Management of Financial Resources for Sustained Success
Management of Financial Resources for Sustained Success
Financial resource is a very important resource which an organization needs not only for its functioning but also for its sustained success. For this purpose the organization need to have systems in place that help it to both fund its ambitions and also to manage its financial resources in support of its daily operations, including funding for improvement activities.
Normally financial controls are applied by the management which enable it to take a proactive management position in the business. The three most important financial controls are namely (i) the balance sheet, (ii) the profit and loss statement, and (iii) the cash flow statement. But the management of financial resources is much more than the exercising of the financial controls.
The management of the financial resources is an important function of the management in the organization. This financial management starts with the financial planning. Financial planning is a continuous process of directing and allocating financial resources to meet strategic goals and objectives. The output from financial planning normally takes the form of budgets.
Financial planning works from the strategic and business plans to identify what financial resources are needed to obtain and develop the resources to achieve the goals in the two types of plans. Typically, financial planning results in very relevant and realistic budgets.
Financial planning normally starts at the top of the organization and has basically two components namely (i) planning for operations, and (ii) planning for financing. Operating people focus on production and sales while financial planners are interested in how to finance the operations. Financial planning is the process that encompasses both operations and financing.
In a normal organization, typical financial functions within an organization are a host of the accounting activities such as processing of payables, customer invoicing, payroll administration, and financial reporting etc. Usually over 70 % of all financial management functions are spent on the processing of these accounting transactions. Less than 20 % of financial management is spent on the real financial management, things like performance measurement, risk management, forecasting, strategic planning, investment analysis, and competitive intelligence etc. All of these things are where real value comes from. Therefore, one of the first steps for financial functions is to take when it comes to creating value is to move out of the traditional accounting box and into real financial management.
One of the most important steps for making the financial function a source of value is to depart from the traditional accounting model. This requires a different way of thinking about how to measure the performance. In financial management, the emphasis is on increasing value and not necessarily earnings. In order to make this transition over to value creation, it is important to understand why accounting runs contrary to value creation. This value is the market value of the organization.
Market values are determined by the future expected cash flows that will be generated over the life of the business. The problem with the traditional accounting model is that all of the emphasis is on the earnings, especially the quantity of earnings. What counts in valuations is the quality of the earnings. In financial management, the economic performance (such as cash flows) is important as opposed to accounting performance (such as net income). Accounting distorts true measures of value and then the economic performance is usually not understood.
Generally people look to financial statements when measuring performance. But the balance sheet provides only the book values of assets and not their market values. The balance sheet discloses total amounts invested. It does not tell anything about the success of these investments i.e. whether the assets earned more than the cost of capital. Hence the financial statements are not the true barometer for measuring performance.
It has been said that one must measure what one expect to manage and accomplish. Without measurement, one has no reference to work with and thus, he tends to operate in the dark. One way of establishing references and managing the financial affairs of the organization is to use ratios. Ratios are simply relationships between two financial balances or financial calculations. These relationships establish the references for the management to understand how well the organization is performing financially. Ratios also extend the traditional way of measuring financial performance i.e. relying on financial statements. By applying ratios to a set of financial statements, one can better understand financial performance.
The organization need to know the most important financial performance parameters such as cash flow, turnover, return on equity (ROE), liquidity ratios etc. Further financial analysis is important since it can tell a lot about the financial health of the organization. Without this analysis, the organizational management may end up staring at a bunch of numbers on budgets, cash flow projections and profit and loss statements. Analysis includes cash flow analysis and budget deviation analysis. Analysis also includes balance sheet analysis and income statement analysis. There are some techniques and tools to help in financial analysis, for example, profit analysis, break-even analysis and ratios analysis that can substantially help to simplify and streamline financial analysis.
The ratio analysis is important for the financial management. Return on equity is one of the ratio which is at the heart of the financial management since the organization wants to maximize returns for the shareholders of the organization. Further there are three ways of influencing ROE. It can change the profit margins, it can change the turnover of assets, or it can change the use of financial leverage. The organization is to look into the methods which can influence the three components of ROE.
There are several detail ratios that the organization can monitor, such as leverage ratio, liquidity ratio, turnover ratios, profitability ratio, quick ratio, current ratio, and debt to equity ratio etc. Detail ratios help the organization to monitor specific financial conditions, such as liquidity or profitability. Ratios are best used when compared or benchmarked against another reference, such as an industry standard or ‘best in class’ within the industry. This type of comparison helps the organization to establish financial goals and identify problem areas. It also can use vertical and horizontal analysis for easy identification of changes within financial balances.
However these ratios do have limitations. After all, ratios are usually derived from financial statements and financial statements have serious limitations. Additionally, comparisons are usually difficult because of operating and financial differences between organizations. None the less, for the purpose of analyzing a set of financial statements, ratio analysis is probably one of the most popular approaches to understanding financial performance.
The organization, for its performance, is also to be aware of other measures which are important for the organisation, given the nature of its business. Use of tools such as risk management, discounted cash flow (DCF), sensitivity analysis, internal rate of return (IRR), cost benefit analysis (CBA), economic value added (EVA) and activity based costing (ABC) can all help the organisation to better manage its financial capabilities. These measures are described below. Fig 1 shows different analysis tools and financial ratios for monitoring.
Fig 1 Analysis tools and Financial ratios
Risk management is attempting to identify and then manage threats that could severely impact or bring down the organization. Generally, this involves reviewing operations of the organization, identifying potential threats to the organization and the likelihood of their occurrence, and then taking appropriate actions to address the most likely threats. Traditionally, under management of financial resources , risk management is thought of as mostly a matter of getting the right insurance coverage. Further through, accurate, and regular audits reduce threats and risks.
Discounted cash flow
DCF analysis is a method of valuing a project, organization, or asset using the concepts of the time value of money. All future cash flows are estimated and discounted by using cost of capital to give their present values. The sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question.
Using DCF analysis to compute the NPV takes as input cash flows and a discount rate and gives as output a present value. The opposite process takes cash flows and a price (present value) as inputs, and provides as output the discount rate.
The most widely used method of discounting is exponential discounting, which values future cash flows as ‘how much money would have to be invested currently, at a given rate of return, to yield the cash flow in future’.
Sensitive analysis is a technique used to determine how different values of an independent variable impacts a particular dependent variable under a given set of assumptions. It is an analysis that finds out how sensitive an output is to any change in an input while keeping other inputs constant. This technique is used within specific boundaries that will depend on one or more input variables.
In corporate finance, it refers to an analysis of how each of the input variables in a capital budgeting decision (such as discount rate, cash flows growth rate, tax rate, etc.) affects the net present value, IRR or any other output while keeping other variables constant.
Sensitivity analysis is useful because it tells the organizational management how dependent the output value is on each input. It gives the management an idea of how much room it has for each variable to go adverse. It helps in assessing risk.
Internal rate of return
The IRR is a rate of return used in capital budgeting to measure and compare the profitability of investments. In the context of savings and loans, the IRR is also called the effective interest rate. The term ‘internal’ refers to the fact that its calculation does not incorporate external or environmental factors (e.g., the interest rate or inflation).
The IRR on an investment is the annualized effective compounded return rate that makes the NPV of all cash flows (both positive and negative) from a particular investment equal to zero. It can also be defined as the discount rate at which the present value of all future cash flow is equal to the initial investment or in other words the rate at which an investment breaks even.
In more specific terms, the IRR of an investment is the discount rate at which the net present value of costs (negative cash flows) of the investment equals the net present value of the benefits (positive cash flows) of the investment.
IRR calculations are commonly used to evaluate the desirability of investments or projects. The higher a project’s IRR, the more desirable it is to undertake the project.
Because the IRR is a rate quantity, it is an indicator of the efficiency, quality, or yield of an investment.
Cost benefit analysis
CBA is a systematic approach to estimating the strengths and weaknesses of alternatives that satisfy transactions, activities or functional requirements for a business. It is a technique that is used to determine options that provide the best approach for the adoption and practice in terms of benefits in labour, time and cost savings etc. The CBA is also defined as a systematic process for calculating and comparing benefits and costs of a project or decision.
Broadly, CBA has two purposes namely (i) to determine if it is a sound investment/decision (justification/feasibility), and (ii) to provide a basis for comparing projects. It involves comparing the total expected cost of each option against the total expected benefits, to see whether the benefits outweigh the costs, and by how much.
In CBA, benefits and costs are expressed in monetary terms, and are adjusted for the time value of the money, , so that all flows of benefits and flows of project costs over time (which tend to occur at different points in time) are expressed on a common basis in terms of their NPV.
CBA is often used to appraise the desirability of a given policy. It is an analysis of the expected balance of benefits and costs, including an account of foregone alternatives and the status quo. CBA helps predict whether the benefits of a policy outweigh its costs, and by how much relative to other alternatives (i.e. one can rank alternate policies in terms of the cost benefit ratio).
Economic value added
The most widely used approach to measure the value creation is EVA. In corporate finance, EVA is an estimate of the organization’s economic profit. It is the value created in excess of the required return of the organization’s investors. EVA is the profit earned by the organization less the cost of financing the organization’s capital. The idea is that value is created when the return on the organization’s economic capital employed is greater than the cost of that capital.
The idea behind EVA is rooted in economic income as opposed to accounting income. As economic income moves up or down, so goes the value of the business. The problem is that calculating economic income is not easy. It needs hundreds of adjustments. For example, under traditional accounting we would expense cash disbursed for research and development (R & D), but in arriving at economic income we would capitalize R & D since it provides a future economic benefit. The list of adjustments from accounting to economic is extensive such as depreciation, gains / losses, reserves, deferred taxes, etc. Since EVA is at the center of value based management, it is important to keep the number of adjustments to those material items that significantly distort value.
Activity based costing
ABC is a costing methodology that identifies activities in an organization and assigns the cost of each activity with resources to all products and services according to the actual consumption by each. This model assigns more indirect costs (overhead) into direct costs compared to conventional costing.
ABC is an approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs. Resources are assigned to activities, and activities to cost objects based on consumption estimates. The latter utilizes cost drivers to attach activity costs to outputs.
With ABC, the organization can soundly estimate the cost elements of entire products, activities and services. ABC helps the organization in taking such decisions like (i) identify and eliminate those products and services that are unprofitable and lower the prices of those that are overpriced, (ii) identify and eliminate production or service processes that are ineffective and allocate processing concepts that lead to the very same product at a better yield.
In the organization, the ABC methodology assigns the organizational resource costs through activities to the products and services provided to its customers. ABC is generally used as a tool for understanding product and customer cost and profitability based on the production or performing processes. As such, ABC has predominantly been used to support strategic decisions such as pricing, outsourcing, identification and measurement of process improvement initiatives.
ABC is applicable throughout organization’s financing, costing and accounting.