Meaning of Financial Management
Financial management is concerned with efficient acquisition and allocation of funds. In other words, financial management is concerned with flow of funds and involves decisions related to procurement of funds, investment of funds in long term and short term assets and distribution of earnings to owners.
In simple words we can say Financial Management refers to efficient acquisition of finance, efficient utilization of finance and efficient distribution and disposal of surplus for smooth working of company.
Some common definitions of financial management:
“Financial management is concerned with managerial decisions that result in the acquisition and finance of long-term and short-term assets for the firm. As such, it deals with the situations that require selection of specific assets or combination of assets. The selection of specific liabilities as well as the problem of growth and size to enterprise. The analysis of these decisions is based upon the expected inflow and outflow of funds and their effect upon managerial objectives”
Financial management involves the application of general management principles to a particular financial operation
-Howard and Upton
Role of Financial Management:
All the financial activities of a company are directly or indirectly affected by the financial management.
The common activities and areas which are influenced by financial management are:
1. Size and Composition of Fixed Assets. The size and composition of fixed assets depend directly on investment decision, i.e., how much capital company is planning to invest.
2. Amount and Composition of Current Assets. The amount of current assets and its division in
Cash, bills receivable, inventories etc. also depend upon financial decisions. It depends upon on the amount of fixed assets, credit policy of company, inventory management, etc.
3.The Amount of Long-term and Short-term Financing. The amount to be raised for long-
-term as well as for the short-term depends upon the financial management and organization. The firms which have policy of liquidation prefer to have more of long-term finance although with that pro profit will decrease as company has to pay more interest on long-term debts as compared to short-term debts.
4.Fixing Debt Equity Ratio in Capital. Firm can raise long-term debts by issue of equity shares as well as by issue of debentures and other borrowed fund security. Financial management helps in fixing this ratio.
5. All Items in Profit and Loss Account. All the items of P&LA/C are affected by decisions of financial management. Generally items related to expenses and revenue are recorded in P&L A/C. If we pay more interest, depreciation it will increase expenses and affect P&L A/C.
Objectives of Financial Management
The main and foremost objective of financial management is to maximize the wealth of equity shareholder.
The financial manager in a company makes decisions for the owners, i.e., the shareholders of the firm.
He must take such decisions which will ultimately prove gainful from the point of view of shareholders and shareholders gain only when the price of their share increases in market.
So financial decision which results in increase in value of share is considered very efficient decision. On the other hand, the financial decision which brings fall in the value of equity share is considered poor decision.
This objective of maximizing the wealth of equity share automatically fulfills many other objectives
As equity shareholders get share from residual income only, i.e., they are given dividend only after the claims of suppliers, employees, lenders, creditors and any other legitimate claimants. Therefore, if the shareholders are gaining, it automatically implies that all other claimants are also gaining.
The objective of increase in value of equity share does not mean that finance manager should involve in manipulative activities to bring rise in price. The rise in price must come with the growth of firm, with increase in profit of firm and with satisfaction of all the parties associated with the company.
With the objective of wealth maximization of equity shareholder, following objectives automatically get achieved:
(1) Profit maximization
(2) Maintenance of liquidity
1) Investment decision
2) Financing decision
3) Dividend decision
Investment Decision (Capital Budgeting Decision) (Where to Invest Fixed Capital)
This decision relates to careful selection of assets in which funds will be invested by the firms. A firm has many options to invest their funds but firm has to select the most appropriate investment which will bring maximum benefit for the firm and deciding or selecting most appropriate proposal is investment decision.
The firm invests its funds in acquiring fixed assets as well as current assets. When decision regarding fixed assets is taken it is also called capital budgeting decision.
Factors Affecting investment/Capital Budgeting Decisions:
1. Cash flow of the project. Whenever a company is investing huge funds in an investment proposal it expects some regular amount of cash flow to meet day to day requirement. The amount of cash flow an investment proposal will be able to generate must be assessed properly before investing in the proposal.
2. Return on investment. The most important criteria to decide the investment proposal is rate of return it will be able to bring back for the company in the form of income for, e.g., if project A s bringing 10% return and project B is bringing 15% return then we should prefer project B.
3. Risk involved. With every investment proposal, there is some degree of risk is also involved. The Company must try to calculate the risk involved in every proposal and should prefer the investment proposal with moderate degree of risk only.
4. Investment criteria. Along with return, risk, cash flow there are various other criteria which help in selecting an investment proposal such as availability of labour, technologies, input, machinery, etc.
The finance manager must compare all the available alternatives very carefully and then only decide etc. where to invest the most scarce resources of the firm, i.e., finance.
Investment decisions are considered very important decisions because of following reasons:
(1) They are long term decisions and therefore are irreversible; means once taken cannot be changed.
(2) Involve huge amount of funds.
(3) Affect the future earning capacity of the company
Importance or Scope of Capital Budgeting Decision
Capital budgeting decisions can turn the fortune of a company. The capital budgeting decisions are considered very important because of the following reasons:
1. Long-term growth. The capital budgeting decisions affect the long-term growth of the company. As funds invested in long-term assets bring return in future and future prospects and growth of the company depends upon these decisions only.
2. Large amount of funds involved. Investment in long term projects or buying of fixed assets involves huge amount of funds and if wrong proposal is selected it may result in wastage of huge amount of funds that is why capital budgeting decisions are taken after considering various factors and planning.
3. Risk involved. The fixed capital decisions involve huge funds and also big risk because the return comes in long run and company has to bear the risk for a long period of time till the returns start coming.
4. Irreversible decision. Capital budgeting decisions cannot be reversed or changed overnight. As these decisions involve huge funds and heavy cost and going back or reversing the decision may result in heavy loss and wastage of funds. So these decisions must be taken after careful planning and evaluation of all the effects of that decision because adverse consequences may be very heavy.
Financing Decision (From which source finance or capital to be raised)
The second important decision which finance manager has to take is deciding source of finance. A company can raise finance from various sources such as by issue of shares, debentures or by taking loan and advances. Deciding how much to raise from which source is concern of financing decision. Main sources of finance can be divided into two categories:
1. Owners’ fund,
2. Borrowed fund.
Share capital and retained earnings constitute owners’ fund and debentures, loans, bonds, etc. constitute borrowed fund.
The main concern of finance manager is to decide how much to raise from owners’ fund and how much to raise from 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 owners’ fund there is no fix commitment of repayment and there is no risk involved. But finance manager prefers a mix of both types. Under financing decision finance manager fixes a ratio of owner fund and borrowed fund in the capital structure of the company.
Factors affecting financing decisions:
3. Cash flow position
4. Control considerations
5. Flotation cost
6. Fixed operating cost
7. State of capital market
Dividend Decision (Appropriate Distribution of Profit)
The decision is concerned with 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 company or finance manager has to decide is what to do with the residual or left over profit of the company. The surplus profit is either distributed to equity shareholders in the form of dividend 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 dividend and how much to keep aside as retained earnings. To take the decision finance manager keeps in mind the growth plans and investment opportunities.
If more opportunities are available and company has growth plans then more is kept aside as retained earnings and less is given in the form of dividend, but if company wants to satisfy its shareholders and has less growth plans, then more is given in the form of dividend and less is kept aside as retained earnings.
The decision is also called as residual decision because it is concerned with distribution of residual or left over income.
Factors affecting dividend decision:
- Stability of earnings
- Cash flow position
- Growth opportunities
- Stability of dividend
- Preference of shareholders
- Taxation policy
- Access to capital market consideration
- Legal restrictions
- Contractual constraints
- Stock market reactions
Financial planning means deciding in advance how much to spend, on what to spend according to the funds at your disposal.
In the words of Gerestenbug financial planning includes:
(1) Determination or amount or finance needed by an enterprise to carry out its operations smoothly.
(2) Determination of sources of funds, i.e., the pattern of securities to be issued.
(3) Determination of Suitable policies for proper utilization and administration of funds.
The financial planning begins with determination of total capital requirement. For this the finance managers do the sales forecast and if the future prospects appear to be bright and expect increase in sale, then firm needs to increase its production capacity which means more requirement of long term funds. Higher level of production and increase in sales will require higher fixed as well as working capital.
After estimating the requirement of funds the next step of financial planning is deciding how to raise this finance. Finance may be internally generated by the business or capital may have to be raised from external sources such as equity shares, preference shares, debentures, loans, etc.
Financial planning is broader in scope as it does not end by raising estimated finance. It includes long term investment decision. In financial planning finance manager analyses various investment plans and selects the most appropriate. Finance managers make short term financial plan called budgets.
Objectives of Financial Planning:
1. To ensure availability of funds whenever these are required
2. To see that firm does not raise resources unnecessarily.
Importance of Financial Planning
1. It facilitates collection of optimum funds.
2. It helps in fixing the most appropriate capital structure.
3. Helps in investing finance in right projects.
4 Helps in operational activities.
5. Base for financial control.
6. Helps in proper utilization of finance.
7. Helps in avoiding business shocks and surprises.
8. Link between investment and financing decisions
9. Helps in coordination.
10. It links present with future.
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