Financial Management: An Introduction

Concept and Definitions of Financial Management

A. Concept of Finance

Finance may be appropriately defined as the process of raising, providing and managing
of all the money to be used in connection with the business activities.
The Encyclopaedia Britannica defines finance as the act of providing the means the
payment.
According to Guthmann and Dougall, “Finance may be broadly defined as the activity
concerned with planning, raising, controlling and administering of funds used in the
business”.
Therefore, finance can be defined as the activities concerned with planning, acquiring,
administering of funds used in any business organisation.
B. Definition of Financial Management

Financial Management is an accessory of the finance function. It involves the application

of general management principles to a particular financial operation.
The definition of financial management as observed by Raymond Chambers: “Financial
management may be considered to be the management of the finance functions. It may be
described as making decisions on financial matters and facilitating and reviewing their
execution”.
Financial Management has been defined by Joseph and Massie as the operational activity
of a business that is responsible for obtaining and effectively utilizing the funds necessary
for efficient operations.
Therefore, financial management is mainly concerned with the proper management of
fund and it sees that the funds are procured in a manner that the risk, cost and control
considerations are properly balanced in a given situation and there is optimum utilisation
of fund.

Objectives of Financial Management

A firm’s financial management may often have the following as their objectives:

1. The maximization of firm’s profit,

2. The maximization of firm’s value/wealth.

The maximization of profit is often considered as an implied objective of a firm. To

achieve the aforesaid objective, various types of financing decisions may be taken.
Options resulting into maximization of profit may be selected by the firm’s decision
makers. They even sometime adopt policies yielding exorbitant profits in short run which
may be proved to be unhealthy for the growth, survival and overall interest of the firm.
The profit of the firm in this case is measured in terms of its total accounting profit
available to its shareholders.
The value/ wealth of a firm is defined as the market price of the firm’s stock. The market
price of a firm’s stock represents the focal judgement of all market participants as to what
the value of the particular firm is. It takes into account present and prospective future
earnings per share, the timing and risk of these earnings, the dividend policy of the firm
and many other factors that bear upon the market price of the stock.

The value maximization objective of a firm is superior to its profit maximization

objective due to following reasons:

1. The value maximization objective of a firm considers all future cash flows,
dividends, earnings per share, risk of a decision etc., whereas profit maximization
objective does not consider the effect of EPS, dividend paid or any other returns
to shareholders or the wealth of the shareholders.
2. A firm that wishes to maximize the shareholders wealth may pay regular
dividends, whereas a firm with the objective of profit maximization may refrain
from dividend payment to its shareholders.
3. Shareholders would prefer an increase in the firm’s wealth against the generation
of increasing flow of profit.
4. The market price of a share reflects the shareholders expected return, considering
the long term prospects of the firm, reflects the differences in timings of the
returns, considers risk and recognizes the importance of distribution of returns.

The maximization of a firm’s value as reflected in the market price of a share is viewed
as a proper goal of the firm. The profit maximization can be considered as a part of the
wealth maximization strategy.

Two Basic Functions of financial Management

Financial Management deals with the procurement of funds and their effective utilisation
in the business. The first basic function of financial management is procurement of funds
and the other is their effective utilisation.

Procurement of Fund

Funds can be procured from different sources and their procurement is a complex
problem for business concerns. Fund procured from different sources have different
characteristics in terms of risk, cost and control.
- The fund raised by issuing equity share poses no risk to the company. The funds
raised are quite expensive. The issue of new shares may dilute the control of
existing shareholders.
- Debenture is a relatively cheaper source of funds, but involves high risk as they
are to be repaid in accordance with the terms of agreement. Also interest payment
has to be made under any circumstances. Thus there are risk, cost and control
considerations, which must be taken into account before raising funds.
- Funds can also be procured from banks and financial institutions subject to certain
restrictions.
 - Instruments like commercial papers, deep discount bonds etc. Also enable to raise
funds.
- Foreign direct investments (FDI) and Foreign Institutional Investors (FII) are to
major routes for raising funds from international sources, besides ADR’s and
GDR’s.

Effective utilisation of funds

Since all the funds are procured at a certain cost, therefore it is necessary for the finance
manager to take appropriate and timely actions so that the funds do not remain idle. If
these funds are not utilised in the manner so that they generate an income higher than the
cost of procuring them, then there is no point in running the business.

Functions of Finance Manager

The main function of the finance manager is to manage funds in such a way so as to
ensure their optimum utilisation and their procurement in a manner that the risk, cost and
control considerations are properly balanced in a given situation. To achieve these
objectives the finance manager performs the following functions:

a. Estimating the Requirement of Funds

The finance manager has to estimate the requirement of funds for both for long term
purposes, i.e., investment in fixed assets and for short term purposes, i.e., for working
capital. Forecasting the requirements of funds involves the use of techniques of
budgetary control and long-range planning.

b. Decision regarding Capital Structure

Once the requirement of funds has been estimated, a decision regarding various
sources from which these funds would be raised has to be taken. A proper balance has
to be made between the loan funds and own funds. He has to ensure that he raises
sufficient long term funds to finance fixed assets purchase and other long term
investments and to provide for the needs of working capital.

c. Investment Decision

The investment of funds in a project has to be made after careful assessment of

various projects through capital budgeting. Assets management policies are to be laid
down regarding various items of current assets, for example, receivable in
coordination with sales manager, inventory in coordination with production manager.

d. Dividend Decision

The finance manager is concerned with the decision as to how much to retain and
what portion to pay as dividend depending on the company’s policy. Trend of
earnings, trend of share market prices, requirement of funds for future growth, cash
flow situation etc. are to be considered.
 e. Evaluating financial performance

A finance manager has to constantly review the financial performance of the various
units of the organisation generally in terms of ROI. Such a review helps the
management in seeing how the funds have been utilised in various divisions and what
can be done to improve it.

f. Financial Negotiation

The finance manager plays a very important role in carrying out negotiations with the
financial institutions, banks and public depositors for raising of funds on favourable
terms.

g. Cash Management

The finance manager lays down the management and cash disbursement policies with
a view to supply adequate funds to all units of organisation and to ensure that there is
no excessive cash.
h. Keeping touch with Stock Exchange

Finance manager is required to analyse major trends in stock market and their impact
on the price of the company’s share.

Inter-relationship between Investment, Financing and Dividend Decisions

The finance functions are divided into three major decisions, viz., investment, financing
and dividend decisions. It is correct to say these decisions are inter-related because the
underlying objective of these three decisions is the same, i.e., maximization of
shareholders’ wealth. Since investment, financing and dividend decisions are all
interrelated, one has to consider the joint impact of these decisions on the market price of
the company’s share and these decisions should also be solved jointly. The decision to
invest in a new project needs the finance for the investment. The financing decision, in
turn, is influenced by and influences dividend decision because retained earnings used in
internal financing deprive shareholders of their dividends. An efficient financial
management can ensure optimal joint decisions. This is possible by evaluating each
decision in relation to its effect on the shareholders’ wealth.

The above three decisions are briefly examined below in the light of their
interrelationship and to see haw they can help in maximizing the shareholders’ wealth,
i.e., market price of the company’s shares.

Investment Decision: The investment of long term funds is made after a careful assessment
of the various projects through capital budgeting and uncertainty analysis. However, only
that investment proposal is to be accepted which is expected to yield at least so much
return as is adequate to meet its cost of financing. This have an influence on the
profitability of the company and ultimately on its wealth.
Financing Decision: Funds can be raised from various sources. Each source of funds
involves different issues. The finance manager has to maintain a proper balance between
long-term and short-term funds. With the total volume of long term funds, he has to
ensure a proper mix of loan funds and owner’s funds. The optimum financing mix will
increase return to equity shareholders and thus maximize their wealth.

Dividend decision:The finance manager is also concerned with the decision to pay or
declare dividend. He assists the top management in deciding as to what portion of the
profit should be paid to the shareholders by way of dividends and what portions should
be retained in the business. An optimal dividend pay-out ratio maximizes shareholders’
wealth.

The above discussion makes it clear that investment, financing and dividend decisions are
interrelated and are to be taken jointly keeping in view their joint effect on the
shareholders’ wealth.

Methods and Tools of Financial Management

Finance manager has to decide optimum capital structure to maximize the wealth of the
shareholders. For this judicious use of financial leverage or trading on equity is important
to increase the return to shareholders. In planning the capital structure, the aim is to have
proper mix of debt, equity and retained earnings. EPS analysis, PE ratio and
mathematical models are used to determine the proper debt-equity mix to derive
advantage to the owners and enterprise.

In the area of investment decisions, pay back method, average rate of return, internal rate
of return, net present value, profitability index are some of the methods in evaluating
capital expenditure proposals.

In the area of working capital management, certain techniques are adopted such as ABC
Analysis, Economic Order Quantity and Cash Management Models etc. to improve
liquidity and to maintain adequate circulating capital.

For evaluation of firm’s performance, ratio analysis is pressed into service and with the
help of ratios an investor can decide whether to invest in a firm or not. Fund floe
statement, cash flow statement and projected financial statements help a lot to the finance
manager in providing funds in right quantities and at right time.

Role of Information on Finance Function

The information age has given a fresh perspective on the role of financial management
and finance managers. With the shift in paradigm it is imperative that the role of chief
finance manager changes from a controller to a facilitator. In the emergent role of chief
finance officer acts as a catalyst to facilitate changes in an environment where the
organisation succeeds through self managed teams. The chief finance manager must
transform himself to a front-end organizer and leader who spend more time in
networking, analysing the external environment, making strategic decisions, managing
and projecting cash flows. In due course, the role of chief financial officer will shift from
an operational to a strategic level.

Of course on an operational level, the chief finance officer can not be excused from his
backend duties. The knowledge requirements for the evaluation of a chief finance officer
will extend from being aware about capital productivity and cost of capital to human
resources initiatives and competitive environment analysis. He has to develop general
management skills for a wider focus encompassing all aspects of business that depend on
or dictate finance.