Page 10 - DMGT409Basic Financial Management

Unit 1: An Overview of Financial Management

(a) Maintenance of Liquid Assets: Financial management aims at maintenance of adequate Notes
liquid assets with the firm to meet its obligations at all times. However, investment
in liquid assets has to be adequate – neither too low nor too excessive. The finance
manager has to maintain a balance between liquidity and profitability.
(b) Maximization of Profi t: “Profit maximization” is a term which denotes the maximum
profit to be earned by an organization in a given time period. The profit- maximization
goal implies that the investment, financing and dividend policy decision of the
enterprise should be oriented to profit maximization.

The term “Profit” can be used in two senses – first, as the owner-oriented concept

and the second, as the operational concept.

Profit as the owner-oriented concept, refers to the amount of net profit, which goes

in the form of dividend to the shareholders. Profit as the operational concept means

profitability, which is an indicator of economic efficiency of the enterprise.

Profitability-maximization implies, that the enterprise should select assets, projects

and decisions, that are profitable and reject the non-profitable ones. It is in this sense,

that the term profit- maximization is used in fi nancial management.

Merits of Profit – Maximization
1. Best Criterion on Decision-Making: The goal of profit – maximization is regarded as the best

criterion of decision-making as it provides a yardstick to judge the economic performance
of the enterprises.
2. Efficient Allocation of Resources: It leads to efficient allocation of scarce resources as they

tend to be diverted to those uses which, in terms of profitability, are the most desirable.
3. Optimum Utilization: Optimum utilization of available resource is possible.
4. Maximum Social Welfare: It ensures maximum social welfare in the form of maximum
dividend to shareholders, timely payment to creditors, higher wages, better quality and
lower prices, more employment opportunities to the society and maximization of capital
to the owners.

However, the profit-maximization objective suffers from several drawbacks which are as
follows.
1. Time Factor Ignored: The term ‘Profit’ does not speak anything about the period of profi t-

whether it is short-term profit or long-term profi t.

2. It is Vague: The term ‘Profit’ is very vague. It is not clear in what exact sense the term
profit is used. Whether it is Accounting profit or Economic profit or profit after tax or profi t

before tax.
3. The Term ‘Maximum’ is also Ambiguous: The term ‘maximum’ is also not clear. The concept

of profit is also not clear. It is therefore, not possible to maximize what cannot be known.
4. ‘It’ Ignores Time Value: The profit maximization objective fails to provide any idea

regarding the timing of expected cash earnings. The choice of a more worthy project lies in
the study of time value of future inflows of cash earnings. It ignores the fact that the rupee

earned to day is more value able than a rupee earned later.
5. ‘It’ Ignores the Risk Factor: According to economists, profit is a reward for risk and

uncertainty bearing. It is also a dynamic surplus or profi t is a reward for innovation. But

when can the organization maximize profits ? Profit – maximization objective does not
make this clear.

LOVELY PROFESSIONAL UNIVERSITY 3