MEANING OF FINANCIAL MANAGEMENT

Financial management is that managerial activity which is concerned with planning and
controlling of the firm’s financial resources. In other words it is concerned with acquiring,
financing and managing assets to accomplish the overall goal of a business enterprise (mainly
to maximise the shareholder’s wealth).
In today’s world where positive cash flow is more important than book profit, Financial
Management can also be defined as planning for the future of a business enterprise to ensure
a positive cash flow. Some experts also refer to financial management as the science of
money management. It can be defined as:
“Financial Management comprises of forecasting, planning, organizing, directing, co-
ordinating and controlling of all activities relating to acquisition and application of the
financial resources of an undertaking in keeping with its financial objective.
EVOLUTION OF FINANCIAL MANAGEMENT
Financial management evolved gradually over the past 50 years. The evolution of Financial
Management is divided into three phases. Financial Management evolved as a separate field
of study at the beginning of the century. The three stages of its evolution are:
The Traditional Phase: During this phase, Financial Management was considered necessary
only during occasional events such as takeovers, mergers, expansion, liquidation, etc. Also,
when taking financial decisions in the organisation, the needs of outsiders (investment
bankers, people who lend money to the business and other such people) to the business was
kept in mind.
The Transitional Phase: During this phase, the day-to-day problems that financial managers
faced were given importance. The general problems related to funds analysis, planning and
control were given more attention in this phase.
The Modern Phase: Modern phase is still going on. The scope of Financial Management has
greatly increased now. It is important to carry out financial analysis for a company. This
analysis helps in decision making. During this phase, many theories have been developed
regarding efficient markets, capital budgeting, option pricing, valuation models and also in
several other important fields in financial management.
FINANCE FUNCTIONS/ FINANCE DECISION
The finance functions are divided into long term and short term functions/decisions
Long term Finance Function Decisions
(a) Investment decisions (I): These decisions relate to the selection of assets in which
funds will be invested by a firm. Funds procured from different sources have to be invested in
various kinds of assets. Long term funds are used in a project for various fixed assets and also
for current assets. The investment of funds in a project has to be made after careful
assessment of the various projects through capital budgeting. A part of long term funds is also
to be kept for financing the working capital requirements. Asset management policies are to
be laid down regarding various items of current assets. The inventory policy would be
determined by the production manager and the finance manager keeping in view the
requirement of production and the future price estimates of raw materials and the availability
of funds.
(b) Financing decisions (F): These decisions relate to acquiring the optimum finance to
meet financial objectives and seeing that fixed and working
capital are effectively managed. The financial manager needs to possess a good knowledge of
the sources of available funds and their respective costs and needs to ensure that the company
has a sound capital structure, i.e. a proper balance between equity capital and debt. Such
managers also need to have a very clear understanding as to the difference between profit and
cash flow, bearing in mind that profit is of little avail unless the organisation is adequately
supported by cash to pay for assets and sustain the working capital cycle. Financing decisions
also call for a good knowledge of evaluation of risk, e.g. excessive debt carried high risk for
an organization’s equity because of the priority rights of the lenders. A major area for risk-
related decisions is in overseas trading, where an organisation is vulnerable to currency
fluctuations, and the manager must be well aware of the various protective procedures such
as hedging (it is a strategy designed to minimize, reduce or cancel out the risk in another
investment) available to him. For example, someone who has a shop, takes care of the risk of
the goods being destroyed by fire by hedging it via a fire insurance contract.
(c) Dividend decisions (D): These decisions relate to the determination as to how much
and how frequently cash can be paid out of the profits of an organisation as income for its
owners/shareholders. The owner of any profit-making organization looks for reward for his
investment in two ways, the growth of the capital invested and the cash paid out as income;
for a sole trader this income would be termed as drawings and for a limited liability company
the term is dividends.
The dividend decision thus has two elements – the amount to be paid out and the amount to
be retained to support the growth of the organisation, the latter being also a financing
decision; the level and regular growth of dividends represent a significant factor in
determining a profit-making company’s market value, i.e. the value placed on its shares by
the stock market.
All three types of decisions are interrelated, the first two pertaining to any kind of
organisation while the third relates only to profit-making organisations, thus it can be seen
that financial management is of vital importance at every level of business activity, from a
sole trader to the largest multinational corporation.
Short-term Finance Decisions/ Function
Working Capital Management (WCM): Generally short term decision are reduced to
management of current asset and current liability (i.e., working capital Management)
IMPORTANCE OF FINANCIAL MANAGE- MENT
Importance of Financial Management cannot be over-emphasized. It is, indeed, the key to
successful business operations. Without proper administration of finance, no business
enterprise can reach at its full potentials for growth and success. Money is to an enterprise,
what oil is to an engine.
Financial Management is all about planning investment, funding the investment, monitoring
expenses against budget and managing gains from the investments. Financial management
means management of all matters related to an organization’s finances.
The best way to demonstrate the importance of good financial management is to describe
some of the tasks that it involves:-
• Taking care not to over-invest in fixed assets
• Balancing cash-outflow with cash-inflows
• Ensuring that there is a sufficient level of short-term working capital
• Setting sales revenue targets that will deliver growth
• Increasing gross profit by setting the correct pricing for products or services
• Controlling the level of general and administrative expenses by finding more cost-
efficient ways of running the day-to-day business operations, and
• Tax planning that will minimize the taxes a business has to pay.
SCOPE OF FINANCIAL MANAGEMENT
As an integral part of the overall management, financial management is mainly concerned
with acquisition and use of funds by an organization. Based on financial management guru
Ezra Solomon’s concept of financial management, following aspects are taken up in detail
under the study of financial management:
(a) Determination of size of the enterprise and determination of rate of growth.
(b) Determining the composition of assets of the enterprise.
(c) Determining the mix of enterprise’s financing i.e. consideration of level of debt to
equity, etc.
(d) Analysis, planning and control of financial affairs of the enterprise.
Role of Financial Controller: The role of financial controller has undergone changes over the
years. Until the middle of this century, its scope was limited to procurement of funds under
major events in the life of the enterprise such as promotion, expansion, merger, etc. In the
modern times, the role of financial controller includes besides procurement of funds, the three
different kinds of decisions as well namely investment, financing and dividend. All the three
types of decisions would be dealt in detail during the course of this chapter.
The given figure depicts the overview of the role and functions of financial controller. It also
gives the interrelation between the market value, financial decisions and risk return trade off.
The financial controller, in a bid to maximize shareholders’ wealth, should strive to maximize
returns in relation to the given risk; he should seek courses of actions that avoid unnecessary
risks. To ensure maximum return, funds flowing in and out of the firm should be constantly
monitored to assure that they are safeguarded and properly utilized.
OBJECTIVES OF FINANCIAL MANAGEMENT
Profit Maximisation
It has traditionally been argued that the primary objective of a company is to earn profit;
hence the objective of financial management is also profit maximisation. This implies that the
finance manager has to make his decisions in a manner so that the profits of the concern are
maximised. Each alternative, therefore, is to be seen as to whether or not it gives maximum
profit.
However, profit maximisation cannot be the sole objective of a company. It is at best a
limited objective. If profit is given undue importance, a number of problems can arise. Some
of these have been discussed below:
(i) The term profit is vague. It does not clarify what exactly it means. It conveys a
different meaning to different people. For example, profit may be in short term or long term
period; it may be total profit or rate of profit etc.
(ii) Profit maximisation has to be attempted with a realisation of risks involved. There is a
direct relationship between risk and profit. Many risky propositions yield high profit. Higher
the risk, higher is the possibility of profits. If profit maximisation is the only goal, then risk
factor is altogether ignored. This implies that finance manager will accept highly risky
proposals also, if they give high profits. In practice, however, risk is very important
consideration and has to be balanced with the profit objective.
(iii) Profit maximisation as an objective does not take into account the time pattern of
returns. Proposal A may give a higher amount of profits as compared to proposal B, yet if the
returns of proposal A begin to flow say 10 years later, proposal B may be preferred which
may have lower overall profit but the returns flow is more early and quick.
(iv) Profit maximisation as an objective is too narrow. It fails to take into account the
social considerations as also the obligations to various interests of workers, consumers,
society, as well as ethical trade practices. If these factors are ignored, a company cannot
survive for long. Profit maximization at the cost of social and moral obligations is a short
sighted policy.

Wealth Maximisation/ Value Creation

We will first like to define what is Wealth Maximization Model. Shareholders wealth are the
result of cost benefit analysis adjusted with their timing and risk
It is important that benefits measured by the finance manager are in terms of cash flow.
Finance manager should emphasis on Cash flow for investment or financing decisions not on
Accounting profit. The shareholder value maximization model holds that the primary goal of
the firm is to maximize its market value and implies that business decisions should seek to
increase the net present value of the economic profits of the firm. So, for measuring and
maximising shareholders wealth finance manager should follow:
• Cash Flow approach not Accounting Profit
• Cost benefit analysis
• Application of time value of money.
How do we measure the value/wealth of a firm?
According to Van Horne, “Value of a firm is represented by the market price of the
company's common stock. The market price of a firm's stock represents the focal judgment of
all market participants as to what the value of the particular firm is. It takes into account
present and prospective future earnings per share, the timing and risk of these earnings, the
dividend policy of the firm and many other factors that bear upon the market price of the
stock. The market price serves as a performance index or report card of the firm's progress. It
indicates how well management is doing on behalf of stockholders.”