Function of Financial Management

                                 Russian State University for Business

Orenburg branch 
 
 
 
 
 
 
 

The Essay: Financial Management: 

Function of Financial Management. 
 
 
 
 
 
 

 
 
 

                                                                                                     Vorokosova Mariya

      2 st year studies

                                                                                                               Finance Depo

Supervisor: O.N.Safonova 
 
 
 
 
 
 
 
 
 
 

December-2011

Orenburg

                                           

                                Contents. 

       Introduction………………………………………………………3

Part 1. Financial Management terms.……………………………………5

1.1  Financial Management objectives………………………………..6

Part 2.  Functions of Financial Management……………………………...7

             2.1.   The investment decision……………………………………9

             2.2    The financing decision………………………………….....13

             2.3.   The dividend decision……………………………………..14

             Conclusion………………………………………………………15

             References……………………………………………………….16

Appendix №1   CD-RW

Appendix №2    Report 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

                                 Introduction. 

       Ever since 1494 when a monk of Italian origin, Lucas Pacioli wrote the first book on modern accounting, financial management has grown to become the key to corporate growth. Financial management can be simply termed as efficient management of finances of a business/organization in order to achieve financial objectives  

       The key objectives of a financial management are to generate wealth for the business and its shareholders, to provide a return of investment and to generate cash flow. There are two main aspects of financial management, namely, the procurement of funds and the effective use of those funds. On the procurement of funds, one may note here that funds may be procured from different sources and funds procured from different sources have different characteristics in terms of cost, risk and control in financial-management-speak. Funds issued through equity participation, that is, the financier acquires some stake in the company, are least risky as the money used to buy equity can only be repaid upon the liquidation of the company. But in terms of cost, these funds are pricey compared to others mainly because the dividend expectations are normally higher than the prevailing interest rates. 

     In principle, financial management comprises of risk, cost and control. For a proper balancing of risk and control, the cost of funds should be at the minimum. 

       Sound financial management is essential in all types of organizations, whether they are profit motivated, public or state owned bodies or those that are altruistic in nature. 

      Financial management ultimately will involve making of some financial decisions, and there are three types of such financial management decisions; long term investment decisions, long-term financing decisions and working capital management decisions. The third type of financial management decision, unlike the first two, is short term in nature. the decision in this segment involve managing cash, inventories and short term financing. All financial management decisions should form part of overall strategy and not be seen as separate.  The investment decision of financial management involves the managers deciding on the kind and nature of assets that they want to hold. So, inevitably this will involve selling, buying, reducing or holding of various assets. Managing those aforementioned activities is called capital budgeting. The process of decision making  on investments will involve one of the cardinal principles of financial management, which is that a firm should hold only those assets which yield a return not less than a prescribed minimum 

     Long term financing decision, as the name suggests, involve deciding the mode of procurement of funds to finance the necessary long term investments. The corporate “graveyard” is littered with companies that went burst not because their products had no market or that the workers were lazy, but because the decision makers did not adhere to the principles of good financial management. If, carried out competently, financial management increases the output from the factors of production, especially capital. Good financial management is especially essential for start-ups which need it for their survival. It is also important to an organization even if the profits are not in any way the motivation. Most of non-profit organizations have scant respect for good financial management, but even such bodies, and indeed everyone should be encouraged, if only for a wider utilitarian objective. 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

                
 

              1.      Financial Management terms. 

          Finance is the application of economic principles and concepts to business

decision-making and problem solving. The field of finance can be

considered to comprise three broad categories: financial management,

investments, and financial institutions:

          

         Financial management.

Sometimes called corporate finance or business finance, this area of finance is concerned primarily with financial decision-making within a business entity. Financial management decisions include maintaining cash balances, extending credit, acquiring other firms, borrowing from banks, and issuing stocks and bonds.

         Investments.

This area of finance focuses on the behavior of financial markets and the pricing of securities. An investment manager’s tasks, for example, may include valuing common stocks, selecting securities for a pension fund, or measuring a portfolio’s performance.

        Financial institutions.

This area of finance deals with banks and other firms that specialize in bringing the suppliers of funds together with the users of funds. For example, a manager of a bank may make decisions regarding granting loans, managing cash balances, setting interest rates on loans, and dealing with government regulations. 

        No matter the particular category of finance, business situations that call for the application of the theories and tools of finance generally involve either investing (using funds) or financing (raising funds). Managers who work in any of these three areas rely on the same basic knowledge of finance. In this book, we introduce you to this common body of knowledge and show how it is used in financial decision-making. Though the emphasis of this book is financial management, the basic principles and tools also apply to the areas of investments and financial institutions. In this introductory chapter, we’ll consider the

types of decisions financial managers make, the role of financial analysis, the forms of business ownership, and the objective of managers decisions. Finally, we will describe the relationship between owners and managers. 
 
 
 
 
 
 
 
 
 
 

          1.1           Financial Management objectives. 

      

           The financial management is generally concerned with procurement, allocation and control of financial resources of a concern.

          

          The objectives can be-

1. To ensure regular and adequate supply of funds to the concern.
2. To ensure adequate returns to the shareholders which will depend upon the earning capacity, market price of the share, expectations of the shareholders.
3. To ensure optimum funds utilization. Once the funds are procured, they should be utilized in maximum possible way at least cost.
4. To ensure safety on investment, i.e, funds should be invested in safe ventures so that adequate rate of return can be achieved.
5. To plan a sound capital structure-There should be sound and fair composition of capital so that a balance is maintained between debt and equity capital.

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

                  2.             Functions of Financial Management 

      Estimation of capital requirements: A finance manager has to make estimation with regards to capital requirements of the company. This will depend upon expected costs and profits and future programmes and policies of a concern. Estimations have to be made in an adequate manner which increases earning capacity of enterprise. 

       Determination of capital composition: Once the estimation have been made, the capital structure have to be decided. This involves short- term and long- term debt equity analysis. This will depend upon the proportion of equity capital a company is possessing and additional funds which have to be raised from outside parties. 

    Choice of sources of funds: For additional funds to be procured, a company has many choices like-

        Issue of shares and debentures

        Loans to be taken from banks and financial institutions

        Public deposits to be drawn like in form of bonds.

    Choice of factor will depend on relative merits and demerits of each source and period of financing. 

    Investment of funds: The finance manager has to decide to allocate funds into profitable ventures so that there is safety on investment and regular returns is possible. 

    Disposal of surplus: The net profits decision have to be made by the finance manager. This can be done in two ways:

    Dividend declaration - It includes identifying the rate of dividends and other benefits like bonus.

     Retained profits - The volume has to be decided which will depend upon expansional, innovational, diversification plans of the company.  

    Management of cash: Finance manager has to make decisions with regards to cash management. Cash is required for many purposes like payment of wages and salaries, payment of electricity and water bills, payment to creditors, meeting current liabilities, maintainance of enough stock, purchase of raw materials, etc. 

    Financial controls: The finance manager has not only to plan, procure and utilize the funds but he also has to exercise control over finances. This can be done through many techniques like ratio analysis, financial forecasting, cost and profit control, etc. 
 
 

          Financial management encompasses many different types of decisions.

We can classify these decisions into three groups: investment decisions, financing decisions, and decisions that involve both investing and financing.

         Investment decisions are concerned with the use of funds the buying, holding, or selling of all types of assets: Should we buy a new die stamping machine? Should we introduce a new product line? Sell the old production facility? Buy an existing company? Build a warehouse? Keep our cash in the bank? 

       Financing decisions are concerned with the acquisition of funds to be used for investing and financing day-to-day operations. Should managers use the money raised through the firms’ revenues? Should they seek money from outside of the business? A company’s operations and investment can be financed from outside the business by incurring debts, such as though bank loans and the sale of bonds, or by selling ownership interests. Because each method of financing obligates the business in different ways, financing decisions are very important.

 

       Many business decisions simultaneously involve both investing and financing. For example, a company may wish to acquire another firm an investment decision. However, the success of the acquisition may depend on how it is financed: by borrowing cash to meet the purchase price, by selling additional shares of stock, or by exchanging existing shares of stock. If managers decide to borrow money, the borrowed funds must be repaid within a specified period of time. Creditors (those lending the money) generally do not share in the control of profits of the borrowing firm. If, on the other hand, managers decide to raise funds by selling ownership interests, these funds never have to be paid back. However, such a sale dilutes the control of (and profits accruing to) the current owners. 

      Whether a financial decision involves investing, financing, or both,

it also will be concerned with two specific factors: expected return and

risk. And throughout your study of finance, you will be concerned with

these factors. Expected return is the difference between potential benefits and potential costs. Risk is the degree of uncertainty associated with these expected returns. 

      Financial management is concerned with the acquisition, financing, and management of assets with some overall goal in mind. Thus the decision function of financial management can be broken down into three major areas: the investment, financing, and dividend decisions 
 
 
 
 
 

         

     2.1.      The investment decision 
 

          Management must allocate limited resources between competing opportunities (projects) in a process known as capital budgeting. Making this investment, or capital allocation, decision requires estimating the value of each opportunity or project, which is a function of the size, timing and predictability of future cash flows. 

        In general, each project's value will be estimated using a discounted cash flow (DCF) valuation, and the opportunity with the highest value, as measured by the resultant net present value (NPV) will be selected This requires estimating the size and timing of all of the incremental cash flows resulting from the project. Such future cash flows are then discounted to determine their present value. These present values are then summed, and this sum net of the initial investment outlay is the NPV. 

        The NPV is greatly affected by the discount rate. Thus, identifying the proper discount rate – often termed, the project "hurdle rate" – is critical to making an appropriate decision. The hurdle rate is the minimum acceptable return on an investment—i.e. the project appropriate discount rate. The hurdle rate should reflect the riskiness of the investment, typically measured by volatility of cash flows, and must take into account the project-relevant financing mix. Managers use models such as the CAPM or the APT to estimate a discount rate appropriate for a particular project, and use the weighted average cost of capital (WACC) to reflect the financing mix selected. (A common error in choosing a discount rate for a project is to apply a WACC that applies to the entire firm. Such an approach may not be appropriate where the risk of a particular project differs markedly from that of the firm's existing portfolio of assets.) 

        In conjunction with NPV, there are several other measures used as (secondary) selection criteria in corporate finance. These are visible from the DCF and include discounted payback period, IRR, Modified IRR, equivalent annuity, capital efficiency, and ROI. Alternatives (complements) to NPV include MVA / EVA (Joel Stern, Stern Stewart & Co) and APV (Stewart Myers). See list of valuation topics. 

       In many cases, for example R&D projects, a project may open (or close) various paths of action to the company, but this reality will not (typically) be captured in a strict NPV approach. Management will therefore (sometimes) employ tools which place an explicit value on these options. So, whereas in a DCF valuation the most likely or average or scenario specific cash flows are discounted, here the “flexible and staged nature” of the investment is modelled, and hence "all" potential payoffs are considered. The difference between the two valuations is the "value of flexibility" inherent in the project. 

         The two most common tools are Decision Tree Analysis (DTA) and Real options analysis (ROA);they may often be used interchangeably: 

       DTA values flexibility by incorporating possible events (or states) and consequent management decisions. (For example, a company would build a factory given that demand for its product exceeded a certain level during the pilot-phase, and outsource production otherwise. In turn, given further demand, it would similarly expand the factory, and maintain it otherwise. In a DCF model, by contrast, there is no "branching" – each scenario must be modelled separately.) In the decision tree, each management decision in response to an "event" generates a "branch" or "path" which the company could follow; the probabilities of each event are determined or specified by management. Once the tree is constructed: (1) "all" possible events and their resultant paths are visible to management; (2) given this “knowledge” of the events that could follow, and assuming rational decision making, management chooses the actions corresponding to the highest value path probability weighted; (3) this path is then taken as representative of project value. See Decision theory: Choice under uncertainty.