financial management basics

1. Financial Management
M. Y. Khan and S.P.Jain
Financial management is that management activity which is
concerned with the planning and controlling of the firm’s
financial resources. Moreover, it is concerned with the
acquisition, financing, and management of assets with some
overall goal in mind.
The theme of Financial Management is structured round the
decision-making in the three inter-related financial areas:
i) investment-long-term as well as current assets
ii) Financing and
iii) Dividend policy
It was a branch of economics till 1890, still today, it has no
unique body of knowledge of its own and draws heavily
on economics for its theoretical concepts

2. Why do you study FM as a academicians?
The subject of financial management is of immense
interest to both academicians and practicing
managers great interest of academicians because-
i) the subject is still developing
ii) there are still certain areas where –controversies
exist for which no unanimous solutions have been
reached yet.
iii) among the most critical decisions of the firm those
which relate to finance.
iv) An understanding of the theory of financial
management provides them with concept and
analytical insights to make those decisions skillfully.

3. Finance and Related Disciplines
Financial management, as an integral part of the overall
management, is not a totally independent area.
• It draws heavily on related disciplines and fields of study,
namely-economics, accounting, marketing, production and
quantitative methods- all of these are inter-related, though
there are key difference among them.
a) Micro Economics: The concepts and theories of micro
economics relevant to financial management are
i) supply and demand relationship and profit maximization
strategies
ii) issues related to the mix of productive factors, “optimal
sales level and product pricing strategies.

4. iii) Measurement of utility performance, risk and determination of
value and
iv) The rationale for depreciating assets.
v) Marginal analysis-marginal revenue and marginal cost
Thus financial managers must be familiar with the basic micro
economics.
b)Macro economics: provides the financial manager with insight into
policies by which economic activity is controlled. It is
concerned with over-all institutional environment in which the
firm operates. Its concerned with the- institutional structure of
the banking system, money and capital markets, financial
intermediaries, monetary, credit, and financial policies and
economics policies dealing with and controlling level of activity
with in an economy.
Financial managers should recognize and understand how monetary
policy affects the cost and the availability of funds.
Be skilled in financial policy and how it affects the economy.

5. Be aware of the various financial institutions and other modes of
operations to evaluate the potential investment/financing outlets
and
Understand the consequences of various levels of economic activity
and changes in economic policy for their decision environment
and soon.
On the other hand, draws on micro economic theories of the
operations of firms and profit maximization.
b) Finance and Accounting: closely related.
Two dimensions:
i) accounting is an important input in financial decision making
ii) The end-product of accounting is financial statements such as
the balance sheet, the income statement (profit and loss) and the
statement of changes in financial position (sources and uses of
funds statement)

6. Finance and Accounting
Past performance and future directions for Financial Manager
Differences:
The first difference relates to the treatment of funds while the
relates to decision-making
i) Treatment of Funds:
Income and expenses (A/C)
Cash flows- inflow and outflow (Finance)
ii) Decision Making: The primary focus of the accounting is on
collection and presentation of data while the financial manager’s
major responsibility relates to financial planning, controlling and
decision-making
Thus, in a sense, where accounting ends finance begins.

7. Finance and Other Related Disciplines
c) Finance and other related disciplines:
The marketing, production and quantitative methods are, thus,
only indirectly related to day decision-making by financial
managers and are supportive in nature while economics and
accounting are the primary disciplines on which financial
manager draws substantially.
The relationship between financial management and the
supportive disciplines is depicted in Fig-1.1

8. 1. Investment Analysis
2. Working capital Management
3. Sources and cost of funds
4. Determination of capital
structure
5. Dividend policy
6. Analysis of risks and returns
Primary Disciplines
 Accounting
 Macroeconomics
 Microeconomics
Other Related Disciplines
 Marketing
 Production
 Quantitative methods
Shareholder wealth
maximization
Fig:1.1:Financial Decision Areas
Resulting in
Fig: 1.1 Impact of Other Disciplines on Financial
Management

9. Functions of Finance
According to the new approach, financial management is concerned
with the solution of three major problems relating to the
financial operations of a firm, corresponding to the three
questions, namely, investment, financing and dividend
decisions.
The three major decisions as functions of finance are:
i) The investment decision
ii) The financing decision and
iii) The dividend policy decision

10. Functions of Finance
A) Investment decision: relates to the selection of assets in which
funds will be invest by a firm. The assets which can be acquired
fall into two broad groups:
i) long-term assets which will yield a return over a period of time in
future
ii) short-term or current assets defined as these assets which in the
normal course of business are convertible into cash usually with
in a year.
The first category of assets is popularly known as capital budgeting
and second type of assets is working capital management.
a) Capital Budgeting: the long-term investment decision is probably
the most crucial financial decision of a firm.

11. Functions of Finance
It relates to the selection of an assets or investment proposal or
course of action and the long-term assets can be either new or
old/existing ones.
The first aspect of the capital budgeting decision relates to the choice
of the new asset out of the alternatives available or the re-
allocation of capital when an existing assets fails to justify the
funds committed.
The second element of the capital budgeting decision is the analysis
of risk and uncertainty.
Finally, the evolution of the worth of a long-term project implies a
certain norm or standard against which the benefits are to be
judged. The requisite norm is known as by different names
such as- cut-off rate, hurdle rate, require rate, minimum rate of
return and so on.

12. Functions of Finance
b) Working Capital Management: is concerned with the
management of the current assets. It is an important and
integral part of financial management as short-term survival
is a pre requisite to long-term success.
Two basic ingredients of WC:
(i) an overview of working capital management as a whole and
(ii) efficient management of the individual current assets such as
cash, receivables and inventory.
B) Financing Decision: It is asset-mix or the composition of the
assets of a firm.
There are two aspects of the financing decision:
First, the theory of capital structure which shows the theoretical
relationship between the employment of debt and the return to
the shareholders.

13. Functions of Finance
One dimension of the financing decision is :
i) Is there an optimum capital structure?
ii) In what proportion should funds be raised to maximize the return
to the shareholders?
The second aspect of the financing decision is the determination of an
appropriate capital structure, given the facts of a particular case.
Thus, the financing decision covers two inter-related aspects: a)
capital structure theory and b) capital structure decision.
C) Dividend Policy Decision: The third major decision of financial
management is the decision relating to the dividend policy
decision. It should be analyzed in relation to the financing
decision of a firm.
Two alternatives are available in dealing with the profits of a firm:
they can be distributed to the shareholders in the form of dividend
or they can be retained in the business.

14. Managerial Goal: Profit Vs Wealth
The term ‘ objective’ is used in the sense of a goal or decision criteria
for the three decisions involved in financial management.
It is generally agreed in theory, that the financial goal of the firms
should be the maximization of owners’ economic welfare.
Owners’ economic welfare could be maximized by the maximizing
the shareholders’ wealth as reflected in the market value of
share.
Profit Maximization (decision criteria): means maximizing the taka
income of firms. Firm produces goods and services.

15. Profit Maximization
They may function in market economy and government controlled
economy.
• Market economy: prices of goods and services are determined in
competitive markets and expected to produce goods and services
desired by society as efficiencient as possible.
• Government controlled economy
• Prices system: directs managerial efforts towards more profitable
goods and services. Prices are determined by the demand and supply
conditions as well as the competitive forces, and they guide allocation
of resources for various productive activities.
The rationale behind profitability maximization, as a guide to financial
decision making is a simple.Profit is a test of economic efficiency.
The term profit can be used into areas:
i) As a owner-oriented concept it refers to the amount and share of
national income which is paid to the owners of business (ie; those who
supply equity capital)
ii) A variant of the term is profitability.

16. Profit Maximization Criterion
Profit maximization criterion has questioned and criticized on several
grounds. The reason fall into two broad groups:
a) based on misapprehensions about the workability and fairness of
the private enterprise itself.
b) difficultly of applying this criterion in actual real-world
situations.
Profit maximization fails to serve as an operational criterion for
maximizing the owner’s economic welfare and feasible measure
for making alternative courses of action in terms of their economic
efficiency.
It suffers from the following limitations:
i) It is vague
ii) It ignores the timing of returns
iii) It ignores risk.

17. Profit Maximization Criterion
i)Definition of profit: Profit is a test of economic efficiency. It
provides the yardstick by which economic performance can
be judged. Finally it ensures maximum social welfare.
The precise meaning of the profit maximization objective is
unclear. The definitions of the profit is ambiguous.
a) Does it mean short-or-long-term profit?
b) Does it refer to profit before or after tax
c) Total profits or profit per share?
d) Does it mean total operating profit or profit accruing to
shareholders.

18. Profit Maximization Criterion
ii) Time value of money: The profit maximization objective does not
make a distinction between returns received in different time
periods. It gives no consideration to the time value of money, and
it values benefits received today and benefits received after a
period as the same.
Time- pattern of Benefits (profits)
Alternative A (Tk.) Alternative B (Tk.)
Period I 5,000 ---
Period II 10,000 10,000
Period III 5,000 10,000
Total 20,000 20,000

19. Profit Maximization Criterion
iii) Uncertainty of returns: The streams of benefit may posses
different degree of certainty. Two firms may have same
total expected earnings, but if the earnings of one firm
fluctuate considerably as compared to the other, it will be
more risky.
Uncertainty about Expected Benefits (Profits)
State of Economy Profits (TK.)
Alternative A B
Recession (Period-I) 900 0
Normal (Period-II) 1000 1000
Bomm (Period-III) 1,100 2,000
Total 3,000 3,000

20. Wealth Maximization
Wealth maximization: means maximizing the net present value ( or
wealth) of a course action. The net present value of a course of
action is the difference between the present value of its benefits
and the present value of its costs.
The objective of wealth maximization takes care of the questions of
the timing and risk of expected benefits. The wealth
maximization is consistent with the objective of maximizing
owner’s economic welfare.
The wealth maximization principle implies that the fundamental
objective of a firm should be to maximize the market values of
shares.

21. Wealth Maximization
Wealth maximization is considered as better measure than profit
maximization:
i) Clear concept of wealth
ii) It considered time vaule of money
iii) Focus on market price of share
iv) Risk trade-off
v)Cash flow consider
vi) Look for growth
vii) Dividend policy
viii) Market increase
How is the market price of a firm’s share determined?
A. Need for a valuation approach: The objective of maximizing the
market value of the firm’s shares requires a valuation model

22. .
B. Risk-return trade-off: The financial decisions of the firm are
interrelated and jointly affect the market value of its share by
influencing return and risk of the firm.
The relationship between return and risk can be simply expressed
as follows:
Return= Risk-free+ Risk Premium(i)
Risk free rate is a compensation for time and risk premium for
risk. A proper balance between return and risk should be
maintained to maximum the market value of firm’s shares, and
every financial decision involves this trade-off. such a balance
is called risk-return trade off.
The interrelation between market value, financial decisions and
risk-return trade- off is depicted in figure(overview of the
functions of financial management)

23. Financial Management
Maximization of Share Value
Financial Decisions
Investment
Decisions
Liquidity
Management
Financing
Decisions
Dividend
Decisions
Return Risk
TRADE - OFF

24. Organization of Finance Function
The tasks of financial management and allied areas like-
accounting are distributed between these two key financial
officers. Their functions are distributed below: The main
concern of the treasurer is with the financing activities:
i) obtaining finance ii) banking administration, iii) investor
relationship iv) short-term financing v) credit administration
vi) investments and vii) insurance.
The functions of the controller are related mainly in:
i)financial accounting ii) Internal Audit iii) taxation
iv) management accounting and control v) budgeting, planning
and control and vi) economic appraisal and so on.

25. Classification of Finance:
1. Public finance: i) Internal source ii) International source
2. Non-Govt. finance/private finance
i) Personal finance
ii) Business finance : Personal business finance, State owned
business finance, Financing Autonomous finance.
3. Non-business finance

26. Principles of Business Finance
1. Principles of risk-return trade-off
2. Principles of Cash flow
3. Principles of Internal finance
4. Principles of Time value of money
5. Principles of Delete repayment
6 Principles of Liquidity & profitability
7. Principles of Minimum cost of capital
8. Principles of Recovery
9. Principles of Ideal principle of financing
10. Principles of dividend policy
11. Principles of priority
12. Principles of firm’s goal congruence
13. Principles of business cycle.