Types of Financial Decisions in Financial Management
Finance is an essential and indispensable aspect of any organization—whether it’s a profit-making or a non-profit organization. Firms need funds to sustain their routine operations and to remain viable at the end of the day.
Financial management refers to an organization’s ability to plan, organize, direct, and regulate its financial activities and procedures effectively and efficiently. This may include funds acquisition, allocation, and utilization—but is not limited to these functions alone.
- Significant Roles of Financial Management Practices
- Types of Financial Decisions in Financial Management
- 1. Investment Decision/Capital Budgeting Decisions
- What Are The Factors Affecting Investment Decisions?
- 2. Financing Decision
- What Are The Factors affecting Financing Decisions?
- 3. Dividend Decision
- Inter-Relationships between Financial Decisions
- Bottom Line
Significant Roles of Financial Management Practices
Financial management practices exist to help a business achieve its goals. The financial managers must be well-conversant with the organization’s nature of the operation. A finance manager of a bakery, for example, must be familiar with bakery finances. Additionally, they must have the tax policies and other relevant policies that affect their industry at their fingertips. Let’s see the significant roles of financial management practices:
1. Financial Decisions and Controls
Financial management and financial managers play a critical role in the organization’s financial decision-making and financial control. To develop the organization’s financial decisions, the financial managers employ ratio analysis, financial forecasting, profit, loss analysis, etc.
2. Financial Planning
Finance managers are in charge of the organization’s financial activities and resources planning. They analyze available data to determine the organization’s needs, priorities, and overall financial condition and develop plans and budgets accordingly.
3. Capital Management
The financial management process is responsible for regularly estimating the organization’s capital requirements, determining the capital structure and composition, and choosing the capital funding source.
4. Cash Flow Management
Businesses must have enough working capital and cash flow to sustain their daily operational costs and unexpected expenses. Financial management keeps track of accounts payable and receivable to ensure that there is always enough cash on hand for such expenditures—daily and emergency expenses.
5. Disposal of Surplus
The financial managers of the organizations make decisions on how the surplus or earnings of the organizations are used. They determine whether to pay dividends and how much should be paid out, and the percentage of profits that must be retained and reinvested in the company.
6. Financial Reporting
Financial management keeps track of all the organization’s financial records and uses them as a database for forecasting and planning financial actions. Additionally, these records are essential for their periodic financial reporting following the government policies.
7. Risk Management
Financial management helps an organization forecast risks, implement mitigation measures, and efficiently respond to unforeseen hazards and emergencies.
Types of Financial Decisions in Financial Management
Financial Management classifies financial decisions under three main categories: Investment Decisions, Financing Decisions, and Dividend Decisions.
1. Investment Decision/Capital Budgeting Decisions
The assets and resources of a corporation are limited and must be used to their full potential. To achieve the best possible results, a company should choose where to invest. The organization must carefully go through its investment options before making the investment decision.
The investment decision is arguably the most important of the three decisions. It starts with determining the entire amount of assets that the company needs to hold. In other words, investment decisions concern the assets in which a company will put its money.
The required assets for investment decisions fall into two groups:
- Long-term/fixed assets—plants, machinery, land, premises, among others. They’re significant investments that pay off over time. It can be characterized as a company’s decision to invest its current finances most efficiently in fixed assets that will provide a predictable stream of benefits over time.
- Current assets/Working capital—raw materials, work-in-process, finished goods, debtors, cash, and so on. You can convert these assets into cash without losing value within a financial year.
- Capital budgeting decisions are essential for a firm since their long-term success depends on their short-term achievements. Firms should trade-off between risk and return. Maintaining more assets reduces return, but they have less risk while maintaining fewer assets has more risks.
What Are The Factors Affecting Investment Decisions?
- Cash flow of the venture: When a company launches a new business, it invests a significant amount of money at the outset. Nonetheless, the organization requires at least some type of revenue to sustain its operations daily or in case of any emergency. Therefore, the venture must have some consistent financial flow to keep it afloat.
- Profits: The primary goal of any business enterprise is to earn revenue and, more importantly, profits. The most crucial factor to consider when selecting a venture is the rate of return it will provide for the business in terms of profit. For example, if, for the same period, venture A generates a 15% return while venture B generates a 25% return, you should choose project B.
- Investment Criteria: A business has access to various Capital Budgeting techniques that you can use to evaluate different investment opportunities. These processes are used to assess investment proposals to select the best one. Above all, they’re based on multiple factors, including the amount of money invested, interest rates, cash flows, and the rate of return on investments.
2. Financing Decision
Making sound financial decisions about when, where, and how a firm acquires funds is critical for any organization. A company benefits the greatest when the market value of its stock rises, which is a symbol of growth for the company and an increase in investors’ wealth. Consequently, this affects the constitution of various instruments in the company’s capital structure.
After assessing the required amount and selecting assets to be purchased, the financial manager concentrates on the finance mix, capital structure, and leverage to determine the proportion of debt and equity in the capital structure.
To maximize shareholders’ wealth, the financial mix should be at optimum. An appropriate balance between risk and return will have to be achieved. Debt has a fixed cost (interest), which can assist raise the return on equity and raise the risk. One permanent source of funds is the issuance of equity shares, but owners will expect higher rates of return.
What Are The Factors affecting Financing Decisions?
- Cost: The focus of a financing decision is on asset allocation and cost reduction. An organization can have numerous funding sources, but they all come at a price that varies greatly. An organization should carefully examine them to choose the most cost-effective source.
- Risk: Starting a business with cash from diverse sources carries a variety of risks. Borrowed funds have a higher risk profile than equity funds. This risk assessment is one of the essential factors in funding selections.
- Cash flow position: Cash flow refers to the organization’s daily return. Its cash flow condition influences investors’ decisions on whether or not to invest in a company.
- Control: Existing investors can raise cash by borrowing money if they need to gain control of the business; but, if they are willing to dilute the company’s ownership, you can utilize stock to raise capital. The level of power relinquished is a crucial financial choice.
- Condition of the market: The condition of the market has a significant impact on financing decisions. During boom times, equity is the most common issue, but during a depression, a company will have to rely on debt. Such judgments are crucial in the funding process.
3. Dividend Decision
Dividends are a portion of profits that can be distributed to equity shareholders. You should examine dividend payments in light of a company’s financial decisions. When dealing with a firm’s net profits, there are two options: distributing profits as dividends to regular shareholders if there is no need to retain earnings or keep them in the firm if they are required to fund any business activity.
However, You should consider the impact of dividend distribution or retention on shareholders’ wealth. The best dividend policy maximizes the stock’s market value and, as a result, the company’s market value. Another component of dividend policy is considering the factors to consider when setting payouts.
What Are The Factors Affecting Dividend Decisions?
- Earnings: Investors receive returns from both current and previous income. A business with higher and more steady revenues can pay a higher dividend than one with lower earnings. Therefore, earning is an essential stocks market value factor in determining the dividend.
- Dividend Balancing: Most businesses try to keep their dividends per share in check. Every year, a stable dividend is paid. If the organization’s earning potential has increased, a modification is made rather than only the current year’s income.
- Development Opportunity: If an organization holds more cash out of their income to fund their essential investment, they will have significant development opportunities. The dividend declared by growing corporations is lower than that declared by non-development companies.
- Shareholders’ preferences: When issuing dividends, the organization must keep in mind the investors’ preferences. Some shareholders demand that at least a certain amount of money be paid out in dividends. The preferences of such investors should be taken into account by the organizations.
- Stock market rates: An increase in dividends generally has a favorable impact on the stock market; however, a decrease or no increase may negatively impact it. Therefore, the stock rate is imperative while choosing dividends.
- Contractual and legal constraints: When offering a loan to a company, the lending party may, on occasion, impose specific terms and restrictions on the future payment of dividends. The organizations must ensure that the profit payout process does not go against the agreed terms.
Inter-Relationships between Financial Decisions
All of the above-mentioned financial management decisions are interconnected rather than independent. A capital budgeting decision necessitates calculating current costs and benefits, for which a suitable discount rate is required. The discount rate in capital budgeting decisions is usually the cost of capital resulting from a firm’s capital structure decision.
As a result, investment and finance decisions are linked. When a company’s operating risk is high due to a significant investment in long-term assets—a capital budgeting decision—it should have a low debt capital and low financial risk. The decision to pay a dividend is influenced by its operating profitability, influenced by its capital budgeting decision.
Firms sometimes employ retained earnings to fund their investment projects, and if any profit is left over, it is dispersed as a dividend. As a result, dividends and capital budgeting on the one hand and dividends and financing decisions on the other are connected.
Every company is different—it has its own set of ideals and a unique way of conducting business. Finance, however, is something that all businesses have in common, and the success of every organization is dependent on it. So far, we’ve looked at the numerous types of financial management decisions that a firm must make to fulfill its objectives.