Traditional vs. Modern Finance – How Do They Compare?
Every company or industry plans its finances and resource utilisation following certain principles to make maximum profit. Different approaches to financial management aim to ensure benefits and gains for companies and their shareholders.
This blog will take you through traditional and modern approaches to financial management. Keep reading to learn the difference between traditional and modern finance and to understand which is better for your company.
What is financial management?
The process of organising, monitoring, planning, and controlling an organisation’s finance-related activities is called financial management. With financial management, an organisation aims to grow its own and its investors’ profits by optimising its use of resources.
A finance manager forecasts, budgets, supervises and manages a company’s cash flow to maximise the profits.
What are the objectives of financial management?
The sole aim of financial management is to maintain an organisation’s finances. To fulfil this motive, its financial managers must look into the following objectives of financial management.
- Create and execute a stable financial structure by assessing your financial position and efficient capital distribution for debt and equity.
- Utilise funds efficiently and incur fewer expenses.
- Maintain a secure, sustainable and adequate funding source.
- Ensure sustainable and stable returns to investors.
- Look for suitable and profitable investment opportunities.
What is the “Traditional Approach” to financial management?
Financial management has changed and evolved with time. The traditional approach refers to the style of financial management that emerged in the 1920s. During this period, the term “corporate finance” gained popularity.
Corporate finance was the layman’s term during that period, enveloping today’s financial management objectives. This initial stage of corporate finance or financial management is the traditional approach to financial management.
The traditional approach to financial management was primarily focused on earning more funds to grow the business. Companies following the traditional method usually implement the following measures to maximise their profits:
- Maintain accounting and legal relationships between investors (source of funds) and the firm
- Gather and connect with sources of finance from various services or products
- Collect funds from the capital market
The traditional approach does not pay much importance to a company’s requirement for external funding. This process also includes preparing and preserving a company’s financial reports. The financial management team also worked to manage a company’s cash level to meet its daily obligations.
What are the drawbacks of traditional financial management?
However, in due course of time, the traditional finance management process was rejected for various flaws. The points below highlight the drawbacks that companies faced while following traditional financial management.
- The traditional approach to financial management offers an outsider’s perspective. As a result, internal decision-making processes are not adequately acknowledged.
- There is no planning to execute the allocation of funds which is essential in today’s financial management.
- The traditional approach mainly focuses on addressing specific problems rather than everyday issues.
- Traditional financing does not give much importance to the allocation of working capital.
How does modern financial management differ from traditional Finance?
Critics pointed out many drawbacks of traditional financial management, so a new and modern approach was implemented. This modern approach offers a broader outlook on a company’s financial planning.
Unlike the traditional approach, modern financial management considers the procurement and effective utilisation of funds. It takes into consideration the internal parties and problems that affect an organisation. Modern financing mainly focuses on three questions to overcome the shortcomings of traditional financing:
- What is the total quantum of funds that a company needs to commit?
- What assets should a company acquire?
- What initiatives should a company take to finance the required funds?
A finance manager makes the mentioned decisions in favour of the company by following the modern financing approach.
The selection of assets that businesses invest in, whether for a long or short period of time, is associated with this decision.
Capital budgeting is the process by which financial planners choose and invest in assets which bear long-term benefits. The modern financial approach also encourages finance managers of firms to deal with assets that have high liquidity.
The scope of modern financing also allows firms to consider ways to increase the company’s cash flow. This is a crucial decision making process addressing a firm’s need for funds as and when required.
Dividend Payout Decisions
This is a major decision that a finance manager must undertake for a firm. Here, the team considers the company’s net income to evaluate investors’ dividends while simultaneously retaining profit for themselves.
This is a pivotal decision to ensure that every shareholder receives fruitful returns from the company. By meeting this need, the firm secures trust with shareholders in the long run.
The introduction of modern financing approaches, globalisation of trade, and increased use of IT are some of the most popular trends of the 21st century. Business owners and executives need to study and implement these trends to get new chances of reducing risk and increasing revenue for a firm. Today, most businesses follow the modern finance approach for long-term growth.
Frequently Asked Questions
What is the role of financial management?
Financial management involves activities like finance control, financial reporting, risk management, cash flow management and disposal of surplus for a company.
What are the roles of a firm’s function as per modern financing?
A firm’s primary function is to bring maximum funds to meet time-based requirements. Other than that, firms must focus on acquiring sufficient funds, maximising their value, increasing profitability, and efficiently utilising their resources.
Why did financial experts reject the traditional approach?
Traditional finance was unsuccessful in addressing concerns like expected returns to meet the optimum financial performance standard. Also, the need for a firm to commit capital funds for specific purposes and the cost of capital funds for enterprise are a few problems that were left unanswered.
Do companies still use traditional finance management?
Since the 1950s, most companies have shifted to the modern approach to financing. As a result, they replaced traditional financial management, and it was slowly rendered obsolete.