Financial Management

Financial Management refers to that part of the management activity which is concerned with the planning and controlling of firms financial resources. It deals with finding out various sources for raising funds for the firm. The sources must be suitable and economical for the needs of the business. The most appropriate use of such funds also forms a part of financial management.

Definition of Financial Management

Managerial activities which deals with planning and controlling of firms financial resources. -Financial management is the operational activity of a business that is responsible for obtaining and effectively utilising the funds necessary for efficient operations. J.L. Massie Business finance can be broadly defined as the activity concerned with the planning, raising, controlling and administering the funds used in the business. Guthmann and Dougall.

Financial management is indispensible to any organisation as it helps in: 1.Financial planning and successful promotion of an enterprise; 2.Acquisition of funds as and when requires at the minimum possible cost; 3 Proper use and allocation of funds; 4 Taking sound financial decisions; 5 Improving the profitability through financial controls; 6 Increasing the wealth of the investors and the nation

Finance Function: Finance Function is the most important of all business functions It remains a focus of all activities. The need for money is continuous. It starts with the setting up of enterprise and remains at all times. The development and expansion of business rather needs more commitment for funds.
The funds will have to be raised from various sources. The sources will be selected in relation to the implications attached with them. The receiving of money is not enough, its utilisation is more important. The money once received will have to be returned also.

IF its use is proper then its return will be easy otherwise it will create difficulties for repayment.

Approaches to Finance Function

The approaches to Finance Function is classified in two categories.
- Traditional approach
- Modern approach

Traditional approach

According to this approach, the scope of the finance function is restricted to procurement of funds by corporate enterprise to meet their financial needs. The term procurement refers to raising of funds externally as well as the inter related aspects of raising funds.

Traditional approach

The inter related aspects are the institutional arrangement for finance, financial instruments through which funds are raised and legal and accounting aspects between the firm and its sources of funds.

In traditional approach the resources could be raised from the combination of the available sources.

Limitations of traditional approach

This approach is confirmed to procurement of funds only.
It fails to consider an important aspects i.e. allocation of funds.

It deals with only outside i.e. investors, investment bankers.

Limitations of traditional approach

The internal decision making is completely ignored in this approach. The traditional approach fails to consider the problems involved in working capital management.

The traditional approach neglected the issues relating to the allocation and management of funds and failed to make financial decisions.

Modern approach

The modern approach is an analytical way of looking into financial problems of the firm. According to this approach, the finance function covers both acquisition of funds as well as the allocation of funds to various uses. Financial management is concerned with the issues involved in raising of funds and efficient and wise allocation of funds.

Main Contents of Modern approach

How large should an enterprise be and how far it should grow?

In what form should it hold its assets? How should the funds required be raised? - Financial management is concerned with finding answer to the above problems.

Functions of Finance
Financial decisions refer to decisions concerning financial matters of a business concern.

There are three finance functions Investment decision Financing decision Dividend decision

1 Investment Decisions: Investment Decision relates to the determination of total amount of assets to be held in the firm, the composition of these assets and the business risk complexions of the firm as perceived by its investors. Since funds involve cost and are available in a limited quantity , its proper utilisation is very necessary to achieve the goal of wealth maximisation.
The investment decisions can be classified under two broad groups: (i)Long-term investment decisions and (ii) Short-term investment decision. The long- term investment decision is referred to as the capital budgeting and the short-term investment decision as Working capital management.

Capital Budgeting is the process of making investment decisions in capital expenditure.These are expenditures, the benefits of which are expected to be received over a long periodof time exceeding one year. The finance manager has to assess the profitability of various projects before committing the funds. The investment proposals should be evaluated in terms of expected profitabiility, costs involved and the risks associated with the projects.
The investment decision is important not only for the setting up of new units but also for the expansion of present units, replacement of permanent assets, research and development Project costs and reallocation of funds.

Management of Working Capital

The management of working capital has two aspects.

- Overview of working capital management and

- Efficient management of individual current asset such as cash, receivable and inventory.

Working Capital Management

Working capital management or current asset management is an important part of investment decision.

Proper management of working capital ensures firms liquidity and solvency. A conflict exists between profitability and liquidity while managing current asset.

Working Capital Management

If a firm does not invest sufficient funds in current assets it may become illiquid and may not meet its current obligations.

If the current asset are large, the firm would lose its profitability and liquidity. The financial manager should develop proper techniques of managing current assets so that neither insufficient nor unnecessary funds are invested in current assets.

2 Financing Decisions: Once the firm has taken the investment decision and committed itself to new investment, it must decide the best means of financing these commitments Since, firms regularly make new investments, the need for financing and financial decisions are on going.
The financing decision is not only concerned with how best to finance new assets, but also concerned with the best overall mix of financing for the firm. Financial decision is concerned with the financial mix or capital structure. The mix of debt and equity is known as capital structure.

The debt-equity ratio should be fixed in such a way that it helps in maximising the profitability of the concern. The raising of more debts will involve fixed interest liability and dependence upon outsiders. It may help in increasing the return on equity but will also enhance the risk. The raising of funds through equity will bring permanent funds to the business but the shareholders will expect higher rates of earnings. The financial manager has to strike a balance between various sources so that the overall Profitability of the concern improves. If the capital structure is able to minimise the risk and raise the profitability then the market prices of the shares will go up maximising the wealth of shareholders.

3 Dividend Decision: The third major financial decision relates to the disbursement of profits back to investors who supplied capital to the firm. The term dividend refers to that part of profits of a company which is distributed by it among Its shareholders. It is the reward of shareholders for investment made by them in the share Capital of the company.
The dividend decision is concerned with the quantum of profits to be distributed, to retain all the profits in business or to keep a part of profits in the business and distribute others among shareholders.

Dividend Decision

A firm distribute all profits or retain them or distribute a portion and retain the balance with it.

Which course should be allowed? The decision depends upon the preference of the shareholders and investment opportunities available to the firm.

Dividend Decision

Dividend decision has a strong influence on the market prize of the share. So the dividend policy is to be determined in terms of its impact on shareholders value. The optimum dividend policy is one which maximizes the value of shares and wealth of the shareholders.

Dividend Decision

The financial manager should determine the optimum pay out ratio i.e. the proportions of net profit to be paid out to the shareholders. The above three decisions are inter related. To have an optimum financial decision the three should be taken jointly.

Objectives of Financial Management or Financial Goals:

Financial management is concerned with procurement and use of funds. Its main aim is to use business funds in such a way that the firms value/earnings are maximised. There are various alternatives available for using business funds. Financial management provides a frame work for selecting a proper course of action and deciding a viable commercial strategy. The main objective of a business is to maximise the owners economic welfare. This objective can be achieved by: 1 Profit Maximisation, and 2 Wealth Maximisation

1 Profit Maximisation:

Profit earning is the main aim of every economic activity. A business being an economic institution must earn profit to cover its costs and provide funds for growth. No business can survive without earning profit.

Profit is a measure of efficiency of a business enterprise. Profits also serve as a protection against risks which cannot be ensured.
The accumulated profits enable a business to face risks like fall in prices, competition from other units, adverse government policies etc Thus, profit maximisation is considered as the main objective of business.

The following arguments are advanced in favour of profit maximisation as the Objective of business:
(i) When profit-earning is the aim of business then profit maximisation should be the obvious objective.

(ii)Profitability is a barometer for measuring efficiency and economic prosperity of business enterprise, thus, profit maximisation is justified on the grounds of rationality. (iii)Economic and business conditions do not remain same at all the times. There may be adverse business conditions like recession, depression, severe competition etc. A business will be able to survive under unfavourable situation, only if it has some past earnings to rely upon.

(iv) Profits are the main sources of finance for the growth of a business. So, a business should aim at maximisation of profits for enabling its growth and development (v) Profitability is essential for fulfilling social goals also. A firm by pursuing the objective of profit maximisation also maximises socio-economic welfare. Drawbacks of Profit maximisation: Even as an operational criterion for maximising owners economic welfare profit maximisation has been rejected because of the following drawbacks: (i)

Ambiguity: The term profit is vague and it cannot be precisely defined. It means different things for different people. Should we consider short-term profits or long term profits? Does it mean total profits or earnings per share? Should we take profits before tax or after tax ? Does it mean operating profit or profit available for shareholders?

Further, it is possible that profits may increase but earnings per share decline. For Example, if a company has presently 10,000 equity shares issued and earns a profit of Rs. 1,00,000 the earnings per share are Rs 10.
Now, if the company issues 5,000 shares and makes a total profit of Rs1,20,000 the total profits have increased by Rs. 20,000, but the earnings per share will decline to Rs. 8. (ii) Ignores Time Value of Money : Profit maximisation objective ignores the time value of money and does not consider the magnitude and timing of earnings. It Treats all earnings as equal though they occur in different periods. It ignores the fact that cash received today is more important than the same amount of cash reeceived after 3 years. The stockholders may prefer a regular return from investment even if it is smaller than the expected higher returns after along period.

(iii) Ignores Risk Factor: It does not take into consideration the risk of the prospective earnings stream. Some projects are more risky than others. Two firm may have same expected earnings per share, but if the earning stream of one is more risky then the market value of its shares will be comparatively less.

(iv) Dividend Policy: The effect of dividend policy on the market price of shares is also not consider in the objective of profit maximisation.

2 Wealth Maximisation: Wealth maximisation is the appropriate objective of an Enterprise. Financial theory asserts that wealth maximisation is the single substitute for a stockholders utility. When the firm maximises the stockholders wealth, the Individual stockholder can use this wealth to maximise his individual utility. It means that by maximising stockholders wealth the firm is operating consistently towards maximising stockholders utility.

A stockholders current wealth in the firm is the product of the number of shares owned, multiplied with the current stock price per share. Stockholders Current wealth in a firm = ( Number of shares owned) x (Current stock price per share) Wo=NPo Given the number of shares that the stockholder owns, the higher the stock price per share the greater will be the stockholders wealth. Thus, a firm should aim at maximising its current stock price. This objective helps in increasing the value of shares in the market..The shares market price serve as performance index or report card of its progress.

What is meant by shareholders wealth maximisation ?

SWM means maximising the net present value of a course of action to shareholders. Net Present Value(NPV) or wealth 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 that has a positive NPV creates wealth for shareholders and therefore is desirable.
A financial action resulting in negative NPV should be rejected since it would destroy Shareholders wealth .Between mutually exclusive projects the one with the highest NPV should be adopted

The following arguments are advanced in favour of wealth maximisation as the goal of financial management:

(i) It serves the interests of owners,(shareholders) as well as other stakeholder in the firm; i.e. suppliers of loaned capital, employees, creditors and society.

(ii) The objective of wealth maximisation implies long-run survival and growthof the firm. (iii) It takes into consideration the risk factor and the time value of money as the current present value of any particular course of action is measured
(iv) The effect of dividend policy on market price of shares is also considered as the decisions are taken to increase the market value of the shares

v) The goal of wealth maximisation leads towards maximising stockholders utility or value maximisation of equity shareholders through increase in stock price per share. Criticism of Wealth Maximisation: (i) It is a prescriptive idea. The objective is not descriptive of what the firms actually do. (ii)There is some controversy as to whether the objective is to maximise the stockholders wealth or the wealth of the firm which includes other financial claimholders such as debentureholders, preferred stockholders, etc.

In spite of all criticism, the wealth maximisation is the most appropriate objective of a firm.