Finance

Finance plays a central role in the overall well-being of all economies in the world. It impacts all players in the economy regardless of whether they have a background of financial knowledge or not. Like corporations, people face various financing and investment decisions. Having a solid foundation in regard to financial matters can assist an individual in making an informed decision on matters pertaining to financing and investment. All businesses deal with finance, as they are required to have a financial understanding of how to fund their projects and effectively manage their budgets.

At the government level, the financial knowledge plays a central role in the budgeting process, because it helps the government raise revenue to finance the projects it tends to undertake and design a good tax system that can spur the economic growth and development (Wood & Sangster, 2012). This paper discusses various concepts of financial management and their importance to various stakeholders in any economy.

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The fundamental areas of business finance include investment, corporate finance, financial institutions, and international finance. Investment entails working with extra assets, such as cash, to buy bonds and stock. The value of the financial asset is the function of risk and return. Career opportunities in financial investment include positions of a security analyst, portfolio manager, financial adviser, and a stockbroker. Financial institutions form a corporation that specializes in dealing with financial matters and include banks, brokerage firms, and insurance companies. Financial institutions are normally established in order to provide financial transactions like an investment, loans offering, and deposits taking.

International finance is a component of financial economics that concerns macroeconomics and monetary interrelation affecting two or more nations. International finance studies the forces of the world’s financial systems, exchange rate, the balance of payments, foreign direct investment (FDI), international monetary system, and their linkage to international trade. International finance enables an individual to work in foreign countries, which helps to assess and manage global risks, such as foreign exchange and political risks. The key dimension set pertaining to international finance includes market imperfection, expanded opportunity set, as well as political and foreign exchange risks.

These dimensions largely originate from the fact that independent and sovereign countries have the power and rights to issue their own currency, formulate fiscal and monetary policies, as well as regulate the movement of factors of production across their territories. Factors affecting international finance include exchange rate and political reasons. The language barrier in international business can be overcome by encouraging people to run business in foreign countries.

Business finance is a term that entails a wide number of activities that revolve around prudence management of cash and valuable assets of a firm. Business finance functions in many universities that offer business-related course endeavors in order to equip students with knowledge about accounting methodology, financial investment strategies, and debt management. Financial knowledge is critical in the marketing of financial products. Studying finance enables an individual to prepare a personal budget, to make personal plans, especially in regard to college students, to manage daily cash flow, especially in regard to those people who have more than one source of income, and to develop the retirement plan (Wood & Sangster, 2012). Furthermore, the financial management of individual business involves a lot of other aspects apart from keeping accurate records. One must manage finances in an effective and efficient manner because individual financial disciple affects all facets of the individual business.

Financial management plays a central role in tax planning. Good financial management practice demands that a business have liquid cash to cater for current tax obligations, as well as ensure there is proper timing when purchasing major assets in order to get tax benefits. For instance, if a business current year is not going to demand high tax payment, but the subsequent year is going to demand it, a firm can postpone the purchase of an asset until the following year when the tax burden will be lower (Wood & Sangster, 2012).

By studying finance, the managers are in a position of interpreting financial statements that enable them to make strategic management decisions, which have the potential to improve the profitability of a company as well as the performance management. Furthermore, having knowledge of finance, a person has to be in the position of answering more questions than a person without the knowledge, as well as making informed financial decisions (Seethamraju, 2012). The Chief Finance Officer is the top financial officer in any financial institution. Another key financial position includes that of a treasurer who is in charge of financial planning, cash management, capital expenditure, and credit management, while the controller is tasked with data processing, cost, and financial accounting.

Financial Management Decisions

Financial management entails making decisions that effectively and efficiently manage funds in a manner that is in tandem with the goals and objectives of a firm. Financial managers make financial decisions and work on capital management, capital budgeting, and capital structure decisions. Every financial manager should endeavor to make three fundamental decisions pertaining to their role as a finance manager. These decisions include financing, investment, and dividend decisions. The fundamental goal of financing and investment is to optimize shareholder value. The financial decision deals with the question of how to financially support investment and further expenses. Corporations can use retained profits by selling equity or borrowing money from financial institutions like banks. The investment decision deals with the question of how disposable financial resources can be invested to later return to their owners in bigger sizes. Every investment undertaken by a business can be financed via company retained earnings or from external players.

Forms of Business Organization

Business organizations can be classified into three broad categories based on the ownership and form of control. The three categories of the business organization include:

  • sole proprietorship;
  • partnership;
  • corporation.

A Sole Proprietorship

A sole proprietorship is a business owned and controlled by one person, in assistance with family members. The sole proprietor is responsible for the day to day running of the business (Wood & Sangster, 2012). The sole proprietor alone contributes to the capital for starting the business and makes investment decisions. The liabilities of a sole proprietorship are unlimited. The merit of this form of business organization is that the decision-making process is faster, and a few legal requirements are needed to own a sole proprietorship business. Other advantages of a sole proprietorship include easy forming and operating.

The sole proprietorship takes all profit, is subjected to less regulation from the government and less taxation, as the business income is taxed together with the income of the entrepreneur. Demerits of a sole proprietorship include the limited lifespan of the business because the operations of the business cease with the demise of the proprietor. Capital injection into the business is limited by the personal wealth of the sole proprietor, and it is difficult for the sole proprietor to sell their business. Also, in the case of financial failure, the sole proprietors bear the repercussions of it by themselves (Seethamraju, 2012).

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The Partnership

The partnership is a form of business organization with at least two and a maximum of twenty or sometimes fifty members, in cases of service-oriented partnership, such as a medical or legal one. A partnership can be further classified into two broad categories, namely general partnership and limited partnership. In a general partnership, all partners in the partnership business have unlimited liabilities, while in a limited partnership, all partners of the business have limited liabilities. The merits of partnerships include the availability of more capital to operate a business, a relatively easy start, and fewer taxes as compared to a corporation, because business income is taxed together with those of individual partners.

The partnership also ensures better management of business operations as compared to sole proprietorship form of business, because partners may have different expertise which can be beneficial to the business. The demerits of the partnership include the fact that partnership can be easily dissolved in case of disagreements among the partners, the unlimited liabilities assigned to individual partners in case of the general partnership, as well as difficulties in transferring ownership in the partnership (Wood & Sangster, 2012).

The Corporation

The corporation is a separate legal entity, and the shareholders of a corporation have limited liabilities. Corporations exist in two types — namely, there are S-corporations and limited liability corporations. The corporation is the most common form of business organization, and it requires more legal requirements in regard to its formation compared to a sole proprietorship. Corporations are also able to raise capital faster as compared to sole proprietorship businesses. Corporations have an unlimited term of life because the demise of a shareholder does not affect the continuality of a business. Incorporation is a separation of management from ownership. Transfer of ownership is easy for corporations, especially for public corporations. Furthermore, corporations are better managed compared to other forms of business, because they have the financial resources that allow them to hire professionals. However, the decision-making process for corporations, especially for large ones, takes time, and it is normally bureaucratic in nature (Wood & Sangster, 2012).

The separation of management from ownership can lead to agency problems, whereby instead of management working for the best interests of shareholders, the managers may decide to pursue their selfish goals which are detrimental both to business and to shareholders. In order to mitigate the agency problem, shareholders are forced to incur more expenses in terms of engaging external auditors and putting in place internal control systems, such as employing internal auditors and risk and compliance personnel. Corporations also face the problem of double taxation, whereby their income is taxed twice, which increases operational costs. For example, an income generated by a corporation is taxed at the corporate rate, and dividends of the shareholder are also subject to taxation on the personal rate, which can easily discourage the processes of investment.

Goals of Financial Management

The financial goal of all businesses is to maximize their profits, cut expenses, and expand the market share. The ultimate goal of the financial side of any business operation is to add value to the investment of shareholders. Financial management endeavors to optimize the use of financial resources through maximizing the revenue generation and minimizing the cost, which results in increased profitability. Corporation revenue is increased by widening or expanding the market share of the company’s product, which can be achieved through aggressive sales and marketing as well as advertisement of the company’s products. The goal of financial management is to increase the profitability of a company both in the short and in the long run.

The Agency Problem

The agency problem is a conflict of interest, inherent in any form of relationship where one party is required to act in the best interest of another party. In corporate finance, agency problem entails a conflict of interest between a company’s owners and its management. From the agency perspective, the problem arises when the principal — shareholder, hires an agent — manager, in order to work in the best interest of the principal, but the agent decides to pursue their own interests contrary to the expectations of the principal (Wood & Sangster, 2012).

Mitigation of Agency Problem

The fundamental principle of agency theory argues that there is the likelihood of mischief when the stakeholders’ interests diverge from management’s interests. In those cases and for a number of reasons, the management of a company may want to provide themselves with higher remuneration that is way above the market rates and is unaffordable and unsustainable to the business. While that basic tenet of agency theory is still intact, other factors originated directly from agency theory are yet to be settled. Indeed, even after several years of conceptualization and experimentation, three main approaches recommended mitigating the basic agency problem continue to be contentious. Since the agency problem is driven by information asymmetry constant and open communication, the relevant stakeholders can play a key role in mitigating the agency problem.

The agency problem can be mitigated by attempts to establish a balance between various conflicting interests. For instance, senior management of a company may ask for a fair remuneration while continuing to work in shareholder’s interests and ensuring the maximum return of their investment. The remuneration of a company’s management may be linked to performance, so those managers who work hard in order to stimulate business growth are fairly compensated. The shareholders may also decide to incur agency costs, such as the cost of engaging the external auditor to give an expert opinion in regard to the financial activities conducted by the management. Corporations may also circumvent the issues arising from agency problems by incorporating monitoring, seeking help from third parties, seeking the opinion of experts when necessary, as well as designing contractual incentives. The stockholders can also threaten the management with dismissal and hostile takeover in case they do not fulfill their expectations.

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Financial Statements

In today’s competitive business world, business managers are required to make a financial decision that may be intended to assist the company in making good use of its capital or expenses management. For making a decision, some financial information is required. Good financial managers have several instruments at their disposal which help them achieve these goals together and get a good grasp on business’ financial position. The required information can only be obtained from three basic financial statements, namely, from the balance sheet, income statement, and cash flow statement. Conversance with fundamental types of financial statements, as well as the ability to interpret them, plays a central role in making informed business decisions. When financial statements are accurately prepared, they offer an accurate image of the operations of a business in a specified period of time. The financial manager then evaluates such financial statements in order to make an operational decision.

The balance is also referred to as the statement of financial position. A balance is a summary of all assets and liabilities of a business at a specific date (Barnes, 2011). The information contained in the balance sheet informs the stakeholders of the financial decisions that were made in regard to their business. A good financial manager is able to project growth and efficiency from the numbers contained in a balance sheet. When preparing a balance sheet, the assets are arranged in the order of decreasing liquidity.

For instance, the process starts with non-current assets, such as lands and buildings, then proceeds to current and more liquid assets, such as cash. Assets can be broadly grouped into current and fixed assets. Fixed assets can also exist in an intangible form, such as lands and buildings, or in an intangible form, such as goodwill. Basically, the balance has three items of assets on one side, and liabilities and equity on the other side. The balance sheet is designed in such a manner that assets are equal to liabilities and shareholders’ equity. However, it is important to note that a business balance sheet does not include some valuable assets, such as profitable employees who may offer incredible resources in regard to business performance.

The right side of a balance sheet contains liabilities and capital. The listing of liabilities starts with current liabilities, proceeds to long-term or noncurrent liabilities, and finally ends with the owners’ equity (Barnes, 2011). The portion of owners’ equity may contain the share capital and retained earnings. The difference between a current asset and current liabilities is called working capital. Working capital is a parameter that measures the short-run financial health of a business as well as the efficiency of a business in its operations. For instance, by using the balance sheet of U.S Corporation, it becomes clear that a total current asset for the year 2008 was $ 1,403 million, and the number of total liabilities for the same period equaled $389 million. Hence the working capital for U.S Corporation on 31st December 2008 was $1,014 million ($1,403- $389). This implies that after U.S Corporation settles its current liabilities, it will remain with $ 1,014 million, a clear indication that the company is extremely liquid.

The balance sheet normally presents business’ assets, liabilities, and equity in their book value. However, in most cases, the book value of balance sheet items is close to its market value. Book value in relation to the balance sheet refers to the balance sheet item, carried on a statement of financial position. In relation to an asset, book value can be estimated when an asset of the business is carried on from the previous period to the next, after deducting depreciation. Market value is the price that a balance sheet item can receive in a competitive market. The book value and market value are always different because book value is theoretical in nature in the sense that it does not reflect market dynamics, while market value represents the actual amount an item can fetch if it were to be sold in a competitive market. Hence, the market is more relevant in the decision-making process. Current assets and current liabilities tend to have book value and market value that are fairly close (Barnes, 2011). However, this is not the case with other assets, liabilities, and equities of a business.

Income Statement

The income statement is a business’ financial statement that reveals how income is transformed into net revenue. The income statement is a detailed account of business operation over a specified period of time. Income statement contains revenue and expenses only. When preparing an income statement, the business revenues are recorded first, followed by expenses that are deducted from the revenues, and income without tax limitations. According to the matching principle of generally accepted accounting principles (GAAP) of financial accounting, the revenue should be recognized when fully earned and matched with the expenses incurred to generate it, in that specific period of time when revenue is being recognized (Barnes, 2011).

The matching principle also allows the deduction of indirect costs, such as the depreciation of machinery used in the production process. For this reason, it is not a true presentation of cash flow during the period under consideration. Unlike the cash flow statement, the income statement incorporates intangibles expenses, such as depreciation and amortization, but it does not indicate these expenses are actually paid out. Hence the income statement presents a projected profit over a specified period of time. Taxes are another income statement item that affects the profitability of a business. Taxes keep on changing, as it is a fiscal tool used by governments to stabilize the economy. The two common tax rates applicable in the United States of America are marginal and average tax rates. The information contained in income statements assists financial managers in making an informed decision in regard to the operation costs management, as well as the price at which products must be sold to maintain the desired profit margin (Barnes, 2011).

Cash Flow Statement

The cash flow statement is one of the critical statements that inform the stakeholders of the management decisions. While the business can be perceived as profitable based on normal accounting practice, the cash flow statement helps to establish whether a business has financial resources to meet its short-run financial obligations. While earned net incomes are frequently depicted in the income statement, they can be manipulated to present a healthy financial situation, while the cash flow statement shows the reality of a business in terms of its ability to meet its financial obligations when necessary. A decline in business’ cash flow operations ratio is a sign that the business needs to reassess its pricing systems, the cost of inventory, debts, overhead expense, and other short-run decisions, in order to boost its ‘cash position’ (Barnes, 2011).

Standardized Financial Statements

Standardized financial statements, also referred to as common-size statements, are statements of finance where all accounts are expressed as a percentage of total assets or total sales for balance sheet and income statement respectively (Stoichev, 2014). Standardized financial statements present all items in terms of percentage. A common size statement makes a comparison between financial information about different companies possible. Standardized statements are particularly important when comparing companies of different sizes in the same industry as they grow.

Financial Ratios

Financial ratios allow a better comparison between the financial performance of different companies over time. Without ratios, a financial statement would be of no use to all players in the financial sector, except to the individuals highly skilled on financial matters. Through ratios, financial statements are interpreted, providing valuable information that meets the needs of all users. Ratio analysis is the first step in assessing the financial position and performance of a business entity. Ratios remove the mystique that revolves around the financial statements, thus making it easier to pinpoint an item of interest in the financial statements (Stoichev, 2014).

Financial ratios are useful to both internal players and external users. They are grouped into five broad categories, namely liquidity, financial leverage, turnover, profitability, and market value ratios. Some of the liquidity ratios include the current ratio, computed by dividing the total current assets into total current liabilities. For instance, if the total income of company X is $2,447,830, and the total liabilities are $ 1,968,662, then the current ratio will be 1.2 (2,447,830/1,968,662). Another liquidity ratio is an acid test which is computed by subtracting inventories from total current assets and then dividing the resulting figure into a number of total liabilities of a business entity. Using the model illustrated above, we can assume that company X has total inventory worth $300,459, meaning that the quick ratio or acid test ratio will be 1.1, which is ($2,447,830-300,459)/1,968,662. An ideal quick ratio is 1, hence this business is making good use of its assets. Examples of financial leverage ratios include total debt, debt to equity, and equity multiplier ratio.

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The total asset turnover ratio, which is computed by dividing the total turnover into the number of total assets, is a measure of efficiency in the use of business assets. It is common for businesses to have total asset turnover or less than 1 because non-current assets are expensive to acquire and are meant to generate sales for a long period of time. Profitability ratios include return on the assets (ROA), return on equity (ROE), and profit margin. Other financial ratios include payout and retention ratio for a public company that gives dividends to its shareholder (Stoichev, 2014).

Retained earnings are important in measuring the growth rate of a business entity. The internal business growth rate indicates the extent to which a business entity can increase its assets by solely using retained earnings to finance their purchase. Financial ratios that indicate business growth include the total asset turnover ratio, which measures the efficiency of the asset use. The profit margin measures business operation efficiency. Financial leverage ratio helps to select the optimal debt levels for a business entity, as well as the dividend policy which determines how much dividends should be paid and how much of them should be retained for future investment opportunities (Seethamraju, 2012).

Evaluation of the financial statements is important to both internal and external users of financial statements. Internally, the evaluation of financial statements enables the management of the business entity to evaluate the performance of a business and the planning process. External evaluation of the financial statements enables various stakeholders, such as creditors, customers, suppliers, shareholders, and the government, to make an informed decision, as they relate to business. Moreover, the evaluation of financial statements plays a central role during the benchmarking of different business entities (Seethamraju, 2012).

The Accounting Cycle

The accounting cycle is the process that entails identification, collection, and analyzing the transactions and documents. The transactions are documented in books of original entry, then the journalized figures are posted in general and subsidiary ledgers, along with record adjusting entries and eventual preparation of financial statements (Barnes, 2011). Recording of adjusting entries is critical, especially when expenses or revenue impact more than one accounting cycle. Each adjustment entry impacts either revenue or expense, and ultimately the asset of liabilities of a business entity. Types of adjustment entries include accruing uncollected revenues, conversion of assets into expenses, conversion of liabilities into revenue, and accruing unsettled expenses. Examples of adjustment entries which entail conversion of assets into expenses include expiring insurance policy and computation of depreciation.

Depreciation

Depreciation refers to the methodical allotment of the cost of depreciable property into the expense. Depreciable assets are tangible objects, capable of maintaining their shape and size, but their economic value declines with continued use. The most common method of computing depreciation includes the straight-line method and the reducing balance method. The straight-line method of computing depreciation apportions depreciation expenses evenly throughout the useful lifespan of an asset. Reducing-balance methods of depreciation computations entail the reduction of the value of a given asset by a given rate, usually expressed in terms of percentage until the book value of the asset declines to nil.

For instance, assuming that on May 2, 2013, JCS limited purchased a motor vehicle which lifespan is ten years for $100,000, its salvage value would be $5000 at the end of 10 years. The depreciation per year using the straight-line method would be (100,000-5,000)/10, which is $9,500 per annum. By using the same example, we can assume that the rate of depreciation equals 12%, and the amount of depreciation of the motor vehicle at the end of the second year would be (100,000-12,000)*12%, which is $10,560.

Conclusion

In the current competitive business environment, business managers are required to make financial decisions that have to assist the company in making good use of its capital and expenses management. While making the decision, some specific financial information is required. Good financial managers have several instruments at their disposal which help them achieve these goals and acquire a good grasp on business’ financial position. Financial management entails making decisions that effectively and efficiently manage funds in a manner that is in tandem with the goals and objectives of a firm.

Financial managers make financial decisions and work on capital management, capital budgeting, and capital structure decisions. Financial managers have to possess knowledge in regard to the basic accounting, preparation of financial statements, and other functions. All businesses deal with finance, as they are required to have a financial understanding of how to fund their projects and effectively manage their budgets.

At the government level, the financial knowledge plays a central role in the budgeting process, because it helps the government raise revenue to finance the projects it tends to undertake and design a good tax system that can spur economic growth and development. In regard to comprehensive logic, financial knowledge is significant to all people.

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