Goal of Finance

Maximizing Profit
Limitation of Profit Maximization
Wealth Calculation
Interested Parties
Agency Problem

Introduction - Goals of Financial Management

All businesses aim to maximize their profits, minimize their expenses
and maximize their market share. Here is a look at each of these
goals.
Maximize Profits A company's most important goal is to make money
and keep it. Profit-margin ratios are one way to measure how much
money a company squeezes from its total revenue or total sales.
There are three key profit-margin ratios: gross profit margin, operating
profit margin and net profit margin.
1. Gross Profit Margin
The gross profit margin tells us the profit a company makes on its cost
of sales or cost of goods sold. In other words, it indicates how
efficiently management uses labor and supplies in the production
process.
Gross Profit Margin = (Sales - Cost of Goods Sold)/Sales
Suppose that a company has $1 million in sales and the cost of its
labor and materials amounts to $600,000. Its gross margin rate would
be 40% ($1 million - $600,000/$1 million).
The gross profit margin is used to analyze how efficiently a company is
using its raw materials, labor and manufacturing-related fixed assets to
generate profits. A higher margin percentage is a favorable profit
indicator.
Gross profit margins can vary drastically from business to business and
from industry to industry. For instance, the airline industry has a gross
margin of about 5%, while the software industry has a gross margin of
about 90%.

2. Operating Profit Margin

By comparing earnings before interest and taxes (EBIT) to
sales, operating profit margins show how successful a company's
management has been at generating income from the operation of the
business:
Operating Profit Margin = EBIT/Sales
If EBIT amounted to $200,000 and sales equaled $1 million, the
operating profit margin would be 20%.
This ratio is a rough measure of the operating leverage a company can
achieve in the conduct of the operational part of its business. It
indicates how much EBIT is generated per dollar of sales. High
operating profits can mean the company has effective control of costs,
or that sales are increasing faster than operating costs. Positive and
negative trends in this ratio are, for the most part, directly attributable
to management decisions.
Because the operating profit margin accounts for not only costs of
materials and labor, but also administration and selling costs, it should
be a much smaller figure than the gross margin.
3. Net Profit Margin
Net profit margins are those generated from all phases of a business,
including taxes. In other words, this ratio compares net income with
sales. It comes as close as possible to summing up in a single figure
how effectively managers run the business:
Net Profit Margins = Net Profits after Taxes/Sales
If a company generates after-tax earnings of $100,000 on its $1 million
of sales, then its net margin amounts to 10%.
Often referred to simply as a company's profit margin, the socalled bottom line is the most often mentioned when discussing a
company's profitability.
Again, just like gross and operating profit margins, net margins vary
between industries. By comparing a company's gross and net margins,
we can get a good sense of its non-production and non-direct costs like

administration, finance and marketing costs.

For example, the international airline industry has a gross margin of
just 5%. Its net margin is just a tad lower, at about 4%. On the other
hand, discount airline companies have much higher gross and net
margin numbers. These differences provide some insight into these
industries' distinct cost structures: compared to its bigger, international
cousins, the discount airline industry spends proportionately more on
things like finance, administration and marketing, and proportionately
less on items such as fuel and flight crew salaries.
In the software business, gross margins are very high, while net profit
margins are considerably lower. This shows that marketing and
administration costs in this industry are very high, while cost of sales
and operating costs are relatively low.
When a company has a high profit margin, it usually means that it also
has one or more advantages over its competition. Companies with high
net profit margins have a bigger cushion to protect themselves during
the hard times. Companies with low profit margins can get wiped out in
a downturn. And companies with profit margins reflecting a
competitive advantage are able to improve their market share during
the hard times, leaving them even better positioned when things
improve again.
Like all ratios, margin ratios never offer perfect information. They are
only as good as the timeliness and accuracy of the financial data that
gets fed into them, and analyzing them also depends on a
consideration of the company's industry and its position in the
business cycle. Margins tell us a lot about a company's prospects, but
not the whole story.
Minimize Costs
Companies use cost controls to manage and/or reduce their business
expenses. By identifying and evaluating all of the business's expenses,
management can determine whether those costs are reasonable and
affordable. Then, if necessary, they can look for ways to reduce costs
through methods such as cutting back, moving to a less expensive
plan or changing service providers. The cost-control process seeks to
manage expenses ranging from phone, internet and utility bills to
employee payroll and outside professional services.

To be profitable, companies must not only earn revenues, but also

control costs. If costs are too high, profit margins will be too low,
making it difficult for a company to succeed against its competitors. In
the case of a public company, if costs are too high, the company may
find that its share price is depressed and that it is difficult to attract
investors.
When examining whether costs are reasonable or unreasonable, it's
important to consider industry standards. Many firms examine their
costs during the drafting of their annual budgets.
Maximize Market Share
Market share is calculated by taking a company's sales over a given
period and dividing it by the total sales of its industry over the same
period. This metric provides a general idea of a company's size relative
to its market and its competitors. Companies are always looking to
expand their share of the market, in addition to trying to grow the size
of the total market by appealing to larger demographics, lowering
prices or through advertising. Market share increases can allow a
company to achieve greater scale in its operations and improve
profitability.
The size of a market is always in flux, but the rate of change depends
on whether the market is growing or mature. Market share increases
and decreases can be a sign of the relative competitiveness of the
company's products or services. As the total market for a product or
service grows, a company that is maintaining its market share is
growing revenues at the same rate as the total market. A company
that is growing its market share will be growing its revenues faster
than its competitors. Technology companies often operate in a growth
market, while consumer goods companies generally operate in a
mature market.
New companies that are starting from scratch can experience fast
gains in market share. Once a company achieves a large market share,
however, it will have a more difficult time growing its sales because
there aren't as many potential customers available.
Next we'll take a look at the potential conflicts of interest that can arise
in the management of a business's finances.

What Steps Do Companies Take to Maximize Profit or Minimize Loss?

by Jay Way, Demand Media
Companies may take different approaches to maximize profit or
minimize loss based on their own organizational strengths. While
product differentiation and low price can be critical to maximizing
profit, controlling cost and maintaining market share may be more
important in to minimizing loss. Regardless of what assets a company
owns and how much cash it holds, loss over extended periods of time
will eventually weaken a company's asset positions and decrease the
amount of its cash holdings.
Product Differentiation
Companies that can differentiate themselves by providing top-quality
products or services often are able to command higher prices in the
market. While price alone does not guarantee profit, it does give
companies the opportunity to maximize profit. All else being equal, the
higher the price that companies charge for their products' or services'
superior quality, the more profit companies can expect. The
differentiation strategy works only if companies have a target market
in which customers are less price-sensitive, but more quality-conscious
than customers of other markets.
Low-Price Strategy
Customers in the market are not homogeneous. When customers look
for products or services with basic functions at competitive prices,
companies catering to these customers may adopt the low-price
strategy. When the demand for a product or service is highly elastic,
the lower the price, the stronger the demand will be. While companies
are expected to earn less revenue per unit at a lower price, the much
increased sales volume will lead to more total profit. The ability to have
mass production and expanded distribution is the key to the success of
a low-price strategy.
Control Cost

Companies can suffer losses at times not because of lacking sales

revenue, but from cost overruns. Controlling cost is a major step
toward minimizing loss. When companies can operate at a consistent
low-cost level, they will be in a better position to absorb any price
decline or market downturn and stay profitable. The lower the cost, the
larger the profit margin. If the cost rises to a level that results in a thin
profit margin, companies become vulnerable to any price shock or
sales deterioration and can sustain significant losses.
Maintain Market Share
Companies that experience anemic sales are unlikely to achieve
profitability. While revenue from each unit of sale may be enough to
replace unit variable cost and earn some unit profit, companies rely on
the accumulation of unit profit from multiple units of sales to fully
cover fixed costs and break even. Without sufficient sales volume to
maintain a necessary level of market share, companies may not be
able to cover all the fixed and overhead costs. To minimize loss,
companies must aim to achieve the break-even sales volume by
maintaining a satisfactory level of market share.
References (3)
About the Author
An investment and research professional, Jay Way started writing
financial articles for Web content providers in 2007. He has written for
goldprice.org, shareguides.co.uk and upskilled.com.au. Way holds a
Master of Business Administration in finance from Central Michigan
University and a Master of Accountancy from Golden Gate University in
San Francisco.
What Must a Firm Do to Maximize Profit Margins?
by Tyler Lacoma, Demand Media
Profit margins are the amounts that companies make beyond what it
costs to create goods or services, such as costs of goods sold,
production costs, inventory costs and similar expenses. A high profit
margin indicates high profitability for the business, although what
constitutes a good margin varies by industry. Many firms, in a desire to
make themselves appear profitable in the long term, choose to focus
intensely on maximizing profit margins. There are several key methods
to use for this process.

Efficiency Strategies
Efficiency strategies seek to change the way that businesses actually
make their products for the better. The profit margin depends not only
on sales revenues but on how costly it is to produce goods. This means
that if a business can find cheaper supplies or a more cost-effective
way of manufacturing, it can raise the profit margin. This is why many
businesses invest money in inventory management and lean
manufacturing techniques.
Pricing Strategies
Pricing strategies are more oriented toward the sales aspect of profit
margins. If a company can sell the same number of products for a
higher price, then profit margins will increase. This often depends on
the industry. Some industries are highly competitive and locked into a
very strict range of prices. Other industries are more flexible and
businesses can change their pricing strategies and value offerings to
generate more revenue in an effort to bump up profit margins.
Related Reading: Low Gross Profit Margin vs. Low Net Profit Margin
Customer Management
Customer management refers to the process of changing how
customers respond to sales techniques. Many businesses have a group
of clients that consume much sales time while spending little. A
business can improve profit margins by analyzing clients and dropping
customers that take up valuable time but do not generate significant
revenues.
Innovation
Businesses can raise margins through innovation, typically by raising
profits without raising the cost or time of the work involved. For
example, a business may be able to offer installation for an extra fee
without incurring high extra costs. Other companies may be able to sell
their franchise or license. Other may be able to operate overseas to
take advantage of new markets.

References (2)
About the Author
Tyler Lacoma has worked as a writer and editor for several years after
graduating from George Fox University with a degree in business
management and writing/literature. He works on business and
technology topics for clients such as Obsessable, EBSCO, Drop.io, The
TAC Group, Anaxos, Dynamic Page Solutions and others, specializing in
ecology, marketing and modern trends.
What Is the Profit Maximization Rule?
In capitalist economies, the primary goal of for-profit companies is to
maximize their profits. This doesn't mean that companies focus on
profits at the expense of everything else, though. Instead, every
company must find the point at which employee pay, customer
discounts and other undertakings maximize profits rather than cutting
into them. The rule companies use to determine this formula is called
the profit maximization rule.
The Right Formula
In economics, the profit maximization rule is represented as MC = MR,
where MC stands for marginal costs, and MR stands for marginal
revenue. Companies are best able to maximize their profits when
marginal costs -- the change in costs caused by making a new item -are equal to marginal revenues. Although this looks like a
mathematical formula, it's a highly complex and ever-shifting equation
that must take into account virtually every factor in the market.
Balancing Expenses and Revenues
When you design or sell a new product, you incur a variety of costs
that can include manufacturing or purchasing from a manufacturer,
advertising the product, packaging and -- particularly if the product
requires upkeep or is a live plant -- product care. To maximize profits,
these costs need to be lower than or equal to the additional revenues
you make from the product.
Related Reading: Graphic Ways to Depict Profit Maximization
Planning for the Unexpected

When you design a budget for creating a new product, it can be

challenging to anticipate all costs. For example, a controversial product
could yield bad reviews or negative publicity that causes you to make
lower profits than planned. Consequently, you'll have to constantly
adjust your profit maximization equation rather than planning for profit
maximization a single time.
Employee Costs
One of the most significant costs faced by most businesses is the
combined cost of paying employees, maintaining office safety and
providing upkeep for employee work spaces. To maximize profits, you'll
have to spend the lowest possible amount to get the minimum quality
you need. This doesn't necessarily mean paying minimum wage,
though. Instead, it means you have to pay the lowest wage that
qualified employees will accept, and hire the smallest possible number
of employees to complete your daily tasks.
Profit Maximization
Profit maximization is the main aim of any business and therefore it is
also an objective of financial management. Profit maximization, in
financial management, represents the process or the approach by
which profits (EPS) of the business are increased. In simple words, all
the decisions whether investment, financing, or dividend etc are
focused to maximize the profits to optimum levels.
Profit maximization is the traditional approach and the primary
objective of financial management. It implies that every decision
relating to business is evaluated in the light of profits. All the decision
with respect to new projects, acquisition of assets, raising capital,
distributing dividends etc are studied for their impact on profits and
profitability. If the result of a decision is perceived to have positive
effect on the profits, the decision is taken further for implementation.
Profit Maximization Theory / Model: The Rationale / Benefits:
Profit maximization theory of directing business decisions
encouraged because of following advantages associated with it.

is

o
o Economic Survival: Profit maximization theory is based on
profits and profits are a must for survival of any business.
o Measurement Standard: Profits are the true measurement of
viability of a business model. Without profits, the business
losses its primary objective and therefore has a direct risk on its
survival.
o Social and Economic Welfare: The profit maximization
objective indirectly caters to social welfare. In a business,
profits prove efficient utilization and allocation of resources.
Resource allocation and payments for land, labor, capital and
organization takes care of social and economic welfare.
Limitations of Profit Maximization as an objective of Financial
Management:
Profit maximization is criticized for some of its limitations which are
discussed below:
o Haziness of the concept Profit: The term Profit is a
vague term. It is because different mindset will have different
perception about profit. For e.g. profits can be the net profit,
gross profit, before tax profit, or the rate of profit etc. There is
no clear defined profit maximization rule about the profits.
o Ignores Time Value of Money: The profit maximization
formula simply suggests higher the profit better is the
proposal. In essence, it is considering the naked profits without
considering the timing of them. Another important dictum of
finance says a dollar today is not equal to a dollar a year
later. So, the time value of money is completely ignored.

o Ignores the Risk: A decision solely based on profit

maximization model would take decision in favor of profits. In
the pursuit of profits, the risk involved is ignored which may
prove unaffordable at times simply because higher risks directly
questions the survival of a business.
o Ignores Quality: The most problematic aspect of profit
maximization as an objective is that it ignores the intangible
benefits such as quality, image, technological advancements
etc. The contribution of intangible assets in generating value for
a business is not worth ignoring. They indirectly create assets
for the organization.
Profit maximization ruled the traditional business mindset which
has gone through drastic changes. In the modern approach of business
and financial management, much higher importance is assigned to
wealth maximization in comparison of Profit Maximization vs. Wealth
Maximization. The loosing importance of profit maximization is not
baseless and it is not only because it ignores certain important areas
such as risk, quality, and time value of money but also because of the
superiority of wealth maximization as an objective of business or
financial management.
What is the cost of sales?
Cost of sales is the caption commonly used on a manufacturer's or
retailer's income statement instead of the caption cost of goods sold or
cost of products sold.
The cost of sales for a manufacturer is the cost of finished goods in its
beginning inventory plus the cost of goods manufactured minus the
cost of finished goods in ending inventory.
The cost of sales for a retailer is the cost of merchandise in its
beginning inventory plus the net cost of merchandise
purchased minus the cost of merchandise in its ending inventory.
The cost of sales does not include selling expenses or general and
administrative expenses, which are commonly referred to as SG&A.

What are direct costs of sales?

A:

Direct cost of sales, or cost of goods sold (COGs), measures the

amount of cash a company spends to produce a good or a service sold
by the company. The direct cost of sales only includes the expenses
directly related to production. The direct costs generally include direct
materials, direct labor, utilities and shipping costs.
COGs is reported on a company's income statement and may be
considered an expense. There are several ways to calculate COGs. One
way is to add the cost of finished goods at the beginning of the period
and cost of additional inventory purchased during the period minus the
cost of finished goods at the end of the period. This calculation yields
the total cost of goods sold during a specified fiscal period.
For example, suppose company ABC manufactures computer chips.
ABC's direct costs include the materials to make the computer chips,
the utilities to operate the machine that produces the chips and the
labor costs used to put the chips together. However, the cost of
training employees to deliver the chips or the cost of labor used to sell
the chips is not included.
Suppose company ABC has $25 million worth of finished computer
chips at the beginning of the year. Company ABC's cost of computer
chips added throughout the year is $10 million. ABC has $8 million
worth of inventory at the end of the year. The COGs for ABC is $27
million ($25 million + $10 million - $8 million). This figure is entered
into ABC's income statement.

Rate of Return on Equity

Financial Ratios and indicators can assist in determining the health of a

business. There is a minimum of 21 different ratios and indicators that can
be looked at by many financial institutions. You cannot look at a single ratio
and determine the overall health of a business or farming operation. Multiple
ratios and indicators must be used along with other information to determine
the total and overall health of a farming operation and business. This series
of articles will look at 21 commonly used ratios and indicators.

Rate of Return on Equity is a measure of Profitability and is determined

based on information derived from a business or farm operations Income
Statement. The term Profitability is the difference between the value of what
is produced or service provided and the cost of producing that product or
providing that service. The Rate of Return on Equity specifically provides the
percentage of interest that has been earned on the investments into the
business by its owner and should be compared with the possible interest that
could have been earned if the money was invested elsewhere.
The following equation will determine your Rate of Return on Equity:
Rate of Return on Equity = Return on Equity/Average Farm Net Worth
Return on Equity = Net Income Value of operator unpaid labor and
management (a dollar amount will have to be given to the value of the
operators unpaid labor and management, this should be equal to what it
would take to hire someone to do the equivalent work in labor and
management)
Rate of return on equity is measured as a percentage. This is one of those
measures that is easy to understand, the larger the number the better the
return on the owners investments (Owners equity) into the business. The one
question that must be answered by the owner when looking at this number is
whether this return is worth the investment of labor, management, and
equity compared to other sources of investment.
If you have any further question please feel free to contact your local Farm
Management Educator or the author.

DEFINITION OF 'EARNINGS PER SHARE - EPS'

The portion of a company's profit allocated to each outstanding share
of common stock. Earnings per share serves as an indicator of a
company's profitability.
Calculated as:

When calculating, it is more accurate to use a weighted average

number of shares outstanding over the reporting term, because the

number of shares outstanding can change over time. However, data

sources sometimes simplify the calculation by using the number of
shares outstanding at the end of the period.
Diluted EPS expands on basic EPS by including the shares of
convertibles or warrants outstanding in the outstanding shares
number.

Net cash flow

Refers to the difference between a company's cash inflows and outflows in a
given period. In the strictest sense, net cash flow refers to the change in a
company's cash balance as detailed on its cash flow statement.
How it works/Example:
Net cash flow is also known as the "change in cash and cash equivalents." It is very
important to note that net cash flow is not the same as net income, free cash flow,
or EBITDA.
You can approximate a company's net cash flow by looking at the period-over-period
change in cash on the balance sheet. However, the statement of cash flows is a more
insightful place to look. Net cash flow is the sum of cash flow from operations (CFO),
cash flow from investing (CFI), and cash flow from financing (CFF).
Let's look at the 2010 cash flow statement for Wal-Mart (NYSE: WMT) as presented by
Yahoo! Finance. At the bottom of the cash flow statement, we see that the change in
cash and cash equivalents is calculated to be $632 million. This means that when the
cash flow from operations, cash flow from investing, and cash flow from financing is
added up, Wal-Mart added $632 million to its cash balance in 2010.

Introduction - The Agency Problem

An agency relationship occurs when a principal hires an agent to perform some
duty. A conflict, known as an "agency problem," arises when there is a conflict of
interest between the needs of the principal and the needs of the agent.
In finance, there are two primary agency relationships:

Managers and stockholders

Managers and creditors

1. Stockholders versus Managers

If the manager owns less than 100% of the firm's common stock, a
potential agency problem between mangers and stockholders exists.

Managers may make decisions that conflict with the best interests of the
shareholders. For example, managers may grow their firms to escape a
takeover attempt to increase their own job security. However, a takeover
may be in the shareholders' best interest.

2. Stockholders versus Creditors

Creditors decide to loan money to a corporation based on the riskiness of

the company, its capital structure and its potential capital structure. All of
these factors will affect the company's potential cash flow, which is a
creditors' main concern.

Stockholders, however, have control of such decisions through the

managers.

Since stockholders will make decisions based on their best interests, a

potential agency problem exists between the stockholders and creditors.
For example, managers could borrow money to repurchase shares to
lower the corporation's share base and increase shareholder return.
Stockholders will benefit; however, creditors will be concerned given the
increase in debt that would affect future cash flows.

Motivating Managers to Act in Shareholders' Best Interests

There are four primary mechanisms for motivating managers to act in
stockholders' best interests:
Managerial compensation
Direct intervention by stockholders
Threat of firing
Threat of takeovers
1. Managerial Compensation
Managerial compensation should be constructed not only to retain competent
managers, but to align managers' interests with those of stockholders as much
as possible.
This is typically done with an annual salary plus performance bonuses and
company shares.

Company shares are typically distributed to managers either as:

Performance shares, where managers will receive a certain number

shares based on the company's performance
Executive stock options, which allow the manager to purchase
shares at a future date and price. With the use of stock options,
managers are aligned closer to the interest of the stockholders as
they themselves will be stockholders.
2. Direct Intervention by Stockholders
Today, the majority of a company's stock is owned by large institutional
investors, such as mutual funds and pensions. As such, these large institutional
stockholders can exert influence on mangers and, as a result, the firm's
operations.
3. Threat of Firing
If stockholders are unhappy with current management, they can encourage the
existing board of directors to change the existing management, or stockholders
may re-elect a new board of directors that will accomplish the task.
4. Threat of Takeovers
If a stock price deteriorates because of management's inability to run the
company effectively, competitors or stockholders may take a controlling interest
in the company and bring in their own managers.
Parties Interested In Financial Statement Analysis
The analysis of financial figures contained in the company's profit and loss account and
balance sheet by employing appropriate technique is known a financial statement
analysis. Financial statement analysis is useful to different parties to obtain the required
information about the organization. Following are the parties interested in financial
statement analysis.
1. Shareholders
Shareholders are interested in financial statement analysis to know the profitability of
the organization. Profitability shows the growth potentiality of an organization and
safety of investment of shareholders.
2. Investors And Lenders
Investors and lenders are interested to know the solvency position of an organization.
They analyze the financial statement position to know about the safety of their
investment and ability to pay interest and repayment of principle amount on due date.
3. Creditors
Creditors are interested in analyzing the financial statements in order to know the short
term liquidity position of an organization. Creditors analyse the financial statement to
know either the organization is enable to pay the amount of short term liabilities on due
date.

4. Management
Management is interested to analyze the financial statement for measuring
the effectiveness of its policies and decisions.It analyze the financial statements to
know short term and long term solvency position,profitability,liquidity position and
return on investment from the business.
5.Government
Government is interested to analyze the financial position in determining the amount of
tax liability. It also helps for formulating effective plans and policies for economic
growth.