Scope of Financial Management

1. Introduction

Financial management provides a framework for making sound financial decisions. It encompasses both the acquisition of funds and their efficient allocation to various uses within a firm. In essence, it's an integral part of overall management that aims to maximize value and ensure the long-term viability of the business.

2. Core Principles

The central idea of financial management is to address fundamental questions about how a firm should manage its finances:

• How much capital should a company commit?
• What assets should the company acquire?
• How should the company finance its operations?

These questions boil down to three core financial decisions:

1. Investment Decisions: How to allocate funds to various assets.
2. Financing Decisions: How to acquire the funds needed to finance those assets.
3. Dividend Policy Decisions: How to distribute profits to shareholders or reinvest them in the business.

3. Key Decision Areas

3.1. Investment Decisions

The investment decision is about selecting the assets a firm will invest in. These assets fall into two broad categories:

1. Long-Term Assets: These yield returns over an extended period (e.g., buildings, machinery). Decisions related to these assets are called capital budgeting.
2. Short-Term (Current) Assets: These assets are easily convertible into cash, typically within a year (e.g., inventory, cash). Managing these is called working capital management.

3.1.1. Capital Budgeting

Capital budgeting is a crucial financial decision that involves:

• Selecting Long-Term Investments: Choosing projects that will provide benefits over the life of the project.
• Evaluating Investment Proposals: Appraising potential assets based on their relative benefits and returns.
• Analyzing Risk and Uncertainty: Considering the uncertainty associated with future benefits and their associated risk.
• Establishing a Cut-Off Rate: Determining the minimum rate of return that an investment must meet to be considered acceptable. This rate is often expressed in terms of the cost of capital.

In summary, capital budgeting involves:

• The long-term assets and their composition
• The business risk complexion of the firm
• The concept and measurement of the cost of capital

3.1.2. Working Capital Management

Working capital management deals with the management of short-term assets. Key aspects include:

• Balancing Profitability and Risk: Managing the trade-off between profitability and liquidity. Insufficient working capital can lead to illiquidity and bankruptcy, while excessive working capital can negatively impact profitability.
• Efficient Asset Management: Ensuring that individual current assets, like cash, receivables, and inventory, are managed efficiently to prevent shortages or unnecessary tie-up of funds.

Working capital management consists of an overview of working capital management as a whole, and efficient management of the individual current assets.

3.2. Financing Decisions

The financing decision focuses on how a firm obtains the funds to finance its investments. This is about determining the right mix of:

• Debt (Fixed-Interest Financing): Funds borrowed with a fixed interest rate.
• Equity (Variable-Dividend Securities): Funds raised from owners or shareholders.

Key aspects of the financing decision include:

• Capital Structure Theory: Understanding the relationship between debt and equity in relation to maximizing shareholder returns. The use of debt implies higher returns to shareholders but also increases financial risk.
• Optimum Capital Structure: Aiming for a balance of debt and equity that maximizes returns while managing risk.
• Appropriate Capital Structure: Determining the right proportions of debt and equity in a particular situation.

The financing decision covers capital structure theory, and the practical capital structure decisions.

3.3. Dividend Policy Decisions

The dividend policy decision focuses on how a firm decides to distribute its profits. This involves choosing between:

• Distributing Profits: Paying dividends to shareholders.
• Retaining Profits: Reinvesting earnings back into the business.

A key factor in the dividend decision is the dividend payout ratio, which is the proportion of net profits that are paid to shareholders. The final decision depends on factors like shareholder preferences and investment opportunities within the firm.

In essence, dividend decisions include determining the dividend pay-out ratio and also consider the various factors that determine a company's dividend policy in practice.

4. Key Activities of the Financial Manager

The primary activities of a financial manager are:

1. Performing Financial Analysis and Planning:

   • Transforming financial data to monitor financial health.
   • Evaluating the need for increased or reduced productive capacity.
   • Determining additional or reduced financing needs.
   • Developing cash flow plans to achieve firm goals.

2. Making Investment Decisions:

   • Determining the optimal mix of current and fixed assets.
   • Deciding on optimal levels of each type of current asset.
   • Deciding which fixed assets to acquire, modify, or dispose of.

3. Making Financing Decisions:

   • Determining the most appropriate mix of short-term and long-term financing.
   • Selecting the best individual sources of short-term or long-term financing, considering their costs and implications.

5. Conclusion

Financial management is a crucial function that involves making decisions related to investment, financing, and dividends. It provides a framework for analyzing financial problems and allocating resources effectively. The modern approach to financial management recognizes that these decisions are interconnected and must be made in a coordinated manner. The financial manager uses various analytical techniques to make decisions that will help achieve the objectives of the firm, ultimately driving the creation of value.