One needs money to make money. Finance is the life-blood of business and there must be a continuous flow of funds in and out of a business enterprise. Money makes the wheels of business run smoothly. Sound plans, efficient production system and excellent marketing network are all hampered in the absence of an adequate and timely supply of funds.
Sound financial management is as important in business as production and marketing. A business firm requires finance to commence its operations, to continue operations and for expansion or growth. Finance is, therefore, an important operative function of business.
A large business firm has to raise funds from several sources and has to utilise those funds in alternative investment opportunities. In order to ensure the most judicious utilisation of funds and to provide a reasonable rate of return on the investment, sound financial policies and programmes are required. Unwise financing can drive a business into bankruptcy just as easily as a poor product, inept marketing or high production costs.
On the other hand, adequate and economical financing can provide the firm a differential advantage in the market place. The success of a business enterprise is largely determined by the way its capital funds are raised, utilised and disbursed. In the modern money-using economy, the importance of finance has increased further due to increasing scale of operations and capital intensive techniques of production and distribution.
In fact, finance is the bright thread running through all business activity. It influences and limits the activities of marketing, production, purchasing and personnel management. The success of a business is measured largely in financial terms. The efficient organisation and administration of the finance function is thus vital to the successful functioning of every business enterprise.
Financial management may be defined as planning, organising, directing and controlling the financial activities of an organisation. According to Guthman and Dougal, financial management means, “the activity concerned with the planning, raising, controlling and administering of funds used in the business.” It is concerned with the procurement and utilisation of funds in the proper manner.
Financial activities deal with not only the procurement and utilisation of funds but also with the assessing of needs for funds, raising required finance, capital budgeting, distribution of surplus, financial controls, etc.
Ezra Solomon has described the nature of financial management as follows: “Financial management is properly viewed as an integral part of overall management rather than as a staff specially concerned with funds raising operations.
In this broader view, the central issue of financial policy is the wise use of funds and the central process involved is a rational matching of the advantage of potential uses against the cost of alternative potential sources so as to achieve the broad financial goals which an enterprise sets for itself.
In addition to raising funds, financial management is directly concerned with production, marketing and other functions within an enterprise whenever decisions are made about the acquisition or distribution of funds.”
Objectives of Financial Management:
Financial management is one of the functional areas of business. Therefore, its objectives must be consistent with the overall objectives of business. The overall objective of financial management is to provide maximum return to the owners on their investment in the long- term.
This is known as wealth maximisation. Maximisation of owners’ wealth is possible when the capital invested initially increases over a period of time. Wealth maximisation means maximising the market value of investment in shares of the company.
Wealth of shareholders = Number of shares held ×Market price per share.
In order to maximise wealth, financial management must achieve the following specific objectives:
(a) To ensure availability of sufficient funds at reasonable cost (liquidity).
(b) To ensure effective utilisation of funds (financial control).
(c) To ensure safety of funds by creating reserves, re-investing profits, etc. (minimisation of risk).
(d) To ensure adequate return on investment (profitability).
(e) To generate and build-up surplus for expansion and growth (growth).
(f) To minimise cost of capital by developing a sound and economical combination of corporate securities (economy).
(g) To coordinate the activities of the finance department with the activities of other departments of the firm (cooperation).
Very often maximisation of profits is considered to be the main objective of financial management. Profitability is an operational concept that signifies economic efficiency. Some writers on finance believe that it leads to efficient allocation of resources and optimum use of capital.
It is said that profit maximisation is a simple and straightforward objective. It also ensures the survival and growth of a business firm. But modern authors on financial management have criticised the goal of profit maximisation.
Ezra Solomon has raised the following objections against the profit maximisation objective:
Objections against the Profit Maximisation Objectives:
(i) The concept is ambiguous or vague. It is amenable to different interpretations, e.g., long run profits, short run profits, volume of profits, rate of profit, etc.
(ii) It ignores the timing of returns. It is based on the assumption of bigger the better and does not take into account the time value of money. The value of benefits received today and those received a year later are not the same.
(iii) It ignores the quality of the expected benefits or the risk involved in prospective earnings stream. The streams of benefits may have varying degrees of uncertainty. Two projects may have same total expected earnings but if the earnings of one fluctuate less widely than those of the other it will be less risky and more preferable. More uncertain or fluctuating the expected earnings, lower is their quality.
(iv) It does not consider the effect of dividend policy on the market price of the share. The goal of profit maximisation implies maximising earnings per share which is not necessarily the same as maximising market-price share. According to Solomon, “to the extent payment of dividends can affect the market price of “the stock (or share), the maximisation of earnings per share will not be a satisfactory objective by itself.”
(v) Profit maximisation objective does not take into consideration the social responsibilities of business. It ignores the interests of workers, consumers, government and the public in general. The exclusive attention on profit maximisation may misguide managers to the point where they may endanger the survival of the firm by ignoring research, executive development and other intangible investments.
Prof. Ezra Solomon has advocated wealth maximisation as the goal of financial decision-making. Wealth maximisation or net present worth maximisation is defined as follows: “The gross present worth of a course of action is equal to the capitalised value of the flow of future expected benefits, discounted (or as capitalised) at a rate which reflects their certainty or uncertainty.
Wealth or net present worth is the difference between gross present worth and the amount of capital investment required to achieve the benefits being discussed. Any financial action which creates wealth or which has a net present worth above zero is a desirable one and should be undertaken.
Any financial action which does not meet this test should be rejected. If two or more desirable courses of action are mutually exclusive (i.e., if only one can be undertaken), then the decision should be to do that which creates most wealth or shows the greatest amount of net present worth. In short, the operating objective for financial management is to maximise wealth or net present worth.”
Wealth maximisation is more operationally viable and valid criterion because of the following reasons:
(a) It is a precise and unambiguous concept. The wealth maximisation means maximising the market value of shares.
(b) It takes into account both the quantity and quality of the expected steam of future benefits. Adjustments are made for risk (uncertainty of expected returns) and timing (time value of money) by discounting the cash flows,
(c) As a decision criterion, wealth maximisation involves a comparison of value of cost. It is a long-term strategy emphasising the use of resources to yield economic values higher than joint values of inputs.
(d) Wealth maximisation is not in conflict with the other motives like maximisation of sales or market share. It rather helps in the achievement of these other objectives. In fact, achievement of wealth maximisation also maximises the achievement of the other objectives. Therefore, maximisation of wealth is the operating objective by which financial decisions should be guided.
The above description reveals that wealth maximisation is more useful if objective than profit maximisation. It views profits from the long-term perspective. The true index of the value of a firm is the market price of its shares as it reflects the influence of all such factors as earnings per share, timing of earnings, risk involved, etc.
Thus, the wealth maximisation objective implies that the objective of financial management should be to maximise the market price of the company’s shares in the long-term. It is a true indicator of the company’s progress and the shareholder’s wealth.
However, “profit maximisation can be part of a wealth maximisation strategy. Quite often the two objectives can be pursued simultaneously but the maximisation of profits should never be permitted to overshadow the broader objectives of wealth maximisation.