CHAPTER 1 - SCOPE AND OBJECTIVES OF FINANCIAL MANAGEMENT

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?

(Dividend Decision)

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).

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.”

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
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
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 public may dilute the control of
the existing shareholders.

Debentures: Debentures as a source of funds are comparatively cheaper than the 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 the 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 agreement. Also, the interest payment
has to be made whether or not the company makes profits.
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.
Different lending services provided by Commercial Banks are depicted as follows:-

International Funding: Funding today is not limited to 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 ADR’s (American depository receipts) and GDR’s (Global
depository receipts). Obviously, the mechanism of procurement of funds has to be modified in the
light of the requirements of foreign investors.

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 or expansion, in exchange for an
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 per cent 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 effective utilisation 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 utilised in the manner so 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 the 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

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 organisation, 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

Value of a firm will depend on various finance functions/decisions. It can be expressed as:
V = f (I,F,D)
The finance functions are divided into long term and short term functions/decisions

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.

(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 as to the
difference between profit and cash flow, bearing in mind that profit is of little avail unless the
organisation is adequately supported by cash to pay for assets and sustain the working capital cycle.
Financing decisions also call for a good knowledge of 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 organisation 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.
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 organisation as income for its
owners/shareholders. The owner of any profit-making organization looks for 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 organisation, 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 organisation while
the third relates only to profit-making organisations, 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 decision are reduced to management of
current asset and current liability (i.e., working capital Management)

IMPORTANCE OF FINANCIAL MANAGEMENT

Financial Management is all about planning investment, funding the investment, monitoring
expenses against budget and managing gains from the investments. Financial management means
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

Based on financial management guru Ezra Solomon’s concept of financial management, following
aspects are taken up in detail under the study of financial management:
(a) Determination of size of the enterprise and determination of rate of growth.
(b) Determining the composition of assets of the enterprise.
(c) Determining the mix of enterprise’s financing i.e. consideration of level of debt to equity, etc.
(d) Analysis, planning and control of financial affairs of the enterprise.
Role of Financial Controller: The role of financial controller has undergone changes over the years.
Until the middle of this century, its scope was limited to procurement of funds under major events in
the life of the enterprise such as promotion, expansion, merger, etc. In the modern times, the role of
financial controller includes besides procurement of funds, the three different kinds of decisions as
well namely investment, financing and dividend.
OBJECTIVES OF FINANCIAL MANAGEMENT
Profit Maximisation: It has traditionally been argued that the primary objective of a company is to
earn profit; hence the objective of financial management is also profit maximisation.
(i) The term profit is vague. It does not clarify what exactly it means. It conveys a different meaning
to different people. For example, profit may be in short term or long-term period; it may be total
profit or rate of profit etc.
(ii) Profit maximisation has to be attempted with a realisation of risks involved. There is a direct
relationship between risk and profit. Many risky propositions yield high profit. Higher the risk, higher
is the possibility of profits. If profit maximisation is the only goal, then risk factor is altogether
ignored. This implies that finance manager will accept highly risky proposals also, if they give high
profits. In practice, however, risk is very important consideration and has to be balanced with the
profit objective.
(iii) Profit maximisation as an objective does not take into account the time pattern of returns.
Proposal A may give a higher amount of profits as compared to proposal B, yet if the returns of
proposal A begin to flow say 10 years later, proposal B may be preferred which may have lower
overall profit but the returns flow is more early and quick.
(iv) Profit maximisation as an objective is too narrow. It fails to take into account the social
considerations as also the obligations to various interests of workers, consumers, society, as well as
ethical trade practices. If these factors are ignored, a company cannot survive for long. Profit
maximization at the cost of social and moral obligations is a short-sighted policy.

Wealth Maximisation/ Value Creation

Wealth = Present value of benefits – Present Value of Costs
The shareholder value maximization model holds that the primary goal of the firm is to maximize its
market value and implies that business decisions should seek to increase the net present value of the
economic profits of the firm. So, for measuring and maximising shareholders wealth finance manager
should follow:
 Cash Flow approach not Accounting Profit
 Cost benefit analysis
 Application of time value of money.
According to Van Horne, “Value of a firm is represented by the market price of the company's
common stock. The market price of a firm's stock represents the focal judgment 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 market price
serves as a performance index or report card of the firm's progress. It indicates how well
management is doing on behalf of stockholders.”
Value of a firm (V) = Number of Shares (N) × Market price of shares (MP)
Or
V = Value of equity (V e ) + Value of debt (V d )

CONFLICTS IN PROFIT VERSUS VALUE MAXIMISATION PRINCIPLE

In any company, the management is the decision taking authority. As a normal tendency the
management may pursue its own personal goals (profit maximization). But in an organization where
there is a significant outside participation (shareholding, lenders etc.), the management may not be
able to exclusively pursue its personal goals due to the constant supervision of the various
stakeholders of the company-employees, creditors, customers, government, etc.
The wealth maximization objective is generally in accord with the interests of the various groups such
as owners, employees, creditors and society, and thus, it may be consistent with the management
objective of survival.

Example: Profit maximization can be achieved in the short term at the expense of the long term goal,
that is, wealth maximization. For example, a costly investment may experience losses in the short
term but yield substantial profits in the long term. Also, a firm that wants to show a short term profit
may, for example, postpone major repairs or replacement, although such postponement is likely to
hurt its long term profitability.

FINANCIAL DISTRESS AND INSOLVENCY

Financial distress is a position where Cash inflows of a firm are inadequate to meet all its current
obligations. Now if distress continues for a long period of time, firm may have to sell its asset, even
many times at a lower price. Further when revenue is inadequate to revive the situation, firm will not
be able to meet its obligations and become insolvent. So, insolvency basically means inability of a
firm to repay various debts and is a result of continuous financial distress.

AGENCY PROBLEM AND AGENCY COST

Though in a sole proprietorship firm, partnership etc., owners participate in management but in
corporates, owners are not active in management so, there is a separation between owner/
shareholders and managers. In theory managers should act in the best interest of shareholders
however in reality, managers may try to maximise their individual goal like salary, perks etc., so there
is a principal agent relationship between managers and owners, which is known as Agency Problem.
Agency Problem leads to Agency Cost. Agency cost is the additional cost borne by the shareholders
to monitor the manager and control their behaviour so as to maximise shareholders wealth.
Generally, Agency Costs are of four types (i) monitoring (ii) bonding (iii) opportunity (iv) structuring.
following efforts have been made to address these issues:
 Managerial compensation is linked to profit of the company to some extent and also with the long
term objectives of the company.
 Employee is also designed to address the issue with the underlying assumption that maximisation
of the stock price is the objective of the investors.
 Effecting monitoring can be done.