INTRODUCTION TO FINANCIAL MANAGEMENT

FINANCIAL MANAGEMENT
Financial Management is that branch of business management process, which deals with
management of financial resources of an enterprise. Financial management is the skillful and
proper management of financial resources. In other words, financial management is the
process of planning, organising, directing, and controlling the financial activities, i.e.
procurement and utilization of funds.
Definition
Financial management is concerned with optimal procurement as well as usage of finance.
According to Solomon, "Financial management is concerned with the efficient use of an
important economic resource, namely, Capital Funds".
According to Howard and Upton, "Financial management is the application of the planning
and control functions of the finance functions".
FEATURES OF FINANCIAL MANAGEMENT
1. It involves management of financial resources.
2. It relates to planning, raising, acquiring, administrating, disbursing and controlling of
finance.
3. It helps in meeting overall objectives of the organisation.
4. It requires at all levels and all types of organisations.
5. It provides sense of financial security and safety.
Scope of Financial Management

Financial management encompasses four major areas:

1. Planning
The financial manager projects how much money the company will need in order to
maintain positive cash flow, allocate funds to grow or add new products or services and
cope with unexpected events, and shares that information with business colleagues.

2. Budgeting
The financial manager allocates the company’s available funds to meet costs, such as
mortgages or rents, salaries, raw materials, employee T&E and other obligations.
Ideally there will be some left to put aside for emergencies and to fund new business
opportunities.

3. Managing and assessing risk

The financial managers to assess and provide compensating controls for a variety of risks,
including:

4. Procedures
The financial manager sets procedures regarding how the finance team will process and
distribute financial data, like invoices, payments and reports, with security and accuracy. These
written procedures also outline who is responsible for making financial decisions at the
company — and who signs off on those decisions.

Traditional and modern approach of financial management

Traditional approach

The traditional approach to financial management was primarily focused on earning more
funds to grow the business. Companies following the traditional method usually implement the
following measures to maximise their profits:

• Maintain accounting and legal relationships between investors (source of funds) and
the firm
• Gather and connect with sources of finance from various services or products
• Collect funds from the capital market
The traditional approach does not pay much importance to a company’s requirement for
external funding. This process also includes preparing and preserving a company’s financial
reports. The financial management team also worked to manage a company’s cash level to
meet its daily obligations.
Modern approach
Unlike the traditional approach, modern financial management considers the procurement and
effective utilisation of funds. It takes into consideration the internal parties and problems that
affect an organisation. Modern financing mainly focuses on three questions to overcome the
shortcomings of traditional financing:
• What is the total quantum of funds that a company needs to commit?
• What assets should a company acquire?
• What initiatives should a company take to finance the required funds?
A finance manager makes the mentioned decisions in favour of the company by following the
modern financing approach.
Objectives of financial management
The main objectives of financial management are
1) Profit maximisation , and
2) Wealth maximisation
1) Profit maximisation
According to this viewpoint, the objective of an enterprise is to maximise profits. When
a finance manager considers investment, financing and other related decisions, he
should select that alternative which may maximise profit or reduce cost. In other words,
all such activities which may increase profit should be undertaken and those which
reduce profit should be avoided. A firm can maximise its profits by maximising output
for a given input or uses minimum inputs for producing a given output. Thus, it relates
to optimising the input-output relationships of resources to minimise the wasteful cost.
2) Wealth Maximization
Another alternate objective of financial management is to maximize the wealth or value
or net present worth. The financial manager of a firm makes decisions for the
shareholders of the firm. Thus, from the shareholders' point of view, a good decision
increases the value of their shares and a bad decision reduces it. The word 'wealth' or
value signifies worth to the owners of the business. It may be market price of equity
shares or net worth of the enterprise in terms of net present value (NPV). Value
maximization goal is based on the cash inflows and outflows. Thus, according to wealth
maximization objective, business operations should be conducted in such a way as to
ensure maximum net present value to the shareholders.
Profit maximisation Vs Wealth maximisation
Basis Profit maximisation Wealth maximisation
1. Concept A firm should produce A firm should maximise
maximum output for a the wealth by increasing
given input or uses the future cash inflows
minimum input for a
given output
2. Purpose To maximise earnings of To maximise the wealth
the shareholders of shareholders
3. Rationality Need for maximum Need for enhancing
profit for survival and shareholder’s wealth as
growth a gratitude for their
commitment of funds
4. Time span The concept relates to The concept is a long
relatively shorter period term one
 5. Time value Does not consider time Consider time value of
value of money money
6. Immediate Management Shareholders
beneficiaries
7. Clarity Ignores risk factor and Considers risk element
the concept is vague and wealth is clearly
defined

Finance Function
The finance function deals not only with the attainment of funds, but it also deals with the
utilisation of funds. Financial management deals with solving three main finance-related
problems faced by a firm. These three problems relate to investment, financing and dividend.
According to the modern definition, following are the main functions performed by modern
financial management (Financial Decisions): 1. Investment decision, 2. Financing decision,
and 3. Dividend decision.
Investment Decisions
The investment decision is concerned with the identification of assets which require
investment. Assets are classified into two categories as below: 1. Long-Term Assets: They are
the assets which are expected to create value for a long period of time. Generally, this time
period is longer than one year. They are also known as fixed assets. 2. Short-Term Assets: They
are also known as current assets. These assets are expected to be converted into cash in less
than a year. Financial management concerns itself with the financing of both kinds of assets.
The part of financial management dealing with current assets is known as working capital
management while capital budgeting part of financial management is concerned with long-
term assets. Investment decisions may be classified into two main categories, i.e. Capital
Budgeting Decisions and Working Capital Decisions 1. Capital Budgeting Decisions: Capital
Budgeting is defined as the process by which a business determines which fixed asset purchases
or project investments are acceptable and which are not. Capital budgeting decisions are one
of the most important decisions taken by a firm as these decisions may determine the long-term
financial health of a firm. These decisions involve analysis of various alternatives available and
determining the best alternatives for investment. 2. Working Capital Decisions: Working capital
decisions are short-term in nature. A business needs to properly manage its short term working
capital requirements in order to remain profitable and liquid. An efficient firm maintains an
optimal mix of profitability and liquidity. However, profitability and liquidity are inversely
related.
Financing Decision:
Financing decisions refers to the decisions regarding the procurement of funds required for a
firm. There are different sources which a finance manager can explore, for meeting the fund
requirements. The most crucial and difficult aspect of financing decision is determination of
the combination of ownership capital (equity) and borrowed capital. The debt equity mix is
often called the capital structure. When a firm uses more amount of debt capital, the risk
element also increases. Therefore the financial manager must decide the optimum level of
borrowed funds which can be safely infused into the capital structure of the firm.
Dividend Decision:
Dividend decision is another important decision that needs to be taken by a finance manager.
A finance manager can either choose to retain the business profits for future or may decide to
distribute them among various stakeholders. Thus, a finance manager needs to decide whether
to retain or distribute the firm's profits. Usually, the firm distributes dividend in constant
situation for fulfilling the demand of shareholders and rest is kept in the firm for growth. The
distribution of dividend shareholders will increase the goodwill of the firm among the
shareholders. The non-declaration of dividend affects the market price of the firm's equity
share.

RISK AND RETURN

Risk may be defined as the possibility of suffering an injury or loss. In the context of 'Business
or Financial World', it represents the uncertainty associated with an investment. In other words,
risk is the possibility that the actual return on an investment may be different from the expected
return. Type of Risks
1. Systematic Risk and 2. Unsystematic Risk
Systematic Risk
The risk, which is inherent to the entire market or system, is termed 'Systematic Risk' as or
'Uncontrollable Risk'. It is also referred to as "Un diversifiable Risk," as it affects the entire
market and not one specific stock or industry. Further, it is associated with economic, social,
political and legal aspects of all the securities in the economy. 'Systematic Risk' is
unpredictable. "Systematic Risk' is classified into following sub-categories:
i. Market Risk: Market risk is the risk that the value of an investment will decrease
due to movements in market factors.
ii. Interest Rate Risk: Interest rate risk is the possibility of an unexpected change in
interest rates prevailing in the market, which affects the value of an investment
adversely.
iii. Purchasing Power Risk: 'Purchasing power risk' is the possible reduction in the
purchasing power of the expected returns.
Unsystematic Risk
It is also known as 'Diversifiable Risk', as it can be managed and controlled. Unsystematic
risk can be eliminated by diversification. This risk represents the fluctuation in return of a
security due to specific to a particular firm only. Unsystematic Risk' may be specific to an
industry or company and is caused due to one or more of the following:
i. Lack of managerial ability,
ii. Technological advancement in the process of production,
iii. Procurement of raw material,
iv. Lack of human resources, and
v. Change in consumer preferences.