FINANCE FUNCTION– IMPORTANCE In general, the term “Finance” is understood as provision of funds as and when needed. Finance is the essential requirement –sine qua non– of every organisation. • Required Everywhere: All activities, be it production, marketing, human resources development, purchases and even research and development, depend on the adequate and timely availability of finance both for commencement and their smooth continuation to completion. Finance is regarded as the life-blood of every business enterprise. • Efficient Utilisation More Important: Finance function is the most important function of all business activities. The efficient management of business enterprise is closely linked with the efficient management of its finances. The need of finance starts with the setting up of business. Its growth and expansion require more fund CONCEPT OF FINANCIAL MANAGEMENT • Financial management deals with the study of procuring funds and its effective and judicious utilisation, in terms of the overall objectives of the firm, and expectations of the providers of funds. • 1. “Financial Management is concerned with the efficient use of an important economic resource, namely, Capital Funds” —Solomon • 2. “Financial Management is concerned with the managerial decisions that result in the acquisition and financing of short-term and long-term credits for the firm” —Phillioppatus • 3. “Business finance is that business activity which is concerned with the conservation and acquisition of capital funds in meeting financial needs and overall objectives of a business enterprise” —Wheeler SCOPE OF FINANCIAL MANAGEMENT • Financial management is concerned with optimum utilisation of resources. Resources are limited, particularly in developing countries like India. So, the focus, everywhere, is to take maximum benefit, in the form of output, from the limited inputs • The need of financial management is more in loss-making organisations to turn them to profitable enterprises. Study reveals many organisations have sustained losses, due to absence of professional financial management • Approaches: Broadly, it has two approaches: • Traditional Approach-Procurement of Funds • Modern Approach-Effective Utilisation of Funds Traditional Approach • The scope of finance function was treated, in the narrow sense of procurement or arrangement of funds. The finance manager was treated as just provider of funds, when organisation was in need of them. The utilisation or administering resources was considered outside the purview of the finance function. It was felt that the finance manager had no role to play in decision making for its utilisation. • As per this approach, the following aspects only were included in the scope of financial management: • (i) Estimation of requirements of finance, • (ii) Arrangement of funds from financial institutions, • (iii) Arrangement of funds through financial instruments such as shares, debentures, bonds and loans, and • (iv) Looking after the accounting and legal work connected with the raising of funds. Traditional Approach - Limitations • The traditional approach was evolved during the 1920s and 1930s period and continued till 1950. The approach had been discarded due to the following limitations: • (i) No Involvement in Application of Funds • (ii) No Involvement in day to day Management • (iii) Not Associated in Decision-Making Allocation of Funds Modern Approach • Since 1950s, the approach and utility of financial management has started changing in a revolutionary manner. Financial management is considered as vital and an integral part of overall management. The emphasis of Financial Management has been shifted from raising of funds to the effective and judicious utilisation of funds. The modern approach is analytical way of looking into the financial problems of the firm. Advice of finance manager is required at every moment, whenever any decision with involvement of funds is taken. • Nowadays, the finance manger is required to look into the financial implications of every decision to be taken by the firm. His Involvement of finance manager has been before taking the decision, during its review and, finally, when the final outcome is judged. In other words, his association has been continuous in every decision-making process from the inception till its end. FUNCTIONS OF FINANCE • Finance function is the most important function of a business. Finance is, closely, connected with production, marketing and other activities. In the absence of finance, all these activities come to a halt. In fact, only with finance, a business activity can be commenced, continued and expanded • Financial Decisions or Finance Functions are closely inter-connected. We can classify the finance functions or financial decisions into four major groups • (A) Investment Decision or Long-term Asset mix decision • (B) Finance Decision or Capital mix decision • (C) Liquidity Decision or Short-term asset mix decision • (D) Dividend Decision or Profit allocation decision Investment Decision • Investment decisions relate to selection of assets in which funds are to be invested by the firm. Investment alternatives are numerous. Resources are scarce and limited. They have to be rationed and discretely used. • Investment decisions relate to the total amount of assets to be held and their composition in the form of fixed and current assets • The investment decisions result in purchase of assets. Assets can be classified, under two broad categories: • (i) Long-term investment decisions – Long-term assets • (ii) Short-term investment decisions – Short-term assets Investment Decision • Long-term Investment Decisions: The long-term capital decisions are referred to as capital budgeting decisions, which relate to fixed assets. The fixed assets are long term, in nature. Basically, fixed assets create earnings to the firm. They give benefit in future. It is difficult to measure the benefits as future is uncertain • Short-term Investment Decisions: The short-term investment decisions are, generally, referred as working capital management. The finance manger has to allocate among cash and cash equivalents, receivables and inventories. Though these current assets do not, directly, contribute to the earnings, their existence is necessary for proper, efficient and optimum utilisation of fixed assets. Finance Decision • Once investment decision is made, the next step is how to raise finance for the concerned investment. Finance decision is concerned with the mix or composition of the sources of raising the funds required by the firm. In other words, it is related to the pattern of financing. • In finance decision, the finance manager is required to determine the proportion of equity and debt, which is known as capital structure. • There are two main sources of funds, shareholders’ funds (variable in the form of dividend) and borrowed funds (fixed interest bearing). These sources have their own peculiar characteristics. The key distinction lies in the fixed commitment. Finance Decision • Borrowed funds are • to be paid interest, irrespective of the profitability of the firm. Interest has to be paid, even if the firm incurs loss and this permanent obligation is not there with the funds raised from the shareholders. • The borrowed funds are relatively cheaper compared to shareholders’ funds, however they carry risk. This risk is known as financial risk i.e. Risk of insolvency due to non-payment of interest or non-repayment of borrowed capital • The shareholders’ funds are • Permanent source to the firm. • The shareholders’ funds could be from equity shareholders or preference shareholders. • Equity share capital is not repayable and does not have fixed commitment in the form of dividend. • Preference share capital has a fixed commitment, in the form of dividend and is redeemable, if they are redeemable preference shares. Finance Decision • Barring a few exceptions, every firm tries to employ both borrowed funds and shareholders’ funds to finance its activities. The employment of these funds, in combination, is known as financial leverage. Financial leverage provides profitability, but carries risk. Without risk, there is no return. This is the case in every walk of life! Liquidity Decision • Liquidity decision is concerned with the management of current assets. Basically, this is Working Capital Management. Working Capital Management is concerned with the management of current assets. It is concerned with short-term survival. Short term-survival is a prerequisite for long-term survival. • When more funds are tied up in current assets, the firm would enjoy greater liquidity. With excess liquidity, there would be no default in payments. So, there would be no threat of insolvency for failure of payments. • However, funds have economic cost. Idle current assets do not earn anything. Higher liquidity is at the cost of profitability. Profitability would suffer with more idle funds. Investment in current assets affects the profitability, liquidity and risk. A proper balance must be maintained between liquidity and profitability of the firm. This is the key area where finance manager has to play significant role. The strategy is in ensuring a trade-off between liquidity and profitability Liquidity Decision • It is a continuous process as the conditions and requirements of business change, time to time. In accordance with the requirements of the firm, the liquidity has to vary and in consequence, the profitability changes. This is the major dimension of liquidity decision working capital management. Working capital management is day to day problem to the finance manager. His skills of financial management are put to test, daily Dividend Decision • Dividend decision is concerned with the amount of profits to be distributed and retained in the firm. • Dividend - The term ‘dividend’ relates to the portion of profit, which is distributed to shareholders of the company. It is a reward or compensation to them for their investment made in the firm. The dividend can be declared from the current profits or accumulated profits. Dividend Decision • Dividend or retention? Normally, companies distribute certain amount in the form of dividend, in a stable manner, to meet the expectations of shareholders and balance is retained within the organisation for expansion. Non-declaration of dividend affects the market price of equity shares, severely. • One significant element in the dividend decision is the dividend payout ratio. The dividend decision depends on the preference of the equity shareholders and investment opportunities, available within the firm. • A higher rate of dividend, beyond the market expectations, increases the market price of shares. However, it leaves a small amount in the form of retained earnings for expansion. Dividend Decision • The business that reinvests less will tend to grow slower. The other alternative is to raise funds in the market for expansion. It is not a desirable decision to retain all the profits for expansion, without distributing any amount in the form of dividend. • There is no ready-made answer, how much is to be distributed and what portion is to be retained. • Retention of profit is related to • Reinvestment opportunities available to the firm. • Alternative rate of return available to equity shareholders, if they invest themselves.
