The financial manager in an organisation deals with all things finance. This can include raising funds externally through borrowings or investments, development of budgets, recording financial transactions and preparing financial statements and providing reports to senior management.
Although the financial manager is at the heart of the finances of an organisation, it is important for all managers to have an understanding of financial management so they can operate their departments within budget and understand the bigger picture of financial management for the organisation.
Finance: an overview
It is necessary to study finance as all organisations revolve around an issue of finance. It pays wages, dividends to shareholders, pays for the cost of services to people benefiting from non profits, provides buildings and infrastructure and on and on and on.
People, particularly at a senior level, need a working knowledge of finance and financial management to engage professionally with their organisation and make meaningful contributions. Additionally, it is of benefit to be able to assess the financial health of an organisation and also have the ability to plan and budget for future income and expenditure.
Types of business structure
Sole Proprietorship (sole trader)
An individual trading under their own name or a registered business name where all the profits and expenses of the business accrue to the individual.
Where two or more people join together to run a business and share in the profit or loss accrued. All partners have unlimited liability so this form of structure can be dangerous as you can expose yourself to risk.
A company can be public or private. Shares determine ownership and number of shares determines control when voting. The owners have limited liability to the extent of the assets of the corporation. Their personal assets are not at risk unless they have provided Director’s guarantees.
Five basic principles of finance
1. Money has a time value
An important consideration that is often overlooked. The value of money diminishes over time. A $100 today will be worth more than $100 in 12 months’ time.
2. There is a risk—return trade-off
As risk rises with an investment, so must the return. The concept here is that in order to take the risk, the rewards must be commensurate with that risk. This can be a complex assessment and also subjective.
3. Cash flows are the source of value (“Cash is King”)
Cash flow and not profit is what is important for value. Profit is not necessarily cash. Depreciation for example is a non cash expense. Accrued dividends are of no value to shareholders until paid in cash. When investing, incremental cash flows are what need to be considered. Incremental cash flows are the cash effect, positive or negative, on an organisations cash flow totals. So, incremental cash flow is the difference between a project taken on or not taken on. This is also referred to as the opportunity cost.
4. Market prices reflect information
The value of shares or companies is reflected based on the available information. The more information available, the quicker the market can respond with changes of value. The greater the level of information available and transparency, the less likely insider trading becomes.
5. Individuals respond to incentives
In a corporate environment, the shareholders, who are the owners or principals, hire managers or agents to run the organisation for them. This is known as the “agency relationship”. The managers are obliged to run the company for the benefit of the shareholders to maximise returns for them. However, should a conflict arise, then it raises the question as to whether the managers will act in their own interest or that of the shareholders. This situation is known as the “agency problem” in finance.
This fifth principle relates to the fact that managers will only work for shareholders while it is in their best interest to do so. As a result, companies pay incentives to managers to improve the response of managers in working for the shareholders. This can be at the risk of reduced share price or cash flows and can be referred to as “agency costs”
Enhancing value through financial decisions
The role of the financial manager is to maximise shareholder value. This is not maximising profit but cash flows. Profit does not tell us when cash flows are to be received. Profit maximisation also ignores the risk associated with cash flows.
Financial decisions relation to shareholder value include:-
1. What long-term investments should the business undertake?
This question addresses the issues of capital budgeting, investment appraisal or project evaluation. These are all the same thing depending on the question being asked. For the purposes of this subject, the term capital budgeting will be used.
2. How should the business raise money to fund these investments?
This question addresses the question of the organisations capital structure and looks at raising money via debt, (what an organisation owes) or equity (what an organisation owns).
3. How can the business best manage its cash flows as they arise in its day-to-day operations?
This question addresses the issue of working capital in an organisation. This is the ratio or balance between its current assets such as cash at bank, receivables and inventory compared to its current liabilities such as short term finance payments due, accounts payable and other short term debts.
More and more organisations are realising that you cannot maximise shareholder value without consideration of ethical concerns. These centre around environment, social impact and governance (ESG). This is also often referred to as the Triple Bottom Line (TPL). So it needs to be recognised that business has responsibilities to more stakeholders than just their shareholders. They have a responsibility to government, the community at large, the environment and being aware of these responsibilities will improve their sustainability and resilience.
Ethics are of paramount important in organisations. Pursuing questionable activities or engaging in fraud can only lead to failure of the organisation.
This module has demonstrated that financial managers are responsible for delivering long term economic value to stakeholders. However, it is becoming more and more recognised that this long term value needs to be done within the framework or responsible sustainability for the environment, social factors and governance (ESG). Recent failures in operations of companies as a result of Covid and disruption of supply chains has also brought home the importance of resilience in organisations.References
- Module 1 Introduction to financial management: Introduction 2022, Aib.edu.au, viewed 28 August 2022, <https://learning.aib.edu.au/mod/book/view.php?id=113072>.
- Titman, S, Martin, T, Keown, AJ & Martin, J 2019, Financial management: Principles and applications, 8th edn, Pearson, Melbourne.