Financial Management means planning, organizing, directing and controlling the financial activities such as procurement and utilization of funds of the enterprise. It means applying general management principles to the financial resources of the enterprise.
In simple terms objective of Financial Management is to maximize the value of the firm, however, it is much more complex than that. The management of the firm involves many stakeholders, including owners, creditors, and various participants in the financial market.
Financial management provides a framework for selecting a proper course of action and deciding a viable commercial strategy. The main objective of a business is to maximise the owner’s economic welfare. This objective can be achieved by:
- Profit Maximisation
- Wealth Maximisation
- Profit Maximisation:-
This is the main objective of financial management. The finance manager strives to achieve optimal profit in the short term and long-term course of business. The finance manager shall try to achieve as high as profits. The company makes a decent profit in the long run if the finance manager makes the proper decisions using the various methods and tools available.
Advantages of profit maximization:-
- Economic survival: Profit is vital for the survival of any business
- Measurement standard: Profits are the right measurement of the viability of a business model. In the absence of profits, the business loses its key goal and incurs a direct risk to its survival.
- Social and economic welfare: In a business, profits demonstrate proficient use and allotment of resources. Resource allocation and payments for land, labour, capital and the organisation lends itself to social and economic welfare.
Disadvantages of profit maximisation:-
- ‘Profit’ definition is unclear: Different perceptions of the term exist among organisations and individuals. For example, profit can be the gross profit, net profit, before tax profit or the profit rate.
- Time value of money is ignored: The formula is based on the idea that the higher the profit, the better the proposal, but what about its timing? In finance, when considering present value, we know that cash now won’t have the same value in the future.
- Attention not paid to risk: In the pursuit of profit, risks involved are ignored, which may prove unaffordable at times, simply because higher risk directly questions the survival of a business.
- Ignores quality: The most challenging part of profit maximisation as a goal is that it neglects the intangible benefits such as quality, image, technological advancements etc. However, the input of intangible assets in generating value for a business is not worth neglecting, as they indirectly create assets for the organisation.
- Wealth Maximisation:-
It means shareholders’ value maximization. Wealth maximization means earning maximum wealth for shareholders. So, the finance manager tries to give maximum dividends to shareholders. The dividend declaration and payout policy are decided by financial management. Dividend decisions include a proper dividend policy regarding the distribution or retaining of company profits. This is related to the performance of the company. Better the performance, the higher is the market value of shares. In nutshell, the finance manager tries to maximize shareholders’ value.
Advantages of Wealth Maximisation:-
- It is more related to cash flows than profits. Cash flows are more certain and regular and there is a lack of uncertainty that otherwise is associated with profit.
- Profits are more manipulative but cash flows are not. Thus wealth maximization is less prone to manipulation than profit maximization which is reliant on the profit.
- It is more long term focussed as compared to profit maximization which has a short term focus. Profit maximization is easy to attain because managers may adopt unethical ways to bring short term profits based on long term sustainability.
- They consider the factors of risk and uncertainty while taking into consideration the discounting rate which reflects both the time and risk.
Disadvantages of Wealth Maximisation:-
- It is more based on an idea that is prospective and not descriptive.
- The objectives laid in such a technique are not clear.
- Wealth maximization is to a great extent dependant on the profitability of the business as only after the business is profitable it can think of enhancing the wealth of the shareholders.
- It is based on the generation of cash flows and not on the accounting profit.