Finance Function.pptx
- 2. 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. Finance exists everywhere, be it production, marketing, human resource development or undertaking research activity. Understanding the universality and importance Meaning
- 3. All decisions mostly involve finance. When a decision involves finance, it is a financial decision in a business firm. In all the following financial areas of decision-making, the role of finance manager is vital. 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
- 5. 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 allocate and ratio the resources among the competing investment alternatives or opportunities. The effort is to find out the projects, which are acceptable. Investment decisions relate to the total amount of assets to be held and their composition in the form of fixed and current assets. Both the factors influence the risk the organization is exposed to. The more important aspect is how the investors perceive the Investment Decision or Long-term Asset mix decision
- 6. • 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. • The investment decision is important not only for setting up new units but also for expansion of existing units. Decisions related to them are, generally, irreversible. Often, reversal of decisions results in substantial loss. • When a brand new car is sold, even after a day of its purchase, still, buyer treats the vehicle as a second-hand Long-term investment decisions – Long-term assets
- 7. The short-term investment decisions are, generally, referred to, 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. Short term investment decision
- 8. • 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). Finance decision
- 9. • These sources have their own peculiar characteristics. The key distinction lies in the fixed commitment. 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.
- 10. On the other hand, 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. However, preference share capital has a fixed commitment, in the form of dividend and is redeemable, if they are redeemable preference shares.
- 11. 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. When the return on capital employed (equity and borrowed funds) is greater than the rate of interest paid on the debt, shareholders’ return get magnified or increased.
- 12. For examples; Total investment Rs.1,00,000 Return 15%. Composition of investment: Equity Rs. 60,000 Debt @ 7% interest Rs. 40,000 Return on investment @ 15% Rs. 15,000 Interest on Debt Rs. 2,800 7% on Rs.40,000 Earnings available to Equity shareholders Rs. 12,200 Return on equity (ignoring tax) is 20%, which is at the expense of debt as they get 7% interest only. In the normal course, equity would get a return of 15%. But they are enjoying 20% due to financing by a combination of debt and equity. The finance manager follows that combination of raising funds which is optimal mix of debt and equity. The optimal mix
- 13. Liquidity decision is concerned with the management of current assets. 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. In consequence, the firm would not experience any difficulty in making payment of debts, as and when they fall due. 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 Liquidity decision
- 14. 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. This is, indeed, a balancing act and continuous process. 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
- 15. 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. Which course should be followed – 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 Dividend decision
- 16. If dividend is not distributed, there would be great dissatisfaction to the shareholders. Non- declaration of dividend affects the market price of equity shares, severely. One significant element in the dividend decision is, therefore, the dividend payout ratio i.e. what proportion of dividend is to be paid to the shareholders. The dividend decision depends on the preference of the equity shareholders and investment opportunities, available within the
- 17. 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. 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
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