Financial management is the process of managing the funds both for individuals and organizations to ensure proper utilization of funds. The principles of financial management work as a guideline for managing financial activities. If you follow the core principles then you will never become financially loser. To get the most benefit from a financial action, the person needs to be careful enough to handle the risk and return trade balance. The broad principles of corporate finance are:
1) Investment Decision
2) Financing Decision
3) Dividend Decision
4) Liquidity Decision
1. Investment Decision
The firm has scarce resources that must be allocated among competing uses. On the one hand the funds may be used to create additional capacity which in turn generates additional revenue and profits and on the other hand some investments results in lower costs. In financial management the returns, from a proposed investment are compared to a minimum acceptable hurdle rate in order to accept or reject a project. The hurdle rate is the minimum rate of return below which no investment proposal would be accepted. In financial management we measure (estimate) the return on a proposed investment and compare it to minimum acceptable hurdle rate in order to decide whether or not the project is acceptable. The hurdle rate is a function of riskiness of the project, riskier the project higher the hurdle rate. There is a broad argument that the correct hurdle rate is the opportunity cost of capital. The opportunity cost of capital is the rate of return that an investor could earn by investing in financial assets of equivalent risk.
2. Financing Decision
Another important area where financial management plays an important role is in deciding when, where, from and how to acquire funds to meet the firm’s investment needs. These aspects of financial management have acquired greater importance in recent times due to the multiple avenues from which funds can be raised. Some of the widely used instruments for raising finds are ADRs, GDRs, ECBs Equity Bonds and Debentures etc. The core issue in financing decision is to maintain the optimum capital structure of the firm that is in other words, to have a right mix of debt and equity in the firm’s capital structure. In case of pure equity firm (Zero debt firms) the shareholders returns should be equal to the firm’s returns. The use of debt affects the risk and return of shareholders. In case, cost of debt is used the firm’s rate of return the shareholder’s return is going to increase and vice versa. The change in shareholders return caused by change in profit due to use of debt is called the financial deaverage.
3. Dividend Decision
Dividend decisions is the third major financial decision. The share price of a firm is a function of the cash flows associated with the share. The share price at a given point of time is the present value of future cash flows associated with the holding of share. These cash flows are dividends. The finance manager has to decide what proportion of profits has to be distributed to the shareholders. The proportion of profits distributed as dividends is called the dividend pay out ratio and the retained proportion of profits is known as retention ratio. The dividend policy must be designed in a way, that it maximises the market value of the firm’s share. The retention ratio depends upon a host of factors the main factor being the existence of investment opportunities. The investors would be indifferent to dividends if the firm is able to earn a rate or return which is higher than the cost of the capital. Dividends are generally paid in cash, but a firm may also issue bonus shares. Bonus share are shares issued to the existing shareholders without any charge. As far as dividend decisions are concerned the finance manager has to decide on the question of dividend stability, bonus shares, retention ratio and cash dividend.
4. Liquidity Decision
A firm must be able to fulfill its financial commitments at all points of time. In order to ensure that the firm should maintain sufficient amount of liquid assets. Liquidity decisions are concerned with satisfying both long and short-term financial commitments. The finance manager should try to synchronise the cash inflows with cash outflows. An investment in current assets affects the firm’s profitability and liquidity. A conflict exists between profitability and liquidity while managing current assets. In case, the firm has insufficient current assets it may default on its financial obligations. On the other hand excess funds result in foregoing of alternative investment opportunities.
