Financial management revolves around the balance sheet. Why, you ask? Its primary role is to oversee the company's balance sheet.
Wait, what? What does this mean?
Alright, let's break it down. Financial management primarily involves managing the company's investments, which includes acquiring fixed assets.
Next, how does the company finance these fixed asset acquisitions? The options are long-term liabilities and equity.
Lastly, it's about maintaining the company's operational efficiency by ensuring current assets exceed current liabilities.
See? Do you grasp my point? If not, don’t worry! I'll explain everything in detail in this post.
Table of Contents
Financial Management: Key Questions and Balance Sheet
Before delving into why financial management centers around the balance sheet, let's first grasp the essence of financial management.
Quoting from the book Fundamentals of Corporate Finance, 13th Edition (Stephen A. Ross, Randolph Westerfield, etc., 2022)[1], corporate financial management addresses three fundamental queries:
- What long-term investments should you pursue? In simpler terms, what business avenues will you venture into, and what infrastructure, machinery, and equipment will you require?
- Where will you procure the long-term financing to support your investments? Will you invite other stakeholders, or will you opt for borrowing?
- How will you handle day-to-day financial operations, such as collecting payments from customers and disbursing funds to suppliers?
These inquiries directly impact the company’s balance sheet!
The first inquiry revolves around determining the investments or fixed assets necessary for the company. Once realized, their worth is documented on the balance sheet under fixed assets.
The second inquiry pertains to securing funding for these investments or fixed asset acquisitions. Once financing is arranged, its value is recorded on the balance sheet under long-term liabilities or equity.
The third inquiry focuses on managing routine financial activities, ultimately ensuring a harmonious equilibrium between current assets and current liabilities.
But is that all? Aren’t there specific financial terms for these activities and questions?
Certainly!
- Capital budgeting: Pertaining to the investments or fixed assets the company needs to procure.
- Capital structure: Addressing the sourcing of funds to finance these investments or fixed asset purchases.
- Working capital management: Concerning the maintenance of balance between current assets and current liabilities.
Stay tuned as I dissect each of these activities further. This is paramount for enhancing your financial acumen.
Strategic Investments: Capital Budgeting and Balance Sheets
This relates to the first question: what long-term investments should the company undertake?
It involves financing everything related to fixed assets, such as building factories, purchasing machinery, vehicles, buildings, or even acquiring other companies.
What's the purpose?
There are various reasons: expanding the market, increasing production capacity, acquiring knowledge from other companies, and more.
What you need to understand about capital budgeting is that, from an accounting perspective, the value of these activities is presented on the balance sheet under fixed assets and not directly recognized as an expense in the company’s income statement.
In simple terms, all costs related to acquiring fixed assets are first capitalized on the balance sheet.
According to Finquery[2], "Capitalization is the act of recording a purchase as an asset on the balance sheet rather than recognizing the entire purchase as a one-time expense on the income statement. Fixed assets bought outright are capitalized when purchased by crediting the cash account to reduce it and debiting an asset account to increase it. On an ongoing basis over the asset’s useful life, fixed assets are depreciated until they reach their salvage value."
In capital budgeting, financial managers need to consider the cash outflow for investments and the cash inflows these activities will generate in the future.
It’s crucial to understand that it’s not as simple as having less cash going out than coming in.
When this cash will be received is also an important consideration in capital budgeting.
Why?
Because financial management heavily considers the time value of money. Simply put, $1 today is not the same as $1 a year from now.
This means you need to discount all future cash inflows to their present value to determine the net value of the cash that will be received.
Deciphering Capital Structure: Balancing Debt and Equity
Capital structure follows capital budgeting.
Once you've identified the suitable investment, the next step is to determine where the funds to finance the company's investment or fixed asset purchases will come from.
Understand that fixed assets support the company's operations and can be used for many years, ranging from 4 to perhaps 20 years.
Returns from these investments are not instantaneous and can span several future periods. Thus, the company needs to seek long-term funding sources to have sufficient time to generate revenue to repay its debts.
Two common sources of funding for the company’s investments or fixed asset purchases are issuing bonds or stocks.
From an accounting perspective, the funds obtained from these activities will be recorded under long-term liabilities and equity.
A company can choose to finance its investments entirely with bonds, entirely with stock issuances, or a combination of both.
This process is essentially called capital structure, a financial management function that determines the optimal source of funding for investments.
Several factors need to be considered to determine the optimal capital structure, as both bonds and stocks have their advantages.
For instance, bond costs (coupons or interest) can be used to reduce taxable income, while stock costs (dividends) cannot.
However, concerning interest, companies face the risk of default, which could lead to bankruptcy since coupons must be paid regularly and the bond principal must be repaid at maturity.
This differs from stock costs, where companies have no legal obligation to pay dividends, especially when experiencing losses, and there is no obligation to return the money paid by investors for buying shares.
Therefore, companies must ensure the right or most optimal mix of bond issuance and stock issuance to gain the tax shield benefits from bonds and the payment flexibility benefits to shareholders.
Or as Investopedia[3] puts it, "The optimal capital structure of a firm is the best mix of debt and equity financing that maximizes a company’s market value while minimizing its cost of capital."
Balancing Act: Financial Management with Working Capital
Working capital management can be seen as separate from the previous two activities. This activity aims to ensure the company’s daily operations run smoothly.
According to NetSuite[4], "working capital is calculated by subtracting current liabilities from current assets, as listed on the company’s balance sheet. Current assets include cash, accounts receivable, and inventory. Current liabilities include accounts payable, taxes, wages, and interest owed."
In Fundamentals of Corporate Finance, 13th Edition (Stephen A. Ross, Randolph Westerfield, etc., 2022), three essential aspects are highlighted in this activity:
- How much cash and inventory should we keep on hand?
- Should we sell on credit? If so, what terms will we offer, and to whom will we extend them?
- How will we obtain any needed short-term financing? Will we purchase on credit, or will we borrow in the short term and pay cash? If we borrow in the short term, how and where should we do it?
This is essentially the same as capital budgeting and capital structure, but in a short-term version.
In accounting terms, all assets obtained from this activity will be presented in the current assets section, and the funding sources will be presented in current liabilities.
Confused? It’s actually simple!
For instance, inventory sold by the company. To procure it, the company might rely on credit from suppliers for a certain period.
Then, to attract more customers, the company might offer credit to its customers when selling inventory.
However, the company must manage this so that the payment terms for receivables are not longer than the payment terms to suppliers, ensuring money is available to pay suppliers.
The company also needs a backup plan for instances where customers don’t pay on time. It may need to seek additional funding to purchase inventory or pay suppliers to avoid disrupting operations.
In this case, the company might borrow from a bank or negotiate with suppliers by issuing promissory notes.
In essence, this activity is crucial because its cycle is very fast. Within a single reporting period, a company might repeatedly use credit to purchase inventory, convert inventory to receivables, receivables to cash, use cash to pay off debt, and so on.
Therefore, if a company fails to manage this, it could face bankruptcy or at least lose supplier trust, complicating its operations.
To avoid this, a company must maintain its working capital. Though not always guaranteed, positive working capital is a sign of good management.
Why do I say not guaranteed? Because working capital management isn’t as simple as maintaining a positive balance. It’s about balancing the components of each current asset and current liability.
For example, a company that invests too heavily in inventory while neglecting cash may struggle during tough times since, despite being classified as current assets, inventory isn’t as liquid as cash for settling current liabilities.
Conversely, if a company over-invests in cash, it might also be disadvantageous, as the returns from cash, typically placed in deposits, are minimal. Additionally, the company may fail to meet sudden spikes in orders, missing growth opportunities.
Financial Management: Balancing the Sheets, Concluding Thoughts
So, now it’s clear what I meant at the beginning of this post when I said that financial management is about the balance sheet.
Capital budgeting is about how financial management builds the balance sheet on the fixed asset side.
Capital structure is about how the company maintains balance in the long-term liabilities and equity sections of the balance sheet.
Working capital management is about ensuring current assets exceed current liabilities.
It might appear as if I'm insisting too much! Isn’t the income statement also a part of financial management?
Well, yes, but not entirely. In my view, the income statement is more related to the marketing and operational departments.
Wait, why? Explain!
Yes, sales fall under sales and marketing; their value depends on their ability, while costs fall under operations, related to efficiency and their magnitude.
However, this doesn’t mean financial management has no role in the income statement. It’s just my impression that financial management is mainly about the balance sheet!
ARTICLE SOURCES
- Ross, S. A., Westerfield, R. W., & Jordan, B. D. (2022). Fundamentals of Corporate Finance (13th ed.). McGraw Hill.
- Belk, B. (2022, August 3). Asset Capitalization Explained with a Lease Example. FinQuery. Retrieved May 14, 2024, from https://finquery.com/blog/asset-capitalization-explained-with-lease-example/
- Hayes, A. (2022, April 25). Optimal Capital Structure Definition: Meaning, Factors, and Limitations. Investopedia. Retrieved May 14, 2024, from https://www.investopedia.com/terms/o/optimal-capital-structure.asp
- Beaver, S. (2022, August 22). What Is Working Capital? How to Calculate and Why It’s Important. NetSuite. Retrieved May 14, 2024, from https://www.netsuite.com/portal/resource/articles/financial-management/working-capital.shtml
