Financial management

Financial management- Characteristics and Objectives

Meaning and Definitions

Etymologically the word ‘financial management is the composition of two words ‘financial’ and ‘management’. Financial means procuring sources of money supply and allocation of these sources on the basis of forecasting monetary requirements of the business. The word ‘management refers to planning organization, co-ordination and control of human activities and physical resources for achieving the objectives of an enterprises. Thus, financial management is that part of business management which is concerned with the planning and controlling of a firm’s financial resources i.e. management of finance function.

In the words of Howard and Upton, “Financial management is the application of the planning and control function of the finance function.”

Joseph L. Bradlay defines that “Financial management is the area of business management developed to a judicious use of capital and careful selection of sources of capital in order to enable a spending unit to move in the direction of reaching its goals.”

Joseph L. Massie has stated that, “Financial management is the operational activity of a business that a responsible for obtaining and effectively utilizing the funds necessary for effective operations.

In nutshell, financial management is the planning, organizing, directing and controlling of the procurement and utilization of funds and safe disposal of profit to the end that individual, organizational and social objectives are accomplished.

Characteristics of Financial Management

The main characteristics of financial management or finance function can be identified as follows:

  1. Essential part of Business Management:

    The concept of financial management is broad based with the result that it has become vital and integral part of overall management. Each activity of business is linked with finance. For example, the responsibility for technical advice about plant, machines, tools, raw materials, fuel etc. lies with the production manager. But, final decision in this regard can not be taken till the finance manager gives green signal about all its financial aspects.

  2. Continuous Administrative Function:

    In traditional approach, financial management was mainly confined to raising of funds needed. It was a episodic business activity. The modern approach places greater emphasis on judicious and rational use of funds raised. This aspect has made financial management a continuous administrative function. The finance manager of a large business enterprises performs the functions of capital budgeting and management of working capital which is a continuous headache for him.

  3. Scientific and Analytical :

    At present, the financial management has become less descriptive and more scientific and analytical in nature. In the present while taking financial decisions, modern mathematical and statistical methods are used for financial analysis, and evaluation of difference altrnarives.

  4. Centralised Nature:

    The financial management or finance function is basically of centralised nature in all functional areas of management, because the objectives of the business can be achieved more effectively by centralisation of finance function. As such, decentralization of finance function is not desirable like other functions (production, marketing, personnel) of the enterprises.

  5. Different from Accounting Function:

    Most of the persons regard accounting and finance as the same thing due to common use of accounting terminology and financial records, but it is not true. Finance function is different from accounting function. Accounting is basically involved with data accumulation while finance is primarily involved with data analysis for use in decision-making.

  6. Wide Scope :

    The scope of financial management is very wide and complex. Now, the scope of financial management is not confined only to raise capital for meeting long-term requirements of the enterprises. But, acquisition of funds for short-term and long-term needs of the enterprise, proper allocation of funds and their optimal utilization are also within its scope. Moreover, it is also responsible for accounting, capital budgeting, audit, cost control, cash and credit control and other routine functions.

  7. Applicable to All Types of Organizations:

    Financial management is applicable to all types of manufacturing and service organizations, whatever may be their size, nature, ownership and control. It is wrong to say that financial management can be applied only to these organizations whose basic aim is to earn profits’.

Goals or Objectives of Financial Management

Objectives are expressed in terms of goals, aims, purposes, targets to be attained over a period of time. They also provide standards or criteria to judge or evaluate the performance or success of an enterprise. The main objectives of business are survival and growth. In order to survive in the business and to grow, a business must earn sufficient profits to maximize the economic welfare of its owners. But, the question is, how to maximize the owners’ economic welfare? Financial experts differ while finding a solution to this problem. There are two well known criteria in this regard:

  1. profit maximum;
  2. wealth maximization.

(I) Profit Maximisation

Profit maximization as an objective of financial management can be justified on the following grounds:

  1. Rational:

    Profit is the device which transforms the selfishness of mankind into channels of useful service. A rational human being performs an economic activity with the objective of utility maximization. Since, utility can easily be measured in terms of profits, therefore, the objective of profit maximization seems rational.

  2. Test of Business Performance :

    Business has all along been considered as an economic institution and thus a common measurement of its efficiency is profit. The profit earned by any business enterprises is the result of its production, marketing and managerial efficiency. It is the ultimate test of business performance.

  3. Main Source of inspiration :

    It is the profit which inspires persons or group of persons to be more efficient than others by hard labour and competition. If the attraction of profit is over, there will be no place of competition. In such situation, the speed of development and progress will be at standstill.

  4. Maximum Social Welfare :

    If ensures maximum social welfare by providing maximum dividend to shareholders, timely payment to creditors, more wages and other benefits to workers, better quality products at cheaper rate to consumers, more employment to society and maximum return to the owners.

  5. Basis of Decision-making :

    All strategic and statistical decisions in a business are taken keeping in view the profit earning objective. This is the only criterion for rational decisions. It is the risk premium that covers the cost of staying in business.

However, with all these claims, the criterion of profit maximization has been criticized on many grounds. First, a firm pursuing the objective of profit maximization exploits workers and the consumers. Hence, it is immoral and leads to a number of corrupt practices. Further, it leads to social inequalities and degrades human values which are an indispensible part of an ideal social system. Second, it is claimed that profit maximization can not be a genuine objective under modem imperfect market conditions, as it may hold good in case of perfect competition. Thus, justification for profit maximization in case of imperfect competition is over. Third, the objective of profit maximization was developed about a century ago when business depended, on, private property and self financing. These were the characteristics of individual ownership or sole proprietorship. Under these circumstances, the only aim of the owner was to increase his individual wealth and this could easily be achieved by pursuing the goal of profit maximization

From the above description, it can easily be concluded that profit maximization criterion is inappropriate and unsuitable as an operational objective of financial management. In imperfect competition, the profit maximization criterion will certainly encourage concentration of economic power and monopolistic tendencies. That is why, the objective of wealth maximization is considered as the appropriate and feasible objective as against the objective of profit maximisation.

[II] Wealth Maximisation

The objective of profit maximization, as discussed above, is not only vague and ambiguous, but it also notes the two basic criteria of financial management i.e. (i) risk, and (ii) time value of money. Therefore, wealth maximization is taken as the basic objective of financial management, rather than profit maximization. It is also known as ‘Value Maximization’ or ‘Net Present Value Maximization’. According to Ezra Soloman of Stanford University, the ultimate objective of financial management should be the maximization of wealth. Prof. Invin Friend has also supported this view.

Wealth maximization means to maximize the net present value (or wealth) of a course of action. It (NPV) the difference between the gross present value of the benefits of that action and the amount of investment required to achieve those benefits. The gross present value of a course of action is found out by discounting or capitalizing its benefits at a rate which reflects their timings and uncertainty. A financial action which has a positive net present value creates wealth. Financial actions resulting in negative net present value should be rejected. Among a number of desirable projects the one with the highest net present value should be accepted. If this criterion is followed in making financial decisions, the wealth or net present value of the firm will be maximized.

The wealth maximization objective is consistent with the objective of maximizing the wealth of the owners (shareholders) by increasing the value of the firm. The value of the firm is represented by the market price of a company’s shares. It takes into account the present and prospective future earnings per share, the timings and risk of these earnings, the dividend policy of the firm and many other factors. Therefore, for the purpose of maximization of wealth, the basic objective of a company should be to maximize the market value of its shares, because the value of the enterprise to the shareholders increases when there is an increase in the market price of the shares.

Superiority of Wealth Maximization:

We have discussed the goals or objectives of financial management. Now, the question arises of the choice i.e. which should be the goal of financial management in decision-making i.e. profit maximization or wealth maximization. In present day changed circumstances, wealth maximization is a better objective because it has following points in its favour :

  1. It measures income in terms of cash flows, and avoids the ambiguity now associated with accounting profit because income from investments is measured on the basis of cash flows rather than on accounting profits.
  2. It recognizes time value of money by discounting the expected income of different years at a certain discount rate (cost of capital)
  3. It analyses risk and uncertainty so that the best course of action can be selected out of different alternatives.
  4. It is not in conflict with other motives like maximization of sales or market value of shares. It rather helps in the achievement of all these other objectives. Therefore, maximization of wealth is the operating objective by which financial decisions should be guided.

To sum up, the wealth maximization is more useful objective than profit maximization. It considers profit from the long-term perspective. The real index of the value of a firm is the market price of its shares as it reflects the influence of all the factors such as earnings per share, timing of earnings, risk involved etc. Therefore, the wealth maximization objective implies that the objective of financial management should be to maximize the market price of the company’s shares in the long-term. It is a true indicator of the company’s progress and the shareholders’ Wealth..

However, profit maximization can be a part of a wealth maximization strategy.

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