Scope, Objectives and Types of Financing
What financial management decides
Financial management is the function within a firm concerned with three interrelated decisions: the investment decision — which assets or projects the firm should commit funds to; the financing decision — from which sources, and in what mix, those funds should be raised; and the dividend decision — how much of the firm's earnings should be distributed to shareholders and how much retained for reinvestment. A fourth area, working capital management, is sometimes treated as a decision in its own right and sometimes folded into the investment decision, since it concerns the firm's investment in short-term assets such as inventory and receivables.
These three decisions are not independent of one another, and this interdependence is why the rest of this paper is structured as a chain. The financing decision determines the cost of capital, which becomes the discount rate used to evaluate investment decisions. The dividend decision determines how much is retained rather than distributed, which affects how much external financing the investment decision requires. A finance manager who treats these as three separate problems, solved one after another with no reference to each other, will produce internally inconsistent conclusions — this is the same cumulative logic introduced in the method chapter, now grounded in the decisions it actually governs.
Profit maximisation versus wealth maximisation
Classical economic theory once treated profit maximisation as the natural objective of a firm, and it remains an intuitive starting point: a firm exists to earn profit, so maximising profit sounds like the obvious goal. Financial management rejects this as the operating objective, for reasons worth stating precisely rather than accepting on authority.
Profit maximisation ignores the time value of money. A rupee of profit earned this year and a rupee of profit earned five years from now are treated as equivalent under a pure profit-maximisation lens, when in reality money available sooner is worth more than the same amount available later, because it can be reinvested and can be received with more certainty. Two projects with identical total profit over their lives, but with one delivering its profit earlier, are not equally valuable, yet profit maximisation cannot distinguish between them.
Profit maximisation ignores risk. Two courses of action might promise identical expected profit, but one might carry far greater variability or uncertainty around that expectation. A firm choosing purely to maximise profit, with no regard to the risk attached to earning it, would be indifferent between a safe and a volatile path to the same expected number — a distinction that matters enormously to the shareholders actually bearing that risk.
Profit maximisation is an ambiguous, short-term-biased measure. "Profit" can mean several different things — accounting profit before or after tax, profit per share, total profit — and a firm chasing accounting profit in the near term can do so at the expense of long-term value, for instance by deferring necessary maintenance or research spending to inflate a single year's reported number.
Wealth maximisation is the objective financial management adopts instead, operationalised as the maximisation of the market value of the firm's equity shares, or equivalently, the maximisation of shareholders' wealth. It resolves each of the objections above: it explicitly incorporates the time value of money, since a share's market value reflects the present value of the stream of benefits shareholders expect to receive over time, appropriately discounted; it explicitly incorporates risk, since the market discounts riskier expected cash flows at a higher rate, so a riskier path to the same expected profit is correctly valued lower; and it is unambiguous, since market value is a single, observable figure rather than a choice among several accounting definitions of profit.
Wealth maximisation is sometimes criticised as applicable only to listed companies whose shares trade in an observable market, and for unlisted firms the objective is understood as maximising the intrinsic or fundamental value the firm would command were its shares to be valued, applying the same underlying logic of discounted future benefits.
The finance function and the finance manager's role
The finance manager sits at the centre of the three decisions described above, and the role has broadened considerably from a narrow, custodial function — merely arranging funds and keeping records — to a genuinely strategic one. Modern finance managers are involved in investment appraisal, in structuring the firm's financing mix, in setting dividend policy, in managing working capital, and increasingly in risk management, given how exposed firms are to interest rate, currency and market risk. This broadened scope is why Strategic Management sits in the same paper as Financial Management: financing decisions are no longer merely operational, they are strategic choices with consequences for the firm's competitive position.
Types of financing: the long-term and short-term landscape
Sources of finance are conventionally classified along two axes: by duration — long-term versus short-term — and by ownership — owned funds versus borrowed funds. Understanding this classification matters because different sources carry different costs, different risk to the firm, and different suitability depending on what the funds are for.
Long-term sources
Equity share capital represents ownership funds with no fixed obligation to pay a return; equity shareholders receive dividends only when declared and bear the residual risk of the business, in exchange for which they hold voting control and the entire upside if the firm performs well. Equity carries no repayment obligation and no fixed charge on profit, making it the safest source from the firm's perspective in terms of solvency risk, but it is also typically the most expensive source, since equity investors demand a higher expected return to compensate for bearing the residual risk.
Preference share capital sits between equity and debt: it carries a fixed dividend rate, payable before any equity dividend, and a preferential claim on capital in a winding up, but that dividend is payable only out of profits and, if the preference shares are non-cumulative, is lost entirely for a year in which it is not paid, unlike interest on debt which accrues regardless of profit.
Debentures and long-term loans represent borrowed funds carrying a fixed rate of interest, payable irrespective of whether the firm has earned a profit, and usually a fixed date of repayment. Interest is a tax-deductible expense, making debt a comparatively cheap source of finance after tax, but the fixed obligation to pay interest and repay principal, regardless of the firm's performance in a given year, means debt increases financial risk — the firm's fixed financial commitments rise in proportion to how much it borrows.
Retained earnings, the portion of profit ploughed back into the business rather than distributed as dividend, function as an internal source of long-term finance, avoiding both the cost and the procedural burden of raising external capital, though they are of course limited to whatever the firm actually earns and chooses to retain.
Term loans from financial institutions and banks and lease financing, where a firm uses an asset without owning it outright in exchange for periodic lease rentals, round out the common long-term sources, the latter being particularly relevant where a firm wants the use of a costly asset without the large upfront capital outlay ownership would require.
Short-term sources
Short-term financing meets working capital needs — funding the day-to-day operating cycle of purchasing inventory, converting it to finished goods, selling on credit and collecting from debtors — rather than funding fixed assets or long-term expansion.
Trade credit, the credit extended by suppliers allowing a firm to pay for goods some period after receiving them, is the most widely used and often the least formally costed source of short-term finance, though it is not free where a supplier offers a cash discount for early payment that the firm forgoes by using the full credit period.
Bank credit in its various forms — cash credit, overdraft, and short-term working capital loans — is the primary formal short-term source for most firms, typically secured against inventory or receivables and priced with reference to the bank's lending rate.
Commercial paper, an unsecured, short-term promissory note issued by financially strong, typically large and well-rated companies directly to investors, offers a cheaper alternative to bank borrowing for firms with the credit standing to access it, bypassing the bank as intermediary.
Factoring, where a firm sells its receivables to a specialised financial institution, the factor, at a discount in exchange for immediate cash, converts a firm's book debts into ready funds and, depending on the arrangement, can also transfer the risk of debtor default to the factor.
Why this classification matters beyond definitions
The point of learning this landscape is not to recite a list of sources but to recognise the general principle that governs sound financing: match the duration of the source to the duration of the need. Long-term, fixed assets should ordinarily be financed by long-term sources, since financing a factory building with short-term bank credit that must be repaid or renewed every few months exposes the firm to renewal risk and mismatched cash flow timing. Working capital needs, by contrast, are appropriately financed at least partly by short-term sources, since the operating cycle itself is short and the need recurs and self-liquidates as inventory converts to cash. This maturity-matching principle recurs later in the working capital management chapter, where it becomes the basis for choosing among conservative, aggressive and matching financing policies.
How this chapter connects forward
This chapter sets the vocabulary and the objective — wealth maximisation — that every later FM chapter assumes. Cost of capital is nothing more than the price the firm pays for each of the sources introduced here, weighted by how much of each the firm actually uses. Capital structure is the study of how the mix between owned funds and borrowed funds should be chosen. Understanding the sources themselves, and why wealth maximisation rather than profit maximisation is the objective against which every financing and investment choice is judged, is therefore the necessary starting point for everything that follows in this paper.
