Finance & Accounting Unit -IV

Finance & AccountingUnit -IV

Unit –IVScope and Objectives of Financial Management CONTENT • Approaches to Financial Management: • Traditional View-Modern View- • Investment Decisions-Dividend Decisions- Liquidity and Profitability • Comparison with Accounting and Economics • Financial Management’s Importance in Business: • Significance of Financial Controller • Finance Manager as a Facilitator- • Organization Chart of Finance Function- • Reason for Centralizing Finance Function • Financial Objectives of Business Firm: • Profit Maximization • Wealth Maximization • Value Maximization • Other Maximization Objectives

MEANING OF FINANCE TYPES OF FINANCE PUBLIC FINANCE PRIVATE FINANCE • Government institutions • State govt. • Local self govt. • Central govt. • Personal Finance • Business finance • Finance of nonprofit Organisation. Finance is often defined simply as the management of money or “funds” so that money is available at the time when it is required .

Why do we need to study finance? Almost half of all new ventures fail because of poor financial management -Dun & Brandstreet

What is Finance? • Who needs money? • Every one? you? • Can you or a business survive without cash? Why? • So what is Finance? • First, how to have money • …

Personal finance • Where does money for individuals (personal finance) come from: • Our own money in pocket • Borrows: from friends or credit cards • Received from Government if entitled to some benefits • Earned by doing something or sales of products and services

Business finance • Business finance: a business has the same source of money for individuals • Its own money • Borrows: from friends, colleagues, banks and lending institutions • Received from Government grants. Eg. new in deprived sectors • Earned by sales of products and services • From venture capitalists (seeking profit for spare funds) • From private individuals (Business Angels – often seen in entertainment sector) • Private companies • Microloans

To obtain funding for a business project • Determine how much money is needed to start your company • Prove to your investor that your company requires the predetermined amount of money • Offer incentives, interest, or collateral for the investor’s contribution • Make arrangements to pay back the loan

Classifying businesses • Each type of business can have different ways to finance itself, so we need to look at types of business ownerships • Sole trader – owned by one person • Partnership – owned by two or more and based on agreement among them • Limited company: owned by two or more but separate in law from people who own and control

Sources of Finance

Business Growth

Financial Management • Finance is the life blood of a business. • Financial Management study about the process of procuring and judicious use of financial resources with a view to maximizingthe value of the firm thereby the value of the owners i.e. equity shareholders in a company is maximized.

Approaches to Financial Management Traditional View • Financial management is primarily concerned with acquisition, financing and management of assets of business concern in order to maximize the wealth of the firm for its owners. • The basic responsibility of the Finance manager is to acquire funds needed by the firm and investing those funds in profitable ventures that will maximize firm's wealth, as well as, yielding returns to the business concern. • The success or failure of any firm is mainly linked with the quality of financial decision

Traditional View • The focus of Financial management is on efficient and judicious use of resources to attain the desired objective of the firm. • The basic objectives of Financial management centres around (a) the procurement funds from various sources like equity share capital, preference share capital. debentures, term loans, working capital finance, and (b) effective utilization of funds to maximize the profitability of the firm and the wealth of its owners. • The responsibilities of the Finance managers are linked to the goals of ensuring liquidity, profitability or both and are also related to the management of assets and funds of any business enterprise.

Traditional View • The traditional view of Financial management looks into the following functions, that a Finance manager of a business firm will perform: (a) Arrangement of short-term and long-term funds from financial institutions. (b) Mobilization of funds through financial instruments like equity shares, preference shares, debentures, bonds etc. (c) Orientation of finance function with the accounting function and compliance of legal provisions relating to funds procurement, use and distribution.

Traditional View • With the increase in complexity of modern business situation, the role of a Finance manager is not just confined to procurement of funds, but his area of functioning is extended to judicious and efficient use of funds available to the firm, keeping in view the objectives of the firm and expectations of the providers of funds.

Modern View • The globalization and liberalization of world economy has caused to bring a tremendous reforms in financial sector which aims at promoting diversified, efficient and competitive financial system in the country. • The financial reforms coupled with diffusion of information technology has caused to increase competition, mergers, takeovers, cost management, quality improvement, financial disciplineetc. • Globalization has caused to integrate the national economy with the world economy and it has created a new financial environment which brings new opportunities and challenges to the individual business concern.

Modern View • Financial management in India has changed substantially in scope and complexity in view of recent Government policy. • The information age has given a fresh perspective on the role of Financial management and Finance managers. • With the shift in paradigm it is imperative that the role of Chief Finance Officer (CFO) changes from Controller to a Facilitator.

Modern View • In view of modern approach, the Finance manager is expected to analyze the firm and to determine the following: • The total funds requirement of the firm, • The assets to be acquired, and (iii) The pattern of financing the assets. • The Finance manager of a modern business firm will generally involve in the following three types of decisions - (1) Investment decisions, (2) Finance decisions, and (3) Dividend decisions:

Investment Decisions • Investment decision are those which determine how insufficient resources (funds) available are committed to projects. The project may be as small as purchase of an equipment or as big as acquisition of an entity. • Investment 'in fixed assets require supporting investment in working capital in the form of inventory, receivables, cash etc. • Investment which enhance internal growth is termed as 'internal investment' and acquisition of entities represents 'external investment.

Investment Decisions • The investment decisions should aim at investment in assets only when they are expected to earn a return greater than a minimum acceptable return, which is also called as 'hurdle rate'. • The minimum return should reflect whether the money raised from debt or equity meets the returns on investments made elsewhere on similar investments. • The hurdle rate has to be set at higher for riskier projects and has to reflect the financing mix used i.e. the proportion of debt and equity. • The Finance function involves not only in investment decisions, but also in disinvestment decisions, for example withdrawing from unsuccessful projects or restructuring with a strategic motive.

Investment Decisions • Investment decisions relate to the careful selection of viable and profitable investment proposals, allocation of funds to the investment proposals with a view to obtain net present value of the future earnings of the company and to maximize its value. • It is the function of a Finance manager to carefully analyze the different alternatives of investment, determination of investment levels in different assets i.e., fixed assets and current assets. • The investment decisions of a Finance manager cover the following areas: (a) Ascertainment of total volume of funds, a firm can commit. (b) Appraisal and selection of capital investment proposals.

Investment Decisions (c) Measurement of risk and uncertainty in the investment proposals. (d) Prioritizing of investment decisions. (e) Funds allocation and its rationing. (f) Determination of fixed assets to be acquired. (g) Determination of levels of investments in current assetsviz; inventory, receivables, cash, marketable securities etc., and its management. (h) Buy or lease decisions. (i) Asset replacement decisions. (j) Restructuring, reorganization, mergers and acquisitions. (k) Securities analysis and portfolio management etc.

Dividend Decisions • Dividend decisions concerned with the determination of amount of profits to be distributed to the owners and the frequency of such payments. • The dividend decisions will effect in two ways (a) the amount to be paid out and its influence on share price, (b) the amount of profit to be retained for internal investment which maximizes the value of firm and ultimately improves the share value of the firm. • The level and regular growth of dividends represent a significant factor in determining a profit-making company's market value and the value of its shares in the stock market.

Dividend Decisions • The Finance manager will involve in taking the following dividend decisions: (a) Determination of dividend and retention policies of the firm. (b) Consideration of impact of levels of dividend and retention of earnings on the market value of the share and the future earnings of the company. (c) Consideration of possible requirement of funds by the firm for expansion and diversification proposals for financing existing business requirements. (d) Reconsideration of distribution and retentions policies in boom and recession periods. (e) Considering the impact of legal and cashflow constraints on dividend decisions.

Dividend Decisions • The investment, finance and dividend decisions are interrelated to each other and, therefore, the Finance manager while taking any decision, should consider the impact from all the three angles simultaneously. • The corporate finance theory centers around three important objectives of a finance function: (a) Allocation of funds i.e. investment decisions, '(b) Generation of funds i.e. financing decisions, and (c) Distribution of funds i.e. dividend decisions. • The guiding factors for the above said finance decisions are as follows: (i) The wealth maximization objective of firm, and (ii) The existence of efficient capital markets.

Liquidity and Profitability • Ezra Solomon states that "liquidity measures a company's ability to meet expected as well as unexpected requirements of cash to expand its assets, reduce its liabilities and cover up any operating losses." The balancing of liquidity and profitability is one of the prime objectives of a Finance manager. • One of the important problems faced by Finance manager is the dilemma of liquidity vs. profitability. • Liquidity ensures the ability of the firm to honour its short-term commitments. The liquidity means the firm's ability to pay trade creditors as and when due, ability to honour its bills payable on due-dates, ability to pay salaries and wages on time when it is due, ability to meet unexpected expenses etc. • It also reflects the firm's ability to convert its assets into cash, cash equivalents and other most liquid assets. The liquidity of the firm indicates the ability of the organization to realize value in money, and its ability to pay in cash the obligations that are due for payment.

Liquidity and Profitability • Under profitability objective, the Finance manager has to utilize the funds in such a manner as to ensure the highest return. • Profitability concept signifies the operational efficiency of an organization by value addition through the utilization of resources i.e., men, materials, money and machines. • It refers to a situation in terms of efficiency in utilization of resources to achieve profit maximization for the owners. • There is an inverse relationship between profitability and liquidity. The higher the liquidity the lower will be the profitability and vice versa.

Liquidity and Profitability • Liquidity and profitability are competing goals for the Finance manager. • Under liquidity management, the Finance manager is expected to manage all its current assets including near cash assets in such a way as to ensure its effectivity with a view to minimize costs. • Sometimes, even if the profit from operations is higher, the firm may face liquidity problems due to the fact that the amount representing the profit may be in the form of either in fixed assets like plant, buildingsetc. or in.the form of current assets like inventory, debtors - other than in the form of cash and bank balances.

Liquidity and Profitability • In situations where the firm faces the liquidity problems, will hamper the working of the company which result in lower profitability of the firm. • If, more assets of the firm are held in the form of highly liquid assets it will reduce the profitability of the firm. • Lack of liquidity may lead to lower rate of return, loss of business opportunities etc. • Therefore, a firm should maintain a trade-off situation where the firm maintains its optimum liquidity for greater profitability and the Finance manager has to strike a balance between these two conflicting objectives.

Comparison with Accounting and Economics • Financial Management and Accounting • Just as production and sales are major functions in an enterprise, finance too is an independent specialized function and it is well connected with other functions. • Financial management is a separate management area. In many organizations accounting and finance functions are clubbed and the finance function is often considered as part of the functions of the Accountant. • But the Financial management is something more than an art of accounting and book keeping in the sense that, accounting function discharges the function of systematic recording of transactions relating to the firm's transactions in books of account and summarizing the same for presenting in financial statements viz., Profit and loss account and Balance sheet, Funds flow and Cash flow statements.

Comparison with Accounting and Economics • The Finance manager will make use of the accounting information in analysis and review of the firm's business position in decision making. • In addition to the analysis of financial information available from the books of account and records of the firm, a Finance manager uses the other methods and techniques like capital budgeting techniques, statistical and mathematical models and computer applications in decision making to maximize the value of the firm's wealth and value of the owners' wealth. • Financial management is the key function, many firms prefer to centralize the function to keep constant control on the finances of the firm.

Comparison with Accounting and Economics • Any inefficiency in Financial management will be concluded with a disastrous situation. But, as far as, the routine matters are concerned, the finance function could be decentralized with adoption of responsibility accounting concept. • It is advantageous to decentralize accounting function to speedup the process of information. But since the accounting information is used in taking financial decisions, proper controls should be exercised on accounting function in processing of accurate and reliable information to the needs of the firm. • The centralization or decentralization of accounting and finance functions mainly depend on the attitude of the top level management.

Financial Management and Economics • The Finance manager must be familiar with the micro and macroeconomic environment aspects of business. • Microeconomics deal with the economic decisions of individuals and firms. It focus on the optimal operating strategies based on the economic data of individuals and firms. • The concepts of microeconomics helps the Finance manager in decisions like • price fixation, • determination of capacity and operating levels, • break-even analysis, • volume-cost-profit analysis, • capital structure decisions, • dividend distribution decisions, • profitable product-mix decisions etc.

Financial Management and Economics • Macroeconomics looks at the economy as a whole, in which a particular business concern is operating. • Macro economics provide insight into policies by which economic activity is controlled. • The success of the business firm is influenced by the overall performance of the economy-and is dependant upon the money and capital markets, since-the investible funds are to be procured from the financial markets. • A firm is operating with in the institutional framework, which operates on the macroeconomic theories. The government's fiscal and monetary policy will influence the strategic financial planning of the enterprise.

Financial Management and Economics • The Finance manager should also look into the other macroeconomic factors like • rate of inflation, real interest rates, • level of economic activity, trade cycles, • market competition both from new entrants and substitutes • international business conditions, foreign exchange rates, • bargaining power of buyers, unionization of labor, • domestic savings rate, depth of financial markets, • availability of funds in capital markets, • growth rate of economy, government's foreign policy, • financial intermediation and banking system etc.

Importance of Financial Management in Business Significance of Financial Management • The importance of Financial management is known from the following aspects: • Applicability • Chances of Failure • Return on Investment

Significance of Financial Management • Applicability – • The principles of finance is applicable wherever there is cash flow. The concept of cash flow is one of the central elements of financial analysis, planning, control and resource allocation decisions. • Cash flow are important because financial health of the firm depends on its ability to generate sufficient amounts of cash to pay its employees, suppliers, creditors and owners. • Any organization, whether motivated with earning of profit or not, having cash flow requires to be viewed from the angle of financial discipline. • Therefore, Financial management is equally applicable to all forms of business like sole traders, partnerships, companies. It is also applicable to nonprofit organizations like trusts, societies, governmental organizations, public sector enterprises etc.

Significance of Financial Management • Chances of Failure- • A firm having latest technology, sophisticated machinery, high caliber marketing and technical experts etc. may fail to succeed unless its finances are managed on sound principles of Financial management. • The strength of business lies in its financial discipline. Therefore, finance function is treated as primary, which enable the other functions like production, marketing, purchase, personnel etc. to be more effective in achievement of organizational goals and objectives.

Significance of Financial Management • Return on Investment - • Anybody invests his money will mean to earn a reasonable return on his investment. • The owners of business try to maximize their wealth. It depend on the amount of cash flows expected to be generated for the benefit of owners, the timing of these cash flows and the risk attached to these cash flows. The greater the time and risk associated with the expected cash flow, the greater is the rate of return required by the owners. • The Financial management study the risk-return perception of the owners and the time value of money.

Importance of Financial Management in Business Functions of Financial Controller • The important functions of a Financial controller in a large business firm consist of the following: • Provision of Capital • Investor Relations • Short-term Financing • Banking and Custody - • Credit and Collections - • Insurance - • Investments - • Planning for Control - • Reporting and Interpreting - • Evaluating and Consulting - • Tax Administration -

Continue…. • Government Reporting - • Protection of Assets - • Economic Appraisal- • Managing Funds - • Measuring of Return - • Cost control - • Price Setting - • Forecasting Profits - • Forecast Cash flow -

Finance Manager as a Facilitator • In the current economic scenario, Financial management has assumed much greater significance. • It is now a question of survival of entities in the total spectrum of economic activity, with pragmatic readjustment of Financial management. • The financial sector reforms achieved the diversified, efficient and competitive financial sector. • Previously, the Finance manager's primary task is taken as to plan for acquisition and use of funds so as to maximize the value of the firm. • The Financial management in India has widened substantially, in scope and complexity, in view of recent government policy. • The information age has given a fresh perspective on the role of Financial management and Finance managers, with the shift in paradigm it is imperative that the role of Chief Finance Officer (CFO) changes from a controller to a facilitator. • Today's Finance managers are seized with variety of financial problems and are trying to overcome it by innovative means.

Finance Manager as a Facilitator • The Finance manager's role has shifted to act as a catalyst in the fast changing economic environment. He provides the necessary information for strategic planning of the enterprise. • He should transform from a functional head to a 'strategic leader' who should able to use the networking systems, face the external complexities, strategic financial planning aligning with strategic objectives of the group, hedging of the foreign exchange risk, raising of low cost funds from global financial markets, meeting the regulatory provisions of international financial markets, dissemination of financial information about the firm and improve the market efficiency in pricing of stocks of the firm, improve the capital productivity in increasing the profitability of the firm, etc. • This will require the shift in view of operational function of a Finance manager to a strategic head who works in the environment of self managed teams rather than in a controlled environment.

Reasons for Centralizing Finance Function • The argument in favor of centralizing the finance function is based on the following reasons. • Strategic Decisions - Many of the strategic decisions like setting up of financial goals, investment in capital projects, raising of finances through issue of variety of equity, semi-equity and debt instruments, constant appraisal of financial position, making availability of funds as per schedule, attaining target rate of return on capital employed etc. are taken by the top level management. Finance manager as a part of top management team involve in strategic decision making, therefore, it requires the centralization of finance function. • Cashflow - The success of the firm depend on its ability to generate cashflows. The cash flow is to be generated to meet the expectations of various stakeholders viz., shareholders, debenture holders, banks, financial institutions, creditors, employees etc. Strict planning and control is required to generate the cash inflow and proper planning is required for cash outflow, to maintain the liquidity as well as long-term solvency of firm. This requires the finance decisions to be taken at a single point.

Continue… • External Orientation - Finance manager need to liaison with external agencies like banks, financial institutions, shareholders, debenture holders, government, SEBI, RBI, tax authorities etc. This requires proper coordinated action, therefore, the centralized finance function is a necessity. • Coordination - The efficiency of other functions in an organization like production, marketing, purchase, personnel etc. is linked with availability of funds in time. Finance manager acts as a coordinator or facilitator of all other functions, in achieving the organizational goals.

Continue… • Financial Discipline - The centralized finance function minimizes the risk of misappropriation of funds. The cash outflow should be according to the plan/schedule, and necessary approvals to be taken from the higher level. It requires the centralized decision making power as regards finance function. • Information Flow - The finance function requires the information, quantitative as well as monetary, on constant basis from all levels and functions of the organization. The ability of finance decisions have direct impact on the success of the organization. The information flow will reduce the uncertainty in finance decisions. Only the centralized finance function can have access to reliable and quick information.

Financial Objectives of Business Firm: • Profit Maximization • Wealth Maximization • Value Maximization • Other Maximization Objectives

Profit Maximization • Profit as an objective has emerged from over a century of economic theory. • In this traditions economic theory, the typical firm was small, owner managed and competing with a large number of similar firms. • Under these circumstances, profit is the rational objective because: (1) The profit of the firm became the income of the owner. Maximization of profit then ensured the self-interests of the owner / manager, who both decide the actions of the firm and ensure that these are carried out. (2) The force of competition imposed profit maximization upon the firm to survive in business • The behavioral assumption of profit maximization has served economic theory well. • Because Profit is the difference between revenue and cost once revenue and costs are identified the assumption of profit maximization enables predictions to be readily made about the consequence of any environmental change.

Finance & Accounting Unit -IV