Financial management is crucial for maximizing shareholder wealth and ensuring a company's long-term success. It involves making decisions that increase stock value, attract investors, and support growth. Financial managers play a key role in capital budgeting, working capital management, and risk assessment.
Short-term financial management focuses on liquidity and working capital, while long-term management involves capital budgeting and strategic planning. The goal is to balance risk and return, aligning managerial decisions with shareholder interests to create sustainable value and maintain a competitive edge.
The Role and Goals of Financial Management
Goal of financial management
- Maximize shareholder wealth determined by the market value of the firm's common stock
- Involves making decisions that increase the value of the firm's shares (stock price appreciation, dividends)
- Aligns the interests of managers and shareholders ensures efficient allocation of resources
- Attracts investors and facilitates raising capital (IPOs, bond issuances)
- Contributes to the long-term sustainability and growth of the firm supports competitive advantage
Responsibilities of financial managers
- Capital budgeting
- Evaluating and selecting long-term investment projects (new factories, R&D)
- Assessing the profitability and risk of potential investments using financial metrics (NPV, IRR)
- Determining the optimal mix of debt and equity financing for projects balancing cost and risk
- Working capital management
- Managing short-term assets and liabilities (cash, inventory, accounts receivable/payable)
- Ensuring sufficient liquidity to meet short-term obligations avoiding financial distress
- Optimizing the firm's cash conversion cycle minimizing working capital needs
- Financial planning and forecasting
- Developing long-term financial plans and budgets guiding strategic decision-making
- Projecting future cash flows, profitability, and financial position under different scenarios
- Identifying potential financial challenges and opportunities proactively addressing them
- Risk management
- Identifying and assessing financial risks (market risk, credit risk, liquidity risk)
- Implementing strategies to mitigate or hedge against risks (derivatives, insurance)
- Monitoring and adjusting risk management strategies as needed adapting to changing conditions
Shareholder wealth maximization
- Focuses on increasing the market value of the firm's common stock reflecting intrinsic value
- Market value is determined by the present value of expected future cash flows to shareholders
- Financial decisions should aim to increase the present value of these cash flows (positive NPV projects)
- Implications for financial decision-making
- Evaluating investment opportunities based on their potential to generate positive net present value (NPV)
- Considering the trade-off between risk and return when making financial decisions balancing potential rewards and downside
- Balancing short-term and long-term objectives to ensure sustainable value creation avoiding myopic decisions
- Aligning managerial incentives with shareholder interests through compensation (stock options) and governance structures (board oversight)
Short-term vs long-term financial management
- Short-term financial management
- Focuses on managing current assets and liabilities over a period of up to one year
- Ensures the firm has sufficient liquidity to meet its short-term obligations avoiding default
- Involves decisions related to working capital management, such as inventory control and accounts receivable management (credit policies)
- Aims to minimize the cost of short-term financing (commercial paper, lines of credit) while maintaining adequate liquidity
- Long-term financial management
- Focuses on making decisions that affect the firm's long-term financial health and value creation over multiple years
- Involves capital budgeting decisions, such as evaluating and selecting long-term investment projects (capital expenditures)
- Determines the optimal capital structure, balancing the use of debt (bonds, loans) and equity financing (common stock, retained earnings)
- Develops long-term financial plans and strategies to support the firm's growth and competitive advantage (mergers and acquisitions, international expansion)