Friday, 6 March 2015

Finance and Other Related Disciplines


Finance and Other Related Disciplines

Apart from economics and accounting, finance also draws-for its day-to-day decisions-on sup­portive disciplines such as marketing, production and quantitative methods. For instance, financial managers should consider the impact of new product development and promotion plans made in marketing area since their plans will require capital outlays and have an impact on the projected cash flows. Similarly, changes in the production process may necessitate capital expenditures which the financial managers must evaluate and finance. And, finally, the tools of analysis developed in the quantitative methods area are helpful in analysing complex financial manage­ment problems.

 

The marketing, production and quantitative methods are, thus, only indirectly related to day-to­day decision making by financial managers and are supportive in nature while economics and accounting are the primary disciplines on which the financial manager draws substantially.

The relationship between financial management and supportive disciplines is depicted in Fig 1.1.

 

 

 

 

 

 

 

Financial Decision Area                                                                                                Primary Discipline

                                                                                                            1. Accounting

1. Investment analysis                                                      Support                                         2. Macroeconomics

2~ Working capital management:                                                                                           3. Micro economics

3. Sources and cost of funds

4. Determination of capital structure

5. Dividend policy.          '

6. Analysis of risks and returns                                        Support                                           Other Relates Discipline

1.    Marketing

2.    Production

3.    Quantatative method

                     Resulting in

Shareholders Wealth Maximisation

 

 

SCOPE OF FINANCIAL MANAGEMENT

The approach to the scope and functions of financial management is divided, for purposes of exposition, into two broad categories: (a) The Traditional Approach, and (b) The Modem Approach.

 

Traditional Approach

The traditional approach to the scope of financial management refers to its subject-matter, in academic literature in the initial stages of its evolution, as a separate branch of academic Study. The term 'corporation finance' was used to describe what is now known in the academic world as 'financial management'. As the name suggests, the concern of corporation finance was with the financing of corporate enterprises. In other words, the scope of the finance function was treated by the traditional approach in the narrow sense of procurement of funds by corporate enterprise to meet their financing needs. The term 'procurement' was used in a broad sense so as to include the whole gamut of raising funds externally. Thus defined, the field of study dealing with finance was treated as encompassing three interrelated aspects of raising and administering resources from outside: (i) the institutional arrangement in the form of financial institutions which comprise the organisation of the capital market; (ii) the financial instruments through which funds are raised from the capital markets and the related aspects of practices and the procedural aspects of capital markets; and (iii) the legal and accounting relationships between a firm and its sources of funds. The coverage of corporation finance was, therefore, conceived to describe the rapidly evolving complex of capital market institutions, instruments and practices. A related aspect was that firms require funds at certain episodic events such as merger, liquidation, reorganisation and so on. A detailed description of these major events constituted the second element of the scope of this field of academic study. That these were the broad features of the subject-matter of corporation finance is eloquently reflected in the academic writings around the period during which the traditional approach dominated academic thinking. 1 Thus, the issues to which literature on finance addressed itself was how resources could best be raised from the combination of the available sources.

The traditional approach to the scope of the finance function evolved during the 1920s and 1930s and dominated academic thinking during' th~ forties and through the early ftfties. It has now been discarded as it suffers from serious limitations. The weaknesses of the traditional approach fall into two broad categories: (i) those relating to the treatment of various topics and the emphasis attached to them; and (ii) those relating to the basic conceptual and analytical framework of the definitions and scope of the finance function.

The first argument against the traditional approach was based on its emphasis on issues relating to the procurement of funds by corporate enterprises. This approach was challenged during the period when the approach dominated the scene itself.2 Further, the traditional treatment of finance was criticised3 because the finance function was equated with the issues involved in raising and administering funds, the theme was woven around the viewpoint of the suppliers of funds such as investors, investment bankers and so on, that, is the outsiders. It implies that no consideration was given to viewpoint of those who had to take internal financial decisions. The traditional treatment was, in other words, the outsider-looking-in approach. The limitation was that internal decision making (ie. insider-looking-out) was completely ignored.

 The second ground of criticism of the traditional treatment was that the focus was on financing problems of corporate enterprise. To that extent the scope of financial management was confirmed only to a segment of the industrial enterprises, as non-corporate organisations lay outside its scope.

Yet another basis on which the traditional approach was challenged was that the treatment was built too closely around episodic events, such as promotion, incorporation, merger, consolidation, reorganisation and so on. Financial management was' confirmed to a description of these infrequent happenings in the life of an enterprise. As a logical corollary, the day-to-day financial problems of a normal company did not receive much attention.         

Finally, the traditional treatment was found to have a lacuna to the extent that the focus was on long-term financing. Its natural implication was that the issues involved in working capital manage­ment were not in the purview of the finance function.

The limitations of the traditional approach were not entirely based on treatment or emphasis of different aspects. In other words, its weaknesses were more fundamental. The conceptual and analytical shortcoming of this approach arose from the fact that it confirmed financial management to issues involved in procurement of external funds, it did not consider the important dimension of allocation of capital. The conceptual framework of the traditional treatment ignored what Solomon aptly described as the central issues of financial management. These issues were reflected in the following fundamental questions which a finance manager should address. Should an enter­prise commit capital funds to certain purposes? Do the expected returns meet financial standards of performance? How should these standards be set and what is the cost of capital funds to the enterprises? How does the cost vary with the mixture of financing methods used? In the absence of the coverage of these crucial aspects, the traditional approach implied a very narrow scope for financial management. The modem approach provides a solution to these shortcomings.

Modem Approach

The modern approach views the term financial management in a broad sense and provides a conceptual and analytical framework for financial decision making. According to it, the finance function covers both acquisition of funds as well as their allocations. Thus, apart from the issues involved in acquiring external funds, the main concern of financial management is the efficient and wise allocation of funds to various uses. Defined in a broad sense, it is viewed as an integral part of overall management.

The new approach is an analytical way of viewing the financial problems of a firm. The main contents of this approach are: What is the total volume of funds an enterprise should commit? What specific assets should an enterprise acquire? How should the funds required be financed? Alternatively, the principal contents of the modem approach to financial management can be said to be: (0 how large should an enterprise be, and how fast should it grow? (ii) In what form should it hold assets? and (Hi) what should be the composition of its liabilities?

The three questions posed above cover between them the major' financial problems of a firm. In other words, the financial management, according to the new approach, is concerned with the solution of three major problems relating to the financial operations of a firm, corresponding to the three questions of investment, financing and dividend decisions. Thus, financial management in modern sense of a firm can be broken down into three major decisions as functions of finance: (D The investment decision, (ii) the financing decision, and (iii) the dividend policy decision.

 

Investment Decision The investment decision relates to the selection of assets in which funds will be invested by a firm. The assets which can be acquired fall into two broad groups: (I) long-term assets which yield a return over a period of time in future, (ii) short-term or current assets, defined as those assets which in the normal course of business are convertible into cash without diminution in value, usually within a year. The first of these involving the first category of assets is popularly known in financial literature as capital budgeting. The aspect of financial decision making with reference to current assets or short-term assets is popularly termed as working capital management.

 

Capital Budgeting Capital budgeting is probably the most crucial financial decision of a firm. It relates to the selection of an asset or investment proposal or course of action whose benefits are likely to be available in future over the lifetime of the project. 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 reallocation of capital when an existing asset fails to justify the funds committed. Whether an asset will be accepted or not will depend upon the relative benefits and returns associated with it. The measurement of the worth of the investment proposals is, therefore, a major element in the capital budgeting exercise. This implies a discussion of the methods of appraising investment proposals.

The second element of the capital budgeting decision is the analysis of risk and uncertainty. Since the benefits from the investment proposals extend into the future, their accrual is uncertain. They have to be estimated under various assumptions of the physical volume of sale and the level of prices. An element of risk in the sense of uncertainty of future' benefits is, thus, involved in the exercise. The returns from capital budgeting decisions should, therefore, be evaluated in relation to the risk associated with it.

 

Finally, the evaluation 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 by different names such as cut-off rate, hurdle rate, required rate, minimum rate of return and so on. This standard is broadly expressed in terms of the cost of capital. The concept and measurement of the cost of capital is, thus, another major aspect of capital budgeting decision. In brief, the main elements of capital budgeting decisions are: (I) the long-term assets and their composition, (ii) the business risk complexion of the firm, and (Hi) the concept and measurement of the cost of capital.

 

Working Capital Management Working capital management is concerned with the management of current assets. It is an important and integral part of financial management as short-term survival is a prerequisite for long-term success. One aspect of working capital management is the trade-off between profitability and risk (liquidity). There is a conflict between profitability and liquidity. If a firm does not have adequate working capital, that is, it does not invest sufficient funds in current assets, it may become illiquid and consequently may not have the ability to meet its current obligations and, thus, invite the risk of bankruptcy.. If the current assets are too large, profitability is adversely affected. The key strategies and considerations in ensuring a trade-off between profitability and liquidity is one major dimension of working capital management. In addition, the individual current assets should be efficiently managed so that neither inadequate nor unnecessary funds are locked up. Thus, the management of working capital has two basic ingredients: (1) an overview of working capital management as a whole, and (2) efficient management of the individual current assets such as cash, receivables and inventory.

 

Financing Decision the second major decision involved in financial management is the financing decision. The investment decision is broadly concerned with the asset-mix or the composition of the assets of a firm. The concern of the financing decision is with the financing-mix or capital structure or leverage. The term capital structure refers to the proportion of debt (fixed-interest sources of financing) and equity capital (variable-dividend securities/source of funds). The financ­ing decision of a firm relates to the choice of the proportion of these sources to finance the investment requirements. 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. The use of debt implies a higher return to the shareholders as also the financial risk. A proper balance between debt and equity to ensure a trade-off between risk and return to the shareholders is necessary. A capital structure with a reasonable proportion of debt and equity capital is called the optimum capital structure. Thus, one dimension of the financing decision whether there is an optimum capital structure and in what proportion should funds be raised to maximise the return to the shareholders? The second aspect of the financing decision is the determination of to an appropriate capital structure, given the facts of a particular case. Thus, the financing decision covers two interrelated aspects: (1) the capital structure theory, and (2) the capital structure decision.

 

Dividend Policy Decision The third major decision area of financial management is the decision relating to the dividend policy. The dividend decision should be analysed in' relation to the financing decision of a firm. Two alternatives are available in dealing with the profits of a firm: (0 they can be distributed to the shareholders in the form of dividends or (i0 they can be retained in the business itself. The decision as to which course should be followed depends largely on a significant element in the dividend decision, the dividend-payout ratio, that is, what proportion of net profits should be paid out to the shareholders. The fmal decision will depend upon the preference of the shareholders and investment opportunities available within the firm. The second major aspect of the. dividend decision is the factors determining dividend policy of a firm in practice. .

To conclude, the traditional approach to the functions of financial management had a very narrow perception and was devoid of an integrated conceptual and analytical framework. It had rightly been discarded in the ac:ldemic literature. The modem approach to the scope of financial management has broadened its scope which involves the solution of three major decisions, namely, investment, fmancing and dividend. These are interrelated and should be jointly taken so that financial decision making is optimal. The conceptual framework for optimum financial deci­sions is the objective of financial management. In other words, to ensure an optimum decision in respect of these three areas, they should be related to the objectives of financial management.











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Finance and Accounting


Finance and Accounting

The relationship between  finance and accounting, conceptually speaking, has two dimensions: CO they are closely related to the extent that accounting is an important input in financial decision

making; and (ii) there. are key differences in viewpoints between them.      .

Accounting function is a necessary input into the finance function. That is, accounting is a subfunction of finance. Accounting generates information/data relating to operations/activities of the firm. The end-product of accounting constitutes financial statements such as the balance sheet, the income statement (profit and loss account) and the statement of changes in financial position/ sources and uses of funds statement/cash flow statement. The information contained in these statements and reports assists financial managers in assessing the past performance and future directions of the firm and in meeting legal obligations, such as payment of taxes and so on. Thus, accounting and finance are functionally closely related. Moreover, the finance (treasurer) and accounting (controller) activities are typically within the control of the vice-president/director (finance)/Chief financial officer (CFO) as shown in Fig. 1.2.

These functions are closely related and generally overlap; indeed, financial management and accounting are often not easily distinguish­able. In small firms the controller often carries out the finance function and in large firms many accountants are intimately involved in various finance activities.

But there are two key differences between finance and accounting. The first difference relates to the treatment of funds, while the second relates to decision making.

 

Treatment of Funds The viewpoint of accounting relating to the funds of the firm is different from that of finance. The measurement of funds (income and expenses) in accounting is based on the accrual principle/system. For instance, revenue is recognised at the point of sale and not when collected. Similarly, expenses are recognised when they are incurred rather than when actually paid. The accrual-based accounting data do not reflect fully the financial circumstances of the firm. A firm may be quite profitable in the accounting sense in that it has earned profit (sales less expenses) but it may not be able to meet current obligations owing to shortage of liquidity. due to uncollectable receivables, for instance. Such a firm will not survive regardless of its levels of profits.

,The viewpoint of finance relating to the treatment of funds is based on cashflows. The revenues are recognised only when actually received in cash (Le. cash inflow) and expenses are recognised on actual payment (Le. cash outflow). This is so because the financial manager is concerned with maintaining solvency of the firm by providing the cashflows necessary to satisfy its obligations and acquiring and financing the assets needed to achieve the goals of the firm. Thus, cashflow-based returns help financial managers avoid insolvency and achieve the desired financial goals.

To illustrate, total sales of a trader during the year amounted to Rs 10,00,000 while the cost of sales was Rs 8,00,000. At the end of the year, it has yet to collect Rs 8,00,000 from the customers. The accounting view and the financial view of the firms performance during the year are given below.

 

Accounting View                                                                                Financial View

(Income Statement)                                                             (Cash Flow Statement)

Sales                                              Rs 10,00,000                        Cash inflow                     Rs 2,00,000

        Less: Cost                     Rs    8,00,000                              Less cash outflow      Rs 8,00,000

                                            _____________                                                       ___________

Net Profit                                      Rs    2,00,000                              Net cash outflow        Rs 6,00,000

 

Obviously, the firm is quite profitable in accounting sense, it is a financial failure in, terms of actual cash flows resulting from uncollected receivables. Regardless of its profits, the firm would not survive due to inadequate cash inflows to meet its obligations.

Decision Making Finance and accounting also differ in respect of their purposes. The purpose of accounting is collection and presentation of financial data. It provides consistently developed and easily interpreted data on the past, present and future operations of the firm. The financial manager uses such data for financial decision making. It does not mean that accountants never make decisions or financial managers never collect data. But the primary focus of the functions of accountants 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, finance begins where accounting ends.











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FINANCIAL MANAGEMENT -AN OVERVIEW


FINANCIAL MANAGEMENT -AN OVERVIEW

 

INTRODUCTION

Finance may be defined as the art and science of managing money. The major areas of finance are: (1) financial services and (2) managerial finance/corporate finance/financial management. While financial services is concerned with the design and delivery of advice and financial products to individuals, businesses and governments within the areas of banking and related institutions, personal financial planning, investments, real estate, insurance and so on, financial management is concerned with the duties of the financial managers in the business firm. Financial managers actively manage the financial affairs of any type of business, namely, financial and non-financial, private and public, large and small, profit-seeking and not-for-profit. They perform such varied tasks as budgeting, financial forecasting, cash management, credit administra­tion, investment analysis, funds management and so on. In recent years, the changing regulatory and economic environments coupled with the globalisation of business activities have increased, the complexity as well as the importance of the financial managers' duties. As a result, the financial management function has become more demanding and complex. This Chapter provides an overview of financial management function. It is organised into seven Sections:

. Relationship of finance and related disciplines

. Scope of financial management

. Goal /objectives ,of financial management

. Agency problem

. Organisation of the finance function

. Emerging role of finance managers in India

. An overview

 

FINANCE –FINANCE AND RELATED DISCIPLINE

 

Financial management, as an integral part of overall management, is not a totally independent area. It draws heavily on related disciplines and fields of study, such as economics, "accounting, marketing, production and quantitative methods. Although these disciplines are interrelated, there are key differences among them. In this Section, we discuss these relationships.

 

 

Finance and Economics

 

The relevance of economics. to financial management can be described in the light of the two

broad areas of economics: macroeconomics and microeconomics.

Macroeconomics is concerned with the overall institutional environment in which the firm operates. It looks at the economy as a whole. Macroeconomics is concerned with the institutional structure of the banking system, money and capital markets, financial intermediaries, monetary, credit and fiscal policies and economic policies dealing with, and controlling level of, activity within an economy. Since business firms operate in the macroeconomic environment, it is impor­tant for financial managers to understand the broad economic environment. Specifically, they should (1) recognise and understand how monetary policy affects the cost and the availability of funds; (2) be versed in fiscal policy and its effects on the economy; (3) be ware of the various financial institutions/financing outlets; (4) understand the consequences of various levels of eco­nomic activity and changes in economic policy for their decision environment and so on. Microeconomics deals with the economic decisions of individuals and organisations. It concerns itself with the determination of optimal operating strategies. In other words, the theories of microeconomics provide for effective operations of business firms. They are concerned with defining actions that will permit the firms to achieve success. The concepts and theories of microeconomics relevant to financial management are, for instance, those involving (1) supply and demand relationships and profit maximisation strategies, (2) issues related to the mix of productive factors, 'optimal' sales level and product pricing strategies, (3) measurement of utility preference, risk and the determination of value, and (4) the rationale of depreciating assets. In addition, the primary principle that applies in financial management is marginal analysis; it suggests that financial decisions should be made on the basis of comparison of marginal revenue and marginal cost. Such decisions will lead to an increase in profits of the firm. It is, therefore, important that financial managers must be familiar with basic microeconomics.

To illustrate, the financial manager of a department store is contemplating to replace one of its online computers with a new, more sophisticated one that would both speed up processing time and handle a large volume of transactions. The new computer would require a cash outlay of Rs 8,00,000 and the old computer could be sold to net Rs 2,80,000. The total benefits from the new computer and the old computer would be Rs 10,00,000 and Rs 3,50,000 respectively. Applying marginal analysis, we get:

 

Benefits with new computer                                                                                  Rs 10,00,000

Less: Benefits with old computer Marginal benefits (a) Cost of new computer                       3,50,000

 

Marginal Benefits    (a)                                                                                                                                  Rs 6,50,000

Cost of new computer                                                                                                        Rs 8,00,000

Less: Proceeds from sale of old computer Marginal cost (b) Net benefits [(a) - (b)]      Rs 2,80,000

Marginal cost          (b)                                                                                                                    Rs 5,20,000

Net benefits (a) –(b)                                                                                                                           1,30,0000

 

As the store would get a net benefit of Rs 1,30,000, the old computer should be replaced by the new one.

 Thus, a knowledge of economics is necessary for a financial manager to understand both the financial environment and the decision theories which underline contemporary financial manage­ment. He should be familiar with these two areas of economics. Macroeconomics provides the financial manager with an insight into policies by which economic activity is controlled. Operating within that institutional framework, the financial manager draws on microeconomic theories of the operation of firms and profit maximisation. A basic knowledge of economics is, therefore, neces­sary to understand both the environment and the decision. techniques of financial management.

 











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