Financial management has a close relationship with economics on the one hand and accounting on the other.
Relationship of Finance to Economics:
There are two essential linkages between economics and finance. The macroeconomic environment defines the setting within which a firm operates and the microeconomic theory provides the conceptual underpinning for the tools of final decision-making.
Key macroeconomic factors like the growth rate of the economy, the domestic savings rate, the role of the government in economic affairs, the tax environment, the nature of external economic relationships, the availability of funds to the corporate sector, the rate of inflation, the real rate of interest and the terms on which the firm can raise finances define the environment in which the firm operates. No financial manager can afford to ignore the key developments in the macroscopic sphere and the impact of the same on the firm.
While an understanding of the macroeconomic developments sensitizes the financial manager to the opportunities and threats in the market environment, a firm grounding in macroeconomic principles sharpens their analysis of decision alternatives. Finance, in essence, is applied microeconomics according to which a decision should be guided by a comparison of incremental benefits and costs – applies to some managerial decisions in finance.
A basic knowledge of macroeconomics is necessary for understanding the environment in which the firm operates and a good grasp of microeconomic principles is helpful in sharpening the tools of financial decision-making.
Relationship of Finance to Accounting:
The finance and accounting functions are closely related and almost invariably fall within the domain of the chief financial officer. Given this affinity, it is not surprising that in popular perception finance and accounting are more often considered indistinguishable or at least substantially overlapping. However, a student of finance should know how the two differ and how the two relate.
The following discussion highlights the differences and relationship between the two.
1. Scorekeeping vs value maximizing:
Accounting is concerned with scorekeeping, whereas finance is aimed at value maximizing. The primary aim of accounting is to measure the performance of the firm, assess its financial condition and find the base for tax payment. The principal goal of financial management is to create shareholders value by investing in positive net present value projects and minimizing the cost of financing. Of course, financial decision making requires considerable inputs from accounting. As Gitman says: ” The accountant’s role is to provide consistently developed and easily interpreted data about the firm’s past, present and future operations. The financial manager uses these data, either in raw form or after certain adjustments and analyses, as an important input to the decision-making process.
2. Accrual method vs cash flow method:
The accountant prepares the accounting reports based on the accrual method recognizes revenues when the sale occurs (irrespective of whether cash is paid or not). The focus of the financial manager, however, is on cash flows. He is concerned about the magnitude, timing and risk of cash flows as these are the fundamental determinants of values.
3. Certainty vs Uncertainty:
Accounting deals primarily with the past. It records what has happened. Hence, it is characterized by a high degree of subjectivity.