Financial Management

Financial analysis

Managers use accounting ratios to assess profitability, liquidity, solvency (e.g. gearing ratio) and management efficiency (e.g. inventory turnover, trade receivables collection period).

Budgeting

A budget is a financial plan for a future period expressed in money terms. Budgetary control compares actual results with the budget:

• A favourable variance raises profit (e.g. actual cost below budget).
• An adverse variance reduces profit (e.g. actual sales below budget).

Managers then find the causes and take remedial actions.

A cash budget forecasts cash receipts and payments:

$\text{Closing cash balance} = \text{Opening cash balance} + \text{Cash receipts} - \text{Cash payments}$

Non-cash items such as depreciation are excluded.

Sources of financing

	Short-term	Long-term
Debt	Bank overdraft, trade credit, short-term loans	Bank loans, mortgage loans, debentures, leasing
Equity		Issue of ordinary shares, retained profits

• Internal financing: retained profits, selling unused assets, tighter working capital management.
• External financing: borrowing, issuing shares or debentures.

	Equity (ordinary shares)	Debt (loans, debentures)
Return	Dividends at the directors' discretion	Interest must be paid
Repayment	Not repayable	Repayable on maturity
Control	New shareholders have votes, so control is diluted	No voting rights
Tax	Dividends paid from after-tax profit	Interest is tax-deductible

Capital investment appraisal

• Accounting rate of return (ARR) = average annual profit ÷ average investment × 100%.
• Payback period: the time taken for net cash inflows to repay the initial investment.
• Net present value (NPV) = present value of net cash inflows − initial investment; accept if positive.
• Internal rate of return (IRR): the discount rate at which NPV = 0.

Non-financial factors: impact on staff, the environment, the firm's image, and the reliability of forecasts.

Working capital management

$\text{Working capital} = \text{Current assets} - \text{Current liabilities}$

• Cash management: keep enough cash to pay debts as they fall due.
• Accounts receivable management: a credit policy (credit standards, credit period, collection) balances sales growth against bad debts and money tied up.
• Inventory management: use the economic order quantity and a re-order level to balance holding and ordering costs.

Risk management

• Pure risk (only loss or no loss, e.g. fire) versus speculative risk (loss or gain, e.g. investing).
• Risk control strategies: avoid, reduce, retain or transfer (e.g. by buying insurance).