Financial Management in Any Type

Financial Management

In any type of business, the determination of investment, financing and the risks involved have significant impact on the continuity of the firm's existence and in the achievement of its goal - which is primarily to earn a profit. In so doing the firm's activities, the financial intermediaries play a vital role in ensuring the efficient functioning of the arbitrage process. Whenever there is an opportunity for profit, these financial intermediaries may enter the scene.

Financial intermediaries may be a firm, an individual, or an institution. Their purpose is to make a profit by means of acting as a mediator between the parties, most commonly the ultimate lender and the ultimate borrower. The financial intermediaries' functions may depend on the firm's needs. For financial transactions that involve savings, loans, insurance, mutual fund and other type of investments, commercial banks are the most common financial intermediaries. The commercial bank will then use the money that the firm has invested to extend loans to its customers. These customers may be buyers for home mortgage or loan grantees for business or education.

When it comes to the risks involved in investing the firm's or an individual's money, it is less risky to lend through financial intermediaries than lending directly to the borrowers. This is due to the fact that financial intermediaries are mostly engaged to diversification. Because of the many types of businesses that they are engaged with, they can best assess which one is good and safe.

Most often, we think of financial intermediaries as the one making the market more efficient because of lowering the cost of financial services. Note that this is not always true. A thorough monitoring by the financial manager in managing the financial transactions of the organization is of the essence.

In the pursuit of attaining a good result of operation through expansion or addition of a business segment, financial institutions may resort to obtain additional capital through borrowing of funds. The firm will then pay for the loan in a fixed period for a fixed amount, including the interests incurred. Here, a large proportion of fixed cost is used in the operation of the firm. This is known as operating leverage - the use of borrowed funds for operation, with heavy commitment to fixed costs. Operational leverage is defined as the percentage change in operating income that occurs as a result of a change in the percentage change in the number of units sold. This ratio is very useful in determining the income potential of the firm.

The use of leverage is likely to result in a net tax advantage. This is because the degree of the tax shield will increase as the degree of leverage increases. However, as the firm increases its degree of operating leverage, its earnings before income taxes (EBIT) becomes more volatile. This means that the operational earnings of the company can change dramatically over a short time period in either direction, which leads to the uncertainty or the amount of risk involved. This is due to the impact of a change in revenue on profit or cash flow. It arises whenever a firm increases its revenues without a proportionate increase in operating expenses.

In deciding the most favorable level of leverage, it is a must for the firm to measure its acceptable or tolerable systematic risk/return on every transaction that corresponds with the way the company would like to finance. In measuring the degree of acceptability, the firm may compare the result to the operational leverage of other firms within the same industry. If the company has a very high degree of leverage, it is not a good indication of stability. The company is more susceptible to experience recession in the business. This is because every sale is being contributed to paying for fixed costs. The company will be compelled to continue its business to meet its obligations regardless of the outcome of sales.

As mentioned earlier, any business activity faces an accompanying risk and uncertainty. Since risk in inevitably present in whatever direction, it is a wise strategy to measure the amount of risk the company is able to handle depending on its financial capacity. There are two measures of risk that is widely used in finance - the Standard Deviation and the Coefficient of Variables.

In analyzing a given set of data, the variation of the dispersion of its values is measured by getting the standard deviation. It is computed by getting the square root of the variance. When we say variance, it means that we have to get the average of the squared differences between the data points and the mean. Mean is simply the average of the data being analyzed. If the result of the deviation is small, then the values are close to the mean. On the other hand, if the deviation is large, it means that the samples used are far from the mean, therefore, it can not be considered as reliable or predictable.