Unit 1
INTRODUCTION TO FINANCIAL MANAGEMENT
Finance touches every aspect of our life and holds the key to all activities. It has been described as the life blood of any business. The blood in our body needs to be regulated to ensure smooth circulation for healthy survival. Management of finance in a optimal manner is inevitable for success of any business. The finance function has been defined differently by different writers and differently over time. The simplest way of understanding finance is to say that finance is what finance does. In other words, finance as the art and science of managing money. The only conclusion one may make with respect to finance is that it has a marvelous ability to evoke different concepts in the minds of men.
Financial management means money management. Financial management is concerned with the planning and controlling of the financial resources of the business firm. The term financial management has emerged from the generic discipline of management. As an academic discipline, the subject of financial management has undergone radical changes in relation to its scope, functions and objectives. In the past, the financial management was confined to raising of the funds and its procedural aspects. In the broader sense, it is now concerned with the optimum use of financial resources in addition to its procurement. Therefore, financial management is that part of management which is concerned mainly with:
- Fund Raising: raising the right type of funds in the most economic and suitable manner.
2. Use of Funds: using the funds in the most profitable and safest possible manner.
According to James Van Horne:
“Financial management connotes responsibility for obtaining and effectively utilizing funds necessary for the efficient operation of an enterprise.”
According to I.M. Pandey:
“Financial management is that managerial activity which is concerned with the planning and controlling of the firm’s financial resources”.
Financial management provides the best guide for future resource allocation by the firm. It performs facilitation, reconciliation and control function in an organization. It permits and recommends investment where the opportunity is greatest. Financial management produces relatively uniform yardsticks for judging most of the enterprise’s operations and projects. It is continually concerned with an adequate rate of return on investment which is necessary to assure the successful survival of an enterprise. The problem of attracting new capital and providing funds for capital needs is solved if the return on investments is adequate. Because it is continuing drawing attention to such matters, financial management is essential to effective top management.
Definitions of Financial Management
The simple definition of Financial Management is the ways and means of managing money’. This statement can be further expanded to define Financial Management: the determination, acquisition, allocation and utilization of the financial resources with the aim of achieving the goals and objectives of the enterprise.
According to Archer and Ambrosia:
“Financial management is the application of the planning and control functions to the finance function”.
Joseph and Massie:
“Financial management is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient operation”.
Raymond Chambers:
“Financial management may be considered to be the management of the finance function. It may be described as making decisions on financial matters and facilitating and reviewing their execution. It may be used to designate the field of study which lie beneath these processes”.
All decisions that have monetary benefit come under the purview of financial management. There are basically, two approaches for understanding the scope of financial management: one is traditional approach and the second one is the modern approach.
- Traditional approach: Traditional approach views the scope of finance function in a narrow sense of arrangement of funds by business firm to meet their financing needs. Hence, the following three inter-related aspects of raising and administering financial resources were covered:
- Arrangement of finance from institution;
- Raising funds in the capital market through financial instruments including the procedural aspects;
- Legal and accounting aspects involved for raising finance for the firm.
The traditional approach was criticized for the reasons:
- It emphasis only the issues relating to procurement of funds and ignored the issues related to internal financial decisions.
- It focused only on the problems related to corporate entities ignoring the non-corporate bodies. The scope of financial management was confined only to a particular segment of business enterprises.
- It laid more emphasis on the onetime events (episode) such as promotion, incorporation, reorganization, etc., taking place in the corporate life of the concern/ignoring the day-to-day financial problems of the concern.
d. The focus was more on long term financing. Working capital management was considered to be outside the purview of finance function.
According to Solomon, the traditional approach has ignored the central issues of financial management which comprise the following:
- Should the enterprise commit capital funds to certain purpose?
- Do the expected returns meet financial standards of performance?
- How should these standards be set and what is the cost of capital funds to the enterprise?
- How does the cost vary with the mixture of financing methods used?
Therefore, the traditional approach while ignoring the above crucial aspects implied a very narrow scope for financial management. These defects were taken care by the Modern approach.
2. Modern Approach: The traditional approach focused on sources of funds and was too often largely concerned with specific procedural details. Experts pointed out the following two defects of traditional approach:
- It does not recognize the relationship between financing mix and the cost of capital and fails to solve the problems relating to optimum combination of finance, and
- It also fails to deal with the problems relating to the valuation of the firm and the cost of capital.
The modern approach aims at formulating rational policies for the optimal use, procurement and allocation of funds; unlike the traditional approach which has focused only on the sources of funds and their procedural details. The modern approach apart for covering the acquisition of external funds; includes the efficient andwise allocation of funds for various uses. Emphasis has shifted from a detailed analysis, of operating procedures in the acquisition, custody and disbursement of funds to the formulation of rational decisions on the optimal use and allocation of funds. Financial decision making has become fully integrated in more advanced companies with top management policy formulation via capital budgeting, loan range planning, evaluation of alternate uses of funds, and establishment of measurable standards of performance in financial terms.
In the words of Solomon, a financial manager should know the following:
- How large should an enterprise be and how fast should it grow?
- In what form should it hold its assets?
- What should be the composition of its liabilities?
Thus, the modern approach views the term financial management in a broad sense and provides a conceptual and analytical framework for financial decision making. Therefore, financial management, in the modern sense of the term, can be related to three major decision making areas. They are as follows:
- Investment Decision i.e. Where to invest funds and in what amounts?
- Financing Decisions i.e. Where to raise funds from and in what amount?
- Dividend Decisions i.e. How much of profits should be paid by way of dividends and how much should be retained in the business?
All the above three decisions contribute towards the goal of wealth maximization.
- Investment Decisions: Investment decisions involve identifying the asset or projects in which the firms limited resources should be invested. It involves the major task of measuring the prospective profitability of investment in assets of the company or in new projects. The decisions relating to acquisition of fixed assets investment are known as capital budgeting decisions and the decisions relating to current assets investment are known as working capital management decisions. Capital budgeting decisions relate to selection of an asset or investment proposal or course of action which have hot long term implications on the cash flows and profitability of such investment. It helps in judging whether it is financial feasible to commit funds in future. An important aspect of working capital, the profitability would be adversely affected, whereas with too inadequate working capital, it would be unable to meet itsfinancial commitment on time and thereby invite the risk of insolvency. The investment in the fixed assets of the company determines the production capacity of the company. The production should be sufficient to demand in the market. Production should not fall short or be too excessive in relation to the demand for the product in the market. Further, the fixed assets must be productive enough to ensure the returns expected from such investment. This should be supported by sufficient investment in the working capital assets. The working capital assets should be adequate enough to maintain sufficient liquidity to augment the sales level. Investment decisions yield returns in future. Future performance is subject to uncertainty and risk. Therefore, investment decisions require careful analysis before substantial amounts are committed in fixed assets. The investment decisions having long term implications and affects the cash inflows in the years to come. Hence any wrong decision taken in the initial year, would adversely affect the future profitability and growth. Hence appropriate techniques need to be adopted for proper evaluation of investment decisions.
2. Financing Decisions: Financing decisions involve deciding on the most cost effective method of financing the chosen investments. Financing decisions relate to the financing pattern of the firm. It involves in deciding as to when, where and how to acquire the funds to meet the firm’s investment needs. Different sources of finance have different advantages with different degree of risks. Hence it becomes imperative to decide as to how much finance is to be raised and from which sources. The prime objective being to keep the cost of finance at the minimum with maximum utilization of funds. Primarily, there are two main sources of finance: one is the owned funds and second is the borrowed funds. Owned funds are the shareholder’s monies on which dividend are paid. Dividend payment depends upon the profitability of the company and is not binding. There is no commitment involved in the shareholders’ funds. On the other hand, borrowed funds involve fixed commitments; their repayments are secured by a charge created on the assets and interest payments are obligatory irrespective of the profits or losses of the company. Hence, it increases the financial risk of the company. The borrowed funds are relatively cheaper, but entail a certain degree of risk, therefore, due prudence must be exercised while determining the mix of owned and borrowed funds.
3. Dividend Decision: Dividend Decisions involve the decisions as regards what amount of profits earned should be distributed by way of dividends and what amount should be retained in the business. Dividend policy is to be decided having regard to itsimplicate on the shareholder wealth in the firm. The aim is to decide an optimum dividend policy which would maximize the market price of shares. This is a crucial decision as it determines the reputation of the management of the company and therefore, the market value of the shares. If the management decides to retain profits, it should be able to generate adequate returns (by investing such retained profits), which should be much more that what the, shareholders could have got, had they received the dividends and invested the amount elsewhere. If the management is not able to generate adequate returns on reinvestment of retained profits, then it should prefer to pay dividends rather than retaining the profits. Therefore, the two important factors which affects the dividend decisions are: firstly, the investment opportunities available to the firms and secondly, the opportunity rate of return of the shareholders. The topic has been dealt in more details in the subsequent chapters of this book.
The importance of financial management is known from the following aspects:
- Applicability – The principles of finance is applicable wherever there is cash flow. The concept of cash flow is one of the central elements of financial analysis, planning, control and resource allocation decisions. Cash flow is important because financial health of the firm depends on its ability to generate sufficient amounts of cash to pay its employees, suppliers, creditors and owners. Any organization, whether motivated with earning of profit or not, having cash flow requires to be viewed from the angle of financial discipline. Therefore, financial management is equally applicable to all forms of business like sole traders, partnerships, companies. It is also applicable to non-profit organizations like trusts, societies, governmental organizations, public sector enterprises etc.
2. Chances of Failure – A firm having latest technology, sophisticated machinery, high caliber marketing and technical experts etc. may fail to succeed unless its finances are managed on sound principles of financial management. The strength of business likes in its financial discipline. Therefore, finance function is treated as primary, which enable the other functions like production, marketing, purchase, personnel etc. to be more effective in achievement of organizational goals and objectives.
3. Return on investment – Anybody invests his money will mean to earn a reasonable return on his investment. The owners of business try to maximize their wealth. It depends on the amount of cash flows expected to be generated for the benefit of owners, the timing of these cash flows and the risk attached to these cash flows. The greater the time and risk associated with the expected cash flow, the greater is the rate of return required by the owners. The Financial management studies the risk-return perception of the owners and the time value of money.
The job of a finance manager is full of duties and responsibilities. He has to perform various duties connected with finance. In order to perform the finance duties successfully, a finance manager should be competent. He should possess the following qualities:
- Personality is the sum total of physical and mental qualities. A finance manager should have a pleasing personality. Good height, good physique, good appearance would be an asset to a finance manager. He should be physically and mentally healthy enough to bear the strain of finance in an organization.
- The job of a finance manager involves analytical work. He should have a high degree of intelligence to understand the finance problems immediately. An intelligent finance manager can control the finance properly.
- A finance manager should take initiative in performance of work. He should do the job at his own i.e. without being told by others.
- A finance manager should have vast fund of power of imagination to his credit. He should have a research mind which is very creative. He should be able to bring innovation in financial management of an organization.
- A finance manager should have self-confidence to face the challenges involved in his job.
- A finance manager is a leader of financial administration. He should have an effective Communication Skill. He should understand the problems of his subordinates and communicate instructions to solve them.
- The job of a finance manager involves decision making. He has to take various decisions which have financial implications on the working of the organization. He should have the quality to judge the situation and take right decision accordingly.
- He should be honest in his job. Finance requires utmost honesty on the part of the manager and the subordinates also.
- He should have an administrative skill to administer the finance function. He should be able to plan, organize, direct, control and coordinate the activities of the finance area. He has to see that the financial decisions are properly implemented.
- A finance manager should be self-disciplined. He should be able to enforce discipline in the organization.
- A finance manager should have patience. He should not take hasty decisions which have adverse impact on the financial health of the organization. He should listen to the views of others.
The important functions of a financial controller in a large business firm consist of the following:
- Provision of Capital – To establish and execute programmes for the provision of capital required by the business.
2. Investor Relations – To establish and maintain an adequate market for the company’s securities and to maintain adequate liaison with investment bankers, financial analysis and shareholders.
3. Short-term Financing – To maintain adequate sources for company’s current borrowing from commercial banks and other lending institutions.
4. Banking and Custody – To maintain banking arrangement, to receive, have custody of and disburse the company’s monies and securities.
5. Credit and Collections – To direct the granting of credit and the collection of accounts due to the company, including the supervision of required special arrangements for financing sales, such as time payment and leasing plans.
6. Insurance – To provide insurance coverage as required.
7. Investments – To achieve the company’s funds required and to establish policies for investment in pension and other similar trusts.
8. Planning for Control – To establish, coordinate and administer an adequate plan for the control of operations.
9. Reporting and interpreting – To compare performance with operating plans and standards, and to report and interpret the results of operations to all levels of management and to the owners of the business.
10. Evaluating and Consulting – To consult with all segments of management responsible for policy or action concerning any phase of the operation of the business as it relates to the attainment of objectives and the effectiveness of policies, organization structure and procedures.
11. Tax Administration – To establish and administer tax policies and procedures.
12. Government Reporting – To supervise or coordinate the preparation of reports to government agencies.
13. Protection of Assets – To ensure protection of assets for the business through internal control, internal auditing and proper insurance coverage.
14. Economic Appraisal – To appraise continuously economic, social forces and government influences, and to interpret their effect upon the business.
15. Managing Funds – To maintain sufficient funds to meet the financial obligations.
16. Measuring of Return – To determine required rate of return for investment proposals.
17. Cost control – To facilitate cost control and cost reduction by establishment of budgets and standards.
18. Price Setting – To supply necessary information for setting of prices of products and services of the concern.
19. Forecasting Profits – To collect relevant data to make forecast of future profit levels.
20. Forecast Cash flow – To forecast the sources of cash and its probable payments and to maintain necessary liquidity of concern.
Many of the well-known authors on the subject have highlighted the following two important goals of financial management. They are as follows:
1. PROFIT MAXIMIZATION:
The objective of making profit is a commercial imperative. Profit generation is essential for survival and growth of the business. Profit generation is also regarded as a measure of success of the business. Profit is an important yardstick for measuring the economic efficiency of any firm. Any business would be making the use of economic and human resources available to generate profits. The cost of these resources is required to be met from the revenue generated from the use of these resources and the surplus remaining would be needed for the growth and expansion of the company. It is only an efficiently run business which can afford to meet the cost of resources and generate profits. Therefore, the survival and growth of any business depends upon its ability in earnings profits. It is therefore contended that profit maximization is one of the primary goals of the organization without which the survival of the organization itself is threatened.
THE DRAWBACKS OF THE GOAL OF PROFIT MAXIMIZATION
Although profit is an important yardstick for measuring the economic efficiency of any firm, yet it has got certain limitations which are listed below:
- It ignores the risk which is associated with the investment in such profitable ventures. It ignores the risk or uncertainly of expected returns or benefits. Risk is defined as the chance that the actual outcome of a decision may differ from the expected outcome and in finance; risk investment is one whose potential returns are expected to have a high degree of variation or volatility. Some with an investment with high profits potential but having a high degree of risk. When profit maximization is aimed as the main objective, all profitable investment projects are accepted without having regard to the risk factor. An investment may have profit potential but may not be worth the risk.
2. The objective of profit-maximization assumes the existence of perfect market conditions in which various resources are efficiently managed. However, modern markets suffer from many imperfections. It leads to inequitable distribution of income and wealth.
3. It ignores the time value of money without having any regard to the timings of costs and returns. It takes into account only the size of the profits without considering the timings of the prospective earnings.
4. Profit maximization as an objective is considered to be vague and ambiguous. It does not define adequately as to what profits are, what profits to be considered, whether from the point of view of funds employed or from the shareholders point of view, or short term or long term profits etc.
5. Profit maximization as an objective ignores other important aspects of financing e.g. Borrowing capacity etc.
6. The objective of profit maximization focuses on interests of the owners alone and ignores the interest of other interested parties such as employees, consumers, government and society in general.
7. The perception of the management as regards profit maximization substantially differs from the perception of the shareholders.
Another variant of profit maximization is to consider the rate of return on investment. If the rate of return on investment is higher than the cost of funds, then such investment opportunities can be undertaken.
2. WEALTH MAXIMIZATION:
According to this objective, the owners of the company i.e. the shareholders are more interested in maximizing their wealth rather than in profit maximization. Maximization of the wealth of the shareholders means maximizing the net worth of the company for its shareholders. This reflected in the market price of the shares held by them. Therefore, wealth maximization means creation of maximum value for company’s shareholders which mean maximizing the market price of the share. Wealth maximization refers to the gradual increase in value of the net assets of the organization. Profit generation adds to the increase in the value of the net assets of the organization. With greater profits, the EPS (earnings per share) goes up; resulting an increase in the value of the net assets belonging to the shareholders of the company.
The market price of the shares is an important indicator of the wealth maximization of the organization. Wealth maximization is the net present value of a financial decision. Net present value is the difference between the gross present value of the revenue generated from such decision and the cost of such decision. A financial action with a positive net present value creates wealth and therefore is desirable. The total cash inflows over the years in termsof present value must be greater the outflows of cash invested for generating such cash inflows. This results in financial advantage leading to increase in the value of net assets. The increase in the value of net wealth should in turn help in generating greater volume of profits. This action results in financial gains to the shareholders increasing the earnings per share.
Prof. Solomon has suggested wealth maximization as the best criterion. According to him “Wealth or net present worth is the difference between gross present worth and the amount of capital investment required to achieve the benefits. Any financial action which creates wealth or which has a net present worth above zero is a desirable one and should be undertaken. Any financial action which does meet this test should be rejected”.
Solomon states that wealth maximization provides an unambiguous measure of what financial management should seek to maximize in making investment and financing decisions.
Future earnings of a company are subject to uncertainties and exposed to risk. Financial decisions for which the consequences are known at a later date may either result in increasing or decreasing the net wealth of the shareholders. Unforeseen economic and social conditions may adversely affect the company. Hence the process of wealth generation is a difficult task.
Therefore, the goal of wealth maximization implies a long term perspective of the goal. The interest of the management in maximizing the market price of the share is compatible with that of the shareholders’ interest. This helps the management in allocating the resources in the best possible manner balancing the risks and the returns.
THE MERITS OF THE GOAL OF WEALTH MAXIMIZATION ARE AS FOLLOWS:
- It is a very effective and meaningful criterion to measure the performance of the company.
2. The objective of wealth maximization is consistent with the objective of maximization of the shareholders’ economic welfare.
3. The objective is also consistent with the objective of perpetual survival of the company and its long term profitability.
4. It is operationally feasible and logical.
5. It includes the motive of profit maximization as it emphasis on maximization of long term profitability and ensures maximum return on owners investment.
6. The objectives allow for timings of profits and also consider the timings of perspective benefits.
7. It ensures fait return on the investments, and takes into account the uncertainty of the benefit also.
8. It offers rational guidelines for effective use of the resources available.
THE DRAWBACKS OF THE GOAL OF WEALTH MAXIMIZATION
- The basic assumption is that there an efficient capital market wherein the market price of the share is truly reflected. This assumption seldom holds in real practice.
2. The market price is influenced by various economic and political factors which are difficult to anticipate and judge.
3. The various parties having their stake in the company have conflicting interests and therefore difficult to reconcile their divergent views.
3. OTHER GOALS OR OBJECTIVES OF FINANCIAL MANAGEMENT
- To ensure adequate returns to the shareholders which should be fair in the given market conditions.
b. To contribute to the operational efficiency of all other areas of management.
c. To infuse financial discipline in the organization.
d. To build up a strong financial base so that the enterprise can fall back upon its reverses during lean years and withstand the shocks of the business.
Profit Maximisation v/s Wealth Maximisation
SR NO | PROFIT MAXIMISATION | WEALTH MAXIMISATION |
1 | Profits are earned maximized, so that firm can over-come future risks which are uncertain. | Wealth is maximized, so that wealth of share-holders can be maximized. |
2 | Profit maximization is a yards stick for calculating efficiency and economic prosperity of the concern. | In wealth maximization stockholders’ current wealth is evaluated in order to maximize the value of shares in the market. |
3 | Profit is measured in terms of efficiency of the firm. | Wealth is measured in terms of market price of shares. |
4 | Profit maximization involves problem of uncertainty because profits are uncertain. | Wealth maximization involves problems related to maximizing shareholder’s wealth or wealth of the firm |
