Unit 1

Finance as an area of study

Finance is an area of study. It is a broad term that describe activities that is associate with banking leverage or debt, credit, capital market , , money, and investments . Finance encompasses oversight, creation, and study of money, banking, credit, investments, assets, and liabilities that make up financial systems.

Many of the basic concepts in finance originate from micro and macroeconomic theories.

Finance is defined as the management of money and includes activities such as investing, borrowing, lending, budgeting, saving, and forecasting.

There are three main types of finance

: (1) Personal,

(2) Corporate, and

(3) public/government.

1.2 Function of financial management

Financial management refers to the effective and efficient planning, organizing, directing and controlling of financial activities and processes of an organization. It means applying general management principles to financial resources of the enterprise.

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.

1.3 Goal of finance manager/Management

Goals of financial management should be so articulated as to help achieve the objective of wealth maximization and maximisation of profit pool. Financial goals may be stated as maximizing short-term profits and minimizing risks.

These goals imply that finance manager should take financial decisions in such a way as to ensure high level of profits. He should seek courses of action that avoid unnecessary risks and anticipate problem areas and ways of overcoming difficulties.

In the pursuit of the above goals, finance manager should recognize the inter-relationship between profit and risk. In fact, value of a firm is influenced jointly by return and risk. In real world, the relationship between the two is inverse. Investments promising high profits will be more riskier than their counterparts.

It is therefore, the prime responsibility of the finance manager to strike judicious balance between return and risk in order to maximize value of the firm. To assure maximum profits to the firm, a finance manager must monitor the cash inflows and outflows of the business and thereby ensure effective utilization of resources.

He should also endeavor to build in sufficient flexibility in the financial operations of the enterprise so as to deal with uncertainty. He has to gain flexibility by identifying strategic alternatives both in regard to investment outlets and acquisition of funds.

Another major financial goal of a firm is imparting sufficient liquidity and profitability of the enterprise. Thus, a finance manager while managing funds has to ensure that the firm has adequate liquid resources on hand to satisfy its obligations at all times and in addition it has a certain level above its expected needs to act as a reserve to meet emergencies.

But if the enterprise carries large amount of funds in cash, it loses opportunity cost of the funds and, therefore, goal of high level of profit suffers.

An enterprises to improve his return must ensure optimum utilization of resources. Thus, finance manager is in dilemma. The dilemma is: high profitability means low liquidity and vice-versa. He must, therefore, strike satisfactory trade-off between profitability and liquidity.

1.4 Agency costs

Agency costs are a type of internal cost that a principal may incur as a result of the agency problem. They include the costs of any inefficiencies that may arise from employing an agent to take on a task, along with the costs associated with managing the principal-agent relationship and resolving differing priorities. While it is not possible to eliminate the agency problem, principals can take steps to minimize the risk of agency costs.

1.5 Agency problem

The agency problem is a conflict of interest inherent in any relationship where one party is expected to act in another's best interests. In corporate finance, the agency problem usually refers to a conflict of interest between a company's management and the company's stockholders. The manager, acting as the agent for the shareholders, or principals, is supposed to make decisions that will maximize shareholder wealth even though it is in the manager’s best interest to maximize his own wealth.

About Prajjwal pokharel

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Business Finance Chapter 1