What do you understand by the term Financial Management? Explain the scope & functions of financial management?

Q1. What do you understand by the term Financial Management? Explain the scope & functions of financial management?

or

Define financial management and its importance. Explain the duties of a financial manager?

Ans. Business concern needs finance to meet their requirements in the economic world. Any kind of business activity depends on the finance. Hence, it is called as lifeblood of business organization. Whether the business concerns are big or small, they need finance to full fill their business activities.

In the modern world, all the activities are concerned with the economic activities and very particular to earning profit through any venture or activities. The entire business activities are directly related with making profit. (According to the economics concept of factors of production, rent given to landlord, wage given to labour, interest given to capital and profit given to shareholders or proprietors), a business concern needs finance to meet all the requirements. Hence finance may be called as capital, investment, fund etc., but each term is having different meanings and unique characters. Increasing the profit is the main aim of any kind of economic activity.

Finance may be defined as the art and science of managing money. It includes financial service and financial instruments. Finance also is referred as the provision of money at the time when it is needed. Finance function is the procurement of funds and their effective utilization in business concerns.

The concept of finance includes capital, funds, money, and amount. But each word is having unique meaning. Studying and understanding the concept of finance become an important part of the business concern.

Financial management is an integral part of overall management. It is concerned with the duties of the financial managers in the business firm.

The term financial management has been defined by Solomon, “It is concerned with the efficient use of an important economic resource namely, capital funds”.

The most popular and acceptable definition of financial management as given by S.C. Kuchal is that “Financial Management deals with procurement of funds and their effective utilization in the business”.

Howard and Upton : Financial management “as an application of general managerial principles to the area of financial decision-making.

Thus, Financial Management is mainly concerned with the effective funds management in the business. In simple words, Financial Management as practiced by business firms can be called as Corporation Finance or Business Finance.

SCOPE OF FINANCIAL MANAGEMENT

Financial management is one of the important parts of overall management, which is directly related with various functional departments like personnel, marketing and production. Financial management covers wide area with multidimensional approaches. The following are the important scope of financial management.

1.   Financial Management and Economics

Economic concepts like micro and macroeconomics are directly applied with the financial management approaches. Investment decisions, micro and macro environmental factors are closely associated with the functions of financial manager. Financial management also uses the economic equations like money value discount factor, economic order quantity etc. Financial economics is one of the emerging area, which provides immense opportunities to finance, and economical areas.

2.   Financial Management and Accounting

Accounting records includes the financial information of the business concern. Hence, we can easily understand the relationship between the financial management and accounting. In the olden periods, both financial management and accounting are treated as a same discipline and then it has been merged as Management Accounting because this part is very much helpful to finance manager to take decisions. But nowaday’s financial management and accounting discipline are separate and interrelated.

3.   Financial Management or Mathematics

Modern approaches of the financial management applied large number of mathematical and statistical tools and techniques. They are also called as econometrics. Economic order quantity, discount factor, time value of money, present value of money, cost of capital, capital structure theories, dividend theories, ratio analysis and working capital analysis are used as mathematical and statistical tools and techniques in the field of financial management.

4.   Financial Management and Production Management

Production management is the operational part of the business concern, which helps to multiple the money into profit. Profit of the concern depends upon the production performance. Production performance needs finance, because production department requires raw material, machinery, wages, operating expenses etc. These expenditures are decided and estimated by the financial department and the finance manager allocates the appropriate finance to production department. The financial manager must be aware of the operational process and finance required for each process of production activities.

5.   Financial Management and Marketing

Produced goods are sold in the market with innovative and modern approaches. For this, the marketing department needs finance to meet their requirements.

The financial manager or finance department is responsible to allocate the adequate finance to the marketing department. Hence, marketing and financial management are interrelated and depends on each other.

6.   Financial Management and Human Resource

Financial management is also related with human resource department, which provides manpower to all the functional areas of the management. Financial manager should carefully evaluate the requirement of manpower to each department and allocate the finance to the human resource department as wages, salary, remuneration, commission, bonus, pension and other monetary benefits to the human resource department. Hence, financial management is directly related with human resource management.

The three core elements of financial management are:

a.  Financial planning

Financial planning is done to ensure the availability of capital investments to acquire the real assets. Real assets are lands, buildings, plants and equipments. Capital investments are required for establishing and running the business smoothly.

b.  Financial decisions

 Decisions need to be taken on the sources from which the funds required for the capital investments could be obtained.

 There are two sources of funds - debt and equity. In what proportion the funds are to be obtained from these sources is to be decided for formulating the financing plan.

c.  Financial control

Financial control involves managing the costs and expenses of a business. For example, it includes taking decisions on the routine aspects of day-to-day management of collecting money which is due from the firm’s customers and making payments to the suppliers of various resources.

Finance functions deal with the functions performed by the finance manager. They are closely related to financial decisions. In the course of performing these functions, finance manager takes several decisions and performs various important functions:

 Financing decisions

 Investment decisions

 Liquidity decisions

 Dividend decisions

Financing decisions

Financing decisions relate to the composition of relative proportion of various sources of finance. The sources could be:

(a) Shareholder’s Fund: Equity Share Capital, Preference Share Capital, Accumulated Profits.

(b) Borrowing from outside agencies: Debentures, Loans from Financial Institutions.

Financial management weighs the merits and demerits of different sources of finance while taking financing decision. Irrespective of the choice of source, be it singular or a combination of both, there is a cost involved. The cost of equity is the minimum return the shareholders would have received if they had invested elsewhere. Borrowed funds cost involves interest payment. Both types of funds, thus, incur cost, and this is the cost of capital to the company. Hence, it can be said that the cost of capital is the minimum return expected by the company.

Financing decisions relate to the acquisition of such funds at the least cost. In order to calculate the specific cost of each type of capital, recognition should be given to two dimensions of cost:

 Explicit Cost

 Implicit Cost

A firm's explicit costs are the actual cash payments it makes to those who provide resources. Explicit costs are rent paid on land hired, wages paid to the employees, and interest paid on capital. In addition to this, a firm also pays insurance premium and taxes and sets aside depreciation charges.

Explicit cost of any source of capital may be defined as the discount rate that equates the present value of funds received by the firm net of underwriting costs, with the present value of expected cash outflows. These outflows may be interest payments, repayment of principal, or dividend. It can also be stated as the Internal Rate of Return a firm pays for financing.

Implicit costs are the opportunity costs of using resources owned by the firm or provided by the firm's owners. To the firm, the implicit costs mean the money payments that self-employed resources could

have earned in their best alternative uses.

In all financing decisions, a firm has to determine the capital structure, i.e. composition of debt and equity.

Debt is cheap because interest payable on loan is allowed as deduction in computing taxable income on which the company is liable to pay income tax to the Government of India.

Normally, a finance manager tries to choose a pattern of capital structure which minimizes the cost of capital and maximizes the owner’s return. An investor in a company’s shares has two objectives for investing:

 Income from capital appreciation (capital gains on sale of shares at market price)

 Income from dividends

The ability of the company to offer both these incomes to its shareholders determines the market price of the company’s shares.

Financing decision involves the consideration of managerial control, flexibility and legal aspects, and regulatory and managerial elements.

Investment decisions

To survive and grow, all organisations have to be innovative. Innovation demands managerial proactive actions. Proactive organisations continuously search for innovative ways of performing the activities of the organisation. Innovation is wider in nature. It could be:

 Expanding by entering into new markets.

 Adding new products to its product mix.

 Performing value added activities to enhance customer satisfaction.

 Adopting new technology that would drastically reduce the cost of production.

 Rendering services or mass production at low cost or restructuring the organisation to improve productivity.

These innovations change the profile of an organisation. These decisions are strategic because they are risky. However, if executed successfully with a clear plan of action, investment decisions generate super normal growth to the organisation.

A firm may become bankrupt if the management fails to execute the decisions taken. Therefore, such decisions have to be taken after taking into account all the facts affecting the decisions and their execution.

There are two critical issues to be considered in these decisions. They are:

 Evaluation of expected profitability of the new investments.

 Rate of return required on the project.

Dividend decisions

Dividends are payouts to shareholders. Dividends are paid to keep the shareholders happy. Dividend decision is a major decision made by the finance manager.

Dividend is that portion of profits of a company which is distributed among its shareholders according to the resolution passed in the meeting of the Board of Directors. This may be paid as a fixed percentage on the share capital contributed by them or at a fixed amount per share. The dividend decision is always a problem before the top management or the Board of Directors as they have to decide how much profits should be transferred to reserve funds to meet any unforeseen contingencies and how much should be distributed to the shareholders. Payment of dividend is always desirable since it affects the goodwill of the concern in the market on the one hand, and on the other, shareholders invest their funds in the company in a hope of getting a reasonable return. Retained earnings are the sources of internal finance for financing of corporate’s future projects but payment of dividend constitute an outflow of cash to shareholders. Although both -expansion and payment of dividend - are desirable, these two are in conflicting tasks. It is, therefore, one of the important functions of the financial management to constitute a dividend policy which can balance these two contradictory view points and allocate the reasonable amount of

profits after tax between retained earnings and dividend. All of this is based on formulation of a good dividend policy.

Dividend policy influences the dividend yield on shares. Dividend yield is an important determinant of an investor’s attitude towards the security (stock) in his portfolio management decisions.

The following issues need adequate consideration in deciding on dividend policy:

 Preferences of shareholders – Do they want cash dividend or capital gains?

 Current financial requirements of the company.

 Legal constraints on paying dividends.

 Striking an optimum balance between desire of shareholders and the company’s funds requirements.

Liquidity decisions

The liquidity decision is concerned with the management of the current assets, which is a prerequisite to long-term success of any business firm. This is also called as working capital decision.

The main objective of the current assets management is the trade-off between profitability and liquidity, and there is a conflict between these two concepts. If a firm does not have adequate working capital, it may become illiquid and consequently fail to meet its current obligations thus inviting the risk of bankruptcy. On the contrary, if the current assets are too enormous, the profitability is

adversely affected. Hence, the major objective of the liquidity decision is to ensure a trade-off between profitability and liquidity. Besides, the funds should be invested optimally in the individual

current assets to avoid inadequacy or excessive locking up of funds. Thus, the liquidity decision should balance the basic two ingredients, i.e. working capital management and the efficient allocation of funds on the individual current assets.

In other terms, liquidity decisions deal with working capital management. It is concerned with the day to-day financial operations that involve current assets and current liabilities.

The important elements of liquidity decisions are:

 Formulation of inventory policy

 Policies on receivable management

 Formulation of cash management strategies

Policies on utilization of spontaneous finance effectively