Financial Management - Chapter 1

Subject: Financial Management

Chapter: One

Chapter No. 1 – Introduction to Financial Management Contents Finance function as different from Accounts function Objectives of Financial Management – short-term and long-term Financial system and markets in India – Government of India, Ministry of Finance at the helm, statutes, statutory authorities, financial intermediaries, other financial institutions, agents who operate in the markets etc. Brief introduction to “Financial Instruments”

At the end of the chapter the student will be able to Map the differences between Finance and Accounts functions in an organisation and explain the integration of these functions Link the short-term and long-term objectives of Financial Management to profitability and wealth maximization respectively Draw the Financial system in India and Differentiate one financial instrument from another

Introduction Financial Management is an integral part of Business Management. Finance is one of the key functions in an organisation. The other key functions in an organisation are: Production Human Resources Marketing Each of the above function has got sub-divisions – for example Production has maintenance, Administration has purchases etc. Finance deals with financial resources. Financial management as a corollary would deal with management of financial resources and related areas.

Some of the key finance functions are: Financial planning and estimation of finance required for the organisation Mobilisation of financial resources required as above Ensuring that the funds are available in adequate quantity at appropriate time and at an affordable cost Management of cash in the organisation through cash flow statement Management of investment outside the business enterprise in other organisations Punjab Technical University, Online Virtual Campus

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Subject: Financial Management

Chapter: One Management of risk in dealing with foreign exchange for imports and exports Note: The above list is not exhaustive.

Let us examine briefly the above functions with some examples.

Financial planning and estimation of finance required for the organisation Any activity in a business enterprise requires planning for proper execution in time. Finance is required for any activity at least in the beginning and hence financial planning is the prime function of “Finance”. This involves detailed study of any activity from understanding the total funds requirement for that activity, when the funds will be required and how much funds will be required at different stages. For a new enterprise the entire resources have to come from outside (externally); for an existing enterprise, a part of the resources at least will be available from the profits made in the past and retained in business after declaring dividend. Example No. 1: We require Rs. 200 lacs for an activity. Let us see how it affects an existing enterprise. Let us assume the profits available to be Rs. 60 lacs. Then we require further resources of Rs. 140 lacs only. This is the difference between an existing enterprise and a new one. Financial planning will take this into account.

Mobilisation of financial resources Having ascertained in the above example that we require Rs. 200 lacs for a set activity, for a new enterprise we require the entire amount to be mobilised. For an existing enterprise with available profits of Rs. 60 lacs, we require only Rs. 140 lacs. The Financial manager will then assess all the alternative resources available to him (for details please refer to Chapter no. 4) keeping in mind the following parameters: Adequacy (availability in adequate quantity) Timely (availability in time) and At an affordable cost

Adequate supply in time etc. This has been explained this in the above point. For reinforcement the student’s attention is drawn to one of the objectives of financial management at least in the short run, the objective of maximising profits of the organisation. The profits so maximised in turn enhance the Earning Per Share (EPS – for formula please refer to Chapter no. 9).

Management of cash in the organisation This involves the following steps: Ascertaining the average cash requirement by looking at the past figures and for a new enterprise, estimating this figure. Preparing the cash flow statement for a given period, taking all the cash inflows and cash outflows during the period to determine whether there is a surplus or deficit at the end of the period Arranging for funds from outside especially through a bank with whom the enterprise has loan facilities in case of deficit in the cash flow statement; if on the contrary, the cash flow statement reveals a surplus, dealing with this surplus in a suitable manner (For further details, please refer to chapter no. 7 on “working capital management”)

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Subject: Financial Management

Chapter: One

Management of investment outside the organisation Over a period of time the enterprise reinvests a part of the profits for future growth of the organisation in business. The Finance manager can invest such funds outside the business in other enterprises also provided the parent enterprise does not require them immediately. Short-term surplus as revealed by the Cash flow statement is also invested for short duration. Thus investment outside one’s own business becomes the responsibility of the Finance Manager

Management of risk in foreign exchange etc. A business enterprise may require imports and do exports also. Whenever this is done the invoice is in foreign currency. In imports the business enterprise requires foreign exchange while in exports it gets foreign exchange. There is a risk involved while doing imports or exports. The risk is that the exchange rate of the foreign currency in terms of Indian Rupees can keep changing. We will explain this through an example. Example no. 2 We have a US Dollar bill for 1000 receivable after a month. Presently the exchange rate is 1 US Dollar = Rs.48.25. By the time the money is received after a month, in case the rate is less than Rs. 48.25, we will lose money. On the contrary if the exchange rate is more than Rs. 48.25 we will gain. Exactly opposite will be the effect in the case of imports. The importer will pay less if the exchange rate decreases and more if the exchange rate increases. There are ways and means of minimising the risk of foreign exchange. Finance manager is expected to take care of such risks.

Difference between finance function and accounts function Finance and accounts functions may be integrated in an organisation. This means that one department handles both. In most of the small and medium size units in India, the functions will be integrated. A business enterprise will require a full-fledged finance department only when the functions listed above are predominant functions impacting business in a big way. If the finance functions are not predominant functions, Accounts department looks after Finance also. Constant requirement of funds, surplus for investment etc, could be some of the factors influencing the need for a full-fledged Finance department.

Accounts function Core accounts have to take care of the following areas: Maintaining accounts on a regular basis for all items of income, expenditure, assets and liabilities Conforming to Generally Accepted Accounting Practices (GAAP – India), Accounting principles, Various Accounting standards of the Institute of Chartered Accountants of India (ICAI), Requirements under the Companies’ Act like following “Accrual system of accounting” (as opposed to cash system of accounting), Requirements under The Income Tax Act while maintaining the Accounts of the limited company Finalisation of accounts at the end of the accounting period (financial year) and preparation of final accounts in the formats prescribed in the Companies’ Act – Schedule VI after claiming depreciation as per provisions of Companies’ Act – Schedule XIV Conforming to provisions relating to Advance Tax payment in four instalments – first instalment by 15/6, second instalment by 15/9, third instalment by 15/12 and the last instalment by 15/3. Conforming to provisions relating to statutory audit of accounts under the Companies’ Act Preparation of revenue and capital budgets Management Information System (MIS) relating to Accounts and Finance Note: Further details on the above are not given here as they are outside the scope of textbook on “Financial Management”. As the students can see, most of them are self-explanatory.

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Subject: Financial Management

Chapter: One

Short-term and long-term objectives of Financial Management Short-term objective The short-term objective of Financial Management is to procure financial resources at an affordable cost thereby increasing the return to the shareholders in the form of Earnings Per Share (EPS). EPS comprises two elements namely Dividend per share (DPS) and Retained Earnings per share (REPS or Reserves per share). This objective is often times referred to as “profit maximisation”. This is known as the short-term objective as it is done on a continuous, year-to-year basis. One or more of the following measures can achieve this: Monitoring of costs on a continuous basis through budgets Suitable cost reduction techniques wherever the costs are high Minimisation of cost of borrowed capital from outside through financial discipline Proper mix of equity and debt (known as financial leverage – for further details please refer to Chapter no. 5 – Operating and financial leverages Control over liquidity available in the organisation so as to minimise the cost of carrying too much cash1 etc.

Long-term objective The long-term objective of financial management is to increase the wealth of the shareholders. The term “wealth” refers to various business assets of the enterprise that are free of debt. This means that this wealth belongs to the equity shareholders. It is often reflected in the “book value” of the share as reflected in the balance sheet. The formula for book value is: Equity share capital + Reserves and Surplus Number of equity shares issued This can be explained through an example. Example no. 3 Equity share capital = Rs. 100 lacs (paid up capital) Reserves and surplus = Rs. 200 lacs Number of shares = 10 lacs with the Face Value being Rs.10/Then the book value of the share would be = Rs. 100 lacs + Rs. 200 lacs = Rs. 30/-. 10 lacs shares This means that at the starting point the book value was Rs.10/- and this has gone up to Rs. 30/- due to the prudent policy of the management of retaining profits within the organisation. Thus the short-term objective also is a contributory factor to realising the long-term objective of wealth maximisation. Some of the measures through which we achieve the long-term objective are: Strategic financial management decisions relating to expansion, take over of another business, financial rerestructuring through financial re-engineering (example – swap a costly loan for a cheaper loan provided the credibility of the firm is quite high), joint venture etc. Thus while profitability reflects the operating efficiency wealth maximisation reflects the managerial/entrepreneurial efficiency. To sum up, both short-term objective and long-term objective need to be put in place for sustained growth of a business enterprise. To an extent at least, the long-term objective is dependent upon the short-term objective of profit maximisation.

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Carrying too much liquidity involves cost. This cost is referred to as “opportunity cost”. It simply means that by carrying too much liquidity, the business enterprise has foregone an opportunity of getting a return on such amount that it will have got by employing the funds in business. On the contrary, carrying too little cash is also risky as the enterprise may not be able to fulfil its obligations to creditors etc. in time. Punjab Technical University, Online Virtual Campus

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Subject: Financial Management

Chapter: One

Financial system in India In order to understand financial management better, we need to understand the “Financial System” that exists in India. Any country needs a system to regulate, supervise, monitor and control the players, intermediaries, the investors etc. who take part in the financial markets in the system. Further an efficient system alone can ensure that the national objective on “Economy” of the country is met by aligning the developments in the system with the national priorities. An example of the national priority deciding the development in the financial markets is – “infrastructure development and need for longer duration financial resources” and development of “deep discounted bonds” to meet this requirement. (For further details please refer to Chapter no. 4 – Financial sources)

Constituents of the Indian Financial System The Government of India, Ministry of Finance, heads the Indian financial system. The ministry in turn is bifurcated into various departments like the Department of Economic Affairs, the Department of Company Affairs etc. The Indian financial system consists of: The financial markets The statutes governing the various segments of the financial markets The statutory authorities responsible for regulating, supervising, monitoring and controlling the markets and its components The financial intermediaries Special organisations Agents operating in different segments of the financial markets and Financial instruments/securities issued in the markets to raise resources

The financial markets The financial markets consist of: Money markets – maximum duration of 12 months Capital markets – Minimum duration 12 months and maximum duration could be even 20-25 years Foreign exchange markets Insurance market Banking and Mutual funds The money markets and capital markets in turn do have “Primary market” and “Secondary market”. Primary market means issue of financial instruments by companies and others that want to raise financial resources from the market. Secondary market refers to that market wherein the financial instruments issued in the Primary market change hands from one investor to another for financial consideration.

Segments of money markets:

Call money market exclusively for banks to be borrowers – inter-bank operations for a very short period. One day to fourteen days. Fourteen day borrowing is in the notice money market that is also a part of the Call Money Market. Only scheduled commercial banks are permitted to be borrowers in this market. While some banks will be borrowers, some others will be lenders. There is no specific market place. Deals are done over the phone.

Segments of money markets

Commercial paper issued by companies and Public Sector Undertakings as part of working capital requirement. This is a promissory note issued by companies requiring short-term funds (say from 15 days to 180 days or six months).

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Subject: Financial Management

Chapter: One Maximum period is twelve months. The six-month commercial paper can be extended for a further period of six months, making a total of 12 months. Commercial bills discounted by banks and Non-banking Financial Institutions. These are short-term bills usually not exceeding 90-120 days covering commercial transactions in the private sector. Treasury bills issued by Government of India through the RBI for meeting budgetary deficits. These are for fixed maturity periods of 91 days and 364 days.

The Reserve Bank of India controls the money markets in India. It is known as money market regulator.

Primary market Primary market in the money market is wherein the Institutions requiring funds issue securities like treasury bills and get finance and there is no specific market place excepting in the case of treasury bills. RBI conducts auction of treasury bills after due notice in national dailies and hence this can be construed as the “market place”.

Secondary market The secondary market is provided by Discount and Finance House of India Limited (DFHI) a subsidiary of RBI. It provides a two-way quotation, one for purchasing money market instruments and another for selling money market instruments. For example, a holder of Treasury bill of Government of India can sell it to DFHI and anyone wants to purchase treasury bills, he can approach DFHI who can sell it to him. There is no secondary market for call money or notice money market.

Segments of capital markets:

GOI bonds Various state government bonds Bonds issued by Public Sector undertakings like BHEL etc. Bonds issued by private sector companies, banks and financial institutions Debentures issued by private sector companies Equity share capital issued by private sector companies Preference share capital issued by private sector companies

In the case of public issues by private sector companies, banks, financial institutions and mutual funds, Securities Exchange Board of India (SEBI) is the controlling authority. It is referred to as the capital market regulator. However SEBI does not control Government bonds or securities issued by Public Sector Undertakings. GOI bonds and state government bonds are handled and controlled by RBI. Public sector undertaking like Bharat Heavy Electricals Limited (BHEL) come directly under GOI – MOF.

Primary market There is no specific market place for this. This again, like in the case of money market, facilitates issue of securities by those who require funds in the medium to long-term. The public issue process is supervised and controlled by the lead merchant banker/bankers in the case of all public issues. Primary market ends with the listing of securities on stock exchanges by the Registrar to the Issue. Details of operators in the primary market have been given under “Agents operating in financial markets”.

Secondary market

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Subject: Financial Management

Chapter: One The secondary market begins with the listing of securities on the stock exchanges by the Registrar to the issue. It has a market place in the form of stock exchanges. Its operations are through share brokers who are registered with respective stock exchanges. The stock exchanges in turn are controlled and regulated by SEBI. Details of operators in the secondary market have also been given under “Agents operating in the financial markets”.

Statutes governing the various segments of the financial markets and the statutory authorities Statute means an Act passed either by the Parliament or State legislature. Money market – No specific statute – controlled by RBI Capital market – Securities Contracts Regulations Act and Rules as well as SEBI regulations for the various operators in the Capital market – controlled by SEBI. Mutual Funds also come under the Regulations of SEBI. Insurance – Insurance Regulatory and Development Act (IRDA) – controlled by the Insurance Regulatory and Development Authority coming under GOI, Ministry of Finance Banking – Banking Regulations Act controlled by RBI Non-banking Financial Companies (NBFCs – example Kotak Mahindra Finance Company Limited) – Non-Banking Financial Companies Act of RBI Functioning of limited companies registered in India – The Companies’ Act – controlled by the Company Law Board 2 (CLB) coming under GOI, Ministry of Finance. The principal officer is known as “The Registrar of Companies” (ROC). Foreign Exchange market – Foreign Exchange Management Act and Exchange Control Regulations Act both coming under the RBI Some segments of the financial markets like the Indian companies accessing international markets come directly under the GOI, Ministry of Finance

The financial intermediaries A financial intermediary means an institution like a bank mobilising resources from saving units in the economy and deploying these resources by giving loans to or by investment in users of these financial resources for creating economic wealth. Banking companies Financial Institutions (FIs) Mutual Funds (MFs) Non-banking Financial Companies (NBFCs)

Special organisations These come under one of the financial market regulators or directly under GOI – Ministry of Finance All-India Financial Institutions – GOI – MOF Central Board of Direct Taxes – CBDT – GOI – MOF Stock Exchanges – SEBI National Bank for Agriculture and Rural Development (NABARD) – RBI Institute of Chartered Accountants of India (ICAI) – GOI – MOF 2

Company Law Board is primarily responsible for conduct of the affairs of limited companies registered in India under the Companies’ Act. The difference in roles of CLB and SEBI is that the latter is mainly concerned with issue of securities in the capital market protecting the interests of various kinds of investors. SEBI is not controlling The Companies’ Act while CLB is not controlling the SCRA. They play complementary roles. Punjab Technical University, Online Virtual Campus

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Subject: Financial Management

Chapter: One Institute of Cost and Works Accountants of India (ICWA) – GOI – MOF Institute of Company Secretaries of India (ICSI) – GOI – MOF Institute of Chartered Financial Analysts of India (ICFAI) – GOI – MOF Foreign Investment Promotion Board (FIPB) – GOI - MOF

Agents operating in different segments of the financial markets The agents operating in the capital market are more. Hence we examine them briefly here. In respect of other segments of the financial markets from a study of the above it will be clear to the students as to who the operators are in the respective segments. Primary market: Merchant banker3 (the principal operator) Share brokers who underwrite4 besides marketing the issue Bankers to the issue who collect the share application money along with the share application forms Advertisement companies and publicity companies Printers for printing the stationery required for the issue Registrars to the Issue who take the responsibility of issuing the securities to successful investors (in case the issue collects more money than the issue size), refund excess money together with interest and getting the securities listed on a Stock Exchange Secondary market:

Stock Exchanges – controlled and regulated by SEBI Share brokers – controlled by respective stock exchanges Depositories – National level special organisations coming under the national stock exchanges and assume responsibility for collating details of ownership of shares issued by a limited company. 5

Depository participants – Retail level operators who maintain Electronic Share Accounts of various owners of securities Financial instruments Already referred to under financial markets above. For further details, please refer to chapter on financial sources

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Merchant banker controls the Primary market and is fully responsible for the issue of public securities like equity shares, debentures, bonds etc. the capital market instruments. He is the principal operator and controls and monitors all the other operators in the capital market. He is fully accountable to SEBI for the smooth conduct of the operations in the capital markets. He has to ensure 100% conformity with SCRA rules and regulations as well as SEBI rules and regulations. 4

Underwriting in the capital market means giving an undertaking to invest money in securities issued to public should the issue fail to collect the required amounts as per SEBI rules and regulations. Underwriting as such does not involve any funds and hence is referred to as “fee based activity”. However once the issue fails to collect the required amount, the underwriter is expected to make good the deficit amount to the extent undertaken by him. 5

At present, we have two depositories operating at the national level – National Securities Depositories Limited (NSDL – owned by the National Stock Exchange) and Central Depository Services Limited (CDSL – owned by the Bombay Stock Exchange). As per capital market regulations, in the secondary market, the securities can be sold only in the “demat” or electronic form and not in the physical form. Accordingly under the national level depositories, depository participants operate at the retail level. They maintain the individual demat accounts on behalf of the shareholders and investors of other securities. These demat accounts are often referred to as “Electronic Share Accounts”. The DPs transfer the data from the retail level to the national level depositories who in turn collate information about ownership of securities and submit data to the signatory companies with whom they have signed contracts. Punjab Technical University, Online Virtual Campus

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Subject: Financial Management

Chapter: One

Questions for reinforcement of learning 1.

With the help of details given under Indian Financial System, draw the map of Indian Financial system, starting from Government of India – Ministry of Finance. Also visit website – www.nic.in to know more about the functioning of Government of India – Ministry of Finance, its different departments and their functions etc.

2.

What is the difference between a share broker and a depository participant?

3.

Is there a statute controlling the money markets in India? Who provides the secondary market in the money markets segment?

4.

What are the instruments in the money market and capital market?

5.

What do you understand by the term “underwriting” in the capital market?

6.

Can you name some NBFCs operating in India?

7.

Try to bifurcate the banking sector in India into different segments like private sector, public, co-operative and commercial banks. Further bifurcate the private sector banks into banks of Indian origin and foreign banks.

8.

Does ICICI still exist as a Financial Institution? If not, why?

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