What is financial management? You understand that a business is created to sell a good or a service and make a profit. Producing, marketing, and distributing products are important aspects of generating a profit. Even more important, however, is a company’s ability to manage the financial resources required to accomplish these tasks. Without sound financial management, there is no business!

Situations like the one facing Cindy Li’s company are not uncommon. Good financial controls and planning enable a company, regardless of its size or how long it has existed, to respond to unexpected challenges or planned expansions. Just as you might save money to ensure that you can pay next month’s rent or make plans for a big purchase such as a car or home, businesses must also plan and save. To remain competitive, businesses make large strategic investments, such as buying or building new factories or investing in more advanced machinery or technology. At the same time, businesses also must ensure they can pay their monthly bills.

Financial management is the strategic planning and budgeting of funds for a firm’s short-term needs (one year or less) and long-term needs (more than one year). Financial management requires a firm to implement controls to ensure its money and budgets are managed in a way that allows it to reach its financial goals. Tracking past financial transactions, controlling current revenue and expenses, and planning for a company’s future financial needs are the foundation of financial management.

All successfully run businesses have people designated to manage the financial decisions and transactions of the company. In many small companies, the owner makes most of the financial decisions and transactions, with or without the help of outside consultants. But as a company grows, it is often necessary to establish a finance department. Generally, the finance department has two divisions: accounting and financial management. Accounting, which we’ll cover later in this chapter, is concerned primarily with creating historically accurate financial reports for investors and lenders and for those who make financial decisions for the company.

What is the role of a financial manager? A financial manager is responsible for the financial health of a company. In smaller companies, the financial manager may be the owner or someone who may have other responsibilities within the business. More established or larger companies often have a chief financial officer (CFO). The CFO is a senior manager who is responsible for overseeing the company’s financial activities, ultimately to ensure that the company is profitable, and is using its financial resources shrewdly. CFOs are necessary when a business’s finances become complicated or when the business is in a high growth phase and extra financial expertise and planning is critical. As shown in Figure 15.1, a financial manager or CFO, is responsible for planning and managing a company’s financial resources, including the following:

Figure 15.1

Financial Management Responsibilities

• Developing plans that outline a company’s financial short- and long-term needs

• Defining the sources and uses of funds needed to reach goals

• Monitoring the cash flow of a company to ensure obligations are paid in a timely and efficient manner and funds owed to the company are collected efficiently

• Investing any excess funds so those funds can grow and be used for future developments

• Raising capital for future growth and expansion

• Evaluating financial outcomes and expectations and generating financial reports

How does the financial manager plan for a firm’s financial needs? Because a company’s financial needs are both short and long term in nature, a financial manager must plan for both by developing a financial plan. In addition, a financial manager must ensure the firm’s funds are used optimally and the company is ultimately profitable. To meet these objectives, a financial manager oversees three important processes: forecasting financial needs, developing budgets and plans to meet those needs, and establishing controls to ensure that the budgets and plans are being followed.

What is involved in planning for and managing a firm’s financial needs? Good financial management begins with a financial plan. As shown in Figure 15.2, a financial plan uses information from a firm’s overall corporate strategic plan, financial statements, and external financial environment to identify the amounts and types of capital the company will need in the short and long term.

Figure 15.2

The Financial Planning Process

For example, referring back to the opening scenario, a priority among the goals Cindy Li’s company’s board of directors and management team discussed was to produce a new device to go head-to-head with a competitor’s product. As the head financial manager, it is Cindy’s responsibility to communicate with various departments of the company, such as production, marketing, and human resources, to determine the financial impact this strategy will have on these areas of the organization. Among the questions she will have to answer are the following: How much product do we need to sell? Do we need to expand to meet demand? Do we have the human and capital resources to expand our product line?

Cindy will then need to develop short- and long-term sales and other financial forecasts to ensure that her firm’s strategic goals are financially feasible. Financial forecasts are especially important when a firm’s strategic goals include large capital projects, such as acquiring new facilities, replacing outdated technology, or expanding into a new line of business. It is critical that such forecasts be as accurate as possible. If they are not, serious consequences can result. Additionally, she will need to manage revenue and expenses for the plan as it is carried out.

In addition, financial managers must anticipate the impact external factors will have on a company’s financial situation. If, for example, a slowdown in the economy is looming, a financial manager knows it will affect his or her company in many ways. Steps may need to be taken to handle the possibility that customers’ payments might be harder to collect or that revenues will be less as a result of reduced sales. Because of the result from either or both of these possibilities, plans for expanding buildings or purchasing new equipment might have to be postponed.

How does a company know it has enough resources to meet its forecasted needs? The accounting area of the finance department generates financial statements. These statements include the income statement, the balance sheet, and the statement of cash flows. We’ll discuss financial statements in more detail later in the chapter, but for now you just need to know that together they create a financial picture that explains what a company has done over the current year and in past periods. Moreover, they serve as a basis for management to develop expectations of the company’s financial condition in future periods.

Using these expectations, a financial manager develops a budget—a management tool that outlines a company’s planned cash flows, expected operating expenses, and anticipated revenue. An operating (master) budget includes all the operating costs for an entire organization, including its inventory, sales, purchases, manufacturing, marketing, and other expenses. The operating budget maps out the projected number of units the firm expects to sell, the income generated from them, and all of the operating costs incurred to produce and sell them.

How are funds obtained for large projects? Another component of the budgeting process is the capital budget. The capital budget outlines the financial needs for significant purchases, such as real estate, manufacturing equipment, plant expansions, or technology, as part of a company’s long-range plans. Because large capital investments are often financed with borrowed money or money raised through the sale of stocks or bonds, it is important to plan ahead to ensure funds are available when they are needed. During the capital budgeting process, each department in an organization makes a list of its anticipated capital needs. The firm’s senior managers and the board members evaluate these needs to determine which will best maximize the company’s overall growth and profitability. Capital needed for the routine replacement of equipment or technology may not require much evaluation. Other requests for capital, such as those needed to take the company in a new direction, will require closer evaluation.

A company’s actual capital expenditures are often outlined in its annual report. For example, according to its 2015 annual report, Apple anticipates capital expenditures for 2016 to include data centers, information systems hardware, software and enhancements for corporate facilities, and retail store facilities.1 Sometimes, a project budget is prepared to identify the costs needed to accomplish a project—an endeavor that has a specific start and end date, such as installing and upgrading a computer system or renovating an existing building.

What is cash flow? Cash flow is the amount of money a company actually receives and spends over a specific period. The cash flow budget, as illustrated in Figure 15.3, is an estimate of a company’s short-term cash inflows and outflows, and identifies any cash flow gaps for the business. Cash flow gaps occur when cash outflows are greater than cash inflows. Cash flow budgets help financial managers determine whether a business needs to seek outside sources of funds beyond what it generates by its own business operations.

Figure 15.3

Cash Flow Budget

Cash flow budgets also indicate whether a business will have enough cash on hand to grow and fund future investment opportunities. Moreover, financial managers use the cash flow budget to help plan for the repayment of the firm’s debts and cover unusual operating expenses.

Why is monitoring cash flow important? Cash flow specifically measures whether there are sufficient funds to pay a firm’s outstanding bills. A company can have the best-selling product on the market, but if the flow of funds coming in and going out of a business is not managed properly, the firm can easily fail. That’s why monitoring cash flows is so important.

For small seasonal businesses, such as ski shops and pool installation companies, cash management is critical for carrying a business through the slow months. Seasonal business owners must be disciplined to not spend surplus cash generated during the busy season. Although many investors focus on a company’s profitability, a company’s liquidity—how quickly an asset can be turned into cash—is often a better indicator of a firm’s strength. Companies go bankrupt when they cannot pay their bills, not because they are unprofitable; a firm can remain unprofitable for a period of time as long as it has enough cash on hand. As you will read later in this chapter, accountants also play a big role in helping financial managers monitor cash flows using ratios such as the current and quick ratios.

How does a company know if it is staying on budget? After a budget is developed, it must be compared periodically to a company’s actual performance. Ideally this happens every month. Without such a comparison, it is hard to determine whether a company is performing as expected. To understand this concept better, think about your personal financial situation. Let’s say you decide to save some money. At the end of the month, you have $50 in your savings account. Is that good or bad? It all depends on what you originally planned to save. If you intended to save only $35 during the month but end up with $50, that is great. If you intended to save $75, then the outcome is not as good, and you should modify your spending to bring you back into budget.

The same is true with the financial performance of a company. If the actual numbers generated by a company closely match the budget, this shows that the company is fulfilling its plans. However, if the actual numbers differ greatly from those projected by the budget, this indicates that corrective actions or adjustments should be taken.

What must financial managers consider when seeking outside funds? In your personal life, you most likely have different types of financing options to help you manage your financial needs. For example, you may have a checking account or credit card to pay for short-term expenses. You might have a savings account as well as some loans to pay for bigger, long-term expenses, such as your tuition, car, or home.

Similarly, companies have different financing options available to them. How do financial managers evaluate these options and choose the best one? They do so by assessing several criteria, including how much and how quickly the money is needed, how long the financing is needed, the cost of the financing, and the riskiness of the project being financed. Short-term financing options for small businesses and start-ups generally include grants, short-term loans, or lines of credit from banks as well as credit from suppliers. Long-term financing needs may be met with bank loans or mortgages, venture capital, or funds from an angel investor. Larger, more established companies have other options to raise funds that we will discuss later in the chapter.