CHAPTER ONE
OVERVIEW OF FINANCIAL
MANAGEMENT
1.1 Meaning and Definition of Finance and
Financial Management
• In simple terms, finance is defined as the
activity concerned with the planning, raising,
controlling and administering of the funds
used in the business. Thus, finance is the
activity concerned with the raising and
administering of funds used in business.
• Financial management is an integral part of
overall management. It is concerned with the
duties of the financial managers in the
business firm. It is concerned with the
efficient use of an important economic
resource namely capital funds.
• Financial Management deals with
procurement of funds and their effective
utilization in the business.
1.2 Basic Principles of Financial Management
Principle 1: Money has a time value
• Perhaps the most fundamental principle of
finance is that money has a time value. A
dollar received today is more valuable than a
dollar received one year from now. That is, we
can invest the dollar we have today to earn
interest so that at the end of one year we will
have more than one dollar.
Principle 2: There is a risk-return tradeoff
• This principle is based on the idea that
individuals are risk-averse, which means that
they prefer to get a certain return on their
investment rather than an uncertain return.
However, the world is an inherently risky
place, so at least some individuals will have to
make investments that are risky.
Principle 3: Cash flows are the source of value
• Profit is an accounting concept designed to
measure a business’s performance over an
interval of time. Cash flow is the amount of
cash that can actually be taken out of the
business over this same interval. Cash flows
represent actual money that can be spent
which determines an investment’s value.
Principle 4: Market prices reflect information
• Investors respond to new information by
buying and selling their investments. The
speed with which investors act and the way
that prices respond to the information
determine the efficiency of the market. The
prices of financial claims traded in the public
financial markets respond rapidly to the re-
lease of new information.
1.3 SCOPE OF FINANCIAL MANAGEMENT
Financial Management today covers the entire range
of activities and functions given below. The head of
finance is considered to be importantly of the Chief
Executive Officer in most organizations and performs
a strategic role. His responsibilities include:
Estimating the total requirements of funds for a
given period.
Raising funds through various sources, both
national and international, keeping in mind the
cost effectiveness;
Investing the funds in both long term as well as
short term capital needs;
Funding day-to-day working capital requirements
of business;
Collecting on time from debtors and paying to
creditors on time;
Managing funds and treasury operations;
Ensuring a satisfactory return to all the stake
holders;
Paying interest on borrowings;
Repaying lenders on due dates;
Maximizing the wealth of the shareholders over the
long term;
Interfacing with the capital markets;
Awareness to all the latest developments in the
financial markets;
Increasing the firm’s competitive financial strength in
the market; and
Adhering to the requirements of corporate
governance.
1.4 FUNCTIONS OF FINANCIAL MANAGEMENT
The functions of financial management can be
broadly classified into three major decisions,
namely:
(a) Investment decisions,
(b) Financing decisions,
(c) Dividend decisions.
The functions of financial management are
briefly discussed as under:
(a) Investment Decision
• The investment decision is concerned with the
selection of assets in which funds will be invested
by a firm. The assets of a business firm include
long term assets (fixed assets) and short term
assets (current assets). Long term assets will yield
a return over a period of time in future whereas
short term assets are those assets which are
easily convertible into cash within an accounting
period i.e. a year. The long term investment
decision is known as capital budgeting and the
short term investment decision are identified as
working capital management.
(b) Financing Decision
• The second important function is financing
decision. The financing decision is concerned
with capital – mix, financing – mix or capital
structure of a firm. The term capital structure
refers to the proportion of debt capital and
equity share capital. Financing decision of a
firm relates to the financing – mix. This must
be decided taking into account the cost of
capital, risk and return to the shareholders.
(c) Dividend Decision
• The third major function is the dividend policy
decision. Dividend policy decisions are
concerned with the distribution of profits of a
firm to the shareholders. How much of the
profits should be paid as dividend? i.e.
dividend pay-out ratio. The decision will
depend upon the preferences of the
shareholder, investment opportunities
available within the firm and the opportunities
for future expansion of the firm.
1.5 Goals/ Objectives Of Financial Management
• The very objective of Financial Management is to
maximize the wealth of the shareholders by
maximizing the value of the firm. This prime objective
of Financial Management is reflected in the EPS
(Earning per Share) and the market price of its shares.
• The earlier objective of profit maximization is now
replaced by wealth maximization. Since profit
maximization is a limited one it cannot be the sole
objective of a firm. The term profit is a vague
phenomenon and if given undue importance problems
may arise whereas wealth maximization on the other
hand overcomes the drawbacks of profit
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