NATURE & SCOPE OF

FINANCIAL
MANAGEMENT
Module 1
Financial Management
Semester 2
Contents
• Introduction

• Nature & Scope of Financial Management

• Objectives, Primary Objective of Corporate Management

• Principle – Agency problem

• Organisation of Finance Function

• Emerging Role of Finance Managers

Introduction
• Finance is the lifeline of any business.

• Finance, like most other resources, are always limited. On the other hand, wants
are always unlimited.

• Therefore, it is important for a business to manage its finance efficiently.

• Finance is the study and management of money, investments, and other financial
instruments. It involves the processes of acquiring, allocating, and managing
resources to achieve financial objectives.
Finance can be broken down into three main areas;

• Personal Finance
This focuses on managing individual or household financial decisions. It includes budgeting, saving,
investing, planning for retirement, managing debt, and buying insurance.

• Corporate Finance
This involves the financial activities of businesses, such as raising capital (through debt or equity),
investing in projects, managing cash flow, and making strategic financial decisions to maximize
shareholder value.

• Public Finance
This deals with the financial activities of governments and public entities. It involves budgeting,
taxation, expenditures, and managing public debt to provide services and infrastructure for society.
Financial Management
• Financial Management means planning, organizing, directing and controlling the
financial activities such as procurement and utilization of funds of the enterprise.

• It means applying general management principles to financial resources of the

enterprise.

• “Financial management is that area of business management devoted to a

judicious use of capital and a careful selection of the source of capital in order to
enable a spending unit to move in the direction of reaching the goals.”

Definition by J.F. Brandley

Significance of Financial Management
Determination of Business Success: Sound financial management leads to
optimum utilization of resources which is the key factor for successful enterprises. If
we analyse the factors which lead to an enterprise turning sick one of the main
factors would be mismanagement of financial resources. Financial Management
helps in preparation of plans for growth, development, diversification and expansion
and their successful execution.
Optimum Utilisation of Resources: One of the basic objectives of financial management is
to measure the input and output in monetary terms. Since finance managers are responsible
for the allocation of resources, they are also responsible to ensure that resources are used in
an optimum manner. In fact, the failure of business enterprise is not due to inadequacy of
financial resources, but is the result of defective management of financial resources. In a
country like India, where capital is scarce effective utilisation of financial resources is of
great significance.

Focal Point of Decision Making: Financial management is the focal point of decision-
making as it provides various tools and techniques for scientific financial analysis. Some of
the techniques of financial management are comparative financial statement, budgets, ratio
analysis, variance analysis, cost- volume, profit analysis, etc. These tools help in evaluating
the profitability of the project.
• Measurement of Performance: The performance of the firm is measured by its financial results.
The value of the firm is determined by the quantum of earnings and the associated risk with these
earnings. Financial decisions which increases earnings and reduces risk will enhance the value of
the firm.

• Basis of Planning, Co-ordination and Control: Each and every activity of the firm requires
resource outlays which are ultimately measured in monetary terms. The finance department being
the nodal department is closely associated with the planning of most of the activities of the
various departments. Since most of the activities of the firm require co-ordination among various
departments, the finance department facilitates this co-ordination by supplying the requisite
information. Since the result of various activities are measured in monetary terms, again the
finance department is closely involved in control and monitoring activities.
• Advisory Role: The finance manager plays an important role in the success of any
organizations.

• Information Generator for Various Stakeholders: In this modern era where

business managers are trustees of public money, it is expected that the firm
provides information to the various stakeholders about the functioning of the firm.
One of the major objectives of financial management is to provide timely

information to various stakeholders.

 Principles of financial management / Finance
Functions
• Investment Decision: The firm has scarce resources that must be allocated among competing uses.
On the one hand the funds may be used to create additional capacity which in turn generates
additional revenue and profits and on the other hand some investments results in lower costs. In
financial management the returns, from a proposed investment are compared to a minimum
acceptable hurdle rate in order to accept or reject a project. The hurdle rate is the minimum rate of
return below which no investment proposal would be accepted. In financial management we
measure (estimate) the return on a proposed investment and compare it to minimum acceptable
hurdle rate in order to decide whether or not the project is acceptable. The hurdle rate is a function
of riskness of the project, riskier the project higher the hurdle rate. There is a broad argument that
the correct hurdle rate is the opportunity cost of capital. The opportunity cost of capital is the rate of
return that an investor could earn by investing in financial assets of equivalent risk.
• Financing Decision

Another important area where financial management plays an important role is in deciding when,
where, from and how to acquire funds to meet the firm’s investment needs. These aspects of
financial management have acquired greater importance in recent times due to the multiple avenues
from which funds can be raised. Some of the widely used instruments for raising finds are ADRs,
GDRs, ECBs Equity Bonds and Debentures etc. The core issue in financing decision is to maintain
the optimum capital structure of the firm that is in other words, to have a right mix of debt and
equity in the firm’s capital structure. In case of pure equity firm (Zero debt firms) the shareholders
returns should be equal to the firm’s returns. The use of debt affects the risk and return of
shareholders. In case, cost of debt is used the firm’s rate of return the shareholder’s return is going
to increase and vice versa. The change in shareholders return caused by change in profit due to use
of debt is called the financial leverage.
• Dividend Decisions

Dividend decisions is the third major financial decision. The share price of a firm is a function of the cash
flows associated with the share. The share price at a given point of time is the present value of future cash
flows associated with the holding of share. These cash flows are dividends. The finance manager has to decide
what proportion of profits has to be distributed to the shareholders. The proportion of profits distributed as
dividends is called the dividend pay out ratio and the retained proportion of profits is known as retention ratio.
The dividend policy must be designed in a way, that it maximizes the market value of the firm’s share. The
retention ratio depends upon a host of factors− the main factor being the existence of investment
opportunities. The investors would be indifferent to dividends if the firm is able to earn a rate or return which
is higher than the cost of the capital. Dividends are generally paid in cash, but a firm may also issue bonus
shares. Bonus share are shares issued to the existing shareholders without any charge. As far as dividend
decisions are concerned the finance manager has to decide on the question of dividend stability, bonus shares,
retention ratio and cash dividend
• Dividend Decision

Dividend decisions is the third major financial decision. The share price of a firm is a function of the cash
flows associated with the share. The share price at a given point of time is the present value of future cash
flows associated with the holding of share. These cash flows are dividends. The finance manager has to
decide what proportion of profits has to be distributed to the shareholders. The proportion of profits
distributed as dividends is called the dividend pay out ratio and the retained proportion of profits is known as
retention ratio. The dividend policy must be designed in a way, that it maximises the market value of the
firm’s share. The retention ratio depends upon a host of factors− the main factor being the existence of
investment opportunities. The investors would be indifferent to dividends if the firm is able to earn a rate or
return which is higher than the cost of the capital. Dividends are generally paid in cash, but a firm may also
issue bonus shares. Bonus share are shares issued to the existing shareholders without any charge. As far as
dividend decisions are concerned the finance manager has to decide on the question of dividend stability,
bonus shares, retention ratio and cash dividend
• Liquidity Decision

A firm must be able to fulfill its financial commitments at all points of time. In order to
ensure this the firm should maintain sufficient amount of liquid assets. Liquidity decisions
are concerned with satisfying both long and short-term financial commitments. The
finance manager should try to synchronize the cash inflows with cash outflows. An
investment in current assets affect the firm’s profitability and liquidity. A conflict exists
between profitability and liquidity while managing current assets. In case, the firm has
insufficient current assets it may default on its financial obligations. On the other hand
excess funds result in foregoing of alternative investment opportunities.
 Objectives of financial management
• For optimal financial decisions, it is essential to define objectives of financial
management.

• These objectives serve as decision-criterion. Financing is a functional area of business

and, therefore, the objectives of financial management must be in tune with the
overall objectives of the business.

• The main objectives of business are survival and growth. In order to survive in the
business and to grow, a business must earn sufficient profits.

• It must also maintain good relations with investors, employees, customers and other
groups of society.
• Profit Maximization
The basic objective of every business enterprise is the welfare of its owners. It can be achieved by the
maximization of profits. Therefore, according to this criterion, the financial decisions (investment, financing
and dividend) of a firm should be oriented to the maximization of profits (i.e. select those assets, projects and
decisions which are profitable and reject those which are not profitable). In other words, actions that increase
profits are be undertaken and those that decrease profits are to be avoided. Profit maximization as an objective
of financial management can be justified on the following grounds.

Rational

Test of Business Performance

Main Source of Inspiration

Maximum Social Welfare

Basis of Decision-Making
Drawbacks of Profit Maximization Concept
• It is vague
• It ignores time value of money
• It ignores risks
• It ignores social responsibility
It can be easily concluded that profit maximization criterion is inappropriate and
unsuitable as an operational objective of financial management.

In imperfect competition, the profit maximization criterion will certainly encourage

concentration of economic power and monopolistic tendencies.

That is why, the objective of wealth maximization is considered as the appropriate

and feasible objective as against the objective of profit maximization.
• Wealth Maximisation

The objective of profit maximization, as discussed above, is not only vague and ambiguous, but it
also ignores the two basic criteria of financial management i.e. (i) risk and (ii) time value of money.
Therefore, wealth maximization is taken as the basic objective of financial management, rather than
profit maximization. It is also known as ‘Value Maximization’ or ‘Net Present Value Maximization’.
According to Ezra Soloman of Stanford University, the ultimate objective of financial management
should be the maximization of wealth. Prof. Irwin Friend has also supported this view. Wealth
Maximization means to maximize the net present value (or wealth) (NPV) of a course of action. It
NPV is the difference between the gross present value of the benefits of that action and the amount of
investment required to achieve those benefits. The gross present value of a course of action is
calculated by discounting or capitalizing its benefits at a rate which reflects their timings and
uncertainty
Today, wealth maximization is a better objective because

• It measures income in terms of cash flows, and avoids the ambiguity now associated with
accounting profits as, income from investments is measured on the basis of cash flows
rather than on accounting profits.

• It recognizes time value of money by discounting the expected income of different years at
a certain discount rate (cost of capital).

• It analyses risk and uncertainty so that the best course of action can be selected from
different alternatives.

• It is not in conflict with other motives like maximization of sales or market value of
shares. It helps rather in the achievement of all these other objectives.
 Primary Objective of Corporate Management
• Efficiently and effectively utilize the resources that the management has in hand.

• Optimizing the resources to provide the most output possible.

• Increasing efficiency of operations, production and services to allow for greater

production, sales and profits.

• Maximizing profits.

• Maintaining quality

• Upholding workplace morale.

• Reducing risks

• Generating business strategies

Principal Agency Problem
• Based on business entity concept. Business entity concept explain business as a
separate entity from its owners.
• Agency problem arises when the agent act for his personal benefit which may
conflict the interests of his principal.
• Here, agency is any organization which providing or rendering services or
producing products.
• Principal is the owner and agent is the management of the organization.
• The relationship between the owner and agent is known as the agency relation.
• The agency problem arises when the owners objective and the managers
objectives are not in the same alignment.
Causes of agency problem

• Conflict of interest between owners and management

• Conflict of interest between majority shareholders and minority shareholders.

• Conflict of interest between owners and other parties of contract (stakeholders).

Agency Cost

• The cost incurred to prevent or eliminate agency problem in an organization. The

types of agency cost includes;
• Monitoring Cost: The monitoring outflows relate to payment for audit and control
procedures to ensure that managerial behavior is tuned to actions that tend to be in the
best interest of the shareholders. (Direct Cost)
• Bonding cost: The firm pays to obtain a fidelity bond from a third-party bonding
company to the effect that the latter will compensate the former up to a specified
amount for financial losses caused by dishonest acts of managers. (Direct Cost)
• Opportunity Cost: costs result from the inability of large companies to respond to
new opportunities. The management may face difficulties in seizing profitable
investment opportunities quickly. (Indirect Cost)
• Structuring Cost: The most popular, powerful, and expensive method is to structure
management compensation to correspond with share price maximization. The
objective is to give managers incentives to act in the best interests of the owners
through incentive plans and performance plans.
Organization of finance function
• The organization of finance function implies the division and classification of functions
relating to finance because financial decisions are of utmost significance to firms.
Therefore, to perform the functions of finance, we need a sound and efficient
organization.
• The main responsibility to perform finance function rests with the top management yet
the top management (Board of Directors) for convenience can delegate its powers to any
subordinate executive which is known as Director Finance, Chief Financial Controller,
Financial Manager or Vice President of Finance.
• The organization of finance function is not similar in all businesses but it is different
from one business to another. The organization of finance function for a business
depends on the nature, size financial system and other characteristics of a firm.
 Role of finance managers
Raising of Funds
• In order to meet the obligation of the business it is important to have enough cash and liquidity. A
firm can raise funds by the way of equity and debt.
• It is the responsibility of a financial manager to decide the ratio between debt and equity. It is
important to maintain a good balance between equity and debt.
Allocation of Funds
• Once the funds are raised through different channels the next important function is to allocate the funds.
• The funds should be allocated in such a manner that they are optimally used. In order to allocate funds in the
best possible manner the following point must be considered
• The size of the firm and its growth capability
• Status of assets whether they are long-term or short-term
• Mode by which the funds are raised
• These financial decisions directly and indirectly influence other managerial activities. Hence formation of a
good asset mix and proper allocation of funds is one of the most important activity
Profit Planning
• Profit earning is one of the prime functions of any business organization.
• Profit earning is important for survival and sustenance of any organization. Profit
planning refers to proper usage of the profit generated by the firm.
• Profit arises due to many factors such as pricing, industry competition, state of the
economy, mechanism of demand and supply, cost and output.
• A healthy mix of variable and fixed factors of production can lead to an increase in
the profitability of the firm.
• Fixed costs are incurred by the use of fixed factors of production such as land and
machinery. In order to maintain a tandem it is important to continuously value the
depreciation cost of fixed cost of production.
• An opportunity cost must be calculated in order to replace those factors of
production which has gone thrown wear and tear. If this is not noted then these
fixed cost can cause huge fluctuations in profit.
Understanding Capital Markets
• Shares of a company are traded on stock exchange and there is a continuous sale
and purchase of securities. Hence a clear understanding of capital market is an
important function of a financial manager.
• When securities are traded on stock market there involves a huge amount of risk
involved. Therefore a financial manger understands and calculates the risk
involved in this trading of shares and debentures.
• Its on the discretion of a financial manager as to how to distribute the profits.
Many investors do not like the firm to distribute the profits amongst share holders
as dividend instead invest in the business itself to enhance growth.
• The practices of a financial manager directly impact the operation in capital
market.