CHAPTER 1 NATURE, PURPOSE AND SCOPE OF FINANCIAL MANAGEMENT NATURE OF FINANCIAL MANAGEMENT Financial Management, also referred to as managerial finance, corporate finance, and business finance, is-a decision making process concemed 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, isa 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 Scanned with CamScanner4 Chapter 1 idual portion is growing, it must Ise is being benefited too. Because the goal of financial the value of the share(s), there is a need to learn how id distribute satisfactory amount of alue of the share(s), shareholders are benefiting in the sense that the resi be true that everyone el management is to maximize to identify investments, arrangements an dividends or share in the profits that favorably impact the vé Finally, our goal does not imply thatthe 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 acquisition, Traditionally, financial management is primarily concemed + siness concern in order to @#aximiz® the financing and management of assets of bu: The basic responsibility of the Finance Manager is to needed by the firm, and a 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: 1. 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 expanded to judicious and @ffigighit USEVORTURUSPavailable 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 — Scanned with CamScannerNature, Purpose and Scope of Financial Management _5 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 @Stallfundsirequirementiof the firm b. The @SSetSOnneSoUreee tbe acquired and c. The bestipatterpof 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, GHIVESHehP decisions 2. CFiRAREIRB 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. Scanned with CamScanner6 Chapter | FINANCING DECISIONS inancing 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 differen, } 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 capita, structure decision. If the cost of capital of each component is reduced, the overaly ; weighted average cost of capital and minimization of risks in financing will leag to the profitability of the organization and create wealth to the owner. DIVIDEND DECISIONS The dividend decision is concemed 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 be 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 capita 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 Fequires 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 —f Scanned with CamScannerNature, Purpose and Scope of Financial Management _7 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. Scanned with CamScanner8 Chapter | RELATIONSHIP BETWEEN FINANCIAL MANAGEMENT, ACCOUNTING AND ECONOMICS FINANCIAL MANAGEMENT AND ACCOUNTING Just as marketing and production are major functions in an enterprise, finance tog 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. Financial statements help managers to make business decisions involving the best use of cash, the attainment of efficient operations, the optimal allocation of funds among assets, and the effective financing of investment and operations. The interpretation of financial statements is achieved partly by using financial ratios, pro forma and 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. It should be pointed out that the managers of a firm are supplied with more detailed statistical information than what appears in published financial statements. These data are especially important in developing cash flow concepts for evaluating the relative merits of different investment projects. This information permits managers to determine incremental cash flows (an approach that looks at the net returns @ given project generates in comparison with alternative investments), thus enabling them to make more accurate assessments of the: profitabilities of specific — Scanned with CamScannerNature, Purpose and Scope of Financial Management _9 investments. It is the responsibility of managers to direct their accountants to prepare internal statements that include this information so that they can make the best investment decisions possible. 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 Financial managers can make better decisions if they apply these basic economic principles. For example, economic theory teaches us to seek the best allocation of resources. To this end, financial managers are given the responsibility to find the best and least expensive sources of funds and to invest these funds into the best and most efficient mix of assets. In doing so, they try to find the mix of available resources that will achieve the highest return at the least risk within the confines of an expected change in the economic climate. Good financial management has a sound grasp of the way economic and financial principles impact the profitability of the firm. Financial managers do a better job when they understand how to respond effectively to changes in supply, demand, and prices (firm-related micro factors), as well as to more general and overall economic factors (macro factors). Learning to deal with these factors provides important tools for effective financial planning, The finance manager must be familiar with the microeconomic and macroeconomic environment aspects of business. When making investment decisions, financial managers consider the effects of changing supply, demand, and price conditions on the firm’s performance. Understanding the nature of these factors helps managers make the most advantageous operating decisions. Also, managers should determine when it is best to issue equity shares, bonds or other financial instruments. Scanned with CamScanneros 10_Chapter 1 The sale of products at a profit depends heavily on how well managers are able ,, analyze and interpret supply and demand conditions. Supply considerations relay, specifically to the control nf production costs, where the key element is to hold costs down so that prices can be set at competitive levels. The best machinery Must be bought; and the most qualified product workers available must be hired, The goal is to squeeze out the biggest possible profit under given supply Conditions, Maintaining a low-cost operation will enable the firm to charge competitive prices for its products and maintain its market share while still obtaining a Teasonable return. < Knowledge of economic principles can be useful in generating the highest sales possible. Understanding’‘and appropriately responding to changes in demand allows financial managers to take full.advantage of market conditions, To accomplish this, the best managers develop and adopt reliable, workable statistical techniques that forecast demand and pinpoint when directional changes in sales take place. 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 thé 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 01 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, foreigt exchange rates, bargaining power of buyers, utiionization of labor, domestic savings rate, depth of financial markets, availability of funds in capital markels growth rate of economy, government’s foreign policy, financial intermediation. banking system, and so forth. Scanned with CamScannerNature, Purpose and Scope of Financial Management “11 FINANCIAL MANAGEMENT AND PUBLIC RESPONSIBILITY Finance is a very challenging and rewarding field. Financial managers are given the responsibility to plan the future growth and direction of a firm which can greatly affect the community in which it is based. The decisions reached by a financial manager ultimately represent a blend of theoretical, technical and judgmental matters that must reflect the concerns of society. The primary goal for managers of publicly owned companies implies that decisions should be made to maximize the long-run value of the firm’s equity shares. At the same time, managers know that this does not mean maximize shareholder value “at all costs”, Managers have the obligation to behave ethically and they must follow the law and other society-imposed constraints. Financial managers have certain obligations to those who entrust them with the running of the firm. They must have.a clear sense of ethics and must avoid pay offs or other forms of personal gain. Managers should not engage in practices that can damage the image of the firm but should articulate as much as possible in social activities to demonstrate that they are cognizant of the importance of the + community and those who buy their products or services. In short, financial managers must reconcile social and environmental requirements with profit-making motive. Adherence to social values may not produce the most efficient use of assets’or the lowest costs, but it will enhance the image of the firm. Looking after the interest in community, setting up of training facilities, casing for the safely and the welfare of the workers, providing free college education for the dependents of the employees can produce long-term benefits in the form of higher productivity and more harmonious relationships between labor and management. Although there may be conflict between promoting socially responsible programs. and the profit motive, maintaining some concern for social needs when pursuing the goal of maximizing the wealth of the firm is a primary responsibility of a firm. Scanned with CamScanner12 Chapter | REVIEW QUESTIONS Questions 1. What is the purpose of financial management? Describe the kinds of activities that financial management deals with. What is the difference in perspective between finance and accounting? Explain the shareholder wealth maximization goal of the firm and how it can be measured. Make an argument for why it is a better goal than maximizing profit. . Name and describe as many corporate stakeholders as you can. What conflicts of interest can arise between managers and stockholders? What are the three types of financial management decisions? For each type of decision, give an example of a business transaction that would be relevant. What goal should always motivate the action of a firm’s financial manager? What do financial managers try to maximize, and what is their second objective? : In trying to achieve optimum profits, what may a firm, ignore? .. State the kinds of assurances that investors and creditors seek from a firm. . What environmental considerations prevent the firm from achieving the best results in terms of cost control and profitability? Explain what this means. . What are some of the micro- and macro-economics factors that influence the decisions of a firm? . What three accounting statements help the manager monitor a firm's performance? What can the balance sheet tell the firm about its assets and financial structure? . What are some of the nonfinancial aspects of the Manager’s role in society, such as responsibility toward workers, treatment of -monitories, and dealing with gender problems? Scanned with CamScanner‘ Nature, Purpose and Scope of Financial Management _13 15. Besides maximizing the wealth of the firm, what are some of the other goals of financial management? Multiple Choice Questions L. What is the primary goal of financial management? a. — Increase earnings b. Maximizing cash flow ©.” Maximizing shareholders’ wealth d. Minimizing risk of the firm Proper-risk return management means that’ a. _ the firm should take as few risks as possible. b. consistent with the objectives of the firm, an appropriate trade- off between risk and return should be determined. c. _ the firm should earn highest return possible. d. the firm should value future profits more highly than current profits. Which of the following is not a major area of concern and emphasis in modern financial management? a. — Inflation and its effect on profits b. Stable short-term interest rates c. Changing international environment d. Increased reliance on debt Which of the following is not a major area of concern and emphasis in modern financial management? a. Marginal analysis b. — Risk-return trade-off c. Commodity trading d. Changing financial institutions A financial manager’s goal of maximizing current or short-term earnings may not be appropriate because a. _ it fails to consider the timing of the benefits. b. increased earnings may be accompanied by unacceptably higher levels of risk. earnings are subjective; they can be defined in various ways such as accounting or economic earnings. d. All of the given choices. c. Scanned with CamScanner