SCOPE AND OBJECTIVES OF FINANCIAL MANAGEMENT,
INTRODUCTION: FINANCIAL MANAGEMENT
We will like to explain Financial Management by giving a very simple scenario. For the purpose of starting any new business/venture, an entrepreneur goes through the following stages of decision making:-
| Stage 1 | Stage 2 | Stage 3 | Stage 4 |
|---|---|---|---|
| Decide which assets (premises, machinery, equipment etc.) to buy. | Determining what is total investment (since assets cost money) required buying assets. | assets entrepreneur would also need to determine how for much cash he would need to run the daily operations (payment for raw material, salaries, wages etc.). In other words this is also defined as Working Capital requirement. | Apart from buying The next stage is to the decide what all sources, does the entrepreneur need to tap to finance the total investment (assets and working capital). The sources could be Share Capital (Including Entrepreneur’s own funds) or Borrowing from Banks or from Investment Financial Institutions etc. |
While deciding how much to take from each source, the entrepreneur would keep in mind the cost of capital for each source (Interest/Dividend etc.). As an entrepreneur he would like to keep the cost of capital low.
Thus, financial management is concerned with efficient acquisition (financing) and allocation (investment in assets, working capital etc.) of funds with an objective to make profit (dividend) for owners. In other words, focus of financial management is to address three major financial decision areas namely, investment, financing and dividend decisions.
Any business enterprise requiring money and the 3 key questions being enquired into
1. Where to get the money from? (Financing Decision)
2. Where to invest the money? (Investment Decision)
3. How much to distribute amongst shareholders to keep them satisfied?
MEANING OF FINANCIAL MANAGEMENT
Financial management is that managerial activity which is concerned with planning and controlling of the firm’s financial resources. In other words it is concerned with acquiring, financing and managing assets to accomplish the overall goal of a business enterprise (mainly to maximise the shareholder’s wealth).
In today’s world where positive cash flow is more important than book profit, Financial Management can also be defined as planning for the future of a business enterprise to ensure a positive cash flow. Some experts also refer to financial management as the science of money management. It can be defined as:
“Financial Management comprises of forecasting, planning, organizing, directing, co-ordinating and controlling of all activities relating to acquisition and application of the financial resources of an undertaking in keeping with its financial objective. Another very elaborate definition given by Phillippatus is:
“Financial Management is concerned with the managerial decisions that result in the acquisition and financing of short term and long term credits for the firm.” As such it deals with the situations that require selection of specific assets (or combination of assets), the selection of specific problem of size and growth of an
enterprise. The analysis of these decisions is based on the expected inflows and outflows of funds and their effect on managerial objectives. There are two basic aspects of financial management viz., procurement of funds and an effective use of these funds to achieve business objectives.
Procurement of Funds
Since funds can be obtained from different sources therefore their procurement is always considered as a complex problem by business concerns. Some of the sources for funds for a business enterprise are:
Debentures and Bonds
Angel Financing
Venture Capital
Commercial Banks (Short, Medium & Long)
Owner’s Funds
In a global competitive scenario, it is not enough to depend on the available ways of raising finance but resource mobilization has to be undertaken through innovative ways on financial products which may meet the needs of investors. We are constantly seeing new and creative sources of funds which are helping the modern businesses to grow faster. For example: trading in Carbon Credits is turning out to be another source of funding.
Funds procured from different sources have different characteristics in terms of risk, cost and control. The cost of funds should be at the minimum level for that a proper balancing of risk and control factors must be carried out. Another key consideration in choosing the source of new business finance is to strike a balance between equity and debt to ensure the funding structure suits the business.
Let us discuss some of the sources of funds (discussed in detail in later chapters):
(a) Equity: The funds raised by the issue of equity shares are the best from the risk point of view for the firm since there is no question of repayment of equity capital except when the firm is under liquidation. From the cost point of view, however, equity capital is usually the most expensive source of funds. This is because the dividend expectations of shareholders are normally higher than the prevalent interest rate and also because dividends are an appropriation of profit, not allowed as an expense under the Income Tax Act. Also, the issue of new shares to the public may dilute the control of the existing shareholders.
(b) Debentures: Debentures as a source of funds are comparatively cheaper than shares because of their tax advantage. The interest the company pays on a debenture is free of tax, unlike a dividend payment which is made from taxed profits. However, even when times are hard, interest on debenture loans must be paid whereas dividends need not be. However, debentures entail a high degree of risk since they have to be repaid as per the terms of the agreement. Also, the interest payment has to be made whether or not the company makes profits.
(c) Funding from Banks: Commercial Banks play an important role in funding of the business enterprises. Apart from supporting businesses in their routine activities (deposits, payments, etc.) they play an important role in meeting the long-term and short-term needs of a business enterprise.
(d) International Funding: Funding today is not limited to the domestic market. With liberalization and globalization, a business enterprise has options to raise capital from International markets also. Foreign Direct Investment (FDI) and Foreign Institutional Investors (FII) are two major routes for raising funds from foreign sources besides ADRs (American depository receipts) and (Global depository receipts). Obviously, the mechanism of procurement of funds has to be modified in light of the requirements of foreign investors.
(e) Angel Financing: Angel Financing is a form of an equity-financing where an angel investor is a wealthy individual who provides capital for start-up o expansion, in exchange for ownership/equity in the company. Angel investors have idle cash available and are looking for a higher rate of return than what is given by traditional investments. Typically, angels, as they are known as, will invest around 25 to 60 percent to help a company get started This source of finance sometimes is the last option for startups which doesn’t qualify for bank funding and are too small for venture capital financing.
Effective Utilisation of Funds
The finance manager is also responsible for the effective utilization of funds. He has to point out situations where the funds are being kept idle or where proper use of funds is not being made. All the funds are procured at a certain cost and after entailing a certain amount of risk. If these funds are not utilized in a manner that they generate an income higher than the cost of procuring them, there is no point in running the business. Hence, it is crucial to employ the funds properly and profitably. Some of the aspects of funds utilization are:
(a) Utilization for Fixed Assets: The funds are to be invested in a manner so that the company can produce at its optimum level without endangering its financial solvency. For this, the finance manager would be required to possess sound knowledge of techniques of capital budgeting.
Capital budgeting (or investment appraisal) is the planning process used to determine whether a firm’s long-term investments such as new machinery, replacement machinery, new plants, new products, and research development projects would provide the desired return (profit).
(b) Utilization for Working Capital: The finance manager must also keep in view the need for adequate working capital and ensure that while the firms enjoy an optimum level of working capital they do not keep too much funds blocked in inventories, book debts, cash etc.
EVOLUTION OF FINANCIAL MANAGEMENT
Financial management evolved gradually over the past 50 years. The evolution of financial management is divided into three phases. Financial Management evolved as a separate field of study at the beginning of the century. The three stages of its evolution are:
The Traditional Phase: During this phase, financial management was considered necessary only during occasional events such as takeovers, mergers, expansion, liquidation, etc. Also, when taking financial decisions in the organization, the needs of outsiders (investment bankers, people who lend money to the business, and other such people) to the business was kept in mind.
The Transitional Phase: During this phase, the day-to-day problems that financial managers faced were given importance. The general problems related to funds analysis, planning, and control were given more attention in this phase. The Modern Phase: Modern phase is still going on. The scope of financial
management has greatly increased now. It is important to carry out financial analysis for a company. This analysis helps in decision-making. During this phase, many theories have been developed regarding efficient markets, capital
budgeting, option pricing, valuation models, and also in several other important fields in financial management.
FINANCE FUNCTIONS/FINANCE DECISION
The value of a firm will depend on various finance functions/decisions. It can be expressed as:
V = f (I,F,D).
Long-term Finance Function Decisions.
(a) Investment decisions (I): These decisions relate to the selection of assets in which funds will be invested by a firm. Funds procured from different sources have to be invested in various kinds of assets. Long-term funds are used in a project for various fixed assets and also for current assets. The investment of funds in a project has to be made after careful assessment of the various projects through capital budgeting. A part of long-term funds is also to be kept for financing the working capital requirements. Asset management policies are to be laid down regarding various items of current assets. The inventory policy would be determined by the production manager and the finance manager keeping in view the requirement of production and the future price estimates of raw materials and the availability of funds.
(b) Financing decisions (F): These decisions relate to acquiring the optimum finance to meet financial objectives and seeing that fixed and working capital are effectively managed. The financial manager needs to possess a good knowledge of the sources of available funds and their respective costs and needs to ensure that the company has a sound capital structure, i.e.
a proper balance between equity capital and debt. Such managers also need to have a very clear understanding of the difference between profit and cash flow, bearing in mind that profit is of little avail unless the organization is adequately supported by cash to pay for assets and sustain the working capital cycle. Financing decisions also call for a good knowledge of the evaluation of risk, e.g.
excessive debt carried high risk for an organization’s equity because of the priority rights of the lenders. A major area for risk-related decisions is in overseas trading, where an organization is vulnerable to currency fluctuations, and the manager must be well aware of the various protective procedures such as hedging (it is a strategy designed to minimize, reduce or cancel out the risk in another investment) available to him.
For example, someone who has a shop, takes care of the risk of the goods being destroyed by fire by hedging it via a fire insurance contract.
(C) Dividend decisions(D): These decisions relate to the determination as to how much and how frequently cash can be paid out of the profits of an organization as income for its owners/shareholders. The owner of any profit-making organization looks for a reward for his investment in two ways, the growth of the capital invested and the cash paid out as income; for a sole trader this income would be termed as drawings, and for a limited liability company the term is dividends.
The dividend decision thus has two elements – the amount to be paid out and the amount to be retained to support the growth of the organization, the latter being also a financing decision; the level and regular growth of dividends represent a significant factor in determining a profit-making company’s market value, i.e. the value placed on its shares by the stock market.
All three types of decisions are interrelated, the first two pertaining to any kind of organization while the third relates only to profit-making organizations, thus it
can be seen that financial management is of vital importance at every level of business activity, from a sole trader to the largest multinational corporation. Short-term Finance Decisions/Function.
Working capital Management (WCM): Generally short-term decisions are reduced to the management of current assets and current liabilities (ie., working capital Management)
IMPORTANCE OF FINANCIAL MANAGEMENT
The importance of Financial Management cannot be over-emphasized. It is, indeed, the key to successful business operations. Without proper administration of finance, no business enterprise can reach its full potential for growth and success. Money is to an enterprise, what oil is to an engine.
Financial management is all about planning investment and funding the investment. monitoring expenses against budget and managing gains from the investments. Financial management means the management of all matters related to an organization’s finances.
The best way to demonstrate the importance of good financial management is to describe some of the tasks that it involves:-
- Taking care not to over-invest in fixed assets
- Balancing cash-outflow with cash-inflows Ensuring that there is a sufficient level of short-term working capital
- Setting sales revenue targets that will deliver growth
- Increasing gross profit by setting the correct pricing for products or services Controlling the level of general and administrative expenses by finding more cost-efficient ways of running the day-to-day business operations, and
- Tax planning that will minimize the taxes a business has to pay.
SCOPE OF FINANCIAL MANAGEMENT
As an integral part of the overall management, financial management is mainly concerned with the acquisition and use of funds by an organization. Based on financial management guru Ezra Solomon’s concept of financial management, the following aspects are taken up in detail under the study of financial management:
(a) Determination of the size of the enterprise and determination of the rate of growth.
(b) Determining the composition of assets of the enterprise.
(C) Determining the mix of the enterprise’s financing ie, consideration of the level of debt to equity, etc.
(d) Analysis, planning, and control of the financial affairs of the enterprise.
The scope of financial management has undergone changes over the years. Until the middle of this century, its scope was limited to the procurement of funds under major events in the life of the enterprise such as promotion, expansion, merger, etc.
In modern times, financial management includes besides procurement of funds, the three different kinds of decisions as well namely investment, financing, and dividend. All three types of decisions would be dealt with in detail during the course of this chapter.
The given figure depicts the overview of the scope and functions of financial management. It also gives the interrelation between the market value, financial decisions, and risk-return trade-off.
The finance manager, in a bid to maximize shareholders’ wealth, should strive to maximize returns in relation to the given risk; he should seek courses of action that avoid unnecessary risks. To ensure maximum return, funds flowing in and out of the firm should be constantly monitored to assure that they are safeguarded and properly utilized.