Scope of Financial management – Two Decisions
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Every business or companies require both tangible and intangible assets. To acquire assets, company requires finance. Thus financial management is concerned with the acquisition and use of funds in an efficient and wise manner to achieve the objective of an organization.
Thus two questions (decisions) that determines financial management of a firm.
- Where to invest? or What real assets should the firm invest? (investment or capital budgeting decision)
- How to raise the fund or cash for the investment? (financing decision)
We are going to discuss about the two decisions below:
Investment decision
Investment decision is related to the selection of asset in which a firm should invest. That is to determine which long term and short term assets it needs to invest. The long term decisions are called capital budgeting decisions and short term decisions are called working capital management. Investment of funds in long term (capital budgeting) and short term (working capital) is made according to the requirements of the firm at proper time. It is a decision that results in value creation of the firm.
The decision also required for the reverse of investment, disinvestment, that is reducing, eliminating or replacing assets which cannot be economically justifiable.
Financing decision
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Decision deals with procurement of optimum finance to meet fixed asset and working capital requirements and also for achieving financial objectives. It is to determine correct financing mix or capital structure or leverage for an organization. That is the determination of optimum capital structure for the organization along with optimal working capital management. The financing decision is made after identifying correct source by considering cost, risk and control. The cost of fund should be at minimum level for that a proper balancing of risk and control factors must be carried out while taking the financing decision. That is the objective is to minimize the cost with a proper balancing of risk and control.
One source of financing is retained earnings. Retained earnings is that portion of the profit which is not given to shareholders as dividend. So a dividend decision is called as a financial decision. Dividend decision is how much and how frequent the gains and profits must be paid out to shareholders and how much to retained to support the growth of the organization.
What proportion of net profits should be paid out to shareholders is called dividend payout ratio. The dividend payout ratio is determined by the organization by considering various factors which includes, its growth plan, cost of retained earnings, other cost of capital, etc. Some of the sources of funds available are: (i) Owners Funds or Equity, (ii) Debentures and Bonds, (iii) Hire Purchases and Leasing, (iv) Angel Financing, (v) Venture Capital, (vi) Commercial Banks (Short, Medium, Long).