RIFT VALLEY UNIVERSITY

LEGA TAFO CAMPUS

DEPARTMENT OF BUMA
FINANCIAL MANAGEMENT

CHAPTER 1
AN INTRODUCTION TO FINANCIAL MANAGEMENT
1.1 INTRODUCTION
Business concern needs finance to meet their requirements in the economic world. Any kind of
business activity depends on the finance. Hence, it is called as lifeblood of business organization.
Whether the business concerns are big or small, they need finance to fulfil their business
activities.
In the modern world, all the activities are concerned with the economic activities and very
particular to earning profit through any venture or activities. The entire business activities are
directly related with making profit. (According to the economics concept of factors of
production, rent given to landlord, wage given to labor, interest given to capital and profit given
to shareholders or proprietors), a business concern needs finance to meet all the requirements.
Hence finance may be called as capital, investment, fund etc., but each term is having different
meanings and unique characters. Increasing the profit is the main aim of any kind of economic
activity.
MEANING OF FINANCE
Finance may be defined as the art and science of managing money. It includes financial service
and financial instruments. Finance also is referred as the provision of money at the time when it
is needed. Finance function is the procurement of funds and their effective utilization in business
concerns.
The concept of finance includes capital, funds, money, and amount. But each word is having
unique meaning. Studying and understanding the concept of finance become an important part of
the business concern.
DEFINITION OF FINANCE
 According to Khan and Jain, “Finance is the art and science of managing money”.
 According to Oxford dictionary, the word „finance‟ connotes „management of money‟.
 Webster‟s Ninth New Collegiate Dictionary defines finance as “the Science on study of
the management of funds‟ and the management of fund as the system that includes the
circulation of money, the granting of credit, the making of investments, and the provision
of banking facilities.

DEFINITION OF BUSINESS FINANCE

According to the Wheeler, “Business finance is that business activity which concerns with the
acquisition and conversation of capital funds in meeting financial needs and overall objectives of
a business enterprise”.

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 RIFT VALLEY UNIVERSITY
LEGA TAFO CAMPUS
DEPARTMENT OF BUMA
FINANCIAL MANAGEMENT

According to the Guthumann and Dougall, “Business finance can broadly be defined as the
activity concerned with planning, raising, controlling, administering of the funds used in the
business”.
In the words of Parhter and Wert, “Business finance deals primarily with raising, administering
and disbursing funds by privately owned business units operating in non-financial fields of
industry”.
Corporate finance is concerned with budgeting, financial forecasting, cash management, credit
administration, investment analysis and fund procurement of the business concern and the
business concern needs to adopt modern technology and application suitable to the global
environment.
According to the Encyclopedia of Social Sciences, “Corporation finance deals with the financial
problems of corporate enterprises. These problems include the financial aspects of the promotion
of new enterprises and their administration during early development, the accounting problems
connected with the distinction between capital and income, the administrative questions created
by growth and expansion, and finally, the financial adjustments required for the bolstering up or
rehabilitation of a corporation which has come into financial difficulties”.
1.2 DEFINITION OF FINANCIAL MANAGEMENT
 Financial management is an integral part of overall management. It is concerned with the
duties of the financial managers in the business firm.
 The term financial management is concerned with the efficient use of an important
economic resource namely, capital funds”.
 The most popular and acceptable definition of financial management as given by S.C.
Kuchal is that “Financial Management deals with procurement of funds and their
effective utilization in the business”.
 Howard and Upton: Financial management “as an application of general managerial
principles to the area of financial decision-making.
 Weston and Brigham : Financial management “is an area of financial decision-making,
harmonizing individual motives and enterprise goals”.
 Joshep and Massie : Financial management “is the operational activity of a business that
is responsible for obtaining and effectively utilizing the funds necessary for efficient
operations.
 Thus, Financial Management is mainly concerned with the effective funds management
in the business. In simple words, Financial Management as practiced by business firms
can be called as Corporation Finance or Business Finance.
1.3 SCOPE OF FINANCIAL MANAGEMENT
Financial management is one of the important parts of overall management, which is directly
related with various functional departments like personnel, marketing and production. Financial
management covers wide area with multidimensional approaches. The following are the
important scope of financial management.

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 RIFT VALLEY UNIVERSITY
LEGA TAFO CAMPUS
DEPARTMENT OF BUMA
FINANCIAL MANAGEMENT

A. Financial Management and Economics

Economic concepts like micro and macroeconomics are directly applied with the financial
management approaches. Investment decisions, micro and macro environmental factors are
closely associated with the functions of financial manager. Financial management also uses the
economic equations like money value discount factor, economic order quantity etc. Financial
economics is one of the emerging area, which provides immense opportunities to finance, and
economical areas.
B. Financial Management and Accounting
Accounting records includes the financial information of the business concern. Hence, we can
easily understand the relationship between the financial management and accounting. In the
olden periods, both financial management and accounting are treated as a same discipline and
then it has been merged as Management Accounting because this part is very much helpful to
finance manager to take decisions. But nowaday‟s financial management and accounting
discipline are separate and interrelated.
C. Financial Management or Mathematics
Modern approaches of the financial management applied large number of mathematical and
statistical tools and techniques. They are also called as econometrics. Economic order quantity,
discount factor, time value of money, present value of money, cost of capital, capital structure
theories, dividend theories, ratio analysis and working capital analysis are used as mathematical
and statistical tools and techniques in the field of financial management.
D. Financial Management and Production Management
Production management is the operational part of the business concern, which helps to multiple
the money into profit. Profit of the concern depends upon the production performance.
Production performance needs finance, because production department requires raw material,
machinery, wages, operating expenses etc. These expenditures are decided and estimated by the
financial department and the finance manager allocates the appropriate finance to production
department. The financial manager must be aware of the operational process and finance
required for each process of production activities.
E. Financial Management and Marketing
Produced goods are sold in the market with innovative and modern approaches. For this, the
marketing department needs finance to meet their requirements.
The financial manager or finance department is responsible to allocate the adequate finance to
the marketing department. Hence, marketing and financial management are interrelated and
depends on each other.
F. Financial Management and Human Resource
Financial management is also related with human resource department, which provides
manpower to all the functional areas of the management. Financial manager should carefully

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 RIFT VALLEY UNIVERSITY
LEGA TAFO CAMPUS
DEPARTMENT OF BUMA
FINANCIAL MANAGEMENT

evaluate the requirement of manpower to each department and allocate the finance to the human
resource department as wages, salary, remuneration, commission, bonus, pension and other
monetary benefits to the human resource department. Hence, financial management is directly
related with human resource management.
1.4 OBJECTIVES OF FINANCIAL MANAGEMENT
Effective procurement and efficient use of finance lead to proper utilization of the finance by the
business concern. It is the essential part of the financial manager. Hence, the financial manager
must determine the basic objectives of the financial management. Objectives of Financial
Management may be broadly divided into two parts such as:
1. Profit maximization
2. Wealth maximization.
Profit Maximization
Main aim of any kind of economic activity is earning profit. A business concern is also
functioning mainly for the purpose of earning profit. Profit is the measuring techniques to
understand the business efficiency of the concern. Profit maximization is also the traditional and
narrow approach, which aims at, maximizes the profit of the concern. Profit maximization
consists of the following important features.
1. Profit maximization is also called as cashing per share maximization. It leads to maximize
the business operation for profit maximization.
2. Ultimate aim of the business concern is earning profit; hence, it considers all the possible ways
to increase the profitability of the concern.
3. Profit is the parameter of measuring the efficiency of the business concern. So it shows the
entire position of the business concern.
Favorable Arguments for Profit Maximization
The following important points are in support of the profit maximization objectives of the
business concern:
(i) Main aim is earning profit.
(ii) Profit is the parameter of the business operation.
(iii)Profit is the main source of finance.
(iv)Profitability meets the social needs also.

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 RIFT VALLEY UNIVERSITY
LEGA TAFO CAMPUS
DEPARTMENT OF BUMA
FINANCIAL MANAGEMENT

Unfavorable Arguments for Profit Maximization

The following important points are against the objectives of profit maximization:
i. Profit maximization leads to exploiting workers and consumers.
ii. Profit maximization creates immoral practices such as corrupt practice, unfair trade
practice, etc.
iii. Profit maximization objectives leads to inequalities among the stakeholders such as
customers, suppliers, public shareholders, etc.
Drawbacks of Profit Maximization
Profit maximization objective consists of certain drawback also:
i. It is vague: In this objective, profit is not defined precisely or correctly. It creates some
unnecessary opinion regarding earning habits of the business concern.
ii. It ignores the time value of money: Profit maximization does not consider the time value
of money or the net present value of the cash inflow. It leads certain differences between
the actual cash inflow and net present cash flow during a particular period.
iii. It ignores risk: Profit maximization does not consider risk of the business concern. Risks
may be internal or external which will affect the overall operation of the business
concern.
Wealth Maximization
Wealth maximization is one of the modern approaches, which involves latest innovations and
improvements in the field of the business concern. The term wealth means shareholder wealth or
the wealth of the persons those who are involved in the business concern.
Wealth maximization is also known as value maximization or net present worth maximization.
This objective is a universally accepted concept in the field of business.
Favorable Arguments for Wealth Maximization
i. Wealth maximization is superior to the profit maximization because the main aim of the
business concern under this concept is to improve the value or wealth of the shareholders.
ii. Wealth maximization considers the comparison of the value to cost associated with the
business concern. Total value detected from the total cost incurred for the business
operation. It provides extract value of the business concern.
iii. Wealth maximization considers both time and risk of the business concern.
iv. Wealth maximization provides efficient allocation of resources.
v. It ensures the economic interest of the society.
Unfavorable Arguments for Wealth Maximization
(i) Wealth maximization leads to prescriptive idea of the business concern but it may not
be suitable to present day business activities.
(ii) Wealth maximization is nothing, it is also profit maximization, it is the indirect name
of the profit maximization.

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 RIFT VALLEY UNIVERSITY
LEGA TAFO CAMPUS
DEPARTMENT OF BUMA
FINANCIAL MANAGEMENT

(iii) Wealth maximization creates ownership-management controversy.

(iv) Management alone enjoy certain benefits.
(v) The ultimate aim of the wealth maximization objectives is to maximize the profit.
(vi) Wealth maximization can be activated only with the help of the profitable position of
the business concern.
1.5 FUNCTIONS OF FINANCE MANAGER
Finance function is one of the major parts of business organization, which involves the
permanent and continuous process of the business concern. Finance is one of the interrelated
functions which deal with personal function, marketing function, production function and
research and development activities of the business concern. At present, every business concern
concentrates more on the field of finance because, it is a very emerging part which reflects the
entire operational and profit ability position of the concern. Deciding the proper financial
function is the essential and ultimate goal of the business organization.
Finance manager is one of the important role players in the field of finance function. He must
have entire knowledge in the area of accounting, finance, economics and management. His
position is highly critical and analytical to solve various problems related to finance. A person
who deals finance related activities may be called finance manager.
Finance manager performs the following major functions:
1. Forecasting Financial Requirements
It is the primary function of the Finance Manager. He is responsible to estimate the financial
requirement of the business concern. He should estimate, how much finances required to acquire
fixed assets and forecast the amount needed to meet the working capital requirements in future.
2. Acquiring Necessary Capital
After deciding the financial requirement, the finance manager should concentrate how the
finance is mobilized and where it will be available. It is also highly critical in nature.
3. Investment Decision
The finance manager must carefully select best investment alternatives and consider the
reasonable and stable return from the investment. He must be well versed in the field of capital
budgeting techniques to determine the effective utilization of investment. The finance manager
must concentrate to principles of safety, liquidity and profitability while investing capital.
4. Cash Management
Present day‟s cash management plays a major role in the area of finance because proper cash
management is not only essential for effective utilization of cash but it also helps to meet the
short-term liquidity position of the concern.

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 RIFT VALLEY UNIVERSITY
LEGA TAFO CAMPUS
DEPARTMENT OF BUMA
FINANCIAL MANAGEMENT

5. Interrelation with Other Departments

Finance manager deals with various functional departments such as marketing, production,
personnel, system, research, development, etc. Finance manager should have sound knowledge
not only in finance related area but also well versed in other areas. He must maintain a good
relationship with all the functional departments of the business organization
1.6 IMPORTANCE OF FINANCIAL MANAGEMENT
Finance is the lifeblood of business organization. It needs to meet the requirement of the business
concern. Each and every business concern must maintain adequate amount of finance for their
smooth running of the business concern and also maintain the business carefully to achieve the
goal of the business concern. The business goal can be achieved only with the help of effective
management of finance. We can‟t neglect the importance of finance at any time at and at any
situation. Some of the importance of the financial management is as follows:
 Financial Planning
Financial management helps to determine the financial requirement of the business concern and
leads to take financial planning of the concern. Financial planning is an important part of the
business concern, which helps to promotion of an enterprise.
 Acquisition of Funds
Financial management involves the acquisition of required finance to the business concern.
Acquiring needed funds play a major part of the financial management, which involve possible
source of finance at minimum cost.
 Proper Use of Funds
Proper use and allocation of funds leads to improve the operational efficiency of the business
concern. When the finance manager uses the funds properly, they can reduce the cost of capital
and increase the value of the firm.
 Financial Decision
Financial management helps to take sound financial decision in the business concern. Financial
decision will affect the entire business operation of the concern. Because there is a direct
relationship with various department functions such as marketing, production personnel, etc.
 Improve Profitability
Profitability of the concern purely depends on the effectiveness and proper utilization of funds by
the business concern. Financial management helps to improve the profitability position of the
concern with the help of strong financial control devices such as budgetary control, ratio analysis
and cost volume profit analysis.

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 RIFT VALLEY UNIVERSITY
LEGA TAFO CAMPUS
DEPARTMENT OF BUMA
FINANCIAL MANAGEMENT

 Increase the Value of the Firm

Financial management is very important in the field of increasing the wealth of the investors and
the business concern. Ultimate aim of any business concern will achieve the maximum profit and
higher profitability leads to maximize the wealth of the investors as well as the nation.
1.7 Agency problem
As you understand, in a corporate form of business organization owners (stockholders) do not
run the activities of the firm. Rather, the stockholders elect the board of directors, who in turn
assign the management on behalf of the owners. So, basically, managers are agents of the owners
of the corporation and they undertake all activities of the firm on behalf of these owners.
Managers are agents in a corporation to maximize the common stockholders‟ well-being.
However, there is a conflict of goals between managers and owners of a corporation and mangers
may act to maximize their interest instead of maximizing the wealth of owners. Managers are
interested to maximize their personal wealth, job security, life style and fringe benefits.
The natural conflict of interest between stockholders and managerial interest create agency
problems. Agency problems are the likelihood that mangers may place their personal goals a
head of corporate goals. Theoretically, agency problems are always there as long as mangers are
agents of owners.
Corporations (owners) are aware of these agency problems and they incur some costs as a result
of agency.
These costs are called agency cost and include:
1. Monitoring expenditures – are expenditures incurred by corporations to monitor or control
the activities of managers. A very good example of a monitoring expenditure is fees paid by
corporations to external auditors.
2. Bonding expenditures – are cost incurred to protect dishonesty of mangers and other
employees of a firm. Example: fidelity guarantee insurance premium.
3. Structuring expenditures – expenditures made to make managers fell sense of ownership to
the corporation. These include stock options, performance shares, cash bonus etc.
4. Opportunity costs – unlike the previous three, these costs are not explicit expenditures.
Opportunity costs are assumed by corporations due to hindrances of decisions by them as a result
of their organizational structure and hierarchy.

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 RIFT VALLEY UNIVERSITY
LEGA TAFO CAMPUS
DEPARTMENT OF BUMA
FINANCIAL MANAGEMENT

1.8 The financial Market and corporations

Finance people must understand not only the internal environment, but also the financial
environment and markets within which the firm operates. They need to know where capital
required is raised, where the financial instruments are traded, and how stock prices are
determined.
Financial Institutions
Financial institutions are financial intermediaries, which are specialized financial firms that
facilitate the transfer of funds from savers to demanders of capital. They accept savings from
customers and lend this money to other customers or they invest it. In many instances, they pay
savers interest on deposited funds. In some cases, they impose service charges on customers for
the services they render. For example, many financial institutions impose service charges on
current accounts.
The key participants in financial transactions of financial institutions are individuals, businesses,
and government. By accepting the savings from these parties, financial institutions transfer again
to individuals, business firms, and governments. Since financial institutions are generally large,
they gain economies of scale in the transfer of money between savers and demanders. By pooling
risks, they help individual savers to diversify their risk.
Financial Instruments
Financial instruments are written and formal documents of transferring funds between and
among individuals, businesses, and governments. They include loans and borrowing contracts,
promissory notes, commercial papers, treasury bills, bonds, and stocks.
Under normal circumstances, two parties are involved in any financial instrument. For holders,
who have invested their money, financial instruments are financial assets. A financial asset gives
the holder the right to claim against the income and assets of its issuer. For the issuer, on the
other hand, financial instruments represent either liabilities or equity items.
For instance, if you consider a bond, it represents an investment (financial asset) for the holder,
and a debt item for its issuer. Similarly, if you consider a common stock, it represents an
investment and equity item for the holder and issuer respectively.
The issuer gives the financial asset to the purchaser (holder) in exchange for some valuable
consideration, usually in the form of cash or another financial asset.
Financial Markets
Financial markets are markets in which financial instruments are bought and sold by suppliers
and demanders of funds. They, unlike financial institutions, are places in which suppliers and
demanders of funds meet directly to transact business.
Functions of Financial Markets
Generally, financial markets play three important roles in functioning of corporate finance.

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 RIFT VALLEY UNIVERSITY
LEGA TAFO CAMPUS
DEPARTMENT OF BUMA
FINANCIAL MANAGEMENT

1. They assist the capital formation process. Financial markets serve as a way through
which firms can obtain the capital they need for their operations and investment.
2. Financial markets serve as resale markets for financial instruments. They create
continuous liquid markets where firms can obtain the capital they need from individuals
and other businesses easily.
3. They play a role in setting the prices of securities. The price of a financial instrument is
determined through the interaction of demand and supply of the security in the financial
markets.
Classification of Financial Markets
There are many types of financial markets and hence several ways to classify them. For our
purpose, here we shall consider the following two classifications.
1. Classification on the basis of maturity
This is based on the maturity dates of securities
i) Money Markets - are financial markets in which securities traded have maturities of
one-year or less. Examples of securities traded here include treasury bills, commercial
papers, short term promissory notes and so on.
ii) Capital Markets - are financial markets in which securities of long-term funds are
traded. Major securities traded in capital markets include bonds, preferred and
common stocks.
2. Classification on the basis of the nature of securities
This is based on whether the securities are new issues or have been outstanding in the market
place.
i) Primary Markets - are financial marketers in which firms raise capital by issuing new
securities.
ii) Secondary Markets - are financial markets in which existing and already outstanding
securities are traded among investors. Here the issuing corporation does not raise new
finance.

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