NATURE AND SCOPE OF FINANCIAL MANAGEMENT

CHAPTER I

NATURE AND SCOPE OF FINANCIAL MANAGEMENT

                

                      Finance is one of the basic foundations of all kinds of economic activities. Finance is defined as “provision of money at the time when it is required”. Every enterprise, whether big, medium, or small, needs finance to carry on its operations and to achieve its targets. Without adequate finance, no enterprise can possibly accomplish its objectives. So finance is regarded as the lifeblood of any business enterprise. The subject of finance has been traditionally classified into two;

Public Finance: - It deals with the requirements, receipts and disbursement of funds in the govt. Institutions like states, local self-govt. and central govt.

Private Finance: - It is concerned with requirements, receipts, and disbursement of fund in case of an individual, a profit seeking business organization and a non-profit organization.

         Thus, private finance can be classified into;

Personal Finance: - Personal finance deals with the analysis of principle and practices involved in managing one’s own daily need of fund.

Finance of Non-Profit Organization: - The finance of non-profit organization is concerned with the practices, procedures and problems involved in financial management of charitable, religion, educational, social and other similar organizations.

Business Finance: - The study of principle, practices, procedures and problems concerning financial management of profit making organization engaged in the field of industry, trade and commerce is undertaken under the discipline of business finance. Business finance deals with the finance of business objectives and it is concerned with the planning and controlling firm’s financial resources.

                     According to GuthMan and Dougal business finance can be defined as the “activity concerned with planning, raising, controlling and administrating of funds used in the business”.

Wheeler defines business finance as “that business activity which is concerned with the acquisition and conservation of capital funds in meeting the financial needs and overall objectives of business enterprise.”

                     Financial management is concerned with business finance, i.e. the finance of profit seeking organization. Business finance can further be classified into 3 categories, viz.

a) Sole proprietary finance

b) Partnership firm finance

c) Company or corporation finance

                  Corporation finance or broadly speaking business finance can be defined as the process of rising, providing and administrating of all money/funds to be used in a corporate (business) enterprises.   

  

Financial Management

            Financial management is concerned with the management of funds in a corporate enterprise or financial management is concerned with the procurement and use of funds in a business. Financial management is the managerial activity, which is concerned with the planning and controlling of the firms financial resources.

Definitions:

         According to Solomon Ezra, “financial management is concerned with the efficient use of an important economic resource, namely capital funds”.

           “Financial management is concerned with the managing of finance of the business for smooth functioning and successful accomplishment of the enterprise objectives”

            The term financial management, managerial finance, corporation finance and business finance are virtually equivalent and are used inter-changeably, most financial managers how ever seems to prefer either financial management or managerial finance..

Finance function

                    Finance function is the most important of all business functions. It remains a focus of all activities. It is not possible to substitute or eliminate this function because; the business will close down in the absence of finance. According to Solomon Ezra “finance function as the study of the problems involved in the use and acquisition of funds by a business”. It starts with the setting up of an enterprise and remains at all times. The funds will have to be raised from various sources. The receiving of money is not enough, its utilization is more important. The money once received will have to be returned also. It may be easy to raise funds but it may be difficult to repay them.

Aims of Finance function

                  The primary aim of finance function is to arrange as much funds for the business as are required from time to time. This function has the following aims:

1. Acquiring Sufficient Funds: - The main aim of finance function is to assess the financial needs of an enterprise and then finding out suitable sources for raising them. The sources should be commensurate with the need of the business. If funds are needed for longer period’s then long term sources like share capital, debentures, term loans may be explored. A concern with longer gestation period should rely more on owner’s funds instead of interest- bearing securities because profits may not be there for some years.

2. Proper Utilization of Funds: - Though raising of funds is important but their effective utilization is more important. The funds should be used in such a way that maximum benefit is derived from them. The returns from their use should be more than their cost. It should be ensured that funds do not remain idle at any point of time.

3. Increasing Profitability: - The planning and control of finance function aims at increasing profitability of the concern. To increase profitability sufficient funds will have to be invested. Finance function should be so planned that the concern neither suffers from inadequacy of funds nor wastes more funds than required. A proper control should also be exercised so that scarce resources are not frittered away on uneconomical operations.

4. Maximizing Firm’s Value: -Finance function also aims at maximizing the value of the firm. Besides profits, the type of sources used for raising funds, the cost of funds, the condition of money market, the demand for products are some other considerations which also influence a firm’s value.

Financing Decisions or Decisions of Financial Manager

a.Investment Decision: - The investment decision relates to the selection of assets in which funds will be invested by a firm. The assets, which can be acquired, fall into two broad groups- Long term assets and Short term assets. The aspect of financial decision making with reference to long term assets is termed as “capital budgeting” and to short term assets or current assets is termed as “working capital management”

b. Financing Decisions: - It is the second important function to be performed by the financial manager. Broadly he/she must decide when, where and how to acquire funds to meet the firms investment needs. The financial manager must strive to obtain the optimum best capital structure for his/her firm. The mix of debt and equity is known as the firm’s capital structure. Optimum capital structure means capital structure that maximizes the value of firm and minimizes the cost of capital.

c. Dividend Decision: - - It is the third important function to be performed by the financial manager. The financial manager must decide whether the firm should distribute all profits or retain them or distribute a portion and retain the balance.

d. Liquidity Decision: - Liquidity means the capacity of a firm to convert an asset into cash within a short period without much loss. It is a decision regarding the outflow and inflow of cash. In addition to the management of long-term asset, the current assets should be managed efficiently against the dangers of ill liquidity.

Scope or Content of Financial Management/ Finance Function:-  

              The main objective of financial management is to arrange sufficient finances for meeting short term and long term needs. A financial manager will have to concentrate on the following areas of finance function:

1.      Estimating Financial Requirements: -

                   The first task of financial manager is to estimate short term and long-term financial requirements of his business. For this purpose, he will prepare a financial plan for present as well as for future. The amount required for purchasing fixed assets as well as for working capital will have to be ascertained.

2.      Deciding Capital Structure: -

                     The capital structure refers to the kind and proportion of different securities for raising funds. After deciding about the quantum of funds required, it should be decided which type of securities should be raised. It may be wise to finance fixed assets through long-term debts and current assets through short-term debts.

3.      Selecting a Source of Finance: -

                     After preparing capital structure, an appropriate source of finance is selected. Various sources from which finance may be raised include: share capital, debentures, financial institutions, commercial banks, public deposits etc. If finance is needed for short period then banks, public deposits and financial institutions may be appropriate. On the other hand, if long-term finance is required then, share capital, and debentures may be useful.

4.      Selecting a pattern of Investment: -

                     When funds have been procured then a decision about investment pattern is to be taken. The selection of an investment pattern is related to the use of funds. A decision will have to be taken as to which asset is to be purchased. The funds will have to be spent first on fixed assets and then an appropriate portion will be retained for working capital. The decision-making techniques such as capital budgeting, opportunity cost analysis etc. may be applied in making decisions about capital expenditures.

5.      Proper cash Management: -

                      Cash management is an important task of finance manager. He has to assess various cash needs at different times and then make arrangements for arranging cash. The cash management should be such that neither there is a shortage of it and nor it is idle. Any shortage of cash will damage the credit worthiness of the enterprise. The idle cash with the business will mean that it is not properly used. Cash flow statements are used to find out various sources and application of cash.

6.      Implementing Financial Controls:-

                     An efficient system of financial management necessitates the use of various control devises. Financial control devises generally used are budgetary control, break even analysis; cost control, ratio analysis etc. The use of various techniques by the finance manager will help him in evaluating the performance in various areas and take corrective measures whenever needed.

7.      Proper use of Surplus: -

                    The utilization of profit or surplus is also an important factor in financial management. A judicious use of surpluses is essential for expansion and diversification plan and also in protecting the interest of shareholders. The finance manager should consider the following factors before declaring the dividend;

a.         Trend of earnings of the enterprise

b.         Expected earnings in future.

c.          Market value of shares.

d.         Shareholders interest.

e.          Needs of fund for expansion etc.

        Objectives/Goals of Financial Management or Business Finance

                   The firms’ investment and financing decisions are unavoidable and continuous. In order to make them rationally the firm must have a goal. It is generally agreed in theory that the financial goal of the firm should be the maximization of owner’s economic welfare. Owner’s economic welfare could be maximized while maximizing the shareholders wealth as reflected in the market value of shares. The main objective of a business is to maximize the owner’s economic welfare. This objective can be achieved by;

1)      Profit Maximization  2) Wealth Maximization

Profit Maximization: -

 Profit maximization means maximizing the rupee income of a firm. Profit earning is the main aim of every economic activity. No business can survive without earning profit. Profit is a measure of efficiency of a business enterprise. Profit also serve as a protection against risk which enables a business to face risk like fall in prices, competition from other units, adverse govt. polices etc. So the profit maximization is considered as the main objective of business.

Arguments for profit maximization;

1. When profit earning is the aim of business, the profit maximization should be the main    objective.

2. Profitability is a barometer for measuring efficiency and economic prosperity of a business enterprise.

3. Profits are the main source of finance for the growth of a business.

4. Profitability is essential for fulfilling social goals.

5. A business will be able to survive under unfavorable situation only if it has some past earnings.

Criticism of Profit Maximization: -

1.It is vague: - The price meaning of profit maximization objective is unclear. Whether short term or long term profit, profits before tax or after tax, total profit or earning per share and so on.

2. Ignores the timing of the return: - The profit maximization objective ignores the time value of money. If values benefits received today and benefits received after a period as the same, it avoids the fact that cash received today is more important than the same amount of cash received after some years.

3. It ignores risk: - The streams of benefit may possess different degree of certainty. Two firms may have same total expected earnings, but if the earnings of one firm fluctuate considerably as compared to the other, it will be more risky. Profit maximization objective ignores this factor.

4. The effect of dividend policy on the market price of share is also not considered in the objective of profit maximization.

5. Profit maximization criteria fail to take into consideration the interest of govt., workers and other persons in the enterprise.

6. The firm’s goals cannot be to maximize profit but to attain a certain level or rate of profit, holding a certain shares of the market or a certain level of sales.

Wealth Maximization: -

            It is assumed that the goal of the firm should be to maximize the wealth of its current shareholders. Wealth maximization is the appropriate objective of an enterprise. Financial theory asserts that wealth maximization is the single substitute for a stockholder’s utility. When the firm maximizes the stockholder’s wealth, the individual stockholder can use this wealth to maximize his individual utility. It means that by maximizing stockholder’s wealth the firm is operating consistently towards maximizing stockholder’s utility. A stockholder’s current wealth in the firm is the product of the number of shares owned, multiplied with the current stock price per share. Stockholder’s current wealth in a firm = (Number of shares owned) x (Current stock price per share). The financial manager must know the factors, which influences the market price of shares; otherwise he would find himself unable to maximize the market value of company’s shares. The wealth maximization is a criterion for every financial decision. Besides profit, the type of sources used for raising funds, the cost of funds, the condition of money market are some factors that influence the market value of shares.

Implications of wealth maximization

     It serves the interests of suppliers of long term and short-term loaned capital, employees, management and society.

 1. Short – term lenders are primarily interested in liquidity position so that they get their                              payments in time.

 2. The long –term lenders get a fixed rate of interest from the earnings and also have a priority     over share holders in return of their funds.

 3. The employees may also try to acquire share of company’s wealth through bargaining etc.

 4. Management is the elected body of shareholders. The shareholders may not like to change a management if it is able to increase the value of their holdings.  The efficient allocation of productive resources will be essential for raising the wealth of the company

 5. The economic interest of society is served if various resources are put to economical and efficient use.

Arguments against Wealth Maximization: -

1.The objective of wealth maximization is not necessarily socially desirable.

2.The firm should not to increase the shareholders wealth but also to see the interest of customers, creditors, suppliers, community and others.

3.There is some controversy as to whether the objective is to maximize the shareholders wealth or the wealth of the firm, which includes other financial claim holders such as debenture holder’s preference stock holders etc.

4.The objective is not descriptive of what the firms actually do to maximize the wealth.

  Finance manager:

           A financial manager is a person who is responsible to carryout finance functions. He is one of the members of the top management team. The financial manager, there fore, must have a clear understanding and strong grasp of the nature and scope of the finance functions.

Functions of a Finance Manager

               The changed business environment in the recent past has widened the role of a financial manager. The Functions of a Finance Manager are;

1.      Financial Forecasting and Planning: -

               A financial manager has to estimate the financial needs of a business. How much money will be required for acquiring various assets? The amount will be needed for purchasing fixed assets and meeting working capital needs. He has to plan the funds needed in the future. How these funds will be acquired and applied is an important function of a finance manager.

2.      Acquisition of Funds: -

               After making financial planning, the next step will be to acquire funds. There are a number of sources available for supplying funds. These sources may be shares, debentures, financial institutions, commercial banks etc. The selection of an appropriate source is a delicate task. The choice of a wrong source for funds may create difficulties at a later stage. The pros and cons of various sources should be analyzed before making a final decision.

3.      Investment of Funds: -

              The funds should be used in the best possible way. The cost of acquiring them and the returns should be compared. The channels, which generate higher returns, should be preferred. The technique of capital budgeting may be helpful in selecting a project. The objective of maximizing profits will be achieved only when funds are efficiently used and they do not remain idle at any time. A financial manager has to keep in mind the principles of safety, liquidity and soundness while investing funds.

4.      Helping in Valuation Decisions: -

              A number of mergers and consolidations take place in the present competitive industrial world. A finance manager is supposed to assist management in making valuation etc. For this purpose, he should understand various methods of valuing shares and other assets so that correct values are arrived at.

5.      Maintain Proper Liquidity: -

              Every concern is required to maintain some liquidity for meeting day-to-day needs. Cash is the best source for maintaining liquidity. It is required to purchase raw materials, pay workers, meet other expense, etc. A finance manager is required to determine the need for liquid assets and then arrange liquid assets in such a way that there is no scarcity of funds.                                          

      

         Risk

            Risk means possibility of loss or injury. In other words Risk is the difference between expected return and actual return. Risk can be traditionally classified into two .They are;

1. Systematic risk and

2. Unsystematic risk

Systematic risk

            Systematic risk represents that portion of the total risk of an investment that cannot be eliminated or minimized through diversification. Systematic risk is also known as non-diversifiable risk or market risk e.g.:

1.      The govt. changes the interest rate policy.

2.      The corporate tax rate is increased.

3.      Changes in inflation rate.

4.      Changes in investor’s expectation.

5.       Respective credit policy.

Unsystematic risk

                        Unsystematic risk represents that portion of the total risk of an investment, which can be eliminated or minimized through diversification. Unsystematic risk is also known as diversifiable or unique risk. e.g.-

      1. Strikes.

      2. Availability of raw material.

      3. Management capabilities and decisions.

      4. Competition.

Risk -return trade off

            Financial decisions of a firm often involve alternative courses of actions. A finance manager has to select amongst the various alternatives available to him. For example, while making an-investment decision, he has to decide whether, the firm should go in for a machinery having capacity of 50,000 units or 2,00,000 units. In the same manner the financing decision may involve a choice between a debt equity ratios of 1:1 or 2:1, the divided decision may be concerned with the quantum of profits to be distributed. The alternative course of action implies different risk-return relationship as there is positive relationship between the amount of risk assumed and the amount of expected return. A machine with higher capacity may give a higher expected return but involves higher risk of investment, whereas the machine with lower capacity may have a lower expected return and a lower risk of investment. A higher debt-equity ratio may help in increasing the return on equity but will aisa enhance the financial risk.

           While making a financial decision, one has to answer the basic questions: What is the expected return? What is the risk involved? How would the decision influence the market value of the firm?   The financial manager has to strike a balance between various so$gees so that the overall profitability of the firm and its market value increases.  

 Time value of money:-

            The time value of money is perhaps the most fundamental principle needed to understand and make financial decision. The concept in general, implies that a rupee today is worth more than a rupee a year later. The computation of value over time is done through the process of compounding and discounting;

1.     Compounding of single sum:-

       The process of computing the future value, based on the initial amount, the interest per period and the number of periods is called compounding. The future value to be received after a number of years can be calculated by using the following equations:-

a) Annually

           F= P(1+r)ⁿ              

b) Half yearly

             F=P(1+r/2) ²ⁿ

c) Quarterly

             F=P(1+r/4) ⁴ⁿ

P= Present Value

r= Rate of interest

n= Number of years

2.     Discounting of a single sum:-

       The process of finding the present value based on future amounts, interest rate per period and the number of periods is known as discounting. Discounting is exactly the reverser of compounding. This can be calculated by using the following equations

P =      F                   

                 (1+r) ⁿ