G23MBA2023 Financial Management

Module 1: Introduction to Financial Management

Faculty: Dr. Shalini H S

Associate Professor
Acharya Bangalore B-School (Autonomous)

Contents: Concept of Financial management - Meaning and definitions, Scope of Financial

Management, finance functions, Interface of Financial Management with other functional areas,
Financial Goals of a firm, Agency problem and Emerging role of finance manager in India.
-5 Hours

Concept of Financial Management: Finance is the lifeline of any business.

However, finances, like most other resources, are always limited. On the other hand,
wants are always unlimited. Therefore, it is important for a business to manage its
finances efficiently. As an introduction to financial management, in this module, we
will look at the nature, scope, and significance of financial management, along with
financial decisions and planning.

Introduction to Financial Management:

Let’s define financial management as the first part of the introduction to financial
management. For any business, it is important that the finance it procures is invested in a
manner that the returns from the investment are higher than the cost of finance. In a nutshell,
financial management –

• Endeavors to reduce the cost of finance

• Ensures sufficient availability of funds

• Deals with the planning, organizing, and controlling of financial activities like the
procurement and utilization of funds

Some Definitions of Financial Management:

“Financial management is the activity concerned with planning, raising, controlling and
administering of funds used in the business.” – Guthman and Dougal

“Financial management is that area of business management devoted to a judicious use of

capital and a careful selection of the source of capital in order to enable a spending unit to
move in the direction of reaching the goals.” – J.F. Brandley
“Financial management is the operational activity of a business that is responsible for
obtaining and effectively utilizing the funds necessary for efficient operations.”- Massie

Scope of Financial Management: Financial management has a wide scope.

According to Dr. S. C. Saxena, the scope of financial management includes the
following five A's.

1. Anticipation: Financial management estimates the financial needs of the company. That
is, it finds out how much finance is required by the company.

2. Acquisition: It collects finance for the company from different sources.

3. Allocation: It uses this collected finance to purchase fixed and current assets for the
company.

4. Appropriation: It divides the company's profits among the shareholders, debenture

holders, etc. It keeps a part of the profits as reserves.

5. Assessment: It also controls all the financial activities of the company. Financial
management is the most important functional area of management. All other functional areas
such as production management, marketing management, personnel management, etc. depend
on financial management. Efficient financial management is required for survival, growth
and success of the company or firm. The introduction to financial management also requires
you to understand the scope of financial management. It is important that financial decisions
take care of the shareholders’ interests.

Further, they are upheld by the maximization of the wealth of the shareholders, which
depends on the increase in net worth, capital invested in the business, and plowed-back
profits for the growth and prosperity of the organization.

The scope of financial management is explained in the diagram below:

 You can understand the nature of financial management by studying the nature of investment,
financing, and dividend decisions.

Core Financial Management Decisions:

In organizations, managers in an effort to minimize the costs of procuring finance and using it
in the most profitable manner, take the following decisions:

Investment Decisions: Managers need to decide on the amount of investment available out of
the existing finance, on a long-term and short-term basis. They are of two types:

• Long-term investment decisions or Capital Budgeting mean committing funds for a long
period of time like fixed assets. These decisions are irreversible and usually include the ones
pertaining to investing in a building and/or land, acquiring new plants/machinery or replacing
the old ones, etc. These decisions determine the financial pursuits and performance of a
business.

• Short-term investment decisions or Working Capital Management means committing

funds for a short period of time like current assets. These involve decisions pertaining to the
investment of funds in the inventory, cash, bank deposits, and other short-term investments.
They directly affect the liquidity and performance of the business.

Financing Decisions: Managers also make decisions pertaining to raising finance from long-
term sources (called Capital Structure) and short-term sources (called Working Capital). They
are of two types:

• Financial Planning decisions which relate to estimating the sources and application of funds.
It means pre-estimating financial needs of an organization to ensure the availability of
adequate finance. The primary objective of financial planning is to plan and ensure that the
funds are available as and when required.

• Capital Structure decisions which involve identifying sources of funds. They also involve
decisions with respect to choosing external sources like issuing shares, bonds, borrowing
from banks or internal sources like retained earnings for raising funds.
Dividend Decisions: These involve decisions related to the portion of profits that will be
distributed as dividend. Shareholders always demand a higher dividend, while the management
would want to retain profits for business needs. Hence, this is a complex managerial decision.
 Finance Functions: Finance functions can be classified into: i) Executive Functions
and ii) Routine functions.

I. Executive Functions:

1. Estimating capital requirements: The Company must estimate its capital requirements
(needs) very carefully. This must be done at the promotion stage. The company must estimate
its fixed capital needs and working capital need. If not, the company will become over-
capitalized or under-capitalized.

2. Determining capital structure: Capital structure is the ratio between owned capital and
borrowed capital. There must be a balance between owned capital and borrowed capital. If
the company has too much owned capital, then the shareholders will get fewer dividends.
Whereas, if the company has too much of borrowed capital, it has to pay a lot of interest. It
also has to repay the borrowed capital after some time. So, the finance managers must
prepare a balanced capital structure.

3. Estimating cash flow: Cash flow refers to the cash which comes in and the cash which goes
out of the business. The cash comes in mostly from sales. The cash goes out for business
expenses. So, the finance manager must estimate the future sales of the business. This is
called Sales forecasting. He also has to estimate the future business expenses.

4. Investment Decisions: The business gets cash, mainly from sales. It also gets cash from
other sources. It gets long-term cash from equity shares, debentures, term loans from
financial institutions, etc. It gets short-term loans from banks, fixed deposits, dealer deposits,
etc. The finance manager must invest the cash properly. Long-term cash must be used for
purchasing fixed assets. Short-term cash must be used as a working capital.

5. Allocation of surplus: Surplus means profits earned by the company. When the company
has a surplus, it has three options, viz.,

 It can pay dividend to shareholders.

 It can save the surplus. That is, it can have retained earnings.
 It can give bonus to the employees.
6. Deciding additional finance: Sometimes, a company needs additional finance for
modernization, expansion, diversification, etc. The finance manager has to decide on
following questions.

 When the additional finance will be needed?

 For how long will this finance be needed?
 From which sources to collect this finance?
 How to repay this finance?

Additional finance can be collected from shares, debentures, loans from financial institutions,
fixed deposits from public, etc.

7. Negotiating for additional finance: The finance manager has to negotiate for additional
finance. That is, he has to speak to many bank managers. He has to persuade and convince
them to give loans to his company. There are two types of loans, viz., short-term loans and
long-term loans. It is easy to get short-term loans from banks. However, it is very difficult to
get long-term loans.

8. Checking the financial performance: The finance manager has to check the financial
performance of the company. This is a very important finance function. It must be done
regularly. This will improve the financial performance of the company. Investors will invest
their money in the company only if the financial performance is good. The finance manager
must compare the financial performance e of the company with the established standards. He
must find ways for improving the financial performance of the company.

II. Routine Functions: The routine functions are also called as Incidental Functions.
Routine functions are clerical functions. They help to perform the Executive functions of
financial management. The six routine functions of financial management are listed below.

1. Supervision of cash receipts and payments.

2. Safeguarding of cash balances.

3. Safeguarding of securities, insurance policies and other valuable papers.

4. Taking proper care of mechanical details of financing.

5. Record keeping and reporting.

6. Credit Management.

Note: You can also write the schematic diagram which is there in the PPT and then explain
the terms which make the answer more effective.

Financial Goals of a firm: The main objectives of financial management are:-

1. Profit maximization: The main objective of financial management is profit maximization.

The finance manager tries to earn maximum profits for the company in the short-term and the
long-term. He cannot guarantee profits in the long term because of business uncertainties.
However, a company can earn maximum profits even in the long-term, if: 01. The Finance
manager takes proper financial decisions. 02. He uses the finance of the company properly.

2. Wealth maximization: Wealth maximization (shareholders' value maximization) is also a

main objective of financial management. Wealth maximization means to earn maximum
wealth for the shareholders. So, the finance manager tries to give a maximum dividend to the
shareholders. He also tries to increase the market value of the shares. The market value of the
shares is directly related to the performance of the company. Better the performance, higher
is the market value of shares and vice-versa. So, the finance manager must try to maximize
shareholder's value.

3. Proper estimation of total financial requirements: Proper estimation of total financial

requirements is a very important objective of financial management. The finance manager
must estimate the total financial requirements of the company. He must find out how much
finance is required to start and run the company. He must find out the fixed capital and
working capital requirements of the company. His estimation must be correct. If not, there
will be shortage or surplus of finance. Estimating the financial requirements is a very difficult
job. The finance manager must consider many factors, such as the type of technology used by
company, number of employees employed, scale of operations, legal requirements, etc.

4. Proper mobilization: Mobilization (collection) of finance is an important objective of

financial management. After estimating the financial requirements, the finance manager must
decide about the sources of finance. He can collect finance from many sources such as shares,
debentures, bank loans, etc. There must be a proper balance between owned finance and
borrowed finance. The company must borrow money at a low rate of interest.
5. Proper utilization of finance: Proper utilization of finance is an important objective of
financial management. The finance manager must make optimum utilization of finance. He
must use the finance profitable. He must not waste the finance of the company. He must not
invest the company's finance in unprofitable projects. He must not block the company's
finance in inventories. He must have a short credit period.

6. Maintaining proper cash flow: Maintaining proper cash flow is a short-term objective of
financial management. The company must have a proper cash flow to pay the day-to-day
expenses such as purchase of raw materials, payment of wages and salaries, rent, electricity
bills, etc. If the company has a good cash flow, it can take advantage of many opportunities
such as getting cash discounts on purchases, large-scale purchasing, giving credit to
customers, etc. A healthy cash flow improves the chances of survival and success of the
company.

7. Survival of company: Survival is the most important objective of financial management.

The company must survive in this competitive business world. The finance manager must be
very careful while making financial decisions. One wrong decision can make the company
sick, and it will close down.

8. Creating reserves: One of the objectives of financial management is to create reserves. The
company must not distribute the full profit as a dividend to the shareholders. It must keep a
part of its profit as reserves. Reserves can be used for future growth and expansion. It can
also be used to face contingencies in the future.

9. Proper coordination: Financial management must try to have proper coordination between
the finance department and other departments of the company.

10. Create goodwill: Financial management must try to create goodwill for the company. It
must improve the image and reputation of the company. Goodwill helps the company to
survive in the short-term and succeed in the long-term. It also helps the company during bad
times.

11. Increase efficiency: Financial management also tries to increase the efficiency of all the
departments of the company. Proper distribution of finance to all the departments will
increase the efficiency of the entire company.
12. Financial discipline: Financial management also tries to create a financial discipline.
Financial discipline means: 01. To invest finance only in productive areas. This will bring
high returns (profits) to the company. 02. To avoid wastage and misuse of finance.

13. Reduce cost of capital: Financial management tries to reduce the cost of capital. That is, it
tries to borrow money at a low rate of interest. The finance manager must plan the capital
structure in such a way that the cost of capital it minimized.

14. Reduce operating risks: Financial management also tries to reduce the operating risks.
There are many risks and uncertainties in a business. The finance manager must take steps to
reduce these risks. He must avoid high-risk projects. He must also take proper insurance.

15. Prepare capital structure: Financial management also prepares the capital structure. It
decides the ratio between owned finance and borrowed finance. It brings a proper balance
between the different sources of capital. This balance is necessary for liquidity, economy,
flexibility and stability.

Agency Problem: The agency problem is a conflict of interest inherent in any

relationship where one party is expected to act in another's best interests. In corporate
finance, the agency problem usually refers to a conflict of interest between a
company's management and the company's stockholders. The manager, acting as the
agent for the shareholders, or principals, is supposed to make decisions that will
maximize shareholder wealth even though it is in the manager’s best interest to
maximize his own wealth.

The agency problem does not exist without a relationship between a principal and an agent.
In this situation, the agent performs a task on behalf of the principal. Agents are commonly
engaged by principals due to different skill levels, different employment positions or
restrictions on time and access. For example, a principal will hire a plumber—the agent—to
fix plumbing issues. Although the plumber ‘s best interest is to collect as much income as
possible, he is given the responsibility to perform in whatever situation results in the most
benefit to the principal.

The agency problem arises due to an issue with incentives and the presence of discretion in
task completion. An agent may be motivated to act in a manner that is not favorable for the
principal if the agent is presented with an incentive to act in this way. For example, in the
plumbing example, the plumber may make three times as much money by recommending a
service the agent does not need. An incentive (three times the pay) is present, causing the
agency problem to arise.

Agency problems are common in fiduciary relationships, such as between trustees and
beneficiaries; board members and shareholders; and lawyers and clients. A fiduciary is an
agent that acts in the principal's or client's best interest. These relationships can be stringent
in a legal sense, as is the case in the relationship between lawyers and their clients due to the
U.S. Supreme Court's assertion that an attorney must act in complete fairness, loyalty, and
fidelity to their clients.

Emerging role of finance manager in India: There has been a total attitudinal
change among owners towards the finance manager. He is no longer referred to as my
accountant. Instead of being a commodity, the finance manager is now a part of the
top management. The finance manager does not cover the routine duties of finance
and accounting. As a member of top management, he is also responsible for
formulation and implementation of policies and decision making.

The finance manager job has vastly changed. Earlier it was a support function now it is
mainline. And finance itself has been a profit center.

In these competitive times, survival depends largely on an organization’s capabilities to

anticipate and prepare for change rather than just react to it. The role of the financial officer,
thus, becomes crucial to meet these technological, economic and political, changes.

Key challenges of Finance Manager

Investment Planning

Investment planning focuses on effective investment strategies and to analyze the risk
associate with it. Finance manager is responsible for analyze the risk and help management to
reduce this risk so that it does not affect the financial goal of an organization.

Financial Structure

Financial structure is the way in which company assets are financed such as short term,
borrowings long term debt, and equity. Finance manager analyze the government rules and
regulation, banks norms, capability of the organization and the available options in the
market to finance the company’s assets that helps management to decide which option is
profitable for the organization.

Treasury Operations

Treasury operations is basically the overall responsibility for administering the banking
functions of organization, cash management and investment services. These all activities are
directly linked with the growth of organization and profit.

Investor Communication

Finance department provides investors with an accurate account of the company's affairs.
This helps investors to make informed buy or sell decisions.

Management Control

Control is one of the managerial functions like planning, organizing, directing etc. It
basically includes the three steps, to set the standards, measure actual performance and taking
corrective action. Finance manager help organization to set the targets and helps organization
to achieve that target by continuously monitoring the actual performance with set standards.

Clearly, the clout of the finance manager is growing along with the change in his role and
reforms in the financial sector gather speed, this trend will only increase.

Financial managers aim to boost the levels of resources at their disposal. Besides, they
control the functioning on money put in by external investors. Providing investors with
sufficient number of returns on their investments is one of the goals that every company tries
to achieve. Efficient financial management ensures that this becomes possible.

Interface of financial management with other functional areas: One common factor
among all managers is that they use resources and since resources are obtained in exchange
for money, they are in effect making the investment decision and in the process of ensuring
that the investment is effectively utilized they are also performing the control function.

1. Marketing-Finance Interface: There are many decisions, which the Marketing Manager
takes which have a significant location, etc. In all these matters assessment of financial
implications is inescapable impact on the profitability of the firm. For example, he should
have a clear understanding of the impact the credit extended to the customers is going to have
on the profits of the company. Otherwise in his eagerness to meet the sales targets he is liable
to extend liberal terms of credit, which is likely to put the profit plans out of gear. Similarly,
he should weigh the benefits of keeping a large inventory of finished goods in anticipation of
sales against the costs of maintaining that inventory. Other key decisions of the Marketing
Manager, which have financial implications, are:

 Pricing

 Product promotion and advertisement

 Choice of product mix

 Distribution policy.

2. Production-Finance Interface: As we all know in any manufacturing firm, the

Production Manager controls a major part of the investment in the form of equipment,
materials and men. He should so organize his department that the equipment’s under his
control are used most productively, the inventory of work-in-process or unfinished goods and
stores and spares is optimized and the idle time and work stoppages are minimized. If the
production manager can achieve this, he would be holding the cost of the output under
control and thereby help in maximizing profits. He has to appreciate the fact that whereas the
price at which the output can be sold is largely determined by factors external to the firm like
competition, government regulations, etc. the cost of production is more amenable to his
control. Similarly, he would have to make decisions regarding make or buy, buy or lease etc.
for which he has to evaluate the financial implications before arriving at a decision.

3. Top Management-Finance Interface: The top management, which is interested in

ensuring that the firm’s long-term goals are met, finds it convenient to use the financial
statements as a means for keeping itself informed of the overall effectiveness of the
organization. We have so far briefly reviewed the interface of finance with the non-finance
functional disciplines like production, marketing etc. Besides these, the finance function also
has a strong linkage with the functions of the top management. Strategic planning and
management control are two important functions of the top management. Finance function
provides the basic inputs needed for undertaking these activities.

4. Economics – Finance Interface: The field of finance is closely related to economics.

Financial managers must understand the economic framework and be alert to the
consequences of varying levels of economic activity and changes in economic policy. They
must also be able to use economic theories as guidelines for efficient business operation. The
primary economic principle used in managerial finance is marginal analysis, the principle that
financial decisions should be made and actions taken only when the added benefits exceed
the added costs. Nearly all-financial decisions ultimately come down to an assessment of
their marginal benefits and marginal costs.

5. Accounting – Finance Interface: The firm’s finance (treasurer) and accounting

(controller) activities are typically within the control of the financial vice president (CFO).
These functions are closely related and generally overlap; indeed, managerial finance and
accounting are often not easily distinguishable. In small firms the controller often carries out
the finance function, and in large firms many accountants are closely involved in various
finance activities. However, there are two basic differences between finance and accounting;
one relates to the emphasis on cash flows and the other to decision making.

******End of Module 1******