Financial Management 2.

Module-1
INTRODUCTION TO INANCIAL MANAGEMENT

INTRODUCTION
Finance is called “The science of money”. It studies the principles and the methods of
obtaining control of money from those who have saved it, and of administering it by those into
whose control it passes. Finance is a branch of economics till 1890. Economics is defined as
the study of the efficient use of scarce resources. The decisions made by the business firm in
production, marketing, finance and personnel matters form the subject matters of economics.
Finance is the process of conversion of accumulated funds to productive use. It is so
intermingled with other economic forces that there is difficulty in appreciating the role of it
plays.
Howard and Uptron in his book introduction to Business Finance defined, “as that
administrative area or set of administrative function in an organization which relate with the
arrangement of cash and credit so that the organization may have the means to carry out its
objectives as satisfactorily as possible”.

In simple terms finance is defined as the activity concerned with the planning, raising,
controlling and administering of the funds used in the business. Thus, finance is the activity
concerned with the raising and administering of funds used in business.

Financial Management: Meaning

Financial Management is a managerial activity which is concerned with the planning and
controlling of the firm’s financial resources.

Definitions:

Howard and Uptron define Financial Management “as an application of general managerial
principles to the area of financial decision-making”.
Weston and Brigham define Financial Management “as an area of financial decision making,
harmonizing individual motives and enterprise goal”.

The objective of financial management

Financial Management as the name suggests is the management of finance. It deals

with planning and mobilization of funds required by the firm. There is only one thing which
matters for everyone right from the owners to the promoters and that is money. Managing of
finance is nothing but managing of money.
Every activity of an organization is reflected in its financial statements. Financial
Management deals with activities which have financial implications.
The very objective of Financial Management is to maximize the wealth of the
shareholders by maximizing the value of the firm. This prime objective of Financial
Management is reflected in the EPS (Earning per Share) and the market price of its shares.
The earlier objective of profit maximization is now replaced by wealth
maximization. Since profit maximization is a limited one it cannot be the sole objective of a
firm. The term profit is a vague phenomenon and if given undue importance problems may
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arise whereas wealth maximization, on the other hand, overcomes the drawbacks of profit
maximization.
Thus the objective of Financial Management is a tradeoff between risk and return. The
objective of Financial Management is to make efficient use of economic resources mainly
capital.
The objectives of Financial Management involve acquiring funds for meeting short
term and long term requirements of the firm, deployment of funds, control over the use of funds
and to a trade-off between risk and return.

Profit Maximization versus Wealth Maximization

Profit maximization and wealth maximization are two different financial objectives pursued
by businesses and investors.
Profit Maximization:
Profit maximization is a short-term financial objective where a company aims to maximize its
profits or net income. It involves increasing revenues and reducing costs to achieve the highest
possible profit within a specific period. The primary focus is on optimizing operational
efficiency, pricing strategies, and cost-cutting measures to generate the highest earnings.

Pros:
 Provides a clear and straightforward financial goal.
 Can lead to increased shareholder value and dividends in the short term.
Cons:
 May lead to neglect of long-term investments and growth opportunities.
 Ignores the time value of money and does not consider risk factors.
 Can encourage unethical practices or neglect of social and environmental
responsibilities.

Wealth Maximization:
Wealth maximization is a long-term financial objective where the primary aim is to increase
the overall wealth or value of the firm. Unlike profit maximization, wealth maximization
considers the time value of money and incorporates risk assessment. It focuses on increasing
the market value of the company's shares and the value of the shareholders' investment over
time.
Pros:
 Takes into account the long-term perspective, promoting sustainable growth.
 Considers risk and return factors, providing a more comprehensive evaluation.
 Aligns with the interests of shareholders and stakeholders.
Cons:
 May not provide a clear-cut strategy for decision-making as profit maximization does.
 Requires complex financial models to incorporate various risk factors.
 The measurement of wealth maximization can be subjective and challenging.

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Scope and Functions of financial management

The modern approach to the Financial Management is concerned with the solution of major
problems like investment financing and dividend decisions of the financial operations of a
business enterprise. Thus, the functions of Financial Management can be broadly classified into
three major decisions, namely:
(a) Investment Decisions.
(b) Financing Decisions.
(c) Dividend Decisions.

1. Investment Decision:
The investment decision is concerned with the selection of assets in which funds will
be invested by a firm. The asset of a business firm includes long-term assets (fixed assets) and
short-term assets (current assets). Long-term assets will yield a return over a period of time in
future whereas short-term assets are those assets which are easily convertible into cash within
an accounting period i.e. a year. The long-term investment decision is known as Capital
Budgeting whereas the short-term investment decision is identified as Working Capital
Management. Capital Budgeting may be defined as long-term planning for making and
financing proposed capital outlay. In other words, Capital Budgeting means the long-range
planning of allocation of funds among the various investment proposals. Another important
element of Capital Budgeting decision is the analysis of risk and uncertainty. Since the return
on the investment proposals can be derived for a longer time in future, the Capital Budgeting
decision should be evaluated in relation to the risk associated with it.

On the other hand, the Finance Manager is also responsible for the efficient
management of current assets i.e. Working Capital Management. Working Capital constitutes
an integral part of Financial Management. The Finance Manager has to determine the degree of
liquidity that a firm should possess. There is a conflict between profitability and liquidity of a
firm. Working Capital Management refers to a Trade-off between Liquidity (Risk) and
Profitability. Insufficiency of funds in current assets results inadequate liquidity and possessing
of excessive funds in current assets reduces profits. Hence, the Finance Manager must achieve a
proper trade-off between liquidity and profitability. In order to achieve this objective, the
Finance Manager must equip himself with sound techniques of managing the current assets
like cash, receivables and inventories etc.
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2. Financing Decision
The second important decision is financing decision. The financing decision is
concerned with capital – mix, (Financing – mix) or Capital Structure of a firm. The term Capital
Structure refers to the proportion of debentures capital (debt) and equity share capital. Financing
decision of a firm relates to the financing – mix. This must be decided to take into account the
cost of capital, risk and return to the shareholders. Employment of debt capital implies a higher
return to the shareholders and also the financial risk. There is a conflict between return and risk
in the financing decisions of a firm. So, the Finance Manager has to bring a trade-off between
risk and return by maintaining a proper balance between debt capital and equity share capital.
On the other hand, it is also the responsibility of the Finance Manager to determine an
appropriate Capital Structure.

3. Dividend Decision
The third major decision is the Dividend Policy Decision. Dividend policy decisions are
concerned with the distribution of profits of a firm to the shareholders. How much of the profits
should be paid a dividend? i.e. dividend payout ratio. The decision will depend upon the
preferences of the shareholder, investment opportunities available within the firm and the
opportunities for future expansion of the firm. The dividend payout ratio is to be determined in
the light of the objectives of maximizing the market value of the share. The dividend decisions
must be analyzed in relation to the financing decisions of the firm to determine the portion of
retained earnings as a means of direct financing for the future expansions of the firm.

The above figure explains the bird’s eye – view of Financial Management, particularly
the functions of Financial Management. The three decision areas are interrelated. So, the Finance
Manager has to achieve an optimum combination of these functions so as to maximize the wealth
of shareholders and the market value of the firm. Since financing decisions of a firm are affecting
other functional areas of management, it is the responsibility of the Finance Manager to see that
the financial decisions must be geared to other functional areas of management like marketing,
production, personnel, accounts and research and development etc.

Changing Role of Finance Manager

The role of a finance manager has evolved significantly over the years, driven by
technological advancements, changes in business dynamics, and the increasing complexity of
financial operations. Traditionally, finance managers were primarily focused on accounting
and financial reporting tasks. However, in the modern business landscape, finance managers
play a more strategic and multifaceted role. Some key aspects of the changing role of finance
managers include:

1. Strategic Decision Making: Finance managers are now more involved in strategic
decision-making processes. They provide valuable insights and financial analysis to support
top-level executives in making informed business decisions. Finance managers contribute to
budgeting, financial planning, investment analysis, and overall corporate strategy.

2. Data Analysis and Technology: The increasing availability of data and technological
advancements have transformed the finance function. Finance managers now need strong data
analysis and technology skills to utilize financial software, data analytics tools, and artificial
intelligence for better financial reporting and forecasting.

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3. Risk Management: Finance managers are responsible for identifying and managing
financial risks. They play a crucial role in developing risk management strategies to mitigate
exposure to market risks, credit risks, currency risks, and other financial uncertainties.

4. Performance Measurement: Finance managers are tasked with tracking and

measuring the financial performance of the organization. They establish key performance
indicators (KPIs), conduct variance analysis, and provide insights into improving financial
performance.

5. Compliance and Regulation: Finance managers must stay updated with financial
regulations and compliance requirements. They ensure that the company follows accounting
standards and legal obligations related to financial reporting.

6. Business Partnering: Finance managers collaborate with other departments and act
as business partners to provide financial expertise and support. They work closely with
marketing, operations, and sales teams to align financial goals with overall business objectives.

7. Investor Relations: In publicly traded companies, finance managers play a crucial

role in managing relationships with investors and analysts. They communicate financial
performance and growth strategies to stakeholders, including shareholders and financial
markets.

8. Cost Optimization: Finance managers are increasingly involved in cost optimization

efforts. They assess cost structures, identify areas for cost reduction, and implement strategies
to improve the company's efficiency and profitability.

9. Sustainability and ESG Reporting: With increasing emphasis on environmental,

social, and governance (ESG) factors, finance managers are involved in measuring and
reporting on the company's sustainability performance and impact on society.

10. Ethical Leadership: Finance managers are expected to demonstrate ethical

leadership and maintain high standards of financial integrity. They ensure accurate financial
reporting, transparency, and compliance with ethical practices.

Agency Problem
The agency problem is a scenario of a conflict of interest which is inherent in all relations
wherein one party is anticipated to operate in the best interests of another party. In the field of
corporate finance, the agency problem generally points the conflict of interest among the
company’s stakeholders and the management of the company.

The mangers, who act as the shareholders’ agents, are tasked with the responsibility of making
decisions that are going to maximize the wealth of the shareholders despite them acting in their
best interest in order to enhance their own fortune.

Minimizing Risks Associated with the Agency Problem

Agency costs are a type of internal cost that a principal may incur as a result of the agency
problem. They include the costs of any inefficiencies that may arise from employing an agent

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to take on a task, along with the costs associated with managing the principal-agent
relationship and resolving differing priorities. While it is not possible to eliminate the agency
problem, principals can take steps to minimize the risk of agency costs.

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