The Nature and Role of Strategic Financial Management in an Organization - Essay Example

The Role of Financial Decision Making In Achieving Organizational Objectives I. Introduction Finance refers to the income or resources of corporations, governments or individuals. If these resources belong to an organization, the funds need to be managed judiciously by taking the appropriate financial approaches, for them to be harnessed effectively in achieving the firm's strategic objectives. This essay thus attempts to expound on the following issues: What is the nature and role of strategic financial management in an organization How can financial decision-making be utilized and optimized to help an organization achieve its strategic objectives What are the effects of long-term financial decisions on corporate structures and management policies What is the relevance of such financial instruments as fixed capital and working capital on the financial decision-making of an organization By putting forward selected theoretical models of financial strategy, the essay discusses their relevance to an organization's efforts to attain financial and operational viability. For this purpose, the essay picks out one of the Tenant Management Offices (TMOs) in London as case study for the simple reason that we are familiar with some aspects of this organization. The TMO is also a service-oriented firm with limited resources, such that a well-taken financial decision is critical to its organizational integrity. This essay is structured such that the succeeding sections consist of an assessment, a lineup of conceptual models, a critical evaluation and a conclusion. In the assessment section, the essay discusses the importance of financial planning in the context of TMO's organizational structure and strategic goals. The conceptual models review the available literature on the subject, while the critical evaluation attempts to relate the academic models so mentioned to the real world, meaning the TMO. As part of the conclusion, we will appraise the financial decisions and strategies most suitable for the TMO based on all the preceding data. II. Assessment The TMO administers a London borough consisting of 238 homes of individual designs on eight blocks of a small housing project alongside a main road. This is one of the oldest of similar setups in London, where the blocks of houses had been there as far back as 1947 such that they are in dire need of refurbishing and maintenance. Families of multi-racial origin occupy these housing units under either a tenancy or leasehold agreement, and the estate is easily accessible by bus and subway train services. This TMO became a self-governing body in April 2003, as did four other TMOs managing similar estates in the London area, when the local government compartmentalized its function of providing low-cost housing services to constituents. This fragmentation process came on the heels of the privatization binge involving local government assets and service, a major program of the national government since 1979. Now, the TMO runs the borough through a management committee headed by an operations manager and supported by a six-man staff. The turnover of housing functions to TMO was part of the central government's cost-cutting program and strategy of getting politics out of social services, which tended to hamper activities in this area when local authorities were in control. Thus, management of the housing funds was shifted to agencies, which would be more accountable at the central level and less accountable to local political forces (Cairncross & Calpham). In ceding the function to the TMOs, however, the local authorities set the ground rules that exhort the former to utilize "creative accounting measures." These include; 1) building up a revenue balance to regular the yearly expenditures; 2) sale of suitable assets to generate income for use as capital expenditure; 3) rescheduling existing debts; 4) capitalizing the expenditure on such activities as repair and modernization previously considered as revenue expenditure; 5) and deferring the purchase schemes and "lease and lease-back" schemes on TMO property leased to private investors in return for a lump-sum credit facility. Under the charter granting the TMO total control of the 238-house estate, it is mandated to administer the place in consonance with relevant laws such as the Human Rights Act, Environment Protection Act, Crime and Disorderly Conduct Law and Harassment Act, among others. Thus, the TMO's functions and services include: 1) maximizing its income by ensuring that rental and service payments are paid regularly; 2) performing day-to-day maintenance and repair work as per the tenancy and leasehold agreements; 3) seeing that the communal areas in the estate are safe and clean; and 4) ensuring peace by mediating in neighbors' disputes, acting on sources of nuisance and coordinating the transfer and sale of the housing units when the need arises. The overall goal of the TMO is to match the customers' demand with services based on existing housing management laws. All these the TMO is expected to accomplish on an operational budget of only 420,000 pound sterling annually, which is paid in quarterly installments by the local government. The other main funding sources include the European Social Fund, the Neighborhood Renewal program and charitable organizations, which provide assistance in the form of specific grant, revenue support grants, and local public service agreements. Of course, there is income from the users of the firm's housing service. Added up, the collective funds do not amount to much as these are ranged against the TMO's service requirements. This presents a problem because the deterioration of the old houses and communal facilities in the estate has come to a point where repair and refurbishment need to be undertaken over the next three to four years at an estimated cost of 6.5 million pound sterling. The local government indicated its willingness to underwrite the said repair works, but for this to happen the TMO must earn a 2-star rating when the Audit Commission conducts its inspection of the organization in January 2007. This means that the TMO must show that it has husbanded its scant financial resources judiciously and efficiently, employing accepted strategies of financial planning and management that translate to an improvement in resources and services. Since the service provided by TMO is socially oriented, the guidepost set by the Audit Commission on financial management in social service is most appropriate. According to AC, service planning in agencies like TMO has to be the main driver for change, which must be amply supported by strategic financial planning as well as appropriate human resource planning systems. Otherwise, the organization's priorities will be skewed if any unforeseen crisis or pressure comes up. The problem is that financial planning invariably involves the future and any kind of planning geared for future needs turns off many people in management. Surveys of firms in the US, for example, showed that less than half engage in long-range planning (Soriano & Nehrt, 1989). This is attributed to the fact that planning calls for spending a lot of time, energy and money today for results that will not be seen or experienced until some time in the future. Consequently, too many companies are concerned only with producing today's demands and managerial efforts are devoted to maximizing short-run profits. Planning is efficient and forward-looking if it follows five major phases. In the initial phase, the company' resources and capabilities, as well as the business environment, are carefully assessed and recorded. The second phase involves the setting of specific objectives within the framework of the company's major policies, reflecting the constraints and advantages found in the company and its environment. For the third step, the strategic plan is developed and prepared, which is followed by long-range planning. Finally, the annual plans are formulated. Since planning is a process, it must also include activities in operations, control and revision. (Soriano & Nehrt, 1989) This five-stage planning process in operational strategy matches the four-phase approach set by the Audit Commission as essential in financial planning for social service agencies. The first phase in this activity calls for a "review of the past." This involves monitoring recent trends in demand and expenditure, in the flow of funds, performances and outcomes, including the firm's year-end position. Comparative data are also gathered about actual costs and the cost drivers. In the second phase, the future is forecast through expected trends in demands and expenditure, financial implications of demographic trends, future flow of funds, and implications on the firm of national policies, local priorities and initiatives. The third phase is for devising the strategies and plans on such aspects as service, human resource and asset management. For the fourth and final phase, the annual budgets are set based on existing levels of financial resources and incorporating provisions for flexible response to unexpected changes in demand. In the field of social service, the Audit Commission believes that financial planning is effective if it uses both the medium-term and longer-term approach, depending on the circumstances. The short-term approach is shunted aside as risky and incapable of introducing prudence in financial management and harnessing policy as engine of change in social service. With a longer-term approach, a firm can accurately determine the level of funds available for its use, which becomes the basis of budget allocation that would facilitate efforts at service development or reduction. This approach will also give the firm an accurate picture of demand and demographic change, such that future commitments can be incorporated in the budget plan. All these entail no risks, too. The same set of benefits may be derived from a medium-term financial strategy, which includes putting the firm in a better position to deal with increased investment and disinvestments or realignment of resources. Like the longer-term approach, the medium-term strategy also spares the firm of the reactive response to budget reduction or increase characterized by the short-term method, which can throw service priorities and strategic objectives off balance. III. Conceptual Models Finance decisions are intended to achieve the goals of corporate finance, which for the most part seeks to ascertain that all corporate investments are backed by sufficient funds (Wikipedia). Since cash flow is involved, the financing mix that will be used can impact the valuation. Management must identify the optimal mix of financing or the capital structure that yields the most value. The sources of financing may be a combination of debt and equity. If the debt option is used to finance a project, this means a liability that must be serviced, in which case there are cash flow implications regardless of the project's success. Financing by equity, on the other hand, is less risky in terms of cash flow commitments but results in a dilution of ownership and earnings. Often the cost of equity is also higher than the cost of debt, and so equity financing is likely to result in an increased hurdle rate or discount rate, which may offset any reduction in cash flow risks. Management must also try to match the financing mix with the asset being financed as closely as possible in terms of both timing and cash flows. Moreover, management must decide wisely whether to invest in additional projects, reinvest in existing operations or return free cash as dividends to shareholders. The level of dividend is based on the firm's actual profit and expected profits for the upcoming year, after all its business expenses have been met. This is an option when there are no net positive value opportunities, in which the expected yields go beyond the hurdle rate. A dividend policy is widely accepted as value neutral, since it may be dispensed in cash or through a share buyback. III.1. Corporate Finance Corporate finance is related in some ways to managerial finance, but the latter is broader in scope and describes the financial techniques available to all types of business enterprise, corporate or not. Its primary goal is to enhance the book value of a company without exposing it to unnecessary risks. To achieve this end, the firm must see to it that the undertaking it chooses yields a return on capital that exceeds the cost of capital. The ROC is a function of working capital management while a COC is part of previous decisions on capital investment. In terms of time coverage, the long-term choices of corporate finance consist of capital investment decisions, which is used to determine the projects to be financed, whether to finance that investment with debt or equity, and whether or when to pay dividends to stockholders. As for short-term finance decisions, these involve management of working capital, which focuses on the management of cash, inventories, and credit terms on borrowing and lending. The investment tools used in corporate finance derive from almost all areas of the financial world. Some of these tools specifically developed by and for corporations have broad application to entities other than corporations, such as partnerships, non-profit organizations, government agencies, mutual funds and personal wealth management. In this non-corporate exercise, however, their application is severely limited because the other entities do not deal in as much quantities of money as corporations. For this reason, corporate finance is not the same as personal or public finance. (Wikipedia) III.2. Fixed Capital vs. Working Capital In corporate finance, fixed capital refers to any real or physical capital not used up in producing a product or providing certain services. Since it stays in one place and lacks portability, fixed capital is contrasted with circulating capital, which could be raw materials, operating expenses and the like. In some cases, a fixed capital "circulates" too but this activity has a much longer gestation period and may take five, 10 even 20 years before it yields value or is discarded and depreciates. Fixed capital includes plant, machinery, vehicles and equipment, buildings, and the value of land improvements. Land itself is a fixed asset, not capital, since it is for all intents and purposes, a product. Attempts have been made to estimate the value of fixed capital stock for the whole economy using book value, tax assessments, price inflation, etc. But it was found difficult to come up with an accurate estimate because even the owners themselves are usually in the dark as to the current value of their assets. Thus, when business executives invest in fixed capital or accumulate it by tying up their money in a fixed asset with an eye on making future profit, there is an element of risk in this venture. As for working capital, it represents the amount of day-to-day operating liquidity available to business, such that it is also known as operating capital. Without such liquidity, the assets that may be awash in a company cannot be readily converted into cash. Operating capital comes in the form of cash, cash equivalents, inventories and debts, which in financial terms are called current assets or accounts receivables and current liabilities or accounts payable. These accounts are especially important because they represent business areas where managers have the most direct impact Of these, the current accounts payable is the most critical as it is payable in only 12 months, thus involving a short-term claim to current assets. The common types of short-term debt are bank loans and lines of credit. Financial decisions on the management of working capital are usually based on cash flows and the company's level of profitability. Here, management tries to strike a balance between the firm's short-term assets and short-term liabilities. The purpose is to ensure the firm's continuous operation with enough cash flow to meet both maturing short-term debt obligations and upcoming requirements for operational expenses. For this reason, working capital managements entail short-term decisions that can be reversed according to cash flows and the firm's profitability. (University of Arizona) In effect, these short-term financial decisions call for cash management, inventory management, and proper handling of debtors. In cash management, the objective is to guarantee the availability of cash to meet day-to-day operating expenses, while inventory management ensures continuous and uninterrupted production or service. The goal of debtors' management is to identify the most attractive credit policy that would pull in customers. To determine the cash flow in support of good decisions on working capital management, the cash conversion cycle is often used, which is the number of days counted from the release of cash outlay for raw materials to receiving payment from the customer. This period corresponds to the time that the firm's cash is tied up in operations and made unavailable for other activities. In this context, the most useful measure of profitability is the ROC method because it links short-term policy with long-term decision making. When the economy contracts, manufacturing and even service and non-profit companies go after working capital to free up cash trapped in their business (Gamble, R., 2004). In this condition, cash is earnings and worth more than inventory, such that financial managers try to maximize it whenever possible. One of the best ways to do this is to reduce the firm's working capital. III.3. Financial Risk Management Financial risk management is the process of measuring risks and then developing and implementing strategies to manage those risks efficiently. All large corporations maintain risk management teams in full force, while small firms practice the strategy only marginally and in an informal character. Whatever the method, the risks targeted in this management process are those that can be managed or hedged. To avoid such risks, such current financial indicators as commodity prices, interest rates, foreign exchange rates and stock prices usually used as inputs in the process. In this activity, the most popular instruments are derivative contracts, which include futures contracts, forward contracts, swaps and options. However, these financial instruments are costly to create and monitor so the most effective financial risk management methods are those involving derivatives that are traded on well-established financial markets. IV. Critical Analysis The upcoming inspection of TMO's finances and operations by the Audit Commission certainly has far-reaching implications for its continued viability and operational efficiency. Thus, the agency must be able to show that throughout its yearlong operations, its service planning has been supported by strategies on financial and human resource planning that serve to keep its financial ledger healthy and robust, complemented by a faultless service record on the TMO estate. The questions the TMO should answer beforehand are: Do its financial and operational strategies and priorities fortify it against unforeseen crises and pressures Has it steered clear of the short-term approach in favor of the long-term and medium-term strategy to lessen the risks in its financial decision-making If the answers to these questions are yes, then the TMO is likely to pass muster as a 2-star service agency that takes the right financial decisions. The low-risk financial undertakings are of special significance to an organization like TMO, handicapped as it were by the lack of working capital. In this connection, it would be a good idea for TMO to follow the lead of service and non-profit organizations in the US that take advantage of the economic crunch by freeing the cash trapped in their business and letting the money earn interest in suitable financial transactions. There is also a lesson to be learned from a comparative study conducted on the financial planning systems of companies in Germany and UK (Mueller, F., 1994). At the German firm Bosch, for example, the study found that its financial activities were tightly aligned with the local banking system for long-term business while the same activities at Lucas in UK were highly dependent on meeting the present demands of the stock market. The most glaring result of these differences in financial planning was that the German companies were quick to modernize, while the process comes the hard way for UK firms. The same devotion to long-term financial planning is noted in Japanese companies, such that most of them are successful in their financial ventures. V. Conclusion With the limited financial resources of TMO, the best route for the organization to take is by maximizing service benefits with a decision-making tool called Option Appraisal (Audit Commission). This aids decision-making through an accurate assessment of the advantages and disadvantages of the options that may be taken to achieve a firm's objectives. It is particularly useful during uncertain times when new service requirements come up. The two most common types of OA tools are the Decision Tree Analysis (DTA) and Real Options. In the use of DTA, each management decision is taken in response to an event that may generate a branch or path for the firm to follow. Thus, management proceeds with stage 2 only if stage 1 yields positive result, and stage 3 will be undertaken depending on the outcome of stage 2. As for Real Options, these methods attach the cost of a project on the value of some other assets or underlying variables. To illustrate, the viability of, let us say, a mining project is contingent on the prevailing market price of gold, such that if the price of gold is too low, management discards its mining rights. In measuring profitability in aid of decision-making, on the other hand, the most efficient tool is the ROC, which yields what is known as return on equity (ROE), or the percentage between the company's one-year income and the capital it utilized. Based on the above literature, TMO would do well to adopt a financial plan that identifies all its alternative sources of funds that may be used to cover for unexpected changes in its service programs. The best route is the long-term or medium-term strategy, which poses less risks and promises more dividends. This approach can be used in the TMO's management of its funds coming from the government's "Invest to Save" program, a national program that provides additional resources to develop services in support of government priorities; the Private Finance Initiative, a private sector assistance for development activities; capital funding, which is borrowed from lending agencies with liberal repayment terms; funding from cooperating organizations such as the health agencies and the Housing Corp.; and revenue financing from the council. As noted above, TMO is strong on fixed capital and weak on working capital, such that its financial decision-making should look out for the risks inherent in these ventures. The risks may be avoided by keeping to the road of long-term or short-term financial decisions. VI. Bibliography Audit Commission. "Making Ends Meet: Managing the Money in Social Service." http://www.joint-reviews.gov.uk/money/ Financialmgt/1-22.html#1-221 Cairncross, L. & Calpham, D. "Housing Management, Consumers and Citizens." Gamble, R. (2004). "Counting the Benefits of Working Capital Management." Business Finance, March 2004. Mueller, F. (1994). "Organization Studies." Summer 1994. Soriano, E. & Nehrt, L. (1989). "Business Policy in an Asian Context." Center for Policy and Development Concern, 3rd Ed., 1989. University of Arizona. "Working Capital Management." Study Finance.com Wikipedia. "Corporate Finance." http://en.wikipedia.org.wiki/Corporate finance Read More