introduction to financial management and financial system

FINANCIAL MANAGEMENT CHAPTER - 1

INTRODUCTION TO FINANCIAL MANAGEMENT AND FINANCIAL SYSTEM

INTRODUCTION:

Finance is essential for running day to day operations of business. Without finance business activities cannot be undertaken. Financial management is concerned with the management of flow of funds and involves decisions relating to procurement of funds, investment of funds in short term as well as long term assets and distribution of earnings to owners.

MEANING AND DEFINITION OF FINANCIAL MANAGEMENT:

                FM means raising adequate funds at the minimum cost and using them effectively in the business.

According to HOAGLAND, FM is concerned mainly with such matters as, how the business corporation raises its finance and how it makes use of it.

In the words of PHILLIPPATUS, FM is concerned with the managerial decisions that result in the acquisition and financing of long term and short term credits of the firm. It deals with the situations that require selection of specific assets and liability as well as the problem of size and growth of outflows of funds and their effects upon managerial objectives.

Finance is the art and science of managing money. We can also say that FM is concerned with the duties of the financial managers in the business firm.

Thus, FM means application of managerial techniques like planning, organizing and controlling of finance related issues of the business entity.

EVOLUTION OF FINANCIAL MANAGEMENT:

Today, we perceive FM as a separate discipline from management and accounting. There as certain principles, concepts and generally accepted rules of finance. All these have not developed overnight. Its evolution to the present status may be divided into three broad phases- the traditional phase, the transitional phase and the modern phase. We shall discuss each of these three as approaches to FM based on scope of FM.

1.       The traditional approach:

-          Approach was practiced till 1950.

-          Very narrow approach.

-          Role of finance manager was confined only to raising of funds for long term as and when required in the business.

-          Financial managers were not required to see to it that the funds raised were being used effectively in the business or not.

-          Here, analytical and quantitative tools were not used to arrive at a decision.

-          Traditional approach totally ignored the fact that finance is required for day to day routine activities also and financial managers were required to address such requirements.

-          It is not practically feasible to implement this approach in today’s time where financial managers are expected to do a lot more than just procure funds.

-          Again, cut throat competition and importance of taking timely decisions to grab the opportunities available, this approach is not practically possible and has to be discarded.

2.       The transitional / extensive approach:

-          Few years immediately after 1950 were considered as extensive or transitional approach to FM.

-          The scope of FM was too wide as it included all the business transaction involving cash.

-          Since the scope was tremendously large, it became too difficult for a single person to manage things efficiently. Hence, the approach was discarded.   

3.       The modern approach:

-          Era after 1950 till today falls under modern approach to FM

-          This is a practical approach to FM and has relevance to both small as well as large entities.

-          The scope of FM is well defined and it involves collection of funds and its effective utilization.

-          It divides the work of financial manager into two main parts when long term decisions are to be taken: (1) acquisition of funds required in the business at the least possible cost and (2) investing the funds obtained in an optimum manner so as to maximize returns.

-          FM is also concerned with taking decisions relating to distribution of profits i.e. deciding the dividend policy and retention of profits.

-          A well equipped and well organized Finance department came into existence.

DIFFERENCE BETWEEN TRADITIONAL APPROACH AND MODERN APPROACH OF FM:

TRADITIONAL APPROACH	MODERN APPROACH
Narrowly defined concept of FM	Comparatively a wide concept
Only concerned with raising long term funds	Concerns both raising as well as use of funds
Era before 1950	Ear after 1950
Applicable only to large joint stock companies	Applicable to all the business entities
Only long term decisions were taken	Long as well as short term decisions are taken
Outside looking approach	Both, inside as well as outside orientation.
It is a descriptive approach	It is an analytical approach

GOALS OF FINANCIAL MANAGEMENT:

Firms have to take financial decisions regularly on a continuous basis. In order to take wise decisions, a clear understanding of the objectives is must. The main goals of FM are:

1.       Basic goals:

a.       profit maximization

b.      wealth maximization

2.       Other goals:

a.       To ensure fair return to shareholders in the form of dividend regularly

b.      Gathering funds for future requirements

c.       To ensure operational efficiency

It is generally agreed in theory that the financial goal of the firm should be:

1.       Maximization of profit:

Every business is undertaken with the main intention to earn profit. Financial management is resorted to achieve this basic objective and hence, profit maximization is very widely accepted goals of FM. Decisions are taken keeping in view the impact on profitability. Under this objective, all the financial decisions are taken to increase the profitability of the business enterprise. EG While selecting the source of raising funds, generally the cheapest available source is selected. Similarly, while utilization of funds, care is taken that the funds are utilized in the optimum manner so as to give the maximum returns. The profit is regarded as a yardstick for the economic efficiency of any firm and that’s why also it is quite natural to have this objective. However, there are few pitfalls in profit maximization objective:

1.       The concept of profit is vague. It is quite not clear that profit means which profit, Gross Profit or Net Profit, Profit before interest and tax or Cash Profit? Hence it can be interpreted by different people quite differently.

2.       This perspective may be useful in short term but in long run, it is not maximum profits that are expected by shareholders but increment in their wealth.

3.       It ignores the time value of money.

4.        It ignores the risk

5.        It ignores other aspects of decision making. Like, it is not just enough for the corporate today to earn more and more profits. They have to satisfy their moral responsibilities also like paying the tax obligations honestly and regularly, undertaking charity campaigns for society, limiting pollution and developing resources for the human resources etc. but all this is ignored in race for maximizing profit.

Thus, profit maximization fails to be an operationally feasible objective of financial management. It cannot be totally ignored but it cannot also be a sole intention of FM

2.       Maximization of wealth of the shareholders:

It is now well accepted that objective of FM is maximization of shareholders wealth i.e. maximizing the value of a share of a firm. Shareholders invest into the share of the company not only to receive a regular flow of dividend every year but also to earn capital gain when they sell their holdings. Hence, under this objective, financial decisions are taken considering the impact of a particular decision on the overall value of the firm’s assets. Decisions are taken in such a way that the shareholders receive the highest combination of dividends and increase in market price of the share. This seems very practical. Indirectly it covers the concept of profit maximization also. The concept of wealth is very clear and it considers risk factor also. Hence, it is a better objective of FM. However, it also suffers from some limitations:

1.       Market price of the share is subject to influence from several other factors which are not directly controllable.

2.       It does not render social responsibilities directly.

PROFIT MAXIMIZATION VS. WEALTH MAXIMIZATION:

The maximization of shareholders wealth as reflected in the market price of the share is viewed as a proper goal of FM. Profit maximization can be considered as a part of the wealth maximization strategy, but should never be permitted to over shadow the latter.

INTERRELATIONSHIP OF FM WITH OTHER DISCIPLINES:

1.       ECONOMICS:

Traditionally finance was considered as a part of economics. However, with the evolution of modern finance theory, finance evolved as an independent discipline and separated itself from economics. But still they are deeply related to each other. The relevance of economics to FM can be described in light of the two broad areas of economics- micro economics & macro economics.

                Macro economics is concerned with the overall institutional structure of banking system, capital and money markets, financial intermediaries, monetary, credit and fiscal policies and economic policies. All this influence the working activities of an enterprise. Financial managers should understand them thoroughly to take proper financial decisions.

                Theories of micro economics are useful for effective operations of business firms. The concepts and theories of micro economics relevant to financial managers are – supply and demand relationships, optimum utilization of all the factors of production, measurement of utility preference, risk and value determination, marginal analysis etc. if financial managers understand these then they can be useful in taking financial decisions more efficiently.

                A basic knowledge of economics, is therefore, necessary to understand both the environment and decision techniques of FM

2.       ACCOUNTANCY:

Accountancy serves as an information system to finance. The financial data generated through accounting is useful in finance for decision making. The financial statements serve as accounting information in taking decisions. We can also say that accounting is the sub function of FM because output of accounting is input for FM. Through financial statements only the financial managers scrutinize the past performances to take future decisions. Thus, finance and accountancy are interrelated. However, there are few major conceptual differences between the two. Knowledge of accountancy is necessary for financial managers. In small enterprises, accounts and finance both are managed by the same executive. In larger firms we find two different departments for accounts and finance.

3.       MATHEMATICS & STATISTICS:

FM has borrowed heavily from mathematics and statistics too. When we go for advanced financial management, we make use of various mathematical relationships and formulae. EG In calculation of present value of cash flows we make use of the mathematical formula for calculation of compound interest, concept of standard deviation is used in risk analysis. We use the technique of interpolation in finding out IRR. Concept of average is used in calculation of ARR. Similarly ratios and proportions are also useful in various tools and techniques of FM. Thus, even mathematics and statistics provides important basis for decision making in finance and financial managers are expected to have basic understand of these too.  

4.       OTHER AREAS OF MANAGEMENT:

Finance also draws decisions on supportive disciplines such as marketing, production, general management etc. Financial managers should consider the impact of new product development and promotion plans made in marketing area since they will require funds which will be provided through FM. Similarly changes in production process may require additional capital. Likewise, Concepts of PODC (planning, organizing, directing & controlling) of general management proves very useful in taking decisions. Thus all these areas are supportive to financial managers and he has to operate in co ordination with other areas of management to achieve optimum results.

FINANCE FUNCTIONS / DECISION AREAS OF FM / SCOPE OF FM:

According to the modern approach to FM, the financial manager has to focus his attention on:

1.       Procuring the required quantum of funds as and when needed at the least possible cost.

2.       Investing these funds in various assets in the most profitable manner. &

3.       Distributing the returns to the shareholders in order to satisfy their expectations.

So we can say that there are three major types of decisions that the financial managers are required to take and they constitute the scope of FM Viz-

(1)    Financing Decisions

(2)     Investment Decisions

(3)    Dividend Decisions

Now we shall briefly discuss each of them in detail

1.       FINANCING DECISIONS:

-          These decisions are relating to the selection of a source from where capital is to be collected and its corresponding risk-return tradeoff. All the available alternatives are thoroughly analyzed.

-          Under such decisions only financial manager decides about the capital structure to be adopted in the company and also about the proportion of debt-equity mix in the capital structure.

-          The following major factors affect the financing decisions:

a.       Risk

b.      Cost

c.       Control

d.      Leverage

e.      Flexibility

f.        Market conditions

g.       Legal framework

-          Thus, financing decisions are at the base. The purpose of financing decisions is to decide about the sources from which funds should be raised to finance investment decisions.

2.       INVESTING DECISIONS:

-          These decisions may relate to investment in both capital assets as well as current assets. It requires the financial managers to carefully select the assets in which the funds collected should be invested.

-          Majorly, funds are required for setting up of a company, repairs & renovation, expansion of business, diversification of operations or modernization of existing business.

-          Investment decisions are divided into two: capital budgeting decisions and working capital management decisions. Former is for long term investment while latter refers to short term investment requirements.

-          Capital budgeting decisions are based on cash flows, cost of capital and investment criteria. Tools like NPV, IRR, PBP, CBR, ARR and PI are used in analyzing the capital budgeting problems.

-          Due diligence is required while taking these decisions because these are irreversible decisions, a huge amount of funds is at stake, they affect the long run stability of the enterprise and great uncertainty and risk is attached to them.

-          While taking decisions pertaining to working capital management following factors are considered:

a.       Nature of the business

b.      Seasonal variations

c.       Fluctuations in business cycle

d.      Credit policy

e.      Market competition etc.

-          These decisions are considered important because short term liquidity is very important and the same can be maintained through effective working capital management.

3.       DIVIDEND DECISIONS:

-          Under this decision area, financial manager decides on how the returns generated through operations of business activities are distributed between shareholders and company.

-          It involves deciding about whether to distribute any dividend to the shareholders or not? If yes, then what proportion of income or how much so as to satisfy the shareholders and maintain the market price of the shares.

-          It also requires financial managers to decide about the retention of profit rather than its distribution to shareholders if found necessary for reinvestment in business.

-          The following factors affect the dividend policy decisions:

a.       Financial requirements of the company

b.      Stability of dividend

c.       Capital market conditions

d.      Preferences of shareholders

e.      Legal framework etc.

-          The main objective of dividend policy is to divide the net earnings of the firm in an optimum manner so as to pay dividend to shareholders and retain for further investment in business with the objective of maximizing the wealth of the shareholders.

Thus, all these three decisions are inter related because the underlying objective of all these decisions is same i.e. to maximize the wealth of the shareholders of the company.

FUNCTIONS OF FINANCIAL MANAGERS:

(Note: all the three finance functions discussed above are the functions of the financial mangers. The same answer can be written in a different format.)

                The executive who manages the financial affairs of the company is called a fiancé manager. All the functions of finance managers may be divided into two categories- primary functions & subsidiary functions.

I Primary functions:

1.       Estimating the requirements of funds i.e. financial planning

2.       Deciding the capital structure to be adopted

3.       Ensuring proper utilization of the available funds i.e. proper asset management

4.       Optimum disbursement of profit between shareholders and retention requirements.

5.       Management of cash resources and bank balance

6.       Proper financial control to avoid wasteful expenditures & also controlling financial performance.

II Subsidiary functions:

1.       Ensuring optimum level of inventory & receivables

2.       Safeguarding valuable papers and documents and other financial information

3.       Supply funds to the various business activities

4.       Evaluating the performance and taking corrective measures where required

5.       Carrying out financial negotiations

6.       Keeping the track of stock exchange

7.       Financial reporting

FINANCIAL SYSTEM:

A financial system is a complex unitary whole consisting of different parts inter connected with each other. The different parts of the financial system are individuals, banks, companies, government and other institutions.

In every economic system, there exists an imbalance in the distribution of capital. There are people with surplus funds and there are people with a deficit. A financial system functions as an intermediary and facilitates the flow of funds from the areas of surplus to the areas of deficits. It provides a base where savings are converted into investments.

Following are the important components of a financial system:

1.       Financial Markets:

A financial market can be defined as the market in which financial assets are bought and sold. Financial markets are classified as money market and capital market.

2.       Financial Assets:

Financial assets or instruments are dealt with in financial markets. They represents claim of the holder over the issuer of the financial assets. They are divided into two – long term financial assets which are dealt with in capital market like equity shares, preference shares, debentures, bonds etc. and short term financial assets which are dealt with in money market like treasury bills, money at call & short money, commercial bills of exchange etc.  

3.       Financial Intermediaries:

Financial intermediaries play a role of establishing a link between the requirers of funds and the investors of funds in the financial system. They collect the funds from the public in various ways, to lend to business units to meet their financial requirements. RBI, Commercial Banks, Financial Institutions, Insurance companies, mutul funds, stock exchanges etc are some institutions which act as intermediaries in a financial system.

4.       Regulating Bodies or Institutions:

Financial system is regulated by SEBI and RBI. They lay down the norms for smooth and continuous functioning of the financial markets as well as the providers for proper co ordination between all the components of the financial system.

FUNCTIONS OF THE FINANCIAL SYSTEM:

Following functions are undertaken in the financial system:

1.       Through financial systems the savings of general public are channelized into the business sector where it gets converted into investment.

2.       They provide the investors with the opportunity to liquidate their investments as and when they require.

3.       It offers a variety of instruments which provides protection against health, life and income risks. Even diversification of risk becomes possible.

4.       It offers a very convenient payment system through clearing houses.

INDIAN FINANCIAL SYSTEM:

There are two sectors in the Indian Financial System – the unorganized sector and the organized sector. The unorganized sector is scattered particularly in rural areas of our country and is outside the preview of the regulations and control of the government authorities. Even after 65 years of Independence we find lack of proper infrastructure and communication system integrating the interior villages with the developed city areas. Because of absence of banking system, such a sector exists in our financial system. The organized sector on the other hand consists of financial markets, assets and intermediaries. It is well regulated by a network of government authorities.

Like in any other financial system, our Indian financial system also consists of certain demanders of funds like individuals, partnership firms, companies, banks and other financial institutions, government etc who are in need of money. On the other hand there are parties with surplus funds and they seek profitable investment opportunities who act as financers. Suppliers of finance include individuals, companies, banks, mutual funds, merchant bankers etc. They come into the contact through financial markets and carry out the transaction of exchanging their needs. 

Now we shall discuss each element of the Indian financial system in detail. It consists of financial markets (capital market & money market), financial assets (equity, bonds, treasury bills, repos etc) and financial intermediaries (stock exchanges, commercial banks, financial institutions etc).

INDIAN FINANCIAL MARKETS:

                Financial market in India may be divided into 3 parts- 1) Capital Market, 2) Money Market, 3) Market of Government securities.

1.       Capital Market:

·         It is a market for long term financial assets.

·         The major financial instruments of capital market are equity shares, preference shares, debentures, bonds, mutual funds etc.

·         It is governed by The Securities Exchange Board of India

·         Indian capital market is further divided into – primary market and secondary market.

A. Primary market:

·          It is a market for new issues of securities. It is also known as a market for fresh issue.

·         Generally a new company or an existing company issues share for the first time in such markets. Hence it is market where initial public offering (IPO) of shares and bond is made by the company.

·         It provides a system wherein different corporate, mutual funds & institutions issue their financial instruments and the investors subscribe these instruments.

·         The main players of the market are shares or bond issuing companies, underwriters, merchant bankers, share brokers, potential investors and SEBI.

B. Secondary market:

·         It is a market in which the subsequent sale and purchase of the shares and bonds take place.

·         It is a well organized market which functions as per established rules & regulations.

·         When an initial investor in primary market is in need of funds, he tries to augment his investments and sell the shares in this market. Here, those having surplus funds purchase these shares through stock exchange.

·         We can also say that the secondary market is the share market which is provided by stock exchange.

·         The eminent stock exchanges operating in India are NSE (National Stock Exchange), BSE (Bombay Stock Exchange)  & OTCE (Over The Counter Exchange)

·         The main players of secondary markets are stock exchanges, brokers and sub brokers, investors and speculators and clearing house.

·         The transactions of stock exchange are regulated by SEBI.

·         The screen based trading, the script less trading, depository system are a few recently introduced features of the Indian Capital Market.

2.       Money Market:

·         A money market is a market for short term debt transactions.

·         The period of borrowing and lending generally ranges from 1 day to 1 year.

·         The money market in India can be discussed under two parts, formal money market and informal money market.

I Informal money market:

·         It includes the indigenous bankers, money lenders, shroffs, nidhis, chit funds etc.

·         Their operations and regulations are based on traditional practices used over the years.

·         Generally it is rampant in rural areas of India and is scattered in different geographical areas. Hence, it is out of the purview of any Government authorities.

·         The basic characteristics of informal money market are – informal procedures, high rate of interest, flexible terms and loans as per the convenience of the parties.  

·         The unorganized sector of Indian Financial System is this informal money market only.

II Formal money market:

·         It provides the mechanism to the requirers of funds to borrow funds to meet their short term needs for funds. It also provides for investment for shorter period of time.

·         It is characterized by the presence of RBI, commercial banks, investment banks, financial institutions, companies, Discount & Finance House of India (DFHI), Mutual Funds, Non banking financial companies (NBFC)

·         The Reserve Bank of India is the apex institution and governs the money market in India.

·         The instruments in Indian Money markets are – gilt edged securities, treasury bills, repos, call money, commercial papers, bills of exchange, certificate of deposits, inter corporate deposits etc.

·         Formal money market is characterized by – regulation by RBI, strict rules and regulations, low rates of interests, formal operations etc.

3.       Government Securities Market:

·         This is a market where the securities or loans of central government, state governments and other government authorities are traded. These securities are also known as gilt edged securities

·         The main participants in the government securities are the commercial banks, Life Insurance Corporation, provident funds etc.

·         The rate of interest is very low.

FINANCIAL ASSETS:

-          Financial assets represent a financial claim of the holder over the issuer of the financial assets.

-          The assets traded i.e. bought and sold in financial markets can be termed as financial assets.

-          The companies in India issue equity shares, preference shares, debentures, secured deep discount bonds, zero interest debentures, premium notes etc. All these are examples of financial assets.

-          The financial assets can be divided into two – long term assets & short term assets.

-          Long term assets are traded in capital market and include equity shares, preference shares, debentures, right shares, mutual fund unit etc.

-          Short term financial assets are exchanged in money market and include money at call and short notice, commercial deposits, commercial papers, repos, treasury bills etc.

 FINANCIAL INTERMEDIARIES:

-          The financial intermediaries play a role of establishing a link between the debtors and the creditors in the financial system.

-          They make the exchange of needs possible.

-          The financial intermediaries in India may be classified as-

1.       All India level financial institutions (IDBI, SIDBI)

2.       State level financial corporations like GSFC

3.       Commercial banks

4.       Insurance companies

5.       Mutual funds

6.       Non banking financial companies

7.       Agricultural finance companies (NABARD)

8.       Other financial institutions

9.       Clearing houses (NSDL, CDSL)

10.   Discount houses (DFHL)

REGULATORY FRAMEWORK IN INDIA:

-          The regulatory framework for controlling and supervising the financial system in India is an overlapping and complex network of legislations, guidelines, notifications, directives, etc.

-          The main elements of regulatory framework are-

1.       The SEBI Act

2.       The Banking Regulation Act

3.       The RBI Act

4.       The Companies Act of India

5.       The Income Tax Act

6.       Guidelines of RBI & SEBI

7.       Monetary & Fiscal policies

DIFFERENCE BETWEEN MONEY MARKET AND CAPITAL MARKET:

CAPITAL MARKET	MONEY MARKET
Market of long term funds	Market of short term funds
Equity shares, preference shares, debentures are the instruments of capital market	Bills of exchange, repos, treasury bills are the instruments of money market
Regulated by SEBI	Regulated by RBI
Two sub markets: primary market and secondary market.	Two parts: formal money market and informal money market.
Interest rate is high	Interest rate is low
Investors earn dividend	Investors earn interest
Free play of demand and supply of shares determines the market price of the shares	Free play of demand and supply of short term funds determines the rates of interest
Reflects economic health of the economy	Reflects liquidity position of the economy
The main players of the market are shares or bond issuing companies, underwriters, merchant bankers, share brokers, potential investors and SEBI.	The main players of the market are RBI, commercial banks, investment banks, financial institutions, companies, Discount & Finance House of India (DFHI), Mutual Funds, Non banking financial companies (NBFC).

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