Financial management deals with the analysis, interpretation and evaluation of all financial records of the business.
The long-term or strategic role of financial management is to ensure that a new business continues to operate, grows and is able to achieve its goals and objectives.
The decision making process is:
o Owners and managers make decisions and plans
o Owners and managers collect information relating to the decisions and plans
o Owners and managers analyse and evaluate the results of decisions and plans
The strategic role also includes:
Setting financial objectives
Sourcing finance
Preparing budgets and forecasting future finances
Preparing financial statements
Maintaining sufficient cash flow
Distributing funds to other parts of the business
1. Describe the strategic role of financial management
Objectives of financial management (each of these will be examined in more detail later)
The first measure owners want to establish is how much profit their business is making and financial reports give a detailed financial picture of the business’s profitability and stability.
The financial manager’s objectives will include the business’s 5 main goals (PLEGS)
o Profitability
§ The earnings of the business after expenses have been paid.
§ Profitability is measured using net profit from the income statement.
§ Gross profit is sales revenue minus wholesale cost and freight inwards (or COGS).
§ Net profit is the final amount of revenue remaining after all expenses have been paid.
§ Earnings before interest and tax (EBIT) is a more precise measure of profitability, it measures profit made from operations.
o Growth
§ This is the size of the business compared to its competitors in the same market. More profits may be obtained if the size is bigger. It can be achieved by:
§ increasing the physical size of the business by expanding or moving to a larger office or factory
§ increasing the value of the assets in a business
§ increasing sales and profits
o Efficiency
§ This is how much of total revenue is spent on expenses.
§ Efficiency may be calculated using an expense ratio.
Efficiency (Expense ratio) = total expenses/total sales.
§ Another measure of is the business’s ability to collect accounts receivable. E.g. invoices (A bill sent to a customer requiring payment by a date)
o Liquidity
§ This is the ability of the business to pay short-term liabilities using its current assets.
§ Debtors are expected to pay their accounts within a short time so it is a relatively liquid asset.
§ Current assets are cash and other assets that are sold or converted into cash within 12 months.
§ Current liabilities are debts that are due to be paid within 12 months.
§ Current assets need to be greater than current liabilities.
o Solvency
§ This is the ability of the business to pay both short-term and long-term liabilities as they fall due. It shows if the business is financially stable.
§ Gearing: tells you how much debt (or leverage) a business has aka how much is borrowed.. In simple terms how much debt its operations compared to its use of equity finance. E.g. - a business has $1,000,000 mortgage but only put in $100k in savings vs a business with the same mrotgage but put in $500k. The first business would be more highly geared as it has more debt/borrowed more.
§ There must not be too much cash or too little cash to pay liabilities.
Businesses it must often prioritise objectives as they cannot always all be achieved at the same time.
If another one of the business’s objectives is to be environmentally responsible then it must sacrifice efficiency in the operations.
Consumers can also turn to a business’s competitors if a business is not seen to be environmentally responsible.
Examples of conflicts
Expansion vs product development
R & D or use the money for share buy backs
Case study Westfarmers pg 299 answer Q1 & 2
The main functions that a business needs to perform are operations, human resources, marketing and finance.
Middle management develops short-term plans (tactical).
The financial manager must allocate adequate funds to each department to be able to operate successfully. The manager will also need to develop budgets and cost controls for each department.
So how does finance work together with these other functions?
Finance is crucial for each other area
$ is needed for a marketing budget, a promotional campaign, a new product design or log
$ is needed for operations of a business in terms of electricity, quality control, buying inputs
$ is needed for HR to pay employees, new training, recruit new workers
22. (d) Explain the interdependence of finance and operations in a business. Support your answer with relevant examples. 4 marks
Q2 A business is planning to increase its market share by merging with a competitor.
What financial objective does this best illustrate?
(A) Growth
(B) Liquidity
(C) Profitability
(D) Solvency
4 Solvency is the ability of a business to
(A) maximise its profits.
(B) increase its market share.
(C) meet its long-term financial commitments.
(D) meet its short-term financial commitments.
21 Sue is a sole trader whose business is growing rapidly as sales are increasing. As a result of the growth, she needs to purchase stock worth $10,000.
(a) Explain a potential conflict between a short-term and a long-term financial objective for Sue. 3 marks
4 A business ensures all its debts are paid as they fall due.
Which financial objective is the business satisfying?
A. Efficiency
B. Growth
C. Liquidity
D. Solvency
Question 24 (10 marks)
(a) Why is liquidity an objective of financial management? 2 marks