1. Is accounting different to financial management?
It most certainly is. Accounting is concerned with the recording and aggregating of monetary transactions and presenting the outcome in the form of traditional financial statements. Financial management, on the other hand, is the area of management that determines investment and financing decisions.
2. What constitutes investment decisions?
These are the decisions that are taken in respect of the acquisition and disposal of property, plant and equipment, looking for new investment opportunities, and the selection of the most profitable opportunities in absolute terms.
3. What are the financing decisions that need to be considered?
The investment decisions mentioned above need to be paid for somehow and determining the optimal mix of internal and external funds required to finance those opportunities are the financing decisions referred to.
4. Why are these decisions so important?
Each and all of the decisions made should be aimed at a coherent objective and judged according to how well it meets that aim. Financial decisions should be judged according to whether they create value, and how much. It is important to realise that for value to be created not only do the many strands of business need to work together, but each strand needs to understand how that value is created when they work together. This applies at all levels in the business from first line supervisory managers through to directors in the Boardroom.
5. How do we know if an investment decision is a good one?
The financial resources we use to fund investment decisions have a cost and a good investment is one that returns more than the cost of funds over time.
6. How can we be certain of future returns from our investments?
Actually we can’t. So we need to consider how to mitigate the risk and uncertainty associated with investment decisions in our evaluation. There are several options available to us and these include point estimates (considering best, most likely, and worst cash flows), decision trees, simulation, and sensitivity analyses with the projected cash flows.
7. What risks do we have to consider in evaluating investment proposals?
Business risk – relates to the variability of future cash flows as a result of changing economic circumstances and changes in the characteristics of the investment itself.
Financial risk – depends on how the project was funded and how changes in distributions to shareholders and Central Bank interest rates impact on the cost of funding.
8. So, we’ve made our decisions, is that all that’s required?
Not at all! As part of the process of understanding what is happening in our organisation we need to calculate performance measures that convey information about our investment and financing decisions and compare these measures with the original expectations when we made our decisions. The mere calculation of a performance measure is of itself meaningless, however used with care and imagination, this information can reveal much about our decisions and whether we need to take a different approach in future.