Nature and Scope of Financial Management

NATURE AND SCOPE OF FINANCIAL MANAGEMENT
Learning Objectives
familiarize financial objectives &

Goals of a firm
develop conceptual frame work of
financial management.
focus on nature, scope, and functions
of financial management.
discuss the role of finance manager in
changing economic scenario.
A . Backdrop
Role of Finance Manager 40 years ago
maintain financial records
prepare reports on companys status

and performance.
arrange funds needed by the firm to

meet its obligations on time.
His services were required only when need for
funds arose.
A . Backdrop
Role of Finance Manager now -
With technological advances in

industries, increased business
complexities, tightening money market,
despondent state of stock market, his
position has transcended the
traditional role of garnering funds
for the business.
A . Backdrop
Role of Finance Manager now contd.
actively participates in all
management decisions.
deals with total funds employed.
ensures funds are wisely applied
among various projects.
evaluates results of each such
application.
A . Backdrop
In this role , he is now directly

concerned with decisions related to
production, marketing and other
activities that involve commitment
of funds to the new or ongoing uses.
A . Backdrop
To meet global competition from
multinational companies, Indian firms are
forming new business strategy to work on
quality, reduce cost, improve
productivity, and maximize corporate
value.
Financial manager plays a very effective
and integrated role in financial
decisions to implement this strategy.
B . Financial Objectives of a Firm

Corporate objectives are expressed in
the mission and vision statements of
companies.
These are written in qualitative terms

and are more ethical and philosophical
in character and reflect top
managements values.
Being profit seeking organization the
management is supposed to set profit
maximization as its basic objective .

B.1. Profit maximization objective
The objective is stated in terms of

profits
return on investment or
profit-to-sales ratio.
This objective is simple, employs
resources where returns are highest,
and permits quick judgment on
effectiveness of financial decisions.

The objective has certain drawbacks

(a) it is vague
what is profit? total surplus before
tax or after tax? Rate of return on
sales? or capital employed? Owners
funds? Profits on a short term basis or
long term?
Each interpretation has its distinct impact
on financial decisions.


(b) it ignores Time Value Factor
Hence a project returning Rs. 90,000/-

in year and alternative yielding Rs.
15,000/- a year for the next six years
look equally attractive!


(c) it ignores Risk Factor
Two projects can have equal

profitability but different risk
profiles. Risk evaluation is absent in
statement of the profit maximization
objective.

B.2. Wealth maximization objective
This objective is clear & it suggests

that for a project to be undertaken ,
its net present value (gross present
value minus capital investment) must
be positive. While calculating gross
present value stream of earnings
expected in future are discounted at a
rate that reflects their uncertainty.

Net present worth is arrived using formula

A1 A2 An
W = + + . . . - C
(1+K) (1+K)2 (1+K)n
Where W is net present worth, A1 A2 An expected
stream of benefits expected to occur over
years, K is discount rate that reflects degree
of risk & timing, & C initial capital outlay
for the project.

This objective is very clear and

considers time value of money as well as
risk & uncertainty element ; and hence
superior to profit maximization
objective.
In short run if magnitude of risk is not
great , wealth maximization & profit
maximization objectives show no
difference.

B.3. Maximization of Profit Pool
A profit pool is defined as the total

profits earned in an industry at all
points along the industrys value chain.
It includes the disaggregate of
processes, the mapping of the value chain
beyond the confines of legal entities,
the adoption of flexible organizational
structures and creation of net worked
organizations.

A profit pool concept looks beyond the

core business and spots activities
with untapped source of profit. Low
margins on core business are used to
attract customers and high margin
ancillary business is transacted with
them to maximize profit pool.

Increased sales revenue and market

share do not necessarily provide
profit pool. A profit pool map alone
answers the question how and where is
the money made in the industry.

In automobile industry profit is made from
making & selling cars
selling used cars
petrol retail sales
insurance
after sales service
car leasing & finance
Revenue from core activity is more but major
profit is earned from ancillary activities .
C . Financial Goals of a Firm

Maximize short term and long term profits
& minimize risks by striking a balance
between risk & return.
Ensure effective utilization of
resources.
Build sufficient flexibility in financial
operations
Impart liquidity and profitability of the
enterprise.
Goals need to be defined for achievement of the
objective of wealth maximization.
D . Management vs. Owners
The goal of maximizing owners

interest predominates other goals of
the firm so that management is allowed
to continue.
In this role the management acts as a
satisfier for owner rather than as a
maximizer for the firm.
Towards this end management may accept
lower margins to ensure sustained
market share, rather than aggressively
exploit market potential.
E . Social Objective
As a corporate citizen, modern firm

has another objective to assume
social responsibility.
This acknowledges environment
conducive to economic growth provided
to the firm by the society.
Some argue that social responsibility
requires firm to bear more costs and
risks and is , therefore, in conflict
with its economic goals.
E . Social Objective
Experience, however, has proved that
in the long term both economic and
social objectives are mutually
beneficial.
Thus funds deployed to improve social
environment of workforce housing,
schools, hospitals etc. increase costs
immediately. But gains from improved
productivity & reduced turnover,
effectively more than offset them in the
long run.
F . Concept of Financial Management
Interpretations of the term Finance

F1 Acquiring funds on reasonable terms to
pay bills and other obligations promptly.
This is traditional & restrictive view.
F2 Finance means cash, and finance manager

must go in details in all activities in
production, marketing, personnel research
that involve cash. This is very broad and
vague viewpoint.
Interpretations of the term Finance- contd.
F3 Procurement of funds and their wise

application is the modern approach to
finance. The finance manager has to
obtain funds on most economic terms
and apply them to projects that
generate maximum wealth.
This is depicted on the diagram now ..


Interpretations of the term Finance- Modern Approach
Funds Source Funds Application
Internal cash flows Asset Expenditure

from operations a) Current
External debt or b) Fixed
equity from Non-asset Expd.
Individuals a) Labour / Material
Institutions b) Interest Charges
Other firms c) Profit distribution
Government to owners
G . Nature of Financial Management
Financial management is an integral part

of overall management as the function
involves, in addition to fund raising ,
utilization of funds and monitoring their
use. Funds are used for production,
marketing, human resource, research and
all other business activities and hence
financial manager has to fully associate
with all business activities.
Success of strategic business decisions

like entry in new territory, product
line, expansion of capacity, relocation,
depends upon their financial appraisals.
As a part of this appraisal, finance
manager has to continuously review
financial decisions providing dynamic
perspective to financial management.
Various financial functions are

intimately connected with each other.
Proportion of fixed assets to current
assets decides risk complexion, which
in turn influences the terms at which
fresh funds can be raised and methods
to be adopted to finance projects.
Dividend decisions affect financing
decisions which are again influenced
by investment decisions.
In other words, except for management

of income which is his prime
responsibility, finance manager has to
operate with expertise of other
functional heads of the organization
to discharge his responsibilities
effectively.
H . Functions of Financial Management
H.1. Traditional Concept of Finance Function
Determining funds requirements, finding

most economic source for them and timing
of acquiring and disposing funds was
considered as the real scope of financial
management.
Allocation of funds for different assets,
monitoring them to optimize their use,
was considered to be in the scope of non-
financial executives.
This view is criticized by modern

scholars on following grounds,
Just like finance manager is
responsible to acquire funds, he is also
responsible to ensure their proper
utilization over the best alternatives
available. Traditional concept ignores
the second responsibility.
The old concept focuses on one time

jobs of finance manager like
incorporation, consolidation,
recapitalization etc and ignores his
responsibility in resolving day to day
ongoing financial problems.
The old concept focuses on corporate

finance and ignores his responsible role
in management of non incorporated firms,
partnerships, trading concerns, etc.
The old approach considers long term
finance important and ignores finance
managers skills required to tackle day
to day working capital funding.
H.2. Modern Concept of Finance Function
It is an integral part of overall

management & not only an advisory
function.
In addition to procurement of funds at
optimum cost, it has to ensure beneficial
application of funds for business growth.
It includes planning, raising,
allocating & controlling finances to
accomplish broad business objectives.
H.3. Contents of Modern Finance Function
Are categorized by modern scholars as
a] Recurring functions
b] Non-recurring, one time or episodic functions.
a] Recurring functions:
Recurring Finance Functions
1 2 5
Planning for Raising Allocation Monitoring
Funds Funds of of uses of
3 4
Funds Income
1. Planning for funds :

1. Develop long term financial plan to
determine quantum of funds requirements,
its duration and make up of investments.
2. Synchronize cash inflows with outflows.
3. Balance profitability with risk by
deploying all funds and keeping least funds
liquid to meet emergencies.
1. Planning for funds :

4. Capitalization reflects decisions
regarding fund requirements.
5. Capital Structure reflects decisions
regarding forms of financing requirements.
6. Prepare & use Master Plan , Funds Flow
Statement, Forecast of Working Capital,
Cash Budget etc.

2. Raising of funds :
If funds are to be raised through

equity capital, finance has to arrange
for prospectus, appoint agents to
handle capital issue, ensure it is
underwritten, and monitor the process
until shares are issued to
subscribers.

2. Raising of funds : contd.
If funds are to be raised through

borrowings from banks or financial
institutions, finance manager has to
prepare a project report, enter into
agreement, schedule the repayments.
More expertise from him is expected
when funds are borrowed from overseas.

3. Allocation of funds :
While allocating funds over different

assets, factors to be considered by
the Finance Manager are competing
uses, immediate requirements,
management of assets, profit
prospects & overall management plans.

3. Allocation of funds :contd.
Next management of sundry debtors and

inventories is prime responsibility of finance
manager. Sundry debtors are to be maintained
at minimum without adverse effects on sales.
Optimum levels of inventories are to be
maintained to ensure least funds are blocked
but materials are available when needed.

4. Allocation of income :
Finance Manager has to decide how much

of the income is to be retained within
the business for financing investments
or retiring debts & how much to be
distributed to owners.

5. Monitoring uses of funds :

Long term use for capital investment
is monitored by comparing, on a
regular basis, actual results with
those estimated in the project report
used for approval of release of funds.
Comparisons enable corrective action
and revisions to balance expenditure.

5. Monitoring uses of funds : contd.

Short term use for receivables is
monitored by reviewing credit and
collection policies, their strict
implementation, keeping tab on
collection days, controlling ratio of
bad debts to sales etc.


Short term use for inventories is
monitored by reviewing inventory
norms, implementing them , checking
slow moving and non moving items in
stock, keeping inventory turnover
ratio high without causing
interruptions in production due to
lack of materials.

Finance Manager needs to obtain

information, record it, store and
process, analyze and make use of it.
This data allows him to prepare
reports to Management for action.

b] Non-recurring functions.
Are infrequent and usually at the time

of start up of the company, or during
a major liquidity crisis when the
capital has to be re-structured.
Finance manager has to handle
financial aspects of mergers &
acquisitions.
I . Scope of Financial Management
Is very wide; starts from inception of

the company to its growth, expansion &
eventual winding up.
Mainly covers decision areas related

to
investment;
financing &
dividends.
Decision areas related to investment :
Long term investment decisions relate

to allocation of funds to projects
whose benefits accrue over a long
period. For internal investment
decisions, economic viability of
different projects is studied to
select most profitable alternative.
For external investment decisions firm

considers investing in other company
and arranging merger or acquisition.
Or else it considers portfolio
management by selecting a bundle of
securities that provide maximum yield
at minimum risk.
For short term investment decisions

finance manager decides how the funds
are distributed over cash or cash
equivalents, receivables and
inventories.
Here main issue is trade off between
profitability & liquidity.
Decision areas related to financing :

Optimal financing mix or make up of
capitalization is determined by :
Sources of funds
Quantum of funds
Cost of funds used today.
Cost of future funds.
How much quantity from each source?
Which instruments to use and when?
Is service of a financial institute to be used?
Are underwriting services to be used?
Decision areas related to dividends :

Both goals of growth & dividends are
desired, these goals are conflicting
as higher dividends mean lesser
retained earnings required for growth.
Finance manager balances funds over these
purposes in such a way that wealth is
created for stockholders over a period
of time.
J . Cardinal Principles of Financial Management
J .1. Strategic Principle :
All financial decisions be integrated

with overall corporate objectives and
strategies.
It requires finance manager to
consider external economic forces
reflected in fiscal & industrial
policies of the Government.
J .2. Optimization Principle :
Maximum utilization of funds should

be the goal of financial management.
This mandates proper balance between
fixed and working capital.
Shortfall in one category must never
be met by employing surplus of the
other.
J .3. Risk Return Principle :
Maintain proper balance between risk

and return. Firm flush with cash has
no risk, but has no income from cash
lying idle. If all funds are employed
in income earning assets, paucity of
working capital may lead to financial
crisis. Hence need to maintain
balance.
J .4. Marginal Principle :
An enterprise should continue to work

until its marginal income equals its
marginal cost. While investing funds,
a firm should invest in a project so
long as marginal income from that
project is more than marginal cost of
funds required to finance it.
J .4. Marginal Principle : contd.
Projects A,B,C, etc in the next chart,

are arranged in descending order of %
returns from them. Marginal cost of
funds is 18%.
All projects with returns over 18% are

suitable candidates for investment.
J .4. Marginal Principle : contd.

%
30
20
18% marginal cost
10
A B C D E F G
0 50 150 250 350
Investment (cumulative) Rs. Lakhs
J .5. Suitability Principle :
Source of fund selected to finance an

asset should match with the character
of the asset. Hence this principle
dictates that short term financial
needs be met with short term sources
such as short term borrowings,
overdrafts etc.
J .5. Suitability Principle : contd.
Long term assets like plant and

machinery be financed from long term
sources like equity, debentures, long
term loans etc.
J .6. Flexibility Principle :
The financial plan needs to have a

built-in flexibility to meet dynamic
business environment. Several sources
be there to provide alternatives and
bargaining power. If all sources of
funds are fully utilized, the
financial plan becomes rigid.
J .7. Timing Principle :
This principle demands that finance

manager should time his investment
and financing decisions in such a way
to seize all available market
opportunities.
J .8. Ploughing Back Principle :
This principle states that firm must

generate adequate internal cash
surpluses to fund replacement,
modernization and growth of its
capacities. A strong internal
resources position enables finance
manager to obtain more funds from
market at optimum terms.
K . Concept of Financial Management in Public Sector
Principles of prudent financial

management adopted in the private
sector are equally applicable to the
public sector.
Financial management in public sector
has its additional characteristics
related to broad objectives, multiple
controls and very large size of
operations.
The objectives of social gains

regarding development of backward
areas, or provision of employment,
creating basic infra-structure by
providing basic raw materials,
machineries are in conflict with the
normal financial objective of profit
maximization.
For survival & growth, it has to balance these
diverse objectives with making profit for
itself.
The task of financial management

assumes greater significance as the
amount of assets, cash & materials
controlled by public sector firms is
more the budgets of an entire big size
state. This size defines the quality &
depth of financial control that needs
to be exercised in the public sector.
Financial management in the public

sector has to pay greater attention to
the outside economic environment
governed by the economic, fiscal and
industrial policies of the Government.
The funds in this sector are sourced
from three agencies Government,
Banking System & Internal Sources.
Finance manager in the public sector

has to establish greater co-ordination
with other departments for efficient
use of the funds. Two way information
system between the finance & other
departments has to be developed for
this purpose.
Even though profit generation is not

the only goal for Finance manager in
the public sector, he has to control
inventories, increase sales and reduce
costs to maintain overall margins.
The Government and employees expect firms in
the public sector to make profit so that they
are not a liability to former and provides
benefits like bonus to the latter.
Unlike in private sector, finance

manager in public sector is controlled
by top management of his own
undertaking as well as authorities in
various ministries. Multiple reporting
is complex as objectives of internal
management do not always match those
of outside agencies.
L . New Paradigms of Financial Management
Both profit and non-profit firms work

in a fiercely competitive environment
where vigorous growth is essential for
survival.
This is achieved through product

development & innovation and world
class levels in product quality & cost
as well as in network for distribution
and marketing.
One of the critical factors for

failures of large firms, in both
public & private sectors, is use of
archaic outmoded tools for their
financial management. These companies
could not reap benefits of favorable
economic environment.
For progress & survival, all companies

need to follow the new paradigms of
financial management.
New paradigms
Financial management is integral part

of strategic management.
Objectives of financial management must
be tethered to corporate objectives.
Thrust of financial management on value
addition of the organization,
stockholders & stakeholders.
New paradigms
Maximize profit pool and not just profit &

wealth.
Re-engineer finance processes, dig out
hidden costs & eliminate.
Focus on core activities & source rest to
suppliers.
Adopt zero working capital, just in time,
web based accounting and inventory
software.
New paradigms
Evolve new financial instruments like zero

coupon bonds, deep discount bonds,
floating rate bonds, convertible warrants
etc to garner funds efficiently.
Hedge risks arising out of fluctuations
in prices of commodities, shares;
interest and foreign exchange rates.
New paradigms
In short everything possible to

exploit waves of liberalization
and globalization.
Next Financial Statements & Financial

Analysis

Nature and Scope of Financial Management

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NATURE AND SCOPE OF FINANCIAL MANAGEMENT

familiarize financial objectives &

Role of Finance Manager 40 years ago

maintain financial records

prepare reports on companys status

arrange funds needed by the firm to

Role of Finance Manager now -

With technological advances in

In this role , he is now directly

B . Financial Objectives of a Firm

These are written in qualitative terms

B . Financial Objectives of a Firm

The objective is stated in terms of

B . Financial Objectives of a Firm

The objective has certain drawbacks

B . Financial Objectives of a Firm

The objective has certain drawbacks

Hence a project returning Rs. 90,000/-

B . Financial Objectives of a Firm

The objective has certain drawbacks

Two projects can have equal

B . Financial Objectives of a Firm

This objective is clear & it suggests

B . Financial Objectives of a Firm

Net present worth is arrived using formula

B . Financial Objectives of a Firm

This objective is very clear and

B . Financial Objectives of a Firm

A profit pool is defined as the total

B . Financial Objectives of a Firm

A profit pool concept looks beyond the

B . Financial Objectives of a Firm

Increased sales revenue and market

B . Financial Objectives of a Firm

C . Financial Goals of a Firm

D . Management vs. Owners

The goal of maximizing owners

As a corporate citizen, modern firm

F . Concept of Financial Management

Interpretations of the term Finance

F2 Finance means cash, and finance manager

F . Concept of Financial Management

Interpretations of the term Finance- contd.

F3 Procurement of funds and their wise

This is depicted on the diagram now ..

F . Concept of Financial Management

Funds Source Funds Application

Internal cash flows Asset Expenditure

G . Nature of Financial Management

Financial management is an integral part

G . Nature of Financial Management

Success of strategic business decisions

G . Nature of Financial Management

Various financial functions are

G . Nature of Financial Management

In other words, except for management

H . Functions of Financial Management

H.1. Traditional Concept of Finance Function

Determining funds requirements, finding

H . Functions of Financial Management

H.1. Traditional Concept of Finance Function

This view is criticized by modern

H . Functions of Financial Management

H.1. Traditional Concept of Finance Function