Basic Concept of Financial Management

Ramji Acharya

Jul 24, 2022

Basic Concept of Financial Management

What is Financial Management?

Finance is the lifeline of any business. However, finances, like most other resources, are always limited. On the other hand, wants are always unlimited. Therefore, it is important for a business to manage its finances efficiently. As an introduction to financial management, in this article, we will look at the nature, scope, and significance of financial management, along with financial decisions and planning.

Introduction to Financial Management

Let’s define financial management as the first part of the introduction to financial management. For any business, it is important that the finance it procures is invested in a manner that the returns from the investment are higher than the cost of finance. In a nutshell, financial management –

Endeavours to reduce the cost of finance
Ensures sufficient availability of funds
Deals with the planning, organizing, and controlling of financial activities like the procurement and utilization of funds.

Definitions of Financial Management

“Financial management is the activity concerned with planning, raising, controlling and administering of funds used in the business.” – Guthman and Dougal

“Financial management is that area of business management devoted to a judicious use of capital and a careful selection of the source of capital in order to enable a spending unit to move in the direction of reaching the goals.” – J.F. Brandley

“Financial management is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient operations.”- Massie

Nature, Significance, and Scope of Financial Management

Financial management is an organic function of any business. Any organization needs finances to obtain physical resources, carry out the production activities and other business operations, pay compensation to the suppliers, etc. There are many theories around financial management:

Some experts believe that financial management is all about providing funds needed by a business on terms that are most favourable, keeping its objectives in mind. Therefore, this approach concerns primarily with the procurement of funds which may include instruments, institutions, and practices to raise funds. It also takes care of the legal and accounting relationship between an enterprise and its source of funds.
Another set of experts believes that finance is all about cash. Since all business transactions involve cash, directly or indirectly, finance is concerned with everything done by the business.
The third and more widely accepted point of view is that financial management includes the procurement of funds and their effective utilization. For example, in the case of a manufacturing company, financial management must ensure that funds are available for installing the production plant and machinery. Further, it must also ensure that the profits adequately compensate the costs and risks borne by the business.

In a developed market, most businesses can raise capital easily. However, the real problem is the efficient utilization of capital through effective financial planning and control.

Further, the business must ensure that it deals with tasks like ensuring the availability of funds, allocating them, managing them, investing them, controlling costs, forecasting financial requirements, planning profits and estimating returns on investment, assessing working capital, etc.

The Scope of Financial Management

The introduction to financial management also requires you to understand the scope of financial management. It is important that financial decisions take care of the shareholders‘ interests.

Further, they are upheld by the maximization of the wealth of the shareholders, which depends on the increase in net worth, capital invested in the business, and ploughed-back profits for the growth and prosperity of the organization.

Core Financial Management Decisions

In organizations, managers in an effort to minimize the costs of procuring finance and using it in the most profitable manner, take the following decisions:

Investment Decisions

Managers need to decide on the amount of investment available out of the existing finance, on a long-term and short-term basis. They are of two types:

Long-term investment decisions or Capital Budgeting mean committing funds for a long period of time like fixed assets. These decisions are irreversible and usually include the ones pertaining to investing in a building and/or land, acquiring new plants/machinery or replacing the old ones, etc. These decisions determine the financial pursuits and performance of a business.
Short-term investment decisions or Working Capital Management means committing funds for a short period of time like current assets. These involve decisions pertaining to the investment of funds in the inventory, cash, bank deposits, and other short-term investments. They directly affect the liquidity and performance of the business.

Financing Decisions

Managers also make decisions pertaining to raising finance from long-term sources (called Capital Structure) and short-term sources (called Working Capital). They are of two types:

Financial Planning decisions relate to estimating the sources and application of funds. It means pre-estimating the financial needs of an organization to ensure the availability of adequate finance. The primary objective of financial planning is to plan and ensure that the funds are available as and when required.
Capital Structure decisions involve identifying sources of funds. They also involve decisions with respect to choosing external sources like issuing shares, bonds, borrowing from banks or internal sources like retained earnings for raising funds.

Dividend Decisions

These involve decisions related to the portion of profits that will be distributed as dividends. Shareholders always demand a higher dividend, while the management would want to retain profits for business needs. Hence, this is a complex managerial decision.