Financial management

Nature and Scope of Financial Management:-

In simple terms, financial management is the business function that deals with investing the available
financial resources in a way that greater business success and return-on-investment (ROI) is achieved.
Financial management professionals plan, organize, and control all transactions in a business. They focus
on sourcing the capital whether it is from the initial investment by the entrepreneur, debt financing,
venture funding, public issue, or any other sources. Financial management professionals are also
responsible for fund allocation in an optimized way to ensure greater financial stability and growth for
the organization.

Nature of Financial Management:-

Managing money involves careful planning, using resources wisely, following financial rules, and more.
To understand financial management in this field, let’s explore its characteristics in more detail.

1. Risk and Returns Evaluation

Financial management is about making decisions, especially about risk and return on investment. The
relationship between risk and return is important in financial management decisions.

Generally, when an investment is riskier, it usually brings higher returns. The job of a financial manager is
to determine how much risk a company faces. The assessment helps the financial manager make wise
choices that meet company goals. It also satisfies the interests of shareholders, investors, or founders.

2. Capital Requirement Estimation

An organization can plan for its financial needs by implementing financial management techniques. They
can anticipate the funds required based on both day-to-day operations and long-term plans.

Maintaining the right balance between debt and equity is crucial to minimizing the overall cost of capital.
Financial management is essential for determining how to allocate funds among various investments,
such as stocks, bonds, and loans. This allocation aids the organization in obtaining funds while lowering
capital structure costs.

3. Wealth Management

The finance manager watches how cash comes in and goes out to avoid cash problems. The primary goal
is to grow and protect wealth while achieving specific financial objectives.

4. Valuation of Company

Financial management primarily concentrates on determining the worth of a company. This means that
every money-related choice is all about making the company as valuable as possible. The main aim is to
make the company more valuable, and this guides all the financial decisions. These decisions include
things like investing, sharing profits, and raising money.

5. Improve Company’s Stock

The company’s strategy to cut costs and increase earnings enables it to reach its objective of distributing
higher returns to shareholders. The primary responsibility of the finance manager is to identify methods
for increasing profits. This is accomplished by obtaining funds from various sources and making prudent
investment choices.

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6. Source of Funds:

In any business, the choice of funding sources is a challenging decision. Companies have various options,
whether for an extended, intermediate, or brief period. It’s essential for every company to extensively
explore and consider the various funding avenues available, such as stocks, bonds, or debentures. This
helps them select the most suitable and least risky method of raising funds.

7. Selective Investment

Before investing your money, it’s crucial to thoroughly assess and understand the level of risk involved
and the potential returns. Making intelligent investment decisions is essential.

8. Control Management

Implementing effective financial controls is important for a company as it enables them to carefully
monitor and manage their real operating expenses, ensuring that they align with their profit
expectations and objectives.

Capital Structure:-

The most crucial component of starting a business is capital. It acts as the foundation of the company.
Debt and Equity are the two primary types of capital sources for a business. Capital structure is defined
as the combination of equity and debt that is put into use by a company in order to finance the overall
operations of the company and for its growth.

Types :-

Equity Capital

Equity capital is the money owned by the shareholders or owners. It consists of two different types

a) Retained earnings: Retained earnings are part of the profit that has been kept separately by the
organisation and which will help in strengthening the business.
b) Contributed Capital: Contributed capital is the amount of money which the company owners
have invested at the time of opening the company or received from shareholders as a price for
ownership of the company.

Debt Capital

Debt capital is referred to as the borrowed money that is utilised in business. There are different forms
of debt capital.

Long Term Bonds: These types of bonds are considered the safest of the debts as they have an extended
repayment period, and only interest needs to be repaid while the principal needs to be paid at maturity.
Short Term Commercial Paper: This is a type of short term debt instrument that is used by companies to
raise capital for a short period of time

Optimal Capital Structure

Optimal capital structure is referred to as the perfect mix of debt and equity financing that helps in
maximising the value of a company in the market while at the same time minimises its cost of capital.

Capital structure varies across industries. For a company involved in mining or petroleum and oil
extraction, a high debt ratio is not suitable, but some industries like insurance or banking have a high
amount of debt as part of their capital structure.

Financial Leverage

Financial leverage is defined as the proportion of debt that is part of the total capital of the firm. It is also
known as capital gearing. A firm having a high level of debt is called a highly levered firm while a firm
having a lower ratio of debt is known as a low levered firm.

Importance of Capital Structure:-

Capital structure is vital for a firm as it determines the overall stability of a firm. Here are some of the
other factors that highlight the importance of capital structure

1. A firm having a sound capital structure has a higher chance of increasing the market price of the
shares and securities that it possesses. It will lead to a higher valuation in the market.
2. A good capital structure ensures that the available funds are used effectively. It prevents over or
under capitalisation.
3. It helps the company in increasing its profits in the form of higher returns to stakeholders.
4. A proper capital structure helps in maximising shareholder’s capital while minimising the overall
cost of the capital.
5. A good capital structure provides firms with the flexibility of increasing or decreasing the debt
capital as per the situation.

Theories of capital Structure:-

Net Income Approach (NI)

According to this approach, capital structure decision is relevant to the value of the firm. An increase in
financial leverage (Debt Proportion) will lead to decline in the weighted average cost of capital (WACC),
while the value of the firm as well as market price of ordinary share will increase.

As per NI Approach:

Kd and Ke will remain constant.

Ko will decrease with the help of use of Debt.

MV of Equity and Firm will increase with the help of use of Debt.

Traditional Approach

This approach favours that as a result of financial leverage up to some point, cost of capital comes down
and value of firm increases. However, beyond that point, reverse trends emerge.

As per Traditional Approach:

Kd, Ke, Ko and MV of Equity and MV of Firm are variable

Company has to select capital structure with lowest Ko or highest MV of Firm

Net Operating Income Approach (NOI)

According to this approach, capital structure decisions of the firm are irrelevant. Any change in the
leverage will not lead to any change in the total value of the firm and the market price of shares, as the
overall cost of capital is independent of the degree of leverage.

As per NOI Approach:

Kd, Ko and MV of Firm will remain constant in case of without tax structure.

Kd will remain constant in case of with tax structure, with the increase in Debt, MV of firm will increase
and Ko will decrease
Modiglani-Miller Approach (MM)

The NOI approach is definitional or conceptual and lacks behavioral significance. However, Modigliani-
Miller approach provides behavioural justification for constant overall cost of capital and therefore, total
value of the firm.

▪ Assumptions of MM Approach
▪ Capital markets are perfect
▪ All information is freely available
▪ There are no transaction costs
▪ All investors are rational
▪ Firms can be grouped into ‘Equivalent risk classes’
▪ Non-existence of corporate taxes

Note: Solution of practical problems are same under NOI and MM Approaches

Risk Analysis :-

Risk analysis is the procedure of analyzing and recognizing any kind of risk that could adversely affect the
primary business objective or any critical projects that are about to take place in an organization in
regards to avoiding or to take necessary initiatives to reduce such risks in the organization.

Types of Risk Analysis:-

Quantitative Risk Analysis

Quantitative risk analysis involves the use of numerical data and statistical models to estimate the
probability and potential impact of risks.

This type of risk analysis provides a more objective and precise assessment of risk, allowing for better-
informed decision-making and risk management.

Qualitative Risk Analysis

Qualitative risk analysis, on the other hand, relies on expert judgment, experience, and subjective
assessments to evaluate and prioritize risks.

This approach is particularly useful when numerical data is limited or unavailable, or when the risks
being assessed are complex and difficult to quantify.

Scenario-Based Risk Analysis

Scenario-based risk analysis involves the development of hypothetical scenarios that represent different
potential outcomes or risk events.

By evaluating the potential impact of each scenario, investors and wealth managers can better
understand the range of possible outcomes and develop strategies to manage or mitigate the associated
risks.

Historical Risk Analysis

Historical risk analysis examines past data and events to identify patterns and trends that may help
predict future risks.

This type of risk analysis can provide valuable insights into the potential impact of similar events or
conditions on current investments and financial plans.

Risk Analysis Process :-