The Three Basics of Financial Management – A detailed look
The Three Basics of Financial Management. Finance is a key area of professional practice. It is said that, to become a master in any subject, you should be very clear on the basics of that subject. Now scroll down below n check more details about The Three Basics of Financial Management. Here, we have compiled a list of three basic concepts with which the subject ‘Financial Management’ deals:
- Basic Decisions Involved in Financial Management
- Concept of Risk vs. Return
- Profit Maximizations vs. Wealth Maximization
Let us have a detailed look on what do these concepts involve:
Basic decisions Involved in Financial Management
Investment, in simple terms, means utilization of money for profits or returns. They include matters which involve the concepts of Capital Budgeting, Cost of Capital,
- Measuring Risk, Management of Liquidity and Current Assets.
- Investments lead to exchange of current funds for future benefits.
- Capital is a scarce resource and its supply cost is very high.
- Optimal investment decisions need to be made after considering factors like:
- Estimation of Cash Outflows & Inflows; an
- Availability of capital and estimating cost of capital.
After making the investments decisions, we need to take the financial decisions as regards to from where we should procure the funds for investing in our project.
It Involves evaluation of the company’s financial needs and to decide the appropriate type of capital that fits the best to those needs.
It is concerned with determining the appropriate proportion of equity and debt so as to obtain an optimum capital structure.
The dividend decision is a major area of financial management.
The finance manager must decide whether the firm should distribute all the profits or retain them or distribute a portion and retain the balance.
This decision depends on whether the company or its shareholders are in the position to better utilize the funds or not.
Concept of Risk Vs. Return:
- Higher the return, other things being equal, higher the market value; higher the risk, other things being equal, lower the market value.
- The financial manager tries to achieve the proper balance between the considerations of risk and return associated with various financial management decisions to maximize the market value of the firm.
- Risk and Return go together. This implies that a decision alternative with high risk tends to promise higher return and the reverse is also true.
Profit maximizations vs. Wealth maximization:
The following table shows a comparative distinction between the two concepts:
|Profit maximization||Large amount of profits||1. Easy to calculate profits.
2. Easy to determine the link between financial decisions and profits.
|1. Emphasizes the short term.
2. Ignores risk or uncertainty.
3. Ignores the timing of returns.
4. Requires immediate resources.
|Shareholder wealth maximization||Highest market value of common stock||1. Emphasizes the long term.
2. Recognizes risk or uncertainty.
3. Recognizes the timing of returns.
4. Considers return.
|1. Offers no clear relationship between financial decisions and stock price.
2. Can lead to management anxiety and frustration.
These were the three most important parts of ‘Financial Management’. After understanding these conceptually, you can move on towards the detailed study of each topic covered above.