APPROACHES TO FINANCIAL MANAGEMENT
Financial management approach measures the scope of the financial management in various fields, which include the essential part of the finance. Financial management is not a revolutionary concept but an evolutionary. The definition and scope of financial management has been changed from one period to another period and applied various innovations. Theoretical points of view, financial management approach may be broadly divided into two major parts.
Traditional approach is the initial stage of financial management, which was followed, in the early part of during the year 1920 to 1950. This approach is based on the past experience and the traditionally accepted methods. Main part of the traditional approach is rising of funds for the business concern. Traditional approach consists of the following important area.
- Arrangement of funds from lending body.
- Arrangement of funds through various financial instruments.
- Finding out the various sources of funds.
After the 1950’s, a number of economic and environmental factors, such as the technological innovations, industrialization, intense competition, interference of government, growth of population, necessitated efficient and effective utilisation of financial resources. In this context, the optimum allocation of the firm’s resources is the order of the day to the management. Then the emphasis shifted from episodic financing to the managing financial problems, from raising of funds to efficient and effective use of funds. Thus, the broader view of the modern approach of the finance function is the wise use of funds. Since the financial decisions have a great impact on all other business activities, the financial manager should be concerned about deter-mining the size and nature of the technology, setting the direction and growth of the business, shaping the profitability, amount of risk taking, selecting the asset mix, determination of optimum capital structure, etc. The new approach is thus an analytical way of viewing the financial problems of a firm. According to the new approach, the financial management is concerned with the solution of the major areas relating to the financial operations of a firm, viz., investment, and financing and dividend decisions.
A. Investment Decision
The investment decision is the most important one among the three decisions. It relates to the selection of assets in which funds are invested by the firm. The assets, which can be acquired, fall into two broad groups:
- Long-term assets which will yield a return over a period of time in future,
- Short-term/current assets which are convertible into cash in the normal course of business usually within a year.
Accordingly, the asset selection decision of a firm is of two types. The first of these involving the first category of assets is popularly known as capital budgeting. The other one, which refers to short-term assets, is designated as liquidity decision.
Capital budgeting decision: It is the most crucial financial decision of a firm which relates to the selection of an investment proposal whose benefits are likely to arise in future over the life-time of the project.
- The first aspect of the capital budgeting decision is the choice of the investment out of the available alternatives. The selection will be always based on the relative benefits and returns associated with it.
- Another aspect of the capital budgeting decision is the analysis of risk and uncertainty. As, the benefits from the proposed investment relate to the future period, their accrual is uncertain. Thus, an element of risk in the sense of uncertainty of future benefits is involved in this exercise. Therefore, the return from the proposed investment should be evaluated in relation to the risk associated with it.
- Finally, this return should be judged with a certain norm, which is referred by several names such as cut-off rate, required rate, hurdle rate, minimum rate of return, etc. The correct standard to use for this purpose is the company’s cost of capital, which is another important aspect of the capital budgeting decision.
Liquidity decision: The liquidity decision is concerned with the management of the current assets, which is a pre-requisite to long-term success of any business firm. The main objective of the current assets management is the trade – off between profitability and liquidity. If a firm does not have adequate working capital, it may become illiquid and consequently fail to meet its current obligations thus inviting the risk of bankruptcy. On the contrary, if the current assets are too large, the profitability is adversely affected. Hence, the key strategy and the main consideration in ensuring a trade-off between profitability and liquidity is the major objective of the liquidity decision.
B. Financing Decision
The second major decision of the firm is the financing decision for determining the best financing mix of the firm. The major issue in this decision is to determine the proportion of equity and debt capital. Since the involvement of debt capital affects the return and risk of shareholders, the financial manager should get the optimal capital structure to maximise the shareholders’ return with minimum risk, in other words the cost of capital is the lowest and the market value of the share is the highest at that combination of debt and equity. Thus, the financing decision covers two inter-related aspects: (i) capital structure theory, and (ii) capital structure decision.
C. Dividend Decision
The third important decision of a firm is its dividend policy. The financial manager must decide whether the firm should distribute all profits or retain it in the firm or distribute part and retain the balance. The dividend decision should be taken in terms of its impact on the shareholders’ wealth. The optimum dividend policy is one, which maximizes the market value of share. Thus, if the shareholders are not indifferent to the firm’s dividend policy, the financial manager must determine the optimum dividend-payout ratio. Another important aspect of the dividend decision is the factors determining dividend policy of the firm in practice.