Course Code and Title: FINP1 – Financial Management

Lesson Number: 1
Topic: Nature, Purpose, and Scope of Financial Management
Learning Objectives:
After studying Chapter 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
Pre-assessment:

Write T if the statement is true and F if the statement is false.

_____1. Financial management is a part of a large discipline called Finance.

_____2. The goal of financial management is to minimize the current value of the existing stock
or ownership in a business firm.
_____3. There is no need to learn on how to identify investments, arrangements, and dividend
distribution.
_____4. Financial managers should do the necessary means, whether legal or illegal, to
accomplish the objective of financial management.
_____5. Financial manager in a business enterprise is responsible in making financial decisions
in an organization setting.
 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 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
planning 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
fit-in 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:
 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 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.
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 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 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 invests his money 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 is an independent
specialized function and is well knit other functions.
Financial management is a separate management area. In many organizations,
accounting and finance functions are mixed 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 fer 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 firms 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 a given project generates in comparison with
alternative investments), thus enabling them to make more accurate assessments of the profit
abilities of specific 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.
The sale of products at a profit depends heavily on how well managers are able to
analyze and interpret supply and demand conditions. Supply considerations relate specifically to
the control of 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
reasonable 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 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.
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.
Activity:

Write T if the statement is true and F if the statement is false.

_____1. The financial manager should act in the owners’ or shareholders’ best interest by
making decisions that increase the value of the firm or the value of the stock.
_____2. Globalization brings new challenges and opportunities to business enterprises, and to
financial management.
_____3. The financial manager function is on the procurement of short-term funds from financial
institutions only.
_____4. Financial management doesn’t reduce the chance of failure of an organization
_____5. Financial management is not related to other areas such as accounting and
economics.

Reinforcement:

Choose the letter of the best answer:

1. The following are the functions that a financial manager will perform in the traditional
view of Financial management, except:
a. Procurement of short-term as well as long-term funds from financial institutions
b. Mobilization of funds through financial instruments such as equity shares, preference
shares, debentures, bonds, notes, and so forth
c. 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.
d. Selling the business organization to shady investors.
2. The finance manager is expected to analyze the business firm and determine the
following, except:
a. The total funds requirements of the firm
b. The assets or resources to be acquired
c. The best way to put out the company out of business
d. The best pattern of financing the assets
3. The types of financial decision that a finance manager of a modern business firm will be
involved in are the following, except for one:
a. Downloading decisions
b. Investment decision
c. Dividend decisions
d. Financial decisions
4. Financial management process deals with:
a. Investments
b. Financing Decisions
c. Both a and b
d. None of the above
5. The following is the significance of financial management in the different aspects, except
for one:
a. Reduction of chances of failure
b. Measurement of return on investment
c. Broad Applicability
d. Piercing the veil of corporate entity
6. Statement 1: 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, the effective financing of investment and operations.
Statement 2: 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.
a. Statement 1 is True, Statement 2 is False
b. Statement 1 is False, Statement 2 is True
c. Both statements are True
d. Both statements are False
7. The following are included in the financial statements, except
a. Statement of Comprehensive Income
b. Statement of Financial Position
c. Water Flow Statement
d. Statement of Changes in Shareholders’ Equity
8. Statement 1: Financial managers don’t need economics in making financial decisions.
Statement 2: Economics focuses on a both on individual and firm level, and at a
national/global level.
a. Statement 1 is True, Statement 2 is False
b. Statement 1 is False, Statement 2 is True
c. Both statements are True
d. Both statements are False
9. This 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.
a. Financing Decisions
b. Dividend Decisions
c. Selling Decisions
d. Investment Decisions
10. Statement 1: Microeconomics focuses on the optimal operating strategies based on the
economic data of individuals and firms.
Statement 2: Financial manages don’t have obligations with the general public or third
parties.
a. Statement 1 is True, Statement 2 is False
b. Statement 1 is False, Statement 2 is True
c. Both statements are True
d. Both statements are False