A distinction is often made between accounting and finance. For simplification process, think of accounting as telling the story of a business. You tell this story through the statement of financial position (showing the assets, the liabilities and equity), you then proceed to tell a story of the changes in this financial position. These changes could be from the Statement of Profit or Loss (income statement), statement of changes in equity, or better still, from changes in cash flows (operating, financing or investment).
Finance on the other hand can be simplified to mean the art and science of managing a business’ funds. Traditionally, the role of finance was nothing more than the raising of funds aka episodic financing. However, the world has evolved and finance’s role can’t be limited to just this. The new role of finance is not profit maximization. There are faults to this approach. Profit maximization is a vague concept, it ignores the timings of the profits, and can act contrary to the end goal of creating shareholder value through earnings per share.
The goal too can’t be earnings per share. Why? This too can be manipulated. But also, firms now exist in the presence of various stakeholders (suppliers, customers, governments, the public). There must be something beyond that.
The new role of finance is that of shareholder wealth maximization and this is reflected through the market value of a firm’s shares. And to do this, finance must always take decisions both in the long-term and short-term. In the long-term, finance must answer the ‘Investment Question’, of where it should play? What should it invest in? Once this is settled, finance must answer the ‘financing question’, how should the funds be raised? What capital structure? Should it be more debt or equity? And what form of debt? Once the capital mix is defined, the firm will then answer the dividend question. Should everything be paid out as dividend or some should be retained? And for the retained, can it be converted to bonus shares?
However, in the short-term, finance must always answer the liquidity question. And this is about the cash in flows and the out flows. The question of working capital, and the cash conversion cycle. Should the business take the risk and over-trade? Should it punish its suppliers with longer payment terms all in the name of good working capital? What if these suppliers start to factor these payment terms in their quotations? Above all, in taking these decisions, finance must make a trade-off between risk and return.
The new role of finance is that of collaborative partner, working together with all elements of the business to drive finance decisions at source. If finance doesn’t partner with the procurement department, then there’s a risk of over-stocking and thus holding more inventory than needed.
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