These are not mutually exclusive, and indeed they overlap. But, in general, operations refers to the daily management, in detail, of inputs and output; strategy is the longer-term shaping of the company as a whole; and risk management is a wide concept that embraces questions of operating risk, such as whether it is advantageous to use product range diversification to reduce risk or to change the structure of costs (heavy fixed costs cause profits to be volatile if sales revenue is unstable). It also covers financial risk, which is concerned with managing the risks arising from the choice of finance (debt financing can be like a fixed cost) and any risk arising from the foreign currency operations of the company.
The finance function of a company is involved in all three areas: in strategy via the setting of financial criteria for capital investment decisions; in risk management; and in operations by ensuring that sufficient funds, whether in the form of cash balances or lines of credit, are available to meet net cash deficits.
Using this framework, we can identify the three main finance functions of the company and their components (apart from the accounting function) as follows:
Capital budgeting: Capital investment criteria. Financial valuation of capital projects. Cash flow budgeting.
Choice of capital structure: Debt:equity ratio. Choice of debt types. Dividend policy.
Liquidity management: Liquid asset/liability management. Cash flow monitoring.
At the risk of over simplification, we can think of these three areas as following a logical order.
Decisions about capital investment together with projections of cash flows arising from operations determine the net amount of finance required over a planning period to meet planned cash deficits and to ensure a margin of flexibility.
This, in turn, gives rise to a need for decisions concerning the form financing should take, and to decisions about the dividend level. However, financing and dividend decisions have two dimensions. First, a company needs to decide its normal ratio of debt to equity and its normal ratio of dividend to equity earnings (its normal dividend payout ratio). Secondly, it has to decide what departures to make from these normal levels in a particularyear.
Given its investment and financing policy, the job of liquidity management (the treasury function) is to invest surplus cash balances to earn a satisfactory rate of return, subject to envisaged cash flow requirements, and to negotiate any short-term borrowing required. The liquidity management or treasury function also embraces policy decisions concerning the possible hedging of risks arising from unexpected movements in exchange rates, interest rates or commodity prices.
In all three areas of policy, the implications for corporate taxation may be important. It is part of the finance function to ensure that tax minimising possibilities are given their due weight in the companys investment and financing decisions. The matter has to be put in this measured way because tax minimisation may be available only at the expense of some disadvantage (for example, debt interest ranks as an expense for corporation tax purposes but heavy debt financing can endanger solvency).
Perhaps the two crucial areas of financial policy in most companies are the setting of capital investment criteria in financial terms and the level of debt financing. As it is the special responsibility of the finance function to safeguard the interests of shareholders, the former will usually incorporate some minimum required rate of return, which logically should take into account both the prevailing level of interest rates and the riskiness of the project concerned.
Other criteria may also be used, such as the payback period. In some industries, however, many investment decisions may be taken on the basis of some operating criterion, such as the expected occupancy rate in hotels or sales or profit contribution per unit of area in the case of retail stores.
The central tasks of the finance function are to safeguard the financial flexibility of the company and to ensure that capital project criteria are aimed at maximising the wealth of the companys shareholders. This implies that project criteria should take into account the rate of return which shareholders could obtain on investments of a similar degree of risk outside the company.
Three issues nevertheless arise. The first concerns the possible contention that financial criteria should be subordinated to strategic aims. This is a false conflict. It is true that the financial consequences of many important business decisions, such as those concerning innovation, cannot be quantified. But a financial assessment may be helpful in identifying key elements in the assessment of strategic projects, in identifying the minimum level of sales required to justify the venture concerned and in raising the question of alternatives.
For a strategic project to benefit shareholders there must be at least the implicit assumption that, in its effect on the company, the rate of return will be at least commensurate with the risk being imposed on shareholders. It is perhaps up to the finance director, above all, to ask the awkward financial questions that are sometimes needed to keep the self-interested ambitions of other senior managers in check.
The second and related issue concerns the extent to which any financial criterion should dominate the general operations of the company. There is no single answer to this; for there are both successful companies where financial criteria are a close influence on the thinking of senior management and others where they appear to play a relatively remote part. Even in companies where financial criteria appear to play a definitely subordinate role, it remains the case that unless shareholders obtain a satisfactory rate of return their funds are being misused and that the consequent damage to the companys share price will ultimately provoke some reaction in the form of a take-over bid, for example.
The final issue is whether the claims of shareholders, which it has been suggested are the special responsibility of the finance function, should take priority over other claimants on the resources of the company, such as those of customers, employees, suppliers and the local environment. Once again, there need be no conflict between these, to the extent that good relations with these claimants, by giving the company a good reputation, enhance the companys profitability in the long-run.
But some conflicts of interest may be less easy to resolve, and some may even involve moral issues. It is the view of this writer that the responsibility of the finance function, in particular to seek to maximise the wealth of shareholders, does not mean that managers are being asked to act in a manner which absolves them from the considerations of morality and simple decency that they would readily acknowledge in other walks of life.
Nevertheless, it has to be admitted that the possible conflicts of interest facing the finance function, which arise because of the many-sided nature of the responsibilities of managers in general in all types of organisation, do not always have a ready solution.
Summary
Besides accounting, the main finance functions in a company are capital budgeting, choosing the most appropriate capital structure and managing liquidity. In all three areas minimising corporate tax is likely to be an important consideration.
The financial consequences of some business decisions, such as innovation, cannot always be quantified but strategic projects can still be usefully subjected to a financial assessment.
Books Suggested further reading
Marsh, Paul R and Robin Wensley Must finance and strategy clash?,
Harvard Business Review September/October 1989.
Franklin, Allen
Stock markets and resource allocation,
Financial Intermediation in the Construction of Europe, C. Mayer and X. Vives (eds) CEPR Martin, Hellwig
Banking, financial intermediation and corporate finance,
European Financial Integration, A. Giovannini and C. Mayer (eds)
Cambridge University Press, 1990
Harold Rose is visiting Esmee Fairbairn professor of finance at London Business School. He was previously first director of LBS Institute of Finance and was group economic adviser at Barclays Bank
