Chapter I :

An Overview of Financial
Management
Meaning:

Financial management is that administrative area or

set of administrative functions which relate to the
management of finance, both its sources and
uses/application.

Definition:

“Financial management is an application of general

managerial principles to the area of financial decision
making” – Howard and Upton.
A. The Investment Decision:

 Itis concerned with the effective utilization of funds in

one activity or the other.

 This comprises decisions relating to investment in both

capital and current assets.

 The finance manger has to evaluate different capital

investment proposals and select the best keeping in view
the overall objective of the enterprise.
B. The Financing Decision:

 This determines as to how the total funds required by the

firm will be made available through the issue of different
type of securities.

 A company cannot depend upon only one source of capital.

 Hence, before using any particular source of capital, the

relative cost of capital, degree of risk control etc. have to be
carefully examined by the finance manager.
C. The Dividend Decision:

 Dividend decision helps the management in the

declaration and payment of dividend to the
shareholders.

 It decides how much of the earnings should be

distributed among the shareholders and how much
should be retained in the business for future
expansion.
I. Traditional Approach:
 Financial manager was called upon to raise funds during the
major events such as promotion, reorganization, expansion etc.

 His only significant duty was to see that the firm had enough
cash to meet its obligations.

 He is required to raise the needed funds from the combination of

various resources such as:
 Arrangement of funds from financial institutions
 Arrangement of funds from financial instruments such as
shares, bonds etc…
 Looking after the legal and accounting relationship between a
corporation and its sources of funds
Criticism of Traditional Approach

 It treated the subject of finance from the view point of

suppliers of funds and ignored the view point of
management of funds i.e, uses/application of funds.

 The approach focused attention only on the financial

problems of corporate enterprises. Non-corporate
industrial organizations remained outside its scope.

 The problems relating to short term working capital

financing were ignored.

 It did not emphasize on allocation of funds.

II. Modern Approach

 According to modern concept, financial management is

concerned with both acquisitions of funds and their
allocation.

 The four broad decision areas of financial management

are:
 Funds required decision
 Financing decision
 Investment decision
 Dividend decision
 Besides his traditional function of raising money, financial
manager will be determining the size and technology,
setting the pace and direction of growth and shaping the
profitability and risk complexion of the firm by selecting
the best asset mix and by obtaining the optimum financing
mix.

 The finance manager has to look after profit planning

which means operating decisions in the areas of pricing,
volume of output and the firms selection of product lines.

 Profit planning is a prerequisite for optimizing investment

and financing decisions.
A. Financial Management and Cost Accounting

 The finance manager is concerned with proper utilization

of funds and he is rightly concerned with operational
costs of the firm.

 For this purpose the information's supplied by the cost

accounting department is used by him to keep costs under
control.
B. Financial Management and Marketing

 In determining the appropriate price for the products, the

finance manager has to take a joint decision with
marketing manager.

 The marketing manager provides information as to how

different prices will affect the demand for the company's
products in the market.

 While the finance manager supply's information about

costs, change in cost at different levels of production and
the profit margins required to carry on the business.
C. Financial Management and Production

The acquisition of assets and their effective utilization

affects the firms finances. Hence, he has to take a joint
decision regarding current and future utilization of the
firms assets with production manager.

D. Financial Management and Personnel Management

The recruitment, training and replacement of staff are all

the functions of the personnel department. However all
these require finance and therefore it is a joint decision
of both.
E. Financial Management and Financial Accounting

 Financial manager has to take various managerial

decisions to help the organisation in achieving its
objectives.

 To take this decision the information are provided

by the financial accounting.
1. Profit Maximization

 Maximization of profits is the basic objectives of a business

enterprise. Investors purchase the shares of the company
with the hope getting maximum profits from the company
as dividend.

 Financial management aims to safeguard the economic

interest of the persons who are directly or indirectly
concerned with the company. They must get the maximum
return for their contribution.

 This is possible only when the company earns higher profits

or sufficient profits to discharge its obligations to them.
2. Wealth Maximization

 Another main objective of the business enterprise is to maximize the

value of the company in the long run. This is also known as wealth
maximization.

 The wealth maximization objective is consistent with the

objective of maximizing the owners economic welfare.

 Its implies the fundamental principle to maximize the market

value of its shares in the long run in order to work out a
normalized market price.

 The wealth maximization criterion is based on the concept of cash

flows generated by the decision.
 Besides the above main objectives, the following are the
other objectives:

 To ensure a fair return to shareholders

 To build up the reserves for adequate growth and

expansion

 To ensure effective funds operation by efficient and

effective utilization of finances

 To ensure financial discipline in the organization

The functions of financial management can be divided into two viz.,
A. Executive functions and B. Routine functions

A) EXECUTIVE FUNCTIONS

i) Financial forecasting:
 He has to see that an adequate supply of cash is on hand at the
proper time for smooth flow of firms activities.
 Since both cash inflows and outflows are closely related to the
volume of sales, it requires financial forecasting.
 Thus the estimation of the prospective inflow and outflow of cash in
the next year is necessary to maintain the liquidity in the funds.
ii) Investment decisions

 It is the most important aspect of executive functions of

financial manager.

 In this, the allocation of capital to various investment

proposals is made in order of their profitability.

 Each investment decision necessarily involves risk and a

financial help in evaluating the various proposals under
uncertainty with the process of capital budgeting.
iii) Management policy

 The formulation of sound asset management policies is an

essential requirement to successful financial management.

 The fixed and current assets of the firm must be changed

efficiently to ensure success.

 The financial manager is charged with varying degrees of

operating responsibility over existing assets.

 He is more concerned with the management of current

assets than with fixed assets.
iv) Management of income

 It includes the allocation of net earnings among shareholders.

 He tries to get an optimal dividend payout ratio that maximize
shareholders worth in the long run.

v) Management of cash

 Estimating and controlling cash flow is also an important

function of financial management.
 All cash must be managed for the benefit of the owners. He
should try for two things:
a. To choose the best among the alternatives uses of funds and
b. To ascertain the best use that shareholders could find
outside the company.
vi) Assessment of attitude

 Assessing the capital markets attitude towards the

company and its shares.

vii) Decision about new sources of finance

 A business firm is always in need of funds. So he is on the

basis of forecast of the volume of operations, should
decide upon needs and prepare the detailed financial plan
for the procurement of funds – both short term and long
term.

 He is to evaluate the prospective cost of funds as against

the anticipated profit from the use of these funds by the
operating units to which they are to be allocated.
viii) Contract and carry negotiations for new financing

 He has to decide upon the needs and finding out a suitable

source first.

 Then he has to contact the sources and carry on the negotiations

to finalize the terms and conditions of the contract.

ix) Analyze and appraisal of financial performance

 To carry out finance functions smoothly proper analyses like

checking and appraisal of financial performance are very
essential.

 For this purpose various financial statements are prepared,

analysed and then the necessary guidelines are set for future.
x) Advising the top management

 It is an expert duty of financial manager to advise the top

management in respect of financial matters, to suggest
various alternative solutions for any financial difficulty
and to make steady efforts to increase the profitability of
capital invested in the firm.
B) INCIDENT (OR) ROUTINE FUNCTIONS

a. Record keeping and reporting

b. Preparation of various financial statements

c. Cash planning and supervision

d. Credit management

e. Custody and safeguarding the different financial securities

and the like.

f. Providing the top management with necessary and accurate

information on current an prospective financial conditions
of the business as a basis for policy decisions on purchases,
marketing and pricing.
 Anagency relationship arises when the principal
appoint an agent to perform some services or
the decision-making authority is delegated to
the agent.

 However, the agent is not fully responsible for

the decision that is made.

 Within
the financial management context, the
primary agency relationships are those:
 Between shareholders (the principal) and managers
(the agent).
 Between debt-holders (the principal) and
managers (the agent).
A. Stockholders Vs Managers

 A company's shareholders (the principal) delegate decision-

making authority to the managers (the agent).

 Since the managers typically do not own 100% of the firm,

they will neither gain all the benefits created nor bear all
the costs and risks of their decisions.

 The Shareholders goal is to maximize shareholder value

while the manager's goals is job security, power, status, and
compensation etc.

 Thus, managers may have the incentive to take actions that

are not in the best interest of the shareholders. Because
managers usually own only a small interest in most large
corporations, potential agency conflicts are significant.
B. Shareholders (Through Managers) Vs. Creditors

 Managers are the agent of both shareholders and

creditors. Shareholders empower managers to manage
the firm. Creditors empower managers to use the
loan.

 Being employed by the firm, managers are more likely

to act in the best interest of shareholders, not creditors.

 Through their managers/agents, shareholders may

maximize their wealth at the expense of creditors
by taking riskier projects.
 Creditors lend money to a firm based on its perceived business
and financial risk. If shareholders take riskier investments, the
shareholders receive the full benefit of success, but the creditors
may share the losses in case of failure.

 The firm becomes riskier because of increased

leverage. Creditors are hurt because more debt will claim
against the firm's cash flows and assets.

 To protect themselves against shareholders, creditors

often include restrictive covenant in debt agreements. In
the long-run, a firm that deals unfairly with creditors may
impair the shareholders' interest

Thus, as agents of both shareholders and creditors,

managers must treat the two classes of security holders
fairly.

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