Financial Management & Cost Accounting

Module 1. Introduction to financial management

Lesson 1
INTRODUCTION TO FINANCIAL MANAGEMENT

1.1 Definition of Financial Management

Financial management may be defined as a managerial activity which is concerned with the planning and controlling of the financial resources of the firm. Some other definitions of financial management are

(a) Financial management deals with how the corporation obtains the funds (Financing decisions) and how it uses the funds (Investment decisions).

(b) Financial management is the application of planning and controlling function to finance function.

(c) Financial management is the area of the business management devoted to judicious use of capital and a careful selection of sources of capital in order to enable a business firm to move in the direction of reaching its goal.

1.2 Important Finance Functions

The main functions of financial management are:

(a) Investment decision

(b) Raising funds (Financing or capital decision)

(c) Distribution of returns earned from the assets to stakeholders (Dividend Decision)

(d) Liquidity decisions.

(a) Investment Decision (Long Term Asset Mix)

A firm raises funds in order to acquire long term assets. The acquisition of long term assets by a firm is called capital expenditure. Capital budgeting decisions are those decisions which involve capital expenditure. Capital budgeting decisions or capital expenditure decisions are most important for three reasons:

(a) Capital expenditure involves huge cash outlay

(b) Capital expenditure decisions are irreversible and if they are reversible they involve huge costs

(c) Capital expenditure decisions are long term in nature and can affect the firm for a long term

(b) Financing Decisions (Capital Mix Decisions)

In order to meet the investment needs of a firm, the finance managers need to search for sources of long term funds. The main sources of long term funds are:

(a) Equity capital, and

(b) Long term debts like long term loans or bonds, etc

While selecting the best sources of finance, it is important to select the optimum mix or composition of debt or equity which will maximize the value of the firm. The composition of various sources of long term capital of a firm is called the capital structure of the firm. Hence, the capital structure indicates the proportion of debt and equity in the firm. There are many benefits associated with the use of debt capital such as:

(a) Debt is a cheaper source of finance

(b) It may increase the returns of equity shareholders

But debt also carries a risk. It carries a fixed obligation to pay interest. Due to this a higher proportion of debt in the capital structure of the firm can increase the financial risk of the firm. In the event of failure to make sufficient profit, the firm may face the insolvency.

(c) Dividend Decision

In this decision, the finance manager has to take a decision regarding whether to distribute all the profit earned by the firm to its shareholders, or to distribute only a part of the profits or not distribute any profit at all. The proportion of profit distributed as dividend is called dividend payout ratio and the proportion which is retained by the firm is called retention ratio. The divided decisions are taken under the dividend policy of the firm. The dividend policy of the firm can also affect the market value of the firm’s equity shares. Hence, the finance manager has to select an optimum dividend policy, which maximizes the market value of the firm’s share.

(d) Liquidity Decisions

It deals with short term asset mix. Apart from the above discussed three decisions which are primarily of long term nature, the finance manager also has to manage the day to day working capital finance of a firm. The working capital of a firm is represented by the current assets and current liabilities of the firm. The finance manager has to ensure optimum liquidity for the firm and at the same time carry out the day-to-day financial activities of the firm. Hence, the finance manager has to manage the working capital. Working capital decisions are called short term asset mix or liquidity decisions. More liquidity would decrease the risk of the business, however it would also reduce the profit. Thus it is a liquidity-risk-return trade off decision.

1.3 Goal of Financial Management

Financial management is concerned with the raising of funds and efficient allocation of these funds. There activities are primarily contained in the financing, investing and dividend decisions of the firm. The firm’s financing, investing and dividend decisions are unavoidable and continuous. In order to make these decisions rationally, the firm must have a goal. The firm can take all its financial decisions rationally by adhering to this goal. Hence the goal should be theoretically logical and operationally feasible for guiding the financial decision making. Two goals are presented for financial management decision.

(a) Profit Maximization.

(b) Shareholder’s Wealth Maximization.

1.3.1 Profit maximization

It is argued that Profit maximization should be the goal of financial management because of the following reasons. Profit maximization is able to serve the society in an efficient manner. It is argued that the “price system” which is important part of a “market economy” indicates what goods /services the society wants. The goods or services which are required more by the society have high demand, this leads to higher prices of such goods. It further signals all the profit oriented firms to enter into the business or production of such highly demanded goods and services. As a result, the supply of these goods and services increases and subsequently the demand and supply matches. The price at this point is called the equilibrium price. In the same way goods which are not required by the society have lower demand and lower prices. Hence firms tend to move out of business of such low demand products. Thus, ‘price System’ directs all the managerial efforts towards more profitable goods and services.

Profit maximization implies that the firm either produce more output with the same level of inputs or use lees level of input for producing the same level of output. Hence, the resources of the society are efficiently utilised. In order to earn more profit, firms resort to profit maximization and hence make efficient use of the resources. They do so in order to achieve personal interests but in doing so, unknowingly they also serve the interest of the society. Hence, it is argued that ‘profit’ should be considered as the most appropriate measure of the firm’s performance.

Objections to Profit Maximization

There are a few serious objections raised against the goal of profit maximization.

(a) Profit maximization assumes the presence of perfect competition. But it may not be true in the modern markets which are imperfect and where oligopoly and monopoly are common phenomena.

(b) It is vague the precise meaning of profit is not clear. Whether it indicates Short term profit or long term profit? Profit before tax or profit after tax? Operating profit or net profit? Hence it is not clear as to which profit is to be maximized.

(c) It ignores time value of money: The profit maximization criteria may not be able to distinguish projects in which the pattern of cash flow is different i.e. it cannot differentiate between projects which generate cash flows in the earlier years and projects which generate cash flows in the later years. This is because profit maximization goal has no provision for considering the time value of money.

It ignores risk: It means that it ignores the ‘uncertainty ‘associated with the profit. The profit maximization criteria may rate two decisions or projects as same if both of them have same profit. But it is unable to distinguish the project whose profit is more certain.