Bapuji Educational Association (Regd,)

MBA Programme
Bapuji Institute of Engineering and Technology
Davangere

FINANCIAL MANAGEMENT MANUAL

Introduction :
At its core, financial management is the science and art of managing
money. More specifically, it's the application of general management
principles to the financial resources of an enterprise. It encompasses the
strategic planning, organizing, directing, and controlling of all financial
activities within an organization to achieve specific objectives.
Delving deeper, financial management is about:
Optimizing Resource Allocation: It's not just about getting money, but
about putting that money to its most productive use, ensuring every rupee
invested generates maximum value. This involves rigorous capital budgeting
and working capital management.
Balancing Risk and Return: Every financial decision involves a trade-off.
Financial managers constantly assess the inherent risks of various
investments and financing options against their potential returns, aiming to
find an optimal balance that aligns with the firm's risk appetite and value
creation goals. This is quantified using concepts like required rate of return
and cost of capital.
Maximizing Value: While "profit" is important, the ultimate measure of
success in modern finance is the creation of economic value. This means
increasing the present value of the owners' equity, which translates to
maximizing the firm's share price in the market. This value creation is driven
by generating cash flows in excess of the cost of capital.
Ensuring Solvency and Liquidity: A firm must not only be profitable but
also financially healthy. Financial management ensures that the firm has
sufficient liquidity (ability to meet short-term obligations) and solvency (ability
to meet long-term obligations) to continue its operations and avoid financial
distress.
Interdisciplinary Nature: Financial management is not an isolated function.
It interacts heavily with other functional areas like marketing (pricing, sales
terms), operations (inventory management, production planning), human
resources (compensation, benefits), and strategy (resource allocation for
strategic initiatives). A deep understanding of these interactions is crucial for
holistic decision-making.
EVOLUTION AND BROADENED SCOPE OF FINANCIAL MANAGEMENT
The scope of financial management has undergone a profound
transformation, moving from a narrow, descriptive function to a broad,
analytical, and prescriptive discipline.
1. The Traditional Era (Prior to Mid-20th Century): Focus on "Raising
Funds"
Context: Dominated by legalistic and institutional aspects. Corporations
were primarily concerned with episodic events like formation, expansion,
reorganization, and liquidation.
Core Activities: Primarily focused on procurement of funds through
external sources (stock issuance, bond issuance).
Limitations:
Neglected Internal Decisions: Little emphasis on the day-to-day
management of finances or the optimal allocation of funds within the firm.
Limited Scope: Did not cover working capital management, dividend policy,
or risk management comprehensively.
Passive Role: Financial managers were seen more as record-keepers and
facilitators of external financing rather than active decision-makers.
2. The Modern Era (Mid-20th Century Onwards): Focus on "Value
Creation Through Decisions"
Shift in Paradigm: Driven by economic theory, quantitative analysis, and the
growing complexity of business environments. The focus shifted from merely
obtaining funds to their efficient management and allocation to maximize the
overall value of the firm.
Core Areas (The Three Pillars of Financial Management):

• Investment Decisions (Capital Budgeting):

Definition: These decisions relate to the selection of assets in which funds
will be invested by the firm. They are arguably the most critical decisions as
they determine the size and nature of the firm's assets and its ability to
generate future cash flows.
Key Characteristics:
Long-Term Impact: Decisions have consequences for many years, often
irreversible or reversible only at a significant cost.
Large Outlays: Typically involve substantial financial commitments.
Future Uncertainty: Returns are in the future and subject to various risks
(economic, market, technological).
Components:
Capital Expenditure Management: Evaluating and selecting long-term
assets like plant, machinery, technology, R&D projects, new product
development, mergers & acquisitions.
Working Capital Management: Though often viewed as a separate category
due to its continuous nature, it is essentially about investment in short-term
assets (cash, marketable securities, inventory, accounts receivable) and
managing their financing. Efficient working capital management is crucial for
operational liquidity and profitability.
Tools: NPV, IRR, Payback Period, accounting rate of return, profitability
index.

• Financing Decisions (Capital Structure):

Definition: These decisions involve determining the optimal mix of debt and
equity (the capital structure) used to finance the firm's investments. The goal
is to minimize the cost of capital while managing financial risk.
Key Considerations:
Cost of Capital: The blended average rate of return a company must pay to
its providers of funds. Minimizing this is crucial for maximizing firm value.
Financial Risk: The risk to shareholders from using debt. Higher debt implies
higher fixed interest payments, increasing the risk of insolvency.
Control: Equity dilution can impact control.
Flexibility: Ability to raise funds in the future.
Components:
Sources of Funds: Identification and evaluation of various internal (retained
earnings) and external sources (equity shares, preference shares, debentures,
bonds, term loans, public deposits, leasing, etc.).
Optimal Mix: Determining the proportion of different sources to achieve the
lowest weighted average cost of capital (WACC) and enhance shareholder
value.
Timing of Financing: When to raise funds, considering market conditions.

• Dividend Decisions (Payout Policy):

Definition: These decisions concern the distribution of a firm's profits to
its shareholders as dividends versus retaining them for reinvestment
within the firm. This significantly impacts shareholder wealth and future
growth prospects.
Key Considerations:
Growth Opportunities: If the firm has profitable investment opportunities
(positive NPV projects), retaining earnings might be more beneficial than
paying dividends.
Shareholder Preferences: Some investors prefer current income (dividends),
while others prefer capital appreciation (retained earnings leading to future
growth).
Liquidity: The firm's cash position must support dividend payments.
Legal & Contractual Restrictions: Loan agreements or corporate laws may
impose restrictions.
Tax Implications: Differential tax treatment of dividends and capital gains
for investors.
Components:
Dividend Payout Ratio: Percentage of earnings paid out as dividends.
Dividend Policy: Stable, constant payout, residual, or hybrid.
Stock Dividends/Splits: Non-cash distributions that affect share price and
number of shares.
Share Repurchases: An alternative to cash dividends, buying back shares
from the market.
Integrated Decision-Making: All three decision areas are highly
interdependent. Investment decisions dictate the need for funds, financing
decisions provide those funds, and dividend decisions determine the
availability of internal funds for future investments.
In essence, the scope of financial management today is holistic and proactive,
encompassing all aspects of obtaining, utilizing, and managing financial
resources to create and maximize value for the firm's owners.

OBJECTIVES OF FINANCIAL MANAGEMENT

The debate over the primary objective of financial management has evolved
significantly, with modern finance theory largely settling on wealth
maximization due to its comprehensiveness and direct link to shareholder
value.
A. Profit Maximization (A Critical Examination)
Definition: The traditional objective aiming to maximize the net income,
earnings per share (EPS), or return on investment (ROI) of the firm.
Arguments for (Simplified View):
o Simplicity: Easy to understand and measure.
o Benchmark: Provides a clear target for operational efficiency.
o Necessity for Survival: Profits are indeed vital for a firm's
existence, growth, and ability to attract capital.
• Fundamental Flaws and Criticisms (Why it's Suboptimal):
1. Ambiguity of "Profit":
Accounting vs. Economic Profit: Accounting profit (accrual basis) can be
manipulated or does not always reflect true cash generation. Economic
profit (revenue less all costs, including opportunity cost of capital) is more
relevant but harder to measure.
Short-Term vs. Long-Term Profit: Maximizing short-term profit might lead
to sacrificing long-term sustainability (e.g., cutting R&D, neglecting
maintenance, compromising quality).
Total Profit vs. EPS: Maximizing total profit doesn't necessarily mean
maximizing shareholder wealth if the number of shares outstanding
changes.
2. Ignores the Time Value of Money:
A core principle of finance is that a dollar today is worth more than a dollar
tomorrow. Profit maximization treats all profits (regardless of when they
occur) equally. This means it doesn't account for the opportunity cost of
waiting for returns.
Example: Project A yields Rs100K profit in Year 1. Project B yields Rs. 100K
profit in Year 5. Profit maximization would see them as equal, but Project
A is superior due to the time value of money.
3. Disregards Risk:
Profit maximization gives no consideration to the level of risk associated
with earning those profits. A high-profit project that is extremely risky (e.g.,
high probability of failure) might be chosen over a moderately profitable but
much safer project. Investors demand higher returns for higher risks.
Ignoring risk leads to suboptimal investment choices and mispricing of
financial assets.
4. No Direct Link to Shareholder Wealth:
High accounting profits don't always translate into a higher stock price. The
market values future cash flows, their timing, and their risk.
5. Potential for Unethical Behavior:
A singular focus on profit can incentivize managers to engage in unethical
practices (e.g., environmental damage, worker exploitation, deceptive
accounting) to achieve short-term gains, ultimately damaging the firm's
reputation and long-term value.
B. Wealth Maximization (The Paramount Objective)
• Definition: Maximizing the market price per share of the common
stock. This is equivalent to maximizing the present value of the future
net cash flows accruing to the equity shareholders.
 • Synonyms: Shareholder Wealth Maximization, Equity Value
Maximization, Firm Value Maximization (in an all-equity firm).
• Why it's Superior (Addressing Profit Maximization's Flaws):
1. Considers Time Value of Money:
All future cash flows (dividends, capital gains) are discounted back to their
present value using an appropriate discount rate (reflecting the cost of capital
and risk). This correctly values earlier, certain cash flows more highly.
2. Incorporates Risk:
The discount rate used in valuation directly reflects the riskiness of the
expected cash flows. Higher risk implies a higher required rate of return,
which means future cash flows are discounted at a higher rate, leading to a
lower present value (and thus lower share price).
Managers are incentivized to take on acceptable risks that offer
commensurate returns, rather than blindly chasing the highest profit
regardless of risk.
3. Focuses on Cash Flows, Not Accounting Profits:
The market values the actual cash that a business generates and distributes
(or reinvests). Cash flows are less susceptible to accounting manipulations
and represent the true economic substance of the firm's activities.
4. Long-Term Perspective:
To maximize the present value of all future cash flows, financial managers
must adopt a long-term view, investing in R&D, brand building, customer
relationships, and sustainable practices, even if they depress short-term
accounting profits.
5. Alignment with Stakeholder Interests (Broad View):
While primarily focused on shareholders, a healthy, growing firm that
maximizes value for its owners is generally better positioned to satisfy other
stakeholders (employees through stable jobs and fair wages, customers
through quality products, suppliers through consistent business, government
through taxes). Sustainable wealth creation requires a balanced approach to
all stakeholders.
6. Universally Accepted:
This objective forms the cornerstone of modern financial theory and practice
in capital markets.
C. Other Supportive Objectives (Sub-Goals)
These are not primary goals in themselves but are crucial operational and
strategic objectives that contribute to the overarching goal of wealth
maximization.
• Maintaining Adequate Liquidity: Ensuring the firm has sufficient
cash and near-cash assets to meet its short-term obligations without
disruption. Liquidity management prevents financial distress and
allows the firm to seize opportunities.
• Minimizing the Cost of Capital: Procuring funds from various sources
at the lowest possible weighted average cost, given the firm's desired
risk profile. A lower cost of capital directly increases the present value
of future cash flows.
• Optimal Capital Structure: Finding the ideal mix of debt and equity
that minimizes the cost of capital and maximizes firm value.
• Efficient Asset Utilization: Ensuring that all assets (fixed and current)
are employed productively to generate maximum returns.
• Regulatory Compliance and Ethical Conduct: Operating within legal
frameworks and upholding ethical standards is crucial for long-term
reputation and avoids costly penalties or loss of public trust that can
severely erode wealth.
• Growth and Sustainability: A growing firm with sustainable practices
is more likely to generate increasing future cash flows, which is
essential for wealth maximization.

ROLE OF A FINANCIAL MANAGER

The financial manager has evolved from a mere record-keeper to a critical
strategic partner in the firm's leadership, influencing all major business
decisions.
A. The Strategic Role of the Financial Manager
1. Integrator and Coordinator: The financial manager must integrate
financial decisions with other functional areas (marketing, operations,
HR). They understand the financial implications of every operational
decision and facilitate cross-functional coordination.
2. Value Creator: Beyond just managing money, the financial manager is
actively involved in identifying, evaluating, and implementing strategies
that enhance the firm's intrinsic value. This involves understanding
business models, competitive landscapes, and future trends.
 3. Risk Navigator: Proactively identifies, assesses, and mitigates financial
risks (e.g., currency fluctuations, interest rate volatility, credit risk,
commodity price risk) that can erode firm value. This involves using
sophisticated financial instruments and risk management frameworks.
4. Resource Mobilizer: Constantly scans the financial markets for the
most efficient and cost-effective sources of funds, adapting to changing
market conditions and investor sentiments.
5. Performance Measurer and Analyzer: Develops and uses key financial
metrics and analytical tools to measure performance, identify areas for
improvement, and forecast future financial health.
6. Communicator to Stakeholders: Acts as a primary liaison with
investors, analysts, creditors, and rating agencies, ensuring
transparency and building confidence in the firm's financial health and
prospects.

FUNCTIONS OF THE FINANCIAL MANAGER

These functions are directly aligned with the three key decision areas
discussed earlier:
1. Investment Decisions (Capital Budgeting Functions)
Capital Expenditure Planning and Control:
▪ Forecasting Capital Needs: Projecting future needs for fixed assets
based on growth plans, technological advancements, and replacement
cycles.
▪ Project Generation and Identification: Actively seeking out value-
adding investment opportunities across all departments.
Project Evaluation:
▪ Cash Flow Estimation: Meticulously forecasting the incremental cash
flows generated by each project (initial outlay, operating cash flows,
terminal cash flows). This is often the most challenging part, requiring
deep understanding of the business and market.
▪ Risk Analysis: Assessing the sensitivity of cash flows to changes in
variables (e.g., sales volume, costs), using techniques like sensitivity
analysis, scenario analysis, and Monte Carlo simulation. Determining
the project's risk premium.
▪ Discount Rate Determination: Applying the appropriate cost of
capital (or project-specific required rate of return) for discounting
future cash flows.
 ▪ Applying Decision Rules: Utilizing robust capital budgeting
techniques (NPV, IRR) to make accept/reject decisions and rank
competing projects.
▪ Project Implementation and Monitoring: Overseeing the execution
of approved projects, ensuring they stay within budget and schedule.
▪ Post-Completion Audit: Reviewing completed projects to compare
actual results with initial forecasts, learning from experience, and
refining future forecasts and processes.
Working Capital Management:
▪ Cash Management: Optimizing cash balances (not too much, not too
little), managing cash inflows and outflows, investing surplus cash in
short-term marketable securities, and managing banking
relationships. This involves concepts like float management, cash
budgets, and economic conversion cycles.
▪ Inventory Management: Determining optimal inventory levels (raw
materials, WIP, finished goods) to balance carrying costs with stock-
out costs. Utilizing techniques like EOQ, JIT, and ABC analysis.
▪ Receivables Management: Formulating credit policies, setting credit
terms, managing credit sales, and efficient collection of accounts
receivable. Balancing increased sales from credit with potential bad
debts and collection costs.
▪ Payables Management: Optimizing payment to suppliers to maximize
cash flow and take advantage of discounts while maintaining good
supplier relationships.
▪ Short-Term Financing: Arranging short-term loans, lines of credit, or
commercial paper to meet temporary liquidity needs.
2. Financing Decisions (Capital Structure Functions)
Capital Structure Planning:
▪ Debt-Equity Mix Optimization: Determining the optimal proportion of
debt and equity to minimize the weighted average cost of capital (WACC)
and maximize shareholder value, considering factors like financial
leverage, operating leverage, bankruptcy risk, and control.
▪ Cost of Capital Estimation: Calculating the cost of individual
components of capital (cost of equity, cost of debt, cost of preference
shares) and then the overall WACC.
o Sources of Funds Identification and Selection:
▪ Market Analysis: Understanding current capital market conditions,
investor sentiment, interest rate trends, and regulatory changes.
 ▪ External Financing: Deciding on the type, timing, and terms of issuing
new equity (IPOs, FPOs, rights issues), preference shares, debentures,
bonds, or securing term loans from financial institutions. This involves
dealing with investment banks, legal counsel, and regulatory bodies.
▪ Internal Financing: Deciding on the amount of retained earnings to be
used for reinvestment.
o Leverage Management: Analyzing and managing financial leverage
(use of debt) and operating leverage (fixed vs. variable costs) to
enhance shareholder returns while controlling risk.
o Financial Market Relations: Maintaining strong relationships with
banks, financial institutions, credit rating agencies, and
investment bankers.
3. Dividend Decisions (Payout Policy Functions)
o Dividend Policy Formulation:
▪ Payout Ratio Determination: Deciding what percentage of earnings
should be distributed as dividends, considering internal growth
opportunities, cash flow availability, and shareholder expectations.
▪ Stability vs. Payout: Choosing between a stable dividend per share
(preferred by many investors) or a fluctuating payout tied to earnings.
▪ Legal & Contractual Constraints: Ensuring compliance with corporate
laws and loan covenants regarding dividend payments.
o Modes of Dividend Distribution:
▪ Cash Dividends: Regular, special, or liquidating.
▪ Stock Dividends (Bonus Shares): Issuing additional shares proportionally
to existing shareholders, which conserves cash.
▪ Share Repurchases (Buybacks): An alternative to cash dividends, reducing
the number of outstanding shares and increasing EPS, often viewed as
more tax-efficient for shareholders.
o Impact on Share Price: Understanding how different dividend policies
influence investor perception and the firm's stock price.
C. Other Overarching and Ancillary Functions
• Financial Planning and Forecasting: Developing short-term and long-
term financial plans, including cash budgets, pro forma financial
statements, and capital expenditure budgets. This is crucial for
anticipating future needs and challenges.
• Financial Performance Analysis: Conducting ratio analysis, trend
analysis, and common-size statements to assess the firm's profitability,
 liquidity, solvency, and efficiency. Benchmarking against competitors
and industry averages.
• Risk Management
o Currency Risk Management: Hedging against adverse movements in
foreign exchange rates for international transactions.
o Interest Rate Risk Management: Managing exposure to fluctuations
in interest rates on debt and investments.
o Credit Risk Management: Assessing the creditworthiness of
customers and counterparties.
o Operational Risk: Collaborating with other departments to understand
and mitigate financial implications of operational failures.
• Mergers, Acquisitions, and Divestitures: Playing a central role in
evaluating potential targets, structuring deals, conducting due
diligence, valuing companies, and managing post-merger integration or
divestiture processes.
• Investor Relations and Corporate Governance: Communicating the
firm's financial strategy and performance to investors, analysts, and
rating agencies. Ensuring compliance with corporate governance best
practices and shareholder rights.
• Tax Management: Strategic tax planning to minimize the firm's tax
liability within legal frameworks, which directly impacts after-tax profits
and cash flows.
• Internal Controls and Auditing: Ensuring robust internal financial
controls to prevent fraud and errors, and liaising with internal and
external auditors.

INTERFACE OF FINANCIAL MANAGEMENT WITH OTHER FUNCTIONAL

AREAS

Finance is the basis of different economic activities like production, human

resources, marketing and research and development. It is mandatory in every
organization whether small, big, public sector, government organizations,
finance becomes central focus of an organization backing other departments
by utilizing proper financial tools and techniques resulting in effective
functioning of an organization. The figure given below shows the relation of
finance with other areas of management.
Relationship to HR

HR activities Include recruitment, training, and development, fixing

compensation, incentives, promotion and providing other benefits. All these
activities need finance.

Therefore before going to take any of these decisions HR managers need to

consult finance manager. Finance manager takes decision after studying the
impact of HR activity on organization. Therefore there is relation of HR
function.

Relationship of Production

Production department is another functional area that involves huge

investment on fixed assets (machines and tools). For example production of
new product requires new machinery, which involves capital investment.
Before going to select machinery, he/she needs to evaluate the machine or
equipment and select some cases changing manufacturing process. Improper
evaluation involves huge consequences on the firm. Thus production manager
and finance manager need to work closely for effective Investment (optimum
investment) on plant and machinery.

Relationship of Marketing

Marketing functions involves selection of distribution channel and promotion

policies. These two are the primary activities of marketing department and
involves huge cash outflows. Therefore finance and marketing managers need
to work with coordination for maximize value of the firm.

Relationship to R&D

Innovation of products and process is the only way to survive in the

competitive market. Innovation needs to invest funds on R&D. But R&D
department does not give guarantee of development. Therefore it does not
mean that financial manager should not provide funds, or cut funds heavily
to R&D. It should be given importance and try to make balance.

Relationship with accounting

Finance is also connected with accounting. Accounting is a staff function
which supplies date to top management, financial management, sales
management, production management and personal management. The
finance manager requires accurate and scientifically arranged financial
records of the enterprise to guide hi in managing the inflow and outflow of
funds.

Relationship with Purchasing Department

Materials required for production of commodities should be procured on

economic terms and should be utilized in efficient manner to achieve
maximum productivity. In this function the finance manager plays a key role
in providing finance. In order to minimize cost and exercise control various
materials management techniques such as Economic Order Quantity,
determination of stock levels, perpetual inventory systems are applied. The
task of finance manager is to arrange the availability of cash when the bills
for purchase become due.

INDIAN FINANCIAL SYSTEM

A financial system is a set of institutions, such as banks, insurance

companies, and stock exchanges, that permit the exchange of funds.
Financial systems exist on firm, regional, and global levels. Borrowers,
lenders, and investors exchange current funds to finance projects, either for
consumption or productive investments, and to pursue a return on their
financial assets. The financial system also includes sets of rules and practices
that borrowers and lenders use to decide which projects get financed, who
finances projects, and terms of financial deals.

MEANING AND DEFINITIONS OF FINANCIAL SYSTEM: Every country

aiming at its progress depends on the efficiency of its economic system, which
depends on the financial system. The economic development of a nation is
reflected by the progress made by the various economic units. The Economic
units are broadly classified into the corporate sector, government, and
household sector. While performing their activities, these units will be placed
in surplus/deficit/balanced budgetary situations.
There are organisations or people with surplus funds and there are
those with a deficit. A financial system or financial sector functions as an
intermediary and facilitates the flow of funds from the areas of surplus to the
areas of deficit. A Financial System is a composition of various institutions,
markets, regulations and laws, practices, money managers, analysts,
transactions, claims, and liabilities.

DEFINITION OF FINANCIAL SYSTEM:

“It is a set of institutions, instruments, and markets which fosters saving and
channels them to their most efficient use”.- H.R. Machiraju.
“The financial system allocates savings efficiently in an economy to ultimate
users either for investment in real assets or for consumption”. - Van Horne.
“The financial system consists of a variety of institutions, markets and
instruments related systematically and provides the principal means by which
savings are transformed into investments”. - Prasanna Chandra.

STRUCTURE OF INDIAN FINANCIAL SYSTEM:

A financial system (within the scope of finance) is a system that allows the
exchange of funds between lenders, investors, and borrowers. Financial
systems operate at national, global, and firm-specific levels. They consist of
complex, closely related services, markets, and institutions intended to
provide an efficient and regular linkage between investors and depositors.
Money, credit, and finance are used as media of exchange in financial
systems. They serve as a medium of known value for which goods and services
can be exchanged as an alternative to bartering. A modern financial system
may include banks (operated by the government or private sector), financial
markets, financial instruments, and financial services. Financial systems
allow funds to be allocated, invested, or moved between economic sectors.
They enable individuals and companies to share the associated risks.
The formal financial system consists of four components:
➢ Financial Market
 ➢ Financial Institution
➢ Financial Instruments and
➢ Financial Services.
The financial system acts as a connecting link between savers of money
and users of money and thereby promotes faster economic and industrial
growth. Thus financial system may be defined as “a set of markets and
institutions to facilitate the exchange of assets and risks.” Efficient
functioning of the financial system enables proper flow of funds from investors
to productive activities which in turn facilitates investment.
I) Financial Market: -
It is a system through which funds are transferred from surplus sector to the
deficit sector. On the basis of the duration of financial Assets and nature of
the product money market can be classified into three types:

a) Money Market: It is an institutional arrangement of borrowing and lending

into two sectors i.e., the organised sector headed by the RBI and the
unorganized sector. Further, depending upon the type of instrument used,
money market is divided into various sub-markets.
b) Capital Market: - It deals with long term lending’s and borrowings. It is a
market for long-term instruments such as shares, debentures, and bonds. It
also deals with term loans. This market is also divided into 2 types:-
• Primary or New Issue Market
• Secondary Market of Stock exchange.
c) Foreign Exchange market: - It deals with foreign exchange. It is a market
where the exchanging of currencies will takes places. It is the market where
currencies of different country are purchased and sold. Depending on the
exchange rate that is applicable, the transfer of funds takes place in this
market. This is one of the most developed and integrated market across the
globe.
d) Credit Market- Credit market is a place where banks, FIs and NBFCs
purvey short, medium and long-term loans to corporate and individuals.

II) Financial Institution: - It is classified into the following categories and

they are as follows:
a. Banking Institution:- It includes commercial banks, private banks and
foreign banks operating in India. There are Commercial Banks, Public Sector
banks, and development banks (ICICI, IDBI), Agriculture Bank (RRB,
Cooperative Banks, NABARD).
b. Non-Banking Institution: - These are established to mobilise saving in
different modes. These institutions do not offer banking services such as
accepting deposit and Lending Loans. For example LIC, UTI, GIC.
Financial institutions are financial intermediaries. They are
intermediate between savers and investors. They lend money. They also
mobilise savings. The various financial intermediaries, their performing areas
and respective roles are given in following table:
III) Financial Instruments: -
It includes through these instruments financial Institution mobilise saving.
These are of two types namely
a)Long Term : - Shares, Debenture, Mutual Funds, Term Loans.
b) Short Term: - Call Loan (money market), Promissory Notes, Bills of
exchange etc.
IV) Financial Services: -
a) Banking service: - Banking service provided by Commercial banks and
Development banks. Accepting Deposits and lending loans.
b) Non-Banking Services: - These services are provided by Non-Banking
Companies such as LIC and GIC. They accept saving in different modes and
mobiles to various channels of investments.
c) Other Services: - In modern days banks are providing various new services
such as ATM, Credit Cards, Debit Cards, Electronic Transfer of
Funds(ETF),Internet Banking, E-Banking, off shore Banking.

FUNCTIONS OF FINANCIAL SYSTEM: The financial system of a country

performs certain valuable functions for the economic growth of that country.
The main functions of a financial system may be briefly discussed as below:
1. Saving function: An important function of a financial system is to mobilize
savings and channelize them into productive activities. It is through financial
system the savings are transformed into investments.
2. Liquidity function: The most important function of a financial system is
to provide money and monetary assets for the production of goods and
services. Monetary assets are those assets which can be converted into cash
or money easily without loss of value. All activities in a financial system are
related to liquidity-either provision of liquidity or trading in liquidity.
3. Payment function: The financial system offers a very convenient mode of
payment for goods and services. The cheque system and credit card system
are the easiest methods of payment in the economy. The cost and time of
transactions are considerably reduced.
4. Risk function: The financial markets provide protection against life, health
and income risks. These guarantees are accomplished through the sale of life,
health insurance and property insurance policies.
5. Information function: A financial system makes available price-related
information. This is a valuable help to those who need to take economic and
financial decisions. Financial markets disseminate information for enabling
participants to develop an informed opinion about investment, disinvestment,
reinvestment or holding a particular asset.
6. Transfer function: A financial system provides a mechanism for the
transfer of the resources across geographic boundaries.
7. Reformatory functions: A financial system undertaking the functions of
developing, introducing innovative financial assets/instruments services and
practices and restructuring the existing assts, services etc, to cater the
emerging needs of borrowers and investors (financial engineering and re
engineering).
8. Other functions: It assists in the selection of projects to be financed and
also reviews performance of such projects periodically. It also promotes the
process of capital formation by bringing together the supply of savings and
the demand for investible funds.

ROLE AND IMPORTANCE OF FINANCIAL SYSTEM IN ECONOMIC

DEVELOPMENT:
1. It links the savers and investors. It helps in mobilizing and allocating the
savings efficiently and effectively. It plays a crucial role in economic
development through saving-investment process. This savings – investment
process is called capital formation.
2. It helps to monitor corporate performance.
3. It provides a mechanism for managing uncertainty and controlling risk.
4. It provides a mechanism for the transfer of resources across geographical
boundaries.
5. It offers portfolio adjustment facilities (provided by financial markets and
financial intermediaries).
6. It helps in lowering the transaction costs and increase returns. This will
motivate people to save more.
7. It promotes the process of capital formation.
8. It helps in promoting the process of financial deepening and broadening.
REVISION QUESTIONS:

3-Mark Questions (Short Answer Type):

1. Define financial management.

2. Mention any three objectives of financial management.
3. What is the role of a finance manager?
4. List any three types of financial markets.
5. What do you mean by NBFCs?
6. State any three differences between banking and non-banking
financial institutions.
7. What is the scope of financial management?

7-Mark Questions (Medium Answer Type):

1. Explain the objectives and scope of financial management.

2. Discuss the functions of a finance manager.
3. Describe the structure of the Indian Financial System.
4. Explain the types of financial markets with suitable examples.
5. Write a short note on financial institutions and their role in economic
development.
6. Explain the interface of financial management with other functional
areas.
7. Discuss various types of financial instruments available in India.

10-Mark Questions (Long Answer / Essay Type):

1. Explain the meaning, scope, and objectives of financial management in

detail.
2. Discuss in detail the role and functions of a finance manager in a
modern organization.
3. Analyze the structure and components of the Indian Financial System.
4. Discuss the various financial markets, their features, and roles in the
economy.
5. Describe the role of NBFCs in the Indian financial system. How are they
different from traditional banks?
6. Elaborate on the relationship between financial management and other
functional areas such as marketing, HR, and production
 MODULE 2

TIME VALUE OF MONEY

Time Value of Money is an important concept in financial management. It

can be used to compare investment alternatives and to solve problems
involving loans, mortgages, leases, savings, and annuities.

Time Value of Money is based on the concept that, a dollar you have today
is worth more than the promise or expectation that you will receive a
dollar in the future. Money that you hold today is worth more because
you can invest it and earn interest. After all, you should receive some
compensation for foregoing spending. For instance, you can invest your
dollar for one year at a 6% annual interest rate and accumulate $1.06 at
the end of the year. You can say that the future value of the dollar is
$1.06 given a 6% interest rate and one year. It follows that the present
value of the $1.06 you expect to receive in one year is only $1.

A key concept of Time Value of Money is that a single sum of money or a

series of equal, evenly-spaced payments or receipts promised in the future
can be converted to an equivalent value today. Conversely, you can
determine the value to which a single sum or a series of future payments
will grow to at some future date.

FACTORS AFFECTING THE TIME VALUE OF MONEY

Interest Rate (or Discount Rate/Rate of Return): This is arguably the

most crucial factor. Higher interest rates mean that money can grow more
quickly, increasing its future value and decreasing its present value (as a
future sum needs to be discounted more heavily to arrive at its current
worth). Lower interest rates lead to slower growth in future value and a
higher present value of a future sum.Interest can be simple (calculated only
on the principal) or compound (calculated on the principal and accumulated
interest), with compound interest having a much greater impact over time.

Period (or Number of Periods): The length of time over which money is
invested or borrowed significantly impacts its value. Longer time periods
allow for more compounding periods, leading to a greater future value for a
given present sum. Conversely, a longer time reduces the present value of a
future sum. Shorter time periods have a lesser impact on the growth of
money.

Inflation: Inflation is the rate at which the general level of prices for goods
and services is rising, and subsequently, the purchasing power of currency
is falling. High inflation erodes the purchasing power of money over time,
meaning that a given amount of money will buy less in the future. This
reduces the real value of future cash flows and makes money available today
more valuable. Low inflation or deflation has a less significant impact on
the real value of money over time.

Opportunity Cost: This refers to the potential returns that are foregone by
choosing one investment over another. By having money available today,
you have the opportunity to invest it and earn a return. If you delay receiving
money, you miss out on these potential earnings, which is an opportunity
cost. The higher the available returns on alternative investments, the greater
the opportunity cost of not having money today.

Risk and Uncertainty: The future is inherently uncertain. There's always a

risk that future cash flows might not materialize as expected. Money
received today carries no such risk. Therefore, individuals and businesses
generally prefer a certain amount of money today over an uncertain (even if
potentially larger) amount in the future. Higher perceived risk associated
with future cash flows will lead to a higher discount rate being applied,
thereby lowering their present value

VALUATION TECHNIQUES:

The Time Value of Money is a cornerstone of finance, allowing us to compare

the value of money across different points in time. The primary techniques
for valuing money over time involve

1) Future Value or Compound Value Technique

2) Present Value (PV) Or Discounted Cash Flow Technique

These calculations can be applied to single lump sums or a series of

payments (annuities).

Future Value or Compound Value Technique

Future Value tells you how much a sum of money or a series of payments
invested today will be worth at a specific date in the future, given a certain
interest rate. This is also known as compounding

FUTURE VALUE OF SINGLE CASHFLOW :

The Future Value (FV) of a single cash flow tells you how much a specific
amount of money invested today will be worth at a future point in time,
assuming it earns interest at a constant rate. This concept is often referred
to as compounding. The Formula for Future Value of a Single Cash Flow is
FUTURE VALUE OF ANNUITIES

An annuity is a series of equal payments or receipts that occur at evenly

spaced intervals. Leases and rental payments are examples. The payments
or receipts occur at the end of each period for an ordinary annuity while
they occur at the beginning of each period for an annuity due.

PRESENT VALUE Or DISCOUNTED TECHNIQUE

The Present Value (PV) technique is a core concept in finance that values future
cash flows in terms of their worth today. It's built upon the principle of the Time
Value of Money, which states that a rupee today is worth more than a rupee in
the future due to its potential earning capacity (it can be invested and earn a
return) and the effects of inflation and risk.

In essence, the PV technique discounts future amounts back to their current

equivalent value. The rate used for this discounting is called the discount rate,
which typically reflects the opportunity cost of capital, the riskiness of the cash
flow, and inflation.

Why is the Present Value Technique Important?

1. Investment Decisions: It allows investors and businesses to compare

investment opportunities that generate cash flows at different points
in time. By bringing all future cash flows to a common point (the
present), a fair comparison can be made.
2. Capital Budgeting: Companies use PV techniques (especially Net
Present Value - NPV) to evaluate long-term projects. It helps them
decide whether to invest in a project by comparing the present value of
its expected future benefits to the present value of its costs.
3. Valuation: It's fundamental for valuing assets like bonds, stocks, real
estate, and entire businesses. The value of these assets is often derived
from the present value of their expected future cash flows (e.g., interest
payments, dividends, rental income, operating cash flows).
4. Loan Amortization: It helps in calculating loan payments and
understanding how much of each payment goes towards principal and
interest.
5. Personal Finance: Individuals use PV concepts for retirement
 planning (how much to save today to have a certain amount in the
future), mortgage calculations, and evaluating lump-sum settlements
versus periodic payments.

Types of Present Value Techniques (Based on Cash Flow Patterns):

1. Present Value of a Single Lump Sum

This calculates the current worth of a single amount of money to be received

or paid at a specific future date.

Example: You are promised ₹10,000 in 3 years. If the appropriate discount

rate is 7% annually, what is its present value? PV=(1+0.07)310,000
=1.22504310,000≈₹8,162.98

2. Present Value of an Ordinary Annuity

An ordinary annuity is a series of equal payments made at the end of each

period.

Example: What is the present value of receiving ₹500 at the end of each
year for 10 years, if the discount rate is 6% annually? PVA
=500×0.06(1−(1+0.06)−10)≈500×0.06(1−0.558395)
≈500×7.360087≈₹3,680.04

3. Present Value of an Annuity Due

An annuity due is a series of equal payments made at the beginning of each

period.
(1+r)

Example: What is the present value of receiving ₹500 at the beginning of

each year for 10 years, if the discount rate is 6% annually?
PVAD≈3,680.04×(1+0.06)≈₹3,900.84

4. Present Value of a Perpetuity

 A perpetuity is an annuity that continues indefinitely (forever).

Formula: PV = A/r where PV = Present Value, A =Annuity amount,

r = rate of interest

Amortization

Amortization is a method for repaying a loan in equal installments. Part

of each payment is applied toward interest due for the period, and the
remainder is used to reduce the principal (the outstanding loan balance). As
the balance of the loan is gradually reduced, a progressively larger portion
of each payment goes toward reducing principal.

Review Questions:

3-Mark Questions (Short Answers)

1. Define Time Value of Money.
2. Write the formula for the present value of a single cash flow.
3. State any two differences between simple interest and compound
interest.
4. What is an annuity? Give an example.
5. What do you mean by perpetuity?
6. Mention any two practical applications of discounting
7-Mark Questions (Medium-Length Answers)
1. Explain the concept of Time Value of Money with suitable examples.
2. Differentiate between present value and future value. Illustrate with
formulas.
3. Calculate the future value of an annuity of ₹10,000 for 5 years at 10%
p.a. compounded annually.
4. Explain the present value of perpetuity with an example.
5. Calculate simple and compound interest on ₹25,000 for 3 years at
12% P A
10-Mark Questions (Long / Essay Type)
1. Explain in detail the concept of time value of money.
2. Calculate the present value of ₹50,000 receivable after 5 years at 10%
discounting rate.
3. Discuss the process and significance of the loan amortization
schedule with a solved problem.
4. Explain the concept of annuity and perpetuity. Distinguish between
them with formulas and examples.
5. Mr. Ramesh wants to invest ₹15,000 every year for 6 years at 12%
interest compounded annually. Calculate the future value of this
investment.
 WORKING CAPITAL MANAGEMENT

Introduction

One of the vital aspects of the company’s financial management is to manage

its current assets and the current liabilities in such a way that a
satisfactory level of working capital is maintained. Working capital
management means administration of working capital i.e. current assets
and current liabilities. Firm has to manage its property in order to attain its
goal of wealth maximization.

Every business needs funds for two purposes- for its establishment and
to carry out its day to day operations. Long term funds are required to
create production facilities through purchase of fixed assets such as plant
and machinery, land and building etc. funds also needed for short term
purposes for the purchase of raw materials, payment of wages and other
day to day expenses. These funds are known as working capital.

Meaning:

In accounting ―working capital is the difference between the inflow and

outflow of funds in other words it is net cash flow‖.

Working capital Management is concerned with the problem that arises in

attempting to manage the current assets, the current liabilities and the
interrelationship that exists between them.Working Capital = Current Assets
– Current Liabilities

 Current Assets – Those assets which in ordinary course of business

can be converted into cash within short span of time without
undergoing a diminution in the value and without disrupting the
operation. Components of current assets are Cash, Marketable
securities, account receivable and inventory.
 Current Liabilities:-are those liabilities which are intended, at their
inception, to be paid in the ordinary course of business, within in a
year out of the current assets or earnings of the concern. Basic current
liabilities are account payable, bills payable, bank o/d and outstanding
expenses.
 Goal of the working capital management is to manage the firm’s
current asset and liabilities in such a way that a satisfactory level of
working capital is maintained.

Concepts of Working Capital

Gross working capital: It is the amount of funds invested in the various
components of current assets.

Net working capital: It is the difference between current assets and the
current liabilities. The concept of net working capital determines how
much amount is left for operational requirements.

GWC focuses on
• Optimization of investment in current
NWC focuses on
• Financing of current assets
• Liquidity position of the firm
• Judicious mix of short-term and long-term financing

TYPES OF WORKING CAPITAL

On the basis of time, Working capital has been broadly classified into

 Permanent Working capital

 Variable Working capital

1. Permanent or fixed working capital

A minimum level of current assets, which is continuously required by

a firm to carry on its business operations, is referred to as permanent
or fixed working capital.

2. Fluctuating or Variable or Temporary or Seasonal working

capital

The extra working capital needed to support the changing production

and sales activities of the firm is referred to as fluctuating or variable
working capital.

TYPES OF WORKING CAPITAL

OTHER TYPES OF WORKING CAPITAL

Gross Working Capital (GWC)

Definition: Gross Working Capital refers to the total investment a firm makes
in its current assets.

GWC = Total Current Assets

Components of Current Assets: Cash and Bank balances, Accounts

Receivable / Debtors, Inventory / Stock, Short-term investments, Prepaid
expenses, Accrued incomes

Key Points

• GWC does not consider current liabilities.

• Focus is on resources available for operations.
• Useful in short-term investment decisions.

Example: If a company has: Inventory: ₹10 lakh, Debtors: ₹5 lakh, Cash: ₹2

lakh, Prepaid Rent: ₹1 lakh. Then, GWC = ₹10L + ₹5L + ₹2L + ₹1L = ₹18 lakh

Managerial Insight: Helps in planning short-term financing and ensuring that

there are enough assets to run day-to-day operations.

Net Working Capital (NWC)

Definition: Net Working Capital is the difference between current assets and
current liabilities. NWC = Current Assets – Current Liabilities

Components: Current Assets: As listed above

Current Liabilities: Creditors, Bills Payable, Short-term Loans, Outstanding

expenses, Taxes payable

Types of NWC: Positive NWC: CA > CL (good liquidity), Negative NWC: CL > CA
(potential financial stress)

Example: Current Assets = ₹20 lakh, Current Liabilities = ₹14 lakh, NWC =
₹20L – ₹14L = ₹6 lakh,

Managerial Insight: A healthy positive NWC indicates the ability to meet short-
term obligations. Critical for credit rating and financial health assessment.
Negative Working Capital

Definition: Occurs when a firm’s current liabilities exceed its current assets.
Negative WC = CA – CL < 0

Implications: 1) May signal liquidity problems 2) could indicate operational

stress or poor financial planning 3) Sometimes strategic in fast-moving
industries (like FMCG or retail) that operate on advance payments or fast
inventory cycles

Example: Current Assets = ₹12 lakh, Current Liabilities = ₹15 lakh, NWC =
₹12L – ₹15L = –₹3 lakh → Negative WC

Managerial Insight: Needs close monitoring. While it may reduce the need for
working capital financing, it may also mean an inability to meet short-term
debts, leading to a higher risk of bankruptcy.

Balance Sheet Working Capital

Definition: Working capital is derived directly from the balance sheet, usually
at the end of the financial period. Balance Sheet WC = Closing Current Assets
– Closing Current Liabilities

Characteristics: 1) Based on a specific point in time 2) Static view, not suitable

for day-to-day analysis 3) Commonly used in financial reporting

Managerial Insight: Useful for external reporting, but for internal decision-
making, average or cash-based WC provides better insights.

Cash Working Capital

Definition: Also known as operating working capital, this refers to the real-
time or cash-based working capital available during a particular period.

Cash WC = (Current Assets – Cash) – (Current Liabilities – Short-term debt)

OR Cash WC = (Accounts Receivable + Inventory – Accounts Payable)

Focuses on: Core operational assets like inventory and receivables, Excludes
non-operational items like cash or bank overdrafts

Example: Accounts Receivable: ₹8 lakh, Inventory: ₹6 lakh, Accounts Payable:

₹5 lakh, Cash WC = ₹8L + ₹6L – ₹5L = ₹9 lakh
Managerial Insight: This gives a more realistic picture of how much working
capital is tied up in operations and is crucial for cash flow planning
DETERMINANTS OF WORKING CAPITAL OR FACTORS AFFECTING
WORKING CAPITAL
The following are the factors that generally influence the working capital
requirements:
Nature of the Business: The compensation of current assets is a function
of the size of a business and the industry to which it belongs. A public
utility concern, for example, mostly employs fixed assets in its operations,
while the merchandising department generally depends on inventory and
receivables.
Size of the Business: Business size may be measured in terms of the
scale of operations. A firm with a larger scale of operation will need more
working capital than a small firm.
Manufacturing cycle: The Longer the manufacturing process, the higher
the requirement of working capital and vice versa.
Credit Policy: A firm that allows liberal credits to its customers may enjoy
higher sales but will need more working capital as compared to a firm
enforcing strict credit terms.
Business cycle: It refers to the alternate expansion and contraction in
general business activity. During the boom period, the business is
prosperous and requires a large amount of working capital due to an
increase in sales. and a rise in prices. During depression, the normal
tendency is to slow down in the busy. and requires a lesser amount of
working capital.
Growth and expansion: It is difficult to determine the relationship between
the growth in the volume of the business and in the working capital of
the business, yet it may be concluded that for a normal rate of expansion
in the volume of the business, we may have retained profits to provide for
more working capital.
Seasonal Variations: In certain industries, raw materials are not available
throughout the year. They have to buy the raw material in bulk during the
season to ensure an uninterrupted flow and process them during the entire
year.
Credit policy: the credit policy of a concern in its dealings with debtors
and creditors influence considerably the requirements of working capital.
A concern that purchases its requirements on credit and sells its products
on cash requires lesser amount of working capital.
Earning Capacity and Dividend Policy: Some firms have more working
capacity than others due to t h e quality of their products, monopoly
conditions, etc. Such firms with high earning capacity may generate cash
profits from operations and contribute to their working capital. The
dividend policy of a concern also influences the requirements of its working
capital. A firm that maintains a steady rate of cash dividend irrespective
of its generation of profits needs more working capital.
External Factors Affecting Working Capital Requirements
These factors are largely beyond the direct control of a company but
significantly impact its working capital needs.

1. Economic Conditions:
o Inflation: Rising prices for raw materials, labor, and other inputs increase
production costs, demanding more working capital to acquire the same
volume of resources. If selling prices cannot keep pace, profit margins and
cash flow are squeezed.
o Interest Rates (Monetary Policy): Set by the central bank (RBI in India),
higher interest rates make borrowing for working capital (e.g., short-term
loans, overdrafts) more expensive, reducing net working capital and
increasing financial costs. Lower rates make borrowing cheaper.
o Economic Cycles (Boom/Recession):
▪ Boom: Increased demand leads to higher sales, requiring more working
capital for expanded inventory and receivables.
▪ Recession: Reduced demand, slower collection of receivables, and higher
bad debts can severely strain cash flow and tie up existing working capital.
o Currency Fluctuations: For businesses involved in international trade
(import/export), a weakening domestic currency makes imports more
expensive (requiring more working capital) and exports potentially more
competitive (boosting cash inflow).

2. Industry-Specific External Factors:

o Seasonality: Businesses with seasonal demand (e.g., festive goods,
agricultural products) require substantial working capital during peak
seasons to build inventory and meet demand. During off-peak seasons,
reduced sales can lead to idle working capital.
o Competition Level: In highly competitive markets, companies might be
forced to offer more liberal credit terms to customers or maintain higher
inventory levels to avoid stockouts and lose sales, increasing working
capital.
o Technological Advancements (External to the firm): Widespread
adoption of new industry-specific technologies (e.g., automation in textile
industry, advanced logistics software) can streamline processes across the
sector, potentially reducing the industry's overall working capital needs
per unit of output. Conversely, if a company fails to adopt such
technologies while competitors do, it might require more working capital
to remain competitive.
o Availability of Raw Materials/Supply Chain Stability: External
disruptions (e.g., natural disasters, geopolitical events) affecting the
availability or price of raw materials can force companies to hold larger
safety stocks or pay higher prices, increasing working capital.
3. Government Policies and Regulations:
o Taxation Policies: Changes in tax rates (e.g., GST rates, corporate tax),
payment schedules, or new levies can affect cash outflows, impacting
working capital.
o Import/Export Policies & Tariffs: Imposition of tariffs on imported raw
materials increases procurement costs, demanding more working capital.
Export incentives or restrictions can alter cash flow from international
sales.
o Labor Laws: Changes in minimum wage, employee benefits, or working
conditions regulations can increase labor costs, requiring more working
capital for payroll and related expenses.
o Environmental Regulations: Stricter environmental norms might
necessitate investments in new processes or waste management,
potentially impacting immediate cash flows and working capital.

4. Financial Market Conditions:

o Availability of Credit: During periods of tight credit (e.g., financial crises),
banks may be less willing to lend, or may impose stricter criteria, making
it harder and more expensive for companies to obtain necessary working
capital financing.
o Capital Market Access: The general ease (or difficulty) with which
companies can raise funds through equity or long-term debt from the
broader capital markets can indirectly influence reliance on short-term
working capital financing.
5. Natural Disasters and Unexpected Events:
o Impact: Unforeseen events like pandemics, floods, earthquakes, or major
geopolitical conflicts can disrupt supply chains, halt production, reduce
demand, damage inventory, and delay collections. All these factors severely
strain working capital due to increased costs, reduced revenues, and tied-
up funds.

OPERATING CYCLE AND CASH CYCLE

The duration of time required to complete the following events in the case of
a manufacturing firm is called the operating cycle.
Work in
progress

Finished Raw
Goods Materials

Wages /
Salary/
Factory
OH
Debotros
Suppliers
/ AR

Cash
The firm begins with the purchase of raw materials which are paid after a
delay which is termed as account payable period. Firm converts raw
materials into finished goods and then sell the same. The time lag between
finished goods and sale is called Inventory holding period. Customers pay
after some time – the period lapse between date of sale and date of collection
of receivable is called Account receivable Period.

The Operating Cycle is the time duration between the acquisition of inventory
(raw material) and the collection of cash from the sale of finished goods. It
represents the time period during which funds are tied up in working capital.

Operating Cycle = Raw Material Period + Work-in-Progress Period +

Finished Goods Period + Receivables Collection Period

The Cash Conversion Cycle is the time duration between the cash outflow
for purchases and the cash inflow from sales. It measures how long a firm’s
cash is tied up in working capital.
Cash cycle = Operating cycle – Accounts Payable Period

DETERMINATION OF LEVEL OF CURRENT ASSETS

To maximize the wealth of shareholders, the firm requires FA and CA to
support a particular level of output Firm can have a different level of CA. The
level of CA can be measured by relating CA to FA. This may be Conservative
policy, Aggressive Policy, Moderate policy, or Trade off

CONSERVATIVE POLICY
Conservative current assets policy indicates a constant level of fixed assets,
and a higher CA/FA ratio
• It involves greater liquidity & lower risk
• The high level of current assets involves high cost and, in turn, high
liquidity
• Low-risk offers low profit

AGGRESSIVE POLICY
• An aggressive current assets policy indicates a constant level of fixed
assets and a lower CA/FA ratio
• It involves higher risk & poor liquidity
• The low level of current assets involves low cost and, in turn, poor
liquidity
• High-risk offers high profit
MODERATE / TRADE-OFF POLICY
• It is the trade-off between conservative and aggressive policy
• Here, an average level of current assets is maintained
• It involves moderate risk and average liquidity

COMPARISON OF THEIR APPROACHES

Approach Degree of Degree of

Risk Liquidity
Conservative Lowest Highest

Trade off Moderate Moderate

Aggressive Highest Lowest

COMPARISON OF THE THREE APPROACHES

In the above diagram, alternative A indicates the most conservative policy,

where CA/FA ratio is greatest at every level of output. In the same way,
Alternative C is the most aggressive policy & alternative C lies between the
conservative & the aggressive and is the average one.

The cost involved in maintaining a level of current assets

Costs of liquidity: if the firm’s level of current assets is very high, it has
excessive liquidity. Its return on assets will be low as funds are tied up in
idle cash and stocks earn nothing & high level of debtors produces
nothing.
Costs of illiquidity: is the cost of holding insufficient current assets. The
firm will not be able to honor its obligations if it carries too little cash. This
may force firm to borrow at high rate of interest.
THE COST TRADE-OFF
In determining the optimum level of current assets, the firm should
balance the profitability-solvency tangle by minimizing total costs-cost of
liquidity & cost of illiquidity. This is shown in the diagram below:
As you can see in the diagram, with the level of current assets, the cost of
liquidity increases while the cost of illiquidity decreases. & Vice-a-versa.
The firm should maintain its current assets at that level where the sum of
these two costs is minimized.

CURRENT ASSET FINANCING POLICY

Current asset financing policy refers to the way a company funds its
current assets (like cash, inventory, accounts receivable, etc.). The policy
adopted influences the firm's liquidity and risk profile. Current assets
can be financed in various ways.
1) Long-term Financing – Duration of finance is more than a year.
Some examples of long-term sources of finance are equity,
Debenture, bond, etc.
2) Short-term financing- Duration of finance is less than a year.
Some examples of short-term finance are Banks, Commercial
Papers, Factoring, etc.
3) Spontaneous financing: An Automatic source arising from the
normal course of business.- Trade credit, O/s Expenses are
examples.

There are three major types of current asset financing policies:

CONSERVATIVE FINANCING POLICY

A conservative policy uses long-term sources of finance (like equity or
long-term debt) to finance both fixed and current assets, including a
portion of temporary current assets.
Features:
• Higher proportion of long-term funding.
• Low risk, but also low profitability.
• Excess liquidity during off-seasons.
• Working capital is more than sufficient.
Advantages:
• Greater liquidity.
• Lower refinancing risk.
• Better for firms with uncertain cash flows.

Disadvantages:
• Higher cost due to idle funds.
• Lower returns on investments.

AGGRESSIVE FINANCING POLICY

An aggressive policy uses short-term financing (like commercial paper,
short-term loans) even for a part of permanent current assets and
sometimes fixed assets.

Features:
• High reliance on short-term financing.
• High risk, but potentially high return.
• Minimal idle funds.
• Requires accurate cash forecasting.

Advantages:
• Lower interest costs (short-term funds are cheaper).
• Higher profitability if managed well.

Disadvantages:
• High refinancing and interest rate risk.
• Risk of liquidity crunch.
• Stress on financial management

MATCHING OR HEDGING FINANCING POLICY

The firm matches the maturity of assets and liabilities. Long-term
assets and permanent current assets are financed by long-term sources,
while short-term funds finance temporary current assets.
Features:
• Balance between risk and return.
• Stability in financing.
• Moderate liquidity and profitability.
Advantages:
• Reasonable risk management.
• Avoids over-financing and under-financing.

Disadvantages:
• Requires careful planning and forecasting.
• Moderate flexibility.
 Evaluation:
Funding
Policy Liquidity Risk Profitability Suitability
Cost
Firms with uncertain
Conservative High Low Low High
cash flows
Firms with stable and
Aggressive Low High High Low
predictable flows
Balanced approach for
Matching/Hedging Medium Medium Medium Medium
most firms

ESTIMATION OF WORKING CAPITAL REQUIREMENT

Estimation of working capital requirement refers to the process of determining
the amount of funds a business needs to cover its day-to-day operational
expenses, such as purchasing raw materials, paying wages, and managing
inventory and receivables.
Review Questions

3-Mark Questions
1. List any three sources of working capital.

2. Define operating cycle.

3. What is the difference between the cash cycle and the operating cycle?

7-Marks Questions
1. Explain the factors influencing the working capital requirements of a
firm.

2. Discuss various current asset financing policies with suitable examples.

3. Illustrate the steps involved in the determination of the operating cycle.

10-Mark Questions

1. Prepare an estimate of the working capital requirement for a firm given

relevant data.

2. Compare and contrast conservative, aggressive, and moderate current

asset financing policies with advantages and disadvantages.

3. Analyse the importance of working capital management and how it

impacts firm liquidity and profitability.

4. Explain in detail the various factors that affect the working capital
management