Managerial Finance

What is Managerial Finance?

Managerial Finance is fundamental and of critical importance to businesses for business management, the decision-making process, and the organization's overall productivity.

It is the finance branch that discusses financial techniques' impact. The impact of Trend Analysis, Ratio Analysis, Cash Flow Analysis, Forecasting, and so on.

The primary focus of Managerial Finance is on assessing financial techniques and maximizing profits, which will, in turn, influence the stakeholders and increase their wealth.

According to Lawrence Gitman (2003): "Managerial finance is the branch of finance that concerns itself with the managerial significance of finance techniques. It is focused on assessment rather than technique".

The difference between a managerial and a technical approach can be seen.

Weston Brigham- "Managerial activities which deal with planning and controlling of firms and financial sources ." Financial management is an area of financial decision-making harmonizing individual and enterprise motives.

It can be termed an interdisciplinary approach that borrows from managerial accounting and corporate finance. It can be said that it's a combination of accounting and economics.

Financial Management concerns itself with assessment.

The fundamental focus of managerial Finance is on

• Cash flow management

• Financial statements and their analysis

• Financial reporting

• Record keeping

• Comparison with competitors

• Planning and Forecasting

Understanding Managerial Finance

Managerial Finance, also known as executive functions, requires planning, execution, and control skills. For the same reason, they are to be carried out at the managerial level.

To understand managerial Finance better, we need to visualize the functions of Finance into 2 categories.

1st, the routine finance functions ( limited only to the procurement of funds and their allocation. Ignoring the aspect of the utilization of resources acquired.)

2nd, the managerial finance function, which includes:

• Investment decisions

• Finance decisions

• Dividend decisions, and

• Working capital decisions.

It's measuring finance techniques to determine how they can influence a business internally and externally. The objectives of financial management can be explained in 2 points.

• Improving financial techniques contributes to a firm's success. 

• Implement the recommended changes to avoid or minimize losses.

It is a combination of corporate finance and financial management.

The management accounting techniques help management better understand and act on financial information related to profitability and performance; corporate finance techniques help optimize the overall finance structure.

Scope and Key Concepts of Managerial Finance

The primary focus is the financial Statement, its analysis, procedures, and a combination of management accounting and corporate Finance helps optimize profits and maximize shareholders' wealth.

Essentially, managerial Finance is the combination of accounting and economics.

The traditional practices included using financial statements, cash flows, and other subjective financial information to make decisions; now the scope of finance management has expanded. Concepts from corporate and management accounting are also used.

Firstly, financial statements are used for accounting information. Secondly, economic principles are used to make financial decisions that benefit the organization.

We know that net profit is just a nominal account, and cash is a more suitable metric to understand the liquidity and solvency position of the organization. This is what managerial Finance helps in.

Financial managers measure the company's development through financial management techniques like financial statement analysis, comparable analysis, variance analysis, cash flow analysis, and more.

When they carry out such extensive analysis of the performance of companies, they also determine the financial consequences of each action taken and where it would lead.

Managerial Finance techniques are more than what Finance is like. It's the management of finances, procuring them in the first place, their allocation (since financial resources are unique and scarce), and making the best out of them.

It assesses tendencies and recommendations on how to use the assets of the organization for the well-being and survival of the business in the long run.

At the same time, financial managers seek the best external financial institutions and recommend the best combination of financial resources for the shareholders of the company/organization.

In the modern competitive world, it's a compulsion to have what's needed to be competitive.

There must be a vision that the organization will continue to thrive and grow no matter what. Taking the proper steps towards the goal of satisfying stakeholders' demands and fulfilling the potential organization possesses.

Decision-making should be based on different scenarios, considering financial and non-financial factors taken into the picture. It must be done to ensure the proper use of the company's assets.

Managerial Finance is the answer to all the questions asked about financials. Ratio analysis, comparable company analysis, asset management techniques, and Forecasting techniques are crucial to assessing a firm's performance.

It's not limited to assessing a firm's performance, but it also aids in maintaining and boosting them. As a result, it contributes significantly to the strategic planning process and overall productivity.

Although the list isn't exhaustive of the concepts included in managerial Finance, here are some of the topics widely discussed

Cash Management

According to Brigham, Eugene and Johnson, Ramon (1980),

"Cash flow is an accounting term that refers to the amounts of cash being received and spent by a business during a defined period, sometimes tied to a specific project."

Simply speaking, cash management is the collection of cash receipts and managing of cash payments. The cash inflows could result from direct or indirect tickets.

Sale is a direct source, and gain on the sale of discontinued operations is an indirect source.

Since cash is the most liquid asset, it's the most used asset. Therefore, the organization must pay its obligations, plan for future payments, and maintain adequate business stability.

Cash flow management helps to:

• Manage the state or performance of a business or project.

• Determine and solve problems with liquidity. Being profitable does not necessarily mean being liquid. A company can fail because of a cash shortage, even while beneficial.

• Generate project rate of returns. The time of cash flows into and out of projects are used as inputs to financial models such as internal rate of Return and net present value.

Cash management is greatly facilitated by using the Cash Flow Statement (CFS). CFS is one of the four most important financial statements. And explains what income statements and balance sheets can't explain.

The CFS is divided into 3 sections, which helps the user to understand the dominant areas from which the cash is generated.

Preliminarily, there are 3 types of activities, and the cash from them should be evaluated.

• Operating activities

• Investing activities

• Financing activities.

Operating Activities

Activities are related to activities in the ordinary course of business. Transactions recorded on Income Statement are included in operating activities,

In Cash Flows, transactions recorded using accrual accounting are converted into cash accounting.

NI on the income statement includes non-cash revenue like uncollected credit sales and non-cash expenses like unpaid expenses (depreciation, depletion, and amortization).

These items reduce the net income but don't affect the cash flows for the current period. Thus, these items are added back when determining cash flows From operating activities.

Cash inflows under operating cash flows:

• Cash receipts from sales of goods and services

• Collection of accounts receivables

• Cash receipts from royalties, fees, commissions, and other revenues.

Cash outflows under operating cash flows:

• Cash payments to suppliers for employees and goods and services

• Cash payments towards government taxes, duties, fines, penalties, interest on debt, and other fees.

There are 2 acceptable methods to present net cash Flows from operating activities.

The direct method, AKA the Income Statement method, is where Net Cash Flows of Operating Activities are calculated by converting Revenues and Expenses from Accrual Basis to Cash Basis. It's a preferred method but rarely used.

The Indirect Method, AKA Reconciliation Method, is the most popular. It starts by adjusting NI to net cash flows from operating activities. Adjustments include adding back non-cash expenses and paper losses and deducting non-cash revenues and paper gains.

Investing Activities

Activities related to the expenditure intended to generate future incomes and cash flows. Most of the transactions in the investing activities come from changes in long-term assets accounts.

Cash inflows under investing activities from the receipts.

• Receipt from the sale of PPE

• Receipt from the sale of intangible assets

• Receipt from the sale of other long-lived assets

• Sale of investments in other company's equity or securities

• Collections of principals on loans to another entity

Cash Outflows include

• Purchase of PPE

• Purchase of intangible assets

• Acquisition of other company's debt or equity securities

• Granting loans to another company

Financing Activities

Activities are related to changes in long-term liability and equity accounts. Financing activities are related to the transactions that involve the issuance, settlement, or reacquisition of the entity's debt and equity instruments.

Financing cash inflows:

• Sale of entity's equity security

• Issuance of debt (bonds/notes)

• Obtaining resources from owners

Financing cash outflows:

• Payment to stockholders for dividend

• Price made to reacquire capital stock

• Redeem the company's outstanding debt

• Costs for a reduction in outstanding liability (by lessee) of operating or financial lease.

Financial Reporting

FinRep is the continuous process of presenting the financial results and activities for a given period. The method includes collecting, processing, organizing, and presenting financial information for a quarter or a year.

The primary goal of Financial Reporting is to obtain and retain confidence in the organization of the stakeholders. Both internal and external.

The companies use Financial Reports to organize the data, reporting on the present financial situation, projected and future profitability, liquidity, solvency, and other critical financial performance indicators.

The primary objectives fulfilled by the statements include:

• Cash flow tracking

• Evaluation of assets and liabilities

• Analyzing shareholder's equity

• Measuring profitability

There are 2 aspects of financial reporting,

1. Providing reports to stakeholders in a presentable, accessible, and comprehensive manner.

2. Analyze reports based on the information provided above.

Financial Reporting is essential for many reasons.

Primarily we can conclude that it's to provide truthful and accurate information. Both internal and external stakeholders depend upon the reporting to make future decisions. 

Analysts make their projections that depend upon the report's accuracy for their forecasts to be accurate. Based on which the financial and non-financial decisions are taken.

Monitoring expenses and revenues are also one of the reasons why financial reporting is as essential as any other activity in the firm. Often due to a lack of monitoring and tracking expenses, organizations expended more than required. 

Controlling costs is another aspect of financial reporting that helps organizations cut costs and increase profits.

Accounting regulations, standards, and boards are created to ensure accepted methods to present financial data. Compliance with such laws, bars, and panels is of peak importance to ensure uniformity and answerability of the firms.

Financial data and information

They are usually presented in the following formats:

1. Income Statement

The Statement includes the amounts related to sales/revenue and direct and indirect expenses.

It summarizes all the transactions surrounding a company's profitability and operational efficiency. Items in the income statement include-

Sales, cost of goods sold. Gross profit, operating expenses( sg & a), EBITDA, depreciation, amortization, EBIT, income taxes, and net earnings. It's based on the accrual principle.

2. Balance Sheet

Simply put, it exhibits what the firm owns and owes. A summary of the organization's possessions (assets, advances to debtors, and parties) along with obligations to be fulfilled.

Items included in the balance sheet-

• Current Assets- cash, marketable securities, inventory, account receivables.

• Fixed Assets- plant, property, and equipment

• Fictitious Assets- goodwill, patents, copyrights.

• Current Liabilities- short-term obligation ( payable within a year or an operating cycle), Accounts Payable, Deferred Taxes

• Long-Term Liabilities- liabilities payable in the years forward

• Equity Capital

• Retained Earnings

3. Statement Of Cash Flows: Detailed explanation in Cash Management.

4. Statement Of Changes in Equity

When the balance sheet is prepared, it is done according to the Financial Accounting Standards Board, which requires a separate account to be ready for changes in equity to assess an individual shareholder's equity account.

It's intended to help external users to assess how changes in a company's financial structure may affect financial flexibility. Statement of changes in equity present the Statement in the form of a reconciliation statement for the accounting period.

We are beginning with the opening balance of each component of the Statement of changes in the equity.

Components of the Statement:

• Opening balance of retained earnings (RE)

• Net income(loss)

• Dividend distributed for the period

• Positive/negative prior period adjustments

• Retained earnings closing balance

Common changes in the Statement:

• Net income/(loss) for the period increasing(decreasing) RE

• Distribution to owners (dividends paid), decreasing RE

• Issuance of common stock that increases common stock

• Total changes in other comprehensive income (OCI), positive increases RE, negative decreases RE.

• Repurchase of the company's common stock (treasury stock), decreasing RE.

Planning, Predicting, Forecasting

A plan is a detailed explanation of an intention or decision to achieve a said task. Planning is the process of determining what is to be done. How, when, where, and by whom it's to be done.

Planning is the process that guides the organization and personnel and moves them from where they are to where they intend to go. No financial transaction exists in the Planning stage. And it is the means to reach organizational ends.

The planning process includes the following steps:

1. Strategic(long-range)planning, which includes a strategic budget. It describes the long-term position and objectives. It's for 3 to 5 years.

2. Strategic Planning includes the identification of strengths, weaknesses, opportunities, and threats.

3. Then comes Premises. That is the generation of planning assumptions. Managers should be able to answer the question, "What internal and external factors would affect actions planned for the organization?"

4. Establishment of organizational objectives, which might differ and can be multiple.

5. Establishment of management's objectives, which encompasses the effective and efficient use of resources. Effectiveness is the degree to which the goals are achieved. Efficiency is maximizing the output for a given level of input.

6. Then the objectives set at the top should be retranslated to more specific terms as they are communicated downwards. This is called Means-End Hierarchy.

7. Formulate policies, procedures, and rules to keep the organization in check of its actions.

8. Goal congruence is a must. Any activity that is carried out in the enterprise should be done in the best interest of the organization and the stakeholders.

Predicting and Forecasting involve using quantitative models to effectively, efficiently, and accurately estimate the numbers.

Correlation analysis, regression analysis, probability analysis, expected analysis, time series, and many more techniques may help predict figures. 

The process of processing, estimating, or predicting a business's future performance, is an activity that requires solid experience, skills, and professionalism to be executed.

Planning and predicting help a company comes up with business strategies to implement. In addition, they are instrumental in forecasting performance in terms of a firm's revenues, profits, and future expenses.

Capital Allocation

The process involves the steps taken to effectively and efficiently allocate organizations' capital resources. These capital resources are scarce and will exhaust if they aren't used properly.

Capital Allocation is one of the most challenging decisions that upper management has to take. There can be quantitative reasons and qualitative reasons as well to invest.

Sometimes, when Capital is a scarce resource, meaning when it's limited and exclusive, the only project should be chosen that doesn't decrease a firm's ROR.

But, if there is more than one project that positively contributes to the firm, both should be accepted. The organization may choose Capital Budgeting Techniques to decide which project to invest in.

Techniques such as:

• Payback Method, in which the cash flows for the project's life is laid and is observed in which Year the initial investment is being repaid. The answer is the Year in which the investment can be refunded.

• Discounted Payback method, similar to payback method, but uses discounted currency amount, depreciated with the Time Value of Money. The amount is discounted at the present value of money by locating the discount percentage and the duration of cash flows. The answer is the Year in which the investment is repaid.

• Accounting Rate of Return (ARR) looks at the average Return to see if it matches the target return.

ARR(%)= Avg annual return / investment

• Net Present Value (NPV): The difference between cash inflows and outflows. The cash inflows are discounted using a discount rate for the periods the cash flows are expected to incur.

This technique is used to determine which investment will be worthwhile. Since the amount is currently discounted, the projects/investment with positive NPV is preferred over those with negative NPV.

Other Key Concepts

Some of the other key concepts are:

1. Ratio Analysis

Quantitative and measurable analysis of a firm's financial information to learn about

• Liquidity

• Solvency

• Operational efficiency

• Operational profitability

• Turnover

• Business/Financial risk of an organization

It discloses the relationships, inter-dependencies, and points of comparison between the financial data. Both present and historical.

With the help of RA, the financial data can aid in viewing it from various angles and which management likes.

Providing a comprehensive look at the statements and highlighting potential areas of concern. The financial data could be arranged in various combinations to arrive at insights aiding future decision-making for external and internal stakeholders. 

The results are in percentages/decimals/times, each explaining what dollar/currency figures won't.

2. Valuation Analysis

Estimating the total worth of an asset, business, or company. The process may include many valuation techniques resulting in many valuations. These valuations may consist of (but are not limited to):

• Discounted cash flows valuations

• Comparative prices at which competitors have sold

• Valuation of subsidiaries

• Individual asset valuation

It facilitates the organization to identify the fair value of the business, investment, or company. The analysts use different valuation models and analytic techniques to arrive at the most beneficial result.

Valuation Analysis is a vast concept in Finance, but here is our comprehensive course on Valuation and its Modeling that covers every aspect of it.

There are 3 Main Valuation Methods

• Market Approach

• Cost Approach

• Income Approach

The market approach goes for comparable public companies based on prior transactions. The cost approach focuses on the Replacement Principle. The income approach is based on current and projected cash flow values.

In another iteration, industry professionals also use DCF Analysis, Comparable Analysis, and Precedent Transactions. 

• Investment Banking (IB)

• Leveraged Buyouts (LBO)

• Mergers & Acquisitions (M&A)

• Equity Research

• Private Equity

• and many more areas of Finance.

The DCF analysis is when an analyst forecasts Free Cash Flows into the future and discounts to the present using the Weighted Average Cost of Capital.

3. Capital Structure

According to Lawrence Gitman(2003), "Capital structure refers to how a corporation finances itself through some combination of equity, debt, or hybrid securities.

A firm's capital structure is then its liabilities' composition or 'structure.' Capital structure is the specific mix of an organization's preferred equity and debt level. These instruments are used to finance assets and operations.

Equity represents a more expensive yet permanent source of Finance with greater flexibility. But, the Debt is an easily acquired source but payable at regular intervals. The capital structure mix will depend on many factors:

• Company's size

• Maturity of the source

• Mergers and Acquisition

• Company's operations

Key factors affecting the capital structure:

• Company's life cycle

• Cost of Capital: the cost of raising various sources of Finance.

Firms finance their operations by three mechanisms: issuing stock (equity), issuing debt (borrowing from a bank is equal for this purpose) (those two are external financing), and reinvesting prior earnings (internal funding). That makes it Weighted Average Cost of Capital (WACC). 

• Financing considerations: Use of leverage, Finance, and debt.

• Stakeholders' interest.

4. Risk and Return

In Finance, the word return means the profit gained from the invested amount, represented in absolute currency or percentage terms. It refers to the changes in the value of the investment from the time it was initially invested.

Whereas the risk in financial terminology refers to the possibility of events occurring and causing the desired results not occur. A chance of loss, a chance that the results could differ from those expected.

The risk-return range is the relationship between the number of returns gained on the amount of risk taken.

It suggests that the greater the risk, the greater the Return, and vice-versa. If a person aims for greater returns, they should be able to take risks even more significantly. Returns are calculated as:

Final value of investment(incl, dividends and interest) - initial investment value/initial investment value. 

Multiply the decimal number with 100 to translate it into percentage terms.

Risk-adjusted Return on Capital is a risk-based profitability measurement framework for analyzing risk-adjusted financial performance providing a consistent view of profitability across businesses.

Note, yet, that more and more Risk-Adjusted Return on Risk-Adjusted Capital is used as a measure, whereby the risk adjustment of Capital is based on the capital adequacy

Risk-adjusted Return on capital(RAROC) system allocates Capital for 2 primary reasons:

1. Risk management

2. Performance evaluation

For risk management purposes, the main goal of allocating Capital to individual business units is to determine the organization's optimal capital structure.

As a performance evaluation tool, it allows organizations to assign Capital to business units based on the economic value added to each team.

Researched and authored by Farooq Azam Khan, CMA | LinkedIn

Reviewed and Edited by Aditya Salunke I LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Account Statement
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• Risk-Adjusted Return Ratios
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