Fundamentals of Financial Management That You Must Know

Financial management is a process of monitoring, protecting, controlling and reporting a company's financial resources. Accountants and finance teams in the company are responsible for managing finances including loans, debts, investments, bank transactions and other sources of funding. Finance teams ensure that the company follows regulations, stay solvent as well as profitable. In this article, we will be discussing the fundamentals of financial management that play a crucial role in improving a company's financial health.

Table of Contents

• What is Financial Management?
• Fundamentals of financial management
• Objectives of financial management
• Functions of financial management

What is Financial Management?

Financial management is a process of planning and controlling the financial resources of a firm. It is an important area of study in finance since it helps managers in making important financial decisions for the firm. Financial management is a long-term decision-making process that involves planning, and fund allocation among other important steps. Financial management not only helps businesses but also, can give a boost to the economy, industry and commerce. 

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Must Learn Fundamentals of Financial Management

It is important to learn the following concepts to learn and become skilled at financial management:

1. Objectives of the Firm: The primary objective of the firm is to maximize shareholder wealth, ensuring the long-term sustainability and growth of the business. This is achieved through efficient management of resources, profit maximization, and strategic decision-making.

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1. Chief Financial Officer’s Role: CFOs oversee every aspect of an organization's financial function. They are responsible for financial management in the company. This includes managing budgets, monitoring the cash flow, optimizing the capital structure, and ensuring an effective utilization of financial resources. All this is done to increase the profitability of the business for growth.
2. Risk-Return Relationship: This fundamental principle in finance states that the higher the potential returns are, higher the risk is as well. This means that taking higher risks is crucial for gaining higher risks. This is where CFOs play an important role as they evaluate investment opportunities. CFOs aim to create a diversified investment portfolio to lower the overall risk of the portfolio without giving up on potential returns.
3. Time value of money (TVM): This means that as the time progresses the purchasing power of money goes down. In simple words, it means that you can buy less with the same amount of money in future. TVM helps in determining the present value of future cash flows. By discounting future cash flows back to the present, financial managers can assess the current worth of the project, investment or cash flows. This helps in making better investment decisions.
4. Compounding: It is a powerful concept in financial management. It involves earning returns on the original investment. Additionally, it earns returns on accumulated interest or returns. This allows investments to grow exponentially over time. As earnings are reinvested, they generate additional returns. Consequently, the overall investment grows at an increasing rate. This can significantly boost wealth accumulation over the long term.
5. Discounting techniques: These techniques are important in financial management for evaluating the present value of future cash flows. They assist in assessing the profitability, risk, and feasibility of investment decisions. By discounting future cash flows back to their present value, financial managers can make informed decisions about investments, projects, and financing options. This helps in determining the net present value (NPV) of potential investments, which is essential for capital budgeting and strategic planning. 
6. Sources of finance: These sources are important in financial management by providing the necessary funds for business operations, investments, and growth initiatives. They help in optimizing capital structure, managing financial risks, and achieving strategic objectives. Finance sources provide the funds needed to invest in new projects, acquisitions, research and development, or expansion initiatives. Financial managers evaluate different funding options to ensure the most cost-effective and suitable financing for investment opportunities.
7. Cost of capital: The cost of capital is important in financial management as it helps in making decisions on investments, financing, and capital structure. It represents the minimum rate of return investors require. Financial managers compare expected returns to the cost of capital. Acceptable projects exceed this rate; others may be rejected.
8. Working Capital: Proper working capital management supports business growth and expansion initiatives. This is done by ensuring the availability of resources to fund investments and capitalize on growth opportunities. Financial managers assess the company's working capital needs in relation to its growth projections and allocate resources to support sustainable expansion.
9. Weighted average cost of capital (WACC): It facilitates financial management by providing a benchmark to evaluate investing opportunities. Financial managers utilize WACC to discount cash flows, helping determine project viability. This metric also guides decisions regarding capital structure, balancing cost and risk.

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Objectives of Financial Management

The following are the objectives of financial management:

• Compliant with Regulations: Ensuring business operations are in line with legal and regulatory requirements to avoid legal issues and build customer trust.
• Profit Maximization: Managing funds to increase earnings per share (EPS) and profits, focusing on activities that boost profitability.
• Fund Mobilization: Gathering and allocating funds effectively to ensure the business has sufficient capital for operations and investments.
• Capital Assessment: Evaluating costs and capital, including assets and marketing costs, to determine the minimum acceptable rate of return on investments.
• Formulation of Policies: Developing policies for lending, borrowing, and cash management to ensure smooth business operations.
• Liquidity within the Company: Managing cash flow to maintain financial stability and ensure sufficient liquidity for operational needs.
• Building Capital Structure: Creating a balanced mix of equity and debt to finance operations and make financial decisions.
• Utilization of Resources: Optimizing financial resources by managing funds like debentures, bonds, and shares to maximize benefits.
• Contingency Plan: Preparing for financial crises by assessing risks and creating plans to safeguard the company’s financial health.
• Identifying Profitable Investments: Identifying and investing in opportunities that align with the company’s business model for maximum ROI.
• Allocation of Funds: Distributing funds across various business activities to ensure each operation is adequately financed.
• Risk Management: Identifying and mitigating threats to capital, profits, and revenue to ensure the organization’s financial stability.

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Functions of Financial Management

The following are the functions of financial management that are discussed briefly over here:

• Financial Planning and Forecasting: Financial managers estimate future variables for planning actions like budgeting, investing, and saving. This involves analyzing sales forecasts, pro forma statements, and financing modes.
• Cash Management: This function involves deciding how to allocate available cash, whether for repaying debts, covering bills, or investing in inventory to meet current liabilities.
• Cash Flow Forecasting: By estimating future sales and expenses, businesses can predict their cash flow status, helping them plan for expansion and manage periods of cash shortfall.
• Estimating Capital Expenses: Financial managers must account for promotional, current assets, and fixed asset expenses to accurately estimate total capital needs, considering factors like inflation and asset valuation.
• Determining Capital Structure: Deciding the mix of debt and equity financing involves considering loan covenants, sustainability, financial slack, and tax shields to ensure long-term company growth and flexibility.
• Choosing Sources of Funds: After evaluating the pros and cons of various funding sources and the financing period, the appropriate mix of equity, loans, and other financing methods is selected.
• Procurement of Funds: This involves securing capital through equity, IPOs, or loans from financial institutions, based on the chosen sources of funds and financing needs.
• Investment of Funds: The challenge lies in investing funds wisely to maximize profits, using tools like NPV and IRR to assess risk and return, guided by principles of profitability, safety, and liquidity.
• Surplus Disposal: Deciding how to handle surplus profits, whether by reinvesting in the business, distributing as dividends, or offering bonuses, to balance growth and shareholder value.