Finance Functions

Principle & Practice of Management

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Finance Functions

Finance Functions

Finance Functions

Financial Management is indeed, the key to successful business operations. Without proper administration and effective utilisation of finance, no business enterprise can utilise its potentials for growth and expansion.
Financial management is concerned with the acquisition, financing and management of assets with some overall goals in mind. As mentioned in the contents of a modern approach, the discussions on financial management can be divided into three major decisions viz., (1) Investment decision; (2) Financing decision; and (3) Dividend decision (see Figure 1.2). A firm takes these decisions simultaneously and continuously in the normal course of its business. The firm may not take these decisions in a sequence, but decisions have to be taken with the objective of maximising shareholders’ wealth.
1. Investment Decision: It is most important than the other two decisions. It begins with a determination of the total amount of assets needed to be held by the firm. In other words, investment decision relates to the selection of assets, that a firm will invest funds. The required assets fall into two groups:
(a) Long-term Assets (Fixed assets: plant & machinery, land and buildings, etc.): Which involve huge investments and yield a return over a period of time in future. Investment in long-term assets is popularly known as “capital budgeting”. It may be defined as the firm’s decision to invest its current funds most efficiently in fixed assets with an expected flow of benefits over a series of years.
(b) Short-term Assets (Current assets: raw materials, working in the process, finished goods, debtors, cash, etc.): That can be converted into cash within a financial year without diminution in value. Investment in current assets is popularly termed as “working capital management”. It relates to the management of current assets. It is an important decision of a firm, as short-survival is the prerequisite for long-term success. Firms should not maintain more or fewer assets. More assets reduce return and there will be no risk, but having fewer assets is more of a risk as well as more profitable. Hence, the main aspects of working capital management are the trade-off between risk and return.
Management of working capital involves two aspects. First, determination of the amount required for the running of the business and secondly financing these assets. It is discussed in detail in the chapter on Working Capital Management.
2. Financing Decision: After estimation of the amount required and the assets that require purchasing, comes to the next financing decision into the picture. Here, the financial manager is concerned with makeup on the left-hand side of the balance sheet. It is related to the financing mix or capital structure or leverage and he has to determine the proportion of debt and equity. It should be optimum finance mix, which maximises shareholders’ wealth. A proper balance will have to be struck between risk and return. Debt involves fixed cost (interest), which may help in increasing the return on equity along with an increase in risk. Raising of funds by issue of equity shares is one permanent source, but the shareholders expect higher rates of earnings. The two aspects of the capital structure are capital structure theories and determination of optimum capital structure.
3. Dividend Decision: This is the third financial decision, which relates to dividend policy. The dividend is a part of profits, that are available for distribution, to equity shareholders. Payment of dividends should be analysed in relation to the financial decision of a firm. There are two options available in dealing with the net profits of a firm, viz., distribution of profits as dividends to the ordinary shareholders’ where there is no need of retention of earnings or they can be retained in the firm itself if they require, for the financing of any business activity. But the distribution of dividends or retaining should be determined in terms of its impact on the shareholders’ wealth. The Financial manager should determine optimum dividend policy, which maximises the market value of the share thereby market value of the firm. Considering the factors to be considered while determining dividends is another aspect of dividend policy. [ Finance Functions ]

Interrelation among Financial Decisions

Although the above-discussed financial management decisions are of three different kinds, they are not independent, but are interrelated as the underlying objective of all the three decisions is the (same) maximisation of shareholders’ wealth.

1. The interrelation between “Investment and Financing Decisions”:

While taking the investment decision, the financial manager decides the type of asset or project that should be selected. The selection of a particular asset or project helps to determine the amount of funds required to finance the project or asset. For example, suppose the investment on fixed assets is Rs. 10 crore and investment in current assets or working capital is Rs. 4 crores. So the total fund required to finance the total assets is Rs. 14 crore.
Once the anticipation of funds required is completed then the next decision is financing decision. Financing decision means raising the required funds by various instruments.
There is an interrelation between investment decision and financing decision, without knowing a number of funds required and types of funds (short-term and long-term) it is not possible to raise funds. To put it in simple words, investment decision and financing decisions cannot be independent. They are dependent on each other. [ Finance Functions ]

2. The interrelation between “Financing Decision and Dividend Decision”:

Financing decision influences and is influenced by dividend decision, since retention of profits for financing selected assets or projects, reduces the profit available to ordinary shareholders, thereby reducing dividend payout ratio. For example, in the illustration above, we have decided the amount required to finance a project is Rs. 14 crore. If the financial manager plans to raise only Rs. 7 crore from outside and the remaining by way of retained earnings, and if the dividend decision is 100% payout ratio, then the financial manager has to depend completely on outside sources to raise the required funds. So, dividends decision influences the financing decision. Hence, there is an interrelation between financing decision and dividend decision. [ finance functions ]

3. The interrelation between “Dividend Decision and Investment Decision”:

Dividend decision and investment decision are interrelated because retention of profits for financing the selected assets depends on the rate of return on proposed investment and the opportunity cost of the retained profits. Profits are retained when the return on investment is higher than the opportunity cost of retained profits and vice-versa. Hence, there is an interrelation between investment decision and dividend decision.
The financial manager has to take an optimal joint decision after evaluating the decisions that will affect the wealth of the shareholders if there is any negative effect on the wealth it should be rejected and vice versa.
The importance of financial management can be ascertained, after going through the following points:
1. Successful promotion: Successful promotion of a business concern depends upon efficient financial management. If the plan adopted, fails to provide adequate capital to meet the requirements of fixed and working capital and particularly the latter, the firm cannot carry on its business successfully. Therefore, sound financial planning is quite essential for the success of a business firm.
2. Smooth running: Since finance is required at each stage of the business such as promotion, incorporation, development, expansion and management of day-to-day expenses, proper financial administration becomes necessary for the smooth running of a business enterprise.
3. Decision making: Financial management provides scientific analysis of all facts and figures through various financial tools such as ratio analysis, Variance analysis, budgets etc. Such an analysis helps the management to evaluate the profitability of the plan in the given circumstances so that a proper decision can be taken to minimise the risk.
4. Solutions to financial problems: Efficient Financial Management helps the top management by providing solutions to the various financial problems faced by it.
5. A measure of performance: Financial Management is considered as a yardstick to measure the performance of the firm. [ Finance Functions ]
The importance of Financial Management in an enterprise may very well be realised by the following words. “Financial Management is properly viewed as an integral part of the overall management rather than as a staff speciality concerned with fundraising operation. In addition to raising funds, financial management is directly concerned with production, marketing and other finance functions within an enterprise, whenever decision are made about the acquisition or distribution of assets”.
Thus, financial management has attained a good deal of importance in modern business. [ Finance Functions ]