Learn, Explain What are the Goals of Financial Management?
The goals of financial management can be classified in many ways. Official goals, operative goals, and operational goals are one classification. Official goals are the general aims of the organization. Maximization of return on investment and market value per share may be termed as official goals of financial management. Operative goals indicate what the organization is really attempting to do. They are focused and help in choice making. Also Learned, Meaning, Definition, Features, and Scope, What are the Goals of Financial Management?
The expected return on investment, cost of capital, debt-equity norms, etc dong with time horizon are specified or their acceptable ranges/limits are static keeping in view the official goals. The operational goals of financial management are more directed quantitative and verifiable. The scale, mix, and timing of specific form of finance are detailed.
The official, operative and operational goals are structured with a pyramidal shape, the official goals at the top (concerned with the top executives), operative goals at the middle (concerned with middle management) and operational goals at the base. The financial management goals can also be classified in a functional way. Return related goals, solvency related goals, liquidity-related goals, valuation related goals, risk related goals, cost-related goals and so on.
Return related goals refer to the aims on minimum, average and, maximum returns. What should be the minimum return from a project in order to accept the same, what should be average return the firm should settle for and what is the maximum return possible (for risk increases with return)? Similarly, goals as to solvency, liquidity, market value etc., can be thought of you have to state to what extent the stated goal factor is important and be actively pursued/and the extent of the goal factor required; the minimum, average and the maximum levels be specified.
1. Profit Maximization:
Profit maximization is a stated goal of financial management. Profit is the excess of revenue over expenses. Profit maximization is, therefore, maximizing revenue given the expenses, or minimizing expenses given the revenue or a simultaneous maximization of revenue and minimization of expenses. Revenue maximization is possible through pricing and scale strategies.
By increasing the selling price one may achieve revenue maximization, assuming demand does not fall by a commensurate scale. By increasing quantity sold by exploiting the price-elasticity of the demand factor, revenue can be maximized. Expenses minimization depends on the variability of costs with volume, cost consciousness and market conditions for inputs. So, a mix of factors is called for profit maximization.
This objective of financial management is a favored one for the following reasons:
- Profit is a measure of success in business. Higher the profit greater is the degree of success.
- Profit is a measure of performance. Performance efficiency is indicated by the quantum of profit.
- Profit making is essential for the growth and survival of any undertaking. Only profit making business can think of tomorrow and beyond. It can only think of renewal and replacement of its equipment and can go for modernization and diversification. Profit is an engine doing away the odds threatening the survival of the business.
- Profit making is the basic purpose of business. It is accepted by society. A losing concern is a social burden. The sick business undertakings cause a heavy burden to all concerned, we know. So, profit criterion brings to the light operational inefficiency. You cannot conceal your inefficiency if profit is made the criterion of efficiency.
- Profit making is not a sin. The profit motive is a socially desirable goal, as long as your means are good.
However, profit maximization is not very much favored. Certain limitations are pointed out. First, the concept of profit is vague. There are several concepts of profit like gross profit, profit before tax, profit after tax, net profit, divisible profit and so on. So the reference to the profit has to be clear. Second, profit maximization in the long-run or in the short-run is to be stated clearly.
Long-run or in the short-run profit orientations differ in nature, emphasis, and strategies. Third, profit maximization does not consider the scale factors. Size of business and level of profit have to be related. Otherwise, no sensible interpretation of performance or efficiency is possible. Fourth, profit has to be related to the time factor. Inflation eats up money value. A rupee today is worthier today than tomorrow and day after. Time value of money is not considered in profit maximization.
2. Profitability Maximization:
Profit as an absolute figure conveys less and conceals more. Profit must be related to either sales, capacity utilization, production or capital invested. Profit when expressed in relation to the above size or scale factors it acquires greater meaning. When so expressed, the relative profit is known as profitability. Profit per rupee sales, profit per unit production, profit per rupee investment, etc., are more specific. Hence, the superiority of this goal to the profit maximization goal.
Further profit per rupee investment or return on investment, (ROI) is a comprehensive measure. ROI = Return or Profit / Average Capital invested.
Profit divided by sales measures the profit per rupee of sales and sales divided by investment measures the number of times the capital is turned over. The former is an index of profit earning capacity and the latter is an index of activeness of the business. Maximization of profitability (ROI) is possible through either the former or the latter or both.
The favorable scores of this objective are the same as those of the profit maximization objective. The unfavorable scores of this objective again are the same as those of the profit maximization objective except one aspect. Profit maximization goal does not relate profit to any base. But profitability maximization relates profit to sales and/or investment. Hence it is a relative measure. So it is better than profit maximization goal on this score. But as other limitations continue, this objective to gets only a ‘qualified’ report as to its desirability.
3. EPS Maximization:
Maximization Earnings Per Share (EPS) involves maximizing earnings after tax given the number of outstanding equity shares. This goal is similar to profitability maximization in respect of merits and demands. It is very specific both as to the type of profit and the base to which it is compared. One disadvantage is that EPS maximization may lead to value depletion too because the effect of dividend policy on value is totally discarded.
4. Liquidity Maximization:
Liquidity refers to the ability of a business to honor its short-term liabilities as and when these become due. This ability depends on the ratio of current assets to current liabilities, the maturity patterns of currents assets and ‘the current liabilities, the composition of current assets, the quality of non-cash current assets; the relations with the short-term creditors; the relations with bankers and the like.
A higher current ratio, a perfect match between the maturity of current assets and current liabilities, a well balanced composition of current assets, healthy and ‘moving‘ current assets, i.e., those that can be converted into liquid assets with much ease and no loss, understanding creditors and ready to help bankers would help to maintain a high-liquidity level for a business. All these are not easy to obtain and these involve costs and risks.
How far is it a good goal? It is a good goal, though not a wholesome one. Every business has to generate sufficient liquidity to meet its day-to-day obligations. Last, the business would suffer. A liquidity rich business can exploit some rare opportunities like buying inventory in large quantity when the price is lower, lend to the call money borrowers when the interest rate is high, retire short-term-creditors taking advantage of cash discounts and so on. So many benefits accrue. But, high liquidity might result in idle cash resources and this should be avoided. Yes, excess liquidity and profitability move in the opposite directions, they are conflicting goals and have to be balanced.
5. Solvency Maximization:
Solvency is long run liquidity. Liquidity is short-run solvency. The business has to pursue the goal of solvency maximization. Solvency is the capacity of the business to meet all its long-term liabilities. The earning capacity of the business, the ratio of profit before interest and tax to interest, the ratio of cash flow to debt amortization, the equity-debt ratio and the proprietary ratio influence the solvency of a business. Higher the above ratios greater is the solvency and vice-versa.
Is this a significant goal? Yes, Solvency is a guarantee for continued operation, which in turn is necessary for survival, growth, and expansion. Borrowed capital is a significant source of finance. Its cost is less; it gives tax leverage; So, equity earnings increase; so market valuation increases. So, wealth maximization is enabled through the borrowed capital. But to use borrowed capital, solvency management is essential. You have to decide the extent to which you can use debt capital and ensure that the cost of debt capital is minimum.
Higher dependence and higher cost (higher than the ROI) would spell doom to the business. If the cost is less, (cost is the post-tax interest rate), and your earnings are stable, a higher debt may not be difficult for servicing. Solvency maximization is increasing your ability to service increasing debt and does not mean using less debt capital. Increasing the debt serviceability would require generating more and stable cash flows through the operations of the business. Ultimately, the nature of investments and business ventures influence solvency.
6. Minimization of Risk:
So far, maximization financial goals were dealt with. Now, if we turn the coin, the minimization goals come to light. Minimization of risk is one of the goals. Risk refers to fluctuation, instability or variations in what we cherish to obtain. Variations in sales, profit, capacity utilization, liquidity, solvency, market value and the like are referred to risk. Business risk and financial risk are prominent among different risks. Business risk refers to variation in profitability while financial risk refers to variation in debt servicing capacity.
The business risk, alternatively, refers to variations in expected returns. Greater the variations, greater the business risk. Risk minimization also does not mean taking any risk at all. It means minimizing risk given the return and given the risk of maximizing return. Risk reduction is possible by going in for a mix of risk-free and risky investments. A portfolio of investments with risky and risk-free investments could help reducing business risk. So, diversification of investments, as against concentration, helps in reducing business risk.
Financial risk arises when you depend more on high-geared capital structure and your cash flows and profits before interest and tax (PBIT) vary. To minimize financial risk, the quantum of debt capital be limited to the serviceable level, which depends on the minimum level of PBIT and the cash flow. Of course, debt payment scheduling and rescheduling may help in financial risk reduction and the creditor must be agreeing to such schedules/reschedules. Here; too, a portfolio of debt capital can be thought of to reduce risk.
7. Minimization of Cost of Capital:
Minimization of cost of capital is a laudable goal of financial management. Capital is a scarce resource, a price has to be paid to obtain the same. The minimum return expected by equity investors, the interest payable to debt capital providers, the discount for prompt payment of dues, etc., are the costs of different forms of capital. The different sources of capital – equity, preference share capital, long-term debt, short-term debt and retained earnings, have different costs. In theory, equity is the costliest source. Preference share capital and retained earnings cost less than equity. The debt capital costs less, besides there is the tax advantage.
So, to minimize cost you have to use more debt and less of other forms of capital. Using more debt to reduce cost is however is beset with some problems, viz., you take heavy financial risk, create charge on assets and so on. Some even argue, that more debt means more risk of insolvency and bankruptcy cost arises. So, debt capital has, besides the actual cost, another dimension of cost – the hidden cost. So, minimizing cost of capital means minimizing the total of actual and hidden costs.
This is a good goal. Minimization of capital cost increases the value of the firm. If the overall cost of capital is less, the firm can take up even marginal projects and make good returns and serve the society as well. But, it should avoid the temptation to fritter away scarce capital. Capital should be directed into productive and profitable avenues only.
8. Minimization of Dilution of Control:
Control on the business affairs is, generally, the prerogative of the equity shareholders. As the Board holds a substantial equity it wants to preserve its hold on the affairs of the business. The non-controlling shareholders too, in heir financial pursuit, want no dilution of their enjoyment of fruits of equity ownership. Dilation takes place when you increase the capital base. By seeking debt capital control dilation is minimized. Also, by rights issue of equity dilation of control can be minimized.
It is evident, minimization of dilution of control is essentially a financing -mix decision and the latter’s relevance and significance had been already dealt with. But you cannot minimize dilution beyond a point, for providers of debt capital, directly or indirectly, affect business decisions. The convertibility clause is a shot in the arm for those creditors. Yes, controlling power has to be distributed.
9. Wealth Maximization:
Wealth maximization means maximization of the net worth of the business, i.e. the market valuation of a business. In other words, increasing the market valuation of equity share is what is pursued here. This objective is considered to be superior and wholesome. The pros and cons of this goal are analyzed below.
Taking the positive side of this goal, we may mention that this objective takes into account the time value of money. The basic valuation model followed discounts the future earnings, i.e. the cash flows, at the firm’s cost of capital or the expected return. The discounted cash inflow and outflow are matched and the investment or project is taken up only when the former exceeds the latter.
The term cash flow used here is capable of only one interpretation, unlike the term profit. Cash inflow refers to profit after interest and tax but before depreciation. Otherwise put, profit after tax and interest as increased by depreciation. Cash outflow is the investment. The salvage value of an investment, at its present value, can be reduced from investment or added to inflow. So, the cash flow concept used in wealth maximization is a very clear concept.
This goal considers the risk factor in the financial decision, while the earlier two goals of financial management are silent as though risk factor is absent. The not only risk is there and it is increasing the level of return generally. So, by ignoring risk, you cannot maximize profit forever wealth maximization objective give credence to the whole scheme of financial evaluation by incorporating risk factor in the evaluation. This incorporation is done through enhanced discounting rate if need be.
The cash flows for normal-risk projects are discounted at the firm’s cost of capital, whereas risky projects are discounted at a higher than the cost of the capital rate so that the discounted cash inflows are deflated, and the chance of taking up the project is reduced. Cash flows – inflows and outflows are matched. So, one is related to the other: i.e. there is the relativity criterion too. So, wealth maximization goal comes clear off all the limitations all the goals mentioned above. Hence, wealth maximization goal is considered a superior goal. This is accepted by all participants in the business system.
1o. Maximization of Economic Value Added:
A modern concept of financial management goal is emerging now, called as maximization of economic value added (EVA). EVA = NGPAT – INTE, where, EVA is economic value added, NGPAT is net generating profit after tax but before interest and dividend and INTE is the cost of combined capital. INTE = Interest paid on debt capital plus fair remuneration on equity. EVA is simply put the excess of profit overall expenses, including expenses towards fair remuneration paid/payable on equity fund.