Financial Management for Beginners: How to Make Good Financial Decision
6 June 2022
Financial management is one of the most significant aspects of starting and running a business. It involves applying general management practises to the financial resources of a company. With proper financial management, a company can ensure that it has sufficient finances to expand and maintain profitability.
Read along to know the basics of financial management, its importance and scope.
What Is Financial Management?
Financial management refers to the management of all financial functions and aspects of a company or an individual. It involves strategic planning, organizing, controlling and evaluating all financial activities including procurement of funds, utilization, etc.
Good financial management allows the CFO (Chief Financial Officer) of a company to make informed decisions, get insights on how to procure funds and create a long-term vision. It helps in maintaining organizational efficiency, maximizing profits and minimizing expenses.
Scope of Financial Management
There are 3 main scopes (elements) of proper financial management:
Financial decisions: This is concerned with deciding where to procure funds. These decisions will depend on the source, cost of financing, time and return expectations. A firm can raise funds from debt, equity, and short-term and long-term sources, depending on its investment needs.
Investment decisions: This involves evaluating risks, cost of capital and expected benefits to find the right investment option. There are two elements of investment decisions. The first is capital budgeting, which involves fixed and long-term investments. The latter is concerned with investing in short-term assets (working capital)..
Dividend decisions: This involves the allocation of a company’s profits. While shareholders want to claim dividends for personal profits, the company managers want them for expenses. The financial manager needs to measure the potential for growth and increase in investments while making a decision.
What are the Functions of Financial Management?
The following are some of the functions of financial management:
Estimating capital requirements: The financial manager must estimate how much capital a firm requires to maintain or expand operations. Such estimations will depend on factors such as expected expenses, profits and future plans.
Choosing source of funds: There are several ways for a company to acquire additional capital. This includes shares, debentures, loans, public deposits (bonds), etc. The company will decide on the sources based on their merits and demerits.
Investment plans: Any business needs to invest its unused funds to passively grow its capital. The financial manager will find the most suitable option based on their profitability and safety.
Cash management: Cash is required for various purposes like meeting liabilities, paying wages, electricity bills, buying raw materials, maintaining stocks, etc. The company has to decide how much cash to keep in hand for these requirements.
Managing risks: The financial manager has to assess all the risks that a business faces, including market risks, liquidity risks, credit risks and operational risks. Then, he/she has to formulate contingencies for them.
Allocating profits: Once a firm acquires profits, it can decide to distribute it among shareholders to reinvest them for innovation or expansions. The company needs to assess its current and upcoming needs to make an informed decision.
Why Is Financial Management Important?
Financial management provides the foundation for proper fund utilisation and strategic planning to uphold fiscal supervision. Managing finances is crucial since it adds value to an organisation and strengthens the customer relationship. Financial management involves managing cash movement, risk management and managing credit.
Imagine a financial institution (banks or Non-banking financial institutions) operating under the strict supervision of the central bank. Since the Central Banks control the monetary mechanism, they can regulate the general functioning of banks by tweaking repo/reverse repo rate values, etc. Banks essentially earn profits from the difference in interest income earned from extending loans and interest paid by their customers.
When banks face financial trouble, they may reach the central bank for policy changes that can keep them running. This may include raising taxes or aiming to reduce non-performing assets.
The Objective of Financial Management
Some basic objectives or perks of efficient financial management include:
Profit maximization and wealth management: Organizations function with the principal objective of earning maximum profits. Higher profits ensure capital accumulation and brighter prospects. It also ensures that the company’s shareholders are satisfied with their involvement. Dividend sharing, for example, preserves goodwill and improves the company’s performance in the share market.
Liquidity management and proper mobilization: Monitoring liquidity is important because it helps deal with uncertainty. Imagine a bank that has most of its reserves given as loans, and it is struggling to pay customers their deposit amounts. It should either borrow from the RBI to feed its liquidity or release public bonds. This also implies that companies should be able to finance their funds through multiple sources like shares, debentures and bonds, etc.
Meeting financial commitments and boosting efficiency: Timed payment of dues is a practice that efficient financial managers exercise. This highlights their goodwill and manages financial commitments with ease. Moreover, it helps create a substantial reserve to enable an optimal dividend pay-out policy in the long run.
The Five A’s of Financial Management
The five A’s of managing finances resourcefully include-
Anticipation of funds: Financing a business from the beginning involves capital requirements. As a major factor of production, labour intensive work requires regular payment salary income and the company must acquire/produce revenue to meet the requirements. Companies may also introduce a capital structure consisting of debts, common equity, etc.
Acquisition of funds: Fund acquisition succeeds anticipation in the natural order of dealing with capital. Companies may obtain funding from internal sources like owner’s investment, fixed assets and retained earnings or from financial institutions, shares and bonds, etc.
Allocation of funds: The decision to invest is evaluated on safety, liquidity, and profitability. So assessing risks is important. Funds must then be invested in areas that require capital to continue operations. Companies invest a lot of funds in research and development purposes as well. Mahindra could never reach a milestone in the automobile world if it could not assess situations and invest in research.
Appropriation of funds: Finance experts believe that an organisation should learn to manage its funds efficiently. This also involves profit and dividend management.
Assessment of plans and policies: Managing finances includes analysing and controlling all financial instruments and the annual balance sheet data. It helps identify if the company is secure and productive. It also serves shareholders’ interests by evaluating policies and guidelines.
1. Capital budgeting: Employing funds in different assets is integral to any organisation. Long-term investment decisions affect profitability and liquidity. Hence they are generally irreversible and struggle to maintain the organisation’s dignity.
For example, to cope with competition, Mahindra made long term decisions to invest in electric vehicles. This decisive decision can potentially change the course of the Indian automobile sector or can backflip if not done right. Bad capital budgeting can destabilize their financial fortune and affect their position in the stock market.
2. Capital structure: Sourcing funds to ensure smooth functioning is the quintessential decision organisations need to make. Raising funds from long-term sources includes equity, shares, debentures, bank loans, etc. Capital structure essentially considers the risks involved in the repayment of such borrowed funds.
The cost of raising/repaying capital varies, and so does the risk associated with it. Additionally, floatation costs like commissions, brokerage, etc., make funding less appealing.
3. Dividend decision: Profit distribution determines how well a company understands and regards contributions. Sharing dividends among shareholders involves devising an approach determined by the dividend per share. Normally, it does not change concerning minor changes in profits.
Dividend sharing also determines a company’s growth prospects and cash flow positions. Availability of adequate cash is crucial, especially when the economy is vulnerable to fluctuations.
4. Working capital management decision involves effectively employing an organisation’s available working capital. Companies need to analyse their assets and liabilities for a stable cash flow. This would eventually assist them in meeting short term debt obligations and maintaining production costs.
Working capital management works with several financial ratios that can effectively ensure the smooth operation of the cash conversion cycle.
With Hindustan Motors shutting down operations in 2014, it is evident that growing financial indiscipline, critical fund shortage and inappropriate demand can be fatal for an organisation. Efficient financial management is therefore essential for profit maximisation and long-run survival.
FAQs on Financial Management
Q1. What are the best books on financial management?
Ans: Some books on financial management include ‘Fundamentals of Financial Management by Eugene Brigham, Financial management: Theory and Practice by Brigham and Ehrhardt, etc.
Q2. What is the relation between accounting and financial management?
Ans: Financial management can decide if an organization requires more capital from various means. This is then handled by accountants who use statistics from the balance sheet and analyze the circumstances.
Q3. How is treasury management different from financial management?
Ans: Treasury dept. implements the financial plans formulated, coordinated and administered by financial managers. Thus the former is short term depending on the execution, while the latter is for the long run.
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Disclaimer: This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information, and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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