Financial Management: Definition, Objectives, Functions, Approaches, Decisions, and Importance

What is Financial Management?

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

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

In other words, Financial Management refers to the application of general management principles to the various financial resources which are projected. This encompasses planning, organizing, directing and controlling financial activities.

Definition of Financial Management

These are some definition of financial management given below:

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

Weston and Brigham: Financial management “is an area of financial decision-making, harmonizing individual motives and enterprise goals”.

Joshep and Massie: Financial management “is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient operations.

Objectives of Financial Management

Objectives of financial management may be broadly divided into two parts such as:

  1. Profit Maximization
  2. Wealth Maximization

Profit Maximization

The main aim of any kind of economic activity is earning profit. A business concern is also functioning mainly for the purpose of earning profit. Profit is the measuring technique to understand the business efficiency of the concern.

Profit maximization is also the traditional and narrow approach, which aims, maximize the profit of the concern. Profit maximization consists of the following important features.

  1. Profit maximization is also called as cashing per share maximization. It leads to maximize the business operation for profit maximization.
  2. Ultimate aim of the business concern is earning profit, hence, it considers all the possible ways to increase the profitability of the concern.
  3. Profit is the parameter of measuring the efficiency of the business concern. So it shows the entire position of the business concern.
  4. Profit maximization objectives help to reduce the risk of the business.

Wealth Maximization

Wealth maximization is one of the modern approaches, which involves the latest innovations and improvements in the field of the business concern. The term wealth means shareholder wealth or the wealth of the persons who are involved in the business concern.

Wealth maximization is also known as value maximization or net present worth maximization. This objective is a universally accepted concept in the field of business.

Functions of Financial Management

Followings are the functions of financial management which are given below:

  1. Estimation of Capital Requirements
  2. Determination of Capital Composition
  3. Choice of Sources of Funds
  4. Disposal of Surplus
  5. Management of Cash
  6. Financial Controls

Estimation of Capital Requirements

A finance manager has to make estimation with regard to the capital requirements of company. This will depend upon expected costs and profits and future programmes and policies of concern. Estimations have to be made in an adequate manner that increases earning capacity of the enterprise.

Determination of Capital Composition

Once the estimation has been made, the capital structure has to be decided. This involves short-term and long-term debt-equity analysis. This will depend upon the proportion of equity capital a company is possessing and additional funds which have to be raised from outside parties.

Choice of Sources of Funds

For additional sources of funds to be procured, a company has many choices like

  • Choice of Issue of shares and debentures
  • Loans to be taken from banks and financial institutions.
  • Public deposits to be drawn like in form of bonds.

The finance manager has to decide to allocate funds into profitable ventures so that there is safety on investment and regular returns are possible.

Disposal of Surplus

The net profits decision has to be made by the finance manager. This can be done in two ways:

  • Dividend declaration: It includes identifying the rate of dividends and other benefits likebonus.
  • Retained profits: The volume has to be decided which will depend upon expansion,innovational, diversification plans of the company.

Management of Cash

The Finance Manager has to make decisions with regard to cash management. Cash is required for many purposes like payment of wages and salaries. Water bills, payment to creditors, meeting current liabilities, maintenance of enough stock, purchase of raw materials, etc.

Financial Controls

The finance manager has not only to plan, procure and utilize the funds but he also has to exercise control over finances. This can be done through many techniques like Ratio analysis, financial forecasting, cost and profit control, etc.

Approaches to Financial Management

The financial management approach may be broadly divided into two major parts.

  1. Traditional Approach
  2. Modern Approach

Traditional Approach

The traditional approach is the initial stage of financial management, which was followed, in the early part of the year 1920 to 1950. This approach is based on past experience and the traditionally accepted methods. The main part of the traditional approach is the raising of funds for the business concern.

The traditional approach consists of the following important area.

  1. Arrangement of funds from the lending body.
  2. Arrangement of funds through various financial instruments.
  3. Finding out the various sources of funds.

Modern Approach

The modern approach was started during the mid-1950s. Its scope is wider since it covers the conceptual and analytical frameworks for financial decision-making. In other words, it covers both procurement of funds as well as their allocation.

Allocation is not just haphazard allocation, it is efficient allocation among various investments, which will help maximize shareholders’ wealth. The main contents of the new approach are:

  • What is the total volume of funds an enterprise should commit?
  • What specific assets should an enterprise acquire?
  • How should the required funds be financed?

Decisions in Financial Management

The various decisions under financial management can be categorized under the following four heads.

  1. Investment Decisions
  2. Finance Decisions
  3. Dividend Decisions
  4. Working Capital

Investment Decisions

The Investment Decision relates to the decision made by the investors or the top-level management with respect to the number of funds to be deployed in the investment opportunities. Capital Budgeting is the process of selecting the asset or an investment proposal that will yield returns over a long period.

  • The first step involved in Capital Budgeting is to select the asset, whether existing or new on the basis of benefits that will be derived from it in the future.
  • The next step is to analyze the proposal’s uncertainty and risk involved in it. Since the benefits are to be accrued in the future, the uncertainty is high with respect to its returns.
  • Finally, the minimum rate of return is to be set against which the performance of the long-term project can be evaluated.

Finance Decisions

The second important decision which a finance manager has to take is deciding the source of finance. A company can raise finance from various sources such as by issue of shares, debentures or by taking loans and advances.

Deciding how much to raise from which source is a concern of the financing decision. Mainly sources of finance can be divided into two categories:

  • Owners fund.
  • Borrowed fund.

While taking this decision the finance manager compares the advantages and disadvantages of different sources of finance. The borrowed funds have to be paid back and involve some degree of risk whereas in the owners’ fund there is no fixed commitment of repayment and there is no risk involved.

But finance manager prefers a mix of both types. Under financing, the decision finance manager fixes a ratio of owner fund and borrowed fund in the capital structure of the company.

Dividend Decisions

This decision is concerned with the distribution of surplus funds. The profit of the firm is distributed among various parties such as creditors, employees, debenture holders, shareholders, etc. Payment of interest to creditors, debenture holders, etc. is a fixed liability of the company, so what the company or finance manager has to decide is what to do with the residual or leftover profit of the company.

The surplus profit is either distributed to equity shareholders in the form of dividends or kept aside in the form of retained earnings. Under dividend decision, the finance manager decides how much to be distributed in the form of dividends and how much to keep aside as retained earnings.

Working Capital

Effective financial management will increase the range of opportunities open to an enterprise to pursue its strategic plan. A liquidity problem, apart from being expensive, reduces options and diverts the attention of management away from a longer-term perspective.

  • There are commonly three working capital issues on which a business would need to make a decision whether to offer discounts to debtors for prompt settlement of accounts (Receivables Management)
  • Whether to dispose of slow-moving stocks at reduced prices, and by how much to reduce them (Inventory Management)
  • Whether to purchase by cash or on credit, allowing for discounts which might be on offer. (Cash Management)

Importance of Financial Management

The importance of financial management is as follows:

  1. Financial Planning
  2. Acquisition of Funds
  3. Proper Use of Funds
  4. Financial Decision
  5. Improve Profitability
  6. Increase the Value of the Firm
  7. Promoting Savings

Financial Planning

Financial management helps to determine the financial requirement of the business concern and leads to take financial planning of the concern. Financial planning is an important part of the business concern, which helps to the promotion of an enterprise.

Acquisition of Funds

Financial management involves the acquisition of required finance for the business concern. Acquiring needed funds play a major part in financial management, which involve a possible source of finance at minimum cost.

Proper Use of Funds

Proper use and allocation of funds lead to improving the operational efficiency of the business concern. When the finance manager uses the funds properly, they can reduce the cost of capital and increase the value of the firm.

Financial Decision

Financial management helps to make sound financial decisions in the business concern. The financial decisions will affect the entire business operation of the concern. Because there is a direct relationship with various department functions such as marketing, production personnel, etc.

Improve Profitability

The profitability of the concern purely depends on the effectiveness and proper utilization of funds by the business concern. Financial management helps to improve the profitability position of the concern with the help of strong financial control devices such as budgetary control, ratio analysis and cost volume profit analysis.

Increase the Value of the Firm

Financial management is very important in the field of increasing the wealth of the investors and the business concern. The ultimate aim of any business concern will achieve maximum profit and higher profitability leads to maximizing the wealth of the investors as well as the nation.

Promoting Savings

Savings are possible only when the business concern earns higher profitability and maximizes wealth. Effective financial management helps to promote and mobilize individual and corporate savings.

The business concern or corporate sectors cannot function without the importance of financial management.

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