Introduction of financial management : Basics and Definitions
The primary task of an Accountant is to deal with funds, ‘Management of Funds’ is an important aspect of financial management in a business undertaking or any other institution like hospital, art society, and so on.
The term ‘Financial Management‘ has been defined differently by different authors.
According to Solomon “Financial Management is concerned with the efficient use of an important economic resource, namely capital funds.”
Phillippatus has given a more elaborate definition of the term, as , “Financial Management, is concerned with the managerial decisions that results in the acquisition and financing of short and long term credits for the firm.”
Thus, it deals with the situations that require selection of specific problem of size and growth of an enterprise. The analysis of these decisions is based on the expected inflows and outflows of funds and their effect on managerial objectives.
The most acceptable definition of financial management is that given by S.C.Kuchhal as, “Financial management deals with procurement of funds and their effective utilisation in the business.”
Thus, there are 2 basic aspects of financial management :
1) procurement of funds :
As funds can be obtained from different sources thus, their procurement is always considered as a complex problem by business concerns. These funds procured from different sources have different characteristics in terms of risk, cost and control that a manager must consider while procuring funds. The funds should be procured at minimum cost, at a balanced risk and control factors.
Funds raised by issue of equity shares are the best from risk point of view for the company, as it has no repayment liability except on winding up of the company, but from cost point of view, it is most expensive, as dividend expectations of shareholders are higher than prevailing interest rates and dividends are appropriation of profits and not allowed as expense under the income tax act. The issue of new equity shares may dilute the control of the existing shareholders.
Debentures are comparatively cheaper since the interest is paid out of profits before tax. But, they entail a high degree of risk since they have to be repaid as per the terms of agreement; also, the interest payment has to be made whether or not the company makes profits.
Funds can also be procured from banks and financial institutions, they provide funds subject to certain restrictive covenants. These covenants restrict freedom of the borrower to raise loans from other sources. The reform process is also moving in direction of a closer monitoring of ‘end use’ of resources mobilised through capital markets. Such restrictions are essential for the safety of funds provided by institutions and investors. There are other financial instruments used for raising finance e.g. commercial paper, deep discount bonds, etc. The finance manager has to balance the availability of funds and the restrictive provisions tied with such funds resulting in lack of flexibility.
In the globalised competitive scenario, it is not enough to depend on available ways of finance but resource mobilisation is to be undertaken through innovative ways or financial products that may meet the needs of investors. Multiple option convertible bonds can be sighted as an example, funds can be raised indigenously as also from abroad. Foreign Direct Investment (FDI) and Foreign Institutional Investors (FII) are two major sources of finance from abroad along with American Depository Receipts (ADR’s) and Global Depository Receipts (GDR’s).
The mechanism of procuring funds is to be modified in the light of requirements of foreign investors. Procurement of funds inter alia includes:
- Identification of sources of finance
- Determination of finance mix
- Raising of funds
- Division of profits between dividends and retention of profits i.e. internal fund generation.
2) Effective use of such funds :
The finance manager is also responsible for effective utilisation of funds. He must point out situations where funds are kept idle or are used improperly. All funds are procured at a certain cost and after entailing a certain amount of risk. If the funds are not utilised in the manner so that they generate an income higher than cost of procurement, there is no meaning in running the business.
It is an important consideration in dividend decisions also, thus, it is crucial to employ funds properly and profitably. The funds are to be employed in the manner so that the company can produce at its optimum level without endangering its financial solvency. Thus, financial implications of each decision to invest in fixed assets are to be properly analysed.
For this, the finance manager must possess sound knowledge of techniques of capital budgeting and must keep in view the need of adequate working capital and ensure that while firms enjoy an optimum level of working capital they do not keep too much funds blocked in inventories, book debts, cash, etc.
Fixed assets are to financed from medium or long term funds, and not short term funds, as fixed assets cannot be sold in short term i.e. within a year, also a large amount of funds would be blocked in stock in hand as the company cannot immediately sell its finished goods.