SFM Basics and Role of CFO

FINANCIAL MANAGEMENT AND CORPORATE STRATEGY
Learning objective: to learn about the basics of financial management and role of
CFO in managing the business
1. Two Basic Functions of Financial Management
Procurement of Funds: Funds can be obtained from different sources having

different characteristics in terms of risk, cost and control. The funds raised from
the issue of equity shares are the best from the risk point of view since
repayment is required only at the time of liquidation. However, it is also the most
costly source of finance due to dividend expectations of shareholders. On the
other hand, debentures are cheaper than equity shares due to their tax
advantage. However, they are usually riskier than equity shares. There are thus
risk, cost and control considerations which a finance manager must consider
while procuring funds. The cost of funds should be at the minimum level for that
a proper balancing of risk and control factors must be carried out.
Effective Utilization of Funds: The Finance Manager has to ensure that funds are
not kept idle or there is no improper use of funds. The funds are to be invested in
a manner such that they generate returns higher than the cost of capital to the
firm. Besides this, decisions to invest in fixed assets are to be taken only after
sound analysis using capital budgeting techniques. Similarly, adequate working
capital should be maintained so as to avoid the risk of insolvency.
2. Profit Management vs. Wealth Management

A firm's financial management may often have the following as their objectives:
(i) The maximization of firm's profit.
(ii) The maximization of firm's value / wealth.
The maximization of profit is often considered as an implied objective of a firm.

To achieve the aforesaid objective various type of financing decisions may be
taken. Options resulting into maximization of profit may be selected by the firm's
decision makers. They even sometime may adopt policies yielding exorbitant
profits in short run which may prove to be unhealthy for the growth, survival and
CA Ragini B. Khurana Page 1

overall interests of the firm. The profit of the firm in this case is measured in
terms of its total accounting profit available to its shareholders.
The value/wealth of a firm is defined as the market price of the firm's stock. The
market price of a firm's stock represents the focal judgment of all market
participants as to what the value of the particular firm is. It takes into account
present and prospective future earnings per share, the timing and risk of these
earnings, the dividend policy of the firm and many other factors that bear upon
the market price of the stock.
The value maximization objective of a firm is superior to its profit maximization

objective due to following reasons.
 The value maximization objective of a firm considers all future cash flows,
dividends, earning per share, risk of a decision etc. whereas profit
maximization objective does not consider the effect of EPS, dividend paid or
any other returns to shareholders or the wealth of the shareholder.
 A firm that wishes to maximize the shareholders wealth may pay regular
dividends whereas a firm with the objective of profit maximization may refrain
from dividend payment to its shareholders.
 Shareholders would prefer an increase in the firm's wealth against its
generation of increasing flow of profits.
 The market price of a share reflects the shareholders expected return,
considering the long-term prospects of the firm, reflects the differences in
timings of the returns, considers risk and recognizes the importance of
distribution of returns. The maximization of a firm's value as reflected in the
market price of a share is viewed as a proper goal of a firm. The profit
maximization can be considered as a part of the wealth maximization strategy.
3. Finance Functions – Investment, financing and dividend decisions
The finance functions are divided into three major decisions, viz., investment,
financing and dividend decisions. It is correct to say that these decisions are inter-
related because the underlying objective of these three decisions is the same, i.e.
maximization of shareholders' wealth.

Investment decision: The investment of long term funds is made after a careful
assessment of the various projects through capital budgeting and uncertainty
analysis. However, only that investment proposal is to be accepted which is
expected to yield at least so much return as is adequate to meet its cost of
financing. This have an influence on the profitability of the company and
ultimately on its wealth.
Financing decision: Funds can be raised from various sources. Each source of
funds involves different issues. The finance manager has to maintain a proper
balance between -long-term and short-term funds. With the total volume of long-
term funds, he has to ensure a proper mix of loan funds and owner's funds. The
optimum financing mix will increase return to equity shareholders and thus
maximize their wealth.
Dividend decision: The finance manager is also concerned with the decision to
pay or declare dividend. He assists the top management in deciding as to what
portion of the profit should be paid to the shareholders by way of dividends and
what portion should be retained in the business. An optimal dividend pay-out
ratio maximizes shareholders wealth.
The above discussion makes it clear that investment, financing and dividend
decisions are interrelated and are to be taken jointly keeping in view their joint
effect on the shareholders' wealth.
4. Role of Finance Manager in the Changing Scenario of Financial Management in

India:
In the modern enterprise, the finance manager occupies a key position and his
role is becoming more and more pervasive and significant in solving the finance
problems. The traditional role of the finance manager was confined just to raising
of funds from a number of sources, but the recent development in the socio-
economic and political scenario throughout the world has placed him in a central
position in the business organization. He is now responsible for shaping the
fortunes of the enterprise, and is involved in the most vital decision of allocation
of capital like mergers, acquisitions, etc. He is working in a challenging
environment which changes continuously.

Emergence of financial service sector and development of internet in the field of
information technology has also brought new challenges before the Indian
finance managers. Development of new financial tools, techniques, instruments
and products and emphasis on public sector undertaking to be self-supporting
and their dependence on capital market for fund requirements have all changed
the role of a finance manager. His role, especially, assumes significance in the
present day context of liberalization, deregulation and globalization.
5. Responsibilities of Chief Financial Officer (CFO)

The chief financial officer of an organization plays an important role in the
company's goals, policies, and financial success. His main responsibilities include:
(a) Financial analysis and planning: Determining the proper amount of funds to be
employed in the firm.
(b) Investment decisions: Efficient allocation of funds to specific assets.
(c) Financial and capital structure decisions: Raising of funds on favorable terms
as possible, i.e., determining the composition of liabilities.
(d) Management of financial resources (such as working capital).
(e) Risk Management: Protecting assets

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FINANCIAL MANAGEMENT AND CORPORATE STRATEGY

1. Two Basic Functions of Financial Management

Procurement of Funds: Funds can be obtained from different sources having

2. Profit Management vs. Wealth Management

The maximization of profit is often considered as an implied objective of a firm.

CA Ragini B. Khurana Page 1

The value maximization objective of a firm is superior to its profit maximization

3. Finance Functions – Investment, financing and dividend decisions

CA Ragini B. Khurana Page 2

4. Role of Finance Manager in the Changing Scenario of Financial Management in

CA Ragini B. Khurana Page 3

5. Responsibilities of Chief Financial Officer (CFO)

(b) Investment decisions: Efficient allocation of funds to specific assets.

(d) Management of financial resources (such as working capital).

(e) Risk Management: Protecting assets

CA Ragini B. Khurana Page 4

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