What I the main objective of financial management ? If you were asked to clarify in one sentence , what will be your answer ? The answer apparently should be simple . To make money for the company , fair and simple . No , that is where the complications get introduced .
Who is the company ? No more is the company a one man show that it used to be at earlier times . The companies are big and are run by many shareholders through the board of directors .The day to day decision making is done by professional managers who are well qualified salaried employees .
There is a difference of opinion amongst economists and financial managers as to what should be the main objective of financial management in a firm. The economists feel that wealth maximization should be the main objective while financial managers in general opine that profit maximization should be the objective . We will see both these views in somewhat detail and then I will present my opinions .
Profit Maximization
In this case the financial manager takes steps to ensure that the company makes maximum amount of profits at the end of the year .
Profit is the difference between the sales price and the costs. So profit maximization can be done by getting the maximum sales price and by spending the least amount of money .
In the market place , the sales price is determined by the market itself and the manufacturer does not have any control over it .
The manufacturer can only vary the costs which mainly comprise of two elements - cost of goods sold and the efficiency of operation .Again the purchase price being determined by the market forces , the manufacturer will not have much control over it . In that case the profit maximization can be achieved only by working at the maximum operational efficiency.
The objections to this theory are as follows . First and foremost the profit maximization assumes perfect competition in the marketplace , which for all practical purposes does not exist .
Secondly as we saw earlier on that in the first phase of development the businesses are self financing with single owner. The only aim of the single owner is to enhance his individual wealth and personal power which is amply satisfied by the goal of profit maximization .
But now the single owner is by and large been replaced by professional managers who are salaried employees , and equity shareholders . The business firm also has to deal with other interested parties which are the government , customers , employees and the society . In this scenario , profit maximization is not adequate objective .
If a cigarette manufacturing firm , goes on concentrating on making profit without caring for the health of the society , it will soon find itself at the wrong end of the law and will have to pay heavy penalties to the society . If a chemical company does not want to install a water treatment plant and sends all the dirty water into the river nearby , it will , in the long run will have to pay severe damages . If the firm , tends to pay meager salaries to the employees in order to save money , the key employees may leave the company and then in the long run company will suffer .
Also the term profit itself is somewhat ambiguous .
Is it short term profit or long term profit ?
Short term profits may endanger the long term survival .
Is it before tax profit or after tax profit ?
In the case it is profit after tax , the profit can be enhance by tax manipulation rather than better performance .
Is it total operating profit or the percentage profit per share ?
The bottomline can be made to look good by large scale golden handshakes and other sudden cost cutting measures which will lead to problems later on .
Lastly the profit maximization does not consider the time value of money . The profit made today and the profit made after one year is treated to be the same . In an inflationary economy , a dollar today is much more valuable than one dollar one year after .
II Wealth Maximization
It means maximizing the net present value of a course of action.
Net present value = Net present value of benefits- net present value of costs
The financial action which generates positive net present value adds to the wealth of the firm and thus is desirable .
If there are a number of mutually exclusive projects , then the project that gives the maximum net present value should be chosen.
The objective of wealth maximization solves the two problems faced in profit maximization . It considers the time value of money and secondly it consider the risks involved in going for the various alternatives.
The wealth maximization objective is consistent with maximizing the owners economic welfare .As for the shareholders the wealth created by the firm reflects in the market value of the share . Thus the fundamental objective of the financial manager is to maximize the market value of the shares of the company .
Having said all this , let us look on more practical side of the problem .Ii is said that you only stumble twice , once when you are looking too far and the second when you are looking too close . So all theory is fine , but does it give us any immediate benefit ?
I believe that no business can have the same objective throughout its commercial life . It will be unnatural . Let us look at ourselves . We do not have the same goals all the time throughout our lives . As we grow , childhood , adolescence , youth , middle age and old age our objectives , priorities , values and beliefs all keep undergoing transformation depending on the time , place and circumstances . Why should a business , which says that the human beings are its biggest assets , be any different ?
Thus the objectives of the firm and those of financial management will depend on the stage of life cycle at which the firm is operating .
Stage I - Inception
The company has just commenced its operation - is struggling in new market , is putting into place the sales organization , the purchasing policy , the organizational controls . What is most important ?
The survival of the fledgling firm at this stage is most important . In this case the survival does not depend on profits . This is important . The short term survival does not depend on profits but on cash flows.
Many of the firms which went bankrupt during the Asian crisis did not do so because they were not going to make profit at the end of say three years but because their cash flows dried up. There was no short term cash available at all.
Stage II - Rapid Growth
The company has gained a foothold in the market , the name is recognized , the suppliers and the customers are fairly stabilized in the sense some brand loyalty is developed on either side . , the bank is giving regular overdraft and the day to day cash flow is adequate .
Under these circumstance the finance manager has to concentrate on rapid growth in the long term . The company has to invest seriously in the areas of human resources development , training , customer service , advertising , expansion of the product line and so on .
Stage III - Consolidation
The company continues to grow in expanding market mainly due to the past efforts and the brand loyalty . The financial managers concern here is to make investments in long term assets , research and development for new products , organizational development .
Stage IV - Maturity
The markets have stabilized and are expanding at a slow pace. The company brand name is recognized fairly well and the company is well established in the society .
Now as the rate of increase of sales has stabilized , the finance manager has to concentrate mainly on the costs to keep the bottomline healthy . The finance manager has to improve operational efficiency by cutting wasteful expenditure , streamlining and automating various processes and by speeding up the pace of operation .
To summarize this
Stage I - solvency
Stage II - Growth
Stage IIII- systems
Stage IV - cost cutting
Case Study Question
Explain in brief the business stage your organization is and what should be the concerns of the financial manager .
What will you do differently if you were given the charge of the finance funtion ?