What Is Financial Management?
Financial management is a function of management that plans, organizes, directs and controls the financial resources of an organisation. This article explains the scope of financial management.
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Scope of Financial Management
Financial management’s scope covers many decisions within an organisation that fall into one of four main decision groups. Investment decisions are concerned with the deployment of capital to projects. The financing decision is concerned with the choice of the source of funds. The dividend decisions aids in the choice to reinvest profits or reward investor with a dividend. Finally the liquidity decision has to do with the management of working capital to ensure the organisation remains able to meet it’s short term obligations. The different decisions all come together to ultimately impact the profitability of an organisation and its viability in the short and long term.
The first decision, and perhaps the most important that falls under the scope of financial management is the financing decision. Businesses can draw investment funding from two main sources, these are debt and equity. Debt finance has mandatory interest payments, principal repayment and priority in the event of liquidation of a business. Equity finance has optional dividend payment, no principal repayment and is last priority when it comes to liquidation. In addition to these two traditional sources there are hybrid sources of finance which combine the characteristics of debt and equity such as redeemable preference shares. The goal of financial managers in this case is to determine which sources of finance to use and in what proportion of total finance available to the business.
The investment decision also falls into the scope of financial management. The investment decision has two primary functions investment appraisal and arriving at a discount or cut off rate. Investment appraisal is concerned with evaluation of projects and evaluating their profitability. A discount rate is a required rate of return that is ideal for investors and investment alternatives can be compared to this rate as a benchmark. The financing decision is a matter of where to finance projects from while the investment decision chooses which projects to finance.
Businesses engage in various projects and each project is treated as a standalone investment. Through the use of various investment appraisal techniques financial managers decide which projects are worth the management investing in. Examples of widely used methods of investment appraisal are discounted cash flows, payback period, and internal rate of rate. Projects are considered worth investing in if their net effect is positive, that’s is to say, if they increase the amount of money in the business by bringing in more.money than was spent.on them. It is customary to use a number of these methods in combination and not just one single method. Where to invest money falls under the scope of financial management.
Determining a cut off rate
The investment decision also covers the determination of a cut off rate for investments. To put this into a simple example if a business through its various sources of finance accesses capital at 7% per annum it makes little sense to invest in.projects that would give a rate of return lower than 7 percent. There are many methods used to arrive at this cut off rate and they can get very complex. Popular ones include the Weighted Average Cost of Capital (WACC) and the Capital Asset Pricing Model (CAPM). This cut off rate is either used as an absolute lower limit fr rating projects or as a discount rate to applied in models that use discounted cash flows. As the decision of where to investment money falls under the scope of financial management so does the decision of what rate to use as a benchmark fall under financial management’s scope.
As mentioned earlier in the sources of finance, equity investment does not mandate an regular payment but rather an optional dividend. It is within the scope of financial management to assist management in making the dividend decision. Simply put the dividend decision is the process of deciding whether or not pay shareholders a dividend and if so how much. Dividends are profits distributed to shareholders. The flip side of the dividend decision is profit retention, therefore the choice is not one of awarding dividends versus not awarding them but rather awarding dividends versus reinvesting the money into more profitable ventures and maximising shareholder value. Individual shareholders will have different views on which course of action is best for them. If management feels they can continue to earn high returns by reinvesting they may be biased towards that decision. If management feels they have reached the limit of viable projects at present a dividend may be awarded. It is not simply a yes or no decision but also a matter of how much of profit shall be paid out as dividend.
Financial management scope also includes the liquidity decision which involves management of working capital in order to keep the organisation capable of meeting it’s short term and long term obligations. Naturally such a decision would fall to financial management as it goes hand in hand with maintaining and growing shareholder value. A company that cannot remain liquid cannot remain solvent and therefore open. Working capital management involves working out optimal levels of cash, inventory, debtors, creditors and the use of financial instruments where applicable. The scope of working capital budgeting also includes sources of finance for the working capital. Due to the time value of money of money, extending credit to customers comes at a cost. Either the cost of the funds used to fund the goods or the opportunity cost of what could have been achieved with the money while waiting for the customer to pay. Not counting this cost in business can lead to losses that are not apparent at first but a perfectly profitable business can still be loss making because of ignoring the importance of working capital management.
The scope of financial management can be grouped into four general decisions; the financing decision, the investment decision, the dividend decision and working capital management. Financial management supports the ultimate goal of management of shareholder value maximization through keeping an eye key financial measures and employing strategies to ensure those measures are kept positive or improved.