2.3 Reading

Financial management can be defined as: the management of the finances of a business in order to achieve financial objectives. It studies corporate finance and capital markets, emphasizing the financial aspects of managerial decisions. It touches on all areas of finance, including the valuation of real and financial assets, risk management and financial derivatives, the trade-off between risk and expected return, and corporate financing and dividend policy. New business leaders and managers have to develop at least basic skills in financial management. Expecting others in the organization to manage finances is clearly asking for trouble.

Financial management is concerned with the managerial decisions that result in the acquisition and financing of credits, selection of specific assets and it also deals with inflows and outflows of funds and their effect on managerial objectives. In short, financial management deals with procurement of funds and their effective utilization in the business.

One of the primary considerations when going into business is money. Without sufficient funds a company cannot begin operations. The money needed to start and continue operating a business is known as capital.

Finance is securing and utilizing capital and the process of managing the capital is known as financial management. The process of acquiring this capital is known as financing. There are two basic types of financing: equity financing which refers to funds invested by owners and debt financing which refers to funds borrowed from outside sources. Equity financing can be exemplified by the sale of units of ownership known as shares of stock. Often equity financing does not provide the corporation with enough capital and it must turn to debt financing, or borrowing funds.

Financial management is concerned with decision-making in regard to the level and structure of financing and size and composition of assets. To make wise decisions it is necessary to have a clear understanding of objectives which  provide a framework for optimum financial decision-making.

There are two approaches to determine the decision criterion for financial management: profit maximization approach and wealth maximization approach.  The profit maximization criterion implies that business decisions should be oriented to the maximization of profits and actions that increase profits should be undertaken and those that decrease profits are to be avoided.

Profit can be considered a test of economic efficiency, as it provides the yardstick by which economic performance can be judged and ensures maximum social welfare. But profitability maximization cannot be the only basic criterion for the financial management decisions. The main flaws of profit maximization as an objective of financial management are as follows: ambiguity, timing and quality of benefits.

Actually, the term profit is a vague and ambiguous concept. Profit may be short-term or long-term; total profit or rate of profit; before-tax or after-tax and so on. It’s not quite clear which of these variants of profit should be maximized? Obviously, a loose expression like profit cannot form the basis of operational financial management.

Profit maximization treats all benefits as equally valuable ignoring the distinction between returns received in different time periods. While working out profitability, the bigger the better principle is adopted because the decision is based on the total benefits received irrespective of when they were received. In  practice  benefits in early years should be valued more highly than equivalent benefits in later years because  they can be re-invested to earn a return. The  basic dictum of financial planning is the earlier the better as benefits received sooner are more valuable than benefits received later.

Quality of benefits should also be taken into consideration. It refers to the degree of certainty with which benefits can be expected. The more certain the expected return, the higher the quality of the benefits. An uncertain and fluctuating return implies risk to the investors. The investors are risk-averters, i.e. they want to avoid or at least minimize risk.

As it is clear from the above, that profit maximization criterion is inappropriate and unsuitable as an operational objective of investment, financing and dividend decisions of a firm. It is not only vague and ambiguous but also it ignores two important dimensions of financial analysis: risk, and time value of money. The alternative to the profit maximization is the wealth maximization.