Financial Management is concerned with the acquisition and utilization of capital funds in meeting the financial needs and overall objectives of a business enterprise. Thus the primary function of finance is to acquire capital funds and put them for proper utilization, with which the firm’s objectives are fulfilled. The firm should be able to procure sufficient funds on reasonable terms and conditions and should exercise proper control in applying them in order to earn a good rate of return, which in turn allows the firm to reward the sources of funds reasonably, and leaves the firm with good surplus to grow further. These activities viz. financing, investing and dividend payment are not sequential they are performed simultaneously and continuously.
Financial Management Decisions – Three Major Decisions in Financial Management
The Financial Management can be broken down in to three major decisions or functions of finance. They are: (i) the investment decision, (ii) the financing decision and (iii) the dividend policy decision.
1. Investment Decisions
The investment decision relates to the selection of assets in which funds will be invested by a firm. The assets as per their duration of benefits, can be categorized into two groups: (i) long-term assets which yield a return over a period of time in future (ii) short-term or current assents which in the normal course of business are convertible into cash usually with in a year. Accordingly, the asset selection decision of a firm is of two types. The investment in long-term assets is popularly known as capital budgeting and in short-term assets, working capital management.
- Capital budgeting: Capital budgeting – the long term investment decision – is probably the most crucial financial decision of a firm. It relates to the selection of an asset or investment proposal or course of action that benefits are likely to be available in future over the lifetime of the project. The long-term investment may relate to acquisition of new asset or replacement of old assets. Whether an asset will be accepted or not will depend upon the relative benefits and returns associated with it. The measurement of the worth of the investment proposals is, therefore, a major element in the capital budgeting exercise. The second element of the capital budgeting decision is the analysis of risk and uncertainty as the benefits from the investment proposals pertain the future, which is uncertain. They have to be estimated under various assumptions and thus there is an element of risk involved in the exercise. The return from the capital budgeting decision should, therefore, be evaluated in relation to the risk associated with it. The third and final element is the ascertainment of a certain norm or standard against which the benefits are to be judged. The norm is known by different names such as cut-off rate, hurdle rate, required rate, minimum rate of return and so on. This standard is broadly expressed in terms of the cost of capital is, thus, another major aspect of the capital budgeting decision. In brief, the main elements of the capital budgeting decision are: (i) The total assets and their composition (ii) The business risk complexion of the firm, and (iii) concept and measurement of the cost of capital.
- Working Capital Management: Working capital management is concerned with the management of the current assets. As we know, the short-term survival is a pre-requisite to long-term success. The major thrust of working capital management is the trade-off between profitability and risk (liquidity), which are inversely related to each other. If a firm does not have adequate working capital it may not have the ability to meet its current obligations and thus invite the risk of bankrupt. One the other hand if the current assets are too large the firm will be loosing the opportunity of making a good return and thus may not serve the requirements of suppliers of funds. Thus, the profitability and liquidity are the two major dimensions of working capital management. In addition, the individual current assets should be efficiently managed so that neither inadequate nor unnecessary funds are locked up.
2. Finance Decisions
The second major decision involved in financial management is the financing decision, which is concerned with the financing – mix or capital structure of leverage. The term capital structure refers to the combination of debt (fixed interest sources of financing) and equity capital (variable – dividend securities/source of funds). The financing decision of a firm relates to the choice of the proportion of these sources to finance the investment requirements. A higher proportion of debt implies a higher return to the shareholders and also the higher financial risk and vice versa. A proper balance between debt and equity is a must to ensure a trade–off between risk and return to the shareholders. A capital structure with a reasonable proportion of debt and equity capital is called the optimum capital structure. The second aspect of the financing decision is the determination of an appropriate capital structure, which will result, is maximum return to the shareholders and in turn maximizes the worth of the firm. Thus, the financing decision covers two inter-related aspects: (a) capital structure theory, and (b) capital structure decision.
3. Dividend Policy Decisions
The third major decision of financial management is relating to dividend policy. The firm has two alternatives with regard to management of profits of a firm. They can be either distributed to the shareholder in the form of dividends or they can be retained in the business or even distribute some portion and retain the remaining. The course of action to be followed is a significant element in the dividend decision. The dividend pay out ratio i. e. the proportion of net profits to be paid out to the shareholders should be in tune with the investment opportunities available within the firm. The second major aspect of the dividend decision is the study of factors determining dividend policy of a firm in practice.