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Financial Management

Introduction:

 

Finance is regarded as the lifeblood of a business enterprise. It is the basic foundation of all kinds of economic activities. Finance is the master key that provides access to all the sources for being employed in manufacturing and merchandising activities. The success of an organization largely depends on efficient management of its finances.

 

Meaning of Financial Function:

 

Finance is one of the functional areas in an organization. It is one of the most important of all business functions. Finance department plays a vital role in the organization. It may be described as heart in the human body. The basic function of the heart in the human body is to pump the necessary blood to all parts of the body. Similarly, the finance department in the organization has to supply the necessary finances to all the other departments (functions) to carryout their activities. It is the responsibility of the finance department to identify the financial requirements and supply the needed funds at the right time.

 

Objectives & Structure of Financial Management:

 

Meaning of Financial Management:

 

Financial management is basically concerned with planning, organizing and controlling of financial resources of an organization. It is applicable to every type of organization, irrespective of its size, kind and nature. It can be used in all organizations where there is a use of finance. Every management aims to utilize its funs in a best possible and profitable way. So this subject is acquiring a universal applicability. Financial management was a branch of economics till 1980 and thus as a separate discipline is of recent origin. It was earlier known as corporation finance and managerial finance.

 

 

 

Objectives of Financial Management:

 

It is generally agreed that the objective of financial management should be maximization of economic welfare of shareholders. In order to achieve this and to make wise decisions, a clear understanding of the objectives which are sought to be achieved is necessary. The objectives provide a framework for optimum financial decision making. The following are the two widely discusses approaches in financial literature to achieve the above objective.

 

 

1. Profit Maximization

2. Wealth Maximization

 

 

 

Profit maximization:

 

It is an important concept in economic theory. It simply means that maximizing the rupee income of the firm. According to this approach, actions that increase profits should be undertaken and those that decrease profits are to be avoided. The profit maximization criterion implies that the investment, financing and dividend policy decisions of a firm should be oriented to the maximization of profits.

 

This objective is justified on the following grounds:

 

h The very survival of the organization will be depending upon whether it is able to earn profits or not.

h Profit is a test of economic efficiency.

h It indicates the effective utilization of resources.

h It ensures maximum social welfare.

 

Profit maximization suffers from the following limitations:

 

1. Profit maximization concept is vague or ambiguous:

 

The definition of profit itself is ambiguous. Its has no precise connotation. It is amenable to different interpretations by different people. For example, profit may be short-term profit or long-term, it may total profit or rate of profit, it may be before tax or after tax, it may be return on capital employed or return on total assets. Hence, a loose expression like profit cannot form the basis of operational criterion for financial management.

 

 

2. It ignores timing of benefits:

 

The second limitation to the objective of profit maximization is that it ignores the differences in time pattern of the benefits received from investment proposals. The principle of the bigger the better is adopted for decision making.

 

 

 

3. It ignores quality of benefits:

 

The profit maximization concept ignores consistency or the degree of certainty in getting returns from investment proposals. In view of the above limitations, the profit maximization criterion is considered as inappropriate and unsuitable operational criterion for financial decisions. It is not only vague and ambiguous but it also ignores risk and time value of money. As an alternative to the profit maximization, the other criterion, that is, wealth maximization is developed.

 

 

 

Wealth Maximization:

 

This is also known as value maximization or net present worth maximization. Net present value is the difference between the gross present value of benefits from an investment proposal and the investment required achieving these benefits. The gross present value of a course of action is found out by discounting or capitalizing its benefits at a rate, which reflects their timing or uncertainty. Any financial action with a positive net present worth should be undertaken otherwise it should be rejected.

 

 

The objective of wealth maximization resolves two basic limitations of profit maximization.

1. It considers time value of money.

2. It takes care of uncertainty of expected benefits and the benefits are measured in terms of cash flows and not accounting profits.

 

The wealth maximization objective is consistent with the objective of maximization of economic welfare of shareholders. The wealth of shareholders id reflected by the market value of the company shares. Hence, wealth maximization implies the maximization of the market value of the companys shares, which is the fundamental objective of the firm.

 

For the above reasons, the wealth maximization criterion is considered to be superior to the profit maximization as an operational objective.

 

Traditional approach

The traditional approach to financial management was popular in the initial stages of its evolution as a separate branch of academic study. Under this approach the role of finance smanager was limited to raising and administering of funds needed by the corporate enterprises to meet their financial needs. It broadly covers the following three aspects:

1.Arrangement of funds from financial institutions.

2.Arrangement of funds through instruments as shares, bonds etc.

3.The legal and accounting relationships between a firm and its sources of funds.

The scope traditional approach to the scope of finance function evolved during the 1920s and 1930s and dominated academic thinking during the fifties and through the early forties. It has now been discarded as it suffers from serious limitations.

 

Modern approach

 

 

The traditional approach outlived its utility due to changed business situations since mid 1950s. The modern approach views the term financial management in a broad sense and provides a conceptual and analytical framework for financial decision making. According to it, the finance function covers both funds as well as their allocations.

 

The new approach is an analytical way of viewing the financial problems of a firm

. The principle contents of the modern approach to financial management can be said to be:

* How large should an enterprise be, and how fast it should grow

*In what form should it hold assets

*What should be the composition of its liabilities

 

The questions posed above cover between them the major financial problems of a firm. In other words, financial management, according to the new approach is concerned with the solution of three major problems relating to the financial operations of a firm. They are:

1.The investment decision

2.The dividend policy decision.

 

Thus,finance is regarded as the lifeblood of a business enterprise.The success of an organization largely depends on efficient management of its finances.