Financial Management

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What is financial management?

Financial Management can be defined as:

The management of the finances of a business / organization in order to achieve financial objectives

Taking a commercial business as the most common organizational structure, the key objectives of financial management would be to:

• Create wealth for the business

• Generate cash, and

• Provide an adequate return on investment bearing in mind the risks that the business is taking and the resources invested

There are three key elements to the process of financial management:

Financial Planning

Management need to ensure that enough funding is available at the right time to meet the needs of the business. In the short term, funding may be needed to invest in equipment and stocks, pay employees and fund sales made on credit.

In the medium and long term, funding may be required for significant additions to the productive capacity of the business or to make acquisitions.

Financial Control

Financial control is a critically important activity to help the business ensure that the business is meeting its objectives. Financial control addresses questions such as:

• Are assets being used efficiently?

• Are the businesses assets secure?

• Does management act in the best interest of shareholders and in accordance with business rules?

Financial Decision-making

The key aspects of financial decision-making relate to investment, financing and dividends:

• Investments must be financed in some way – however there are always financing alternatives that can be considered. For example it is possible to raise finance from selling new shares, borrowing from banks or taking credit from suppliers

• A key financing decision is whether profits earned by the business should be retained rather than distributed to shareholders via dividends. If dividends are too high, the business may be starved of funding to reinvest in growing revenues and profits further.

Managerial finance is the branch of finance that concerns itself with the managerial significance of finance techniques. It is focused on assessment rather than technique.

The difference between a managerial and a technical approach can be seen in the questions one might ask of annual reports. One concerned with technique would be primarily interested in measurement. They would ask: are moneys being assigned to the right categories?

One concerned with management though would want to know what the figures mean.

• They might compare the returns to other businesses in their industry and ask: are we performing better or worse than our peers? If so, what is the source of the problem? Do we have the same profit margins? If not why, do we have the same expenses? Are we paying more for something than our peers?
• They may look at changes in asset balances looking for red flags that indicate problems with bill collection or bad debt.
• They will analyze working capital to anticipate future cash flow problems.

Managerial finance is an interdisciplinary approach that borrows from both managerial accounting and corporate finance.

The Role of Managerial Accounting

To interpret financial results in the manner described above, managers use Financial analysis techniques.

Managers also need to look at how resources are allocated within an organization. They need to know what each activity costs and why. These questions require managerial accounting techniques such as activity based costing.

Managers also need to anticipate future expenses. To get a better understanding of the accuracy of the budgeting process, they may use variable budgeting.

The Role of Corporate Finance

Managerial finance is also interested in determining the best way to use money to improve future opportunities to earn money and minimize the impact of financial shocks. To accomplish these goals managerial finance uses the following techniques borrowed from corporate finance:

• Valuation
• Portfolio theory
• Hedging
• Capital structure

Financial risk management

Risk management is the process of measuring risk and then developing and implementing strategies to manage that risk. Financial risk management focuses on risks that can be managed ("hedged") using traded financial instruments (typically changes in commodity prices, interest rates, foreign exchange rates and stock prices). Financial risk management will also play an important role in cash management.

This area is related to corporate finance in two ways. Firstly, firm exposure to business risk is a direct result of previous Investment and Financing decisions. Secondly, both disciplines share the goal of enhancing, or preserving, firm value. All large corporations have risk management teams, and small firms practice informal, if not formal, risk management.

Derivatives are the instruments most commonly used in financial risk management. Because unique derivative contracts tend to be costly to create and monitor, the most cost-effective financial risk management methods usually involve derivatives that trade on well-established financial markets. These standard derivative instruments include options, futures contracts, forward contracts, and swaps.

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