[FINANCIAL MANAGEMENT] MBA IInd sem

Meaning of Finance
Finance is a field that deals with the allocation of assets and liabilities over time under conditions of certainty and
uncertainty. Finance also applies and uses the theories of economics at some level. Finance can also be defined as the
science of money management. A key point in finance is the time value of money, it states that purchasing power of one
unit of currency can vary over time. Finance aims to price assets based on their risk level and their expected rate of return.
Finance can be broken into three different sub-categories: public finance, corporate finance and personal finance.

Meaning of Financial management

Financial management refers to the efficient and effective management of money (funds) in such a manner as
to accomplish the objectives of the organization. It is the specialized function directly associated with the top
management. The significance of this function is not only seen in the 'Line' but also in the capacity of 'Staff' in
overall administration of a company. It has been defined differently by different experts in the field.
It includes how to raise the capital, how to allocate it i.e. capital budgeting. Not only about long term budgeting
but also how to allocate the short term resources like current assets. It also deals with the dividend policies of
the share holders.

Definitions of Financial Management

Financial Management is an area of financial decision making, harmonizing individual motives and enterprise
goals. By Weston and Brigham

Financial management may be defined as that area or set of administrative function in an organization which
relate with arrangement of cash and credit so that organization may have the means to carry out its objective as
satisfactorily as possible . - by Howard & Opton.

Financial management is a body of business concerned with the efficient and effective use of either
equity capital, borrowed cash or any other business funds as well as taking the right decision for profit
maximization and value addition of an entity.- Kepher Petra; Kisii University.

Traditional v/s modern approach of financial management

Traditional Approach
The traditional approach to the scope of financial management refers to its subject matter in the academic literature in
the initial stages of its evolution as a separate branch of study. According to this approach, the scope of financial
management is confined to the raising of funds. Hence, the scope of finance was treated by the traditional approach in
the narrow sense of procurement of funds by corporate enterprise to meet their financial needs. Since the main
emphasis of finance function at that period was on the procurement of funds, the subject was called corporation
finance till the mid-1950's and covered discussion on the financial instruments, institutions and practices through

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which funds are obtained. Further, as the problem of raising funds is more intensely felt at certain episodic events
such as merger, liquidation, consolidation, reorganisation and so on. These are the broad features of the subject matter
of corporation finance, which has no concern with the decisions of allocating firm's funds. But the scope of finance
function in the traditional approach has now been discarded as it suffers from serious criticisms. Again, the limitations
of this approach fall into the following categories.
The emphasis in the traditional approach is on the procurement of funds by the corporate enterprises, which was
woven around the viewpoint of the suppliers of funds such as investors, financial institutions, investment bankers, etc,
i.e. outsiders. It implies that the traditional approach was the outsider-looking-in approach. Another limitation was that
internal financial decision-making was completely ignored in this approach
The second criticism leveled against this traditional approach was that the scope of financial management was
confined only to the episodic events such as mergers, acquisitions, reorganizations, consolation, etc. The scope of
finance function in this approach was confined to a description of these infrequent happenings in the life of an
enterprise. Thus, it places over emphasis on the topics of securities and its markets, without paying any attention on
the day to day financial aspects.
Another serious lacuna in the traditional approach was that the focus was on the long-term financial problems thus
ignoring the importance of the working capital management. Thus, this approach has failed to consider the routine
managerial problems relating to finance of the firm.
During the initial stages of development, financial management was dominated by the traditional approach as is
evident from the finance books of early days. The traditional approach was found in the first manifestation by Green's
book written in 1897, Meades on Corporation Finance, in 1910; Doing's on Corporate Promotion and Reorganization
in 1914, etc.
As stated earlier, in this traditional approach all these writings emphasized the financial problems from the outsiders'
point of view instead of looking into the problems from managements, point of view. It over emphasized long-term
financing lacked in analytical content and placed heavy emphasis on descriptive material. Thus, the traditional
approach omits the discussion on the important aspects like cost of the capital, optimum capital structure, valuation of
firm, etc. In the absence of these crucial aspects in the finance function, the traditional approach implied a very
narrow scope of financial management. The modern or new approach provides a solution to all these aspects of
financial management.
Modern Approach

After the 1950's, a number of economic and environmental factors, such as the technological innovations,
industrialization, intense competition, interference of government, growth of population, necessitated efficient and
effective utilisation of financial resources. In this context, the optimum allocation of the firm's resources is the order
of the day to the management. Then the emphasis shifted from episodic financing to the managerial financial
problems, from raising of funds to efficient and effective use of funds. Thus, the broader view of the modern approach
of the finance function is the wise use of funds. Since the financial decisions have a great impact on all other business
activities, the financial manager should be concerned about deter-mining the size and natu re of the technology, setting
the direction and growth of the business, shaping the profitability, amount of risk taking, selecting the asset mix,
determination of optimum capital structure, etc. The new approach is thus an analyti-cal way of viewing the financial
problems of a firm. According to the new approach, the financial management is concerned with the solution of the
major areas relating to the financial operations of a firm, viz., investment, and financing and dividend decisions. The
modern financial manager has to take financial decisions in the most rational way. These decisions have to be made in

[FINANCIAL MANAGEMENT] MBA IInd sem

such a way that the funds of the firm are used optimally. These decisions are referred to as managerial finance
functions since they require special care with extraordinary administrative ability, management skills and decision making techniques, etc.

Scope/Elements
1. Investment decisions includes investment in fixed assets (called as capital budgeting). Investment in
current assets is also a part of investment decisions called as working capital decisions.
2. Financial decisions - They relate to the raising of finance from various resources which will depend
upon decision on type of source, period of financing, cost of financing and the returns thereby.
3. Dividend decision - The finance manager has to take decision with regards to the net profit distribution.
Net profits are generally divided into two:
a. Dividend for shareholders- Dividend and the rate of it has to be decided.
b. Retained profits- Amount of retained profits has to be finalized which will depend upon
expansion and diversification plans of the enterprise.
The following explanation will help in understanding each finance function in detail

Investment Decision
One of the most important finance functions is to intelligently allocate capital to long term assets. This activity
is also known as capital budgeting. It is important to allocate capital in those long term assets so as to get
maximum yield in future. Following are the two aspects of investment decision
Evaluation of new investment in terms of profitability
Comparison of cut off rate against new investment and prevailing investment.
Since the future is uncertain therefore there are difficulties in calculation of expected return. Along with
uncertainty comes the risk factor which has to be taken into consideration. This risk factor plays a very
significant role in calculating the expected return of the prospective investment. Therefore while considering
investment proposal it is important to take into consideration both expected return and the risk involved.
Investment decision not only involves allocating capital to long term assets but also involves decisions of using
funds which are obtained by selling those assets which become less profitable and less productive. It wise
decisions to decompose depreciated assets which are not adding value and utilize those funds in securing other
beneficial assets. An opportunity cost of capital needs to be calculating while dissolving such assets. The correct
cut off rate is calculated by using this opportunity cost of the required rate of return (RRR)

Financial Decision

[FINANCIAL MANAGEMENT] MBA IInd sem

Financial decision is yet another important function which a financial manger must perform. It is important to
make wise decisions about when, where and how should a business acquire funds. Funds can be acquired
through many ways and channels. Broadly speaking a correct ratio of an equity and debt has to be maintained.
This mix of equity capital and debt is known as a firms capital structure. A firm tends to benefit most when the
market value of a companys share maximizes this not only is a sign of growth for the firm but also maximizes
shareholders wealth. On the other hand the use of debt affects the risk and return of a shareholder. It is more
risky though it may increase the return on equity funds. A sound financial structure is said to be one which aims
at maximizing shareholders return with minimum risk. In such a scenario the market value of the firm will
maximize and hence an optimum capital structure would be achieved. Other than equity and debt there are
several other tools which are used in deciding a firm capital structure.

Dividend Decision
Earning profit or a positive return is a common aim of all the businesses. But the key function a financial
manger performs in case of profitability is to decide whether to distribute all the profits to the shareholder or
retain all the profits or distribute part of the profits to the shareholder and retain the other half in the business.
Its the financial managers responsibility to decide a optimum dividend policy which maximizes the market
value of the firm. Hence an optimum dividend payout ratio is calculated. It is a common practice to pay regular
dividends in case of profitability Another way is to issue bonus shares to existing shareholders.

Liquidity Decision
It is very important to maintain a liquidity position of a firm to avoid insolvency. Firms profitability, liquidity
and risk all are associated with the investment in current assets. In order to maintain a tradeoff between
profitability and liquidity it is important to invest sufficient funds in current assets. But since current assets do
not earn anything for business therefore a proper calculation must be done before investing in current assets.
Current assets should properly be valued and disposed of from time to time once they become non profitable.
Currents assets must be used in times of liquidity problems and times of insolvency.

Functions of Financial Management

1. Estimation of capital requirements: A finance manager has to make estimation with regards to capital
requirements of the company. This will depend upon expected costs and profits and future programmes
and policies of a concern. Estimations have to be made in an adequate manner which increases earning
capacity of enterprise.
2. Determination of capital composition: Once the estimation have been made, the capital structure have
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.
3. Choice of sources of funds: For additional funds to be procured, a company has many choices likea. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.

[FINANCIAL MANAGEMENT] MBA IInd sem

Choice of factor will depend on relative merits and demerits of each source and period of financing.
4. Investment of funds: The finance manager has to decide to allocate funds into profitable ventures so
that there is safety on investment and regular returns is possible.
5. Disposal of surplus: The net profits decision have to be made by the finance manager. This can be done
in two ways:
a. Dividend declaration - It includes identifying the rate of dividends and other benefits like bonus.
b. Retained profits - The volume has to be decided which will depend upon expansion,
innovational, diversification plans of the company.
6. Management of cash: Finance manager has to make decisions with regards to cash management. Cash
is required for many purposes like payment of wages and salaries, payment of electricity and water bills,
payment to creditors, meeting current liabilities, maintainance of enough stock, purchase of raw
materials, etc.
7. 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.
OBJECTIVES OF FINANCIAL MANAGEMENT
Effective procurement and efficient use of finance lead to proper utilization of the finance by the business concern. It
is the essential part of the financial manager. Hence, the financial manager must determine the basic objectives of the
financial management. Objectives of Financial Management may be broadly divided into two parts such as:
1. Profit maximization
2. Wealth maximization.
Profit Maximization
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 techniques to understand the business efficiency of the concern.
Profit maximization is also the traditional and narrow approach, which aims at, maximizes 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.
Favorable Arguments for Profit Maximization
The following important points are in support of the profit maximization objectives of the business concern:
(i) Main aim is earning profit.
(ii) Profit is the parameter of the business operation.
(iii) Profit reduces risk of the business concern.
(iv) Profit is the main source of finance.

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(v) Profitability meets the social needs also.
Unfavourable Arguments for Profit Maximization
The following important points are against the objectives of profit maximization:
(i) Profit maximization leads to exploiting workers and consumers.
(ii) Profit maximization creates immoral practices such as corrupt practice, unfair trade practice, etc.
(iii) Profit maximization objectives leads to inequalities among the stake holders such as customers, suppliers, public
shareholders, etc.
Drawbacks of Profit Maximization
Profit maximization objective consists of certain drawback also:
(i) It is vague: In this objective, profit is not defined precisely or correctly. It creates some unnecessary opinion
regarding earning habits of the business concern.
(ii) It ignores the time value of money: Profit maximization does not consider the time value of money or the net
present value of the cash inflow. It leads certain differences between the actual cash inflow and net present cash flow
during a particular period.
(iii) It ignores risk: Profit maximization does not consider risk of the business concern. Risks may be internal or
external which will affect the overall operation of the business concern.
Wealth Maximization
Wealth maximization is one of the modern approaches, which involves latest innovations and improvements in the
field of the business concern. The term wealth means shareholder wealth or the wealth of the persons those who are
involved in the business concern. Wealth maximization is also known as value maximization or net present worth
Maximization. This objective is an universally accepted concept in the field of business.
Wealth of shareholders = Number of shares held Market price per share.
In order to maximise wealth, financial management must achieve the following specific objectives:
(a) To ensure availability of sufficient funds at reasonable cost (liquidity).
(b) To ensure effective utilisation of funds (financial control).
(c) To ensure safety of funds by creating reserves, re-investing profits, etc. (minimisation of risk).
(d) To ensure adequate return on investment (profitability).
(e) To generate and build-up surplus for expansion and growth (growth).
(f) To minimise cost of capital by developing a sound and economical combination of corporate securities (economy).
(g) To coordinate the activities of the finance department with the activities of other departments of the firm
(cooperation).

Favorable Arguments for Wealth Maximization

(i) Wealth maximization is superior to the profit maximization because the main aim of the business concern under
this concept is to improve the value or wealth of the shareholders.

[FINANCIAL MANAGEMENT] MBA IInd sem

(ii) Wealth maximization considers the comparison of the value to cost associated with the business concern. Total
value detected from the total cost incurred for the business operation. It provides extract value of the business
concern.
(iii) Wealth maximization considers both time and risk of the business concern.
(iv) Wealth maximization provides efficient allocation of resources.
(v) It ensures the economic interest of the society.
Unfavorable Arguments for Wealth Maximization
(i) Wealth maximization leads to prescriptive idea of the business concern but it may not be suitable to present day
business activities.
(ii) Wealth maximization is nothing, it is also profit maximization, it is the indirect name of the profit maximization.
(iii) Wealth maximization creates ownership-management controversy.
(iv) Management alone enjoy certain benefits.
(v) The ultimate aim of the wealth maximization objectives is to maximize the profit.
(vi) Wealth maximization can be activated only with the help of the profitable position of the business concern.