8 Reasons Why Financial Management is Important for Business
Did you know that 82% of businesses fail due to poor cash flow management? Effective financial management can help avoid this common pitfall by ensuring businesses have enough cash to cover expenses and invest in growth opportunities.
Managing money is at the core of all major business decisions. Good financial management is important for every sector, industry, and type of business, making it a key duty for business leaders and directors.
Every part of a business, small or large, affects its financial performance. This performance, in turn, influences the company’s financial stability and future success. To ensure a business thrives, its finances must be carefully monitored and managed by senior management.
What is Financial Management?
Financial management is the process of handling money to achieve business goals. This is usually done by senior leaders like Chief Financial Officers (CFOs) or finance vice-presidents. It includes planning, directing, monitoring, and controlling a company's funds to make good financial decisions. Essentially, it applies management principles to a company's financial setup.
The main aims of financial management are to ensure the business is successful and profitable. It also:
- Supports compliance with laws and regulations
- Maximizes profits, stakeholder returns, and overall company value
- Tracks liquidity and cash flow
- Provides economic stability
- Ensures up-to-date financial reporting and supplies financial information for key performance indicators (KPIs)
- Develops financial scenarios to help with forecasting
- Upholds risk management efforts
While many businesses have their own financial teams and managers, some also seek help from financial institutions and other experts to assist with financial management.
3 Main Types of Financial Management
All financial decisions can impact a company’s assets, liabilities, revenue, and profit margins. They also affect the company’s overall performance and capital structure. Thus, financial planning should focus on both short-term and long-term business goals.
Key decisions for financial health include:
- Identifying resources
- Establishing procedures
- Acquiring assets
- Raising funds
- Managing day-to-day capital
- Managing expenses and allocations
To achieve these goals, financial management is divided into three main types of decision-making: investment decisions, financing decisions, and dividend decisions.
1. Investment Decisions
Investment decisions aim to make the best investments in various assets to deliver the highest returns for investors. Leaders must consider the rate of return, project cash flow, and investment criteria. These decisions can be for the short term or long term.
- Long-term investment decisions (capital budgeting decisions): These involve managing fixed capital and usually involve large sums of money over long periods, from one year to over ten years. Because they are difficult and costly to reverse, thorough evaluation is required. Examples include launching a new product line, opening new facilities, acquiring another firm, or investing in machinery.
- Short-term investment decisions (working capital decisions): These deal with daily business operations. Effective short-term decisions ensure healthy working capital and impact short-term profits and liquidity. They relate to inventory management, cash management, and receivables.
Both types of investment decisions require setting investment goals, understanding risk profiles, and monitoring investment performance.
2. Financing Decisions
Financing decisions involve finding the best ways to raise money from both short-term and long-term sources. Leaders must consider financial risks, the cost of capital, and how much money will come from loans versus shareholder funds.
Factors include cost, risk, flotation costs, cash flow, fixed operating costs, control considerations, and the state of capital markets.
3. Dividend Decisions
Dividend decisions involve balancing the distribution of profits (dividends) among shareholders with the amount of profit retained for future growth. Factors influencing this include earnings stability, dividend stability, growth opportunities, cash flow, shareholder preferences, tax policies, stock market responses, access to financial markets, and legal constraints.
8 Importance of Financial Management in Business
Financial management is important for any business to succeed and last. It involves planning, organizing, directing, and controlling financial activities to achieve the company's goals. Effective financial management ensures a business has enough funds to meet its needs, make profits, and grow. Here are some main reasons why financial management matters:
1. Ensures Adequate Funding
Financial management helps businesses figure out how much money they need for both short-term operations and long-term projects. By accurately predicting financial needs, businesses can avoid running out of money or having too much money sitting unused. This balance ensures that all parts of the business run smoothly and that the company can take advantage of growth opportunities.
A U.S. Bank study found that 82% of businesses fail due to cash flow problems, which proper financial management can prevent. Additionally, the SBA reports that businesses with strong financial planning are more likely to survive beyond the first five years.
2. Maximizes Profitability
Making money is a main goal for any business.Through careful financial planning and analysis, companies can find ways to save money and invest in areas that offer the highest returns. Financial management helps set realistic profit targets and monitor performance against these targets, ensuring the company remains profitable.
For instance, Walmart's effective financial management strategies have enabled it to consistently reduce costs and improve profitability. According to their latest financial reports, Walmart’s cost-saving measures and efficient supply chain management have helped the company achieve a net income of $13.9 billion in 2023.
3. Manages Risks
Every business faces financial risks, like market changes or unexpected expenses. Financial management involves identifying, assessing, and reducing these risks. This proactive approach helps businesses prepare for uncertainties and minimizes the potential negative impact on the company’s finances.
For example, during the COVID-19 pandemic, many businesses faced sudden financial challenges. Companies with strong financial management practices were better able to navigate these uncertainties. A survey by PwC found that 76% of CFOs planned changes to their risk management approaches post-pandemic to better prepare for future disruptions.
4. Supports Decision Making
Financial data is important for making informed decisions. Financial management provides accurate and timely financial information, helping managers make decisions that are in the best interest of the company. Expanding operations, launching a new product, or entering a new market all require sound financial management to ensure decisions are based on solid financial analysis.
For example, when Apple decided to enter the wearables market with the Apple Watch, they relied on detailed financial analysis to project costs, potential revenue, and market demand. This informed decision-making process contributed to the Apple Watch generating over $41 billion in revenue in 2023, making Apple the leader in the wearables market.
5. Improves Cash Flow Management
Managing cash flow effectively is essential for the daily operations of a business. Financial management involves monitoring cash inflows and outflows to ensure the company has enough money to meet its needs. Proper cash flow management helps businesses avoid cash shortages and make the best use of their resources.
According to a survey by Intuit, 69% of small business owners have been kept awake at night by concerns about cash flow. Effective financial management can help alleviate these concerns by providing a clear picture of the company's cash position and enabling better cash flow planning.
6. Enhances Financial Control
Financial control makes sure the company uses its resources efficiently. This includes setting budgets, monitoring expenses, and following financial policies and procedures. Strong financial control helps prevent fraud and ensures the company operates within its financial limits.
For example, the Enron scandal highlighted the importance of financial control and transparency. In response, many companies strengthened their financial controls to prevent similar issues. According to a report by Deloitte, companies with strong internal controls are less likely to experience significant financial misstatements and fraud.
7. Facilitates Long-Term Planning
Financial management is about managing the present and planning for the future. It involves setting long-term financial goals and making plans to reach them. This includes planning for big investments, managing debt, and ensuring the company can sustain its growth over the long term.
Apple Inc. is a prime example of effective financial management. In 2023, Apple continued its tradition of strategic long-term planning by allocating $25 billion for research and development. This investment is aimed at developing new technologies, such as augmented reality and autonomous systems, ensuring the company's competitive edge and sustained growth.
8. Increases Investor Confidence
Investors need to trust a company's financial stability and growth potential. Effective financial management shows that the company is well-managed and financially sound. This can attract more investors, secure better financing terms, and ultimately contribute to the company’s growth and success.
For example, Tesla's strong financial management and transparent reporting have built investor confidence, resulting in a market capitalization of over $1 trillion by the end of 2023. This confidence enabled Tesla to raise significant capital, including a $2 billion stock offering, to fund expansion and innovation, such as new battery technologies and Gigafactory expansions. By 2023, Tesla's revenue reached $81.5 billion, showcasing the success of its financial strategies.
Final Thoughts
Financial management is essential for business success. It ensures that a company has the money it needs, makes profits, manages risks, and supports smart decision-making. By improving cash flow management, enhancing financial control, facilitating long-term planning, and increasing investor confidence, good financial management helps businesses achieve their goals and grow.
As a small business owner or a manager in a large company, mastering financial management is important for navigating the financial landscape and driving your business toward success.
FAQs
Why is financial management important for a business's success?
Financial management is important because it ensures a company has the funds to operate and grow. It involves planning, organizing, directing, and controlling financial activities to meet goals. Effective financial management helps avoid cash shortages, maximize profits, manage risks, and make informed decisions, ensuring smooth operations and growth opportunities.
How does financial management help in maximizing profitability?
Financial management maximizes profitability by setting realistic profit targets, identifying cost-saving opportunities, and investing in high-return areas. By monitoring performance, businesses can remain profitable. Companies like Walmart have improved profitability through effective financial management strategies, resulting in significant net income.
What role does financial management play in managing business risks?
Financial management helps manage business risks by identifying, assessing, and mitigating potential threats. This proactive approach prepares businesses for uncertainties like market fluctuations or unexpected expenses. During the COVID-19 pandemic, businesses with strong financial management handled financial challenges more effectively.
How does financial management improve cash flow management?
Financial management improves cash flow by monitoring cash inflows and outflows, ensuring enough liquidity to meet obligations. Proper cash flow management helps avoid shortages and optimize resource use. Effective financial management provides a clear picture of cash positions, enabling better planning and alleviating concerns about cash flow issues.
