Traditional vs. Modern Finance – How Do They Compare?

Every company or industry plans its finance and resource utilisation following certain principles to make the most profit. There are different approaches to financial management that aim to ensure benefits 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 financial manager forecasts, budgets, supervises, and manages a company’s cash flow to maximise its profit.

What are the objectives of financial management?

The sole aim of the financial management team of an organisation is to maintain finances. To fulfil this motive, its financial managers must look into the following objectives of financial management.

  • Create and execute a stable financial structure with a steady platform and capital distribution for debt and equity.
  • Utilise funds efficiently while incurring the least cost.
  • Maintain a secure, sustainable and adequate funding source.
  • Ensure sustainable 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. It was during this period that the term “corporate finance” gained popularity.

Corporate finance was the colloquial term of this period enveloping the objectives of today’s financial management. This initial stage of corporate finance or financial management is referred to today as the traditional approach to financial management. 

The traditional approach to financial management is primarily focused on earning more funds to grow the business. Companies following the traditional approach usually implement these 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 heed to a company’s requirement for external funding. This process also comprises functions like 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 episodic problems and not daily-to-day issues.
  • Traditional financing does not give much importance to the allocation of working capital.

How does modern financial management differ from traditional Finance?

As critics pointed out the many flaws of traditional financial management, a new and modern approach was put into action. This modern approach offers a broader outlook on a company’s financial planning.

Unlike the traditional approach, modern financial management aims to consider both the procurement and effective utilisation of funds. It factors in concerns about the internal parties and problems that affect an organisation. Modern financing 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 must a company take to finance the required funds?

A finance manager makes the following decisions in favour of the company by following the modern financing approach.

Investment Decisions

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. 

Financing Decisions

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.

Final Word

The advent of modern financing approaches, globalisation of commerce, 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 risks 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.

Darshan is an up-and-coming Investment analyst making headway in the field of capital markets. He has completed his Chartered Accountancy and CFA Level 1 exam. He is currently working as a Credit Associate in Wint Wealth.

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Disclaimer: This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The article may also contain information which are the personal views/opinions of the authors. The information contained in this article is for general, educational and awareness purposes only and is not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision, whether related to investment or otherwise, taken on the basis of this article.

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