What is the Importance of Financial Management?

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By: Site Engineer, Staff

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The goals of financial management are to maximize the owner’s wealth and ensure constant cash inflows and outflows in the organization. The process of financial management is to estimate cash inflows and outflows, compare inflows and outflows and utilize surplus funds and make up for scarce funds, analyze the outside fund and establish a system for tracking the flow of funds.

Every company from the little shop to multi-national companies worries about money, how to get it and how to use it. This area of concern is known as financial management.

The entrepreneur should know that the complexity involved in managing finance; hence he should be very careful in handling this particular department because money is the life wire of any organization.

Money, here, represents the raw cash while finance connotes all forms of money. This includes each or any other form of asset, which can be converted to cash in the short-term, e.g., equity certificates, debt certificates etc.

Finance involves two parts among other things namely:

  • The sourcing of funds, and
  • The utilization of the funds so sourced.

In this article, we will discuss on how to source, make, keep and invest money in order to achieve the organizational objectives.

Entrepreneurs will now know how to manage the funds into their organizations, plan and allocate the funds effectively, so as to keep their organizations alive in operation and financially.

The Goals of Financial Management

A company’s financial goals are much like your own. Most companies want to have enough money to run their activities such as pay their bills and still have some left over to improve the business. The ultimate objective is to increase the owners’ wealth, by making the business grow and prosper.

In a public corporation, success in achieving this is measured by the stock’s price per share. In a privately owned venture, the money the owner could obtain by selling the business measures it.

Maximizing the owner’s wealth sounds simple enough.

Theoretically, all you have to do is develop a good product and sell it for more than it costs to produce. However, timing is a problem. Before you can claim any sales revenue, you need money to get started. Once the business is off the ground, your need for outside funds continues. You may need extra cash to speed the up the business operation. If you want to expand, you will also need money for facilities and equipment.

It takes money to make money companies often need to borrow additional funds in order to meet up. The use of borrowed money to make money is called leverage because the loan acts like a lever. It magnifies the power of the borrower.

By the time you combine your own funds (your equity) with borrowed money, you have a bigger pool of capital to work with. In as much you earn a greater percentage of profit on the borrowed money than it costs you in interest payments, you stay ahead. However, leverage works both ways: borrowing may magnify your losses as well as your gains. Companies are, therefore, advised to be careful to evaluate the risk associated with projects that require the use of borrowed fund.

There are many sources of the fund in existence and that is the reason why borrowing is complicated, each has advantages and disadvantages, costs and benefits. The financial manager’s problem is to find the combination of funding sources with the lowest cost of capital. To choose the test expenditures; the financial manager needs a selection process that highlights the options best able to meet the company’s objectives.

The Process of Financial Management

Developing a financial plan for a company is similar with developing a personal financial plan because the financial manager must figure out how much money that is needed, when he needs it, and where it will come from.

The process consists of five basic steps:

  • Compare inflows and outflows. If surplus funds exist, determine how to use the funds most productively. If funding falls short, find ways to reduce outflows and increase inflows.
  • If outside funding will be required, analyze alternative sources and select the most cost-effective combination.
  • Establish a system for tracking the flow of funds and measuring the return, on investment.
  • Estimate the month-by-month flow of funds out of the business, including both operating expenses and capital investments
  • Estimate the month-by-month flow of funds into the business from all sources.

In small-scale businesses, the entrepreneur or the owner is responsible for financial planning. In a big corporation, financial planning is the responsibility of a department that reports to the financial controller, who oversees the inflow and outflow of money.

The Sources and Use of Funds

Where can a firm obtain the money it needs? The most obvious sources are revenues-cash received from sales, rentals of property, interest on short-term investments, and so on. Other likely sources are suppliers who may be willing to do business on credit; thus enabling the company to postpone payment.

Most firms also obtain money in the form of loans from banks, insurance companies, or other commercial lenders. In addition, some companies, particularly large corporations raise funds by selling stocks and bonds to investors.

The money obtained from these sources is used to cover the expenses of the business and to acquire new assets. Some financing needs related to day-to-day operations, for example, meeting the payment roll, buying inventory, funding, and advertising campaign, paying the rent and utilities, and shipping the product.

In addition, companies also use the money for buying land, production facilities, and equipment. As you might imagine, finding money to take care of next month’s payroll is different from arranging for long term financing. For this reason, financial matters are often discussed in terms of time periods: short-term and long-term.

Sources of Finance

There are various sources of funds that the entrepreneurs can get help in financing their business. These sources of funds are classified under three major categories:

  • Short-term sources (up to 1 year),
  • Medium-term sources (1-7 years), and
  • long-term sources (7 years and above).

1. Short-Term Sources

These sources include the followings:

  • Borrowing From Cooperatives: Small business operators can borrow from cooperatives under an arrangement.
  • Debt Factoring: Funds are sourced within a short period through debt factoring; that is by selling the debt to specialized institutions on commission, which will now take over the collection, in many cases these financial institutions charge commission to pay the costs of processing the accounts and the collection.
  • Acceptance Credits: Example of this type of acceptance credits is a bill of exchange.
  • Borrowing from Friends and Relations: This involves borrowing money from friends and relations to carry out business activities.
  • Trade Credit: This is the most widespread source of short-term financing for business. Rather than borrowing money to pay for products or suppliers, a company buys on credit from the supplier. The degree of formality in such arrangements may range from a simple handshake to written agreement. Two of the most common forms of trade credit are open-book credit and promissory notes. Open book credit sometimes referred to as an “open account” is a payment arrangement that allows the purchaser to take possession of goods and pay for them later. While the promissory note is an unconditional written promise to repay a certain sum of money on a specified date.
  • Accruals: Organizations at times save funds from delaying the payments of some services already lent to them for some period before the payment is made. For example, if the salaries of the workers are delayed for some period, the amount so saved can be used for a short investment before payment.
  • Bank Borrowing: Funds can be sourced through bank borrowings like overdrafts and other short-term loans.
  • Speeding up Payment From Trade Debtors: Organizations can source funds through speeding up payment from trade debtors. This can be done because some companies are always relaxed when it comes to paying their debts. A constant reminder system is very important.

2. Medium-Term Finance

The followings are the major sources of medium-term financing:

  • Hire Purchase Agreement: A hire purchase agreement is a credit sale agreement by which the owner of the asset grants the purchaser the right to take possession of the asset but ownership will not pass until the hire purchase payments or installments have been made. The purchaser will make the hire purchase payment over an agreed period.
  • Term Loans: This is a negotiated loan between a bank and a company for between 4-10 years usually at a fixed rate of interest. Secured loans are those backed by some specific valuable item or items known as collateral (e tangible asset a lender can claim if a borrower defaults on a loan), which may be seized by the lender, should the borrower fail to repay the loan at the agreed period of time. The three types of collateral are accounts receivable, inventories, and other property. An unsecured loan is one that requires no collateral. Instead, the lender relies on the general credit record and the earning power of the borrower.

The line of credit is agreed on the maximum amount of money bank is willing to lend the business during a specific period of time, usually a year. Once a line of credit has been established, the business may obtain unsecured loans for any amount up to that limit, provided the hank has funds. However, a line of credit does not guarantee that the loan is available.

  • Teasing: A lease is a contract between the owner of an asset (lessor) and the user of the asset (lessee) granting the user or lessee the exclusive right to use the asset, for an agreed period in return for the payment of rent.
  • In most cases, firms prefer the use of facilities more than owning them, but that does not mean that owning the facilities is bad. One good way of obtaining the use of facilities and equipment is to buy them, or in the alternative lease them.

Leasing takes several different forms, the three most important of which are:

  • Sale-and-Lease Back: This is an operation whereby a firm sells land, buildings or equipment and simultaneously leases the property back for a specific period under specific terms. The firm that is selling the property is called the lessee while the film that is buying is called the lessor. Under this arrangement, the payment is set so as to return the full purchase price to the investor or the lessor while providing a specific rate of return on the lessor’s outstanding investment.
  • Operating Lease: This is a lease under which the lessor maintains and finances the property, also called serve lease. Here payment is frequently “not fully amortized” i.e not fully paid off. Equally again as a distinguishing characteristic is that it carries a cancellation clause in the agreement which gives the lessee the right to cancel the lease before the expiration of the basic-agreement.
  • Financial, or Capital Lease: This is a lease that does not provide for maintenance services.
    • This is not cancelable and
    • This is fully amortized over its life (e the lessor receives rental payments which are equal to the full price of the leased equipment plus a return on the investment). Under financial leases arrangement, the leased equipment is new and the lessor buys it from a manufacturer or a distributor instead of from the user or lessee as in the sale and lease hack method.

Factors Affecting Leasing Decisions

  • Estimated Residual Value
  • Increased Credit Availability

3. Long-Term Financing

The followings are the sources of long-term financing:

  • Loan Stock/Debenture: Loan stock is long-term debt finance raised by a company for which interest is paid usually at a fixed rate.
  • Preference Shares or Preferred Stock: Preference shares are shares that give their owners first claim on a company’s dividends and assets. Their special privileges to their holders are:
  • They are preferred as to dividends. Dividends on preferred stocks must be paid before any dividends are paid on common stock or ordinary shares.
  • They are preferred as to assets. If a company fails, preferred shareholders have the right to receive their share of whatever assets are left (after the company’s debts have been paid) before ordinary shareholders receive anything.

Generally, the preferred shareholders play a smaller role in company affairs than do the common shareholders. In some companies, preferred shareholders have no voting power at all.

  • Ordinary Shares or Common Stock: Ordinary shares are shares whose owners have the last claim on distributed profits and assets.

In spite of its name, preferred stock is far less popular than common stock as a vehicle for raising money. In fact, many corporations issue only common stock, which entitles shareholders to participate in the selection of the company’s board of directors and to speak out on other issues such as corporate ethics, acquisitions and takeovers.

Why do people buy common stock, when they could have more security with preferred stock? This is because, in addition to receiving dividends, the owners of common stock can make a lot of money if the price of the stock goes up.

Preferred stock is dependable and stable; you can count on your dividends, but me value of the shares does not usually change much. Common stock, on the other hand, is less predictable but potentially more valuable with luck you receive dividends, and the price of the stock may go up dramatically.

Stock Splits

A dividend is not the only benefit a company can offer its common shareholders. Another alternative is a stock split, a procedure whereby the company doubles (or triples, or whatever) the number of share that each certificate represents. In a 2-for-l stock split, for example, a company whose stock was selling for $50.00 per share would double the number of shares outstanding, giving each shareholder two shares instead.

  • Retained Earnings: Retained earnings is part of a company’s profit not paid out as an ordinary dividend (e. undistributed profit). It is always a source of finance or fund to the company, which normally ploughed the profit back on investments.
  • Bonds: When a company needs to borrow a large sum of money. It may not be able to get the entire amount from a single source. Under such circumstances, it may borrow from many individual investors by issuing bonds. A bond is a corporate IOU (I Owe You) that obligates the company to repay a certain sum, plus interest, to the bondholder or certificate of indebtedness that is sold to raise funds.

Each bond has a denomination, the amount of the loan represented by one bond. It usually shows the date when the full amount of the bond, or the principal, must be repaid. Bonds typically have maturity dates of 10 years or more.

Secured and Unsecured Bonds

Just like loans, bonds may be either secured or unsecured.

  • Secured bonds are backed by specific property of one kind or another that will pass to the bondholders if the issuer does not live the terms of the agreement. The security may be a mortgage on a piece of real estate or a claim to other assets, such as freight cars, airplanes, or plant equipment owned by a company.
  • Unsecured bonds also called debentures, are backed not by collateral but by the general good name of the issuing company. If the bond issuing company fails, the bondholders have a claim on the assets, but only after creditors with specific collateral have been paid.

Mix of Funding Vehicles

Apart from timing their borrowing properly, financial managers must choose and decide on the balance among these options. Financial managers analyze the pros and cons of internal versus external financing, short-versus equity.

Debt Versus Equity

In choosing between debt and equity, companies consider various factors, some of which are summarized below. Generally speaking, debt is cheaper than equity; companies can deduct the interest on debt-from their taxes, whereas dividend payments on stock (earnings distributed to shareholders) are not deductible. Because debt interest payment come out of pre-tax, whereas stock dividends come after tax, the company does not have to came nearly as much to pay interest on the debt as it could to pay the same amount in dividends on stock. Debt has a high degree of risk as one of its own major disadvantages.

Debt

Characteristics: Claim on Income

Company must pay interest on debt held by bondholders and lenders before paying any dividends to shareholders. Interest payments must be met regardless of operating results.

Characteristics: Claim on Assets

If the company fails, bondholders and lenders have a claim on company assets, which are sold and used to reimburse the creditors.

Characteristics: Repayment Terms

Company must repay lenders and retire bonds on specific schedules.

Characteristics: Tax Treatment

Company can deduct interest payments from its corporate income tax.

Characteristics: Influence over management

Creditors can only impose limits on management if interest payments are not received.

Equity

Characteristics: Claim on Income

Shareholders may receive dividends after creditors have received interest payments; however, the company is required to pay dividends.

Characteristics: Claim on Assets

After all, creditors have been paid, shareholders can claim any remaining assets.

Characteristics: Repayment Terms

Company is not required to repay shareholders for their investment in the enterprise.

Characteristics: Tax Treatment

Company must pay dividends from after-tax income.

Characteristics: Influence over management

As owners of the company, shareholders can vote on some aspects of corporate operations: influence varies depending on whether the stock is widely distributed or closely held.

 

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