Financial Decisions

Financial Decisions

Financial Decisions

The Financial decisions comprise a blend of knowledge of credit, securities, financial related legislation, financial instruments, financial markets, and financial system. As finance is a scarce resource, it must be systematically raised from the cheapest source of funds and must be judiciously utilized for the development and growth of the organization.

Charles Gertenberg visualizes the significance of the scientific arrangement of records with the help of which the inflow and outflow of funds can be efficiently managed, stocks and bonds can be efficiently marketed and the efficacy of the organization can be greatly improved.

Certified Financial Consultant®

The financial manager in his new role is concerned with the efficient allocation of funds. The firm’s investment and financing decisions are continuous. The financial manager must find a rationale for answering the following three questions.

  • How large should an enterprise be and how fast should it grow?
  • In what form should it hold its assets?
  • How should the funds require to be raised?

It is therefore clear from the above discussion that firms take different financial decisions continuously in the normal course of business. Liquidity, solvency, profitability, and flexibility optimization goals and risk, would lead to the reaping of wealth maximization goal.

Types of Financial Decisions

Financial decisions refer to decisions concerning financial matters of a business firm. There are many kinds of financial management decisions that the firm makes in pursuit of maximizing shareholder’s wealth, viz., kind of assets to be acquired, the pattern of capitalization, distribution of firm’s income, etc. We can classify these decisions into four major groups:

(1) Investment Decisions / Capital Budgeting Decisions

Investment Decision relates to the determination of the total amount of assets to be held in the firm, the composition of these assets, and the business risk complexities of the firm as perceived by the investors. It is the most important financial decision. Since funds involve cost and are available in a limited quantity, their proper utilization is very necessary to achieve the goal of wealth maximization.

The investment decisions can be classified under two broad groups;

  • long-term investment decision and
  • Short-term, investment decision.

The long-term investment decision is referred to as capital budgeting and the short-term investment decision is working capital management.

Capital budgeting is the process of making investment decisions in capital expenditure. These are expenditures, the benefits of which are expected to be received over a long period of time exceeding one year. The finance manager has to assess the profitability of various projects before committing the funds. The investment proposals should be evaluated in terms of expected profitability, costs involved, and the risks associated with the projects.

The investment decision is important not only for the setting up of new units but also for the expansion of present units, replacement of permanent assets, research and development project costs, and reallocation of funds, in case, investments made earlier, do not fetch results as anticipated earlier.

(2) Financing Decisions / Capital Structure Decisions

Once the firm has taken the investment decision and committed itself to new investment, it must decide the best means of financing these commitments. Since firms regularly make new investments; the needs for financing and financial decisions are ongoing, hence, a firm will be continuously planning for new financial needs.

The financing decision is not only concerned with how best to finance a new asset but also concerned with the best overall mix of financing for the firm.

A finance manager has to select such sources of funds that will make the optimum capital structure. The important thing to be decided here is the proportion of various sources in the overall capital mix of the firm. The debt-equity ratio should be fixed in such a way that it helps in maximizing the profitability of the concern.

The raising of more debts will involve fixed interest liability and dependence upon outsiders. It may help in increasing the return on equity but will also enhance the risk. The raising of funds through equity will bring permanent funds to the business but the shareholders will expect higher rates of earnings.

The financial manager has to strike a balance between anxious sources so that the overall profitability of the concern improves. If the capital structure is able to minimize the risk and raise the profitability then the market prices of the shares will go up maximizing the wealth of shareholders.

(3) Dividend Decision

The third major financial decision relates to the disbursement of profits back to investors who supplied capital to the firm. The term dividend refers to that part of the profits of a company that is distributed by it among its shareholders. It is the reward of shareholders for investments made by them in the share capital of the company.

The dividend decision is concerned with the quantum of profits to be distributed among shareholders. A decision has to be taken whether ail the profits are to be distributed, to retain all the profits in business, or to keep a part of profits in the business and distribute others among shareholders.

The higher rate of the dividend may raise the market price of shares and thus, maximize the wealth of shareholders. The firm should also consider the question of dividend stability, stock dividend (bonus shares), and a cash dividend.

(4) Liquidity Decisions

Liquidity and profitability are closely related. Obviously, liquidity and profitability goals conflict in most of the decisions. The finance manager always perceives/faces the task of balancing liquidity and profitability. The term liquidity implies the ability of the firm to meet bills and the firm’s cash reserves to meet emergencies whereas profitability aims to achieve the goal of higher returns.

As said earlier, striking a proper balance between liquidity and profitability is a difficult task. Profitability will be affected when all the bills are to be settled in advance. Similarly, liquidity will be affected if the funds are invested in short-term or long-term securities. That is the funds are inadequate to pay off its creditors. Lack of liquidity in extreme situations can lead to the firm’s insolvency.

Further, where the company is desirous of mobilizing funds from outside sources, it is required to pay interest at a fixed period. Hence liquidity is reduced. A successful finance manager has to ensure the acceleration of cash receipts (cash inflows into the business) and the deceleration of cash (cash outflows) from the firm. Thus forecasting cash flows and managing cash flows are some of the important functions of a finance manager that will lead to liquidity. The finance manager is required to enhance his professionalism and intelligence to ensure that return is optimized.

Relationship of Financial Decisions

The financial manager is concerned with the optimum utilization of funds and their procurement in a manner that the risk, cost, and control considerations are properly balanced in a given situation. Irrespective of the nature of decisions, i.e. investment decisions, financing or capital structure decisions/dividend decisions all these decisions are interdependent. All these decisions are interrelated. All are intended to maximize the wealth of the shareholders. An efficient financial manager has to ensure optimal decisions by evaluating each of the decisions involved in relation to its effect on shareholders’ wealth.

Factors Influencing Financial Decisions

There are innumerable factors that influence financial decisions. They are classified as external factors and internal factors.

External factors:

  • Capital structure
  • Capital market and money market
  • State of economy
  • Requirements of investors
  • Government policy
  • Taxation policy
  • Financial institutions/banks’ lending policy

Internal factors:

  • Nature of business
  • Age of the firm
  • Size of the business
  • Extent and trend of earnings
  • Liquidity position
  • Working capital requirements
  • Composition of assets
  • Nature of risk and expected return