1.3 How Finance Fits into Business Management

Functional Areas of Business

Within a typical company there are several different functional areas, including marketing, operations, accounting, human resources, strategic management, and finance. Before we can explain how finance fits into the corporate firm, we first need to quickly cover the other areas.

Marketing

Marketing is responsible for selling a product or service. A marketing team does this through market research, advertising, promotions, and the like. Frankly, anyone who has attempted to start their own company quickly realizes that marketing really is paramount. If you cannot sell your product or service, you do not have a company! As one of our marketing colleagues reminded us over lunch one day, “You have to have a top line to have a bottom line.” By this, he meant that marketing is responsible for generating the top line of the income statement: sales. Finance has a lot of control over what happens between the top line (sales) and the bottom line (net income). Without a top line, you can’t generate a bottom line.

When we think of marketing, we often think of slick print ads, funny TV commercials, or well-polished car salespeople. However, these show only one aspect of marketing. If we look a little deeper, we can see the quantitative facet of marketing that relies on heavy research and data analytics.

Operations

Operations is typically in charge of actually producing products or providing services in a business. The operations group determines the optimal way to structure the factory for optimal efficiency. Operations management is a highly quantitative field that uses math to figure out these optimalities. Within operations is a subfield known as supply chain management (SCM), which has grown quickly in the past decade. An SCM team is responsible for ordering the materials necessary for building the product and then shipping the product to the next participant in the supply chain. SCM involves building networks of suppliers and customers to create value through the value chain. Walmart and Amazon are famous for their outstanding SCM, which is part of what has allowed the companies to be so successful. Both firms continually use cutting-edge inventory techniques to rule the retailing sector.

Industry and research experts have stressed the importance of SCM in business:

Accounting

Accounting divisions have the job of recording what has happened in the past and formatting the historical data in the company balance sheet, income statement, and statement of cash flows. Accountants are essentially historians who use numbers as their language. Within the firm, accountants may specialize as tax experts, managerial accountants (cost accountants), or financial accountants (auditors). Most business schools offer these three different tracks for their accounting students. The intent of most accounting students is to become certified public accountants (CPA) by passing a state CPA exam and fulfilling other educational and work requirements. Within a smaller firm, it is not unusual for the accounting and finance departments to be combined. As such, the line between the two disciplines is very blurry, and a company’s finance or accounting department will wear both hats. In large corporations, accounting is almost always its own department as a form of protection—separating the internal auditors from the finance function.

Human Resources

A company’s organizational behavior (OB) or human resources (HR) department is responsible for the company’s people. You may have heard the often-quoted phrase, “our employees are our greatest asset.” While this quote may only be a recruiting tool at some firms, we can at least hope that companies value their employees. The OB or HR department has the job of recruiting and retaining the firm’s employees. Often, an employee who is newly hired will work with the HR professionals the first week to get situated in a new job. OB or HR will help new employees set up a 401K plan, explain the company’s various other benefits (for example, health insurance), and go over the company’s various regulations and policies.

Strategic Management

Strategic management (also known as management or strategy) typically provides internal consulting at large firms. Many firms outsource the strategy initiatives to management consulting firms such as Bain & Company, McKinsey & Company, and Deloitte. Most schools have an emphasis or major in strategy.

Finance—How It Fits In

Now that we’ve reviewed the various functions in the typical firm, the next time you watch re-runs of The Office you may better understand how accounting (Angela, Kevin, and Oscar) fits in with sales (Jim, Andy, Dwight, and others) and HR (Toby) and how they all fit in with management (Michael)! Now that you have a basic understanding of these functional areas, we can discuss how finance fits into the organizational structure of a firm.

Suppose your firm has a new initiative to launch a video game console (think of Microsoft launching the Xbox many years ago). The operations team has come up with the design and manufacturing plan for the console. It has proposed how the production line in the factory will be set up from start to finish. The supply chain folks have contacted the suppliers for all the parts necessary to manufacture the console. They have also modeled the distribution of the completed product to their down-chain customers. Marketing has performed the marketing analysis and has deemed that there is a strong demand for the product despite the existence of competitors, such as Nintendo and PlayStation. HR has estimated how much it would cost to hire the additional people needed to carry out the plan. The head office has been employing an external consulting firm to provide strategic management throughout the process. Accounting is prepared to record the financial information, after the product is launched, to create the necessary financial statements.

The financial management team is now up to bat. Finance will take all of the information provided by the other departments and conduct a cost-benefit analysis to see if it makes sense to launch the gaming console. First, a forecast will be made to determine if the benefits will outweigh the costs. As part of this forecast, the finance group will determine how to finance the project. Have there been enough retained earnings in the company to finance the project through current cash? If not, should the firm seek debt or equity investors? Once it has the forecast, the financial management team can compute the free cash flows for the project. Once the team has determined the form of financing, it can also compute the cost of capital for the project. Having these two inputs will allow the team to use discounted cash flow analysis to determine if the company should go ahead with the launch. (Don’t worry, we’ll learn about all these things later on!)

We use Xbox as our example here because, ironically, Microsoft did very little of the aforementioned analysis before launching the game console. This was in spite of entrenched competition from existing video game firms. It took many years for Microsoft to start making a profit on Xbox, and this delay is attributed to skipping the finance analysis. If you're interested, read this Motley Fool article, “How One of Microsoft’s Greatest Consumer Successes is a Financial Failure.” According to this article, the Xbox has lost billions for dollars for Microsoft over the years.

Generally, a company survives and maximizes owner value by constantly investing in projects. The finance team determines which projects will add the most value to the firm. Along with making the investing decision, finance also determines which form of financing is optimal. This capital budgeting decision is just one function of finance. After you make it through all of the topics in this course, you’ll know the other functions as well.

Responsibilities of the Financial Manager

The remainder of this course will focus on the responsibilities of the financial manager. You will come to understand those responsibilities as you do the following throughout the course:

1. Learn to measure the health of the firm via financial statement analysis. Using ratio analysis and free cash flow measures, you will learn how to assess whether a firm is doing well and in what areas a firm can improve. You will also learn how to use ratios as goals for a firm.

2. Learn to prepare financial forecasts by creating pro forma financial statements.

3. Use discounted cash flows to value stocks, bonds, and other assets that generate cash flows.

4. Learn how to think about and quantify risk in a financial setting.

5. Learn how to estimate the various components of the weighted average cost of capital (WACC) and why the WACC is important to the firm.

6. Use a portfolio of capital budgeting tools to determine which investments will add value to a firm.

7. Learn several methods for valuing a company as an entity.