Everything you need to know about the scope to financial management. To understand the scope and functions of financial management, it becomes essential to explain its approaches.
The importance of financial manager in the business is increasing with the passage of time. The financial manager occupies a significant place in modern business.
The scope of financial management can be studied under the following heads:- 1. Traditional Approach 2. Modern Approach.
According to modern approach, three important decisions are taken under financial management:- 1. Investment Decision 2. Financing Decision 3. Dividend Decision.
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The scope of financial management also includes:-
1. Anticipation of Funds- Estimation of Financial Needs of the Company 2. Acquisition of Funds-Gathering Funds for the Company from Different Sources 3. Allocation of Funds- Use of Funds to Buy Fixed and Current Assets 4. Appropriation of Funds- Dividing and Distribution of Profits 5. Assessment- Evaluation of Financial Plans and Polices.
Additionally, learn about:- 1. Limitations of Traditional Concept 2. Characteristics of Modern Approach 3. Areas of Interest in the Modern Approach 4. Aspects of Traditional Approach.
Scope of Financial Management: Traditional Approach and Modern Approach
Scope of Finance Function or Financial Management- 2 Major Approaches: Traditional Approach and Modern Approach
To understand the scope and functions of financial management, it becomes essential to explain its approaches. The importance of financial manager in the business is increasing with the passage of time. The financial manager occupies a significant place in modern business.
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He is an active member of the top management group. His work is not only limited to maintaining records, preparing reports or to procure adequate funds from different sources but his role is also assuming greater significance in solving difficult and complex problems of business. He is now being held responsible as maker of business destiny.
Therefore, it has become essential for the financial manager to adopt a more comprehensive and foresighted approach. His decisions affect the size, growth and expansion, profitability and risk of business. But he had not always been considered an important person in making such decisions. However, today he is considered an important functionary.
The following are the two approaches to financial management or finance function:
Scope # 1. Traditional Approach to Finance Function:
This approach was developed around twentieth century. Under this approach, financial management was considered as ‘Corporation Finance’. Under this approach, the financial management was used to procure and administer funds for the corporation.
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The following three things were used to be studied for the procurement of finances:
(i) Institutional sources of finance.
(ii) Issue of financial instruments to collect necessary funds from the capital market.
(iii) Legal and accounting relationship between the business and source of finance.
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According to this approach, finance was needed not for routine matters but for sporadic events like promotion, reorganisation, expansion, liquidation, etc. Managing funds for these events was considered an important function of financial manager. The financial manager was not concerned with internal financing rather he was supposed to maintain relationship with outside parties and financing institutions.
According to traditional approach, he was not responsible for the efficient use of funds. His duty was to get necessary funds on fair terms from the outside parties. The traditional approach of the finance function continued till the fifth decade of the 20th century.
Limitations of Traditional Concept:
The traditional approach to finance function emphasises on procurement of funds only by corporations. Therefore, this approach is considered defective and narrow.
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Following are the main limitations of this approach:
(i) One Sided Approach:
This approach gives more attention to procurement of funds and the problems attached to their administration but ignores the efficient utilisation of funds. This approach attaches more significance to the viewpoint of outside parties (Banks, financial institutions, investors) who provide funds to the business but ignores the internal parties who take financing decisions. It is, therefore, termed as outsider-looking approach.
(ii) More Emphasis on the Financial Problems of Corporations:
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This approach focused attention only on the financial problems of corporate enterprises but non-corporate enterprises, e.g., sole trade and partnership firms, remained outside its scope. It has, thus, narrowed the scope of finance function.
(iii) More Importance to Sporadic Events:
This approach considers the finance section to provide funds on sporadic events like incorporation, mergers, consolidation, reorganisation, etc. and ignores the day to day financial problems of business enterprise.
(iv) More Emphasis on Long Term Funds:
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This approach gives more importance to the problems of long-term financing. Working capital financing decisions are kept outside the scope of finance function.
Thus, traditional approach ignores the central issues of financial management e.g., should an enterprise commit capital funds to certain purposes? Do the expected returns meet financial standards of performance? How should these standards be set and what is the cost of capital funds to the enterprise?
Scope # 2. Modern Approach to Finance Function:
By the end of 1950’s technological improvements, development of strong corporate structure and increasing competition made it essential for the management to make optimum use of available financial resources. Traditional approach became less effective in the changing business environment and accordingly, this new approach developed.
According to this approach, financial management considers the broader and analytical viewpoint. According to this approach, financial management is concerned with both acquisition of funds and their effective and optimum utilisation. Arrangement of funds is an important component of the whole finance function.
This viewpoint not only considers the sporadic events but also the long-term and short-term financial problems. The main components of this approach include financial planning, evaluation of alternative uses of funds, determination of cost of capital, capital budgeting, working capital management, determination of financial standards for the success of business, management of income, etc. Therefore, according to this approach, three important decisions are taken under financial management.
(i) Investment Decision.
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(ii) Financing Decision, and
(iii) Dividend Decision.
Characteristics of Modern Approach:
The following are the main characteristics of modern approach:
(i) More Emphasis on Financial Decisions:
As compared to the traditional approach, modern approach is less descriptive and more analytical. Due to increasing size of business and competition, business management can’t afford to take decisions based on intuition. Right decisions can be taken only on the basis of statistical and accounting data. Such decisions are less risky.
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(ii) Financial Management as an Important Component of Business Management:
Under the traditional approach of finance function, financial manager was not considered to be significant in decision making. But now, he is considered an important part of business and he affects the important decisions of business.
(iii) Continuous Function:
Under traditional approach, financial management was used to arrange funds for sporadic events only but under the modern approach, financial management is a continuous activity and a financial manager has to take various routine financing decisions also.
(iv) Broader View:
The modern approach to finance function expresses broader view as it gives much importance to the optimum use of finance along with the procurement of funds. Besides this, it also includes aspects relating to financial planning, capital budgeting, cost of capital, etc.
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(v) Measure of Performance:
Financial decisions also affect the performance of business. If the financial decisions add to the value of firm, they will be considered good. To maximise the value of firm, a proper balance between profitability and liquidity is must Modern approach to finance function explains that the maintenance of this balance in profitability and liquidity is the main function of financial management.
Scope of Financial Management- Traditional Approach and Modern Approach
There are a number of approaches concerned with financial management. The various approaches have been divided broadly into two major categories for the sake of convenience.
1. The Traditional Approach:
This approach confined the scope of finance function to only procurement of funds needed by a business on most suitable terms. The utilization of funds was kept outside the purview of the finance function. Decisions regarding the application of funds were considered to be taken somewhere else in the organization. Instruments and institutions for raising funds were considered as part of finance function.
The traditional approach suffers from the following serious drawbacks:
i. It is considered as an outsider-looking in approach. It completely ignores the aspect of the internal decision-making regarding proper utilization of procured funds.
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ii. Its focus was on the procurement of long term funds. As a result it ignored the short term needs of the firm. Every firm needs to obtain and manage working capital. Improper management of working capital has resulted in closure of firms. It is equally important to manage ones short term requirements.
iii. The important aspect of allocation of funds has been completely left out. It is important to obtain funds on most suitable terms. It is also important to ensure that the acquired funds are allocated properly to ensure adequate liquidity and profitability.
iv. This approach does not focus on the day to day financial problems faced by an organization. This makes the traditional approach very narrow in scope.
The traditional approach has now been discarded as outdated.
2. The Modern Approach:
The modern approach to financial management includes both the procurement of funds on suitable terms and the effective utilization of funds to ensure both liquidity and profitability. It compares the cost of raising funds with the returns that can be earned by their use.
The funds raised must always give more returns than the cost of raising and keeping them. The modern approach to financial management considers finance function as an integral part of overall management which includes financial planning, raising of funds, allocation of scarce resources, financial control etc.
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The modern approach considers the three basic management decisions, namely:
i. The financing decisions.
ii. The investment decisions.
iii. The dividend decisions.
It is an analytical way of dealing with the financial problems faced by a firm. It uses techniques of models, mathematical programming, simulations and financial engineering to solve the complex problems of present day financial management.
Scope of Financial Management- 2 Main Approaches: Traditional Approach and Modern Approach
There are two approaches to the scope of financial management:
1. Traditional Approach:
This approach to financial management was in force during the early nineties. It focused mainly on procurement of funds, through long-term sources (like financial institutions and capital markets), during the episodic events (incorporation, mergers, acquisitions etc.) of the corporate life.
This approach suffered from the following limitations:
(i) It aimed at procurement of funds and not its utilisation in different investment outlets.
(ii) It emphasised on long-term sources of funds and ignored the short-term financial requirements of the organisations.
(iii) The requirement of long-term sources was also considered during the episodic events. The day-to-day requirement of funds was ignored.
(iv) It catered to financial requirements of the corporate sector only. Financial requirements of non-corporate sector were not looked into.
2. Modern Approach:
Limitations of the traditional approach were overcome in the modern approach to financial management. The focus in this approach is not only on requirement of funds but also its effective utilisation.
Three main areas of interest in the modern approach are:
(i) What should be the size of the firm and what is the total volume of funds committed to the firm and what should be the asset composition of the firm?
(ii) What are the available sources of finance?
(iii) How should the profits of the firm be distributed?
Scope of Financial Management-2 Broad Categories of approaches to Scope: Traditional Approach and Modern Approach
The approach to the scope and function of financial management is divided into two broad categories:
1. Traditional Approach, and
2. Modern Approach.
1. Traditional Approach:
The traditional approach to the scope of financial management, refers to the initial stages of evolution of the subject matter, as a separate branch of discipline. Then the term, ‘corporate management’ was used to describe the present term, ‘financial management’. The term, ‘corporation finance’, then meant financing of corporate enterprises. In other words, the scope of finance function was treated by the traditional approach in the narrow sense of procurement of funds, by corporate enterprises to meet their financing needs.
The term procurement was used in a broad sense, so as to include all sources of raising funds externally. Thus the traditional approach limited the role of financial management to, raising and administering of funds needed by the corporate enterprises and to meet their financial needs.
It broadly covered the following three aspects:
a. Arranging funds from financial institutions,
b. Arranging funds from the capital market, and
c. The legal and accounting relationships between a firm and its sources of funds.
As per this approach the finance manager had a limited role to perform – that is, to keep accurate financial records, report about the status and performance of the firm and the proper management of cash, so that the firm is in a position to pay its bills on time.
Criticisms of Traditional Approach:
The traditional approach of finance was criticized for the following reasons:
(i) Outsider Looking Approach:
The approach equated finance function, with the issues involved in raising and administering funds. It thus treated the subject financial management, from the view point of suppliers of funds, that is, outsiders who supplied funds. Thus it completely ignored the viewpoint of those, who had to take the internal financial decisions, that is, insider looking approach was completely ignored. The traditional approach was in other words, the outsider looking approach.
(ii) Ignored, Non-Corporate Enterprises:
Financial management deals with financing problems of corporate and non-corporate enterprises. But the traditional approach focused on financing problems of corporate enterprises and non-corporate industrial organisations remained outside its scope.
(iii) Ignored, Day to Day Financial Problems:
Another criticism was that, the approach gave too much emphasis on episodic, or infrequent happenings in the life of an enterprise – that is, financial problems related to promotion, incorporation, merger, amalgamation, reorganisation, etc., of corporate enterprises. But the approach did not give any importance, to day to day financial problems of business undertakings.
(iv) Ignored, Working Capital Management:
The traditional approach gave emphasis on the problems of long term financing. The issues related to working capital management were ignored.
(v) No Emphasis on Allocation of Funds:
The approach confined financial management to issues related with procurement of funds. It ignored the central issue of financial management, that is, allocation of funds. Ezra Solomon pointed out these issues in his book, “Theory of Financial Management”.
They are:
(a) Should an enterprise commit capital funds to certain purposes?
(b) Do the expected returns meet financial standards of performance?
(c) How should these standards be set and what is the cost of capital funds, to the enterprise?
(d) How does the cost vary with the mixture of financing methods used?
Traditional approach failed to provide answers to these crucial aspects, thus implying a narrow scope for financial management. The modern approach provides a solution to these criticisms.
2. Modern Approach:
The modern industrial or service firm, must conduct its business in a rapidly changing and highly competitive environment. The success depends on the firm’s ability to react quickly and correctly to constantly changing market conditions. In this context, it is worth quoting that finance is the life blood of a business enterprise. Moreover business needs money, to make more money and it is possible, only when it is properly managed.
So as per the modern approach, financial management is concerned with all aspects of the firm’s operations, including, production of goods and services, sales and marketing activities, personnel training, data processing, etc. As per the modern approach, the term financial management is a broad term, that provides a conceptual and analytical framework, for financial decision making – that is, the finance function covers both acquisition of funds, as well as their allocation.
In other words, financial management according to the new approach, is concerned with providing solutions for three major problems, relating to the financial operations of a firm, namely, investment, financing and dividend decisions. Thus as per the modern approach, financial management can be divided into three major decisions, affecting the finance functions of a firm.
They are:
(a) The investment decision,
(b) The financing decision, and
(c) The dividend decision.
Scope of Financial Management- Aspects of Traditional and Modern Approach
Financial management, as an academic discipline, has undergone significant changes over the years with regards to its scope and coverage. As financial management evolved from traditional phase to the modern phase, it has emerged as a distinct field of study. Therefore, the scope of financial management can be studied with reference to Traditional Approach as well as Modern Approach.
1. Traditional Approach:
The traditional approach, which was popular in the early part of 20th Century, tended to limit the role of financial management to procuring and administering of funds needed by the corporate enterprises to meet their financial needs.
This approach broadly covers three aspects:
(i) Procurement of funds from financial institutions.
(ii) Procurement of funds through shares, debentures, bonds and other financial instruments.
(iii) Looking after legal and accounting relations between a corporate enterprise and its sources of funds.
The scope of finance was treated by the traditional approach in the narrow sense. It focused on procurement of funds by corporate enterprises to meet their financial needs. The finance manager had a limited role to perform. The finance manager, apart from managing funds in such a way as to ensure meeting its obligations on time, was expected to keep accurate financial records, prepare reports on financial status and performance of the enterprise.
Since the main emphasis of finance function during this period was on the procurement of funds, the subject was called corporation finance till the mid-1950s and covered discussion on the financial instruments, institutions and practices through which funds were obtained. Further, as the problem of raising funds was more intensely felt on certain episodic events such as merger, liquidation, consolidation, reorganization, etc., there was little attention paid to the routine financial aspects of a company.
The traditional approach evolved during 1920s and 1930s and that continued to dominate academic thinking during the forties and through the early fifties.
However, it suffered from the following serious limitations:
(a) Outsider-Looking-In Approach:
The emphasis in the traditional approach used to be on the procurement of funds by the corporate enterprises. The subject was woven around the viewpoint of the suppliers of funds such as investors, financial institutions, investment bankers, etc., that is, outsiders. It implies that the traditional approach was the outsider-looking-in approach. It completely ignored internal financial decision-making by the management.
(b) Ignored Routine Problems:
The scope of financial management was confined only to the episodic events such as mergers, acquisitions, reorganizations, etc. This implies that it was confined to these infrequent happenings in the life cycle of an enterprise and day-to-day financial aspects were ignored completely.
(c) Ignored Working Capital Financing:
The focus was on the long-term financial problems thus ignoring the importance of the working capital management. Therefore, this approach failed to consider the routine managerial problems relating to finance of the firm.
(d) No Emphasis on Allocation of Funds:
This approach was confined to the issues involving procurement of fund. It neither emphasized allocation of funds nor their efficient utilization.
(e) Viewed Finance Function as Staff Speciality:
It failed to view financial management as integral part of overall management that seeks to achieve organizational goals. Finance function was viewed as staff speciality that was concerned with funds raising operations. Some core issues like cost benefit analysis of alternative sources of finance to achieve broader financial goals were completely ignored.
Thus, the traditional approach tended to omit such important aspects of finance function as cost of the capital, optimum capital structure and valuation of firm. In the absence of these crucial aspects in the finance function; scope of financial management under the traditional approach was very narrow. The modern (or new) approach provides a solution to all these aspects of financial management.
2. Modern Approach:
The traditional approach outlived its utility due to change in business environment since mid-1950s. Technological improvements, widened marketing operations, advent and usages of computer in financial decision-making, development of various pricing models, valuation models and investment portfolio theories enlarged the scope of finance. There was a shift of emphasis from episodic financing to the managerial financial problems, from raising of funds to optimum utilization of funds.
The total approach to the study of finance has changed and is termed as “Financial Management”. The modern approach is an analytical way of looking at the financial problems of a firm. According to the modern approach, the finance manager’s job is to acquire funds and allocate them judiciously keeping in mind the objectives of the organization.
The modern approach focuses on the following questions:
(i) What is the total volume of funds that an enterprise requires?
(ii) What are the specific assets that an enterprise should acquire?
(iii) How should the requirement of funds be financed?
The above questions relate to the three major areas relating to the financial operations of a firm, viz., investment, financing and dividend decisions.
These are as discussed below:
(a) Investment Decision:
It revolves around spending capital funds on assets that are expected to yield the highest return for the firm over a desired period of time. In other words, the decision is about what to buy so that the firm gains the most value. A major part of capital funds is used to acquire long-term assets (or fixed assets) while another part is used to acquire short-term assets (or current assets). As a result, investment decision tends to influence the assets mix.
Long-term assets are owned by an enterprise and used in the generation of its income. They are not expected to be consumed or converted into cash any sooner than at least one year’s time. Such assets yield a return over a period of time in future. The decisions relating to such long-term or fixed assets are known as capital budgeting decisions.
Short-term assets are those assets which are easily convertible into cash within an accounting period, that is, a year. Short-term assets involve investments on a continuous basis for performing operating activities. The acquisition and management of short-term assets becomes the subject matter of working capital management.
(i) Capital Budgeting:
Capital Budgeting may be defined as long-term planning for acquisition of fixed assets to create the operating infrastructure of a firm. In other words, capital budgeting means the long-range planning of allocation of funds among the various investment proposals in such a way as to yield maximum possible benefits in future. This is a decision that is based on risk and uncertainty.
Therefore, the finance manager has to evaluate risk, measure the cost of capital and estimate the expected benefits to determine whether the investment is feasible or not. It is the function of finance manager to carefully analyse different capital budgeting proposals and select the best among such proposals. Capital budgeting is a very important decision as it affects the long-term success and growth of a firm.
As these are irreversible decisions, a wrong decision can affect the future profitability of the firm. At the same time, it is a very difficult decision because it involves the estimation of costs and benefits which are uncertain and unknown. Most of the costs, which are measured as cash outlays, are incurred much before the receipt of benefits in the form of cash inflows. There is a lot of risk and uncertainty attached to benefits from cash inflows that are expected to be received only in distant future.
(ii) Working Capital Management:
The finance manager is also responsible for the efficient management of current assets and their mix and that is called working capital management. Formally, working capital management refers to determination, investment and monitoring of operating assets – Stock in trade, debtors, marketable securities, cash and cash equivalents along with the short-term maturing obligations – Creditors, bills payables and other deferred payments.
A finance manager needs to provide for adequate levels of working capital in consonance with the operating activity of an enterprise. Working capital constitutes an integral part of financial management. The finance manager has to determine the degree of liquidity that a firm should possess. There is a conflict between profitability and liquidity of a firm.
The maintenance of a higher level of liquidity tends to reduce the level of profitability. Insufficiency of funds in current assets reduces liquidity and possessing of excessive funds in current assets reduces profits. The issues pertaining to trade-off between profitability and liquidity are resolved as a part of working capital management.
In order to achieve a proper trade-off between liquidity and profitability, the finance manager must equip himself with sound techniques of managing the current assets like cash, receivables and inventories and so on.
(b) Financing Decision:
While the investment decision tends to affect the composition (or mix) of assets, financing decision, that is concerned with mobilization of funds for investment from different sources of finance, has a direct bearing on the capital mix (or financial structure) of the firm. The raising of funds requires decisions regarding the methods and sources of finance, relative proportion and choice between alternative sources, time of floatation of securities, impact of capital structure on profitability, liquidity and value of the firm.
The financing of investment proposals is achieved in either of the forms: debt, equity or a combination of both. The employment of debt capital implies a higher risk, albeit with a magnified return to the shareholders by trading on equity. On the other hand, equity as a source of finance is a safer route but returns to the shareholders are lower. The financing decision need to consider the cost of financing available in different forms and their associated risk.
The main task of finance manager is to minimize cost of capital and maximize the returns available to the shareholders. The finance manager must develop the best finance mix (or optimum capital structure) for the enterprise so that the long-term market price of the company’s shares is maximized.
(c) Dividend Decision:
In order to achieve the wealth maximization objective, an appropriate dividend policy must be designed. One aspect of dividend policy is to decide whether to distribute all the profits in the form of dividends or to distribute a part of the profits and retain the balance. The decision will depend upon the preferences of the shareholders, investment opportunities available within the firm and the opportunities for future expansion of the firm.
The finance manager is expected to take decisions with respect to dividend stability, form of dividends, that is, cash dividends or stock dividends, its impact on market value of shares, impact of legal and cash flow constraints on dividend decisions and so on.
The dividend payout ratio is the proportion of net profits to be paid out to the shareholders out of profits. It is determined in the light of the objectives of maximizing the market value of the share. If the payment of dividend does not result in maximizing the wealth of owners by registering an increase in price of shares, the firm should retain the earnings and invest them in profitable opportunities. The dividend decisions must be analyzed in relation to the financing decisions of the firm to determine the portion of retained earnings as a means of direct financing for the future expansions of the firm.
Scope of Financial Management
Scope of financial management means what exactly we study in financial management. Initially the subject of financial management was confined only to collection of funds, but at present, has vast changes in corporate sector, technological development, introduction of specified forms of financial institutions, etc. The scope of Financial Management has undergone radical changes.
Today, Financial management as an academic discipline, has undergone significant changes over the years as regards its scope and coverage.
Therefore, the scope of financial management is divided into the following categories:
A) Traditional Approach
B) Modem Approach
Scope # 1. Traditional Approach:
The traditional approach was popular in the early part of this century, (i.e., between 1920 and 1949)
Under this approach the term ‘Corporate Finance’ was used for Financial management. The role of financial management was limited to raising and administering of funds required by the corporate enterprise (i.e., joint stock companies) to meet their financial needs.
It covered the following three aspects:
1) Arrangement of funds from financial institutions (It is nothing but raising of loans).
2) Arrangement of funds through financial instruments (i.e., raising of funds by issue of shares and debentures).
3) Looking after the legal and accounting relationship between a corporation (i.e., company) and suppliers of the various sources of funds.
Thus under traditional approach scope of financial management is confined to mere raising of funds by a company externally i.e., from outside, the types of funds to be raised, cost of borrowings, the timings of the borrowings and duration of the borrowings, etc. So, according to traditional approach, more importance is given to collection of funds but not financial decision. The role of the finance manager was also limited.
He was expected to keep accurate financial records, prepare reports on the corporation’s status and performance of the corporate enterprise and manage cash in such a way as to meet the bills in time. The term Corporation finance was used in place of the present term Financial management.
The traditional approach found its manifestation in a limited manner in 1897 in the book, Corporation Finance written by Thomas Greene. It was given further impetus by Edword Meade in his book ‘Corporation finance.’ However, it was sanctified firmly by Authur Dewing in 1919 in his book, The Financial Policy of Corporation.
Criticisms:
The traditional approach evolved during 1920, continued to enjoy and dominate academic thinking during 1940 and during the early 1950.
However, in the later 1950, it began to be severely criticised and later, it was abandoned by the modem scholars on the following reasons:
i) Outside looking in approach (External appearance).
ii) Ignored Non-Corporate enterprise.
iii) Ignored Routine Financial Problems.
iv) Ignored Working Capital financing.
v) Ignored Allocation of Funds.
i. Outside Looking in Approach:
Under the traditional approach, the financial function was limited to mere raising of funds and the administering of the funds raised. It thus treated as the subject of finance from the view point of suppliers of funds i.e., outsiders viz., bankers, investors, etc.
But it did not give any importance to the view point of those who had to take internal financing decision making process. Thus scope of financial management becomes one sided i.e., outside looking in approach and ignored completely the inside looking out approach.
ii. Ignored Non-Corporate Enterprise:
According to the traditional approach, attention is given only to the financial problems of corporate enterprises (i.e., joint stock companies). It ignored completely the financial problems of non-corporate undertakings like sole trading and partnership firms.
iii. Ignored Routine Financial Problems:
The traditional approach gives undue importance to the financial problems arising from epismodic (i.e., non-recurring) or infrequent happenings like incorporation, merger, re-organisations, etc., in the life of corporate body. It did not give any importance to the routine day-to-day financial problems of business undertakings.
In the traditional approach, more attention or stress is given to the problems of only long term financing. It ignored the problems relating to financing of short-term or working capital.
v. Ignored Allocation of Funds:
The traditional approach restricted the financial management to issues connected with the procurement of funds. It did not consider the allocation of funds to various uses. It ignored the following central issues of financial management as pointed out by Prof Solomon Ezra of Stanford university, New York.
They are:
a) Should an enterprise commit capital funds to certain purposes?
b) Do the expected returns meet financial standards of performance?
c) How should these standards be set and what is the cost of capital funds to the enterprise?
d) How does the cost vary with mixture of financing methods used? Thus traditional approach failed to provide answer to these questions because its scope was very narrow. However, the modern approach provides a solution to these problems.
Scope # 2. Modern Approach:
The traditional approach was popular till 1949. Since 1950, it has lost its popularity because various changes, viz., technological improvements, widened marketing operations, strong corporate structure, healthy business competitions, all made it imperative for the management to make optimum use of available financial resources for continued survival.
On account of these reasons, from 1950 onwards popularity of traditional approach is reduced and contributed to the emergence of the modern approach.
Under the modern approach, the Financial Management has a vast scope or coverage. According to the modern approach, the Financial management is concerned with not only the raising of funds but also their wise allocation or application of funds. Thus in order to carry out his responsibilities, it is the bounded duty of the finance manager to see that the funds available are allocated to different productive uses efficiently and wisely or effectively.
Thus, according to modem concept, financial management is concerned with both acquisition of funds as well as allocation. The new approach observes the term financial management in a broader sense. In this sense the central issue of financial policy is the wise use of funds and the central process involved is a rational matching of advantages of potential uses against the cost of alternative. Potential uses so as to achieve the broad financial goals which on enterprise sets for itself.
The modern approach is analytical in nature. It looks at the financial problems of an enterprise.
The main issue contained in this approach is as given below:
1) What is the total volume of funds an enterprise should commit?
2) What specific assets should an enterprise be acquired? (i.e., How should the funds be employed)?
3) How should the required funds be raised?
The above questions relate to four broad decisive areas or functions of financial management. In other words, that means the modem approach to financial management covers four broad decisions. These decisions can also be termed as functions outlining the scope of financial management. The four decisive areas or functions of financial management are also called managerial finance functions.
The four decisions or functions of financial management are:
1) Funds requirement decision.
2) Financing decision.
3) Investment decision.
4) Dividend decision.
The components of decisions are studied under the head – The functions of financial management.
Scope of Financial Management– Anticipation, Acquisition, Allocation, Appropriation and Assessment of Funds
The term ‘Scope of financial management’ implies to extent of the area or subject matter that financial management deals with or to which it is relevant. As an integral part of the overall management, the scope of financial management primarily covers planning, raising, controlling, administering of the funds used in the business.
Further financial management also 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.
Scope # 1. Anticipation of Funds – Estimation of Financial Needs of the Company:
(i) Estimating the Financial Requirement:
Prior taking up any business activity such as starting a new business or expanding an existing business which requires financing, estimating amount of fixed capital and working capital required in a given period of time is very essential. In order to estimate the capital requirements of the business, the finance department must prepare a budget. A budget is an estimation of the revenue and expenses over a specified future period of time, on the basis of estimated budget, the finance department identifies capital requirements needed accurately for meeting long term and short term needs of the business.
(ii) Determining the Capital Structure:
Capital structure means the way a business enterprise finances its activities through types and proportion of different securities. Capital structure of a business enterprise is related to the long-term financial requirements of the business enterprise, once the fund requirement is anticipated the firm has to decide on the type of securities to be issued and the relative proportion between them is to be taken.
The capital structure can be a combination of debt, common equity and preferred equity. Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. The capital structure decided should offers a balance between the ideal debt-to-equity range and minimize the firm’s cost of capital.
Scope # 2. Acquisition of Funds – Gathering Funds for the Company from Different Sources:
(i) Identifying Sources of Funds:
There are a number of ways of raising finance for a business, however the type of finance chosen depends on the nature of the business. Big business enterprises generally have a wider variety of finance sources than are smaller ones.
The following are some of the major sources of finance divided on the basis from where they are obtained:
Internal- Within the Business:
a. Retained earnings
b. Owner’s investment
c. Sale of fixed assets
d. Personal sources
External- From Outside Providers:
a. Financial Institutions
b. Shares
c. Venture capital
d. Bonds & Debentures
(ii) Selecting a Source of Finance:
The choice of the source of finance is very critical decision and therefore various factors such as cost of raising funds, period for which funds are needed, conditions attached, charge on assets, burden of fixed charges, dilution of ownership and control etc., and several others factors.
The choice of selecting a specific source of finance should be based on amount of risk involved and the cost of finance. Any source that offers cheapest form of money with minimum amount of risk can be regarded as an ideal source of finance.
Scope # 3. Allocation of Funds – Use of Funds to Buy Fixed and Current Assets:
(i) Assessing Risk and Return:
After procuring funds from various sources the finance department must identify various investment proposals based on the needs and requirements of the business. Further the decision to invest in specific project must be carefully evaluated based on three important principles – safety, liquidity and profitability. Various capital budgeting techniques and analysis can be used to determine the profitability of investment. Capital budgeting process involves evaluation of investment proposal in term of risk and return.
(ii) Investment of Funds:
After assessment of risk and return the next step is investing funds. One of the most important long term decisions for any business relates to investment. Investment is the application funds acquired from various sources to acquire assets or to invest in a project with an objective of making gains in the future. Assets are defined as economic resources that are expected to generate future benefits.
Scope # 4. Appropriation of Funds – Dividing and Distribution of Profits:
Management of earnings, One of the key decisions is financial management is disposition of profits left after meeting all business expenses. Generally, of the total business profits, a portion is retained as reserves for reinvestment in the business and rest is distributed to shareholders as dividend. Thus management of earnings primarily involves deciding as to what portion of the profits should be distributed by way of dividend and what portion should be retained in the business.
Scope # 5. Assessment – Evaluation of Financial Plans and Polices:
This includes analysis and Control of financial affairs of enterprise and addresses questions such as:
i. Are assets being used efficiently?
ii. Are the businesses assets secure and productive?
iii. Do management act in the best interest of shareholders and in accordance with management policies?
Assessment of financial plans and policies helps the business to ensure that it is meeting its goals. Assessing the quality of performance overtime and developing, applying, monitoring, and evaluating a policy, guidelines, systems, procedures, etc., that address or encompass all or most aspects of the finance management function is very important.
Thus assessment or control involves measuring performance against measures and targets (output and outcomes) established during finance management planning, against budget objectives, and/or against financial management performance standards set by company.