FINANCIAL MANAGEMENT – DETAILED NOTES

1. INTRODUCTION TO FINANCE

Meaning of Finance

Finance refers to the management of large amounts of money by governments or large organisations. In a
business organisation, money flows between different sources and destinations and must be properly
managed to ensure efficiency and growth.

Finance is concerned with:

• Acquisition of funds
• Allocation and use of funds
• Management of financial resources

2. FINANCIAL MANAGEMENT
Financial management means the efficient and effective management of money in such a manner as to
accomplish the objectives of the organisation.

It provides a conceptual framework for financial decision-making and is an integral part of overall
management.

Main Objective

To maximise shareholders’ wealth.

Role of Financial Management

• Acquire funds required by the firm

• Ensure funds are used efficiently
• Maintain liquidity
• Ensure profitability
• Balance risk and return

3. SCOPE OF FINANCIAL MANAGEMENT

Financial management covers four major decisions: 1. Investment decisions 2. Financing decisions 3.
Dividend decisions 4. Working capital management

All these decisions are interdependent.

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4. INVESTMENT DECISIONS (CAPITAL BUDGETING)
Investment decisions relate to the acquisition of fixed or non-current assets (capital investments).

Examples

• Purchase of new equipment

• Acquisition of land and buildings
• Establishment of new business units
• Investment in advanced or automated production technology

A company invests in order to maintain or improve its profit-earning capacity.

Factors to Consider

• Relevant cash inflows and outflows

• Risks and expected returns
• Time value of money
• Cost of capital
• Availability of funds

Capital Rationing

When available funds are limited and not all financially viable projects can be undertaken, the firm must
select the optimal combination of projects.

5. FINANCING DECISIONS
Once investment decisions are made, the company must decide how to finance them.

Sources of Finance

(a) Equity Finance

• Ordinary shares
• Retained earnings (reserves)

Shareholders undertake business risk and expect returns in the form of:

• Dividends
• Capital gains

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(b) Debt Finance

• Bank loans
• Debentures
• Other fixed-interest securities

Debt requires:

• Payment of interest
• Repayment of principal

Capital Structure

The financial manager must determine the optimal mix of equity and debt.

Factors considered:

• Cost of each source of finance

• Required rate of return to shareholders
• Interest rate on debt
• Risk level and gearing ratio

6. DIVIDEND DECISIONS
After earning profits, the company must decide whether to:

• Retain profits for reinvestment

• Distribute profits to shareholders as dividends

Dividend Payout Ratio

The proportion of net profits distributed as dividends.

If profits are retained:

• More funds available for reinvestment

• Less need for external financing

If higher dividends are paid:

• Lower internal funds available

• Possible need for external finance
• Future investment opportunities may be limited

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7. WORKING CAPITAL MANAGEMENT
Working capital = Current assets – Current liabilities

Current Assets

• Cash
• Stocks (inventory)
• Debtors (accounts receivable)

Working capital management ensures that the company maintains sufficient liquidity to pay debts as and
when they fall due.

Liquidity vs Profitability

A balance must be maintained between:

• Liquidity (ability to meet obligations)

• Profitability (earning returns)

Too much cash:

• Idle funds
• Opportunity cost of lost investment returns

Too little cash:

• Risk of insolvency
• Inability to pay debts on time

8. INTERDEPENDENCE OF DECISIONS
• Higher dividends reduce reinvestment funds
• More debt increases financial risk
• Expensive finance requires higher investment returns
• Investment decisions affect financing needs
• Working capital affects liquidity and risk

9. ROLE OF THE FINANCIAL MANAGER (CFO)

The Financial Manager is responsible for the overall financial health of the organisation.

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Main Functions

• Financial planning
• Investment appraisal
• Funding decisions
• Working capital management
• Risk management
• Advising the board of directors

Before making decisions, the financial manager must:

• Evaluate financial viability of projects

• Analyse relevant cash flows
• Assess risks and returns
• Consider funding alternatives

10. FINANCIAL MARKETS

Financial markets facilitate the transfer of funds between surplus and deficit units.

They include:

• Money markets (short-term funds)

• Capital markets (medium- and long-term funds)

11. MONEY MARKET

A money market is a financial market for short-term borrowing and lending (up to one year).

Instruments

• Treasury bills
• Certificates of deposit
• Bills of exchange

These instruments are usually fixed-interest and highly liquid.

12. CAPITAL MARKET

Capital markets deal with medium- and long-term finance.

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(a) Primary Market
• Companies raise new finance
• New issues of shares and bonds are made to the public

(b) Secondary Market

• Trading of already issued securities
• Provides liquidity to investors

Secondary markets allow investors to sell securities and recover their funds.

13. ROLE OF CAPITAL MARKETS / BOND MARKETS

Capital markets:

• Provide a source of finance to business units

• Promote economic growth
• Reduce dependence on commercial banks
• Determine fair prices of shares
• Act as a clearing house between buyers and sellers
• Encourage relevant, reliable and timely financial reporting
• Reduce risk to individual buyers and sellers
• Ensure optimum allocation of financial resources

Regulation increases transparency and reduces fraudulent dealings.

14. FINANCIAL INTERMEDIARIES

Financial intermediaries are institutions that act as mediators between lenders and borrowers in a financial
market.

Examples

• Banks
• Pension funds
• Insurance companies
• Mutual funds
• Government savings departments

Intermediation may also occur between the central bank and commercial banks.

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15. FUNCTIONS OF FINANCIAL INTERMEDIARIES
(a) Aggregation
Pooling small individual savings into large loans.

(b) Risk Reduction

Spreading risk across many borrowers.

(c) Maturity Transformation

Allowing short-term deposits while granting long-term loans.

(d) Convenience
Investors can deposit funds without searching for borrowers.

(e) Regulation
Protection of investors through supervision and legal frameworks.

(f) Information
Providing advice and financial information to borrowers and lenders.

16. CREDIT CREATION (FRACTIONAL RESERVE

BANKING)
Banks create money through lending.

If a bank receives deposits and keeps a fraction (e.g., 10%) as reserve, it can lend the remaining 90%.

When loans are deposited back into the banking system, additional credit is created.

This process increases the money supply in the economy.

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17. BENEFITS OF FINANCIAL INTERMEDIATION
(a) Benefits to Investors
• Reduced risk through diversification
• Access to bank expertise in assessing corporate risk
• Economies of scale in investment
• Protection through guarantee or insurance schemes

(b) Benefits to Companies

• Access to pooled large financial resources
• Ability to bridge maturity gap (long-term financing)
• Transparency in interest rates and competition among institutions
• Reduced borrowing costs due to competition
• Possibility of financing high-risk projects through consortium lending
• Improved access to credit and financial services