CHAPTER
NATURE, PURPOSE AND
SCOPE OF FINANCIAL
MANAGEMENT
Expected. Learning Outcomes
After studying Chapter 1, you should be able to:
Describe the nature, goal and basic scope of
financial management.
Explain briefly the three major types of
decisions that the Finance Manager makes.
Discuss the importance or significance of
financial management.
Describe the relationship between Financial
Management and Accounting.
Describe the relationship between Financial
Management and Economics.
O06
Scanned with CamScannerCHAPTER 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 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 CamScannershareholders 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 acqui
financing and management of assets of business concer 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 firm 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
Scanned with CamScannerNature, Purpose and tien
eof Financial Management §
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distiplinw Beds ee Mt Management, quality improvement, financial
Globalization has caused to integrate the national economy with the global
economy and has created a new financial environment which brings nem
Opportunities and challenges to the business enterprises. This development has also
hed 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 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 « modem 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 creat
of wealth,
Scanned with CamScannerFinancing 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 clements of financial analysis, planning, control, and resource
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allocation decisions. Cash flow is important because the financial health of the fim
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 whieh
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 Now, the
greater is the rate of return required by the owners.
Scanned with CamScannerRELATIONSHIP BETWEEN FINANCIAL MANAGEMENT,
ACCOUNTING AND ECONOMICS
FINANCIAL MANAGEMENT AND ACCOUNTING
Just as marketing and production are major functions in an enterprise, finance too
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 4
given project generates in comparison with alternative investments), thus enabling
them to make more accurate assessments of the profitabilities of specific
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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 hen 1) best
to issue equity shares, bonds or other financial instruments.
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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,
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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 relations! 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.
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