The most effective way to obtain and maintain the concentration of directors and managers on management excellence is through Principles-Centered Administration.
In this regard, the application of generally accepted accounting principles such as: consistency or uniformity, relative importance, prudence and cost as the basis of valuation, are essential in the application of coherent policies for the organization.
What does this consist of? What's your objective? Allow a faster and stronger concentration for the achievement of corporate goals. Achieving that speed and strength requires harmony and balance, and in turn obtaining this precise harmony and balance of concentration.
This article aims to demonstrate that harmony and balance exist when the objectives and goals of the company are oriented towards maximizing the wealth of shareholders. And the opposite happens, when it is only oriented to the maximization of profits.
The Myth of Profit Maximization
Generally, the owners of a corporation are not its administrators. Therefore, financial managers or financial management need to know what the objectives of the business owners are.
Some people believe, in the traditional approach to finance, that the goal of the business is always to maximize profits.
In this endeavor, financial management will take only those actions that would be expected to make a significant contribution to the company's overall profits.
And of all the alternatives that are considered, you will select the only one that is expected to have the highest monetary returns. Many times losing the long-term perspective and deteriorating the financing structure of own capital.
But is profit maximization a reasonable goal? No, it fails for several reasons because it ignores:
- The timeliness of returns, the cash flows available to shareholders, and the risk.
From the point of view of the Opportunity of the returns, it is preferable that it happens sooner than later.
This is that the higher returns in year 1 could be reinvested to provide greater returns in the future. As long as those returns exceed the cost of capital. On the contrary, we would be decapitalizing the company, and not precisely creating value for the shareholder, by withdrawing its capital and not the returns.
We will explain this topic later with an example.
With reference to the Cash Flow available to the shareholder, earnings do not necessarily result in cash flows for their benefit. This flow receives the owners either in cash in the form of a dividend or from the profits from the sale of their shares at a price higher than that initially paid. Higher earnings per share do not necessarily mean that the shareholders' meeting will vote to increase dividend payments.
Also, higher earnings per share do not necessarily translate into a higher share price. Sometimes companies have increases in their earnings without there being any favorable change in correspondence with the price of the shares. This occurs only when "increases in earnings are accompanied by increased future cash flows, a higher share price will be expected" ().
A basic premise in financial management is that there is a trade-off between return (cash flow) and risk. Return and risk are actually the main determinants of the share price, which represents the wealth of the owners in the company. Generally shareholders are risk averse, that is, they prefer to avoid risk. When risk is involved, shareholders expect to earn higher rates of returns on higher risk investments and lower rates on lower risk investments.
Since profit maximization does not achieve the objectives of the business owners, it should not be the objective of financial management.
Shareholder wealth maximization
The goal of the business, and consequently that of all financial management, is to maximize the wealth of the owners for whom it works. The wealth of corporate owners is measured by the price of the shares, which in turn is based on the opportunity of the returns, their magnitude and their risk. When considering each decision alternative in terms of its impact on the company's share price, financial managers should only accept those decisions that are expected to increase the share price. Since the share price represents the wealth of the owners in the company: maximizing the share price will maximize the wealth of the owner.
Let's assume the investment and financing structure of the following company:
Annex No. 1. Structural analysis (thousands of US $).
| CONCEPTS | 2005 | (%) | 2004 | (%) | VARIATION | (%) |
| INVESTMENTS | ||||||
| Current active | 1'280,260 | 74.94 | 837,682 | 76.53 | 442,578 | 72.10 |
| Non-Current Assets | 428,170 | 25.06 | 256,870 | 23.47 | 161,300 | 27.90 |
| TOTAL | 1'708,430 | 100.00 | 1'094,552 | 100.00 | 613,878 | 100.00 |
| FINANCING | ||||||
| Foreign Capital | 675,341 | 39.53 | 310,033 | 28.33 | 365,308 | 59.51 |
| Own capital | 1'033,089 | 60.47 | 784,519 | 71.67 | 248,570 | 40.49 |
| TOTAL | 1'708,430 | 100.00 | 1'094,552 | 100.00 | 613,878 | 100.00 |
The analysis of this structure shows us a company, which being industrial, presents the structure of a typical commercial company, which prioritizes the short term instead of the long term.
The period under analysis shows an investment growth equivalent to 56% based on 2004. Of which 442 million dollars were allocated to the short term (72.10%), and the balance of 161 million, to the long term (27.90%).
This great growth, however, was financed supported by foreign capital, which was strengthened in the current year by increasing its position from 28.33% to 39.53%. While in the same proportion own capital decreased, falling from 71.67% to 60.47%. The most notable effect of which is observed in the rise in financial expenses shown in the Profit and Loss Chart, which we omit here where Interest Expenses went from more than 10 million to more than 27 million dollars, also dragging in the fall in Earnings per Share of US $ 6.42 to US $ 3.77
Despite the large increase in sales of 35.72% compared to the previous year, we note that profitability has decreased, both at the level of assets, equity and net sales. However, it is an important profit that cannot go unnoticed: a significant 28% per year.
Although it is true that from the point of view of profitability, it has remained at the same level as the previous year, the financial position of the company for the long term has deteriorated, as shown in Annex No. 1, the financing structure.
Conclusions
1. For an economic-financial management to be harmonious and balanced, its structural indexes must show growth both quantitatively and qualitatively from one year to another. Whose greater strength will be shown in the significant profits that the Profit and Loss Statement will show.
2. Relative growth is more important than quantitative growth. By maximizing shareholder wealth, we are securing the long-term future of the company. Otherwise we will be showing a weakness due to the slow but continuous strengthening of foreign capital.
3. It is not enough to generate profitability if it is not reflected in the increase in shareholders' wealth in the financing structure. If a dividend distribution is agreed, under these conditions, we will be distributing our own capital and the profits generated by the business.
4. A corrective measure in these circumstances would simply be the capitalization of profits. But in reality, shareholders demand profit sharing.
Note:
() Lawrence J. Gitman. "Principles of Financial Management". Tenth Edition. Editorial Pearson Education. Year 2003. Mexico.
