Scope of Financial Management12

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MEANING & DEFINITION OF FINANCIAL MANAGEMENT

Financial Management is that managerial activity which is concerned with the planning and

controlling of the firms financial resources. It encompasses the procurement of the funds in the

most economic and prudent manner and employment of these funds in the most optimum way to

maximize the return for the owner. It is concerned with overall managerial decision making ingeneral and with the management of economic resources in particular. All business decisions

have financial implications and therefore financial management is inevitably related to almost

every aspect of business operations.

Financial Management has been defined differently by different authors. Some definitions of

Financial Management are as follow:

J.F. Bradley, Financial Management is the area of business management devoted to

a judicious use of capital and a careful selection of sources of capital in order to

enable a business firm to move in the direction of reaching its goals.

J.L. Massie, Financial Management is the operational activity of a business that is

responsible for obtaining and effectively utilizing the funds necessary for efficient

operations.

J.F. Weston & E.F. Brigham, Financial Management is an act of financial decision

making, harmonizing individual motives and enterprise goals.

Howard & Upton, Financial Management may be defined as that area or set of

administrative functions in an organization which relate with arrangement of cash and

credit so that the organization may have the means to carry out its objective as

satisfactorily as possible.

Hence, Financial Management is that specialized function of general management which is

concerned with the timely procurement of adequate funds and their effective utilization for theefficient functioning of the business enterprise. Financial Management therefore includes

financial planning, procurement of finance, investment of funds and financial control.

The Financial Management is neither a pure science nor an art. It deals with various methods and

techniques which can be adopted, depending on the situation of business and the purpose of

decision. As a science, it uses various statistical and mathematical models and computer

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applications for solving the financial problems relating to the firm. For Example- Capital

investment appraisal, capital allocation and rationing, optimizing capital structure mix, portfolio

management etc. Along with the above, a Finance Manager is required to apply his analytical

skills in decision making. Hence, Financial Management is both a science as well as an art.

SCOPE OF FINANCIAL MANAGEMENT

The scope of financial management is determined from the stages of development of the study.

Financial management developed as a separate subject from economics in the year 1920. Its

scope has enlarged to make it an integrated and complete subject for every organization. Since

1950 it has assumed an important status. The scope of financial management is usually discussed

in these two phases and called traditional scope and modern scope of financial management.

TRADITIONAL SCOPE OF FINANCIAL MANAGEMENT

Traditionally financial management was used by corporate organizations mainly for the purposeof finding the sources of funds and the methodologies of raising them from such sources and

utilizing them for the organizations requirements. It also incorporated the legal and accounting

requirements relating to sources and uses of funds.

Traditionally Financial Management was known as Corporation Finance and was called the

outsider looking approach .Its emphasis was centered on the following three issues:

To organize funds from different sources like banks, investment companies and financial

institutions.

To use financial instruments in the form of shares, debentures, bonds, fixed deposits for

companys requirements.

To settle the organization of funds through proper administration, preparation of reports,

legal advice and proper accounting records.

The traditional financial management had the following limitation:

1. External Decisions and not Internal Decision Making

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Financial management emphasized the role of those who supplied funds to the corporate

organization. It was focused on outsiders like financial institutions, investment bankers and

banks. Therefore, it did not consider the role of the insideor decision relating to internal

problems of the organization.

2. Long term Decisions and not Day to Day Decision Making

Traditional financial management focused on the long term capital planning. However, a

company cannot run on commercial activities without planning for its day to day working

capital. While investment decisions were given full consideration, working capital

managementwas not given any importance. In fact, it was completely ignored.

3. Procurement and not Allocation of Funds

The main interest of rendering financial management services was in procuring funds for

the business requirements of the firm. The question of how to use the funds and what

techniques should be used to allocate the funds was not considered.

These limitations made financial management an incomplete subject to run an organization

effectively and its role was confined to profit making and duplicating some of the work of

accountants rather making it an independent identity to solve the problems of acquisition and

allocation of funds. With the development of financial management it has become a complete

study of all the requirements of a corporate organization. It has also developed into an insider

looking approach taking care of not only the requirements from the suppliers point of view but

also the requisites of internal decision making and management.

MODERN FINANCIAL MANAGEMENT SCOPE/ FUNCTIONS

The modern scope of Financial Management has enlarged to include the following aspects of

an organization:

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To take financial decisions. (Investment, Financing and Dividend decisions).

Managing the flow of funds (To match inflows and outflows of cash).

To make a profitable venture (To see that losses are minimized).

To create value for wealth management of share holders (To invest and finance

carefully).

To balance conflicting goals for firm (Liquidity Vs Profitability, Profit Maximization Vs

Wealth Maximization, Risk and Return).

To manage different groups of people (Shareholders, management, investors,

government, customers and suppliers).

To take up social responsibility (To maintain fair practices like safety in working

conditions, providing fair wages to employees and looking after community interests).

Modern Financial Management is a concept of overall management of a company. Its scope is

broadly divided into three important decisions which may also be called the functions of

financial management/financial manager. These are investment decisions, financing decisions

and dividend decisions. It covers the areas of sourcing of funds, financial analysis, attaining an

optimum capital structure, profit planning and control, project planning and evaluation and

corporate taxation. It takes care of internal and external management of funds and covers therequirements of different groups of people such as shareholders, management, investors,

government, customers and suppliers.

1. Investment Decision Making

A firm is required to take decisions relating to acquisition of long term assets and current assets.

Capital investment proposals require heavy investment. Therefore, there is the need for

evaluating them through techniques adopted in financial management. The long term decisions

will affect a firm for many future years. Once a volume of funds has been invested it is

important that the assets are used for the requirements of the firm. If allocated incorrectly the

firm will have long term repercussions in its internal management. The scope of financial

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management extends to taking decisions carefully for capital investment also called capital

budgeting.

2. Financing Decisions

A financial manager has to procure funds from different sources. He has to decide the quantum

of funds and the type of source that he should use for the firm. There is a cost attached to every

source of fund and hence balance has to be maintained between debt and equity. Debt as a

source is considered to be cheaper than equity as a resource but it is of high risk and the firm

should be able to repay its interest on taking debt. Financing decisions are taken through an

analysis of leverages to get the benefit of the funds. The scope of financial management

therefore extends to an analysis of operating leverage and financial leverage, earnings per share

of shareholders, the relationship of earnings before interests and taxes and earnings per share

and capital structure relationship. These decisions will help the company in finding out whether

it is able to cover its costs and decisions relating to new projects or expansions of their

operations.

3. Dividend Decisions Making

The scope of financial management also extends to the provision of providing dividends to

shareholders. A company cannot pay all its profits as dividends to shareholders. If it does so, the

company will not be able to fund new projects. Dividend decision making pertains to an

analysis of the right amount of dividend to be distributed to shareholders. It has to take care of

the legal restrictions and accounting processes before giving a dividend. The correct decisionshave to be taken regarding the percentage of reserves before distribution of dividends.

Therefore, financial management within its scope considers investment decision, financing

decision and dividend decision. Thus, it covers all the internal aspects of a firm.

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4. Solving Agency Problems

Financial management has an impact on different kinds of people associated internally and

externally with the organization. It covers the interest of both insiders and outsiders. Many typesof conflicts can arise while managing a firm. In normal pattern financial decisions have to be

taken to satisfy the requirements of shareholders, employees, customers, debt holders, suppliers

of the firm, general public, government and management. The problem that can arise is called

the agency problem or the conflict in decisions that satisfy the different groups of people.

The shareholders would be interested in maximizing their earnings but the creditors would be

interested in receiving a high rate of interest. The employees would be interested in high

perquisites. The management would be concerned about their own interests of profitability in

the firm. The financial manager has to take care that the needs of each of the groups is satisfied.

If there are any conflicts and costs arise out of the agency problem, financial management helpsin solving personal goals to make the working environment friendlier.

Other groups of people that are important for the organization are government, customers,

dealers and general public. All these groups of people are within the working scope of a

financial manager. He has to deal with all these groups of people and come to viable solutions to

make the organization profitable.

5. Balancing Profitability And Liquidity

Conflicts in goals have to be solved as they are within the ambit of the scope of financial

management. A firm has to balance its conflicts between being profitable and liquid. When

profitability increases a financial manager may have the problem of low liquidity as all the

funds may be used to make the profitable. Similarly, if there is too much availability of funds

but the firm does not make use of them then a cost will be attached to it. Hence the scope of

financial management is to balance conflicts in profitability and liquidity.

6. Profit And Wealth Maximization

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Modern financial management considers wealth maximization as a comprehensive term but the

financial manager has to make profits to make a commercial organization viable. He must try to

see that decisions relating to investment, financing and dividends are taken carefully so that the

earning per share of the shareholders increase. However, if profitability is low, earnings will not

increase. Therefore, in a sense profit maximization is incomplete but wealth maximization is a

complete concept and is superior to profit maximization as it works under the principles of

financial management.

7. Risk and Return

High return brings about high risk but an organization has to consider several factors before

undertaking high risk because it can make loss if decisions are not taken properly. Therefore,

the scope of financial management is to invest cautiously through proper calculations by

applying techniques through matching of risk with return. A financial manager must calculate

the risks attached to an investment and its effects on the organization.

Every decision that a financial manager takes will have the dimension of both risk and return.

The degree of risk in each decision will be different. A decision cannot be risk free because

market risks cannot be completely eliminated. There are two important risks. These are called

systematic and unsystematic risk. The unsystematic portion of the risk can be reduced till it

becomes nil if proper controls are scheduled but market risks depend on factors beyond the

control of individual. A combination of risk and return which gives optimum results to a firm is

called risk return trade off.

8. Social Responsibility

The scope of modern financial management now extends to ethics and social responsibility.

Although the functions of financial manager are primarily towards making an organization to

source and use funds effectively, it has an added responsibility of being fair to the people withinand outside the organization. Every organization should be engaged in providing fair wages to

employees and fair dealings with the community.

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OBJECTIVES OF FINANCIAL MANAGEMENT

The objectives of financial management should have the characteristics of clear, unambiguous

and well defined goals. Its decisions should relate to the fact that a firm/ company will have a

long term existence. Profit is a test of economic efficiency of an organization. Financial

management deals with efficient sourcing and utilizing funds but it goes beyond maximization

of profits. It believes in not only the quantity of profits for efficiency in a firm but also the

benefits of quality. It therefore has qualitative and quantitative benefits in a firm.

Profit Maximization is a narrow objective of financial management but Wealth

Maximization can be called the comprehensive term that covers the objectives of financial

management and is superior to profit maximization.

The objectives of financial management are discussed by first understanding the concepts of

profit maximization and wealth maximization. Since profit maximization concept has certain

limitations and is narrow in approach. Wealth maximization is considered to be the ultimate

goal of financial management.

1.1PROFIT MAXIMIZATION

Profit maximization is an accounting term. A firm incurs revenue expenses and receivesrevenue returns during a year. At the end of the year a statement is prepared to find out the

checks and balances of the year. If its revenue is higher than its expenses it makes a profit

and this profit judges the efficiency level of an organization. All organizations apply this

method for providing to the third parties the picture of the firm. This aspect is like the

older concept of financial management. In the modern day world there are more

complexities in an organization. Profit maximization helps an organization to find out

whether it is able to cover its costs or not. However, it has some benefits and limitations:

Benefits of Profit Maximization:

Profit maximization is useful in an organization for the attainment of the following

benefits:

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1. It acts as a barometer to an organization to find out whether the firm is running

efficiently as a commercial enterprise or it is unable to meet its expenses.

2. It provides information about the company to people who would like to invest in it. A

profitable company becomes an attractive investment.

3. If a firm is profitable then the company can decide to expand or diversify its business.

Limitations of Profit Maximization:

Profit maximization has the following limitations:

1. Profit maximization does not study the concept of time value of money.

2. It concentrates towards providing a rosy picture to the third parties and public but it is

not concerned with decision making for internal efficiency.

3. It does not have techniques or theories through which it is able to analyze risks of a

firm.

4. It focuses on profit and does not take any steps towards maximizing the wealth of the

shareholders.

5. It makes quantitative calculations but does not consider the qualitative aspects of an

organization. For example, it does not take steps towards responsibilities and ethics for

society.

6. Profitability is based on accounting concept. It does not give a clear picture because it

does not take inflows and outflows of cash for calculation. It includes depreciation and

this is not a true indication of the cash flows in an organization.

7. Profit maximization must be used with wealth maximization to support the modern

scope of financial management.

1.2WEALTH MAXIMIZATION

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Wealth maximization is based on the principles of the financial management. It is superior

to profit maximization. It takes into consideration time value of money, cash flows, risk

and return and considers only incremental cash flows of the organization. Its main

objective is to create and manage wealth of the shareholders to maximize it while

organizing it.

The wealth of the shareholders can be maximized by taking investment, financing and

dividend decisions carefully. This means that the techniques of financial management

should be applied to get maximum benefit. Wealth can be maximized when the present

value of the share can be calculated through time value management and by using the cash

flows technique in finding out the present value and future values of the share.

Wealth can be maximized by analyzing the features of risk and finding out the amount of

return. This provides an understanding to the market value of the share. Therefore, it

measures the concepts of risk and uncertainty.

Wealth maximization also considers qualitative aspects. It considers the requirements of

different groups of people in the organization. It identifies the requirements of

shareholders, employees, management, government, customers, agents and suppliers. It

resolves agency problems and costs attached to any conflicts arising out of their

interaction.

Modern financial management also applies ethical and social responsibility issues while

maximizing the wealth of the shareholders.

Benefits Of Wealth Maximization:

Benefits of wealth maximization can be summarized as follows:

1. Maximization of shareholders wealth analyses the present value of the share and the

future values through the application of financial management principle.

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2. It applies time value of management through compounding and discounting

techniques for single and multiple cash flow for a future period or finding out the

present value of a share. It also provides an understanding of multiple compound

periods, annuities and annuities due.

3. It applies the cash flow concept which is according to the principles of financialmanagement. It considers cash items only and in this way it is able to calculate the

correct resources of the organization.

4. It applies qualitative analysis to the problems of different groups of people in and

organization. Therefore, it covers the qualitative techniques and also qualitative

aspects in an organization.

5. Wealth maximization is a concept which is applied only with ethical and moral values

such as fair wages, minimum wage regulation, prohibition of child labour, creating

friendly environment, pollution control etc.

6. Wealth maximization is clear, not ambiguous and has proper techniques of analysis

for calculation of the valuation of share, dividend, present and future values of a share.

This reflects in the market value of the share.

PROFIT MAXIMIZATION vs WEALTH MAXIMIZATION

S.No. Basis of Difference Profit Maximization Wealth Maximization

1. Nature It judges the performance of anorganization through the

calculation of profits and losses.

It judges not only the firms performance but also the

earnings per share of theshareholders.

2. Applicability of TimeValue of Money

Concept

It ignores time value of money forfinding out the performance of a

company

It considers time value ofmoney for finding out the

present value and future

value of shares.

3. Consideration It considers accounting profit but

does not take cash flow analysis.

It takes into account cash

flow analysis which is basedon the principles of financial

management.4. Risk ReturnRelationship

It considers return but does notanalyze risks attached to it.

It analyzes both risk andreturn according to the

techniques of financial

management.

5. Basis of Decision

Making

It takes decisions on the basis of

quantitative analysis.

It takes investment financial

and dividend decisions on

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the basis of quantitative and

qualitative aspects.

6. Cash and Non Cashitems

It takes cash and non cash itemsfor finding out the performance of

the company.

It takes only cash items asaccording to the principles

of the financial

management. Non cashitems do not give the correct

picture of cash flows in an

organization.

7. Social and Legal

Aspects

It does not make any analysis on

the qualitative aspects of anorganization.

It analyzes social and legal

aspects of running anenterprise and considers

quantitative and qualitative

aspects.

RELATIONSHIP OF FINANCIAL MANAGEMENT AND OTHER

AREA OF MANAGEMENT

Financial management is closely related to other subjects. An insight of its relationship

with other subjects is as follows:

Financial Management and Financial Accounting:

Accounting is a resource or an input to financial management decisions. Financial

management and financial accounting are complimentary to each other. The accounting

tools are an input to financial decision making. Financial accounting uses financial

statements like balance sheet, profit and loss account; fund flow and cash flow statements

to project the profitability of the firm. Financial management uses the information to make

decisions relating to investment, financing and dividends to reach the goal of wealth

maximization.

The modern concept in which financial management has developed brings about the fact

that both financial management and financial accounting resemble each other. They arecomplementary, yet two different areas of study. It is often stated that the accounting

manager is responsible for providing information to the finance manager for decision

making in a corporate organization.

Financial Management and Economics:

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Financial management branched out from the subject of economics and is complementary

to macro and micro economics. Both finance and economics make an analysis of money

and capital markets, financial intermediaries, banking system, monetary credit and fiscal

policy. Financial management takes the information relating to the financial environment

and prepares policies for firms and takes financial decisions within the ambit of the

monetary and fiscal policies in an economy. Changes in economic policy have to be

applied by the financial manager whole taking decisions.

Micro economics consists of concepts and theories relating to supply and demand, price,

profitability and profit maximization strategies. Financial decisions have to continuously

evaluate price of a product, sales revenue and financing decisions of a firm.

Financial Management And Marketing Management:

Financial management and marketing management are inter related in a firm/company.

All marketing decisions are based on financial implications. Good credit and discount

polices for customers, sales, credit, revenue, advertisement budgets, brands, patents are

part of the activities of a financial manager as it affects the liquidity position of a firm.

Financial Management And Human Resource Management:

Human resource management is complementary and in some ways dependent on a

financial manager to take decision regarding recruitment and placement of manpower as

there are financial implications affecting the liquidity of a firm. People should be hired

only after calculating the costs to the company as well as the benefits occurring after

hiring certain people. A balance will have to be maintained as liquidity and profitability as

well as the well being of the shareholder will be considered.

Financial Management And Production Management:

The production department in an organization is given the responsibility of procuring

material, machineries, spares and consumables and inventory. The financial manger has to13


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take financial decisions and make financial policies after finding out their implications on

decision-making areas like capacity utilization, replacement of machines, installation of

safety systems and increase in production capacity to enhance sales. The policies of

financial manager has a direct implication on the company/firm as a whole because excess

inventory will cause carrying costswhereas reduce inventory will have implication of

cost of not carryingaffecting the production of the firm.

Financial management has thus become useful for obtaining funds as well as for their

efficient allocation. It is related and complementary to financial accounting, economics,

marketing, human resources and production management. The financial manager balances

liquidity with profitability after which he approves of an activity of expenditure. An

insider looking approach is used with the goal of wealth maximization of the

shareholder. The financial manager has thus a high status in an organization.

LIQUIDITY VS. PROFITABILITY

Liquidity and profitability in a firm are conflicting goals that a financial manager has to

balance. Liquidity means that a firm is able to make its payments timely. Profitability will

enable a firm to be informed whether its business is sustainable and will continue to

function. If a firm is profitable, it will continue its operations if it has cash to pay for its

obligations. Therefore, liquidity and profitability move in a circle with risk and return.

Liquidity may be achieved by the following:

(i) Managing Flow of Funds: Adequate cash in the company for making payments.

(ii) Matching Cash Flows: A firm forecasting its future cash inflows with its cash

outflows.

(iii) Sourcing of Funds: To identify resources within the organization and the

possibility of raising funds as required on an immediate basis for making

payments.

(iv) Cash Reserves: To identify internal reserves to meet contingencies of the firm.

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Profitability can be attained in the following manner:

(i) High Risk High Profitability: To increase profitability by using leverage.

(ii) Forecasting Future Profit: To evaluate expected profits by forecasting them.

(iii) Measure Cost of Capital: To find out the cost of each source of capital as it is

linked to profitability.

(iv) Cost Control Measure: To control each department by proper maintenance of

records and making effective policies.

(v) Pricing: A good pricing system of the products of the organization will help in

bringing about profitability in a firm.

METHODS / TECHIQUES OF FINANCIAL MANAGEMENT

Modern financial management covers tools and techniques of evaluation in the following

areas:

1. Capital Budgeting: The techniques in capital budgeting provide an analysis for

selection of a single project as well as for taking mutually exclusive decisions through

different traditional and modern discounting methods of payback period, average rate of

return, net present value, profitability index and internal rate of return.

2. Cost of Capital: Decisions relating to sources of capital and costs relating to different

sources of funds can be taken by applying the tools a method of determining cost of

capital and optimum capital structure of a firm.

3. Operating and Financial Leverage: Leverages provide an assessment of the

commercial viability and financial viability of a concern. By applying these techniques a

firm can avoid financial distress situation.

4. Working Capital: Modern financial management provides models, theories, concepts

and practical applications for management of cash, procurement of optimum inventory

and effective management of current assets.

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5. Fund Flow and Cash Flow Analysis: This technique provides to a financial manager

the basis for finding out the sources of funds and their utilization. The projected analysis

of funds and cash assists a firm in future working capital requirements of a firm.

6. Dividend Decisions: Dividend models provide a basic understanding to the corporate

policy, amount, form and time of dividend payment.

7. Economic Value Added (EVA): A financial manager has the important function to

create economic value to the organization. EVA will provide the company after tax

profits from operations by deducting the cost of capital employed to produce those

profits. EVA brings about financial discipline and maximizes the wealth of the firm by

taking correct decision.

S.No. Type of Decision Tools/Methods1. Investment Decisions Capital Budgeting Payback, Average

Rate Of Return, Net Present Value,

Internal Rate Of Return, ProfitabilityIndex.

Working Capital Management, ABC

Analysis, Inventory Pricing, Aging

Schedule, Cash Management Models,

Concentration Banking, EOQ Model,Liquidity vs. Profitability, Receivables

And Discount Management.

2. Financing Decisions Operating and Financial Leverage,

Trading on Equity, Cost Of Capital.

3. Dividend decisions Dividend Policy, Models, Forms,Payment.

4. Performance Evaluation Decisions Ratio Analysis, Cash Flow, Fund FlowAnalysis, Budgetary Control, EVA.

ORGANIZATION OF FINANCE FUNCTION

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Financial management is important and inter related with the other departments of a firm. It

prepares financial policies for all the departments of the firm. The organization structure of a

firm shows that all large firms have voice presidents in different fields directly below the

president of accompany. Amongst the vice presidents of different departments there is also aposition especially for a vice president in the area of finance. The financial function assumes

important due to its work of both a controller and a treasurer. The company prepares policies,

evaluates and reviews tax planning and management, cost accounting management, credit

administrating, investments and banking through its financial controller functions.

The Treasury function is engaged with financing planning and fund raising, cash

management, credit management and foreign exchange management. Its function consists of

providing a good cash balance and matching of cash inflows and cash outflows to meetliquidity requirements of the firm. It is able to control conflict situations such as agency

problems. It also involves public relation and interaction of the firm with capital market and

financial markets.

The primary concern of the financial departments is the creation of wealth for its shareholders.

Apart from the shareholders the financial managers have to take a decision to satisfy various

groups of people. Financial decision-making is also under the constraints of responsibility

towards government, legal and environmental aspects and responsibilities towards society.

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BOARDOF DIRECTORS

PRESIDENT


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The financial manager has to be closely connected with the borrowers of the firm. It covers

individuals and organizations providing funds to the company. The finance function manager

has to be responsible towards such borrowers. Financial policies and decisions have to be taken

to favor the customers and suppliers of the firm to enhance the reputation and value of the firm.

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Vice-President

Marketing

Vice-President

Finance

Vice-President

Production

Chief

Finance

Manager

Chief

Finance

Manager

Tax

Manager

Data

Processing

Capital

Expenditur

e Manager

Appraisal

or

Cost

Accounting

Financial

Accounting

Manager

Appraisal or

Reporting

Cash

Manager

Portfolio

Manager

Credit

Collection


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Financial decision-making thus affects shareholder, government agencies, customers, creditors

and debtors of the firm and the general public. The finance director is responsible for taking

decisions to suit the requirements of all these groups of people and institutions.

The finance function also covers functional areas such as marketing, human resources and

production. Each financial manager has a role to play and the reports to the vice- president of

finance. The managers perform the specific treasury and controlling functions. Each manager

looks after one of these functions. The ultimate authority is that of the finance vice-president

and reports to the president and other functional vice-presidents regarding policies and controls

of that functional department. The financial policies are continuously reviewed and evaluated.

They work according to the principles of financial management.

**********************

SOURCES OF FINANCE

CLASSIFICATION OF SOURCES OF FINANCE

The different sources of finance that are required by a company can be classified into long term,

medium term and short term funds. The short term requirements are usually due to the non

synchronization of cash inflows with outflows. Short term sources of funds are useful for

investment in current assets. Such requirements range from a period of one day to a maximum of

one year. The sources of short term financing are trade credit, factoring and forfeiting, bill

discounting, overdrafts and cash credits from banks and borrowing against receivables. The firmcan also get short term funds from customers as advances on purchases, and through the use of

credit cards. Long term requirements are for acquisition of long term fixed assets. Long term

sources of funds are needed for a period of 5 to 25 years for investments when a company takes a

decision to start a new venture or expand its present business. The sources of long term finance

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are from internal resources like retained earnings and external sources are from equity capital,

debentures, bonds, preference shares, term loans and innovative instruments.

A company also needs medium term finance for a period of 1 to 5 years. Medium term finance isneeded by a company to make permanent additions to their working capital or to buy fixed

assets. Repayment of loan taken by the company for such an intermediate period is done by

liquidating the assets is financed or through profits or cash flow it generates from its operations.

The sources of medium term finance are leasing and hire purchase as well as fixed deposits from

public and directors of the company and medium term loans from banks.

The classification of sources of funds can be summarized as follow:

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SOURCES OF FINANCE

LONG TERM

a) Equity Share Capital

b) Redeemable Preference

Share

c) Debentures/Bonds

d) Long Term Loans

e) Seed Capital

a) Medium Term

Loans

b) Deferred Credit

c) Public FixedDeposit

d) Leasing & Hire

Purchase

a) Cash Credit

b) Overdraft

c) Bill Discounting

d) Commercial Paper

e) Export Credit

f) Trade Credit

MEDIUM TERM SHORT TERM


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FACTORS AFFECTING THE CHOICE OF A SOURCE OF FINANCE

Funds for financing companys requirements should be analyzed before the company looks for

sources of funds. Factors to be considered while taking funds for a companys requirements are

as follow:

1) RISK

The objective of financial management is to maximize the wealth of the shareholders. To fulfill

this objective the financial manager should consider the risk and return of all the loans taken on

behalf of the company for short term, medium term and long term requirements. Every source of

funding is a loan be it short or long and has the various kinds of risks attached to it. If the

company requires a higher return it has to be prepared for higher risks. Higher risks may

temporarily bring about a good return but in the long run it is a potential threat to the

shareholders and to the existence of a company so the risks and return trade off must be

considered. Market risk is not controllable as it depends on factors external to the company.Internal risks can be controlled through good management policies. To emphasize, risk and

return dimension cannot be ignored, the amount of funding required should be carefully analyzed

before the company actually decides on taking it.

2) RETURN ON FUNDS:

When funds are sourced from the market the financial manager must remember his obligations

towards the shareholders. He should assess the level of expectation of return of the shareholders.

He must see the effect of new finance in the company with respect to the expected profitability of

the company. Interest will have to be paid on the borrowed capital. This may have the effect of

increasing or decreasing profitability. Only when the financial manager feels that the return

brought about will be good from taking a loan he should take it.

3) COST OF FINANCING:

There are several costs attached to funding an enterprise. The cost of serving the finance through

interest payments is a major cost and needs analysis before committing the company to it. There

is a cost of excess funding as well as if the funds were less than the firms requirements. The cost

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of illiquidity in the event of not using the funds increases the cost to the company. If a company

does not use the funds that it has scored and cannot return it, the funds become illiquid.

4) DEGREE OF CONTROL:

Type of funds must be analyzed carefully to see that the control of the shareholder is not diluted

by taking loans. The increase in the numbers of creditors will reduced the power of the

shareholders as they have to return the money to their creditors in addition to paying them

interest. The capital structure of the company should be balanced and there should not be a very

high level of debt on it. A ratio of 2:1 is acceptable as debt reduces cost because of deduction in

taxation.

MAJOR SOURCES OF FINANCE TAPPED BY THE

COMPANY

I) SECURITY FINANCING

Security financing is a method of getting external source of financing for the company. Theimportant securities which help in raising funds for a company are as follow:

EQUITY SHARES: Equity Shares are called ownership shares because the

holder of the shares participates in earnings of the company by receiving dividends from it.

The ownership rights are exercised through voting in important decision making areas of the

company. Equity shares are called high risk securities because its return varies with the

profitability of a company. Dividend is declared by the company only after making a

provision for reserves, depreciation and taxation. However, equity shares have the benefit of

being traded in a secondary market if its shares are listed on the stock markets.

PREFERENCE SHARES: Preference shares have ownership rights in the company.

They have a right to receive dividends of the company. They have a preferential right receive

dividends before the equity shareholders of the company. Preference shares do not have

voting shares and they have fixed dividends. Although preference shares resemble equity

shares they have certain special features. They can be issued as cumulative or non-

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cumulative shares, redeemable or irredeemable, participating and non-participating,

convertible and non-convertible shares.

DEBENTURES/BONDS: Debentures and Bonds are debt securities they have thesame features. They have a specified rate of interest and a date of maturity. They are both a

form of sourcing finance for long term purposes.

II) LOAN FINANCING

Long term loans are taken by the industrial organization at the time of starting a new business for

expanding their business activities. These loans are of period between 5 years to 10 years. InIndia such loans were being disbursed to industry by financial institutions like Industrial

Development Bank of India (IDBI), Industrial Credit and Investment Corporation of India

(ICICI) and Industrial Financial Corporation of India (IFCI). These institutions were specially

setup to provide financial support and facility to industry for development. Commercial banks

since 1991 after Indias new economic reforms have emerged into institutions providing long

term loans in addition to their services to provide loans only for working capital requirements to

industries.

ADVANTAGES DISADVANTAGES

1) Term loans taken by industry from

financial institutions are attractive because

they have a low rate of interest and have alow financial burden on the resources of the

company.

1) Term loans have restrictions on the working

of the company.

2) It has the advantage of a moratorium

period. Thereby, the company does not haveto pay in the beginning years of taking a

loan.

2) Some covenants are negative and the

functioning of the company become difficult because permission has to be taken from the

lender for every small change it wants toincorporate.

3) Interest charges are tax deductible. 3) Flexibility in working is reduced and the

company has to work according to the rules and

regulations framed by the lender until the loan isreturned.

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III) PROJECT FINANCING

Project financing refers to managing and financing the economic activities of large

infrastructural projects. High cost with large volume of funds such as power stations, fertilizer plants, satellites, oil, gas and hotel projects are some infrastructure related project. Special

techniques are required to manage its finances. The financial techniques which had been applied

to oil and gas are now being used for financing other large projects. The two most important

aspects in project financing of these industries are risk and cash flow analysis.

Project finance is a series of techniques for assessing risks and calculations of cash flows

generated by a project. It is a method of risk sharing by the owner or sponsors and lenders of the

company. Project finance is risk management and risk sharing approach so that the owner or

sponsors exposure is limited. Banks and equity investors can get a greater spread over their cost

of funds or returns, enhancing their overall yield on portfolios. In this manner developingcountries can develop many projects. If government and private players become partners, then

government can use funds belonging to other than their own for developing projects with limited

liability for any shortfalls of cash required for payments of debt and equity holders.


1) It provides the companys owners tofinance large projects beyond the financialability of the company.

1) The projects consists of a large volumeof funds and are subject to risks. These add tothe cost of the project and are subject to losses.

2) The sponsors accounts do not have

the impact of the project finance because it is

a separate entity.

2) Project finance requires good management

from the lenders and the sponsors. It requires

risk management and cash flow analysis.

3) The high leverage used by project

financing benefits the equity holders.

3) Project finance requires many expenses like

government guarantees, paying royalties,raising debt.

4) Sponsors, customers, suppliers and

government share the risk of the project andtherefore projects of large magnitude can be

started for the development of the company.

4) Project financing requires surrender of all or

part of the interest to another company inexchange for finance and reduced net profits

and interest of these sponsors.

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IV) LOAN SYNDICATION

Loan syndication is a service provided by merchant bankers for financing a project or for

working capital requirements of a company. The financial institutions like IFCI, IDBI, ICICI,

Life Insurance Corporation of India, Unit Trust of India and General Insurance Companies and

State financial institutions like SFCs and SDCs are suppliers of finance for loan syndication.

The merchant bankers undertake the service of loan procurement and raising of loans from India

and abroad. They prepare the loan application forms and follow up the loan procedure with

financial institutions and banks.

V) BOOK BUILDING

New Issue Market and stock market are complementary to each other as they are inter-linked

through the functions that they perform. New Issue Market/Primary Market performs the

function of providing an environment for the sale and purchase of new issues; whereas stock

market has the function of trading the securities after the new securities are allotted and then

listed with it.


1) The company does not have to

identify potential sources of finance fortaking loans; merchant bankers take up the

work for a fee.

1) Merchant bankers provide services that are

fee based. This is an additional burden on theresources of the company besides the interest

charges that they have to pay to the financial

institutions and banks.2) Merchant bankers have preliminary

discussions with the financial institutions for

the benefit of both the parties. The companycan rely on their trusted merchant bankers to

get them the best deals.

3) Merchant bankers draw up the loandeed and also get the amount disbursed

quickly.

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Book building is the term which is used in the context of the sale of a new security offered forthe first time in the New Issue Market before the trading of this share begins in the stock market.

This is a new concept in India and is one of the developments in the financial market to bring

about a fair and just system of issuing shares through openness and public demand.

Book building is a process of offering shares to public in the new issue market through public

demand by bidding for the shares. Based on these bids price is discovered. A price band is given

and the public is asked to bid for the price within that band. The preferred price settles the

pricing of the issue. Book building facility was developed in the initial public offer to bring about

the flexibility of price and quantity, which would be decided on the basis of demand.

The bidding process is to be open for 5 days. The retail bidder has the option to bid at cut off

price, they are allowed to revise their bids and the bidding demand is displayed at the closingtime each day. The syndicate members can bid at any price.

VI) DEPOSITORY OR PAPERLESS TRADING

Dematerialization of securities for electronic trading of shares is one of the major steps for

improving and modernizing the stock market and enhancing the level of investors protection. Itis expected that it would eliminate bad deliveries and forgery of shares and expedite the transfer

of shares. Long-term benefits are expected to accrue to the market through the removal of

physical securities.

The stock market in India was computerized and trading was made online. The Depository Act

was passed in 1996 for trading online in shares that were dematerialized and transfer of security

through electronic book entry to help in reducing settlement risks and infrastructure bottlenecks.

The dematerialized securities do not have any identification numbers or distinctive numbers.

Dematerialization takes place in India through a multiple depository system. In India, there are

two depository services. The National Securities Depository Ltd. (NSDL) was set up in

November 1996. Another depository called the Central Depository Service Ltd. (CDSL) was also

set up for the purpose of transferring dematerialized shares. Trading of new Initial public offers26


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was to be in dematerialized form upon the listing of the shares. Dematerialized form of trading is

done only in shares. Debt instruments however, are not transferable by endorsement delivery.

ADVANTAGES1) Transactions carried out through the depository system eliminate risks, as it does not

have physical certificates. The problems regarding bad deliveries or fake certificates areavoided.

2) The transfer of securities is done electronically. As soon as the transaction is carried out

securities are transferred immediately.

3) There is no stamp duty on transfer of securities because there is no physical transfer of

certificate.

VII) FACTORING

Factoring is a financial service for financing credit sales in which receivables are sold by a

company to a specialized financial intermediary called factor. The factor provides several

services to the company that draws up an agreement, for managing its receivables. These

services pertain specially to protection of the company from credit risks. In addition the factor

also manages the finances of the company, maintains its accounts and collects its debts. For this

service the factor charges a fee or a commission for taking the responsibility of realizing thereceivables from the customers. Factoring involves 3 parties in the agreement. These are the

seller, the buyer and the factor.

While factoring is a financial intermediary for credit sales within the country. Forfeiting is

financing of receivables that arise out of international trade. Banks and financial institutions

purchase trade bills or promissory notes through discounting and cover the risk of non payment

at the time of collection of dues. The purchaser becomes responsible for the risk. He pays cash to

the seller on discounting of the bills.

VIII)VENTURE CAPITAL

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Venture capital finance is a private equity investment fund through which funds are borrowed by

investors who have the technical know how. The venture capitalists make an agreement whereby

they support the project and fund it, in return for momentary gains, shareholding and acquisition

rights in the business financed by them. This service has the advantage of merging of technical

ability with financial strength with part ownership of an enterprise coupled with capital gains.

The first venture capital fund in India was established by Industrial Finance Corporation of India

(IFCI) in 1975. It was called the Risk Capital Foundation (RCF). Venture Capital funds in India

are of four different types. These are the sponsored venture capital funds by development

financial institutions, the state level sponsored development financial institutions, funds

promoted by public sector banks and the private venture capital funds.

IX) CREDIT RATING

Credit rating is a service provided by a credit rating agency for evaluating a security and rating it

by grading it according to its quality. In India, credit rating had its inception in 1987 with the

incorporation of the first service company named Credit Rating Information Services of India

Limited (CRISIL). There are four rating agencies in India. These are CRISIL (Credit Rating

Information Services of India), ICRA (Investment Information and Credit Rating Agency of

India), CARE (Credit Analysis and Research Ltd.) and Duff and Phelps. These rating agencies

are registered and regulated by SEBI. CRISIL has about 42% market share and CARE 36%.


1) The information provided by rating

agencies is like a ready reference for

investors. They do not have to look into thebooks of account of the company.

1) Credit rating depends on the factors analyzed

by a credit rating company. It has no liability

because it is making its own estimation of thecompany.

2) Merchant bankers, brokers, traders,

loan providing agencies make their own

estimates of the company before dealing

with it. The creditability of the company isreinforced by information provided by well

known credit rating agencies.

2) Rating by the credit rating agency is after

taking the external and internal factors of the

company bit its rating is made specifically for a

debt instrument and not a business house.

3) The company whose credit rating

has been done by an agency is repute is

ranked as a safe option and its debt

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securities are preferred by investors.

X) COMMERICAL PAPER (CP)

A commercial paper is an unsecured, short term negotiable instrument with affixed maturity. It isused for raising short term debt. It is an obligation of the issuer. It is an unsecured promissory

note. It does not have any collateral and it si issued for a period between 7 days and three

months. In India, commercial papers are popularly used between 91 to 180 days. It is a promise

by the borrowing company to return the loan on the specified date of payment.

Commercial paper no doubt is a very important alternate source to bank financing for short term

requirements. It is not tied to any specific trade transaction and very little paper work is involved.

A corporate organization can directly issue commercial papers to investors. This direct dealingbetween a company and an investor is called a direct paper. This is called dealer paper. The

dealer buys at a lower price and sells at a higher price and gets a commission. In India, this is a

relatively new instrument. It was introduced in 1990 with the objective of providing short term

borrowing. A company is allowed to issue commercial papers. Individuals, non-residents

Indians, banks, companies and registered organizations can invest in commercial papers. Non-

residents Indians cannot transfer or repatriate the commercial papers issued to them. They are

issued at a discount on the face value and their rate is determined through the interplay of market

process of demand and supply. Reserve Bank of India regulates the commercial papers in India.


1) The commercial paper is made

without pledging any assets. It is a promise

based on reputation of the company.

1) Commercial paper does not have any

collateral. It depends on the credit worthiness of

the company.

2) The guarantee in the agreement isbased on credit worthiness, earning capacity

and liquidity of the company.

2) Commercial paper is not as reliable a sourceas a bank. A buyer of a commercial paper has

no obligation towards anyone.

3) A commercial paper is a very useful

instrument for short term requirements as no

documentation is required.

3) Commercial paper cannot be liquidated

before the maturity date.

4) The commercial paper can be

designed between the issuer and the acceptor

and according to their needs the maturityperiod can be fixed.

4) There is no flexibility after the commercial

paper has been designed and signed.

5) It is not necessary to have any trading

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transaction between the parties entering into

an agreement and making a commercial

paper.

XI) CERTIFICATE OF DEPOSIT (CDs)

A certificate of deposit is a securitized short term deposit issued by the banks at high interest

rates during the period of low liquidity. The liquidity gap is met by banks by issuing CDs for

short term periods of time. Since the interest rate is attractive CDs are kept till maturity. CDs are

becoming popular because since 2004 there has been a reduction on their stamp duty, withdrawal

of tax deduction at source, opportunity for trading in the stock market and requirement of closure

of deposits only at maturity. In India, CDs are being issued by banks either directly or through

dealers. A CD is negotiable short term instrument in bearer form. They are a part of bankdeposits and are issued for 90 days but the maturity period can vary according to the

requirements of corporate organizations. The minimum issue of CDs to single investor is Rs. 10

lakhs and can be further issued in multiple of Rs. 5 lakhs. They can issue at a discount on the

face value and they are transferable after a lock in period of 30 days from the time of issue. The

CDs market is larger than the CPs market. The rate of CDs is determined by the market. They are

used for interim requirements and for financing current transactions.


1) Certificate of Deposits is financed by

banks. It is a formal financing method and it hasa structured form which is filled in by the bank.

1) Certificate of deposits is a high cost of

financing as banks charge a high rate ofinterest.

2) It provides liquidity through funding to

small, medium and large companies during a

period when finance is difficult to get from other

market sources.

2) Certificate of deposits is an expensive

instrument as they have stamp duties levied

on it.

3) The maturity date of the instrument can

be designed for a particular investor dependingon his requirement for funds. This gives

flexibility to the instrument

4) CDs have the facility of being traded in

the stock exchange.

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XII) GLOBAL DEPOSITORY RECEIPTS (GDRs)

GDRs are an instrument for raising equity capital by organizations which are in Asian countries.

They are placed in USA, Europe and Asia. They have a low cost and help in bringing liquidity. A

company usually raises capital simultaneously from two countries. For example, the GDR may

be issued in India and simultaneously placed in USA and Europe through one security. The

issuer deals with a single depository bank which facilitates the secondary and inter-market

trading amongst investors which are situated in different countries. It is a fungible instrument and

the issuer does not have any exchange risk. He can freely use the foreign exchange collected

from this issue. Government of India allowed Indian companies to mobilize funds from foreign

markets through Euro issues of global depository receipts and foreign currency convertible

bonds. Companies with a good track record can issue GDRs for developing infrastructure

projects in power, telecommunications and petroleum and in construction and development of

roads, airports and ports in India.

FEATURES OF GDRs

Some of the features ofGlobal Depository Receipts are as follows:

1) Financial Instrument: It is a financial instrument in the form of a depository recipts.

It has been created by a depository bank outside the Indian boundary. It deals with a fixednumber of equity shares of a company.

2) Trading: It is listed and traded in a foreign market.

3) Custodian Bank: The shares are issued in Indian currency in the Indian market with

an Indian bank as its custodian.

4) Price: The prices of the Global Depository Recipts are quoted in U.S. Dollars.

5) Voting Rights: The Global Depository Receipts do not have any voting rights in the

issuing company.

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6) Conversion: The instrument gives the right of conversion to the holder from GDRs to

equity shares of the company. It also has the right and option to convert the equity shares

into GDRs.

7) Shareholders: The issuing company has to deal with the depository bank which is its

only customer. It does not have to deal with multiple shareholders.

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Documents

Scope of Financial Management12