Financial Management - Introduction to Financial Management

 Financial Management

 

Introduction to Financial Management

 

Meaning and Concept of Financial Management

 

Financial management implies management of finance in such a way that every financial decision and activity gives maximum possible benefit to the firm, as the outcome of such decision and activity, at minimum possible cost to the firm. Here, benefit to the firm should be such that it ultimately increases the value of the firm leading to increase in the wealth of the individual shareholders.

 

Finance is the most important resource for running any organisation effectively. In case of any business organisation this resource is also termed as capital. Therefore, it is clear that the basic objective of financial management is to utilize the available finance in a manner which is the most beneficial to the organisation as well as to the people who are interested in the growth and well-being of the organisation.

 

The basic objective of financial management as stated above can be completely fulfilled only if the finance is utilized as a resource in the most cost effective manner. Here we need to understand what is meant by cost of finance. First of all, it can be stated that like every other resource finance is also scarce and accordingly, it also has a cost. By cost of finance we mean the charge one has to pay in the form of interest or dividend for using certain amount of finance.

 

In case of a business organisation, therefore, the major activities related to financial management can be enumerated as follows:

 

1. Determining cost of different forms of finances (i.e. determining cost of capital)

 

There are various forms of finances which are used in a business firm for its efficient operation and sustained growth. Examples of such finances are equity share capital, preference share capital, debt capital (e.g. debentures, long-term loans from banks and/or financial institutions, etc.), retained earnings (e.g. reserves and surplus) and short-term working capital loans from banks. Finance manager is responsible to identify the cost of each of these different forms of finances.

 

2. Determining the optimum capital structure

 

Capital structure may be defined as a combination of debt capital and equity capital of a corporate entity (business firm). Optimum capital structure may be defined as that capital structure or combination of debt capital and equity capital which leads to the minimum overall cost of capital and maximum value of the business firm (corporate entity). Therefore, finance manager is responsible to maximise the value of the firm by designing an optimum capital structure.

 

3. Raising finance for the firm

 

Different major ways by which finances can be raised for the firm are:–

a)	By issue of equity/preference shares;
b)	By issue of debentures;
c)	By taking loans from banks and financial institutions; and
d)	By appropriating a portion of net earnings.

 

Responsibility of the finance manager in regard to raising finance lies in ensuring that the finances are raised in right time, in right amount, in right proportion and at the least possible cost.

 

4. Evaluating and identifying the most profitable projects for future investment

 

The process of evaluation and identification of profitable projects is also known as capital budgeting. Capital budgeting is a process of identifying and selecting the projects to be taken up for execution, out of many such projects to choose from, in such a way that the projects so selected for future investment are in line with the overall objectives and goal of the firm in terms of maximisation of shareholders’ wealth. Therefore, the finance manager has to see that the future projects are selected for capital investment in such a manner that ensures maximisation of the firm’s as well as the shareholders’ wealth.

 

5. Minimising financial and operating risks of the firm

 

Financial risk is the risk of the firm not being able to cover its fixed financial costs, whereas Operating risk is the risk of the firm not being able to cover its fixed operating costs. Examples of fixed financial costs are interest on loans and interest on debentures, whereas examples of fixed operating costs are depreciation on fixed assets, rent of office premises and buildings and insurance premiums on fixed assets. Finance manager is expected to ensure that both the financial and operating risks are well under control.

 

6. Minimising the requirement for working capital

 

Working capital is the excess of current assets, loans and advances over current liabilities and provisions. In other words,

 

Working Capital =

Current Assets, Loans and Advances − Current Liabilities and Provisions

 

Working capital may also be defined as the capital which is not fixed and which is required to run the operations of the business organisation on day to day basis. Maintaining working capital at the optimum level throughout the accounting year also requires incurring a cost which is basically the opportunity cost of not investing the working capital in any other forms. In other words, cost of working capital is the amount of interest/earnings lost by not investing the working capital in any other forms and manners. Finance manager is, therefore, expected to ensure that the requirement of working capital is minimised as much as possible so that the cost of the working capital is also at a minimum possible level.

 

7. Fixing the optimum dividend-payout ratio

 

Dividend-payout ratio is the ratio of dividend per equity share to the earnings per equity share (EPS). Therefore, in other words,

Dividend-payout ratio =

(Dividend per Equity Share ÷ EPS) x 100 %

 

If there are profitable investment opportunities available within the firm, the dividend-payout ratio should be as low as possible so that the retained earnings could be invested in the available profitable ventures. On the other hand, if there are no profitable investment opportunities available within the firm, the dividend-payout ratio may be as high as possible. Finance manager is, therefore, expected to take the decision in regard to the dividend-payout ratio in a manner which ensures the maximisation of the value of the firm as well as the shareholders’ wealth.

Maximisation of shareholders’ wealth

 

In the theory of financial management, it is generally accepted that the goal of a business firm is to maximise the wealth of the shareholders. The wealth of the equity shareholders is represented by the market value of the equity shares. The shareholders’ wealth is maximised only when the market value of the equity shares is maximised.

 

In any business firm, the current wealth of a shareholder can be calculated as follows:

 

W0 =

N x P0

 

  Where,

W0 =	Current wealth of the shareholder
N =	Number of shares owned by the shareholder
P0 =	Current market price per share

 

The wealth of all the shareholders together is also considered as the value of the firm. The goal of wealth maximisation, therefore, implies that the financial decisions of a business firm should be taken in such a way that they lead to higher market price of its equity shares. All financial decisions of a business firm are interrelated and they jointly affect the market value of its equity shares. The financial manager, therefore, while aiming at wealth maximisation of the shareholders, should strive to maximise returns from investments in relation to a given level of risks.

 

The criticisms against the wealth maximisation goal are:–

 

1)	It assumes an efficient capital market;
2)	It may not be socially desirable;
3)	It does not give due weight to customers’ satisfaction; and
4)	It may lead to a conflict between the goals of the owners and the goals of the management.

 

 

Difference between Equity Shares and Preference Shares

 

Equity Shares:

 

1.	Meaning: Equity shares are those shares that do not enjoy any preference as regards payment of dividend and repayment of capital.
2.	Rate of Dividend: The rate of dividend on equity shares is not fixed. It fluctuates, as it depends on the profits made by a company i.e. higher the profits, higher the dividend, lower the profits, lower the dividend.
3.	Return of Capital: Equity shareholders are paid their capital after the preference shareholders are paid.
4.	Voting Rights: Equity shareholders have normal voting rights.
5.	Classification: Equity shares have no classification.
6.	Right of Dividend: Equity shareholders receive dividend after it is paid to preference shares.

 

Preference Shares:

 

1.	Meaning: Preference shares are those shares which enjoy preference as regards payment of dividend and repayment of capital.
2.	Rate of Dividend: The rate of dividend on preference shares is fixed.
3.	Return of Capital: Preference shareholders are paid their capital first.
4.	Voting rights: Preference shareholders do not have normal voting rights.
5.	Classification: Preference shares are classified into many types like cumulative preference shares, non-cumulative preference shares, convertible preference shares, non-convertible preference shares, participating preference shares, non-participating preference shares, redeemable preference shares and irredeemable preference shares.
6.	Right of Dividend: Preference shareholders receive dividend first.

 

Difference between Equity Shares and Preference Shares

 

Points of difference	Equity Shares	Preference Shares
1. Meaning	Equity shares are those shares that do not enjoy any preference as regards payment of dividend and repayment of capital	Preference shares are those shares which enjoy preference as regards payment of dividend and repayment of capital
2. Rate of Dividend	The rate of dividend on equity shares is not fixed. It fluctuates, as it depends on the profits made by a company i.e. higher the profits, higher the dividend, lower the profits, lower the dividend	The rate of dividend on preference shares is fixed
3. Return of Capital	Equity shareholders are paid their capital after the preference shareholders are paid	Preference shareholders are paid their capital first
4. Voting Rights	Equity shareholders have normal voting rights	Preference shareholders do not have normal voting rights
5. Classification	Equity shares have no classification	Preference shares are classified into many types like cumulative preference shares, non-cumulative preference shares, convertible preference shares, non-convertible preference shares, participating preference shares, non-participating preference shares, redeemable preference shares and irredeemable preference shares
6. Right of Dividend	Equity shareholders receive dividend after it is paid to preference shareholders	Preference shareholders receive dividend first

 

Difference between Equity Shares and Debentures

 

Points of difference	Equity Shares	Debentures
1. Meaning	Equity shares are those shares that do not enjoy any preference as regards payment of dividend and repayment of capital	Debenture is the most common form of loan capital which is made available by investors to a company on a long-term basis
2. Rate of Dividend / Interest	The rate of dividend on equity shares is not fixed. It fluctuates, as it depends on the profits made by a company i.e. higher the profits, higher the dividend, lower the profits, lower the dividend	Debenture interest is paid at a pre-determined fixed rate. It is payable, whether there is any profit or not.
3. Return of Capital	Equity shareholders are paid their capital after the debenture holders are paid	Debenture holders are paid their capital before the equity shareholders are paid
4. Voting Rights	Equity shareholders have normal voting rights	Debenture holders have no voting rights
5. Classification	Equity shares have no classification	There are different classes of debentures, such as Secured/ Unsecured; Redeemable/ Irredeemable; Convertible/ Non-convertible, etc.
6. Right of Dividend	Equity shareholders receive dividend after interest is paid to the debenture holders	Debenture holders receive interest before dividend is paid to equity shareholders
7. Ownership	Equity shareholders are the owners of the company	Debenture holders are the creditors of the company
8. Chargeability	Dividends are appropriation of profits and these are not deductible in determining taxable profit of the company	Interests on debentures are the charges against profits and these are deductible as expense in determining taxable profit of the company
9. Place in the balance sheet	In the company balance sheet equity shares are shown under “Share Capital”	In the company balance sheet debentures are shown under “Secured Loans”
10. Convertibility	Equity shares cannot be converted into debentures in any circumstances	Debentures can be converted into equity shares as per the terms of issue of debentures