FINANCIAL MANAGEMENT

Prof. N. N. PandaGIACR Engg. College, Rayagada

Financial Management Meaning, Objectives and Functions

Financial Management means planning, organizing, directing and controlling the financial activities such as procurement and utilization of funds of the enterprise. It means applying general management principles to financial resources of the enterprise.

Scope/Elements1. Investment decisions includes investment in fixed assets (called as capital budgeting). Investments in current assets are also a part of investment decisions called as working capital decisions.2. Financial decisions - They relate to the raising of finance from various resources which will depend upon decision on type of source, period of financing, cost of financing and the returns thereby.

3. Dividend decision - The finance manager has to take decision with regards to the net profit distribution. Net profits are generally divided into two: a. Dividend for shareholders- Dividend and the rate of it has to be decided. b. Retained profits- Amount of retained profits has to be finalized which will depend upon expansion and diversification plans of the enterprise.

Objectives of Financial ManagementThe financial management is generally concerned with procurement, allocation and control of financial resources of a concern. The objectives can be-1. To ensure regular and adequate supply of funds to the concern.2. To ensure adequate returns to the shareholders which will depend upon the earning capacity, market price of the share, expectations of the shareholders?3. To ensure optimum funds utilization. Once the funds are procured, they should be utilized in maximum possible way at least cost.4. To ensure safety on investment, i.e, funds should be invested in safe ventures so that adequate rate of return can be achieved.5. To plan a sound capital structure-There should be sound and fair composition of capital so that a balance is maintained between debt and equity capital.

Functions of Financial Management1. Estimation of capital requirements: A finance manager has to make estimation with regards to capital requirements of the company. This will depend upon expected costs and profits and future programmes and policies of a concern. Estimations have to be made in an adequate manner which increases earning capacity of enterprise.2. Determination of capital composition: Once the estimation have been made, the capital structure have to be decided. This involves short- term and long- term debt equity analysis. This will depend upon the proportion of equity capital a company is possessing and additional funds which have to be raised from outside parties.

3. Choice of sources of funds: For additional funds to be procured, a company has many choices like- Issue of shares and debentures Loans to be taken from banks and financial institutions Public deposits to be drawn like in form of bonds. Choice of factor will depend on relative merits and demerits of each source and period of financing.4. Investment of funds: The finance manager has to decide to allocate funds into profitable ventures so that there is safety on investment and regular returns is possible.

5. Disposal of surplus: The net profits decision has to be made by the finance manager. This can be done in two ways: Dividend declaration - It includes identifying the rate of dividends and other benefits like bonus. Retained profits - The volume has to be decided which will depend upon expansion, innovation, diversification plans of the company.

6. Management of cash: Finance manager has to make decisions with regards to cash management. Cash is required for many purposes like payment of wages and salaries, payment of electricity and water bills, payment to creditors, meeting current liabilities, maintenance of enough stock, purchase of raw materials, etc.7. Financial controls: The finance manager has not only to plan, procure and utilize the funds but he also has to exercise control over finances. This can be done through many techniques like ratio analysis, financial forecasting, cost and profit control, etc.

FINANCE FUNCTIONS/DECISIONSThe following explanation will help in understanding each finance function in detail – Investment DecisionOne of the most important finance functions is to intelligently allocate capital to long term assets. This activity is also known as capital budgeting. It is important to allocate capital in those long term assets so as to get maximum yield in future. Following are the two aspects of investment decisionA. Evaluation of new investment in terms of profitabilityB. Comparison of cut off rate against new investment and prevailing investment.

Financial DecisionFinancial decision is yet another important function which a financial manger must perform. It is important to make wise decisions about when, where and how should a business acquire funds. Funds can be acquired through many ways and channels. Broadly speaking a correct ratio of an equity and debt has to be maintained. This mix of equity capital and debt is known as a firm’s capital structure.

Dividend DecisionEarning profit or a positive return is a common aim of all the businesses. But the key function a financial manger performs in case of profitability is to decide whether to distribute all the profits to the shareholder or retain all the profits or distribute part of the profits to the shareholder and retain the other half in the business. It’s the financial manager’s responsibility to decide a optimum dividend policy which maximizes the market value of the firm.

Liquidity DecisionIt is very important to maintain a liquidity position of a firm to avoid insolvency. Firm’s profitability, liquidity and risk all are associated with the investment in current assets. In order to maintain a trade-off between profitability and liquidity it is important to invest sufficient funds in current assets. But since current assets do not earn anything for business therefore a proper calculation must be done before investing in current assets.

PROJECT APPRAISAL Definition - Systematic and comprehensive review of the economic, environmental, financial, social, technical and other such aspects of a project to determine if it will meet its objectives.

The following are the points through which a project has to be appraised – 1. Technical – consideration of a project’s supplies (inputs) and its production (output), focusing on technical relations and aspects such as climatic features and attributes, soils, water, spatial considerations, etc.2. Institutional/organizational – concerns for the administration and management of projects. Here the focus is on the institutional factors and setting (e.g. laws and regulations), communication networks, structures of authority and responsibility, etc.

3. Social – consideration of the project’s impact on and implications for particular groups and regions, gender implications, wider effects on the health, culture, quality of life, etc. of those affected by it directly and indirectly. 4. Commercial – covering all the commercial considerations and arrangements for procurement of supplies and the marketing of output.

5. Financial – budgeting considerations such as operating expenses and investment funds required for various participating agencies; credit terms to be arranged, etc.6. Economic – this addresses the project’s impact and it’s worthwhileness from the viewpoint of the whole society. It is different from financial analysis in that it goes beyond the concerns of participating agents alone.

Tools of Financial Decision Making1. NPV Method2. IRR Method3. Pay-back Period Method4. Profitability Index Method-NPV /initial investment5. Accounting Rate of Return Method-avg. acc profit/initial investment

WORKING CAPITAL MANAGEMENT

Capital required for a business can be classified under two main categories, viz,1. Fixed Capital, and 2. Working Capital

Every business needs funds for two purposes-for its establishment and to carry out in day-to-day operation.

Long-term funds are required to create production facilities through purchase of fixed assets such as Plant and Machinery, Land, Building, Furniture, etc. investments in those assets represent that part of firm’s capital which is blocked on a permanent or fixed basis and Fixed Capital.

Funds are also needed for short-term purposes for the purchase of raw materials, payment of wages and other day-to-day expenses etc. These funds are known as Working Capital. In simple words, working capital refers to that part of the firm’s capital which is required for financing current assets.

THE NEED OR OBJECTS OF WORKING CAPITALThe need for working capital arises due to the time gap between production and realization of cash from. There is an operating cycles involved in the sales and realization of cash. There are time gaps in purchases of raw materials and production; Production and sales; and sales and realization of cash.

Thus, Working Capital is needed for the following purposes:i. For the purchase of raw materials, components and spares.ii. To pay wages and salaries.iii. To incur day-to-day expenses and overhead costs such as fuel, power and office expenses, etc.iv. To meet the selling costs as packing, advertising, etc.v. To provide credit facilities to the customers.vi. To maintain the inventories of raw material, work-in-progress, stores and spares and finished stock.

KINDS OF WORKING CAPITAL• On the basis of concept • On the basis of time

On the basis of Concept: Working capital is classified as gross working capital and net working capital.

1. Gross Working Capital: The term working capital refers to the gross working capital and represents the amount of funds invested in current assets. Thus, the gross working capital is that capital invested in total current assets of the enterprise.2. Net Working Capital: The excess of total current asset over total current liabilities is known as Net working Capital. Net Working Capital = Current Assets – Current Liabilities

On the basis of Time: Working capital may be classified as:1. Permanent or Fixed Working capital: Permanent or fixed working capital to the minimum amount which is required to ensure effective utilization of fixed facilities and for maintaining the circulation of current assets. This minimum level of working capital is called as Permanent Working Capital as this part of capital is permanently blocked in current assets.

The permanent working capital can further be classifies as: i. Regular Working Capitalii. Reserved Working Capital2. Temporary or variable working Capital: It is the amount of working capital which is required to meet the seasonal demands and some special exigencies. Variable working capital further be classifies as-i. Seasonal Working Capitalii. Special Working Capital

FACTORS DETERMINING THE WORKING CAPITAL REQUIREMENTSThe working capital requirements of a concern depend upon a large number of factors such as nature and size of business, the character of their operations, and the length of production cycles.

The following are important factors generally influencing the working capital requirements:1. Nature of Business - The working capital requirements of a firm basically depend upon the nature of its business. Public utility undertakings like Electricity, Water Supply and Railways need very limited working capital because they offer cash sales only and supply services, not products, and as such no funds are ties up in inventories and receivables. On the other hand trading and financial firms require less investment in fixed assets but have to invest large amounts in current assets like inventories, receivables and cash; as such they need large amount of working capital.

2. Size of Business or Scale of Operations - The working capital requirements of a concern are directly influenced by the size of its business which may be measured in terms of scale of operations. Greater the size of business unit, generally larger will be the requirements of working capital.

3. Production Policy - In certain industries the demand is subject to wide fluctuations due to seasonal variations. The requirements of working capital, in such cases, depend upon the production policy.

4. Manufacturing Process/Length of Production Cycle - In manufacturing business, the requirements of working capital increase in direct proportion to length of manufacturing process. Longer the process period of manufacture, larger is the amount of working capital required.

5. Seasonal Variations - In certain industries raw material is not available throughout the year. They have to buy raw materials in bulk during the season to ensure an uninterrupted flow and process them during the entire year. A huge amount is blocked in the form of material during such season, which gives rise to more working capital requirements.

6. Credit Policy - The credit policy of a concern in its dealings with debtors and creditors influence considerably the requirements of working capital. A concern that purchases its requirements on credit and sells its products/services on cash requires lesser amount of working capital. On the other hand a concern buying its requirements for cash and allowing credit to its customers.

7. Rate of Growth of Business - The working capital requirements of a concern increase with the growth and expansion of its business activities. 8. Earning Capacity and Dividend Policy - Some firms have more earning capacity than others due to quality of their products, monopoly conditions, etc. Such firms with high earning capacity may generate cash profits from operations and contribute to their working capital.

9. Price Level Changes - Changes in the price level also affect the working capital requirements. Generally, the rising prices will require the firm to maintain larger amount of working capital as more funds will be require to maintain the same current assets. The effect of rising prices may be different for different firms. Some firms may be affected much while some others may not be affected at all by the rise in prices.

Advantages of having adequate WC1. Solvency of Business2. Goodwill3. Easy Loans4. Supply of Raw Materials5. Payment of wages, salaries, etc.6. Ability to face financial crisis.

Financing WC1. Permanent sources like shares, debentures, public deposits and loans from financial institutions.

2. Temporary sources like commercial banks, trade credits, advances and account receivables.