Financial decision making in the modern worldPosted on: March 15, 2022
Financial decision making is key to driving business forward. Without data on vital financial information, it can be difficult for business leaders to plan ahead or make decisions that benefit the whole company from stakeholders to shareholders. For this reason, financial reporting is an integral part of business operations.
Throughout the unpredictability of the pandemic, financial documentation has been crucial to supporting business decisions. In a McKinsey & Company article on corporate financial planning from May 2020, it was acknowledged that the usual range of driver-based models and metrics used for the budgeting process, forecasting, and root-cause analysis could no longer be relied upon in the wake of Covid-19.
Corporate finance planning teams had to move quickly to reassess their preferred views of information and the standard reports that they had built over the years. With the prospect of further stock market crashes looming since the outset of the pandemic, businesses have been looking at real-time financial reports and forecasts on a monthly, if not weekly basis, to stay afloat in the most challenging times.
Key financial statements
The three main financial statements that are most commonly used to make business decisions and for planning are the cash flow statement, the profit and loss account (or income statement as it is sometimes known), and the balance sheet.
What is a cash flow statement?
The cash flow statement can help speed up the financial decision-making process. This is because it’s not only a statement, it can also be used to forecast. Even if a profit and loss statement is looking healthy, the cash flow statement will alert decision makers to net cash figures and whether the business’ bills can be paid.
If a business sees a drop in its operating cash flow this is a red flag that signals a need to make short-term decisions such as increasing pricing, reducing inventory, or limiting overheads to improve the business’ cash situation. Without a steady and predictable cash flow, especially through periods of growth, even a viable business can suddenly find itself struggling for survival.
What is a profit and loss (P&L) statement?
The P&L statement is the most useful for getting a snapshot of a business’ well-being. For this reason, it’s probably the one that’s consulted on the most regular basis, particularly by small and medium-sized business owners.
In the UK, incorporated companies are required by law to present their profit and loss sheet to HMRC each financial year. The P&L statement can show you the financial health of the company for a specific timespan, whether that’s a tax year, a calendar year, a month, or a quarter. It’s a useful document for investors and shareholders to get an idea in one glance of how a business is performing.
What is a balance sheet?
Some decision-makers view the balance sheet as a more thorough summary of how secure a business’ financial position is because it shows:
- Source of funds (how much money the business currently has)
- Assets (how money has been used)
- Liabilities (what the company owes)
The balance sheet can be very useful to the business manager who knows what they’re looking for. It can present suggestions for efficiencies as well as opportunities for growth. For example, unpaid invoices mean cash is being unnecessarily withheld and could cause financial problems to escalate if not routinely pursued. Think of it in terms of a bank – if your customers aren’t paying on time, they’re essentially borrowers of interest-free money. A business is not a bank, so ensuring that customers or clients pay invoices in a timely manner helps the business to avoid cash flow problems.
Current liabilities are also a quick-to-spot indicator of short-term liquidity or lack thereof. Liquidity ratios such as the current ratio, quick ratio, and cash ratio can be used to determine a company’s ability to pay its short-term debt obligations. Investors and creditors want to see healthy liquidity ratios above 1.0. A ratio of 2.0 would mean that a company is able to cover its current liabilities twice over. A ratio of 3.0 would indicate they could cover current liabilities three times over, and so on.
What investors look for
Potential investors in a company tend to look at the three main financial accounting documents and will analyse a company’s shareholder equity and retained earnings. Shareholder equity is arrived at by subtracting total liabilities from the business’ total assets. Retained earnings is part of shareholder equity and is the percentage of net earnings that was not paid to shareholders as dividends. Assessing these figures supports sound investment decisions.
When making investment decisions, the foundation of the valuation process is the concept of financial discounting. Discounting is used to determine the present value of the future cash flow, at a certain interest rate. Investment is based on the idea that a payment received in the future should be worth more than a payment received today – that the investor is compensated for the costs and risks of waiting. And yet, hyperbolic discounting is the very human impulse to choose immediate reward over future reward, even if immediate reward offers us less.
In finance, this is captured in the concept of time value of money (TVM). Investors bank on their shares increasing in the future and so need to make savvy decisions on the probability of this happening by looking at a company’s financial statements and continuing to review them periodically.
Develop key financial decision-making skills with an MBA
Robust financial management skills are always in demand; in today’s VUCA environment of volatility, uncertainty, complexity, and ambiguity they are even more in demand. Traditional approaches to financial management in the world of corporate finance are experiencing a shake-up. As we move into a post-pandemic world, the business landscape continues to shift and is unlikely to return to its previous state.
Take the opportunity to lean into the shifting landscape with a 100% online MBA from Keele University. Learn from real-world case studies and sharpen your problem-solving abilities while you study part-time. Find out more about Keele’s online MBA course and how you can gain this valuable qualification while you continue to work.