Financial management
Financial management ensures a business has the money it needs, uses it well, and manages risk.
The role of finance
Financial managers plan how to obtain funds, decide how to invest them, and manage cash and risk. The goal is usually to maximise the value of the business for its owners while staying able to pay its bills.
Budgeting
A budget is a financial plan for a future period, setting expected revenues and expenses. Budgets guide decisions, allocate resources, and provide targets. Comparing actual results with budgets (variance analysis) shows where performance differs from plans and why.
Cash flow management
Cash flow management ensures there is enough cash to pay suppliers, employees, and lenders on time. A cash flow forecast predicts inflows and outflows month by month. Businesses improve cash flow by collecting receivables faster, managing inventory, negotiating supplier terms, and arranging lines of credit for shortfalls.
Working capital
Working capital is current assets minus current liabilities. Too little can mean difficulty paying bills; too much may mean cash is tied up idly in stock or receivables. The cash conversion cycle measures how long cash is tied up between paying suppliers and collecting from customers.
Sources of finance: debt
Debt financing means borrowing: bank loans, overdrafts, lines of credit, and, for larger firms, bonds. Debt must be repaid with interest regardless of performance, but lenders do not take ownership, and interest is often tax-deductible. Too much debt raises the risk of financial distress.
Sources of finance: equity
Equity financing means raising money by selling ownership: from the owners' own savings, friends and family, angel investors, venture capital firms, or by selling shares publicly through an initial public offering (IPO). Equity need not be repaid, but owners give up a share of control and future profits.
Time value of money
A dollar today is worth more than a dollar in the future, because it can be invested to earn returns. Future value: \(FV = PV(1 + r)^n\). Present value: \(PV = \frac{FV}{(1 + r)^n}\). Businesses use these ideas to evaluate investments: net present value (NPV) adds the present values of an investment's future cash flows and subtracts its cost; a positive NPV adds value.
Worked example
A business can invest 10,000 dollars today in equipment that will save 6,000 dollars at the end of each of the next two years. At a 10% discount rate, the present value of savings is \(\frac{6{,}000}{1.1} + \frac{6{,}000}{1.1^2} \approx 5{,}455 + 4{,}959 = 10{,}414\). NPV is about 414 dollars, positive, so the investment adds value.
Key takeaways
Financial management obtains, invests, and protects funds. Budgets plan; variance analysis compares results with plans. Cash flow forecasts prevent shortfalls. Working capital is current assets minus current liabilities. Debt requires repayment with interest but keeps ownership; equity gives up ownership but needs no repayment. The time value of money underpins NPV: positive NPV investments add value.
Flashcard
Obtaining, investing, and managing funds
Check your understanding
What is a key difference between debt and equity financing?