What is Financial Management?
Why is it so important for entrepreneurs and how does it work? It is of the utmost importance for every business owner and manager to closely monitor the financial situation of the company. After all, you do not want surprises and the decisions and the investments that you make, should be deliberate and consciously taken. In this article I give a brief historical perspective and describe the structure of Financial Management. It consists out of Financial Accounting the field which we focuses on generating financial overviews. Management Accounting whereby we work with the statements from the companies perspective and focus on what actions to take. And Corporate Finance that evaluates potential investments from a cash flow perspective.
The oldest documents of accounting date from 1340. This way of accounting was first described by the Italian monk Luca Pacioli in his work from 1494 Review of Arithmetic, Geometry, Ratio and Proportion. The great thing about Financial Management is that if you understand the structure and apply it correctly you can rest assured that it will not change in the next 50 years. After all, the structure has not changed much since the 12th century. It is great to read the annual report from the East Indian Trading Company made in the 15th century. It describes for example: "bribery of the sultan of Brunei for 3.000, - Dutch Guilders", nowadays we would not describe it like that ... ;-)
By the issuing of shares (and thus the creation of ownership not directly involved in the management of the company), the importance of the annual reports increased. In the old days the owners of the firm were involved and knew the situation of the company and had direct access to the financial status. Due to the separation in ownership and management there was a need for information at the owners of the firm. In order to protect the owners of the firm the governments made legislation so that every company with publicly traded shares had to issue an Annual Report containing at least the Profit and Loss Statement, The Balance Sheet at the beginning and end of the year and the Cash Flow statement, accompanied by the comments from management and a declaration of approval by the accountant. Nowadays you can find the annual report of all publicly traded companies on their website. So should you think about a new employer check out their financials first!
The term Annual Report and Financial Statement are often mixed up or used as synonyms. The financial makes a clear distinction between them. The Annual Report is the whole report from the firm including General corporate information, the Directors report, an Auditor’s report, the Financial Statements and the Notes to the financial statements. The Auditor’s report is generated to assure the stockholders no major errors have been found in the investigation of the books. The Financial Statements are the core of the annual report and consist always out of the Profit and Loss Statement, the Balance Sheet and the Cash Flow Statement, with explanations to them in the notes.
The financial statements are prepared on the basis of the seven accounting principles. They form the guidelines for the accountant who makes the overviews. He will always try to make the financial overviews complete, reliable, comparable and consistent for the period. He will also base his assessment on the continued existence of the company (going concern principle) and, where necessary, make conservative estimations. After all, the goal is to make a good financial representation situation of the company.
The value chain describes the activities of the company. It starts with the (A) purchase of goods. As a result, (B) stock and debt arise. By (A) selling the goods they (B) disappear from the company and a claim arises. At the (A) receipt of the payment by the customer the (B) claim disappears and the company has cash at hand. As a final step, the (A) payment to the supplier can be made so the (B) debt is gone at the expense of cash. This all with the intention to purchase for a low price and sell it for a high. Every time an (A) activity is performed it is registered in the P&L or Cash Flow Statement. The (B) consequence of the activity is registered at the Balance Sheet. This double entry of the activity and the result is the core
of double entry bookkeeping.
2.2 The three financial overviews
Financial Management consists out of three types of overviews. They are the Balance Sheet, The Profit and Loss Statement and the Cash Flow Statement. These overviews can be presented in many different ways, in parts or combined. However, the content is always based on the seven accounting principles and the structures of the three overviews.
The Balance Sheet is the overview in which we write down what the company possesses with the specific value on the assets side. On the liabilities and equity side it is described who has which claim towards the company. Or in other words to whom does it belong. Because one side describes "what do I have" and on the other side "who’s is it", it has to be the same value.
The cash flow statement describes all the cash that enters and leaves the company in a specific period. We distinct between operational cash flows from the normal activities, money flows generated by investments (or the sale of investments) and the financing cash flow. The latter concerns the flow to and from the bank, or other forms of debt and the cash flow to and from the owners. Problem with the cash flow statement is that you know how much cash has come into or has flown out of the company, but you do not know whether that is good or bad. We have the loss and profit statement for that question.
The Profit and Loss Statement is the most widely applied and least well interpreted overview that financials make. It starts with the turnover, this is the monetary value of the delivered products and services of the period. From this are deducted the costs, these are the things that you have consumed (raw materials) and the things that have reduced in value by using them (machines, buildings).
To clarify, the turnover of your work at your employer is NOT your salary, this is your receipt of cash and is represented in your cash flow statement. The turnover of your work is the number of days worked multiplied by your daily fee (= wage + 13th month + holiday allowance + carefully estimated bonus). Similarly, your costs are not the payment at the supermarket but the actual (= eaten + discarded) number of jars of peas, ...., ....
For every annual report it is clearly stated whether it are the consolidated statements or the statutory (unconsolidated) statements.
3.1 Why to consolidate?
Companies often work in groups at which one belongs to the other. They are active in different countries or have different tasks. By example there is a Canon Sales Netherlands, Canon Sales Germany, Canon Production Japan, Canon….. and there is the Canon Inc in Tokyo to which all companies “belong”. If you want to analyse the financial results it is important to know if you are reviewing a part or the whole.
To consolidate is NOT the same as adding up. Basically what you do is drawing a new outer line. As standalone companies we have A and B. They both report on their activities with the outside world. By example the revenue. This is the value of the goods delivered to other parties in a specific period. When you are combining different companies in one whole it is important to distinguish between deliveries inside the group and outside the group.
Company A has delivered for a value of 110 of products in the period, of which 100 outside the group and 10 to B. Company B has delivered for a value of 220 of products in the period of which 200 outside the group and 20 to A. If we consolidate the companies they have a combined revenue of 300 outside the group. Deliveries between group members are eliminated and not included in the total. Basically we draw a new outer line and look at what has crossed over. The consequence of consolidation is most present in the revenue, therefore the profit (profit made on deliveries to group members are not “real”, not realised) and the inventory value (of products bought from within the group). Only at the moment the goods leave the group the revenue is realized.
The financial statements consist ALWAYS out of THE three financial overviews that we know. The opening Balance Sheet, the Profit and Loss Statement and the Cash Flow Statement. It is impossible to evaluate the performance of a company looking at only one or two overviews.
The Balance Sheet represents the Assets (what is the value of the belongings that I have?) and the Equity and Liabilities (whom has a claim on the firm for what value?). The financial statements always give you the beginning and end Balance Sheet. Two items out of the Balance Sheet are explained into more detail. The development in profit from the past is (=profit from the year) is explained in detail in the Profit and Loss Statement and the development in Cash is explained in detail in the Cash Flow Statement.
The three overviews are graphically combined based on the Value Cycle whereas the sale is the starting point for the Profit and Loss Statement after which all the costs are deducted resulting in a profit or loss. The Cash Flow Statement records all the flows of currencies into and out of the company and all is registered in between on the Balance Sheet.
This unique way of explaining how finance works is based on my dyslexia because to me all is one structure, one way of doing things with graphs and little words. For you one way to understand finance and get the logic of the entire field of Financial Management. In the remainder of the book we will continue to use one and the same picture every time again…… and again….. and again…..
No matter how complicated the companies activities become, all above the Creditors and Debtors are part of the Profit and Loss and all below to the Cash Flow Statement. Just draw the picture and you will know!
The field of Management Accounting focusses on the financial statements and predominantly the profit and loss statement. Typical issues are pricing, cost developments, revenue developments and assessments. This, of course, from different perspectives, such as per product type, in time, by country or area, by customer type and so on. Key aspects of the field of management accounting are the objectives to profit maximization with capital minimization, so that a maximum return is generated for each shareholder. To realize this there is a jungle of ratios to assess the performance of the company. However, these can almost always be traced back to high profit and low capital.
The disciplines main focus is on the Cash Flow Statement and on the assessment of large (capital) investments. As with Management Accounting, the intention of Financial Accounting can also be reduced to two objectives. First of all, I want my money back as soon as possible (time) and of course with a minimum of risk.
In this article I have listed the most important aspects for a non-financial manager. Every manager who makes decisions within a company must understand both the current financial situation, but also have a good understanding of the financial impact of possible future actions. For this we use financial statements based on the seven accounting principles and consist out of the Balance Sheet, the Cash Flow Statement and the Profit and Loss Statement.
And lastly Companies do not go bankrupt because they make losses, companies go bankrupt because they have no money left and they cannot find anyone that wants to provide them a loan!
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