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FINANCIAL MANAGEMENT Finance may be defined as the art and science of managing money.

The major areas of finance are financial services and managerial or corporate finance. Financial services is concerned with the design and deliver of advice of financial products to individuals, businesses and governments within the areas of banking and related institutions, personal financial planning, investments, real estate, insurance and so on. Financial management is concerned with the duties of the financial managers in the business firm. In other words, financial management is concerned with the managerial decisions that result in the acquisition and financing of long term and short term, assets for the firm. It deals with capital budgeting, financial forecasting, cash and credit management, investment analysis, fund management etc. In the recent years, the role of financial managers has increased due to changes in regulatory and economic environment coupled with globalization of business activities. Prof. Ezra Soloman says that financial management is concerned with efficient use of an important economic resource namely capital funds. In other words financial management refers to all those managerial activities which are concerned with the ascertainment of the finance, short term and as well as long term needed by the firm, determination of the sources suitable under the given circumstances and collection of funds in time.

Scope of financial management
The scope of financial management is divided into two broad categories namely a) Traditional Approach and b) Modern Approach

Traditional approach
The traditional approach to the scope of financial management refers to its subject matter in the initial stages of its evolution, as a separate branch of academic study. Under the traditional approach, the scope of finance was treated in the narrow sense as it was restricted to procurement of funds externally. This can be summarized as follows: 1. Finance function was concerned with procuring of funds to finance expansion or diversification activities. It was not a part of regular managerial operations. 2. Finance function was viewed from the point of view of supplier of funds, both individuals and institutions. So emphasis was to consider the interest of outsiders. The internal decision making process was given less importance. 3. The focus of attention was on the long term finance of the concern. The concept of working capital and its management did not receive much attention. 4. The finance function was concerned with procuring fund basically by issue of securities like equity shares, preference shares and debt instruments. The knowledge of the sources of funds i.e. what to sell, whom to sell and by what technique to sell was needed The traditional approach to the scope of finance function was evolved during early 20’s which is discarded as it suffers from serious limitations. The weakness of traditional approach was related to the treatment of various topics and the emphasis attached to them and the basic conceptual and analytical framework of the definitions of the finance function.


The second focus was on financing problems of corporate enterprise. Therefore traditional approach was purely an outsider looking approach. It looked into the aspects like promotion. It is not sufficient for the finance manager to see that a firm has sufficient funds to carryout its plans but at the same time he has to ensure wise application of funds in the productive process. incorporation. 2 . The finance function can be now viewed from the point of view of the insiders in the firm to take decisions. 2. Finally the focus was more on long term financing and issues involved and working capital management were not in the purview of the finance function. Finance is the lifeblood of business. Every business unit needs money to make more money. allocating and controlling and not just with any one of them. Apart from the issues involved in acquiring external funds. Finally it is concerned with the investment. financing and dividend decisions. Therefore the traditional approach implied a very narrow scope for financial management. The scope has widened to include the optimum utilization of funds through analytical decision making. The day to day financial problems of the company did not receive much attention. 3. It helps a firm in optimizing the output from a given input of funds. merger. the aim concern of financial management is the efficient and wise allocation of funds to various uses. Modern approach The limitations of the traditional approach have given rise to modern approach. But money will get more money only when it is managed properly. The knowledge of securities. The modern approach provides a solution to these shortcomings. Modern scholars view finance as an integral part of the overall management rather than the fund raising operations. The finance function covers both acquisitions of funds as well as their allocation. the theme was woven around the viewpoint of the suppliers of funds such as investors.The first argument of against traditional approach is that the finance function was equated with the issues involved in rising and administering funds. Thus modern approach views financial management in a broad sense and provides conceptual and analytical framework for financial decision making. The modern approach phase of finance function can be summarized as follows: 1. Importance of financial management The importance of financial management can be expressed as follows: 1. It helps a firm in monitoring the effective employment of funds in fixed assets as well current assets. consolidations. This clearly implies that no consideration was given to internal financial decisions. 2. raising. institutions and markets is a necessary function which has expanded and is a part of finance function. reorganization etc. 3. investment bankers and so on. Therefore the finance function is concerned with the overall activities of planning.

Enforcing financial discipline in the organization in the use of the financial resources through the co-ordination of the operations of the various divisions of organization. controlling inventories and accounts receivables etc. Ensuring a fair return to the shareholders on their investments. Profit may be short term or long term. Building up adequate reserves for financing growth and expansion. Ensuring maximum operational efficiency through planning. It says that a firm should be guided to select assets and projects which are profitable and reject those which are not. that is the value created by the used of resources is more than the total of the input resources. 2. It also ensures maximum social welfare. In other words. capital budgeting. directing and controlling of the utilization of funds. They are: 1. and hence it is one of the basic objectives of any business concern. The earnings of a firm. The profits maximization objective can be stated in terms of profit to sales or return on investment or earning per share. A finance manager must have a well defined objective in the light of which he has to take various decisions. profit maximization and wealth maximization. Other objectives are: 1. 4. Maximization of Profit to ensure enough profits of the firm. profits can be maximized by an efficient use of resources. 2. However. Maintenance of adequate liquid assets in the firm at all times to meet the obligations. 3. it may be 3 . A business firm is a profit seeking organization. They are concerned with designing a method of operating the internal investment and financing of a firm. Ambiguity: The term profit is vague and ambiguous. They are Basic objectives and other objectives. Profit maximization According to this approach. actions that increase profits should be undertaken and those that decrease profits are to be avoided. Objectives of financial management The objectives provide a framework for optimum financial decision making. The objective is not clear as to what type of profit is to be maximized. On these grounds profit maximization serves as a criterion for financial decisions. It leads to efficient allocation of resources. the profit maximization has been criticized on several grounds. It helps in profit planning.e. Profit provides the yardstick for measuring the economic performance of firms. Profit is in fact the test of economic efficiency. Profitability refers to a situation where output exceeds input. The objectives of financial management can be broadly classified into two categories. The basic objectives are: 1. Let us discuss in detail the two basic objectives of financial management i. can be maximized either by increasing the output for a given input or by reducing the cost of production. Maximization of wealth to ensure enough wealth to the owners. It makes allocation of resources to profitable and desirable areas. 3.4. as resources tend to be directed to uses which in terms of profitability are the most desirable.

But the returns differ. the higher is the quality of benefits and visa versa. both alternatives would be ranked equally. Uncertainty about expected benefits State of economy alternative A Period I (Recession) 9 Period II (Normal) 10 Period III (Boom) 11 Total 30 (Rs. in Lacs) Time Period I Period II Period III Total Alternative A 50 100 50 200 Alternative B -100 100 200 From the above table it is clear that the total profit with two alternatives is identical. This is not true in actual practice as benefits in early years should be valued more highly than equivalent benefits in later years. Obviously. But the basic dictum of financial planning is the earlier the better as benefits received sooner are more valuable than benefits received later. While alternative A provides higher returns in earlier years and the profits of alternative B are higher in later years. as there is a direct relationship between risk uncertainty and profit. a loose expression like profit cannot form the basis of operational criterion for financial management. If profit maximization is desired. But in profit maximization amount of profits or rate of profits. Timings of benefits: The profit maximization does not consider the benefits received in different periods from investments proposals. 3. This is because of the fact that a rupee received today has a higher value than a rupee received after a year. The more certain the expected return. The returns earlier can be reinvested to earn return. Uncertainty renders profit maximization unsuitable. 2. Quality here refers to the degree of certainty with which benefits can be expected. In other 4 . This is referred to as time value of money. An uncertain and fluctuating return implies risk to the investors. The profit maximization criterion does not consider the distinction between returns received in different time periods and treats all benefits equally irrespective of the timing. (Rs. Risk and uncertainty (quality of benefits): The concept of profit maximization ignores the factors of risk and uncertainty to which a business is exposed. it may also be profit before tax or profit after tax. it may be operating profit or profit to share holders. If profit maximization is the decision criterion. in lacs) Alternative B 0 10 20 30 The above table clearly indicates that the returns with two alternatives are identical in normal situation but the range of variation is very wide in case of alternative B. returns from the two alternative proposals are considered as identical without considering the timings. which variant of profit to be maximized should be cleared.

So the market price of shares is the operational substitute for net present value as 5 . That means. A financial action which has a positive net present value creates wealth. The value of cash flows is calculated in terms of its present value. financing and dividend decisions of a firm. The difference between the present value of benefits and the present value of cost is the net present value. Again maximizing the profit at the cost of social and moral obligations and ethical trade practices is not a good business policy. In wealth maximization criterion. This means. the wealth is reflected in the market value of shares. There are other firms that are prepared to accept lower profits in order to have growth in the volume of sales and to have stability. Thus the objective of wealth maximization by incorporating risk and time provides an operationally feasible measure for evaluating the worth of the projects. time value of money and quality of benefits. 4. The objective of wealth maximization considers both quantity and quality aspects of benefits. but contribute to social welfare. the returns in alternative B are more uncertain as they fluctuate widely depending upon the state of economy. It satisfies the three requirements of a suitable criterion viz. The procedure of determining the present value consists of two stages. it incorporates risk and makes allowance for difference in timing of benefits. A financial action which has positive net present value is desirable. To conclude. The cash flow is a precise concept with definite meaning. Wealth maximization provides an appropriate and operationally feasible decision criterion for financial management decisions. precise. Wealth maximization: Maximization of wealth means maximizing the wealth of the company over the long run. the profit maximization criterion is inappropriate and unsuitable operational objective of investment. It is not only vague and ambiguous but it also ignores two important dimensions of financial analysis namely risk and time value of money. It provides an unambiguous measure of what financial management should seek to maximize in making investment and financing decisions. a) Determination of an appropriate rate of discount and b) Conversion of the cash flows at the discount rate to the present value. Other objections: A business unit is not run solely with the objective of earning profits. It overcomes the deficiencies associated with accounting profits. The value of the share in the market is the reflection of the firm’s financial decisions. the benefits associated with the assets are measured in terms of cash flows rather than accounting profits. There are some firms that undertake some projects. The wealth maximized by the company is reflected in the market value of the equity shares of the company. But these qualitative aspects are ignored by the business under profit maximization concept. Therefore. From the point of view of shareholders. A financial action which has a negative net present value should be rejected.words. wealth maximization of the market value as shares. this concept also implies the maximization of the market value of the equity shares of the company.. which may yield lower profits.

They are concerned with defining the actions that permit the firms to achieve success. Applying marginal analysis. determination of risk and return etc. Benefit 500000 Benefit from new machine 150000 Less: Benefit from old machine 350000 Marginal benefit Rs. 2. The financial decisions of the firm are interrelated and affect the market value of the shares by influencing return and risk of the firms. we get. Finance and economics The relevance of economics can be described in the light of two broad areas of economics namely macro economics and micro economics. The concept is very clear and not vague as it finds the present worth of future benefits. B. The concept has the following advantages: 1. 3. financial intermediaries. product mix. 800000 200000 600000 250000 6 .a decision criterion. money and capital markets. Macro economics is concerned with overall institutional environment in which the firm operates. The concept takes into account the risk factor and gives due weightage to the risk factor by applying different rates of discount. Such a balance is called risk-return and trade off. this concept provides for the discounting of the annual cash flows from the project at a certain discount rate to calculate present worth of future benefits. In other words. The concepts are demand and supply. monetary. A. pricing strategies. The objective of wealth maximization is in total agreement with the objectives of maximizing economic welfare of the shareholders of the company. The new machine requires a cash outlay of Rs.200000 respectively. financial management is not an independent area. The total benefit from the new and old and old machine is Rs. It takes help from other related fields of study such as economics. 5. profit maximization. The financial manager should strike a balance to maximize returns and minimize risk in order to maximize owner’s wealth. The concept considers the time value of money that a rupee received today has more value than a rupee received after a year. This will help in marginal analysis.150000 from the sale. It is concerned with the institutional structure of banking system. Micro economics deals with economic decisions of individuals and organizations. accounting. 4. Cost Cost of new machine Less: Sale of old machine Marginal cost Net benefit (A-B) Rs. A proper balance between risk and return should be maintained to maximize the value of the firm. For example.500000 and the old machine can fetch Rs. production and quantitative methods. the financial manager of an organization is planning to replace the machinery with latest technology which increases the production with better quality.800000 and Rs. The concept allows the dividend policy of the company to have its effect on the market value of the equity shares. credit and fiscal policies and economic policies dealing with controlling the level of activity within the economy. marketing. Finance and other related disciplines As an integral part of overall management.

And 2. The finance manager uses such data for financial decision making. But there is a key difference between accounting and finance. one person looks after both the accounting and finance functions. revenue is recognized at the point of sale and not when it is actually paid.250000. Example. The revenues are recognized only when they are actually received in cash and expenses are recognized on actual payment. Finance and marketing: The success or failure of a firm depends upon its marketing efforts to a greater extent. This knowledge gives him an insight of the economic activities to be used in financial management.The old machine should be replaced by the new one as it give a net benefit of Rs. Finance and accounting The relationship between accounting and finance has two dimensions. 1. Accounting view Sales Less: Cost Net profit Rs. In accounting incomes and expenses are based on the accrual principle. Such a firm sill not survive regardless of its level of profits. Thus the knowledge of economics is necessary for financial manager to understand the financial environment and decision theories. This is so because the financial manager is concerned with maintaining solvency of the firm to satisfy its obligations and assets financing needed to achieve the goals of the firm. The information contained in these reports and statements assists financial managers in assessing the past performance and future obligations like payment of taxes etc. It does not mean that accountants do not take decisions or financial manager do not collect data. controlling and decision making relates to financial manager. The accrual based accounting do not reflect fully the financial circumstances of the firm. Thus accounting and finance are closely related. but is may not be able to meet current obligations owing to shortage of liquidity due to uncollectible receivables. The end product of accounting constitutes financial statements such as the balance sheet. It generates information relating to operations of a firm. Accounting function is a necessary input into the finance function. 200000 500000 300000 Decision making: The purpose of accounting is collection and presentation of financial data. funds are based on cash flows. income statement and statement of changes in financial position. the financial managers avoid insolvency and achieve the desired financial goals. Proper pricing policy for the company’s products is essential for both effective marketing and efficient financial decision making. They are closely related to the extent that accounting is an important input in financial decision making. Thus. In finance. Financial view 500000 Cash inflow 350000 Less: Cash outflow 150000 Net cash outflow Rs. A firm may be quite profitable in accounting sense. The primary focus is on data collection for accountants while financial planning. The marketing manager can supply information 7 . In small firms. Accounting is a sub function of finance.

2004. packing. They are most important areas of financial management which facilitate a business firm to achieve wealth maximization.about the influence of different prices on demand for the firm’s products. channels of distribution. 4h edition. TMH) Impact of other disciplines on financial management FINANCIAL DECISIONS Financial decisions are decisions relating to the financial matters of a corporate entity. advertisement etc play an important role in making a product run successfully in the market. Not only this other areas of marketing like product mix. Financial Decisions Investment decisions Financing Decisions Dividend Decisions Investment decision: 8 . Financial decisions have been considered as the means to achieve long term objectives of the corporate. Financial Decision areas Primary disciplines Financial Decision areas Investment analysis Working capital management Determination of capital structure Sources of cost of funds Dividend policy Analysis of risk and return Support Support Accounting Macro and micro economics Other related disciplines Support Marketing Production Support Quantitative methods Resulting in Resulting in Shareholders wealth maximization (Source: khan and Jain. At the same time the finance manager can supply information about the cost volume and profit relationship and enable the firm to formulate a suitable pricing policy for the products. brand image. Financial management.

The long term assets can be either new or old/existing. The concern of the financing decision is capital structure. But they are cheaper. sufficient and adequate working capital is required to maintain by the firm to have a trade off between liquidity and profitability. The main elements of capital budgeting decisions are long term assets and their composition. shareholders funds or debt instruments viz. Capital budgeting is the most crucial financial decision of a firm. Whether an asset will be accepted of not will depend upon the relative benefits and returns associated with it. There is a conflict between profitability and liquidity. The evaluation of worth of long term implies certain norms. it cannot invest adequately in current assets and invite the risk of bankruptcy. their accrual is uncertain. Therefore. Short term financing is mainly concerned with working capital management. He has to take decisions regarding the amount of inventory. The resources must be allocated among competitive uses. The first aspect of capital budgeting relates to the choice of new assets out of alternatives available or reallocation of capital when an existing asset fails to justify funds committed. If current assets are excess. Since benefits from the investment proposals extend into the future. raising funds through issue of equity shares viz. The investment decisions include not only those that create revenue or profits but also those that save money. It is an integral part of the financial management as short term survival is the pre requisite of long term success. These sources have their own peculiar features. they have to be estimated in relation to the amount of risk involved and benefits from it. The concept and measurement of cost of capital is another major aspect of capital budgeting decision. borrowed funds. The shareholders funds comprise of equity shares. There are two major sources of finance i. The investment decisions relate to the selection of assets in which funds will be invested by a firm. The second element of capital budgeting decision is the analysis of risk and uncertainty.Investment decision is concerned with the asset mix or composition of assets of a firm. The requisite norm such as cut off rate or minimum of return has to be arrived. It relates to the selection of assets or investment proposal whose benefits are likely to be available in future over the life time of project. Where as borrowed funds carry payment of interest periodically and principal after maturity. Optimum capital structure of mix has to be decided as the mix may bring 9 . The assets that can be acquired can be classified into long term assets and short term assets. business risk and measurement of cost of capital. There is not committed outflow for equity share capital nor repayment of capital. the funds become idle and affect the profit adversely. preference shares and retained earnings.e. Since an element of risk and uncertainty of future benefit if involved. The first category of assets is popularly known as capital budgeting while the second category is termed as working capital management. On the other hand if there is a shortage of funds. cash balance and credit sales to be maintained to have a balance. One aspect of working capital is the trade off between profitability and liquidity. Financing decisions Decisions that deal with the ways in which the resources required by the firm are raised.

5. The success or failure of any firm is mainly linked with the quality of financial decisions. 2. Financial management is the process of procuring the judicious use of financial resources with a view to maximizing the value of the firm thereby the value of the owners. A capital structure with a reasonable proportion of debt and equity capital is called optimum capital structure. The key challenges are in the areas of 1. Foreign Exchange Management. leverage analysis. Dividend decisions This is the third major decision area of financial management. The firm has to decide as to which course of action to be followed or how much of profits to be distributed to shareholders and how much to be retained in the business. Investment Planning. Again it depends upon the factors determining the dividend policy of the firm. The basic responsibility of the finance manager is to acquire funds needed by the firm and investing those funds in profitable ventures that will maximize firms wealth yielding returns to the business. THE FINANCIAL ENVIRONMENT Finance is the life blood of business. Management Control and 6. 3. Thus the traditional approach to financial management had a narrow perception which was discarded. the role of financial managers particularly in India has become all the more important. The conceptual framework for optimum financial decisions is the objective of financial management. EPS analysis. Financial Structure. FUNCTIONS OF FINANCIAL MANAGEMENT ROLE OF FINANCIAL MANAGERS Reflecting on the emerging economic and financial environment in the post liberalization era. financing decision and dividend decision which are interrelated. The finance manager has to evaluate the combination to have a optimum capital structure for which tools like EBIT. capital structure models etc have to be considered. It is primarily concerned with acquisition. financing and management of assets of business concern in order to maximize the wealth of the firm for its owners. 4. The modern approach to the financial management has broadened its scope which involves three important decisions namely investment decision.better return to shareholders. But a proper balance of debt and equity to ensure trade off between risk and return to shareholders is necessary. The basic objectives centers around: 10 . Treasury Operations. But there cannot be any ready made policy for any firm regarding how much profit is to be distributed and how much to be retained. The profits available after tax are to be distributed among the shareholders or retained by the firm for reinvestment. On one hand paying more dividends to shareholders may satisfy their expectations but business may grow slower. complex and demanding. Investor Communication.

They are positively correlated. Markets and Institutions The financial markets are: 1. A very highly risky project will normally yield high return 11 . preference share capital. Globalization has caused to integrate the national economy with world economy and it has created a new financial environment which brings new opportunities and challenges to individual business firm. cost management. The globalization and liberalization of world economy has caused to bring tremendous reforms in financial sector which aims at promoting diversified. In the current scenario. The financial reforms coupled with diffusion of IT have caused to increase competition. it is imperative that the role CFO changes from controller to facilitator. Organized (monitored and controlled) and unorganized markets (beyond control). efficient and competitive financial system in the country. Capital market (long term) and money market (short term). Intermediaries (link between savers and spenders) and non-intermediaries (no link but direct) LIQUIDITY AND PROFITABILITY Liquidity and profitability are two important elements of financial decision. Banking (accepts deposit. The Financial institutions are: 1. Primary market (new) and secondary market (already issued) 3.procurement of funds from various sources like equity share capital. financial discipline etc. Financial management in India has changed substantially in the scope and complexity in view of recent government policy. Today’s finance managers are seized with problems of financial distress and are trying to overcome it by innovative means. quality improvement. financial management has assumed much greater significance. lend them. but his area of functioning is extended to judicious and efficient use of funds available to the firm. With the shift in paradigm. debentures. create credit and provide facilities to customers) and non-banking (mobilize funds and lend but do not create credit) 2. With the increase in complexity of modern business situation. profitability or both. a) The responsibilities of the finance managers are linked to the goals of ensuring liquidity. mergers. keeping in view the objectives of the firm and expectations of the providers of funds. It is a general rule that high return is associated with high risk and vice versa. It is now a question of survival of entities in the total spectrum of economic activity with pragmatic re-adjustment of financial management. term loans. the role of a finance manager is not just confined to procurement of funds. takeovers. 2. This has led to total reformation of the finance function and its responsibilities in the organization. working capital and b) Effective utilization of funds to maximize the profitability of the firm and wealth of the owners. RISK-RETURN TRADE OFF Risk and return are two inherent elements of every financial decision.

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