Introduction to Financial Management

What is Finance?
Finance can be defined as the art and science of managing money. Virtually all individuals and organizations earn or raise money and spend or invest money. Finance is concerned with the process, institutions, markets, and instruments involved in the transfer of money among and between individuals, businesses, and governments.

What is Financial Management?
Financial Management is that managerial activity which is concerned with the planning and controlling of the firm’s financial resources.

Objectives of Financial Management
• The objective of the financial management is to increase or maximize the wealth of the owners by increasing the value of the firm which is reflected in its earning per share and the market prize of the shares.
• What do a finance manager do? Suppose he makes available the required funds at an acceptable cost and those funds are suitably invested and that every thing goes according to plan because of the effective control measures he uses.
• If the firm is a commercial or profit seeking then the results of good performance are reflected in the profits the firm makes. How are profits utilized? They are partly distributed among the owners as dividends and partly reinvested in to the business.
• As this process continues over a period of time the value of the firm increases.
• If the share of the organization is traded on stock exchange the good performance is reflected through the market price of the share, which shows an upward movement. When the market price is more a shareholder gets more value then what he has originally invested thus his wealth increases. Therefore we can say that the objective of financial management is to increase the value of the firm or wealth maximization.

Three decision areas in finance:
• Investment decisions - What assets should the company hold? This determines the left-hand side of the balance sheet.
• Financing decisions - How should the company pay for the investments it makes? This determines the right-hand side of the balance sheet.
• Dividend decisions - What should be done with the profits of the business?

Nature of Financial Management
• Financial management is an integral part of overall management and not merely a staff function.
• It is not only confined to fund raising operations but extends beyond it to cover utilisation of funds and monitoring its uses.
• These functions influence the operations of other crucial functional areas of the firm such as production, marketing and human resources.
• Hence, decisions in regard to financial matters must be taken after giving thoughtful consideration to interests of various business activities.
• Hence, decisions in regard to financial matters must be taken after giving thoughtful consideration to interests of various business activities.
• Finance manager has to see things as a part of a whole and make financial decisions within the framework of overall corporate objectives and policies.
The financial management of a firm affect its very survival because the survival of the firm depends on strategic decisions made in such important matters such as product development, market development, entry in new product line, retrenchment of a product, expansion of the plant, change in location, etc. In all these matters assessment of financial implications is inescapable.

Scope of Finance
A firm secures whatever capital it needs and employs it (finance activity) in activities which generate returns on invested capital (Production and Marketing activities)

Finance Functions
• Function of raising funds, investing them in assets and distributing returns earn from them to share holders respectively known as financing, investment and dividend function.
• While performing these function, a firm attempt to balance cash inflows and outflows. This is called liquidity function.

Investment decision
• Investment decision involves the decision of allocating capital to long term assets that would yield benefits in the future.
• Two important aspects of the investments decisions are:
a. The evaluation of the prospective profitability of new investment.
b. Measurement of a cut-off rate against that the prospective return of new investments could be compared
• Future benefits of investments are difficult to measure and cannot be predicted with certainty.
• Because of the uncertain future, investment decisions involve risk.
Investment proposal should, therefore, be evaluated in terms of both expected return and risk.

Financial Decision
• Must decide when, where and how to acquire funds to meet the firm’s investment needs.
• The central issue is to determine the proportion of equity and debt.
• The mix of debt and equity is known as the firm’s capital structure.
• The financial manager must strive to obtain the best financing mix or the optimum capital structure for the firm.
• The firm’s capital structure is considered to be optimum when the market value of shares is maximized.

Dividend Decision
• The financial manager must decide whether the firm should distribute all profits, or retain them, or distribute a portion and retain the balance.

Liquidity Function
• Current assets that affect a firm’s liquidity is yet another finance function, in addition
• to the management of long-term assets.
• Current assets should be managed efficiently for safeguarding the firm against the danger of illiquidity and insolvency.
• Investment in current assets affect the firm’s profitability, liquidity and risk.

Financial Goal: Profit Vs Wealth
The firm’s investment and financing decision are unavoidable and continuous. In order to make them rationally, the firm must have a goal. It is generally agreed in theory that the financial goal of the firm should be maximizing the shareholder’s wealth as reflected in the market value of shares.

Profit Maximization
• Profit maximization means maximizing the rupee income of firms.
• In market economy, prices of goods and services are determined in competitive market.
• A legitimate question may be raised. Would the price system in free market economy serve the interest of the society? The answer has been given by Adam Smith many year ago. According to him under the condition of free competition, businessmen pursuing their own selfinterest also serve the interest of society.
• It is also assumes that when individual firms pursue the interest of profit maximization, society resource are efficiently utilized.
• While maximizing profit, firm either produces maximum output and uses minimum input. Thus the underlying logic of profit maximization is efficiency. It is assumed to cause the efficient allocation of resources under the competitive market conditions, and profit is considered as the most appropriate measure of firm’s performance.
• Advocates of the profit maximisation objective are of the view that this objective is simple and has the in-built advantage of judging economic performance of the enterprise.
• Further, it will direct the resources in those channels that promise maximum return. This, in turn, would help in optimal utilisation of society's economic resources.
• Since the finance manager is responsible for the efficient utilisation of capital, it is plausible to pursue profitability maximisation as the operational standard to test the effectiveness of financial decisions.

Objection to Profit Maximization
• The profit maximization objective has, however, been criticized in recent years. It is argued that profit maximization assumes assume perfect competition, and in the face of imperfect modern market cannot be legitimate objective of the firm.
• It is also argued that profit maximization, as a business objective, developed in the early 19th century when the characteristics features of the business structure were self financing, private property single ownership.
• The only aim of the single owner than was to enhance his or her individual wealth, which could easily be satisfied by the profit maximization objective.
• Modern business environment is characterized by limited liability and divorce between management and ownership. Business today is financed by shareholders, lenders but is controlled and directed by professional management. The other interested parties are customers, employees, government and society. In practice, the objectives of these constituents (Stake holders) of a firm differ and may conflict with each other. In the new business environment, profit maximization is regarded as unrealistic, difficult, inappropriate and immoral.
• Oligopolies and monopolies are quite common phenomenon of modern economies. Firms producing same goods and services differ substantially in terms of technology and cost.
• In view of such conditions, it is difficult to have a truly competitive price system and thus, it is doubtful if the profit maximizing behavior will lead to optimum social welfare.
• However it is not clear that abandoning profit maximization as a decision criterion would solve the problem.
• Rather government intervention may be sought to correct market imperfections and to promote competition among business firm.
• A market economy, characterized by a high degree of competition, would certainly ensure efficient production of goods and services desired by the society.
• Profit maximisation objective suffers from several drawbacks rendering it an ineffective decisional criterion. These drawbacks are:
a. Definition of Profit
b. Time value of money
c. Uncertainty of returns

Wealth Maximization
• Wealth maximisation objective is a widely recognised criterion with which the performance a business enterprise is evaluated.
• The word wealth refers to the net present worth of the firm. Therefore, wealth maximisation is also stated as net present worth.
• Net present worth is difference between gross present worth and the amount of capital investment required to achieve the benefits. Gross present worth represents the present value of expected cash benefits discounted at a rate.
• Thus, wealth maximisation objective as decisional criterion suggests that any financial action, which creates wealth or which, has a net present value above zero is desirable one and should be accepted and that which does not satisfy this test should be rejected.
• The objectives of shareholders wealth maximization takes care of the question of the timing and risk of the expected benefits. These problems are handled by selecting an appropriate rate (The shareholder’s opportunity cost of capital) for discounting the expected flow of future benefits.
• It is important to emphasize that benefits are measured in terms of actual cash flows, not the accounting profits.
• The wealth created by a company through its actions is reflected in the market value of the company’s shares.

What is undercapitalization?
• Undercapitalization refers to any situation where a business cannot acquire the funds they need. An undercapitalized business may be one that cannot afford current operational expenses due to a lack of capital, which can trigger bankruptcy, may be one that is over-exposed to risk, or may be one that is financially sound but does not have the funds required to expand to meet market demand.
• When a company does not have sufficient capital to conduct normal business operations and pay creditors. This can occur when the company is not generating enough cash flow or is unable to access forms of financing such as debt or equity. If a company can't generate capital over time, it increases its chance of going bankrupt as it loses the ability to service its debts. Undercapitalized companies also tend to choose high-cost sources of capital, such as short-term credit, over lower-cost forms such as equity or long-term debt.
• There are several situations that can lead to an undercapitalized state for a company. When changes in consumer habits render the most profitable products manufactured by the corporation undesirable, the dwindling sales may not be enough to offset the costs of operation. In order to correct the state of undercapitalization, the company will need to either curtail production of the obsolete products to service a smaller market, or develop new products that will be able to attract the attention of a new consumer market.
• There are several different causes of undercapitalization including:
1. Financing growth with short-term capital, rather than permanent capital
2. Failing to secure an adequate bank loan at a critical time
3. Failing to obtain insurance against predictable business risks
• A second scenario that may develop into a lack of sufficient capital involves a start up company. Generally, a new company will attempt to secure backing that provides resources to cover operational costs until the company can begin to generate revenue and make a profit. When the new company fails to attract enough business to meet the production costs within the projected time frame, the venture will be considered undercapitalized. At this juncture, investors can choose to invest additional resources into the company or cut the losses and pull out of the business.
• At other times, changes in consumer tastes or advances in technology will trigger a period in which the company must adapt in order to remain profitable. During this transition, the company may need to seek outside assistance in order to make the adjustments needed to remain a viable entity, or at least cash in assets that are not essential to the base operation in order to keep going. Without correction of this state of undercapitalization, the business will not make it through this transitory period and will eventually fail.

What is over capitalization?
• When a company has too much capital for the needs of its business.
• You might think that more capital is always better, but this isn't the case. If a business has more money than it can work with, it will be burdened with high interest charges and/or dividend payments. To reduce overcapitalization a company can repay its debt or do a share buyback. A concern is said to be over-capitalized if its earnings are not sufficient to justify a fair return on the amount of share capital and debentures that have been issued. It is said to be over capitalized when total of owned and borrowed capital exceeds its fixed and current assets.
• An over capitalized company can be like a very fat person who cannot carry his weight properly. Such a person is prone to many diseases and is certainly not likely to be sufficiently active. Unless the condition of overcapitalization is corrected, the company may find itself in great difficulties.
• Some of the important reasons of over-capitalization are:
1. Idle funds: The company may have such an amount of funds that it cannot use them properly. Money may be living idle in banks or in the form of low yield investments.
2. Over-valuation: The fixed assets, especially good will, may have been acquired at a cost much higher than that warranted by the services which that asset could render.
3. Fall in value: Fixed assets may have been acquired at a time when prices were high. with the passage of time prices may have been fallen so that the real value of the asset may also have come down substantially even though in the balance sheet the assets are being being shown at book value less depreciation written off. Then the book values will be much more than the economic value.
4. Inadequate depreciation provision: Adequate provision may not have been provided on the fixed assets with the result the profits shown by books may have been distributed as dividend, leaving no funds with which to replace the assets at the proper time.

Muhammad Rasyidin bin Abdullah bin Syamsyuddin

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