Essay on Financial Management

After reading this essay you will learn about Financial Management:- 1. Nature of Financial Management 2. Approaches of Financial Management 3. Objectives 4. Goals 5. Responsibilities.

Contents:

1. Essay on the Nature of Financial Management
2. Essay on Approaches of Financial Management
3. Essay on the Objectives of Financial Management
4. Essay on the Goals of Financial Management
5. Essay on the Responsibilities of Financial Management in the Firm

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Essay # 1. Nature of Financial Management:

The nature of financial management refers to its functions, scope and objectives. Financial management itself is concerned with the planning and controlling of the financial resources of the firm. As an academic discipline, it has undergone fundamen­tal changes in relation to its scope, functions and objectives.

In the past, when it was simply a branch of economics, it was treated as the raising of funds. But, at present, it is used in a broader sense which includes the efficient use of resources in addition to procurement of funds.

At the same time, the academic thinking relating to the objective of financial management has also undergone changes over the years. Howev­er, the object of the present study is to describe the functions and objectives of financial management in the academic literature in order to serve as a background to its various aspects which are very important.

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Essay # 2. Approaches of Financial Management:

The scope and functions of financial management are divided into two following broad categories, viz.:

(i) Old or Traditional Approach; and

(ii) New or Modern Approach.

(i) Old/Traditional Approach:

Financial management, at the initial stage of its evolution, was a separate branch of academic study in the academic literature and the term, ‘corporation finance’ was used. At present, this term is being replaced in the academic world by ‘financial management’ which deals with the financing of corporate enterprises.

According to this approach, the scope of financial management and the role of financial manager are considered to be confined to the procurement of funds in a broader sense.

As a result, the entire financing technique was treated as encompassing three interrelated aspects of raising and administering resources from outside:

(i) The organisation of capital market in the form of financial institution;

(ii) Funds are raised from the capital markets through financial instruments along with the practices and procedural aspects of capital markets;

(iii) The legal and accounting relationships between the sources of fund and a firm itself.

Therefore, the area of corporation finance was limited to the covering of complex of capital market institutions, practices and instruments through which funds are obtained. Besides, since the problem of raising funds is more intensely felt in case of an episodic event, detailed description of the events like mergers, consolidations, re-organisation, recapitalisation etc. are contained in the field of academic story.

The traditional approach to financial management did not allow the financial manager to take any decision regarding the allocation of the firm’s funds although he was required to raise the needed funds from various sources. The traditional approach evolved in the 1930s and 1940s which dominated the academic thinking during 1940s and early 1950s.

But, subsequently, the same was discarded due to the following snags:

(i) Since the basic conceptual and analytical framework of the definitions and scope of the finance are limited and

(ii) The treatment of various topics and their emphasis is not enough.

Besides, the traditional approach was criticised for the following reasons:

(a) The traditional approach emphasises on raising and administering funds. The subject of finance is treated from the investors’ point of view. No importance was given to the point of view of the financial decision-maker (i.e., who had to make internal financial decisions). In short, the traditional view is the outsider-looking-in approach.

(b) The traditional approach is considered as the episodic financing function since it stresses overemphasis on topics of securities and its markets, incorporation, promo­tion, merger etc.

(c) Since the traditional approach stresses more emphasis on the long-term problem, it ignores the importance of working capital management.

(d) The traditional approach plays a significant role to the financing problems of non-corporate enterprises.

The shortcomings of the traditional approach were primarily due to the fundamental weaknesses other than the treatment and/or emphasis of different aspects. Its concep­tual and analytical limitations arose from the fact that it recognised only the problem of procuring the external funds and ignored the dimensions of allocations of capital which Solomon described as the central issues of financial management.

Of course, certain ‘traditional’ authors like Gerstenberg and Lincoln emphasised and initiated discussion on the topics of day-to-day financial operations including sales forecasting, budgeting, financial control, cost control, etc., along with the discussion on episodic financial events.

(ii) Modern Approach:

The traditional approach was criticised for its conceptual and analytical grounds by the proponents of modern or contemporary approach since the former neglects the problems of allocation of capital to different assets and the problems of optimum combination of finance, which, in other words, omitted the following two important matters, as pointed out by Dewing:

(i) The traditional approach does not recognise the relationships between financing- mix and the cost of capital and fails to solve the problems relating to optimum combination of finance; and

(ii) It also fails to deal with the problems relating to the valuation of the firm and the cost of capital.

The traditional approach evolved its utility during the 1940s and mid-1950s. But, during and after mid-1950s, an efficient and effective utilisation of a firm’s resources necessitated, as there were a number of economic and environmental factors, like the increasing pace of industrialization, technological inventions and innovations, intense competition, government intervention, population growth etc.

Fortunately, a number of management skills and decision-making techniques were devel­oped which facilitated implementing the optimum allocation of a firm’s resources. In other words, the approach and scope of financial management changed, i.e., the emphasis shifted from raising of funds to the efficient and effective use of funds or from episodic financing to the managerial financial problems.

The modern approach is an analytical way of viewing the financial problems of a firm. No doubt, financial management is an integral part of overall management.

In the words of Solomon, E.:

‘In this broader view the central issue of financial policy is the wise use of funds, and the central process involved in a rational matching of advantages of potential uses against the cost of alternative potential sources so as to achieve the broad financial goals which an enterprise sets for itself’.

Therefore, the primary finance function is to take proper decision about the expenditure and the demand for capital for those expenditures, i.e., the proper and efficient use of allocation of funds.

For this purpose, a financial manager should know the following:

(i) How large should an enterprise be, and how fast should it grow?

(ii) In what form should it hold its assets?

(iii) What should be the composition of its liabilities?

The above questions actually cover the major financial problems of a firm. In short, according to the modern approach, financial management deals with the solution of the above three major problems relating to the financial operations, viz., investment, financing and dividend decisions.

Therefore, financial management includes as functions of finance the three major decisions which are:

(i) The Investment decisions,

(ii) The Financing decisions and

(iii) The Dividend Policy decisions.

The new approach to financial management may be broadened to include profit-planning function also.

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Essay # 3. Objectives of Financial Management:

From the discussion we have made so far, it becomes clear that a firm has to take the following three major decisions:

(i) Where to invest fund and what amount? i.e., the Investment decisions;

(ii) Where to raise funds and what amount? i.e., the Financing decisions;

(iii) How much to pay by way of dividends? i.e., the Dividend Policy decisions.

The investment and the financial policies depend 011 the above decisions. It should be remembered that a clear understanding of the objectives which are sought to be attained is necessary in order to make wise decisions. No doubt, the objective provides a framework for optimum financial decision-making. It is generally accepted that the financial objective of the firm is to maximise the owner’s economic welfare.

For this purpose, two well-established and widely-discussed criteria are presented:

(A) Profit Maximisation and

(B) Wealth Maximisation.

A. Profit Maximisation:

How a private firm should behave depends on profit maximisation as a decision criterion. Under this concept, actions that increase the firm’s profit are undertaken and those that decrease profit are avoided. Profit can be maximised either by increasing output for a given set of scarce input or by reducing the cost of production for a given output. That is, there must be efficient use of resources.

According to Modern Micro economic theory, profit maximi­sation is nothing but a criterion for economic efficiency as profits provide a yardstick by which economic performances can be judged under condition of perfect competition.

Besides, under perfect competition, where all prices accurately reflect true values and consumers are well informed, profit maximisation behaviour by firms leads to an efficient allocation of resources and maximum social welfare.

There is no doubt that financial management deals with the efficient use of economic resources, i.e., capital funds. Since the capital is a scarce item, it follows that the profit maximisation should serve as the primary need for the decision taken by the financial managers of private firms which, in practice, it follows.

But the same has to be transformed to provide the necessary principles and guidelines to the financial managers since the profit maximisation concept does not recognise the real-world problems that we feel when we want to take actual decisions about the efficient use of capital funds.

As a result, we cannot implement the fundamental idea which underlies the rationale of Adam Smith’s ‘invisible hands by which total economic welfare is maximised.

Profit maximisation is widely preferred, but, in fact, the concept has been questioned and criticised on the following grounds:

(a) Vague/Uncertainty:

Practically, profit maximisation, as an operational criterion, becomes unsuitable for the problems of uncertainty in relation to the investment and financing decisions since it considers only the size of benefits and gives no weight to the degree of uncertainty of the future benefits.

For example, two alternative courses of action might have the same expected outcome, but one might be far more risky than the other. The following illustration will make the principle clear: Let there be two investment opportunities, A and B, whose profit depend on the state of economy as illustrated in Table 1.1.

Table 1.1: Showing the uncertainty about expected profits:

From the table 1.1 shown above, it is quite clear that the total returns related to two alternatives become equal to Rs. 30,000 in a normal economy but the range of variation is very wide in case of alternative B. But the same is very narrow in case of alternative A.

In other words, the returns associated with the alternative B are more uncertain and/or risky since they fluctuate widely depending on the state of economy. Similarly, alternative A is better from the standpoint of uncertainty and risk. Here profit maximisation criterion fails to express it.

(b) Ambiguity:

Profit maximisation concerns ambiguity since the term ‘profit’ is vague and can vary widely depending on the principles of accounting applied.

(c) Timing:

Profit maximisation ignores timings. The money received to-day has a higher value than money received next-year, a profit seeking organisation must consider the timing of cash flows and profits. Which is more profitable to a firm, if it selects a 3-year project with a return of 20% or a 5-year project with a return of 17%?

No doubt the latter project may result in a greater total profit if the firm could not immediately re-invest its profits when the same was received from the 3-year project. The principle can be explained with the help of the following Table 1.2.

Table 1.2: Showing the timing of anticipated profit:

From the Table 1.2 shown above, it is clear that the total profits shown by the alternatives A and B are equal. Therefore, if profit-maximisation is decision-criterion, both of them should be given equal importance. But the important difference between them is that alternative-A provides a higher return in earlier years whereas alternative-B provides a higher return in the latter years, i.e., they are not strictly equal.

Because, we all know that the earlier the better as benefits received sooner are more valuable than benefits received later on the ground that the former can be reinvested ‘o earn a return. The same is due to the fact that there is a time value of money.

The profit maximisation criterion does not recognize; the distinction between the returns received in different periods of time and treats them at par which is not true in real-world as the profits (benefits) in earlier years should be valued more highly than the profits (benefits) in the subsequent years.

Therefore, it can be taken into consideration that the profit maximisation, as an operational criterion, is unsuitable and inappropriate of a firm from the standpoint of investment, financing and dividend policy.

It is vague and ambiguous and does not recognise the two basic facts, viz:

(a) Risk and

(b) Time value of money.

It can be stated that the appropriate operational-decision criterion should include the following:

(i) It must be precise and exact;

(ii) It should consider both quality and quantity dimension;

(iii) It should be based on the bigger the better principle; and

(iv) It should recognise the time value of money.

For the reasons shown above, value maximisation has replaced profit maximisation as an operational criterion for management decisions.

B. Wealth Maximisation:

The Value Maximisation or Net Present Worth Maximisation — which is universally accepted as an appropriate and operationally feasible criterion in order to choose among the alternative courses of action for financial management — is to maximise the value of the firm over a long run. It removes the limitations suffered by the earlier method — profit maximisation.

Under this method, the net present value or wealth of a course of action is maximised. The net present value is the difference between the gross present value of the benefits of that action and the amount of investment required to achieve those benefits. On the other hand, the gross present value of the same is determined by discounting or capitalizing its benefits at a rate which reflects their timing and uncertainty.

The operational features of wealth maximisation satisfy all the three requirements of a suitable operational objective of financial courses of action. Let us discuss one by one. The value of an asset is best viewed in terms of the benefits it can produce. The worth of a course of action can be judged in terms of the value of benefits it produces less the cost of undertaking it.

The benefits of an investment or financing decision can be measured in terms of the stream of future expected case flows generated by the decisions, rather than the accounting profit which is the basis for the measurement of benefits in the case of profit maximisation criterion.

The next feature of the wealth maximisation criterion is that it recognises both the quantity and quality dimensions of benefits along with the time value of money. The value of a stream of future cash flows must consider not only the expected value of the flows, but also their degree of uncertainty.

Other things being equal, less uncertain flows are valued more highly than more uncertain flows. Besides, money has time value.

That is, the sum of money received in future is less valuable than it is today. In other words, necessary adjustment must be made in the cash flow pattern in order to incorporate the risk and also to make an allowance for differences in the timing of benefits.

Therefore, the value of a stream of cash flows can be calculated by discounting its elements back to the present at a capitalisation rate that reflects both time and risk.

The capitalisation /discount rate is the rate which reflects both time and risk preferences of the owners of capital. Generally, capitalisation rate is expressed in decimal notation, i.e., if the rate of discount is taken as 16%, the same will be recorded as 0.16 (16/100) Capitalisation rate will be higher if the risk is greater and the period is longer.

It is quite clear that net present value maximisation is, no doubt, superior than the profit maximisation criterion as an operational objective. The value maximisation decision crite­rion involves a comparison of value to cost. An action that has a discounted value, reflecting both time and risk, that exceeds its cost can be said to create value.

Such actions should be undertaken. Conversely, actions with values less than cost reduce the value of the firm and should be rejected. In the case of mutually exclusive alternatives, when only one is to be chosen, the alternative with the greatest net present value should be selected.

According to E. Solomon’s symbols and methods, the net present worth can be ascer­tained as under:

From the above, it becomes crystal clear that value maximisation decision criterion recognises the time value of money and also tackles the risk which is ascertained by the uncertainty of the expected benefits. Moreover, it is a very precise and unambiguous concept and is, therefore, considered as an appropriate and operationally feasible decision criterion.

That is why it is rightly said that maximisation of wealth is more useful than maximisation of profit as a statement of the objective of most business firms. It properly points out that the profit factor should be considered from a long-term point of view. At the same time, it balances this single factor with related goals, such as, growth, stability, risk avoidance and the market price of the firm’s stock.

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Essay # 4. Goals of Financial Management:

There are a number of classifications which can be used to define the specified goals of financial management.

(i) Profit-Risk Approach to Financial Goals and

(ii) Liquidity-Profitability Approach to Financial Goals.

(i) Profit-Risk Approach to Financial Goals:

Under this approach, in order to maximise profits at a given level of risk, finance deals with creating the proper framework. For this purpose, the firm must develop controls over flows of funds which allows sufficient flexibility to respond to change in the operating environment.

This approach, however, recognises the following:

(a) Maximise Profits:

Generally, finance strives for a high level of long-term profit and, at the same time, a short-term profit.

(b) Minimise Risk:

Finance seeks a course of action which avoids unnecessary risk and anticipates problem areas and ways of overcoming difficulties.

(c) Maintain Control:

Funds which are flowing in and out should always be monitored in order to assure that they are safeguarded and properly utilized.

(d) Achieve Flexibility:

We all know that a firm has to deal with an uncertain future. Flexibility can be maintained provided there is careful management of funds and activities. Where there is a sufficient source of funds in advance of needs, it is flexible when actual requirement is made.

Liquidity-Profitability Approach to Financial Goals:

There are two goals which are to be achieved by a financial manager, viz., liquidity and profitability. Liquidity means one’s ability to meet claims and obligations as and when they become due. In other words, the firm can pay all its bills as soon as they become due and have sufficient cash to take anticipated discounts for cash purchases along with a reserve in order to meet certain contingencies.

On the other hand, profitability of a firm is represented by the rate of return on its capital employed (which is measured by Net Profit to Capita Employed). It requires the firm’s operation to yield a long-term profit for shareholders as part of the overall goal of maximising the present value of common stock.

However, the above two classifications are to some extent similar and overlapping. Under the former, an element in minimising risk is the achieving of liquidity, whereas, under the latter, achieving liquidity requires the maximisation of risks. Therefore, the financial manager must understand the firm’s goal and the goals of the finance function.

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Essay # 5. Responsibilities of the Financial Management in the Firm:

An efficient and sound organisation must be set up for the finance functions as the financial decision of a firm is very important. As we know, the top management (viz. Treasure, Controller etc.) is absolutely liable to carry out the decision taken for finance functions.

For this purpose a separate department may be introduced under the direct control of the board of directors to control and organise the financial activities of the firm. At the same time, such department may be headed either by a committee or an official who will consider the financial policy matter and other routine activities may be assigned to others.

Practically, the following reasons advocate why the finance functions should be handed over to the top management:

(i) It is the pivot for a firm. Survival and development of a firm depend on it.

(ii) Liquidity and Solvency position are largely affected by it.

(iii) Financial Functions should always be centralised which result in economise and

(iv) Financing current account is also affected by it.

Needless to mention that the organisation structure differs from firm to firm. It depends on many factors; viz., size, types, nature, types of financial operation, financial employees/ officers, financial health of the firm.

Similarly, the designation also differs from firm to firm, some are called financial controller, some are called financial manager or vice president for finance or director of finance etc. In our country, two other officers are usually appointed under the control of the above personnel — they are Treasurer and Controller.

The functions and duties of the treasurer and controller are noted below:

Treasurer:

i. Securing finance (both long and short-time)

ii. Banking and Custody

iii. Cash management

iv. Collection of credit

v. Investment

vi. Contact with investment community

Controller:

i. Financial accounting and control

ii. Management accounting and control

iii. Taxation

iv. Reporting and Interpreting

v. Economic appraisal

vi. Reporting to Government  

In India, a financial manager, in order to perform his duties effectively and efficiently, must be acquainted with the following:

(i) Capital structure restrictions;

(ii) Control of credit by commercial banks;

(iii) Restrictions /control on investment opportunities;

(iv) Fewer instrument of financing;

(v) Underdeveloped Securities market;

(vi) Uncertainty in the supply of inputs;

(vii) Bureaucratic delays and complexities while getting various approvals.

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