Financial Management Meaning, Scope and Importance

Table of Contents:-

  • Objectives of Financial Management
  • Financial Management Meaning
  • Financial Management Definition
  • Meaning of Financial Management
  • Scope of Financial Management
  • Importance of Financial Management
  • Functions of Financial Management
  • Nature of Financial Management

Objectives of Financial Management

Financial management includes key objectives organizations follow to secure their financial stability and success. These objectives of financial management serve as guiding principles for effective decision making and resource allocation within the field of finance.

Financial management is a business function concerned with the sourcing and acquisition of funds and the proper utilisation of those financial resources for achieving maximum returns for the firm. Allocation of funds or capital is a very important task, as it involves deciding on the best alternative investment proposal out of many investment alternatives available, by using various analytical and scientific appraisal techniques.

For optimum utilisation of financial resources, the firm has to decide on those projects or investment proposals, which are commercially viable. Thus, to select the best investment proposal, a firm should analyse the project from the criteria of low capital cost and maximum return generated from the investment.

Therefore, the two main objectives of financial management are given as follows:

  1. Profit Maximisation
  2. Wealth Maximisation

Objectives of Financial Management

By following these objectives of financial management, businesses can improve their financial performance, reduce risks, and maximize shareholder value.

Objectives of financial management are described in detail as follows:

Profit Maximisation

Profit maximisation is the traditional and narrow approach. As per traditional theories, maximisation of profit is considered to be the sole objective of a business organisation. This theory is also known as cash-per-share maximisation. As per the requirement of the business, the product price and output are placed in such a way under the competition so that the profit can be maximised.

Profit maximisation is said to be the maximisation of returns by the firm in terms of monetary resources and increasing the earnings per share of the shareholders. Companies often select investment proposals that align with their objective of maximizing profits. The business selects only those investment projects which provide excess profit and rejects projects which provide comparatively less profit. Companies aim to maximize their profits by managing the relationship between input and output. They work to reduce their capital costs and try to achieve both maximum profit and shareholders’ wealth maximisation. Thus, with the right selection of projects, the firm can maximise its productivity and efficiency in its operations activities.

Features of Profit Maximisation

Profit is one of the most significant measures for evaluating the effectiveness of any business or economic activity. The survival and growth of a business also depend on its ability to generate profit.

Traditional theories like, profit maximisation are the sole objective of a business concern. Some of the essential features of profit maximisation objective are given as follows:

1) The objective of profit maximisation minimises the risk and uncertainty factors associated with business decisions and operations.

2) Profit maximisation is related to the maximisation of earnings per share of the firm.

3) Increase in profitability is one of the foremost concerns of every business organisation and therefore it requires various strategies and methods to maximize profits.

4) Profit serves as a benchmark for evaluating the operational efficiency, survival and well-being of a business organisation, as it reflects the impact of its business decisions and policies.

Wealth Maximisation

Wealth maximisation is also known as Value Maximisation or Net Present Worth Maximisation. This objective of financial management has all the features of certainty, quality benefits and timing benefits. The goal of wealth maximisation is the widely accepted goal of the business as it reconciles the varied, often conflicting interests of the stakeholders. Furthermore, it is not bound by the constraints that impact other objectives.

According to Ezra Solomon, the wealth maximisation goal is “The gross present worth of a course of action is equal to the capitalised value of the flow of future expected benefits, discounted (or capitalised) at a rate which reflects the uncertainty or certainty. Wealth or net present worth is the difference between gross present worth and the amount of capital investment required to achieve the benefits.”

Shareholders, as the true owners of the company, are entitled to the remaining profits only after fulfilling commitments to all other stakeholders. Shareholders’ claims cannot precede those of any other stakeholders. Therefore, when the company’s objective is to maximize what remains, it indicates that all previous commitments have been met. The firm’s pursuit of these overarching goals ensures that the interests of various stakeholders are taken care of in the process of wealth maximisation as a goal is in accordance with the objectives of the varied stakeholders.

A company cannot consistently increase the wealth of its owners without taking care of the interests of its other stakeholders. For example, if a company’s financial stability weakens, it causes concern among both current and potential lenders about its creditworthiness, which can, in turn, impact its stock prices and the wealth of shareholders. Similarly, a company that fails to retain its current customers will experience a decrease in sales, which can subsequently affect its stock prices.

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Features of Wealth Maximisation

The wealth maximisation criterion has a far and wide range of acceptance because of its key features:

1) It serves as an important aid to investment decisions.

2) It refers to the time-adjusted present value of benefits, thereby deducting the cost of investment.

3) The idea and notion of wealth are distinct and simple to understand.

4) Wealth maximisation takes into concern both the quantity and quality standards of benefits.

5) It also integrates the time value of money, risk and uncertainty factors.

6) It considers that the shareholder’s wealth is maximised only when the market price per share is maximised.

7) It eliminates the associated limitations of the profit maximisation objective of financial management.

8) Maximising the economic well-being of its shareholders is one of the parameters of wealth maximisation.

9) It also avoids agency issues in an organisation, as it encompasses the personal goals of executives, such as recognition, power, status, personal wealth, etc.

Financial Management Meaning

The term ‘Financial Management’ consists of two different words – ‘Financial’ and ‘Management’. . In order to fully grasp the meaning of this term, one needs to understand the meaning of two words. The term ‘Financial’ denotes the process of identifying, obtaining and allocating sources of money. The term ‘Management’ is the process of planning, organising, coordinating and controlling various resources for the accomplishment of organisational goals.

Therefore, Financial Management is that branch of the business management process which deals with the management of the financial resources of the enterprise. Financial management is the skilful and effective management of financial resources.

Financial Management Definition

According to J.F. Bradley, “Financial management is the area of business management devoted to the judicious use of capital and careful selection of sources of capital in order to enable a spending unit to move in the direction of reaching its goals”.

According to Weston and Brigham, “Financial management is an area of financial decision making harmonising, individual motives and enterprise goals”.

Meaning of Financial Management

As per Soloman, “Financial management is concerned with the efficient use of an important economic resource, namely, Capital Funds”.

According to Howard and Upton, “Financial management is the application of the planning and control functions of the finance functions”.

Massie states, “Financial management is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient operations.”

Scope of Financial Management

The scope of financial management has grown over the years. In this respect, various schools of thought and approaches have given their views:

1) Traditional School of Thought

Under this school of thought, the scope of financial management is restricted to the obtaining of funds. The finance manager was supposed to provide the funds as and when required by the organization. The finance function excluded the utilisation of funds. The decisions regarding the application of funds were left to the others.

According to this particular school of thought, the scope of financial management was limited to the following functions:

i) Procurement of required funds from financial institutions.

ii) Assessment of fund requirements.

iii) Managing accounting and legal framework of such transactions.

iv) Acquiring funds through the issuance of financial products like shares, bonds, debentures and loans.

Limitations of the Traditional School of Thought

The traditional school of thought developed in 1920 and it evolved through the forties and early fifties. By the end of the fifth decade, the popularity of this particular school of thought began to wane. The major factors for the decline in its influence are given below:

i) Overlooked Regular Issues: This school of thought primarily dealt with the procurement of funds for big-ticket events such as mergers, acquisitions and incorporations. However, it did not deal with daily financial issues such as the acquisition of working capital, cash management and accounts receivable management.

ii) Overlooked Non-Corporate Enterprises: The traditional school of thought only dealt with financial issues faced by corporate entities. The financial problems faced by non-incorporated businesses such as partnership and sole proprietorship were not given much importance.

iii) Overlooked Working Capital Financing: The traditional school of thought dealt with long-term financing decisions. It does not deal with short-term financing issues such as the management of working capital.

iv) Outsider-Looking-In Approach: The traditional school of thought was mainly concerned with the acquisition and management of funds. It looked at the finance function from an outsider’s point of view. These outsiders generally were bankers, suppliers investors, etc. Due to this, the scope of the finance function was restricted. It completely disregarded the importance of internal financial decision-making.

v) Ignored Allocation of Funds: This approach did not deal with the allocation of funds. It only dealt with the identification of sources of funds and the acquisition of funds. The scope of financial management, as described by Solomon is as follows:

a) Determining the cost of capital and setting up required benchmarks.

b) Should a business pursue a particular project?

c) Determining the proper mix of financing resources.

d) Making a comparison of expected returns with a required rate of return.

2) Modern School of Thought

The modern school of thought takes a wider view of the scope of financial management. According to the school of thought, financial management conceptualises and analyses the process of financial decision making. The finance function deals not only with the attainment of funds but also deals with the utilisation of funds. Therefore, the contemporary school of thought is more comprehensive than the traditional school of thought.

Financial management deals with solving three primary finance-related challenges encountered by a firm. These three problems are investment, financing and dividends. According to the modern definition, the following are the main functions performed by modern financial management:

i) Financing decision,

ii) Investment decision,

iv) Liquidity decision. and

iii) Dividend policy decision,

Importance of Financial Management

The Financial Management function is important in the following ways:

1) Aid to Managerial Decision Areas

Financial management is vital to a company’s policy and managerial decision-making. Major business decisions and choices relating to production, marketing, labour, research and development are based on financial decisions.

2) Wealth Maximisation

Financial management has two primary objectives – profit maximisation and shareholders’ wealth maximisation. The finance function aims to achieve maximum profitability by sourcing funds or capital at a lower cost and utilisation of those funds in profitable assets or projects to maximise returns on investment. For sourcing and application of funds, the finance function has certain techniques such as ratio analysis, budgetary control, cost-volume-profitability analysis, cash flow, fund flow management, etc. Thus, financial management techniques help in improving the profitability of the business.

3) Finance in the Controlling Function

For all business operations finance is a base. Every business activity, such as production, purchase, sales and marketing, and manpower planning involves the flow of funds and thus is controlled and monitored by the finance function. So, the planning and implementation of all the business functions are governed by the function of finance,

4) Administrative in Nature

Unlike before, nowadays financial management has evolved to be more controlling and supervising in nature. Financial management is not only concerned with fund acquisitions but its functions are also extended to sourcing of funds, capital allocation, project appraisal, etc.

5) The Finance Function is Centralised

Finance is one such business function which is administered and controlled centrally. Other business functions such as sales and marketing, production, and purchase are mostly scattered and distributed across various verticals and parameters. The finance function is very carefully monitored and coordinated in a centralised manner.

6) Performance Measure

Financial management often deals with factors that directly affect a business’s profitability and risk factors. So, financial management usually acts as a measure for determining the performance levels of other functions to control and stabilise profitability and risk factors.

7) Financial Management is an Analytical Tool

Financial management employs a variety of scientific, mathematical and analytical tools and methods for the interpretation of data and managerial decision making.

8) Base for Managerial Functions

Proper management of finance is foremost important for all other functions and processes of a business concern. Thus, all other management functions such as coordination, planning and directing can be implemented and achieved, if there is proper financial planning and control.

Functions of Financial Management

Financial management is considered the most important among the various branches of management. It is directly linked with different functional areas: Purchase, Marketing, Production, Personnel, etc. The relationship between financial management on one side and other fields of management on the other is discussed in detail in the following paragraphs:

Functional Areas of Financial Management are listed below:-

  1. Financial Management and Accounting
  2. Financial Management and Mathematics
  3. Financial Management, and Human Resources
  4. Financial Management and Production Management
  5. Financial Management and Economics
  6. Financial Management and Marketing

1) Financial Management and Accounting

Accounting and financial management are closely intertwined, as most accounting records pertain to financial information. Initially, both faculties, namely financial management and accounting, were considered a single discipline during the bygone era, which subsequently evolved into management accounting. Knowledge of management accountancy facilitated critical decision-making. However, under the modern approach, financial management and accounting are considered separate and diverse disciplines, although they remain closely related.

2) Financial Management and Mathematics

In the modern approach, various mathematical and statistical tools and techniques, referred to as Econometrics, are applied in financial management. Some econometrics frequently used in financial management include discount factors, economic order quantity, present value of money, time value of money, capital structure theories, cost of capital, ratio analysis, dividend theories, and working capital analysis.

3) Financial Management and Human Resources

The Human Resources Department (HRD) is responsible for procuring a workforce for all functional departments, including the finance department. The finance department and HRD need to coordinate to assess each department’s workforce requirements. Subsequently, the finance department may allocate necessary funds to HRD for wages, salaries, remunerations, commissions, bonuses, pensions, and other monetary benefits. Thus, the finance department and HRD are closely interconnected.

4) Financial Management and Production Management

The operational core of a manufacturing unit is production management, which stands as the most vital area of business as it facilitates the transformation of money into profit. A business organization’s profit generation commences with the production of the items it deals with. The production function necessitates finance to acquire machinery, tools, raw materials, etc.

Additionally, funds are required for wage payments and operational expenses. The finance department is responsible for evaluating all production-related expenditures and allocating funds accordingly. Personnel within the finance department must possess the competence to comprehend the processes inherent in the production cycle and accurately assess the funds required at each production stage. This ensures the timely and appropriate allocation of funds to the production department, thereby preventing any disruption to the production cycle.

5) Financial Management and Economics

Financial management and certain economic concepts, namely Microeconomics and Macroeconomics, are closely related, as these concepts are applied to financial management approaches. Important economic equations, such as the Money Value Discount Factor, Economic Order Quantity, etc., are frequently used in financial management. One of the upcoming branches of economics is financial economics, which has tremendous potential to provide opportunities in economics and finance.

6) Financial Management and Marketing

Marketing produced goods is as crucial as the production process itself. It entails applying innovative ideas and modern approaches that align with changing times and competitor strategies. The marketing department requires funding for all these endeavours, which is assessed and allocated by the finance department. Consequently, the marketing and finance departments are closely interrelated and must foster mutual understanding to function effectively in tandem.

Nature of Financial Management

Nature of Financial Management includes the following points:-

1. Optimum use of resources: Financial management is concerned with the strategic and efficient distribution of financial resources to maximize the organization’s value. Optimizing the use of available funds involves:

  • Making decisions regarding investment in assets.
  • Capital structure.
  • Working capital management to meet the financial objectives of the business effectively. 

2. Risk Management: Financial management involves identifying, assessing, and managing various types of risks, such as market, credit, liquidity, and operational risks, that may affect the organisation’s financial performance. Organisations can ensure long-term economic stability, optimise opportunities and improve overall strength in a dynamic market environment to achieve organisational goals by managing risks effectively. 

3. Monitoring and Control: Financial monitoring and control is essential for a company as it enables them to monitor and manage their actual operating expenses carefully to ensure that financial goals are achieved. 

4. Selective Investment: There are many financial resources available that help to make informed investment decisions. Before investing money, it’s essential to thoroughly assess and understand the level of risk involved and the potential returns.

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Nature of Financial Management