Financial Management: Meaning, Objectives and Functions

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By: Site Engineer, Staff

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Financial management is managing the money that comes into your enterprises from customers who buy your products or services, and the money that your enterprise pays out for things such as materials, labor, and machinery.

The Need for Sound Financial Management

People start enterprises for many reasons. Some want to be independent, some want to create jobs for members of their family; others want to be respected in their community and to make a contribution to the economy of their country.

No matter what objective you had when you started your enterprise you must keep the enterprise financially healthy in order to achieve that objective.

An enterprise that fails does much damage to its owners, to its workers to its community and to its country. An enterprise that earns a profit for its owners and pays good wages to its workers makes a valuable contribution to its community and to its country.

Financial Records

Financial records measure the progress of your enterprise. With accurate financial records, you will know whether your enterprise is making a profit or losing money and whether it is growing stronger or is headed for trouble. Without accurate financial records, you can be deceived. You may think your enterprise is making a profit when, in fact, it is losing money.

You will get valuable guidance by analyzing the financial records of your enterprise. You will find out many things that will help you make a wise decision.

For example, financial records will tell you:

  • When to order materials, and how much to order?
  • Whether you can afford to expand your enterprises or not?
  • When it will be profitable to borrow money and how much to borrow?
  • Which products- you should stop manufacturing, and which ones you should make in larger quantities?
  • What department of your enterprise needs the closest supervision?

The Neglect of Financial Management

Financial management is neglected for several reasons:

  • Most small-scale industrialists are skilled in a trade. They feel more at home in the workshop than in the office. Therefore, they neglect financial management.
  • Many do not understand financial management. They think that it requires an expert accountant to set up a record keeping system, and therefore neglect financial management entirely.
  • Some enterprise owners do not want any financial information to be recorded. They are trying to deceive the tax collectors, their partners, their workers, or their customers. Usually, they succeed only in deceiving themselves.

It is good to note that if you neglect financial management for any reasons at all, the result is always disastrous. Your enterprise may run short of money to meet expenses and be forced to liquidate even though it produces good products and has a good market. Your enterprise may find that to keep going it has to pay all of its profit to money lenders. You may discover too late that someone in whom you placed confidence should not have been trusted. These things happen to enterprises the world over.

Special Responsibilities Connected With Managing Money

Often as an owner or partner, you are managing money which does not belong entirely to you. Therefore, you must be as careful and as honest as a banker in accounting for money.

For example, the money which is paid in by customers belongs to the enterprise. Even if you are the sole owner the money earned by your enterprise does not belong to you until all of the debts of the enterprise have been paid and all of its future needs have been provided for.

If you mix the income of your enterprise with your own personal income, your accounts will become confused. You will be unable to tell whether your enterprise is profitable or not.

If you own an enterprise and work for it as well, it is better to pay yourself a regular salary than to withdraw money as you need it.

Capital Formation of Private Enterprise

If you want to start a new enterprise or expand the one you have, it will be necessary to raise capital. A new enterprise, or one undergoing a major expansion, has to spend a lot of money before it begins to earn money.

There are important things to keep in mind when raising capital and making plans for spending it:

  • Raise enough money to see your project through.
  • Arrange for permission to use the money for a long (enough) period of time.
  • Make sure the way you plan to use the money fits the expectations of those who provide it.
  • Do not pay more for the use of the money than your enterprise can afford.

Different Kinds of Capital

When raising capital it is important to select the right kind of capital and to get it from a suitable source.

Those who provide capital expect different things. An investor, for example, becomes a part owner of your enterprise. He may want to take part in its management and help to promote its growth. A lender wants to be repaid with interest. He may not care at all whether your enterprise grows, as long as it repays him on schedule. A short-term lender may want his money back in a matter of months, weeks, or even days. His concern for your enterprise might be limited to its ability to fill the order financed by his loan.

If the wrong kind of capital is raised, and the expectations of those who provide the capital are not considered, serious trouble will result. It is possible when financing any project, to determine in advance the right kind of capital, and the best source from which to get it.

Accounting for Capital

Your enterprise assumes liabilities as soon as it is born. For example, the money you invest to get your enterprise started is money you expect to get back eventually. Therefore, your investment is a liability of the enterprises a debt which the enterprise owes to you.

Your enterprise has assets. These are the things it owns such as machinery, equipment, and buildings. Some assets may be in the form of money owed by credit customers. All of these assets depreciate and become less valuable as they get older.

It is important to keep financial records that will tell you from time to time how much your enterprise is worth. The statement prepared for this purpose is called a balance sheet.

The Balance Sheet

The balance sheet is a financial statement showing what your enterprise owns and what it owes on the date the balance sheet is prepared. From it, you can learn the net-worth (or net-deficit) of your enterprise. This will be the difference between what the enterprise owns and what it owes.

You will want to prepare a balance sheet each year in order to know whether your business is increasing or decreasing in value.

Operating Accounts and Statements

Operating accounts and statements tell you the financial results of day-to-day, month-to-month and year-to-year operations of your enterprise. Whereas the balance sheet tells you what your enterprise owes and what it owns on a certain date. The operating statement tells you how much profit or loss your enterprise has realized over a period of time.

The Operating Statement

The operating statement is sometimes called “The Profit and Loss Statement”. It is by far the most useful of all financial statements. Taking the items on the operating statement one-by-one this is what they mean:

Income

Income is all of the money that comes into your enterprise from customers who buy its products or services. It is sometimes called “Turnover”, “Income from Sales”, or “Total Revenue”.

Direct Costs

Direct costs are sometimes called “Cost of Goods Sold” or “Cost of Manufacturing”.

Direct costs are the costs of producing products or performing services. They include the costs of the materials, labor, power, and space which your enterprise uses for manufacturing, and shop overhead.

Gross Profit

Gross profit is simply the income of your enterprise less its direct costs. It is sometimes called “Gross Margin”.

Gross profit is the amount of money your enterprise has left after it has paid all its manufacturing costs. It is the difference between the price your enterprise gets for its products and the cost of manufacturing the products in a service business. It is the difference between the price customers pay for the services and the cost of performing the services.

Marketing Expenses

Marketing expenses include all the expenses your enterprise must pay out for activities that promote sales. Marketing expenses are sometimes called “Selling Expenses”.

The principal marketing expenses are advertising expenses, sales commissions, salaries and travel expenses of salesmen your own travel expenses if the purpose of your travel is to get orders or make sales delivery expenses, and expenses your enterprise may have to pay out in order to collect debts from credit customers.

Many enterprises have difficulty is making a profit because they do not spend enough money on marketing. If the result of the marketing expense of that your enterprise sales more, then you are safe in considering the money well spent.

General and Administrative Expenses

General and administrative expenses are sometimes called “Overhead Expenses” and are the expenses of managing your enterprise.

Your own salary as managing director, for example, is a general and administrative expense. This is because you are sometimes a production supervisor sometimes a salesman, sometimes a personnel manager and sometimes a financial manager. It would not be accurate to charge all of your salaries to manufacturing, or to marketing. Therefore it is classified as a general and administrative expense.

The same would be true of the salary of your accountant, your bookkeeper, and your night watchman.

General and administrative expenses must be kept to a minimum because they do not add much to the earning power of your enterprises.

Operating Profit

Operating profit is gross profitless marketing general and administrative expenses. Operating product is the money left over after all of the expenses of operating your enterprise have been taken away from income. The amount of operating profit your enterprise earns is a good measure of how efficient it is.

Taxes

Income tax is charged by the government on the basis of the income your enterprise earns less authorized costs and expenses of doing business. Excise taxes are based on the quantity of certain specified products an enterprise manufactures and sells.

You must find out what taxes your enterprise will have to pay in advance so that you can be sure to set aside enough money from profits to these taxes.

Net Profit

Finally, after all, costs expenses, and taxes have been taken away from income, what your enterprise has left is Net Profit.

You and other directors of the enterprise may jointly elect to pay all or part of the net profit to the owners in proportion to the share owned by each. Just before this is done, the directors should be certain that they do not need to re-invest this money in order to stay as modern and efficient as competitors.

The Operating Statement and Management

There are many ways in which you may use operating statements to help in making wise management decisions.

For example, you may compare the monthly operating statements of your enterprise to find out if you are selling more or less than in previous months. You may want to know what happens to profits when sales increase and decrease. You may want to find out if your production costs are going up or down and what effect the change has on profits.

A comparison of monthly operating statements will tell you straight away if your enterprise is growing stronger or heading for trouble. The analysis will indicate where the cause of any trouble lies and enable you to concentrate your efforts where they are most needed.

If, as an enterprise owner you start comparing and analyzing monthly operating statements regularly, you will find out so much about your enterprise that you will wonder how you ever managed before.

Financial Record Keeping for Small-Scale Enterprise

A small-scale enterprise should use a financial record keeping system that is not complicated. But it must enable the owner at any time and without difficulty, to determine:

  • How much each has come into the business?
  • How much money is owed to the business?
  • How much cash has been spent by the business?
  • How much money must be set aside to pay debts?
  • How much profit (or loss) is accumulating?

One system that produces the essential information requires financial record books. Two are kept daily, one monthly and one yearly.

If every financial transaction is recorded when it happens, the owner will have all the information he needs to do a good job of financial management.

The four books that he must keep are:

  • Income and Accounts Receivable (daily)
  • Costs, Expenses and Accounts Payable (daily)
  • Operating Statement (monthly)
  • Balance Sheet and Depreciation Accounts (yearly)

Costing and Pricing

The success of your enterprises depends on whether your products are properly priced in relation to the cost of manufacturing and selling them. Obviously, if it costs N100 to manufacture a desk which you sell for N90 your enterprise will not last long. But it is not so obvious that in selling it for N120. You might still go broke.

The most important thing to remember in determining how much it costs to manufacture and sell something is that there are several components to a selling price and all of them must be reckoned and included in the selling price.

  • The cost of materials used in manufacturing the product.
  • The cost of the labor that is used directly in the manufacture of the product.
  • The cost of operating, maintaining, repairing, and renting or depreciating the machinery, equipment, tools factory space and supplies used in manufacturing the product.
  • The cost of supervising the manufacturing of the product.
  • The expense of advertising, selling packing and transporting the product to the customer and collecting payment from the customer.
  • A share of the general and administrative expenses of managing your enterprise.
  • The cost of money which your enterprise may have borrowed to finance the manufacturing of the product.
  • A reasonable profit, which might be called compensation to your enterprise for the risk and trouble it has gone to on behalf of the customer.

Apportioning Overhead Cost

In apportioning overhead costs between different products it is best to arrive at a standard method and use it all the time. Whatever method you select must result in sales prices including enough money to cover the actual overhead of the factory and of the business in general.

The Percent of Direct Labor Method

One of the easiest methods is called “the percent of direct labor method”. To illustrate this method, assume that your enterprise spends an average of N15 per month on overhead.

Assume that your three production workers each work 200 hours per month. Their combined work adds up to 600 man-hours of direct labor per months.

A “Rule of Thumb” Method

There are many ways to arrive at a selling price ranging from complex and accurate costing methods to rough estimates that are called “rules of thumb”. Some enterprise uses the “rule of thumb” pricing formula below:

Cost of Materials plus Twice the Cost of Direct Labor equals Selling Price.

The theory behind this “rule of thumb” is that overhead expenses increase as the cost of production labor increases. “Rules of thumb”, though useful, must be tested thoroughly before being put into practice.

Competitive and Market Factors must be Considered in Pricing

Suppose that your enterprise is one with many competitors and you are all trying to get the same customers to buy your products. If your products are equal in quality but higher in price, everyone who compares your products with those offered by your competitors will buy from your competitors.

Suppose that you have been very careful in reckoning costs and have arrived at a selling price of N16. In the market, you find that competitors’ products of similar quality are being sold N15. You must reduce your price to N15 and then work hard to reduce costs. You have no other choice. Conversely, suppose your enterprise gets so efficient that it could make a profit selling the same product for N15. You may enjoy enough price advantage over competitors if you reduce the price to N14 instead of N13.

When designing a new product you must find out who is going to buy it and how much money they will be able to pay. Then the product must be designed so that it can be manufactured and sold at a profit for a price that the customers are able and willing to pay.

 

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