Financial management is an important process in many organizations because without proper management of cash an organization can incur losses and eventually cease running. Adequate liquid cash is needed by any organization at any time to invest in various profit-generating businesses or simply to meet the companys current operations. A company should be able to convert current assets or current investments into cash whenever the need for cash arises. Various methods are used by companies in financial management. Some of the methods include Internal Rate of Return (IRR), Rate on Investment (ROI), and Return on Equity (ROE) among others.
Internal Rate of Return (IRR)
Internal Rate of Return is the discount rate that reduces or equates the value of cash flow of a company to zero at a particular time. IRR is calculated from various discount rates through trial and error so that the value of cash flow reaches zero. A project with a higher Internal Rate of Return is likely to be considered by a company and money can be invested in it because it is likely to generate a higher income. Internal Rate of Return is a powerful tool that approximates the rate of return expected from money invested in a given business (Pandey, 2009).
Return on Equity (ROE)
Return on Equity is the net income generated by a company after a given period expressed as a percentage of the average shareholders equity. This is a very important ratio to any company because it shows how a given company is efficient in generating money from its net assets. It is used in the comparison of a companys profitability with that of other companies which are in the same industry. According to Jensen Investment (2008), and ROE value that ranges from 13% to 15% is a good indicator of a companys financial strength and shows that such a company can compete equally well with other companies in the same industry.
Return on investment (ROI)
Return on Investment is a ratio used to compare the efficiency of various investments or to evaluate the efficiency of a given investment after a given period. Return of Investment is determined by expressing income from an investment as a proportion of the cost of the investment (Brigham & Ehrhardt, 2011). Projects with a High Rate of Investment are favored and those with a higher ROI are favored even more because they are likely to generate more profits for a company. This ratio is used in comparing various investments and those which are likely to generate higher returns are considered.
The above three financial management methods have been used by a variety of companies. One publicly-traded company which has used the above financial management methods is Proctor & Gamble Co. This is an American multinational corporation that has been ranked top ten among publicly traded companies. It is involved in the production of a variety of household commodities, personal care products such as soaps and detergents, and even the production of prescription drugs.
The three methods of financial management have been effectively applied in this company up to now. According to Bloomberg Businessweek (2012), the net change in cash is 1468 million USD as of 30th June 2009, the value of the same is -1902 million USD as of 30th June 2010 and as of 30th June 2011, the net change in cash is -111 million USD. Calculation of Internal Rate of Return is aimed at determining the discount rates on investments that will equate or reduce cash flows to zero. Considering the data above and bearing in mind that this is a big company that generates which generates billings of dollars annually in terms of profits, one can say that the net change in cash for Proctor & Gamble co. is very much reduced for the three years. This shows that IRR as a method of financial management has been effectively applied by the company.
On the other hand, the companys Rate on Equity is 15.56% as of Dec 31st, 2011(Bloomberg Businessweek, 2012). This proves that the company can compete on equal terms with other companies with the same operations because its rate of generating profits from the available assets is very high. ROE of 15.56% indicates that the company is very strong financially (Jensen Investment, 2008).
Lastly, the company’s annual income ranges from11, 000 to 13000 million USD in three years from 2009 to 2011(Bloomberg Businessweek, 2012). This clearly shows that the company had channeled its money in various investments which generated high returns for those three years. Determination of the best investments to undertake was only possible through calculation and comparison of Return on Investment for the various investments. The company had used ROI as a financial management tool because it made high profits in the three years. According to Bloomberg Businessweek (2011), Proctor & Gamble Co. has announced that by 2013 it will cut jobs for about 5700 employees who are part of the non-manufacturing workforce. These employees are currently working for the company but they may not be generating high returns for the company and that’s why the company is firing them to kick start new investments which have high returns. This move can only be dictated by ROI.
Nowadays companies use the above methods in their management of cash. Internal Rate of Return indicates the rate of return which is expected from money invested in a given business. It is a powerful tool used by companies to show how a business is generating income for the company over a given period (Brigham & Ehrhardt, 2012). On the other hand, Return on Equity is used by many companies today to identify their competitor companies. A higher ROE is preferred by companies because a company with a higher ROE will have more earnings most of which will go to the shareholders. Due to increased earnings, the company will grow faster. Many companies today use ROE to identify businesses of interest where they can invest. Moreover, ROE indicates future business trends and performance and such information is useful to most companies. To raise ROE, most companies get debts or increase their assets. Continuous reinvestment is also required because it generates more earnings which raise ROE for a given company (Jensen Investment, 2008).
Rate on Investment is a method of financial management that provides information for companies on the most cost-effective investments that a company should undertake. To maximize profits the investments which are likely to generate high profits are chosen since making profits is the goal of most companies. Organizations like banks use the ROI of various companies to determine which companies to lend their money because a company that is likely to make profits will attract a lot of creditors who will hope to get higher interest rates. This is because ROI indicates a companys ability to make profits (Pandey, 2009).
Bloomberg Businessweek. (2012). Financial Statements for Proctor & Gamble Co. /The (PG). Web.
Brigham, E.F., & Ehrhardt, M, C. (2011). Financial Management: Theory and Practice.13th Edition. South Western Cengage Learning.
Jensen Investment. (2008).Why Return on Equity is a Useful Criterion for Equity Selection, 1-12. Web.
Pandey, I.M. (2009). Financial Management. 9th Edition. Vikas Publishing House PVT Ltd. Jangpura, New Delhi