Nature of Financial Management: Finance management is a long term decision making process which involves

lot of planning, allocation of funds, discipline and much more. Let us understand the nature of financial
management with reference of this discipline. 1. Finance management is one of the important education
which has been realized word wide. Now a day’s people are undergoing through various specialization courses
of financial management. Many people have chosen financial management as their profession. 2. The nature
of financial management is never a separate entity. Even as an operational manager or functional manager one
has to take responsibility of financial management. 3. Finance is a foundation of economic activities. The
person who Manages finance is called as financial manager. Important role of financial manager is to control
finance and implement the plans. For any company financial manager plays a crucial role in it. Many times it
happens that lack of skills or wrong decisions can lead to heavy losses to an organization. 4. Nature of financial
management is multi-disciplinary. Financial management depends upon various other factors like: accounting,
banking, inflation, economy, etc. for the better utilization of finances. 5. Approach of financial management is
not limited to business functions but it is a backbone of commerce, economic and industry.

Nature or Features or Characteristics of Financial Management

Nature of financial management is concerned with its functions, its goals, trade-off with conflicting
goals, its indispensability, its systems, its relation with other subsystems in the firm, its environment,
its relationship with other disciplines, the procedural aspects and its equation with other divisions
within the organisation.

1. Financial Management is an integral part of overall management. Financial considerations are

involved in all business decisions. So financial management is pervasive throughout the organisation.

2. The central focus of financial management is valuation of the firm. That is financial decisions are
directed at increasing/maximization/ optimizing the value of the firm.

3. Financial management essentially involves risk-return trade-off Decisions on investment involve

choosing of types of assets which generate returns accompanied by risks. Generally higher the risk,
returns might be higher and vice versa. So, the financial manager has to decide the level of risk the
firm can assume and satisfy with the accompanying return.

4. Financial management affects the survival, growth and vitality of the firm. Finance is said to be the
life blood of business. It is to business, what blood is to us. The amount, type, sources, conditions and
cost of finance squarely influence the functioning of the unit.

5. Finance functions, i.e., investment, rising of capital, distribution of profit, are performed in all firms -
business or non-business, big or small, proprietary or corporate undertakings. Yes, financial
management is a concern of every concern.

6. Financial management is a sub-system of the business system which has other subsystems like
production, marketing, etc. In systems arrangement financial sub-system is to be well-coordinated
with others and other sub-systems well matched with the financial subsystem.

Importance Of Financial Management

Financial management is important mainly because it helps to make decisions towards the
maximization of value of the firm . The importance of financial management to a firm are as
follows:

1. Financial Management Helps Setting Clear Goal

Clarity of the goal is important for any firm. Financial management defines the goal of the
firm in clear terms (maximization of the shareholders wealth). Setting goal helps to judge
whether the decisions taken are in the best interest of the shareholders or not. Financial
management also direct the efforts of all functional areas of business towards achieving the
goal and facilitates among the functional areas of the firm.

2. Financial Management Helps Efficient Utilization Of Resources

Firms use fixed as well as current assets which involve huge investment. Acquiring and
holding assets that do not earn minimum return do not add value to the shareholders.
Moreover, wrong decision regarding the purchase and disposal of fixed assets can cause
threat to the survival of the firm. The application of financial management techniques (such
as capital budgeting techniques) helps to answer the questions like which asset to buy, when
to buy and whether to replace the existing asset with new one or not.
The firm also requires current assets for its operation. They absorb significant amount of
a firm'sresources. Excess holdings of these assets mean inefficient use and inadequate
holding exposes the firm into higher risk. Therefore, maintaining proper balance of these
assets and financing them from proper sources is a challenge to a firm. Financial
management helps to decide what level of current assets is to be maintained in a firm and
how to finance them so that these assets are utilized efficiently.

3. Financial Management Helps Deciding Sources Of Financing

Firms collect long-term funds mainly for purchasing permanent assets. The sources of long
term finance may be equity shares, preference shares, bond, term loan etc. The firm needs to
decide the appropriate mix of these sources and amount of long-term funds; otherwise the
firm will have to bear higher cost and expose to higher risk. Financial management
(capital structure theories) guides in selecting these sources of financing.

4. Financial Management Helps Making Dividend Decision

Dividend is the return to the shareholders. The firm is not legally obliged to pay dividend to
the shareholders. However, how much to pay out of the earning is a vital issue. Financial
management (dividend policies and theories) helps a firm to decide how much to pay as
dividend and how much to retain in the firm. It also suggests answering questions such as
when and in what form (cash dividend or stock dividend) should the dividend be paid?

The importance of financial management is not limited to the managers who make decisions
in the firm. Proper financial management will help firms to supply better product to its
customers at lower prices, pay higher salary to its employees and still provide greater return
to investors.

Relationship of Finance to Economics:

There are two essential linkages between economics and finance. The
macroeconomic environment defines the setting within which a firm operates
and the microeconomic theory provides the conceptual underpinning for the
tools of final decision-making.

Key macroeconomic factors like the growth rate of the economy, the domestic
savings rate, the role of the government in economic affairs, the tax environment,
the nature of external economic relationships, the availability of funds to the
corporate sector, the rate of inflation, the real rate of interest and the terms on
which the firm can raise finances define the environment in which the firm
operates. No financial manager can afford to ignore the key developments in the
macroscopic sphere and the impact of the same on the firm.

While an understanding of the macroeconomic developments

sensitizes the financial manager to the opportunities and threats in the market
environment, a firm grounding in macroeconomic principles sharpens their
analysis of decision alternatives. Finance, in essence, is applied microeconomics
according to which a decision should be guided by a comparison of incremental
benefits and costs – applies to some managerial decisions in finance.
A basic knowledge of macroeconomics is necessary for understanding the
environment in which the firm operates and a good grasp of microeconomic
principles is helpful in sharpening the tools of financial decision-making.

Relationship of Finance to Accounting:

The finance and accounting functions are closely related and almost invariably
fall within the domain of the chief financial officer. Given this affinity, it is not
surprising that in popular perception finance and accounting are more often
considered indistinguishable or at least substantially overlapping. However, a
student of finance should know how the two differ and how the two relate.

The following discussion highlights the differences and relationship

between the two.
1. Scorekeeping vs value maximizing:
Accounting is concerned with scorekeeping, whereas finance is aimed at value
maximizing. The primary aim of accounting is to measure the performance of the
firm, assess its financial condition and find the base for tax payment. The
principal goal of financial management is to create shareholders value by
investing in positive net present value projects and minimizing the cost of
financing. Of course, financial decision making requires considerable inputs from
accounting. As Gitman says: ” The accountant’s role is to provide consistently
developed and easily interpreted data about the firm’s past, present and future
operations. The financial manager uses these data, either in raw form or after
certain adjustments and analyses, as an important input to the decision-making
process.

2. Accrual method vs cash flow method:

The accountant prepares the accounting reports based on the accrual method
recognizes revenues when the sale occurs (irrespective of whether cash is paid
or not). The focus of the financial manager, however, is on cash flows. He is
concerned about the magnitude, timing and risk of cash flows as these are the
fundamental determinants of values.

3. Certainty vs Uncertainty:
Accounting deals primarily with the past. It records what has happened. Hence, it
is characterized by a high degree of subjectivity.

All businesses aim to maximize their profits, minimize their expenses and maximize
their market share. Here is a look at each of these goals. 
 Maximize Profits A company's most important goal is to make money and keep it.
Profit-margin ratios are one way to measure how much money a company squeezes
from its total revenue or total sales.

There are three key profit-margin ratios: gross profit margin, operating profit margin
and net profit margin. 

1. Gross Profit Margin 

The gross profit margin tells us the profit a company makes on its cost of sales or
cost of goods sold. In other words, it indicates how efficiently management uses
labor and supplies in the production process.

Gross Profit Margin = (Sales - Cost of Goods

Sold)/Sales
 Suppose that a company has $1 million in sales and the cost of its labor and
materials amounts to $600,000. Its gross margin rate would be 40% ($1 million -
$600,000/$1 million).

The gross profit margin is used to analyze how efficiently a company is using its raw
materials, labor and manufacturing-related fixed assets to generate profits. A higher
margin percentage is a favorable profit indicator.

Gross profit margins can vary drastically from business to business and from industry
to industry. For instance, the airline industry has a gross margin of about 5%, while
the software industry has a gross margin of about 90%.

2. Operating Profit Margin

By comparing earnings before interest and taxes (EBIT) to sales, operating
profit margins show how successful a company's management has been at
generating income from the operation of the business:

Operating Profit Margin = EBIT/Sales


If EBIT amounted to $200,000 and sales equaled $1 million, the operating profit
margin would be 20%. 

This ratio is a rough measure of the operating leverage a company can achieve in
the conduct of the operational part of its business. It indicates how much EBIT is
generated per dollar of sales. High operating profits can mean the company has
effective control of costs, or that sales are increasing faster than operating
costs. Positive and negative trends in this ratio are, for the most part, directly
attributable to management decisions.

Because the operating profit margin accounts for not only costs of materials and
labor, but also administration and selling costs, it should be a much smaller figure
than the gross margin. 

3. Net Profit Margin

Net profit margins are those generated from all phases of a business, including
taxes. In other words, this ratio compares net income with sales. It comes as close as
possible to summing up in a single figure how effectively managers run the business:
 Net Profit Margins = Net Profits after Taxes/Sales
 If a company generates after-tax earnings of $100,000 on its $1 million of sales, then
its net margin amounts to 10%.

Often referred to simply as a company's profit margin, the so-called bottom line is the
most often mentioned when discussing a company's profitability.

Again, just like gross and operating profit margins, net margins vary between
industries. By comparing a company's gross and net margins, we can get a good
sense of its non-production and non-direct costs like administration, finance and
marketing costs.

For example, the international airline industry has a gross margin of just 5%. Its net
margin is just a tad lower, at about 4%. On the other hand, discount airline
companies have much higher gross and net margin numbers. These differences
provide some insight into these industries' distinct cost structures: compared to its
bigger, international cousins, the discount airline industry spends proportionately
more on things like finance, administration and marketing, and proportionately less
on items such as fuel and flight crew salaries.

In the software business, gross margins are very high, while net profit margins are
considerably lower. This shows that marketing and administration costs in this
industry are very high, while cost of sales and operating costs are relatively low.

When a company has a high profit margin, it usually means that it also has one or
more advantages over its competition. Companies with high net profit margins have a
bigger cushion to protect themselves during the hard times. Companies with low
profit margins can get wiped out in a downturn. And companies with profit margins
reflecting a competitive advantage are able to improve their market share during the
hard times, leaving them even better positioned when things improve again.

Like all ratios, margin ratios never offer perfect information. They are only as good as
the timeliness and accuracy of the financial data that gets fed into them, and
analyzing them also depends on a consideration of the company's industry and its
position in the business cycle. Margins tell us a lot about a company's prospects, but
not the whole story. 

Minimize Costs
Companies use cost controls to manage and/or reduce their business expenses. By
identifying and evaluating all of the business's expenses, management can
determine whether those costs are reasonable and affordable. Then, if necessary,
they can look for ways to reduce costs through methods such as cutting back,
moving to a less expensive plan or changing service providers. The cost-control
process seeks to manage expenses ranging from phone, internet and utility bills to
employee payroll and outside professional services.

To be profitable, companies must not only earn revenues, but also control costs. If
costs are too high, profit margins will be too low, making it difficult for a company to
succeed against its competitors. In the case of a public company, if costs are too
high, the company may find that its share price is depressed and that it is difficult to
attract investors.
When examining whether costs are reasonable or unreasonable, it's important to
consider industry standards. Many firms examine their costs during the drafting of
their annual budgets.

Maximize Market Share

Market share is calculated by taking a company's sales over a given period and
dividing it by the total sales of its industry over the same period. This metric provides
a general idea of a company's size relative to its market and its competitors.
Companies are always looking to expand their share of the market, in addition to
trying to grow the size of the total market by appealing to larger demographics,
lowering prices or through advertising. Market share increases can allow a company
to achieve greater scale in its operations and improve profitability.

The size of a market is always in flux, but the rate of change depends on whether the
market is growing or mature. Market share increases and decreases can be a sign of
the relative competitiveness of the company's products or services. As the total
market for a product or service grows, a company that is maintaining its market share
is growing revenues at the same rate as the total market. A company that is growing
its market share will be growing its revenues faster than its competitors. Technology
companies often operate in a growth market, while consumer goods companies
generally operate in a mature market.

New companies that are starting from scratch can experience fast gains in market
share. Once a company achieves a large market share, however, it will have a more
difficult time growing its sales because there aren't as many potential customers
available. 

Next we'll take a look at the potential conflicts of interest that can arise in the
management of a business's finances.