Session objectives

By the end of this session, learners should be able to:

(i) Define financial management
(ii) Explain the nature of financial management
(iii) Explain the key areas of financial management
(iv) Explain the role of financial management in an organization
(v) Explain the main objectives of financial management.

1.2 Meaning of Financial management

What is Finance?

One may view “finance” more generally (that is, the financial sector or system) as an extension
of the monetary system. It is typically said that the financial sector has two main functions: (1) to
maintain an effective payments system; and (2) to facilitate an efficient use of money. The latter
function can be broken down further into two parts. First, to bring together those with excess
money (savers, investors) and those without it (borrowers, enterprises), which is typically done
through financial intermediation (the inner workings of banks) or financial markets (such as
stock or bond markets). Second, to create opportunities for market participants to buy and sell
money, which is typically done through the invention of financial products, or “assets”, with
features distinguished by different levels of risk, return, and maturation.

The modern financial system can thus be seen as an infrastructure built to facilitate transactions
of money and other financial assets, as noted at the outset. It is important to note that it contains
both private elements (such as commercial banks, insurance companies, and investment funds)
and public elements (such as central banks and regulatory authorities). “Finance” can also refer
to the systematic study of this system; most often to the field of financial economics

Finance is defined as the provision of money at the time when it is required. Every enterprise,
whether big, medium, small, needs finance to carry on its operations and to achieve its target. In
fact, finance is so indispensable today that it is rightly said to be the blood of an enterprise.
Without adequate finance, no enterprise can possibly accomplish its objectives.

Financial Management is the application of the general management principles in the area of
financial decision-making, namely in the area s of investment of funds, financing various
activities, and disposal of profits. It is concerned with the managerial decisions that result in the
acquisition and financing of long-term and short-term credits for the firm. As such it deals with
the situations that require selection of specific assets / combination of assets, the selection of
specific liability / combination of liabilities as well as the problem of size and growth of an
enterprise. The main objective of financial management is to ensure that the firm has enough
cash to enable it carry out its activities effectively and efficiently.

FINANCIAL MANAGEMENT

IS CONCERNED WITH

FINANCIAL DECISIONS INVESTMENT ANALYSIS DIVIDENDS DECISIONS

ANALYSIS

RISK AND RETURN ANALYSIS

TO ACHIEVE THE GOAL OF

PROFIT MAXIMIZATION WEALTH MAXIMIZATION.

1.3 Nature of Financial Management

Financial management is applicable to every type of economic entity, irrespective of the size,
kind or nature. Every economic entity aims to utilize its resources in a best possible and
profitable way.
i) Financial Management is an integral part of overall management. Financial considerations are
involved in all business decisions. Acquisition, maintenance, removal or replacement of assets,
employee compensation, sources and costs of different capital, production, marketing, finance
and personnel decision, almost all decisions for that matter have financial implications.
Therefore, financial management is pervasive throughout the organisation.
ii) The central focus of financial management is valuation of the firm. Financial decisions are
directed at increasing/maximization/ optimizing the value of the institution.
iii) 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. Similarly,
cheaper sources of capital have other disadvantages. So to avail the benefit of the low cost funds,
the firm has to put up with certain risks, so, risk-return trade-off is there throughout.
 iv) Financial management affects the survival, growth and vitality of the institution. Finance is
said to be the life blood of institutions. The amount, type, sources, conditions and cost of finance
squarely influence the functioning of the institution.
v) Finance functions, i.e., investment, raising of capital, distribution of profit, are performed in
all firms - business or non-business, big or small, proprietary or corporate undertakings.
Financial management is a concern of every concern including educational institutions.
vi) Financial management is a sub-system of the institutional system which has other subsystems
like academic activities, research wing, etc., In systems arrangement financial sub-system is to
be well coordinated with others and other sub-systems well matched with the financial sub-
system. vii) Financial management of an institution is influenced by the external legal and
economic environment. The legal constraints on using a particular type of funds or on investing
in a particular type of activity, etc., affect financial decisions of the institution. Financial
management is, therefore, highly influenced/constrained by external environment.
viii) Financial management is related to other disciplines like accounting, economics, taxation,
operations research, mathematics, statistics etc., It draws heavily from these disciplines.
ix) There are some procedural finance functions - like record keeping, credit appraisal and
collection, inventory replenishment and issue, etc., these are routinized and are normally
delegated to bottom level management executives.
x) The nature of finance function is influenced by the special characteristic of the business. In a
predominantly technology oriented institutions like CSIR, CECRI, it is the R & D functions
which get more dominance, while in a university or college the different courses offered and
research which get more priority and so on.
1.4 Financial Management – Key Areas
The key areas of financial management are:
(i) Estimating the Capital requirements of the concern. The Financial Manager should exercise
maximum care in estimating the financial requirement of his firm. To do this most effectively, he
will have to use long-range planning techniques. This is because, every business enterprise
requires funds not only for long-term purposes for investment in fixed assets, but also for short
term so as to have sufficient working capital. He can do his job properly if he can prepare
budgets of various activities for estimating the financial requirements of his enterprise.
Carelessness in this regard is sure to result in either deficiency or surplus of funds. If his concern
is suffering because of insufficient capital, it cannot successfully meet its commitments in time,
whereas if it has acquired excess capital, the task of managing such excess capital may not only
prove very costly but also tempt the management to spend extravagantly.
(ii) Determining the Capital Structure of the Enterprise. The Capital Structure of an enterprise
refers to the kind and proportion of different securities. The Financial Manager can decide the
kind and proportion of various sources of capital only after the requirement of Capital Funds has
been decided. The decisions regarding an ideal mix of equity and debt as well as short-term and
long-term debt ratio will have to be taken in the light of the cost of raising finance from various
sources, the period for which the funds are required and so on. Care should be taken to raise
sufficient long-term capital in order to finance the fixed assets as well as the extension
programme of the enterprise in such a wise manner as to strike an ideal balance between the
own funds and the loan funds of the enterprise.
(iii) Deciding the pattern of investment of funds. The Financial Manager must prudently invest
the funds procured, in various assets in such a judicious manner as to optimise the return on
investment without jeopardising the long-term survival of the enterprise.
Two important techniques—
(i) Capital Budgeting; and (ii) Opportunity Cost Analysis—can guide him in finalising the
investment of long-term funds by helping him in making a careful assessment of various
alternatives. A portion of the long-term funds of the enterprise should be earmarked for
investment in the company's working capital also. He can take proper decisions regarding the
investment of funds only when he succeeds in striking an ideal balance between the conflicting
principles of safety, profitability and liquidity. He should not attach all the importance only to
the canon of profitability. This is particularly because of the fact that the company’s solvency
will be in jeopardy, in case major portion of its funds are locked up in highly profitable but
totally unsafe projects. .
(iv) Distribution of Surplus judiciously. The Financial Manager should decide the extent of the
surplus that is to be retained for ploughing back and the extent of the surplus to be distributed as
dividend to shareholders. Since decisions pertaining to disposal of surplus constitute a very
important area of Financial Management, he must carefully evaluate such influencing factors as
—(a) the trend of earnings of the company; (A) the trend of the market price of its shares; (c) the
extent of funds required for meeting the self-financing needs of the company; (d) the future
prospects; (e) the cash flow position, etc.
(v) Efficient Management of cash. Cash is absolutely necessary for maintaining enough
liquidity. The Company requires cash to—(a) pay off creditors; (b) buy stock of materials; (c)
make payments to labourers; and (d) meet routine expenses. It is the responsibility of the
Financial Manager to make the necessary arrangements to ensure that all the departments of the
Enterprise get the required amount of cash in time for promoting a smooth flow of all operations.
Short-age of cash on any particular occasion is sure to damage the credit- worthiness of the
enterprise. At the same time, it is not advisable to keep idle cash also. Idle cash should be
invested in near-cash assets that are capable of being converted into cash quickly without any
loss during emergencies. The exact requirements of cash during various periods can be assessed
by the Financial Manager by preparing a cash-flow statement in advance.

1.5 Functions of Financial Management

A financial manager has to concentrate on the following areas of the finance function.
1. Estimating Financial Requirements:
The first task of the financial manager is to estimate short term and long-term financial
requirement of his business. For this purpose, he will prepare a financial plan for present as well
as future. The amount required for purchasing fixed assets as well as the need
s of funds for working capital has to be ascertained. The estimation should be based on the sound
financial principles so that neither there are inadequate or excess funds with the concern. The
inadequacy will affect the working of the concern and excess funds may tempt a management to
indulge in extravagant spending.
2. Deciding Capital Structure:
The capital structure refers to the kind and proportion of the different securities for raising funds.
After deciding about the quantum of funds required it should be decided which type of security
should be raised. It may be wise to finance fixed securities through long term debts. Long-term
funds should be employed to finance working capital also. Decision about various sources of
funds should be linked to cost of raising funds. If cost of rising funds is high, then such sources
may not be useful. A decision about the kind of the securities to be employed and the proportion
in which these should be used is an important decision which influences the short term and the
long term planning of the enterprise.

3. Selecting a Source of Finance:

After preparing a capital structure, an appropriate source of finance is elected. Various sources
from which finance may be raised, includes share capital, debentures, financial deposits etc. If
finance is needed for short periods then banks, public’s deposits, financial institutions may be
appropriate. If long-term finance is required the share capital, debentures may be useful.

4. Selecting a Pattern of Investment:

When fund have been procured then a decision about investment pattern is to be taken. The
selection of investment pattern is related to the use of the funds. A decision has to be taken as to
which assets are to be purchased? The fund will have to be spent first. Fixed asset and the
appropriate portion will be retained for the working capital. The decision making techniques
such as capital Budgeting, opportunity cost analysis may be applied in making decision about
capital expenditures. While spending in various assets, the principles of safety, profitability, and
liquidity should not be ignored.
5. Proper Cash Management:
Cash management is an important task of financial manager. He has to assess the various cash
needs at different times and then make arrangements for arranging cash. Cash may be required to
make payments to creditors, purchasing raw material, meet wage bills, and meet day to day
expenses. The sources of cash may be Cash sales, Collection of debts, Short-term arrangement
with the banks. The cash management should be such that neither there is shortage of it and nor
it is idle. Any shortage of cash will damage the creditworthiness of the enterprise. The idle cash
with the business mean that it is not properly used. Through Cash Flow Statement one is able to
find out various sources and applications of cash.

6. Implementing Financial Controls:

An efficient system of financial management necessitates the use of various control devices.
Financial control device generally used are;
a. Return Investment
b .Ratio analysis
c. Break even analysis
d. Cost control
e. Cost and internal audit.

7. The use of various control techniques:

This will help the financial manager in evaluating the performance in various Areas and take
corrective measures whenever needed.

8. Proper use of Surpluses:

The utilization of profits or surpluses as also an important factor in financial management. A
judicious use of surpluses is essential for the expansion and diversification plans and also
protecting the interest of the shareholders. The ploughing back of profit is the best policy of
further financing. A balance should be struck in using the funds for paying dividends and
retaining earnings for financing expansion plans.

Financial Management as Science or Art

Financial management is both a science and an art. Its nature is nearer to applied sciences as it
envisages use of classified and tested knowledge as a help in practical affairs and solving
business. Theory of financial management is based on certain systematic principles, some of
which can be tested in mathematical equations like the law of physics and chemistry. Financial
management contains a much larger body of rules or tendencies that hold true in genera! and on
the average. The use of computers, operations research, statistical techniques and econometric
models find wide application in financial management as tools for solving corporate 40 financial
problems like budgeting, choice of investments, acquisition or mergers etc. This takes the
financial management nearer to treatment as a subject of science. Most practical problems of
finance have no hard and fast answers that can be worked out mathematically or programmed on
a computer. They must be solved by judgment, intuition and the "feel" of experience. Thus,
despite its frequent acceptance as an applied science, finance remains largely an art. Because,
according to George A. Christy and Feyton Foster Roden (Finance: Environment and Decisions)
knowledge of facts, principles and concepts is necessary for making decisions but personal
involvement of the manager through his intuitive capacities and power of judgment becomes
essential. As the application of human judgement and skills is also required for effective
financial management, financial management is also an art. In the entire study of financial
management whether it is related to investment decisions, financing decisions i.e. deciding about
the sources of financing, or dividend decisions, there is a mixture of science as well as art. When
techniques for analytical purposes are used, it is science and when choice is application of the
results it is an art.

1.6 Objectives /Goals of Financial Management

Goals act as motivators, serve as the standards for measuring performance, help in coordination
of multiplicity of tasks, facilitate in identifying inter departmental relationships and so on. The
goals can be classified as official goals, operative goals and operational goals.
The main objective f a business is tom maximize the owner’s economic welfare. Financial
management provides a framework for selecting a proper course of action and deciding a
commercial strategy.
The objectives can be achieved by:
(i) Profit maximization
(ii) Wealth maximization

Profit Maximization:
Profit earning is the main aim of every economic activity. A business being an economic
institution must earn profit to cover its costs and provide funds for growth. No business can
survive without earning profit. Profit is a measure of efficiency of a business enterprise. Profit
also serves as a protection against risks which cannot be ensured.

Arguments in favor of Profit Maximization

1. When profit earning is the aim of the business then the profit maximization should be the
obvious objective.
2. Profitability is the barometer for measuring the efficiency and economic prosperity of a
business enterprise, thus profit maximization is justified on the ground of the rationality.
3. Profits are the main source of finance for the growth of the business. So a business should aim
at maximization of the profits for enabling its growth and development.
4. Profitability is essential for fulfilling the social goals also. A firm by pursuing the objectives of
profits maximization also maximizes the socio economic welfare.
5. A business may be able to survive under unfavorable condition only if it had some past
earnings to rely upon.

Arguments against of Profit Maximization

1. It is precisely defined. It means different things for different people. The term ‘Profit’ is vague
and it cannot be precisely defined. It means different things for different people.
Should we mean (i) Short term profit or long term profit? (ii) Total profit or earning per share?
(iii) Profit before tax or after tax? (iv) Operating profit or profit available for the shareholders?
2. It ignores the time value of money and does not consider the magnitude and the timing of
earnings. It treats all the earnings as equal though they occur in different time periods. It ignores
the fact that the cash received today is more important than the same amount if cash received
after, say, three years.
3. It does not take into consideration the risk of the prospective earnings stream. Some projects
are more risky than others. Two firms may have same expected earnings per share, but if the
earning stream in one is more risky the market share of its share will be comparatively less.
4. The effect of the dividend policy on the market price of the shares is also not considered in the
objective of the profit maximization.
In case, earnings per share is the only objective then the enterprise may not think of paying
dividends at all because it retains profits in the business or investing them in the market may
satisfy this aim.

Wealth Maximization:
Financial theory asserts that the wealth maximization is the single substitute for a stake holder’s
utility. When the firm maximizes the shareholder’s wealth, the individual stakeholders can use
this wealth to maximize his individual utility. It means that by maximizing stakeholder’s wealth
the firm is operating consistently toward maximizing stakeholder’s utility. A stake solder’s
wealth in the firm is the product of the numbers of the shares owned, multiplied within the
current stock price per share.

Implication of the wealth maximization:

1. The Concept of wealth maximization is universally accepted, because it takes care of interest
of financial institution, owners, employees and society at large.
2. Wealth maximization guides the management in framing the consistent strong dividend policy
to reach maximum returns to the equity holders.
3. Wealth maximization objective not only serves the interest of the shareholder’s by increasing
the value of their holdings but also ensures the security to the lenders.

Criticism of wealth maximization:

1. It is a prescriptive idea. The objective is not descriptive of what the firm actually does.
2. The objective of wealth maximization is not necessarily socially desirable.
3. There is some controversy as to whether the objective is to maximize the stockholder’s wealth
or the wealth of the firm, which includes other financial claimholder’s such as debenture holders,
preference shareholders.
The objective of wealth maximization may also face difficulties when ownership and
management are separated, as is the case in most of the corporate form of organizations.
When managers act as the agents of the real owner, there is the possibility for a conflict of
interest between shareholders and the managerial interests.