LESSON 1: NATURE, PURPOSE, AND SCOPE OF FINANCIAL MANAGEMENT

Learning Objectives:
1. Describe the nature, goal and basic scope of financial management;
2. Explain briefly the three major types of decisions that the Finance Manager
makes;
3. Discuss the importance or significance of financial management;
4. Describe the relationship between Financial Management and Accounting;
and
5. Describe the relationship between Financial Management and Economics.

NATURE OF FINANCIAL MANAGEMENT

Financial Management, also referred to as managerial finance, corporate

finance and business finance, is a decision making process concerned with
planning, acquiring and utilizing funds in a manner that achieves the firm’s desired
goals. Financial management is part of a larger discipline called FINANCE which
is a body of facts, principles, and theories relating to raising and using money by
individuals, businesses, and governments.

THE GOAL OF FINANCIAL MANAGEMENT

The appropriate goal for the financial manager can be stated as follows:

The goal of financial management is to maximize the current value per share of
the existing stock or ownership in a business firm.

The stated goal considers the fact that the shareholders in a firm are the residual
owners. By this, we mean that they are entitled only to what is left after employees,
supplier, creditors, and anyone else with a legitimate claim are paid their due. If
any of these groups go unpaid, the shareholders or owners get nothing.

Finally, our goal does not imply that the financial manager should take illegal or
unethical actions in the hope of increasing the value of the equity in the firm. The
financial manager should best serve the owners of the business by identifying
goods and services that add value to the firm because they are desired and
valued in the free market place.

SCOPE OF FINANCIAL MANAGEMENT

Traditionally, financial management is primarily responsible with acquisition,

financing and management of assets of business concern in order to maximize
the wealth of the firm for its owners. The basic responsibility of the Finance
Manager is to acquire funds needed by the firm and investing those funds in
profitable ventures that will maximize the firm’s wealth, as well as, generating
returns to the business concern.

Globalization has caused to integrate the national economy with the global
economy and has created a new financial environment which brings new
opportunities and challenges to the business enterprises. This development has
also led to total reformation of the finance function and its responsibilities in the
organization. Financial management has assumed a much greater significance
and the role of the finance managers has been given a fresh perspective.
In view of modern approach, the Finance Manager is expected to analyse the
business firm and determine the following:

1. The total funds requirements of the firm

2. The assets or resources to be acquired; and

3. The best pattern of financing the assets.

TYPES OF FINANCIAL DECISIONS

The three major types of decisions that the Finance Manager of a modern business
firm will be involved in are:
1. Investment Decisions
2. Financing Decisions
3. Dividend Decisions

All these decisions aim to maximize the shareholders’ wealth through maximization
of the firm’s wealth.

INVESTMENT DECISIONS

The investment decisions are those which determine how scarce or limited
resources in terms of funds of the business firms are committed to projects.
Generally, the firm should select only those capital investment proposals whose
net present value is positive and the rate of return exceeding the marginal cost of
capital. It should also consider the profitability of each individual project proposal
that will contribute to the overall profitability of the firm and lead to the creation
of wealth.

FINANCING DECISIONS

Financing decisions assert that the mix of debt and equity chosen to finance
investments should maximize the value of investments made.

The finance decisions should consider the cost of finance available in different
forms and the risks attached to it. The principle of financial leverage or trading on
the equity should be considered when selecting the debt-equity mix or capital
structure decision.

DIVIDEND DECISIONS

The dividend decision is concerned with the determination of quantum of profits

to be distributed to the owners, the frequency of such payments and the amounts
to be retained by the firm.

The dividend distribution policies and retention of profits will have ultimate effect
on the firm’s wealth. The business firm should retain its profits in the form of
appropriations or reserves for financing its future growth and expansion schemes.
SIGNIFICANCE OF FINANCIAL MANAGEMENT

1. Broad Applicability

Any organization whether motivated with earning profit or not

having cash flow requires to be viewed from the angle of financial discipline.
The principles of finance are applicable wherever there is cash flow. The
concept of cash flow is one of the central elements of financial analysis,
planning, control, and resource allocation decisions. Cash flow is important
because the financial health of the firm depends on its ability to generate
sufficient amounts of cash to pay its employees, suppliers, creditors and
owners.

2. Reduction of Chances or Failure

A firm having latest technology, sophisticated machinery, high

calibre marketing and technical experts, and so forth may still fail unless its
finances are managed on sound principles of financial management. The
strength of business lies in its financial discipline.

3. Measurement of Return on Investment

Anybody who invests his money will expect to earn a reasonable

return on his investment. The owners of business try to maximize their wealth.
Financial management studies the risk-return perception of the owners and the
time value of money. It considers the amount of cash flows expected to be
generated for the benefit of owners, the timing of these cash flows and the risk
attached to these cash flows.

RELATIONSHIP BETWEEN FINANCIAL MANAGEMENT, ACCOUNTING AND

ECONOMICS

Financial Management and Accounting

There are two basic differences between finance and accounting; one is related
to the emphasis on cash flows and the other to decision making.

Emphasis on Cash Flows

The accountant’s primary function is to develop and report data for measuring
the performance of the firm, assessing its financial position and paying taxes. The
accountant prepares the financial statements that recognize revenue at the time
of sale (whether payment has been received or not) and recognize expenses
when they are incurred. This approach is referred to as the accrual basis.

The financial manager, on the other hand, places primary emphasis on cash flows,
the intake and outgo of cash. He or she maintains the firm’s solvency by planning
the cash flows necessary to satisfy its obligations and to acquire assets needed to
achieve the firm’s goals. The financial manager uses the cash basis to recognize
the revenues and expenses only with respect to actual inflows and outflows of
cash.

ILLUSTRATION: Nassau Corporation, a small yacht dealer, sold one yacht for
$100,000 in the calendar year just ended. The yacht was purchased during the
year at a total cost of $80,000. Although the firm paid in full for the yacht during
the year, at year-end it has yet to collect the $100,000 from the customer.
Decision Making

The second major difference between finance and accounting has to do with
decision making. Accountants devote most of their attention to the collection and
presentation of financial data. Financial managers evaluate the accounting
statements, develop additional data, and make decisions on the basis of their
assessment of the associated returns and risks.

Financial Management and Economics

Financial managers do a better job when they understand how to respond

effectively to changes in supply, demand and prices (firm-related micro factors),
as well as to more general and overall economic factors (macro factors).

The finance manager must be familiar with the microeconomic and

macroeconomic environment aspects of business.

Microeconomics deals with the economic decisions of individuals and firms. It

focuses on the optimal operating strategies based on the economic data of
individuals and firms.

Macroeconomics looks at the economy as a whole in which a particular business

concern is operating. It provides insight into policies by which economic activity is
controlled. The success of the business firm is influenced by the overall
performance of the economy and is dependent upon the money and capital
markets, since the investible funds are to be procured from the financial markets.

The primary economic principle used in managerial finance is marginal analysis,

the principle that financial decisions should be made and actions taken only when
the added benefits exceed the added costs.

ILLUSTRATION: Jamie Teng is a financial manager for Nord Department Stores, a

large chain of upscale department stores operating primarily in the western United
States. She is currently trying to decide whether to replace one of the firm’s online
computers with a new, more sophisticated one that would both speed processing
and handle a larger volume of transactions. The new computer would require a
cash outlay of $80,000, and the old computer could be sold to net $28,000. The
total benefits from the new computer would be $100,000. The benefits over a
similar time period from the old computer would be $35,000. Applying marginal
analysis, what would be your recommendation to Jaime Teng?
SELF-ASSESSMENT:

1. What is the purpose of the financial management? Describe the kinds of

activities that financial management deals with.

2. Explain the shareholder wealth maximization goal of the firm and how it can
be measured. Make an argument for why it is a better goal than maximizing
profit.

3. What are the three types of financial management decisions? For each type
of decision, give an example of a business transaction that would be relevant.

4. In trying to achieve optimum profits, what may a firm ignore?

5. What are some of the micro- and macro-economics factors that influence the
decisions of a firm?

6. Does profit maximization always lead to shareholders’ wealth maximization?

Explain your answer.

7. Discuss why dividend policy is a very important role of a financial manager.

8. What is the primary goal of financial management?

a. Increase earnings
b. Maximizing cash flow
c. Maximizing shareholders’ wealth
d. Minimizing risk of the firm

9. Proper risk-return management means that:

a. the firm should take as few risks as possible.
b. consistent with the objectives of the firm, an appropriate trade-off between
risk and return should be determined.
c. the firm should earn highest return possible.
d. the firm should value future profits more highly than current profits.

10. Which of the following is not a major area of concern and emphasis on modern
financial management?
a. inflation and its effects on profits
b. stable short-term interest rates
c. changing international environment
d. increased reliance on debt

11. Which of the following is not a major area of concern and emphasis on modern
financial management?
a. marginal analysis
b. risk-return trade-off
c. commodity trading
d. changing financial institutions

Reference:

Cabrera, Ma. Elenita Balatbat (2020), GIC Enterprises & Co., Inc.