Financial management: Definition, scopes and objectives

Financial management: Definition, scopes and objectives

Financial-management

Finance is backbone of business and business need money to make more money that means money begets more money, only when it is properly managed.

Henry ford had said once “money is an arm or leg; you can use it or lose it”. in this money-oriented market its high time to recall his words and hence concept of money management or in broader way we can say finance management come in view.

The Sanskrit saying “Arthah sachivah” which means “finance reigns supreme”.

Definition of Financial Management:

It is that business activity which is concerned with the acquisition and conservation of capital funds in meeting financial needs and over all objectives of business enterprises.

“Financial management is the activity concerned with planning, raising, controlling and administering of funds used in the business.” – Guthman and Dougal

“Financial management is that area of business management devoted to a judicious use of capital and a careful selection of the source of capital in order to enable a spending unit to move in the direction of reaching the goals.” – J.F. Brandley

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

Scope of Financial Management:

The scope and functions of financial management are divided into two broad categories:

1)      Traditional approach

2)      Modern approach   

1)      Traditional Approach:

       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 which funds are obtained. It has no concern with the decisions of allocating firm's funds. The scope of finance function in the traditional approach has now been discarded as it suffers from serious criticisms which are discussed below:

• 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. internal financial decision-making was completely ignored in this approach. 
  
• 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. 

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.

2)      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 determining the size and nature 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 analytical 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 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.

Financial objectives:

Financial targets may include targets for: earnings; earnings per share; dividend per share; gearing level; profit retention; operating profitability. The usual assumption in financial management for the private sector is that the primary financial objective of the company is to maximise shareholders' wealth. In broad  sense this classification is done in two ways:

1. Profit maximization approach
2. Wealth maximization approach
   

Financial-management-objectives

1)      Profit maximisation:

 In much economic theory, it is assumed that the firm behaves in such a way as to maximise profits, where profit is viewed in an economist's sense. Unlike the accountant's concept of cost, total costs by this economist's definition include an element of reward for the risk-taking of the entrepreneur, called 'normal profit'.

Where the entrepreneur is in full managerial control of the firm, as in the case of a small owner-managed company or partnership, the economist's assumption of profit maximisation would seem to be very reasonable. Remember though that the economist's concept of profits is broadly in terms of cash, whereas accounting profits may not equate to cash flows. Even in companies owned by shareholders but run by non-shareholding managers, if the manager is serving the company's (ie the shareholders') interests, we might expect that the profit maximisation assumption should be close to the truth. Although profits do matter, they are not the best measure of a company's achievements.

2)      wealth maximisation:

If the financial objective of a company is to maximise the value of the company, and in particular the value of its ordinary shares, we need to be able to put values on a company and its shares. How do we do it? Three possible methods for the valuation of a company might occur to us. 

(a) Statement of financial position (balance sheet) valuation:  Here assets will be valued on a going concern basis. Certainly, investors will look at a company's statement of financial position. If retained profits rise every year, the company will be a profitable one. Statement of financial position values are not a measure of 'market value', although retained profits might give some indication of what the company could pay as dividends to shareholders. 

(b) Break-up basis: This method of valuing a business is only of interest when the business is threatened with liquidation, or when its management is thinking about selling off individual assets to raise cash. 

(c) Market values: The market value is the price at which buyers and sellers will trade stocks and shares in a company. This is the method of valuation which is most relevant to the financial objectives of a company.

The wealth of the shareholders in a company comes from:

Dividends received, Capital gains from increases in the market value of their shares If a company's shares are traded on a stock market, the wealth of shareholders is increased when the share price goes up.

The price of a company's shares will go up when the company makes attractive profits, which it pays out as dividends or reinvests in the business to achieve future profit growth and dividend growth. However, to increase the share price the company should achieve its attractive profits without taking business risks and financial risks which worry shareholders. If there is an increase in earnings and dividends, management can hope for an increase in the share price too, so that shareholders benefit from both higher revenue (dividends) and also capital gains (higher share prices). 

conclusion:

Financial management is a managerial activity concerned with planning and controlling of the firm's financial resources to generate returns on its invested funds. The raising and using of capital for generating funds and paying returns to the suppliers of capital is the finance function of a firm. Thus the funds raised by the company will be invested in the best investment opportunities, with an expectation of future benefits. As every business activity either directly or indirectly involves the acquisition and use of funds, there is an inseparable relationship between the finance and other functions like production, marketing etc. However, the raising of funds and using of money may not necessarily limit the general running of the business. A firm in a tight financial position will give more priority to financial considerations to devise its marketing and production strategies in tune with its financial constraints.