Types of Financial Decisions in Financial Management
Every business – small, medium, or large – must have good financial management practices in place if it is to succeed and grow. A successful business requires sound financial management. But what does it take to make good, informed financial decisions?
Financial management is the process of making decisions about how to use a company’s financial resources best. It includes the planning, organizing, and controlling of a company’s financial activities. The goal of financial management is to maximize a company’s shareholder value by making the best possible decisions about how to use its financial resources. There are three primary types of financial decisions that financial managers must make: investment decisions, financing decisions, and dividend decisions.
In this article, we will discuss the different types of financial decisions that are taken in order to manage a business’s finances. We will explore the pros and cons of each type and how each decision affects the overall financial picture. Read on to find out more.
Introduction To Financial Management
Financial management is a process that involves making decisions about how to allocate financial resources in order to achieve organizational objectives. The financial manager must decide on the organization's financing mix in the financing decision, which is a crucial decision. A financing Decision is concerned with the borrowing and allocating of funds required for the firm's investment decisions.
Financial management has an impact on all aspects of organizational activity, including both profit and non-profit organizations. Several different activities, including
Fund acquisition,
Resource allocation
Financial performance tracking.
As a result, it has come to play an essential role in all types of organizations. The financing decision is based on two sources of funds:
The first is capital owned by the business, including shareholding and retained earnings.
The second source of funds is borrowed from outside the corporate entity in the form of debenture, loan, bond, and so on. The goal of the financial decision is to achieve an optimal capital structure.
Financial Management Concept
Financial management entails making plans for a person's or a business's future in order to maintain a positive cash flow. It involves the administration and upkeep of financial assets. Financial management also includes the process of determining and controlling risks.
Financial management is more concerned with evaluation than with financial quantification techniques. A financial manager examines available data to assess the performance of businesses. Managerial finance is a diverse discipline that draws on managerial accounting and financial analysis.
Financial management is sometimes referred to as the "science of money management" by some experts. This term is most commonly used in the community of financing financial transactions. On the other hand, financial management is crucial at all stages of human creation because every entity must manage its finances.
Evolution and Emergence of Financial Management
The scope and nature of financial management have evolved and broadened over time. Its evolution can be broadly classified into three stages:
1. Traditional phase
2. Transitional phase
3. Modern phase.
1. Traditional phase
The Traditional period lasted roughly four decades until the early 1940s. During this period, the emphasis of financial management was primarily on episodic events such as capital procurement, engagement with major lenders such as banks, debt servicing, issuance of securities, expansion, merger, and compliance with legal aspects. The approach was primarily descriptive.
2. Transitional phase
The Transitional phase started in the 1940s and lasted until the early 1950s. During this phase, financial management was almost identical in nature and scope to that of the traditional stage.
However, there was a growing emphasis on organizing, procuring, managing and controlling funds to fulfill the business's day-to-day financial needs. Financial issues have begun to be examined within an analytical framework.
3. Modern phase
Due to increased competition, growth opportunities, globalization, breakthroughs in economic theories, and the development of quantitative methods of analysis, the mid-1950s labeled the start of the modern phase in financial management.
This resulted in the development of an increasingly analytical and empirical approach to financial decision-making. The management or insider's point of view has become core to financial management.
Key Objectives of Financial Management
Financial management is concerned with acquiring, allocating, and controlling a business's financial resource management.
Financial management may have a variety of key objectives, including.
To ensure a steady and adequate supply of funds.
To guarantee adequate returns.
To ensure efficient utilization of funds.
To ensure investment security.
To establish solid financial leverage, and so on.
Scope and Extent of Financial Management
Financing a business necessitates numerous short- and long-term decisions, expanding financial management's scope.
Short-term Financial Decisions
Short-term financial decisions are primarily concerned with the business firm's day-to-day capital requirements or working capital management. These decisions have an impact on the firm's liquidity and profitability.
Long-term Financial Decisions
Long-term financial decisions, on the other hand, are concerned with financing the enterprise, investing funds, and managing earnings.
Types of Financial Decisions
Financial decisions are divided into three types. These types are referred to as the basics of financial decisions that the financial manager must make:
Investment Decisions
Financing Decisions
Dividend Decisions
Working Capital Decisions
Investment Decisions
Any prospective investment made by a business unit must be assessed regarding the risk, the cost of capital, and the expected benefits. As a result, the two key elements of investment decisions are
Capital budgeting
Liquidity.
Simply put, capital budgeting is the dedication and allocation of funds to long-term investments that will generate earnings in the future.
It also considers decisions regarding the replacement and renovation of old assets. A finance manager's primary responsibility is to balance current and fixed assets to maximize profitability while maintaining the desired level of liquidity for the component.
Making these decisions is not for the faint of heart; it entails extensive estimation of expenses and benefits that cannot be determined with surety and are unknown.
Factors Influencing Investment Decisions
Venture cash flow
When a company launches a new venture, it begins by investing a large sum of money. However, the organization anticipates at least one source of revenue to cover daily expenses. As a result, there needs to be some consistent cash flow within the venture to sustain it.
Investment Criteria
A business utilizes multiple Capital Budgeting procedures to evaluate various investment propositions. Most notably, they are based on calculations involving investment, cash flows, interest rates, and the rate of return on propositions. These are applied to investment proposals in order to select the best one.
Profits:
The primary reason for starting a business is to earn revenue but also profits. The essential criteria in selecting the venture are the organization's rate of return in relation to its profit essence. For example, project B should be preferred if venture A earns 10% and venture B earns 15%.
Financing Decisions
Firm financing decisions are concerned with an organization's financing mix or financial structure. Financing a company necessitates significant decisions regarding methodologies and finance sources relative to the proportion and selection of sustainable resources, period of floatation of equities, and so on.
Numerous funds can be used to meet an organization's investment needs. The finance manager is responsible for designing the optimal combination of finance structures for an organization that involves the least amount of money to raise and maximizes the long-term market prices of the company's shares.
Furthermore, while financing, a balance of debt and equity must be maintained in order to generate a sufficient return on equity with the least amount of risk. The utilization of debt or leverage ratio affects both the rates of return and risk of capital investment.
To maximize the per-share value of equity stock, the financial manager is tasked with making the best decisions possible regarding the means of issuing debt securities and the timing of raising funds for the company.
Factors Influencing Financial Decisions
Cash flow position.
The cash flow position is the company's daily earnings. A strong cash flow position encourages investors to put money into the company.
Control
In this case, where existing investors have control of the company or organization and raise funds by borrowing money, equity can be used to raise funds if they are willing to give up control of the business.
Cost
Financing decisions are made based on fund allocation and cost-cutting. The cost of raising funds from various sources varies greatly, so the most affordable source should be used.
Risk
The risks of starting a business with funds vary depending on the source. Borrowed funds are riskier than equity funds.
Market condition
The market condition has a significant impact on financing decisions. During a boom period, the majority of equity is issued, but during a depression, a firm's debt is used.
Dividend Decisions
If a company wants to maximize its wealth, it must have an appropriate, well-thought-out dividend policy. One of the most important decisions to make when developing an adequate dividend policy is to select between the two alternatives -
One, distribute all profits to shareholders or not.
Two, keep a portion of profits and disseminate the remainder as dividends.
While deciding on the dividend payout ratio, the finance manager is also anticipated to research various investment opportunities for further growth and expansion. The dividend pay ratio is the percentage of net profits that are distributed to shareholders as dividends. Aside from this, a finance manager must consider dividend stability, dividend forms, such as cash stock dividends or dividends, and so on.
Factors Influencing Dividend Decisions
Profitability and Growth
Businesses with growth potential prefer to keep more of their earnings in order to fund the new project. As a result, companies with near-term growth prospects will proclaim fewer dividends than companies with no growth plans.
Taxation Policy
Dividend rates are also affected by the government's taxation policy. Under current tax laws, shareholders prefer higher dividends because they receive tax-free income from dividends. However, dividend decisions are made by corporations.
Earnings Stability
A business that is steady and has consistent earnings can manage to declare a higher dividend than a company that does not have such earnings stability.
Preferences of shareholders
When releasing dividends, the organization must consider the preferences of the investors. Some shareholders insist on receiving at least a certain amount of funds in dividends. Organizations should consider the choices of such shareholders.
Contractual and legal restrictions
When making a lender to a corporation, the lending entity may enforce precise words and restrictions on future dividend payments. Businesses must ensure that the earnings distribution process does not violate the agreed-upon terms.
Working Capital Decisions.
These decisions are related to the firm's working capital requirements, i.e., the unit's financial assets and current liabilities. Current assets include
Cash
Receivables
Inventory
Short-term securities, and so on.
Current liabilities include
Creditors
Bills payable
Outstanding expenses,
Bank overdrafts, and so on.
When we converse about existing assets and debts, we relate to all those liabilities and assets which have their sophistication within a financial reporting year.
Factors Influencing Working Capital Decision
Scale of Operation
Firms that operate on a large scale must keep more debtors, inventory, and so on. Hence, these businesses typically necessitate a significant portion of working capital. Smaller businesses, on the other hand, need less working capital.
Operating Effectiveness
A company with a high level of operating efficiency will necessitate less working capital; however, a company with a low level of operating efficiency will require so much working capital. As a result, the length of an organization's operating cycle directly impacts its working capital requirements.
Seasonal Factors
Companies that sell goods all season long require consistent working capital. However, companies selling seasonal products require a significant amount of working capital due to increased demand, and the firm must preserve more stock and deliver the goods at a rapid pace. In contrast, it needs less working capital during the off-season because demand is low.
Significance of Financial Management
The significance of financial management is illustrated by the following:
Enterprise Efficiency
Finance is critical to the organization's smooth operation. Finance is to a business what oil is to an engine. Finance is required at every stage, including promotion, incorporation, expansion, and meeting day-to-day expenses.
Successful Marketing
Financial efficiency and effective management are critical to the success of the business promotion. A flawed plan has been identified as one of the leading causes of business promotion failures. A solid financial plan is essential for the success of a business enterprise in this regard.
Decision-Making
Profitability is the driving force behind all decisions. Financial management provides a scientific study of all data and figures, budgets, and financial statements, among other things. These data assist financial management in calculating the strategy's profitability under given conditions and guiding them in making appropriate decisions to minimize risk.
Business Problem-Solving
Financial management offers a variety of solutions to top management problems and grows and promotes organizational strength.
Coordination of Multiple Activities
Financial management ensures complete coordination between the various departments to achieve organizational goals, including production, sales, purchasing, marketing, and accounts. The finance manager is in charge of meeting the financial requirements of diverse departments on time.
For instance, if the accounting department fails to meet its commitments to the procurement department for the purchase of unprocessed materials, the production department will suffer from a lack of raw materials, resulting in a lack of supply and a decrease in sales.
As a result, the company's income will suffer. Thus, financial management takes up a central position in the business entity to oversee and coordinate all of the enterprise's activities.
Performance Metrics
The financial results are provided by financial management. As a result, financial results are used to assess an enterprise's performance and the size of its earnings. Financial decisions that increase the risks reduce the firm's value, whereas financial decisions that increase the enterprise's profitability increase the firm's value.
As a result, risk and cash flow are the two most essential components of any business. In this perspective, J.F. Weston and E.F. Brigham Convey that "Financial decisions influence both the overall size of earnings flow of profitability and the risk level of the firm. Political decisions hinder risk and profitability, and these two factors together determine the firm's value."
Risk Management
Financial management enables an organization to predict risks, and implement measures to mitigate and respond to unpredicted hazards and emergencies efficiently.
Approaches and Strategies of Financial Management
Theoretically, the financial management approach can be divided into two major parts:
Traditional Approach,
Modern Approach
Traditional Approach
The traditional approach is only concerned with raising funds. The traditional approach was the first phase of financial management that was used from 1920 to 1950. This approach was limited because it was solely concerned with acquiring funds.
Modern scholars have promoted the modern approach to financial management after criticizing this method on a number of different grounds.
Modern Approach:
Based on the modern approach, a financial manager is willing to take responsibility for the agreement of funds and wise utilization of funds. As a result, the finance manager is concerned with all financial activities, such as planning, raising, allocating, and controlling finance. As a result, the modern approach has a broader scope than the traditional approach.
According to the modern approach, finance functions are divided into two broad categories: i. executive/primary functions and ii. subsidiary functions.
Components of Financial Management
Financial management consists of three main components:
Financial Planning
Financial Control
Financial Decision-Making
1. Financial Planning
It refers to the planning of the use of cash support, such as raising funds, determining the amount of capital, and ensuring that the increased finance is low-cost and low-risk. Short-term funds may be needed to meet operations and maintenance and working capital needs, such as reimbursing for the use of current assets and credit sales. Finance is required in the long run to carry out acquisitions, mergers and acquisitions, growth, and diversification of the organization.
2. Financial Control
It refers to the technique of overseeing and monitoring the organization's financial operations. Financial control is among the most crucial activities, which ensures that a business meets its objectives by correcting errors in financial operations. It aids in the efficient utilization of resources in order to achieve the organization's goal within the time frame specified.
3. Financial Decision-Making
Assists the organization in making various decisions involving the use of funds. Making an investment in a project, disseminating dividends, and maintaining liquidity are all important financial decisions.
Interrelationship B/W Financial Decisions
All financial management decisions mentioned above are interrelated rather than independent. A reasonable discount rate is needed in order to calculate the current costs and benefits for a capital budgeting decision. In capital budgeting decisions, the discount rate is typically the cost of capital arising from a firm's capital structure decision.
As a result, financial and investment decisions are inextricably linked. When a company's operating risk is high due to a substantial investment in long-term equity (a capital budgeting decision), it ought to have low debt, equity, and financial risk. The decision to distribute a dividend is impacted by operating profitability, which is influenced by capital budgeting.
Firms may use preserved earnings to fund investment projects, and any profit that remains is distributed as a dividend. As a result, dividends and capital budgeting are linked on the one hand, and dividends and financing decisions on the other.
Conclusion:
Every business is unique, with its own values and ways of doing business. Finance, however, is a commonality that all companies have widely known, and any business's success depends on it. So far, we've looked at the various types of financial management decisions that only a company must make in order to achieve its goals.
However, as we all know, the risk is indeed associated with profit. In layman's terms, profit is directly related to risk; the greater the profit, the higher the risk associated with it. So, to maximize profits, a finance manager must make decisions that will increase the enterprise's profitability.
The risk factor can be ignored in the short run, but the entity cannot overlook the uncertainty in the long run. Shareholders are investing in the business with the expectation of receiving better yields if they observe that nothing has been done to boost their wealth.