An overview of financial management

Chapter I :
An Overview of Financial
Management

 In the modern world virtually every organization, public
and private, runs on money.
 The most common application of the term ‘finance’
involves raising money to acquire assets.
 Companies finance assets when they raise money to
acquire those assets. They do that by borrowing, selling
stock, or using money they have earned.
 Financial management means the management and control
of money and money-related operations within a business.

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.

Decision Areas of Financial Management
A. The Investment Decision:
 It is 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.

Roles of the Financial Manager
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.

 Finance, production and marketing are the three important
activities of a business firm. A firm secures capital for its
need through finance activity and employs it through
production and marketing activities.
 Thus business firm is an entity that engages in activities to
perform the functions of finance, production and marketing.
It acquires funds from the sources called investors when
invested, the funds are called investments.

 The firm expects to receive returns on investments over time,
and periodically distributes returns to investors. These
processes are not sequential, but simultaneous and
continuous.

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 value 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 / ROUTINE FUNCTIONS
 Record keeping and reporting
 Preparation of various financial statements
 Cash planning and supervision
 Credit management
 Custody and safeguarding the different financial
securities and the like.
 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.

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 /
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

 An agency 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.

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.
 The finance manager supplies 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 organization in achieving its
objectives.
 To take this decision the information are provided by the
financial accounting.

 A financial market is a broad term describing any
marketplace where buyers and sellers participate in the
trade of assets such as equities, bonds, currencies and
derivatives.
 Financial markets are typically defined by having
transparent pricing, basic regulations on trading, costs and
fees, and market forces determining the prices of securities
that trade.
 Financial markets can be found in nearly every nation in
the world. Some are very small, with only a few
participants, while others - like the New York Stock
Exchange (NYSE) and the forex markets - trade trillions of
dollars daily.

 Investors have access to a large number of financial
markets and exchanges representing a vast array of
financial products.
A. Capital Markets:
 A capital market is one in which individuals and
institutions trade financial securities.
 Organizations and institutions in the public and private
sectors also often sell securities on the capital markets in
order to raise funds.
 Thus, this type of market is composed of both the
primary and secondary markets.

 Any government or corporation requires capital (funds)
to finance its operations and to engage in its own long-
term investments.
 To do this, a company raises money through the sale of
securities - stocks and bonds in the company's name.
These are bought and sold in the capital markets.
i. Stock Markets:
 Stock markets allow investors to buy and sell shares in
publicly traded companies. They are one of the most vital
areas of a market economy.

 They provide companies with access to capital and
investors with a slice of ownership in the company and
the potential of gains based on the company's future
performance.
 This market can be split into two main sections: the
primary market and the secondary market.
 A Primary Market issues new securities on an
exchange. Companies, governments and other groups
obtain financing through debt or equity based securities.
It is also known as "new issue markets”, are facilitated by
underwriting groups, which consist of investment banks
that will set a beginning price range for a given security
and then oversee its sale directly to investors.

 The primary markets are where investors have their first
chance to participate in a new security issuance. The
issuing company or group receives cash proceeds from
the sale, which is then used to fund operations or expand
the business.
 The Secondary Market is where investors purchase
securities or assets from other investors, rather than from
issuing companies themselves. The Securities and
Exchange Commission (SEC) registers securities prior to
their primary issuance, then they start trading in the
secondary market on the New York Stock Exchange,
NASDAQ or other venue where the securities have been
accepted for listing and trading.

ii. Bond Markets:
 A bond is a debt investment in which an investor lends
money to a corporate or government, which borrows the
funds for a defined period of time at a fixed interest rate.
 Bonds are used by companies, municipalities, states and
U.S. and foreign governments to finance a variety of
projects and activities.
 Bonds can be bought and sold by investors on credit
markets around the world. This market is alternatively
referred to as the debt, credit or fixed-income market.
 The main categories are Corporate bonds, Municipal
bonds, and U.S Treasury bonds, Notes and Bills, which
are collectively referred to as simply "Treasuries”.

B. Money Markets:
 The money market is a segment of the financial market in
which financial instruments with high liquidity and very
short maturities are traded. Money market investments
are also called cash investments.
 The money market is used by participants as a means for
borrowing and lending in the short term, from several
days to just under a year.
 Money market securities consist of negotiable
Certificates of Deposits (CDs), Banker's Acceptances,
U.S. Treasury Bills, Commercial Paper, Municipal Notes
etc.,

C. Derivatives Market:
 The derivative is named so for a reason: its value is derived
from its underlying asset or assets.
 A derivative is a contract, but in this case the contract price
is determined by the market price of the core asset.
 The derivatives market adds yet another layer of
complexity and is therefore not ideal for inexperienced
traders looking to speculate.

D. Forex and the Interbank Market:
 The interbank market is the financial system and trading of
currencies among banks and financial institutions,
excluding retail investors and smaller trading parties. While
some interbank trading is performed by banks on behalf of
large customers, most interbank trading takes place from
the banks' own accounts.
 The forex market is where currencies are traded. The forex
market is the largest, most liquid market in the world with
an average traded value that exceeds $ 2 trillion per day and
includes all of the currencies in the world. The forex is the
largest market in the world in terms of the total cash value
traded, and any person, firm or country may participate in
this market.

E. The OTC Market:
 The over-the-counter (OTC) market is a type of secondary
market also referred to as a dealer market. It refers to stocks
that are not trading on a stock exchange such as the
NASDAQ, NYSE or American Stock Exchange (AMEX).
 This generally means that the stock trades either on the
over-the-counter bulletin board (OTCBB) or the pink
sheets.
 OTCBB and pink sheet companies have far fewer
regulations to comply with than those that trade shares on a
stock exchange. Most securities that trade this way are
penny stocks or from very small companies.
**********

An overview of financial management

More Related Content

What's hot

Similar to An overview of financial management

More from premarhea

Recently uploaded

In this document

An overview of financial management