Financial Management

Financial Management means planning, organizing, directing and controlling

the financial activities such as procurement and utilization of funds of the
enterprise. It means applying general management principles to financial
resources of the enterprise.

“Financial management is the activity concerned with planning, raising,

controlling and administering of funds used in the business.” – Guthman and
Dougal

“Financial management is that area of business management devoted to a

judicious use of capital and a careful selection of the source of capital in order to
enable a spending unit to move in the direction of reaching the goals.” – J.F.
Brandley

Nature of financial management

The nature of financial management includes the following −
 Estimates capital requirements
Financial management helps in anticipation of funds by estimating working
capital and fixed capital requirements for carrying business activities.
 Decides capital structure
Proper balance between debt and equity should be attained, which minimizes
the cost of capital.
Financial management decides proper portion of different securities (common
equity, preferred equity and debt).
 Select source of fun
Source of fund is one crucial decision in every organisation. Every organisation
should properly analyse various source of funds (shares, bonds, debentures
etc.) and must select appropriate funds which involves minimal risk.
 Selects investment pattern
Before investing the amount, the investment proposal should be analysed and
properly evaluates its risk and returns.
 Raises shareholders value
It aims to increase the amount of return to its shareholders by decreasing its
cost of operations and increase in profits.
Finance manager should focus on raising the funds from different sources and
invest them in profitable avenues.
 Management of cash
Finance manager observes all cash movements (inflow and outflow) and
ensures they should face any deficiency or surplus of cash.
 Apply financial controls −
Implying financial controls helps in keeping the company actual cost of
operation within limits and earning the expected profits.
There different approaches involved like developing certain standards for
business in advance, comparing the actual cost or performances with pre-
established standards and taking all require remedial measures.
Scope of financial management
Financial management covers wide area with multidimensional approaches. It
plays an important role in overall management by dealing with various
functional departments like personnel, marketing and production.
The scope of financial management is explained below −
 Financial management and economics
Financial economics is one of the emerging area, which provides immense
opportunities to finance and economical areas.
Using macro and micro economics concepts for financial management
approach.
Financial managers use investment decisions, micro and macro environmental
factors, money value discount factor, economic order quantity etc.
 Financial management and accounting
In olden days, both financial management and accounting treated as same and
merged, but now-adays, both are separated and interrelated.
 Financial management and mathematics
Latest approach of the financial management applied large number of
mathematical and statistical tools and techniques called econometrics.
  Financial management and production management
Production performances need finance, because the expenses of production
(raw material, machinery wages, operating expenses etc.) are carried out by
finance department and appropriate funds are allotted to each stage of
production.
 Financial management and marketing
The finance manager or department is responsible to allocate the adequate
funds to marketing department by which goods will be sold by innovative and
modern approaches.
 Financial management and human resources −
Financial manager should carefully evaluate the requirement of manpower in
respective departments and allocates finance to human resource department
in the form of wages, salary, bonus and other monetary benefits.

Objectives of Financial Management

1. Profit Maximization

A business is set up with the main aim of earning huge profits. Hence, it is the
most important objective of financial management. The finance manager is
responsible to achieve optimal profit in the short run and long run of the
business. The manager must be focused on earning more and more profit. For
this purpose, he/she should properly use various methods and tools available.

2. Wealth Maximization

Shareholders are the actual owners of the company. Hence, the company
must focus on maximizing the value or wealth of shareholders. The finance
manager should try to distribute maximum dividends among the shareholders
to keep them happy and to improve the goodwill of the company in the
financial market. The declaration of dividend and payout policy is decided with
the help of financial management. A proper dividend policy related to the
declaration of dividends or retaining the company's profit for future growth
and development is part of dividend decisions. But this is based on the
performance of the company and the amount of profit earned. Better
performance means a higher value of shares in the financial market. In
nutshell, the finance manager focuses on maximizing the value of
shareholders.

2. Wealth Maximization

Shareholders are the actual owners of the company. Hence, the company
must focus on maximizing the value or wealth of shareholders. The finance
manager should try to distribute maximum dividends among the shareholders
to keep them happy and to improve the goodwill of the company in the
financial market. The declaration of dividend and payout policy is decided with
the help of financial management. A proper dividend policy related to the
declaration of dividends or retaining the company's profit for future growth
and development is part of dividend decisions. But this is based on the
performance of the company and the amount of profit earned. Better
performance means a higher value of shares in the financial market. In
nutshell, the finance manager focuses on maximizing the value of
shareholders.

4. Proper Estimation of Financial Requirements

Financial management also helps the finance manager in estimating the

proper financial needs of the company. This means the estimations related to
the requirement of capital to start or run a business, the need for fixed and
working capital of the company, etc., can be done with effective management
of finance. If this management will not be present in the company then there
will be a higher possibility of having a shortage or surplus of finance. For this
estimation, a financial manager checks various factors like the technology used
by the organization, the number of employees working, the scale of
operations, and the legal requirements of the company to run its business.

5. Proper Mobilization

Financial management helps in the effective utilization of sources of

finance. It means without wasting them and getting the maximum benefit from
the available resources. The finance manager is responsible for managing the
different sources of funds such as shares, debentures, bonds, loans, etc. So,
after estimating the financial requirements, the manager must decide which
source of the funds he/she should use to avail the maximum benefit.
6. Proper Utilization of Financial Resources

With proper financial management, the organization can make optimum

utilization of financial resources. To achieve this, a financial manager has
various tools that he/she can use. They include managing receivables, better
management of inventory, and effective payment policy in hand. This will not
only save the finance of the organization but will also reduce the wastage of
other resources.

7. Developing Financial Scenarios

With the help of financial management, financial scenarios can be developed.

It can be done by forecasts and the current state of the company. But for this
purpose, the financial manager has to assume a wide range of possible
outcomes as per the current and future market conditions.

8.Decreases Operating Risk

There are lots of risks and uncertainties that a financial manager has to face in
the day-to-day operations of the business. Financial management helps in
reducing these issues and gives the solutions to deal with the problems. It can
avoid the high-risk allocation of capital for the expansion and growth of the
business. Other than this, FM also tells how the decisions can be taken with a
proper consultancy.

Financial Decisions/function
Financial decisions are the decisions taken by managers about an
organization’s finances. These decisions are of great significance for the
organization’s financial well-being. The financial decisions pertaining to
expenditure management, day-to-day capital management, assets
management, raising funds, investment, etc. The assets and liabilities of the
organisation are affected by financial decisions. Undertaking efficient financial
decisions can lead to immense revenue over a long term period. Investment
decisions are significantly immense decisions. Besides this, financing and
dividend are also essential aspects of financial decisions. Keep on reading to
know more about it, including the various factors affecting financial decisions.
 Investment Decisions
Investment decisions pertain to how managers must invest in various
securities, instruments, assets etc. These decisions are considered more
important than financing and dividend decisions.

Here, the decision is taken regarding how investment should occur in different
asset classes and which ones to avoid. It also involves whether to go for short
term or long term assets. This decision is taken under the organisational
requirements.

Process

Investing in an asset, security, or project requires a lot of patience; ideally, the

decision-making process should be analytical. Following is a five-step process
decision-making process that guides investors:

1. Analyze Financial Position: For financial management, one has to understand

the company or individual’s current financial condition.
2. Define Investment Objective: Then, investors must set up an investment
objective—whether to invest short-term or long-term. They should also be
aware of their risk appetite (level of risk they desire to take).
3. Asset Allocation: Based on the objective, investors must allocate assets into
stocks, debentures, bonds, real estate, options, and commodities.
4. Select Investment Products: After narrowing down on a particular asset class,
investors must further select a particular asset or security. Alternatively, this
could be a basket of assets that fit the requirements.
5. Monitor and Due Diligence: Portfolio managers keep an eye on the
performance of each investment and monitor the returns. In case of poor
performance, they must take prompt action.

Factors Affecting Investment Decision

An investment is a planned decision, and some of the factors that are

responsible for these decisions are as follows:

 Investment Objective: The purpose behind an investment determines the

short-term or long-term fund allocation. It is the starting point of the decision-
making process.
 Return on Investment: Managers prioritize positive returns—they try to
employ limited funds in a profitable asset or security.
 Return Frequency: The number of periodic returns an investment offer is
crucial. Financial management is based on financial needs; investors choose
between investments that yield monthly, quarterly, semi-annual, or annual
returns.
 Risk Involved: An investment may possess high, medium, or low risk, and the
risk appetite of every investor and company is different. Therefore, every
investment requires a risk analysis.
 Maturity Period or Investment Tenure: Investments pay off when funds are
blocked for a certain period. Thus, investor decisions are influenced by the
maturity period and payback period.
 Tax Benefit: Tax liability associated with a particular asset or security is
another crucial deciding factor. Investors tend to avoid investment
opportunities that are taxed heavily.
 Safety: An asset or security offered by a company that adheres to regulatory
frameworks and has a transparent financial disclosure is considered safe.
Government-backed assets are considered the most secure.
 Inflation Rate: In financial management, investors look for investment
opportunities where returns surpass the nation’s inflation rate.

Financing Decisions
Managers take these decisions to facilitate financing for the organisation. The
relation of financing decisions is to raise equity while reducing debt as much as
possible. Often, they are taken in light of the investment decisions.

These decisions must be taken continuously as the organisation needs funds

regularly. Financing decisions should not be very rigid to allow room for
manoeuvre if an emergency arises or the economic situation changes
suddenly.

 Factors Affecting Financing Decision:

 Cost- The cost of raising funds varies from one source to another. For example,
equity is generally more expensive than debt.
 Cash flow position- A good cash flow position means ease in using borrowed
funds.
 Economic condition- Finances can be raised easily during an economic boom,
while a recession makes it hard to raise finances.
 Risk- The risk associated with various financing sources is not the same.
Borrowed funds involve more risk than the owner’s fund as interest.
 Flotation cost- This is the cost involved in issuing securities like expenses on
the prospectus, the fee of underwriting, and the commission or brokerage.

Dividend Decision
After making a profit, an organisation has to decide how much reward to give
to its shareholders. This reward must be given to them in return for their
investment in the company’s stock. Giving too little can cause a loss of trust
and confidence of shareholders in the organisation. However, giving too much
would reduce the profit margin of the organisation. So, an optimum balanced
dividend decision must be taken in this situation.

These decisions involve how many profit portions to hand over to the
shareholders in dividends. It also consists of the timing of giving dividends to
the shareholders. An excessive delay in giving dividends would be bad for the
reputation of the organisation in the eyes of the shareholders and the public.

 Factors affecting Dividend Decision:

 Preference of shareholders- Shareholders’ preferences must be considered
when deciding the dividend amount. If this amount falls too below the
shareholders’ expectations, the organisation’s reputation will be affected. This
is a risk that every organisation must avoid.
 Earnings- High dividend rate can be declared by organisations with stable
earnings.
 Dividends stability- Organizations try to stabilise dividends as much as follows.
As such, no altering in dividend share should occur due to small or minor
changes.
 Taxation policy- A high tax on dividends would mean that organisations would
do lower dividend payouts generally. The situation would be reversed if tax
rates were lower.
 Growth prospects- If the estimated growth prospects of the organisation are
good shortly, the number of dividends will be low.
 Cash flow- When declaring dividends, an organisation must ensure that it has
sufficient cash available. As such, the organisation’s cash flow position is a
crucial factor to consider.
Wealth Maximization vs Profit Maximization

What is Profit Maximization?

The process of increasing the profit earning capability of the company is

referred to as Profit Maximization. It is mainly a short-term goal and is
primarily restricted to the accounting analysis of the financial year. It ignores
the risk and avoids the time value of money. It primarily concerns the
company’s survival and growth in the existing competitive business
environment.

Profit is the basic building block of a company to accrue capital in the

shareholder’s equity. Profit maximization helps the company survive against all
the odds of the business and requires some short-term perspective to achieve
the same. Though the company can ignore the risk factor in the short term, it
can not do the same in the long term as shareholders have invested their
money in the company with expectations of getting high returns on their
investment.

What is Wealth Maximization?

The ability of a company to increase the value of its stock for all the
stakeholders is referred to as Wealth Maximization. It is a long-term goal and
involves multiple external factors like sales, products, services, market share,
etc. It assumes the risk. It recognizes the time value of money given the
business environment of the operating entity. It is mainly concerned with the
company’s long-term growth and hence is concerned more about fetching the
maximum chunk of the market share to attain a leadership position.
Wealth Maximization considers the interest concerning shareholders, creditors
or lenders, employees, and other stakeholders. Hence, it ensures building up
reserves for future growth and expansion, maintaining the market price of the
company’s share, and recognizing the value of regular dividends. So, a
company can make any number of decisions for maximizing profit, but when it
comes to decisions concerning shareholders, then Wealth Maximization is the
way to go
 Wealth Maximization

 Wealth Maximization is the ability of the company to increase the value for
the stakeholders of the company, mainly through an increase in the market
price of the company’s share over time. The value depends on several tangible
and intangible factors like sales, quality of products or services, etc.
 It is mainly achieved throughout the long-term as it requires the company to
attain a leadership position, which translates to a larger market share and
higher share price, ultimately benefiting all the stakeholders.
 To be more specific, the universally accepted goal of a business entity has been
to increase the wealth for the shareholders of the company as they are the
actual owners of the company who have invested their capital, given the risk
inherent in the business of the company with expectations of high returns.
 Wealth maximization is a long-term objective that gradually happens and
hence, the management is always ready to pay for the discretionary expenses,
including research and maintenance.
 For effective wealth maximization, the companies normally choose to reduce
the prices and have a strong backup in the form of market share.
 A wealth-oriented firm is focused on making expenses keeping in mind the
long-term sales objectives. It believes that such expenditure will help increase
the value of the business.
 Companies aiming to maximize wealth focus on risk mitigation measures to
avoid risk of losses in future.

#2 – Profit Maximization

 Profit Maximization is the ability of the company to operate efficiently to

produce maximum output with limited input or to produce the same output
 using much lesser input. So, it becomes the most crucial goal of the company
to survive and grow in the current cut-throat competitive landscape of the
business environment.
 Given this form of financial management, companies mainly have a short-term
perspective when it comes to earning profits, which is very much limited to the
current financial year.
 If we get into the details, profit is actually what remains out of the total
revenue after paying for all the expenses and taxes for the financial year. Now
to increase profit, companies can either increase their revenue or minimize
their cost structure. It may need some analysis of the input-output levels to
diagnose the company’s operating efficiency and identify the key improvement
areas where processes could be tweaked or changed in their entirety to earn
larger profits.
 When it is about maximizing profits for a business, companies aim to make
instant profits. Hence, they choose not to pay for discretionary expenses,
which include advertising costs, research and maintenance expenditure, etc.
 Unlike wealth maximization, profit maximization favors the choice of
increasing product prices to keep the margins as high as possible. Hence, the
companies do so to ensure more and more instant profit making.
 Businesses aiming to maximize profits have a focus on managing their existing
level of sales efficiently and productively. In short, they emphasize short-term
sales goals for profits, which sometimes hampers their long-term goals.
 To show they are earning profits, companies choose to minimize expenditure,
which makes them unprepared for the hedges required at a later stage.

When it comes to financial calculations and investments, two fundamental concepts

that play a significant role are compounding and discounting. These concepts help
determine the future value and present value of money, respectively. Understanding
the difference between compounding and discounting is essential for making
informed financial decisions. In this article, we will delve into the meaning,
applications, and key distinctions between compounding and discounting.

Points Compounding Discounting

Meaning The process of calculating future values of an The process of calculating present values of
investment or loan based on the compound future cash flows based on the time value of
interest. money.
Calculation Future value is calculated by adding interest Present value is calculated by discounting
to the principal amount over multiple future cash flows back to their present value
 periods. using a predetermined rate.
Time orientation Future-oriented calculation. Present-oriented calculation.
Objective Determines the growth of an investment over Determines the current worth of future cash
time. flows.
Application Commonly used for investments, savings Commonly used in financial valuation,
accounts, and loans. investment analysis, and determining the value
of future cash flows.
Formula Future Value (FV) = P(1 + r/n)^(nt) Present Value (PV) = FV / (1 + r/n)^(nt)
Variables P: Principal amount, r: Interest rate, n: FV: Future value, r: Discount rate, n: Number
Number of compounding periods per year, t: of discounting periods per year, t: Number of
Number of years, FV: Future value years, PV: Present value
Outcome Results in a higher future value due to the Results in a lower present value due to the time
accumulation of interest over time. value of money and discounting of future cash
flows.
Effect of time Increases the value of the investment over Reduces the value of future cash flows as time
time. progresses.
Time period Typically used for long-term investments or Typically used for evaluating short-term or
loans. immediate financial decisions.
Application Calculating compound interest earned on a Determining the present value of future cash
example savings account. flows for an investment decision.
Compound The interest earned is added to the principal, Not applicable.
interest resulting in interest on interest.
Use in finance Commonly used in finance and banking to Commonly used in financial valuation,
determine the growth of investments and the discounted cash flow analysis, and investment
cost of loans. decision-making.
Frequency of Calculated periodically based on the Calculated when evaluating future cash flows
calculation compounding period (e.g., annually, or investment opportunities.
quarterly, monthly).
Time value of Recognizes that the value of money Recognizes that the value of money is worth
money decreases over time due to factors such as more in the present compared to the future.
inflation and opportunity cost.
Reverse Future value can be calculated from the Present value can be calculated from the future
calculation present value using the compounding value using the discounting formula.
formula.
Risk and Compound interest may lead to higher Discounting helps assess the present value of
uncertainty returns but also involves the risk of loss. future cash flows, considering the uncertainty
and risk associated with them.
Decision-making Helps individuals and businesses evaluate the Helps individuals and businesses assess the
growth potential of investments. value and feasibility of future cash flows and
investment opportunities.
Influence on Compounding affects long-term financial Discounting influences short-term financial
decision-making planning and investment strategies. decisions and investment evaluations.
Inflation Compound interest does not account for Discounting can account for inflation by
inflation explicitly. adjusting the discount rate accordingly.
Time factor The longer the compounding period, the The longer the discounting period, the greater
greater the impact on future value. the impact on present value.
Reverse Future value can be calculated from the Present value can be calculated from the future
calculation present value using the compounding value using the discounting formula.
formula.

Understanding Compounding
What is Compounding?

Compounding refers to the process of reinvesting the interest earned on an

investment, which leads to exponential growth over time. It involves earning interest
not only on the initial principal amount but also on the accumulated interest. In
simple terms, compounding allows your money to work for you and generate
additional income through the power of compound interest.

The Power of Compound Interest

Compound interest is the primary driver of growth in compounding. It occurs when

the interest earned on an investment is added back to the principal amount, and
future interest calculations include this increased balance. Over time, the interest
earned keeps accumulating and contributing to the growth of the investment. This
compounding effect can significantly enhance the overall returns on an investment,
especially over long periods.

Compound Interest Formula

A = P(1 + r/n)^(nt)

Where:

o A represents the future value of the investment

o P is the principal amount (initial investment)
o r is the interest rate per period
o n denotes the number of compounding periods per year
o t represents the number of years

Exploring Discounting
What is Discounting?

Unlike compounding, discounting is the process of determining the present value of

future cash flows. It involves estimating the current worth of money to be received or
paid at a future date. Discounting takes into account the time value of money, which
states that the value of money decreases over time due to factors such as inflation,
risk, and opportunity cost.

Present Value and Future Value

The present value represents the current worth of a future amount, while the future
value denotes the value of an investment or cash flow at a specific future date.
Discounting allows us to determine the present value by discounting the future value
based on an appropriate discount rate.

Discounting Formula

PV = FV / (1 + r)^t

Where:

o PV represents the present value

o FV is the future value
o r is the discount rate
o t denotes the number of years

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Differences between Compounding and Discounting

Time Value of Money

Both compounding and discounting consider the time value of money but in
different ways. Compounding emphasizes the future value of money by accounting
for the growth of investments over time. On the other hand, discounting focuses on
the present value of money by considering the current worth of future cash flows.

Direction of Cash Flows

Compounding involves investments where the initial cash flow is in the form of a
principal amount, and subsequent cash flows come from accumulated interest. In
contrast, discounting deals with future cash flows and calculates their present value.
The direction of cash flows is opposite between compounding and discounting.
Application Areas
Compounding finds its application in various scenarios such as long-term
investments, savings accounts, retirement planning, and compound interest on loans.
Discounting is commonly used in capital budgeting, valuation of financial
instruments, determining the present value of future cash flows, and analyzing
investment projects.