Financial Management: Objectives, Tasks, and Tools

Posted on Sep 2, 2024 in Economy

Financial Management Objectives

The two main objectives of financial management are:

  1. Profitability: Maximizing returns on investment for owners or shareholders.
  2. Liquidity: Ensuring the rapid conversion of assets into cash.

Financial management is responsible for managing a company’s financial resources to ensure profitability and liquidity. Profitability is achieved when a company’s operations generate returns on investments that exceed the cost of capital. This is known as the financial manager’s dilemma: balancing profitability with liquidity.

Sources of Funds

To achieve profitability and cash flow, the finance function seeks funding from various sources, including:

  • Investors who buy shares
  • Creditors who provide loans
  • Retained earnings from previous years

Financial Administrator Tasks

Financial administrators interpret and analyze financial data to make informed management decisions. Key tasks include:

A) Balance Sheet Analysis

The balance sheet is a financial statement that reports a company’s assets, liabilities, and equity at a specific point in time. It provides a snapshot of the company’s financial health.

B) Income Statement Analysis

The income statement, also known as the profit and loss statement, reports a company’s financial performance over a period of time. It shows how much revenue the company generated, the expenses incurred, and the resulting profit or loss.

C) Financial Planning, Control, and Analysis Tools

Financial administrators use various tools for planning, control, and analysis, including:

  • Financial ratios and indicators
  • Funds flow statements
  • Budgets
  • Cash flow statements
  • Financial forecasting

1) Liquidity and Turnover Ratios

A) Liquidity Ratios: These ratios measure a company’s ability to meet its short-term obligations. Examples include:

  • Current Ratio: This ratio measures a company’s ability to pay its short-term liabilities with its current assets. It is calculated by dividing current assets by current liabilities.

B) Turnover Ratios: These ratios measure how efficiently a company uses its assets to generate sales. Examples include:

  • Accounts Receivable Turnover: This ratio measures how quickly a company collects its receivables. It is calculated by dividing net credit sales by average accounts receivable.
  • Inventory Turnover: This ratio measures how quickly a company sells its inventory. It is calculated by dividing the cost of goods sold by average inventory.

2) Debt Ratios

Debt ratios measure a company’s reliance on debt financing. Examples include:

  • Debt Ratio: This ratio measures the proportion of a company’s assets financed by debt. It is calculated by dividing total debt by total assets.
  • Debt-to-Equity Ratio: This ratio measures the proportion of debt to equity used to finance a company’s assets. It is calculated by dividing total debt by total equity.

3) Performance Ratios

Performance ratios measure a company’s profitability and efficiency. They can be classified into two groups:

  • Profitability Ratios: These ratios measure a company’s profitability in relation to its sales, assets, or equity. Examples include gross profit margin, net profit margin, return on assets (ROA), and return on equity (ROE).
  • Efficiency Ratios: These ratios measure how efficiently a company uses its assets and resources. Examples include inventory turnover, accounts receivable turnover, and asset turnover.

D) Funds Flow Statement Analysis

The statement of sources and uses of funds, also known as the cash flow statement, tracks the movement of cash both into and out of a company over a period of time. It provides a detailed view of the company’s cash inflows and outflows.

E) Budgeting

Budgeting involves creating a detailed financial plan for a specific period. Common types of budgets include:

  1. Operating Budgets: These budgets outline a company’s projected revenue and expenses related to its core operations.
  2. Cash Budgets: These budgets project a company’s cash inflows and outflows, ensuring sufficient liquidity to meet short-term obligations.
  3. Capital Budgets: These budgets plan for long-term investments in fixed assets, such as property, plant, and equipment.

F) Financial Forecasting

Financial forecasting involves projecting future financial performance based on historical data, industry trends, and economic conditions. Pro forma financial statements, such as the projected balance sheet and income statement, are commonly used in financial forecasting.

G) Project Evaluation

Project evaluation assesses the financial viability of potential investments. Common tools for project evaluation include:

  • Payback Period: This metric calculates the time required for an investment to generate enough cash flow to cover its initial cost.
  • Net Present Value (NPV): This method discounts future cash flows back to their present value, considering the time value of money. Projects with a positive NPV are generally considered financially viable.
  • Internal Rate of Return (IRR): This metric calculates the discount rate at which the NPV of a project equals zero. Projects with an IRR higher than the required rate of return are generally considered acceptable.