BCA II Semester (Accounting and Financial Management) Unit - IV

What is Financial Management?

Financial Management is all about planning, organizing, directing, and controlling the economic pursuits such as acquisition and utilization of capital of the firm. To put it in other words, it is applying general management standards to the financial resources of the firm.

Scope of Financial Management

To understand the financial management scope, first, it is essential to understand the approaches that are divided into two sections.

1. Traditional Approach 
2. Modern Approach

Approach 1: Traditional Approach to Finance Function

During the 20th century, the traditional approach was also known as corporate finance. This approach was initiated to procure and manage funds for the company. For studying financial management, the following three points were used

(i) Institutional sources of finance.

(ii) Issue of financial devices to collect refunds from the capital market.

(iii) Accounting and legal relationship l between the source of finance and business.

In this approach, finance was required not for regular business operations but occasional events like reorganization, promotion, liquidation, expansion, etc. It was considered essential to have funds for such events and regarded as one of the crucial functions of a financial manager. 

Though he was not accountable for the effective utilization of funds, however, his responsibility was to get the required funds from external partners on a fair term. The traditional approach of finance management stayed until the 5th decade of the 20th century. The traditional approach only emphasized on the fund’s procurement only by corporations. Hence, this approach is regarded as narrow and defective.

Limitations of Traditional Approach

• One-sided approach- It is more considerate towards the fund procurement and the issues related to their administration, however, it pays no attention to the effective utilization of funds.
• Gives importance to the Financial Problems of Corporations- It only focuses on the financial problems of corporate enterprises, so it narrows the opportunity of the finance function.
• Attention to Irregular Events- It provides funds to irregular events like consolidation, incorporation, reorganization, and mergers, etc. and does not give attention to everyday business operations.
• More Emphasis on Long Term Funds- It deals with the issues of long-term financing. 

 Approach 2: Modern Approach to Finance Function

With technological improvement, increase competition, and the development of strong corporate, it was important for Management to use the available financial resources in its best possible way. Therefore, the traditional approach became inefficient in a growing business environment.

The modern approach had a more comprehensive analytical viewpoint with a focus on the procurement of funds and its active and optimum use. The fund arrangement is an essential feature of the entire finance function.

The main elements of this approach are an evaluation of alternative utilisation of funds, capital budgeting, financial planning, ascertainment of financial standards for the business success, determination of cost of capital, working capital management, Management of income, etc. The three critical decisions taken under this approach are.

(i) Investment Decision

(ii) Financing Decision

(iii) Dividend Decision 

Features of Modern Approach

The following are the main features of a modern approach.

• More Emphasis on Financial Decisions- This approach is more analytic and less descriptive as the right decisions for a business can be taken only on the base of accounting and statistical data. 
• Continuous Function- The modern approach is a constant activity where the financial manager makes different financing decisions unlike the traditional method, 
• Broader View- It gives importance not only to optimum use of finance also abut the fund’s procurement. Similarly, it also incorporates features relating to the cost of capital, capital budgeting, and financial planning, etc.
• The measure of Performance- Performance of a firm is also affected by the financial decision taken by the Management or finance manager. Therefore, to maximize revenue, the modern approach keeps a balance between liquidity and profitability.

The other scope of financial management also includes the acquisition of funds, gathering funds for the company from different sources, assessment and evaluation of financial plans and policies, allocation of funds, use of funds to buy fixed and current assets, appropriation of funds, dividing and distribution of profits, and the anticipation of funds along with estimation of financial needs of the company.

Roles of Financial Management:

• Taking part in utilising the funds and controlling productivity.
• Recognizing the requisites of capital (funds) and picking up the sources for that capital.
• Investment accords incorporate investment in fixed assets known as capital budgeting. Investing in current assets are part and parcel of investment decisions known as working capital decisions.
• Financial decisions associated with the finance raised from different sources which would rely upon the accord on – the kind of resource, when is the financing done, cost incurred and the returns as well.
• In the case of dividend decision, the finance manager is the who is responsible for the accord that is taken by him or her; regarding the net profit distribution (NPD). However, Net profits are classified into two(2) types:

1. Dividend for shareholders: The rate of dividend and the amount of dividend has to be decided
2. Retained profits: The amount of contained (retained) gains has to be ascertained which would rely upon the development and variety of strategies of the trading concern. 

Difference Between Wealth and Profit Maximization

The key difference between Wealth and Profit Maximization is that Wealth maximization is the company’s long-term objective to increase the value of the stock of the company, thereby increasing shareholder’s wealth to attain the leadership position in the market. In contrast, profit maximization is to increase the capability of earning profits in the short run to make the company survive and grow in the existing competitive market. 

What is Wealth Maximization?

The ability of a company to increase the value of its stock for all the stakeholders is referred to as Wealth Maximization. It is a long-term goal and involves multiple external factors like sales, products, services, market share, etc. It assumes the risk. It recognizes the time value of money given the business environment of the operating entity. It is mainly concerned with the company’s long-term growth and hence is concerned more about fetching the maximum chunk of the market share to attain a leadership position.

Wealth Maximization considers the interest concerning shareholders, creditors or lenders, employees, and other stakeholders. Hence, it ensures building up reserves for future growth and expansion, maintaining the market price of the company’s share, and recognizing the value of regular dividends. So, a company can make any number of decisions for maximizing profit, but when it comes to decisions concerning shareholders, then Wealth Maximization is the way to go.

What is Profit Maximization?

The process of increasing the profit earning capability of the company is referred to as Profit Maximization. It is mainly a short-term goal and is primarily restricted to the accounting analysis of the financial year. It ignores the risk and avoids the time value of money. It primarily concerns the company’s survival and growth in the existing competitive business environment.

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• BUS202: Principles of Finance
• Sections
• Course Introduction
• Course Syllabus
• Unit 1: Introduction To Finance
• Unit 2: Financial Statements and Financial Analysis
• Unit 3: Working Capital Management
• Unit 4: Time Value Of Money
• Unit 5: Stocks, Bonds, and Financial Markets
• Unit 6: Capital Budgeting Techniques
• Unit 7: Risk, Return, and the CAPM
• Unit 8: Corporate Capital Structure
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BUS202: Principles of Finance

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5. BUS202: Principles of Finance
6. Sections
7. Unit 1: Introduction To Finance
8. 1.1: Introduction to Concepts in Finance
9. Introducing Finance

 

Back to '1.1: Introduction to Concepts in Finance\'

Introducing Finance

Read this introductory article, which will help you understand what the field of finance encompasses. What do you learn in a course in finance that you do not learn in financial accounting? How does finance build on what you learned? What does a financial manager do?

Types of Financial Decisions: Investment and Financing

Investment and financing decisions boil down to how to spend money and how to borrow money.

Learning Objective

• Identify the criteria a corporation must use when making a financial decision

Key Points

• The primary goal of both investment and financing decisions is to maximize shareholder value.
  
• Investment decisions revolve around how to best allocate capital to maximize their value.
  
• Financing decisions revolve around how to pay for investments and expenses. Companies can use existing capital, borrow, or sell equity.
  

Terms

• equity

  Ownership, especially in terms of net monetary value, of a business.

• expected return

  Considering the magnitude and likelihood of exogenous events, the yield that an investor predicts s/he will earn on average.

• financing

  A transaction that provides funds for a business.

There are two fundamental types of financial decisions that the finance team needs to make in a business: investment and financing. The two decisions boil down to how to spend money and how to borrow money. Recall that the overall goal of financial decisions is to maximize shareholder value, so every decision must be put in that context.

Investment

An investment decision revolves around spending capital on assets that will yield the highest return for the company over a desired time period. In other words, the decision is about what to buy so that the company will gain the most value.

To do so, the company needs to find a balance between its short-term and long-term goals. In the very short-term, a company needs money to pay its bills, but keeping all of its cash means that it isn't investing in things that will help it grow in the future. On the other end of the spectrum is a purely long-term view. A company that invests all of its money will maximize its long-term growth prospects, but if it doesn't hold enough cash, it can't pay its bills and will go out of business soon. Companies thus need to find the right mix between long-term and short-term investment.

The investment decision also concerns what specific investments to make. Since there is no guarantee of a return for most investments, the finance department must determine an expected return. This return is not guaranteed, but is the average return on an investment if it were to be made many times.

The investments must meet three main criteria:

1. It must maximize the value of the firm, after considering the amount of risk the company is comfortable with (risk aversion).
2. It must be financed appropriately (we will talk more about this shortly).
3. If there is no investment opportunity that fills (1) and (2), the cash must be returned to shareholder in order to maximize shareholder value.

Financing

All functions of a company need to be paid for one way or another. It is up to the finance department to figure out how to pay for them through the process of financing.

There are two ways to finance an investment: using a company's own money or by raising money from external funders. Each has its advantages and disadvantages.

There are two ways to raise money from external funders: by taking on debt or selling equity. Taking on debt is the same as taking on a loan. The loan has to be paid back with interest, which is the cost of borrowing. Selling equity is essentially selling part of your company. When a company goes public, for example, they decide to sell their company to the public instead of to private investors. Going public entails selling stocks which represent owning a small part of the company. The company is selling itself to the public in return for money.

Every investment can be financed through company money or from external funders. It is the financing decision process that determines the optimal way to finance the investment.

Liquidity

The liquidity and profitability of a company are directly related to the working capital. When a company maintains high temporary working capital in current assets, it is known to be more liquid. The companies that maintain a lower level of working capital are known as less liquid.

Companies that maintain higher liquidity and considered to be at lower risk. They are able to meet the needs of the company and their reservoir of current assets lets them have the freedom to stay solvent.

However, more liquid companies have lower profitability because their funds are tied up in operations and these funds cannot be used for the production and expansion of the company.

In general, there are two main aims of working capital management. They are −

• Solvency and
• Profitability.

Solvency

Solvency is the capability of a company to meet its maturing obligations.

• These obligations may be met with current assets or temporary working capital. To be solvent, a company should be very liquid in nature. Being liquid means having enough cash or cash equivalent funds to meet the general, day-to-day business needs.

• When a company maintains enough current assets, it won’t have to have any difficulty in meeting the claims of the creditors when the payment is due. The creditors, therefore, prefer companies that have high liquidity.

• A company with high liquidity and less risk is, however, less profitable too. As the business operations and production funds are used as current assets, the companies that are very liquid become less profitable. It is a direct outcome of the risk-return trade-off as well.

What Is the Time Value of Money (TVM)?

The time value of money (TVM) is the concept that a sum of money is worth more now than the same sum will be at a future date due to its earnings potential in the interim. The time value of money is a core principle of finance. A sum of money in the hand has greater value than the same sum to be paid in the future. The time value of money is also referred to as the present discounted value.

KEY TAKEAWAYS

• The time value of money means that a sum of money is worth more now than the same sum of money in the future.
• The principle of the time value of money means that it can grow only through investing so a delayed investment is a lost opportunity.
• The formula for computing the time value of money considers the amount of money, its future value, the amount it can earn, and the time frame.
• For savings accounts, the number of compounding periods is an important determinant as well.
• Inflation has a negative impact on the time value of money because your purchasing power decreases as prices rise.

The major differences between compounding and discounting techniques in time value of money are as follows −

Compounding technique

• It is a process of calculating future value using present investment.

• It determines money gained by an investment.

• It is also called as present value.

• Compound interest rate.

• Uses future value/compounding factor.

• Its formula is Fv= Pv(1+r)^n

• Amount increases in this method.

• Right side to left (time line).

• If the rate is low then, future value will decrease and if the rate is high then, future value will increase.

Discounting technique

• It calculates future cash flows using present value.

• It determines the amount to be invested to get maximum future gains.

• It is also called future value.

• Discount rate.

• It uses present value/discounting factor.

• Its formula is Pv=Fv/((1+r)^n).

• Amount decreases in this method.

• Left to right side (time line).

• If the rate is low then, present value will increase, if rate is high then, present value will decrease.

Meaning of Long-term and Short-term sources of Finance

Sources of Finance are the means used for raising funds by business for carrying out their activities. Every business always need some amount of money for ensuring their continuity. They acquire these funds using different sources of funds available in market. Business chooses a particular source of finance according to their needs and capacity.

Sources of funds are classified on various bases such as on time-period, control, source of generation and ownership. On time-period basis these sources are further classified into long term and short term source of finance.

Short-term sources of finance are those which are used for raising funds for short period of time that is less than one year. Money raised through short term source is required to be paid back within one year. Long-term sources of finance are those which help in getting funds for longer period that is more than one year. Funds raised through these can be paid back over many years.

Short-Term Sources of Finance

Short-term sources of funds: Money acquired must be paid back within one year. These sources are used for fulfilling short-term funds requirements.

Various types of short-term sources of funds are as follows:-

Commercial Paper

Commercial paper is an unsecured promissory note issued by high creditworthy companies for raising short-term funds. The maturity period of this source ranges from 91 to 180 days. Commercial papers are issued by companies to banks, insurance companies, or business funds at discount on face value and are redeemed at their face value on maturity.

Trade Credit

It means credit provided to the business by the supplier of raw materials or goods for the short term. Trade credit helps businesses in continuing their operations without interruption as it helps them in getting supplies without any immediate payment. Businesses are not required to pay any interest amount on trade credit.

Bank Overdraft

Bank overdraft is a credit facility extended by the bank to their account holders for a shorter period. Under this facility, customers can overdraw the amount from their account up to a certain limit set by the bank. Customers need to pay interest over the overdrawn amount to the bank.

Bill Of Exchange

Bill of exchange is a financial instrument which is drawn by the creditor upon his debtor. It is a written negotiable instrument which contains an unconditional order for paying the mentioned amount to the holder of the instrument. This instrument is either payable on-demand or on the maturity of a particular time period.

Bank Loan

It means borrowing from the bank at a specific rate of interest for a particular period of time. Bank grants loan to borrower against some sort of security which they need to deposit at the time of taking the loan. Customers need to pay interest regularly to bank on the sanctioned amount. A loan is repaid to the bank either in lump sum amount or in instalment as may be decided at the time of entering the contract.

Certificates Of Deposit

It is an unsecured negotiable instrument issued by commercial banks or financial institutions to investors. Certificate of deposit is issued to depositors against the amount deposited by them for a fixed maturity period. The maturity period of these instruments is decided in accordance with the needs of depositors and ranges from 90 to 365 days.

Long-term and Short-term sources of Finance

Long-Term Sources of Finance

Long-term sources of fund: Fund raised through these instruments can be paid back over many years. It enables in fulfilling money requirements needed for longer time period.

Various types of long-term sources of fund are as described below:-

Equity Shares

It is the capital market instrument issued by companies for acquiring funds for a long period of time. These shares represent ownership capital in the business. Equity shareholders are real owners of the business and have full voting rights. They have full control over the functioning of the company and also elect directors.

Preference Shares

Companies can issue another type of shares for raising long-term funds known as preference shares. These shares carriers some preferential rights over ordinary or equity shares. Preferential shareholders are eligible to get a fixed rate of dividend on their shareholdings and that too before paying any dividend to equity shareholders. In addition to this, these shareholders are paid back their capital amount before the equity shareholders.

Debentures

A debenture is a debt instrument issued by the company for raising long-term funds. It represents debt capital and holders of these instruments are creditors of company who possess no voting rights. On debentures, fixed rate of interest is paid irrelevant of whether profit earned or not by the company.

Retained Earnings

It means reinvesting the profit earned by the company back into its activities for expansion and growth. Companies instead of disturbing all of their earnings among shareholders, retain some part of it for investing it back into their operations. This is also termed as ploughing back of profits.

Term Loans

It refers to long term loans taken by business from commercial banks or other financial institutions. Lending institutions require some sort of security for approving the loan amount. Borrowers need to pay a fixed rate of interest regularly to the lending company and full borrowed amount before the period of maturity.