Basic Principles of Financial management

Financial Management
Good financial planning cannot be underestimated. Many surveys have identified that around 74% of business closures were attributable to poor financial management. A good business will have a business plan that incorporates financial budget for projected sales, expenses, net profits, staff needs and capital acquisition (purchase of assets)
- The level of profitability in a business will have an impact on the liquidity of the business, and this must be continuously monitored. The amount of cash in the business daily and the credit available from bankers must be sufficient to allow the businesses to trade. The measure of business’s efficiency is the manner, in which it maintains its records promptly, collects its overdue receivables and maintains an inventory that turns over quickly.
- The ultimate measure of business success is the return on shareholder’s funds, often expressed as net profit divided by shareholders funds.
- Actual results should be reported against budgets at least monthly. This enables management to correct adverse trends . Corrections may include improved staff training, better cost control, improved purchasing from suppliers, and better marketing through advertising, etc.
- The importance of cash in a business and the speed with which it flows through the business accounts can be the difference between survival and failure. Cash is needed to pay bills. A business id deemed to be insolvent when it is unable to pay its debts as and when they arise. Bank lines of credit are very important to any business.
- The financial controls needed in s successful business are intended to minimise risk. Expense control should be firm and production costs should avoid wastage without compromising quality. Minimising risk is supplemented by insurance for fire, burglary, theft and loss of profits, etc.
- Many people enter business with little basic knowledge. Financial planning is about gaining knowledge in preparation for a course of action for any enterprise. It is important to know about financial reports such as budgets, cash flow, profit and loss statements and balance sheets. Record systems are the means of being able to check progress against past results.
- The planning cycle begins with a business looking at its present financial position. Then the managers prepare a business plan with objectives and budgets. Next are the implementation and control phrases. Planning is strategic or operational.
- Major participants in the financial market are:
- Investment/merchant banks
- Commercial banks – provide customers with a range of products including deposit and cheque accounts, credit/debit cards, personal loans and mortgages
- Money market dealers – buy and sell government securities on the secondary market, and offer cash or deposit facilities to major organisations.
- Finance companies – major providers of business finance, factoring, leasing and property financing
- Insurance/superannuation funds – involved in domestic and commercial mortgages, property developments, bonds, shares and government securities.
- Building societies/credit unions- make advances to customers for housing and personal loans, similar to banks.
- The reserve bank of Australia acts as banker for the government; implements monetary policy independently but in conjunction with the government of the day; monitors commercial banks; monitors foreign exchange rates; manages coin and note issues; and monitors economic data.
- Merchant/investment banks are major players in the short-term money markets, dealing with all money market instruments or securities such as commercial bills. They act as primary advisors to corporations seeking to issue shares or debentures/bonds. They also underwrite new share/debenture issues, and tender and deal in government securities.
- The Australian Stock Exchange Limited (ASX) has many customers, but the principle ones are investors, listed companies and stockbrokers , who are intermediaries (links) between them and the capital markets.
- Domestic market influences on our capital markets include where we are on the economic cycle; economic management policies of the Federal Government ; interest rate changes by the Reserve Bank; level of unemployment ; industrial stability; consumer demand; the level of investment in the economy; the innovation rate; and the level of inflation.
- Overseas market influences are affected by the world economic position. These effects flow into our capital markets. Interest rates, unemployment, government management, consumer demand, industrial stability and regional conflicts all affect our markets.
- Like most countries, Australia can point to certain indicators of financial health eg. Changes in inflation rates; the consumer price index; the rate of unemployment; the level of new investment; the increase/decrease in our overseas debt; rate of imports; stock market index; value of currency etc. All these indicators combine to identify trends in our financial markets.
- Internal funds are generated from monies furnished by the owners of the business. If a business is successful financially, the owners may decide to leave some or all of the profits from operations inside the business. These are known as retained profits. A large, old and well-established business may have several hundred million dollars in retained profit. A new small business may have little or no retained profits.
- When business owners decide to borrow , they must obtain the funds from external sources. Short term funding refers to borrowing likely to be repaid within one year. Long term funding refers to borrowing that will be repaid over a term as long as 10-20 years. Mortgages (loans secured by real property or business assets) and debentures (loans from the general public) are commonly used to meet long term funding needs. It is important not to confuse sources of funds (eg banks) with types of finance (overdraft, mortgages).
- Factoring allows businesses to obtain external funds by selling their accounts receivable. Factoring occurs when businesses allow credit in payment for merchandise. The factoring company charges the business a small fee and the business has the advantage of receiving an immediate credit in its bank account. As factoring has become a more common business practice, businesses specialising in factoring have been established in Australia.
- Borrowers need to take care that they will be able to repay the borrowed funds during the life of the intended business expenditure. For example, short term borrowing via on overdraft to fund and expected 90-day cash shortage is considered acceptable business practice. However, taking a long-term mortgage to fund the same expected 90-day cash shortage is generally not considered sound management.
- Philosophies vary about the right combination of debt and equity finance. If the business is unable to repay the debt, including principle, interest and associated charges, creditors may take control of the business. Too much debt financing can mean that all stakeholders are at risk.
- Gearing refers to the percentage of funding that is borrowed against an asset or the total assets of a business. The greater percentage of funding that is borrowed, the higher the gearing ratio. In most cases, a business is unwise to owe more than it owns.
- Both balance sheets and revenue statements are normally prepared at the end of the financial year. They are designed to answer two questions:
- Is the business profitable (from the revenue statement)
- What is the business’s financial position (from the balance sheet)
- The accounting equation (A=L+OE) , from the balance sheet is also expressed as (A–L=OE). For example of the assets of a business are sold for $100 000 and the owners repay all liabilities of $60 000, the remaining $40 000 is what the owner gets to keep – that is, the owners equity
- Current ratios range from 0.6:1 to 3.0:1, depending on how easily inventories and accounts receivable can be converted to cash, and how quickly cash flows in from a sale.
- The higher the debt to equity ratio, the higher the risk for creditors and owners. Solvency (gearing) ratios, like liquidity ratios can vary widely, from debt free to over 300%. A gearing ratio below 100% is usually considered safe or conservative.
- Generally the higher a businesses gross profit ratio, net profit ratio and return on owner’s equity ratio , the better for the business. Profitability ratios are typically starting points for evaluating businesses.
- Efficient managers work to lower expense ratios by monitoring and cutting costs wherever possible. Conversely, they seek to raise accounts receivable turnover ratio by establishing realistic credit policies and monitoring credit collections.
- Ratios allow analysts to compare a business with other similar businesses. Through ratios analysts can also examine the operations of any business over time, or compare a business with a benchmark .
- Both financial reporting and ratio analysis, however useful, have limitations. One business may legally use a different accounting method of its competitors. Another business may value its goodwill differently. The true value of assets may be understated on balance sheets because of historical cost accounting . Analysts need to be wary.
- The term working capital refers to an actual dollar amount. Most businesses need more current assets than current liabilities at all times. A key management responsibility is to ensure the business always has enough working capital to pay for the continuing operating costs incurred by the business.
- The relationship between current assets and current liabilities is often expressed as a ratio.
- A business’s current mix of payables, short-term loans and overdrafts is also largely controllable. Businesses that do not control the mix of their current assets are likely to experience liquidity problems – that is, they will not be able to pay current operating expenses. This commonly occurs when managers allow accounts receivable to become overdue.
- A business’s current liability mix of payables, short-term loans and overdrafts is also largely controllable, and is another important responsibility for managers. Normally, businesses that allow their current liabilities to become greater than their current assets are asking for trouble because creditors, such as telephone companies and suppliers, are likely to stop extending credit when accounts are not paid on time.
- A common management trend is for businesses to manage or improve their dollar amounts and their ratios of working capital by lessening assets or by selling assets and then leasing them back. Factoring is the management strategy of selling accounts receivable, at a discount, to a third party in order to convert accounts receivable to cash. Effective ways to improve the quality of working capital are to improve the collection of receivables, install just-in-time inventory controls, have sales of excess stock and install cost control programs.
- Regrettably many businesses do not recognise the importance of checking cash resource daily . This is vital knowledge to enable creditors, wages, loans and other expenses to be paid. Cash will be tied up in receivables, inventories, or in other investments the business has made. The bank overdraft , usually secured, is intended to be a fluctuating account according to the needs of the business.
- Cash flow statements are presented to management monthly. They show the opening cash flow balance from last month, the total cash received from all sources, receivables , cash sales, proceeds for asset sales, loans received etc and the total payments made out, such as expenses , new inventory and loan repayments. The balance at the end of the month should be within capability of the business bank overdraft. A good cash flow statement should also show the value of receivables, inventory and ideally the sales last month to give a trend.
- Businesses may sell goods for cash or on credit . Management should have policies for checking customer creditworthiness and effective methods of collecting accounts. Customers who do not pay on time will tie up the cash in a business and can jeopardise the success of a business
- Suppliers who value large orders often may offer a discount for bulk purchase or for earlier payment. Discounts can be very effective in lowering the costs of a business, provided the business can manage its cash well. Management can also buy goods on extended terms whereby a supplier has agreed to allow the purchaser to pay over a set period by certain instalments at fixed times.
- Management should have other strategies to ensure the available cash in their business is effectively used. They may sell off idle assets, watch for wastage, and consider factoring and leasing.
- Large companies have found that special cost centres enable different managers to overview how costs are progressing against budget. Production, marketing, administration, research and development may be cost centres. A small business usually has one cost centre. All businesses need to minimise expenses and ensure a senior person is controlling expenses. Costs are made up of two types.
- Fixed costs – such as monthly rent, insurance and leasing charges that do not vary with volume or sales
- Variable costs – vary with the volume of business
- Revenues may be controlled by varying the sales mix and the target markets. As effective pricing policy meets or beats competition, seeks a greater market share and sells surplus stocks.
- Unconscionable conduct usually falls into two major categories; those practices that are illegal , either deliberately or through ignorance, and those practices that may be unethical , through the use of unacceptable actions, generally dictated by the society in which we live.
- Ethics is a set of principles by which our actions are judged by others. It is about how we make decisions to do the right thing and involves honesty, fairness, caring and courage to make the right decision. Businesses can sometimes have dilemmas in deciding between the interests of shareholders , staff, customers, the environment and the wider community.
- Public companies come under more scrutiny as they involve the investment of other people’s money. All public companies must have recognised accounting firm appointed as auditors, who must complete a full investigation of the accounting records each year. The audit report to shareholders is included in each annual report.
- All businesses must follow certain reporting conventions. The Australian accounting profession has laid down minimum standards that must be followed in reporting financial results. The audit report gives a true and fair view of the company’s financial position
- The corporations Law sets out the minimum criteria all companies must meet. Directors may be personally liable for breaches, and heavy penalties can be imposed. Proprietary/private companies must also meet these standards. Certain types of illegal conduct include, bribery, misuse of funds in the business, directors acting against the interest of the company, failure to declare conflicts of interest and continuing to trade while insolvent.
- The Australian Securities and Investment Commission is empowered to administer the Corporation Law and to ensure that all businesses meet their statutory obligations. Such statutory obligations include the duty to act with reasonable care and diligence, to ensure the correct payment of taxes, to act honestly in the exercise of their powers, and to report changes of address or company directors.
- Unethical behaviour is unacceptable conduct. Excuses are often used and rejected as reasons. Certain types of conduct such as asset stripping, giving gifts for favours, illegally obtaining information through others, disposing of waste in the wrong manner and taking advantage of staff, are all unethical and in certain circumstances may be illegal.