Financial Management - An Introduction

Financial Management - Meaning, Objectives and Functions

1.1  INTRODUCTION

Financial Management is nothing but management of the limited financial resources the organisation

has, to its utmost advantage. Resources are always limited, compared to its demands or needs.

1.2  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.

Financial management is defined as the management of flow of funds in a firm and it deals with financial decision making of the firm. Financial management helps in improving the allocations of working capital within business operations. In financial management the emphasis is laid on optimum utilization of funds.

1.3  DEFINITION OF FINANCIAL MANAGEMENT

Financial management deals with the study of procuring funds and its effective and proper utilisation, in terms of the overall objectives of the firm, and expectations of the providers of funds. The basic objective is to maximise the value of the firm. The purpose is to achieve maximisation of share value to the owners i.e. equity shareholders.

1. “Financial Management is concerned with the efficient use of an important economic resource, namely, Capital Funds”                                                                                        —Solomon

2. “Financial Management is concerned with the managerial decisions that result in the acquisition and financing of short-term and long-term credits for the firm”

                                                                                                                —Phillioppatus

3. “Financial Management deals with procurement of funds and their effective utilisation in the business”                                                                                                 —                                                                                                                                                                      --  S.C. Kuchhal

From the above definitions it is cleared that the Basic requirements of financial management. From his definition, two basic aspects emerge:

(A) Procurement of funds.

(B) Effective and judicious utilisation of funds

1.4  NATURE OF FINANCIAL MANAGEMENT

Financial management refers to that part of management activity, which is concerned with the planning and controlling of firm’s financial resources. Financial management is a part of overall management. All business decisions involve finance. Where finance is needed, role of financemanager is inevitable. Financial management deals with raising of funds from various sources,dependant on availability and existing capital structure of the organisation. The sourcesmust be suitable and economical to the organisation. Emphasis of financial management is more onits efficient utilisation, rather than raising of funds, alone.

1.5  SCOPE OF FINANCIAL MANAGEMENT

FM scope may be defined in terms of the following questions:

How large should the firm be and how fast should it grow?
2. What should be the composition of the firm’s assets?
3. What should be the mix of the firm’s financing?
4. How should the firm analyze, plan, and control its financial affairs?

Approaches: Broadly, it has two approaches:

1)      Traditional Approach-Procurement of Funds

2)      Modern Approach-Effective Utilisation of Funds

Traditional Approach

The scope of finance function was treated, in the narrow sense of procurement or arrangement of funds. The finance manager was treated as just provider of funds, when organisation was in need of them.

As per this approach, the following aspects only were included in the scope of financial management:

(i) Estimation of requirements of finance,

(ii) Arrangement of funds from financial institutions,

(iii) Arrangement of funds through financial instruments such as shares, debentures, bonds and loans, and

(iv) Looking after the accounting and legal work connected with the raising of funds.

Modern Approach

Since 1950s, the approach and utility of financial management has started changing. The emphasis of Financial Management has been shifted from raising of funds to the effective and judicious utilisation of funds. The modern approach is analytical way of looking into the financial problems of the firm. Advice of finance manager is required at every moment, whenever any decision with involvement of funds is taken. Nowadays, the finance manger is required to look into the financial implications of every decision to be taken by the firm.

1.6  OBJECTIVES OF FINANCIAL MANAGEMENT

A goal of the firm is the target against which a firm’s operating performance is measured. The goals serve as the point of reference to a decision maker. The objectives or goals of financial management are:
1. Profit Maximization.
2. Wealth Maximization.
3. Return Maximization.

1. Profit Maximization: The objective of financial management is to earn maximum profits. Various important decisions are taken to maximize the profit of the firm. Profit maximization as an objective of financial management results in efficient allocation of resources. Companies collect their finance by issuing shares to the public. Investors also purchase shares in hope of getting good returns from the company in the form of dividend. If the company does not earn good profits and fails to distribute higher dividends, the people would not invest in such a company and people who have already invested will sell their stock.

2. Wealth Maximization: The objective of wealth maximization of shareholders considers all future cash flows, dividends, earning per share, risk of a decision, etc. This goal directly affects the policy decision of the firm about what to invest in and how to finance these investments. Shareholders are always interested in maximization of wealth which depends upon the market price of the shares. Increase in market price lead to appreciation in shareholder’s wealth and vice versa. So the major goal of financial management is to maximize the market price of the equity shares of the company.

3. Return Maximization: The third objective of financial management says to safeguard the economic interest of all the persons who are directly or indirectly connected with the company – whether they are shareholders, creditors or employees. All these parties must also get maximum return on the investment and this can be possible only when the company earns higher profits to discharge its obligations to them.

1.7 FUNCTIONS OF FINANCE / FINANCIAL DECISIONS

Finance function is the most important function of a business. Finance is, closely, connected with production, marketing and other activities. In the absence of finance, all these activities come to a halt. In fact, only with finance, a business activity can be commenced, continued and expanded. Finance exists everywhere, be it production, marketing, human resource development or undertaking research activity. Understanding the universality and importance of finance, finance manager is associated, in modern business, in all activities as no activity can exist without funds.

Financial Decisions or Finance Functions are closely inter-connected. All decisions mostly involve finance. When a decision involves finance, it is a financial decision in a business firm.We can classify the finance functions or financial decisions into four major groups:

(A) Investment Decision or Long-term Asset mix decision

(B) Finance Decision or Capital mix decision

(C) Dividend Decision or Profit allocation decision

(D) Liquidity Decision or Short-term asset mix decision (in Modern concept)

(A) Investment Decision

Investment decisions relate to selection of assets in which funds are to be invested by the firm. Investment options are numerous. Resources are scarce and limited.They has to be optimally and discretely used.

Investment decisions allocate the resources among the competing investment alternatives or opportunities. The effort is to find out the projects, which are acceptable.

Investment decisions relate to the total amount of assets to be held and their composition

in the form of fixed and current assets.

The investment decisions result in purchase of assets. Assets can be classified, under two

broad categories:

(i) Long-term investment decisions – Long-term assets

(ii) Short-term investment decisions – Short-term assets

(B) Finance Decision

The next step is how to raise finance for the concerned investment. Finance decision is concerned with the mix or composition of the sources of raising the funds required by the firm. In other words, it is related to the pattern of financing. In finance decision, the finance manager is required to determine the proportion of equity and debt, which is known as capital structure. There are two main sources of funds, shareholders’ funds (variable in the form of dividend) and borrowed funds (fixed interest bearing). The borrowed funds are relatively cheaper compared to shareholders’ funds, however they carry risk.

The finance manager follows that combination of raising funds which is optimal mix of debt and equity. The optimal mix minimises the risk and maximises the wealth of shareholders.

(C) Dividend Decision

Dividend decision is concerned with the amount of profits to be distributed and retained in the firm.

Dividend: The term ‘dividend’ relates to the portion of profit, which is distributed to shareholders of the company. It is a reward or compensation to them for their investment made in the firm. The dividend can be declared from the current profits or accumulated profits.

Which course should be followed – dividend or retention? One significant element in the dividend decision is, therefore, the dividend payout ratio i.e. what proportion of dividend is to be paid to the shareholders. The dividend decision depends on the preference of the equity shareholders and investment opportunities, available within the firm.

There is no ready-made answer, how much is to be distributed and what portion is to be retained. Retention of profit is related to

• Reinvestment opportunities available to the firm.

• Alternative rate of return available to equity shareholders, if they invest themselves.

(D) Liquidity Decision

Liquidity decision is concerned with the management of current assets. Basically, this is Working Capital Management. Working Capital Management is concerned with the management of current assets. It is concerned with short-term survival. Short term-survival is necessary for long-term survival.

When more funds are tied up in current assets, the firm would enjoy greater liquidity. In consequence, the firm would not experience any difficulty in making payment of debts, as and when they fall due. With excess liquidity, there would be no default in payments. So, there would be no threat of insolvency for failure of payments.

All the major functions or decisions – Investment function, Finance function, Liquidity function and Dividend function, are inter-related and inter-connected.Let us illustrate, both these aspects with an example.

Example: If a firm wants to undertake a project requiring funds, this investment decision can

not be taken, in isolation, without considering the availability of finances, which is a finance decision. Both the decisions are inter-connected.

If the firm allocates more funds for fixed assets, lesser amount would be available for current assets. So, financing decision and liquidity decision are inter-connected.So, an efficient financial management takes the optimal decision by considering the implications or impact of all the decisions, together, on the market value of the company’s shares. The decision has to be taken considering all the angles, simultaneously.

1.8 ROLE OF FINANCE MANAGER

Financial manager is an important position within the structure of any firm. A financial manager is responsible for providing financial advice and support to clients and colleagues to enable them to make sound business decisions. Financial managers oversee the preparation of financial reports, execute cash management strategies, and direct a corporation’s investment activities.

1. Mobilization of funds
2. Deployment of funds
3. Control over the use of funds
4. Risk and Return trade off

1. Mobilization of funds: Every organization must have right amount of finance at the right time to achieve its objectives. For this purpose the finance manager must study the financial markets (both global and local) carefully, and identify those markets from where he can get the required funds at an accepted cost.

2. Deployment of funds: The financial manager studies the risk and return of a particular project and compares it with other projects and thereafter decides in which project he has to invest.

3. Control over the use of funds: Control is necessary at every stage of plan execution. If the desired results of the plan are to be achieved then at every stage of execution the manager has to give a check and a control, if necessary.

4. Risk and Return trade-off: It is the duty of the finance manager to achieve right balance between risk and return while taking the decisions regarding investment and financing.

1.9 LIQUIDITY VS PROFITABILITY (RISK–RETURN TRADE-OFF)

In every area of financial management, the finance manger is always faced with the dilemma of liquidity vs. profitability. He has to strike a balance between the two.

Liquidity means that the firm has:

(A) Adequate cash to pay bills as and when they fall due, and

(B) Sufficient cash reserves to meet emergencies and unforeseen demands, at all time.

Profitability goal, on the other hand, requires that the funds of the firm be so utilised as to yield the highest return.

Liquidity and profitability are conflicting decisions. When one increases, the other decreases. More liquidity results in less profitability and vice versa. This conflict finance manager has to face as all the financial decisions involve both liquidity and profitability.

Example: Firm may borrow more, beyond the risk-free limit, to take the advantage of cheap interest rate. This decision increases the liquidity to meet the requirements of firm. Firm has to pay committed fixed rate of interest, at fixed time, irrespective of the return the liquidity (funds) gives.

Profitability suffers, in this process of decision, if the expected return does not materialise. This is the risk the organisation faces by this financial decision.

Risk: Risk is defined as the variability of the expected return from the investment.

Return: Return is measured as a gain or profit expected to be made, over a period, at the time of making the investment.

Example: If an investor makes a deposit in a nationalised bank, carrying an interest of 7% p.a., virtually, the investment is risk free for repayment, both principal and interest. However, if a similar amount is invested in the equity shares, there is no certainty for the amount of dividend or even for getting back initial investment as market price may fall, subsequently, at the time of sale.

A bank deposit is a safe investment, while equity shares are not so. So, risk is associated with the quality of investment.

The relationship between risk and return can be expressed as follows:

Return = Risk free rate + Risk premium

Risk free rate is a compensation or reward for time and risk premium for risk. Risk and return go hand in hand. Higher the risk, higher the required return expected. It is only an expectation, at the time of investment. There is no guarantee that the return would be, definitely, higher. If one wants to make an investment, without risk, the return is always lower. For this reason only, deposit in a bank and post office carry lower returns, compared to equity shares. So, every financial decision involves liquidity and profitability implications, which carries risk as well as return. However, the quantity of risk differs from one decision to another. Equally, the return from all the decisions also varies, even from time to time.

More risk, chances of higher return exist. One thing must be remembered, there is no guarantee of higher returns, with higher risk. The classical example is lottery. There is a great risk, if one invests amount in a lottery. There is no guarantee that you would win the lottery. However, liquidity and profitability are conflicting decisions. There is a direct relationship between higher risk and higher return. In the above example, building higher inventories, more than required, is a higher risk decision. This higher risk has created liquidity problem. But, the benefit of higher return is also available. Higher risk, on the one hand, endangers liquidity and higher returns, on the other hand, increases profitability.

Balanced Approach: A finance manager cannot avoid the risk, altogether, in his decision making. At the same time, he should not take decisions, considering the returns aspect only. At the time of taking any financial decision, the finance manger has to weigh both the risks and returns in the proposed decision and optimize the risk and returns, at the same time. A proper balance between risk and return should be maintained by the finance manager to maximise the market value of shares. A particular combination where both risk and return are optimized is known as Risk–Return Trade-off.