THE ESSENCE OF FINANCIAL MANAGEMENT

Financial Management  and Financial Accounting form a core component of all organizations and are integrated into various Software platforms. Though I studied Engineering at a basic level I had acquaintance with Financial Accounting and Management from time to time.

There  are various aspects of Financial management and to a newcomer to the area this write-up would act as a motivator. Finance and Financial equations are key to any activity of commerce since time immemorial. Financial Accounting or Accounts in general forms the primary corner-stone of all Financial Management.

ASSETS   =   LIABILITY  +  OWNERS EQUITY  + BORROWED EQUITY

Is one of the most fundamental equations of Commerce. Assets  are items which can be sold in the future and has future utility.

PROFITS  +  COSTS  =   PRICE   is   another equation.

Note  how  the financial cycle works.  Assets are bought with borrowed money also called a liability. A liability has to be paid back  in the future with the profits. This is covered by Conventional Banking…owners equity is the money borrowed by the owner from himself.. though has to be replenished but without a hard and fast time frame. Borrowed equity is a share in the activity from a large number of people and covers the scope of Stock markets and Stock Banking..

Two of the key words in Accounting ARE  CREDIT  and  DEBIT. Credit created Debit  and  Debit creates Credit. Sometimes these words are used interchangeably. But there is a science to this.

WHEN SOMEONES FINANCIAL VALUE INCREASES IT IS DEBIT.

WHEN SOMEONES FINANCIAL VALUE DECREASES IT IS CREDIT.

TWO PEOPLE ARE NEEDED TO COMPLETE A TRANSACTION AND THE REFERENCE POINT FOR THESE WORDS IS THE SECOND PARTY.

Say  A  pays money to a bank B. The Financial value of the Bank is increasing. Say the amount is  C. The amount C is debited into the account of B  and credited from the account of A.  In effect all Credits from one source must equal the debits into various targets. A  is the first party and B is the second party.

Some times people say is Salary credited into my account.  This is right. The person to whom salary has to be paid is the first party.. Second party is the organization. In this transaction lossof value is to the  second party and hence the word Credited.

Similarly we use the word Debit card. The second party is the shop owner ..in the transaction  the value increases to the shop and hence the word Debit.

Financial Ratios  are supposed to indicate the totalhealth of Commercial transactions at any point of time..some of them are taken over shorter financial cycles and the others over longer periods.

A-L Ratio or Assets to  Liability ratio matches Assets to liabilities of a larger time horizon of say an year and also reflects in the Balance Sheet. Assets involves  Moveable…..fixed  and liquid assets. Liquid assets means ready cash. It is the ultimate financial health of an Enterprise. Theoretically Assets must equal liabilities at least. A balance sheet forcefully matches Assets and all possible liabilities. Most important…it takes into account all foreseen liabilities in the next year and balances it with the asset. This is Balance sheet. It involves Appreciation and Depreciation.

Let us take a simple example of a Balance Sheet. Balance Sheet is sometimes a highly confused component of Financial Management but the essence of it is very simple.

“Mark is going out of his house for a stroll. He has 100 dollars with him. Can we write a balance sheet …yes we can.

ASSETS =  $100

POSSIBLE FOOD EXPENSES  = $40

POSSIBLE TRAVEL EXPENSES  =  $30

POSSIBLE PURCHASE OF GIFT = $30

TOTAL LIABILITIES = $100   TOTAL ASSETS  - $100   SO IT IS BALANCED.

The essence or meaning of a Balance Sheet is that if Mark is going out he should not be going empty handed and must carry at least  $100 with him. Balance sheets are that simple.

Let us continue our discussion on Financial Ratios. The next ratio is Current ratio. It is the ratio of moveable assets and liquid assets  to liabilities and does not include fixed assets. It is a medium term running ratio and indicates if the entity can move on. If at an individual level a person is carrying a debit card it would be a moveable asset in a current ratio calculation.

The next important ratio is the Quick ratio It is  Quick means it indicates instantaneous sustainability .Mark goes to a Hotel He has $100 with him he checks on the menu and a burger say costs 110 dollars. Liability is more than Quick Asset which forbids him from buying the Burger. In simple terms Quick ratio is ratio of  cash liability at an instant and Cash in hand.

This discussion can be extended even further. Assets to liability ratio concerns fund flow  and quick ratio concerns cash flow. As could be understood fund flow creates cash flows and both are money …Funds at a higher order and cash at a lower order. Profit and loss statements show cash flows whereas Assets to liability ratio indicates Fund flows.

Capital budgeting could be termed as Fund flow and Capital Budgeting is Budgets set aside for the purchase of Capital items. Capital items are large immovable assets which are subsequently put into recurring use. Once the funds are committed then there is a higher exit barrier.

So much for the essence of Financial management .Financial Management is a simple , interesting and common sense subject which is ancient in origin and something which is less hard and fast.