four elements of financial management essay

four elements of financial management essay

The Four Elements of Financial Management: A Comprehensive Analysis

1. Introduction to Financial Management

The above scenarios lead one to conclude that organizations in both the private and the public sectors are not well managed. While this may be a strong statement, it comes out of performances over the years in both the private and the public sectors. It is thus essential for management to examine the organization, what it does well, and what changes are required. This examination will help management to ensure that the assets of an organization are well managed. In the private sector, financial management examines how funds are raised, how they are allocated in markets offering the highest return, how funds are raised to meet obligations, how to raise liquidity when funds are required, and how to minimize risk. On the other hand, performance measures examine whether the organization is as profitable as it should be. In the public sector, financial management is concerned with the efficient and cost-effective allocation and use of resources in meeting the main strategic objectives. The above definition covers the management of not only funds but also the allocation of resources and the allocation of activities that the organization undertakes.

In today’s economy, the majority of organizations either struggle to create wealth or have not capitalized on their potential to do so. In the private sector, most companies create inflated accounting profits for several years only to find themselves on the verge of bankruptcy. Others indulge in manipulation of share prices and accounting practices to create artificial wealth, which later is dissipated by collapsing share prices. In the public sector, there are many organizations that are unable to deliver the services expected from them. Others operate independently of the stated mission of the ministry to whom they are supposed to report. In their day-to-day running, internal client satisfaction is sacrificed for external client satisfaction, which in many cases is still low. In many of these cases, the groundwork for the present adverse situation was laid much earlier. The end result is that the employing ministry must bail them out.

2. Financial Planning and Forecasting

The term forecasting refers to the attempt to foretell the future so as to provide inputs for planning. Forecasting is a component of the decision-making process which lists expected future conditions that will appear in making a decision about an asset, project, or decision. It is often used to make short-term resource and operations planning decisions by providing information on the demand for a company’s products and services. Once the demand forecast has been determined, an analysis of the current production capacity available in a firm helps determine the company’s ability to meet the forecasted demand.

Financial planning involves deciding in advance the financial activities of a firm which bring together the objectives of the firm, the available resources, and the changing financial environment so as to optimize the financial plan. Financial planning is the act of preparing for future events to be achieved through present actions. Under a well-thought-out financial plan, the company’s future financial performance should be facilitated through developing and putting in place adequate plans for financing cash flows from sales, investments, mergers, acquisitions, and the like, as well as managing the company’s growth and development in an orderly manner. Financial planning provides a guide to management as to how financial resources should be structured, timing, and duration of the assets and liabilities of the company. Financial planning helps ensure that a company’s financial structure required to support the company’s activities as well as the company’s overall objectives.

3. Investment Decisions and Capital Budgeting

Decisions include whether to enter into a particular line of business, whether to change the existing one, whether to expand the existing capacity, whether to modernize the existing capacity, etc. Capital budgeting is the name given to the investments that are in the form of current expenditures whose benefits are expected to be accrued or realized over more than one year. Most major projects proposed in the business sector require a complete analysis of both anticipated benefits and the estimated costs. These analysts usually end up estimating the future free cash flows and figuring out how it will affect the firm’s share price. Failure in terms of making a sound investment decision in the available business enterprise often spells the total undertaking of money, time, energy, and other resources made in the investment decision-making process. Thus, capital budgeting can be viewed as the planning process that facilitates a company or an organization to understand its ability to deploy capital in a business enterprise.

Investment decisions are defined as the decision to acquire real assets or projects. Real assets are expected to provide services for the long term. For example, purchasing fixed assets. Here, acquiring a fixed asset will generate returns over an extended period of time and the investment decision is the primary task of financial management. Companies have to evaluate a large number of investment proposals in order to select the profitable ones. The process of evaluating the firm’s investment in a proposal and deciding whether to accept or reject the proposal is known as capital budgeting. This is a process by which organizations evaluate the long-term investment decisions by taking time to consider and plan about the capital projects a company will undergo in a certain year. It involves the ways of decision-making on the allocation of the funds in order to make the investments which will bear fruits in the future. The firm has to select the most profitable project under capital budgeting. Generally, a firm will invest in nice projects in which they obtain the maximum benefit. In simple words, it is an activity that a company undertakes to determine the right investments in relation to time and size.

4. Financing Decisions and Capital Structure

The decisions about the level and the type of assets and the level and type of liabilities are known as “financing decisions” and “investment decisions” of the firms, respectively. The nature of financing and investment decisions is such that it is difficult to think of one without the consequences of the other. The interaction between these two decisions can be observed from the point of view of accounting, taxation, externalities, monitoring, information asymmetry, and cost of bankruptcy. An “interest tax shield” is a result of debt financing that might change a project with a negative net present value into a positive one. Use of an experimental list of projects has demonstrated that this factor is influential. Indeed, Modigliani and Miller demonstrated that in the absence of any bankruptcy costs, the value of the firm is not influenced by the financing decision.

Companies have various options to finance asset investments. The three forms of financing used in practice are equity, debt, and leasing. Each form has its own advantages and disadvantages which are taken into consideration while making investment and financing decisions. The optimal combination of these forms of financing is called the firm’s capital structure. The capital structure decision focuses on the relative mix of securities being issued. In their seminal work, Modigliani and Miller attempted to investigate whether the capital structure has an impact on the total value of the firm. They explained the information content of dividend policy and debt policy.

5. Risk Management and Financial Controls

i. Risk Management: Risk management shall consider the objectives of the organization and be part of the strategic management process. It is concerned with both the risks entrepreneurs face in trying to achieve profit goals and those that relate to surviving threats such as loss of sales due to competition, escalating or unpredictable costs of labor or materials, environmental standards and a resulting decline in product appeal, or loss of a key part or supplier. Responding to the challenges from institutional investors, companies have also taken a more comprehensive approach to lower the cost of equity, debt, and comply with regulatory and stock exchange rules, and benchmark against industry best risk management practices. With increasing interest for transparency and responsiveness by rating agencies, regulatory bodies, interest groups, media, and the public, the message of actions for firms has become more crucial. On the one hand, there are pressures from institutional investors, investment banks, and large stakeholders to publicly announce and adhere to better corporate governance firm.

Risk management is not merely aimed at minimizing loss, but involves balancing the reward of gaining an expected profit over an acceptable level of risk. Financial controls, on the other hand, ensure that the threats against the financial objectives are being managed effectively. Checks, balances, and segregation of duties are the responsibilities of senior management and cannot be delegated. However, such a high degree of prudence will tend to make the enterprise less competitive unless weighed against. Again, the challenge for financial managers is in striking an appropriate balance commensurate with the enterprise’s strategic positioning. The financial objective is to safeguard the organization’s assets and ensure effective operational, financial, and compliance reliability.