Chapter One

An Overview of Financial Management

1.1. The nature of financial management

Definition of financial management

The phrase financial management comprises to words finance and management. Finance is
the life blood of business organization. Finance is the art and science of managing money.
Finance includes financial services and institutions. Finance also referred to as provision money
as needed.

Solomon: Financial management is concerned with the efficient use of an important economic
resource namely, capital funds.

S.C. Kuchal: Financial Management deals with procurement of funds and their effective utilization in
the business”.

Howard and Upton : Financial management “as an application of general managerial principles to
the area of financial decision-making.

Weston and Brigham : Financial management “is an area of financial decision-making, harmonizing
individual motives and enterprise goals”.

Financial Management as practiced by business firms can be called as Corporation Finance or

Business Finance.

1.2. Scope of Financial Management

Financial management helps a particular organisation to utilise their finances most profitably. This is
achieved via the following two conducts. The scope of financial management is divided into two
categories: Traditional Approach and Modern Approach

Traditional Approach

According to this approach, the scope of financial function is restricted to procurement of funds by the
corporate organizations to meet their financial needs. The term procurement here refers to raising of
funds externally as well as the interdependent aspects of raising funds.

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The following three things are used for the procurement of finance: Institutional source of finance,
Issuance of financial instruments to collect necessary funds from the capital market and Legal and
accounting relationship between the business and the source of finance.

Modern approach

The main components of financial management include financial planning, evaluation of alternative
use of funds, capital budgeting, determination of cost of capital, determination of the financial
standard for the success of the business, management of income, etc.

Therefore, according to this approach, three important decisions are taken by the finance
manager. The three decisions are: Investment decision financing decision, and dividend
decision

Investment Decision: This decision is related to the selection of assets in which funds will be
invested by the firms. The asset that is acquired by a firm may be a long term asset or short term
asset. The decision taken to invest the funds in long term assets is known as capital budgeting
decision. Hence, capital budgeting is the process of selecting assets or an investment proposal that
yields return for a long term. The decision taken to invest the funds in short term assets or current
assets is known as working capital management. The working capital management deals with the
management of current assets that are highly liquid in nature.

Financing Decision

This scope of financial management indicates the possible sources of raising finances from
various resources. They are of 2 different types – Financial planning decisions attempt to
estimate the sources and possible application of accumulated funds. A proper financial
planning decision is crucial to ensure the availability of funds whenever required. Capital
structure decisions involve identifying various sources of funds. It facilitates the selection of
the best external sources for short or long-term financial requirements. The financing
decision is related to the procurement of funds required at the right time. After the decision
related to the fund requirement is made then the financial manager has to select the various
options for financing and select the best and cost effective method for financing so that the
business runs smoothly without any unnecessary obstacles such as inadequate funds.

Dividend Decision: It involves decisions taken with regards to net profit distribution. It is
divided into two categories – Dividend for the shareholders. Retained profits (usually
depends on a particular company’s expansion and diversification plans).The dividend

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decision is concerned with determining the percentage of profit earned to be paid to the
shareholders as dividend. Here the financial manager makes the decision regarding how
much dividend is to be paid out or how much to retain as retained earnings.

1.3. FINANCIAL MARKETS

Financial markets are markets on which financial instrument are traded. People and
organizations wanting to borrow money are brought together with those having surplus funds
in the financial markets.

Types of Markets

Different financial markets serve different types of customers or different parts of the
country. Financial markets also vary depending on the maturity of the securities being traded
and the types of assets used to back the securities. For these reasons it is often useful to
classify markets along the following dimensions:

1. Physical asset versus financial asset markets: Physical asset markets (also called
“tangible” or “real” asset markets) are those for products such as wheat, autos, real estate,
computers, and machinery. Financial asset markets, on the other hand, deal with stocks,
bonds, notes, mortgages, and other claims on real assets, as well as with derivative
securities whose values are derived from changes in the prices of other assets.
2. Spot versus futures markets: Spot markets are markets in which assets are bought or
sold for “on-the-spot” delivery (literally, within a few days). Futures markets are
markets in which participants agree today to buy or sell an asset at some future date.
3. Money versus capital markets: Money markets are the markets for short-term,
highly liquid debt securities. The New York, London, and Tokyo money markets are
among the world’s largest. Capital markets are the markets for
intermediate- or long-term debt and corporate stocks. There is no hard and fast rule on
this, but when describing debt markets, “short term” generally means less than 1 year,
“intermediate term” means 1 to 10 years, and “long term” means more than
10 years
4. Primary versus secondary markets: Primary markets are the markets in which
corporations raise new capital. The corporation selling the newly created stock receives
the proceeds from the sale in a primary market transaction. Secondary markets are
markets in which existing, already outstanding, securities are traded among investors.

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5. Private versus public market: Private market markets in which transactions are worked
out directly between two parties. Public Markets in which standardized contracts are
traded on organized exchanges.
1.4. Financial institutions

A financial institution is one that facilitates allocation of financial resources from its source to
potential users. It is any institution that collects money and puts it into assets such as stocks,
bonds, bank deposits, or loans is considered a financial institution. Financial institution is
responsible for the supply of money to the market through the transfer of funds from
investors to the companies in the form of loans, deposits, and investments. There are three
ways of capital transfer from savers to investors;

1.5. Objectives of Financial Management

Objectives of Financial Management may be broadly divided into two parts such as:

 Profit maximization
 Wealth maximization

Profit Maximization

Main aim of any kind of economic activity is earning profit. A business concern is also functioning
mainly for the purpose of earning profit. Profit is the measuring techniques to understand the business
efficiency of the concern. Profit maximization is also the traditional and narrow approach, which aims
at, maximizes the profit of the concern.

Unfavourable Arguments for Profit Maximization

The following important points are against the objectives of profit maximization:

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 (i) Profit maximization leads to exploiting workers and consumers.
(ii)Profit maximization creates immoral practices such as corrupt practice, unfair trade practice,
etc.
(iii) Profit maximization objectives leads to inequalities among the stake holders such as
customers, suppliers, public shareholders, etc.

Drawbacks of Profit Maximization: Profit maximization objective consists of certain drawback

also:

(i) It is vague: In this objective, profit is not defined precisely or correctly. It creates some
unnecessary opinion regarding earning habits of the business concern.
(ii) It ignores the time value of money: Profit maximization does not consider the time value of
money or the net present value of the cash inflow. It leads certain differences between the
actual cash inflow and net present cash flow during a particular period.
(iii) It ignores risk: Profit maximization does not consider risk of the business concern. Risks
may be internal or external which will affect the overall operation of the business concern.

Wealth Maximization

Wealth maximization is one of the modern approaches, which involves latest innovations and
improvements in the field of the business concern. The term wealth means shareholder wealth or the
wealth of the persons those who are involved in the business concern.

Wealth maximization is also known as value maximization or net present worth maximization. This
objective is universally accepted concept in the field of business.

1.6. Forms of business organizations

There are three basic forms of business organizations;
a. Sole Proprietorship

The vast majority of small businesses start out as sole proprietorships. These firms are
owned by one person, usually the individual who has day-to-day responsibility for running
the business. Sole proprietorships own all the assets of the business and the profits generated
by it. They also assume complete responsibility for any of its liabilities or debts. In the eyes
of the law and the public, you are one in the same with the business.

Advantages of a Sole Proprietorship

 Easiest and least expensive form of ownership to organize.

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  Sole proprietors are in complete control, and within the parameters of the law, may
make decisions as they see fit.
 Profits from the business flow-through directly to the owner’s personal tax return.
 The business is easy to dissolve, if desired.

Disadvantages of a Sole Proprietorship

o Sole proprietors have unlimited liability and are legally responsible for all debts
against the business. Their business and personal assets are at risk.
o May be at a disadvantage in raising funds and are often limited to using funds from
personal savings or consumer loans.
o May have a hard time attracting high-caliber employees, or those that are motivated
by the opportunity to own a part of the business.
o Some employee benefits such as owner’s medical insurance premiums are not directly
deductible from business income (only partially as an adjustment to income).
b. Partnerships

In a Partnership, two or more people share ownership of a single business. Like

proprietorships, the law does not distinguish between the business and its owners. The
Partners should have a legal agreement that sets forth how decisions will be made, profits will
be shared, disputes will be resolved, how future partners will be admitted to the partnership,
how partners can be bought out, or what steps will be taken to dissolve the partnership when
needed.

Advantages of a Partnership
 Partnerships are relatively easy to establish; however time should be invested in
developing the partnership agreement.
 With more than one owner, the ability to raise funds may be increased.
 The profits from the business flow directly through to the partners’ personal tax return.
 Prospective employees may be attracted to the business if given the incentive to become
a partner.
 The business usually will benefit from partners who have complementary skills.
Disadvantages of a Partnership
 Partners are jointly and individually liable for the actions of the other partners.
 Profits must be shared with others.

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  Since decisions are shared, disagreements can occur.
 Some employee benefits are not deductible from business income on tax returns.
 The partnership may have a limited life; it may end upon the withdrawal or death of a
partner.
c. Corporations

A Corporation, chartered by the state in which it is headquartered, is considered by law to be

a unique entity, separate and apart from those who own it. A Corporation can be taxed; it can
be sued; it can enter into contractual agreements. The owners of a corporation are its
shareholders. The shareholders elect a board of directors to oversee the major policies and
decisions. The corporation has a life of its own and does not dissolve when ownership
changes.

Advantages of a Corporation

 Shareholders have limited liability for the corporation’s debts or judgments against the
corporation.
 Generally, shareholders can only be held accountable for their investment in stock of the
company. (Note however, that officers can be held personally liable for their actions,
such as the failure to withhold and pay employment taxes.
 Corporations can raise additional funds through the sale of stock.
 A Corporation may deduct the cost of benefits it provides to officers and employees.
 Can elect S Corporation status if certain requirements are met. This election enables
company to be taxed similar to a partnership.
Disadvantages of a Corporation

 The process of incorporation requires more time and money than other forms of
organization.
 Corporations are monitored by federal, state and some local agencies, and as a result may
have more paperwork to comply with regulations.
 Incorporating may result in higher overall taxes. Dividends paid to shareholders are not
deductible from business income; thus this income can be taxed twice.