3 Main Approaches to Financial Management | Management

The following points highlight the three main approaches to financial management. The approaches are: 1. Traditional View 2. Modern View 3. Liquidity and Profitability.

Approach # 1. Traditional View:

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 firm and investing those funds in profitable ventures that will maximize firm’s wealth, as well as, yielding returns to the business concern.

The success or failure of any firm is mainly linked with the quality of financial decisions. The focus of Financial management is on efficient and judicious use of resources to attain the desired objective of the firm.

The basic objectives of Financial management centres around (a) the procurement funds from various sources like equity share capital, preference share capital, debentures, term loans, working capital finance, and (b) effective utilization of funds to maximize the profitability of the firm and the wealth of its owners.

The responsibilities of the Finance managers are linked to the goals of ensuring liquidity, profitability or both and are also related to the management of assets and funds of any business enterprise.

The traditional view of financial management looks into the following functions, that a Finance manager of a business firm will perform:

(a) Arrangement of short term and long-term funds from financial institutions.

(b) Mobilization of funds through financial instruments like equity shares, preference shares, debentures, bonds etc.

(c) Orientation of finance function with the accounting function and compliance of legal provisions relating to funds procurement, use and distribution.

With the increase in complexity of modern business situation, the role of a Finance manager is not just confined to procurement of funds, but his area of functioning is extended to judicious and efficient use of funds available to the firm, keeping in view the objectives of the firm and expectations of the providers of funds.

Approach # 2. Modern View:

The globalization and liberalization of world economy has caused to bring a tremendous reforms in financial sector which aims at promoting diversified, efficient and competitive financial system in the country. The financial reforms coupled with diffusion of information technology has caused to increase competition, mergers, takeovers, cost management, quality improvement, financial discipline etc.

Globalization has caused to integrate the national economy with the world economy and it has created a new financial environment which brings new opportunities and challenges to the individual business concern. This has led to total reformation of the finance function and its responsibilities in the organization.

Financial management in India has changed substantially in scope and complexity in view of recent Government policy. Today’s Finance managers are seized with problems of financial distress and are trying to overcome it by innovative means. In the current economic scenario, financial management has assumed much greater significance.

It is now a question of survival of entities in the total spectrum of economic activity, with pragmatic readjustment of financial management. The information age has given a fresh perspective on the role of financial management and Finance managers. With the shift in paradigm it is imperative that the role of Chief Finance Officer (CFO) changes from Controller to a Facilitator.

In view of modern approach, the Finance manager is expected to analyse the firm and to determine the following:

(i) The total funds requirement of the firm,

(ii) The assets to be acquired, and

(iii) The pattern of financing the assets.

The Finance manager of a modern business firm will generally involve in the following three types of decisions:

(1) Investment decisions,

(2) Finance decisions, and

(3) Dividend decisions.

(1) Investment Decisions:

Investment decisions are those which determine how scarce resources in terms of funds available are committed to projects. The project may be as small as purchase of equipment or as big as acquisition of an entity.

Investment in fixed assets requires supporting investment in working capital in the form of inventory, receivables, cash etc. Investment which enhance internal growth is termed as ‘internal investment’ and acquisition of entities represents ‘external investment’.

The investment decisions should aim at investment in assets only when they are expected to earn a return greater than a minimum acceptable return, which is also called as ‘hurdle rate’. The minimum return should reflect whether the money raised from debt or equity meets the returns on investments made elsewhere on similar investments.

The hurdle rate has to be set at higher for riskier projects and has to reflect the financing mix used i.e., the proportion of debt and equity. The Finance function involves not only in investment decisions, but also in disinvestment decisions, for example withdrawing from unsuccessful projects or restructuring with a strategic motive.

Investment decisions relate to the careful selection of viable and profitable investment proposals, allocation of funds to the investment proposals with a view to obtain net present value of the future earnings of the company and to maximize its value.

It is the function of a Finance manager to carefully analyze the different alternatives of investment, determination of investment levels in different assets i.e., fixed assets and current assets.

The investment decisions of a Finance manager cover the following areas:

(a) Ascertainment of total volume of funds, a firm can commit.

(b) Appraisal and selection of capital investment proposals.

(c) Measurement of risk and uncertainty in the investment proposals.

(d) Prioritizing of investment decisions.

(e) Funds allocation and its rationing.

(f) Determination of fixed assets to be acquired.

(g) Determination of levels of investments in current assets viz., inventory, receivables, cash, marketable securities etc., and its management.

(h) Buy or lease decisions.

(i) Asset replacement decisions.

(j) Restructuring, reorganization, mergers and acquisitions.

(k) Securities analysis and portfolio management etc.

(2) Finance Decisions:

The financing objective asserts that the mix of debt and equity chosen to finance investments should maximize the value of investments made. The debt equity mix should minimize the hurdle rate allows the firm to take more new investments and increase the value of existing investments.

Financing decisions relate to acquiring the optimum finance to meet financial objectives and seeing that working capital is effectively managed. Financing decisions call for good knowledge of costs of raising finance, procedures in hedging risk, different financial instruments and obligations attached to them etc. Important principle to consider in financing is that long-term assets should be financed with long-term debt and short-term assets should be financed with short-term debt.

Firms that violate this basic rule do so at their own risk. It is one of the important functions of a Finance manager is procurement of funds for the firm’s investment proposals and its working capital requirements.

In fund raising decisions, he should keep in view the cost of funds from various sources, determination of debt-equity mix, the advantages and disadvantages of debt component in the capital mix, impact of taxation and depreciation in maximization of earnings per share to the equity holders, consideration of control and financial strain on the firm in determining level of gearing, impact of interest and inflation rates on the firm etc.

The Finance manager involved in the following finance decisions:

(a) Determination of degree or level of gearing.

(b) Determination of financing pattern of long-term funds requirement.

(c) Determination of financing pattern of medium and short-term funds requirement.

(d) Raising of funds through issue of financial instruments viz., equity shares, preference shares, debentures, bonds etc.

(e) Arrangement of funds from banks and financial institutions for long-term, medium-term and short-term needs.

(f) Arrangement of finance for working capital requirement.

(g) Consideration of interest burden on the firm.

(h) Consideration of debt level changes and its impact on firm’s bankruptcy.

(i) Taking advantage of interest and depreciation in reducing the tax liability of the firm.

(j) Consideration of various modes of improving the earnings per share and the market value of the share.

(k) Consideration of cost of capital of individual components and weighted average cost of capital to the firm.

(l) Analysis of impact of different levels of gearing on the firm and individual shareholder.

(m) Optimization of financing mix to improve return to the equity shareholders and maximiza­tion of wealth of the firm and value of the shareholders’ wealth.

(n) Portfolio management.

(o) Consideration of impact of over capitalization and under capitalization on the firm’s profitability.

(p) Consideration of foreign exchange risk exposure of the firm and decisions to hedge the risk.

(q) Study of impact of stock market and economic conditions of the country on modes of financing.

(r) Maintenance of balance between owners’ capital to outside capital.

(s) Maintenance of balance between long-term funds and short-term funds.

(t) Evaluation of alternative use of funds.

(u) Setting of budgets and review of performance for control action.

(v) Preparation of cash-flow and funds flow statements and analysis of performance through ratios to identify the problem areas and its correction, etc.

For financing decisions, the capital structure is broadly divided into:

(a) Equity, and

(b) Debt.

Equity:

The raising funds through issue of shares attract flotation costs. The shareholder expects the return in the form of dividends and capital appreciation of their investment reflected in the increase in stock market price.

The dividend payments are made only if the distributable profits are available with the company, after payment of interest charges and tax payments. Any further issue of shares by the existing companies may dilute the controlling interest.

The equity is considered as low risk but most expensive way of funding the company’s projects. The equity funds are not returnable except in the case of liquidation. However, the buy-back of shares is allowed under the provisions of the Companies Act, 1956.

The equity holders will participate in the policy decisions of the company. In company form of business, only legal personality exists, hence all decisions are carried through the agents who work for remuneration. Therefore, agency problems arise with the managers.

Debt:

The debt funds are raised in the form of debentures, bonds, term loans etc. The expectation of the providers of debt is obtain return in the form of interest payments which should commensurate with the risk attached to their investment. The debt is repaid as per the agreement. The interest should be paid irrespective of the profitability of the firm.

The portion of debt component in capital structure will facilitate the trading on equity Le. the interest on debt is payable at a fixed rate and if the firm’s return on capital employed is more than the interest payable, the excess return over fixed interest will be added to the profits available to equity providers.

But the high proportion of gearing i.e., excess reliance on debt funds will increase the financial risk of the firm. The cost of debt is always lower than cost of equity, since any interest payable will reduce the tax liability of the firm. The non-repayment of interest and principal amounts in time may sometimes call for liquidation of the company.

(3) Dividend Decisions:

Dividend decisions concerned with the determination of quantum of profits to be distributed to the owners and the frequency of such payments. The dividend decisions will effect in two ways (a) the amount to be paid out and its influence on share price, and (b) the amount of profit to be retained for internal investment which maximizes the value of firm and ultimately improves the share value of the firm.

The level and regular growth of dividends represent a significant factor in determining a profit-making company’s market value and the value of its shares in the stock market. The dividend decisions of a Finance manager is mainly concerned with the decisions relating to the distribution of earnings of the firm among its equity holders and the amounts to be retained by the firm.

The Finance manager will involve in taking the following dividend decisions:

(a) Determination of dividend and retention policies of the firm.

(b) Consideration of impact of levels of dividend and retention of earnings on the market value of the share and the future earnings of the company.

(c) Consideration of possible requirement of funds by the firm for expansion and diversification proposals for financing existing business requirements.

(d) Reconsideration of distribution and retentions policies in boom and recession periods.

(e) Considering the impact of legal and cash-flow constraints on dividend decisions.

The investment, finance and dividend decisions are interrelated to each other and, therefore, the Finance manager while taking any decision, should consider the impact from all the three angles simultaneously.

In the words of Ezra Solomon “the function of Financial management is to review and control decision to commit and recommit funds to new and on going uses. Thus in addition to raising funds, Financial management is directly concerned with production, marketing and other, functions within an enterprise whatever decisions are made about the acquisition or distribution of assets”.

This statement will reflect the modern view of financial management. From the point of view of modern corporate firm, financial management is related not only to fund raising but encompasses the wider perspective of managing the finances for the company efficiently. Hence, Financial management is nothing but managerial decision making on asset mix, capital mix and profit allocation.

The corporate finance theory centres around three important objectives of a finance function:

(a) Allocation of funds i.e. investment decisions,

(b) Generation of funds i.e. financing decisions, and

(c) Distribution of funds i.e., dividend decisions.

The guiding factors for the above said finance decisions are as follows:

(i) The wealth maximization objective of firm, and

(ii) The existence of efficient capital markets.

The whole subject of financial management is based on following tenets:

(a) The owners will have primary interest in the firm’s success and growth.

(b) The shareholder’s wealth is the determinant of current share price.

(c) The firm will go on spending on capital investment proposals so long as it generates positive net present values.

(d) The firm’s capital structure and dividend decisions are irrelevant, since they are guided by the management control over firm and also depends on the efficiency of capital market.

Interrelationship of Investment, Financing and Dividend Decisions:

The corporate finance theory has broadly categorized the financial decisions into investment, financing and dividend decisions. All these financial decisions aims at the maximization of shareholders’ wealth through maximization of firm’s wealth.

i. Investment Decisions:

The firm should select only those capital investment proposals whose net present value is positive and the rate of return on the projects should exceed the marginal cost of capital. In situations of capital rationing, the investment proposals are selected based on maximization of net present value. The profitability of each individual project will contribute to the overall profitability of the firm and leads to creation of wealth.

ii. Financing Decisions:

The financing of capital investment proposals are done in two forms of finances in general i.e., equity and debt. The finance decisions should consider the cost of finance available in different forms and the risks attached to it. The reduction in cost of capital of each component would lead to reduction in overall weighted average cost of capital.

The principle of trading on equity should be kept in view while selecting the debt-equity mix or capital structure decisions. The relative advantages and risk attached to debt financing and equity financing should also be considered. The lower cost of capital and minimization of risks in financing will lead to the profitability of the organization and create wealth to the owners.

iii. Dividend Decisions:

The dividend distribution policies and retention of profits will have ultimate effect on the firms wealth. The company should retain its profits in the form of reserves for financing its future growth and expansion schemes. The conservative dividend payments will adversely affect the firms’ share prices in the market. Therefore, an optimal dividend distribution policy will lead to the maximization of shareholders’ wealth.

In conclusion, it is viewed that the basic aim of the investment, financing and dividend decisions is 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 maximizes the shareholders wealth.

Approach # 3. Liquidity and Profitability:

Ezra Solomon states that “liquidity measures a company’s ability to meet expected as well as unexpected requirements of cash to expand its assets, reduce its liabilities and cover up any operating losses.”

The balancing of liquidity and profitability is one of the prime objectives of a Finance manager. One of the important problems faced by Finance manager is the dilemma of liquidity vs. profitability. Liquidity ensures the ability of the firm to honour its short-term commitments.

The liquidity means the firm’s ability to pay trade creditors as and when due, ability to honour its bills payable on due-dates, ability to pay salaries and wages on time when it is due, ability to meet unexpected expenses etc. It also reflects the firm’s ability to convert its assets into cash, cash equivalents and other most liquid assets.

The liquidity of the firm indicates the ability of the organization to realize value in money, and its ability to pay in cash the obligations that are due for payment. To maintain concern’s liquidity, the Finance manager is expected to manage all its current assets and liquid assets in such a way as to ensure its affectivity with a view to minimize its costs. Under profitability objective, the Finance manager has to utilize the funds in such a manner as to ensure the highest return.

Profitability concept signifies the operational efficiency of an organization by value addition through the utilization of resources i.e., men, materials, money and machines. It refers to a situation in terms of efficiency in utilization of resources to achieve profit maximization for the owners.

There is an inverse relationship between profitability and liquidity. The higher the liquidity the lower will be the profitability and vice versa. Liquidity and profitability are competing goals for the Finance manager. Under liquidity management, the Finance manager is expected to manage all its current assets including near cash assets in such a way as to ensure its affectivity with a view to minimize costs.

Sometimes, even if the profit from operations is higher, the firm may face liquidity problems due to the fact that the amount representing the profit may be in the form of either in fixed assets like plant, buildings etc. or in the form of current assets like inventory, debtors – other than in the form of cash and bank balances. In situations where the firm faces the liquidity problems, will hamper the working of the company which result in lower profitability of the firm.

If, more assets of the firm are held in the form of highly liquid assets it will reduce the profitability of the firm. Lack of liquidity may lead to lower rate of return, loss of business opportunities etc.

Therefore, a firm should maintain a trade-off situation where the firm maintains its optimum liquidity for greater profitability and the Finance manager has to strike a balance between these two conflicting objectives. If, more assets of the firm are held in the form of highly liquid assets, it will reduce the profitability of the firm.