Every business works with limited resources — financial management is simply the process of planning and monitoring the use of a company’s financial resources. The goal of implementing sound financial practices is to use resources effectively to achieve the organization’s objectives.
Financial management activities can include cash flow management, profitability analysis, and risk management.
This guide will explain these fundamental concepts behind sound financial business management and how they apply to your company. Here’s a quick look at what we’ll cover:
- What financial management means for your business
- Why financial management is essential in 2021
- 6 fundamental concepts for sound management
- Challenges of implementing these concepts
- How to get started with financial management
Let’s begin with how financial management applies to your business.
What is financial management?
Financial management helps owners plan for the future, using reasonable assumptions regarding production, sales, and costs. Financial managers use these metrics to assess risks and make changes to improve company performance.
You can apply financial controls to manage both liquidity and solvency, which are metrics used to manage cash.
When you consider liquidity, think about your company checkbook.
Liquidity refers to the ability to generate sufficient current assets to pay current liabilities. If you can’t generate enough current assets, you may need to borrow money to fund your business operations and pay current liabilities.
Current assets include cash and assets that will be converted into cash within a year. Accounts receivable and inventory are often a firm’s largest current asset balances. Current liabilities include accounts payable and the current portion of long-term debt that must be paid within a year.
The working capital formula is current assets less current liabilities, and you need to maintain a positive working capital balance.
Liquidity has a short-term focus, while solvency measures long-term financial health.
Working with solvency
Solvency is the ability to generate profits over some years, so a business can continue to purchase assets and make payments on long-term debt.
Successful business owners have to manage both liquidity and solvency. You need to get cash in the door over the next several months and generate profits to repay bank loans.
You can use ratio analysis to assess your firm’s liquidity, solvency, and other factors. If sound financial management helps companies plan for the future, accounting practices that produce accurate financial statements is what enables them to do so.
What is the difference between financial management and accounting?
Financial management requires both finance and accounting knowledge. Owners use the financial statements and corporate finance concepts, including financial analysis.
Accounting refers to these specific tasks:
- Gather source documents: Accountants use vendor invoices, purchase orders, and bank statements to document transactions.
- Post transactions: Businesses post journal entries to record transactions.
- Record adjustments: At the end of each month, accountants post adjusting entries to record revenue and expenses in the proper period.
- Generate financial statements: The trial balance is a list of each account and the current balance. Companies use the adjusted trial balance to generate the balance sheet, income statement, and statement of cash flow.
When a business produces timely financial statements with quality accounting practices, managers can use the data to make informed decisions. Financial management includes both accounting and financial data. With this in mind, here’s why accurate accounting and financial data is so important in today’s business environment.
Why proper financial management is essential in 2021
The CBIZ Main Street Index noted that 43% of small and mid-sized US businesses reported a significant to severe impact due to the COVID-19 pandemic. Many companies have operated as a loss or break-even during the pandemic, and some firms have lower cash balances.
A business requires assets to create and deliver a product or service to customers. When you create a plan to purchase or replace fixed assets, the process is called capital budgeting. Budgeting is more difficult when a business isn’t profitable and collects less cash, and financial management becomes more important.
A challenging business environment may require some companies to raise additional capital. A firm’s capital structure refers to the percentage of capital raised from issuing stock or debt. Here are two financial management decisions related to capital structure:
- Financing debt: Does your business generate consistent earnings that give you the ability to service debt payments? If you have a track record of profitability, you may be able to finance principal and interest payments on debt.
- Pay a dividend or retain earnings: A dividend is a share of company earnings paid to stakeholders who own stock. When you generate earnings, you can choose to pay a dividend, retained earnings for use in the business, or a combination of both.
Sound financial management can create a capital structure that enables a business to respond positively in a challenging business environment. Here are the financial concepts your business should be intimately familiar with if you’re looking to thrive in 2021.
The six most important financial management fundamentals
There are dozens of financial management tasks, but you need to first address the fundamentals. Here are the six most important financial management concepts and how to apply them to your growing business.
1. Budgeting and forecasting
You should create a formal budgeting process and complete the budget before the start of the next year. Assume, for example, that you own a manufacturing business. Use these steps to start creating a budget:
- Sales: Forecast annual unit sales for each product.
- Production: Determine labor costs, raw materials, and overhead costs based on the sales forecast. Procurement costs depend on sales.
- Cash management: Project cash inflows and outflows, based on cash receipts from customers, and cash payments for production and other costs.
Add detail regarding costs incurred for marketing, sales, and to manage your office. A budget rarely matches your actual results but does provide a starting point for business management.
Managing cash flows is just as important as generating a profit.
2. Managing cash flow
A business must produce sufficient cash inflows to purchase raw materials, finance payroll, and pay for marketing costs. The accounts receivable turnover ratio is a great metric to manage cash flow.
It’s a common business problem: your sales are growing, but you’re not collecting payments fast enough. Eventually, you may run short on cash. Monitor the accounts receivable turnover ratio to manage cash, using this formula:
(Net annual credit sales) / (average accounts receivable)
Let’s define each component of the formula:
- Credit sales: Sales to customers who don’t pay immediately
- Net credit sales: Credit sales less any uncollectible balances
- Average accounts receivable: (Beginning plus ending balance for a month or year), divided by two
A well-managed business can increase credit sales and keep the accounts receivable balance at a reasonable level. If you can increase the turnover ratio, you’ll collect receivables at a faster rate.
When you apply financial management concepts to your business, you can manage debt, use assets efficiently, control inventory costs, and assess profitability.
3. Monitoring debt and debt payments
Financial management helps you to manage risk, including the risk of carrying too much debt. Some businesses can’t generate enough cash to finance the interest payments on debt. To avoid this issue, use the debt to equity ratio. Here’s the formula for the ratio:
(Total liabilities / total equity)
This ratio tracks increases and decreases in liabilities as a percentage of equity. Total liabilities include current liabilities (such as accounts payable) and long-term debt.
If liabilities are increasing at a faster rate than equity, your firm may be taking on too much debt.
4. Managing inventory
If you operate a retail or wholesale business, inventory may be the biggest asset balance on the balance sheet. Inventory may require a big cash investment, and you can use the inventory turnover ratio to monitor inventory and cash collections.
This ratio is the cost of goods sold divided by average inventory.
Your goal is to increase sales (which increases the cost of goods sold) and minimize inventory costs. Assume that a firm generates $2,000,000 in sales and that the average inventory balance is $200,000.
The turnover ratio is 10 ($2,000,000 / $200,000).
Suppose the business can produce the same $2,000,000 in sales with a $100,000 inventory investment; the ratio increases to 20. Manage inventory using this ratio.
5. Using assets efficiently
How efficiently do you use assets to generate revenue? Use the return on assets (ROA) formula to answer that question. The formula is:
(Net income) / (average total assets)
Well-managed companies can increase the profit generated from each dollar of assets. If you understand how well you use assets, you can make better investment decisions down the road.
Let’s say that a tree service business uses a $20,000 truck that carries $5,000 in equipment. If the company can increase the profit generated from using the truck by $10,000, the firm increases ROA.
6. Assessing profitability, rewarding shareholders
You can assess profitability using the earnings per share (EPS) formula:
(Net income available to common shareholders) / (average common stock shares outstanding)
EPS measures how much profit a business generates for each share of common stock. If you can produce more earnings per share, the common stock is more valuable. When you increase EPS, you can pay a portion of earnings as a dividend to shareholders and retain some earnings for use in the business.
As you incorporate more financial management concepts into your business workflows, here are some possible headwinds to be aware of so you don’t get sidetracked.
Challenges of implementing financial management best practices
Business owners may need to address these factors when they work through financial management issues:
- Seasonality: Some retailers generate 50% or more of their annual sales in the last few months of the year. Seasonality makes it more difficult to plan cash inflows and outflows.
- Product life cycles: A product’s life cycle has a big impact on sales forecasting. If you sell a product that is losing market share to competitors or is becoming outdated, projecting sales is a challenge.
- Determining benchmarks for analysis: Companies use benchmarks to assess their performance, and finding the right benchmarks may be difficult. Ideally, you should find companies in your industry and firms with a similar level of annual sales. If you’re struggling to find benchmarks, ask a CPA knowledgeable about your industry for help.
Before you dive into more complex financial management concepts with your team, try to identify any obstacles before starting the process. When you do decide to test the waters, here are some best practices to get off on the right foot.
How to start using sound financial management practices in your business
Follow these steps to start using financial management concepts in your business:
- Assign accounting roles: Clearly define the accounting roles performed by your bookkeeper, accountant, and possibly by a CFO. Defining roles ensures that the accounting work gets completed promptly, so you can create financial statements.
- Procedures manual: Document every routine task that you must complete in a procedures manual. The manual states how each task is performed, who is responsible, and how often the work is completed. Make the manual available to your entire staff, and update the document as needed.
- Formalizing the budgeting process: The procedures manual should include instructions for the budgeting process. Give your staff time to work on the process before year-end, and hold your employees accountable. Don’t end the year without having a budget in place.
Financial management requires time and effort, but the benefits far outweigh the costs involved.
Taking advantage of financial management concepts can help your business plan for the future and prepare for success. Budgeting and forecasting software tools simplify the financial management process, enabling your business to plan for multiple scenarios. With accounting software you can generate the financial reporting you need with customizable, built-in reports to help your plan for the future, whatever may come.
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