FIN306

Basic Financial Management

Unit-1
Meaning and Definition of Financial Management

• Financial management is concerned with the acquisition of funds and their

optimum utilization. It is all about acquiring funds at minimum cost and
generate optimum return by its optimum utilization. Funds are acquired to meet
financial aspects of business activity.
• 1. According to J.S. Massie: “Financial management is the operational
activity of a business that is responsible for obtaining and effectively utilizing
the funds necessary for efficient operations.”
• 2. According to Howard and Upton: “Financial management is the
application of planning and controlling functions of finance function.”
• 3. According to the Guthman and Dougal: “Business finance can be broadly
defined as the activity concerned with planning, raising, controlling,
administering of the funds used in the business”
Scope of Financial Management
Financial Management is a sub-system in an organization which has to
coordinate with other subsystems such as production, marketing etc. Following
are scope of financial management
1. Financial Management and Economics:
Economic concepts of micro and macroeconomics are of great relevance in financial
management. Micro economic concepts like demand and supply, cost theory, production
theory etc. are very useful for any financial manager. In the same way, Macroeconomics
concepts of inflation, per capita income, aggregate-demand, aggregate supply etc. are also
useful for finance manager.
2. Financial Management and Accounting:
A finance manager has to make decisions about future. The accounting records are base for
future decisions on the basis of which future decisions are being made. Extensive analysis of
historical accounting information is made for future financial decisions. Cost and
Management accounting provide useful accounting data to finance managers.
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Scope of financial management
3. Financial Management and Mathematics:
Finance functions make use of various statistical and mathematical tools and
techniques. Time value of money, discounting and compounding, economic
order quantity etc. are widely used in capital budgeting and working capital
management. Nowadays, modern techniques of econometrics are being used in
decision making along with correlation, regression and other various methods.
4. Financial Management and Marketing: Marketing managers make various
marketing decisions. They frame plans regarding pricing, product promotion,
product mix etc. they also make decisions about market segmenting, targeting
and positioning, choice & length of distributional channels. Finance managers
work with marketing managers on most suitable plans and allocate needed
funds. Thus marketing and financial manager are related to each other.
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Scope of financial management
5. Financial Management and Human Resource: HR department provides
personnel to all department of a firm. A finance manager has to take decisions
about requirement and allocation of funds for recruitment, selection, training
and development of manpower in the organisation. Thus, a finance manager is
in close contact with HR manager for such decisions and effective decisions
related with manpower cannot be taken if both departments don’t work in
harmony with each other.
6. Financial Management and Production Management: Factors of
productions are employed to undertake production. These include land, labour,
capital and entrepreneurship. All these requires returns in the form of rent,
wages, and profit. All these payments are sanctioned by finance department.
Finance function
Finance function is the most important function of a business. Finance is,
closely, connected with production, marketing and other activities. In the
absence of finance, all these activities come to a halt. In fact, only with finance,
a business activity can be commenced, continued and expanded.
Finance exists everywhere, be it production, marketing, human resource
development or undertaking research activity.
Understanding the universality and importance of finance, finance manager is
associated, in modern business, in all activities as no activity can exist without
funds.
All decisions mostly involve finance. When a decision involves finance, it is a
financial decision in a business firm.
Financial Decisions or Functions

Classify the finance functions or financial decisions into

four major groups:

1. Investment Decision or Long-term Asset mix decision

2. Finance Decision or Capital mix decision

3. Liquidity Decision or Short-term asset mix decision

4. Dividend Decision or Profit allocation decision

1. Investment Decision
Investment decisions relate to selection of assets in which funds are
to be invested by the firm. Investment alternatives are numerous.
Resources are scarce and limited.
Investment decisions allocate and ration the resources among the
competing investment alternatives or opportunities. The effort is to
find out the projects, which are acceptable.
Investment decisions relate to the total amount of assets to be
held and their composition in the form of fixed and current
assets. Both the factors influence the risk the organization is
exposed to.
The more important aspect is how the investors perceive the risk.
2. Finance Decision
Finance decision is concerned with the mix or composition of the
sources of raising the funds required by the firm. In other words, it is
related to the pattern of financing.
In finance decision, the finance manager is required to determine the
proportion of equity and debt, which is known as capital structure.
There are two main sources of funds, shareholders’ funds (variable in
the form of dividend) and borrowed funds (fixed interest bearing
The borrowed funds are relatively cheaper compared to
shareholders’ funds, however they carry risk. This risk is known as
financial risk i.e. Risk of insolvency due to non-payment of interest
or non-repayment of borrowed capital.
On the other hand, the shareholders’ funds are permanent source to
the firm.
3. Liquidity Decision
Liquidity decision is concerned with the management of current
assets. Working Capital Management is concerned with the
management of current assets. It is concerned with short-term
survival. Short term-survival is a prerequisite for long-term
survival.

A proper balance must be maintained between liquidity and

profitability of the firm. This is the key area where finance manager
has to play significant role. The strategy is in ensuring a trade-off
between liquidity and profitability.

. Working capital management is day to day problem to the finance

manager. His skills of financial management are put to test, daily.
4. Dividend Decision
Dividend decision is concerned with the amount of profits to be distributed
and retained in the firm.
The term ‘dividend’ relates to the portion of profit, which is distributed to
shareholders of the company. It is a reward or compensation to them for their
investment made in the firm.
If dividend is not distributed, there would be great dissatisfaction to the
shareholders. Non-declaration of dividend affects the market price of equity
shares, severely.
The dividend payout ratio i.e. what proportion of dividend is to be paid to the
shareholders.
A higher rate of dividend, beyond the market expectations, increases the
market price of shares. However, it leaves a small amount in the form of
retained earnings for expansion. The business that reinvests less will tend
to grow slower.
Objectives of Financial Management
It is essential to identify the objective because all the efforts of
finance manager would be to achieve that objective. The two basic
objective are profit maximization objective and wealth
maximization objective.
1. Profit Maximization Objective
It is implied objective of any business activity. Every business
activity is started with the ultimate aim of making profit. Profit
maximization objective in financial management means that all
financial decisions are made with a view to maximise profit of the
firm with all its investments and savings. This objective helps
measure of economic performance and efficiency of any business
concern.
Favourable Arguments for profit Maximization objective
1. Rationality: It is rational that every business activity is undertaken to earn
maximum profit.
2. It ensures effective utilization of resources: The limited resources are employed
to earn maximum profits and costs are reduced to minimum.
3. It measures success of any business decisions and operations: whether the
implemented decisions were good or bad, whether the business operations were
efficient are not could be known with the help of amount of profit earned.
4. Profit is main source of finance: Fund is needed to carry out business operations,
expansion and diversification. So, for upcoming years the retained part of profits
could be used.
5. Maximization of social benefit: A business enterprise could fulfill social
responsibility obligations in the form of social activities like health, education etc.
it is possible only when the enterprise earns maximum profits.
6. Profit reduces risk of business: The future is uncertain. There are many risks
involved in businesses, if a firm has sufficient profits, it could cope with such risks.
Unfavorable Argument for Profit Maximization Objective
1. It is Vague and ambiguous: The term profit is not clear. It has not ee defined
precisely and accurately. Whether it is Profit after tax or before tax, accounting
profit or incremental profit etc.
2. It ignores time value of money: It is based on the concept of “bigger is better”
which means higher benefit is better it better for firm. But it does not consider
the time period of occurrence of the benefit. It is incorrect to treat cash inflows
occurring at different point of time as same.
3. It ignores risk factor: There are many internal as well as external risks
involved which is not taken into consideration in profit maximization objective.
4. It leads to exploitation of workers and consumer: To earn more profit an
enterprise tries to charge more price and to take more work from workers with
less pays.
5. It leads to unethical, corrupt, unfair trade practices.
2. Wealth Maximization
Wealth maximization is a FINANCIAL management
technique that concentrates its focus on increasing the net
worth or shareholder capital gains, of a company or firm.
Wealth also signifies Net Present Value(NPV) which is the
difference between present value of cash inflows and present
value of cash outflows. In this way, wealth maximization
objective considers time value of money and assign different
values to cash inflows occurring at different point of time.
So, investments should be made in such a way that it
maximizes Net Present Value to shareholder
Arguments in favor of Wealth Maximization objective
1. It is superior: This objective is superior to profit maximization as its main aim is
to maximise shareholder’s wealth.
2. It is precise and unambiguous: It is based on the concept of cash flows rather
than profit.
3. Considers time value of money: Wealth maximization objective takes into
account the time value of money as it considers timing of cash inflows. The cash
inflows occurring at different period of time are discounted with appropriate
discount rate.
4. Considers risk: This objective also considers future risk associated with
occurrence of cash flow. This is done with the help of discounting rate. Higher the
discount rate, higher the risk and vice-versa.
5. Ensures efficient allocation of resources: Resources are allocated wisely to
increase shareholder’s wealth.
6. Ensures economic interest of society: When wealth of shareholder is maximized,
it ultimately upholds economic interest of society.
Unfavorable arguments for wealth maximization objective
1. Creates owner-management problem: The concept of wealth maximization
creates owner-management problem as owners want to maximize their profits and
management want to maximise shareholder’s wealth.
2. Ignores other stakeholders: This objective has been criticized on the ground that
it is inclined towards wealth maximization of shareholders only and ignores other
stakeholders such as creditors, suppliers, employees etc.
3. Criteria of market value is not fair: The criteria of wealth maximization is based
on market value of shares which is not a correct measure. Because value of shares
could increase or decrease due to other economic factors which are beyond the
control of the firm.
4. It is just another form of profit maximization: Ultimate aim is to earn
maximum profits. Without earning profits wealth cannot be maximized.
5. Management alone enjoy certain benefits.
6. It is not suitable for present day businesses.