What is Financial Management:
Financial Management is a managerial activity that focuses on the planning and control of financial resources. It involves applying general managerial principles to make financial decisions and aligning individual motives with long-term goals. The core of financial management is the effective utilization of both generated and borrowed funds.
How Funds Are Effectively Utilized:
The primary objective when investing funds is to maximize the return on investment. Fund allocation should be based on factors like risk tolerance, time horizon, financial goals, and expectations. Funds or money can be allocated to either long-term or short-term investments, considering these factors.
Objectives of Financial Management:
- Profit Maximization: The fundamental goal of financial management is profit maximization. The required return on profit is directly proportional to the risk associated with the investment. Higher profit expectations typically involve taking on more significant risks.
- Wealth Maximization: Wealth maximization encompasses profit maximization. For some investors, increasing overall wealth holds greater importance than merely increasing profits. Wealth maximization is usually achievable through long-term investments.
Where to Invest Money:
Investment decisions involve allocating money now with the anticipation of future returns. Two critical factors guide the evaluation of investment opportunities: return and risk. Higher-risk investments are expected to yield higher returns and vice versa. Investments can be categorized as short-term or long-term, depending on factors like liquidity, risk, and expected returns.
Short-Term Investments:
Short-term investments typically have a duration of 1 month to 1 year. They do not usually offer high returns. Common examples include fixed deposits.
Long-Term Investments:
Long-term investments are designed to generate returns over an extended period, often exceeding one year and sometimes spanning decades. Common examples include stocks, real estate, and National Pension Scheme (NPS) investments.
Considerations for Investment Decisions:
- Optimal Capital Structure: Designing a capital structure that maximizes returns while minimizing overall investment risk.
- Capital Budgeting: Forecasting returns on proposed long-term investments and comparing them with different investment options.
- Tax Implications: Considering the impact of taxes when evaluating investment decisions.
- Balancing Profitability and Liquidity: Formulating policies to strike a balance between profitability and liquidity.
- Time Value of Money: Recognizing the significance of the time value of money in investment decisions.
What is the Time Value of Money:
The concept of the time value of money is straightforward: a rupee today is worth more than a rupee in the future because time has value. It aligns with the saying, “Time is Money.” When assessing investment decisions, it’s essential to calculate returns while considering the time value of money. A 10% return, for instance, is not truly beneficial unless the time required to earn that return is factored in.
Concept of Return:
Expected return comprises two components:
- Series of recurring payments such as dividends, interest, rent, etc.
- Capital appreciation in the base value of the investment.
Concept of Risk:
Risk refers to the variability of actual outcomes compared to expected outcomes for a particular course of action. It can be broadly classified into two types:
a. Systematic Risk or Non-Diversifiable Risk: Factors like economic, political, and social conditions contribute to this risk.
b. Unsystematic Risk or Diversifiable Risk: Factors specific to an entity or industry, including business risk, financial risk, and default risk.