Introduction to Financial Management

Management > Financial Management > Introduction

The planning, directing, monitoring, organizing, and controlling of the monetary resources of an organization is called financial management.  It is the art and science of managing money It is concerned with procurement and effective utilization of funds for the benefit of its shareholders. It utilizes all those managerial activities that are required to procure funds at the least cost and their effective deployment.

The scope of Financial Management:

Investment Decision:

The investment decision involves the evaluation of risk, measurement of the cost of capital and estimation of expected benefits from a project.  Investment decisions involve decisions with respect to composition or mix of assets Capital budgeting, working capital decisions, and liquidity are the major components of investment decision.

• Capital Budgeting: These are investment decisions which include investment in fixed or permanent assets which would give returns or yield earnings in the future or replacement and renovation of old assets. Capital budgeting is a very important decision as it affects the long-term success and growth of the organization. It is a difficult process because it involves the estimation of costs and benefits which are uncertain and unknown at the time of decision.
• Liquidity: Liquidity refers to how easily assets can be converted into cash. Cash is the most liquid asset. Assets like stocks and bonds are very liquid since they can be converted to cash in a short time.  However, large assets such as property, plant, and equipment cannot be easily converted to cash in a short time. The finance manager must maintain an appropriate balance between fixed and current assets in order to maximize profitability and to maintain desired liquidity in the firm.

Working Capital Decisions:

Current assets are those assets which are convertible into cash within an accounting year. While, current liabilities are those liabilities, which are likely to mature for payment within an accounting year.

These are the decisions which include investments in current assets (which include receivables, inventory, short-term securities, etc.) and current liabilities (which include creditors, bills payable, bank overdrafts, outstanding expenses, etc.)

Financing Decisions:

Financing decisions involve decisions about the financing mix or the financial structure of the firm. These decisions involve the raising of finance from various resources which will depend upon the decision on the type of source, the period of financing, cost of financing and the returns on it.

The finance manager must develop the best finance mix or optimum capital structure for the firm such that a proper balance between debt and equity is maintained and the return to equity shareholders is high and their risk is low. Use of debt or financial leverage affects both the return and risk to the equity shareholders.

Dividend Decisions:

The main objective of financial management is wealth maximization for shareholders. Hence an appropriate dividend policy must be developed. Net profits are generally divided into two parts a) dividend for shareholders and b) retained profits.

Thus the finance manager has to make a decision whether to distribute all the profits in the form of dividends or to distribute a part of the profits and retain the balance. He has to make the decision about the optimum dividend payout ratio. The retained profit must be employed in the investment opportunities available to the firm, plans for expansion and growth, etc.

Core Elements of Financial Management

Financial Planning:

Management needs to ensure that enough funding is available at the right time to meet the needs of the business. Financial planning is done to ensure the availability of capital investments to acquire real assets (which include lands, buildings, plants, and equipment). For this long or medium-term finance is required. In the short term, funding may be needed to invest in equipment and stocks, pay employees and fund sales made on credit. Financial planning is required for establishing and running the business smoothly.

Financial Decisions:

These are the decisions need to be taken on the sources of finance required for capital investments. There are two sources of funds the debt and equity. Finance manager takes the decision in what proportion the funds are to be obtained from these sources so that the objective of wealth maximization of shareholders is achieved.

Financial Control:

Financial control is a critically important activity to help the business ensure that the business is meeting its objectives. It involves managing the costs and expenses of a business. It includes making decisions on the routine aspects of the day-to-day management of collecting money which is due from the firm’s customers and making payments to the suppliers of various resources.

Objectives of Financial Management:

Profit Maximization:

The main aim of any kind of economic activity is earning a profit. It is the measuring tool for the economic success and efficiency of the firm. Hence the main objective of financial management is profit maximization. The finance manager tries to earn maximum profits for the company in the short-term and the long-term.

Due to the uncertainty in the business, the finance manager cannot guarantee profits in the long run but ensures that the firm can earn maximum profits even in the long run by taking proper financial decisions and optimally utilizing the funds available through finance.

Wealth Maximization:

Wealth maximization (shareholders’ value maximization) is also the main objective at par with profit maximization of financial management. Wealth maximization means to earn maximum wealth for the shareholders. This objective is a universally accepted concept in the field of business to overcome limitations of profit maximization.

The wealth maximization is possible only when the company pursues policies that would increase the market value of shares of the firm. The market value of the shares is directly related to the performance of the firm.  Also, the finance manager tries to give a maximum dividend to the shareholders.

Proper Estimation of Total Financial Requirements:

The finance manager must estimate the total financial requirements of the company. He has to do cash budgeting for fixed assets requirements, working capital requirements by considering the liquidity. If the proper estimation is not done there is a shortage or surplus of finance. During estimation, the finance manager has to consider the type of technology used, the number of employees employed, the scale of operations, the legal requirements, etc.

Prepare Capital Structure:

Capital structure decides the ratio between owned finance and borrowed finance (debt-equity ratio). It brings a proper balance between the different sources of. capital. This balance is necessary for the liquidity, economy, flexibility, and stability of the firm.

Proper Mobilization of Finance:

After estimating the financial requirements and preparing the capital structure of the firm, the finance manager must decide about the sources of finance. Shares, debentures, bank loans, etc. are different sources of finance. There must be a proper balance between owned finance and borrowed finance (debt-equity ratio). The finance manager should ensure that the firm gets finance at a low rate of interest. It reduces the cost of capital.

Proper Utilization of Finance:

The finance manager must make optimum utilization of finance. He must use the finance profitable so that there is wealth maximization for shareholders. The finance should not be utilized in unprofitable projects of the firm. The finance should not be blocked in inventories. The credit period should be short. He should ensure to reduce the operating risks due to the uncertainties in business. It can be done by avoiding high-risk projects and taking a proper insurance policy. The financial manager must try to have proper coordination between the finance department and other departments of the firm to increase the efficiency and the productivity so that there is no wastage of fund.

Maintaining Proper Cash Flow:

The company must have a proper cash flow to pay the day-to-day expenses such as the purchase of raw materials, payment of wages and salaries, rent, electricity bills, etc. Good cash flow helps in getting cash discounts on purchases, large-scale purchasing, giving credit to customers, etc. Healthy cash flow improves the chances of survival and success of the company.

Credit Reserves:

The company must not distribute the full profit as a dividend to the shareholders. It must keep a part of its profit as reserves. Reserves are important because they can be utilized for future growth and expansion. It can be used as a financial cushion for contingencies in the future.

Create Goodwill:

Financial management must try to create goodwill for the company by improving the image and reputation of the firm. It helps the firm to survive in the short-term and succeed in the long-term. It also helps the company during bad times. It also helps in acquiring finance for future projects.

Next Topic: Profit and Wealth Maximization

Management > Financial Management > Introduction