The aim of any business is to maximize profitability and minimize losses. In order to meet financial goals, organizations require a financial management plan. There are two forms of financial management; the traditional profit maximization approach and the more modern wealth maximization approach. The financial management goal chosen will depend on the objectives of the firm and its shareholders and the time horizon (long term or short term) in which profits are required. The article provides a clear explanation on these distinct forms of financial management and explains the factors that make them different from one another.
What is Profit Maximization?
Traditionally organizations were primarily focused on profit maximization. Profit maximization is short term strategy and focuses on making profits in the short term, which may result in taking courses of action that could be harmful in the long term. A corporation’s management is generally interested in profit maximization and strives to reach projected monthly, quarterly, and annual revenue. The goal of profit maximization is pursued by management because of the pressure put on them by stakeholders to achieve profit goals set. Management may also be concerned with profit maximization as this directly influences their remuneration, bonuses, and benefits.
What is Wealth Maximization?
Wealth maximization takes on a different, modern approach where the organization will focus on maximizing wealth in the long run as opposed to making short term gains. Wealth maximization focuses on cash flows that a firm receives, instead of looking at profits made during the short term. Wealth maximization is preferred by most shareholders who are willing to sacrifice short term profits in order to make longer term returns. Since shareholders are the owners of the firm, they will focus more on the longer term wealth created by the firm and will like to see greater reinvestment made presently to achieve greater value in the future. Wealth maximization goal is achieved when the market value of shares increases; this is one major reason why shareholders focus on wealth maximization. As market value of shares increase (as a result of the wealth maximization goal), shareholders can sell their shares at a higher price, thereby making larger capital gains.
Wealth Maximization vs Profit Maximization
Financial management is essential for any organization that seeks to manage their finances in an orderly manner. Wealth maximization and profit maximization are two important goals of financial management and are quite different to each other. Profit maximization looks at the shorter term and focuses on making larger profits in the short term, which could be at the expense of long term benefits. Wealth maximization, on the other hand, focuses on the long term and strives at long term value creation. As an example, a company has the option to invest $200,000 in a new technology to develop its product offering. If the investment is made now, the current profit levels of $400,000 will be reduced to $200,000. However, once the investment is made, the product that is currently sold for $10 can be sold for $15 in the future, which will then result in the market value of shares increasing by 10%. The bargain here is whether the $200,000 investment should be sacrificed for short term profits, or whether the investment should be made so that the product can be sold at a higher price, which will then increase market value, creating long term wealth.
Summary:
• There are two forms of financial management; the traditional profit maximization approach and the more modern wealth maximization approach.
• Profit maximization is short term strategy and focuses on making profits in the short term, which may result in taking courses of action that could be harmful in the long term.
• Wealth maximization takes on a different, modern approach where the organization will focus on maximizing wealth in the long run as opposed to making short term gains.