Financial Management Essentials

Financial Management Overview

• Financial management involves planning and managing a business's funds to achieve its objectives
• Businesses acquire necessary funds to operate and ensure optimal fund usage in the short and long term
• Financial management has three main functions: analyzing the financial position, managing assets, and managing liabilities
• Success requires reasonable liquidity and profitability

Analyzing Financial Position

• Analyzing a business's financial position involves evaluating its financial health through measuring and monitoring its liquidity and profitability
• Financial ratios are used to objectively assess the financial standing of the business
• Liquidity represents a company's ability to meet its short-term financial obligations and debts continuously and on time, including salaries, wages, and taxes
• Failure to maintain sufficient liquidity may lead to liquidation
• Profit represents the difference between income and costs
• Business profitability is the ability to generate income exceeding total costs through the productive use of assets

Asset Management

• Assets are divided into fixed and current
• Fixed assets are owned and required for more than 12 months, which includes land, buildings, equipment, vehicles, and furniture
• Current assets include cash and assets that can be converted to cash within 12 months, such as inventory and trade receivables
• Financial managers must avoid over-capitalization through unnecessary duplication and must ensure an optimal balance between fixed (long-term) and current (short-term) assets

Liability Management

• When managing liabilities, financial managers must determine the best funding structure, considering the mix of short and long-term financing and sources
• Maintaining ongoing access to short and long-term funds at favorable interest rates and under suitable repayment conditions is also important
• Long-term funds consist of owners' equity and long-term liabilities
• Owners' equity refers to the money invested in the business by owners for asset acquisition
• Long-term liabilities include obligations lasting over one year, like mortgages and bank loans
• Short-term funds are current liabilities, which are obligations owed to creditors due within one year, such as trade payables, bank overdrafts, and factoring
• Inability to manage liabilities can lead to insolvency or liquidation

Core Principles of Financial Management

• Sound financial decisions are based on 3 core principles: cost-benefit, risk-return, and time-value-of-money

Cost-Benefit Principle

• In any decision, benefits should exceed costs
• Cost-benefit decision-making requires:
  • Clarifying objectives
  • Calculating costs and benefits of alternatives
  • Determining standards to measure alternatives
  • Deciding on the most appropriate course of action

Risk-Return Principle

• Risk is the potential for danger or loss
• Risk evaluation involves calculating the chance of actual outcomes differing from desired outcomes
• The risk-return principle establishes a trade-off: higher risk should correspond to higher expected return

Time-Value-of-Money Principle

• Money has value over time as a business can increase its value by investing and earning interest

Consideration of Core Principles

• Investing in assets will have no interest earned on the investment based on the time-value-of-money principle
• The cost-benefit principle shows there could be a greater return on investment in assets than from investing in a bank
• Applying the risk-return principle means considering all options for earning a greater return from high-risk investments

Financial Statements

• Financial statements give a written summary of a business's financial activities

Balance Sheet

• Balance sheets list all assets and liabilities at a specific point in time, detailing how net assets were financed
• Net assets are Total assets – total liabilities
• Financing is done through owners' equity and profits
• The balance sheet equation illustrates these components

Income Statement

• Income statements give a financial summary of profitability, and list all incomes less expenses over a specific period, e.g. 12 months
• Sales revenue is matched with expenses to ascertain whether a business is operating at a profit or loss

Break-Even Analysis

• Break-even analysis examines the relationship between costs, volume, and profit at different levels of sales activity
• It is also known as cost-volume-profit analysis
• It helps determine the sales volume needed to cover all costs, and how to generate a satisfactory profit figure
• The break-even point is whether the business makes a profit or incurs a loss

Break-Even Analysis Exercise

• Break-even analysis addresses such questions as “At what volume of sales are all my costs covered?”
• The formula N = F ÷ (SP – V) is used to calculate the number of units needed to sell with:
  • N = number of units where no profit or loss is made
  • F = total fixed costs
  • SP = selling price per unit
  • V = variable costs per unit

Financing

• Businesses require financing
• It is dependent on whether short-term, medium-tern, or long-term financing is required
• Short-term commitments covers less than 1 year like rent, wages and telephone bills
• Medium-term commitments covers 1-5 years and includes vehicles and machinery
• Long-term commitments covers more than 5 years like building etc

Types of Financing

• Short-term is less that 1 year
• Long-term financing is more than 1 year
• Types of short-term financing include trade credit, bank credit and factoring of trade receivable debtors
• Types of long-term financing include equity funding, long-term bank loans and financial leases

Cash Budget

• A cash budget is a forecast showing estimated future cash receipts and payments, indicating the forecasted cash balance at fixed intervals
• Prepared budget shows the cash flow in and out, and shows the ability to pay debts and expenses
• Cash budget is a comparison to actual cash flow
• Budget can assist with identifying monthly balances and foresee potential shortfalls or excess, which can be invested for short-term returns.

Trade Receivables

• A trade receivable is money owed for provided services or goods
• Trade receivables starts with giving credit to customers and attracts more business
• Crediting attracts and retains customers and increases sales revenue
• Trade receivables should be collected quickly without being too forceful
• Credit management is based on credit policy, credit terms and collection policy

Credit Policy

• Credit policy outlines determinant conditions of how much credit customers get
• The four C’s are character, capacity, capital, and conditions of evaluating customers
  • Character is the customers record of loans
  • Capacity is the customers ability to pay
  • Capital is the customers financial resources
  • Conditions are whether current economic or business conditions may effect finances

Credit Terms

• Credit terms gives length of term and cash discount
• Considers length of terms given to customer such as 30, 60 or 90 days and cash discounts
• Should consider industry standards, costs of discount, and terms of tax invoice

Collection Policy

• Collection policy lists out procedures and methods of how receivables are collected
• Slow payments increase investments tied to trade receivables
• Credit collections are conducted vie phone calls, letters, debt collectors, attorneys and emails

Inventory Management

• Inventory covers raw materials, finished goods and stock
• Overall objective it to minimize investments without interruption to production which may result in a loss of sales
• Enough inventory should be available to cover production demands
• Cash tied to inventory should be kept to a minimum