Financial Management - Meaning, Objectives and Functions

Meaning of Financial Management

Financial Management means planning, organizing, directing and controlling the

financial activities such as procurement and utilization of funds of the enterprise. It
means applying general management principles to financial resources of the enterprise.

Scope/Elements

1. Investment Decision - The most important decision. It begins with the firm
determining the total amount of assets needed to be held by the firm. There are 2
types of investment decision.

a) Capital Investment Decision - Involves large sums of money. The impact is critical.
Examples: acquire a new machine or to set up a new plant.

b) Working Capital Investment Decision - a more routine or schedule form of

decision. Examples are determination of the amount of inventories, cash and account
receivables to hold within a certain period.

2. Financial decisions - They relate to the raising of finance from various resources
which will depend upon decision on type of source, period of financing, cost of
financing and the returns thereby.

3. Dividend decision - The finance manager has to take decision with regards to the
net profit distribution. Net profits are generally divided into two: Dividend for
shareholders- Dividend and the rate of it has to be decided. Retained profits-
Amount of retained profits has to be finalized which will depend upon expansion
and diversification plans of the enterprise.

Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and
control of financial resources of a concern. The objectives can be-
1. To ensure regular and adequate supply of funds to the concern.
2. To ensure adequate returns to the shareholders which will depend upon the
earning capacity, market price of the share, expectations of the shareholders.
3. To ensure optimum funds utilization. Once the funds are procured, they should be
utilized in maximum possible way at least cost.
4. To ensure safety on investment, i.e, funds should be invested in safe ventures so
that adequate rate of return can be achieved.
5. To plan a sound capital structure-There should be sound and fair composition of
capital so that a balance is maintained between debt and equity capital.

Functions of Financial Management

 1. Estimation of capital requirements: A finance manager has to make estimation
with regards to capital requirements of the company. This will depend upon
expected costs and profits and future programmed and policies of a concern.
Estimations have to be made in an adequate manner which increases earning
capacity of enterprise.
2. Determination of capital composition: Once the estimation have been made, the
capital structure have to be decided. This involves short- term and long- term debt
equity analysis. This will depend upon the proportion of equity capital a company
is possessing and additional funds which have to be raised from outside parties.
3. Choice of sources of funds: For additional funds to be procured, a company has
many choices like-
a. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.

Choice of factor will depend on relative merits and demerits of each source and
period of financing.

4. Investment of funds: The finance manager has to decide to allocate funds into
profitable ventures so that there is safety on investment and regular returns is
possible.
5. Disposal of surplus: The net profits decision have to be made by the finance
manager. This can be done in two ways:
a. Dividend declaration - It includes identifying the rate of dividends and
other benefits like bonus.
b. Retained profits - The volume has to be decided which will depend upon
expansion, innovational, diversification plans of the company.
6. Management of cash: Finance manager has to make decisions with regards to
cash management. Cash is required for many purposes like payment of wages and
salaries, payment of electricity and water bills, payment to creditors, meeting
current liabilities, maintenance of enough stock, purchase of raw materials, etc.
7. Financial controls: The finance manager has not only to plan, procure and utilize
the funds but he also has to exercise control over finances. This can be done
through many techniques like ratio analysis, financial forecasting, cost and profit
control, etc.

Financial Management in the new millennium:

The focus on value maximization continues as we begin the 21st century. However, two
other trends are becoming increasingly important:
1. The globalization of business and
2. The increased use of information technology.
Both of these trends provide companies with exciting new opportunities to increase
profitability and reduce risks. However, these trends are also leading to increased
competition and new risks.
1. The globalization of business:
Four factors have led to the increased globalization of businesses:
• Improvements in transportation and communications lowered shipping costs and made
international trade more feasible.
• The increasing political clout of consumers, who desire low-cost, high quality products.
• As technology has become more advanced, the costs of developing new products have
increased. These rising costs have led to joint ventures between companies.
• In a world populated with multinational firms able to shift production to wherever costs
are lowest.

2. Information technology:
As we advances into the new millennium, we will see continued advances in computer
and communications technology, and this will continue to revolutionize the way financial
decisions are made. Computers are linking networks of personal computers to one
another, to the firms’ own mainframe computers, to the internet and to their customers’
and suppliers’ computers. Thus, financial managers are increasingly able to share
information and to have face-to-face meetings with distant colleagues through video-
conferencing.
Changing technology provides both opportunities and threats. Improved technology
enables businesses to reduce costs and expand markets. At the same time, changing
technology can introduce additional competition, which may reduce profitability in
existing markets.

Legal forms of organizations: There are three main forms of business organization:
Sole proprietorship is an unincorporated business owned by one individual.
Major advantages are:
• It is easily and inexpensively formed.
• It is subject to few government regulations and
• The business avoids corporate income taxes.
Major disadvantages are:
• It is difficult for a proprietorship to obtain large sums of capital.
The proprietor has unlimited personal liability for the business debts, which can result in
losses that exceed the money he or she has invested in the company, and
• The life of a business organized as a proprietorship is limited to the life of the
individual who created it.

Partnership is an unincorporated business owned by two or more persons.

Major advantages are:
• It is easily and inexpensively formed.
• The business avoids corporate income taxes.
Major disadvantages are:
• Unlimited liability
• Limited life of the organization
• Difficulty of transferring ownership, and
• Difficulty of raising large amounts of capital.

Corporation is a legal entity created by laws, and it is separate and distinct from its
owner and managers.
Major advantages are:
• Unlimited life
• Easy transferability of ownership interest
• Limited liability
Major disadvantages are:
• Corporate earnings may be subject to double taxation at the corporate level as well as at
the individual level.
• Setting up a corporation is more complex and time consuming.

Goal of a Financial Manager: There are two goals of a financial manager-

1. Profit Maximization
2. Shareholder’s’ Wealth Maximization
Profit Maximization: To achieve the goal of profit maximization the financial manager
takes only those actions that are expected to contribute to the firm’s overall profit.
Companies commonly a measure profit in terms of EPS which is the amount earned
during the accounting period on each outstanding share of common stock and is
calculated as follows:
Earnings available to Common stock holders
EPS=
No. of common stock outstanding
To be clear, let’s consider the following example: Suppose there is two projects X & Y.
Each is expected to have the following EPS over its 3 years life:
Investment Year 1 Year 2 Year 3 Total X
X Tk. 1.40 Tk. 1.00 Tk. 0.40 Tk. 2.80
Y 0.60 1.00 1.40 3.00

Based on profit maximization goal investment Y would be preferred over investment X,

because it results higher EPS over 3 years. But if we analyze precisely we would find that
the decision based on the profit maximization would not be an appropriate goal due to the
following reasons: 1. It ignores timing of return 2. It ignores cash flows available to the
stockholders 3. It ignores risk Shareholders receive cash either in the form of dividend or
the proceeds from selling their share for a higher price than initially paid. A greater EPS
does not necessarily mean that the owner will receive a higher dividend. Furthermore a
higher EPS does not necessarily translate into higher stock price. If EPS will increase the
future cash flows only then the stock price will increase.
Shareholders’ Wealth Maximization: The objective of shareholders’ wealth maximization
is an appropriate and operationally feasible criterion. The wealth of owners is generally
measured by the share price of the stock. Shareholders’ wealth maximization criterion
considers the timing of cash flows, magnitude of cash flows & risk associated with it.
So, when considering any financial decision alternative, the financial manager should
accept only those actions that are expected to increase share price. Since share price
represents the wealth of owners in a firm, Share price maximization is consistent with
owners’ wealth maximization. Beside the aforementioned goals there are some other
possible financial goals like- survival, avoiding financial distress & bankruptcy, beating
the competition, minimizing the cost and maintaining steady earnings growth.
Agency Problem: An agency relationship arises whenever one or more individuals,
called owners hire another individual or organization, called agent to perform some
service and delegate decision making authority to that agent. A characteristic feature of
corporate enterprise is the separation between that owners and agents where the latter
enjoys substantial autonomy in regard to the affairs of the firm. So, there may be a
conflict of interest between these two parties and the potential conflict between owners
and managers for their personal interest is referred as agency problem.

Agency Relationships: In financial management, the primary agency relationships are

those between (1) Stockholders and managers, (2) Stockholders (through managers) and
debt holders.
Conflicts of interest among stockholders, bondholders and managers are called agency
problem. It is assumed that the managers and the shareholder if left alone will each
attempt to act in his or her own self- interest. Which creates the conflicts of interest can
be termed as agency conflicts.

1. Stockholders Vs. managers: In the case of Joint Stock Company, ownership is

separated from management. For this reason, owners directly cannot take part in
management. The responsibility of management is on the hand of the professional
manager. Sometimes professional managers, give priority of their own interest
without consideration to stockholder’s interest. As a result, conflicts of interest
between managers and owners are created.

Resolving the problem:

Most firms today use a package of economic incentives, along with some monitoring, to
influence a manager’s performance and thus reduce the agency problem. The following
incentives or factors that motivate managers are discussed below:

(a) Performance-based compensation plans: Managers compensation usually depends

on the company’s performance. If any organization is performing better the manages can
be compensated and the compensation can be in the form of

1. A specified annual salary designed to cover living expenses,

2. A bonus paid at the end of the year which depends on the company’s profitability
during the year and,
3. Options to buy stock, or actual shares of stock, which reward the executives for
the firm’s long- term performance.

(b) Direct intervention by shareholders: Although a great deal of stock is owned by

individuals, an increasing percentage is owned by institutional investors such as
insurance companies, pension funds, and mutual funds. These institutional investors can
enforce a firm’s managers for improving their performance and sometimes give
suggestions regarding how the business should be run.
(c) The threat of firing: The CEOs or other top executives can be forced out of office
due to the company’s poor performance.

(d) The threat of takeover: Hostile takeover is most likely to occur when a firm’s stock is
undervalued relative to its potential because of poor management; the managers of the
acquired firm are generally fixed. Thus, managers have a strong incentive to take, actions
which maximize stock prices and possible to avoid taking over.

2. Creditors VS Owners:

Creditors want to have principal’ and interest payment form owners timely. But owners
are not willing to pay the claim of the creditors from their personal income if a sufficient
amount of profit is not earned by the company. As a result, conflict arises. Sometimes
managers on behalf of shareholders hurt the interest of bondholders by investing in a
highly risky project which is financed by debt capital.