MODULE 1

NATURE, PURPOSE AND SCOPE OF FINANCIAL MANAGEMENT

LEARNING OBJECTIVES

After studying Module 1, you should be able to:

1. Describe the nature, goal and basic scope of financial management.

2. Explain briefly the three major types of decisions that the Finance Manager makes.

3. Discuss the importance or significance of financial management.

4. Describe the relationship between Financial Management and Accounting.

5. Describe the relationship between Financial Management and Economics.

Nature of Financial Management

Financial Management, also referred to as managerial finance, corporate finance, and business
finance, is a decision making process concerned with planning, acquiring and utilizing funds in a
manner that achieves the firm's desired goals. It is also described as the process for and the
analysis of making financial decisions in the business context. Financial management is part of a
larger discipline called FINANCE which is a body of facts, principles, and theories relating to
raising and using money by individuals, businesses, and governments. This concerns both
financial management of profit-oriented business organizations particularly the corporate form of
business, as well as, concepts and techniques that are applicable to individuals and to
governments.

The Goal of Financial Management

Assuming that we confine ourselves to for-profit businesses, the goal of financial management is
to make money and add value for the owners. This goal, however, is a little vague and a more
precise definition is needed in order to have an objective basis for making and evaluating
financial decisions. The financial manager in a business enterprise must make decision for the
owners of the firm. He must act in the owners' or shareholders' best interest by making decisions
that increase the value of the firm or the value of the stock.

The appropriate goal for the financial manager can thus be stated as follows:

The goal of financial management is to maximize the current value per share of the existing
stock or ownership in a business firm.

The stated goal considers the fact that the shareholders in a firm are the residual owners. By this,
we mean that they are entitled only to what is left after employees, supplier, creditors and anyone
else with a legitimate claim are paid their due. If any of these groups go unpaid, the shareholders
or owners get nothing. So, if the shareholders are benefiting in the sense that the residual portion
is growing, it must be true that everyone else is being benefited too, Because the goal of financial
management is to maximize the value of the share(s), there is a need to learn how to identify
investments, arrangements and distribute satisfactory amount of dividends or share in the profits
that favorably impact the value of the share(s).

Finally, our goal does not imply that the financial manager should take illegal or unethical
actions in the hope of increasing the value of the equity in the firm. The financial manager
should best serve the owners of the business by identifying goods and services that add value to
the firm because they are desired and valued in the free market place.

Scope of Financial Management

Traditionally, financial management 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. 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 the firm's wealth, as well as,
generating returns to the business concern. Briefly, the traditional view of Financial Management
looks into the following functions that a financial manager of a business firm will perform:

l. Procurement of short-term as well as long-term funds from financial institutions

2. Mobilization of funds through financial instruments such as equity shares, preference shares,
debentures, bonds, notes, and so forth

3. Compliance with legal and regulatory provisions relating to funds procurement, use and
distribution as well as coordination of the finance function with the accounting function

With modern business situation increasing in complexity, the role of Finance Manager which
initially is just confined to acquisition of funds, expanded to judicious and efficient use of funds
available to the firm, keeping in view the objectives of the firms and expectations of the
providers of funds.

More recently though, with the globalization and liberalization of world economy, tremendous
reforms in financial sector evolved in order to promote more diversified, efficient and
competitive financial system in the country. The financial reforms coupled with the diffusion of
information technology have brought intense competition, mergers, takeovers, cost management,
quality improvement, financial discipline and so forth.

Globalization has caused to integrate the national economy with the global economy and has
created a new financial environment which brings new opportunities and challenges to the
business enterprises. This development has also led to total reformation of the finance function
and its responsibilities in the organization. Financial management has assumed a much greater
significance and the role of the finance managers has been given a fresh perspective.
In view of modern approach, the Finance Manager is expected to analyze the business firm and
determine the following:

a. The total funds requirements of the firm

b. The assets or resources to be acquired and

c. The best pattern of financing the assets

Types of Financial Decisions

The three major types of decisions that the Finance Manager of a modern business firm will be
involved in are:

1. Investment decisions

2. Financing decisions

3. Dividend decisions

All these decisions aim to maximize the shareholders' wealth through maximization of the firm's
wealth.

Investment Decisions

The investment decisions are those which determine how scarce or limited resources in terms of
funds of the business firms are committed to projects. Generally, the firm should select only
those capital investment proposals whose net present value is positive and the rate of return
exceeding the marginal cost of capital. It should also consider the profitability of each individual
project proposal that will contribute to the overall profitability of the firm and lead to the creation
of wealth.

Financing Decisions

Financing decisions assert that the mix of debt and equity chosen to finance investments should
maximize the value of investments made.

The finance decisions should consider the cost of finance available in different forms and the
risks attached to it. The principle of financial leverage or trading on the equity should be
considered when selecting the debt-equity mix or capital structure decision. If the cost of capital
of each component is reduced, the overall weighted average cost of capital and minimization of
risks in financing will lead to the profitability of the organization and create wealth to the owner.
Dividend Decisions

The dividend decision is concerned with the determination of quantum of profits to be distributed
to the owners, the frequency of such payments and the amounts to be retained by the firm.

The dividend distribution policies and retention of profits will have ultimate effect on the firm's
wealth. The business firm should retain its profits in the form of appropriations or reserves for
financing its future growth and expansion schemes. If the firm, however, adopts a very
conservative dividend payments policy, the firm's share prices in the market could adversely
affected. An optimal dividend distribution policy therefore will lead to the maximization of
shareholders' wealth.

To summarize, the basic objective of the investment, financing and dividend decisions is to
maximize the firm's wealth. If the firm enjoys the stability and growth, its share prices in the
market will improve and will lead to capital appreciation of shareholders' investment and
ultimately maximize the shareholders' wealth.

SIGNIFICANCE OF FINANCIAL MANAGEMENT

The importance of financial management is known for the following aspects:

Broad Applicability

Any organization whether motivated with earning profit or not having cash flow requires to be
viewed from the angle of financial discipline. The principles of finance are 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 the financial
health of' the firm depends on its ability to generate sufficient amounts of cash ' to pay its
employees, suppliers, creditors. and owners.

Financial management is equally applicable to all forms of business like sole traders,
partnerships, and corporations. It is also applicable to nonprofit organizations like trust, societies,
government organizations, public sectors, and so forth.

Reduction of Chances of Failure

A firm having latest technology, sophisticated machinery, high caliber marketing and technical
experts, and so forth may still fail unless its finances are managed on sound principles of
financial management. The strength of business lies in its financial discipline. Therefore, finance
function is treated as primordial which enables the other functions like production, marketing,
purchase, and personnel to be effective in the achievement of organizational goal and objectives.
Measurement of Return on Investment

Anybody who invests his money will expect to earn a reasonable return on his investment. The
owners of business try to maximize their wealth. Financial management studies the risk-return
perception of the owners and the time value of money. It considers 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.

RELATIONSHIP BETWEEN FINANCIAL MANAGEMENT, ACCOUNTING AND

ECONOMICS

Financial Management and Accounting

Just as marketing and production are major functions in an enterprise, finance too is an
independent specialized function and is well knit with other functions.

Financial management is a separate management area. In many organizations, accounting and

finance functions are intertwined and the finance function is often considered as part of the
functions of the accountant. Financial management is however, something more than an art of
accounting and bookkeeping. Accounting function discharges the function of systematic
recording of transactions relating to the firm's activities in the books of accounts and
summarizing the same for presentation in the financial statements such as the Statement of
Comprehensive Income, the Statement of Financial Position, the Statement of Changes in
Shareholders ' Equity and the Cash flow Statement.

The finance manager will make use of the accounting information in the analysis and review of
the firm's business position in decision making. In addition to the analysis of financial
information available from the books of accounts and records of the firm, a finance manager uses
the other methods and techniques like capital budgeting techniques, statistical and mathematical
models, and computer applications in decision making to maximize the value of the firm's wealth
and value of the owner's wealth. In view of the above, finance function is considered a distinct
and separate function rather than simply an extension of accounting function.

Financial management is the key function and many firms prefer to centralize the function to
keep constant control on the finances of the firm. Any inefficiency in financial management will
be concluded with a disastrous situation. But, as far as the routine matters are concerned, the
finance function could be decentralized with adoption of responsibility accounting concept. It is
advantageous to decentralize accounting function to speedup the processing of information. But
since the accounting information is used in making financial decisions, proper controls should be
exercised in processing of accurate and reliable information to the needs of the firm. The
centralization or decentralization of accounting and finance functions mainly depends on the
attitude of the top level management.
Financial Management and Economics

The finance manager must be familiar with the microeconomic and macroeconomic environment
aspects of business.

Microeconomics deals with the economic decisions of individuals and firms. It focuses on the
optimal operating strategies based on the economic data of individuals and firms. The concept of
microeconomics helps the finance manager in decisions like pricing, taxation, determination of
capacity and operating levels, break-even analysis, volume-cost-profit analysis, capital structure
decisions, dividend distribution decisions, profitable product-mix decisions, fixation of levels of
inventory, setting the optimum cash balance, pricing of warrants and options, interest rate
structure, present value of cash flows, and so forth.

Macroeconomics looks at the economy as a whole in which a particular business concern is

operating. Macroeconomics provides insight into policies by which economic activity is
controlled. The success of the business firm is influenced by the overall performance of the
economy and is dependent upon the money and capital markets, since the investible funds are to
be procured from the financial markets. A firm is operating within the institutional framework,
which operates on the macroeconomic theories. The government's fiscal and monetary policies
will influence the strategic financial planning of the enterprise. The finance manager should also
look into the other macroeconomic factors like rate of inflation, real interest rates, level of
economic activity, trade cycles, market competition both from new entrants and substitutes,
international business conditions, foreign exchange rates, bargaining power of buyers,
unionization of labor, domestic savings rate, depth of financial markets, availability of funds in
capital markets, growth rate of economy, government's foreign policy, financial intermediation,
banking system, and so forth.