Basic principles of financial management

Brümmer LM, Hall JH, Du Toit E

• Publisher: Van Schaik Publishers
• Year: 2017
• ISBN:
  9780627034701
• Topic: Didattica
• Subtopic: Istruzione superiore

No financial task can be performed without at least a basic understanding of the principles of financial management. By applying these principles to the reading of financial statements, it is possible to observe how an organisation has earned and spent income, and what its current financial position is. Basic principles of financial management is designed as a guide to the world of finance. Basic principles of financial management provides an opportunity to learn the language of the financial world. It sets out the concepts and conventions of managerial finance and the main topographical features of the new territory of the statement of financial position (balance sheet), income statement and cash flow statement. The information is offered in as simple a manner as the subject matter allows. Even a layperson will glean valuable tips on how to manage finance in terms of systems and units of administration, and thus be better equipped to understand financing and investment decisions.

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Introduction

What you need to know

Why would anyone want to read a Statement of Financial Position (previously called a balance sheet), and try to decipher all the figures and strange expressions on it? For anyone who knows nothing about it, reading a Statement of Financial Position is like trying to figure out hieroglyphics, but there is a wealth of important and interesting information hidden behind all that apparently incomprehensible material. That is where one will find all the financial information about an organisation and what keeps it afloat.

Just as a doctor may use a thermometer as the first step in determining the state of a patient’s health, financial managers, shareholders or prospective investors use the Statement of Financial Position as their initial gauge in determining the state of an organisation’s financial health. They then apply other investigatory techniques, as doctors may do, before they are in a position to make an assessment. We might therefore conclude that the Statement of Financial Position plays an important role in attempting to assess an organisation’s degree of financial success.

However, the Statement of Financial Position is not the only instrument used to assess an organisation’s financial health. It is really only one component of a set of documents, generally referred to collectively as an organisation’s financial statements. These usually consist of the Statement of Comprehensive Income (normally called the income statement) and the cash flow statement, each of which complements the other two. This is especially true of the Statement of Financial Position and the Statement of Comprehensive Income: the one is seldom read without the other, therefore when we speak about reading a Statement of Financial Position, we really mean that we are reading all three documents because, on its own, the Statement of Financial Position will provide only part of the story. 2

Financial statements from previous years provide a history of the organisation’s affairs. When they are compared with those of the current year, we can judge whether or not the organisation has progressed over the years.

What are financial statements?

Before going any further, we need to briefly define these three documents. After this, it should begin to be clear why the Statement of Financial Position, for example, does not provide all the information that may be required by the reader.

The Statement of Financial Position

The Statement of Financial Position may be defined as a document which reflects the state of an organisation’s financial and business affairs on a particular day, usually the last day of the financial year. However, the directors may wish to keep a closer watch on the organisation’s affairs and would therefore require financial statements more often than once a year, say quarterly or half-yearly. In each of these cases, the Statement of Financial Position would reflect the state of affairs on the last day of each respective period.

Typically, the Statement of Financial Position reflects the organisation’s assets and liabilities, both long and short term. Since the liabilities represent the total funds used to finance the assets, the total asset value must equal the total of the liabilities. This means that the one amount must balance with the other.

The Statement of Comprehensive Income

The Statement of Comprehensive Income may be defined as a document which reflects the results of the organisation’s business and financial transactions during an entire financial year or other shorter period. Typically, the Statement of Comprehensive Income reflects the total income from sales, less all operating, administration and marketing costs. Thereafter, it reflects how rewards were dispensed in the form of interest, taxes and dividends to all parties who had vested interests in the organisation during the year. Finally, the Statement of Comprehensive Income reflects the amount of net income (if any) that is to be retained in the organisation for major uses such as paying off long-term loans and expanding its operations.

The cash flow statement

The cash flow statement may be defined as a document indicating how cash has flowed into and out of the organisation during the year or other given period. For example, it would show cash flowing in from total cash sales, but cash from total credit sales would be reflected only when the asset trade receivables or accounts receivable are reduced.

You will learn later that cash flows into the organisation when assets are reduced (or sold) and when liabilities are increased, for example when shares are issued or money is borrowed. Similarly, cash flows out when loans are repaid, or trade and 3other payables are paid. Any transaction which is reflected in the cash flow statement will also be recorded in the Statement of Financial Position and Statement of Comprehensive Income in the appropriate place and manner.

Consequently, following on the remark made earlier concerning their importance, we may assume that the Statement of Financial Position and the Statement of Comprehensive Income are the two primary documents comprising an organisation’s financial statements, while others, including the cash flow statement, are secondary, and play only supporting roles.

The purpose of financial management

The purpose of reading financial statements is to observe how an organisation has earned and spent income, and what its current financial position is. This is accomplished by applying the principles of financial management. The financial manager must know these principles in order to manage the organisation’s financial affairs, to preserve its assets, and to maintain its liquidity and solvency positions (these terms will all be defined later). Likewise, other interested readers who wish to understand how the organisation operates must become acquainted with the principles of financial management.

The purpose of this book

This book is therefore directed not only at all students of financial management, but also at all individuals, from clerks to managers, who are engaged in managing the financial affairs of the institution in which they are employed. It is especially directed at individuals who have a limited knowledge of financial management and wish to supplement it.

No financial tasks can be performed without at least a basic understanding of the principles of financial management. The most elementary form of instruction in this field would be to learn by working in tandem with someone else. However, such opportunities are not always available. The authors trust that this book will therefore provide a thorough grounding in the basics of financial management.

This book is also directed at prospective investors who have only limited knowledge of the methods applied to assess the financial value of investment projects prior to investing cash through loans or by purchasing shares. Other potential readers would be individuals from other fields who are suddenly thrust into the financial field. Imagine if a marketing manager with virtually no knowledge of financial management were to be unexpectedly promoted to the position of managing director. Having a set of financial statements thrust before him for his comment may prove very embarrassing. The study of an uncomplicated book such as this one could effectively prevent embarrassment in similar situations.

And, finally, this book is directed at ordinary individuals who want to know how to balance their own weekly, monthly or annual budgets. Although such people might not use documents as formal as financial statements, the principles of financial management would nonetheless be applied in some or other form, and 4knowledge of these basic principles could be a valuable asset. After all, knowledge is power!

Presentation of the subject

For the benefit of either ordinary individuals or students, the authors have worked on the assumption that their knowledge of financial management and its ramifications is relatively scanty or even non-existent. This book will therefore begin at an appropriately basic level and proceed with adequate explanations to the level required by a senior officer of an organisation.

As may be seen in the table of contents, this book is divided into chapters, the first of which is this introductory one. In addition, the table of contents provides a comprehensive list of all the headings and subheadings, which should help the reader find a particular topic with comparative ease. The comprehensive index at the end of the book should further aid in quickly tracking down other items not presented in the table of contents.

Chapter 2 comprises a brief discussion of various terms which generally seem to cause confusion.

Chapter 3 provides explanations of the application of some of the basic mathematical principles required in financial management. Although some readers might not require this information, others may find it useful.

In Chapter 4, the actual financial statements are studied. In the discussion of the Statement of Comprehensive Income and the Statement of Financial Position, the various items they contain are considered in some detail, not only each in its own right, but also from a content and informational point of view. For example, a discussion of the payment of dividends on the Statement of Comprehensive Income includes an explanation of the different kinds of shareholder and their respective rights. This is expanded upon in the discussion on the Statement of Financial Position by means of a further explanation of ordinary and preference share capital, and the integration of each of these items into the organisation’s capital structure.

In Chapter 5, the cash flow statement is discussed.

Chapter 6 demonstrates what information may be obtained from the study of an organisation’s financial statements. This information is obtained by means of financial analysis, which should indicate the levels of liquidity, activity, solvency and profitability in the affairs of the organisation.

Chapter 7 embraces a very important topic, namely the management of working capital, also known as the management of net current assets. Financial managers are spending more of their time and effort on the management of current assets and liabilities than previously.

Chapter 8 discusses the principles of financial planning as well as the cash budget.

The value of money, or cash, is influenced by time, and Chapter 9 deals with the time value of money.

Chapter 10 covers the investment decision. This important area, in turn, 5involves the use of capital budgeting techniques, which financial managers use to determine whether or not to purchase fixed assets, and how such purchases will affect the profitability of the organisation.

Chapter 11 deals with the concept of valuation, which involves the cost of capital, which is also termed the required rate of return. The rate of return is a focal point around which decisions are made in determining whether or not, for example, to make certain capital purchases. The required rate of return is important because the determination of the capital structure of the organisation depends on it. Capital structure, in turn, will be influenced by financ...

Table of contents

• Title Page
• Imprint Page
• Dedication
• About the contributors
• Contents
• Chapter 1: Introduction
• Chapter 2: Definitions of terms
• Chapter 3: Fundamentals of mathematical calculations
• Chapter 4: The financial statements of an organisation
• Chapter 5: The cash flow statement
• Chapter 6: The analysis of financial statements
• Chapter 7: Working capital and cash management
• Chapter 8: Financial planning: the cash budget
• Chapter 9: The time value of money
• Chapter 10: The capital investment decision
• Chapter 11: Valuation and the required rate of return
• Chapter 12: Capital structure and financial leverage: the financing decision
• Chapter 13: Risk and leverage, and break-even analysis
• Chapter 14: Dividend policy
• Chapter 15: The leasing of non-current assets
• Chapter 16: Finale
• Appendix A
• Appendix B
• Index