Fm ch 1 summary

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Summary

Chapter One

Nature and Scope of Financial Management

Learning Objectives :

This first chapter attempts to

Familiarize students with financialobjectives & Goals of a firm.

Develop conceptual frame work of financialmanagement.

Focus on nature, scope, and functions offinancial management.

Discuss the role of finance manager inchanging economic scenario.

A . Backdrop

Role of Finance Manager 40 years ago

Finance manager was expected to maintain financialrecords and prepare reports on companys status andperformance. He was further required to arrangefunds needed by the firm to meet its obligations on

a timely basis.

In other words, his services were required onlywhen need for funds arose. He had no strategic rolein management of the firm.

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Role of Finance Manager now -

With technological advances in industries andincreased business complexities, there has been amajor expansion in the role. The tightening moneymarket and despondent state of stock market havealso contributed to this change. His position hastranscended the traditional role of garnering fundsfor the business and he has become an integral partof companys strategic management.

In this capacity, the finance manager activelyparticipates in all management decisions. He has todeal with total funds employed in the enterprise.

Further he is now responsible to ensure that fundscollected by him are wisely applied among variousprojects. And towards this end he has to evaluateresults of each such application.

As a result, he is now directly concerned withdecisions related to production, marketing andother activities that involve commitment of fundsto the new or ongoing uses.

To meet global competition from multinationalcompanies, Indian firms are forming new businessstrategy to work on quality, reduce cost, improveproductivity, and maximize corporate value.Financial manager plays a very effective andintegrated role in financial decisions that arerequired to implement this strategy.

B . Financial Objectives of a Firm :

Corporate objectives are expressed in the missionand vision statements of companies.

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These are written in qualitative terms and are moreethical and philosophical in character and reflecttop managements values.Being profit seeking organization the management is

supposed to set profit maximization as its basic

objective.

B.1. Profit maximization objective

This objective is stated in terms of quantum ofprofits to be earned, targeted rate of return oninvestments or desired profit-to-sales ratio.

This objective is simple to understand, requiresemployment of resources where returns are highest,and permits quick judgment on effectiveness offinancial decisions.

The objective also suffers from certain drawbacks

Firstly, it is vague as one is not clear about whatis profit? Is it total surplus before tax or after

tax? Or it is it a rate of return on sales? or oncapital employed? Or on owners funds?

Profits on a short term basis are not synonymouswith those on long term basis. Each interpretationhas its distinct impact on financial decisions.

Secondly, it ignores Time Value Factor so crucialto financial decisions. Hence a project returningRs. 90,000/- in year and alternative yielding Rs.15,000/- a year for the next six years will lookequally attractive under this objective!

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Thirdly, it ignores Risk Factor. Two projects canhave equal profitability but different riskprofiles. Risk evaluation is absent in statement ofthe profit maximization objective.

B.2. Wealth maximization objective

This objective is clear & it suggests that for aproject to be undertaken, its net present value(gross present value minus capital investment) mustbe positive. While calculating gross present valuestream of earnings expected in future arediscounted at a rate that reflects their

uncertainty. Thus both Time and Risk factors arecovered in decision making process.

Net present worth is arrived using formulaA A A1 2 n

W = + + . . . - C(1+K) (1+K)2 (1+K)n

Where W = net present worth,A1, A2, An = expected stream of benefits

expected to occur over years,K = discount rate that reflects degree ofrisk & timing, andC = initial capital outlay for the project

This objective is very clear and as stated earlier,considers time value of money as well as risk &uncertainty element; and hence superior to profitmaximization objective.

It must be noted that, in short run, if magnitudeof risk is not great, wealth maximization & profitmaximization objectives show no difference.

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B.3. Maximization of Profit Pool

A profit pool is defined as the total profitsearned in an industry at all points along theindustrys value chain. It includes thedisaggregate of processes, the mapping of the valuechain beyond the confines of legal entities, theadoption of flexible organizational structures andcreation of net worked organizations.

A profit pool concept looks beyond the corebusiness and spots activities with untapped sourceof profit. Low margins on core business are used toattract customers and high margin ancillary

business is transacted with them to maximize profitpool.

Increased sales revenue and market share do notnecessarily provide profit pool. A profit pool mapalone answers the question how and where is themoney made in the industry.

For example in automobile industry profit is madefrom

making & selling cars selling used cars petrol, diesel retail sales insurance after sales service car leasing & finance

Revenue from core activity is more but at lowermargins, and major profit is earned from ancillaryactivities where margins and customer royalty arehigh.

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C . Financial Goals of a Firm

Major goals of all enterprises are :

Maximize short term and long term profits &minimize risks by striking a balance between risk &return.

Ensure effective utilization of resources.

Build sufficient flexibility in financialoperations

Impart liquidity and profitability of the

enterprise.

These Goals need to be defined for achievement

of the objective of wealth maximization.

D . Management vs. Owners

The goal of maximizing owners interestpredominates, other goals of the firm so thatmanagement is allowed to continue and survive in

competitive environment.

In this role the management acts as a satisfier forowner rather than as a maximizer for the firm.

Towards this end management may accept lowermargins to ensure sustained market share(satisfier role), rather than aggressively exploitmarket potential (maximizer role).

E . Social Objective

As a corporate citizen, modern firm has anotherobjective to assume social responsibility.This objective acknowledges the fact thatenvironment conducive to economic growth, in which

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it operates, is provided to the firm by thesociety.

Some argue that social responsibility requires firmto bear more costs and risks and is, therefore, tothat extent in conflict with its economic goals.

Experience, however, has proved that in the longterm both economic and social objectives aremutually beneficial.

Thus funds deployed to improve social environmentof workforce housing, schools, hospitals etc. increase costs immediately. But gains from improved

productivity & reduced turnover, effectively morethan offset them in the long run.

F . Concept of Financial Management

Interpretations of the term Finance

F1 - Finance function involves acquiring fundson reasonable terms to pay bills and other

obligations of the enterprise promptly. This istraditional & restrictive view of Finance.

F2 - Finance means cash, and finance managermust go in details in all activities in production,marketing, personnel research that involve use ofcash. This is very broad and vague viewpoint.

F3 - Procurement of funds and their wiseapplication is the modern approach to finance. Thefinance manager has to obtain funds on mosteconomic terms and apply them to projects thatgenerate maximum wealth.

This is depicted on the diagram below -

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Interpretations of the term Finance- ModernApproach

Funds Source Funds Application

Internal cash flows Asset Expenditurefrom operations a) Current

b) Fixed

External debt or Non-asset Expenditure.equity from

Individuals a) Labour / Material

Institutions b) Interest ChargesOther firms c)Profit distributionGovernment to owners

G . Nature of Financial Management

Financial management is now considered to be anintegral part of overall management as the functioninvolves, in addition to fund raising, utilization

of funds and monitoring their use. Funds are usedfor production, marketing, human resource, researchand all other business activities and hencefinancial manager has to fully associate with allbusiness activities.

Success of strategic business decisions like entryin new territory, product line, expansion ofcapacity, relocation, depends upon their financialappraisals. As a part of this appraisal, financemanager has to continuously review all financialdecisions providing dynamic perspective tofinancial management.

Various financial functions are intimatelyconnected with each other. Proportion of fixed

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assets to current assets decides risk complexion,which in turn influence the terms at which freshfunds can be raised and methods to be adopted tofinance projects. Dividend decisions affectfinancing decisions which are again influenced byinvestment decisions.

In other words, except for management of incomewhich is his prime responsibility, finance managerhas to operate with expertise of other functionalheads of the organization to discharge hisresponsibilities effectively.

H . Functions of Financial Management

H.1. Traditional Concept of Finance Function

Determining funds requirements, finding mosteconomic source for them and timing of acquiringand disposing funds, was considered as the realscope of financial management.

Allocation of funds for different assets,monitoring them to optimize their use, was

considered to be in the scope of non-financialexecutives.

This view is criticized by modern scholars onfollowing grounds,

Just like finance manager is responsible toacquire funds, he is also responsible to ensuretheir proper utilization over the best alternativesavailable. Traditional concept ignores the secondresponsibility

The old concept focuses on one time jobs offinance manager like incorporation, consolidation,recapitalization etc and ignores his responsibility

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in resolving day to day ongoing financial problemswhich assume equal importance.

The old concept focuses on corporate finance andignores his responsible role in management of nonincorporated firms, partnerships, trading concerns,etc.

The old approach considers long term financeimportant and ignores finance managers skillsrequired to tackle day to day working capitalfunding.

H.2. Modern Concept of Finance Function

It is an integral part of overall management &not only an advisory function.

In addition to procurement of funds at optimumcost, it has to ensure beneficial application offunds for business growth.

It includes planning, raising, allocating &controlling finances to accomplish broad business

objectives.

H.3. Contents of Modern Finance Function

Are categorizes by modern scholars as

a] Recurring functionsb] Non-recurring, one time or episodic functions.

a] Recurring functions:

Recurring finance function encompasses all suchfinancial activities as are carried regularly forthe efficient conduct of a firm.

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Recurring Finance Function

Planning for Raising Allocation Allocation MonitoringFunds of Funds of Funds of Income of uses

Funds

1. Planning for funds :This function seeks to

1.

Develop long term financial plan to determinequantum of funds requirements, its duration andmake up of investments.

2.

Synchronize cash inflows with outflows so thatthe organization does not have any funds

unutilized.

3. Balance profitability with risk by deployingall funds and keeping least funds liquid tomeet emergencies.

4. Capitalization reflects decisions regardingfund requirements. These decisions are takenafter considering company objectives andstrategy, top management philosophy, fiscal &financial policies of the Government.

5. Capital Structure reflects decisionsregarding forms of financing requirements.These decisions are based on cardinalprinciples of risk, cost, control, flexibility,and timing.

6. Prepare & use Master Plan , Funds Flow

Statement, Forecast of Working Capital,Cash Budget etc. These are the tools of thefinance manager.

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2. Raising of funds :

If funds are to be raised through equitycapital, finance has to arrange for prospectus,appoint agents to handle capital issue, ensure itis underwritten, and monitor the process untilshares are issued to subscribers.

If funds are to be raised through borrowingsfrom banks or financial institutions, financemanager has to prepare a project report, enter intoagreement, schedule the repayments. More expertisefrom him is expected when funds are borrowed fromoverseas.

3. Allocation of funds :

While allocating funds over different assets,factors to be considered by the Finance Manager arecompeting uses of funds over different projects,immediate requirements, and management of assets,profit prospects & overall management plans.

Next management of sundry debtors and inventoriesis prime responsibility of finance manager. Sundrydebtors are to be maintained at minimum withoutadverse effects on sales. Optimum levels ofinventories are to be maintained to ensure leastfunds are blocked but materials are available whenneeded.

4. Allocation of income :

Finance Manager has to decide how much of theincome is to be retained within the business forfinancing investments or retiring debts & how muchto be distributed to owners.

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5. Monitoring uses of funds :

Long term use for capital investment is monitoredby comparing, on a regular basis, actual resultswith those estimated in the project report used forapproval of release of funds. Comparisons enablecorrective action and revisions to balanceexpenditure.

Short term use for receivables is monitored byreviewing credit and collection policies, theirstrict implementation, keeping tab on collectiondays, controlling ratio of bad debts to sales etc.

Short term use for inventories is monitored byreviewing inventory norms, implementing them ,checking slow moving and non moving items in stock,keeping inventory turnover ratio high withoutcausing interruptions in production due to lack ofmaterials.

Finance Manager needs to obtain information, recordit, store and process, analyze and make use of it.This data allows him to prepare reports to

Management for action.

b] Non-recurring functions.

These functions are infrequent and usually at thetime of start up of the company, or during a majorliquidity crisis when the capital has to be re-structured. Finance manager has additionally tohandle financial aspects of mergers & acquisitions.

I . Scope of Financial Management

The scope is very wide and starts from inception ofthe company to its growth, expansion & eventualwinding up.

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The functions mainly cover decision areas relatedto

investment;

financing &

dividends.

Decision areas related to investment :

Long term investment decisions relate to allocationof funds to projects whose benefits accrue over a

long period.

For internal investment decisions, economicviability of different projects is studied toselect most profitable alternative

For external investment decisions, firm considersinvesting in other company and arranging merger oracquisition.

Or else it considers portfolio management byselecting a bundle of securities that providemaximum yield at minimum risk.

For short term investment decisions finance managerdecides how the funds are distributed over cash orcash equivalents, receivables and inventoriesHere the main issue is trade off betweenprofitability & liquidity.

Decision areas related to financing :

Optimal financing mix or make up of capitalizationis determined by following factors.

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Sources of funds Quantum of funds Cost of funds used today. Cost of future funds. How much quantity from each source? Which instruments to use and when? Is service of a financial institute to be used? Are underwriting services to be used?

Decision areas related to dividends :

Both goals of growth & dividends are desired, thesegoals are conflicting as higher dividends meanlesser retained earnings required for growth.

Finance manager balances funds over these purposesin such a way that wealth is created forstockholders over a period of time.

J . Cardinal Principles of Financial Management

J .1. Strategic Principle :

All financial decisions be integrated with

overall corporate objectives and strategies.

J .2. Optimization Principle:

Maximum utilization of funds should be the goalof financial management. This mandates properbalance between fixed and working capital.

J .3. Risk Return Principle :

Maintain proper balance between risk andreturn. Firm flush with cash has no risk, but hasno income from cash lying idle.

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J .4. Marginal Principle :

An enterprise should continue to work until itsmarginal income equals its marginal cost.

J .5. Suitability Principle:

Source of fund selected to finance an asset shouldmatch with the character of the asset. Hence shortterm financial needs be met with short term sourcessuch as short term borrowings, overdrafts etc.

J .6. Flexibility Principle :

The financial plan needs to have a built-inflexibility to meet dynamic business environment.

J .7. Timing Principle :

The finance manager should time his investment andfinancing decisions in such a way to seize allavailable market opportunities.

J .8. Ploughing Back Principle :

The firm must generate adequate internal cashsurpluses to fund replacement, modernization andgrowth of its capacities.

K. Concept of Financial Management in Public Sector

Principles of prudent financial management adoptedin the private sector are equally applicable to thepublic sector. Financial management in publicsector has its additional characteristics relatedto broad objectives, multiple controls and verylarge size of operations.

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The objectives of social gains regardingdevelopment of backward areas, or provision ofemployment, creating basic infra-structure byproviding basic raw materials, machineries are inconflict with the normal financial objective ofprofit maximization.

For survival & growth, it has to balance thesediverse objectives with making profit for itself.

The task of financial management assumes greatersignificance as the amount of assets, cash &materials controlled by public sector firms is morethe budgets of an entire big size state. This size

defines the quality & depth of financial controlthat needs to be exercised in the public sector.

Financial management in the public sector has topay greater attention to the outside economicenvironment governed by the economic, fiscal andindustrial policies of the Government.

The finance manager in the public sector has toestablish greater co-ordination with other

departments for efficient use of the funds. Two wayinformation systems between the finance & otherdepartments have to be developed for this purpose.

Even though profit generation is not the only goalfor Finance manager in the public sector, he has tocontrol inventories, increase sales and reducecosts to maintain overall margins. The Governmentand employees expect firms in the public sector tomake profit so that they are not a liability toformer and provides benefits like bonus to thelatter.

Unlike in private sector, finance manager in publicsector is controlled by top management of his ownundertaking as well as authorities in various

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ministries. Multiple reporting is complex asobjectives of internal management do not alwaysmatch those of outside agencies.

L . New Paradigms of Financial Management

Both profit and non-profit firms work in a fiercelycompetitive environment where vigorous growth isessential for survival.

This is achieved through product development &innovation and world class levels in productquality & cost as well as in network fordistribution and marketing.

One of the critical factors for failures of largefirms, in both public & private sectors, is use ofarchaic outmoded tools for their financialmanagement. These companies could not reapbenefits of favorable economic environment. Forprogress & survival, all companies need to followthe new paradigms of financial management.

New paradigms

Financial management is integral part ofstrategic management.

Objectives of financial management must betethered to corporate objectives.

Thrust of financial management on value additionof the organization, stockholders &stakeholders.

Maximize profit pool and not just profit &wealth.

Re-engineer finance processes, dig out hiddencosts & eliminate.

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Focus on core activities & source rest tosuppliers.

Adopt zero working capital, just in time, webbased accounting and inventory software.

Evolve new financial instruments like zero couponbonds, deep discount bonds, floating rate bonds,convertible warrants etc to garner fundsefficiently.

Hedge risks arising out of fluctuations in pricesof commodities, shares; interest and foreign

exchange rates.

Next Chapter Two Financial

Statements & Financial Analysis

Keep up!

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