The Financing Decision is a crucial decision made by the financial manager relating to the financing-mix of an organization. Financial decisions are concerned with the borrowing and allocation of funds required for investment decisions. These decisions are essential to the continuity of the business over the long term. It includes decisions regarding the magnitude of funds to be invested to accomplish its goals, kind of assets to be acquired, the capital structure, the pattern of distribution of the firm’s income. The nature of financial decisions varies from one firm to the other. It may also be different for the same firm over a period of time.

There are two sources for funds for financing the company’s own money, such as share capital, retained earnings or borrowing funds from the outside in the form of debentures, loans, bonds, etc.

External Factors Affecting Financial Decisions:

External factors affecting financial decisions are the environmental factors within which a firm has to operate. These factors are beyond the control and influence of the management. But the finance manager can take the best decision considering all these factors.

State of the Economy:

The economic condition of the country greatly influences the financing decision. In times of prosperity when investors are ready to invest more and more savings. Thus the firm can raise the required funds from the market easily. In such conditions expectations of investors are more hence payouts will be more. Hence in such environment raising funds by the issue of debentures is a better choice.

In times of depression raising fund is difficult. Hence in such conditions, internal financing is a better choice. For such eventualities, the firm should have hefty reserves. The time when the economy is showing recovery from depression is the best time for raising funds. The finance manager should not miss the chance of exploiting opportunities.

Structure of Capital and Money Market:

If a country has good and developed capital and money market, then it is easy for the finance manager to raise the required funds for long-term and short-term from different sources. It helps the finance manager’s bargaining power and also helps him to raise the funds at any period of time.

Government Policy:

All the decisions taken by the finance minister should be according to the law of the land. The finance manager should only those projects which are allowed by the government. During the issue of equity or any other financial instrument guidelines issued by government institutions (SEBI in India) should be followed.

Taxation Policy:

Tax is a large chunk of outgoing money from the business. Hence it influences financial decisions. The tax policy is declared by the government. The government may issue tax holidays for important projects like infrastructure projects. (roads, bridges, airports, rails, ports, telecommunication, etc.). The finance manager should take advantage of such policies.

The method of depreciation (straight line, diminishing balance, annuity) should be selected judiciously to reduce the tax burden.

Tax liability also depends on the method of valuation of inventory. The two methods used are LIFO (last in first out) and FIFO (first in first out). The finance manager has to decide on the method in advance.

The interest on the debt is a tax-deductible expenditure while dividends are considered for the tax deduction. Hence the debt is a better option to save tax.

Investor’s Requirements:

Investors may have a varying degree of safety, liquidity and profitability notions. The psychology of investor changes as per their economic conditions and the economic condition of society as a whole. In this global era, world economic condition also impacts the investor’s psyche. Financial decisions depend on their requirements. Conservative and liquidity conscious investor prefers equity investment than other instruments. Dividend payout policy of the firm impacts an investor’s decision to invest money.

The Policy of Financial Institutions:

Every financial institution has its own policy of lending. A particular financial institution may be liberal for granting finance to large projects but not keen to finance a small project. Such institution lay more conditions and regulations on finance to small projects. Hence the finance manager has to consider the policy of the institution. The terms and conditions of a financial institution should be studied carefully and only accepted when they are not affecting the objectives and strategy of the firm. Sometimes the capital structure of the firm is required to be changed to acquire the finance.

Internal Factors Affecting Financial Decisions:

Internal factors affecting financial decisions include nature of the business, the size of business, expected return, the cost and risk involved, the asset structure of the business, the structure of ownership, the expectations of investors, the age of the firm, the liquidity in company funds and its working capital requirements, and the attitude of the management.

Nature of the Business:

In manufacturing and public utility business, the most of the fund required is utilized for fixed assets while in trading firms it is mainly utilized for current assets. The fund requirements of capital goods industries are more than consumer good industries.

The firms engaged in the production of staple goods (Consumer goods (such as bread, milk, paper, sugar) that are bought often and consumed routinely), have stability in their level of earnings. Such firms can rely on debt for acquiring additional funds for the business. Because they have constant cash flow, irrespective of economic conditions. Similarly, large manufacturing units producing goods which have continuous demand can rely on debt for acquiring additional fund.

The firms producing seasonal goods or whose demand oscillates, avoid the burden of fixed charges.

Size of the Business:

The fund requirements depend on the size of the business. Large size businesses require large funds for buying assets and automated machinery. They require fund for constructing buildings and plants. Small-scale business can continue with leased assets. The credit position in the financial market of larger business may be more than the smaller business. The small business owners are hesitant about going public. They arranged their fund sources among close circles. Large businesses find it easier to procure needed funds from different sources of capital and money markets.

The number of shareholders in small business is less and hence can be persuaded very easily for a particular policy. In large businesses, due to a large number of stakeholders, it is difficult to pursue a particular policy.

Age of the Firm:

New firms find it very difficult to raise finance from investors due to the relatively greater risks involved. For raising finance the new firms have to approach underwriters and stockbrokers and pay them higher commission and brokerage for sale of their securities. Thus the debt-equity ratio of new firms is small. The fund may be raised by issuing debentures but it may lead to a condition where a large part of income might be used to pay the interest on loans. A small amount might be available for dividend payout and for keeping reserves.

older companies which have proved themselves in their past and on the basis of their credibility may not face a major problem in raising funds from the market. Such firms usually float debentures for their long-term financial requirements. They also utilize a part of the reserves for covering their additional financial needs. Thus the debt-equity ratio is higher in the case of old businesses.

Probabilities of Regular and Steady Earnings:

If the cash flow is continuous and showing a gradual increase then the reliance on debt may be desirable. If the cash flow is irregular but the yearly average is constant and growing then preferential shares can be issued to raise funds. When earnings of the firm fluctuating violently in the past and the future earnings cannot be predicted with reasonable certainty, then debt path should be avoided. In such cases issue of common stock must be preferred.

Firms that are in the growth stage of their cycle typically finance that growth through debt, to grow faster. But the revenues of growth firms are typically unstable and unproven. Hence if the growth rate is not sustained for a longer period, the firm may come into a debt trap.

Liquidity Position of the Firm:

Liquidity describes the degree to which an asset or security can be quickly bought or sold in the market without affecting the asset’s price. Before taking the dividend decision the finance manager should consider the funds required to meet maturing obligations, working and fixed capital requirements. if a company has sufficient amount of cash resources in hand at the time when some loans taken in the past are due, then the finance manager should conserve cash to meet the past obligations and the dividend policy should be changed accordingly.

Working Capital Requirement:

If a large sale has been done on credit then there may be a temporary cash crunch, which may affect the requirement of working capital. In such a case, the working capital requirements of the firm may be so immediate that may affect conservative dividend policy.

Management Style:

Management style or attitudes depends on the concern of control of the business and risk. In such cases, the management raises funds by issuing debentures and preferential stock which do not affect the controlling position of the management in the firm. But it increases the debt of the firm. Thus it is better to sacrifice control by infusing some additional equity financing than the risk of all control to creditors due to additional debt.

In a conservative management style, the firm may go for equity financing rather than debt financing. Aggressive management may try to grow the firm quickly, using significant amounts of debt to increase profits. 

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Management > Financial Management > Functions of Financial Manager: Financial Decisions

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The planning, directing, monitoring, organizing, and controlling of the monetary resources of an organization is called financial management.  It is the art and science of managing money It is concerned with procurement and effective utilization of funds for the benefit of its shareholders. It utilizes all those managerial activities that are required to procure funds at the least cost and their effective deployment.

The scope of Financial Management:

Investment Decision:

The investment decision involves the evaluation of risk, measurement of the cost of capital and estimation of expected benefits from a project.  Investment decisions involve decisions with respect to composition or mix of assets Capital budgeting, working capital decisions, and liquidity are the major components of investment decision.

• Capital Budgeting: These are investment decisions which include investment in fixed or permanent assets which would give returns or yield earnings in the future or replacement and renovation of old assets. Capital budgeting is a very important decision as it affects the long-term success and growth of the organization. It is a difficult process because it involves the estimation of costs and benefits which are uncertain and unknown at the time of decision.
• Liquidity: Liquidity refers to how easily assets can be converted into cash. Cash is the most liquid asset. Assets like stocks and bonds are very liquid since they can be converted to cash in a short time.  However, large assets such as property, plant, and equipment cannot be easily converted to cash in a short time. The finance manager must maintain an appropriate balance between fixed and current assets in order to maximize profitability and to maintain desired liquidity in the firm.

Working Capital Decisions:

Current assets are those assets which are convertible into cash within an accounting year. While, current liabilities are those liabilities, which are likely to mature for payment within an accounting year.

These are the decisions which include investments in current assets (which include receivables, inventory, short-term securities, etc.) and current liabilities (which include creditors, bills payable, bank overdrafts, outstanding expenses, etc.)

Financing Decisions:

Financing decisions involve decisions about the financing mix or the financial structure of the firm. These decisions involve the raising of finance from various resources which will depend upon the decision on the type of source, the period of financing, cost of financing and the returns on it.

The finance manager must develop the best finance mix or optimum capital structure for the firm such that a proper balance between debt and equity is maintained and the return to equity shareholders is high and their risk is low. Use of debt or financial leverage affects both the return and risk to the equity shareholders.

Dividend Decisions:

The main objective of financial management is wealth maximization for shareholders. Hence an appropriate dividend policy must be developed. Net profits are generally divided into two parts a) dividend for shareholders and b) retained profits.

Thus the finance manager has to make a decision whether to distribute all the profits in the form of dividends or to distribute a part of the profits and retain the balance. He has to make the decision about the optimum dividend payout ratio. The retained profit must be employed in the investment opportunities available to the firm, plans for expansion and growth, etc.

Core Elements of Financial Management

Financial Planning:

Management needs to ensure that enough funding is available at the right time to meet the needs of the business. Financial planning is done to ensure the availability of capital investments to acquire real assets (which include lands, buildings, plants, and equipment). For this long or medium-term finance is required. In the short term, funding may be needed to invest in equipment and stocks, pay employees and fund sales made on credit. Financial planning is required for establishing and running the business smoothly.

Financial Decisions:

These are the decisions need to be taken on the sources of finance required for capital investments. There are two sources of funds the debt and equity. Finance manager takes the decision in what proportion the funds are to be obtained from these sources so that the objective of wealth maximization of shareholders is achieved.

Financial Control:

Financial control is a critically important activity to help the business ensure that the business is meeting its objectives. It involves managing the costs and expenses of a business. It includes making decisions on the routine aspects of the day-to-day management of collecting money which is due from the firm’s customers and making payments to the suppliers of various resources.

Objectives of Financial Management:

Profit Maximization:

The main aim of any kind of economic activity is earning a profit. It is the measuring tool for the economic success and efficiency of the firm. Hence the main objective of financial management is profit maximization. The finance manager tries to earn maximum profits for the company in the short-term and the long-term.

Due to the uncertainty in the business, the finance manager cannot guarantee profits in the long run but ensures that the firm can earn maximum profits even in the long run by taking proper financial decisions and optimally utilizing the funds available through finance.

Wealth Maximization:

Wealth maximization (shareholders’ value maximization) is also the main objective at par with profit maximization of financial management. Wealth maximization means to earn maximum wealth for the shareholders. This objective is a universally accepted concept in the field of business to overcome limitations of profit maximization.

The wealth maximization is possible only when the company pursues policies that would increase the market value of shares of the firm. The market value of the shares is directly related to the performance of the firm.  Also, the finance manager tries to give a maximum dividend to the shareholders.

Proper Estimation of Total Financial Requirements:

The finance manager must estimate the total financial requirements of the company. He has to do cash budgeting for fixed assets requirements, working capital requirements by considering the liquidity. If the proper estimation is not done there is a shortage or surplus of finance. During estimation, the finance manager has to consider the type of technology used, the number of employees employed, the scale of operations, the legal requirements, etc.

Prepare Capital Structure:

Capital structure decides the ratio between owned finance and borrowed finance (debt-equity ratio). It brings a proper balance between the different sources of. capital. This balance is necessary for the liquidity, economy, flexibility, and stability of the firm.

Proper Mobilization of Finance:

After estimating the financial requirements and preparing the capital structure of the firm, the finance manager must decide about the sources of finance. Shares, debentures, bank loans, etc. are different sources of finance. There must be a proper balance between owned finance and borrowed finance (debt-equity ratio). The finance manager should ensure that the firm gets finance at a low rate of interest. It reduces the cost of capital.

Proper Utilization of Finance:

The finance manager must make optimum utilization of finance. He must use the finance profitable so that there is wealth maximization for shareholders. The finance should not be utilized in unprofitable projects of the firm. The finance should not be blocked in inventories. The credit period should be short. He should ensure to reduce the operating risks due to the uncertainties in business. It can be done by avoiding high-risk projects and taking a proper insurance policy. The financial manager must try to have proper coordination between the finance department and other departments of the firm to increase the efficiency and the productivity so that there is no wastage of fund.

Maintaining Proper Cash Flow:

The company must have a proper cash flow to pay the day-to-day expenses such as the purchase of raw materials, payment of wages and salaries, rent, electricity bills, etc. Good cash flow helps in getting cash discounts on purchases, large-scale purchasing, giving credit to customers, etc. Healthy cash flow improves the chances of survival and success of the company.

Credit Reserves:

The company must not distribute the full profit as a dividend to the shareholders. It must keep a part of its profit as reserves. Reserves are important because they can be utilized for future growth and expansion. It can be used as a financial cushion for contingencies in the future.

Create Goodwill:

Financial management must try to create goodwill for the company by improving the image and reputation of the firm. It helps the firm to survive in the short-term and succeed in the long-term. It also helps the company during bad times. It also helps in acquiring finance for future projects.

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Management > Financial Management > Introduction

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