INTRODUCTION TO FINANCE

In general, finance is defined as the provision of money at the time it is required. Specifically it

is defined as procurement of funds and their effective utilization. Financial management is

defined as the management of flow of funds in a firm. All business decisions have financial

implications and therefore financial management is inevitably related with every aspect of

business operations.

FINANCIAL DECISIONS IN A FIRM

The decisions of raising funds investing them in assets and distributing returns earned from

assets to shareholders are respectively known as financing decision, investment decisions and

dividend decision. A firm attempts to balance cash inflows and outflows while performing these

decisions. There are three broad areas of financial decision making – capital budgeting, capital

structure and working capital management.

1. Capital Budgeting: Means allocation of funds to different long term assets like investing

in lands, machineries, infrastructures, distribution networks etc. It also involves

investment in any project.

2. Capital Structure: It involves determining the best mix of debt, equity and hybrid

securities to employ. Once a firm has decided the investment project it wants to

undertake, it has to figure out ways and means of financing them. The key issues in
 capital structure decision are: - what should be the optimal debt-equity ratio? - Which

specific instruments should be employed? - Which capital market should the firm

access? - When should the firm raise finances? - What price the firm should offer its

securities? Besides these – what should be the optimal dividend payout ratio? In this

case the objective is to minimize the cost of financing without impairing the ability of

the firm to raise finances.

3. Working Capital Management: It is also referred to as short-term financing decisions.

Related to day-to-day financing activities and deals with – - current assets (inventories,

debtors, short term holdings of marketable securities and cash) - current liabilities

(short-term debt, trade creditors, accruals and provisions) The key issues in this case are

– - what should be the optimum level of inventory? - Credit policy of the firm? - Where

should the firm invest its short-term cash surpluses? - What sources of short-term

finance are appropriate for the firm?

FUNCTIONS OF FINANCE

The functions of finance involve three major decisions a company must make – the investment

decisions, the financing decisions, and the dividend / share repurchase decisions. 1. The

Investment Decisions: Capital investment is the allocation of capital to investment proposals

whose benefits are to be realized in the future. The assets which can be acquired fall into two
groups – I) long term assets – which yield a return over a period of time in future. ii) Short term

assets – those assets which in normal course of business are convertible into cash without any

loss in value, usually within a year. The decisions regarding long term assets are known as

capital budgeting and regarding short term assets as working capital management. 2. Financing

Decisions: It relates to the choice of the proportion of sources to finance the selected

investment proposals. Thus, financing decisions covers mainly capital structure decisions. 3.

Dividend Policy Decisions: The dividend should be analyzed in relation to the financing decision

of a firm. Two alternatives are available in dealing with the profits of the firm – they can be

distributed to the shareholders in the form of dividends or they can be retained in the business

itself. The final decision will depend upon the preference of the shareholders and investment

opportunities available before the firm.

GOALS/OBJECTIVES OF FINANCIAL MANAGEMENT

A goal of a firm may be defined as a target against which the firm’s operating performance can

be measured. A clear understanding of objective is very essential because it provides a frame

work for optimum financial decision making. A good objective should have following

characteristics: - it should be clear and unambiguous - time frame should be there to evaluate

success and failure of any decision - it should be consistent with the long term objective of the
firm Followings are the two most discussed goals of financial management – profit

maximization, and wealth maximization.

1. Maximization of the profit of the Firm: It is often considered as the implied objective.

Various types of financial decisions are taken with a view to maximize the profit of the

firm. It also leads to the welfare of the society. Hence it will result in efficient allocation

of resources not only from the point of view of the firm but also for the society.

However there are some limitations of this objective – - it ignores risk - it ignores time

value of money - it is vague and ambiguous - it may widen the gap between the

perception of management and that of shareholders Thus profit maximization fails to be

an operationally feasible objective of financial management.

2. Maximization of Shareholder’s Wealth: This objective is generally expressed in terms of

maximization of a value of a share of the firm. It is actually the economic value of the

firm which is defined as “the present value of the future cash flows generated by a

decision, discounted at appropriate rate of discount which reflects the degree of

associated risk. The shareholders wealth is represented by the present value of all the

future cash flows in the form of dividends or other benefits expected from the firm. The

market price of share reflects its present value. Therefore the economic value of

shareholders' wealth is the market price of the share. Thus, all financial decisions are
 evaluated in terms of the firm’s future cash flows. With this objective, the management

will allocate the resources in the best possible ways within the given constraints of risk.

In operational terms, this objective seems to be practical. The investors form

expectations about the future cash flows and these expectations are reflected in the

market price of the share. However there are certain limitations of this objective – -

there should be an efficient capital market wherein the effect of a decision is truly

reflected in the market price of the share. - The market price of shares should not be

influenced by speculative activities. But wealth maximization is considered as superior

objective than that of profit maximization.

CONFLICT OF GOAL BETWEEN MANAGEMENT AND OWNERS: AGENCY PROBLEMS

In companies, owners and management are separated from each other. Management of a

company is consisting of professionals who are more qualified and having technical expertise to

run the business. Because of difference in interest between owners (shareholders) and

managers, a chance of conflict is there. To mitigate agency problem, effective monitoring has to

be done and proper incentives have to be offered.

ORGANIZATION OF THE FINANCE FUNCTION

It differs from company to company depending on their respective needs. The titles used to

designate the key finance officer are also differs from company to company like – Vice

President (Finance), Chief Executive (Finance), General Manager (Finance), Director (Finance),

Chief Finance Officer (CFO).

CFO supervises the work of treasurer and controller. Treasurer – obtaining finance, banking

relationship, cash management, credit admin, C.B. Controller – financial accounting, internal

auditing, taxation, management accounting and control.

RELATIONSHIP OF FINANCE TO OTHER AREAS OF MANAGEMENT

1. Relationship to Economics: There are two important linkages between economics &

finance - - macro economic environment defines the setting within which a firm

operates, and - micro economic theory provides the conceptual understanding of the

tools of financial decision making.

2. Relationship to Accounting: They are closely related but differ with each other primarily

in three aspects - 1. Record-Keeping Vs Value Maximizing Accounting is mainly

concerned with record keeping, whereas finance is aimed at value maximizing. The

primary objective of accounting is to measure the performance of the firm, assess its

financial condition, and determine the base for tax payment. The primary goal of
 finance is to create shareholder value by investing in positive NPV projects and

minimizing the cost of financing.

3. Accrual Method Vs Cash Flow Method Accounting is mainly concerned with the cash-

flow while finance is concerned about magnitude, timing and risk of cash-flows.

4. Certainty Vs Uncertainty Accounting deals with the past data hence it is relatively

certain while finance is concerned mainly with the future hence it is having a high

degree of uncertainty.

5. Relationship to Marketing: Marketing is one of the most important areas on which the

success or failure of a firm depends. Price of a product can only be set after consultation

with the finance manager.

6. Relationship to Production Department: Any decision of the production department will

affect the financial position of the firm. Thus all the decisions should be evaluated in the

light of the objective of maximization of shareholder’s wealth. Thus finance managers

have an important role to play.

7. Relationship to Personnel Management: The recruitment, training and placement of

staff are the responsibility of the personnel department and all of these require finance.

Thus the decision regarding these aspects can not be taken in isolation of finance

department.