Scope and Objectives of

1 Financial Management
CHAPTER

THEORY
Meaning of Financial management is concerned with the efficient use of an important
Financial economic resource, namely capital funds .
Management In other words, financial management answers the following questions:
(a) Where to invest? i.e. Investment Decisions
(b) From where to raise funds? i.e. Financing Decision
(c) How much earning to be retained and how much to be distributed? i.e.
Dividend Decision
(d) How to manage working capital? i.e. Working Capital Management

Characteristics (a) Essential part of Business Management

of Financial (b) Continuous Administrative Function
Management (c) Scientific and Analytical
(d) Centralized Nature
(e) Different from Accounting Function

Functions (a) Procurement of funds: Funds can be obtained from different sources
of Financial like equity, debt, debentures, preference shares etc. The cost of funds
Management should be at the minimum level and for that a proper balancing of risk
and control factors must be carried out.
(b) Effective Utilization of Funds: The funds are to be invested in a
manner such that they generate returns higher than the cost of capital
to the firm.

Evolution (a) Traditional Phase: During this phase, financial management was
of Financial considered necessary only during occasional events such as takeovers,
Management mergers, expansion, liquidation, etc.
(b) Transitional Phase: During this phase, the day-to-day problems that
financial managers faced were given importance e.g. problems related
to funds analysis, planning etc.
(c) Modern Phase: Modern phase is still going on. The scope of financial
management has greatly increased now. It is important to carry out
financial analysis for a company. This analysis helps in decision making.
Importance It is a key to successful business. Its importance can be understood by the
of Financial tasks involved in it which are as follows:
Management (a) Preparing budget to provide appropriate targets to various departments
(b) Setting short term sales and cost targets for various departments
(c) Managing the cash flow needs of the organization
(d) Ensuring appropriate investment in fixed assets and working capital
(e) Ensuring correct pricing decisions for the products or services
(f) Tax planning to minimize tax burden of the organization

Objective (a) Profit Maximi ation: Based on this objective, the investment,
of Financial financing and dividend policy decisions of a firm should be oriented to
Management the maximization of profit. This objective leads to efficient allocation
of resources, as resources tend to be directed to uses which in terms of
profitability are most desirable.
Limitations of profit maximization:
(1) Ignores risk; (2) Ambiguity; (3) Ignores the time value of
money
(b) ealth Maximi ation: Wealth/Value maximisation means that the
primary goal of a firm should be to maximize its market value and
implies that business decisions should seek to increase the net present
value of the economic profits of the firm
i.e. wealth = Present value of benefits: present value of costs.

Superiority Basis ealth Maximi ation Profit Maximi ation

of Wealth
Maximi ation Over Cash Flows Consider all cash flows Don’t consider effect on EPS,
Profit Maximi ation and effect on EPS, dividend, etc.
dividend, etc.

Dividend Firms may pay regular Firms may refrain from

dividends to dividend payments
shareholders.

Preference by Shareholders prefer Shareholders may consider

shareholders increase in wealth increasing profit flow against
increase in wealth.

Ambiguity No ambiguity in Lot of ambiguity exists in

measurement of cash measurement of accounting
flows profit.

4 Financial Management PW
Financial (a) Investment Decision: It relates to the selection of assets in which
Management funds will be invested by a firm. Only that investment proposal is to
Decisions for be accepted which is expected to yield at least so much return as is
Achievement adequate to meet its cost of financing.
of Wealth (b) Financing Decision: The finance manager has to maintain a proper
Maximi ation balance between long-term (capital employed) and short-term funds
(working capital). The optimum financing mix will increase return to
equity shareholders and thus maximise their wealth.
(c) Dividend Decision: Finance Manager assists in deciding as to what
portion of the profit should be paid to the shareholders by way of
dividends and what portion should be retained in the business. An
optimal dividend pay-out ratio maximises shareholders’ wealth.

Inter-Relationship The decision to invest in a new project needs the finance for the investment.
between The financing decision, in turn, is influenced by and influences dividend
Investment, decision because retained earnings used in internal financing deprive
Financing and shareholders of their dividends. The optimal joint decision is possible by
Dividend Decisions evaluating each decision in relation to its effect on the shareholder’s wealth.

Risk-Return Trade ‰ In financial management, the risk is defined as the variability of

Off expected returns from an investment. Risk and Return go together. The
rate of return required by a firm, to a great extent, depends upon the
risk involved.
‰ A finance manager cannot avoid the risk altogether nor can make a
decision by considering the return aspect only. In order to maximise
the firm’s shares a balance must be maintained between risk and return
which is called Risk-Return Trade off.

Functions of (a) Estimating the requirement of funds

Finance Manager (b) Decision regarding capital structure
(c) Investment Decision
(d) Dividend Decision
(e) Evaluating financial performance
(f) Financial negotiation
(g) Cash Management

Role of Finance ‰ The traditional role of the finance manager was confined just to raising
Manager or Chief of funds from a number of sources.
inancial Officer ‰ The recent development in the socio-economic and political scenario
(CFO) throughout the world has placed him in a central position in the
business organization.
‰ He is now responsible for shaping the fortunes of the enterprise, and is
involved in the most vital decision of allocation of capital like merger,
acquisitions, strategic planning, risk management, pricing analysis,
profitability analysis etc.

Scope and Objectives of Financial Management 5

Agency Problem ‰ In modern organization, there is separation of ownership and
management.
‰ The management acts on behalf of owners and is their agents.
Consequently management should act in such a manner so as to
maximize wealth of their principals i.e. owners.
‰ However this may not happen because owners and management have
different interests.
‰ Due to these different interest and separation of management from
ownership, management may behave in a manner which is inconsistent
with the interest of owners. These behavioural problems on the part of
management lead to agency problems.
Agency Costs ‰ These are the costs that are directed to reduce the impact of agency
problems. These costs may be direct or indirect.
‰ Example of the direct agency costs are salary, bonuses and perks paid
to employees etc.
‰ There are also certain indirect agency costs, for example management
may not take certain risky projects with high returns.
Financial Distress ‰ There are various factors which needs to be managed on continuous
and Insolvency basis e.g. price of product, demand, price of inputs, proportion of debt
etc.
‰ If these are not managed properly than it may lead to financial distress
where cash inflows are inadequate to meet current obligations of firm.
‰ If financial distress continues for longer time, it may lead to sale assets
and may lead to insolvency situation where firm is not able to repay
various debts.

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