FINANCIAL DECISIONS- ALL YOU NEED TO KNOW

Financial decisions are the decisions that managers take with regard to the finances of a company. These are crucial decisions for the financial well-being of the company. These decisions can be in terms of acquisition of assets, financing and raising funds, day-to-day capital and expenditure management, etc. Financial decisions, therefore, affect both the assets and liabilities of a company. They can lead to profits, revenue generation, and receipt of funds and assets for the company. They can also be in terms of expenditure, the creation of liabilities, and an exodus of funds for a company.

Financial decisions refer to decisions concerning financial matters of a business firm. There are many kinds of financial management decisions that the firm makes in pursuit of maximising shareholder’s wealth, viz., kind of assets to be acquired, pattern of capitalisation, distribution of firm’s income etc. We can classify these decisions into three major groups :

1. Investment decisions.
2. Financing decisions.
3. Dividend decisions.

Investment Decisions. Investment Decision relates to the determination of total amount of assets to be held 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 utilisation is very necessary to achieve the goal of wealth maximisation.

The investment decisions can be classified under two broad groups: (i) Long-term investment decision and (ii) Short-term investment decision. The long-term investment decision is referred 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 expected to be received 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 be evaluated in terms of expected profitability, costs involved 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 influenced by trade off 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 organisation.

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 on going. 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 optimum capital structure. The important thing to be decided here is the proportion of various sources in the overall capital mix of the firm. The debt-equity ratio should be fixed in such a way that it helps in maximising 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 sharehoders 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 minimise the risk and raise the profitability then the market prices of the shares will go up maximising the wealth of shareholders.

Dividend Decision Under dividend decisions, whenever a company makes a profit, it decides to reward its shareholders in return for their investment, trust, and confidence in the company. This reward is called a dividend. At the same time, managers must decide to retain part of the profit for the future needs of the company. This is known as retained earnings.

Managers have to make the important decision of how many portions of the profit the company should pay out in dividends and what part they should keep with them. Giving away higher dividends makes the stock attractive and increases the market price and the overall market value of the company. But they also have to take into account earnings and their stability, the growth prospects of the company, its cash flow status, dividend taxes, and above all, its own funding requirements, etc.