The Responsibilities and Importance of Financial Managers

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The Responsibilities and Importance of Financial Managers

Business Essentials · Chapter 21: Financial Management and PlanningSection 21.1 · lesson 91 of 10511 min · free with a free account

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In this lesson

Deciding what a business does next with its money.

  • Describe financial management and its 3 decisions
  • Weigh the objective, solvency, and the agency problem
  • Explain working capital and the cash conversion cycle
  • Assess performance with 4 categories of ratio

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Financial Management and Planning

Financial Managers: Responsibilities and Importance

A wholesaler wins bigger customers, and sales climb for months. Then she has to borrow more than ever. Growth caused the cash problem. This section explains how. It's educational content, not financial, investment, tax, or legal advice. Real financing or investment decisions call for a qualified professional. We'll define financial management, and the three decisions at its core. We'll weigh its objective, the solvency constraint, and the agency problem. Then we'll dig into working capital, and the cash conversion cycle. And we'll see how four categories of ratio assess performance, and where ratios fall short.

Defined

Looking Forward, Not Backward

Financial management is the acquisition and deployment of funds to achieve a business's objectives. The clearest way to separate it from accounting is direction of attention. Accounting looks backward. It records and reports what has already happened. Financial management looks forward. It decides what to do next. And it uses accounting's output as an input, not as its subject. So a financial manager reads the statements from the last chapter for a different reason. Not to understand the past for its own sake. But to decide what the business should do about its assets, its funding, and its future.

3 Decisions

Investment, Financing, Distribution

Financial management centers on three decisions. The investment decision asks what assets the business should acquire. That might be equipment, inventory, or a whole new capability. The financing decision asks how to pay for those assets. That question gets full treatment in the next two subchapters. The distribution decision asks what to return to owners, as dividends or withdrawals. And what to retain in the business for future use. Here's a useful way to hold the whole field in your head. Every other responsibility in this section serves one of these three decisions.

The Objective

Whose Value, and the Constraint That Always Holds

What is financial management trying to achieve? The conventional answer is maximizing owner value, increasing what the business is worth to its owners. That framing is contested, so it's worth stating carefully. The stakeholder view holds that a business has obligations to employees, customers, suppliers, and the community. Those obligations aren't reducible to owner value. A decision that maximizes owner value in the short run may impose costs, which a fuller accounting would weigh. The conventional position answers that a business serves everyone best by staying financially sound. And by being clear about whose value it's optimizing, since an institution answerable to no one tends to serve no one well. This course presents both views, and takes no position. But one constraint holds whichever objective you choose. The business must stay solvent. Solvent means able to meet its obligations as they come due. Maximize long-run value while running out of cash next month, and you won't survive to see the long run. So solvency isn't a rival objective. It's the precondition for pursuing any objective at all.

The Agency Problem

When Managers Don't Share Owners' Goals

The agency problem arises because managers act on behalf of owners, but may not share their goals. A manager might favor decisions that increase job security, or personal pay. Or decisions that grow the size and prestige of the business she runs. Even where those choices diverge from what would maximize the owners' value. Several mechanisms narrow that gap. Performance-based pay ties a manager's compensation to measures that align with owners' interests. A board of directors oversees management on the owners' behalf, in businesses structured with one. Financial reporting and audit give owners visibility into what management actually did. And in an owner-operated small business, the problem shrinks a great deal. The person making decisions and the person bearing their consequences are often the same individual.

In Practice

6 Responsibilities of Financial Management

In practice, the responsibilities fall into six areas. Financial planning determines what funds the business will need, and when. Capital budgeting evaluates which long-term investments, like equipment or expansion, are worth making. Working capital management handles the short-term resources that keep daily operations running. Financing secures the funds the business needs, on acceptable terms. Risk management, from the chapter on risk and insurance, identifies and treats threats to the financial position. And reporting and control monitor performance against plan, flagging deviations that need attention. Each of the six, in the end, serves the investment, financing, or distribution decision.

Working Capital

The Near-Daily Job in a Small Business

In a small business, working capital takes more of the financial manager's time than anything else. That's because it's the constant, near-daily job of meeting obligations as they fall due. It has four parts. Receivables are what customers owe the business. Collect them promptly, without damaging relationships. Payables are what the business owes its suppliers. Pay on the best terms you can negotiate, without straining them. Inventory is goods held for sale or use. Hold enough to meet demand, without tying up excess cash. Cash is what's immediately available. Keep enough to bridge the gaps, but not so much that it sits idle. One concept ties all four together, the cash conversion cycle. It measures the days between paying for inventory, and collecting cash from the sale. Take the days inventory is held, add the days customers take to pay, and subtract the days suppliers give you.

Figure 21.1.1

A 48-Day Gap the Business Must Fund

Here's the cycle for a described business, with illustrative figures. Inventory sits for thirty-eight days before it's sold. Customers then take thirty-two days to pay. So seventy days pass between buying inventory and collecting the cash. But suppliers give the business only twenty-two days before payment is due. Thirty-eight, plus thirty-two, minus twenty-two, leaves a forty-eight day gap. The business has to fund that gap itself. Every one of those forty-eight days, it has paid for inventory and labor without collecting from the sale. That's exactly the working capital need that financing exists to cover. Notice the levers. Hold inventory for less time, collect sooner, or win longer supplier terms, and the gap shrinks.

Profit And Cash

Why the Cycle Matters to a Financial Manager

A positive cycle, like this one, means the business funds the gap between paying and collecting. Typically it does so through working capital financing sources. Now suppose the business offers more generous payment terms, to win sales. Its receivables period lengthens, the gap widens, and its funding need grows. Remember from the last chapter that profit and cash are different things under accrual accounting. For a financial manager, that isn't an abstract accounting point. It's the daily reality of the job. Much of the role's attention isn't on whether the business is profitable. The income statement already answers that. It's on whether there'll be cash on the specific days obligations come due. The cash conversion cycle is one lens on exactly that question.

Table 21.1.1

4 Categories of Ratio

Financial performance is assessed through four categories of ratio. Each answers a different question. Liquidity asks whether the business can meet its short-term obligations. The current ratio divides current assets by current liabilities. Well above one suggests ample short-term resources. Near or below one signals possible trouble paying on time. Solvency, or leverage, asks how the business is funded, and how much risk that carries. Debt-to-equity divides total liabilities by owners' equity. A high ratio means heavy reliance on borrowing, and fixed obligations. Profitability asks how well activity turns into profit. Net profit margin divides net income by revenue. A margin that falls even as revenue rises means costs are outpacing sales. Efficiency asks how well the business uses its assets, for example through inventory turnover. Low turnover means inventory is sitting too long, tying up cash. No single ratio gives the full picture. Strength in profitability can hide a weakness in liquidity.

Limits And Practice

Reading Ratios, and Who Does This Job

Ratios have real limits. Comparing across industries is risky, because capital needs and operating patterns differ. A ratio that's strong in one industry may be weak in another. So compare against the business's own history, or against genuinely similar businesses. Accounting methods matter too. Different permitted methods can change ratios on identical underlying economics. Most fundamentally, a ratio raises a question. It doesn't answer one. A low current ratio tells you liquidity is tight. It doesn't tell you why. For that, you look behind the ratio, the way the cash conversion cycle breaks liquidity into its parts. In a small business, the financial manager is usually the owner, often without the title or any finance staff. The responsibilities don't disappear. They just concentrate in fewer hands. That's a big reason working capital so often dominates a small business owner's financial attention.

Case Vignette

The Gap That Grew With Growth

Farrah owns a wholesale supplier of restaurant equipment. She usually gives smaller customers fifteen days to pay. To win several larger restaurant chains, she offers them sixty days. Sales to the new accounts grow steadily, and she's pleased. But she's drawing more heavily on her line of credit than expected, and can't explain why. The cash conversion cycle shows the cause. Her receivables period, blended across all customers, has lengthened considerably. Her inventory and payables periods haven't changed. So the gap between paying for inventory and collecting has widened, and her credit line is funding it. The big chains set their own payment practices, and are unlikely to accept fifteen-day terms. So Farrah now treats the wider cycle as a financing need to plan for, not a mystery. With her adviser, she'll weigh faster-paying customers, tighter inventory, or better supplier terms. Those are the levers left, since she can't close the gap from the receivables side alone.

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FAQ

Questions students ask us

About The Responsibilities and Importance of Financial Managers

What does a financial manager do?
A financial manager acquires and deploys funds to achieve a business's objectives, looking forward rather than recording the past as accounting does. The work centers on three decisions: investment (what assets to acquire), financing (how to pay for them), and distribution (what to return to owners and what to retain). In practice it covers financial planning, capital budgeting, working capital, financing, risk management, and reporting and control.
How do you calculate the cash conversion cycle?
The cash conversion cycle equals days inventory is held, plus days customers take to pay, minus days suppliers allow before payment is due. It measures the gap between paying for inventory and collecting cash from the sale. For example, 38 days of inventory plus 32 days of receivables minus 22 days of payables leaves a 48-day gap the business must fund. Holding inventory less, collecting sooner, or winning longer supplier terms shrinks it.
What is the agency problem in finance?
The agency problem arises because managers act on behalf of owners but may pursue their own goals, such as job security, higher pay, or a larger, more prestigious business, even when that does not maximize owner value. Mechanisms that narrow the gap include performance-based pay, oversight by a board of directors, and financial reporting with audit. In an owner-operated small business the problem shrinks, because the decision-maker bears the consequences.
What are the four main types of financial ratios?
Financial ratios fall into four categories. Liquidity ratios, such as the current ratio (current assets divided by current liabilities), test the ability to meet short-term obligations. Leverage ratios, such as debt-to-equity (total liabilities divided by owners' equity), show reliance on borrowing. Profitability ratios, such as net profit margin (net income divided by revenue), show how activity becomes profit. Efficiency ratios, such as inventory turnover, show how well assets are used.

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