CHAPTER 1

Nature, Purpose and Scope of Financial Management

Objectives:
1. Describe the concept of financial management.
2. Describe the goals of financial management (raising finance, allocation of financial resources, maintaining
control over resources).
3. Identify the scope of financial management.
4. Describe the significance of financial management.
5. Recognize the core of financial management.

Any company's financial health is crucial. Finances, like most other resources, are, however, finite. Wants, on the
other hand, are often limitless. As a result, it is important for a company to effectively control its finances.
It is important for any company to invest the funds it receives in such a way that the investment yields a higher return
than the cost of capital. Financial management, in a nutshell –

● Endeavors to reduce the cost of finance

● Ensures sufficient availability of funds
● Deals with the planning, organizing, and controlling of financial activities like the procurement and
utilization of funds

Definitions of Financial Management

“Financial management is the activity concerned with planning, raising, controlling and administering of funds used
in the business.” – Guthman and Dougal

“Financial management is that area of business management devoted to a judicious use of capital and a careful
selection of the source of capital in order to enable a spending unit to move in the direction of reaching the goals.” –
J.F. Brandley

“Financial management is the operational activity of a business that is responsible for obtaining and effectively
utilizing the funds necessary for efficient operations.”- Massie

Nature, Significance, and Scope of Financial Management

Any company's financial management is a natural part of its operation. To procure physical resources, carry out
manufacturing activities and other business operations, pay compensation to vendors, and so on, every company
requires funds. There are several financial accounting theories:

1. Some experts believe that financial management is all about getting a company the money it needs on the
most attractive terms possible while keeping its goals in mind. As a result, this strategy is mainly concerned
with the acquisition of assets, which can include instruments, institutions, and fundraising activities. It also
looks after the legal and accounting aspects of a company's relationship with its funding source.
Another group of experts believes that money is all in finance. Since all business transactions, whether
directly or indirectly, include cash, finance is concerned with everything the company does.

2. The third and most commonly held viewpoint is that financial management encompasses both the acquisition
and effective use of funds. In the case of a manufacturing company, for example, financial managers must
ensure that funds are sufficient for the installation of the manufacturing plant and machinery. It must also
ensure that earnings are sufficient to cover the costs and risks faced by the company.
Many companies can easily raise capital in a developed market. The real issue, however, is maximizing capital use
through successful financial planning and control.

Furthermore, the company must ensure that it handles activities such as allocating funds, handling them, investing
them, controlling expenses, predicting financial needs, preparing income and calculating returns on investment,
evaluating working capital, and so on.

Any company's financial health is crucial. Finances, like most other resources, are, however, finite. Wants, on the
other hand, are often limitless. As a result, it is important for a company to effectively control its finances.
It is important for any company to invest the funds it receives in such a way that the investment yields a higher return
than the cost of capital. Financial management, in a nutshell –

● Endeavors to reduce the cost of finance

● Ensures sufficient availability of funds
● Deals with the planning, organizing, and controlling of financial activities like the procurement and
utilization of funds

The Scope of Financial Management

You must also consider the scope of financial management in order to understand the introduction of financial
management. It is important that financial decisions consider the needs of shareholders.

Furthermore, they are supported by the maximization of shareholder wealth, which is dependent on increases in net
worth, capital invested in the company, and income plowed back for the organization's growth and prosperity.

The scope of financial management is explained in the diagram below:

You can understand the nature of financial management by studying the nature of investment, financing, and dividend
decisions.

Core Financial Management Decisions

Managers of companies make the following decisions in order to reduce the costs of obtaining finance and to use it in
the most efficient way possible:

Investment Decisions: Managers must determine the amount of investment available from existing funds, both long-
and short-term. There are two kinds of them:
● Capital Budgeting, also known as Long-term investment decisions, imply committing funds for a long time,
similar to fixed assets. These decisions are normally irreversible and involve those involving the purchase of
 a building and/or property, the acquisition of new plants/machinery or the replacement of old ones, and so
on. These choices influence a company's financial goals and results.
● Working capital management, also known as short-term investment decisions, refers to committing funds for
a short period of time, such as current assets. These decisions include cash, bank deposits, and other short-
term investments, as well as inventory investment. They have a direct impact on a company's liquidity and
profitability.

Financing Decisions: Managers must also make decisions on raising funds from long-term (Capital Structure) and
short-term sources (called Working Capital). There are two kinds of them:
● Financial Planning Decisions that include estimating the origins and applications of funds. It entails
anticipating a company's financial needs in order to ensure that sufficient funds are available. The primary
goal of financial planning is to prepare ahead of time to ensure that funds are available when needed.
● Capital Structure Decisions that include locating funding sources. They also include decisions on whether to
raise funds from external sources such as selling shares, bonds, or borrowing from banks, or from internal
sources such as retained earnings.

Dividend Decisions: These are decisions over how much of a company's earnings will be paid as dividends.
Shareholders often seek a higher dividend, while management prefers to keep income for operational purposes. As a
result, this is a difficult managerial decision.
Business Organization

Objectives:
1. Identify the different types of business organization
2. Compare how different each type of business organization from one another
3. Identify which type of business organization best suit a specific business

The single most important decision you'll make as a business owner is how to organize your company. A variety of
variables, all of which will determine your company's future, will be influenced by the shape your business takes.
Understanding the benefits and drawbacks of each business organization category is critical for aligning your priorities
with your business organization type.
Company’s form will affect:
● How you are taxed
● Your legal liability
● Costs of formation
● Operational costs

Sole Proprietorship
A sole proprietorship is the simplest and most common type of business ownership. It is a business that is owned and
operated solely for the benefit of the owner. Since the company's survival is solely dependent on the owner's decisions,
when the owner dies, the business dies with him.

ADVANTAGES DISADVANTAGES
● All profits are subject to the owner ● Owner is 100% liable for business debts
● There is very little regulation for ● Equity is limited to the owner’s personal
proprietorships resources
● Owners have total flexibility when running the ● Ownership of proprietorship is difficult to
business transfer
● Very few requirements for starting—often only ● No distinction between personal and business
a business license income

Partnership
There are two types of these: general and exclusive. In general, both partners invest their capital, land, labor, and other
resources in the company and are equally liable for its debts. In other words, even though you just put a small amount
of money into a general partnership, you might be held liable for the entire debt. General partnerships do not need a
formal agreement; between the two company owners, partnerships may be implicit or even verbal.
A formal agreement between the partners is needed for limited partnerships. They must also file a relationship
certificate with the department. Limited partnerships allow partners to restrict their personal responsibility for business
debts based on their ownership or investment percentage.

ADVANTAGES DISADVANATGES
● Shared resources provide more capital for the ● Each partner is 100% responsible for debts and
business losses
● Each partner shares the total profits of the ● Selling the business is difficult – requires
company finding new partner
 ● Similar flexibility and simple design of a ● Partnership ends when any partner decides to
proprietorship end it
● Inexpensive to establish a business partnership,
formal or informal

Limited Liability Company (LLC)

An LLC, like a limited partnership, limits shareholders' liability while providing some of the income benefits
of a partnership. In essence, an LLC combines the benefits of alliances and companies, eliminating some of
the drawbacks of each.

ADVANTAGES
● Limits liability to the company owners for
debt or losses
● The profit of the LLC are shared by the
owners without double taxation
DISADVANTAGES
● Ownership is limited by certain state laws
● Agreements must be comprehensive and
complex
● Beginning an LLC has high costs due to
legal and filing fees

Corporation
Corporations are considered legal persons and are considered distinct entities for tax purposes. This assumes, among
other items, that a corporation's earnings are taxed as the corporation's "personal gain." The money paid to shareholders
as dividends or gains is then taxed as the owners' personal income.

ADVANTAGES
● Limits the liability of owners to debt or losses
● Profit and losses belong to the corporation
● Can be transferred to new owners fairly easily
● Personal assets cannot be seized to pay for
business debts
DISADVANTAGES
● Corporate operations are costly
● Establishing a corporation is costly
● Start a corporate business requires complex
paper work
● With some exemptions corporate income tax is
higher