Finance is the backbone of any business. A business would not be able to run without finance and may get deceased. Finance is basically the art and science of managing monetary resources of a business concern and is extremely crucial for the survival of a business entity. Finance plays an important role, right from the generation of the business idea to its day-to-day functioning and up to the liquidation stage of a business. The Finance aids in the procurement of various resources such as raw materials, machinery, and equipment, human resources, etc., and helps to maintain the smooth flow of business operations. Thus, an efficient and healthy financial management system in an organization is essential.
The term ‘Finance’ has been defined in various ways by different schools of thought. Basically, the term finance revolves around the management of money or the financial resources of a business enterprise. The discipline of finance is concerned with the sources, allocation, application, and usage of money by a business entity for maximizing its returns and stakeholder’s satisfaction.
According to John J. Hampton, “The term finance can be defined as the management of the flows of money through an organization, whether it will be a corporation, school, bank or government agency”.
Meaning and Definition of Financial Management
The term ‘Financial Management’ consists of two words — ‘Financial’ and ‘Management’. In order to fully grasp the meaning of this term, one needs to understand the meaning of both words separately. “Financial” denotes the process of identifying, obtaining and allocating sources of money. “Management” is the process of planning, organizing, coordinating and controlling various resources for the accomplishment of organizational goals.
Therefore, Financial Management is that branch of the business management process, which deals with the management of financial resources of an enterprise. Financial management is the skillful and proper management of financial resources.
According to Howard and Upton, “Financial management is. the application of the planning and control functions of the finance functions”.
According to Weston and Brigham, “Financial management is an area of financial decision making, harmonising, individual motives and enterprise goals”.
Functions of Financial Management
Following are the main functions of financial management:
1) Investment Decision:
The investment decision is concerned with the identification of assets that require investment. Assets are classified into two categories as below:
- Long-Term Assets: They are the assets that are expected to create value for a long period of time. Generally, this time period is longer than one year.
- Short-Term Assets: They are also known as current assets. These assets are expected to be converted into cash in less than a year.
Financial management concerns itself with the financing of both kinds of assets. The part of financial management dealing with current assets is known as working capital management while capital budgeting part of financial management is concerned with long-term assets. The mix of long-term and short-term assets determine the risk profile of a business. This mix also determines the cost of capital incurred by a firm. Investment decisions may be classified into Avo main categories:
- Capital Budgeting Decisions: Capital budgeting decisions are one of the most important decisions taken by a firm as these decisions may determine the long-term financial health of a firm. These decisions involve the analysis of various alternatives available and determining the best alternatives for investment. Financial management has developed various techniques for making these decisions.
- Working Capital Decisions: Working capital decisions are short-term in nature. A business needs to properly manage its short-term working capital requirements in order to remain profitable and liquid. An efficient firm maintains an optimal mix of profitability and liquidity. However, profitability and liquidity are inversely related. The shortage of working capital may increase the risk profile of the business as it will not be able to meet its current liabilities appropriately. At the very same time, if more assets are held than required, it will negatively impact the profitability of the concerti. The process of optimizing working capital is called working capital management. For maintaining proper capital management, account receivables and inventory should be managed properly. Financial managers are also required to take non-recurring investment decisions. The main examples of these decisions are re-organizations, liquidations, and mergers.
2) Financing Decision:
The financing strategy is the second strategy of financial management. In investment strategy, the asset-mix or the asset structure of the firm is planned, whereas financing strategy is related to the financing mix or the capital structure of the firm or leverage. The capital structure is defined as the ratio of debt and equity capital of a firm. They have their own distinct characteristics. The basic difference is in the fixed commitment. A firm needs to pay interest on the borrowed (debt) funds, whether it has earned profit or not.
The firm has to pay interest on borrowed funds even if the firm has suffered loss, but this is not necessary in the case of shareholders’ funds. The borrowed funds carry risk but are cheaper in comparison with shareholder’s funds. This risk referred to as financial risk. The financial risk is defined as the risk of insolvency due to failure in payment of interest or failure in repayment of borrowed capital.
The shareholders’ funds are the fixed source of capital for the firm. They are of two kinds, which are equity share capital and preference share capital. The basic difference between the two is that equity share capital is not repayable and do not have a fixed commitment, but preference share capital is repayable and has fixed commitment like a dividend. The preference shares, which have a redeemable dividend, are known as redeemable preference shares. The financing strategy decides the ratio of sources of finance for investment.
3) Dividend Policy Decision:
Dividend policy decision is another important decision that needs to be taken by is the finance manager. These decisions are closely related to financing decisions. A finance manager can either choose to retain the business profits for the future or may decide to distribute them among various stakeholders. Thus, a finance 4nanager needs to decide whether to retain or distribute the firm’s profits.
Usually, the firm distributes dividends in the constant situations for fulfilling the demand. of shareholders and rest is kept in the firm for growth. The distribution of dividends among shareholders will increase the goodwill of the firm among shareholders. The non-declaration of dividend affects the market price of the firm’s equity share. The dividend payout ratio refers to as the amount to be paid as a dividend to the shareholder and it is also one of the important factors of dividend strategy.
The factors which affect dividend strategy are the preference of equity shareholders and investment opportunities present within the firm. The high rate of dividends as compared to market expectation will increase the market price of the share. The retained earning is left for expansion. The growth of the firm will increase with the reinvestment done by the firm. The business can also expand with the help of raising funds. Market. The firm should not keep all the profit but also distribute the dividend among the shareholders.
4) Liquidity Decision:
These decisions deal with the proper administration of the current assets of a firm. In this way, liquidity decisions are closely related to working capital decisions. Working capital management is also concerned with the proper utilization of current assets. It is important for the short-term existence of a firm. These decisions also determine the course of the long-term existence of a firm. If current assets are more than required, then it ensures a firm’s better liquidity. This means that the firm will be able to honor its commitments on a regular basis. This also denotes that a firm is not likely to default on its repayments and hence it can avoid the risk of insolvency.
However, the excess funds tied up in ‘current assets can have alternative use and thus have a cost of utilization. These unutilized funds can have a negative impact on a firm’s profitability. A finance manager needs to strike a balance between liquidity and profitability. These decisions are continuous in nature and need to be re-adjusted periodically. These decisions are taken after properly judging the requirements and financial health of a firm. Working capital management is a regular problem, which also tests the finance manager’s skills.