Copy_of_FM_-Unit1_2_Reference_Material(03-07-2024).pdf

FINANCIAL MANAGEMENT
INTRODUCTION

FINANCIAL MANAGEMENT
Definition of Financial Management:
• Financial Management is concerned with the efficient use
of an important economic resource, namely capital funds.
-Solomon
• 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.
- Phillioppatus

• Financial Management deals with
procurement of funds and their effective
utilization in the business.
-S.C.Kuchhal
• Financial Management is the application of
the planning and control function to the
finance function.
-Archer and Ambrosio

Scope of Financial Management:
Traditional Approach:
• According to this approach, the scope of
financial management is confined to the
raising of funds.
• Hence, the scope of finance was treated by
the traditional approach in the narrow sense
of procurement of funds by corporate
enterprises to meet their financial needs.

• Since the main emphasis of finance function at that period
was on the procurement of funds, the subject was called
Corporation finance till the mid-1950’s and covered
discussion on the financial Instruments, Institutions and
practices through which funds are obtained.
The scope of finance function in the traditional approach has
now been discarded due to the following limitations:
• The traditional approach was the “outsider-looking in”
approach.
• Internal financial decision making was completely ignored.

• It places over emphasis on the topics of securities and
its markets, without paying any attention on the day to
day financial aspects.
• This approach has failed to consider the routine
managerial problems relating to finance of the firm.
Modern Approach:
• The emphasis of financial management has been
shifted from raising of funds to the effective and
judicious utilization of funds.
• The modern approach of the finance function focuses
on ‘wise use of funds’.

• Since financial decisions have a great impact on
all other business activities, the finance manager
should be concerned about determining the size
and nature of technology, setting the direction
and growth of the business, shaping the
profitability, amount of risk taking, selecting the
mix of assets, determination of optimum capital
structure etc.
• The modern approach is thus an analytical way
of viewing the financial problems of a firm.

• According to this approach, the financial
management is concerned with the solution
for the major areas relating to the financial
operations of a firm viz., investment, financing
and dividend decisions.

JOB OF FINANCIAL MANAGER:
• The Finance Manager has the responsibility of carrying
out all the functions expected of financial
management.
The important functions of finance manager are as
follows:
(i)Forecasting Financial requirements:
• The first function of finance manager is to forecast the
required funds in the firm. Certain funds are required
for long term purposes i.e. investment in fixed assets
etc. A careful estimate of such funds, and of the exact
timing, when such funds are required must be made.

• Also an assessment has to be made regarding
requirements of working capital which
involves estimating the amount of funds
blocked in various current assets and the
amount of funds likely to be generated for
short periods through current liabilities.

(ii) Financing decision
• Once the requirement of funds has been
estimated, the finance manager has to take
decision regarding various sources from where
these funds would be raised.
• The finance manager has to carefully look into
the existing capital structure and see how the
various proposals of raising funds will affect it. He
has to maintain a proper balance between long
term funds and short term funds.

(iii)Investment Decision
• Investment decisions relate to selection of assets in
which funds are to be invested by the firm.
• Investment decisions allocate and ration the resources
among the competing investment alternatives or
opportunities.
• The investment decisions result in purchase of assets.
Assets can be classified under two broad categories:
• Long term investment decisions-Long term assets.
• Short term investment decisions-Short term assets

(a) Long term investment decisions
• The long term investment decisions are
referred to as capital budgeting decisions,
which relate to fixed assets.
(b) Short term investment decisions
• The short term investment decisions are
generally referred as working capital
management.

(iv) Dividend Decision
• The finance manager is also concerned with
the decision to pay or declare a dividend.
• Generally firms distribute certain amount of
profit in the form of dividend, in a stable
manner, to meet the expectations of
shareholders and balance is retained within
the firm for expansion.

(v) Deciding overall objectives
• The finance manager has to determine the
overall goals of finance department. The goals
help in effective financial planning and decision
making.
(vi) Supply of funds to all parts of the organization
• The finance manager has also to ensure that all
sections i.e. branches, factories, departments and
units of the organization are supplied with
adequate funds.

(vii)Evaluating financial performance:
• Analysis of the financial performance helps the
management for assessing how the funds have
been utilized in various divisions and what can be
done to improve it.
(viii)Financial negotiation:
• A major portion of the time of the Finance
Manager is utilized in carrying out negotiations
with the financial institutions, banks and public
depositors.

(iX) Keeping touch with stock exchange
quotations and behavior of share prices
• This involves analysis of major trends in the
stock market and judging their impact on the
prices of the shares of the firm.
• See Fig: page no.1.9

FUNCTIONS OF FINANCIAL MANAGEMENT:
Estimation of capital requirements:
• A finance manager has to make estimation with regards to
capital requirements of the company.
Determination of capital composition:
• Once the estimation have been made, the capital structure
have to be decided. This involves short-term and long-term
debt equity analysis.
Choice of sources of funds:
• For additional funds to be procured, a company has many
choices like-
• Issue of shares and debentures
• Loans to be taken from banks and financial institutions.

Investment of funds:
• The finance manager has to decide to allocate
funds into profitable ventures so that there is
safety on investment and regular returns is
possible.
Disposal of surplus:
The net profits decision have to be made by the
finance manager. This can be done in two ways:
• Dividend declaration
• Retained profits

Management of cash:
• Finance manager has to make decisions with
regards to cash management.
Financial controls:
• The finance manager has not only to plan,
procure and utilize the funds but he also has
to exercise control over finances.

LIQUIDITY VS PROFITABILITY
(RISK-RETURN TRADE OFF)
The finance manager is always faced with the
dilemma of liquidity Vs profitability. He has to
strike a balance between the two.
Liquidity means that the firm has
• (a)adequate cash to pay bills as and when they
fall due, and
• (b)Sufficient cash reserves to meet emergencies
and unforeseen demands, at all time.

• Profitability goal, on the other hand, requires
that the funds of the firm be so utilized as to
yield the highest return.
• See Fig: Page no. 1.15

OBJECTIVES OF FINANCIAL MANAGEMENT:
Financial goals-profit maximization verses wealth
maximization
Profit maximization:
• According to this concept, a firm should
undertake all those activities which add to its
profits and eliminate all others which reduce its
profits.
• This objective highlights the fact that all
decisions- financing, dividend and investment
should result in profit maximization.

Wealth maximization
• According to this concept, the finance
manager should take such decision which
increase net present value of the firm and
should not undertake any activity which
decrease net present value. This concept
eliminates all the three basic criticisms of the
Profit maximization concept.

• Video
• Wealth Maximization

ORGANIZATION OF FINANCE FUNCTIONS
• The vital importance of the financial decisions to
a firm makes it imperative to setup a sound and
efficient organization for the finance functions.
• The ultimate responsibility of carrying out the
finance functions lies with the top management.
• Thus, a department to organize financial activities
may be created under the direct control of the
Board of Directors.

• The executive heading the finance
department is the firm’s chief finance
officer(CFO).
• The finance committee or CFO will decide the
major financial policy matters, while the
routine activities would be delegated to lower
levels.
• See fig: page no.1.9

FINANCIAL MANAGEMENT AND OTHER FUNCTIONAL AREAS:
• Financial Management and Production Management
• Production Management is the operational part of the
business concern, which helps to multiply the money into
profit.
• Profit of the firm depends upon the production
performance.
• Production performance needs finance, because
production department requires raw materials, machinery,
etc.
• These expenditures are decided and estimated by the
finance department and the finance manager allocates the
appropriate finance to production department.

• Financial Management and Material Management
• Material department covers the areas such as storage, maintenance
and supply of material, procurement etc.
• The finance manager and material manager in a firm may come
together while determining economic order quantity, safety level,
storing place requirement, storage personnel requirement, etc.
• Financial Management and Personnel Management
• The personnel department is entrusted with the responsibility of
recruitment, training and placement of the staff.
• This department is also concerned with the welfare of the
employees and their families.
• This department works with the finance manager to evaluate
welfare, revision of their pay scale, incentive schemes, etc.

• Financial Management and Marketing Management
• The marketing department is concerned with the selling of goods and
services to the customers.
• It is entrusted with framing marketing, selling, advertising and other
related policies to achieve the sales target.
• It is also required to frame policies to maintain and increase the market
share, to create a brand name etc. For all this, finance is required.
• Financial Management and Accounting
• Accounting records include the financial information of the firm. In the
olden days, both Financial Management and Accounting are treated as a
same discipline and then it has been merged as Management Accounting,
because this part is very much helpful to finance manager to take
decisions.
• But now a days Financial Management and Accounting discipline are
separate and interrelated.

• Financial Management and Mathematics
• Modern Approaches of the financial
Management apply large number of
Mathematical and Statistical tools and
techniques. They are also called Econometrics.
• Economic Order quantity, cost of capital, Ratio
Analysis and working capital analysis are used as
mathematical and statistical tools and techniques
in the field of financial Management

• Financial Management and Economics
• Economic Concepts like Micro and Macro economics are
directly applied with the financial management
approaches.
• Investment decisions, Micro and Macro environmental
factors are closely associated with the functions of finance
manager.
• Financial Management also uses the economic equations
like money value discount factor, economic order quantity
etc.
• Financial Economics is one of the emerging area, which
provides immense opportunities to finance and economical
areas.

THE CHANGING SCENARIO OF FINANCIAL
MANAGEMENT IN INDIA
• Modern financial management has come a long way
from the traditional corporate finance.
• Due to the changes in the global environment, the
finance manager needs to have a broader and far-
sighted out look, and must realize that his actions
would have far-reaching consequences for the firm
because they influence the size, profitability, growth,
risk and survival of the firm, and as a consequence,
affect the overall value of the firm.

Some of the important changes in the
environment are:
• Interest rates have been freed from
regulation.
• The rupee has become fully convertible on
current account.
• Optimum debt-equity mix is possible.
• With free pricing of issues.

• Ensuring Management control

Unit II
Financial statement Analysis:
• Financial analysis is the process of identifying the
financial strengths and weaknesses of the firm by
properly establishing relationships between the items
of the balance sheet and the profit and loss account.
Ratio analysis:
• Ratio analysis is a powerful tool of financial analysis.
• A ratio is defined as “ the indicated quotient of two
mathematical expressions” and as “ the relationship
between two or more things”.

In financial analysis, a ratio is used as a
benchmark for evaluating the financial
position and performance of the firm.
Types of ratios:
• Liquidity ratios
• Leverage/solvency ratios
• Activity /turnover/performance ratios
• Profitability ratios

• Liquidity ratios measure the firm’s ability to
meet current obligations.(liabilities)
• Leverage ratios/solvency ratios show the
proportions of debt and equity in financing
the firm’s assets.
• Activity ratios/turnover/performance reflect
the firm’s efficiency in utilizing its assets.
• Profitability ratios measure overall
performance and effectiveness of the firm.

LIQUIDITY RATIOS
Current ratio
This ratio is also called working capital ratio.
• Current ratio=Current assets/Current liabilities
Quick ratio/liquid ratio/acid test ratio/the near
money ratio
• Quick ratio=current assets-inventories/current
liabilities
• Liquid ratio=liquid assets/current liabilities

Cash ratio/Absolute liquidity ratio/cash
position ratio/super quick ratio
• Cash ratio=cash in hand and cash at bank +
Marketable securities/current liabilities
Ratio of Inventory to Working Capital:
Ratio of inventory to working capital=
Inventory(stock)/Working capital

LEVERAGE RATIOS / SOLVENCY RATIOS
Debt-Equity ratio
• Debt-Equity ratio=Total long-term debt/Share
holders’ funds
• Debt-Equity ratio=Out siders’ funds/Share
holders’ funds
Interest Coverage ratio
• Interest coverage ratio = EBIT(Earnings/net profit
before interest and tax)/Interest on long-term
loans or debentures

Fixed assets ratio
• Fixed assets ratio=Net fixed assets/Long-term
funds
Proprietary ratio
• Proprietary ratio=shareholders’ funds/Total
tangible assets

ACTIVITY RATIOS /TURNOVER/PERFORMANCE
RATIOS
Inventory turnover ratio (or) stock turnover ratio
• Inventory turnover ratio =cost of goods
sold/Average inventory
Debtors(Receivable turnover) turnover ratio:
• Debtors(accounts receivable) turnover ratio = Net
credit sales/Average debtors or Average accounts
receivable

Fixed Assets turnover ratios:
• Net assets turnover ratio =sales or cost of goods sold
/Net fixed assets
Working capital turnover ratio:
• Working capital turnover ratio= Sales or cost of goods
sold / Net working capital
(Working capital=Current asset-Current liabilities)
Capital turnover ratio:
• Capital turnover ratio=Sales or Cost of goods sold
/Capital employed
(Capital employed=debt + equity)

PROFITABILITY RATIOS
Gross profit ratio
Gross profit ratio= Gross profit/Net sales *100
Where,
Gross profit =Net Sales-Cost of goods sold
Cost of goods sold=opening stock+ net purchases +direct
expenses – Closing stock
Net profit ratio
• Net profit ratio =Profit after tax or Net profit /Net sales
*100

FUNDS FLOW STATEMENT:
Meaning of funds:
• The term funds refers to cash, to cash
equivalents or to working capital and all
financial resources that are used in business.
• The word fund refers to working capital. The
working capital indicates the differences
between current assets and current liabilities.

Funds flow statement:
• It is a statement summarizing the significant
financial changes in items of financial position
that have occurred between the two different
balance sheet dates.
• This statement is prepared on the basis of
working capital concept of funds.
• Funds flow statement helps to measure the
different sources of funds and application of
funds from transactions involved during the
course of business.

Objectives of funds flow statement:
• To indicate the results of financial management
policies.
• To lay emphasis on the most significant changes that
have taken place during a Specified period.
• To show as to how the general expansion in a business
has been financed or to describe the sources from
which additional funds were derived.
• To illustrate the relationship between profits from
operations, distribution of dividend and raising new
capital or contracting term loans.

• To give recognition to the fact that the
business exists on flow of funds and is not a
static organization.

Importance or uses of funds flow statement:
• It highlights the different sources and
application or uses of funds between two
accounting periods.
• It brings into light the financial strength and
weakness of a concern.
• It acts as an effective tool to measure the
cause of changes in working capital.

• It helps the management to take corrective
action when there are deviations between
two balance sheet figures.
• It is an instrument used by the investors for
effective decisions at the time of their
investment proposals.
• It also presents detailed information about
profitability, operational efficiency and
financial affairs of a concern.

• It serves as a guide to the management to
formulate its dividend policy, retention policy,
investment policy,etc.
• It helps to evaluate the financial consequences of
business transactions involved in operational
finance and investment.
• It gives detailed explanation about the movement
of funds from different sources or uses of funds
during a particular accounting period.

PREPARATION OF FUNDS FLOW STATEMENT:
• Funds flow statement is generally prepared for a
year on the basis of balance sheet and additional
information.
It involves the following steps:
• Preparation of schedule of changes in working
capital
• Preparation of non-current accounts
• Calculation of funds from operations.
• Preparation of funds flow statement.

• Refer page no.(FFS.7 to FFS.19)

Preparation of Non-current accounts:
• If no additional information is given for non-
current accounts, the sources or application of
funds can be ascertained by comparing the
current year’s figure of the concerned asset or
liability account with previous year’s figure.

• In case, any-additional information is given for
non-current accounts, it is necessary to open
an account for each non-current asset and
non-current liability to dig out the hidden
information as balancing figures.
• The balancing figure may be a sources of
funds or an application of funds or an item to
be debited or credited to adjusted profit and
loss account.

The following non-current accounts are
generally prepared to ascertain hidden
information:
• Fixed asset account
• Accumulated depreciation account
• Investments account
• Provision for taxation account.

CASH FLOW STATEMENT:
• Cash flows refer to the actual movement of
cash into and out of an organization.
• In other words, the movement of cash is
inclusive of inflow of cash and outflow of cash.
• When the cash flows into the organization, it
represents inflow of cash. Similarly, when the
cash flows out of the organization concern, it
is called as cash outflow.

ADVANTAGES AND LIMITATIONS OF CASH FLOW
STATEMENT:
Advantages of Cash Flow statement:
• Cash flow statement is very useful in preparing cash
budgets.
• As cash is the very basis of business operations cash
flow proves very useful in evaluating the cash position
of the concern.
• The projected cash flow statement helps finance
manager in exploring the possibility of repayment of
long term debts which depends upon the availability of
cash.

• Cash flow statement can be used for making appraisal of
various capital investment projects just to determine their
liquidity and profitability.
• A comparison of the cash flow statement of previous year
and projected cash flow statement reveals deviations of
actuals from budgeted. This helps in taking requisite
corrective action.
• For payment of liabilities which are likely to mature
immediately, cash is more important than working capital.
• cash flow statement is certainly a better tool of analysis
than funds flow statement as far as short term analysis is
concerned.

• Cash flow statement enables the management to
explain why the company is facing difficulties in
paying dividend while it has earned good profits.
• It helps in taking loans from banks and other
financial institutions; the repayment capacity of
the company can be understood by going through
the cash flow statement.
• It supplements the analysis provided by funds
flow statement as cash is a part of the working
capital.

Limitations of cash flow statement:
• Cash balance as per cash flow statement may not give
real picture of liquidity as it gets easily affected by
postponing purchases, etc.
• Cash is used to signify fund in a narrow concept. It
does not give a complete picture of the financial
position of the concern. even the term cash is not
precisely defined.
• Comparison over a period of time can be misleading. A
company cannot be said to be better off in the current
year as compared to the previous year just because its
cash flow has increased.

• Inter-industry comparison of cash flow statement can also
be misleading, for it does not measure the economic
efficiency of one company in relation to another.
• Usually a company with heavy capital investment will have
more cash inflow.
• Cash flow statement cannot replace funds flow statement
or income statement. Funds flow statement gives an
exhaustive view of the financial changes than cash flow
statement.
• Cash can be easily influenced by managerial decisions such
as making certain payments in advance or postponing
payments.

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