FINANCIAL MANAGEMENT

MEANING ,NATURE ,CONCEPTS AND OBJECTIVES

• Financial management is about analysing financial situation making
financial decision setting financial objectives. Formulating financial
plan to attain this objectives and providing effective system of
financial control to ensure plan to progress towards the set of
objective.
• Financial management is that managerial activity which is concerned
with the planning and controlling of the firm’s financial resources.
Though it was a branch of economics till 1890, as a separate activity
or discipline it is of recent origin. Still it has no unique body of
knowledge of its own and draws heavily on economics for its
theoretical concepts even today.
• According to Weston and Brighan, “Financial Management is an area of
financial decision making, harmonising individual motives and
enterprise goals”.
• 2. According to Howard and Upon, “ Financial Management is the
application of the planning and controlling functions to the finance
function”.
• 3. According to Ezra Soloman and Pringle John, “Financial Management
is concerned with the effective use of an economic resource namely
capital fund”.
• 4. A formal definition of finance would be determining acquisition,
allocation, understanding and utilisation of financial resources usually
in the aim of achieving of some particular goals of objective.
SCOPE OF FINANCIAL MANAGEMENT
• Financial Management means the entire excise of managerial efforts
devoted to the management of finance, both its sources and uses of
financial resources of an enterprise. Financial management has
undergone significant changes over years as regards its scope and
coverage. As such the role of finance manager has also undergone
fundamental changes over the years. In order to have a better
understanding of these changes, it will be appropriate to study both
traditional approach and modern approach to the finance function.
I.TRADITIONAL APPROACH:
• The traditional approach, which was popular in the early part of this century,
limited role of financial management to raising and administering of funds
required by the enterprise to meet their financial needs. It broadly covered the
following three aspects,
• i) Arrangement of funds from financial institutions.
• ii) Arrangement of funds through issue of financial instruments.
• iii) Looking after the legal and accounting relationship between a corporation and
its sources of funds. Thus the traditional concept of financial management
included the whole exercise of raising funds externally. The finance manager had
a limited role to perform. He was expected to keep accurate financial records,
prepare reports on the financial performance and manage cash in a way that the
corporation is in a position to pay bills in time. The term “Corporate Finance” was
used in place of the present term “Financial Management”.
1. Outsiders looking in Approach:
• This approach treated the subject of finance from the view point of
suppliers of funds i.e., outsiders, bankers and investors etc. It
followed an outsider-looking in approach and not the insider looking-
out approach, since it completely ignored the viewpoint of those who
had to take internal financing decisions.
• 2. Ignored Routine Problems:
• The approach gave undue emphasis to infrequent happenings in the
life of an enterprise. The subject of financial management was
confined to the financial problems arising during course of,
incorporation, mergers, consolidations and reorganisation of
corporate enterprise. As a result this approach did not give any
importance to day-to-day financial problems of business
undertakings.
• 3. Ignored Non-Corporate Enterprise:
• The approach focused only the financial problems of corporate
enterprise. Noncorporate industrial organisations remained outside
its scope.
• 4. Ignored Working Capital Financing:
• The approach laid emphasis on the problems of long term financing.
The problems relating to financing short term or working capital were
ignored
 II. MODERN APPROACH:
• The traditional approach outlived its utility due to changed business situations since mid-
1950. Technology improvements, innovative marketing operations, development of strong
corporate structure, keen business competition, all made it imperative for the management
to make optimum use of available to the financial manager, based on which he could make
sound decisions. The scope of financial management increased with the introduction of
capital budgeting techniques. As a result of new methods and techniques, capital
investment projects led to efficient allocation of capital within the firm.
i. During the next two decades various pricing models, valuation models and investment
portfolio theories also developed.
ii. Efficient allocation of capital became an important area of study under financial
management.
iii. Eighties witnessed an era of high inflation, which caused the interest rates to rise
dramatically. Thus, raising loan on suitable terms became an important aspect of financial
management.
iv. In the new volatile environment investment and financing decisions became more risky
than ever before.
v. These environmental changes enlarged the scope of finance. The concept of managing a
firm as a system emerged. External factors now no longer could be evaluated in isolation.
• i) Investment Decision: The investment decision is a selection of
assets in which funds will be invested by a firm. These are broadly
divided into two parts; they are (a) Long-term Assets and (b) Short-
term Assets.
• a) Long-term Assets: These are the asset which yield over a period of
time in future such as capital budgeting. The capital budgeting is a
crucial financial decision and it is a process begin with identifications
of potential investment opportunities. The capital budgeting
decisions relates to the choice of assets out of the alternatives or
reallocation of capital when an old assets fails to justify. It is a
decision which analyse the risk and uncertainty The worth of long
term project implies a certain standard for benefits.
• b) Short-term Assets: It is also known as current assets. The short-
term assets are resources of a firm in the form of cash or converted in
cash without the diminution in value. Example: The working capital
management. It is day to day activity of finance which deals with
current assets and current liabilities. The two basic ingredients of
working capital are
i) An overview of working capital management as a whole
ii) Efficient management of the individual current assets such as cash,
Bills receivables and inventory.
ii) Financial Decision:
• The financial decision is process perform by financial manager to
decide, when, where from and how to acquire funds to meet the
investment needs. The main aspect is to determine the appropriate
proportion of debt and equity mix known as capital structure.
• iii) Dividend Decision:
The financial manager must decide whether the firm should distribute
all profit or return to them or distribute a portion. The proportion of
profit distributed as dividend is known as dividend payout ratio and
retained portion of profit is called retention ratio.
FUNCTIONS OF FINANCIAL MANAGEMENT
• I. Liquidity Functions:
In seeking sufficient liquidity to carry out the firm’s activities, the
financial manager performs tasks such as the following:
➢ The day-to-day operations require the firm to be able to pay its bills
properly.
➢ This is largely a matter of matching cash inflows against cash
outflows.
➢ The firm must be able to forecast the sources and timing of inflows
from customers and use them to pay creditors and suppliers.
• 2) Raising Fund:
The firm receives financing from a variety of sources. At different times
some sources will be more desirable than others. The possible source
may not at a given time, have sufficient funds available to meet firm’s
need. The financial manager must identify the amount of funds
available from each source and the periods when they will be needed.
Then the manager must take steps to ensure that the funds will
actually be available and committed to the firm.
• 3) Managing the Flow of Internal Funds:
A large firm has a number of bank accounts for various operating
division. The money that flows among these internal accounts should
be carefully monitored. Frequently, a firm has excess cash in one bank
account when it has a need for cash elsewhere. By continuously
checking on the cash balances in the head quarters and each operating
division’s accounts, the manager can achieve a high degree of liquidity
with minimum external borrowing.
• 4) Profitability Functions:
In seeking profits for the firm the financial manager provides specific
inputs into the decision making process, based on the financial training
and actions. With respects to profitability, the specific functions are,
• i) Cost Control: Most large corporations have detailed cost accounting
systems to monitor expenditure in the operational areas of the firm.
Data are fed into a system on a daily basis and computer-processed
reports containing important information on activities are displayed
on a screen.
• ii) Pricing:
Some of the important decisions made by a firm involve the prices
established for products and service. The philosophy and approach to
pricing policy are critical elements in the company’s marketing efforts,
image and sales level. Determination of the appropriate price should be
a joint decision of marketing manager provides information on how
differing price will affect demand in the market and firm’s competitive
position.
• iii) Forecasting Profits:
The financial manager is responsible for gathering and analysing the relevant
data and making forecasts of profits levels. To estimate profits from future
sales, the firm must be aware of current costs likely increases in costs and
likely changes in the ability of the firm to sell its products at the planned
selling prices.
• iv) Measuring Required Return:
Every time a firm invests its capital, it must make a risk return decision. Is the
level of return offered by the project adequate for the level of risk there in?
The required rate of return that must be expected from a proposal before it
can be accepted. It is sometimes called the cost of capital. Determining the
firm’s required return or cost of capital is a profitability function.
• v) Management functions:
In performing many functions leading to liquidity and profitability, the
financial manager operates in two distinct roles. One role is manager,
decision maker, a participant in the corporate team trying to maximise
the value of the firm over the long run. The other role is an expert of
financial matters and money markets, an individual with specific
knowledge and skills in the area of money management. These roles
are recognised in the two categories of functions performed by the
financial manager.
• vi) Managing Assets:
Assets are the resources by which the firm is able to conduct business.
The term assets include buildings, machinery, vehicles, inventory,
money and other resources owned or leased by the firm. A firm’s
assets must be carefully managed and a number of decisions must be
made concerning their usage. The function of asset management
attests to the decision making role of the financial manager. Finance
personnel meet with other officers of the firm and participate in
making decisions affecting the current and future utilisation of the
firm’s resources. The decision making role crosses liquidity and
profitability lines, converting idle equipment to cash, so as to improve
liquidity, reducing costs and improving profitability.
II. Managing Funds:
• Funds may be viewed as the liquid assets of the firm. The term funds
includes cash held by the firm, money borrowed by the firm, money
borrowed by the firm, money gained from purchases of common and
preferred stock. In the management of funds, the financial manager acts as
a specialised staff officer to the CEO of company. The manager is
responsible for having sufficient funds for the firm to conduct its business
and to pay its bills. Money must be allocated to finance receivables and
inventories, to make arrangements for the purchase of assets and to
identify sources of long term financing. Cash must be available to pay
dividends declared by the company. The management of funds has both
liquidity and profitability aspects. If the companies are inadequate, the firm
may default on the payment of bills, interest on its Debt or repayment of
principle when a loan is due. If the firm does not carefully choose its
financing sources it may pay excessive interest costs with a subsequent
decline in profits.
FINANCE FUNCTIONS
• Although it may difficult to separate the finance functions from production,
marketing and other functions, yet the functions themselves can be readily
identified. The functions of raising funds, investing them in assets and
distributing returns earned from assets to shareholders are respectively
known as financing, investment and dividend decisions. While performing
these functions, a firm attempts to balance cash inflows and outflows. This
is called liquidity decision and we may add it to the list of important
finance decision or functions. Finance functions or decisions include,
1. Investment or long term asset-mix decision.
2. Financing or Capital- mix decision.
3. Dividend or Profit allocation decision.
4. Liquidity or Short term asset-mix decision.
I.Investment Decision:
• Investment decision or capital budgeting involves the decision of allocation of capital or commitment of
funds to long term assets that would yield benefits in the future. Two Important aspects of the investment
decision are,
• 1. The evaluation of the prospective profitability of new investments and
• 2. The measurement of a cut off rate against that the prospective return of new investments could be
compared.
• i. Future benefits of investments are difficult to measure and cannot be predicted with certainly.
• ii. Because of the uncertain future, investment decisions involve risk. Investment proposals should,
therefore, be evaluated in terms of both expected return and return.
• iii. Besides the decision to commit funds in new investment proposals, capital budgeting also involves
decision of recommitting funds when an asset becomes less productive or non-profitable.
• iv. There is a broad agreement that the correct cut off rate is the required rate of return or the opportunity
cost of capital.
• v. However, there are problems in computing the opportunity cost of capital in practice from the available
data and information. A decision maker should be aware of these problems.
 Financing decision
• i. Financing decision is the second important function to be performed by financial
manager.
• ii. Broadly, he or she must decide when, where and how to acquire funds to meet the
firm’s investment needs.
• iii. The central issue before him or her is to determine the proportion of equity and debt.
• iv. The mix of debt and equity is known as the firm’s capital structure for his or her firm.
• v. The firm’s capital structure is considered to be optimum when the market value of
shares is maximized.
• vi. The use of debt affects the return and the risk of shareholders, it may increase the
return on equity funds bit it always increases risk.
• vii. When the shareholders return is maximized with minimum risk, the market value per
share will be maximized and the firm’s capital structure would be considered optimum.
• viii. Once the financial manager is able to determine the best available sources.
• ix. In practice, a firm considers many other factors such as control, flexibility, loan
convenient, legal aspects etc., in deciding its capital structure.
Dividend decision
• i. Dividend decision is the third major financial decision.
• ii. The financial manager must decide whether the firm should distribute all profits or
retain them or distribute a portion of profit and retain the balance in the business.
• iii. Like the debt policy, the dividend policy is one that maximises the market value of the
firm’s shares.
• iv. Thus, if shareholders are not indifferent to the firm’s dividend policy, the financial
manager must determine the optimum dividend-payout ratio.
• v. The pay-out ratio is equal to the percentage of dividends to earnings available to
shareholders.
• vi. The financial manager should also consider the questions of dividends regularly.
• vii. Periodically, additional shares called bonus shares (or stock divided) are also issued to
the existing shareholders in addition to the cash dividend.
 IV.Liquidity Decision:
• i. Current assets management that affects a firm’s liquidity is yet another r important fiancé function,
in addition to the management of long-term assets.
• ii. Current assets should be managed efficiently for the safeguarding the firm against the dangers of
liquidity and insolvency.
• iii. Investment in current assets affects the firm’s profitability, liquidity and risk. A conflict exists
between profitability and liquidity while managing current assets.
• iv. If the firm does not invest sufficient funds in current assets, it may become liquid.
• v. But it would lose profitability, as idle current assets would not earn anything.
• vi. Thus, a proper trade-off must be achieved between profitability and liquidity.
• vii. In order to ensure that neither insufficient nor unnecessary funds are invested in current assets.
• viii. He or she should estimate firm’s needs for current assets and make sure that funds would be
made available when needed.
• ix. It would be clear that financial decision directly concern the firm’s decision to acquire or dispose
off assets and require commitment or recommitment of funds on a continuous basis.
• x. It is in this context that finance functions are said to influence production, marketing and other
functions of the firm.
OBJECTIVES / GOALS OF FINANCIAL
FUNCTION
• i. The firm’s investment and financing decisions are unavoidable and
continues.
• ii. In order to make them rationally the firms must have a goal.
• iii. It is generally agreed in theory that the financial goal of the firm
should be the maximisation of owners’ economic welfare.
• iv. Owners’ economic welfare could be maximised by the
shareholders wealth as reflected in the market value of shares.
• v. In this section, we show that the Shareholders Wealth
Maximization (SWM) is to theoretically logical and operationally
feasible normative goal for guiding the financial decision making.
 I. PROFIT MAXIMISATION:
• i. Profit maximization means maximising the rupee or any other currency such as dollar, pound
or both income of firms.
• ii. Profit is a primary motivating force for any economic activity. Firm is essentially being an
economic organisation, it has to maximise the interest of its stakeholders. To this the firm has
to earn profit from its operations.
• iii. In fact, profits are useful intermediate beacon (encouragement/inspiration/ guiding
light/symbol of hope/signal) towards which a firm’s capital should be directed.
• iv. McAlpine rightly remarked that profit cannot be ignored since it is both a measure of the
success of business and means of its survival and growth.
• v. Profit is the positive and fruitful difference between revenues and expenses of a business
enterprise over a period of time.
• vi. If an enterprise fails to make a profit, capital invested is eroded /wrinkled/windswept and
this situation prolongs, the enterprise ultimately ceases to exist.
• vii. The overall objective of business enterprise is to earn at least satisfactory returns on the
funds invested, consistent with maintaining a sound financial position.
Limitations:
• 1. Vague:
• i. The term “profit” is vague and it does not clarify what exactly it
means. It has different interpretations for different people. Does it
mean short-term or long-term; total profit or net profit; profit before
tax or profit after tax; return on capital employed.
• ii. Profit maximisation is taken as objective, the question arises which
of the about concepts of profit should an enterprise try to maximise.
Apparently, vague expression like profit can form the standard of
efficiency of financial management.
• 2. Ignores Time Value of Money:
• i. Time value of money refers a rupee receivable today is more
valuable than a rupee, which is going to be receivable in future
period.
• ii. The profit maximisation goal does not help in distinguishing
between the returns receivable in different periods.
• iii. It gives equal importance to all earnings through the receivable in
different periods. Hence, it ignores time value of money.
• 3. Ignores Quality of Benefits:
• i. Quality refers to the degree of certainty with which benefits can be expected.
• ii. The more certain expected benefits, the higher are the quality of the benefits and vice
versa.
• iii. Two firms may have same expected earnings available to shareholders, but if the
earnings of one firm show variations considerably when compared to the other firm, it
will be more risky.
• ❖ Profit maximisation objective leads to exploiting employees and consumers. It also
leads to colossal /vast inequalities and lowers human values that are an essential part of
ideal social systems.
• ❖ It assumes perfect competition and in the existence of imperfect competition, it
cannot be a legitimate/lawful/legal objective of any firm. It is suitable for self-financing,
private property and single ownership firms.
• ❖ A company is financed by shareholders, creditors and financial institutions and
managed and controlled by professional managers. A part from these people, there are
some others who are interested towards company (i.e., employees, government,
customers and society).
• ❖ Hence one has to take into consideration all these parties interests, which is not
possible under the objective of profit maximisation. Wealth maximisation objective is the
alternative of profit maximisation.
 II. SHAREHOLDERS WEALTH MAXIMISATION
(SWM) :
• i. On account of above discussed limitations of profit maximisations shareholders
wealth maximisation is an appropriate goal for financial decision making.
• ii. It is operationally feasible since it satisfies all the three requirements of a suitable
operational objective of financial courses of action namely exactness, quality of
benefits and the time value of money.
• iii. The objective of Shareholders wealth maximization is an appropriate and
operationally feasible criterion to choose among the alternative financial actions.
• iv. It provides an unambiguous measure of what financial management should seek
to maximise in making investment and financing decisions on behalf of owners
(shareholders).
• v. Shareholders Wealth Maximisation means maximising the net present value (or
wealth) of a course of action to shareholders.
• vi. The Net Present Value (NPV) of course of action is the difference between the
present value of its benefits and present value of its costs.
 III. EARNING PER SHARE (EPS) MAXIMISATION :
• i. Apart from the above discussed goals, there are several alternative goals, which will again
help to maximise value of the firm or market price per share. They are:
• ii. Maximisation of Return on Equity(ROE)
• iii. Maximisation of Earnings Per Share (EPS)
• iv. Management of Reserves for Growth and Expansion.
• v. If we adopt maximising earnings per share as the financial objective of the firm, this will
also not ensure the maximisation of owner’s economic welfare.
• vi. It also suffers from the flows already mentioned, i.e., ignores time and risk of the
expected benefits. Apart from these problems, maximisation of earnings per share has
certain deficiencies as a financial objective.
• vii. For example, Note the following observation,
• viii. For one thing, it implies that the market value of employee’s shares is a function of
earnings per share, which may not be true in many instances.
• ix. If the market value is not a function of earnings per share, then maximisation of the
latter will not necessarily result in the highest possible price for the company’s shares.
 PROFIT MAXIMIZATION Vs WEALTH MAXIMISATION
• Profit maximisation is basically a single period or almost, short term goal, to
be achieved within one year, it is usually intercepted to mean the
maximisation of profits within a given period of time. A corporation may
maximise its short term profits at the expense of its long term profitability. In
contrast, stockholder wealth maximisation is a long term goal, since
stakeholders are interested in future as well as present profits. Wealth
maximisation is generally preferred because it consider, Wealth for the long
term. Risk or uncertainty. The timing of return. 4) The stakeholders return.
Timing of returns is important, the earlier the return is received, the better,
since a quick return reduces the uncertainty about receiving the return and
the money received can be reinvested sooner. The following Table summarises
the advantages and disadvantages of these two often conflicting goals
 RISK-RETURN TRADE-OFF
• i. Risk is present in every business decision, whether it is corporate decision or personal decision.
• ii. When we say risk, most of us think in the negative sense.
• iii. For example, driving a two wheeler too fast is risky, because it may lead to accident, which in turn may take like of
the people sitting on the vehicle and people moving on the road.
• iv. A student planning to take slips with him/her for examination and trying to copy from them.
• v. It is risky when he / she is caught by the room supervisor or squad.
• vi. According to the business dictionary risk refers, threat or damage injury or liability or loss of other negative
occurrence caused by external or internal vulnerabilities.
• vii. But, from business point of view risk is the variability in an expected return. In other words, business people see the
risk in broader perspective. They see risk in the business when they realize less return than expected.
• viii. Actual return may be less than the expected return, because of risks like, business risk, financial risk, default risk,
delivery risk, interest rate risk, exchange rate risk, liquidity risk, investment risk and political risk.
• ix. For example, selection of an asset for production department or developing a new product or financial decisions
like- developing capital structure, working capital management, and dividend decision.
Therefore, the decision makers have to assess risk and return of investing on asset before taking any financial decision.
 TIME VALUE OF MONEY
• i. The simple concept of time value of money is that the value of the money
received today is more than the value of same amount of money received after a
certain period.
• ii. In other words, money received in the future is not as valuable as money
received today. The sooner one receives money, the better it is.
• iii. Taking the case of a rational human being, given the option to receive a fixed
amount of money at either of two time periods, he will prefer to receive it at the
earliest.
• iv. If you are given the choice of receiving Rs.1,000 today or after one year, you
will definitely opt to receive today than after one year.
• v. This is because of you value the current receipt of money higher than future
receipt of money after one year.
• vi. The phenomenon is referred to as time preference for money.
 REASONS FOR TIME PREFERENCE MONEY:
• 1. The future is always uncertain and involves risk. An individual can never
be certain of getting cash inflows in future and hence he will like to receive
money today instead of waiting for the future.
• 2. People generally prefer to use their money for satisfying their present
needs in buying more food or clothes or another car than deferring them for
future.
• i. The present needs are considered urgent as compared to future needs.
• ii. Moreover, there may also be a fear in one’s mind that he may not be able
to use the money in future for fear of illness or death.
• 3. Money has time value because of the opportunities available to invest
money received at earlier dates at some interest or otherwise to enhance
future earnings. For example, if you have Rs.100 today, you can put it in your
bank account and earn interest. After one year the interest would be Rs.8
(taking rate of interest at 8% p.a.) and you would have Rs.108 at the end of
the year. So, if you have a choice between Rs.108 next year or Rs.100 next
year. Any rational person would prefer the larger amount.
TECHNIQUES OF TIME VALUE OF MONEY:
• There are two techniques for adjusting the time value of money:
• Compounding Technique
• Discounting or Present Value Technique
The time preference for money encourages a person to receive the money at
present instead of waiting for future. But he may like to wait if he is duly
compensated for the waiting time by way of ensuring more money in future.
The future value at the end of period I can be calculated by a simple formula given
below:
V1 = Vo (1+i)
Where V1 = Future value at the period I
Vo= Value of money at time O i.e., original sum of money.
i= Interest Rate.
COMPOUNDING FACTORS TABLES:
• Using the Compound Factor Tables, the future value of money can be
calculated as below:
• Vn = Vo(CFi , n)
• Where CFi , n is compound factor at (i) present and n periods
DOUBLING PERIOD:
• Compound factor tables can be easily used to calculate the Doubling period,
i.e., the length of period which an amount is going to take to double at a
certain given rate of interest.
• So far we have considered only one compounding of interest annually. But in
many cases, interest may have to be compounded more than one year. For
example, banks may allow interest on quarterly basis or a company may allow
compounding of interest twice a year on 30th June and 31st December every
year. The future value of money in such cases can be calculated below:
Vn = Vo(1+i / m)m x n
Where Vn = future value of money after n years.
Vo = Value of money at time O, i.e., original sum of money.
i= interest rate
m = number of times (frequency) of compounding per year.
Evolution of Financial Management:
• Financial Management has emerged as a distinct field of study, only in
the early part of this century, as a result of consolidation movement
and formation of large enterprises. Its evolution may be divided into
three phases.,
• 1. The Traditional Phase
• 2. The Transitional Phase
• 3. The Modern Phase
 1. The Traditional Phase:
• This phase lasted for about four decades. It finest expression was shown in the
scholarly work of Arthur S.Dewing, in his book titled “the Financial Policy of
Corporation in 1920’s. In this phase the focus of financial management was on
four selected aspects.
• i) It treats the entire subject of finance from the outsider’s point of view
(investment banks, lenders, others) rather than the financial decision-makers
viewpoint in the firm.
• ii) It places much importance on corporation finance and too little on the
financing problems of non-corporate enterprises.
• iii) The sequence of treatment was on certain episodic events like formation,
issuance of capital, major expansion, merger, reorganisation and liquidation
during the life cycle of an enterprise.
• iv) It placed heavy emphasis on long term financing, institutions, instruments,
procedures used in capital markets and legal aspects of financial events.
2. The Transitional Phase:
• 1. It began around the early 1940s and continued through the early
1950s.
• 2. The nature of financial management in this phase is almost similar
to that of earlier phase but more emphasis was given to day-to-day
(working capital) problems faced by the finance managers.
• 3. Capital budgeting techniques were developed in this phase only.
• 4. Much more details of this phase are given in the book titled “essays
on business finance”.
 3. The Modern Phase:
• 1. It began in the mid 1950s. It has showed commendable development with a combination of
ideas from economic and statistics that has lead financial management to be more analytical and
quantitative.
• 2. The main issue of this phase was rational matching of funds to their uses, which leads to the
maximisation of shareholders wealth.
• 3. This phase witnessed significant developments. The areas of advancements are: capital
structure.
• 4. The study says the costs of capital and capital structure are independent in nature.
• 5. Dividend policy, suggests that there is the effect of dividend policy on the value of the firm.
• 6. This phase has also seen one of the first applications of linear programming.
• 7. For estimation of opportunity cost of funds, multiple rates of return give way to calculate
multiple rates of a project.
• 8. Investment decisions under conditions of uncertainty, gives formulas for determination of
expected cash inflows and variance of net present value of projects and gives how probabilistic
information helps the firm to optimise investment decisions involving risk.
• 9. Portfolio analysis gives the idea for allocation a fixed sum of money among the available
investment securities.
THE ROLE OF FINANCE FUNCTION IN THE
CONTEMPORARY SCENARIO.
• Today’s highly dynamic business environment is driven by opening
and expanding global markets; multiple corporate governance
requirements; pressure on improving efficiency, cost cutting,
demand for higher return on investment; greater stress on timely
valuable information; rapid changes in technology and increased use
of technology, sharp focus on aligning the companies towards the
customer needs and increasing focus on core unpredictable
activities.
• It indicates that the business environment is diverse multi-faced and
unpredictable. Not only the business environment at the same time, we
have seen major accounting scandals around the world-Enron, parmalat,
WorldCom, Qwest Communications, Tyco international, Health South
Corporation, Adelphia, Peregrine Systems, AIG and Satyam Computer
services.
• These scandals have occurred due to the misdeeds like overstating
revenues, understating expenses, overstating value of assets,
underreporting the liabilities, misuse of funds, some cases with billions
and dollars due to the collapsed share prices, shook public confidence in
the global security markets.
• Therefore, today’s business environment place extraordinary demands
on corporate executives and particularly the burden of finance function
is accelerated without limit.
• As a result, in recent years, executive roles have been forced to evolve and in
some instances, change dramatically and companies restructured their
traditional models to become leaner, faster and more responsive.
• Finance function plays a pivotal role in restructuring traditional models and it
has become core of business operations, reporting and ensuring financial
integration than ever before.
• The role of finance manager is no longer confined to accounting, number of
crunching, financial reporting and risk management and finance manager once
considered as an executive with proficiency in figures, is no longer confined to
the game of numbers. Having undergone the changes over the period of time,
they now play a major role in driving the business for their organisation by
acting as strategic business partner of the chief executive officer (CEO).
• Put in simple words, the role and responsibilities of finance manager have
become complex and demanding and require constant reinvention of the role.
 The following are the new functions of finance
manager:
• 1. Continuous focus on margins and ensure that the organisation stays committed
to value creation.
• 2. Work across the functional divide of the company and exhibit leadership skills.
• 3. Understand what’s driving the numbers and provide operation insights,
including a sense of external market issues and internal operating trends and
become key strategy player.
• 4. Aware and use the highly innovative financial instruments.
• 5. Know the emergence of capital market as central stage for raising money.
• 6. Adding more value to the business through innovations in impacting human
capital.
• 7. Must balance the need to cut overhead with the need to create a finance
organisation able to meet long-term goals by---designing financial processes,
systems and organise that can support the business in the future and initiating cost
reductions that further cut organisational fat, but not operational muscle.
DuPont analysis
• The DuPont analysis (also known as the DuPont identity or DuPont
model) is a framework for analyzing fundamental performance
popularized by the DuPont Corporation. DuPont analysis is a useful
technique used to decompose the different drivers of return on
equity (ROE). The decomposition of ROE allows investors to focus on
the key metrics of financial performance individually to identify
strengths and weaknesses.
Formula and Calculation of DuPont Analysis

• The Dupont analysis is an expanded return on equity formula, calculated by

multiplying the net profit margin by the asset turnover by the equity
multiplier.
• DuPont Analysis=Net Profit Margin×AT×EM
• where:
• Net Profit Margin=Net Income/​Revenue
• AT=Asset turnover
• Asset Turnover=Sales​/ Average Total Assets
​EM=Equity multiplier
• Equity Multiplier=Average Total Assets​​/ Average Shareholders’ Equity
• A DuPont analysis is used to evaluate the component parts of a
company's return on equity (ROE). This allows an investor to
determine what financial activities are contributing the most to the
changes in ROE. An investor can use analysis like this to compare
the operational efficiency of two similar firms. Managers can use
DuPont analysis to identify strengths or weaknesses that should be
addressed.
• There are three major financial metrics that drive return on equity
(ROE): operating efficiency, asset use efficiency, and financial leverage.
Operating efficiency is represented by net profit margin or net income
divided by total sales or revenue. Asset use efficiency is measured by
the asset turnover ratio. Leverage is measured by the equity
multiplier, which is equal to average assets divided by average equity.
DuPont Analysis vs. ROE
• The return on equity (ROE) metric is net income divided by
shareholders’ equity. The Dupont analysis is still the ROE, just an
expanded version. The ROE calculation alone reveals how well a
company utilizes capital from shareholders.
• With a Dupont analysis, investors and analysts can dig into what
drives changes in ROE, or why an ROE is considered high or low. That
is, a Dupont analysis can help deduce whether its profitability, use of
assets, or debt that’s driving ROE.
Limitations of Using DuPont Analysis

• The biggest drawback of the DuPont analysis is that, while expansive,

it still relies on accounting equations and data that can be
manipulated. Plus, even with its comprehensiveness, the Dupont
analysis lacks context as to why the individual ratios are high or low,
or even whether they should be considered high or low at all.