FINANCIAL MANAGEMENT

Proper use and allocation of funds leads to improve the operational efficiency of the business
concern. When the finance manager uses the funds properly, they can reduce the cost of capital
and increase the value of the firm. Financial management helps to take sound financial decision
in the business concern.Mar 31, 2016

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 financial resources of the enterprise.

Objectives of Financial Management

 Profit Maximization. Profit earning is the main aim of every economic activity. A business being
an economic institution must earn profit to cover its costs and provide funds for growth. ...
 Wealth Maximization. Wealth maximization is the appropriate objective of an enterprise.

Financial management is concerned with procurement and use of funds. Its main aim is to use
business funds in such a way that the firm’s value / earnings are maximized. Financial
management provides a frame work for selecting a proper course of action and deciding a viable
commercial strategy. The main objective of a business is to maximize the owner’s economic
welfare. This objective can be achieved by;

1. Profit Maximization, and

2. Wealth Maximization.

1. Profit Maximization
Profit earning is the main aim of every economic activity. A business being an economic
institution must earn profit to cover its costs and provide funds for growth. No business can
survive without earning profit. Profit is a measure of efficiency of a business enterprise. Profits
also serve as a protection against risks which cannot be ensured. The accumulated profitsenable a
business to face risks like fall in prices, competition from other units, adverse government policies
etc. Thus, profit maximization is considered as the main objective of business. The following
arguments are advanced in favor of profit maximization as the objective of business:

1. When profit-earning is the aim of business then profit maximization should be the obvious
objective.
2. Profitability is a barometer for measuring efficiency and economic prosperity of a business
enterprise.
3. Economic and business conditions do not remain same at all times. There may be adverse
business conditions like recession, depression, severe competition etc. A business will be able
to survive under unfavorable situation, only if it has some past earnings to rely upon.
Therefore, a business should try to earn more and more when situation is favorable.
4. Profits are the main sources of finance for the growth of a business. So, a business should aim
at maximization of profits for enabling its growth and development.
5. Profitability is essential for fulfilling social goals also. A firm by pursuing the objective of profit
maximization also maximizes socio-economic welfare.

However, profit maximization objective has been criticized on many grounds. They are:

 A firm pursuing the objective of profit maximization starts exploiting workers and the
consumers. Hence, it is immoral and leads to a number of corrupt practices.
 It is also argued that profit maximization should be the objective in the conditions of perfect
competition and in the wake of imperfect competition today, it cannot be the legitimate
objective of a firm
 One has to reconcile the conflicting interests of all the parties connected with the firm. Thus,
profit maximization as an objective of financial management has been considered inadequate.
Even as an operational criterion for maximizing owner’s economic welfare, profit maximization
has been rejected because of the following drawbacks;

1. The term ‘profit’ is vague and it cannot be precisely defined. It means different things for
different people. Should we consider short-term profits or long-term profits? Does it mean total
profits or earnings per share? Even if, we take the meaning of profits as earnings per share and
maximize the earnings per share, it does not necessarily mean increase in the market value of
share and the owner’s economic welfare.
2. Profit maximization objective ignores the time value of money and does not consider the
magnitude and timing of earnings. It treats all earnings as equal when they occur in different
periods. It ignores the fact that cash received today is more important than the same amount of
cash received after, three years.
3. It does not take into consideration the risk of the prospective earnings stream. Some projects
are more risky than other.
4. The effect of dividend policy on the market price of shares is also not considered in the
objective of profit maximization.

2. Wealth Maximization
Wealth maximization is the appropriate objective of an enterprise. When the firm maximizes the
stockholder’s wealth, the individual stockholder can use this wealth to maximize his individual
utility. It means that by maximizing stockholder’s wealth the firm is operating consistently
towards maximizing stockholder’s utility.
A stockholder’s current wealth in the firm is the product of the number of shares owned,
multiplied with the current stock price per share.
This objective helps in increasing the value of shares in the market. The share’s market price
serves as a performance index or report card of its progress. It also indicates how well
management is doing on behalf of the shareholder.
However, the maximization of the market price of the shares should be in the long run. Every
financial decision should be based on cost-benefit analysis. If the benefit is more than the cost,
the decision will help in maximizing the wealth.
 Implications of Wealth Maximization

There is a rationale in applying wealth maximizing policy as an operating financial management

policy. It serves the interests of suppliers of loaned capital, employees, management and
society. Besides shareholders, there are short-term and long-term suppliers of funds who have
financial interests in the concern. Short-term lenders are primarily interested in liquidity position
so that they get their payments in time. The long-term lenders get a fixed rate of interest from the
earnings and also have a priority over shareholders in return of their funds.
Wealth maximization objective not only serves shareholder’s interests by increasing the value of
holdings but ensures security to lenders also. The economic interest of society is served if various
resources are put to economical and efficient use.
Criticisms of Wealth Maximization

The wealth maximization objective has also been criticized by certain financial theorists mainly
on following accounts;

1. It is a prescriptive idea. The objective is not descriptive of what the firms actually do.
2. The objective of wealth maximization is not necessarily socially desirable.
3. There is some controversy as to whether the objective is to maximize the stockholders wealth
or the wealth of the firm which includes other financial claimholders such as debenture
holders, preferred stockholders, etc.,
4. The objective of wealth maximization may also face difficulties when ownership and
management are separated as is the case in most of the large corporate form of organizations.

In spite of all the criticism, we are of the opinion that wealth maximization is the most
appropriate objective of a firm and the side costs in the form of conflicts between the
stockholders and debenture holders, firm and society and stock holders and managers can be
minimized.
Functions of Financial Management
I. Estimation of capital requirements- a financial manager has to make estimation with
regards to capital requirements of the company. This will depend upon

Life Cycles of a Business

Most companies experience losses and negative cash flows during their startup period. Financial
management is extremely important during this time. Managers must make sure that they have
enough cash on hand to pay employees and suppliers even though they have more money going
out than coming in during the early months of the business. This means the owner must make
financial projections of these negative cash flows so he has some idea how much capital will be
needed to fund the business until it becomes profitable.
As a business grows and matures, it will need more cash to finance its growth. Planning and
budgeting for these financial needs is crucial. Deciding whether to fund expansion internally or
borrow from outside lenders is a decision made by financial managers. Financial management is
finding the proper source of funds at the lowest cost, controlling the company's cost of capital and
not letting the balance sheet become too highly leveraged with debt with an adverse effect of its
credit rating.

Operations

In its normal operations, a company provides a product or service, makes a sale to its customer,
collects the money and starts the process over again. Financial management is moving cash
efficiently through this cycle. This means that managing the turnover ratios of raw materials and
finished goods inventories, selling to customers and collecting the receivables on a timely basis
and starting over by purchasing more raw materials. In the meantime, the business must pay its
bills, its suppliers and employees. All of this must be done with cash, and it takes astute financial
management to make sure that these funds flow efficiently.

Even though economies have a long-term history of going up -- occasionally, they will also
experience sharp declines. Businesses must plan to have enough liquidity to weather these
economic downturns, otherwise they may need to close their doors for lack of cash.
Reporting

Every business is responsible for providing reports of its operations. Shareholders want regular
information about the return and security of their investments. State and local governments need
reports so that they can collect sales tax. Business managers need other types of reports, with key
performance indicators, which measure the activities of different parts of their businesses. As
well, a comprehensive financial management system is able to produce the various types of
reports needed by all of these different entities.
Taxes

The government is always around to collect taxes. Financial management must plan to pay its
taxes on a timely basis.

Financial management is an important skill of every small business owner or manager. Every
decision that an owner makes has a financial impact on the company, and he has to make these
decisions within the total context of the company's operations.
Investing is a skill, hone it and you get better with at it in time.

Investment Goals:

1. To save money and make it a habi

2. To optimize maximum return from savings and investment
3. To gain real experience to various instruments from low medium to high risk
investment
4. To achieve enough passive income and be able to fully retire and be financially free
5. To prioritize wealth accumulation and focus on investment for one’s retirement
goals
6. To ensure that your wealth is properly bestowed on the next generation
7. To serve as inspiration for others so they can also achieve financial freedom that
you currently enjoy

Asset Allocation – is the process of deciding what portion of an investment portfolio should be
invested in the different asset classes such as stocks, bonds and cash (traditional asset classes)

Categories of asset classes:

i. Traditional which includes cash, stocks and bonds

ii. Alternative Asset includes mutual fund commodities, real estate, private equity and
hedge funds

Characteristics of the 3 major asset classes

a. Stocks had the greatest risk and highest returns. Offering greater potential for growth,
advisable for longer period of time investment
b. Bond are generally less volatile than stocks but offer more modest returns.
c. Cash and cash equivalent such as savings deposit, certificate of deposit, treasury bills,
money market deposit accounts are the safest investment but offer the lowest return due
to risk of inflation

Factors to Consider:

i. Time horizon-investors with longer time horizon may feel comfortable on riskier or
more volatile investment than those with shorter time horizon who prefer less risk
investments.
ii. Risk tolerance – depends on the character of the investors. (aggressive and
conservative investors)
iii. Rate of return – is the gain or loss in an investment over a specific time period
expressed as a percentage of the investment cost.
 Why is Asset Allocation Important?

By investing in more than one asset category, you’ll reduce the risk that you’ll lose money
and portfolio’s overall investment returns will have a smoother ride. If one asset category’s
investment return falls, you’ll be in a position to counteract your losses in that asset category with
better investment returns in another asset category. It like not putting all the eggs into one basket.
This diversification strategy involves spreading your money among various investment in the hope
that if one investment losses money, the other investment will more than make up for those losses.

Phases of Investor Life Cycle

1. 1st Phase is the Accumulation Phase

2. Second phase is the consolidation phase and
3. Third phase is the spending/gifting

Accumulation Consolidation Spending/Gifting

Early to middle age of their Begins between 45 to 54 Begins at retirement
career
Individual net worth is small Net worth should be Income declines
growing rapidly
Asset accumulation to satisfy Paid off most of their Living expenses are covered
immediate needs outstanding debts by social security and
Spending exceeds his/her Earning exceeds expenses income from prior
income Income is high and primary investments
Debt management is the goal should be saving for Individuals wealth is large
primary consideration retirement enough and the individual
is old enough
Provide financial assistance
to others
Willing to make relatively Start a serious investment Less tolerant of risk
high risk investment program Current income generated
from the portfolio should
be enough to meet the
expenses

Learning
:
*the most important aspect of the investor life cycle is that as one moves through the
phases, the asset allocation must be adapted to account for the different requirements and
needs for each phase
*understanding what phase you are in is an important and ensure that you reconcile your
own needs with that of the phase as each person is different and one size not fit all.
Portfolio Management Process is the process in which investor takes to aid him in meeting
his investment goals

The procedure is as follows:

1. Create policy statement – contains the investor’s goals and constraint is as it
relates to his investments.
2. Develop an Investment Strategy – entails creating a strategy that combines the
investor’s goals and objectives with current financial market and economic
conditions
3. Implement the plan created – this entails putting the investment strategy to work.
Investing in a portfolio that meets the clients goals and constraint requirements
4. Monitor and update the plan – to be able to adjust for the changes that have
occured