MANAGEMENT: CONCEPT & PRINCIPLES
• Management is required in all kinds of organisations— whether government or private, whether business or non-business.
• It is necessary so that individuals make their best contribution towards group objectives.
• It consists of a series of interrelated functions that are performed by all managers.
Concept of Management
• Management is a very popular term and has been used extensively for all types of activities and mainly for taking charge of different activities in any enterprise.
• “Management is the process of designing and maintaining an environment in which individuals, working together in groups, efficiently accomplish selected aims”. – Harold Koontz and Heinz Weihrich
• “Management is the process of working with and through others to effectively achieve organisational objectives by efficiently using limited resources in the changing environment.” – Kreitner
Characteristics of Management
• Management is a goal-oriented process
• Management is all pervasive
• Management is multidimensional
o Management of work
o Management of people
o Management of operations
• Management is a continuous process
• Management is a group activity
• Management is a dynamic function
• Management is an intangible
Importance of Management
• Management helps in achieving organisation’s goals
• Management creates a dynamic organisation and promotes Stability and Growth
• Management helps in achieving personal objectives as well as development of society
• Management increases Efficiency and Effectiveness.
Nature of Management
I. As a Process
• Management consists of a series of inter-related activities of planning, organising and controlling.
• All activities are undertaken in a proper sequence with a systematic approach so as to ensure that all actions are directed towards achievement of common goals.
• Thus, it is regarded as a process of organising and employing resources to accomplish the predetermined objectives.
II. As an Art
Management can be art on account of following features:
• Existence of theoretical knowledge – There are various theories of management, as propounded by many management thinkers, which prescribe certain universal principles.
• Based on practice and creativity – A manager applies this acquired knowledge in a personalised and skillful manner in the light of the realities of a given situation.
• Personalised application – A successful manager practices the art of management in the day-to- day job of managing an enterprise based on study, observation and experience
III. As a Science
• Systematised body of knowledge – Management has a systematised body of knowledge. It has its own theory and principles that have developed over a period of time, but it also draws on other disciplines such as Economics, Sociology, Psychology and Mathematics.
• Principles based on experimentation – The principles of management have evolved over a period of time based on repeated experimentation and observation in different types of organisations. Despite the limitations of applying on human beings, management scholars have been able to identify general principles of management.
• Universal validity – Since the principles of management are not as exact as the principles of science, their application and use is not universal. They have to be modified according to a given situation. However, they provide managers with certain standardised techniques that can be used in different situations.
Levels of Management
• There are certain levels of management with varying degree of authority and responsibilities.
• Managers performing different types of duties may be divided into three categories:
- Top-Level Management
- Middle-Level Management
- Lower-Level Management
Functions of Management
• Coordination and Control
Taylor’s Scientific Management:
In the early 20th Century, Fredrick Winslow Taylor, foreman and later the chief engineer of a steel company in U.S.A., suggested a new approach to management known as ‘Scientific Management’.
• Science not Rule of Thumb: Development of a true scientific approach to management replacing the old rule of thumb method, which would enable managers, among other things, to determine the best method of performing each task
• Harmony, Not Discord: Scientific selection and placement of workers so that each worker could be assigned the task for which he is best suited
• Cooperation, Not Individualism: Close co-operation between management and labour to ensure that work is carried out in accordance with the scientific principles which are developed.
• Development of Each and Every Person to His or Her Greatest Efficiency and Prosperity: Scientific training and development of workers so as to achieve the highest level of efficiency.
Fayol’s Principles of Management
Scientific management was primarily concerned with increasing the efficiency of individual workers at the shop floor. It did not give adequate attention to role of managers and their functions.
Around the same time, Henri Fayol, Director of a coal mining company in France made a systematic analysis of the process of management.
Fayol explained what amounts to a manager’s work and what principles should be followed in doing this work.
The 14 principles of management given by him are:
1. Division of Work: Work is divided into small tasks, such that a trained specialist is required to perform each job. Thus, division of work leads to specialization.
2. Authority and Responsibility: There should be a balance between authority and responsibility. An organisation should build safeguards against abuse of managerial power. At the same time a manager should have necessary authority to carry out his responsibility.
3. Discipline: According to Fayol, discipline requires good superiors at all levels, clear and fair agreements and judicious application of penalties.
4. Unity of Command: According to Fayol there should be one and only one boss for every individual employee. If an employee gets orders from two superiors at the same time the principle of unity of command is violated and this results in undermining of authority, lack of discipline and instability.
5. Unity of Direction: All the units of an organisation should be moving towards the same objectives through coordinated and focused efforts.
6. Subordination of Individual Interest to General Interest: Every worker has some individual interest for working in a company. However, in all the situations the interests of the organization should supersede the interest of any one individual.
7. Remuneration of Employees: The overall pay and compensation should be fair to both employees and the organization.
8. Centralization and Decentralization: There is a need to balance subordinate involvement through decentralisation with managers and retention of final authority through centralization.
9. Scalar Chain: Organisations should have a chain of authority and communication that runs from top to bottom and should be followed by managers and the subordinates
10. Order: People and materials must be in suitable places at appropriate time for maximum efficiency. In other words ‘A place for everything (everyone) and everything (everyone) in its (her/his) place’.
11. Equity: There should be kindliness and justice in the behavior of managers towards workers. All employees should be treated fairly.
12. Stability of Tenure of Personnel: Personnel should be selected and appointed after due and rigorous procedure. Plowever, once selected should be provided a minimum fixed tenure. In other words, Employee turnover should be minimised to maintain organisational efficiency.
13. Initiative: Workers should be encouraged to develop and carry out their plans for improvements
14. Team Spirit (Esprit de Corps): Management should promote a team spirit of unity and harmony among employees.
Comparison between Fayol’s & Taylor’s Principles of Management
|S. No.||Basis of difference||Henri Fayol||F. W. Taylor|
|1||Perspective||Top level of management||Shop floor level of a factory|
|2||Unity of Command||Staunch Proponent||Did not feel that it is important as under functional foremanship a worker received orders from eight specialists.|
|3||Applicability||Applicable universally||Applicable to specialised situations|
|4||Basis of formation||Personal experience||Observations and experimentation|
|5||Focus||Improving overall administration||Increasing Productivity|
|7||Expression||General Theory of Administration||Scientific Management|
Functions of Management
Management is described as the process of planning, organising, directing and controlling the efforts of organisational members and of using organisational resources to achieve specific goals. Different experts have classified functions of management.
Henry Fayol distinguishes between the principles and elements of management. Principles are the rules and guidelines, while elements are the functions of management. He has grouped the elements into five managerial functions — planning, organizing, commanding, coordinating, and controlling.
According to George & Jerry, “There are four fundamental functions of management i.e. Planning, Organising, Actuating and Controlling.
The controlling function comprises co-ordination, reporting and budgeting, and Luther Guelick coined the word POSDCORB where:
The most useful method of classifying managerial functions is to group them around the components of planning, organizing, staffing, directing, and controlling. The above functions of management are common to all business enterprises as well as to organizations of other fields, but the manner in which these are carried out will not be the same in different organizations.
• Planning is the basic function of management. It implies decision-making as to what is to be done, how it is to be done, when it is to be done and by whom it is to done.
• Planning is thus, the preparatory step for actions and helps in bridging the gap between the present and the future.
• Planning, thus, involves setting objectives and developing best courses of action to achieve these objectives.
Features of Planning
• Primary function of management – as every activity needs to be planned before it is actually performed.
• Focus on achieving objectives – goal directed
• Planning is persuasive – at all levels of management and at also at all functional areas.
• Continuous Process
• Planning is futuristic
• Involves decision making
• Intellectual Activity – Requires certain conceptual skills, good foresight and sound judgment to anticipate future events, develop alternative courses of action.
Importance of Planning
• Planning gives direction
• Planning reduces the risks of uncertainty
• Planning reduces overlapping and wasteful activities
• Planning promotes innovative ideas
• Planning facilitates decision making
• Planning establishes standards for controlling.
Process of Planning
1. Setting Objectives / Goals
2. Developing Premises
3. Identifying alternative courses of action
4. Evaluating alternative courses
5. Selecting an alternative
6. Implementing the plan
7. Follow-up action
Process of Organising
• Identification and division of work
• Assignment of duties
• Establishing reporting relationships
Importance of Organising
• Benefits of specialisation
• Clarity in working relationships
• Optimum utilization of resources
• Adaptation to change
• Effective administration
• Development of personnel
• Expansion and growth
• After planning and selection of the organisation structure, the next step in the management process is to fill the various posts provided in the organisation. This is termed as the management of staffing function.
• In the simplest terms, staffing refers to the managerial function of employing and developing human resources for carrying out the various managerial and non-managerial activities in an organisation.
Importance of Staffing
No organisation can be successful unless it can fill and keep filled the various positions provided for in the structure with the right kind of people.
• Proper Staffing helps in discovering and obtaining competent personnel for various jobs
• Staffing makes for higher performance, by putting right person on the right job
• Staffing ensures the continuous survival and growth of the enterprise through the succession planning for managers
• Staffing helps to ensure optimum utilisation of the human resources
• Staffing improves job satisfaction and morale of employees through objective assessment and fair reward for their contribution
Process of Staffing
1. Estimating the Manpower Requirements
4. Placement and Orientation
5. Training and Development
6. Performance Appraisal
8. Promotion and career planning
Aspects of Staffing
There are three main aspects of staffing:
• Training & Development.
• While managing an enterprise, managers have to get things done through people. In order to be able to do so, they have to undertake many activities, like guide the people who work under them, inspire and lead them to achieve common objectives.
• All these activities of a manager constitute the directing function.
• Thus, directing is concerned with instructing, guiding, supervising and inspiring people in the organisation to achieve its objectives.
• In simple terms, directing means giving instructions and guiding people in doing work.
Characteristics of Directing
• Directing initiates action
• Directing takes place at every level of management
• Directing is a continuous process
• Directing flows from top to bottom.
Importance of Directing
• Directing helps to initiate action by people in the organisation towards attainment of desired objectives.
• Directing integrates employees efforts in the organisation in such a way that every individual effort contributes to the organisational performance.
• Directing guides employees to fully realise their potential and capabilities by motivating and providing effective leadership.
• Directing facilitates introduction of needed changes in the organisation.
• Effective directing helps to bring stability and balance in the organisation.
Principles of Directing
• Maximum individual contribution: Directing techniques must help every individual in the organisation to contribute to his maximum potential for achievement of organisational objectives.
• Harmony of objectives: Directing should provide harmony by convincing that employee rewards and work efficiency are complimentary to each other
• Unity of Command: A person in the organisation should receive instructions from one superior only.
• Appropriateness of direction technique: Appropriate motivational and leadership technique should be used while directing the people based on subordinate needs, capabilities, attitudes and other situational variables.
• Managerial communication: Effective managerial communication across all the levels in the organisation makes direction effective
• Use of informal organisation: A manager should realise that informal groups or organisations exist within every formal organisation. He should spot and make use of such organisations for effective directing.
• Leadership: While directing the subordinates, managers should exercise good leadership as it can influence the subordinates positively without causing dissatisfaction among them.
• Follow through: Mere giving of an order is not sufficient. Managers should follow it up by reviewing continuously whether orders are being implemented accordingly or any problems are being encountered. If necessary, suitable modifications should be made in the directions.
Elements of Directing
• The process of directing involves guiding, coaching, instructing, motivating, leading the people in an organisation to achieve organisational objectives.
• The activities can broadly be grouped into four categories which are the elements of directing. These are:
Co-ordination & Controlling
• In every organisation, different types of work are performed by various groups and it becomes essential that the activities of different work groups and departments should be harmonised.
• This function of management is known as ‘co-ordination’. In other words, coordination is the orderly arrangement of individual and group efforts to provide unity of action in the pursuit of a common goal.
• According to Henri Fayol, “Control consists in verifying whether everything occurs in conformity with the plan adopted, the instructions issued and principles established.”
• In simple terms, controlling means ensuring that activities in an organisation are performed as per the plans.
Importance of Controlling
• Accomplishing organisational goals
• Judging accuracy of standards
• Making efficient use of resources
• Improving employee motivation
• Ensuring order and discipline
• Facilitating coordination in action.
Process of Controlling
Controlling is a systematic process involving the following steps.
1. Setting performance standards
2. Measurement of actual performance
3. Comparison of actual performance with standards
4. Analysing deviations
5. Taking corrective action
Techniques of Control Traditional Techniques
• Personal observation
o Enables the manager to collect first hand information
o Creates a psychological pressure on the employees to perform well as they are aware of being observed.
• Statistical reports
o Statistical analysis the form of averages, percentages, ratios, correlation, etc., present useful information regarding performance of the organisation in various areas.
• Breakeven analysis
o Breakeven analysis is used to study the relationship between costs, volume and profits.
o It determines the probable profit and losses at different levels of production
• Budgetary control
• Return on investment (Rol)
• Ratio analysis
• Responsibility accounting
• Management audit
• PERT and CPM
• Management information system (MIS)
Relation between Planning & Controlling
Planning and controlling are closely related and reinforce each-other.
• Once a plan becomes operational, controlling is necessary to monitor the progress, measure it, discover deviations and initiate corrective measures to ensure that events conform to plans.
• Planning based on facts makes controlling easier and effective;
• Controlling improves future planning by providing information derived from past experience.
• Planning without controlling is meaningless. Similarly, controlling is blind without planning.
• Making decisions has been identified as one of the primary responsibilities of any manager. Decisions may involve allocating resources, appointing people, investing capital or introducing new products.
• Decision-making is at the core of all planned activities. Decision-making is a process of selection from a set of alternative courses of action which is thought to fulfill the objectives of the decision problem more satisfactorily than others.
Process of Decision Making
• There are generally eight steps in the process of decision-making but all decisions might not fully conform to the neat eight step pattern. The steps, however, may be skipped or combined.
• These steps are:
1. Identifying the problems.
2. Defining the objectives to be met in solving the problem.
3. Making a pre-decision
o Taking a decision about how to make a decision.
4. Generating alternatives
5. Evaluating alternate solutions
6. Choice to be made
7. Implementation of the chosen alternatives
8. Follow up
o Monitoring the effectiveness of any attempted solution
Types of Managerial Decisions
There are multiple categories of managerial-decisions. Five most widely recognised classifications are:
• Personal and Organisational Decisions.
• Routine & Strategic Decisions
• Programmed and Non-programmed Decisions
• Individual and group decisions
• Policy and operating decisions
This classification ignores the dimension of how complex the problem is and how much certainty can be placed with the outcome of a decision.
Considering, these two dimensions four kinds of decision modes can be identified:
o Decisions that are routine and repetitive in nature
o Decision that involves a problem with a large number of decision variables, where the outcomes of each decision alternative can be computed.
o A judgemental decision involves a problem with a limited number of decision variables, but the outcomes of decision alternatives are unknown.
o An adaptive decision involves a problem with a large number of decision variables, where outcomes are not predictable, because of the complexity and uncertainty of such problems, decision makers are not able to agree on their nature or on decision strategies.
Models of Decision Making
Models of the decision-making process help one understand how decisions are made.
These models are:
• Contingency model
• Economic man model
• Administrative man model
• Implicit Favourite Model or Gamesman Model
• Social man model
Beach and Mitchell (1978) felt that the decision maker uses one of three general types of decision strategies:
• Aided analytic
o The aided analytic strategy employs some sort of formal model or formula, or an aid such as a checklist.
• Unaided analytic
o An unaided analytic strategy is one in which the decision maker is very systematic in his or her approach to the problem and perhaps follows some sort of model, but does it all in his or her head.
• No analytic
o Here the decision maker chooses by habit or uses some simple rule of thumb (“nothing ventured, nothing gained” or “better safe than sorry”) to make the choice.
Economic Man Model
The economic man-model assumes that people are economically rational and so people attempt to maximise outcomes in an orderly and sequential process. Hence, people will select the decision or course of action that has the greatest advantage or payoff from among the many alternatives. This model suggests the following orderly steps in the decision process:
• 1. Discover the symptoms of the problem or difficulty
• 2. Determine the goal to be achieved or define the problem to be solved
• 3. Develop a criterion against which alternative solutions can be evaluated
• 4. Identify all alternative courses of action
• 5. Consider the consequences of each alternatives as well as the likelihood of occurrence of each
• 6. Choose the best alternative by comparing the consequences of each alternative (step5) with the decision criterion (step3) and
• 7. Act or implement the decision.
Administrative man model
• This model was presented by Simon as is also called as Bounded Rationality Model. This model assumes that people, while they may seek the best solution, usually settle for much less because the decisions they confront typically demand greater information processing capabilities than they possess.
The following three steps are involved in the process of this model.
• Sequential attention to alternative solutions:
o In this step, all the alternatives are identified and evaluated one at a time. If one of the alternatives fails then the next alternative is considered
• Use of heuristics:
o A heuristic is a rule which guides the search for alternatives into areas that have a high probability for yielding satisfactory solutions. In this step if the previous solution was working then a similar set of alternatives are used in that situation.
o Here the alternatives which are workable are found to be satisfying.
• Marketing refers to the process of ascertaining consumers’ needs and supplying various goods and services to the final consumers or users to satisfy those needs.
Traditional Concept of Marketing
• Traditionally, marketing means selling goods and services that have been produced.
• Thus, all those activities, which are concerned with sale of goods and services, have been called marketing.
• In the traditional sense, the term ‘market’ refers to the place where buyers and sellers gather to enter into transactions involving the exchange of goods and services.
Modern Concept of Marketing
• The modern concept of marketing considers the consumers’ wants and needs as the guiding spirit and focuses on the delivery of such goods and services that can satisfy those needs most effectively.
• Similarly, in modern marketing sense, the term market has a broader meaning. It refers to a set of actual and potential buyers of a product or service.
What is Marketing?
• Marketing is a broad concept that starts with identifying consumer needs, then plan the production of goods and services accordingly to provide them the maximum satisfaction.
• Phillip Kolter defines marketing as, “a social process by which individual groups obtain what they need and want through creating offerings and freely exchanging products and services of value with others”.
• These refer to some combination of products, services, information, or experiences offered to a market to satisfy consumer needs or wants.
• They are not just limited to physical products; they can also include services such as intangible like activities or benefits offered for sale.
Important features of Marketing
• Needs and Wants
o The process of marketing helps individuals and groups in obtaining what they need and want.
• Creating a Market Offering
o Market offering refers to a complete offer for a product or service, having given features like size, quality, taste, etc; at a certain price; process of purchasing, available at a given outlet or location and so on.
• Customer Value
o A product will be purchased by customers only if it is perceived to be giving greatest benefit or value for the money.
o The job of a marketer, therefore, is to add and convey this value of the product to the probable customers, so they may prefer the particular product against competing items.
• Exchange Mechanism
o The process of marketing works through the exchange mechanism. The individuals (buyers and sellers) obtain what they need and want through the process of exchange.
Objectives of Marketing:
• Provide satisfaction to customers.
• Increase in demand
• Provide better quality product to the customers
• Create goodwill for the organisation
• Generate profitable sales volume
Importance of Marketing:
• Marketing helps business to keep pace with the changing tastes, fashions, preferences of the customers. Additionally, it also helps the business in meeting competition most effectively.
• Marketing helps the business in increasing its sales volume, generating revenue and ensuring its success in the long run.
• Marketing also contributes to providing better products and services to the consumers and improve their standard of living.
• Marketing helps in making products available at all places and throughout the year.
• Marketing plays an important role in the development of the economy.
o Various functions and sub-functions of marketing like advertising, personal selling, packaging, transportation, etc. generate employment for a large number of people, and accelerate growth of business.
Difference between Marketing and Selling
• The terms ‘marketing’ and ‘selling’ are related but not synonymous. ‘Marketing’ emphasises on earning profits through customer satisfaction.
• In marketing, the focus is on the consumer’s needs and their satisfaction.
• ‘Selling’ on the other hand focuses on product and emphasises on selling what has been produced. Hence, Selling is a small part of the wide process of marketing.
|Marketing includes selling and other activities like various promotional measures, marketing research, after sales service, etc.||Selling is confined to persuasion of consumers to buy firm’s goods and services.|
|It starts with research on consumer needs, wants, preference, likes, dislike etc., and continues even after the sales have taken place.||Selling starts after the production process is over and ends with the handing over the money to the seller by the buyer.|
|Priority is needs of buyer.||Priority is the seller.|
|Focus is on earning profit through maximisation of customers’ satisfaction.||Focus is on earning profit through maximisation of sales.|
|It is an integrated approach to achieve long term goals like creating, maintaining and retaining the customers.||All activities revolve around the product that has been produced.|
Functions performed in Marketing
• Marketing Research – Gathering and Analysing Market Information
• Marketing Planning
• Product Designing and Development
• Standardisation and Grading
• Packaging & Labelling
• Pricing the Product
• Promotion of the Product
• Storage and Warehousing
• Physical Distribution
• After-Sale Services/ Customer Support Services Marketing Management Philosophies
The concept or philosophy of marketing has evolved over a period of time as follows:
The Production Concept
• During the earlier days of industrial revolution, the demand for industrial goods started picking up but the number of producers were limited. As a result, the demand exceeded the supply. Selling was not an issue.
• It was believed that profits could be maximised by producing at large scale, thereby reducing the average cost of production.
• It was also assumed that consumers would favour those products which were widely available at an affordable price.
• Thus, availability and affordability of the product were considered to be the key to the success and hence greater emphasis was placed on improving the production and distribution efficiency.
The Product Concept
• Mere availability and low price of the product could not ensure increased sale as customers started looking for products which were superior in quality, performance and features.
• Therefore, the emphasis of the firms shifted from quantity of production to quality of products.
• Hence, product improvement came to be considered as the key to profit maximisation of a firm.
The Selling Concept
• With the passage of time, supply of goods improved resulting in increased competition among sellers.The product quality and availability did not ensure the survival and growth of firms.
• This led to greater importance to attracting and persuading customers to buy the product.
• Hence, the focus of business firms shifted to pushing the sale of products through aggressive selling techniques.
The Marketing Concept
• In Selling Concept, making sale through any means became important but in long-term it was realised that the customer satisfaction matters the most and this gave way to new paradigm of Marketing Concept.
• This assumes that in the long run an organisation can achieve its objective of maximisation of profit by identifying the needs of its present and prospective buyers and satisfying them in an effective way.
• In this, customer’s satisfaction becomes the focal point of all decision making in the organisation.
The Societal Marketing Concept
• The marketing concept cannot be considered as adequate if we look at the challenges posed by social problems like environmental pollution, deforestation, shortage of resources, population explosion and inflation.
• The societal marketing concept holds that the task of any organisation is to identify the needs and wants of the target market and deliver the desired satisfaction in an effective and efficient manner so that the long-term well-being of the consumers and the society is taken care of.
• Thus, the societal marketing concept is the extension of the marketing concept as supplemented by the concern for the long-term welfare of the society.
• There are large number of factors affecting marketing decisions.
• Some of these are controllable factors like brand-name, location, price, where to advertise etc and others are non-controllable factors like government taxes, policy, inflation etc.
• Thus, from a number of alternatives available a firm chooses a particular combination to develop a market offering.
• The combination of variables chosen by a firm to prepare its market offering is also called marketing mix.
Definition: The marketing mix refers to the set of actions, or tactics, that a company uses to promote its brand or product in the market.
Elements of Marketing Mix:
• The marketing mix consists of various elements, popularly known as four Ps of marketing. These are:
• Product means goods or services or ‘anything of value’, which is offered to the market for sale. Price:
• Price is the amount of money customers have to pay to obtain the product.
• It depends on costs of production, segment targeted, ability of the market to pay, supply – demand and a host of other direct and indirect factors.
• Place refers to the point of sale.
• In every industry, catching the eye of the consumer and making it easy for them to buy it is the main aim of a good distribution or ‘place’ strategy. Retailers pay a premium for the right location.
• Promotion of products and services include activities that communicate availability, features, merits, etc. of the products to the target customers and persuade them to buy it.
• In services marketing, an extended marketing mix is used, typically comprising 7 Ps.
o Including the original 4 Ps and
o Process, People, and Physical evidence.
• Occasionally service marketers will refer to 8 Ps, comprising these 7 Ps and Performance.
• Robert F. Lauterborn proposed a 4 Cs classification in 1990.
• This classification is a more consumer- orientated version of the 4Ps.
• It includes:
o Product —> Commodity
o Price —> Cost
o Promotion —> Communication
o Place —> Channel
SOURCES OF FINANCE
• Any type of business or occupation requires money at every stages of its operation. Whether it is a small business or large, manufacturing or trading or transportation business, money is an essential requirement for every activity.
• Money required for carrying out business activities is called business finance. Finance is needed to establish a business, to run it, to modernise it, to expand, or diversify it.
Types of Business Finance:
• The type and amount of funds required usually differs from one business to another.
• Hence, there exists multiple classification of business finance based on different selected parameters.
- Based on the period for which the funds are required, the business finance is classified into three categories.
• Short-term Finance
o The short-term finance is required for a period of one year or less
• Medium-term Finance
o Investments / Finance are required for more than one year but less than five years.
• Long-term Finance
o The amount of funds required by a business for more than five years is called long-term finance
- On the basis of ownership, the sources of business finance can be broadly classified into two categories:
• Owner’s funds
o It consist of equity share capital, preference share capital and reserves and surpluses or retained earnings.
• Borrowed funds
o It can be in the form of loans, debentures, public deposits etc.
Sources of Short-Term Finance
• Trade credit
• Bank credit
o Loans and Advances
o Cash Credit
o Bank Overdraft
o Discounting of Bills
• Customers’ Advances
• Instalment Credit
• Loans from Unorganised sectors
Sources of Long-Term Finance
• Issue of Shares
• Retention of Profit
• Issue of Debentures
• Loans from financial institutions
• Public Deposits
• Lease financing
• Foreign Investment
Sources of Short-Term Finance
• Trade credit refers to credit granted to manufacturers and traders by the suppliers of raw material, finished goods, components, etc.
• Usually business enterprises buy goods on 30 to 90 days credit.
• This means that the goods are delivered but payments are not made until the expiry of the period of credit.
• Commercial banks usually provide short-term finance to business firms, known as bank credit.
• When bank credit is granted, the borrower gets a right to draw the amount of credit as and when needed. Bank credit may be granted in any of the following ways:
Loans and Advances
• When a bank advances a certain amount of money, repayable after a specified period, it is known as bank loan.
• Such advance is credited to a separate loan account and the borrower has to pay interest on the whole amount of loan irrespective of the amount of loan actually drawn.
• Usually loans are granted against security of assets.
• Arrangement whereby banks allow the borrower to withdraw money upto a specified limit.
• This facility is granted against the security of goods in stock or promissory notes or other marketable securities like government bonds.
• Interest is charged only on the amount actually withdrawn and not on the amount of entire limit.
• In this case, bank allows its depositors or accountholders to withdraw money in excess of the balance in his current deposit account, upto a specified limit.
• Limit is decided by credit worthiness of the borrower. Interest is charged only on the overdrawn money.
Discounting of Bills
• Banks also give advance money by discounting bill of exchange.
• On maturity of the bill, the payment is received by the bank from the drawee.
Bill of Exchange:
• A bill of exchange is a written order once used primarily in international trade that binds one party to pay a fixed sum of money to another party on demand or at a predetermined date.
• Bills of exchange are similar to cheques.
• The business can take advance money from the bank against the amount to be realised from the debtors.
• Customers’ advance represents a part of the payment towards sale price of the product(s), which will be delivered at a later date.
Loans from Unorganised sectors
• In addition to the above methods of raising funds, the businessmen always have the option to take the money from the unorganised sector like loans from the moneylender (called indigenous bankers), friends and relatives.
Sources of Long-Term Finance
- Owner’s Capital
Issue of Shares
• Share is the smallest unit into which the total capital of the company is divided. The investors who have purchased the shares or invested money in the shares are called the shareholders.
• They get dividend as return of their investment.
• A company can issue two types of shares, – Equity Shares and Preference shares.
• Equity shares are shares that do not enjoy any preferential right in the matter of claim of dividend or repayment of capital.
• The equity shareholders get dividend only after making the payment of dividends on preference shares.
• The equity shareholders are the owners of the company and exercise their authority through the voting rights.
• There is no fixed rate of dividend as it depends on surplus profits.
• Preference Shares are shares that carry preferential rights in respect of dividend and return of capital.
• Before any dividend is paid to the equity shares, the dividend at a fixed rate must be paid on the preference shares. I lowever, this dividend is payable only if there are profits.
• Also in case of winding up of company, preference shareholders get priority over equity shareholders, on the return of their capital.
• Preference shares do not have any normal voting right. So, they cannot take part in the management of the company. Only in case of special circumstances, they get right to vote in general meetings.
Types of Preference Share
A company has the option to issue different types of preference share:
• Convertible and Non-convertible Preference Share:
o The preference shares, which can be converted into equity shares after a specified period of time, are known as convertible preference share. Otherwise, it is known as non-convertible preference share.
• Cumulative and Non-cumulative Preference Share:
o In cumulative preference shares, the unpaid dividends are accumulated and carried forward for payment in future years. On the other hand, in non-cumulative preference share, the dividend is not accumulated if it is not paid out of the current year’s profit.
• Participating and Non-participating Preference Share:
o Participating preference shares have a right to share the profit after making payment to the equity shares. The non-participating preference shares do not enjoy such a right.
• Redeemable and Irredeemable Preference Share:
o Preference shares having a fixed date of maturity is called as redeemable preference share. Here, the company undertakes to return the amount to the preference shareholders immediately after the expiry of a fixed period. Where the amount of the preference shares is refunded only at the time of liquidation, are known an irredeemable preference shares.
Retained Earnings / Retention of Profit
• Retained earnings refer to part of profit that was not distributed as dividend, which is usually kept in the form of general reserve.
• It is an internal source and does not involve any cost of floatation and the uncertainties of external financing.
o Regarded as the most dependable source of long-term finance.
o Also strengthens the firm’s equity base, which enables to borrow at better terms and conditions.
o Dependent on the accuracy of profits
o Possibility of reckless use of funds by the management.
- Borrowed Capital
Issue of Debentures
• The companies can raise long term funds by issuing debentures that carry assured rate of return for investors in the form of a fixed rate of interest.
• A debenture is a written acknowledgement of money borrowed. It specifies the terms and conditions, such as rate of interest, time of repayment, security offered, etc.
• The debenture-holders are the creditors of the company and are entitled to get interest irrespective of profit earned by the company.
• They do not have any voting right. So they do not interfere in the day- to-day management of the business.
• Ordinarily, debentures are fully secured. In case the company fails to pay interest on debentures or repay the principal amount, the debenture-holders can recover it from sale of its assets.
Types of Debentures:
Debentures may be classified as:
• Redeemable and Irredeemable Debentures:
o Redeemable debentures are repayable on a specified date.
o On the other hand, there is no fixed time to pay back the money in case of irredeemable debentures.
o These debenture holders cannot demand to get back their money as long as the company does not make any default in payment of interest.
o Hence, these debentures are also called perpetual debentures.
• Convertible and Non-convertible Debentures:
o Convertible debentures-holders are given the option to convert their debentures into equity shares.
o But in case of non-convertible debentures the company does not give any such option.
• Secured and Unsecured Debentures:
o Secured debentures are issued with a charge on the assets of the company as security.
o This charge may be fixed i.e., on specified asset, or it may be floating. Secured debentures are also known as mortgaged debentures.
o On the other hand, unsecured debentures are issued with merely a promise of payment without having any charge on any assets as security.
o So these debentures are also known as naked or simple debentures.
• Registered and Bearer Debentures:
o For registered debentures the issuing company maintains a record of the debenture-holders.
o Any sale or transfer of such debentures must be registered with the company.
o On the other hand, bearer debentures are just like negotiable instruments and transferable by mere delivery.
o The company keeps no record of such debenture-holders. Interest coupons are attached to them and anybody can produce the coupon to get the interest.
Difference Between Shares & Debentures:
|Status||Shareholders are the owners of the company. They provide ownership capital which is not refundable unless the company is liquidated||Debenture-holders are the creditors of the company. They provide loans generally for a fixed period, which are to be paid back.|
|Rights||They have the right to vote and say in management of the company||They do not have right to vote and no say in management of company.|
|Returns||They get dividends but returns are not fixed.||Interest is paid on debentures at a fixed rate.|
|Return payable only when company makes profit.||Interest is payable even when company operates at loss.|
|Priority of Repayment||Share capital is paid back only after paying the debenture-holders and creditors.||Debenture-holders have the priority of repayment over shareholders.|
|Risk||High, no certainty of return.||Low, certainty of return|
Loans from financial institutions
• Financial institutions grant loans for a maximum period of 25 years.
• These loans are covered by mortgage of the company’s property and/or hypothecation of stocks shares etc.
• The rate of interest payable is lower than the market rate and the amount of loan is large.
• Example of financial institutions are –
• Industrial Finance Corporation of India (IFCI)
• Industrial Credit and Investment Corporation of India (ICICI)
• Industrial Development Bank of India (IDBI)
• Small Industries Development Bank of India (SIDBI)
• Export and Import Bank of India (EXIM Bank)
• Venture Capital Institutions
• Under this method companies can raise funds by inviting their shareholders, employees and the general public to deposit their savings with the company.
• To attract the public, the company usually offers a higher rate of interest than the interest on bank deposit.
• Sometimes, a company, to meet its financial requirements, may sell its own existing fixed asset (machinery or building) to a leasing company at the current market price on the condition that the leasing company shall lease the asset back to selling company for a specified period. Such an arrangement is known as ‘Sell and Lease Back’.
• The company in such arrangement gets the funds without having to part with the possession of the asset involved which it continues to use on payment of annual rent for the lease.
• Foreign Sources also play an important part in meeting the long-term financial needs of the business in India. These usually take the form of:
• These include loans obtained at concessional rates of interest with long maturity period and commercial borrowings.
• The major sources of concessional loans have been the International Monetary Fund (IMF), Asian Development Bank (ADB), and World Bank etc.
• ECB is basically a loan availed by an Indian entity from a non-resident lender.
• Most of these loans are provided by foreign commercial banks and other institutions.
• It is a loan availed of from non-resident lenders with a minimum average maturity of 3 years.
• Foreign Direct Investment (FDI) is the investment through capital instruments by a person resident outside India
(a) in an unlisted Indian company; or
(b) in 10 percent or more of the post issue paid-up equity capital on a fully diluted basis of a listed Indian company.
• Foreign Portfolio Investment is any investment made by a person resident outside India in capital instruments where such investment is
(a) less than 10 percent of the post issue paid-up equity capital on a fully diluted basis of a listed Indian company or
(b) less than 10 percent of the paid up value of each series of capital instruments of a listed Indian company.
• Fully diluted basis means the total number of shares that would be outstanding if all possible sources of conversion are exercised.
Deposits from NRIs
• Non-Resident Indians (NRIs) constitute an important source of long-term finance for industries in India.
• The most common form of their contribution is in the form of deposits under Foreign Currency Non-Resident Account (FCNRA) and Non-Resident (External) Rupee Account (NRERA).
• One of the important decisions under financial management relates to the financing pattern or the proportion of the use of different sources in raising funds.
• Most companies plan to raise funds for their capital needs using a judicious mix between owners funds (equity) and borrowed funds (debt).
• This mix of equity and debt actually used by a company for meeting its requirement of capital is known as its capital structure.
• Capital structure of a company, thus, affects both the profitability and the financial risk, it is considered be optimal when the proportion of debt and equity is such that it results in an increase in the value of the equity share.
• In other words, all decisions relating to capital structure should emphasize on increasing the shareholders’ wealth.
• Thus, capital structure of a company affects the rate of return on owners’ capital (shareholders’ funds).
• This in turn, determines the earnings per equity share (EPS) and has its effect on the market value of company’s shares.
• Hence, the choice of an appropriate capital structure becomes a very important decision for the finance manager of any company.
Importance of Capital Structure:
• Increase in value of the firm:
o An optimal capital-structure of a company leads to increase the market price of shares, which results in increase in the value of the firm.
• Maximization of return
• Minimization of Cost of Capital
• Provides Risk information:
o An analysis of Capital-Structure of Business, can help in determining how risky it is to invest in a business.
• Deciding about the capital-structure of a firm involves determining the relative proportion of various types of funds.
• This depends on various factors. Important factors, which determine the choice of capital-structure, are as follows:
• Cash Flow Position:
• Return on Investment (Rol)
• Cost of debt
• Tax Rate
• Debt Service Coverage Ratio (DSCR)
• Cost of Equity
• Floatation Costs:
• Risk Consideration
• Capital Structure of other Companies
Trading on Equity
• Trading on Equity Trading on Equity refers to the use of high debt for ensuring higher returns for the equity shareholders.
• This is workable when the profitability is high and the rate of return on investment of funds is higher than the rate of interest to be paid on the borrowed money.
• Situation where income of shareholders is maximised and cost of capital is minimised.
COST OF CAPITAL
• The cost of capital is the cost of a company’s funds (both debt and equity).
• From Investor’s point of view, it is the rate of return that must be received by the firm on its investment projects, to attract investors for investing capital in the firm and to maintain its market value.
• In simple terms, it may be described as the expected return appropriate for the expected level of risk.
• It is also termed as cut-off rate, the minimum rate of return, or hurdle rate.
• Useful in determining company’s capital structure.
• Deciding future projects/investments – For an investment to be worthwhile, the expected return on capital has to be higher than the cost of capital.
• It helps to evaluate a company’s investment program and its competitive position.
• Helpful in capital budgeting decisions regarding the sources of finance used by the company.
Cost of Capital and Capital Structure
• Cost of capital is an important factor in determining the company’s capital structure.
• Companies look for the optimal mix of financing (Debt + Equity) that provides adequate funding and that minimizes the cost of capital.
• Factors affecting cost of capital:
• Capital Structure
• Dividend Policy
• Financial and Investment Decisions
• Interest Rates
Types of Cost of Capital Implicit & Explicit Capital Costs
• Implicit cost also known as the opportunity cost is the of the opportunity foregone in order to take up a particular project.
• It is the rate of return associated with the best investment opportunity for the firm and its shareholders that will be forgone if the project presently under consideration by the firm were accepted.
• Explicit cost of any source may be defined as the discount rate that equates the present value of the funds received by a firm with the present value of expected cash outflows.
Historical & Future Capital Costs:
• Historical costs are those costs which have already been incurred in order to finance a particular project.
• Future Costs are the expected costs of funds for financing a particular project.
Weighted average cost of capital (WACC)
• WACC is the combined cost of each component of funds raised by the firm.
• The weights are the proportion of the value of each component of capital in the total capital.
Marginal Capital Costs
• Marginal capital cost is defined as the cost of obtaining one additional unit (1 rupee in India) of new capital.
Specific Capital Cost
• The cost of each component of capital is known as specific Capital Costs.
• Companies raise capital from different sources such as equity, debentures, loan etc.
• It is the cost of equity capital, cost of debentures, etc., individually.
Cost of Debt
• It is the interest rate that a company pays on its existing debt.
• However, since interest expense is tax-deductible, the debt is calculated on an after-tax basis as follows:
Cost of Debt = Interest Expense * (1- Tax Rate)/ Total Debt
Cost of Equity
• It is the expected rate of return for the company’s shareholders.
Cost of Retained Earnings
• Retained earnings refers to the portion of net income which is retained by the corporation rather than distributed to its owners as dividends.
Profit Vs. Wealth Maximization
• For optimal financial decisions, it is essential to define objectives of financial management. These objectives serve as decision-criterion.
• Financing is a functional area of business and, therefore, the objectives of financial management must be in tune with the overall objectives of the business.
• The main objectives of business are survival and growth.
o In order to survive in the business and to grow, a business must earn sufficient profits.
o It must also maintain good relations with investors, employees, customers and other groups of society. It should also provide maximisation of owners’ economic welfare.
• Consequently, there are two well known criteria in this regard:
o Profit Maximisation
o Wealth Maximisation
• According to this criterion, the financial decisions (investment, financing and dividend) of a firm should be oriented to the maximisation of profits (i.e. select those assets, projects and decisions which are profitable and reject those which are not profitable).
• Hence, actions that increase the firm’s profit are undertaken while those that decrease profit are avoided.
Merits of Profit Maximisation:
• Excellent allocation of resources
• Main Source of Inspiration
• Maximum Social Welfare
• Basis of Decision-Making
• Under perfect competition, profit maximisation behaviour by firms leads to an efficient allocation of resources with maximum social welfare.
• Since, the capital is a scarce material, the financial manager should use these capital funds in the most efficient manner for achieving the profit maximisation.
• It is, therefore, argued that profitability maximisation should serve as the basic criterion for the ultimate financial management decisions.
Drawbacks of Profit Maximisation
• It is vague
• It ignores time value of money
• It ignores risks
• It ignores social responsibility
• Considering the shortcomings of profit maximisation, wealth maximisation is taken as the basic objective of financial management.
• It is also known as ‘Value Maximisation’ or ‘Net Present Value Maximisation’.
• The wealth maximisation goal states that the management should seek to maximise the present value of the expected returns of the firm.
• The present value of future benefits is calculated by using its discount rate (cost of capital) that reflects both time and risk.
Superiority of Wealth Maximisation
• It measures income in terms of cash flows, and avoids the ambiguity now associated with accounting profits as, income from investments is measured on the basis of cash flows rather than on accounting profits.
• It recognises time value of money by discounting the expected income of different years at a certain discount rate (cost of capital).
• It analyses risk and uncertainty so that the best course of action can be selected from different alternatives.
• It is not in conflict with other motives like maximisation of sales or market value of shares. It helps rather in the achievement of all these other objectives.
Comparison of Profit Maximisation & Wealth Maximisation
|Profit Maximisation||Wealth Maximisation|
|• Its main objective is to earn large amount of profits.||• Its main objective is to achieve highest market value of common stock.|
|• It emphasises short term||• It emphasises long term|
|• It ignores time value of money||• It considers time value of money|
|• It ignores risk and uncertainty||• It recognises risk and uncertainty.|
|• It ignores timing of return||• It recognises the timings of return.|
• It should be clear that profit maximisation is a strictly short-term approach to managing a business, which can be damaging over the long term.
• On the other hand, Wealth maximisation, which focuses attention on the long term, increases the value of the business and eventually pays-off better.