CHAPTER ONE

AN OVERVIEW OF FINANCIAL MANAGEMENT

At the end of these chapter students be able to;
 Define finance and financial management
 Explain Evolution of financial management
 Discuss classification and sources of finance
 Examine nature and scope of financial management.
 Explain the goal of a firm in financial management
1.1. Introduction
Business concern needs finance to meet their requirements in the economic world. Any kind of
business activity depends on finance. Hence, it is called as lifeblood of business organization.
Whether the business concerns are big or small, they need finance to fulfill their business
activities.
In the modern world, all the activities are concerned with the economic activities and very
particular to earning profit through any venture or activities. The entire business activities are
directly related to making profit. (According to the economics concept of factors of production,
rent given to landlord, wage given to labor, interest given to capital and profit given to
shareholders or proprietors), a business concern needs finance to meet all the requirements.
Hence finance may be called as capital, investment, fund etc. Increasing the profit is the main
aim of any kind of economic activity.
1.1.1. Definition of Finance
Finance is the art and science of managing money or the word ‘finance’ connotes ‘management
of money’. In other words, finance can be defined as “the Science on study of the management
of funds’ and the management of fund as the system that includes the circulation of money, the
granting of credit, the making of investments, and the provision of banking facilities. It includes
financial service and financial instruments.
Finance is a distinct area of study that comprises facts, theories, concepts,
principles,
techniques and practices related with raising and utilizing of funds (money)
by
individuals, businesses, and governments.
Finance is a very wide and dynamic field of study. It directly affects the
decisions of all
individuals and organizations that earn or raise money and spend or invest it.
Therefore,
finance is also an area of study that deals with how, where, by whom, why,
and through
what money is transferred among and between individuals, businesses, and
governments.
It is concerned with the processes, institutions, markets, and instruments

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involved in the
transfer of funds.
Finance also is referred as the provision of money at the time when it is needed. The concept of
finance includes capital, funds, money, and amount. Finance, in general, consists of three
interrelated areas:
a) Money and capital markets, which deals with securities markets and financial institutions
b) Investments, which focus on the decision of individual and institutional investors and
c) Financial management or business finance; which involves the actual management of
business firms.
Major Areas of Finance
Since the concepts and areas of finance are very broad, the academic
discipline of finance
can be viewed as made of specialized areas. There are several ways to
summarize the
major areas of finance. One way is to review the career opportunities under
it. Another
way is based on the differences in the objectives of different organizations.
For the sake
of simplifying our discussion, we summarize the major fields of finance based
on career
opportunities in finance.
The career opportunities again can be divided into different categories. For
our
convenience, these opportunities can be categorized into two broad areas.
i) Financial Services
This is a part of finance which involves personal career opportunities as a
loan officer,
financial planner, stockbroker, real estate agent, and insurance broker. It is
generally
concerned with the design, development, and delivery of these financial
services to
individuals, business organizations, and governments.
ii) Financial Management
Financial management is concerned with the financial decisions of a business
firm. This
firm can be large or small, private or public, financial or non-financial, profit –
seeking or
not-for-profit. It involves specific financial functions of the firm.
Definition of Financial Management

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Financial management is an integral part of overall management. It is concerned with the duties
of the financial managers in the business firm. The term financial management has been defined
by someone, “It is concerned with the efficient use of an important economic resource namely,
capital funds”.
The most popular and acceptable definition of financial management as given by S.C. Kuchalis
that “Financial Management deals with procurement of funds and their effective utilization in the
business”.
Financial Management can be clearly defined by viewing it as a subject, a
process, or a
function.
Financial management is one major area of study under finance. It deals with
decisions
made by a business firm that affect its finances. Financial management is
sometimes
called corporate finance, business finance, and managerial finance. These
terms are used
interchangeably in this material.
Financial management can also be defined as a decision making process
concerned with
planning for raising, and utilizing funds in a manner that achieves the goal of
a firm.
There are many specified business functions performed by a business unit.
These include
marketing, production, human resource management, and financial
management.
Financial management is one of the important functions of a firm. It is a
specified
business function that deals with the management of capital sources and
uses of a firm.
Howard and Upton: Financial management “is an application of general managerial principles
to the area of financial decision-making.
Joshep and Massie: Financial management “is the operational activity of a business that is
responsible for obtaining and effectively utilizing the funds necessary for efficient operations.
Thus, Financial Management is mainly concerned with the effective funds management in the
business. In simple words, Financial Management as practiced by business firms can be called as
Corporate Finance or Business Finance.
Business finance can broadly be defined as the activity concerned with planning, raising,
controlling, administering of the funds used in the business.
Corporate finance is concerned with budgeting, financial forecasting, cash management, credit
administration, investment analysis and fund procurement of the business concern and the

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business concern needs to adopt modern technology and application suitable to the global
environment.
Why Study Financial Management?
If you are approaching financial management for the first time, you might
wonder why
students like you study the field of financial management and what career
opportunities
exist.
Many business decisions made by firms have financial implications.
Accordingly,
financial management plays a significant role in the operation of the firm.
People in all
functional areas of a firm need to understand the basics of financial
management.
Accountants, information systems analysts, marketing personnel and people
in
operations, all need to be equipped with the basic theories, concepts,
techniques, and
practices of managerial finance if they have to make their jobs more efficient
and achieve
their goals. That is why the course Financial Management is offered to
students in the
fields of accounting, management, business administration, and
management
information systems.
If you develop the necessary training and skills in financial management, you
have career
opportunities in a good deal of positions as a financial analyst, capital
budgeting, project
finance, cash, and credit manager, financial manager, banker, financial
consultant, and
even as a general manager. The author hopes you will appreciate the
importance of
financial management as you learn it more.
1.1.2. Classification of finance
Finance can be broadly categorized into three main areas:
 Personal finance: Deals with individual financial decisions, budgeting,
saving, and investing.

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  Corporate finance: Focuses on financial management within
companies, including capital structure, investment decisions, and
financial planning.
 Public finance: Involves government revenue, expenditure, and fiscal
policies.

1.1.3. Evolution of finance

Finance emerged as a field separate and distinct from economics around
1900. The first
major focus of financial management during its early years of development
was the
means how large corporations of the time could raise capital. This was a
period when
the establishment of very large companies like the Rockefeller oil and
Morgan steel was
marked.
The economic depression of the 1930s made financial management to shift
to topics like
preservation of capital, maintenance of liquidity, reorganization of financially
troubled
companies, and the bankruptcy process.
ntil 1950s, the study of financial management had been descriptive or
definitional in
nature. But in the mid 1950s, more analytical, decision – oriented approach
began to
evolve. These include capital budgeting, cash and inventory management,
capital
structure formulation, and allocation of income as dividends and retained
earnings.
Starting the late 1960s, the primary focus of financial management has been
on the
relationships between risk and return of a firm’s financial decision. That is
financial
management has focused on the maximization of earnings (return) for a
given level of
risk; or minimization of risk for a given level of return.
1.1.4. Sources of finance
These sources can be broadly categorized into three main types based on
the time period and nature of funding:

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Long-Term Sources of Finance:- the time period is greater than 10 years
includes common stock, preferred stock and long term debt instruments
(bond, note payable, debenture and mortgage loans.
Medium-Term Sources of Finance:- These funds are required for a period
exceeding one year but not exceeding five years. Examples include funds
needed for defined revenue expenditures (e.g., heavy publicity,
advertisement campaigns).
Short-Term Sources of Finance: - These funds are needed for a short
period, often not exceeding one year (i.e., the accounting period). Used for
financing current assets and meeting working capital requirements.
In terms of source of fund classified as internal and external sources of
finance;

Internal source of finance:- a firms internal

source of finance is a profit reinvested in the
business called retained earnings. Such sources
of finance are less risky source of finance.

1.2. The nature and scope of financial management

The functions of financial management are planning for acquiring and utilizing
funds by a firm as well as distributing funds to the owners in ways that
achieve goal of the firm. In general, the functions of financial management
include three major decisions a firm
must make. These are:
1. Investment decisions
2. Financing decisions
3. Dividend decisions
1.2.1. Investment Decisions
They deal with allocation of the firm’s scarce financial resources among
competing uses.
These decisions are concerned with the management of assets by allocating
and utilizing
funds within the firm. Specifically, the investment decisions include:
i) Determining the asset mix or composition: - determining the total
amount of
the firm’s finance to be invested in current and fixed assets.

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ii) Determining the asset type: - determining which specific assets to
maintain
within the categories of current and fixed assets.

iii) Managing the asset structure, i.e., maintaining the composition of

current
and fixed assets and the type of specific assets under each category.
The investment decisions of a firm also involve working capital management
and capital
budgeting decisions. The former refers to those decisions of a firm affecting
its current
assets and short – term liabilities. The later, on the other hand, involves long
– term
investment decisions like acquisition, modification, and replacement of fixed
assets.
Generally, the investment decisions of a firm deal with the left side of the
basic
accounting equation: A = L + OE (Assets = Liabilities + Owners’ Equity).

1.2.2. Financing Decisions

The financing decisions deal with the financingof the firm’s investments,
i.e., decisions
whether the firm should use equity or debtfunds in order to finance its
assets. They are
also concerned with determining the most appropriate composition of short –
term and
long – term financing. In simple terms, the financing decisions deal with
determining the
best financing mix or capital structureof the firm.
The financing decisions of a firm are generally concerned with the right side
of the basic
accounting equation.
1.2.3. Dividend Decisions
The dividend decisions address the question how much of the cash a firm
generates fromoperations should be distributed to owners in the form of
dividends and how much should be retained by the business for further
expansion. There are trade-offs on the dividend policy of a firm. On the one
hand, paying out more dividends will make the firm to be perceived strong
and healthy by investors; on the other hand, it will affect the future growth of
the firm. So the dividend decision of a firm should be analyzed in relation to

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its financing decisions.
1.3. The goal of a firm in financial management
The goal of financial management is to make money or add value for the owners. This goal is a
little vague, of course, so we examine some different ways of formulating it in order to come up
with a more precise definition. Such a definition is important because it leads to an objective
basis for making and evaluating financial decisions.
Possible Goals
 Survive.
 Avoid financial distress and bankruptcy.
 Beat the competition.
 Maximize sales or market share.
 Minimize costs.
 Maximize profits.
 Maintain steady earnings growth.
The goals listed here are all different, but they do tend to fall into two classes. The first of these
relates to profitability. The goals involving sales, market share, and cost control all relate, at least
potentially, to different ways of earning or increasing profits.
The goals in the second group, involving bankruptcy avoidance, stability, and safety, relate in
some way to controlling risk. Unfortunately, these two types of goals are somewhat
contradictory. The pursuit of profit normally involves some element of risk, so it isn’t really
possible to maximize both safety and profit. What we need, therefore, is a goal that encompasses
both factors.
The goal that incorporates the above listed derived from the overall company’s goal of
shareholders’ we call it wealth maximization, which is reflected through the increased dividend
per share, and the appreciations of the prices of shares in formulating financial policies and
evaluating alternative course of operation. In order to do so, this overall goal of wealth
maximization needs to be related to take the following specific objectives of financial
management into account. These are:
 Financial management aims at determining how large the business firm should be and how
fast should it grow.
 Financial management aims at determining the best percentage composition of the firm’s
assets (asset portfolio decision, of decisions related to capital uses).
 Financial management aims at determining the best percentage composition of the firm’s
combined liabilities and equity decisions related to capital sources.
Effective procurement and efficient use of finance lead to proper utilization of the finance by the
business concern. It is the essential part of the financial manager. Hence, the financial manager
must determine the basic objectives of the financial management. Objectives of Financial
Management may be broadly divided into two parts such as:
1. Profit maximization
2. Wealth maximization.
Profit Maximization
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Main aim of any kind of economic activity is earning profit. A business concern is also
functioning mainly for the purpose of earning profit. Profit is the measuring techniques to
understand the business efficiency of the concern. Profit maximization is also the traditional and
narrow approach, which aims at, maximizes the profit of the concern. Profit maximization
consists of the following important features.
1. Profit maximization is also called as cashing per share maximization. It leads to maximize
the business operation for profit maximization.
2. Ultimate aim of the business concern is earning profit; hence, it considers all the possible
ways to increase the profitability of the concern.
3. Profit is the parameter of measuring the efficiency of the business concern. So it shows the
entire position of the business concern.
4. Profit maximization objectives help to reduce the risk of the business.
Favorable Arguments for Profit Maximization
The following important points are in support of the profit maximization objectives of the
business concern:
(i) Main aim is earning profit.
(ii) Profit is the parameter of the business operation.
(iii) Profit reduces risk of the business concern.
(iv) Profit is the main source of finance.
(v) Profitability meets the social needs also.
Unfavorable Arguments for Profit Maximization
The following important points are against the objectives of profit maximization:
(i) Profit maximization leads to exploiting workers and consumers.
(ii) Profit maximization creates immoral practices such as corrupt practice, unfair trade
practice, etc.
(iii) Profit maximization objectives leads to inequalities among the shareholders suchas
customers, suppliers, public shareholders, etc.
Drawbacks of Profit Maximization
Profit maximization objective consists of certain drawback also:
(i) It is vague: In this objective, profit is not defined precisely or correctly. It creates
some unnecessary opinion regarding earning habits of the business concern.
(ii) It ignores the time value of money: Profit maximization does not consider thetime
value of money or the net present value of the cash inflow. It leads certain differences
between the actual cash inflow and net present cash flow during particular period.
(iii) It ignores risk: Profit maximization does not consider risk of the business concern.
Risks may be internal or external which will affect the overall operation of the
business concern.
Wealth Maximization
Wealth maximization is one of the modern approaches, which involves latest innovations and
improvements in the field of the business concern. The term wealth means shareholder wealth or
the wealth of the persons those who are involved in the business concern. Wealth maximization
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is also known as value maximization or net present worth maximization. This objective is a
universally accepted concept in the field of business.
Favorable Arguments for Wealth Maximization
(i) Wealth maximization is superior to the profit maximization because the main aimof
the business concern under this concept is to improve the value or wealth ofthe
shareholders.
(ii) Wealth maximization considers the comparison of the value to cost associated
withthe business concern. Total value detected from the total cost incurred for
thebusiness operation. It provides extract value of the business concern.
(iii) Wealth maximization considers both time and risk of the business concern.
(iv) Wealth maximization provides efficient allocation of resources.
(v) It ensures the economic interest of the society.
Unfavorable Arguments for Wealth Maximization
(i) Wealth maximization leads to prescriptive idea of the business concern but it maynot
be suitable to present day business activities.
(ii) Wealth maximization is nothing, it is also profit maximization, it is the indirectname
of the profit maximization.
(iii) Wealth maximization creates ownership-management controversy.
(iv) Management alone enjoys certain benefits.
(v) The ultimate aim of the wealth maximization objectives is to maximize the profit.
(vi) Wealth maximization can be activated only with the help of the profitable positionof
the business concern.
FINANCE AND RELATED FIELDS
Though finance had ceded itself from economics, it is not totally an
independent field of
study. It is an integral part of the firm’s overall management. Finance heavily
draws
theories, concepts, and techniques from related disciplines such as
economics,
accounting, marketing, operations, mathematics, statistics, and computer
science. Among
these disciplines, the field of finance is closely related to economics and
accounting.
Finance versus Economics
Finance and economics are closely related in many aspects. First, economics
is the
mother field of finance. Second, the economic environment within which a
firm operates
influences the decisions of a financial manager. A financial manger must
understand the

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interrelationships between the various sectors of the economy. He must also
understand
such economic variables as a gross domestic product, unemployment,
inflation, interests,
and taxes in making financial decisions.
Financial managers must also be able to use the structure of decision-
making provided by
economics. They must use economic theories as guidelines for their efficient
financial
decision making. These theories include pricing theory through the
relationships between
demand and supply, return analysis, profit maximization strategies, and
marginal
analysis. The last one, particularly, is the primary economic principle used in
financial
management.
Basic Differences between Finance and Economics
Finance is less concerned with theory than is economics. Finance is basically
concerned with the application of theories and principles.
ii) Finance deals with an individual firm; but economics deals with the
industry
and the overall level of the economic activity.
Finance versus Accounting
Accounting provides financial information through financial statements.
Therefore, these
two fields are closely linked as accounting is an important input for financial
decision making. Besides, the accounting and finance functions generally
overlap; and usually it is
difficult to distinguish them. In many situations, the accounting and finance
activities are
within the control of the financial manager of a firm.
Basic Differences between Finance and Accounting
i) Treatment of income: - in accounting income measurement is on
accrual
basis. Under this method revenues are recognized as earned and
expenses as
incurred. In finance, however, the cash method is employed to
recognize the
revenue and expenses.

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ii) Decision-making: - the primary function of accounting is to gather
and
present financial data. Finance, on the other hand, is primarily
concerned with
financial planning, controlling and decision-making. The financial
manger
evaluates the financial statements provided by the accountant by
applying
additional data and then makes decisions accordingly.
iii) Accounting is highly governed by generally accepted accounting
principles.

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