INTRODUCTION TO FINANCIAL MANAGEMENT

Financial Management is the planning, organizing, directing and controlling the financial activities
of the enterprise. It means applying general management principles to financial resources of the
enterprise. Financial Management is a discipline concerned with the generation and allocation of
scarce resources i.e. funds to the most efficient user through a market pricing system i.e. cost of
capital. This is a branch of economics concerned with generation and allocation of scarce resources
to the most efficient users (competing projects) within the firm. The allocation of these resources
is done through the market price mechanism (demand and supply mechanism). Financial
management entails planning for future of a person or business enterprise to ensure a positive cash
flow. It includes the administration and maintenance of financial assets. It also covers the process
of identifying and managing risks. The primary concern in financial management is the assessment
rather than the techniques of financial quantification. Some experts refer to financial management
as art and the science of money management

Scope of financial management

The scope of financial management can be clearly explained by exploring the roles and functions
of a financial manager in a contemporary corporate set-up. A financial manager has some
traditional roles but there are some other various emerging roles due to changes in the environment.
The traditional roles can be divided into two: routine and managerial functions.
a) Routine functions
These are functions that do not necessarily require skills and expertise of a finance manager. These
decisions concern routine procedures and systems and involve a lot of paper work and time. They
are thus delegated to junior staff in the organization. For effective execution of management
functions, routine functions have to be performed. They are short term in nature and require little
technical expertise and skills from the finance manager. They involve a lot of paper work and are
mostly delegated to all junior staff. They include:
• Supervision of cash receipts and payments
• Safeguarding of cash balance
• Custody and safeguarding of important documents
• Record keeping and reporting
 b) Managerial functions
These are functions that require skills and expertise of a finance manager. These decisions are
made at the top most level of management and cannot be delegated to junior staff in the
organization. They include:
i. Investment decisions
ii. Financial functions
iii. Liquidity functions
iv. Dividend functions
These are as discussed below:
i. Investment Decisions
This involves allocation of capital to long term assets i.e. capital budgeting. It also involves
decisions of using funds which are obtained by selling those assets which become less profitable
and less productive. It is a wise decision 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. This will be discussed in detail under capital
budgeting. This involves determination of where the acquired funds should be put in order to
generate revenue. The funds can be committed in the following investments taking into accounts
the critical variables in each investments project

➢ Internal investments –involves carrying out internal expansion of the firm and deciding to
withdraw, if the investments turn out to be unprofitable e.g. opening a new branch.
➢ External investments – e.g. mergers and acquisitions of similar or dissimilar business firms.
E.g. a branch or a subsidiary.
The projects are evaluated in terms of risk and returns. Replacement of old and unproductive assets
is also done here.
ii. Financial Decisions
This has to do with when, where and how should a business acquire funds. Capital structure also
must be looked into i.e. the mix or composition of long term sources of capital e.g. equity capital
and debt. A good capital structure is said to be one which aims at maximizing shareholders return
with minimum risk thus the market value of the firm will maximize and hence an optimum capital
structure would be achieved. Thus, this function involves looking for finances to acquire the assets
of the firm. The finances may come from the ordinary shares, long-term debts, preference shares
etc and the financial manager must identify the right funds, which has the lowest cost. The financial
manager must know that the principle objective of carrying out the financing role is to ensure that:
• Funds are made available at the right time
• Funds are made available for the correct length of time
• Funds are obtained at the lowest cost
• Funds are used in the most effective way

iii. Dividend Decision

A financial manager has 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. It’s the financial manager’s responsibility to decide an 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. Dividend decisions are very tricky because the value of the firm is
sometimes determined by the amount of the dividends that the firm has to pay.
➢ This decision is closely related to financing decision in that most companies may wish to
use retained profits as a source of finance.
➢ The company can only pay dividends out of the profits made and this reduces the amount
of retained profits.
➢ If it finances its projects from retained earnings, then little or no dividends have to be paid
and this has a direct effect on the value of the firm.
➢ The financial manager therefore has to decide the following:
• How much to pay (dividend per share)
• When to pay (interim and final dividend)
• Why to pay (does payment affect the value of the firm?)
• How to pay (cash or bonus issue)

iv. Liquidity functions

Liquidity refers to the ability of the firm to meet its short maturing financial obligations as and
when they become due for payment. It can also be referred to as working capital management. The
management of investments in current assets (cash, stock, debtors) is important because it affects
the firm’s liquidity, profitability and risk. The more current assets a firm has the more liquid it is.
This reduces the risk of becoming insolvent. It is very important to maintain a liquidity position of
a firm to avoid insolvency. Firm’s profitability, liquidity and risk all are associated with the
investment in current assets. In 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.
The finance manager must however set an optimal level of each class of current assets since they
are non-income generating assets. He must ensure that neither insufficient nor unnecessary funds
are invested in current assets. In this regard a trade off must be made between liquidity and
profitability.

Other emerging roles of a financial manager

➢ Inflation and its effects on interest rates.
➢ Use of new and innovative methods of financing long-term investments e.g. offshore
borrowing.
➢ Dramatic increase in the use of financial telecommunication e.g. electronic Funds Transfer,
transmission of information using internet and use of computers for analyzing financial
decisions using financial models
➢ Deregulation of financial institutions and accompanying trend away from specialized
institutions towards broadly and diversified financial service corporation.
➢ Use of new financial instruments for raising funds e.g. commercial paper, securitization
and self-registration.
➢ Constant interaction with other financial markets and players for exchange of information.
➢ Use of derivative instruments such as options, swaps, forward etc to hedge against foreign
exchange risk and changes in interest rates.

Goals or Objectives of a business entity

Any business firm would have certain objectives which it aims at achieving. The major goals of
a firm are broadly classified into two:
 a) Financial goals
b) Non-financial goals
Financial goals include:
➢ Profit maximization
➢ Shareholders' wealth maximization
Non-financial goals include:
➢ Social responsibility
➢ Business Ethics
a) Financial goals
➢ Profit maximization
Profit maximization refers to achieving the highest possible profits during the year. This could be
achieved by either increasing sales revenue or by reducing expenses. Note that:

Profit = Revenue – Expenses

The sales revenue can be increased by either increasing the sales volume or the selling price. It
should be noted however, that maximizing sales revenue may at the same time result to increasing
the firm's expenses. The pricing mechanism will however, help the firm to determine which goods
and services to provide so as to maximize profits of the firm. This is considered to be a classical/
traditional objective of the firm, which involves making the highest possible profits during the
year. Profits can be maximized/increased by increasing the selling price (volume can not be
increased since the firm is operating at full capacity.)
- Increase in selling price can only be achieved in short run in a competitive environment.
The increase will affect the customers.
- Reduction in expenses e.g. retrenchment will affect employees. A firm could evade tax to
maximize profits.
This goal thus suffers from the following limitations.

1. It is a short-term goal especially in a competitive environment. It ignores the going concern

concept.
2. It ignores the plight of some stakeholders e.g. customers, employees, government, supplies
etc. except shareholders.
3. It is vague – Does the goal refer to maximization of after profits, before tax profits, short-
term profits or long-term profits?
4. It is only applicable with one-man business and cannot be applied in contemporary
corporate set-up where ownership of business is joint e.g. quoted companies.
5. It ignores the fact that business firms compete in the market and all have different levels of
diversification, technology and size.
6. It ignores the concept of time value of money.
It ignores the uncertainty of returns (the element of risk)

➢ Shareholders' wealth maximization

Shareholders' wealth maximization refers to maximization of the net present value of every
decision made in the firm. Net present value is equal to the difference between the present value
of benefits received from a decision and the present value of the cost of the decision. A financial
action with a positive net present value will maximize the wealth of the shareholders, while a
decision with a negative net present value will reduce the wealth of the shareholders. To achieve
this goal a firm has to forego current consumption in order to free up funds for investment. Wealth
is measured in terms of a firm's share price. This was developed due to limitations of profits
maximization objective. It involves maximization of the market price of ordinary shares, which is
determined through the use of fundamental analysis. Technically, wealth maximization is
maximization of NPV of the firm.
Where: NPV = Net present value
Io = Initial Capital/cash outlay
K = Cost of capital/required rate of return
This goal has the following advantages:
• It considers all stakeholders of the firm e.g. employees, customers, government,
Shareholders etc.
• It is a long term objective and considers all the cash flows
• It considers the time value of money by discounting cash flows
 • It considers uncertainty of returns (risk) since the discounting rate can be adjusted
according to the riskiness of the project.
This goal however has the following disadvantages:
• Ignores social responsibility
• It’s subjective since it’s based on estimates of future cash flows
• It assumes perfect market exists.

b) Non-financial goals
➢ Social responsibility
The firm must decide whether to operate strictly in their shareholders' best interests or be
responsible to their employers, their customers, and the community in which they operate. The
firm may be involved in activities which do not directly benefit the shareholders, but which will
improve the business environment. This has a long term advantage to the firm and therefore in the
long term the shareholders wealth may be maximized.
➢ Business Ethics
Related to the issue of social responsibility is the question of business ethics. Ethics are defined
as the "standards of conduct or moral behavior". It can be thought of as the company's attitude
toward its stakeholders, that is, its employees, customers, suppliers, community in general,
creditors, and shareholders. High standards of ethical behavior demand that a firm treat each of
these constituents in a fair and honest manner. A firm's commitment to business ethics can be
measured by the tendency of the firm and its employees to adhere to laws and regulations relating
to:
• Product safety and quality
• Fair employment practices
• Fair marketing and selling practices
• The use of confidential information for personal gain