Learn and Understand, What are the Major Types of Financial Decisions?
Financial decision is yet another important function which a financial manager must perform. It is important to make wise decisions about when, where and how should a business acquire funds. Funds can acquire through many ways and channels. The types are 1. Investment decisions, 2. Financing decisions, 3. Dividend decisions, and 4. Liquidity decisions. Broadly speaking a correct ratio of an equity and debt has to maintain. This mix of equity capital and debt is known as a firm’s capital structure. Also learn, Concept of Financial Decisions, What are the Major Types of Financial Decisions?
A firm tends to benefit most when the market value of a company’s share maximizes this not only is a sign of growth for the firm but also maximizes shareholders wealth. On the other hand, the use of debt affects the risk and return of a shareholder. It is riskier though it may increase the return on equity funds.
A sound financial structure is said to be one which aims at maximizing shareholders return with minimum risk. In such a scenario the market value of the firm will maximize and hence an optimum capital structure would achieve. Other than equity and debt there are several other tools which are used in deciding a firm capital structure.
Some of the important functions which every finance manager has to take are as follows:
i. Investment decision.
ii. Financing decision.
iii. Dividend decision, and.
iv. Liquidity Decision.
The Following types are explained below:
1. Investment Decisions:
Investment Decision relates to the determination of total amount of assets to hold in the firm, the composition of these assets and the business risk complexions of the firm as perceived by its investors. It is the most important financial decision. Since funds involve cost and are available in a limited quantity, its proper utilization is very necessary to achieve the goal of wealth maximization.
The investment decisions can classify into two broad groups:
(i) Long-term investment decision and
(ii) Short-term investment decision.
The long-term investment decision is referring to as the capital budgeting and the short-term investment decision as working capital management.
Capital budgeting is the process of making investment decisions in capital expenditure. These are expenditures, the benefits of which are expecting to receive 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 evaluate in terms of expecting profitability, costs involving 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 result as anticipated earlier.
Short-term investment decision, on the other hand, relates to the allocation of funds as among cash and equivalents, receivables and inventories. Such a decision is influencing the tradeoff between liquidity and profitability.
The reason is that the more liquid the asset, the less it is likely to yield and the more profitable an asset, the more illiquid it is. A sound short-term investment decision or working capital management policy is one which ensures higher profitability, proper liquidity and sound structural health of the organization.
2. Financing 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 new assets but also concerned with the best overall mix of financing for the firm.
A finance manager has to select such sources of funds which will make the optimum capital structure. The important thing to decide here is the proportion of various sources in the overall capital mix of the firm. The debt-equity ratio should fix 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 various 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. Also learn, What is the Definition of Price Perception?
3. Dividend Decisions:
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 profits of a company which is distributing 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 concerning with the quantum of profits to distribute among shareholders.
A decision has to take whether all the profits are to distribute, 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 cash dividend.
4. Liquidity Decisions:
It is very important to maintain a liquidity position of a firm to avoid insolvency. Firm’s profitability, liquidity, and risk all are associating with the investment in current assets. In order to maintain a tradeoff between profitability and liquidity, it is important to invest sufficient funds in current assets. But since current assets do not earn anything for business, therefore, a proper calculation must do before investing in current assets.
Current assets should properly value dispose of from time to time once they become not profitable. Currents assets must use in times of liquidity problems and times of insolvency.