BBA 4th SEMESTER- FINANCIAL MANAGEMENT

Unit I Nature of Financial Management- Notes 1

Topics included:

1. Introduction, meaning, definition of Financial Management

2. Nature of Financial Management
3. Approaches to finance function
4. Financial Decisions/ Finance Function
5. Objectives of Financial Management
6. Scope of Financial Management
7. Relationship of Finance with other disciplines
8. Organisation of Finance Function
9. Responsibilities of Finance Manager and New Role of Finance Manager
10. Importance of Financial Management
Introduction:

Finance is the lifeblood of any business. However, finances, like most other resources,
are always limited. On the other hand, wants are always unlimited. Therefore, it is
important for a business to manage its finances efficiently.

Financial management refers to the strategic planning, organising, directing, and

controlling of financial undertakings in an organisation or an institute. It also
includes applying management principles to the financial assets of an
organisation, while also playing an important part in fiscal management.

Some Definitions

“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
NATURE OF FINANCIAL MANAGEMENT
APPROACHES TO FINANCE FUNCTION

A number of approaches are associated with finance function but for the sake of
convenience, various approaches are divided into two broad categories:

1. The Traditional Approach

2. The Modern Approach

1. The Traditional Approach:

The traditional approach to the finance function relates to the initial stages of its
evolution during 1920s and 1930s when the term ‘corporation finance’ was used to
describe what is known in the academic world today as the ‘financial
management’. According to this approach, the scope, of finance function was
confined to only procurement of funds needed by a business on most suitable
terms.

The utilisation of funds was considered beyond the purview of finance function. It
was felt that decisions regarding the application of funds are taken somewhere else
in the organisation. However, institutions and instruments for raising funds were
considered to be a part of finance function.

The scope of the finance function, thus, revolved around the study of rapidly
growing capital market institutions, instruments and practices involved in raising
of external funds.

The traditional approach to the scope and functions of finance has now been
discarded as it suffers from many serious limitations:

(i) It is outsider-looking in approach that completely ignores internal decision

making as to the proper utilisation of funds.
(ii) The focus of traditional approach was on procurement of long-term funds.
Thus, it ignored the important issue of working capital finance and management.

(iii) The issue of allocation of funds, which is so important today, is completely

ignored.

(iv) It does not lay focus on day to day financial problems of an organisation.

2. The Modern Approach:

The modern approach views finance function in broader sense. It includes both
rising of funds as well as their effective utilisation under the purview of finance.
The finance function does not stop only by finding out sources of raising enough
funds; their proper utilisation is also to be considered. The cost of raising funds and
the returns from their use should be compared.

The funds raised should be able to give more returns than the costs involved in
procuring them. The utilisation of funds requires decision making. Finance has to
be considered as an integral part of overall management. So finance functions,
according to this approach, covers financial planning, rising of funds, allocation of
funds, financial control etc.

The new approach is an analytical way of dealing with financial problems of a

firm. The techniques of models, mathematical programming, simulations and
financial engineering are used in financial management to solve complex problems
of present day finance.

The modern approach considers the three basic management decisions, i.e.,
investment decisions, financing decisions and dividend decisions within the scope
of finance function.
Financial Decisions/ Finance Function

Financial Decisions relates to the financial matters of a corporate entity.

Finance function is the most important function of a business. Finance is, closely,
connected with production, marketing and other activities. In the absence of
finance, all these activities come to a halt. In fact, only with finance, a business
activity can be commenced, continued and expanded. Finance exists everywhere,
be it production, marketing, human resource development or undertaking research
activity. Understanding the universality and importance of finance, finance
manager is associated, in modern business, in all activities as no activity can exist
without funds. All decisions mostly involve finance. When a decision involves
finance, it is a financial decision in a business firm. In all the following financial
areas of decision-making, the role of finance manager is vital.

There are three types of financial decisions. The types are: 1. Investment
decisions 2. Financing decisions 3. Dividend decisions.
Type # 1. Investment Decisions:
Investment Decision relates to the determination of total amount of assets to be
held in the firm, the composition of these assets and the business risk complexions
of the firm as perceived by its investors. It is the most important financial decision.
Since funds involve cost and are available in a limited quantity, its proper
utilisation is very necessary to achieve the goal of wealth maximisation.

The investment decisions can be classified under two broad groups:

i) Long-term investment decision and

(ii) Short-term investment decision.

The long-term investment decision is referred to as the capital budgeting and the
short-term investment decision as working capital management.

Capital budgeting is the process of making investment decisions in capital

expenditure. These are expenditures, the benefits of which are expected to be
received over a long period of time exceeding one year. The finance manager has
to assess the profitability of various projects before committing the funds.

The investment proposals should be evaluated in terms of expected profitability,

costs involved and the risks associated with the projects.

The investment decision is important not only for the setting up of new units but
also for the expansion of present units, replacement of permanent assets, research
and development project costs, and reallocation of funds, in case, investments
made earlier do not fetch result as anticipated earlier.

Short-term investment decision, on the other hand, relates to the allocation of funds
as among cash and equivalents, receivables and inventories. Such a decision is
influenced by tradeoff between liquidity and profitability.

The reason is that, the more liquid the asset, the less it is likely to yield and the
more profitable an asset, the more illiquid it is. A sound short-term investment
decision or working capital management policy is one which ensures higher
profitability, proper liquidity and sound structural health of the organisation.

Type # 2. Financing Decisions:

Once the firm has taken the investment decision and committed itself to new
investment, it must decide the best means of financing these commitments. Since,
firms regularly make new investments; the needs for financing and financial
decisions are ongoing.

Hence, a firm will be continuously planning for new financial needs. The financing
decision is not only concerned with how best to finance new assets, but also
concerned with the best overall mix of financing for the firm.

A finance manager has to select such sources of funds which will make optimum
capital structure. The important thing to be decided here is the proportion of
various sources in the overall capital mix of the firm. The debt-equity ratio should
be fixed in such a way that it helps in maximising the profitability of the concern.

The raising of more debts will involve fixed interest liability and dependence upon
outsiders. It may help in increasing the return on equity but will also enhance the
risk.

The raising of funds through equity will bring permanent funds to the business but
the shareholders will expect higher rates of earnings. The financial manager has to
strike a balance between various sources so that the overall profitability of the
concern improves.

If the capital structure is able to minimise the risk and raise the profitability then
the market prices of the shares will go up maximising the wealth of shareholders.

Type # 3. Dividend Decision:

The third major financial decision relates to the disbursement of profits back to
investors who supplied capital to the firm. The term dividend refers to that part of
profits of a company which is distributed by it among its shareholders.
It is the reward of shareholders for investments made by them in the share capital
of the company. The dividend decision is concerned with the quantum of profits to
be distributed among shareholders.

A decision has to be taken whether all the profits are to be distributed, to retain all
the profits in business or to keep a part of profits in the business and distribute
others among shareholders. The higher rate of dividend may raise the market price
of shares and thus, maximise the wealth of shareholders. The firm should also
consider the question of dividend stability, stock dividend (bonus shares) and cash
dividend.
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