Financial management is that managerial activity which is related to the planning and controlling of the firm’s financial resources. Finance was developed as a spate discipline after the 1890s. Before that, it was considered as the branch of economics. Still, finance does not have a unique body of knowledge of its own. So it depends heavily on economics for its theoretical concepts. Financial management has a crucial scope, role and functions in business decisions and management.
Financial management is of huge importance in academic sectors and for the practicing managers. The subject is still developing so it holds immense importance in the academic sector and for practicing managers it provides ideas and techniques and concepts in crucial financial decision making. It means the understanding of the theories and concepts of financial management will make it easy in crucial financial decision making for practicing managers.
In every business firm, there are major three activities as finance, production, and marketing. The process of securing needed capital and employing it in organizational activities (production and marketing) is called finance. The invested capital (employment of finance into production and marketing) generates returns to the business firm. Therefore we can say that a business firm operates the activities of finance and its employment. It means activities relating to finance, production, and marketing.
The firm gets or acquires funds from the sources known as investors. The fund so acquired is if invested called investment. The firm expects to receive a return on their investment over time. And then periodically disburse the generated return periodically to investors. This is not sequential but performed simultaneously and continuously.
Raising capital funds, using them for generating returns, and distributing returns to the investors and suppliers of funds are considered as major functions of the firm.
Financial management functions are carried out in order to achieve the objectives of organizations. Financial management functions are mainly viewed from two approaches as traditional function or role and the new role or functions. Raise of funds is taken as a traditional role or function whereas raise and allocation of funds are taken as a new role of financial management or finance managers. The first approach confines the functions of financial management is the procurement of funds only and ignores the utilization of funds whereas, the second approach not only focuses on the procurement of funds but effective utilization of funds as well.
Traditional Approach to Scope, Role, and Functions of Financial Management
The traditional approach to scope, role, and functions of financial management refers to its subject matter in the academic literature in the initial stage of its evolution as a separate branch of knowledge and academic study.
The term corporation finance was used to describe what we know in the academic sector as financial management. Corporation finance was related to the financing of corporate enterprises. Thus the role, scope, and functions of financial management under the traditional approach were limited only up to the procurement of funds by corporate enterprises to meet their financing needs. Thus the field of study dealing with the attainment of the needed funds was regarded as financial management. The traditional approach to scope and functions of financial management was originated during the 1920s.
With passes of time, the conceptual framework of traditional scope, role, and function was unable to answer the issues like should an enterprise commit capital funds to certain purposes? Do the projected proceeds or returns convene or meet the financial standard of performance? How to set these standards what is the price of capital funds to the enterprises? How does the cost vary with the mixture of financial methods used?
In the absence of coverage of these issues, traditional concepts seemed very limited for broader concepts and functions of financial management. The modern approach provides a solution to these limitations.
A Modern Approach to Scope, Role, and Functions of Financial Management
This approach views the meaning, scope, role, and functions of financial management in the broader sense. It has provided a conceptual and analytical framework for financial decision-making and management. According to the modern approach financial management covers both acquisitions of funds and its allocation.
So along with issues of acquiring external funds, the major concern of financial management is the efficient and wise allocation of funds to various uses. So under the modern approach financial management is considered an integral part of overall management.
The new or modern approach is an analytical way of looking at the financial problems of a business. Thus the modern view of financial management ensures solutions to the issues like what is the total volume of funds an enterprise should commit? What specific assets should an enterprise acquire? Hoe should the funds required to be financed? How big must an enterprise be, and how quickly should it raise or grow? In what firm should it hold assets? What should be the composition of liabilities?
Financial management in new approach is related to solution of above issues relating to the financial operation of the firm (financing, investment and distribution of return or investment-production and marketing, financing and distribution of return-dividends).
The major scope, role, and functions of financial management in the new approach are listed below;
It is a managerial decision concerning investment in short as well as long term business plans. Investment decision includes decisions concerned with acquisition, modification, and replacement of long-term assets. For example building, plant and machinery, lands, equipment, and so on.
Long-term investment proposals involve high risk as the business environment is unpredictable and the future is uncertain. It is the duty of a financial manager to estimate the expected risk and return and make decisions accordingly.
The financial manager should accept the long-term investment proposal only If it maximizes shareholder’s wealth. Capital budgeting techniques are used by finance managers to choose the best investment alternative.
Financing decision includes decisions concerned with determining the sources of funds and deciding the appropriate source of fund which benefits the organization. It is all about making an efficient capital structure of the firm.
Under the financial decision, a manager should assess what amount of capital is required and which source could be relied upon. The sources of long-term financing may be equity capital or debt capital. Sourcing from debt capital is beneficial because the interest expenses on debt capital are deductible and the effective cost of debt capital is lower comparatively than other sources. However, the use of excess debt capital might create a risk of bankruptcy and also increase the financial risk perceived by shareholders.
An appropriate combination of debt and equity capital may be more beneficial to an organization. It is the duty of the financial manager to decide an appropriate combination of capital structure so that a proper balance between risk and return can be maintained that reduces the cost of capital and maximizes shareholders’ wealth.
Dividend policy decision
Another major decision, scope, role, and function of financial management is taking decisions relating to the dividend policy. There are always two alternatives relating to the profit of the firm. They can be distributed to the shareholders in the form of dividend or they can be retained in the business as retained earnings.
If the company follows the disbursement of profit to its shareholders then it is called a dividend decision. While taking it the major issue may be the dividend payout ratio means what proportion of profits is to be distributed or paid out to the shareholders.
So, dividend decision is deciding the part if earnings to be distributed among the shareholders. The total net income after making payment to preference shareholders belongs to common shareholders.
However, an organization is not always liable to pay a dividend to its common shareholders. The financial manager might pay all the earnings as dividends, retain all the earnings for reinvestment, and pay a certain portion of the total earnings as dividends and retain the rest for reinvestment.
The financial manager has to consider the existing practices of the organization, the attitude of the shareholders, further investment opportunities, and legal requirements while making dividend decisions. Further, he should also decide whether to pay the dividend in cash or in stock or in cash and stock both ways.
Working capital management
Working capital management is related to the management of the current assets of the business organizations. It is a vital and prominent part of financial management in modern businesses. The short-run survival is essential and prerequisite to survive in the long-run. So working capital management and decision relating to the trade-off between profitability and liquidity (risk) is crucial in the business.
All the managerial decision regarding current asset decision and financing decision comes under the working capital decision. Investment in current assets and has a great impact on the organization’s profitability and liquidity.
Liquidity means the capacity of an organization to meet short term obligations. More investment made in current assets enhances the liquidity of an organization and at the same time negatively affects the profitability because idle current assets do not earn anything.
Looking at the scope, role, and functions of financial management, the traditional approach had a very narrow perception and was devoid of an integrated conceptual and analytical framework of financial management and overall management of the business. On the other hand, the new approach has enlarged the area, scope, role, coverage, and functions of financial management. It includes the solution to the basic three issues of business firms like investment, finance, and dividends. These three functions are simultaneous, continue, and interrelated and should be taken into consideration jointly to reach the goal of optimum financial management. So there are crucial and high-flying scope, roles, and functions of financial management in every business organization.