Cash Flows are important for financial decision-making.

Remember that Financial Decisions are evaluated in term of

Return Risk

What Is Return?

Let’s now Understand it!

Return is …

Return is looking into the brighter side!!!

RETURN...

RETURN presents- • benefits • gains • profits • interest • yield • the extra we get when

we invest some money.

It is a positive parameter in the sense that more of it is

more desirable.

What Is Risk?

Let’s now Understand it!

Risk is ………

Risk is looking into the darker side of the Future

Risk is usually measured as ...

the PROBABILITY OF LOSS

the EXPECTED LOSS

• Range • Mean Absolute Deviation • Standard Deviation/Variance/Coefficient of Variation • Semi-Variance • Variance from Subjective Expected Value • Co-variance

VARIATIONS & FLUCTUATIONS:

the SENSITIVITY OF RETURN TO POSSIBLE CHANGES - percentage changes.

Types of Risk

Systematic Risk

Unsystematic Risk

Market Risk

Interest Rate Risk

Purchasing Power Risk or Inflation Risk

Types of Risk…(Continued…)

Financial Risk - Financial Leverage

Management Risk

Industry Risk

Economy/Country Risk

Credit Risk/Default Risk

System Risk

Relation Between Risk and Return

Is there any relation between Risk and Return?

Relationship between Return and Risk

Can we say that a person who has taken high risk will get higher return?

Should a person go for higher risk if he/she has to earn higher return?

• Is it HIGH RISK, HIGH RETURN? • Or, Is it HIGH RETURN HIGH RISK?

Should a person be compensated by higher return for taking higher risk?

• A situation in which what appear to be abnormally high returns on an investment are in fact compensation for bearing the risk of an event that has not yet taken place.

PESO PROBLEM:

In the Ultimate Analysis, the structure of Financial Management is…

Maximization of Shareholders Value

Risk & Return

Investment Decisions

Financing Decisions

Dividend Decisions

Working Capital

Decisions

The Objective

Parameters impacting objective

Main Decisions

Maximization of Shareholders’

value

Objective of the Firm

The

Risk and Return

1. Accounting 2. Marketing 3. Production 4. Human Resource Management 5. Taxation 6. Law 7. Quantitative Methods

Summary

Thank You Prof. C. P. Gupta