INTRODUCTION TO FINANCIAL MANAGEMENT

Finance is regarded as the life blood of a business enterprise. This is because

in the modern money-oriented economy, finance is one of the basic
foundations of all kinds of economic activities. Every company requires money
to conduct its business operations and other activities. Every organization
requires finance in its various stages, be it incorporation stage where the
organization needs money to develop the infrastructure or during the
developmental stage, where capital infusion is required to carry on business
processes.

Business concern needs finance to meet their requirements in the economic

world. Any kind of business activity depends on the finance. Hence, it is called
as lifeblood of business organization. Whether the business concerns are big
or small, they need finance to fulfil their business activities.

In the modern world, all the activities are concerned with the economic
activities and very particular to earning profit through any venture or activities.
The entire business activities are directly related with making profit.
(According to the economics concept of factors of production, rent given to
landlord, wage given to labor, interest given to capital and profit given to
shareholders or proprietors), a business concern needs finance to meet all the
requirements. Hence finance may be called as capital, investment, fund etc.,
but each term is having different meanings and unique characters. Increasing
the profit is the main aim of any kind of economic activity.

What Is Finance?
Finance can be defined as the art and science of managing money.
Virtually all individuals and organizations earn or raise money and spend or
invest money. Finance is concerned with the process, institutions, markets,
and instruments involved in the transfer of money among individuals,
businesses, and governments. Finance also is referred as the provision of
money at the time when it is needed. Finance function is the procurement of
funds and their effective utilization in business concerns. The concept of
finance includes capital, funds, money, and amount. But each word is having
unique meaning. Studying and understanding the concept of finance become
an important part of the business concern.

CLASSIFICATION OF FINANCE
Finance is one of the important and integral part of business concerns,
hence, it plays a major role in every part of the business activities. It is used in
all the area of the activities under the different names.
 Public Finance
 Private Finance
 Corporate/Business Finance
 Financial Services
DEFINITION OF FINANCIAL MANAGEMENT

Financial management is an integral part of overall management. It is

concerned with the duties of the financial managers in the business firm.

The term financial management has been defined by Solomon, “It is

concerned with the efficient use of an important economic resource namely,
capital funds”.

The most popular and acceptable definition of financial management

as given by S.C. Kuchal is that “Financial Management deals with
procurement of funds and their effective utilization in the business”.

Howard and Upton : Financial management “as an application of

general managerial principles to the area of financial decision-making.

Weston and Brigham : Financial management “is an area of financial

decision-making, harmonizing individual motives and enterprise goals”.

Joshep and Massie : Financial management “is the operational

activity of a business that is responsible for obtaining and effectively utilizing
the funds necessary for efficient operations.

Thus, Financial Management is mainly concerned with the effective

funds management in the business. In simple words, Financial Management
as practiced by business firms can be called as Corporate Finance or
Business Finance.

It is the planning, directing, monitoring, organizing, and controlling of

the monetary resources of an organization.

Financial Management refers to the management of finance. It is the

effective and efficient utilization of financial resources. Creating balance
among financial planning, procurement of funds, profit administration and
sources of funds.

On the basis of the above definitions, the following are the main
characteristics of the financial management:

Analytical thinking

Continuous
Centralized Nature
Improvement

Basis of
Coordination
Managerial
Between Process
Decisions

Maintaining
Balance Between
Risk and
Profitability
The A’s of Financial Management

NATURE OF FINANCIAL MANAGEMENT

Finance has changed from primarily a descriptive study to one that

encompasses rigorous analysis and normative theory, from a field that was
concerned primarily with the procurement of funds to one that includes the
management of assets, the allocation of capital, and the valuation of the firm
to one that stresses decision making within the firm. Some of the areas that
have contributed to the complexity of modern financial management and
which have contributed to the development of financial management include:

 It is an integral part of overall management

 The Central Focus is the valuation of the firm
 Acquiring the sufficient Funds.
 It involves Risk Return Trade off Decisions.
Affects the Survival, Vitality and Growth of the Firms.
 It is a subsystem of the Business System.
 Proper Utilization of Funds.

SCOPE OF FINANCIAL MANAGEMENT

Estimating Financial Requirement

Deciding Capital Structure

Selecting Source of Finance

Selecting a Pattern of Investment
Proper Cash Management
Implement Financial Control
Effective Use of Surplus
OBJECTIVES OF FINANCIAL MANAGEMENT
Effective procurement and efficient use of finance lead to proper
utilization of the finance by the business concern. It is the essential part of the
financial manager. One of the most important responsibilities of the financial
manager is to determine the basic objectives of the financial management.
Objectives of financial management are two-fold:
• Profit maximization
• Wealth maximization

Objectives

Profit

Wealth

Figure 3. Objectives of Financial Management

This is the main aim of any economic activity to cover its costs/ expenses and
able to have the opportunity for expansion. Some people believe that the
firm’s objective is always to maximize profit. To achieve this goal, the financial
manager would take only those actions that were expected to make a major
contribution to the firm’s overall profits.

Favorable Arguments
 The Barometer for measuring efficiency.
 Profit Reduces risk of a business concern.
 Profit is main source of finance.
 Profit helps to meet social needs.

Unfavorable Arguments
 Profit Maximization leads to exploitation of
Workers and Consumers.
 Profit Maximization Creates immoral activities.
 Profit Maximization leads to inequalities among
stakeholders
Drawbacks of Profit Maximization
 It is Vague
 It ignores the time value of money.
 It ignores risk
 Dividend Policy
2. Wealth Maximization

The goal of the firm, and therefore of all managers and employees, is
to maximize the wealth of the owners for whom it is being operated. The
wealth of corporate owners is measured by the share price of the stock, which
in turn is based on the timing of returns (cash flows), their magnitude, and
their risk.

Favorable Arguments
 Wealth Maximization is superior to the Profit
Maximization.
 It provides exact value of business concern.
 It considers both time and risk.
 Wealth Maximization provides effective allocation
of Resources.
 It ensures economic interest of the Society.
Unfavorable Arguments
 The ultimate aim of the wealth maximization is to
maximize profit.
 Wealth Maximization can be activated only with
the profitable position of the business concern.

APPROACHES TO FINANCIAL MANAGEMENT

Financial management is divided into two approaches which divide the
scope and functions of financial management — traditional and modern
approach.

 Traditional Approach
Under this approach, the main concern is to finance the
Corporate enterprises to raise and administer the funds. In this,
Financing is required for episodic events like incorporation,
Merger, Acquisition, Promotion etc.

 Modern Approach
The modern or new approach is an analytical way of
looking into the financial problems of the firm. In this Approach,
it focus on procurement as well as effective utilization of funds
and considers three basic management decisions, Investment
Decision, Financing Decision and Dividend Decision.

FUNCTIONS OF FINANCE MANAGER IN MODERN AGE

Finance manager is one of the important role players in the field of
finance function. He must have entire knowledge in the area of accounting,
finance, economics and management. His position is highly critical and
analytical to solve various problems related to finance. A person who deals
finance related activities may be called finance manager.
 Finance manager performs the following major functions:
1. Forecasting and Planning
2. Financing Decision
3. Investment Decision
4. Dividend Decision
5. Cash Management
6. Financial Negotiation
7. Evaluating Financial Performance

IMPORTANCE OF FINANCIAL MANAGEMENT

Every business enterprise should maintain sufficient amount of funds
for its smooth functioning. Every concern should also manage its activities to
achieve its objectives and reach its goals. Business’ can only reach their goal
through effective finance management. Some importance of financial
management is as follows:
 Economic Growth and Development
 Improved Standard of Living
 Promotes Efficiency
 Effective Utilization of Funds
 Improve Profitability
 Increase the Value of the Firm

Legal Forms of Business Organization

The three most common legal forms of business organization are the sole
proprietorship, the partnership, and the corporation. Other specialized forms
of business organization also exist. Sole proprietorships are the most
numerous. However, corporations are overwhelmingly dominant with respect
to receipts and net profits. Corporations are given primary emphasis in this
module.

Sole Proprietorships

A sole proprietorship is a business owned by one person who operates

it for his or her own profit. About 75 percent of all business firms are sole
proprietorships. The typical sole proprietorship is a small business, such as a
bike shop, personal trainer, or plumber. The majority of sole proprietorships
are found in the wholesale, retail, service, and construction industries.

Typically, the proprietor, along with a few employees, operates the

proprietorship. He or she normally raises capital from personal resources or
by borrowing and is responsible for all business decisions. The sole proprietor
has unlimited liability; his or her total wealth, not merely the amount originally
invested, can be taken to satisfy creditors. The key strengths and weaknesses
of sole proprietorship are summarized in Table 1.1.
Partnerships

A partnership consists of two or more owners doing business together

for profit. Partnerships account for about 10 percent of all businesses, and
they are typically larger than sole proprietorships. Finance, insurance, and
real estate firms are the most common types of partnership. Public accounting
and stock brokerage partnerships often have large numbers of partners. Most
partnerships are established by a written contract known as articles of
partnership. In a general (or regular) partnership, all partners have unlimited
liability, and each partner is legally liable for all of the debts of the partnership.
Strengths and weaknesses of partnerships are summarized in Table 1.1.

Corporations

A corporation is an artificial being created by law. Often called a “legal

entity,” a corporation has the powers of an individual in that it can sue and be
sued, make and be party to contracts, and acquire property in its own name.
Although only about 15 percent of all businesses are incorporated, the
corporation is the dominant form of business organization in terms of receipts
and profits. It accounts for nearly 90 percent of business receipts and 80
percent of net profits. Although corporations are involved in all types of
businesses, manufacturing corporations account for the largest portion of
corporate business receipts and net profits. The key strengths and
weaknesses of large corporations are summarized in Table 1.1. The owners
of a corporation are its stockholders, whose ownership, or equity, is
evidenced by either common stock or preferred stock.

Other Limited Liability Organizations

A number of other organizational forms provide owners with limited
liability. The most popular are limited partnerships (LPs), S corporations (S
corps), limited liability corporations (LLCs), and limited liability partnerships
(LLPs). Each represents a specialized form or blending of the characteristics
of the organizational forms described before. What they have in common is
that their owners enjoy limited liability, and they typically have fewer than 100
owners. Each of these limited liability organizations is briefly described in
Table 1.2.

The Agency Issue

We have seen that the goal of the financial manager should be to

maximize the wealth of the firm’s owners. Thus managers can be viewed as
agents of the owners who have hired them and given them decision-making
authority to manage the firm. Technically, any manager who owns less than
100 percent of the firm is to some degree an agent of the other owners.

In theory, most financial managers would agree with the goal of owner
wealth maximization. In practice, however, managers are also concerned with
their personal wealth, job security, and fringe benefits. Such concerns may
make managers reluctant or unwilling to take more than moderate risk if they
perceive that taking too much risk might jeopardize their jobs or reduce their
personal wealth. The result is a less-than-maximum return and a potential
loss of wealth for the owners.

The Agency Problem

From this conflict of owner and personal goals arises what has been called
the agency problem, the likelihood that managers may place personal goals
ahead of corporate goals. Two factors—market forces and agency costs—
serve to prevent or minimize agency problems.
Market Forces One market force is major shareholders, particularly
large institutional investors such as mutual funds, life insurance companies,
and pension funds. These holders of large blocks of a firm’s stock exert
pressure on management to perform. When necessary, they exercise their
voting rights as stockholders to replace under performing management.
Another market force is the threat of takeover by another firm that
believes it can enhance the target firm’s value to restructuring its
management, operations, and financing. The constant threat of a takeover
tends to motivate management to act in the best interests of the firm’s
owners.

Agency Costs To minimize agency problems and contribute to the

maximization of owners’ wealth, stockholders incur agency costs. These are
the costs of monitoring management behavior, ensuring against dishonest
acts of management, and giving managers the financial incentive to maximize
share price.

The most popular, powerful, and expensive approach is to structure

management compensation to correspond with share price maximization. The
objective is to give managers incentives to act in the best interests of the
owners. In addition, the resulting compensation packages allow firms to
compete for and hire the best managers available. The two key types of
compensation plans are incentive plans and performance plans.
Incentive plans tend to tie management compensation to share price.
The most popular incentive plan is the granting of stock options to
management. These options allow managers to purchase stock at the market
price set at the time of the grant. If the market price rises, managers will be
rewarded by being able to resell the shares at the higher market price.

Many firms also offer performance plans, which tie management

compensation to measures such as earnings per share (EPS), growth in EPS,
and other ratios of return. Performance shares, shares of stock given to
management as a result of meeting the stated performance goals, are often
used in these plans. Another form of performance-based compensation is
cash bonuses, cash payments tied to the achievement of certain performance
goals.

ACTIVITY

Answer the following:

1. The modern approach is an improvement over the traditional approach of

financial management” . Do you Agree?

2. What factors do you think have accounted for the growth of financial
management?

3. What are the major differences between accounting and finance with
respect to emphasis on cash flows and decision making?

4. Define agency costs, and explain why firms incur them. How can
management structure management compensation to minimize agency
problems? What is the current view with regard to the execution of many
compensation plans?