WHAT IS FINANCIAL MANAGEMENT?

Financial management is concerned with the acquisition, financing,

and management of assets with some overall goal in mind. Thus, the decision

function of management can be broken down into three major areas :

the investment, financing, and asset management decisions.

Investment Decision

The investment decision is the most important of the firm’s three major decisions. It begins with a determination of the total amount of assets needed to be held by the firm. Picture the firm’s balance sheet in your mind for a moment. Imagine liabilities and owners’ equity being listed on the right side of the firm’s balance sheet and its assets on the left. The financial manager needs to determine the dollar amount that appears above the double lines on the left-hand side of the balance sheet—that is, the size of the firm. Even when this number is known, the composition of the assets must still be decided. For example, how much of the firm’s total assets should be devoted to cash or to inventory?

Financing Decision

The second major decision of the firm is the financing decision. Here the financial manager is concerned with the makeup of the right-hand side of the balance sheet. If you look at the mix of financing for firms across industries, you will see marked differences. Some firms have relatively large amounts of debt, while others are almost debt free. Does the type of financing employed make a difference? If so, why? And, in some sense, can a certain mix of financing be thought of as best?

Once the mix of financing has been decided, the financial manager must still determine how best to physically acquire the needed funds. The mechanics of getting a short-term loan, entering into a long-term lease arrangement, or negotiating a sale of bonds or stock must be understood.

Asset Management Decision

The third important decision of the firm is the asset management decision. Once assets have been acquired and appropriate financing provided, these assets must still be managed efficiently. The financial manager is charged with varying degrees of operating responsibility over existing assets. These responsibilities require that the financial manager be more concerned with the management of current assets than with that of fixed assets.

THE GOAL OF THE FIRM

Efficient financial management requires the existence of some objective or goal because judgment as to whether or not a financial decision is efficient must be made in light of some standard. Although various objectives are possible, we assume that the goal of the firm is to maximize the wealth of the firm’s present owners.

Shares of common stock give evidence of ownership in a corporation. Shareholder wealth is represented by the market price per share of the firm’s common stock, which, in turn, is a reflection of the firm’s investment, financing, and asset management decisions. The idea is that the success of a business decision should be judged by the effect that it ultimately has on share price.

Profit Maximization Versus Shareholder’s wealth maximization

Profit maximization means to increase the firm’s total profits as much as possible in the shortest time period possible.

Shareholders wealth maximization means to have the highest market value of the firm’s shares.

Profit maximization is not the same as wealth maximization. The shareholders’ wealth in a firm is better reflected by the stock price and not its profits.

The goal of profit maximization is not appropriate by itself because:

a) it emphasizes short-term focus

b) it does not consider the magnitude and the timing of earnings

c) it does not consider the risk of the investments and the impact on the earnings

When the financial manager concentrates on shareholders’ wealth maximization, he is forced to take into account all the above factors and therefore is the primary goal of financial management

Functions of a Financial Manager

Daily Occasional Profitability Goal

n Cash management n Credit management n Inventory control n Receipt and payment of funds	n Stock issue n Bond issue n Capital budgeting n Dividend decision

Maximize

Shareholder’s

Wealth

Risk