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What is Financial Management? Essential Overview

What is financial management featured image
Strong financial management is central to business success. Image credit: Jason Briscoe

If you’re in business you’ll know that surviving as a company while also investing in growth are two goals you constantly need to balance. This is where financial management becomes essential.

In fact, it is often the main factor determining the success of your business.

At a basic level, if you spend more than you have coming in, you’ll quickly go out of business. On the other hand, if you don’t invest profits properly, you’ll struggle to grow or even stay competitive.

Financial management is all about how you use your resources. This includes directing investment towards business verticals which offer the best return on investment, as well as cutting operation costs.

Let’s take a look at the various aspects of financial management with some essential tips and tricks, to help you achieve optimum financial management, along the way.

What is Financial Management?

Financial management is the process of optimally allocating your business’s funds to their appropriate tasks. This is a responsibility that is exclusive to the top management of your business.

Aspects of financial management diagram
There are many different elements to financial management. Image credit: MtpPLC

Here are some of the fields involved in financial management:

  • Raising capital: These financial decisions are concerned with raising finances for your business taking into consideration the available sources, time available for raising the funds and the resulting returns.
  • Budgeting: This involves making important decisions regarding investments in different assets, services and business verticals.
  • Investment planning: This is the process of outlining your future financial goals and objectives in relation with your financial resources. The goal is to have a general idea of the progress you’re making, as well as providing you with data that you may use to evaluate the effectiveness of your processes.
  • Capital Structure: The documentation of finances for all operations including the sources of funds and any debts created by them.

Before we get into the details of financial management let us discuss the variables commonly associated with it.

  1. Risk: This can either be the potential for financial loss or the possibility of defaulting on a loan
  2. Return on investment (ROI): A return is a profit made on an investment which can either be measured in amounts gained or as a percentage of the money invested. One of the most common methods of measuring return is the ROI to evaluate performance.
  3. Working capital: This is the capital that the business owns that is used to pay for day to day expenses.
  4. Capital structure: This term refers to the distribution of resources in your company caused by equity and debt.
High and low yield capital structures
Different capital structures carry with them different levels of risk. Image credit: CorporateFinanceInstitute

The Purpose of Financial Management

Good financial management provides your business with an adequate supply of resources for your ventures. In turn, this provides you with a good reputation to allow for further growth through investors.

This is why the following factors should be considered when coming up with a financial plan.

1. Investor Approval

Having large return figures is great, however, it is not the only important factor to be considered.

When it comes to investors, your company’s reliability is extremely important. Instead of having large return figures every once in a while, an investor will be much more confident in your business when your returns are consistent over time.

Additionally, having strong communication channels with your investors will help you become more accountable. This also boosts their faith in the success of your ventures which consequently leads to bigger investments.

Finally, transparency is also an important factor since investors expect to have all information and decisions available to them.

2. Process Documentation

In order to optimise your business decisions, it is important that you streamline the process of documenting your financial status.

Keeping all financial records and documentation ensures that you comply with universal accounting standards created by experts aiming to optimise the management of businesses.

Additionally, this is needed to ensure that your tax and regulatory affairs are in order. Keeping a strong paper trail helps you to prove that you’ve complied with local business laws over time.

Financial Management Objectives

When it comes to financial management, it’s crucial to know what you’re trying to achieve. Having a clear understanding of these objectives will allow you to create a much more coherent plan.

Before we get into that, here are some of the common objectives of financial management:

  • Optimisation of expenditure and fund allocation to maximise profits and minimise costs.
  • Maintaining adequate funds for your processes.
  • Calculate and ensure the viability of each process for the investors.
  • Evaluate risks and approve new ventures.
    Streamlining the capital structure in order to ensure a balance between equity and debts.

In order to maintain funding for your ventures, it is important for your business to remain profitable. This can be done through the various ratios for evaluating your business. We will be discussing the most commonly used ratios.

Gross Profit Ratio

The gross profit ratio measures the amount of money left from revenue after paying the costs of the produced goods.

Gross profit ratio
This is the ratio of your gross profits to your revenues. Image credit: Double Entry Bookkeeping.

This is commonly used by evaluators and investors to compare your company to the competition in order to identify the effectiveness of your current processes.

Return on Equity Ratio

This ratio is commonly used by analysts to determine the amount of net income gained compared to the shareholders’ equity in the business. This essentially shows how effectively your business capitalizes on the funds provided by investors.

Return on equity ration
This is the ratio of your net profits to your shareholders' equity. Image credit: Corporate Finance Institute

Comparing the company’s yearly ROE can give a general idea of the company’s growth over the years.

Net Profit Margin Ratio

This simple ratio gives a general idea of how viable your business plan is. It taxes in consideration taxes in order to generally determine how profitable your business is.

In order to improve these ratios, it is important for the business to increase their efficiency in order to minimize costs which in turn increases the profit margin on sales.

Net income ration
This is the ratio of your net income to your revenue. Image credit: Double Entry Bookkeeping

Consequently, having high efficiency also allows your business to obtain a larger share of the market which not only increases your sales but also gives investors more confidence in your business.

Financial Management of a Business

In order to start working on the financial management of your business, it is important to have a management plan that will help you set goals and understand the decisions that need to be made in order to maximise your company’s resources.

1. Finding a Financial Strategy

There are several approaches when it comes to financial management. Every approach is viable and will depend on the nature of your business. In order to come up with a solid financial strategy, the following questions need to be answered:

  • What is the current state of the company?
  • What are the future goals/ objectives?
  • What are the available methods of reaching these goals?
  • What are the involved risks and how will they be managed?
  • What is the planned balance between growing and saving revenue?

It is extremely important to strike a balance between spending and saving your company’s revenue. On one hand, you might be tempted to use all of your profits in order to further grow the business.

However, this leaves you with little working capital to pay for goods and services needed to keep up with the demand. Additionally, some unforeseen circumstances might create unexpected costs.

As such, your business should have an emergency fund in order to survive through difficult times.

2. Creating a Financial Plan

A financial plan uses the previous general strategy to create a customised plan of operation specific to your business.

This helps you have a clear path to follow when making decisions while also allowing for easy communication of objectives which improves the process of managing.

Your financial plan will mostly depend on the following:

  1. Required capital: This is based on the cost of assets necessary for the business to function. Additionally, the capital needs to fund your research and promotional efforts. When considering the necessary capital it is important to consider both long and short-term necessities.
  2. Capital Structure: The amount of risk you are willing to take strongly affects the means by which your assets will be funded. Generally, there are two main capital structures. The first being “Low Leverage” where most of your company’s assets are based on invested equity. Choosing to minimise the amount of debt gives you a much safer business approach However if you are confident in the success of your operations, it is better to opt for a “High Leverage” structure which involves a higher risk and inherently higher rewards.
  3. Financial Policies: Based on your chosen capital structure, you’ll need to set up policies regarding finances. These are the general rules of funding which will ensure that your vision is shared with your managers allowing for more financial management tasks to be delegated to them.
  4. Finding a Financial Manager: After you have set up the financial guidelines for your business, it is important to have a dedicated financial manager in order to ensure that all decisions match your vision. This manager will be responsible for evaluating your company’s current financial status, document it and impose any necessary immediate decision. Here’s a list of the roles that you can expect your financial manager to fulfil.

Financial Management Tools

Financial Management is a process that can be incredibly time-consuming which is why it is important that you ensure that it is being done efficiently.

This is why it is important to ensure that you streamline the process of gathering data, documentation, and analysis in order to allow your business to quickly make decisions in order to keep up with changes in the market.

These tools will help you save valuable time and effort so you can focus on innovation.

1. Accounting Software

First things first, before you can worry about managing your finances, you need to ensure that all the relevant data is available for analysis. This can be done using the various accounting software that will allow you to track invoices, expenses, and even taxes.

There are many accounting tools which will help you automate the process of invoicing customers by allowing you to know when they see your invoice while also automating the process of sending and reminding them of payments.

These are great tools for businesses that do not have a dedicated accounting department.

2. Budgeting Software

Traditionally, business owners used excel to manage their budgeting. However, statistics show that a large portion of these spreadsheets contain errors since excel offers no “Logic checks”.

This is why modern tools have been created to help you more easily manage your budgeting while also providing you with the convenience of having your sheets in the cloud which allows for easy collaboration while also letting you access them from anywhere.

3. Financial Software

Now that you have your inputs ready, it is important to have a solid tool that gathers all that data in one place for ease of access. Additionally, these tools can be set up to automatically calculate key performance markers that will give you a real-time indication of your company’s financial “health”.

You should choose a tool that provides you with a visual representation of all the relevant data. These tools allow you to import data from a wide variety of services functioning as a hub for all your company’s data.

Understanding Financial Management

Financial management is the process of allocating funds to their appropriate tasks, ensuring your business is utilizing resources to its fullest potential. The result? Maximising the profits and establishing you in your relevant market.

Financial management also ensures that your company is positively regarded by investors allowing you to obtain more investments that will help your business grow exponentially.
We discussed the several necessary steps needed to begin financial management.

First, we need to create a plan that involves the required fund needed for normal operations, the sources of funding and the general capital structure that you would like to impose. Then, we outlined how you can obtain these funds whether through equity or debts.

Finally, we discussed some of the useful tools to help you with financial management in order to save your precious time and effort.

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