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Financial Management
Financial management refers to the efficient and effective management of organization. It is strategically planning how a business should money (funds) in such a manner as to accomplish the objectives of the earn and spend money. This includes decisions about raising capital, borrowing money and budgeting. Financial management also involves setting financial goals and analyzing data.
The general meaning of finance refers to providing funds, as and when needed. However, as management function, the term ‘Financial Management’ has a distinct meaning.
Financial management deals with the study of procuring funds and its effective and judicious utilization, in terms of the overall objectives of the firm, and expectations of the providers of funds.
The basic objective is to maximize the value of the firm.
The purpose is to achieve maximization of share value to the owners i.e. equity shareholders.
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DEFINITIONS
The term financial management has been defined, differently, by various authors. Some of the authoritative definitions are given below:
- “Financial Management is concerned with the efficient use of an important economic resource, namely, Capital Funds” —Solomon
- “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” — Phillioppatus
- “Business finance is that business activity which is concerned with the conservation and acquisition of capital funds in meeting financial needs and overall objectives of a business enterprise” —Wheeler
- “Financial management is concerned with raising financial resources and their effective utilisation towards achieving the organisational goals” --Dr. S. N. Maheshwari
- “Financial management is the process of putting the available funds to the best
areas such as production management, marketing management, personnel management, etc. depend on financial management. Efficient financial management is required for survival, growth and success of the company or firm.
Aim of finance functions
The following are the aims of finance function: 1. Acquiring Sufficient and Suitable Funds : The primary aim of finance function is to assess the needs of the enterprise, properly, and procure funds, in time. Time is also an important element in meeting the needs of the organisation. If the funds are not available as and when required, the firm may become sick or, at least, the profitability of the firm would be, definitely, affected. It is necessary that the funds should be, reasonably, adequate to the demands of the firm. The funds should be raised from different sources, commensurate to the nature of business 6 Financial Management and risk profile of the organisation. When the nature of business is such that the production does not
commence, immediately, and requires long gestation period, it is necessary to have the long-term sources like share capital, debentures and long term loan etc. A concern with longer gestation period does not have profits for some years. So, the firm should rely more on the permanent capital like share capital to avoid interest burden on the borrowing component.
- Proper Utilisation of Funds : Raising funds is important, more than that is its proper utilisation. If proper utilisation of funds were not made, there would be no revenue generation. Benefits should always exceed cost of funds so that the organisation can be profitable. Beneficial projects only are to be undertaken. So, it is all the more necessary that careful planning and cost-benefit analysis should be made before the actual commencement of projects.
3. Increasing Profitability : Profitability is necessary for every organisation. The planning and control functions of finance aim at increasing profitability of the firm. To achieve profitability, the cost of funds should be low. Idle funds do not
business, in all activities as no activity can exist without funds. Financial Decisions or Finance Functions are closely inter-connected. All decisions mostly involve finance. When a decision involves finance, it is a financial decision in a business firm. In all the following financial areas of decision-making, the role of finance manager is vital. We can classify the finance functions or financial decisions into four major groups: (A) Investment Decision or Long-term Asset mix decision
(B) Finance Decision or Capital mix decision
(C) Liquidity Decision or Short-term asset mix decision
(D) Dividend Decision or Profit allocation decision
(A) 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. They have to be rationed and discretely used. 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 organisation is exposed to. The more important aspect is how the investors perceive the risk.
The investment decisions result in purchase of assets. Assets can be classified, under two broad categories:
(i) Long-term investment decisions – Long-term assets
(ii) Short-term investment decisions – Short-term assets
Long-term Investment Decisions : The long-term capital decisions are referred to as capital budgeting decisions, which relate to fixed assets. The fixed assets are long term, in nature. Basically, fixed assets create earnings to the firm. They give benefit in future. It is difficult to measure the benefits as future is uncertain.
Once investment decision is made, the next step is how to raise finance for the concerned investment. 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). These sources have their own peculiar characteristics. The key distinction lies in the fixed commitment. Borrowed funds are to be paid interest, irrespective of the profitability of the firm. Interest has to be paid, even if the firm incurs loss and this permanent obligation is not there with the funds raised from the shareholders. 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. The shareholders’ funds could be from equity shareholders or preference shareholders. Equity share capital is not repayable and does not have fixed commitment in the form of dividend. However, preference share capital has a fixed commitment, in the form of dividend and is redeemable, if they are redeemable preference shares.
Barring a few exceptions, every firm tries to employ both borrowed funds and shareholders’ funds to finance its activities. The employment of these funds, in combination, is known as financial leverage. Financial leverage provides profitability, but carries risk. Without risk, there is no return. This is the case in every walk of life!
When the return on capital employed (equity and borrowed funds) is greater than the rate of interest paid on the debt, shareholders’ return get magnified or increased. In period of inflation, this would be advantageous while it is a disadvantage or curse in times of recession.
Example :
The finance manager follows that combination of raising funds which is optimal mix of debt and equity. The optimal mix minimises the risk and maximises the wealth of shareholders.
(C) Liquidity Decision Liquidity decision is concerned with the management of current assets. Basically, this is Working Capital Management. 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.
When more funds are tied up in current assets, the firm would enjoy greater liquidity. In consequence, the firm would not experience any difficulty in making payment of debts, as and when they fall due. With excess liquidity, there would be no default in payments. So, there would be no threat of insolvency for failure of payments. However, funds have economic cost. Idle current assets do not earn anything. Higher liquidity is at the cost of profitability. Profitability would suffer with more idle funds. Investment in
current assets affects the profitability, liquidity and risk. 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. This is, indeed, a balancing act and continuous process. It is a continuous process as the conditions and requirements of business change, time to time. In accordance with the requirements of the firm, the liquidity has to vary and in consequence, the profitability changes. This is the major dimension of liquidity decision working capital management. Working capital management is day to day problem to the finance manager. His skills of financial management are put to test, daily.
(D) Dividend Decision
Dividend decision is concerned with the amount of profits to be distributed and retained in the firm.
Dividend : 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
without distributing any amount in the form of dividend.
There is no ready-made answer, how much is to be distributed and what portion is to be retained. Retention of profit is related to
- Reinvestment opportunities available to the firm.
- Alternative rate of return available to equity shareholders, if they invest themselves.
Objective of finance function
- Profit maximisation : The main objective of financial management is profit maximisation within the private sector. The finance manager is responsible to assist in earning maximum profits for the company, in the short-term and for the long-term. However they cannot guarantee profits in the long term because of the uncertainty of business. However, a company can earn maximum profits if:- A. Management and the finance manager take proper financial decisions and plan well. B. The organisation uses the finances of the company carefully and strategically.
- Wealth maximisation : Wealth maximisation (shareholders’ value maximisation) is also a main objective of financial management. Wealth maximisation means to earn maximum wealth for the shareholders. So, the finance manager will attempt to achieve maximum dividends to shareholders, and they will also try to increase the market value of the shares. The market value of the shares should be directly related to the performance of the company. The better the performance, the higher is the market value of shares and vice-versa. So, the finance manager must try to maximise shareholder’s value.
- Wealth maximization uses the concept of future expected cash flows rather then the ambiguous term Profits.
- It considers time value of money.
- It considers Risk associated with investment
- Also the Pay Back Period of specific projects.
The company must borrow money at as low a rate of interest as achieveable.
- Proper utilisation of finance cash : Proper utilisation of finance is an important objective of financial management. The finance manager must plan the optimum use of finance. They must use the finance profitably delivering best value for money. They must not waste the money of the organisation. They must assist and advise not to invest the company’s financial resources into unprofitable projects. They must forecast adequately the cash flow to enable smooth stock control. They must have a good supply of short credit.
- Maintaining proper cash flow : Maintaining proper cash flow is a short-term objective of financial management. The company must have a proper cash flow to pay the day-to-day expenses such as purchasing of raw materials, the payment of wages and salaries, rent, electricity bills, etc. If the company has good cash flow, it can take advantage of many opportunities such as taking cash discounts on purchases, large-scale purchasing, giving credit to customers, etc. A healthy cash flow improves the chances of survival and success of the company. Also gives strength against competition and the ability to make acquisitions.
- Survival of company : Survival is the most important objective of sound financial management. The company must survive in this competitive business world. The finance manager must be very careful while making financial decisions.
- Creating reserves : One of the objectives of financial management is to create reserves. The company should not distribute the full profits as a dividend to the shareholders. It should keep a part of its profit in reserves. Reserves can be used for future growth and expansion. It can also be used to face contingencies in the future if any emergencies should arise, or give strength for a possible merger or acquisition.
- Proper co-ordination : Financial management assist and try to have proper planning and coordination between the finance department and other departments of the company.
- Creating goodwill : Financial management must try to create goodwill for the company. It must improve the image and reputation of the company. Goodwill helps the company to survive in the short-term and succeed in the long-term. It also helps the company during bad times. It
