16 Fundamentals of Finance Management

M. V. Subha

Introduction

The term finance refers to ‘provision of money’ that is used for various purposes. Finance per se is important to the day to functioning of all enterprises due to its multiple uses. One of the reasons for the significance of finance is that it can be used for multiple activities like consumption, savings, donations etc. Secondly, finance is important because it is a scare resource and it is not available for free. Finance can be procured at a cost and therefore, the financial resources are used with much care and diligence. The third significant aspect of finance is that, when invested properly it is capable of growing. When you invest in financial instruments, they are capable of appreciation and income generation and therefore people consider the management of finance a very important activity. This confirms the fact that irrespective of the size of the enterprise, finance is very much required for its smooth functioning and growth.

Financial management is an important managerial activity that is concerned with financial decision making in the area of investment of funds, financing activities and distribution of profits.

Relationship between Finance and other Disciplines

Financial management is one of the important functions of management and many a times referred to as the life blood of business. But the subject of finance does not operate in isolation and it is largely dependent on various other related disciples.

a.Economics

The subject of financial management draws heavily from economics. Economics essentially is the study of allocation of scarce resources among competing ends. Finance as a resource is scarce and not easily available which has to be carefully allocated among the various departments in the organization. Therefore, financial management draws heavily from the field of Economics to make appropriate financial decisions based on the principles of economics. Economics can be basically divided into Micro economics and Macro economics. The study of Macro economics deals with the environment in which firms operate and considers the economy as a whole.

Its takes care of the structure, presence of financial institutions, functioning of capital markets, the monetary policy and fiscal policies of the government etc. As enterprises do not operate in isolation the impact of the macroeconomic policies on the functioning of the enterprise needs to be recognized while taking financial decisions. Microeconomics is concerned with ‘the theory of the firm’, which describes the functioning of the enterprise and their economic decisions. Various micro economic concepts like Theory of demand and supply, Production functions, Cost analysis, Utility theories etc are usually taken into consideration while taking financial decisions.

b. Accounting

There is a strong relationship between Finance and Accounting. Essentially accounting provides the input data for financial decision making. Accounting per se deals with the systematic recording of financial transactions. The Accounting information is usually used to take financial decisions by way of financial statement analysis, cost benefit analysis etc. In that way, we see that accounting significantly contributes to financial management. Accounting principles are based on Accrual principle and the all transactions are viewed at the time of sale and not at the time of collecting them. In case of financial management, the treatment of funds is based on principle of cash flows where they are considered at the time of actually incurring them. Accounting is largely concerned with the way of presentation of data, whereas financial management largely depends on decisions regarding financial planning, allocation and control of financial resources.

c. Other Disciples

Financial activity encompasses various areas and therefore conceptual application of basic concepts from different areas of finance becomes indispensible. Various areas like Product development, Advertisement and promotion, Product launching etc are important in the domain of marketing which requires large financial outlays. Financial managers should be able assess and appreciate its requirements and create provisions for allocation of funds. Production is also an integral part of the enterprise and an area where funds are constantly required for purchase of machinery, its upkeep and maintenance. Therefore financial decision making in the organization cannot happen successfully without understanding the fundamental concepts of various areas of finance. To supplement the quality of financial decision making, finance also draws from Quantitative methods.

Scope of financial Management

The scope of financial management is generally divided into two categories:

a. Traditional approach

The traditional approach to financial management describes the range of activities that come under its purview. Traditionally, the subject of financial management was referred to as Corporate Finance and later re-coined as Financial Management. The scope was largely concerned with the activities of procurement of required funds for the organization and making available the funds that are needed by them. All activities concerned with procurement of financial resources from outside and administrative activities associated with the same fell into the category of financial management. It was largely external oriented where the activities involved around deciding of instruments, liaison with financial institutions, legal procedures surrounding procurement of funds. This approach suffered from serious limitations due to its external centric approach as it was largely concerned with how funds could be made available to enterprises and it did not concentrate on the effective utilization of funds within the enterprise.

b. Modern Approach

This approach tries to provide a conceptual and analytical framework for financial decision making. This method overcomes the limitation of the traditional approach and considers not only with the acquisition of funds but also the decision of allocation of funds among various competing ends. This approach helps the firms to decide on the type of, amount of funds required by the enterprise. This will make the firm to decide on its scope and scale of operations and its future course of action. Thus this will enable the organizations to decide on the size of the enterprise, form of assets and liabilities of the firm. This leads to three important decisions that a firm has to take like the Investment Decision, Financing Decision and Dividend decision. Accordingly these decisions form the functions of financial management.

1. Investment decision refers to those functions that are related to the type of investment to be made in the form of assets and also trying to decide on the composition of long term and short term assets. The investment decisions are thereby categorized into Capital Budgeting or Long term investment decisions and Working Capital Management or short term investment decisions. Investment decisions that relate to investment in assets which yield return over long period of time and involves risk and uncertainty fall under Capital Budgeting decisions. This takes into consideration the minimum rate of return that the project requires since investments are made in current scenario and returns are enjoyed over a longer horizon. This minimum cutoff is referred as Cost of Capital which is an essential component of Capital Budgeting Decisions. On the other hand Working capital management refers to investment in current assets that are required to take care of day to day requirements of business. Finance is required to meet short term obligations and shortfall will lead to loss of credibility. Hence holding cash which affects profitability of the business is traded with Liquidity. Hence arriving at the right amount of current assets against current liabilities is an important aspect of financial decision making.
2. Financing Decision refers the composition of financing of an enterprise. This tries to determine the composition of capital (Equity, Debt etc) that is in tune with the objectives of the enterprise. Each source of finance has a cost and therefore determining the combination of debt and equity that will bring down the overall cost of capital (minimum required rate of return) is to be taken. This decision involves computation of cost of capital, studying the impact of use of particular source of capital on the bottom line of the company and capital structure of the company. Determining the optimal capital structure of that has a favorable impact on the profitability of the firm needs to be considered.
3. Dividend decision is the third important financing decision that is related to the distribution of the profits to the shareholders by way of dividends. The profits of the company can be distributed by the company or it can be retained for future investments avenues of the company. So this decision makes a tradeoff between distribution and investment opportunities available to the firm. When the firm has good opportunities for investment it will retain the earnings else if the options are not very lucrative, it will decide to distribute them as dividends. Retained earnings also carry a cost, since investors will expect more returns in future on the profits retained. Therefore decisions need to be made carefully.

From the above we can conclude that traditional approach to financial management is concerned only with a narrow perspective of acquisition of funds. Whereas, the modern approach caters to the finer needs of acquisition, utilization and allocation of funds within the enterprise. Hence these three decisions become the important functions of financial management.

OBJECTIVES OF FINANCIAL MANAGEMENT

There are two different approaches to deciding on the objectives of financial management. Each approach chooses a different decision criterion.

1.Profit Maximization objective

Under this criterion, the company decides to undertake all those activities that increases the profits of the firm are encouraged and those activities that decrease the profits are discouraged. Here the decision criteria for decision making are the profits that are added. According to this approach the investment decision, financing decision and dividend decisions should all aim at increasing the profit of the enterprise. While trying to define the term ‘profit’ it refers the additional amount earned over and above the cost incurred. The concept of profit might simply be the difference between the Selling price and the Cost price. Therefore if the company is guided by this principle, it will undertake all those projects that generates surplus in all activities. Since profit is a sign that the company is generating more from less, this for long as been considered as a superior decision criteria. However, this method does suffer from certain limitations. The term profit is an ambiguous one, where it could refer to profits in the short run, long run, profit after tax or profit before tax etc. 10% profit is satisfactory to one person whereas it could be very less for another. Another serious limitation to these criteria is the fact that conceptually it considers money received today and in future as equal. The time value of money is not taken into consideration. This approach blindly refers to the excess value generated but does not consider the risk and uncertainty associated with the generation of profits (Quality). Due to the above deficiencies, it may be concluded that though conceptually profit maximization as a decision criteria is acceptable, but suffers the above limitations of ambiguity, timing and quality of benefits.

2. Wealth Maximization objective

This approach is also referred to as Value maximization approach. We call an asset valuable based on the benefits that are likely to be accrued in future when compared to the current value. The value of an asset can be measured in terms of the benefits that the asset is likely to produce. The wealth maximization objective is based on the idea of generation of cash flows by the decision rather than accounting profit, which is the yardstick for measuring the benefits in case of profit maximization objective. Here, trying to measure the benefits in terms of cash flows is avoiding ambiguity. The wealth maximization concept measures the quantity as well as quality of benefits. It also takes into consideration the timing of benefits (time value of money). The idea is to consider the timing as well as the quantum of cash flows, thereby following the cash flows obtained at different point of time differently, but adjusting the cash flows. This is done by discounting the cash flows obtained at latter time periods using a discount factor, which is usually the cost of capital (expected rate o return). The value of an action is termed by the benefits it offers over a course of time. This principle helps us to identify the value to the members who have contributed to the company that is the shareholders. The discount rate reflects the risk associated with the time preferences of money and therefore, the concept of wealth maximization considers both the time value of money as well as the risk. For the above reasons, the wealth maximization concept is much superior over profit maximization objective. The decision criteria would be to undertake those activities that create wealth, and do not undertake those activities that reduce wealth to the organization.

Organization of Finance Department

The financial manager is an integral part of the entire activities of the organization be it Planning, allocation of resources and control. The overall control lies with the head of the organization, followed by Vice President (Finance). The functions of asset management may lie with the Treasurer who has various managers working under him. A financial Controller is usually present in the organization to take care of Tax, Cost accounting, Data processing etc with the help of respective managers. This structure may vary from organization to organization depending on their requirement.

Time Value of Money

Money has time value. This can be understood by recollecting the fact that usually we spend today on assets, invest in business etc in anticipation of returns that will be accrued in future. This benefits will last over the life of the assets, or till we hold the assets (in case of financial assets). There are cash outflows today in anticipation of future cash flows in future. For logical reasoning, the cash flows obtained at different time intervals, it becomes necessary to convert the sums of money to a common point of time.

The concept of time value of money means that the value of a unit of money is different in different time periods. The money that is held in hand today is worth more than the money that is likely to receive in future. Due to this, investors will prefer and value the money received today, than that is likely to be received in future. This is perhaps to the fact that, future is uncertain and entails the fact that due to some reason the quantum and quality of funds may be delayed. Also the fact that, when we have money now, the options for reinvestment is available which is absent in the case of future cash flows. This is called as ‘time preference for money’.

Two techniques like Compounding and Discounting is used for evaluating and comparing cash flows received at different time periods.

Compunding: Whenever we want to find out the future value of the present cash that is in our hand, we use the technique of compounding. Interest is compounded when the amount earned on its initial principal is added back to the principal at the end of the accounting year. So, when we know the initial principal, interest rate and number of years we would like to calculate, the compounded value can be calculated using the formula,

Future Value (FV) = Present Value(1+r)n

This is called as the future value of cash flows.

Discounting: The concept of discounting is used to evaluate the values of cash flows obtained at different time intervals. In order for logical comparisons all the values have to be brought to present value terms and therefore, the future values are discounted using a discount rate which is usually the opportunity cost of capital, or cost of capital (minimum accepted rate of return). This is called as the present value of future cash flow and is computed using the formula,

Present Value (PV) = Future Value/(1+r)n

References:

1.  Khan M Y, Jain P K, ‘Financial Manangement-Text and Problems(3rd edition)’, Tata McGraw Hill Publishing Company Limited.

Web links

• https://www.youtube.com/watch?v=mX9nd0eQ-6g
• http://freevideolectures.com/Course/3349/Infrastructure-Finance/3