Basic Concepts of Financial management

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To introduce financial management let us take a Simple Example.

Mr. A decides to start a new enterprise (business) let us have a look at the problems which he is going to face now.

Problem No. 1:- Which types of assets should he purchase. Plant and Machinery, equipment e.t.c which depend on the nature or type of business.

Problem No. 2:- What is the total amount of Investment needed to purchase all the assets.

Problem No. 3:- What is the amount of working capital required (funds required to pay Salaries and wages, rent, raw materials/inventories e.t.c).

Problem No. 4:- What are the sources of funds that are best to be tapped. (Sources of funds may be Share capital, Borrowings from commercial banks and others e.t.c)

                He also needs to consider the risk and cost of each and every source of funds in order to make profits.

All of the above problems above can be dealt with in financial management. And the problems can be broadly classified into the following three categories namely investing, financing and dividend decisions.

                Financial management is concerned with effective acquisition and utilization of funds. It is that managerial activity which manages the firm’s financial resources.

Definition of Financial management as given by Raymond Chamber:

“Financial management comprises forecasting, planning, organizing, directing, coordinating, and controlling of all activities relating to acquisition and application of the financial resources of an undertaking in keeping with its financial objective.”

 Functions of a Chief Financial Officer

                All the decisions involving management of funds come under the purview of Finance manager. Procurement of funds and their effective utilization are the most crucial tasks which Financial Manager undertakes/faces. CFO is required to look into the financial implications of any decision taken in the firm.

Some of the tasks which a Chief Financial Officer undertakes are:

• Financial analysis and planning.
• Decisions regarding capital structure.
• Investment decisions.
• Dividend decisions.
• Cash management.
• Financial negotiations.
• Evaluation of financial performance.
• Keeping updated with stock exchange quotations and behavior of share prices.
• Risk management.
• Management of financial resources.

Wealth Maximization and Profit Maximization:

Profit maximization:

Profit maximization if discussed generally is an implied objective of every Firm. To a layman who thinks upon the concept, profit maximization is all what a Firm is required to attain. But it is not a complete truth. It needs to be cleared first what Profit Maximization exactly means? Because the term profit maximization in itself is vague.

Profit Maximization means to increase the profits of the firm. The profit of a firm in this case is measured in terms of its total accounting profit available to its shareholders.

To achieve the aforesaid objective various types of financing decisions may be taken. The firm may adopt the options resulting in an increase in profits for a short run but the same may prove to be unhealthy for the growth, survival and overall progress of the firm. The market image of the firm may also become suspicious.

Example:- To increase the profits of a firm the decision makers may adopt a false advertisement policy to attract the customers for potential increase in sales and profits. No doubt that the sales would increase for a short period of time. But a false advertisement (misrepresentation) of products will damage the image of the firm completely in the market.

Wealth Maximization:

                The wealth/value of a firm may be defined as the market price of its stock. The focal judgement of all market participants decides the market price of a firm. It takes account of firm present an prospective earnings per share , risk and timing of the earnings, the dividend policy of the firm and many other factors that bear upon the market value of the stock.

                Thus, the wealth maximization is a present and future promising task and does not merely consider the short term earnings for some particular group of persons. It gives benefits to all the stakeholders in one or the other way, for a firm the above listed merits are quite enough and for those at the receiving end, they get real value for their money spent in goods or services of the firm.

Comparison of both of the above:

Profit maximization	Wealth maximization
Short term benefits with potential risks.	Value creation over a period of time.
Does not consider the EPS, dividend paid or any other returns to shareholders or wealth of the shareholders.	Considers all future cash flows, EPS, dividend paid, risks of a particular decision e.t.c.
May refrain from paying regular dividends.	May pay regular dividends also.
Usually not preferred by shareholders.	Always preferable to shareholders.

Wealth maximization should be the proper goal of a firm with profit maximization as a part of it.


Also Read:
Interpolation Formula Used in financial management

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