Financial Management

Introduction

In our present day economy, finance is defined as the provision of money at the time when it is
required. Every enterprise, whether big, medium or small, needs finance to carry out its
operations and to achieve its targets. In fact, finance is so indispensable today that it is rightly
said to be the lifeblood of an enterprise. Without adequate finance, no enterprise can possibly
accomplish its objectives.

Meaning of Business Finance

The term business finance composed of two words (i) business and (ii) finance.

The word business literally means a state of being busy. All creative human activities relating to
the production and distribution of goods and services for satisfying human wants are known as
business. Broadly speaking the term business include industry, trade and commerce.

Wheeler defines business finance as “that business activity which is concerned with the
acquisition and conservation of capital funds in meeting the financial needs and overall
objectives of business enterprise.”

According to Guttmann and Dougall, Business finance can be broadly defined as the activity
concerned with the planning , raising, controlling and administering the funds used in the
business.”

Thus the scope of corporation finance is so wide as to cover the financial activity of a business
enterprise right from its inception to its growth and expansion and in some cases to its winding
up also.

Finance may be defined as the provision of money at the time when it is required.

Having studied the meaning of the two terms business and finance; we can develop the
meaning of the term Business finance as an activity or a process which is concerned with
acquisition of funds, uses of funds and distribution of profits by a business firm. Thus business
finance usually deals with financial planning, acquisition of funds, use and allocation of funds
and financial controls.

Corporation finance, usually deals with financial planning, acquisition of funds, use and
allocation of funds, and financial controls.
SCOPE OR CONTENT OF FINANCE FUNCTION

The main objective of financial management is to arrange sufficient finances for meeting short-
term and long-term needs. These funds are procured at minimum costs so that profitability of
the business is maximised. Taking these things in mind, a Financial Manager will have to
concentrate on the following areas of finance function.

1. Estimating Financial Requirements. The first task of a financial manager is to estimate short-
term and long-term financial requirement of his business. For this purpose, he will prepare a
financial plan for present as well as for future. The amount required for purchasing fixed assets
as well as needs of funds for working capital will have to be ascertained. The estimations should
be based on sound financial principles so that neither there are inadequate nor excess funds
with the concern.

2. Deciding Capital Structure. The capital structure refers to the kind and proportion of
different securities for raising funds. After deciding about the quantum of funds required it
should be deciding which type of securities should be raised. It may be wise to finance fixed
assets through long-term debts. Even here if gestation period is longer, then share capital may
be most suitable.

Long term funds should be employed to finance working capital also, if not wholly then
partially. Entirely depending upon overdrafts and cash credits for meeting working capital
needs, may not be suitable.

3. Selecting a Source of Finance. After preparing a capital structure, an appropriate source of

finance is selected. Various sources from which finance may be raised include share capital,
debentures, financial institutions, commercial banks, public deposits, etc. If finance are needed
for short periods then banks, public deposits and financial institutions may be appropriate; on
the other hand, if long-term finances are required, then share capital and debentures may be
useful.

4. Selecting a Pattern of Investment. When funds have been procured then a decision about
investment pattern is to be taken. A decision will have to be taken as to which assets are to be
purchased? The funds will have to be spent first on fixed assets and then an appropriate
portion will be retained for working capital. While selecting a plant and machinery, capital
budgeting techniques should be used. While spending on various assets, the principles of
safety, profitability and liquidity should not be ignored. One may not like to invest on a project
which may be risky even though there may be more profits.

5. Proper Cash Management. Cash management is also an important task of finance manager.
He has to assess various cash needs at different times and then make arrangement for
arranging cash. Cash may be required to (a) purchase raw materials, (b) make payments to
creditors, (c) Payments of wages bill, (d) meet day to day expenses. The usual sources of cash
may be : (a) cash sales, (b) collection of debts, (c) short-term arrangements with banks. The
cash management should be such that neither there is a shortage of it and nor it is idle.

6. Implementing Financial Controls. Financial control devices generally used are,: (a) Return on
investment, (b) Budgetary control, (c) Break Even Analysis, (d) Cost Control, (e) Ratio Analysis.
Return on investment is the best control device to evaluate the performance of various
financial policies. The higher this percentage better may be the financial performance. The use
of various control techniques by the finance manager will help him in evaluating the
performance in various areas and take corrective measure whenever needed.

7. Proper Use of Surpluses. A use of surpluses is essential for expansion and diversification
plans and also in protecting the interests of shareholders. The ploughing back of profits is the
best policy of further financing but it clashes with the interests of shareholders. The balance
should be maintained in using funds for paying dividend and retaining earnings for financing
expansion plans, etc. The market value of the shares will also be influenced by the declaration
of dividend and expected profitability in future.

FUNCTIONS OF FINANCIAL MANAGEMENT:

Financial management, at present is not confined to raising and allocating funds. The study of
financial institutions like stock exchange, capital market etc. is also emphasised because they
influence underwriting of securities and corporate promotion. The scope of this subject has
widened to cover capital structure, dividend policies, profit planning and control, depreciation
policies, etc.

The technique of financial analysis like financial statements analysis, funds statements, ratio
analysis etc. are also helpful in analysing financial strength of the enterprise. Some of the
functional areas covered in financial management are as follows:

1. Determining Financial Needs. A finance manager is supposed to meet financial needs of

the enterprise. For this purpose, he should determine financial needs of the concern.
Funds are needed to meet promotional expenses, fixed and working capital needs. The
requirement of fixed assets is related to the Type of industry. A manufacturing concern
will require more investments in fixed assets than a trading concern. The working capital
needs depend upon the scale of operations, larger the scale of operations, the higher
will be the needs for working capital.

2. Selecting the source of funds. A number of sources may be available for raising funds. A
concern may resort to issue of share capital and debentures. Financial institutions may be
requested to provide long term funds. The working capital needs may be met by getting cash
credit or overdraft facilities from commercial banks. A finance manager has to be very careful
and cautious in approaching different sources.

3. Financial Analysis and Interpretation. The analysis and interpretation of financial statements
is an important task of a finance manager. He is expected to know about the profitability,
liquidity position, short term and long term financial position of the concern. For this purpose, a
number of ratios have to be calculated. The interpretation of various ratios is also essential to
reach certain conclusions.

4. Cost-Volume-Profit Analysis. Cost-Volume-Profit analysis is an important tool of profit

planning. It answers questions like, what is the behaviour of cost and volume? At what point of
production a firm will be able to cover its costs? How much a firm should produce to earn a
desired profit? To understand cost volume profit relationship, one should know the behaviour
of costs. The cost may be subdivided into fixed costs, variable costs and semi variable costs.

5. Capital Budgeting. Capital budgeting is the process of making investment decisions in capital
expenditures. It is an expenditure the benefits of which are expected to be received over a
period of time exceeding one year. It is an expenditure incurred for acquiring or improving the
fixed assets, the benefits of which are expected to be received over a number of years in future.
For making correct capital budgeting decisions, the knowledge of its techniques is essential. A
number of methods like pay back period, rate of return method, net present value method,
internal rate of return Method and profitability index method may be used for making capital
budgeting decisions.

6. Working Capital Management. Working capital refers to that part of the firm’s capital which
is required for financing short-term or current assets such as cash, receivable and inventories. It
is essential to maintain a proper level of these assets. Cash is required to meet day to day needs
and purchase inventories etc. The scarcity of cash may adversely affect the reputation of a
concern.

7. Profit Planning and Control. Profit planning and control is an important responsibility of the
financial manager. Profit maximisation is, generally, considered to be an important objective of
a business. Profit is also used as a tool for evaluating the performance of management. Profit is
determined by the volume of revenue and expenditure. Revenue may accrue from sales,
investments in outside securities or income from other sources. The expenditure may include
manufacturing costs, trading expenses, office and administrative expenses, selling and
distributing expenses and financial costs. The excess of revenues over expenditure determine
the amount of profit.
8. Dividend Policy. Dividend is the reward of the shareholders for investments made by them in
the share of the company. The investors are interesting in earning the maximum return on their
investments whereas management wants to retain profits for further financing. The company
should distribute a reasonable amount as dividends to its members and retain the rest for its
growth and survival.
OBJECTIVE OF FINANCIAL MANAGEMENT

Financial Management is concerned with procurement and use of funds. Its main aim is to use
business funds in such a way that the firm’s value are maximised. There are various alternatives
available for using business funds. Each alternatives available has to be evaluated in detail. The
pros and cons of various decisions have to looked into before making a final selection. The main
objective of a business is to maximise the owner’s economic welfare. The main objectives of a
business is to Maximise the owner’s economic welfare. This objectives can be achieved by:

1. Profit Maximisation and

2. Wealth Maximisation

1. Profit Maximisation. Profit earning is the main aim of every economic activity. A
business being an economic institution must earn profit to cover its costs and provide
funds for growth. No business can survive without earning profit. Profits also serve as a
protection against risks which cannot be ensured. The accumulated profits enables a
business to face risks like fall in prices, competitions from other units, adverse
government policies etc. Thus, profit maximisation is considered as the main objective
of business. The following arguments are advanced in favour of profit maximisation as
the objective of business:

(i) When profit-earning is the aim of business then profit maximisation should be
the obvious objective.

(ii) Profitability is the barometer for measuring efficiency and economic

prosperity of a business enterprise, thus, profit maximisation is justified on the ground
of rationality.

(iii) Economic and business conditions do not remain same at all the times. There may be
diverse business conditions like recession, depression, severe competition etc. A business will
be able to survive under unfavorable situation, only if it has some past earnings to rely upon.
Therefore, a business should try to earn more and more when situation is favourable.

(iv) Profits are the main sources of finance for the growth of the business. So, a
business should aim at maximisation of profits for enabling its growth and
development.
(v) Profitability is essential for fulfilling social goals also. A firm by pursuing the objectives of
profit maximisation also maximises socio-economic welfare.

However, profit maximisation objective has been criticised on many grounds. A firm pursuing
the objective of profit maximisation starts exploiting workers and the consumers. The concept
of limited liability in the present day business has separated ownership and management. A
company is financed by shareholders, creditors and financial institutions and is controlled by
professional managers. Workers, customers, government and society are also concerned with
it. So, one has to reconcile the conflicting interests of all these parties connected with the firm.
Thus, profit maximisation as an objective of financial management has been considered
inadequate. Profit maximisation has been rejected because of the following drawbacks:

1. The term profit is vague and it cannot be precisely defined. It means different things for
different people. Should we consider short-term profits or long term profit? Does it means total
profits or earnings per share?

2. Profit maximisation objectives ignores the time value of money and does not consider the
magnitude and timing of earnings. It treats all earnings as equal though they occur in different
periods. It ignores the fact that cash received today is more important than the same amount of
cash received after three years. The stockholders may prefer a regular return from investment
even if it is smaller than the expected higher returns after a long period.

3. It does not take into consideration the risk of the prospective earnings stream. Some
projects are more risky than others. The earnings stream will also be risky in the former than
the latter. Two firms may have same expected earnings per share, but if the earnings stream of
one is more risky then the market value of its shares will be comparatively less.

4. The effect of dividend policy on the market price of shares is also not considered in the
objective of profit maximisation. In case, earnings per share is the only objectives then an
enterprise may not think of paying dividend at all because retaining profits in the business or
investing them in the market may satisfy this aim.
 Wealth Maximization

This is also known as value maximization or net present worth maximisation. In current
academic literature value maximization is almost universally accepted as an appropriate
operational decisions criterion for financial managemernt decisions as it removes the technical
limitations which characterise the earlier profit maximisation criterion. Its operational features
satsify all the three ewquirements of a suitable operational objective of financial course of
action, namely. Exactness. Quality of benefits and the time value of money.

The value of an asset should be viewed in terms of the benefits it can produce. The worth of a
course of action can similarly be judged in terms of the value of the benefits it produces less the
cost of undertaking it. A significant element in comp-uting the value of a financial course of
action is the precise estimation of the benefits associated with it. The wealth maximisation
criterion is based on the concept of cash flows generated by the decision rather than
accounting profit which is the basis of the measurement of benefits in the case of the profit
maximisation criterion. Cash-flow is a precise concept with a definite connection. Measuring
benefits in terms of cash flows avoids the ambiguity associated with accounting profits. This is
the first operational features of the net present worth maximisation criterion.

The second important features of the wealth maximisation criterion is that it considers both the
quantity and quality dimensions of benefits. At the same time, it also incorporates the time
value of money. The operational implication of the uncertainty and timing dimemsions of the
benefits emanating from a financial decision is that adjustments should be made in the cash-
flow pattewrn, firstly, to incorporate risk and, secondly, to make an allowance for differences in
the timing of benefits. The value of a stream of cash flows with value maximisation criterion is
calculated by discounting its element back to the present at a capitalisation rate that reflects
both time and risk. The value of a course of action must be viewed in terms of its worth to
those providing the resources necessary for its undertaking. In applying the value maximisation
criterion, the term value is used in terms of worth to the owners, that is, ordinary shareholders.
The capitalisation (discount )rate that isd employed is therefore, the rate that reflects the time
and risk preferences of the owners or suppliers of capital.

In the words of Ezra Solomon

The gross present worth of a course of action is equal to the capitalised value of the flow of
future expected benefits, discounted (or capitalised) at a rate which reflects their certainty or
uncertainty. Wealth or net present value worth is the difference between gross present worth
and the amount of capital investment required to achieve the benefits being discussed. Any
financial action which creates wealkth or which has a net present worth above zero is
adesirable one and should be undertaken. Any financial action which does not meet this test
should be rejected. If two or more desirable courses of action are mutually exclusive (i.e., if only
one can be undertaken ), then the decision should be to do that which creates most wealth or
shows the greatest amount of net present worth.

In the cae of value maximization decision criterion, the time value of money and handling of the
risk as measured by the uncertainty of the expected benefits is an integral part of the exercise.
It is moreover, a precise and unambiguous concept, and therefore, an appropriate and
operationally feasible decision criterion for financial management decisions.

It would also be noted that the focus of financial management is on the value to the owners or
suppliers of equity capital. The wealth of the owners is reflected in the market value of shares.
So, wealth maximisation implies the maximisation of the market price of shares. In other words,
maximisation of the market price of shares is the operatyional substitute for value/wealth/ net
present value maximnisation as a decision criterion.

In brief, what is relevant is not the overall goal of a firm but a decision criterion which should
guide the financial couse of action. Profit/EPS maximisation was initially the generally accepted
theoretical criterion for making efficient economic decisions, using profit as an economic
concept and defining profit maximisation as a criterion for economic efficiency. In current
financial literature, it has been replaced by the wealth maximisation decision criterion because
of the shortcomings of the former as an operational criterion, as (i) it does not take account of
uncertainty of risk, (ii) it ignores the time value of money, and (iii) it is ambiguous in its
computation. Owing to these technical limitations, profit maximisation cannot be applied in real
world situations Its modified form is the value maximisation criterion. It is imoportant to note
that value maximisation is simply extension of profit maximisation to a world that is uncertain
and multipewriod in nature. Where the time period is short and degree of uncertainty is not
great, value maximisation and profit maximisation amount to essentially the same thing.

However, two important issues are related to the value/ share maximisation, namely, economic
value added and focus on stakeholders.

Economic Value Added(EVA) It is a popular measure currently being used by several firms to
determine whether an existing/ proposed investment positively contributes to the
owners/shareholders wealth. The EVA is equal to after-tax operating profits of a firm less the
cost of funds used to finance investments. A positive EVA would increase owners value/wealth.
Therefore, only investment with positive EVA would be desirable from the viewpoint of
maximising shareholder’s wealth. To illustrate, assuming an after-tax profit of Rs 40 crore and
associated costs of financing the investment of Rs 38 crore, the EVA = Rs 2 crore . With the
positive EVA, the investment would add value and increase the wealth of the owners and
should be accepted.
The merits of EVA are (a) its relative simplicity and (b) its strong link with the wealth
maximisation of the owners. It prima facie exhibits a strong link to share prices, that is positive
EVA is associated with increase in prices of shares amnd vice versa. However, EVA is, in effect ,
a repackaged ans well marketed application of the NPV techniques of investment decision. But
EVA is certainly a useful tool for operationalising the oweners value maximisation goal,
particularly with respect to the investment decisions.

Focus on Stakeholders: The shareholders wealth maximisation as the primary goal

notwithstanding, there is a broader focus in financial management to include the interest of the
stakeholders as well as the shareholders. The stakeholders include employees, customers,
suppliers, creditors and owners and others who have a direct link to the firm. The implicatyion
of the focus on stakeholders is that a firm should avoid actions detrimental to them through the
transfer of their wealth to the firm and thus, damage their wealth. The goal should be preserve
the well-being of the stakeholders and not to maximise it.

Concepts of valve and return

Most financial decisions, such as the purchase of assets or procurement of funds, affect the
firm’s cash flows in different time periods. For example, if a fixed asset is purchased, it will
require an immediate cash outlay and will generate cash inflows during much future periods.
Similarly, if the firm borrows funds from a bank or from any other source, it receives cash now
and commits an obligation to pay cash for interest and repay principal in future periods. The
firm may also raise funds by issuing equity shares. The firm’s cash balance will increase at the
time shares are issued, but, as the firm pays dividends in future, the outflow of cash will occur.
Sound decision making require that the cash flows which a firm is expected to receive or give
up over a period of time, should be logically comparable.

In fact, the absolute cash flows, which differ in timing and risk, are not directly comparable.
Cash flows become logically comparable when they are appropriately adjusted for their
differences in timing and risk.

The recognition of the time value of money and risk is extremely vital in financial decision-
making. If the timing and risk of cash flows is not considered, the firm may make decisions that
may allow it to miss its objectives of maximising the owners’ welfare. The welfare of owners
would be maximised when wealth is created from making a financial decision.

TIME PREFERENCE FOR MONEY

If an individual behaves rationally, he or she would not value the opportunity to receive a
specific amount of money now equally with the opportunity to have the same amount at same
future date. Most individuals value the opportunity to receive money now higher than waiting
for one or more periods to receive the same amount. Time preference for money is an
individual’s preference for possession of a given amount of money now, rather than the same
amount at some future time.

Three reasons may be attributed to the individual’s time preference for money:

• Risk

• Preference for consumption

• Investment opportunities

We live under risk or uncertainty. As an individual is not certain about future cash receipts, he
or she prefers receiving cash now. Most people have subjective preference for present
consumption over future consumption of goods and services either because of the urgency of
their present wants or because of the risk of not being in a position to enjoy future
consumption that may be caused by illness or death, or because of inflation. As money is the
means by which individuals acquire most goods and services, they may prefer to have money
now.

Further, most individuals prefer present cash to future cash because of the available
investment opportunities to which they can put present cash to earn additional cash. For
example, an individual who is offered Rs. 100 now or Rs. 100 one year from now would prefer
Rs. 100 now as he could earn on it an interest of, say Rs. 5 by putting it in the saving account in
a bank for one year.

His total cash inflows in one year from now will be Rs. 105. Thus, if he wishes to increase his
cash resources, the opportunity to earn interest would lead him to prefer Rs. 100 now, not Rs.
100 after one year.

In case of the firms as well as individuals, the justification for time preference for money lies
simply in the availability of investment opportunities.In financial decision making under
certainty, the firm has to determine whether one alternative yields more cash or the other. In
case of the firm, this is owned by a large number of individuals (shareholders), it is neither
needed nor is it possible to consider the consumption preferences of owners. The uncertainty
about future cash flows is also not a sufficient justification for time preference for money. We
are not certain even about the usefulness of the present cash held; it may be lost or stolen. In
investment and other decisions of the firm what is needed is the search for methods of
improving decision-maker’s knowledge about the future. In the firm’s investment decision, for
example, certain statistical tools such as probability theory, or decision tree could be used to
handle the uncertainty associated with cash flows.

Required Rate of Return

The time preference for money is generally expressed by an interest rate. This rate will be
positive even in the absence of any risk. It may be therefore called the risk-free rate. For
instance, if time preference rate is 5 per cent, it implies that an investor can forego the
opportunity of receiving Rs 100 if he is offered Rs 105 after one year (i.e., Rs 100 which he
would have received now plus the interest which he could earn in a year by investing Rs100 at 5
per cent). Thus, the individual is indifferent between Rs100 and Rs 105 a year from now as he
considers these two amounts equivalent in value. In reality, an investor will be exposed to some
degree of risk. Therefore, he would require a rate of return, called risk premium, from the
investment, which compensates him for both time and risk. Thus the required rate of return
will be

Required rate of return = Risk free rate + Risk premium.

The risk-free rate compensates for time while risk premium compensates for risk. The required
rate of return may also be called the opportunity cost of capital of comparable risk. It is called
so because the investor could invest his money in assets or securities of equivalent risk. Like
individuals, firms also have required rates of return and use them in evaluating the desirability
of alternative financial decisions. The interest rates account for the time value of money,
irrespective of an individual’s preference and attitudes.

The two common methods of adjusting cash flows for time value of money are

1. Compounding: The process of calculating future values of cash flows and

2. Discounting: the process of calculating present values of cash flows.

FUTURE VALUE

Once the investor has determined his interest rate, say, 10 per cent, he would like to receive at
least Rs 1.10 after one year or 110 per cent of the original investment of Re 1 today. A two year
period is two successive one-year periods. When the investor invested Re1 for one year, he
must have received Rs 1.10 back at the end of that year in exchange for the original Re 1. If the
total amount so received (Rs 1.10) were reinvested , the investor would expect 110 per cent of
that amount or Rs 1.21 Re 1 x 1.10 x 1.10 at the end of the second year.

Compound interest: is the interest that is received on the original amount (principal) as well as
on any interest earned but not withdrawn during earlier periods. Compounding is the process
of finding the future values of cash flows by applying the concept of compound interest.

Simple interest is the interest that is calculated only o the original amount (principal) and thus,
no compounding of interest takes place.

Note: Principal refers to the amount of money on which interest is received.

Semi-annual and Other Compounding Periods: In the above we, have assumed annual
compounding of interest at the end of the year. Very often the interest rates are compounded
more than once in a year. Savings institutions, particularly, compound interests semi-annually,
quarterly and even monthly.

Semi annual Compounding: means that there are two compounding periods within the year.
Interest is actually paid after every six months at a rate of one-half of the annual (stated) rate of
interest.

E.g.: Mr. X places his savings of Rs 1,000 in a two year time deposit scheme of a bank which
yields 6 per cent interest compounded annually. He will be paid 3 per cent interest
compounded over four periods-each of six months duration.
Present Value or Discounting Techniques

The concept of the present value is the exact opposite of that of compound value. While in the
latter approach money invested now appreciates in value because compound interest is added,
in the former approach (present value approach) money is received at some future date and
will be worth less because the corresponding interest is lost during the period. In other words,
the present value of a rupee that will be received in the future will be less than the value of a
rupee in hand today. Thus, in contrast top the compounding approach where we convert
present sums into future sums, in present value approach future sums are converted into
present sums.

Given a positive rate of interest, the present value of future rupees will always be lower. It is for
this reason, therefore, that the procedure of finding present values is commonly called
discounting.

It is concerned with determining the present value of a future amount, assuming that the
decision maker has an opportunity to earn a certain return on his money. This return is
designated in financial literature as the discount rate, the cost of capital or an opportunity cost.

Given a positive rate of interest, the present value of future rupees will always be lower. It is for
this reason, therefore, that the procedure of finding present values is commonly called
discounting.

It is concerned with determining the present value of a future amount, assuming that the
decision maker has an opportunity to earn a certain return on his money. This return is
designated in financial literature as the discount rate, the cost of capital or an opportunity cost.

Mathematical Formulation: Since finding present value is simply the reverse of compounding,
the formula for compounding of the sum can be readily transformed into a present value
formula.

According to the compounding the formula is

A = P(1 + i) n . Therefore, the present value equation becomes:

A 1

P = ----------- = A ---------

(1+ i)n (1+ i)n

In which P is the present value for the future sum to be received or spent; A is the sum to be
received or spent in future ; i is interest rate, and n is the number of years. Thus, the present
value of money is the reciprocal of the compounding value.

Present Values Tables: In order to simplify the present value calculations, table are readily
available for various ranges of i and n.

Present value interest factors (PVIF) for various discount rates and years. Since the factors in
Table A-3 give the present value of one rupee for various combinations of I and n, we can find
the present value of the future lump sum by multiplying it with the appropriate present value
interest factor (PVIF)

In terms of a formula, it will be:

P = A(PVIF)

Example: Mr. x wants to find the present value of Rs 2,000 to be received 5 years from now,
assuming 10 per cent rate of interest. We have to look in the 10 per cent column of the fifth
year in the table

Therefore, present value = Rs 2,000 (0.621)

= Rs, 1,242
Relation of Finance with Other Business Functions

Business function means functional activities that an enterprise undertakes in achieving its
desired objectives. These functions may be classified on the basis of its operational activities.

Finance function of a business is closely related to its other functional areas. Funds will be
wasted in the absence of efficient production and in the absence of proper marketing; he firm
will not be able to engage funds judiciously in the business. Most of the important decisions of
a business enterprise are taken on the basis of availability of funds. However, finance function
in practice should not limit the general running of the business. Financial policies of a firm
should be devised in such a manner so as to match the requirements of other functional areas.
The relationship between finance function and other business functions of an enterprise is
discussed below:

1. Purchase Function: Material required for production should be procured on economic

terms and should be utilized in efficient manner to achieve maximum productivity. In
this function the finance manager plays a key role in providing finance. In order to
minimize cost and exercise maximum control, various material management techniques
such as economic order quantity (EOQ), determinations of stock level, perpetual
inventory system etc are applied. The task of the finance manager is to arrange the
availability of cash when the bills for purchase become due.
2. Production Function: Production function occupies the dominant position i business
activities and it is a continuous process. The production cycle depends largely on the
marketing function because production is justified when they are resulted in revenue
through sales. Production function involves heavy investment in fixed assets and in
working capital. Naturally, a tighter control by the finance manager on the investment in
productive assets becomes necessary. It must be seen that there is neither over-
capitalization nor under-capitalization.
3. Distribution Function: As goods produced are meant for sale, distribution function is an
important business activity. It is more important because it provides continuous inflow
of cash to meet the outflow thereof. So, while choosing different distributing channels,
media of advertisement and sales promotion devices, the cost benefit criterion should
be the guiding factor.
4. Accounting Function: Charles Gastenberg visualizes the influence of scientific
arrangement of records, with the help of which inflow and outflow of funds can be
efficiently managed and stocks and bonds can be efficiently marketed. Moreover, the
efficiency of the whole organization can be greatly improved with correct recording of
financial data. All the accounting tools and control devices, necessary for appraisal of
finance policy can be correctly formulated if the accounting data are properly recorded.
 For example, the cost of raising funds, expected returns on the investment of such
funds, liquidity position, forecasting of sales, etc. can be effectively carried out if the
financial data so recorded are reliable. Hence, the relationship between accounting and
finance is intimate and the finance manager has to depend heavily on the accuracy of
the accounting data.
5. Personnel Functions: Personnel function has assumed a prominent place in the domain
of business management. No business function can be carried out efficiently unless
there is a sound personnel policy backed up by efficient management of personnel.
Success or failure of every business activity boils down to the efficiency of otherwise of
the men entrusted with the respective function. A sound personnel policy includes
proper wage structure, incentives schemes, promotional opportunity, human resource
development and other fringe benefits provided to the employees. All these matters
affect finance.
6. Research and Development: In the world of innovations and competitiveness,
expenditure on research and development is a productive investment and R and D itself
is an aid to survival and growth of the firm. Unless there is a constant endeavor for
improvement and sophistication of an existing product and introduction of newer
varieties, the firm is bound to be gradually out marketed and out of existence.
However, sometimes expenditure on R and D involves a heavier amount,
On the other hand, heavily cutting down expenditure of R and D blocks the scope of
improvement and diversification of the product. So, there must be a balance between
the amount necessary for continuing R and D work and the funds available for such a
purpose. Usually, this balance is struck out by joining efforts of finance manager and the
person at the helm of R and D.
Risk-return Trade Off

Financial decisions incur different degree of risk. Your decision to invest your money in
government bonds has less risk as interest rate is known and the risk of default is very less. On
the other hand, you would incur more risk if you decide to invest your money in sghares, as
return is not certain. However, you can expect a lower return from government bond and
higher from shares. Risk and expected return move in tandem; the greater the risk, the greater
the expected return.

Financial decisionsa of the firm are guided by the risk-return trade-off. Therse decisions are
interrelated and jointly affect the market value of its shares by influencing return and risk of the
firm. The relationship between return and risk can be simply expressed as follows:

Return = Risk free rate + Risk premium

Risk free rate is a rate obtainable from a default risk free government security. An investor
assuming riskfrom her investment requires a risk premium above the risk free rate. Risk free
rate is a compensation for time and risk premium for risk. Higher the risk of an action, higher
will be the risk premium leading to higher required return on that action. A proper balance
between return and risk should be maintained to maximise the market value of a firm’s shares.
Such balance is called risk-return trade off, and every financial decision involves this trade-off.
The interelation between market value, financial decisions and risk-return trade-off is depicted
in figure as follows:
 Financial Management

Maximisation of Share Value

Financial Decisions

Investment Liquidity Financing Dividend

Decisions Management Decisions Decisions

Trade Off

Return Risk

An overview of financial management

The financial manager , in a bid to maximise shareholders wealth, should strive to maximise
return in relation to the given risk, he or she should seek courses of actions that avoid
unnecessary risks. To ensure maximum return, funds flowing in and out of the firm should be
constantly monitored to assure that they are safeguarded and properly utlised. The financial
reporting system must be designed to provide timely and accurate picture of the firm’s
activities.