When the firm does so its rate of return will decline as more funds are tied up in idle cash. This would lead to reduction in profit. Thus a firm should maintain optimum level of current assets. All organizations irrespective of type of business must raise funds to buy the assets necessary to support operations. Thus financing decisions involves addressing two questions:. What is the best mix of financing these investment proposals? The choice between the use of internal versus external funds, the use of debt versus equity capital and the use of long-term versus short-term debt depends on type of source, period of financing, cost of financing and the returns thereby.
Prior to deciding a specific source of finance it is advisable to evaluate advantages and disadvantages of different sources of finance and its suitability for purpose.
Efforts are made to obtain an optimal financing mix, an optimal financing indicates the best debt-to-equity ratio for a firm that maximizes its value, in simple words, and the optimal capital structure for a company is the one which offers a balance between cost and risk.
This decision in financial management is concerned with allocation of funds raised from various sources into acquisition assets or investment in a project. The scope of investment decision includes allocation of funds towards following areas:.
Further, Investment decision not only involves allocating capital to long term assets but also involves decisions of utilizing surplus funds in the business, any idle cash earns no further interest and therefore not productive. So, it has to be invested in various as marketable securities such as bonds, deposits that can earn income. Most of the investment decisions are uncertain and a complex process as it involves decisions relating to the investment of current funds for the benefit to be achieved in future.
Therefore while considering investment proposal it is important to take into consideration both expected return and the risk involved. Thus, finance department of an organization has to decide to allocate funds into profitable ventures so that there is safety on investment and regular returns is possible. Shareholders are the owners and require returns, and how much money to be paid to them is a crucial decision.
Thus payment of dividend is decision involves deciding whether profits earned by the business should be retained rather than distributed to shareholders in the form of dividends. If dividends are too high, the business may be starved of funding to reinvest in growing revenues and profits further. Keeping this in mind an optimum dividend payout ratio is calculated by the finance manager that would help the firm to maximize its market value.
In simple words working capital signifies amount of funds used in its day-to-day trading operations. Working capital primarily deals with currents assets and current liabilities. Infact it is calculated as the current assets minus the current liabilities. One of the key objectives of working capital management is to ensure liquidity position of a firm to avoid insolvency.
The following are key areas of working capital decisions:. Effective administration of bills receivables and payables. The principle of effective working capital management focuses on balancing liquidity and profitability. Whereas the profitability means the ability of the firm to obtain highest returns within the funds available. In order to maintain a balance between profitability and liquidity forecasting of cash flows and managing cash flows is very important.
Financial Management takes financial decisions under three main categories namely, investment decisions, financing decisions and dividend decisions. Let us now discuss each financial decision in detail:. Investment decisions are the financial decisions taken by management to invest funds in different assets with an aim to earn the highest possible returns for the investors. It involves evaluating various possible investment opportunities and selecting the best options.
The investment decisions can be long term or short term. Long term investment decisions are all such decisions which are related to investing of funds for a long period of time. They are also called as Capital Budgeting decisions.
The long term investment decisions are related to management of fixed capital. These decisions involve huge amounts of investments and it is very difficult to reverse such decisions.
Therefore, it is must that such decisions are taken only by those people who have comprehensive knowledge about the company and its requirements. Any bad decision may severely damage the financial fortune of the business enterprise. While taking a capital budgeting decision, a business has to evaluate the various options available and check the viability and feasibility of the available options.
The various factors which affect capital budgeting decisions are:. Investment should be done only if the net cash flows are more than the funds invested.
The investment must be done in the projects which earn the higher rate of return provided the level of risk is same. These techniques involve calculation of rate of return, cash flows during the life of investment, cost of capital etc.
Importance of long term investment decisions:. Examples of c apital budgeting decisions:. Short Term Investment Decisions :. Short term investment decisions are the decisions related to day to day working of a business enterprise. They are also called as working capital decisions because they are related to current assets and current liabilities like management of cash, inventories, receivable etc.
The short term decisions are important for a business enterprise because:. Financing decisions are the financial decisions related to raising of finance. It involves identification of various sources of finance and the quantum of finance to be raised from long-term and short-term sources. While taking financing decision following points need to be considered:. Shareholders receive dividends when business earns profits. In order to raise capital with controlled risk and minimum cost of capital a firm must have a judicious mix of both debt and equity.
Therefore, cost of each type of finance is calculated before taking the financial decision of how much funds to be raised from which source. This decision determines the overall cost of capital and the financial risk for the enterprise. From the above discussions, you must have realized that financing decisions are affected by various factors. Cost of raising funds influence the financing decisions. A prudent financial manager selects the cheapest sources of finance.
Each source of finance has different degree of risk. Finance manager considers the degree of risk involved in each source of finance before taking financing decision. For example, borrowed funds have high risk as compared to equity capital. Floatation cost is the cost of raising finance. A finance manager estimates the floatation cost of various sources and selects the source with least floatation cost.
Therefore, higher the floatation cost less attractive is the source of finance. A business with strong cash flow position prefers to raise funds from debts as it can easily pay interest and the principal. Interest is a deductible expense, saves tax liability of the business making the source of finance cheaper. However, during liquidity crisis business prefers to raise funds from equity. Fixed operating costs of a business influence its financing decisions. For a business with high operating cost, funds must be raised from equity as lower debt financing would be better.
On the other hand, if the operating cost is low, business can afford to pay high fixed charges therefore, more of debt financing may be preferred. Financing decisions consider the degree of control the business is willing to dilute. A company would prefer debt financing if it wants to retain complete control of the business with existing shareholders.
On the other hand, a company willing to lose control will raise funds from equity. Health of the capital market may also affect the financing decision. During boom period, investors are ready to invest in equity but during depression investors look for secured options for investment.
Therefore it is easy for companies to raise funds from equity during boom period. Dividend decisions are the financial decisions related to distribution of share of profits amongst shareholders in the form of dividends. The dividend decision involves deciding the amount of profit after tax to be distributed to the shareholders as dividends and the amount of profit to be retained in the business for further growth of the business.
The decision regarding the amount of profits to be distributed as dividends depends on various factors. Dividends represent the share of profits distributed amongst shareholders. Therefore, earnings is a major determinant of the decision regarding dividends. A company with stable earnings is not only in a position to declare higher dividends but also maintain the rate of dividend in the long run. However a company with fluctuating earnings may declare smaller dividend.
In order to maintain dividend per share, a company prefers to declare same rate of dividends. The growing companies prefer to retain larger share of profits to finance their investment requirements. Therefore, the rate of dividend declared by them is smaller as compared to companies who have achieved certain goals of growth and can share larger share of profits with shareholders.
Dividends involve outflow of cash. A profitable company is in a position to declare dividends but it may have liquidity problems. As a result of which it may not be in a position to pay dividends to its shareholders. Therefore availability of cash also influences dividend decision. For example, a company may declare higher or stable rate of dividend if it has a large number of shareholders who depend on dividends as their regular income.
Dividends are a tax free income for shareholders but the company has to pay tax on share of profits distributed as dividend. Therefore, the decision regarding the amount of profit to be distributed as dividends depends on the tax rate.
They also relate to the firms strategy and generally involve senior management in taking the final decision. Investment decisions: A firms investment decisions involve capital expenditures. They are reffered as capital budgeting decisions. A capital budgeting decision involves the decision of allocation of capital or commitment of funds to long-term assets that would yield benefits cash flows in the future.
Two important aspects of investment decisions are a the evaluation of the prospective profatibilty of new investments b the measurement of a cut-off rate against which the prospective return of new investments could be compared financing decisions: this is the important function to be performed by the financial manager.
It is considered optimum when the market value of shares is maximised. Dividend decisions: The financial manager must decide whether the firm should distribute all profits,or retain them or distribute a proportion and retain the balance. The proportion of profits distributed as dividends is called the dividend pay-out ratio and the retained portion of profits is known as the retention rate.
Short term finance decisions: Short term finance functions or decisions involve a period of less than one year. These decisions are needed for managing the firms day to day fund requirements Liquidity decision: Investment in current assets affects the firms profitability and liquidity. Conclusion: The function of financial management is to review and control decisions to commit or recommit funds to new or ongoing uses.
Thus in addition to raising funds, financial management is directly concerned with production , marketing and other functions , within an enterprise whenever decisions are made about the acquisition or distribution of assets. Open navigation menu. Close suggestions Search Search. User Settings. Skip carousel. Carousel Previous. Carousel Next. What is Scribd? Explore Ebooks. Bestsellers Editors' Picks All Ebooks.
Explore Audiobooks. Bestsellers Editors' Picks All audiobooks. Explore Magazines. Editors' Picks All magazines. Explore Podcasts All podcasts. Difficulty Beginner Intermediate Advanced. The key aspects of financial decision making relate to financing, investment, dividends and working capital management. Investment decisions tells about total amount of assets to be held in the firm.
Since, funds involve cost are available in limited quantity proper utilisation is required for achieving the goal of wealth maximisation. It is more concerned with the amount of finance to be raised from various long term sources. This decision is mainly concerned with distribution of surplus funds.
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