What is the role of financial management?Posted on: September 28, 2022
Financial management helps organisations to plan, organise, and govern financial activities to keep business moving and maintain healthy profits. A key role of financial managers is decision-making, which takes into account the business’ short-term and long-term goals. Financial reporting is a crucial element in helping to make those decisions which can include direct investment activities. Financial reports also support and inform the development of strategies and plans and help with more accurate forecasting.
What are the four major areas of financial management?
Sound fiscal governance requires skills in strategising, decision-making, and controlling of finance. These skills are applied in four major areas.
Financial planning plays a major role in allocating funds for growth, enabling new product or service development, and ensuring positive cash flow even during challenging times or throughout unforeseen events. Planning includes analysing previous expenditure including capital expenses, travel and entertainment (T&E) expenses, workforce expenses, operational expenses, and indirect expenses.
The financial manager allocates budgets for the required spending of the business such as rents, salaries, raw material, and travel and entertainment expenses. Ideally, available funds should not be entirely used up in budgets so that there’s some leeway in the case of an emergency or an opportunity. Budgets may be static or flexible, the latter also providing some leeway, which has been increasingly adopted in the past few years when the pandemic has created uncertainty around financial stability. Larger companies tend to have a master budget supported by other documentation that details cash flow and operations, for instance.
Managing and assessing risk
Risk management has a knock-on effect on both investment planning and budgeting with financial managers responsible for assessing and implementing compensatory controls for risks such as:
- Liquidity risk – this involves tracking current cash flow, estimating future needs for cash, and preparing to free up working capital if needed.
- Market risk – For public companies, the behaviour of financial markets affects stock performance as well as potentially affecting any business investments. This also involves market trends forced by circumstances such as the pandemic e.g. bricks-and-mortar stores becoming online stores.
- Credit risk – Credit is important because it impacts the ability of the company to borrow at favourable rates. Maintaining good lines of credit by ensuring customers pay invoices on time, for example, improves valuation.
- Operational risk – This catch-all category can include risks such as cyber-attacks and how to prevent them or react should one happen, office closures due to extreme weather events or terrorist attacks, and crisis management should a senior member of the team be involved in misconduct. Assessing these risks includes drawing up specific insurance plans and creating disaster recovery and business continuity plans.
Policies and procedures help with the smooth running of financial management systems and beyond, influencing all operations within the business. From basics such as how the finance team securely distributes financial data such as invoices, payments, and reports to who is responsible for final sign off of those decisions, procedures build stability.
What are the four types of financing decisions?
Decision-making is a large part of what financial management entails. Understanding financial statements can help a financial manager to spot positive trends or anomalies which may point to problems further down the line. Financial analysis supports the following three major types of decisions.
Sometimes referred to as capital budgeting decisions, investment decisions should be made with the intent of gaining the highest returns possible. Liquidity is another key component alongside capital budgeting. Capital budgeting is the allocation of capital and commitment of funds in permanent assets which will yield earnings in future. It also involves decisions around the replacement and renovation of old assets.
The finance manager needs to consider a balance between fixed and current assets to maximise profitability and maintain liquidity. Making these decisions can be particularly tricky as they involve the estimation of costs and benefits which are uncertain and unknown.
While investment decisions involve a mix of assets, financing decisions are concerned with the various securities that make up the financial structure – or capital structure – of the company. The raising of funds requires decisions regarding the methods and sources of finance, for example, how much control is a company prepared to give up through offering equity?
Developing the optimum capital structure that maximises the long-term market price of the company’s shares is the goal. Key to this is balance between debt and equity so that the return to equity shareholders is high and their risk is low. Use of debt (such as in a depression) or financial leverage affects both the return and risk to equity shareholders. The market value per share is maximised when risk and return are properly matched. Deciding the appropriate time to raise the funds and the method of issuing securities are vital to this.
The main aspect of dividend policy is deciding whether to distribute all profits in the form of dividends or to distribute only part of the profits and retain the balance. The optimum dividend pay-out ratio (which is the proportion of net profits to be paid out to shareholders) also needs consideration.
When making this decision, the investment opportunities available should be reviewed as should the plans for expansion and growth. Another point to take into account is whether the dividends take the form of cash dividends or stock dividends.
Working capital decision
This is related to investments in current assets and current liabilities. The definition of current assets is assets that are convertible into cash within a year. Similarly, current liabilities are liabilities which are likely to mature for payment within an accounting year. Current assets include cash, receivables, inventory, and short-term securities. Current liabilities are creditors, bills payable, outstanding expenses, and overdrafts, for example.
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