MODULE 1:

Introduction to Financial Management

Meaning of Financial Management:-
Financial management is a process of procuring appropriate amounts and mix of funds at competitive prices
and investing these funds in assets which generates returns greater than the cost of acquired funds. It is
simply the process of acquiring funds and investing the acquired funds.
Financial management can be defined as the management of the finances of an organization in order to
achieve the financial objectives of the organization.
There are two aspects of Financial Management:
 Financial Planning and
 Financial Control
Financial Planning: the financial manager will need to plan to ensure that enough funding is available at
the right time to meet the needs of the organization for short, medium and long-term capital
(a) In the short term, funds may be needed to pay for purchases of stocks or to smooth out
changes in debtors, creditors and cash: the financial manager is here ensuring that working capital
requirements are met.
(b) In the medium or long-term, the organization may have planned purchases of fixed assets
such as plant and equipment, for which the financial manager must ensure that funding is available
Financial Control:refer to the development of policies and procedures by an organization to manage
its financial resources and operate efficiently. the control function of the financial manager becomes
relevant for funding which has been raised. Are the various activities of the organization meeting its
objectives? Are assets being used efficiently? To answer these questions, the financial manager may
compare data on actual performance with forecast performance.
The Nature of Financial Management:-
Financial management is about planning and controlling the financial affairs of an organization, to ensure
that the organization achieves its objectives, particularly its financial objectives. This involves decisions
about:
• How much finance the business needs for its operations, both its day-to-day operations and
for longer-term investment projects
• Where the finance should be obtained from: long-term finance is raised as equity capital
(share capital and profits) or as debt capital, and short-term finance is obtained mainly from trade
suppliers and bank overdrafts
• What should be the balance between long-term and short-term finance, and what should be
the balance between equity capital and debt capital (in other words, what should be the capital
structure of the organization?)
• Investing short term cash surpluses
• Ensuring that the providers of finance are suitably rewarded: the organization must make
sure that it can meet the interest payments on its borrowing, and companies must ensure that
shareholders receive an appropriate dividend out of profits
• Where appropriate, protecting the organization against financial risks
The Scope of Financial Management:-
Financial management covers three broad areas comm0nly known as 3 key decisions in finance and these
areas are:
1. Financing Decisions: this is concerned with fund acquisition in an organization. In order to
make proper financing decisions, one needs to understand
i. Cost of capital – cost of each source as well as the overall costs of capital
ii. Capital structure concepts – various sources of fund
iii. Working capital management
iv. aShort and long-term fund needs
2. Investment Decisions: involves allocating funds in real assets such as machines, buildings
and other projects in order to generate returns. In order to make proper investment decisions, one
needs to understand
i. Investment appraisal techniques (e.g., NPV, IRR, ROCE, Payback period etcetera)
ii. Risks and returns concept
iii. Cost of capital – overall cost of capital (WACC) to be used as a benchmark in evaluating
investments
3. Dividend Decisions: involves deciding how much a company’s earnings should be
distributed to owners (in form of dividend) or re-invested in the business (retained earnings)
Inter-Relationship among Key Finance Decisions:-
The three key decisions are inter-related in such a way that making one decision automatically affects the
rest as shown in the scenarios below:
(a) Investment decisions: (what if under investment decision a company decides to implement
a large number of attractive investment projects)
• Financing – basically the company will acquire more funds to implement the
projects
• Dividend – the company will pay low or no dividend so as to have more retained
earnings as an internal source of funds
(b) Financing decisions: (what if the company finances itself from expensive sources)
• Investment – the number of attractive investment projects will decrease
• Dividend – company’s ability to pay future dividend will be negatively affected (c)
Dividend decisions: (what if the company decides to pay higher dividends)
• Financing – more funds will be needed from external sources
• Investment – some investments projects will be dropped
Therefore, making one decision affects the other decisions
Financial Manager [And His/Her Roles]:-
A Financial Manager is anyone who is responsible for the significant financial decisions of the firm. His/her
roles among others include:
(i) Establishing seasonal fund needs (Working capital)
(ii) Establishing/estimating long-term fund needs
 (iii) Appraising investments and advising on which ones should be implemented
(iv) Suggesting or recommending an appropriate capital structure (mix)
(v) Computing cost of capital and suggesting cheaper sources
(vi) Advising on appropriate dividends decisions
(vii) Linking the firm with providers of capital
(viii) Assessing risk and returns of various investment projects
The Goal/Objective of The Firm:-
A firm can have several goals such as:
• Survival
• Maximization of profit
• Minimization of the costs
• Maximization of market share
• Maximization of long-term shareholders wealth
• Treating employees fairly or retaining the best employees
Maximization of Shareholders Wealth:-
The overall objective of a company might be stated as maximizing the wealth of its owners, the
shareholders. Shareholder wealth is increased by dividend payments and a higher share price. Corporate
strategies are therefore desirable if they result in higher dividends, a higher share price, or both.
Why “Maximization of Long-Term Shareholders Wealth” is the central goal:
(i) Risks: shareholders wealth takes care of risk while profit and other goals do not. This is to
say two firms with identical profits may be exposed to different level of risks
(ii) Future prospects: shareholders wealth considers future prospects of the firm while profit
and other goals do not
(iii) Accounting estimates and judgement (accounting problems) makes profit not suitable to be
a central goal
(iv) Shareholders are the owners hence priority should be given to them in any decision
(maximizing their wealth)
(v) Shareholders wealth communicates what will happen in the future while profit is a historic
figure
(vi) Shareholders wealth considers time value for money
(vii) Unlike other goals, wealth is based on cash flows

Agency Theory and Agency Problem:-

Agency theory was developed by Jensen and Meckling (1976) who defined the agency relationship as a
form of contract between a company’s owners and its managers, where the owners appoint an agent (the
managers) to manage the company on their behalf. As a part of this arrangement, the owners must delegate
decision-making authority to the management.
According to the theory, the separation between ownership and control brings about agency problem.
Agency problem occurs when management (agents) who have been appointed by the shareholders
(owners/principles) to act on their behalf, tend to implement/undertake actions and decisions which do not
necessarily maximize shareholders wealth (benefit the shareholders) instead, they maximize agents wealth.
Reducing the Agency Problem:-
Jensen and Meckling argued that in order to reduce the agency problem, incentives should be provided to
management to increase their willingness to take ‘value maximizing decisions’ – in other words, to take
decisions that benefit the shareholders by maximizing the value of their shares.
Several methods of reducing the agency problem have been suggested. These include:
• Firing non-performing managers
• Take-over threats: this occurs when a company is acquired forceful by another company
• Devising a remuneration package for executive directors and senior managers that gives
them an incentive to act in the best interests of the shareholders.
• Adopting good corporate governance principles: Fama and Jensen (1983), argued that an
effective board must consist largely of independent non-executive directors. Independent non-
executive directors have no executive role in the company and are not full-time employees. They
are able to act in the best interests of the shareholders.
• Providing information to shareholders frequently: frequent communication to
shareholders on company’s performance and position. E.g., Audited Annual Report
• Linking management rewards to shareholders wealth improvement: E.g., giving bonus
inform of shares and only when wealth has been improved or management share ownership plans
• Independent non-executive directors should also take the decisions where there is (or could
be) a conflict of interest between executive directors and the best interests of the company. For
example, non-executive directors should be responsible for the remuneration packages for
executive directors and other senior managers.
Financial Management, Management Accounting and Financial Accounting:-

1. Financial Accounting: Financial accounting is concerned primarily with maintaining a

system of accounts (the ledger accounts) and preparing financial statements for shareholders and
other external users of financial information, i.e., Financial Reporting. Financial accounting is
concerned largely with reporting externally about historical performance.

2. Financial Management: Financial management is different. As its name suggests, it is

concerned mainly with managing the finances of an organization – raising finance and putting it to
efficient and effective use by investing it. Financial managers have a management function as well
as an advisory function to senior management.

3. Management Accounting: Management accountants provide information, both mainly

financial but also nonfinancial, to assist management with making decisions about planning and
controlling the resources of the organization. Management accounting is concerned with internal
reporting to decision-makers within the organization. Management accounting information might
be either historical or forward-looking in nature.
Essentially, however, both financial accounting and management accounting are concerned with the
provision and reporting of information.

MODULE 2:
Sources of Finance
Introduction:-
Business is concerned with the production and distribution of goods and services for the satisfaction of
needs of society. For carrying out various activities, business requires money. Finance, therefore is called
the lifeblood of any business. The requirements of funds by business to carry out its various activities is
called business finance.
Sources of Finance and Financial Management:-
An important aspect of financial management is the choice of methods of financing for a company’s assets.
Companies use a variety of sources of finance and the aim should be to achieve an efficient capital structure
that provides:
• Adequate working capital
• A suitable balance between short-term and long-term funding
• A suitable balance between equity and debt capital in the long-term capital structure
Forms of Sources of Finance:-
1. On the basis of Finance:
i. External sources: External sources require the agreement of the other parties
beyond the directors of the business. Example, finance from an issue of new shares, as
shareholder’s consensus is required.
ii. Internal sources: Internal sources of finance arise from management decisions that
do not require agreement from other parties. E.g., retained earnings, a within directors’
powers.

2. On the basis of Time:

i. Short-term Finance:
Sources of short-term funding are used to finance some current assets. (In some cases, companies operate
with current liabilities in excess of current assets, but this is unusual).
Major sources under this category are:
• Debt Factoring
• Bank Overdraft
• Invoice Discounting
• Short-Term Bank Loans
• Suppliers (Trade Payables)
• Reducing Inventory Levels
• Delaying Payments to Trade Payables
The main points to note about these sources of Short-term finance are as follows:
Bank Overdraft: it lets you borrow money through your current account by taking out more money
than you have in the accountA company might arrange a bank overdraft to finance its need for cash to
meet payment obligations. An overdraft facility is negotiated with a bank, which sets a limit to the
amount of overdraft that is allowed. From the point of view of the bank, the company should be
expected to use its overdraft facility as follows:
• The overdraft should be used to finance short-term cash deficits from operational activities. The
company’s bank balance ought to fluctuate regularly between deficit (overdraft) and surplus. There
should not be a ‘permanent’ element to the overdraft, and an overdraft should not be seen as a long-
term source of funding
 • An overdraft facility is for operational requirements and paying for running costs. An overdraft
should not be used to finance the purchase of longterm (non-current) assets
• The bank normally has the right to call in an overdraft at any time, and might do so if it believes the
company is not managing its finances and cash flows well

(b) Debt Factoring: is when a business sells its accounts receivables to a third party at a
discount. Debt factoring involves the factor (normally a financial institution) taking over the trade
receivables collection for a business. Companies that use debt factors to collect their trade receivables
might obtain financing for most of their trade receivables from the factor. One of the services offered
by a factor is to provide finance for up to 70% or 80% of the value of outstanding trade receivables
that the factor has undertaken to collect. The balance of the debt, less any deductions for fees and
interest, will be paid after an agreement period or when the debt is collected.

(c) Invoice Discounting: This involves a factor or other financial institution providing a loan
based on a proportion of the face value of a business’s credit sales outstanding. A certain percentage of
the value of the approved sales invoices outstanding is usually advanced. A business must agree to
repay the advance within a relatively short period. Responsibility for collecting the trade receivables
outstanding remains within the business and repayment of the advance is not dependent on the trade
receivables being collected.

(d) Reducing Inventory Levels: Holding inventories imposes an opportunity cost on a

business as the funds tied cannot be used for other purposes. Thus, if inventories are reduced, funds
become available to meet future sales demand. However, a business must ensure there is a sufficient
inventory to meet likely future sales demand.

(e) Delaying Payments to Trade Receivables: By providing a period of credit, suppliers are
in effect offering a business an interest free loan. If the business delays payment, the period of the
‘loan’ is extended and the funds are retained within the business. This can be a cheap form of finance
for a business.

(f) Operating Leases: In some cases, operating leases might be an alternative to obtaining
short-term finance. Operating leases are similar to rental agreements for the use of non-current assets,
although they might have a longer term. (Rental agreements are usually very short term).Companies
that obtain the use of non-current assets with operating lease agreements avoid the need to purchase
the assets and to finance these purchases with capital. Operating leases might be used extensively by
small and medium-sized business enterprises which find it difficult to obtain finance to pay for non-
current asset purchases.
ii. Long-term Finance:
Long-term funding is required for a company’s long-term assets and also to finance working capital.
The main sources of long-term capital are:
• Borrowings
• Debt Finance
• Equity Finance
• Hire Purchases
• Retained Earnings (Profits)
• Lease Finance (Finance Leases)
For some companies, long-term finance might be provided in the form of venture capital.

(a) Borrowings: Lenders enter into a contract with the business in which the interest rate,
dates of interest payments, capital repayments and security for the loan are clearly stated. Security is
normally required. There are various forms of borrowings including: term loan, mortgage and loan
notes
 (b) Debt Finance: The term ‘debt finance’ is used to describe finance where:

• The borrower receives capital, either for a specific period of time (redeemable debt) or possibly in
perpetuity (irredeemable debt)
• The borrower acknowledges an obligation to pay interest on the debt for as long as the debt remains
outstanding, and
• The borrower agrees to repay the amount borrowed when the debt matures (reaches the end of the
borrowing period)
For companies, the most common forms of debt finance are: Borrowing from banks and Issuing debt
securities.
Debt finance can be long-term, medium-term or short-term finance. For companies:
a. Long-term finance is usually obtained by issuing bonds. Bonds might also be called loan
stock or debentures.
b. Medium-term debt finance (with a maturity of up to about five or seven years) is usually in
the form of bank loans, but a company might also issue bonds with a maturity of just a few
years. Medium-dated bonds are often called ‘notes’
c. Short-term debt finance is usually in the form of a bank overdraft or similar bank facility.
Large companies might be able to obtain short-term debt finance in other ways, such as:
− by issuing short-term debt securities in the money markets as commercial paper, within a commercial
paper programme
− By arranging a ‘bills acceptances’ programme with a ban

(c) Equity Finance: Equity finance is finance provided by the owners of a company – its
ordinary shareholders, also called equity shareholders. (Some forms of irredeemable preference share
might be regarded as equity finance, but in practice irredeemable preference shares are rare in public
companies).

(d) Hire Purchase: Is a form of credit used to acquire an asset. Under the terms of the Hire
purchase agreement, a customer pays for an asset by instalments over an agreed period. Customer will
pay an initial deposit (down payment) and then make instalment payments at regular intervals, until the
balance outstanding has been paid.

(e) Retained Earnings/Profits: Rather than distributing the profits to shareholders, a business
may decide to retain the profits. The portion of the net earnings of the company that is not distributed
as dividends is known as retained earnings.

(f) Finance Leases: It is a form of lending in which the legal ownership of the asset remains
with the lessor whereas, the risks and rewards associated with the item being leased is transferred to
the lessee. A lessor is an institution that owns the asset and then leases it to the business. A lessee is a
business that leases an asset from the institution.
Finance lease is different from an operating lease. Operating lease is a shortterm agreement in which,
the rewards and risks of ownership stay with the owner. Example. Where a builder hires some earth
moving equipment for a week to carry out a particular job.
Factors Affecting the Choice of the Sources of Finance:-
(a) Cost: there are two types of cost – the cost of procurement of funds and the cost of utilizing
the funds
 (b) Financial strength and stability of operations: business should be in a sound financial
position so as to be able to repay the principal amount and interest on the borrowed amount
(c) Form of organization and legal status: the form of business organization and status
influences the choice of a source. A partnership firm, for example, cannot raise money by issue of
equity shares as these can be issued only by a joint stock company
(d) Purpose and time period: business should plan according to the time period for which the
funds are required
(e) Risk profile: business should evaluate each of the source of finance in terms of the risk
involved
(f) Control: a particular source of fund may affect the control and power of the owners on the
management of a firm
MODULE 3
Time Value of Money Concept
Definition of TVM:-
Time value of money is a key valuation concept in finance that states, “a shilling now is worth more (has
more value) than a shilling in the future”.
Money has a time value, because an investor expects a return that allows for the length of time that the
money is invested. Larger cash returns should be required for investing for a longer term.
Reasons for Time Value of Money:-
(i) Inflation
(ii) Uncertainty: the future is uncertain
(iii) Foregone investment opportunities
(iv) Foregone consumption: individuals prefer present consumption compared to future
Uses of Time Value of Money in Finance:-
(i) Investment appraisal/capital budgeting: several techniques such as NPV, IRR &
Discounted payback uses TVM concepts
(ii) Cost of capital computation: cost of capital is obtained as a rate that equates future cash
flows expected from the security to security’s current price
(iii) Business valuation: value of business is simply given as the PV of future cashflows
expected from the business
(iv) Retirement planning through creation of sinking fund
(v) Asset replacement: An asset replacement decision involves deciding how frequently a
noncurrent asset should be replaced, when it is in regular use, so that when the asset reaches the end
of its useful life, it will be replaced by an identical asset.
Measurements of Investment Returns:-
Investment returns can be measured by compounding or discounting.
1. Compounding:
Compounding is used to calculate the future value of an investment, where the investment earns a
compound rate of interest.
Compounding means:
• Taking today’s cashflows to some future period
• Bringing previous cashflows to the present
• Simply to compute future value (FV)
If an investment is made ‘now’ and is expected to earn interest at r% in each time period, for example each
year, the future value of the investment can be calculated as follows.
Future return = Initial investment × (1 + r)n
The term ‘future value’ or ‘FV’ means the value of an investment or cash flow at a future date. ‘Present
value’ or ‘PV’ refers to value now. The above compound interest formula can therefore be stated as:
FV = PV × (1 + r)n
Notes r = the return on the investment each time period (year). This might be an actual return or a required
return. n = the number of time periods (years) covered by the investment.
r is expressed as a proportion. For example:
• if the return is 12%, r = 0.12
• if the return is 7%, r = 0.07
• if the return is 8.5%, r = 0.085
2. Discounting:
Discounting is the reverse of compounding. Future cash flows from an investment can be converted to an
equivalent present value amount.
Discounting means:
• Bringing future cashflows to the present
• Taking today’s cash flows to some previous day
• Simply means to compute the present value (PV)
Present value of future return = Future value of return × [1/(1 + r)n]
PV = FV × [1/(1 + r)n] or PV = FV × (1 + r)– n
The present value of a future cash flow from an investment is the amount that would have to be invested
now, at the investment cost of capital, to earn that future cash flow.
Discount Factors:
A discount factor is 1/(1 + r)n . Future cash flows or investment values are multiplied by the appropriate
discount factor to convert them into a present value. The discount factor is smaller for higher values of ‘r’
and higher values of ‘n’
Present value = Future cash flow × Discount factor