It is no secret that companies can’t survive without prudent financial management. Therefore, the ability to harness, deploy and manage financial resources judiciously is critical for organizational sustainability and long-term viability.
Finance and compliance management are at the heart of corporate functioning. They cumulatively shape organizational fortunes and determine whether or not enterprises achieve their business goals. Robust financial management enables organizations to utilize their resources optimally and address stakeholders’ needs effectively.
Thus, enterprises need to establish systems and processes that enable their growth and expansion at the desired rate, while seamlessly managing their financial resources to support day-to-day operations, employee engagement, and well-being activities. Just as vital organs in a human body need blood for optimal functioning, an organization needs a constant and unhindered supply of money for growth and operations.
What Is Financial Management?
Financial management is the operational activity of any business that helps it acquire and effectively utilize the funds necessary for efficient operations and revenue generation.
In other words, it concerns optimal procurement and the use of finances to minimize the risks involved in obtaining money and the interest accrued in getting the funds.
Financial management encompasses diverse functions like revenue recognition, payment processing, accounting, and fixed-asset management. Integrating them into a financial management system offers real-time visibility into a company’s finances, while facilitating its day-to-day operations.
Large organizations have been using Enterprise Resource Planning (ERP) systems to achieve the above-stated objectives. However, changing workplace dynamics, coupled with the market landscape caused by COVID-19, have forced companies to revisit their established systems and processes.
Enterprises are realizing that they lack a single source of truth for financial management. That’s why they are adopting Professional Services Automation (PSA) tools that leverage Artificial Intelligence (AI) and offer real-time visibility into important business metrics. These tools streamline financial information and give an up-to-date, live view of a business’s financial state – the type of view that has become a critical component of financial management.
Read this blog to learn more about PSA vs. ERP and why it’s crucial to know the difference.
Importance of Financial Management
Financial management benefits organizations in several ways. It helps them envisage a roadmap for economic sustainability and understand how they can attain their immediate, short-term and long-term objectives. Thus, it is a critical exercise for companies, irrespective of their size and area of operation.
Financial management is also important for these other reasons:
1. It Helps With Financial Scenario Planning
Business leaders need insight into the finances of their businesses to chalk out possible outcomes, maximize profits by preparing for what may lie ahead, and nullify the element of surprise. Thus, they need to undertake financial scenario planning. This process enables organizations to plan for various “what-ifs” to prepare for the unforeseen.
2. It Helps Leaders Make Business Decisions
Businesses need to make decisions around their growth, footprint expansion, hiring and acquisition. Companies’ finances often shape their planning, budgeting, and employee monitoring, and they cannot make these decisions without having a clear view of the state of their finances. Therefore, companies require real-time financial insights to operate seamlessly and to chalk out their broader business strategies, which mandates financial management.
3. It Helps With Exercising Control and Business Alignment
Financial management is vital to deciphering whether or not every department is in sync with the organization’s broader vision and mission. In addition, it helps managers ascertain whether each vertical is working within its allocated budget and is not going overboard, and thereby exercise financial prudence. Such vertical and team-level checks and balances are essential, especially for enterprises with significant budgets.
Strategic vs. Tactical Financial Management
Strategic financial management is organizational planning to achieve broader strategic goals. It entails creating business plans, production plans, personnel plans, marketing and sales plans, and capital expenditure. All these aspects have significant financial implications for an organization. Strategic financial management also involves allocating and managing an organization’s assets and liabilities, and tracking expenses, cash flow, and profitability.
In contrast, tactical financial management concerns organizational governance of day-to-day transactions, adherence to tax compliance, inventory management, working capital cash management, management of fixed assets, financial control and reporting.
Objectives of Financial Management
Financial management has several objectives, and achieving them is crucial for companies to stay on track with their desired growth. We have listed some of the objectives below.
1. Maximizing Shareholders’ Wealth by Maximizing the Market Price of Shares
Organizations need cash flow and investments to carry out their business plans. They access funds by borrowing money from the market, or from institutional investors, such as banks, equity firms, or private investors. But, irrespective of the source of funds, organizations must deliver steady returns on stakeholders’ investments, which builds trust and goodwill and attracts further investment, growth, and expansion.
Thus, it is a cyclical process. So the foremost objective of financial management is to generate wealth for investors by maximizing the company’s share price, making it an attractive investment proposition.
2. Optimal Utilization of Available Resources
Financial management not only entails generating the maximum possible return on investments, but utilizing every penny optimally. Effective and efficient utilization of funds enables organizations to:
- Maximize returns
- Lower the cost of capital
- Improve savings
- Enhance organizational value
- Ensure growth and profitability in the longer-run
Under-utilization or over-utilization of funds can impact organizational sustainability, viability and growth. For example, an organization cannot maximize its earnings if it deploys external sources to meet its capital needs and does not utilize its internal funds adequately. Plus, external sources also impact fund safety, risk management and liquidity.
3. Maintaining Enough Liquidity to Ensure Short-term Growth and Employee Welfare
A company’s liquidity is one of the key indicators of its financial health. Liquidity helps gauge a company’s ability to pay its short-term debts and current liabilities by quickly converting assets or near-cash securities into cash. Companies can use any leftover money to pay dividends to shareholders, grow the firm or invest in employee upskilling activities.
Businesses usually cover their financial liabilities by deploying immediate assets. Therefore, how quickly they can transform their holdings into monies to pay their short-term financial obligations matters.
Financial management allows companies to maintain a healthy liquidity ratio, which fuels their short-term business objectives, in addition to their employee engagement and welfare activities. For example, a company may liquidate stocks, collect accounts receivable, sell inventory, or return unused supplies to its vendors for liquidity. However, organizations can avoid these last-minute and hurried interventions by managing their finances closely.
4. Meeting Financial Objectives and Commitments
Financial management helps meet the financial objectives and commitments of an organization. While financial goals and obligations can vary significantly across companies, they typically encompass the following:
- Revenue generation
- Increase in income
- Enhanced profits
- More robust cash flow
- A more diversified revenue base
Financial objectives focus on delivering suitable profits while following the organizational mission, vision, and goals. Financial objectives help achieve steady cash flow, creditworthiness, growth in earnings, better dividend yield and higher price of shares.
5. Developing Financial Scenarios
Financial scenario planning (also called “what-if” scenario analysis in corporate parlance) is a strategic planning tool that helps improve financial forecasting. Companies use this tool to evaluate opportunities, threats and uncertainties by extrapolating multiple possibilities in the future. As a result, organizations envisage multiple challenges and opportunities to prepare suitable action plans they can act upon based on future developments.
Companies typically use the financial scenario tool to estimate changes in the value of a business or cash flow, most notably when business-enhancing or unfavorable events could affect them.
There are three common types of Financial Scenarios:
A. Base Case Scenarios
Here, management calculates the net present value based on the discount rate, cash flow growth rate, or tax rate.
B. Worst Case Scenarios
Management expects the worst outcomes and prepares for those eventualities. For instance, it considers the highest possible discount rate and subtracts the highest expected tax rate when calculating the organization’s net present value.
C. Best Case Scenarios
With this scenario, when calculating the net present value, companies factor in the lowest possible discount rate, the lowest possible tax rate and the highest possible growth rate. This is the most commonly used type of financial scenario.
In conclusion, financial management is key to developing financial scenarios that help companies prepare to ride out difficult situations or piggyback favorable market churn.
6. Managing Business Relationships
Money, profit, and bottom line invariably shape business relationships. Return on investments impacts corporate relationships and investment decisions. No investor funds a company that does not generate wealth for them.
Therefore, profitability is at the core of business relationships. Financial management helps organizations stay on course with their business goals and create wealth for themselves and their investors. Thus, one cannot understate the importance of financial management in creating and nurturing business relationships.
7. Ensuring Compliance
Adhering to local, national and international financial regulations is integral to seamless corporate functioning. Thus, organizations must comply with the regulations, rules and laws of the capital and finance markets.
Any failure to comply could cause irreparable damage to a company’s reputation, in addition to inviting penal action and a host of legal ramifications. Plus, lack of compliance can also dent a company’s standing among investors, making access to funds all the more difficult. Therefore, organizations must adhere to regulatory objectives to safeguard and insulate investors and other stakeholders, and to uphold the markets’ fairness, efficiency and transparency.
For the uninitiated, financial governance refers to how organizations track financial transactions, control and manage data and performance, and adhere to statutory disclosure.
Functions of Financial Management
Financial management has the following functions:
1. Determines Financial Need
Any enterprise must use its financial and non-financial resources judiciously to succeed and maintain its standing in the market. Therefore, organizations must determine their financial needs by setting aside an appropriate sum as cash on hand to manage their daily business operations.
However, finding the right balance is tricky because holding on to large amounts of cash unnecessarily can deter expansion plans as the money remains unused, becoming an unproductive asset. Meanwhile, less-than-needed funds can cause a cash crunch and impact day-to-day operations. Therefore, finding a middle ground between savings and expenditure is critical.
2. Determines Investment Decisions
Finance heads of organizations make investment decisions after evaluating their borrowing and allocation of funds. Simply put, any firm analyzes its investments to ascertain which mediums can deliver the highest possible returns.
Therefore, organizations make investment decisions after carefully selecting assets to invest in, to maximize returns for themselves and their stakeholders. ‘Assets’ may include long-term investments such as infrastructure that offer returns over a longer duration and short-term investments like finished goods that offer short timeframe returns.
3. Makes Financial Decisions
Financial decisions follow investment decisions, where finance teams chalk out strategies around how to acquire funds. When making financial decisions, organizations decide on the nitty-gritty of fund acquisition – that is, the proportion of debt and equity in the capital structure.
4. Makes Working Capital Decisions
Working capital is calculated by subtracting current assets from current liabilities; Analyzing it helps organizations use their current assets more effectively, hold on to adequate cash flow, and address their immediate and medium-term business needs.
Efficient working capital management can help organizations access funds that remain stuck on the balance sheet. Access to funds lowers their dependence on external borrowing and allows them to expand their business, acquire new companies and invest in technologies and processes that further enhance their efficiencies.
5. Makes Dividend Policy Decisions
Maximizing investors’ wealth is any organization’s foremost priority. A dividend is the portion of an organization’s net profit that it distributes amongst its shareholders. It is the income investors generate for funding an organization.
While organizations release dividends at a predetermined rate, decisions regarding the distribution of equity shares are usually made annually. However, a streamlined and consistent dividend policy works well as it allows investors to predict earnings and signals consistent and predictable policymaking, assuring investors of management’s intentions.
6. Supports Financial Controls
Every organization has some policies, processes and standard operating procedures, which help it track, control, allocate and deploy its financial resources appropriately. These are cumulatively referred to as financial control. Financial control is intrinsically linked to resource management and operational efficiency, and has a significant effect on organizational cash flows; it can help detect and prevent online fraud and overall profitability.
Types of Financial Management
There are three types of financial management. They are:
1. Capital Budget Management
Capital budget management is the process of assessing the investment prospects of long-term assets. Managers or heads of finance choose whether their long-term investment in a specific project is likely to offer sizable returns, which must exceed the cost of bankrolling the project under consideration. In simple terms, capital budget management is a cost-benefit analysis of long-term and, usually, cost-intensive projects.
Investment in these sorts of projects generally involves the purchase of long-term assets – it shapes the firm’s prospects because of its high-stakes nature. While potentially high-risk, such investments benefit stakeholders by enhancing the value of their investments.
2. Capital Structure Management
Capital structure is the ratio of the different types of securities that a firm acquires as part of its long-term financing. It is the proportion of debt, preference and equity capital in the cumulative funding of a firm’s assets. In addition, factors like equity trading, degree of control, and flexibility of financial plans determine the capital structure.
Capital structure decisions influence a firm’s value since they determine its cost of capital, which can affect equity shareholders’ share of the earnings. And, the capital structure can accentuate acquisitions and capital expenditures that can influence an organization’s bottom line.
3. Working Capital Management
Working capital management refers to managing the funds required for the daily operation of any business. It is the sum of the organization’s current assets and liabilities.
Purchase of raw materials, payment of wages of full-time and contractual employees, vendors, and overhead expenses like electricity, rent and maintenance are some uses of working capital. In addition, companies use the working capital to procure raw materials, yet-to-sold finished goods, and goods under construction.
But beyond its role in maintaining daily operations, working capital also acts as an indicator, demonstrating an organization’s short-term liquidity position of cash and cash convertibles.
What Is an Example of Financial Management?
Let us understand how financial management works using an example of a talent assessment company called ‘X.’ Suppose X wants to introduce a new product – psychometric assessments.
First, its CEO will ask for a cost estimate for creating the product, including research, development and deployment, following sales and marketing initiatives. Next, the finance team will determine how to acquire the necessary funds to create the product.
Then, depending on the organization’s outlook, balance sheets and several other factors, it will either raise funds internally or seek institutional support like a bank loan. Finally, once the company acquires the requisite funds, it will design and deploy psychometric assessments cost-effectively.
Suppose the product sells well as organizations wanting to profile their employees, such as banks and taxi aggregators, purchase and use it extensively. In that case, the financial manager will collate data that the management can use to decide its next course of action.
For example, it can invest its earnings in developing the product further by adding more functionalities, or create a new line of assessments, such as behavioral assessments, to widen its product line further. Or, it can pay dividends to shareholders or use the sum accrued for other purposes.
During this process, the finance team will ensure X has sufficient cash reserves to acquire the necessary workforce to develop psychometric assessments. Plus, it will assess whether or not the organization’s spending and earnings are in sync with the estimates drawn before commencing the project.
Frequently Asked Questions
1. What should be the primary goal of financial management?
While organizations undertake financial management for several reasons, its primary goal is to boost stakeholders’ wealth. In the case of a publicly-listed company, this wealth is created by increasing the value of stocks. Conversely, in privately-held companies, an increase in the market value of the owner’s equity signifies wealth creation.
2. What are the types of financial management?
Broadly, there are three types of financial management. They are:
- Capital budget management
- Capital structure management
- Working capital management