Salient Features of Traditional and Modern Approaches to Financial Management.
Traditional Approach:
Financial management emerged as a separate field of study in the early 1900s. The role of financial management is limited to fund raising and administering needed by the corporate enterprises to meet their financial needs.
Enterprise requires funds for certain episodic events like merger, formation of new firms, reorganization, liquidation and so on.
To put it simply, the scope of financial management in traditional approach was in the narrow sense. The field of financial management was interrelated with aspects,
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- Raising of funds from financial institutions,
- Raising of funds through financial instruments — shares and bonds from the capital markets.
- The legal and accounting relationships between an enterprise and its sources of funds (creditors).
Thus, the traditional approach of financial management is only raising of funds needed by the corporation, externally that also limited the role of the finance manager.
Apart from raising the funds externally, the expected functions are: preparation and preservation of financial (statements) reports on the enterprises financial status and managing cash level that is needed to pay day-to-day maturing obligations.
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Traditional approach to the scope of financial management evolved during 1920 and continued to dominate academic thinking during the forties and through the early fifties. But criticism was stated on this approach in the later fifties due to the following:
Ignored Day-to-day Problems:
The traditional approach gives much importance to funds raising for episodic events that are stated in the above discussion. Put in simple words the approach is confined to the financial problems arising in the course of episodic events.
Outsider–looking–in Approach:
This approach equated the function with the issues involved in raising and administering funds. Thus, the subject of finance moved around the suppliers of funds (investors, financial institutions (banks), etc.) who are outsiders.
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It indicates that the approach was outsider-looking-in approach and ignored insider-looking-out approach, since it completely ignored internal decision-making.
Ignored Working Capital Financing:
The approach gave over emphasis on long-term financing problems. It implies that it ignored working capital finance, which is in the purview of the finance function.
Ignored Allocation of Capital:
The main function of this approach is procurement of funds from outside. It did not consider the function of allocation of capital, which is the important one.
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The capital issues of financial management were outside the purview of the traditional phase, which was rightly described by Solomon.
- 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?
- How does the cost vary with the mixture of financing methods used?
Traditional approach failed to provide answers to the above questions due to narrow scope, but modem approach explained below provide answers to the questions, or it overcomes the shortcomings of traditional approach.
Modern Approach:
Modern approach was started during mid-1950s. Its scope is wider since it covers conceptual and analytical framework for financial decision-making. In other words, it covers both procurement of funds as well as their allocation.
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Allocation is not just haphazard allocation, it is efficient allocation among various investments, which will help maximize shareholders’ wealth. The main contents of the new approach are
- What is the total volume of funds an enterprise should commit?
- What specific assets should an enterprise acquire?
- How should the required funds be financed?
The shareholders value maximization focus continuously as we begin the 21st century. However, two other trends are gaining momentum.
- Increased use of information technology and
- Globalization of business.
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Both these trends provide companies with new opportunities to reduce risks and thereby, increase profitability. But these trends are also leading to increased competition and new tasks.
