Introduction to Financial Management

Let’s define financial management as the first part of the introduction to financial management. For
any business, it is important that the finance it procures is invested in a manner that the returns from
the investment are higher than the cost of finance. In a nutshell, financial management –
 Endeavors to reduce the cost of finance
 Ensures sufficient availability of funds
 Deals with the planning, organizing, and controlling of financial activities like the
procurement and utilization of funds
Some Definitions
“Financial management is the activity concerned with planning, raising, controlling and
administering of funds used in the business.” – Guthman and Dougal

“Financial management is that area of business management devoted to a judicious use of capital
and a careful selection of the source of capital in order to enable a spending unit to move in the
direction of reaching the goals.” – J.F. Brandley

“Financial management is the operational activity of a business that is responsible for obtaining
and effectively utilizing the funds necessary for efficient operations.”- Massie

Valuation

Tools of Financial Analysis and Planning

Financial management is an organic function of any business. Any organization needs finances to
obtain physical resources, carry out the production activities and other business operations, pay
compensation to the suppliers, etc. There are many theories around financial management:
1. Some experts believe that financial management is all about providing funds needed by a
business on terms that are most favorable, keeping its objectives in mind. Therefore, this
approach concerns primarily with the procurement of funds which may include instruments,
institutions, and practices to raise funds. It also takes care of the legal and accounting
relationship between an enterprise and its source of funds.
2. Another set of experts believe that finance is all about cash. Since all business transactions
involve cash, directly or indirectly, finance is concerned with everything done by the
business.
3. The third and more widely accepted point of view is that financial management includes the
procurement of funds and their effective utilization. For example, in the case of a
manufacturing company, financial management must ensure that funds are available for

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 installing the production plant and machinery. Further, it must also ensure that the profits
adequately compensate the costs and risks borne by the business.
In a developed market, most businesses can raise capital easily. However, the real problem is the
efficient utilization of the capital through effective financial planning and control.
Further, the business must ensure that it deals with tasks like ensuring the availability of funds,
allocating them, managing them, investing them, controlling costs, forecasting financial
requirements, planning profits and estimating returns on investment, assessing working capital, etc.
The scope of Financial Mangement
The introduction to financial management also requires you to understand the scope of financial
management. It is important that financial decisions take care of the shareholders‘ interests.
Further, they are upheld by the maximization of the wealth of the shareholders, which depends on
the increase in net worth, capital invested in the business, and plowed-back profits for the growth
and prosperity of the organization.
The scope of financial management is explained in the diagram below:

You can understand the nature of financial management by studying the nature of investment,
financing, and dividend decisions.
Learn more about Supply Chain here in detail.
Core Financial Management Decisions
In organizations, managers in an effort to minimize the costs of procuring finance and using it in the
most profitable manner, take the following decisions:
Investment Decisions: Managers need to decide on the amount of investment available out of the
existing finance, on a long-term and short-term basis. They are of two types:
 Long-term investment decisions or Capital Budgeting mean committing funds for a long
period of time like fixed assets. These decisions are irreversible and usually include the ones
pertaining to investing in a building and/or land, acquiring new plants/machinery or replacing
the old ones, etc. These decisions determine the financial pursuits and performance of a
business.

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  Short-term investment decisions or Working Capital Management means committing funds
for a short period of time like current assets. These involve decisions pertaining to the
investment of funds in the inventory, cash, bank deposits, and other short-term investments.
They directly affect the liquidity and performance of the business.
Financing Decisions: Managers also make decisions pertaining to raising finance from long-term
sources (called Capital Structure) and short-term sources (called Working Capital). They are of two
types:
 Financial Planning decisions which relate to estimating the sources and application of
funds. It means pre-estimating financial needs of an organization to ensure availability of
adequate finance. The primary objective of financial planning is to plan and ensure that the
funds are available as and when required.
 Capital Structure decisions which involve identifying sources of funds. They also involve
decisions with respect to choosing external sources like issuing shares, bonds, borrowing
from banks or internal sources like retained earnings for raising funds.
Dividend Decisions: These involve decisions related to the portion of profits that will be distributed
as dividend. Shareholders always demand a higher dividend, while the management would want to
retain profits for business needs. Hence, this is a complex managerial decision.
Solved Question for You
Q1. What are the primary objectives of financial management?
Answer:
The primary objectives of financial management are:
 Attempting to reduce the cost of finance
 Ensuring sufficient availability of funds
 Also, dealing with the planning, organizing, and controlling of financial activities like the
procurement and utilization of funds.

Business Valuation and Its Models | Financial Management

1. Dividend Yield Method:
Ownership of shares in a company entails the holders of shares to receive dividends as and when
declared. Since investors in a company get their return in the form of a dividend, the amount of
dividend paid gives some indication of how valuable the shares will be to the potential buyer.
When valuing a small shareholding (which cannot influence the proportion of earnings to be
distributed), the calculation should be based on the dividends, rather than earnings per share.

If dividend is seen as one of the key factors determining how valuable shares are, it is possible to
look at the relationship between level of dividend and price in other companies and base a price

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on what dividend is normally paid. This concept can be presented as a formula for any individual
company to an accepted average for similar business.
Value of Business = Value per equity share × Total number of equity shares
Disadvantages:
The dividend yield method is subject to the following disadvantages:
1. It ignores the element of capital gain which is the important financial justification for investing
in shares.
2. The growth of a company could be seen as being a mean to securing the flow of dividends to
shareholders in future, rather than a goal in itself.
3. The method is based on the assumption that dividend policy will remain constant. In practice,
companies can and do change their dividend policies.
4. In case of unquoted companies, they are not concerned to keep shareholders happy, so levels
of dividend may well be lower than for quoted companies. This valuation might, under value
unquoted companies.
5. One drawback of the dividend yield valuation of an unlisted share is that it is usually based on
past dividends, and these may not be representative of future expectations which should help,
determine the current price.
The disparity between the dividend policies of unlisted and listed companies is caused by a
number of factors. The listed company tries to prevent falls in its share price which leave it
vulnerable to a takeover bid and unable to attract additional investment. A generous dividend
policy helps maintain a high share price.
Unlisted companies, and especially private companies, find it more difficult to attract external
funds. The need to plough back into the business a large proportion of earnings leaves limited
amounts available for distribution.
Problem 1:
Ashoka Builders Ltd. has an issued and paid up capital of 5,00,000 shares of Rs.10 each. The
company declared a dividend of Rs.12.50 lakhs during the last five years and expects to maintain
the same level of dividends in future. The control and ownership of the company is lying in the
few hands of directors and their family members. The average dividend yield for listed
companies in the same line of business is 18%.
Calculate the value 3,000 shares in the company.
Solution:
Dividend per share = Rs.12,50,000/5,00,000 shares = RS.2.5
Industry’s normal rate of dividend = 18%
Value of 3,000 shares = 3,000 shares × Rs.13.89 = Rs.41,670
Problem 2:

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BC Ltd. has declared dividend during the past five years as follows:

The average rate of return prevailing in the same industry is 15%. Calculate the value per share
of Rs.10 of ABC Ltd. based on the dividend yield method.

Weighted average rate of dividend = 298/15 = 19.87%

Problem 3:
The profit of X Ltd. for the year ended 31st March, 2016 were Rs.60,00,000. After setting apart
amounts for interest on borrowings, taxation and other provisions, the net surplus available to
shareholders is estimated at Rs.15,00,000.
The company’s capital base consisted of:
(i) 1,00,000 Equity shares of Rs.100 each, Rs.50 per share paid up, and
(ii) 25,000 12% Cumulative Redeemable Preference shares of Rs.100 each, fully paid up.
Enquiries in the stock market reveal that shares of companies engaged in similar business and
declaring a dividend of 15% on equity shares are quoted at a premium of 10%.
What do you expect the market value of the company’s shares to be, basing your working on the
yield method?
Solution:

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2. Earnings Yield Method:
To overcome the problems associated with dividends, the yield based upon earnings can be used.
The total amount of profit belongs to the shareholders, whether distributed as dividend or not.
The undistributed profit used to finance the growth of the business helps to increase the value of
the shares, and is just as much a part of the shareholders return on the investment as the dividend.
The value of a company on the earnings yield basis is the value of the stream of profit or
earnings which the company is expected to generate.
Calculation of an earnings yield value involves three steps:
Step 1:
Predict the future maintainable profits (annual earnings) of the company being valued.
Step 2:
Identify the required earnings yield by reference to the results of similar companies.
Step 3:
Apply the earnings yield to future profits using the following formula:

The profit figure is available from the profit and loss account of the company. But when
estimating the future earnings, factors which cause distortions and changes anticipated in the
future should be taken care of. The ability of the valuer to prepare an accurate forecast will
depend on access to relevant information.
Problem 4:
Kavery Industries Ltd. is expected to generate future profits of Rs.54,00,000.
What is its value of business if investments of this type are expected to give an annual return of
18%.
Solution:
Company’s expected future profits = Rs,54,00,000
Industry’s normal rate of return = 18% or 0.18
Value of Business = Rs.54,00,000/0.18 = Rs.3,00,00,000

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Problem 5:
Jain Castings Ltd. agrees to acquire Nayagara Steels Ltd. based on the capitalisation of last three
years profits of Nayagara Steels Ltd. at an earnings yield of 21%.

Calculate the value of business on earnings yield basis.

Solution:
Company’s 3 years average profit = (75 + 89 + 82)/3 = Rs.82 lakhs
Earnings yield = 21% or 0.21

Problem 6:
On 31st March, 2016 the Balance sheet of XYZ Ltd. disclosed the following position:

On 31st March, 2016 the goodwill of the company was valued at Rs.50,000 while other fixed
assets were valued at Rs.3,50,000. The net profit earned by the company amounted to Rs.51,600
for 2013 -14; Rs.52,000 for 2014-15 and Rs.51,650 for 2015-16.
Every year an amount equal to 20% of the profit earned was transferred to general reserve – this
being considered reasonable in the industry in which the company is engaged. A return of 10%
on the investment is considered fair in the industry.
Compute the value of the company’s share by the yield method.
Solution:
(i) Calculation of Expected Average Future Profits:

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Problem 7:
From the following particulars, calculate the value of an equity share:

Rate of tax 40%. Transfer to general reserve every year is 20% of profit. Normal rate of earning
15%.
Solution:
(i) Calculation of Profit Available to Equity Shareholders:

(ii) Calculation of Company’s Expected Rate of Earnings:

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(iii) Calculation of Value of an Equity share:

3. Return on Capital Employed Method:

It is a simple method which considers the rate of return on capital employed which will be
required from the company whose shares are to be valued. This is based on the predetermined
notion of the rate of return investor would expect on this particular type of investment, and then
having decided on the earnings of the company, to calculate the capital sum that would result in
such a rate of return.
The steps used in this method are as follows:
Step 1:
Select the past period of investigation.
Step 2:
Estimate the future maintainable profits, after making any necessary adjustments.
Step 3:
Establish the acceptable normal rate of return on capital invested in a similar type of company,
allowing for the industry effect, the size of the company, and the level of capital gearing.
Step 4:
Capitalize future maintainable profits at a rate established as the acceptable rate of return.

The problem with this type of approach is that the estimate of earnings is usually based on
historical earnings. Whether this is a straight average of the past five years’ earnings, or some
weighted average attaching greater importance to the more recent year’s earnings, it is still based
on past performance.
Problem 8:
Sarojini Steels Ltd.’s after tax profit for the year 2016 is Rs.24 lakhs. The company is expecting
to earn an after tax profit of Rs.30 lakhs in the next five years.
All the companies in the similar business is yielding a post-tax accounting rate of return on
capital employed is 24%.
Calculate the valuation of the company based on rate of return on capital employed.
Solution:
Company’s expected future maintainable profit p.a. = Rs.30,00,000

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Industry’s normal rate of return on capital employed = 24% or 0.24
Value of Business =Rs.30,00,000/0.24 = Rs.1,25,00,000
Problem 9:
From the following data available from the books of Timken Bearings Ltd., calculate the
value of equity shares based on return on capital employed:

The market expectation being 16%

Solution:
The rate of return on capital employed is calculated by adopting weighted average method
is as follows:

Company’s weighted average rate of return on capital employed = 333.6/15 = 22.24% or 0.2224
Market expected rate of return on capital employed = 16% or 0.16

4. Price/Earning Method:
Quoted companies are regularly described in terms of their P/E ratio. Like the earnings yield this
links price and earnings, but P/E ratio is the inverse of earnings yield, dividing price by earnings
rather than earnings by price.
As with the earnings yield, the figures can be calculated per share or for the company as a
whole using simple formula:
Value of Business = Company’s expected future maintainable profits x Industry’s average P/E
ratio
Value of Shares = Company’s expected earnings per share x Industry’s average P/E ratio
The P/E ratio can be used as a valuation tool of shares and business. This ratio sets EPS against
the current market price of the share, and is expressed as a number. It can be seen as the number

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of years which the investor must wait to recoup the invested sum out of earnings, whether they
are distributed as a dividend or not.
The ratio is normally thought of as the number of times earnings an investor would pay for a
small number of shares of a company. If the total shares of company are being purchased, the
market P/E ratio may have to be adjusted.
For valuation under this method, there must be an industry P/E ratio that is appropriate for the
investment. The P/E ratio method would be used when it is not realistic to estimate the yearly
cash flows into the future or indeed the rate at which they will grow. Financial analysts often use
P/E ratios as a guide to the market value.
Listed companies offer significant advantages to their members as their shares are marketable
and their large size gives them an element of stability – these advantages make their shares more
desirable, and therefore more highly priced, than those of an unlisted company. The P/E ratio of
an unlisted company is expected to be less than that for a corresponding listed company, and so
the use of unadjusted quoted ratios can result in over-valuation.
Problem 10:
Permanent Magnets Ltd. is having an issued and subscribed capital of 5,00,000 equity shares of
Rs.10 each fully paid up. The company’s after tax profits for the year 2016 amounting to Rs.28
lakhs. The average present stock exchange price of the company’s share is Rs.19.
The P/E ratio of the four listed companies to be used for calculation, their type of business
seems to be similar to Permanent Magnets Ltd. are:

Calculate the valuation of business and per share based on average P/E ratio of the industry.
Solution:
Calculation of P/E Ratio of Four Listed Companies:

Industry’s average P/E ratio = 25.51/4 = 6.38

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Value of Business = Company’s expected future maintainable profit x Industry’s average P/E
ratio
= Rs.28,00,000 x 6.38 = Rs.178.64 lakhs
= Value of share = Company’s earnings per share x Industry’s average P/E ratio
= Rs.5.60 x 6.38 = Rs.35.73

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