Subject: Financial Management

Chapter: One

Chapter No. 1 – Introduction to Financial

Management
Contents
Finance function as different from Accounts
function
Objectives of Financial Management – short-
term and long-term
Financial system and markets in India –
Government of India, Ministry of Finance at
the helm, statutes, statutory authorities,
financial intermediaries, other financial
institutions, agents who operate in the
markets etc.
Brief introduction to “Financial Instruments”

At the end of the chapter the student will be

able to
Map the differences between Finance and
Accounts functions in an organisation and
explain the integration of these functions
Link the short-term and long-term objectives
of Financial Management to profitability and
wealth maximization respectively
Draw the Financial system in India and

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Chapter: One

Differentiate one financial instrument from

another

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

Some of the key finance functions are:

Financial planning and estimation of finance
required for the organisation
Mobilisation of financial resources required as
above

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Chapter: One

Ensuring that the funds are available in adequate

quantity at appropriate time and at an affordable
cost
Management of cash in the organisation through
cash flow statement
Management of investment outside the business
enterprise in other organisations
Management of risk in dealing with foreign
exchange for imports and exports
Note: The above list is not exhaustive.

Let us examine briefly the above functions with

some examples.
Financial planning and estimation of finance
required for the organisation
Any activity in a business enterprise requires
planning for proper execution in time. Finance is
required for any activity at least in the beginning
and hence financial planning is the prime function
of “Finance”. This involves detailed study of any
activity from understanding the total funds
requirement for that activity, when the funds will
be required and how much funds will be required at
different stages. For a new enterprise the entire
resources have to come from outside (externally);
for an existing enterprise, a part of the resources
at least will be available from the profits made in

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Subject: Financial Management
Chapter: One

the past and retained in business after declaring

dividend.
Example No. 1:
We require Rs. 200 lacs for an activity. Let us see
how it affects an existing enterprise. Let us assume
the profits available to be Rs. 60 lacs. Then we
require further resources of Rs. 140 lacs only. This
is the difference between an existing enterprise
and a new one. Financial planning will take this into
account.

Mobilisation of financial resources

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

Adequate supply in time etc.

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This has been explained this in the above point. For

reinforcement the student’s attention is drawn to
one of the objectives of financial management at
least in the short run, the objective of maximising
profits of the organisation. The profits so
maximised in turn enhance the Earning Per Share
(EPS – for formula please refer to Chapter no. 9).

Management of cash in the organisation

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

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Chapter: One

Management of investment outside the

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

Management of risk in foreign exchange etc.

A business enterprise may require imports and do
exports also. Whenever this is done the invoice is
in foreign currency. In imports the business
enterprise requires foreign exchange while in
exports it gets foreign exchange. There is a risk
involved while doing imports or exports. The risk is
that the exchange rate of the foreign currency in
terms of Indian Rupees can keep changing. We will
explain this through an example.
Example no. 2
We have a US Dollar bill for 1000 receivable after a
month. Presently the exchange rate is 1 US Dollar
= Rs.48.25. By the time the money is received

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Subject: Financial Management
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after a month, in case the rate is less than Rs.

48.25, we will lose money. On the contrary if the
exchange rate is more than Rs. 48.25 we will gain.
Exactly opposite will be the effect in the case of
imports. The importer will pay less if the exchange
rate decreases and more if the exchange rate
increases. There are ways and means of
minimising the risk of foreign exchange. Finance
manager is expected to take care of such risks.

Difference between finance function and

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

Accounts function
Core accounts have to take care of the following
areas:
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Chapter: One

Maintaining accounts on a regular basis for all

items of income, expenditure, assets and liabilities
Conforming to Generally Accepted Accounting
Practices (GAAP – India), Accounting principles,
Various Accounting standards of the Institute of
Chartered Accountants of India (ICAI),
Requirements under the Companies’ Act like
following “Accrual system of accounting” (as
opposed to cash system of accounting),
Requirements under The Income Tax Act while
maintaining the Accounts of the limited
company
Finalisation of accounts at the end of the
accounting period (financial year) and
preparation of final accounts in the formats
prescribed in the Companies’ Act – Schedule VI
after claiming depreciation as per provisions of
Companies’ Act – Schedule XIV
Conforming to provisions relating to Advance
Tax payment in four instalments – first
instalment by 15/6, second instalment by 15/9,
third instalment by 15/12 and the last
instalment by 15/3.
Conforming to provisions relating to statutory
audit of accounts under the Companies’ Act
Preparation of revenue and capital budgets
Management Information System (MIS) relating
to Accounts and Finance

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Note: Further details on the above are not given

here as they are outside the scope of textbook on
“Financial Management”. As the students can see,
most of them are self-explanatory.

Short-term and long-term objectives of

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

leverages
Control over liquidity available in the
organisation so as to minimise the cost of
carrying too much cash1 etc.

Long-term objective
The long-term objective of financial management is
to increase the wealth of the shareholders. The
term “wealth” refers to various business assets of
the enterprise that are free of debt. This means
that this wealth belongs to the equity shareholders.
It is often reflected in the “book value” of the share
as reflected in the balance sheet.
The formula for book value is:
Equity share capital + Reserves and Surplus
Number of equity shares issued
This can be explained through an example.
Example no. 3
Equity share capital = Rs. 100 lacs (paid up capital)
Reserves and surplus = Rs. 200 lacs
Number of shares = 10 lacs with the Face Value
being Rs.10/-

1
Carrying too much liquidity involves cost. This cost is referred to as “opportunity cost”. It simply means that by
carrying too much liquidity, the business enterprise has foregone an opportunity of getting a return on such amount
that it will have got by employing the funds in business. On the contrary, carrying too little cash is also risky as the
enterprise may not be able to fulfil its obligations to creditors etc. in time.

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Subject: Financial Management
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Then the book value of the share would be = Rs.

100 lacs + Rs. 200 lacs = Rs. 30/-.
10 lacs shares
This means that at the starting point the book
value was Rs.10/- and this has gone up to Rs. 30/-
due to the prudent policy of the management of
retaining profits within the organisation. Thus the
short-term objective also is a contributory factor to
realising the long-term objective of wealth
maximisation.
Some of the measures through which we achieve
the long-term objective are:
Strategic financial management decisions
relating to expansion, take over of another
business, financial re-restructuring through
financial re-engineering (example – swap a
costly loan for a cheaper loan provided the
credibility of the firm is quite high), joint
venture etc. Thus while profitability reflects the
operating efficiency wealth maximisation
reflects the managerial/entrepreneurial
efficiency.
To sum up, both short-term objective and long-
term objective need to be put in place for
sustained growth of a business enterprise. To an
extent at least, the long-term objective is
dependent upon the short-term objective of profit
maximisation.

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Subject: Financial Management
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Financial system in India

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

Constituents of the Indian Financial System

The Government of India, Ministry of Finance,
heads the Indian financial system. The ministry in
turn is bifurcated into various departments like the
Department of Economic Affairs, the Department of
Company Affairs etc.
The Indian financial system consists of:
The financial markets
The statutes governing the various segments
of the financial markets

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The statutory authorities responsible for

regulating, supervising, monitoring and
controlling the markets and its components
The financial intermediaries
Special organisations
Agents operating in different segments of the
financial markets and
Financial instruments/securities issued in the
markets to raise resources

The financial markets

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

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the financial instruments issued in the Primary

market change hands from one investor to another
for financial consideration.
Segments of money markets: Call money market
exclusively for banks to be
borrowers – inter-bank operations
for a very short period. One day to
fourteen days. Fourteen day
borrowing is in the notice money
market that is also a part of the
Call Money Market. Only scheduled
commercial banks are permitted to
be borrowers in this market. While
some banks will be borrowers,
some others will be lenders. There
is no specific market place. Deals
are done over the phone.
Segments of money markets Commercial paper
issued by companies and Public
Sector Undertakings as part of
working capital requirement. This is
a promissory note issued by
companies requiring short-term
funds (say from 15 days to 180
days or six months). Maximum
period is twelve months. The six-
month commercial paper can be
extended for a further period of six
months, making a total of 12
months.
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Commercial bills discounted by

banks and Non-banking Financial
Institutions. These are short-term
bills usually not exceeding 90-120
days covering commercial
transactions in the private sector.
Treasury bills issued by
Government of India through the RBI for
meeting budgetary deficits.
These are for fixed maturity periods of 91
days and 364 days.

The Reserve Bank of India controls the money

markets in India. It is known as money market
regulator.

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

Secondary market
The secondary market is provided by Discount and
Finance House of India Limited (DFHI) a subsidiary
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of RBI. It provides a two-way quotation, one for

purchasing money market instruments and another
for selling money market instruments. For
example, a holder of Treasury bill of Government
of India can sell it to DFHI and anyone wants to
purchase treasury bills, he can approach DFHI who
can sell it to him. There is no secondary market for
call money or notice money market.

Segments of capital markets: GOI bonds

Various state government bonds
Bonds issued by Public Sector
undertakings like BHEL etc.
Bonds issued by private sector
companies, banks and financial institutions
Debentures issued by private
sector companies
Equity share capital issued by
private sector companies
Preference share capital issued by
private sector companies
In the case of public issues by private sector
companies, banks, financial institutions and mutual
funds, Securities Exchange Board of India (SEBI) is
the controlling authority. It is referred to as the
capital market regulator. However SEBI does not
control Government bonds or securities issued by
Public Sector Undertakings. GOI bonds and state
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government bonds are handled and controlled by

RBI. Public sector undertaking like Bharat Heavy
Electricals Limited (BHEL) come directly under GOI
– MOF.

Primary market
There is no specific market place for this. This
again, like in the case of money market, facilitates
issue of securities by those who require funds in
the medium to long-term. The public issue process
is supervised and controlled by the lead merchant
banker/bankers in the case of all public issues.
Primary market ends with the listing of securities
on stock exchanges by the Registrar to the Issue.
Details of operators in the primary market have
been given under “Agents operating in financial
markets”.
Secondary market
The secondary market begins with the listing of
securities on the stock exchanges by the Registrar
to the issue. It has a market place in the form of
stock exchanges. Its operations are through share
brokers who are registered with respective stock
exchanges. The stock exchanges in turn are
controlled and regulated by SEBI. Details of
operators in the secondary market have also been
given under “Agents operating in the financial
markets”.

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Statutes governing the various segments of the

financial markets and the statutory authorities
Statute means an Act passed either by the
Parliament or State legislature.
Money market – No specific statute – controlled by
RBI
Capital market – Securities Contracts Regulations
Act and Rules as well as SEBI regulations for the
various operators in the Capital market – controlled
by SEBI. Mutual Funds also come under the
Regulations of SEBI.
Insurance – Insurance Regulatory and Development
Act (IRDA) – controlled by the Insurance Regulatory
and Development Authority coming under GOI,
Ministry of Finance
Banking – Banking Regulations Act controlled by
RBI
Non-banking Financial Companies (NBFCs –
example Kotak Mahindra Finance Company
Limited) – Non-Banking Financial Companies Act of
RBI
Functioning of limited companies registered in
India – The Companies’ Act – controlled by the
Company Law Board2 (CLB) coming under GOI,
Ministry of Finance. The principal officer is known
as “The Registrar of Companies” (ROC).
2
Company Law Board is primarily responsible for conduct of the affairs of limited companies registered in India
under the Companies’ Act. The difference in roles of CLB and SEBI is that the latter is mainly concerned with issue
of securities in the capital market protecting the interests of various kinds of investors. SEBI is not controlling The
Companies’ Act while CLB is not controlling the SCRA. They play complementary roles.

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Foreign Exchange market – Foreign Exchange

Management Act and Exchange Control
Regulations Act both coming under the RBI
Some segments of the financial markets like the
Indian companies accessing international markets
come directly under the GOI, Ministry of Finance

The financial intermediaries

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

Special organisations
These come under one of the financial market
regulators or directly under GOI – Ministry of
Finance
All-India Financial Institutions – GOI – MOF
Central Board of Direct Taxes – CBDT – GOI –
MOF
Stock Exchanges – SEBI

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National Bank for Agriculture and Rural

Development (NABARD) – RBI
Institute of Chartered Accountants of India
(ICAI) – GOI – MOF
Institute of Cost and Works Accountants of
India (ICWA) – GOI – MOF
Institute of Company Secretaries of India (ICSI)
– GOI – MOF
Institute of Chartered Financial Analysts of
India (ICFAI) – GOI – MOF
Foreign Investment Promotion Board (FIPB) –
GOI - MOF

Agents operating in different segments of the

financial markets
The agents operating in the capital market are
more. Hence we examine them briefly here. In
respect of other segments of the financial markets
from a study of the above it will be clear to the
students as to who the operators are in the
respective segments.
Primary market: Merchant banker3 (the principal
operator)
Share brokers who underwrite4 besides
marketing the issue
3
Merchant banker controls the Primary market and is fully responsible for the issue of public securities like equity
shares, debentures, bonds etc. the capital market instruments. He is the principal operator and controls and
monitors all the other operators in the capital market. He is fully accountable to SEBI for the smooth conduct of the
operations in the capital markets. He has to ensure 100% conformity with SCRA rules and regulations as well as
SEBI rules and regulations.

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Bankers to the issue who collect the share

application money along with the share
application forms
Advertisement companies and publicity
companies
Printers for printing the stationery required
for the issue
Registrars to the Issue who take the
responsibility of issuing the securities to
successful investors (in case the issue
collects more money than the issue size),
refund excess money together with interest
and getting the securities listed on a Stock
Exchange

Secondary market: Stock Exchanges – controlled

and regulated by SEBI
Share brokers – controlled by
respective stock exchanges
5
Depositories – National level special
organisations coming under the
national stock exchanges and assume
4
Underwriting in the capital market means giving an undertaking to invest money in securities issued to public
should the issue fail to collect the required amounts as per SEBI rules and regulations. Underwriting as such does
not involve any funds and hence is referred to as “fee based activity”. However once the issue fails to collect the
required amount, the underwriter is expected to make good the deficit amount to the extent undertaken by him.
5
At present, we have two depositories operating at the national level – National Securities Depositories Limited
(NSDL – owned by the National Stock Exchange) and Central Depository Services Limited (CDSL – owned by the
Bombay Stock Exchange). As per capital market regulations, in the secondary market, the securities can be sold
only in the “demat” or electronic form and not in the physical form. Accordingly under the national level
depositories, depository participants operate at the retail level. They maintain the individual demat accounts on
behalf of the shareholders and investors of other securities. These demat accounts are often referred to as
“Electronic Share Accounts”. The DPs transfer the data from the retail level to the national level depositories who in
turn collate information about ownership of securities and submit data to the signatory companies with whom they
have signed contracts.

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responsibility for collating details of

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

Questions for reinforcement of learning

1. With the help of details given under Indian

Financial System, draw the map of Indian

Financial system, starting from Government of
India – Ministry of Finance. Also visit website –
www.nic.in to know more about the functioning
of Government of India – Ministry of Finance,
its different departments and their functions
etc.
2.What is the difference between a share broker
and a depository participant?
3.Is there a statute controlling the money
markets in India? Who provides the secondary
market in the money markets segment?
4.What are the instruments in the money market
and capital market?
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5.What do you understand by the term

“underwriting” in the capital market?
6.Can you name some NBFCs operating in India?
7.Try to bifurcate the banking sector in India into
different segments like private sector, public,
co-operative and commercial banks. Further
bifurcate the private sector banks into banks of
Indian origin and foreign banks.
8.Does ICICI still exist as a Financial Institution? If
not, why?

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