Managing Financial Resources and Decisions



Managing Financial Resources and Decisions

Introduction

Finance is concerned broadly with the generation, allocation, and management of monetary resources for any purpose. It includes personal finance , whereby individuals save, invest, and borrow money to conduct their lives; corporate finance , whereby business organizations raise capital, mainly through the issue of stocks and bonds, and manage it to engage in economic production; and public finance , whereby governments raise revenue by means of taxation and borrowing and spend it to provide services for their citizens. Boatright (2000) mentions this financial activity is facilitated by financial markets, in which money and financial instruments are traded, and by financial intermediaries, such as banks and other financial service providers, which facilitate financial transactions (Boatright, 2000). This paper discusses the following points in a concise and comprehensive within the context of finance management.

Short-Term Solvency

We must emphasize the importance of sufficient cash resources or liquidity, which enables a company to pay its bills and to stay in business. Liquidity means survival, and insufficient liquidity means bankruptcy to a business. The essential nature of liquidity is why current assets (which turn into cash with in a year) and current liabilities (which require cash payments within a year) are shown separately on balance sheets. In the short-term solvency test, liquidity is measured by means of the... (current ratio) (Boatright, 2000). The current ratio is total current assets divided by total current liabilities. It indicates the company's ability to meet current obligations out of its current resources. It is expressed as "2.5 to 1," or "2.5:1," or just "2.5." A current ratio that is greater than one is needed to provide some margin of safety.

Long-Term Solvency

The two tests of long-term solvency focus on a firm's ability to meet its obligations to pay interest and principal on the long-term debt. One test is for interest and one for principal (Hoffman, Kamm & Frederick, 1996).

The test of ability to pay interest on the long-term debt is based on a statistic known as times interest earned. This statistic is the ratio of earnings before interest and taxes (EBIT) to the interest on long-term debt. The numerator represents profit available to meet interest expense. Bear in mind business interest is tax deductible so that income taxes are calculated on income after interest expense...

The ratio to test the safety of principal on long-term debt involves the proportion of long-term debt in the total long-term capital structure of the firm. The long-term capital structure means long-term liabilities plus owner equity on the balance sheet. This ratio shows how the fixed assets plus the working capital (current assets less current liabilities) are financed out of long-term-funds (Hoffman, Kamm & Frederick, 1996).

Practical Use of Financial Ratios

Keep in mind a number of important points for the effective use of ratios. First...it is essential to be sure that you have checked the reliability of the basic data. Remember: Garbage in, garbage out! Be aware of areas where accounting treatment of certain items is not cut and ...