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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.

Scope/Elements

1. Investment decisions includes investment in fixed assets (called as capital budgeting).

Investments in current assets are also a part of investment decisions called as working
capital decisions.

2. Financial decisions - They relate to the raising of finance from various resources which
will depend upon decision on type of source, period of financing, cost of financing and
the returns thereby.

3. Dividend decision - The finance manager has to take decision with regards to the net
profit distribution. Net profits are generally divided into two:

a. Dividend for shareholders- Dividend and the rate of it has to be decided.

b. Retained profits- Amount of retained profits has to be finalized which will depend
upon expansion and diversification plans of the enterprise.

Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and control
of financial resources of a concern. The objectives can be-

To ensure regular and adequate supply of funds to the concern.

To ensure adequate returns to the shareholders this will depend upon the earning
capacity, market price of the share, expectations of the shareholders.

To ensure optimum funds utilization. Once the funds are procured, they should be
utilized in maximum possible way at least cost.

To ensure safety on investment, i.e, funds should be invested in safe ventures so that
adequate rate of return can be achieved.

To plan a sound capital structure-There should be sound and fair composition of capital
so that a balance is maintained between debt and equity capital.

SCOPE OF FINANCIAL MANAGEMENT

Financial management is one of the important parts of overall management, which is directly related
with various functional departments like personnel, marketing and production. Financial
management covers wide area with multidimensional approaches. The following are the important
scope of financial management.
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1. Financial Management and Economics

Economic concepts like micro and macroeconomics are directly applied with the financial
management approaches. Investment decisions, micro and macro environmental factors are closely
associated with the functions of financial manager. Financial management also uses the economic
equations like money value discount factor, economic order quantity etc. Financial economics is one
of the emerging area, which provides immense opportunities to finance, and economical areas.
2. Financial Management and Accounting
Accounting records includes the financial information of the business concern. Hence, we can easily
understand the relationship between the financial management and accounting. In the olden periods,
both financial management and accounting are treated as a same discipline and then it has been
merged as Management Accounting because this part is very much helpful to finance manager to
take decisions. But nowadays financial management and accounting discipline are separate and
interrelated.
3. Financial Management or Mathematics
Modern approaches of the financial management applied large number of mathematical and
statistical tools and techniques. They are also called as econometrics. Economic order quantity,
discount factor, time value of money,
present value of money, cost of capital, capital structure theories, dividend theories, ratio analysis
and working capital analysis are used as mathematical and statistical tools and techniques in the
field of financial management.
4. Financial Management and Production Management
Production management is the operational part of the business concern, which helps to multiple the
money into profit. Profit of the concern depends upon the production performance. Production
performance needs finance, because
Production department requires raw material, machinery, wages, and operating expensesetc. These
expenditures are decided and estimated by the financial department and the finance manager
allocates the appropriate finance to production department. The financial manager must be aware of
the operational process and finance required for each process of production activities.
5. Financial Management and Marketing
Produced goods are sold in the market with innovative and modern approaches. For this, the
marketing department needs finance to meet their requirements. The financial manager or finance
department is responsible to allocate the adequate finance to the marketing department. Hence,
marketing and financial management are interrelated and depends on each other.
6. Financial Management and Human Resource
Financial management is also related with human resource department, which provides manpower to
all the functional areas of the management. Financial manager should carefully evaluate the
requirement of manpower to each department and allocate the finance to the human resource
department as wages, salary, remuneration, commission, bonus, pension and other monetary benefits
to the human resource department. Hence, financial management is directly related with human
resource management.

Functions of Financial Management

1. Estimation of capital requirements: A finance manager has to make estimation

with regards to capital requirements of the company. This will depend upon expected
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costs and profits and future programmes and policies of a concern. Estimations have to
be made in an adequate manner which increases earning capacity of enterprise.

2. Determination of capital composition: Once the estimation have been made, the
capital structure have to be decided. This involves short- term and long- term debt
equity analysis. This will depend upon the proportion of equity capital a company is
possessing and additional funds which have to be raised from outside parties.

3. Choice of sources of funds: For additional funds to be procured, a company has

many choices like-

a. Issue of shares and debentures

b. Loans to be taken from banks and financial institutions

c. Public deposits to be drawn like in form of bonds.

Choice of factor will depend on relative merits and demerits of each source and period
of financing.

4. Investment of funds: The finance manager has to decide to allocate funds into
profitable ventures so that there is safety on investment and regular returns is possible.

5. Disposal of surplus: The net profits decisions have to be made by the finance
manager. This can be done in two ways:

a. Dividend declaration - It includes identifying the rate of dividends and other

benefits like bonus.

b. Retained profits - The volume has to be decided which will depend upon
expansion, innovational, diversification plans of the company.

6. Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and salaries,
payment of electricity and water bills, payment to creditors, meeting current liabilities,
maintenances of enough stock, purchase of raw materials, etc.

7. Financial controls: The finance manager has not only to plan, procure and utilize the
funds but he also has to exercise control over finances. This can be done through many
techniques like ratio analysis, financial forecasting, cost and profit control, etc.

he following explanation will help in understanding each finance function in detail

Investment Decision

One of the most important finance functions is to intelligently allocate capital to long term
assets. This activity is also known as capital budgeting. It is important to allocate capital in
those long term assets so as to get maximum yield in future. Following are the two aspects
of investment decision
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a. Evaluation of new investment in terms of profitability

b. Comparison of cut off rate against new investment and prevailing investment.

Since the future is uncertain therefore there are difficulties in calculation of expected return.
Along with uncertainty comes the risk factor which has to be taken into consideration. This
risk factor plays a very significant role in calculating the expected return of the prospective
investment. Therefore while considering investment proposal it is important to take into
consideration both expected return and the risk involved.

Investment decision not only involves allocating capital to long term assets but also involves
decisions of using funds which are obtained by selling those assets which become less
profitable and less productive. It wise decisions to decompose depreciated assets which are
not adding value and utilize those funds in securing other beneficial assets. An opportunity
cost of capital needs to be calculating while dissolving such assets. The correct cut off rate is
calculated by using this opportunity cost of the required rate of return (RRR)

Financial Decision

Financial decision is yet another important function which a financial manger must perform.
It is important to make wise decisions about when, where and how should a business acquire
funds. Funds can be acquired through many ways and channels. Broadly speaking a correct
ratio of an equity and debt has to be maintained. This mix of equity capital and debt is
known as a firms capital structure.

A firm tends to benefit most when the market value of a companys share maximizes this
not only is a sign of growth for the firm but also maximizes shareholders wealth. On the
other hand the use of debt affects the risk and return of a shareholder. It is more risky
though it may increase the return on equity funds.

A sound financial structure is said to be one which aims at maximizing shareholders return
with minimum risk. In such a scenario the market value of the firm will maximize and hence
an optimum capital structure would be achieved. Other than equity and debt there are
several other tools which are used in deciding a firm capital structure.

Dividend Decision

Earning profit or a positive return is a common aim of all the businesses. But the key
function a financial manger performs in case of profitability is to decide whether to distribute
all the profits to the shareholder or retain all the profits or distribute part of the profits to the
shareholder and retain the other half in the business.

Its the financial managers responsibility to decide a optimum dividend policy which
maximizes the market value of the firm. Hence an optimum dividend payout ratio is
calculated. It is a common practice to pay regular dividends in case of profitability Another
way is to issue bonus shares to existing shareholders.

Liquidity Decision

It is very important to maintain a liquidity position of a firm to avoid insolvency. Firms

profitability, liquidity and risk all are associated with the investment in current assets. In
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order to maintain a tradeoff between profitability and liquidity it is important to invest

sufficient funds in current assets. But since current assets do not earn anything for business
therefore a proper calculation must be done before investing in current assets.

Current assets should properly be valued and disposed of from time to time once they
become non profitable. Currents assets must be used in times of liquidity problems and
times of insolvency.

Financial activities of a firm is one of the most important and complex activities of a firm.
Therefore in order to take care of these activities a financial manager performs all the
requisite financial activities.

A financial manger is a person who takes care of all the important financial functions of an
organization. The person in charge should maintain a far sightedness in order to ensure that
the funds are utilized in the most efficient manner. His actions directly affect the Profitability,
growth and goodwill of the firm.

Following are the main functions of a Financial Manager:

1. Raising of Funds

In order to meet the obligation of the business it is important to have enough cash and
liquidity. A firm can raise funds by the way of equity and debt. It is the responsibility of
a financial manager to decide the ratio between debt and equity. It is important to
maintain a good balance between equity and debt.

2. Allocation of Funds

Once the funds are raised through different channels the next important function is to
allocate the funds. The funds should be allocated in such a manner that they are
optimally used. In order to allocate funds in the best possible manner the following
point must be considered

The size of the firm and its growth capability

Status of assets whether they are long-term or short-term

Mode by which the funds are raised

These financial decisions directly and indirectly influence other managerial activities.
Hence formation of a good asset mix and proper allocation of funds is one of the most
important activities

3. Profit Planning

Profit earning is one of the prime functions of any business organization. Profit earning
is important for survival and sustenance of any organization. Profit planning refers to
proper usage of the profit generated by the firm.

Profit arises due to many factors such as pricing, industry competition, state of the
economy, mechanism of demand and supply, cost and output. A healthy mix of
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variable and fixed factors of production can lead to an increase in the profitability of
the firm.

Fixed costs are incurred by the use of fixed factors of production such as land and
machinery. In order to maintain a tandem it is important to continuously value the
depreciation cost of fixed cost of production. An opportunity cost must be calculated in
order to replace those factors of production which has gone thrown wear and tear. If
this is not noted then these fixed cost can cause huge fluctuations in profit.

4. Understanding Capital Markets

Shares of a company are traded on stock exchange and there is a continuous sale and
purchase of securities. Hence a clear understanding of capital market is an important
function of a financial manager. When securities are traded on stock market there
involves a huge amount of risk involved. Therefore a financial manger understands
and calculates the risk involved in this trading of shares and debentures.

Its on the discretion of a financial manager as to how to distribute the profits. Many
investors do not like the firm to distribute the profits amongst share holders as
dividend instead invest in the business itself to enhance growth. The practices of a
financial manager directly impact the operation in capital market.

Definition of Profit Maximization

Profit Maximization is the capability of the firm in producing maximum output with the
limited input, or it uses minimum input for producing stated output. It is termed as the
foremost objective of the company.

It has been traditionally recommended that the apparent motive of any business
organization is to earn a profit, it is essential for the success, survival, and growth of the
company. Profit is a long term objective, but it has a short-term perspective i.e. one financial
year.

Profit can be calculated by deducting total cost from total revenue. Through profit
maximization, a firm can be able to ascertain the input-output levels, which gives the
highest amount of profit. Therefore, the finance officer of an organization should take his
decision in the direction of maximizing profit although it is not the only objective of the
company.

Definition of Wealth Maximization

Wealth maximization is the ability of a company to increase the market value of its common
stock over time. The market value of the firm is based on many factors like their goodwill,
sales, services, quality of products, etc.
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It is the versatile goal of the company and highly recommended criterion for evaluating the
performance of a business organization. This will help the firm to increase their share in the
market, attain leadership, and maintain consumer satisfaction and many other benefits are
also there.

It has been universally accepted that the fundamental goal of the business enterprise is to
increase the wealth of its shareholders, as they are the owners of the undertaking, and they
buy the shares of the company with the expectation that it will give some return after a
period. This states that the financial decisions of the firm should be taken in such a manner
that will increase the Net Present Worth of the companys profit. The value is based on two
factors:

The risk/return tradeoff could easily be called the "ability-to-sleep-at-night test."

While some people can handle the equivalent of financial skydiving without batting an eye,
others are terrified to climb the financial ladder without a secure harness. Deciding what
amount of risk you can take while remaining comfortable with your investments is very
important.

In the investing world, the dictionary definition of risk is the chance that an investment's
actual return will be different than expected. Technically, this is measured in statistics
by standard deviation. Risk means you have the possibility of losing some, or even all, of
your original investment.

Low levels of uncertainty (low risk) are associated with low potential returns. High levels of
uncertainty (high risk) are associated with high potential returns. The risk/return tradeoff is
the balance between the desire for the lowest possible risk and the highest possible return.
This is demonstrated graphically in the chart below. A higher standard deviation means a
higher risk and higher possible return.
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A common misconception is that higher risk equals greater return. The risk/return tradeoff
tells us that the higher risk gives us the possibility of higher returns. There are no
guarantees. Just as risk means higher potential returns, it also means higher potential
losses.

On the lower end of the scale, the risk-free rate of return is represented by the return on U.S.
Government Securities because their chance of default is next to nothing. If the risk-free
rate is currently 6%, this means, with virtually no risk, we can earn 6% per year on our
money.

The common question arises: who wants to earn 6% when index funds average 12% per
year over the long run? The answer to this is that even the entire market (represented by
the index fund) carries risk. The return on index funds is not 12% every year, but rather -5%
one year, 25% the next year, and so on. An investor still faces substantially greater risk and
volatility to get an overall return that is higher than a predictable government security. We
call this additional return the risk premium, which in this case is 6% (12% - 6%).

Determining what risk level is most appropriate for you isn't an easy question to answer.
Risk tolerance differs from person to person. Your decision will depend on your goals, income
and personal situation, among other factors.

Satisfying vs. maximizing

Shareholders are the real owners of the business. They appoint managers to take essential
decisions with the objective of maximizing wealth of shareholder. Though businesses have
several other objectives, but maximizing price of the stocks is considered to be very
essential objective for all businesses.

Social welfare and maximizing the price of stocks

It is very advantageous for ever society. If business maximizes its price of the stocks. But,
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business should not have any kind of intentions of forming the monopolistic market, keep
away from safety measures and creating pollution. When prices of the stocks are maximized
then it benefits the society.

To great extent the stock owners are society

In the past, ownership of the stocks was with the wealthy people in the society. But at
present, with the marvelous growth of the pension funds, mutual funds and life insurance
companies, a group of people in the society have ownership of stocks either indirectly or
directly. Therefore, when the price of the stocks increases, it eventually improves the quality
of the life for several people in the society.

Consumers benefit
It is very important to have valuable and low price businesses that manufacture good quality
of services and goods at very cheap cost that are possible for the sake of maximizing price
of the stock. Businesses that are interested in maximizing price of the stock should satisfy
all needs of customers, providing good services as well as make changes to the new
products finally. It should increase its sales by creating value for the customers. Few people
believe that businesses increase the costs of the goods when maximizing price of the stock.
However it is not true, for the purpose of surviving in the competitive market businesses
does not increase costs otherwise they will lose their share of market.

Employees benefit
In the past years, it was exclusion that decrease in the employees' level leads to increase in
the price of stocks, but at present a successful business that can increase price of the stocks
can develop as well as recruit more employees that ultimately benefit the society. Successful
businesses takes advantage of motivated and skilled employees are an essential source of
business success.

Managerial actions for the purpose of maximizing shareholders wealth

For the sake of identifying the steps taken by the managers to maximize wealth of
shareholders, the capability of the business to generate money should be known. Cash flows
are determined in three methods. They are unit sales, after operating tax margins and
requirement of capital.

Financing and investment decisions have an impact on the timing, level, and cash flow risk
of the business as well as finally on the price of the stocks. It is important for the manager to
make decisions that can maximize the price of the stocks of the business.

Importance of Financial Management

(1) Financial planning and successful promotion of an enterprise: Financial

management is responsible for planning the finances of an organization and promoting it in
such a way that it can carry out its operations successfully in order to achieve its goals.
(2) Acquisition of funds at minimum cost: Financial management is responsible for
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raising funds for the organization in such a way that the cost associated with it minimum.
(3) Allocation of funds: Financial management is responsible for effectively allocating
funds on various profitable business propositions.
(4) Taking sound financial decisions: Financial management is responsible for taking
sound financial decisions that help the organization to increase its returns by taking the
least possible risk. The three major financial decions are (1) Investment Decisions (2)
Financing Decisions (3) Dividend Decisions
(5) Improving profitability through financial control: Financial management is
responsible for exercising financial control in order to improve the profitability of the
organization. Financial control can be exercised through tools like budgetary control, cost
control, break-even analysis, ratio analysis, cost-benefit analysis and internal audit.
(6) Increasing the wealth of the investors: Financial management is responsible for
increasing the wealth of the investors. Increase in the wealth of the investor community
results in an increase in the overall wealth of the nation.
(7) Promoting and mobilizing individual and corporate savings: Financial
management is responsible for promoting the individuals to save and mobilize their savings
towards profitable investment avenues. Financial management also promotes corporate
savings so that the surplus funds can be mobilized towards the growth and expansion of the
organization.

Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and control
of financial resources of a concern. The objectives can be-

1. To ensure regular and adequate supply of funds to the concern.

2. To ensure adequate returns to the shareholders this will depend upon the earning
capacity, market price of the share, expectations of the shareholders.

3. To ensure optimum funds utilization. Once the funds are procured, they should be
utilized in maximum possible way at least cost.

4. To ensure safety on investment, i.e, funds should be invested in safe ventures so

that adequate rate of return can be achieved.

5. To plan a sound capital structure-There should be sound and fair composition of

capital so that a balance is maintained between debt and equity capital .
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