1.1. Meaning of Financial Management
What is Finance?
Finance is a word that comes from the Latin word “finis”, which means “fine” or “end.” It was later used in French to mean “payment” and “ending.” Thus, finance means to complete or end a contract. It is also used in English to mean the management of money.
Finance can be defined as the “application of and optimal utilization of scarce resources.” It also refers to the process of managing a large amount of money to meet individual or organizational needs. Finance involves the processes of investment, lending, borrowing, saving, budgeting, spending, and forecasting.
Examples of finance include:
- Investing personal income in stocks, bonds, or other financial assets
- Borrowing money for personal or business use from a bank
- Lending money through mortgages or loans to individuals and businesses
- Creating a budget or financial model for a company or a government institution
- Saving personal income in interest-earning bank accounts
- Forecasting monetary needs of an organization and developing a budget for the same.
What is Financial Management?
Financial management is defined as the process of raising and allocating funds to the most productive end user so as to achieve the objectives of a business, an individual, or a government institution.
It also means the planning, organizing, controlling and directing of financial activities to ensure efficient utilization of resources in an organization. Financial managers apply the general principles of management to financial resource planning and control in an organization.
1.2. Nature and Scope of Financial Management
Financial management can be broken down into several types, elements or decision areas. These decision areas or types of financial management include:
- Investment Decisions/Capital Budgeting: investment decisions involve the allocation of financial resources to fixed assets. In this case, the role of the financial manager tries to identify investment opportunities that are worth more (benefits) than they cost to acquire. Capital budgeting is used to evaluate investment risks and returns to enable an organization to make the best financing or investment decisions, or to allocate money to viable investment projects.
- Working Capital Decisions: this involves the investment in current assets such as cash, inventory, and receivables. It involves making decisions on how to allocate financial resources to immediate needs of the company, such as operations and payments for daily transactions. It involves managing funds to support current operations and meet day-to-day financial obligations.
- Dividend Decisions: This has to do with financial decisions that relate to the distribution of profits to investors or owners of the company. Every year, a company has to make decisions on how much money to pay to shareholders as dividends. Net profit can be distributed in two ways: first as dividends to shareholders and secondly, as retained profits to be used in expansion and growth of the business.
- Capital Structure Decisions: Capital structure refers to the financial decisions made to determine how investments should be funded. When choosing the methods of raising funds, the company decides on various alternatives such as equity and loans. Capital structure refers to the ratio of debts to equity; how much debt is used to fund investments compared to equity. A company that utilizes more debts than equity means that they have a high leverage.
1.3. Importance of Financial Management
Financial management plays a critical role in promoting effective investment decisions and efficient operations in an organization. It allows managers to make appropriate decisions with regard to resource allocation to achieve organizational objectives. Financial managers are important in an organization because they make critical decisions on how funds should be spent in line with the organization’s strategic goals. They choose whether to invest in long term projects, pay dividends, fund daily operations, etc.
Objectives of Financial Management
- To ensure regular and adequate provision of funds for investment and operations
- To generate returns for shareholders by focusing on earnings, share prices and shareholder expectations
- To promote optimal allocation and utilization of resources within an organization – gaining maximum returns at the least cost.
- To ensure safe and viable investment decisions are made – achieving a good rate of returns on investment
- To ensure that the organization has the right mix of debt and equity in its capital structure
- To promote proper estimation of financial requirements by establishing financial needs and determining whether the organization has a shortage or surplus of funds.
- To ensure timely payment of financial obligations to creditors and lenders – being able to repay debts and promote financial commitment with lenders and creditors.
Functions of Financial Management
- Estimation of Capital Requirements: companies use financial management to estimate their capital requirements, based on their expected income and expenditure.
- Making capital structure decisions: Financial management is used to make decisions with regards to the short-term and long-term debts, equity, and other ways of funding investments. It helps a company to determine the proportion of equity and debt that is appropriate for their investment decisions.
- Choosing Sources of Funds: Financial management helps a company to choose appropriate sources of funds such as long term debts, shares, loans, or bonds.
- Investment of Funds: Financial management is also necessary to understand how firms make investment decisions; how to allocate funds to investment projects that give the best returns.
- Disposal of Funds: Sometimes a company may have surplus money. Financial management concepts will help them to determine the best ways of disposing them e.g. through dividend payment to shareholders or through retained earnings for future growth and expansion.
- Cash Management: Businesses also need to make appropriate decisions on how to utilize cash to ensure proper cash flows to manage operations, while at the same time ensuring that cash does not lie idle. Cash is used to pay wages, bills, and current liabilities. It is also needed for the maintenance of inventory and purchase of raw materials. Therefore, cash should be managed efficiently to ensure that the company does not run into shortage of funds or have too much surplus that could otherwise be used to generate more income.
- Financial Controls: Another function of financial management is to plan, acquire and utilize funds appropriately to meet the organization’s long term goals.
1.4. The role of financial management in production, marketing and finance
Knowledge of financial management can be used in planning, organizing, and controlling resources during the stage or production
Production department is concerned with the processes of turning inputs into finished products for sale. Financial managers work with the production department to manage costs and set prices appropriately.
Financial management is used to determine the costs of inputs and compare with the price of output, hence determining the pricing model of the company. Setting product prices and controlling costs helps a company to manage profits effectively.
Financial management is also used in marketing to control advertising costs and create budgets for marketing initiatives. An organization may need to launch marketing and advertising campaigns for creating brand awareness. Sometimes they want to outsmart the competition and emerge and gain top of mind awareness. At other times, organization looks to support the sales teams by generating more sales leads through its campaigns. Financial management helps managers to:
- Plan and acquire funds to implement marketing campaigns at the right time
- Keep marketing budgets for various marketing campaigns such as ads
- Analyze the financial feasibility of marketing campaigns.
- Prevent misuse of company’s resources through marketing activities
- Create sales forecast and estimate future financial needs of the marketing department
Financial management is also necessary to gain knowledge about an organization’s finance. Financial managers have a critical role in managing the overall financials of a company and ensure that the company’s financial health is good for current business operations and future growth.
Financial management is used in a finance department to monitor cash flows, determine profitability, and manage expenses. These activities are generally aimed at creating accurate financial information for to be used by management in decision making. For instance, finance departments can create cash flow statements and profit and loss accounts which show whether the company can be profitable to pursue future growth opportunities.
Financial management knowledge is also important for finance department because it enables financial managers to manage credit, establish investments, and manage financial risks and losses.
1.5. Relationship between financial management with other disciplines
Financial management is a multidisciplinary concept that can be applied in various disciplines such as production, marketing, and human resource management. The relationship between financial management and other disciplines can be explained as follows:
- Financial Management and Economics: Investment decisions, micro & macro environmental factors are closely associated with the functions of financial manager. Financial management also uses the economic equations like money value discount factor, economic order quantity etc. Financial economics is one of the emerging area, which provides immense opportunities to finance, and economical areas
- Financial Management and Accounting: Financial management and accounting are interrelated because financial management involves keeping accounting records including the financial information of the business concern.
- Financial Management and Production: Production department is concerned with the processes of turning inputs into finished products for sale. Financial managers work with the production department to manage costs and set prices appropriately. Financial management is used to determine the costs of inputs and compare with the price of output, hence determining the pricing model of the company. Setting product prices and controlling costs helps a company to manage profits effectively.
- Financial Management and Marketing: Financial management is also used in marketing to control advertising costs and create budgets for marketing initiatives. An organization may need to launch marketing and advertising campaigns for creating brand awareness. Sometimes they want to outsmart the competition and emerge and gain top of mind awareness
- Financial Management and Human Resources: Financial management is also related with human resource department, which provides manpower to all the functional areas of the management. Financial manager should carefully evaluate the requirement of manpower to each department and allocate the finance to the human resource department as wages, salary, remuneration, commission, bonus, pension & other monetary benefits to the human resource department. Hence, financial management is directly related with human resource management.
1.6. Financial Goal(s) of a firm
Businesses often exist to make profits and satisfy human needs, which the government is not able to provide. The mission statement of a firm highlights its core business, which means that a company pursues certain financial goals that are specific to their mission. However, most firms have the financial goal of maximizing shareholders’ wealth through sound financial decisions. This requires firms to promote efficiency, profitability, liquidity, and stability.
The major financial goals of a firm are:
- Profit Maximization
- Value Maximization
Microeconomic theory of the firm is founded on profit maximization as the principal decision criterion: markets managers of firms direct their efforts toward areas of attractive profit potential using market prices as their signals. Choices and actions that increase the firm’s profit are undertaken while those that decrease profits are avoided. To maximize profits the firm must maximize output for a given set of scarce resources, or equivalently, minimize the cost of producing a given output.
Applying Profit-Maximization Criterion in Financial Management
Financial management is concerned with the efficient use of one economic resource, namely, capital funds. The goal of profit maximization in many cases serves as the basic decision criterion for the financial manager but needs transformation before it can provide the financial manager with an operationally useful guideline.
As a benchmark to be aimed at in practice, profit maximization has at least four shortcomings: it does not take account of risk; it does not take account of time value of money; it is ambiguous and sometimes arbitrary in its measurement; and it does not incorporate the impact of non-quantifiable events.
- Uncertainty (Risk): The microeconomic theory of the firm assumes away the problem of uncertainty: When, as is normal, future profits are uncertain, the criteria of maximizing profits loses meaning as for it is no longer clear what is to be maximized. When faced with uncertainty (risk), most investors providing capital are risk averse. A good decision criterion must take into consideration such risk
- Timing: Another major shortcoming of simple profit maximization criterion is that it does not take into account of the fact that the timing of benefits expected from investments varies widely. Simply aggregating the cash flows over time and picking the alternative with the highest cash flows would be misleading because money has time value. This is the idea that since money can be put to work to earn a return, cash flows in early years of a project’s life are valued more highly than equivalent cash flows in later years. Therefore the profit maximization criterion must be adjusted to account for timing of cash flows and the time value of money.
- Subjectivity and ambiguity: A third difficulty with profit maximization concerns the subjectivity and ambiguity surrounding the measurement of the profit figure. The accounting profit is a function of many, some subjective, choices of accounting standards and methods with the result that profit figure produced from a given data base could vary widely.
- Qualitative information: Finally many events relevant to the firms may not be captured by the profit number. Such events include the death of a CEO, political development, and dividend policy changes. The profit figure is simply not responsive to events that affect the value of the investment in the firm. In contrast, the price of the firms share (which measures wealth of the shareholders of the company) will adjust rapidly to incorporate the likely impact of such events long before they are their effects are seen in profits.
Because of the reasons stated above, Value-maximization has replaced profit-maximization as the operational goal of the firm. By measuring benefits in terms of cash flows value maximization avoids much of the ambiguity of profits. By discounting cash flows over time using the concepts of compound interest, Value maximization takes account of both risk and the time value of money. By using the market price as a measure of value the value maximization criterion ensures that (in an efficient market) its metric is all encompassing of all relevant information qualitative and quantitative, micro and macro. Let us note here that value maximization is with respect to the interests of the providers of capital, who ultimately are the owners of the firm. – The maximization of owners’ wealth is the principal goal to be aimed at by the financial manager.
In many cases the wealth of owners will be represented by the market value of the firm’s shares – that is the reason why maximization of shareholders wealth has become synonymous with maximizing the price of the company’s stock. The market price of a firms stocks represent the judgment of all market participants as to the values of that firm – it takes into account present and expected future profits, the timing, duration and risk of these earnings, the dividend policy of the firm; and other factors that bear on the viability and health of the firm. Management must focus on creating value for shareholders. This requires Management to judge alternative investments, financing and assets management strategies in terms of their effects on shareholders’ value (share prices).
1.7. Ethical Challenges In Financial Management
Ethics is more than simply obeying laws; it involves doing the right thing as well as the legal thing. Financial managers are required to behave ethically to enhance fairness and equity in distribution of resources. There several ethical challenges that affect financial management in an organization:
- Conflict of Interest: managers are required to act in the best interest of their employers and clients – this is known as fiduciary duty – to ensure that financial resources are utilized efficiently to achieve business objectives and not for personal use.
- Security and Privacy: Managers also face ethical challenges related to security and privacy of consumers’ information. Security breach may lead to credit fraud and loss of financial resources. For example, a hacker may access personal information of a customer and use their details to steal their money.
- Corruption and Bribes: Some managers may accept bribes and engage in corrupt practices in financial management. For example, accountants may be given bribes to create false information about the company’s financial health for selfish reasons. This always leads to scandals and loss of reputation in an organization.
- Unfair/Unequal compensation: Another ethical challenge in financial management occurs when a company pays its employees different salaries based on sex, age, or race without consideration their job or qualifications.
- Dishonesty/Misrepresentation of Information: Misrepresentation of financial information is a serious ethical challenge. Some managers may try to provide false information about their financial performance to influence investment decisions.
To address these ethical challenges, companies need to develop ethical codes that specify the right conduct for all managers and employees. Some of the ethical behaviors and values that should be encouraged in financial management are:
- Honesty and integrity
- Avoiding conflicts of interest
- Serving the best interest of all stakeholders
- Providing accurate, objective, reliable, and relevant financial information
- Compliance with relevant laws and regulations
- Acting in good faith and making independent judgments
- Not sharing confidential information or using it for personal gain
- Maintaining internal control systems to safeguard ethical accounting practices
- Reporting incidences of unethical behavior or violations of the company’s code.