NATURE OF FINANCIAL MANAGEMENT

Introduction:
The Nature of financial management refers to its function, scope and objectives. Financial
management is concerned with the planning and controlling of the financial resources of the firm.
The subject of financial Management is of immense interest to both the academicians and the
practicising managers. It is of great interest to academicians because the subject is still
developing and there are still certain areas were controversies exist for which unanimous
solutions have been reached.

As an academic discipline, it has undergone fundamental changes in relation to its scope,

function and objectives. In the past, when it was a branch of economics, it was treated as the
raising of funds. But at present, it is used in a broader sense, Which includes the efficient use of
resources in addition to procurement of funds.

The practicing Manager dare interested in this subject because among the most crucial decision
of firm or those which relate to finance and an understanding of the theory of financial
management provides them with conceptual and analytical insides, to make those decision
skillful.

Objectives:

Financial management is concerned with decision making in regard to the size and
composition of asset and the level and structure of finance. The objective provides a framework
for the optimum financial decision making.

The firm must make at least three fundamental financial decisions. It must determine

1. Where to invest fund and at what amount i.e investment decision

2. Where to raise funds and at what amount i.e financing decision
3. How much to pay as dividend i.e the dividend policy decisions

These decisions relate to firms investment and financing policies. It is generally agreed
that the financial objective of the firm should be the maximization of owner’s economic welfare.
Two areas from maximization of owners economic welfare is profit maximization and wealth
maximization.

PROFIT MAXIMIZATION:
In the economic theory, the term profit maximization is deep routed term. It simply
means maximizing the rupee income of the firm.

In financial management, profit maximization criterion implies that the investment,

financing and dividend policy decision of the firm should be oriented to the maximization of
profit.

The term profit can be used in two senses:

 As a Owner oriented concept, it refers to the amount and share of rational income which
is paid to the owners of Business i.e., those who supply equity capital.

According to the operational concept, it signifies economic efficiency i.e., according to

the efficiency of the proprietor, output is more than the input.

Hence according to this approach, actions that increase profits should be undertaken and
those that decrease profits are to be avoided.

1. Profit is a test of economic efficiency. It provides the yardstick by which economic

performance can be judged.
2. Efficient allocation of resources
3. It ensures maximum social welfare.

According to Ansoff, the objectives of profit maximization is justified on the following

score of points.

1. A human being performing any economic activity rationally aims at utility

maximization. It is argued that, utility can be easily measured in terms of profit. Thus
profit maximization is justified on the ground of rationality.
2. By maximizing profit, a firm maximizes socio –economic welfare of shareholders.
3. Profit maximization ensures growth and survival i.e. only those firms that maximise
profits survive in the industry.
4. Profit maximization acts as a strong motivating force to acquire monopoly powers, in
the imperfect commodity markets
5. Profit maximization is not an assumption but rather a rational goal to which every
firm attempts to achieve.

Profit maximization criterion is criticized under the two grounds.

1. Those that are based on misapprehensions about the workability and fairness of the
private enterprise itself.
2. Those that arise out of the difficulty of applying this criterion in actual real world
situations.

Apart from the foresaid objectives, it suffers from the following limitations.

1. It is vague
2. It ignores the timing of returns
3. It ignores risk

In the present day business investment, profit maximization has been regarded as
unrealistic, difficult, inappropriate and immoral.

Ambiguity:
The term profit is vague and ambiguous. It is amenable to different
interpretations. For instance,

1. Profti may be Short term profit or long term profit

2. Profit before tax or after tax
3. Total profit or profit per share
 4. Operating profit or profit to shareholders

If profit maximisation objective does not consider, the benefits received in different
periods from the investment proposals.

The following table shows the returns from two alternative proposals x and y
over a period of 3 years.

Profits in different periods

Period X (In Rs.) Y (In Rs.)
I 10000 -
II 20000 20000
III 10000 20000
Total 40000 40000

The above table shows that the returns from the two alternative proposals are identical. If
profit maximization is the objective, the two proposals are of equal important. But there is
difference in time pattern of benefits received from the two proposals.

Proposals X gives higher returns in the earlier year and proposal Y provides large returns
in the later years. The returns received earlier are more valuable because it can be reinvested to
get a return. Therefore proposal X is better, than proposal Y through both the alternative yield
same benefit.

The profit maximization criterion does not consider the time pattern of benefits received
and treats all benefits having equal value.

Quality of Benefits:
The term quality refers to the degree of certainity with which returns are expected. A
more certain and consistent return means, the higher quality of benefits. An uncertain and
fluctuating return means lower quality of benefits. Generally an investor, prefer to get returns,
with least variance. The profit maximization objective does not consider the quality aspects of
benefits. The following table show the return from 2 proposal X and Y.
Period X(In Rs.) Y (In Rs.)
I 18000 -
II 10000 10000
III 12000 20000
Total 30000 30000
The returns from the 2 alternative proposals are identical. But the variation in return is
more in proposal Y so the quality of benefit is low.
In proposal X the variation is marginal and hence the quality of benefit is high the profit
maximization objective ignores the quality aspect of benefit. It fails to provide an operationally
feasible measure for evaluating the alternative force of action in terms of economic efficiency.
That is why another fruitful criterion to maximize shareholder economic welfare wealth
maximization if criterion has been advanced by the scholars.

Wealth Maximization:
This is also known as value maximization or net present worth maximization. It provides
an appropriate and operationally feasible decision criterion for financial management decisions. It
provides an unambiguous measure of what financial management should see to maximize in
making investment and financial decisions. It satisfies a requirement of a suitable criterion i.e.
precise time value of money and quality of benefits.
In wealth maximization criterion the benefits associated with the assets are measured
terms of cash flow rather than accounting profits. The cash flow is a precious content with
definite meaning. IT overcomes the deficiencies associated with accounting profits. This is the
first operation features of wealth maximization.

The second important feature is that it considers quality and quantity dimensions of
benefits. It also benefits the time value of money. The quality of benefits has reference to the
certainty with which benefits are expected to be received in future.
Similarly, money has time value. It implies the benefits received earlier years should be
valued more highly than benefits received later.

Net worth or wealth of a firm is

W=V–C
Where,
W = Net worth
V = Gross Present worth
C = Investment required to acquire the assets.
The wealth maximization objective considers time value of money. At the same time, it
gives due weightage to risk factor.

Conclusion:
In the view of above reason, wealth maximization objective is considered superior to
profit maximization. Wealth maximization is simply an extension of profit maximization to real
life situations where the time period is short and magnitude of uncertainty is not great.