Financial Management - How to manage your finances effectively?

Financial Management

Financial management deals with procurement of funds and effective utilization of funds in business. Financial management is that managerial activity which is concerned with the planning and controlling of the firm’s financial resources. It is an integrated decision making process concerned with acquiring, financing and managing assets to accomplish the overall goal of a business organization. It can also be stated as the process of planning decisions in order to maximize the shareholder’s wealth. Financial managers have a major role in cash management, acquisition of funds and in all aspects of raising and allocating capital. As far as business organizations are concerned, the objective of financial management is to maximize the value of business.

“Financial management comprises the forecasting, planning, organizing, directing, coordinating and controlling of all activities relating to acquisition and application of financial resources of an undertaking in keeping with its financial objective.”

The main aspects of the financial management are-

      1.  Procurement of funds

      2.  Effective utilization of funds to achieve business objectives

Procurement of funds

Funds can be obtained from various sources like equity, preference capital, debentures, term loans, etc. funds procured from various sources have different characteristics in terms of risk, cost and control. Procurement funds involves identification of source of finance, determination of finance mix, raising of funds, divisions of profit between dividends and retention of profits i.e. internal fund generation.

Effective utilization of funds

Funds are procured at a cost. Hence it is crucial to employ them properly and profitably. The finance manager is responsible not only for procurement of funds but also for its effective utilization. He identifies the area where funds remain idle and why they are not used properly.

Finance functions

The long term finance functions are divided into three major decisions, viz, investment, financing and dividend decisions. It is correct to say that these decisions are inter-related because the underlying objectives of these three decisions is same i.e. maximization of shareholders wealth. The decision to invest in a new project needs the finance for the investments. The financing decisions, in turn, is influenced by and influences dividends decisions because retained earnings used in internal financing deprive share-holders of their dividends. An efficient financial management can ensure optimal joint decisions. Generally, short term finance decisions include management of working capital i.e. management of current asset and current liabilities.

The objectives of financial management are Profit Maximization for short term and Wealth Maximization for long term. Financial management is must for survival of business, else, capital is lost. It is essential for growth and development of business. It impacts on society through factor payments. Shareholders wealth are the result of cost benefit analysis adjusted with their timing and risk i.e. time value of money. The objective of a firm should be maximize its value or wealth. Business enterprise may follow some goals like achieving a higher growth rate, attaining a larger market share, gaining leadership in the market in terms of product and technology, promoting employee welfare, increasing customer satisfaction, etc.

Financial Distress and Insolvency

There are various factors like price of the product/services, demand, and price of inputs e.g. raw material, labour, etc. which is to be managed by an organization on a continuous basis likewise, the proportion of debt also needs to be managed by an organization very carefully. Higher debt requires higher interest and if the cash inflow is not sufficient then it will put lot of pressure to the organization. Both short term and long term creditors will put stress to the firm. If all the above factors are not well managed by the firm, it can create situation known as ‘distress.’ “So financial distress is a position where cash inflows of a firm are inadequate to meet all its current obligations.” If distress continues for a long period of time, firm may have to sell its asset, even many times at a price lower than market price. Further when revenue is inadequate to revive the situation, firm will not be able to meet its obligations and may become insolvent. “So, insolvency basically means inability of a firm to repay various debts and is a result of continuous financial distress.”

Agency Problem and Agency Cost

Incorporates structure, owners are not active in management so, there is a separation between owner/shareholders and managers. In theory managers should act in the best interest of shareholders, however in reality, managers may try to maximize their individual goal like salary, perks, etc. So there is a principle agent relationship between managers and owners, which is known as agency problems.

“Agency problem is the chances that managers may place personal goals ahead of the goal of owners.”

“Agency cost is the additional cost borne by the shareholders to monitor the manager and control their behavior so as to maximize shareholders wealth.”

Generally costs are of four types

1.  Monitoring

2.  Bonding

3.  Opportunity

4.  Structuring

The agency problem arises if manager’s interests are not aligned to the interest of the debt lender and equity investors. The agency problem of debt lender would be addressed by imposing negative covenants i.e. the managers cannot borrow beyond a point. This is one of the most important concepts of modern day finance and the application of this would be applied in the Credit Risk Management of Bank, Fund raising, Valuing Distressed companies.

Managerial compensation is linked to profit of the company to some extent and also with long term objectives of the company. Employee is also designed to address the issue with the underlying assumption that maximization of the stock price is the objective of the investors. Effective monitoring can be done.

   

Feel free to mention your thoughts and suggestions in the comment section.

Also if you want to know how to invest your money then do read this article;
Money investment in an easy way.