UNIT ONE

CORE CONCEPTS OF FINANCIAL MANAGEMENT

1

UNIT ONE

CHAPTER ONEINTRODUCTION

2

Lesson 1Chapter 1

IntroductionUnit 1

Core concepts in financial managementAfter reading this lesson you will be able to understand the following: -> Concept of ‘Finance’ under different approaches.> Significance of ‘Finance’.> Nature of financial management.> Relationship between finance and other important functions of the organization.> Role of a Finance Manager in an organization.> New challenges faced by the finance manager.

A very warm welcome to all my students in Third Trimester of PGPACM course at NICMAR, Hyderabad Campus. I will be teaching you FINANCIAL MANAGEMENT; I must tell you that I find this subject as the most interesting subject and all my efforts will be to make it very interesting for you as well. Let’s discuss

Almost every firm, government agency, and organization has one or more financial managers who oversee the preparation of financial reports, direct investment activities, and implement cash management strategies. As computers are increasingly used to record and organize data, many financial managers are spending more time developing strategies and implementing the long-term goals of their organization.

The duties of financial managers vary with their specific titles, which include controller, treasurer or finance officer, credit manager, cash manager, and risk and insurance manager. Controllers direct the preparation of financial reports that summarize and forecast the organization’s financial position, such as income statements, balance sheets, and analyses of future earnings or expenses. Regulatory authorities also in charge of preparing special reports require controllers. Often, controllers oversee the accounting, audit, and budget departments. Treasurers and finance officers direct the organization’s financial goals, objectives, and budgets. They oversee the investment of funds and manage associated risks, supervise cash management activities, execute capital-raising strategies to support a firm’s expansion, and deal with mergers and acquisitions. Credit managers oversee the firm’s issuance of credit. They establish credit-rating criteria, determine credit ceilings, and monitor the collections of past-due accounts. Managers specializing in international finance develop financial and accounting systems for the banking transactions of multinational organizations.

Cash managers monitor and control the flow of cash receipts and disbursements to meet the business and investment needs of the firm. For example, cash flow projections are needed to determine whether loans must be obtained to meet cash requirements or whether surplus cash should be invested in interest-bearing instruments. Risk and insurance managers oversee programs to minimize risks and losses that might arise from financial transactions and business operations undertaken by the institution. They also manage the organization’s insurance budget.

3

Financial institutions, such as commercial banks, savings and loan associations, credit unions, and mortgage and finance companies, employ additional financial managers who oversee various functions, such as lending, trusts, mortgages, and investments, or programs, including sales, operations, or electronic financial services. These managers may be required to solicit business, authorize loans, and direct the investment of funds, always adhering to Federal and State laws and regulations.

Branch managers of financial institutions administer and manage all of the functions of a branch office, which may include hiring personnel, approving loans and lines of credit, establishing a rapport with the community to attract business, and assisting customers with account problems. Financial managers who work for financial institutions must keep abreast of the rapidly growing array of financial services and products. In addition to the general duties described above, all financial managers perform tasks unique to their organization or industry. For example, government financial managers must be experts on the government appropriations and budgeting processes, whereas healthcare financial managers must be knowledgeable about issues surrounding healthcare financing. Moreover, financial managers must be aware of special tax laws and regulations that affect their industry.

Financial managers play an increasingly important role in mergers and consolidations, and in global expansion and related financing. These areas require extensive, specialized knowledge on the part of the financial manager to reduce risks and maximize profit. Financial managers increasingly are hired on a temporary basis to advise senior managers on these and other matters. In fact, some small firms contract out all accounting and financial functions to companies that provide these services.

The role of the financial manager, particularly in business, is changing in response to technological advances that have significantly reduced the amount of time it takes to produce financial reports. Financial managers now perform more data analysis and use it to offer senior managers ideas on how to maximize profits. They often work on teams, acting as business advisors to top management. Financial managers need to keep abreast of the latest computer technology in order to increase the efficiency of their firm’s financial operations.

We all have heard about the term finance, let us discuss on what does it mean and why do you as a student of PGPACM want to study it?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.

Why study finance?An understanding of the concepts, techniques, and practices presented in this course will fully acquaint you with the financial manager's activities. Because most business decisions are measured in financial terms, the financial manager plays a key role in the operation of the firm. People in all areas of responsibility accounting, information systems, management, marketing, and operations- need a basic understanding of the managerial finance function. All managers in

4

the firm, regardless of their job descriptions, work with financial personnel to justify personnel requirements, negotiate operating budgets, deal with financial performance appraisals, and sell proposals based at least in part on their financial' merits. Clearly, those managers who understand the financial decision- making process will be better able to address financial concerns, and will therefore more often get the resources they need to accomplish their own goals.

To make informed decisions about where to get and put money in order to maximize value in both personal and business decisions.

I know you want to ask the following question: -If I have no intention of becoming a financial manger, why do I need to understand financial management?One good reason is “to prepare yourself for the workplace of the future”. More and more businesses are reducing management jobs and squeezing together the various layers of the corporate pyramid. This is being done to reduce costs and boost productivity. As a result, the responsibilities of the remaining management positions are being broadened. The successful manager will need to be much more of a team player that has the knowledge and ability to move not just vertically within an organization but horizontally as well. Developing cross-functional capabilities will be the rule, not the exception. Thus, a mastery of basic financial management skills is key ingredient that will be required in the work place of your not too distant future.

Finance is the study of money management, the acquiring of funds (cash) and the directing of these funds to meet particular objectives. Good financial management helps businesses to maximize returns while simultaneously minimizing risks.

Hardly anybody wants to work in a field where there is no room for experience, creativity, judgment and a pinch of luck but study of finance is not so. There are many reasons that the manager’s job is challenging and interesting. Here are four important ones.-Securities Markets -Understanding Values -Time and uncertainty -Understanding People.I. Securities Markets include Money Markets and Capital Markets.

Money Markets includes:* Markets for short-term claims with original maturity of one year or less.* High-grade securities with little or no risk of default.* Examples:1. Treasury Bills.2. Commercial Paper.3. Certificates of Deposit.

5

Capital markets include:* Market for long-term securities with original maturity of more than one year.*Securities may be of considerable risk.*Example:1.Stocks2.Corporate bonds 3.Government bonds

Primary MarketsA primary market is a market for newly created securities. The proceeds from the sale of securities in primary markets go to the issuing entity. A security can trade only once in the primary market.

Secondary MarketsA secondary market is a market for previously issued securities. The issuing firm is not directly affected by transactions in the secondary markets. A security can trade an unlimited number of times in secondary markets. The volume of trade in secondary markets is such higher than in primary markets.

Investment BankersAn investment banker specializes in marketing new securities in the primary market. Examples of Investment bankers are: Merrill Lynch, Sigma Manufactures Merchant Bank, etc.

Brokers and DealersThese generally participate in the secondary markets. A broker helps investors in buying or selling securities. A broker charges commissions, but never takes title to the security. A dealer buys securities from sellers, and sells them to buyers.

Financial IntermediariesThese are institutions that assist in the financing of firms. Example include; commercial banks and pension funds. These institutions invest in securities of other firms, but they are themselves financed by other financial claims. On the other hand, it is a sort of indirect financing in which savers deposit funds with the banks and financial institutions rather than directly buying bonds or shares and the financial institutions, in turn lend the money to ultimate borrowers. The Commercial Banks, Financial Institutions, Finance and Investment Companies, Insurance Companies, Unit Trust, Pension Funds etc., are examples of financial intermediaries.

II. Understanding ValueUnderstanding how capital markets work amounts to understanding how financial assets are valued. This is a subject on which there has been remarkable progress over the past 10 to 20 years. New theories have been developed to explain the prices of bonds and stocks. And, when put to the test, these theories have worked well. I, therefore, would like to give more stress in this area because the implication of this is applying in almost all parts of the corporate finance.

6

III. Time and UncertaintyThe financial manager cannot avoid coping with time and uncertainty. Firms often have the opportunity to invest in assets which cannot pay their way in the short run and which expose the firm and its stockholders to considerable risk. The investment, if undertaken, may have to be financed by debt, which cannot be fully repaid for many years. The firm cannot walk away from such choices- someone has to decide whether the opportunity is worth more than it costs and whether the additional debt burden can be safely borne.

IV. Understanding PeopleThe financial manager needs the opinions and cooperation of many people. For instance, many new investment ideas come from plant managers. The financial manager wants these ideas to be presented fairly; therefore, the proposers should have no personal incentives to be either overconfident or overcautious. Take another example. In some firms the plant manager needs permissions from the head office to buy a company car but not to lease it, and the line of least resistance may be to lease the car. In other firms the plant manager needs permission from the head office to buy or lease, and the line of least resistance may be to travel everywhere by cab. The financial manager has to be aware of these effects and has to devise procedures that will avoid as far as possible any conflicts of interest.

These are not the only reasons that financial management is interesting and also challenging.

Concept of FinanceDifferent finance scholars have interpreted the term ‘finance’ in real world variably. More significantly, as noted at the very outset of this chapter, the concept of finance has changed markedly with change in times and circumstances. For convenience of analysis different viewpoints on finance can be categorized into following three major groups:F.1. The first category incorporates the views of all those who contend that finance concerns with acquiring funds on reasonable terms and conditions to pay bills promptly. This approach covers study of financial institutions and instruments from which funds can be secured, the types and duration of obligations to be issued, the timing of the borrowing or sale of stocks, the amounts required, urgency of the need and cost. The approach has the virtue of shedding light on the very heart of finance function. However, the approach is too restrictive. It lays stress on only one aspect of finance. The traditional scholars hold this approach of financeF.2. The second approach holds that finance is concerned with cash. Since almost all business transactions are expressed ultimately in terms of cash, every activity within the enterprise is the primary concern of a finance manager. Thus, according to this approach, finance manager is required to go into details of every functional area of business activity, be it concerned with purchasing, production, marketing, personnel, administration, research or other associated activities. Obviously, such a definition is too broad to be meaningful.F.3. A third approach to finance, held by modern scholars, looks at finance as being concerned with procurement of funds and wise application of these funds. Protagonists of this approach opine that responsibility of a finance manager is not only limited to acquisition of adequate cash to satisfy business requirements but extends beyond this to optimal utilisation of funds. Since money involves cost, the central task of a finance manager while allocating resources is to match the benefits of potential uses against the cost of alternative sources so as to maximise value of

7

the enterprise. This is the managerial approach of finance which is also known as problem-centered approach, since it emphasizes that finance manager in his endeavor to maximise value of the enterprise has to deal with vital problems of the enterprise, viz., what capital expenditures should the enterprise make? What volume of the funds should the enterprise invest? How should the desired funds be obtained?

Let us move on to financial management, you all being students of management know the meaning of management. So let us discuss financial management now.

Nature of Financial ManagementFinancial 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. 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.

Another striking feature of financial management that explains its generic nature is the imperativeness of the continuous review of the financial decisions. As a matter of fact, financial decision-making is a continuous decision-making process, which goes on throughout the corporate life. Since a firm has to operate in an environment that is dynamic, it has, therefore, to interact constantly with various environmental forces in addition to changing conditions of the firm and adapt and adjust its objectives and strategies including financial policies and strategies. A one-time financial plan not subjected to periodic review and modifications in the context of changed conditions will be a fiasco because conditions may change to such an extent that the plan is no longer relevant and acts as a hindrance rather than help. Financial planning should, therefore, not be static. It has to be continuously adapted to changing conditions.

As you all are MBA students it is essential for you to know the interface between finance and other functions let us discuss. You all are studying other management subjects also let us relate those with finance.

Interface between finance and other functionsTill now you might have understood about the pervasive nature of finance. Let us discuss in greater detail the reasons why knowledge of the financial implications of their decisions is important for the non-finance managers. 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.

8

Marketing-Finance InterfaceThere are many decisions, which the Marketing Manager takes which have a significant impact on the profitability 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.

Production-Finance InterfaceAs 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 equipments 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.

Top Management-Finance InterfaceThe 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.

Economics - Finance InterfaceThe 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.Accounting - Finance Interface

9

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. complex and diverse responsibilities.

We all know it very well that environment keeps changing and thus brings in new challenges every time, let us discuss on the new challenges been faced by manager.

Managers are presently facing some new challenges as indicated below:> TREASURY OPERATIONS: Short-term fund management must be more sophisticated. Finance managers could make speculative gains by anticipating interest rate movements.> FOREIGN EXCHANGE: Finance Managers will have to weigh the costs and benefits of playing with foreign exchange particularly now that the Indian economy is going global and the future value of the rupee visa a vis foreign currency has become difficult to predict.> FINANCIAL STRUCTURING: An optimum mix between debt and equity will be essential. Firms will have to tailor financial instruments to suit their and investors' needs. Pricing of new issues is an important task in the Finance Manager’s portfolio now.> MAINTAINING SHARE PRICES: In the premium equity era, firms must ensure that share prices stay healthy. Finance managers will have to devise appropriate dividend and bonus policies.> ENSURING MANAGEMENT CONTROL: Equity issues at premium means managements may lose control if they are unable to take up their share entitlements. Strategies to prevent this are vital.

Prepared by:Dr. Sarbesh MishraNICMAR’s CISC, NAC CampusHyderabad – 500 084.E.mail – sarbesh@in.comWebsite: http://www.scribd.com/people/view/1074251

10