FINANCIAL MANAGEMENT – V SEMESTER CHAPTER 1

NATURE 0F FINANCIAL MANAGEMENT

INTRODUCTION
Financial Management was a part branch of economics till 1890’s. In the last half of 20 th
century financial management has undergone many changes. The developments in
science and technology have brought significant changes in the industry and business.
This contributed to the development of financial management as a separate discipline.

MEANING OF FINANCIAL MANAGEMENT

Financial Management is broadly concerned with acquisition and use of funds by a
business firm.

DEFINITIONS
Financial Management has been defined in different ways by different authorities.
 According to Van Horne and Wachowicz, “Financial Management is concerned
with the acquisition, financing and management of assets with some overall goal in
mind.”
 In the words of Prof. Ezra Solomon, “Financial Management is concerned with the
efficient use of an important economic resource namely, Capital Funds.”
The term efficient use of economic resources used in this definition signifies that this
definition covers many functions of financial management. It would mean financing,
investment, restructuring, consolidation etc.
However this definition suffers from certain drawbacks. They are:
1. This definition mentions about the efficient use of only capital funds (i.e. long term
funds) but it does not talk about the short term fund.
2. The definition covers many of the functions of financial management but it does not
specify the characteristics of those functions.

SCOPE OF FINANCIAL MANAGEMENT

There are two well known approaches to financial management. They are:
A. Traditional approach
B. Modern approach
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A. TRADITIONAL APPROACH :

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Under the traditional approach, the term ‘corporation finance’ or ‘corporate finance’
was used for financial management. Under this approach the role of financial
management was limited to mere arrangements of funds for the business.
Even though this is traditional approach, it is valid even in the present day where;
i. The scale of operation is small
ii. Profitability is limited
iii. Where the promoters are not
dynamic The scope is limited only in the
following areas:
1. Raising funds: Operation of business creates demand for funds. These funds are to
be raised from various sources. Each source has a different cost and benefit. The
finance manager must select that source which gives maximum benefit to the
organization. This function becomes significant for those firms which cultivates a
market friendly image. Such an image helps the firm to raise funds not only from
domestic investors as well as from the foreign investors.
2. External reporting: External Reporting refers to sending the copies of annual
reports to the necessary Governmental organization and share holders. So every
joint stock company prepares annual reports and gets them audited and then sends
the copies of annual reports to governmental organization and shareholders.
3. Institutions and instruments: Institutions refers to the institutions operating in the
capital market and the instruments that are used for mobilizing the funds.
Limitations of traditional approach
1. Over-emphasis on external reporting: Due to too much importance to external
reporting, financial management faces more problems. Some of the listed
companies have to report and publish their financial performance every quarter.
Therefore external reporting is no longer an annual affair but it’s done four times
in a year with four quarterly reports and an annual report.
2. Corporate bias: The traditional approach gives attention to the financial problems
of only the corporate bodies like Joint Stock Companies. It completely ignored the

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financial problems of Non corporate bodies like Partnership Firms & sole trading
concern.
3. Insignificant role to working capital management: This approach gives more focus
on the problems of long term financing. It ignores the problems of short term
financing (i.e. working capital).
4. Ignoring routine problems: More importance is given to rare events like mergers,
acquisitions and financial restructuring but the day to day problems are
completely ignored.
5. Descriptive approach: Many quantitative approach techniques and mathematical
models are used in financial management but this approach ignores them and
gives a purely theoretical approach. So this approach is descriptive than
analytical. .
B. MODERN APPROACH
After 1949 the traditional approach lost its popularity. Several changes that had
taken place in the business world had reduced the popularity of traditional approach
and contributed to the emerging of modern approach.
The modern approach assigns the following functions to financial management:
1. Financing decision
2. Investment decision
3. Dividend decision
1. Financing decision: Financing decision refers to decision concerning financial
matters of a business concern. Every business concern raises funds from promoters,
shareholders, creditors and financial institutions.
Financial decision deals with the following:
i. Estimation of funds requirement: The requirement of finance to a business concern
is continuous. Funds are required in all stages of business activities. i.e. funds may
be required to met the promotional expenses, fixed and working capital needs,
capacity expansion , entering new markets etc. so the finance manager has to
estimate the total finance required by the firm.

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ii. Procurement of funds: Once the funds needed are estimated they should be
procured from relevant sources. Each source has a different cost and benefit. The
finance manager has to select that source which is more beneficial to the company.
iii. Planning the capital structure: The funds can be raised from the two sources;
a. Ownership funds:- equity share capital or preference share capital
b. Creditorship funds:- debentures , bonds and long term loans
Financial manager has to plan how much should be the ownership fund
and the Creditorship fund and he has to maintain a balance between both the
sources. Any error regarding the capital structure may create a permanent
impact on the profitability of the firm.
iv. Negotiating with funding agencies: The companies can raise funds from all over
the world. There are many funding agencies like financial institutions, venture
capital funds, mutual funds, insurance company, banks etc. The finance manger
negotiates regarding rate of interest and period of repayment that have a
significant impact on the future financial position of the company.
2. Investment decisions: It refers to the activity of deciding the pattern of investment.
i. Working capital management (short term investment decision): Working capital
refers to the capital needed for the day to day working of the organization. It relates
to the allocation of funds among current assets, management of accounts receivables
and inventory management. Carrying too much of debtors and inventory will have
impact on profitability. Therefore, finance manager has to make a proper balance on
these.
ii. Capital budgeting (long term investment decision): Capital budgeting is a process of
making investment decision in capital expenditure. These are the expenditure whose
benefit is expected for a long period of time.
Capital budgeting provides the necessary tools to evaluate long term
investments like purchase of fixed assets , expanding capacity, buying or
taking over another company.
iii. Portfolio management: Portfolio refers to the combination of various securities. The

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finance manager can invest the surplus funds in money market and capital market

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securities. Therefore, finance manager has to design a portfolio based on the

investment objective of the firm.
iv. Risk management: The finance manager has to take necessary measures to manage
the risk arising from investment made in corporate securities and foreign exchange
markets.
v. Evaluation of performance through bench marking: Bench marks/bench marking are
established for evaluating the performance of various financial components like sale,
gross profit and net profit. Financial performances are evaluated in the light of these
bench marks.

3. Dividend policy decisions: The dividend decision is concerned with allocation of

profits of the firm between payment to shareholders and retained earnings.
i. Profit allocation: Profit should be allocated among various types of reserves such
as general reserve and dividend equalization fund. It is also necessary to meet
future contingencies. Decisions must be taken regarding the types of reserves to be
created and the amount to be transferred to these reserves.
ii. Framing dividend policy: Companies have to decide whether they have to follow
liberal dividend policy or conservative dividend policy. The company must also
decide whether to declare only the final dividend or interim dividend periodically.

OBJECTIVES OF FINANCIAL MANAGEMENT

The following are generally accepted as the objectives. They are;

1. Profit maximization: Maximization of the profit is the basic objective of any

organization. Profit can be maximized by increasing the sales and reducing the costs
or by doing both. The companies that maximize the profits survive well, gain market
share, take over other companies and expand or diversify their business.

The advantages of Profit maximization objective

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I. It provides better returns to the shareholders

II. It provides prompt payment to creditors
III. It provides better salary and working conditions to the employees
IV. Profits are the main source of finance for the growth and efficiency of the business.
V. Earning of profit is necessary for fulfilling social goals.

Limitations of profit maximization objective

A. Vagueness: It doesn’t clarify as to whether the short term profits or long term profits
are to be maximized. It means different things to different people.
B. Ignoring time value of money: Money received today may be having higher value
than a money received after a year. It does not take into consideration the time value
of money.
C. Ignoring risk and uncertainty: Since the main objective is profit maximization, many
of the firms ignores the factor of risk and uncertainty which the business is exposed.
There is a direct relationship between profit, risk and uncertainty.
D. Ignoring the role of growth: - Many corporate ignore the profit in order to achieve
the long term growth. They may totally ignore the profits for many years. But Profit
maximization objective totally ignores the role of growth because their main
intention is to earn more and more profits.

2. Wealth maximization: Wealth maximization refers to the maximization of net present

worth of the company, over the long run. It also implies that maximization of market
value of the equity shares of the company.
Net present value (NPV) = Present value of cash inflow – present value of cash outflow
Net present worth is the difference between gross present worth and the amount of
capital invested.
Wealth is measured by the following formula;

W=

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Wealth can be maximized by a firm in the following ways:

1. By avoiding projects which involve high profit with high risk.
2. By paying dividend to shareholders regularly. Payment of regular dividend
increases the reputation of the firm.
3. By maintaining growth in sales
4. By adopting sound investment policy.

Merits of the concept wealth maximization

1. The concept of wealth maximization is very clear and not vague.

2. It considers the time value of money. It recognizes the fact that rupee received
today has more value than a rupee received after a year.
3. The concept takes in to account the risk factor.
4. The wealth maximization objective also contributes to the maximization of other
objectives.
5. The wealth maximization objective serves the interest of shareholders and also
serves the interest of the lenders.
3. Imparting sufficient liquidity: Every organization should maintain sufficient amount
of cash. Financial management aims at maintenance of adequate liquid assets with
the firm to meet its obligations at all the time. However, investment in liquid assets
has to be adequate. i.e. neither too low nor too excessive. The finance manager has to
maintain balance between liquidity and profitability.
4. Adding to shareholder value: Every corporate tries hard to provide better rewards to
the shareholders out of the shares purchased. This may be in the form of
a) Higher dividend
b) Frequent interim dividend
c) Bonus shares
5. Corporate governance: Every corporate should operate in such a way that it doesn’t
make any of the stakeholders like customers, suppliers, employees, shareholders etc
suffer from its actions or decisions.

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In India, Securities Exchange Board of India (SEBI, puts a clause in the listing
agreement of stock exchanges. It is for the stock exchanges to watch whether price
sensitive information is furnished by the concerned company to the stock exchange
without loss of time. The stock exchange publishes the information on its notice board
and also on its website, so that, everyone has an equal opportunity to know the price
sensitive information at the same time. Such a protection of shareholders interest by
the stock exchange is called corporate governance.
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6 marks questions

1. What is wealth maximization? Explain its any four merits. oct-2014

2. Discuss wealth maximization objective of financial management? In what ways it
is superior to profit maximization?oct-2013, oct-2010
3. Explain the growing importance of financial management to business. Oct-2012
4. Explain the scope of financial management under traditional approach. Oct-2011
5. Describe wealth maximization as an objective of financial management. Oct-

2009 12 marks questions

1. Explain profit maximization and wealth maximization as objective of financial

management. Oct-2012
2. In what ways wealth maximization objective is superior to profit maximization?
Explain. Oct-2011
3. Discuss the scope of financial management under modern approach oct-2014

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