Categories
Finance

Nature of Financial Management

Financial Management is a management function that is concerned with planning, organizing, directing and controlling the financial resources of a business to maintain or improve the financial performance and position of owners of the business. While the ordinary purpose of management is to provide a good or service to customers financial managements role is to ensure that all activities are carried out in a manner that is financially beneficial to the organisation. Financial management nature can be viewed through the tools used in financial management namely bookkeeping & accounting, financial reporting, receivables and payable (liquidity) management, investment appraisal and risk management. Through each of these tools we will see an important element of the nature of financial management.

Sources of Finance

The first and foremost financial management decision that any business undertakes is the appropriate source of finance for a business. Businesses ordinarily have multiple sources of finance which are largely grouped into equity or debt finance. Within these two groups the sources of finance have different requirements when it comes to repayment. Equity finance has no obligation for annual payments. Debt finance has mandatory payments of interest as well as repayment of principal. This makes equity finance more attractive on the surface but equity investors may need to see a certain rate of return on their investment in capital appreciation. In practice businesses use a mix of equity and debt financing and even have different classes within both groups of finance. Businesses cannot simply use debt finance wantonly as a business with a high ratio of debt to equity is considered highly leveraged. Because of the mandatory interest payments this has a big impact on the earnings of the business. There financial management’s nature is to start with the financing decision for the business.

 

Bookkeeping and Accounting

Bookkeeping is the process of collecting and recording financial transaction data of a business into journals and ledgers. Accounting takes bookkeeping information and uses it to analyse the business’ financial performance and financial position. As stated before one of the key concerns of financial management is controlling the organisations financial resources. In order to control something you must first be able to measure it and this is where accounting and bookkeeping come in. Budgeting is also part of the accounting process and an important part of the process of financial management nature. Budgets are planning tools for businesses that are based on how the resources available to management will be deployed. Budgets provide both a resource usage guideline and a benchmark for performance appraisal. The nature of financial management being a discipline that involves a lot of calculation requires record keeping.

 

Reporting

Performance appraisal naturally involves reporting. Financial management provides various reports to different user groups. Financial accounting reports such as the Income statement, balance sheet and statement of cash flows report to external stakeholders on the performance of he business. Financial management by nature also involves a lot of internal reporting to management and employees. For example variance analysis, which goes through budgeted figures and actual figures to find the source of variances whether caused by prices of inputs or quantities utilised. This provides vital information for management on how to improve performance. Ultimately the reporting function of financial management feeds into the organizing and directing elements of the definition of financial management.Reporting internally and externally is a key element of the nature of financial management.

 

Receivables and payables (liquidity)

While issues of resource utilisation and allocation deal with internal matters the issues of receivables and payables are external to the organisation. For receivables, debtors are responsible for payment. A business does of course set its payment terms but choice of when and how to pay ultimately rests with the debtor. On the other hand with payables our business is subject to payment terms set by suppliers and service providers. Whilst we can pay when we want to pay it is important to maintain good relationships with suppliers and service providers for the long term viability of our business. Whilst the issues are external it is important to understand that financial management has influence over how we manage these two variables. Working Capital management is a discipline in financial management that is concerned with maintaining the liquidity of a business based on balancing its receivables and payables. It is a form of capital budgeting. The working capital calculation is a an important feature of the nature of financial management.

 

Investment appraisal

Perhaps the most important function of financial management is investment appraisal. The nature of financial management is after all concerned with multiplying capital invested. Investment appraisal also takes place on a smaller level when management has to decide on whether or not to undertake a project. Financial managers use various frameworks to assess whether or not a business should invest in a project or not. There are various techniques employed such as Discounted Cash Flow, Payback Period and Internal Rate of Return among others but all investment appraisal methods are based on the future cash flows that a project is expected to generate compared to the investment in the project. In reality more than one measure is used at any given point in time. This gives management an idea of how well the investment is expected to perform. Financial management also provides a benchmark against which management can compare investment opportunities to evaluate if they would be worth entering into.

 

Risk Management

Risk management is a discipline in management that has to do with protecting a business or organisation against loss. There are many risks including but not limited to political, environmental, financial, exchange rate, interest rate and many more risks. Financial management nature is such that it takes care of some of these risks through the use of financial management calculations. A good example of this is exchange rate risk management technique. If a company expected some foreign exchange income in the future but was worried about the value of foreign currency at the future date they could use a derivative instrument called a forward rate contract. A forward rate contract is agreed between two parties and provides that the one.party will purchase the currency from the other on a given date at a given rate. This protects the value for the receiving company. However these contracts are not free of charge and the company in question must use financial management calculations to evaluate if the contract is worth entering into. The same principle is used when a business has excess cash and must decide whether to hold the cash in the bank or purchase short term interest bearing securities.

Leave a Reply

Your email address will not be published. Required fields are marked *