Course Code and Title: FINP1 – Financial Management

Lesson Number: 1

Topic: Nature, Purpose, and Scope of Financial Management

Learning Objectives:
After studying Chapter 1, you should be able to:
1. Describe the nature, goal and basic scope of financial management.
2. Explain briefly the three major types of decisions that the Finance Manager makes.
3. Discuss the importance or significance of financial management.
4. Describe the relationship between Financial Management and Accounting.
5. Describe the relationship between Financial Management and Economics
Pre-assessment:

Write T if the statement is true and F if the statement is false.

_____1. Financial management is a part of a large discipline called Finance.

_____2. The goal of financial management is to minimize the current value of the existing stock
or ownership in a business firm.
_____3. There is no need to learn on how to identify investments, arrangements, and dividend
distribution.
_____4. Financial managers should do the necessary means, whether legal or illegal, to
accomplish the objective of financial management.
_____5. Financial manager in a business enterprise is responsible in making financial decisions
in an organization setting.
 CHAPTER 1
NATURE, PURPOSE AND SCOPE OF FINANCIAL MANAGEMENT
NATURE OF FINANCIAL MANAGEMENT
Financial Management, also referred to as managerial finance, corporate finance, and
business finance, is a decision making process concerned with planning, acquiring and utilizing
funds in a manner that achieves the firm's desired goals. It is also described as the process for
and the analysis of making financial decisions in the business context. Financial management is
part of a larger discipline called FINANCE which is a body of facts, principles, and theories relating
to raising and using money by individuals, businesses, and governments. This concerns both
financial management of profit-oriented business organizations particularly the corporate form of
business, as well as, concepts and techniques that are applicable to individuals and to
governments.
THE-GOAL OF FINANCIAL MANAGEMENT
Assuming that we confine ourselves to for-profit businesses, the goal of financial
management is to make money and add value for the owners. This goal, however, is a little vague
and a more precise definition is needed in order to have an objective basis for making and
evaluating financial decisions. The financial manager in a business enterprise must make decision
for the owners of the firm. He must act in the owners' or shareholders' best interest by making
decisions that increase the value of the firm or the value of the stock.
The appropriate goal for the financial manager can thus be stated as follows:
The goal of financial management is to maximize the current value per share of the existing
stock or ownership in a business firm.
The stated goal considers the fact that the shareholders in a firm are the residual owners.
By this, we mean that they are entitled only to what is left after employees, supplier, creditors and
anyone else with a legitimate claim are paid their due. If any of these groups go unpaid, the
shareholders or owners get nothing. So, if the shareholders are benefiting in the sense that the
residual portion is growing, it must be true that everyone else is being benefited too. Because the
goal of financial management is to maximize the value of the share(s), there is a need to learn
how to identify investments, arrangements and distribute satisfactory amount of dividends or
share in the profits that favorably impact the value of the share(s).
Finally, our goal does not imply that the financial manager should take illegal or unethical
actions in the hope of increasing the value of the equity in the firm. The financial manager should
best serve the owners of the business by identifying goods and services that add value to the firm
because they are desired and valued in the free market place.
SCOPE OF FINANCIAL MANAGEMENT
Traditionally, financial management is primarily concerned with acquisition, financing and
management of assets of business concern in order to maximize the wealth of the firm for its
owners. The basic responsibility of the Finance Manager is to acquire funds needed by the fit-in
and investing those funds in profitable ventures that will maximize the firm's wealth, as well as,
generating returns to the business concern. Briefly, the traditional view of Financial Management
looks into the following functions that a financial manager of a business firm will perform:
1. Procurement of short-term as well as long-term funds from financial institutions
 2. Mobilization of funds through financial instruments such as equity shares, preference
shares, debentures, bonds, notes, and so forth
3. Compliance with legal and regulatory provisions relating to funds procurement, use and
distribution as well as coordination of the finance function with the accounting function
With modern business situation increasing in complexity, the role of Finance Manager
which initially is just confined to acquisition of funds, expanded to judicious and efficient use of
funds available to the firm, keeping in view the objectives of the firms and expectations of the
providers of funds.
More recently though, with the globalization and liberalization of world economy,
tremendous reforms in financial sector evolved in order to promote more diversified, efficient and
competitive financial system in the country. The financial reforms coupled with the diffusion of
information technology have brought intense competition, mergers, takeovers, cost
management, quality improvement, financial discipline and so forth.
Globalization has caused to integrate the national economy with the global economy and
has created a new financial environment which brings new opportunities and challenges to the
business enterprises. This development has also led to total reformation of the finance function
and its responsibilities in the organization. Financial management has assumed a much greater
significance and the role of the finance managers has been given a fresh perspective.
In view of modern approach, the Finance Manager is expected to analyze the business
firm and determine the following:
a. The total funds requirements of the firm
b. The assets or resources to be acquired and
c. The best pattern of financing the assets
TYPES OF FINANCIAL DECISIONS
The three major types of decisions that the Finance Manager of a modern business firm will be
involved in are:
1. Investment decisions
2. Financing decisions
3. Dividend decisions
All these decisions aim to maximize the shareholders' wealth through maximization of the
firm's wealth.
INVESTMENT DECISIONS
The investment decisions are those which determine how scarce or limited resources in
terms of funds of the business firms are committed to projects. Generally, the firm should select
only those capital investment proposals whose net present value is positive and the rate of return
exceeding the marginal cost of capital. It should also consider the profitability of each individual
project proposal that will contribute to the overall profitability of the firm and lead to the creation
of wealth.
FINANCING DECISIONS
Financing decisions assert that the mix of debt and equity chosen to finance investments
should maximize the value of investments made.
 The finance decisions should consider the cost of finance available in different forms and
the risks attached to it. The principle of financial leverage or trading on the equity should be
considered when selecting the debt-equity mix or capital structure decision. If the cost of capital
of each component is reduced, the overall weighted average cost of capital and minimization of
risks in financing will lead to the profitability of the organization and create wealth to the owner.
DIVIDEND DECISIONS
The dividend decision is concerned with the determination of quantum of profits to be
distributed to the owners, the frequency of such payments and the amounts to be retained by the
firm.
The dividend distribution policies and retention of profits will have ultimate effect on the
firm's wealth. The business firm should retain its profits in the form of appropriations or reserves
for financing its future growth and expansion schemes. If the firm, however, adopts a very
conservative dividend payments policy, the firm's share prices in the market could be adversely
affected. An optimal dividend distribution policy therefore will lead to the maximization of
shareholders' wealth.
To summarize, the basic objective of the investment, financing and dividend decisions is
to maximize the firm's wealth. If the firm enjoys the stability and growth, its share prices in the
market will improve and will lead to capital appreciation of shareholders' investment and ultimately
maximize the shareholders' wealth.
SIGNIFICANCE OF FINANCIAL MANAGEMENT
The importance of financial management is known for the following aspects:
BROAD APPLICABILITY
Any organization whether motivated with earning profit or not having cash flow requires to be
viewed from the angle of financial discipline. The principles of finance are applicable wherever
there is cash flow. The concept of cash flow is one of the central elements of financial analysis,
planning, control, and resource allocation decisions. Cash flow is important because the financial
health of the firm depends on its ability to generate sufficient amounts of cash to pay its
employees, suppliers, creditors, and owners.
Financial management is equally applicable to all forms of business like sole traders,
partnerships, and corporations. It is also applicable to nonprofit organizations like trust, societies,
government organizations, public sectors, and so forth.
REDUCTION OF CHANCES OF FAILURE
A firm having latest technology sophisticated machinery, high caliber marketing and
technical experts. and so forth may still fail unless its finances are managed on sound principles
of financial management. The strength of business lies in its financial discipline. Therefore.
finance function is treated as primordial which enables the other functions like production,
marketing, purchase, and personnel to be effective in the achievement of organizational goal and
objectives.
MEASUREMENT OF RETURN ON INVESTMENT
Anybody invests his money expect to earn a reasonable return on his investment. The
owners of business try to maximize their wealth. Financial management studies the risk-return
perception of the owners and the time value of money. It considers the amount of cash flows
expected to be generated for the benefit of owners, the timing of these cash flows and the risk
attached to these cash flows. The greater the time and risk associated with the expected cash
flow, the greater is the rate of return required by the owners.
RELATIONSHIP BETWEEN FINANCIAL MANAGEMENT, ACCOUNTING AND ECONOMICS
FINANCIAL MANAGEMENT AND ACCOUNTING
Just as marketing and production are major functions in an enterprise finance is an independent
specialized function and is well knit other functions.
Financial management is a separate management area. In many organizations,
accounting and finance functions are ined and the finance function is often considered as part of
the functions of the accountant. Financial management is however, something more than an art
of accounting and bookkeeping. Accounting function discharges the function of systematic
recording of transactions relating to the firm's activities in the books of accounts and summarizing
the same fer presentation in the financial statements such as the Statement of Comprehensive
Income, the Statement of Financial Position, the Statement of Changes in Shareholders' Equity
and the Cash Flow Statement.
Financial statements help managers to make business decisions involving the best use of
cash, the attainment of efficient operations, the optimal allocation of funds among assets, and the
effective financing of investment and operations. The interpretation of financial statements is
achieved partly by using financial ratios, pro forma and cash flow statement.
The finance manager will make use of the accounting information in the analysis and
review of the firm's business position in decision making. In addition to the analysis of financial
information available from the books of accounts and records of the firm, a finance manager uses
the other methods and techniques like capital budgeting techniques, statistical and mathematical
models, and computer applications in decision making to maximize the value of the firms wealth
and value of the owner's wealth. In view of the above, finance function is considered a distinct
and separate function rather than simply an extension of accounting function.
It should be pointed out that the managers of a firm are supplied with more detailed
statistical information than what appears in published financial statements. These data are
especially important in developing cash flow concepts for evaluating the relative merits of different
investment projects This information permits managers to determine incremental cash flows (an
approach that looks at the net returns a given project generates in comparison with alternative
investments), thus enabling them to make more accurate assessments of the profit abilities of
specific investments. It is the responsibility of managers to direct their accountants to prepare
internal statements that include this information so that they can make the best investment
decisions possible.
Financial management is the key function and many firms prefer to centralize the function
to keep constant control on the finances of the firm. Any inefficiency in financial management will
be concluded with a disastrous situation. But, as far as the routine matters are concerned, the
finance function could be decentralized with adoption of responsibility accounting concept. It is
advantageous to decentralize accounting function to speedup the processing of information. But
since the accounting information is used in making financial decisions, proper controls should be
exercised in processing of accurate and reliable information to the needs of the firm. The
centralization or decentralization of accounting and finance functions mainly depends on the
attitude of the top level management.
FINANCIAL MANAGEMENT AND ECONOMICS
Financial managers can make better decisions if they apply these basic economic
principles. For example, economic theory teaches us to seek the best allocation of resources. To
this end, financial managers are given the responsibility to find the best and least expensive
sources of funds and to invest these funds into the best and most efficient mix of assets. In doing
so, they try to find the mix of available resources that will achieve the highest return at the least
risk within the confines of an expected change in the economic climate. Good financial
management has a sound grasp of the way economic and financial principles impact the
profitability of the firm.
Financial managers do a better job when they understand how to respond effectively to
changes in supply, demand, and prices (firm-related micro factors), as well as to more general
and overall economic factors (macro factors). Learning to deal with these factors provides
important tools for effective financial planning.
The finance manager must be familiar with the microeconomic and macroeconomic
environment aspects of business.
When making investment decisions, financial managers consider the effects of changing
supply, demand, and price conditions on the firm's performance. Understanding the nature of
these factors helps managers make the most advantageous operating decisions. Also, managers
should determine when it is best to issue equity shares, bonds or other financial instruments.
The sale of products at a profit depends heavily on how well managers are able to analyze
and interpret supply and demand conditions. Supply considerations relate specifically to the
control of production costs, where the key element is to hold costs down so that prices can be set
at competitive levels. The best machinery must be bought; and the most qualified product workers
available must be hired. The goal is to squeeze out the biggest possible profit under given supply
conditions. Maintaining a low-cost operation will enable the firm to charge competitive prices for
its products and) maintain its market share while still obtaining a reasonable return.
Knowledge of economic principles can be useful in generating the highest sales possible.
Understanding and appropriately responding to changes in demand allows financial managers to
take full advantage of market conditions. To accomplish this, the best managers develop and
adopt reliable, workable statistical techniques that forecast demand and pinpoint when directional
changes in sales take place.
Microeconomics deals with the economic decisions of individuals and firms. It focuses
on the optimal operating strategies based on the economic data of individuals and firms. The
concept of microeconomics helps the finance manager in decisions like pricing, taxation,
determination of capacity and operating levels, break-even analysis, volume-cost-profit analysis,
capital structure decisions, dividend distribution decisions, profitable product-mix decisions,
fixation of levels of inventory, setting the optimum cash balance, pricing of warrants and options,
interest rate structure, present value of cash flows, and so forth.
 Macroeconomics looks at the economy as a whole in which a particular business concern
is operating. Macroeconomics provides insight into policies by which economic activity is
controlled. The success of the business firm is influenced by the overall performance of the
economy and is dependent upon the money and capital markets, since the investible funds are
to be procured from the financial markets. A firm is operating within the institutional framework,
which operates on the macroeconomic theories. The government's fiscal and monetary policies
will influence the strategic financial planning of the enterprise. The finance manager should also
look into the other macroeconomic factors like rate of inflation, real interest rates, level of
economic activity, trade cycles, market competition both from new entrants and substitutes,
international business conditions, foreign exchange rates, bargaining power of buyers,
unionization of labor, domestic savings rate, depth of financial markets, availability of funds in
capital markets, growth rate of economy, government's foreign policy, financial intermediation,
banking system, and so forth.
FINANCIAL MANAGEMENT AND PUBLIC RESPONSIBILITY
Finance is a very challenging and rewarding field. Financial managers are given the•
responsibility to plan the future growth and direction of a firm which can greatly affect the
community in which it is based. The decisions reached by a financial manager ultimately represent
a blend of theoretical, technical and judgmental matters that must reflect the concerns of society.
The primary goal for managers of publicly owned companies implies that decisions should
be made to maximize the long-run value of the firm's equity shares. At the same time, managers
know that this does not mean maximize shareholder value “at all costs”. Managers have the
obligation to behave ethically and they must follow the law and other society-imposed constraints.
Financial managers have certain obligations to those who entrust them with the running
of the firm. They must have a clear sense of ethics and must avoid pay offs or other forms of
personal gain. Managers should not engage in practices that can damage the image of the firm
but should articulate as much as possible in social activities to demonstrate that they are
cognizant of the importance of the community and those who buy their products or services.
In short, financial managers must reconcile social and environmental requirements with
profit-making motive. Adherence to social values may not produce the most efficient use of assets
or the lowest costs, but it will enhance the image of the firm. Looking after the interest in
community, setting up of training facilities, casing for the safely and the welfare of the workers,
providing free college education for the dependents of the employees can produce long-term
benefits in the form of higher productivity and more harmonious relationships between labor and
management. Although there may be conflict between promoting socially responsible programs
and the profit motive, maintaining some concern for social needs when pursuing the goal of
maximizing the wealth of the firm is a primary responsibility of a firm.