Financial Management - Meaning, Objectives and Functions

Meaning of Financial Management

Financial Management means planning, organizing, directing and controlling the
financial activities such as procurement and utilization of funds of the enterprise.
It means applying general management principles to financial resources of the
enterprise.
Scope/Elements
1. Investment Decision: The most important decision. It begins with the firm
determining the total amount of assets needed to be held by the firm. There are 2
types of investment decision.
a) Capital Investment Decision: Involves large sums of money. The impact is
critical. Examples: acquire a new machine or to set up a new plant.
b) Working Capital Investment Decision: a more routine or schedule form of
decision. Examples: are determination of the amount of inventories, cash and
account receivables to hold within a certain period.
2. Financial decisions: They relate to the raising of finance from various
resources which will depend upon decision on type of source, period of
financing, cost of financing and the returns thereby.
3. Dividend decision: The finance manager has to take decision with regards to
the net profit distribution. Net profits are generally divided into two: Dividend
for shareholders- Dividend and the rate of it has to be decided. Retained profits-
Amount of retained profits has to be finalized which will depend upon expansion
and diversification plans of the enterprise.
Objectives of Financial Management
The financial management is generally concerned with procurement, allocation
and control of financial resources of a concern. The objectives can be-
1. To ensure regular and adequate supply of funds to the concern.
2. To ensure adequate returns to the shareholders which will depend upon the
earning capacity, market price of the share, expectations of the shareholders.
3. To ensure optimum funds utilization. Once the funds are procured, they should
be utilized in maximum possible way at least cost.
4. To ensure safety on investment, i.e., funds should be invested in safe ventures
so that adequate rate of return can be achieved.
5. To plan a sound capital structure-There should be sound and fair composition
of capital so that a balance is maintained between debt and equity capital.
Functions of Financial Management
1. Estimation of capital requirements: A finance manager has to make
estimation with regards to capital requirements of the company. This will depend
upon expected costs and profits and future programmed and policies of a
concern.
2. Determination of capital composition: Once the estimation has been made,
the capital structure has to be decided. This involves short-term and long-term
debt equity analysis. This will depend upon the proportion of equity capital a
company is possessing and additional funds which have to be raised from outside
parties.
3. Choice of sources of funds: For additional funds to be procured, a company
has many choices like:
a) Issue of shares and debentures
b) Loans to be taken from banks and financial institutions
c) Public deposits to be drawn like in form of bonds.
4. Investment of funds: The finance manager has to decide to allocate funds into
profitable ventures so that there is safety on investment and regular returns is
possible.
5. Disposal of surplus: The net profits decision have to be made by the finance
manager. This can be done in two ways:
a) Dividend declaration: It includes identifying the rate of dividends and other
benefits like bonus.
b) Retained profits: The volume has to be decided which will depend upon
expansion, innovational, diversification plans of the company.
6. Management of cash: Finance manager has to make decisions with regards to
cash management. Cash is required for many purposes like payment of wages
and salaries, payment of electricity and water bills, payment to creditors,
purchase of raw materials, etc.
7. Financial controls: The finance manager has not only to plan, procure and
utilize the funds but he also has to exercise control over finances. This can be
done through many techniques like ratio analysis, financial forecasting, cost and
profit control, etc.
Financial Management in the new millennium:
The focus on value maximization continues as we begin the 21st century.
However, two other trends are becoming increasingly important:
1. The globalization of business and
2. The increased use of information technology.
1. The globalization of business: Four factors have led to the increased
globalization of businesses:
• Improvements in transportation and communications lowered shipping
costs and made international trade more feasible.
• The increasing political clout of consumers, who desire low-cost, high
quality products.
• As technology has become more advanced, the costs of developing new
products have increased. These rising costs have led to joint ventures
between companies.
• In a world populated with multinational firms able to shift production to
wherever costs are lowest.
2. Information technology: As we advance into the new millennium, we will
see continued advances in computer and communications technology, and this
will continue to revolutionize the way financial decisions are made. Computers
are linking networks of personal computers to one another, to the firms' own
mainframe computers, to the internet and to their customers' and suppliers'
computers. Thus, financial managers are increasingly able to share information
and to have face-to-face meetings with distant colleagues through video-
conferencing.
Changing technology provides both opportunities and threats. Improved
technology enables businesses to reduce costs and expand markets. At the same
time, changing technology can introduce additional competition, which may
reduce profitability in existing markets.
Legal forms of organizations: There are three main forms of
business organization:
1. Sole proprietorship is an unincorporated business owned by one individual.
Major advantages are:
• It is easily and inexpensively formed.
• It is subject to few government regulations and
 • The business avoids corporate income taxes.
Major disadvantages are:
• It is difficult for a proprietorship to obtain large sums of capital.
The proprietor has unlimited personal liability for the business debts, which
can result in losses that exceed the money he or she has invested in the
company, and
• The life of a business organized as a proprietorship is limited to the life of
the individual who created it.
2. Partnership is an unincorporated business owned by two or more persons.
Major advantages are:
• It is easily and inexpensively formed.
• The business avoids corporate income taxes.
Major disadvantages are:
• Unlimited liability
• Limited life of the organization
• Difficulty of transferring ownership, and
• Difficulty of raising large amounts of capital.
3. Corporation is a legal entity created by laws, and it is separate and distinct
from its owner and managers.
Major advantages are:
• Unlimited life
• Easy transferability of ownership interest Limited liability
Major disadvantages are:
• Corporate earnings may be subject to double taxation at the corporate level
as well as at the individual level.
• Setting up a corporation is more complex and time consuming.

Goal of a Financial Manager: There are two goals of a financial manager-

1. Profit Maximization
2. Shareholder's' Wealth Maximization
1. Profit Maximization: To achieve the goal of profit maximization the financial
manager takes only those actions that are expected to contribute to the firm's
overall profit.
Companies commonly a measure profit in terms of EPS which is the amount
earned during the accounting period on each outstanding share of common stock
and is calculated as follows:
EPS= (Earnings available to Common stock holders ÷ No. of common stock
outstanding)
A greater EPS does not necessarily mean that the owner will receive a higher
dividend. Furthermore, a higher EPS does not necessarily translate into higher
stock price. If EPS will increase the future cash flows only then the stock price
will increase.
2. Shareholders' Wealth Maximization: The objective of shareholders' wealth
maximization is an appropriate and operationally feasible criterion. The wealth of
owners is generally measured by the share price of the stock. Shareholders'
wealth maximization criterion considers the timing of cash flows, magnitude of
cash flows & risk associated with it. So, when considering any financial decision
alternative, the financial manager should accept only those actions that are
expected to increase share price. Since share price represents the wealth of
owners in a firm, share price maximization is consistent with owners' wealth
maximization. Beside the aforementioned goals there are some other possible
financial goals like- survival, avoiding financial distress & bankruptcy, beating
the competition, minimizing the cost and maintaining steady earnings growth.
Agency Problem: An agency relationship arises whenever one or more
individuals, called owners hire another individual or organization, called agent to
perform some service and delegate decision making authority to that agent. A
characteristic feature of corporate enterprise is the separation between those
owners and agents where the latter enjoys substantial autonomy in regard to the
affairs of the firm. So, there may be a conflict of interest between these two
parties and the potential conflict between owners and managers for their personal
interest is referred as agency problem.
Agency Relationships: In financial management, the primary agency
relationships are those between (1) Stockholders and managers, (2) Stockholders
(through managers) and debt holders.
Conflicts of interest among stockholders, bondholders and managers are called
agency problem. It is assumed that the managers and the shareholder if left alone
will each attempt to act in his or her own self- interest. Which creates the
conflicts of interest can be termed as agency conflicts.
1. Stockholders Vs. managers: In the case of Joint Stock Company,
ownership is separated from management. For this reason, owners directly
cannot take part in management. The responsibility of management is on
the hand of the professional manager. Sometimes professional managers,
give priority of their own interest without consideration to stockholder's
interest. As a result, conflicts of interest between managers and owners are
created.
Resolving the problem:
Most firms today use a package of economic incentives, along with some
monitoring, to influence a manager's performance and thus reduce the agency
problem. The following incentives or factors that motivate managers are
discussed below:
a) Performance-based compensation plans: Managers compensation
usually depends on the company's performance. If any organization is
performing better the manages can be compensated and the compensation
can be in the form of
1. A specified annual salary designed to cover living expenses,
2. A bonus paid at the end of the year which depends on the company's
profitability during the year and,
3. Options to buy stock, or actual shares of stock, which reward the executives
for the firm's long-term performance.
b) Direct intervention by shareholders: Although a great deal of stock is
owned by individuals, an increasing percentage is owned by institutional
investors such as insurance companies, pension funds, and mutual funds.
These institutional investors can enforce a firm's managers for improving
their performance and sometimes give suggestions regarding how the
business should be run.
c) The threat of firing: The CEOs or other top executives can be forced out
of office due to the company's poor performance.
d) The threat of takeover: Hostile takeover is most likely to occur when a
firm's stock is undervalued relative to its potential because of poor
management; the managers of the acquired firm are generally fixed. Thus,
 managers have a strong incentive to take, actions which maximize stock
prices and possible to avoid taking over.
2. Creditors VS Owners:
Creditors want to have principal' and interest payment form owners timely. But
owners are not willing to pay the claim of the creditors from their personal
income if a sufficient amount of profit is not earned by the company. As a result,
conflict arises. Sometimes managers on behalf of shareholders hurt the interest of
bondholders by investing in a highly risky project which is financed
by debt capital.
Hostile Takeover: The acquisition of one company (Called the target company)
by another (Called the acquirer) that is accomplished not by coming to an
agreement with the target company’s management but by going directly to the
company’s shareholders or flighty to replace management in order to get the
acquisition approved.