Mb0045 Unit 01-Slm

Financial Management Unit 1

Sikkim Manipal University Page No. 1

Unit 1 Financial Management

Structure:

1.1 Introduction

Objectives

1.2 Meaning and Definition of Financial Management

1.3 Goals of Financial Management

Profit maximisation

Wealth maximisation

Wealth maximisation vs. profit maximisation

1.4 Finance Functions

Financing decisions

Investment decisions

Dividend decisions

Liquidity decisions

1.5 Organisation of Finance function

1.6 Interface between Finance and Other Business Functions

Relation between Finance and accounting

Finance and marketing

Finance and production (operations)

Finance and HR

1.7 Summary

1.8 Glossary

1.9 Terminal Questions

1.10 Answers

1.11 Case Study

1.1 Introduction

Financial management of a firm is concerned with procurement and

effective utilisation of funds for the benefit of its shareholders. It embraces

all those managerial activities that are required to procure funds at the least

cost and their effective deployment.

Reliance and Infosys are examples of admired Indian companies that

employ effective financial management skills to their businesses. They have

been rated well by the financial analysts on many crucial aspects that

enabled them to create value for their shareholders. They employ the best



technology, produce good quality goods or render services at the least cost,

and continuously contribute to the shareholder’s wealth.

The three core elements of financial management are:

a. Financial planning

Financial planning is done to ensure the availability of capital

investments to acquire the real assets. Real assets are lands, buildings,

plants and equipments. Capital investments are required for establishing

and running the business smoothly.

b. Financial decisions

Decisions need to be taken on the sources from which the funds

required for the capital investments could be obtained.

There are two sources of funds - debt and equity. In what proportion

the funds are to be obtained from these sources is to be decided for

formulating the financing plan.

c. Financial control

Financial control involves managing the costs and expenses of a

business. For example, it includes taking decisions on the routine

aspects of day-to-day management of collecting money which is due

from the firm’s customers and making payments to the suppliers of

various resources.

In this unit, you will learn about these core elements of financial

management.

Objectives:

After studying this unit, you should be able to:

analyse the meaning of business finance

describe the goals of financial management

discuss the functions of finance

explain the interface between finance and other managerial functions of a

firm

1.2 Meaning and Definition of Financial Management

Financial management is the art and science of managing money.

Regulatory and economic environments have undergone drastic changes

due to liberalisation and globalisation of Indian economy. These have



changed the profile of Indian finance managers. Indian finance managers

have transformed themselves from License Raj managers to well-informed,

dynamic, proactive managers capable of taking decisions of complex

nature.

Traditionally, financial management was considered as a branch of

knowledge that focused on the procurement of funds. Formation, merger

and restructuring of firms and legal and institutional frame work, instruments

of finance occupied the prime place in this traditional approach.

The modern approach transformed the field of study from the traditional,

narrow approach to a dynamic and extensive approach. The core of modern

approach evolved around the procurement of the least cost funds and its

effective utilisation for maximisation of shareholder’s wealth.

Self Assessment Questions

1. What has changed the profile of Indian finance managers?

2. Finance management is considered as a branch of knowledge with

focus on the __________.

1.3 Goals of Financial Management

Financial management means maximisation of economic welfare of its

shareholders. Maximisation of economic welfare means maximisation of

wealth of its shareholders. Shareholder’s wealth maximisation is reflected in

the market value of the firm’s shares. Experts believe that, the goal of

financial management is attained when it maximises the market value of

shares. There are two versions of the goals of financial management of the

firm – Profit Maximisation and Wealth Maximisation.

Let us now discuss the goals of financial management in detail.

1.3.1 Profit maximisation

Profit maximisation is based on the cardinal rule of efficiency. Its goal is to

maximise the returns with the best output and price levels. A firm’s

performance is evaluated in terms of profitability. Profit maximisation is the

traditional and narrow approach, which aims at maximising the profit of the

concern. Allocation of resources and investor’s perception of the company’s

performance can be traced to the goal of profit maximisation. Profit

maximisation has been criticised on many accounts:



The concept of profit lacks clarity. What does profit mean?

o Is it profit after tax or before tax?

o Is it operating profit or net profit available to shareholders?

In this sense, profit is neither defined precisely nor correctly. It creates

unnecessary conflicts regarding the earning habits of the business

concern. Differences in interpretation of the concept of profit thus expose

the weakness of profit maximisation.

Profit maximisation neither considers the time value of money nor the net

present value of the cash inflow. It does not differentiate between profits

of current year with the profits to be earned in later years.

The concept of profit maximisation fails to consider the fluctuations in

profits earned from year to year. Fluctuations may be attributed to the

business risk of the firm. Risks may be internal or external which will

affect the overall operation of the business concern.

The concept of profit maximisation apprehends to be either accounting

profit or economic normal profit or economic supernormal profit.

Profit maximisation as a concept, even though has the above-mentioned

drawbacks, is still given importance as profits do matter for any kind of

business. Ensuring continued profits ensure maximisation of

shareholder’s wealth.

Figure 1.1 depicts the two goals of financial management.

Figure 1.1: Goals of Financial Management



1.3.2 Wealth maximisation

The term wealth means shareholder’s wealth or the wealth of the persons

those who are involved in the business concern. Wealth maximisation is

also known as value maximisation or net present worth maximisation. This

objective is an universally accepted concept in the field of business.

Wealth maximisation is possible only when the company pursues policies

that would increase the market value of shares of the company. It has been

accepted by the finance managers as it overcomes the limitations of profit

maximisation.

The following arguments are in support of the superiority of wealth

maximisation over profit maximisation:

Wealth maximisation is based on the concept of cash flows. Cash flows

are a reality and not based on any subjective interpretation. On the other

hand, profit maximisation is based on accounting profit and it also

contains many subjective elements.

Wealth maximisation considers time value of money. Time value of

money translates cash flow occurring at different periods into a

comparable value at zero period. In this process, the quality of cash flow

is considered critical in all decisions as it incorporates the risk associated

with the cash flow stream. It finally crystallises into the rate of return that

will motivate investors to part with their hard earned savings. Maximising

the wealth of the shareholders means positive net present value of the

decisions implemented.

Let us now look at some of the key definitions.

Positive net present value can be defined as the excess of present value

of cash inflows of any decision implemented over the present value of

cash out flow.

Time value factor is known as the time preference rate; that is, the sum

of risk free rate and risk premium.

Risk free rate is the rate that an investor can earn on any government

security for the duration under consideration.

Risk premium is the consideration for the risk perceived by the investor

in investing in that asset or security.

Required rate of return is the return that the investors want for making

investment in that sector.



Caselet:

X Ltd is a listed company engaged in the business of FMCG (Fast

Moving Consumer Goods). ‘Listed’ implies that the company’s shares are

allowed to be traded officially on the portals of the stock exchange. The

Board of Directors of X Ltd took a decision in one of its board meetings to

enter into the business of power generation. When the company

informed the stock exchange at the conclusion of the meeting about the

decision taken, the stock market reacted unfavourably. The result was

that the next day’s closing of quotation was 30% less than that of the

previous day. Why did the market react unfavourably?

Investors in FMCG company might have thought that the risk profile of

the new business that the company wants to take up is higher compared

to the risk profile of the existing FMCG business of X Ltd, expecting a

higher return. Then, the market value of the company’s shares started

declining.

Therefore, the risk profile of the company gets translated into a time

value factor. The time value factor so translated becomes the required

rate of return.

1.3.3 Wealth maximisation vs. profit maximisation

Let us now see how wealth maximisation is superior to profit maximisation.

Wealth maximisation is based on cash flow. It is not based on the

accounting profit as in the case of profit maximisation.

Through the process of discounting, wealth maximisation takes care of

the quality of cash flow. Converting uncertain distant cash flow into

comparable values at base period facilitates better comparison of

projects. The risks that are associated with cash flow are adequately

reflected when present values are taken to arrive at the net present

value of any project.

Corporates play a key role in today’s competitive business scenario. In

an organisation, shareholders typically own the company, but the

management of the company rests with the board of directors. Directors

are elected by shareholders. Company management procures funds for

expansion and diversification of capital markets.



In the liberalised set up, society expects corporates to tap the capital

markets effectively for their capital requirements. Therefore, to keep the

investors happy throughout the performance of value of shares in the

market, management of the company must meet the wealth maximisation

criterion.

When a firm follows wealth maximisation goal, it achieves maximisation

of market value of share. A firm can practise wealth maximisation goal

only when it produces quality goods at low cost. On this account, society

gains because of the societal welfare. Maximisation of wealth demands

on the part of corporates to develop new products or render new

services in the most effective and efficient manner. This helps the

consumers, as it brings to the market the products and services that a

consumer needs.

Another notable feature of the firms that are committed to the

maximisation of wealth is that, to achieve this goal they are forced to

render efficient service to their customers with courtesy. This enhances

consumer welfare and benefit to the society.

From the point of evaluation of performance of listed firms, the most

remarkable measure is that of performance of the company in the share

market. Every corporate action finds its reflection on the market value of

shares of the company. Therefore, shareholder’s wealth maximisation

could be considered as a superior goal compared to profit maximisation.

Since listing ensures liquidity to the shares held by the investors,

shareholders can reap the benefits arising from the performance of

company only when they sell their shares. Therefore, it is clear that

maximisation of market value of shares will lead to maximisation of the

net wealth of shareholders.

Therefore, we can conclude that maximisation of wealth is probably the

more appropriate goal of financial management in today’s context. Though

this cannot be a goal in isolation, it is important to understand that profit

maximisation as a goal, in a way, leads to wealth maximisation.


3. _______ is based on cash flows.

4. ________ considers time value of money



1.4 Finance Functions

Finance functions deal with the functions performed by the finance

manager. They are closely related to financial decisions. In the course of

performing these functions, finance manager takes several decisions and

performs various important functions:

Financing decisions

Investment decisions

Liquidity decisions

Dividend decisions

Figure 1.2 depicts the functions of the finance manager.

Figure 1.2: Finance Manager’s Decisions

Let us now discuss these points in detail.

1.4.1 Financing decisions

Financing decisions relate to the composition of relative proportion of

various sources of finance. The sources could be:

(a) Shareholder’s Fund: Equity Share Capital, Preference Share Capital,

Accumulated Profits.

(b) Borrowing from outside agencies: Debentures, Loans from Financial

Institutions.



Financial management weighs the merits and demerits of different sources

of finance while taking financing decision. Irrespective of the choice of

source, be it singular or a combination of both, there is a cost involved. The

cost of equity is the minimum return the shareholders would have received if

they had invested elsewhere. Borrowed funds cost involves interest

payment.

Both types of funds, thus, incur cost, and this is the cost of capital to the

company. Hence, it can be said that the cost of capital is the minimum

return expected by the company.

Financing decisions relate to the acquisition of such funds at the least cost.

In order to calculate the specific cost of each type of capital, recognition

should be given to two dimensions of cost:

Explicit Cost

Implicit Cost

A firm's explicit costs are the actual cash payments it makes to those who

provide resources. Explicit costs are rent paid on land hired, wages paid to

the employees, and interest paid on capital. In addition to this, a firm also

pays insurance premium and taxes and sets aside depreciation charges.

Explicit cost of any source of capital may be defined as the discount rate

that equates the present value of funds received by the firm net of

underwriting costs, with the present value of expected cash outflows. These

outflows may be interest payments, repayment of principal, or dividend. It

can also be stated as the Internal Rate of Return a firm pays for financing.

Implicit costs are the opportunity costs of using resources owned by the firm

or provided by the firm's owners. To the firm, the implicit costs mean the

money payments that self-employed resources could have earned in their

best alternative uses.

Implicit cost is the rate of return associated with the best investment

opportunity for the firm and its shareholders that will be foregone if the

project presently under consideration by the firm was accepted. Opportunity

costs are technically referred to as implicit cost of capital.

Implicit cost is not a visible cost but it may seriously affect the company’s

operations, especially when it is exposed to business and financial risk.



The distinction between implicit and explicit cost is important from the point

of view of the computation of cost of capital.

In India, if a company is unable to pay its debts, creditors of the company

may use legal means to sue the company for winding up and is normally

known as risk of insolvency. A company which employs debt as a means of

financing generally faces this risk especially when its operations are

exposed to high degree of business risk.

In all financing decisions, a firm has to determine the capital structure, i.e.

composition of debt and equity.

Debt is cheap because interest payable on loan is allowed as deduction in

computing taxable income on which the company is liable to pay income tax

to the Government of India.

Whenever funds are to be raised to finance investments, capital structure

decision is involved. A demand for raising funds generates a new capital

structure since a decision has to be made as to the quantity and forms of

financing.

Capital structure refers to the mix of a firm’s capitalisation (i.e. mix of long

term sources of funds for meeting capital requirement.) Capital structure

decision refers to deciding the forms of financing (which sources to be

tapped), their actual requirements (amount to be funded), and their relative

proportions in total capitalisation.

Normally, a finance manager tries to choose a pattern of capital structure

which minimises the cost of capital and maximises the owner’s return. We

will learn more on capital structure and related aspects in Unit 7.

Caselet

The interest rate on loan taken is 12%, tax rate applicable to the company

is 50%, and then when the company pays Rs.12 as interest to the lender,

taxable income of the company will be reduced by Rs.12.

In other words, when the actual cost is 12% with a tax rate of 50%, the

effective cost becomes 6%. Therefore, the debt is cheap. But, every

instalment of debt brings along with it corresponding insolvency risk.

Another thing notable in connection to this is that the firm cannot avoid its

obligation to pay interests and loan instalments to its lenders and

debentures.



An investor in a company’s shares has two objectives for investing:

Income from capital appreciation (capital gains on sale of shares at

market price)

Income from dividends

The ability of the company to offer both these incomes to its shareholders

determines the market price of the company’s shares.

The most important goal of financial management is maximisation of net

wealth of the shareholders. Therefore, management of every company

should strive hard to ensure that its shareholders enjoy both dividend

income and capital gains as per the expectation of the market.

Therefore, to declare a dividend of 12%, a company has to earn a pre-tax

profit of 19%. On the other hand, to pay an interest of 12%, the company

has to earn only 8.4%. This leads to the conclusion that for every Rs.100

procured through debt, it costs 8.4%, whereas the same amount procured in

the form of equity (share capital) costs 19%. This confirms the established

theory that equity is costly but debt is cheap and risky source of funds to the

corporate.

Financing decision involves the consideration of managerial control,

flexibility and legal aspects, and regulatory and managerial elements.

Solved Problem – 1

Dividend = 12% on paid up value

Tax rate applicable to the company = 30%

Dividend tax = 10%

Compute the profit that the company must earn before tax, when a company pays Rs.12 on paid up capital of Rs.100 as dividend.

Solution

Since payment of dividend by an Indian company attracts dividend tax, the company when it pays Rs.12 to shareholders, must pay to the Govt of India

10% of Rs.12 = Rs.1.2 as dividend tax.

Therefore dividend and dividend tax sum up to Rs.12 + Rs.1.2 = Rs.13.2.

Since this is paid out of the post tax profit, in this question, the company

must earn:



dividendthepayanddeclaretorequiredetaxPrrateTax1

paiddividendtaxPost

= )eapproximat(19.Rs1.0

2.13

3.01

2.13

1.4.2 Investment decisions

To survive and grow, all organisations have to be innovative. Innovation

demands managerial proactive actions. Proactive organisations

continuously search for innovative ways of performing the activities of the

organisation. Innovation is wider in nature. It could be:

Expanding by entering into new markets.

Adding new products to its product mix.

Performing value added activities to enhance customer satisfaction.

Adopting new technology that would drastically reduce the cost of

production.

Rendering services or mass production at low cost or restructuring the

organisation to improve productivity.

These innovations change the profile of an organisation. These decisions

are strategic because they are risky. However, if executed successfully with

a clear plan of action, investment decisions generate super normal growth to

the organisation.

A firm may become bankrupt if the management fails to execute the

decisions taken. Therefore, such decisions have to be taken after taking into

account all the facts affecting the decisions and their execution.

There are two critical issues to be considered in these decisions. They are:

Evaluation of expected profitability of the new investments.

Rate of return required on the project.

The Rate of Return required by an investor is normally known as the hurdle

rate or the cut off rate or the opportunity cost of capital.

Investments in buildings and machineries are to be conceived and executed

by a firm to enter into any business or to expand its business. The process

involved is called Capital Budgeting. Capital Budgeting decisions demand

considerable time, attention, and energy of the management. They are

strategic in nature as the success or failure of an organisation is directly

attributable to the execution of Capital Budgeting decisions taken.



Investment decisions are also known as Capital Budgeting decisions and

hence lead to investments in real assets.

The key function of the financial management is the selection of the most

profitable assortment of capital investment. It is also one of the most

important area of decision making for the financial manager because any

action taken by the manager in this area affects the working and the

profitability of the firm in future.

The impact of long-term capital investment decisions is far reaching. It

protects the interests of the shareholders and of the enterprise because it

avoids over-investment and under-investment in fixed assets. By selecting

the most profitable projects, the management facilitates the wealth

maximisation of equity shareholders. We will take a detailed look at Capital

Budgeting in Unit 8.

1.4.3 Dividend decisions

Dividends are payouts to shareholders. Dividends are paid to keep the

shareholders happy. Dividend decision is a major decision made by the

finance manager.

Dividend is that portion of profits of a company which is distributed among

its shareholders according to the resolution passed in the meeting of the

Board of Directors. This may be paid as a fixed percentage on the share

capital contributed by them or at a fixed amount per share. The dividend

decision is always a problem before the top management or the Board of

Directors as they have to decide how much profits should be transferred to

reserve funds to meet any unforeseen contingencies and how much should

be distributed to the shareholders.

Payment of dividend is always desirable since it affects the goodwill of the

concern in the market on the one hand, and on the other, shareholders

invest their funds in the company in a hope of getting a reasonable return.

Retained earnings are the sources of internal finance for financing of

corporate’s future projects but payment of dividend constitute an outflow of

cash to shareholders. Although both - expansion and payment of dividend -

are desirable, these two are in conflicting tasks. It is, therefore, one of the

important functions of the financial management to constitute a dividend



policy which can balance these two contradictory view points and allocate

the reasonable amount of profits after tax between retained earnings and

dividend. All of this is based on formulation of a good dividend policy.

Since the goal of financial management is maximisation of wealth of

shareholders, dividend policy formulation demands the managerial attention

on the impact of its policy on dividend and on the market value of its shares.

Optimum dividend policy requires decision on dividend payment rates so as

to maximise the market value of shares. The payout ratio means what

portion of earnings per share is given to the shareholders in the form of cash

dividend. In the formulation of dividend policy, the management of a

company will have to consider the relevance of its policy on bonus shares.

Dividend policy influences the dividend yield on shares. Dividend yield is an

important determinant of an investor’s attitude towards the security (stock) in

his portfolio management decisions.

The following issues need adequate consideration in deciding on dividend

policy:

Preferences of shareholders – Do they want cash dividend or capital

gains?

Current financial requirements of the company.

Legal constraints on paying dividends.

Striking an optimum balance between desire of shareholders and the

company’s funds requirements.

Companies attempt to maintain a stable dividend policy whereby a stable

rate of dividend is maintained. This also ensures that the company’s market

value of shares stays higher. The main reasons why a stable dividend is

preferred are:

(a) A regular and stable dividend payment may serve to resolve uncertainty

in the minds of shareholders, and it creates confidence among

shareholders.

(b) Many investors are income conscious and favour a stable dividend.

(c) Other things being in balance, the market price invariably vary with the

rate of dividend declared by the company on its equity shares. The value

of shares of a company that has a stable dividend policy does not



fluctuate as much, even if the earnings of the company fluctuate now and

then.

(d) A stable dividend policy encourages investments from institutional

investors.

In this way, stability and regularity of dividends not only affects the market

price of shares but also increases the general credit of the company that

pays the company in the long run. Dividend decisions are thus highly

significant.

1.4.4 Liquidity decisions

The liquidity decision is concerned with the management of the current

assets, which is a pre-requisite to long-term success of any business firm.

This is also called as working capital decision. The main objective of the

current assets management is the trade-off between profitability and

liquidity, and there is a conflict between these two concepts. If a firm does

not have adequate working capital, it may become illiquid and consequently

fail to meet its current obligations thus inviting the risk of bankruptcy. On the

contrary, if the current assets are too enormous, the profitability is adversely

affected. Hence, the major objective of the liquidity decision is to ensure a

trade-off between profitability and liquidity. Besides, the funds should be

invested optimally in the individual current assets to avoid inadequacy or

excessive locking up of funds. Thus, the liquidity decision should balance

the basic two ingredients, i.e. working capital management and the efficient

allocation of funds on the individual current assets.

In other terms, liquidity decisions deal with working capital management. It

is concerned with the day-to-day financial operations that involve current

assets and current liabilities.

The important elements of liquidity decisions are:

Formulation of inventory policy

Policies on receivable management

Formulation of cash management strategies

Policies on utilisation of spontaneous finance effectively

We will look at these elements individually, in detail, over the course of this

book.



1.5 Organisation of finance function

Financial decisions and functions are strategic in character and therefore,

an efficient organisational structure is required to administer the same.

The organisation of finance functions implies the division and classification

of functions relating to finance because financial decisions are of utmost

significance to firms. Finance is like blood that flows throughout the

organisation. In all organisations, CFOs play an important role in ensuring

proper reporting based on the substance of the shareholders of the

company.

Although in case of companies, the main responsibility to perform

finance function rests with the top management. Yet the top management

(Board of Directors), for convenience, can delegate its powers to any

subordinate executive who is known as Director of Finance, Chief Financial

Controller/Officer, Financial Manager, or Vice President of Finance.

Moreover, it is finally the duty of the Board of Directors to perform

the finance functions. There are various reasons behind it to assign the

responsibility to them. Financing decisions are quite important for the

survival of the firm. The growth and expansion of business is always

affected by financing policies. The loan paying capacity of the business

depends upon the financial operations.

For the survival of the firm, there is a need to ensure both long-term and

short-term financial solvency.

Weak functional performance by financial department will weaken

production, marketing, and HR activities of the company. The result would

be the organisation becoming anaemic. Once anaemic, unless crucial and

effective remedial measures are taken up, it will pave way for corporate

bankruptcy. Under the CFO, normally two senior officers manage the

treasurer and controller functions.

Activity 1

List out the functions of Chief Financial Officer that can make or mar the

company’s success.

Hint: All the finance functions are to be discussed.



A Treasurer performs the following functions:

Obtaining finance and utilising funds

Liaison with term lending and other financial institutions

Managing working capital

Managing investment in real assets

A Controller performs the following functions:

Accounting and auditing

Management control systems

Taxation and insurance

Budgeting and performance evaluation

Maintaining assets intact to ensure higher productivity of operating

capital employed in the organisation

In India, CFOs have a legal obligation under various regulatory provisions to

certify the correctness of various financial statements and information

reported to the shareholders in the annual report. Listing norms, regulations

on corporate governance, and other notifications of Government of India

have adequately recognised the role of finance function in the corporate

setup in India.


5. ________ leads to investment in real assets.

6. ____ relate to the acquisition of funds at the least cost.

7. Formulation of inventory policy is an important element of _______.

8. Obtaining finance is an important function of _________.

9. What are the two critical issues to be considered under investment

decisions?

10. Define rate of return.

11. One of the most important decisions made by a finance manager

dealing with maximisation of shareholder’s wealth is ________.

1.6 Interface between Finance and Other Business Functions

1.6.1 Relation between Finance and accounting

In the hierarchy of the finance function of an organisation, the controller

reports to the CFO. Accounting is one of the functions that a controller



discharges. Accounting is a part of Finance. For computation of return on

investment, earnings per share and for various ratios of financial analysis,

the data base will be accounting information. Without a proper accounting

system, an organisation cannot administer the effective function of financial

management.

The purpose of accounting is to report the financial performance of the

business for the period under consideration. All the financial decisions are

futuristic based on cash flow analysis. All the financial decisions consider

quality of cash flow as an important element of decisions. Since financial

decisions are futuristic, they are taken and put into effect under conditions of

uncertainty. Assuming the condition of uncertainty and incorporating the

effect on decision making results in use of various statistical models. In the

selection of the statistical models, element of subjectivity creeps in.

The relationship between finance and accounting has two dimensions:

(a) They are closely associated to the extent that accounting is an

important input in financial decision making

(b) There are definite differences between them

Accounting is a necessary input for the finance function as it generates

information through the financial statements. The data contained in these

financial statements assists the financial managers in assessing the past

performance and providing future directions to the firm and in meeting

certain legal obligations. Thus accounting and finance are functionally

inseparable.

The key differences between finance and accounting related to the

treatment of funds and decision making are discussed below:

(a) Treatment of funds: The measurement of funds in accounting is always

based on the accrual concept, whereas, in case of finance, the

treatment of funds is based on cash flow. That means, here the

revenue is recognised only when cash is actually received or actually

paid.

(b) Decision making: The purpose of accounting is collection and

presentation of financial data. The financial manager uses this data for

financial decision making. It does not mean that accountants never

make decisions or financial managers never collect data. But the



primary focus of the function of accountants is collection and

presentation of data in financial statements while the financial

manager's major responsibility relates to financial planning, con-

trolling, and decision making. Thus, we can say that the role of finance

begins where accounting ends.

1.6.2 Finance and marketing

Marketing decisions, generally, have financial implications. Pricing, product

promotion and advertisement, choice of product mix, distribution policy,

selections of channels of distribution, deciding on advertisement policy,

remunerating the salesmen, etc. all have financial implications. In fact, the

recent behaviour of rupee against US dollar (appreciation of rupee against

US dollar), affected the cash flow positions of export-oriented textile units,

BPOs and other software companies.

It is generally believed that the currency in which marketing manager

invoices the exports decides the cash flow consequences of the

organisation if the company is mainly dependent on exports. Marketing cost

analysis, a function of finance manager, is the best example of application of

principles of finance on the performance of marketing functions by a

business unit. Formulation of policy on credit management cannot be done

unless the integration of marketing with finance is achieved. Deciding on

credit terms to achieve a particular level of sales has financial implications

because sanctioning liberal credit may result in huge and bad debt. On the

other hand, conservative credit terms may depress the sales.

Relation between inventory and sales:

Co-ordination of stores administration with that of marketing management is

required to ensure customer satisfaction and good will. But investment in

inventory requires the financial clearance because funds are locked in, and

the funds so blocked have opportunity cost of capital.

1.6.3 Finance and production (operations)

Finance and operations management are closely related. Decisions on plant

layout, technology selection, productions or operations, process plant size,

removing imbalance in the flow of input material in the production or

operation process and batch size are all operation management decisions.

Their formulation and execution cannot be done unless they are evaluated

from the financial angle. The capital budgeting decisions are closely related



to production and operation management. These decisions make or mar a

business unit. Failure to understand the implications of the latest

technological trend on capacity expansions has cost even blue chip

companies.

Many textile units in India became sick because they did not provide

sufficient finance for modernisation of plant and machinery. Inventory

management is crucial to successful operation management. But

management of inventory involves a number of financial variables.

In any manufacturing firm, the Production Manager controls a major part of

the investment in the form of equipment, materials, and men. He should

organise his department in such a way that the equipments under his or her

control are used most productively, the inventory of work-in-process or

unfinished goods, stores and spares are optimised, and the idle time and

work stoppages are minimised. If the production manager can achieve this,

he or she would be holding the cost of output under control and thereby help

in maximising profits. He or she has to appreciate the fact that while the

price at which the output can be sold is largely determined by external

factors such as competition, market, government regulations, etc., the cost

of production is more amenable to his or her control. Similarly, he or she

would have to make decisions regarding make or buy, buy or lease, etc., for

which he or she has to evaluate the financial implications before arriving at a

decision.

1.6.4 Finance and HR

Financial management is also related to human resource department as it

provides manpower to all the functional areas of the management. Financial

manager should carefully evaluate the requirement of manpower to each

department and then allocate the required finance to the human resource

department as wages, salary, remuneration, commission, bonus, pension,

and other monetary benefits to the human resource department.

Attracting and retaining the best manpower in the industry cannot be done

unless they are paid salary at competitive rates. If an organisation

formulates and implements a policy for attracting competent manpower, it

has to pay the most competitive salary packages to them. However, by

attracting competent manpower, capital and productivity of an organisation



improves. Hence, financial management is closely associated with human

resource management.

1.7 Summary

Let us recapitulate the important concepts discussed in this unit:

Financial Management is concerned with the procurement of the least

cost funds, and its effective utilisation for maximisation of the net wealth

of the firm.

There exists a close relation between the maximisation of net wealth of

shareholders and the maximisation of the net wealth of the company.

The broad areas of decision are Financing decisions, Investment

decisions, Dividend decisions, and Liquidity decisions.

1.8 Glossary

Dividend: Portion of profits of a company which is distributed among its

shareholder.

Explicit costs: The actual cash payments it makes to those who provide

resources.

Financial management: Concerned with procurement and effective

utilisation of funds.

Implicit costs: The opportunity costs of using resources owned by the firm

or provided by the firm's owners.

Caselet:

Infosys does not have physical assets similar to that of Indian Railways.

But if both were to come to capital market with a public issue of equity,

Infosys would command better investor’s acceptance than the Indian

Railways. This is because the value of human resource plays an

important role in valuing a firm.

The better the quality of man power in an organisation, the higher the

value of the human capital and consequently the higher the productivity

of the organisation. Indian Software and IT enabled services have been

globally acclaimed only because of the manpower they possess. But it

has a cost factor - the best remuneration to the staff.



Opportunity cost of capital: The Rate of Return required by an investor is

normally known as the hurdle rate or the cut-off rate.

Wealth: Shareholder wealth.

1.9 Terminal Questions

1. What are the goals of financial management?

2. How does a finance manager arrive at an optimal capital structure?

3. Examine the relationship of financial management with other functional

areas of a firm.

4. Examine the relationship between finance and accounting.

5. Examine the relationship between finance and marketing.

1.10 Answers


1. Liberalisation and globalisation of Indian economy

2. Procurement of funds

3. Wealth maximisation

4. Wealth maximisation

5. Investment decisions

6. Financing decisions

7. Liquidity decisions

8. Treasurers

9. The two critical issues are:

Evaluation of expected profitability of the new investment

Rate of return required on the project

10. Rate of return is normally defined as the hurdle rate or cutoff rate or

opportunity cost of the capital.

11. Dividend decision

Terminal Questions

1. Financial management means maximisation of economic welfare of its

shareholders. The two goals of financial management are 1) profit

maximisation and 2) wealth maximisation. Refer 1.3



2. Financing decisions relate to the composition of relative proportion of

various sources of finance. Whenever funds are to be raised to finance

investments, capital structure decision is involved. Refer 1.4.1

3. The relationship between financial management and other areas of a

firm can be explained by the. Refer 1.6

4. Accounting is a necessary input for the finance function as it generates

information through the financial statements. Refer 1.6.1

5. Marketing decisions, generally, have financial implications. Refer 1.6.2

1.11 Case Study: Hindustan Unilever Limited

Introduction:

Hindustan Unilever Limited (HUL) is India's largest Fast Moving Consumer

Goods Company with a heritage of over 75 years in India and touches the

lives of two out of three Indians.

With over 35 brands spanning 20 distinct categories such as soaps,

detergents, shampoos, skin care, toothpastes, deodorants, cosmetics, tea,

coffee, packaged foods, ice cream, and water purifiers, the Company is a

part of the everyday life of millions of consumers across India. Its portfolio

includes leading household brands such as Lux, Lifebuoy, Surf Excel, Rin,

Wheel, Fair & Lovely, Pond’s, Vaseline, Lakmé, Dove, Clinic Plus, Sunsilk,

Pepsodent, Closeup, Axe, Brooke Bond, Bru, Knorr, Kissan, Kwality Wall’s,

and Pureit.

The Company has over 16,000 employees and has an annual turnover of

around Rs.19,401 crore (financial year 2010 - 2011). HUL is a subsidiary of

Unilever, one of the world’s leading suppliers of fast moving consumer

goods with strong local roots in more than 100 countries across the globe

with annual sales of about €44 billion in 2011. Unilever has about 52%

shareholding in HUL.

Unilever has a long history in sustainability and the use of marketing and

market research to promote behaviour change. In November 2011, for the

first time, it published its own model of effective behaviour change. For

those who are interested, the details of this model can be seen at

http://www.hul.co.in/mediacentre/news/2011/inspiring-sustainable-

living.aspx

http://www.hul.co.in/mediacentre/news/2011/inspiring-sustainable-living.aspx

http://www.hul.co.in/mediacentre/news/2011/inspiring-sustainable-living.aspx



History of the Company:

In the summer of 1888, visitors to the Kolkata harbour noticed crates full of

Sunlight soap bars, embossed with the words "Made in England by Lever

Brothers". With it began an era of marketing branded Fast Moving

Consumer Goods (FMCG).

Soon after followed Lifebuoy in 1895, and other famous brands like Pears,

Lux, and Vim. Vanaspati was launched in 1918 and the famous Dalda brand

came to the market in 1937. In 1931, Unilever set up its first Indian

subsidiary, Hindustan Vanaspati Manufacturing Company, followed by Lever

Brothers India Limited (1933) and United Traders Limited (1935). These

three companies merged to form HUL in November 1956; HUL offered 10%

of its equity to the Indian public, being the first among the foreign

subsidiaries to do so. Unilever now holds 52.10% equity in the company.

The rest of the shareholding is distributed among about 360,675 individual

shareholders and financial institutions.

The erstwhile Brooke Bond's presence in India dates back to 1900. By

1903, the company had launched Red Label tea in the country. In 1912,

Brooke Bond & Co. India Limited was formed. Brooke Bond joined the

Unilever fold in 1984 through an international acquisition. The erstwhile

Lipton's links with India were forged in 1898. Unilever acquired Lipton in

1972 and in 1977 Lipton Tea (India) Limited was incorporated.

Pond's (India) Limited had been present in India since 1947. It joined the

Unilever fold through an international acquisition of Chesebrough Pond's

USA in 1986.

Since the very early years, HUL has vigorously responded to the stimulus of

economic growth. The growth process has been accompanied by judicious

diversification, always in line with Indian opinions and aspirations.

The liberalisation of the Indian economy, started in 1991, clearly marked an

inflexion in HULs and the Group's growth curve. Removal of the regulatory

framework allowed the company to explore every single product and

opportunity segment, without any constraints on production capacity.

Simultaneously, deregulation permitted alliances, acquisitions, and mergers.

In one of the most visible and talked about events of India's corporate

history, the erstwhile Tata Oil Mills Company (TOMCO) merged with HUL,



effective from April 1, 1993. In 1996, HUL and yet another Tata company,

Lakme Limited, formed a 50:50 joint venture, Lakme Unilever Limited, to

market Lakme's market-leading cosmetics and other appropriate products of

both the companies. Subsequently in 1998, Lakme Limited sold its brands to

HUL and divested its 50% stake in the joint venture to the company.

HUL formed a 50:50 joint venture with the US-based Kimberly Clark

Corporation in 1994. Kimberly-Clark Lever Ltd, which markets Huggies

Diapers and Kotex Sanitary Pads. HUL has also set up a subsidiary in

Nepal, Unilever Nepal Limited (UNL), and its factory represents the largest

manufacturing investment in the Himalayan kingdom. The UNL factory

manufactures HULs products like soaps, detergents, and personal products

both for the domestic market and exports to India.

The 1990s also witnessed a string of crucial mergers, acquisitions, and

alliances on the Foods and Beverages front. In 1992, the erstwhile Brooke

Bond acquired Kothari General Foods, with significant interests in Instant

Coffee. In 1993, it acquired the Kissan business from the UB Group and the

Dollops Ice cream business from Cadbury India.

As a measure of backward integration, Tea Estates and Doom Dooma, two

plantation companies of Unilever, were merged with Brooke Bond. Then in

1994, Brooke Bond India and Lipton India merged to form Brooke Bond

Lipton India Limited (BBLIL), enabling greater focus and ensuring synergy in

the traditional Beverages business. 1994 witnessed BBLIL launching the

Wall's range of Frozen Desserts. By the end of the year, the company

entered into a strategic alliance with the Kwality Ice cream Group families

and in 1995 the Milk food 100% Ice cream marketing and distribution rights

too were acquired.

Finally, BBLIL merged with HUL, with effect from January 1, 1996. The

internal restructuring culminated in the merger of Pond's (India) Limited

(PIL) with HUL in 1998. The two companies had significant overlaps in

personal products, speciality chemicals and exports businesses, besides a

common distribution system since 1993 for personal products. The two also

had a common management pool and a technology base. The

amalgamation was done to ensure for the Group, benefits from scale

economies both in domestic and export markets and enable it to fund

investments required for aggressively building new categories.



In January 2000, in a historic step, the government decided to award 74

percent equity in Modern Foods to HUL, thereby beginning the divestment

of government equity in public sector undertakings (PSU) to private sector

partners. HULs entry into bread is a strategic extension of the company's

wheat business. In 2002, HUL acquired the government's remaining stake in

Modern Foods.

In 2003, HUL acquired the cooked shrimp and pasteurised crabmeat

business of the Amalgam Group of Companies, a leader in value added

marine products exports.

HUL launched a slew of new business initiatives in the early part of 2000s.

Project Shakti was started in 2001. It is a rural initiative that targets small

villages populated by less than 5000 individuals. It is a unique win-win

initiative that catalyses rural affluence even as it benefits business.

Currently, there are over 45,000 Shakti entrepreneurs covering over

100,000 villages across 15 states and reaching to over 3 million homes.

In 2002, HUL made its foray into Ayurvedic health and beauty centre

category with the Ayush product range and Ayush Therapy Centres.

Hindustan Unilever Network, Direct to home business was launched in 2003

and this was followed by the launch of ‘Pureit’ water purifier in 2004.

In 2007, the Company name was formally changed to Hindustan Unilever

Limited after receiving the approval of share holders during the 74th AGM

on 18 May, 2007. Brooke Bond and Surf Excel breached the Rs 1,000 crore

sales mark the same year followed by Wheel which crossed the Rs.2, 000

crore sales milestone in 2008.

On 17th October, 2008, HUL completed 75 years of corporate existence in

India.

Following are excerpts from the company’s Annual Report 2010 –

2011:

Financial Highlights:

Net Sales: Rs. 19,401 crore

Net Profit: Rs.2, 306 crore

EPS (Basic): Rs.10.58

EVA: Rs.1, 750 crore



Total expenditure:

60%

16%

6%

6%

6%1% 5%

Materials

Advertising Costs

Staff Costs

Carriage and

Freight

Utilities, Rent,

Repairs etc.

Depreciation

Other

Expenditure

Financial Performance – 10 year track record (Rs. Crores)

P&L

account 2001 2002 2003 2004 2005 2006 2007

2008-09

(15

months)

2009-10 2010-11

Gross

Sales*

11,781.30 10,951.61 11,096.02 10,888.38 11,975.53 13,035.06 14,715.10 21,649.51 18,220.27 20,305.54

Other

Income 381.79 384.54 459.83 318.83 304.79 354.51 431.53 589.72 349.64 586.04

Interest (7.74) (9.18) (66.76) (129.98) (19.19) (10.73) (25.50) (25.32) (6.98) (0.24)

Profit

Before

Taxation

@

1,943.37 2,197.12 2,244.95 1,505.32 1,604.47 1,861.68 2,146.33 3,025.12 2,707.07 2,730.18

Profit

After

Taxation

@

1,540.95 1,731.32 1,804.34 1,199.28 1,354.51 1,539.67 1,743.12 2,500.71 2,102.68 2,153.25

Earnings

Per

Share of

Re. 1#

7.46 8.04 8.05 5.44 6.40 8.41 8.73 11.46 10.10 10.58

Dividend

Per

Share of

Re. 1#

5.00 5.16 5.50 5.00 5.00 6.00 9.00 7.50 6.50 6.50

* Sales before Excise Duty Charge @ Before Exceptional/Extraordinary items #

Adjusted for bonus



Balance Sheet

2001 2002 2003 2004 2005 2006 2007

2008-09

(15 months)

2009-10 2010-11

Fixed Assets 1,320.06 1,322.34 1,369.47 1,517.56 1,483.53 1,511.01 1,708.14 2,078.84 2,436.07 2,468.24

Investments 1,635.93 2,364.74 2,574.93 2,229.56 2,014.20 2,413.93 1,440.80 332.62 1,264.08 1,260.68

Net Deferred Tax

246.48 269.92 267.44 226.00 220.14 224.55 212.39 254.83 248.82 209.66

Net Current Assets

(75.04) (239.83) (368.81) (409.30) (1,355.31) (1,353.40) (1,833.57) (182.84) (1,365.45) (1,304.66)

3,127.43 3,717.17 3,843.03 3,563.82 2,362.56 2,796.09 1,527.76 2,483.45 2,583.52 2,633.92

Share Capital 220.12 220.12 220.12 220.12 220.12 220.68 217.74 217.99 218.17 215.95

Reserves & Surplus

2,823.57 3,438.75 1,918.60 1,872.59 2,085.50 2,502.81 1,221.49 1,843.52 2,365.35 2,417.97

Loan Funds 83.74 58.30 1,704.31 1,471.11 56.94 72.60 88.53 421.94 – –

3,127.43 3,717.17 3,843.03 3,563.82 2,362.56 2,796.09 1,527.76 2,483.45 2,583.52 2,633.92

Others

HUL Share Price on BSE (Rs. Per Share of Re. 1)*

223.65 181.75 204.70 143.50 197.25 216.55 213.90 237.50 238.70 284.60

Market Capitali-sation

(Rs. Crores)

49,231 40,008 45,059 31,587 43,419 47,788 46,575 51,770 52,077 61,459

* Based on year-end closing prices quoted in the Bombay Stock Exchange,

adjusted for bonus shares.

Excerpts from the report on Human Resources:

“…Your Company’s Human Resource agenda for the year focused on

strengthening four key areas: building a robust talent pipeline,

enhancing individual and organisational capabilities for future-readiness,

driving greater employee engagement and strengthening employee

relations further through progressive people practices at the shop

floor…”

“…In the first half of 2010, a comprehensive Talent and Organisation

Assessment was undertaken to understand their readiness to partner

the business ambition in the medium term and a holistic people strategy

was drawn up, which was the basis of the work done in the key areas

mentioned above. This Human Resource agenda not only looks at the

current needs of the business, but also enhances the Company’s

preparedness for the future…”

“…The Company participates in a Global People Survey every 2 years,

which is a leading indicator of employee morale and motivation, with

Employee Engagement being one of the key dimensions measured. For

the current year, the employee participation rate for this survey was over

99% (with an employee base of approximately 15000) and your



Company were ranked among the top performing companies across

Unilever globally in all dimensions. This was on account of a number of

proactive and innovative initiatives to engage our employees, the most

significant being continuous and consistent business linked

engagement, a vision for the future of the business and clarity and

transparency to individuals on their own careers…”

Discussion Questions:

1. Do you think that HUL has preferred the profit maximisation approach

over the wealth maximisation approach? Justify your answer.

(Hint: Refer to wealth maximisation)

2. How do you think an effective interaction between the HR and finance

department of a firm helps in achieving its goals? You may draw

instances from the case provided above.

(Hint: Refer to Finance & HR))

3. Study the pattern of total expenditure as given in the annual report.

Which core element of financial management is this based on?

(Hint: Refer to Financing decisions)

4. HUL is known for its marketing power. Wide bouquets of brands are

handled under their purview, as we have seen above. What is the

correlation between finance and marketing management? How is their

relationship significant to the achievement of final goals of the company?

(Hint: Refer to Finance and Marketing)

(Source: HUL Annual Report 2010 – 2011, www.hul.co.in)

References:

Khan, M. Y. and Jain P. K. (2007). Financial Management, Text,

Problems & Cases, 5th Edition, Tata McGraw Hill Company, New Delhi.

Maheshwari, S.N.(2009)., Financial Management – Principles & Practice,

13th Edition, Sultan Chand & Sons.

Van Horne, James, C (2002), Principles of Financial Management,

Pearson Education.

Prasanna, Chandra (2007), Financial Management: Theory and Practice,

7th Edition, Tata McGraw Hill.

E-Reference:

HUL Annual Report 2010 – 2011, www.hul.co.in retrieved on

10/12/ 2011

http://www.hul.co.in/

Mb0045 Unit 01-Slm

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