Financial management is concerned with the acquisition, financing, and management of assets with an overall goal in mind. Thus, the functions carried out in financial management can be divided into three major areas: investment, financing, and asset management.
Role of Financial Management
The important role of financial management are discussed as under:
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Investment Decision
The investment decision is the most significant of the firm’s three major decisions when it comes to value creation. It begins with determining the total amount of assets required to be held by the firm.
Imagine the firm’s balance sheet for a moment. Liabilities and owners’ equity are listed on the right-hand side of the balance sheet, while assets are shown on the left-hand side.
The financial manager must determine the total dollar amount that appears on the asset side of the balance sheet, which defines the size of the firm. The composition of these assets must also be decided.
For example, should assets be allocated to cash or inventory? Likewise, the reverse side of investment—disinvestment—should not be ignored. Assets that are not economically viable may need to be reduced, eliminated, or replaced.
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Financing Decision
The second major decision of the firm is the financing decision. Here, the financial manager is concerned with the composition of the right-hand side of the balance sheet. If you consider the mix of financing across different companies and industries, you will notice significant variations.
Some companies have relatively large amounts of debt, while others are almost debt-free. Does the type of financing used make a difference? If yes, why? And in some sense, can a particular mix of financing be considered optimal?
Additionally, dividend policy must be viewed as an integral part of the firm’s financing decision. The dividend payout ratio determines the amount of earnings that can be retained within the firm. Retaining a larger portion of earnings means fewer funds are available for dividend payments.
The value of dividends paid to shareholders must be balanced against the opportunity cost of retained earnings used as a source of equity financing. Once the financing mix is determined, the financial manager must also decide how to acquire the required funds.
The mechanics of obtaining short-term loans, entering into long-term lease agreements, or issuing bonds or stocks must be clearly understood.
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Asset Management Decision
The third important decision of the firm is the asset management decision. Once assets are acquired and appropriate financing is arranged, these assets must be managed efficiently. The financial manager is responsible for varying degrees of operational control over existing assets.
These responsibilities require the financial manager to focus more on the management of current assets than on fixed assets. A larger share of responsibility for managing fixed assets usually lies with operational managers who directly use these assets.
