Introduction to Finance

Principles of Finance

Principles of FinanceWhat is Finance?Business indicates the works that are related to distribution and marketing to gain profits. The institution that performs such kind of works is called business institution and to collect the necessity money to perform those works is known as finance. The field of finance is broad and dynamic. It directly affects the lives of every person and every organization. It is the process of organizing the flow of funds so that a business can carry out its objectives in the most efficient manner and meet its obligations as they fall due. Without finance a firm cannot operate its business.Many authors have presented numerous definitions The definition of Business Finance gets alternation in time to time. But there are some definitions which demand for a long time, given by many geniuses. Among them………

“Finance consists of providing and utilizing the money, capital rights, credit and any kind of funds which are employed in the operation of an enterprise.”

- George & Terry“Finance is concerned with the process, institutions, markets and instruments in world in transfer of money among and between individuals, business and governments.”

-Lawrence J. Gitman From these definitions, it is obvious that efficient utilization of all revenue, adequate expenditures and capital rights are implied in the meaning of finance. The immediate aim thereby assigned to finance in any business is simply maintaining the adequate cash balances all times. Analyzing above discussions we can find some features/ Functions of finance:1. Managing funds2. Raising the funds3. Procurement of funds from various sources.Finally, finance can be defined by the involvement with procurement of funds, managing funds and all kinds of payment of an individual business organization and government institution.

What is Business Finance?In our personal, social & corporate world everywhere, money and finance are very important subjects. Every section of our life, we face some financial decisions. So, without those subjects it is impossible to think our daily life. In very narrow concept, it only means bank balance. But in business language, its meaning is wide. Virtually all individual and organizations earn or raise money and spend money. Finance can be defined as the art and science of managing that money where business finance is an art of playing with fund (money) to achieve the goal of a company.

The term business finance refers to the collection of money to produce new goods or services, distribution and marketing activities. It is the act or process of accumulation and utilization of funds in order to accomplish a firm’s ultimate goal of maximization of owners’ wealth.

Many authors have presented numerous definitions. The definition of Business Finance gets alternation in time to time. But there are some definitions which demand for a long time, given by many geniuses. Among them………

“Planning the fund to be utilized to business, collections, control and related administrative activities are called business finance.”

-B. H.G. Guthman & H.E. Dougull

Prof M. Muzahidul Islma, Dept of Banking, Dhaka University


“Financial Planning, monitoring, controlling and application of financial ideas of a business firm is called Business Finance.”

- E.W. Walker

“Business Finance is concerned with the sources of funds available to enterprises of all sizes and the proper use of money or credit obtained from such sources.” - Professor Gloss & BakerAccording to above definitions we can say that business finance is the combination of the activities of measuring the amount of money, potential sources of money, justification of the terms and conditions, total finance, storage and process. That is to reach the ultimate goal of a firm if we make a financial plan, identify sources, raise fund from the most suitable source and reach the goal by investing it in proper sector, then it is called Business Finance.

Factors that influence Financial Decision.

Financial manger takes a great part in a business organization. He takes mainly three decisions. They are (1) Investment decision (2) Financing decision (3) Dividend decision.

Those financial decisions are influenced by many different types of factors. There are two types of factors, which influence financial decisions. They are-

1. Internal factors2. External factors

1. INTERNAL FACTORS: The factors within a firm that can influence the financial decisions of a business organization are called internal factors. Generally, business organizations have a control on those factors. The elements of internal factors are--

I. Size of BusinessII. Nature of Business

III. The Form of Legal OrganizationIV. Situation of Business CycleV. Assets Structure

VI. Regularity and Adequacy of IncomeVII. Economic Life of Business

VIII. Terms of CreditIX. Management Philosophy

Discussion about different types of internal factors is as follows:

Size of Business: A large organization gets more facilities than small organization in case of financing as large firms have more cash flow ability than small organizations. The size of the business organization has a major impact on taking financial decisions.Nature of Business: Some time financial decisions heavily depend on the nature of business. Some business organizations need more current assets whereas some need more fixed assets. For example, manufacturing company needs more fixed assets and non-manufacturing company needs more current assets. So nature of business has created a huge impact on the financial decision of an organization.



The form of legal organization:There is a great influence of the form of legal organization on the financial decision. If the organization is sole proprietorship, it faces a lot of problems in getting loan from bank or other sources. But if it is partnership it gets a lot of facilities in the same.Situation of Business Cycle: The business cycle can influence the financing decisions. The Bad condition as well as good condition of the economy makes a hindrance in the growth of business. So business cycle plays a major role on financing decisions.Assets Structure: Both the condition of assets structure of a business organization and the way of financing the business influence the financing decision very much. The businesses which have more fixed assets collect money from long term sources but the organizations which have little fixed assets with having huge current assets collect money from short term sources.Regularity and adequacy of income: If a firm has regular and adequate income, it gets a lot of facilities than the organization having irregular and inadequate income.Economic Life of Business: The business organizations having long term economic life get more preference for debt. They did not get any problem to collect the credit. But the organization with short economic life faces lots of problem to collect the same as established organization has less risk than new organization. So, economic life of business organization is an important factor for influencing financial decisions.Terms of Credit: The terms of debt agreement and rules and barriers influence the financing activities of a business. The nature of financing is determined by examining the term of debt agreement. The debt agreement can influence on the distributions of dividend.Management Philosophy: Management philosophies also influence the financial decision. Management means organization’s Owners, board of directors and higher-level employee of an organization. If the managerial philosophy is to control the business then management will collect fund by issuing debt rather issuing shares, which increases the number of owners. On the other hand, if management doesn’t have the interest about controlling the firm then it will issue shares to collect the fund considering the risk regarding debt capital.

2. EXTERNAL FACTORS: The factors outside the organization, which are not controlled by the business organization, are called external factors. The elements of external factors are--

I. Govt. regulationsII. Tax system

III. Economic condition of the countryIV. Condition of money market and capital market

This elements are describe in below—

Government Regulations:Government rules and regulations influence the organizational decisions. Every organization must obey the rules and regulation of government. Industrial rules are one of them. In some financial market there are some restrictions in case of investment, which must be considered by the financial manager in making financial decisions.Tax system:Tight tax system discourages the investors to invest whereas flexible tax system encourages investors for the investment.



Economic condition of the country: The stability and development of economic condition of a country have a major impact on financial decisions. Countries having stable economic condition are very attractive to the investors to be invested whereas investors are not interested to invest in the country, which has unstable economic condition. Condition of money market and capital market: The economic development of a country is highly depends on the development of money market and capital market of that country. In boom condition of money market and capital market, investors make investments taking more risk. So, at that time it becomes easier to the management to take money from long term and short term sources.

Three major decisions that financial managers must take.

It is the responsibility of financial management to allocate funds to current and fixed assets to obtain the best mix of financing alternatives and to develop an appropriate dividend policy within the contest of the firm’s objectives. The functions are performed on a day-to-day basis as well as through infrequent use of the capital markets to acquire new funds. There are the three major decisions, which are very much important in case of business finance.

a) Investment decision.b) Financing Decisionc) Dividend Decision.

Investment decision: The most important decision that a business manager has to take is the decision of investment. Investment decision or capital budgeting involves the decision of allocation of capital or commitment of funds to long-term assets that would yield benefits in future. It begins with a determination of the total amount of assets needed by the firm. Assets that can no longer be economically justified may need to be reduced, eliminated, or replaced. So investment should be applied after assessment of the future expected income and risk.

Investment assets are divided as follows - i) Working capital Management.ii) Capital budgeting.

Financing decision: Financing decision is the second important function to be performed by the financial manager. Broadly, he or she must decide when, where and how to acquire funds to meet the firms investment needs. The central issue before him or her is to determine the proportion of equity and debt. In financing if he uses more debt then earning per share will rise but risk will be higher. On the other hand, if he uses more equity then risk will be low but at the same time earning per share will also be low. So there should be an optimum mix for better performance. The mix of debt and equity is known as the firm’s capital structure. The structure in which expenses are less and share price is high is defined as optimum capital structure

Dividend Decision: Dividend policy must be viewed as an integral part of the firm’s financing decision. An important element of dividend policy is the dividend payout ratio that is how much of the net profits should be paid out to the shareholders. It will depend upon the preference of shareholders, investment opportunities available within firm and the factors determining dividend policy in practice. Retaining a greater amount of current earnings in the firm means fewer takas will be available for



current dividend payments. The value of the dividends paid to stockholders must therefore be balanced against the opportunity cost of retained earnings lost as a means of equity financing. The Dividend Distribution Ratio, which can make highest value of share, is called Optimum Dividend Payout Ratio.

Functions of a Finance ManagerIt is the responsibility of financial management to allocate funds to current and fixed assets to obtain the best mix of financing alternatives and to develop an appropriate dividend policy within the contest of the firm’s objectives. The functions are performed on a day-to-day basis as well as through infrequent use of the capital markets to acquire new funds. Scope of business finance may broadly be classified into two groups-

1) Managerial Functions2) Routine Functions.

1) Managerial function: These are the three major decisions, which are very much important in case of business finance.

d) Investment decision.e) Financing Decisionf) Dividend Decision.

Investment decision: The most important decision that a business manager has to take is the decision of investment. Investment decision or capital budgeting involves the decision of allocation of capital or commitment of funds to long-term assets that would yield benefits in future. It begins with a determination of the total amount of assets needed by the firm. Assets that can no longer be economically justified may need to be reduced, eliminated, or replaced. So investment should be applied after assessment of the future expected income and risk. For this reason, a decision maker has to analyze the following functions-

- How much asset should be devoted to cash or inventory- Which investment has comparatively suitable income and expenditure

Investment asset is divided into two types- i) Working capital Management.ii) Capital budgeting.

i) Working capital management:

If a firm’s current liabilities (obligations that must be paid within a year) are subtracted from its current assets then the result will be the value of working capital. Working capital represents the amount of capital available for the day-to-day running of the firm. Sufficient working capital is obviously important to the effective management of a firm’s operations. It is an important and integral part of financial management as short-term survival is a pre-requisite of long term success. A decision maker has to maintain the balance properly between the firm’s profitability and liquidity. He should have proper estimation about the investment of working capital so that the firm does not loss its profitability and ability to repay debt.

In managing current assets, the financial manager needs to concentrate on three assets: cash, accounts receivable and inventory. The primary concern with cash is that it should never be left idle; it should always be working. Funds that are not immediately needed should be invested to earn interest.



ii) Capital budgeting:Capital budget involves the planning to acquire worthwhile projects together with the timing of the estimated cost and cash flows of each project. Those projects require large amount of funds and to have long- term implications for the firm. Capital budgets are difficult to be prepared because estimation of the cash flows over a long period has to be made which involve a great degree of uncertainty. The capital budgets are generally prepared separately from the operating budgets..We can show the scope of business finance by the following diagram:

Scope of finance

Managerial Function Routine Function

Investment Financing Dividend Decision Decision Decision

Working Capital

Capital Budgeting Management

Figure: Scope of finance

Financing decision: Financing decision is the second important function to be performed by the financial manager. Broadly, he or she must decide when, where and how to acquire funds to meet the firms investment needs. The central issue before him or her is to determine the proportion of equity and debt. In financing if he uses more debt then earning per share will rise but risk will be higher. On the other hand, if he uses more equity then risk will be low but at the same time earning per share will also be low. So there should be an optimum mix for better performance. The mix of debt and equity is known as the firm’s capital structure. The structure in which expenses are less and share price is high is defined as optimum capital structure

Dividend Decision: Dividend policy must be viewed as an integral part of the firm’s financing decision. An important element of dividend policy is the dividend payout ratio that is how much of the net profits should be paid out to the shareholders. It will depend upon the preference of shareholders, investment opportunities available within firm and the factors determining dividend policy in practice. Retaining a greater amount of current earnings in the firm means fewer takas will be available for current dividend payments. The value of the dividends paid to stockholders must therefore be balanced against the opportunity cost of retained earnings lost as a means of equity financing. The



Dividend Distribution Ratio, which can make highest value of share, is called Optimum Dividend Payout Ratio.

Routine functions of a Financial Manager

A company needs to perform some regular activities to complete its managerial activities properly. These are called incidental or routine functions. Routine function refers to the daily work of an organization, such as

a. collection of fund and b. maintenance of fund, c. opening insurance policy,d. collection of information regarding external financing, e. book-keeping and report preparing.

Principles of business finance.

In order to achieve an expected goal, it is very necessary for every company to know about the techniques and principles of business finance and the perfect application of those principles. Without having a clear idea about those principles, achieving an expected goal becomes impossible. These principles come under consideration while taking decisions about fund collection, fund investments, financial risk and financing any project. The major principles of business finance are given below:

1. Principles of Risk and Return.2. Principles of Time value of Money.3. Principles of Cash Flow.4. Principles of Profitability and Liquidity.5. Hedging Principles.6. Principles of Diversity.7. Principles of Business Cycle.

1. Principles of Risk and Return: The main theme of this principle is how risk affects the concerned organization when the financial manager takes the financial decision. This principle refers to the combination of financial risk and return. By considering this, management will be able to take the right decisions because the maximum financial decision is taken in uncertainty. In the time of investment, this principle should be under consideration. Firm won’t take additional risk unless it expects to be compensated with additional return. The main objective of this principle is to adjust between risk and returns in the time of investment. That is this principle says, “If risk is high, return is high and if risk is low return is low”.

2. Principals of Time Value of Money: The time value of money is one of the most important concepts in finance. A dollar received today is worth more than a dollar received in the future. Money has a time value. A rational person is not indifferent between having a dollar today and a dollar in the future. Regardless of inflation, a dollar today can be invested and will earn return over a period of time. Principal of time value of money is very important for business finance. When organization finance in any project it must consider this principle.3. Principles of Cash Flow:



Cash flows are the blood of the firm. The primary focus of the financial manager is both on managing day-to-day finances & planning and taking strategic decisions for the creation of shareholder’s value. So Cash flows are very much important for the firm, which is discussed under Principles of cash flow. This principle says cash inflows and cash outflows must be comparable in the business.

4. Principles of liquidity and profitability: Liquidity and profitability stands against one another. There is a trade off between liquidity and profitability. Gaining more of one ordinarily means giving up some of the other. If an organization wants to maintain more liquidity, it will have little to invest. As a result the profit will get down. But if the firm wants to maximize profit, it will have to invest much and in this case the liquidity will have to be kept short which will lead it to a money crisis. So, a financial manager should have the ability to adjust between profitability and liquidity to avoid both excess liquidity and low profit.

5. Hedging Principles:In case of fund collection and investment, this principle is very important. The moral of this principle is that the maturity of the firm’s asset should match with the maturity of that firm’s liability; i.e. short-term assets should be financed by short-term liability; long-term assets should be financed by long term sources of financing.

6. Principles of Diversity: Finance Managers use this principle in Asset Management. The basic of this principle is to invest in several projects instead of investing in a specific single project to reduce the risk and uncertainty in case of an investment decision. For example, say, instead of investing more in a specific asset of a business like stock, one should invest money in other business assets like accounts receivables, marketable security etc. Through this, it is possible to reduce the risk related to investment.

7. Principles of Business Cycle: According to this principle a level of business cycle should be maintained while taking every single financial decision. At the time of finance/investment decision, one should consider the adjustment between investment and business cycle. Both investment decision and business cycle can influence each other. In the time of boom, recession, depreciation and recovery in economy, considering economic condition is the main subject while taking financial decision.

From the above, we can say that principle of finance is very important for financial management in decision-making. If one organization can make the proper use of these principles then this organization will be able to minimize the risk also.


Documents

Introduction to Finance