Financial Management—Introduction

CHAPTER 1: FINANCIAL MANAGEMENT –AN OVERVIEW

1.1. Meaning of Financial Management

Financial Management is the management of funds and assets of the firm for
the purpose of maximizing the value of the firm. It aims to match the flows
of funds in the business with the changing needs of the business.

1.2. Evolution and Scope of Financial Management

Financial management has evolved through three stages. In each stage its
scope has widened.
Three stages and the scope of financial management in these stages is:
 Traditional—main focus was on a) corporate finance; b) sources and
instruments of long term funds—debt instruments like debentures and
bonds and equity instruments like equity and preference shares, c)
legal and accounting aspects of finance, and d) the goal of profit-
maximization.
 Transitional –scope included the management of long term funds as
well as short term funds i.e. working capital management, and
 Modern –focus is on a) management of the inflows and outflows of all
funds (short term and long term), and b) the management of assets
acquired with these funds, c) financial management in all organizations
corporate or otherwise, d) the aim of maximizing the value of the firm.

1.3. Financial Decisions in a Firm

Financial management involves four basic decisions:
 Investment or Capital Budgeting Decision—selecting the most
rewarding investment projects,
 Financing or Cost of Capital and Capital Structure Decision—selecting
the best source of funds and ensuring optimum composition of capital
mix (capital structure),
 Working Capital Management Decision—selecting the most sound
inventory, receivables and cash management policies, and
 Dividend or Payout Decision—selecting the best pay-out ratio and
mode pf dividend payment

1.4. Objectives of Financial Management :

Objectives could be divided into two groups:
 Basic Objectives and
 Operational Objectives.
Basic Objective: Decision-making in financial management can have two
options:
 Profit Maximization or,
 Wealth Maximization.
In the earlier period of the evolution of finance function, the basic objective
used to be ‘profit maximization’—i.e. maximization of accounting profits.
There were several arguments in support of this view:
 It is a simple and straightforward statement of purpose,
 It is easily understood as a rational goal for a business, and
 it focuses the firm’s efforts toward making money.
However, it has several limitations:
 It is vague, based on accounting assumptions,
 it does not take into account the time value of money, and
 it ignores the quality of returns in terms of risk involved.

Wealth maximization is considered a better objective because it capitalizes all

expected cash inflows (income returns as well as capital returns) and
outflows (payments) over the period of investment at its present value.
There are several arguments in favour of ‘wealth maximization objective:
 It considers all estimated returns from an investment—both
revenue returns (dividends, value of rights, bonus issues) as
well as capital returns (bonus shares, and capital appreciation)
throughout the life time of investment,
 it takes into account the time value of money of these returns—
the money today is valued higher than the money to be received
one year or two years later, and
 It takes into account the interest of all the stakeholders in
investment; stakeholders such as investors, customers,
management, society because all of them impact the return
expectations of a business.

Operational Objectives:
 Maximize profits both long term as well as short term
 Minimize risk. Identify risk factors, compute their values and
probabilities and minimize their impact; avoid unnecessary risks.
 Maintain liquidity and solvency; maintain enough liquid funds to meet
immediate payment obligations as well as long term liabilities.
 Maintain adequate control over the flows of funds. and for
safeguarding assets through proper financial reporting system.
 Achieve flexibility in capacity to raise funds and in managing funds.

1.5. Profit Maximization vs. Wealth Maximization.

Traditional writers emphasized profit-maximization (accounting profits) as
the main goal of financial management because:
 It is easy and simple to calculate and understand,
 It is the most conventional and popular basis,
 It is consistent with the owner’s perception of business goal—earning
of profits.
However, it is not appreciated by modern writers because:
 Its definition is vague—long term profits or short term profits; gross
profit (margin) or net profit (margin).
  it may be biased—accountant’s bias or management’s bias,
 It does not take into account the time value of money,
 It does not consider uncertainties in the future flow of funds—risk
factor,
 It overlooks the quality of profit—e.g. degree of customer satisfaction,
growth in sales and market share etc.

Modern writers consider wealth maximization (i.e. maximizing the present

value of the all future cash flows from the decision) as a better goal because:
 It is consistent with the concept of economic value,
 it is objective—no bias,
 It is practical and operative—considers all cash inflows and outflows
throughout the life of the proposal and its time value as well as its risk
value,
 It is normative goal at which every firm must aim at,
 it also balances related goals like customer satisfaction, stability,
growth etc.
Its main limitations are:
 It does not balance the interest of all stake holders like customers,
employees, creditors, community etc,
 It does not take care of social responsibility of business,
 The price of the share in the stock market is not always a true reflector
of the value of the firm,
 Firms in business usually have multiple goals and not a single goal.

1.5. ORGANIZATION OF THE FINANCE FUNCTION:

The finance function is divided into two groups: 1.Treasurer and b)
Controller.
Treasurer functions include:
 Obtaining funds by issue of various securities,
 Managing funds and managing relationships with firm’s bankers,
 Cash management,
 Credit administration,
 Managing investment of funds—Capital budgeting.
Controller functions include:
 Financial accounting,
 Internal auditing,
 Taxation and profit planning,
 Management accounting and control—including Budgetary Control.

1.6. THE FINANCIAL SYSTEM

Meaning: Financial system comprises a variety of intermediaries (financial
institutions, banks, brokers, mutual funds etc), markets (money market for
dealing in short term funds and capital market for dealing in long term funds)
and instruments (cheques, deposit receipts, equity and preference shares,
bonds, debentures, ADRs etc) that are connected with financial transactions
of different kinds.
Functions: Financial system performs the following six functions:
1. Payment facilitation function—payment for exchange of goods and
services through various methods, instruments and agencies.
2. Pooling of funds function—pooling of funds from different sources
through different methods, instruments and agencies for
investment in large scale enterprises.
3. Transfer of funds function—facilitating transfer of funds—spatial
transfer from one place to another; temporal transfer from one
time period to another and account transfers from one account to
another.
4. Risk management function-- managing uncertainty through stock
exchange activities and regulatory financial system –SEBI, RBI etc.
5. Price evaluation function—constant evaluation of the price of
securities, interest rates, cost of capital etc for decentralized
decision making.
6. Profit making function—offering opportunities to make profit from
efficient deployment and use of funds.

Examination Questions:

1. What are the major financial management decisions made by a firm

Explain briefly each of them. 2010
2. The operative objective of financial management is to maximize wealth or
net worth. Explain the statement and examine the finance functions
performed by a financial manager to achieve this goal. 2009
3. Critically evaluate profit maximization as criterion for financial
management decisions in practice. 2008
4. Define Financial Management. What are the major financial decisions,
which a finance manager has to take? 2007
5. ‘The wealth maximization objective provides an operationally appropriate
decision criterion.’ 2006
6. Discuss the important functions of payment by the financial system.
2006
7. Explain the different types of financial decisions a firm makes. 2005
8. Critically evaluate profit maximization as an objective of Financial
Management 2004
9. ‘Investment, financing and dividend decisions are inter-related.’ Elucidate.
2003
9. What are the functions of a good financial system? 2002