1 Financial Management
FINANCIAL MANAGEMENT Kenneth Midgley and Ronald Burns state.
( Finance Functions - Definition and scope of
finance functions - Profit maximization v/s wealth
maximization goal - Organisation of Finance
Function )
Unit 1. Introduction.
A business is an activity which is carried on
with the intention of earning profits. If the
operations of a typical manufacturing organization
are considered, it involves the purchasing of raw
material, processing the same with the help of
various factors of production like labor and
machinery, manufacturing the final product and
marketing and selling the finished product in the
market to earn the profits.
Thus production, marketing and business
financing are the key operational areas in case of
any business organization, out of which finance is
the most crucial one. This is so as the functions of
production and marketing are related with the
function of finance. If the decisions relating to
money and funds fail, it may result into the failure
of the business organization as a whole. Hence, it is
utmost important to take the proper financial
decisions and that too at a proper point of time.
Finance is the life-blood of modern business
economy. We cannot imagine a business without
finance in the modern world. It is the basis of all
economic activities, no matter; the business is big
or small. The problem of finance and that of
financial management is to be dealt within every
organisation. The problem of finance is equally
important to government, semi-governments and
private bodies, and to profit and non-profit
organisations.
Definition.
Financial management is that managerial
activity which is concerned with planning and
controlling of firms financial resources.
According to Paul. G. Hasings, 'Finance' is the
management of the monetary affairs of a company.
It includes determining what has to be paid for
raising the money on the best terms available and
devoting the available resources to best uses."
"Financing is the process of organizing the flow of
funds so that a business can carry out its objectives
in the most efficient manner and meet its
obligations as they fall due."
“Financial Management is an area of financial
decision making harmonizing individual motives
and enterprise goals.”-Weston and Brigam.
“Financial Management is the application of the
planning and control functions to the finance
function.”- Howard and Upton.
“Financial Management is the operational activity
of a business that is responsible for obtaining and
effectively, utilizing the funds necessary for efficient
operations.”- Joseph and Massie.
From the above definitions of the term
finance given above, it can be concluded that the
term business finance mainly involves rising of
funds and their effective utilization keeping in view
the over all objectives of the firm. The management
makes use of the various financial techniques,
devices etc for administering the financial affairs of
the firm in the most effective and efficient way.
Finance and Related Disciplines.
Financial management -an integral part of
over all management is not a totally independent
area. It draws heavily on related disciplines and
fields of study, such as Economics, Accounting,
Marketing, Production, and Quantitative Methods.
Financial Management and Economics.
The relevance of economics to Financial
Management can be described in the lights of the
two broad areas of economics, -macro economics,
and micro economics. Macro economics is
concerned with the over all institutional
environment in which the Company operates. It
looks at the Economy as a whole. It is concerned
with the institutional structure of the banking
system, money and capital markets, financial
intermediaries, monetary credit, and fiscal policies.
Since the business operates in the macro economic
environment, it is important for financial managers
to understand the broad economic environment.
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2 Financial Management
Micro economics deals with the economic
decisions of individuals and organizations. It
concerns itself with the determination of optimal
operating strategies. A financial manger uses these
to run the firm efficiently and effectively.
Financial Management and Accounting.
Accounting function is a necessary input in
to the finance function. ie. accounting is a sub
function of finance. Accounting generates
information about a firm. The end products of
accounting constitute financial statements such as
Balance Sheet, P&L Account and the statement of
changes in financial position. The information
contained in this reports and statements assist
financial managers in assessing the past
performance and taking future decisions of the firm
and in meeting the legal obligations such as
payment of Taxes and so on. Thus accounting and
finance are functionally closely related.
Finance and Other Related Disciplines.
Apart from economics and accounting,
finance also draws considerably for its key day
today decisions- on supportive disciplines such as
Marketing, Production, and Quantitative methods.
For instance financial managers should consider the
impact of new product development and
promotion plans made in the marketing area since
their plans will require Capital or Fund out flows
and have an impact on the projected cash flows.
Similarly changes in the production process may
necessitate capital expenditure which the financial
managers must evaluate and finance. And finally
the tools of analysis developed in the quantitative
techniques are helpful in analyzing complex
financial management problems.
Thus the marketing, production and
quantitative techniques are only indirectly related
to day to day decision making by financial managers
and are supportive in nature , while Economics and
Accounting are primary disciplines on which the
financial managers draws substantially.
Scope of Financial Management.
The approach to the scope and functions of
financial management is divided in to two broad
categories. Traditional Approach and Modem
Approach.
A. Traditional Approach.
The traditional approach to the scope of
financial management refers to the subject matter,
in academic literature in the initial stages of its
development, as a separate branch of academic
study. The term 'Corporation Finance' was used to
describe what is known as Financial management.
As the name suggests, the concern of 'Corporation
Finance' was with the financing of Corporate
enterprises. In other words the scope of finance
function was treated by the traditional approach in
the narrow sense of procurement of fund by
corporate enterprises to meet their financing
needs. So the field of study included,
1. Institutional arrangements in the form of
financial institutions which comprise the
organization of Capital Market.
2. Financial instruments through which Funds are
raised from the capital market. &
3. The Legal and Accounting relationship between a
firm and its sources of funds.
The traditional approach was criticized in the
following grounds.
1. The approach equated finance function with
raising and administering of funds only. The
limitation was that internal decision-making was
completely ignored.
2. The focus was on financing problems of
Corporate enterprises (i.e. Companies). Non
corporate organizations lay outside its scope.
3. The approach laid over emphasis on the
problems of long term financing. Hence day to day
financial problems and working capital
management of a business did not receive any
attention.
B. Modern Approach.
The modern approach views the term
'Financial management' in a broad sense and
provides a conceptual and analytical frame work for
financial decision making. According to it Finance
function covers both acquisitions of funds as well as
their allocations. Thus the Financial Management,
in the modern sense of the term, can be broken
down in to 3 major decisions as functions of
Finance.
1. The investment Decision
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3 Financial Management
2. The Financing Decision
3. The Dividend Policy Decision.
Finance Functions.
( Scope or Content of Finance function / Financial
management )
Functions performed by financial
management can be broken down into three major
decisions viz., (1) Investment decision; (2) Financing
decision; and (3) Dividend decision. A firm takes
these decisions simultaneously and continuously in
the normal course of business.
1. Investment Decision.
The investment decision relates to the
selection of Assets in which funds will be invested
by a firm. The Assets which can be acquired fall in
to two broad categories.
A. Long Term or Fixed Assets, which yield a
return over a period of time in future.
B. Short term or Current Assets which in the
normal course of business are convertible in
to cash usually within a year.
The aspects of financial decision making with
reference to long term assets is popularly known as
Capital Budgeting and financial decision making
with reference to current assets is popularly termed
as Working Capital Management.
A. Capital Budgeting.
Capital Budgeting is probably the most
crucial financial decisions for a firm. It relates to the
selection of an asset or investment proposal or
course of action whose benefits are likely to be
available in future over the life time of the project.
The first aspect of capital budgeting decision
relates to the choice of the new asset out of the
alternatives available or the reallocation of capital,
when an existing asset fails to justify the funds
committed. Whether an asset will be accepted or
rejected will depend upon the relative benefits and
returns associated with it. The measurement of
worth of the investment proposal is, there for, a
major element in Capital budgeting decisions.
The second element of Capital Budgeting
decision is the analysis of risk and uncertainty. Since
the benefits from the investment proposals extend
in to the future, there accrual is uncertain. They
have to be estimated under various assumptions of
the physical volume of sales and the level of prices.
An element of risk in the sense of 'uncertainty of
future benefits' is thus involved in the capital
budgeting. The returns from capital budgeting
decisions should, there fore, be evaluated in
relation to the risk associated with it.
B. Working Capital Management.
Working capital management is concerned
with the management of current asset. One aspect
of working capital management is the trade off
between profitability and risk.
There is a conflict between profitability and
liquidity. If a firm does not have adequate working
capital, it may become illiquid and consequently
may not have the ability to meet its current
obligations. If current assets are too large,
profitability is adversely affected. The key strategies
and considerations in ensuring a trade oil' between
profitability and liquidity is one of the major
dimensions of working capital management. In
addition, the individual current asset should be
efficiently managed so that neither in adequate nor
unnecessary funds are locked up.
2. Financing Decisions.
The second major decision involved in
financial management is the financing decision.
The concern of the financing decision is with the
Financing Mix or Capital Structure or Leverage. The
term capital structure refers to the proportion of
debt (i.e., fixed interest source of financing) and
equity capital (or variable dividend security). The
financing decision of a firm relates to the choice of
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4 Financial Management
the proportion of these sources to finance the
investment requirements. A capital structure with a
reasonable proportion of debt and equity capital is
called optimum capital structure.
3. Dividend Policy Decision.
The third major decision of financial
management is the decision relating to dividend
policy. Two alternatives’ are available in dealing
with the profits of the firm. They can be distributed
to the share holders in the form of dividends or
they can be retained in the business itself. The final
decision will depend upon the preference of the
share holders and the investment opportunities
available within the firm. The optimum dividend
policy is one which maximizes the market value of
the Co's shares. Most profitable Co's pay cash
dividend regularly. Periodically additional shares,
called Bonus shares, are also issued to the existing
share holders in addition to the cash dividend.
4. Liquidity Decision.
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.
In addition to the above functions, the Scope or
Content of Finance function / Financial
management also include:-
5. Estimating financial requirements:-
The financial manager should estimate both long
term and short term financial requirements of his
business. For this purpose he will prepare a
financial plan. The amount required for purchasing
fixed assets and for maintaining working capital
have to be ascertained.
6. Proper Utilisation of Funds :
Though raising of funds is important but their
effective utilisation is more important. The funds
should be used in such a way that maximum benefit
is derived from them. The returns from their use
should be more than their cost. It should be
ensured that funds do not remain idle at any point
of time. The funds committed to various operations
should be effectively utilised. Those projects should
be preferred which are beneficial to the business.
7. Proper cash management:-
The financial manager has to assess the various
cash needs at different times and then make
arrangements for arranging cash. Cash may be
acquired to a) Purchase raw materials, b) make
payments to creditors, 3) meet wage bills, 4) meet
day to day expense etc. the usual source of cash
may be a) Cash sales, b) collection of debts, short
term arrangements with banks etc. The cash
management should be such that neither there is a
shortage of it and nor it is idle.
8. Financial controls:-
An efficient system of financial management needs
various control devices. They include a) return on
investments, b) Budgetary control, c)Break Even
Analysis, d) Cost control, e) ratio Analysis, f) Cost
and Internal Audit. The use of various control
techniques will help manager in evaluating the
performance and to take various corrective
measures when needed.
9. Increasing Profitability. The planning and control
of finance function aims at increasing profitability
of the concern. To increase profitability, sufficient
funds will have to be invested. Finance function
should be so planned that the Company neither
suffers from shortage of funds nor wastes more
funds than required. The cost of acquiring funds
also influences profitability of the business.
Objectives of Financial Management.
Financial management is concerned with
the efficient use of capital funds. It evaluates how
funds are procured and used. Financial
management covers decision making in three inter
related areas namely Investment, Financing and
Dividend policy. The financial manager has to take
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5 Financial Management
these decisions with reference to the objectives of
the firm. The objectives provide a frame work for
optimal financial decision making. There are two
widely discussed approaches in this regard.
1. Profit Maximization Approach
2. Wealth Maximization Approach.
Profit Maximisation Approach.
According to this approach, actions that
increase profits should be undertaken and that
decrease profits should be avoided. Profits
maximization approach implies that the functions
of financial management/ Decisions taken by
financial mangers (i.e. the investment, financing,
and dividend policy decisions) should be oriented
towards maximization of profits or Rupee income of
the firm. Or the Company should select those
assets, projects, and decisions which are profitable
and reject those which are not.
In the Economic theory, the behaviour of a
Company is analyzed in terms of profit
maximization. While maximizing profits, a firm
either produces maximum output for a minimum
input, or uses minimum input for a given out put.
So the underlying logic of profit maximization is
efficiency. Profit is a test of economic efficiency and
it provides a yard stick by which economic
performance can be judged.
The profit maximization criterion has
however been criticized on several grounds. The
main technical flaws are ambiguity, timing of
benefits and quality of benefits.
1. Ambiguity.
One practical difficulty with profit
maximization criterion for financial decision making
is that, the term profit is a vague and ambiguous
concept. It is amenable to different interpretations
by different people. It is not clear in what sense the
term profit has been used. It may be total profit
before tax or after tax or profitability rate. Rate of
profitability may again be in relation to Share
capital; owner's funds, total capital employed or
sales. Furthermore, the word profit does not speak
anything about the short-term and long-term
profits. Profits in the short-run may not be the
same as those in the long run. A firm can maximise
its short-term profit by avoiding current
expenditures on maintenance of a machine. But
owing to this neglect, the machine being put to use
may no longer be capable of operation after
sometime with the result that the firm will have to
make huge investment outlay to replace the
machine. Thus, profit maximisation suffers in the
long run for the sake of maximizing short-term
profit. Obviously a loose expression like profit can't
form the basis of operational criterion for financial
management.
2. Timing Of Benefit
A more important technical objection to
profit maximization is that it ignores the differences
in the time value of the benefits received. Time
value of money refers a rupee receivable today is
more valuable than a rupee, which is going to be
receivable in future period.
Profit maximization gives equal importance
to all earnings through the receivable in different
periods. Hence, it ignores time value of money. This
is not true in actual practice as benefits in early
years should be valued more highly than equivalent
benefits in later years.
3. Quality of Benefits.
Profit maximization ignores the quality
aspect of benefits associated with a financial course
of action. The term quality refers to the degree of
certainty with which benefits can be expected. As a
rule, the more certain the expected return, the
higher is the quality of the benefits. An uncertain
and fluctuating return implies risk to the investors.
To conclude the profit maximization
criterion is unsuitable and in appropriate as an
operational objective of investment, financing and
dividend decision of a firm. It is not only vague and
ambiguous, but it also ignores risk and time value of
money.
Wealth Maximization Approach.
(Shareholders Wealth Maximisation)
This is also known as value maximization or
Net Present Worth maximization. It removes the
technical limitations of profit maximization
criterion.(i.e. ambiguity, timing of benefit and
quality of benefit.)
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6 Financial Management
Wealth maximization means maximizing the
Net Present Value (or wealth) of a course of action.
The Net present value of a course of action is the
difference between the present value of its benefits
and the present value of its costs. A financial action
which has a positive Net Present Value creates
wealth and there fore it is desirable. A financial
action resulting in negative NPV should be rejected.
Between a number of desirable mutually exclusive
projects, the one with the highest NPV should be
adopted.
The objective of wealth maximisation takes
care of the questions of the timing and risk of
expected benefits. These problems are handled by
selecting an appropriate rate for discounting the
expected flow of future benefits. It should be
remembered that the benefits are measured in
terms of cash flows. In investment and financing
decisions it is flow of cash which is important, not
the accounting profits. The Wealth created by a
Company through its actions is reflected in the
market value of companies' shares. The value of the
companies share is represented by the market
price, which in turn, is a reflection of the firm's
financial decisions. The market price of the share
serves as the performance indicator.
The following arguments are advanced in
favour of wealth maximization. ( Advantage /
merits)
functions of finance, we need a sound and efficient
organization.
The ultimate responsibility of carrying out the
finance function lies with the top management.
However, organization of finance function differs
from company to company depending on their
respective requirements.
Financial planning and financial control are quite
significant for a large sized organisation. Therefore,
a finance committee is established between the
Board of Directors and Managing Director. Its main
function is to advise the Board of Directors on
financial planning and financial control and co-
ordinate the activities of various departments. The
following chart explains the organisation of finance
function.
It is evident from the above that Board of Directors
is the supreme body under whose supervision and
control Managing Director, Production Director,
Personnel Director, Financial Director, Marketing
Director perform their respective duties and
functions. Further while auditing credit
management, retirement benefits and cost control
banking, insurance, investment function under
treasurer, planning and budgeting, inventory
management, tax administration, performance
evaluation and accounting functions are under the
supervision of controller.

1. It serves the interest of the owners as well

as other stakeholders. Ie, suppliers of loan,
employees, creditors, society etc.
2. It is consistent with the objective of owners
economic welfare.
3. It helps in the long run survival and growth
of the firm
4. It considers the time value of money and
risk factor.
5. The effect of dividend policy is also
considered.
6. It helps to the increase in the stock price.

Organisation of Finance Function

The organisation of finance function implies the

division and classification of functions relating to
finance because financial decisions are of utmost
significance to firms. Therefore, to perform the
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7 Financial Management
The terms ‘controller’ and ‘treasurer’ are in fact
used in USA. Financial controller who has been a
person of executive rank does not control the
finance, but monitors whether funds so augmented
are properly utilized. The function of the treasurer
of an organization is to raise funds and manage
funds.
The treasures functions include forecasting the 21
financial requirements, administering the flow of
cash, managing credit, flotation of securities,
maintaining relations with financial institutions and
protecting funds and securities. The controller’s
functions include providing information to
formulate accounting and costing policies,
preparation of financial reports, direction of
internal auditing, budgeting, inventory control
payment of taxes, etc.
According to Prof. I.M. Pandey, while the
controller’s functions concentrate the asset side of
the balance sheet, the treasurer’s functions relate
to the liability side.
SIGNIFICANCE / IMPORTANCE OF FINANCIAL
MANAGEMENT.
business concern. Financial decision will affect the
entire business operation of the concern. Because
there is a direct relationship with various
department functions such as marketing,
production personnel, etc.
4. Improve Profitability - Profitability of the
concern purely depends on proper utilization of
funds by the business concern. Financial
management helps to improve the profitability
position of the concern with the help of strong
financial control devices such as budgetary control,
ratio analysis and cost volume profit analysis.
5. Increase the Value of the Firm - Financial
management is very important in the field of
increasing the wealth of the investors and the
business concern. Ultimate aim of any business
concern will achieve the maximum profit and higher
profitability leads to maximize the wealth of the
investors as well as the nation.

Finance is the lifeblood of business organization

and hence Financial management is a very 6. Market value of the business can be increased
important function of overall business through efficient and effective financial
management. Some of the importance of the management.
financial management is as follows:

1. Financial Planning - Financial management

helps to determine the financial requirement of the 7. Efficient financial management is necessary for
business concern and leads to take financial the survival, growth, expansion and diversification
planning of the concern. Acquisition of Funds of a business.
Financial management involves the acquisition of
required finance to the business concern. Acquiring
8. Financial Management significantly influences
needed funds play a major part of the financial
the business's credit rating, employee
management, which involve possible source of
commitment, suppliers' confidence, customers'
finance at minimum cost.
patronage and the like.
2. Proper Use of Funds - Proper use and
allocation of funds leads to improve the operational
efficiency of the business concern. When the
finance manager uses the funds properly, they can
reduce the cost of capital and increase the value of
the firm.
3. Financial Decision - Financial management
helps to take sound financial decision in the
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