Functions of Financial Management

1. Definition

Functions of Financial Management are the systematic activities and decision-making processes undertaken by financial managers to ensure efficient procurement, allocation, and control of financial resources in an organization.

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2. Major Functions

Financial management involves three main decision areas:

2.1 Financing Decision (Capital Structure Decision)

Question: How should funds be raised?

Key Considerations:

• Proportion of debt vs equity
• Cost of different sources
• Risk-return trade-off
• Financial leverage

Example:

Company needs ₹100 lakhs:
Option A: 100% Equity (₹100 lakhs equity)
Option B: 60% Equity + 40% Debt (₹60 lakhs equity + ₹40 lakhs debt)
Option C: 40% Equity + 60% Debt (₹40 lakhs equity + ₹60 lakhs debt)

Decision: Choose option with lowest cost and acceptable risk

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2.2 Investment Decision (Capital Budgeting Decision)

Question: Where should funds be invested?

Types of Investments:

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Example:

Available funds: ₹50 lakhs
Investment Options:
- New machinery: Expected return 15% per year
- Expansion of warehouse: Expected return 12% per year
- Marketable securities: Expected return 8% per year

Decision: Invest in new machinery (highest return)

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2.3 Dividend Decision

Question: How much profit to distribute vs retain?

Two Choices:

1. Distribute as Dividends: Immediate returns to shareholders
2. Retain for Reinvestment: Future growth and higher future dividends

Factors Affecting Decision:

• Company's growth prospects
• Shareholder preferences
• Tax implications
• Liquidity position
• Legal requirements

Example:

Net Profit: ₹20 lakhs

Option A: Distribute 100% (₹20 lakhs dividend, ₹0 retained)
Option B: Distribute 60% (₹12 lakhs dividend, ₹8 lakhs retained)
Option C: Distribute 30% (₹6 lakhs dividend, ₹14 lakhs retained)

Growing companies: Choose Option C (retain more)
Mature companies: Choose Option A or B (distribute more)

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3. Other Important Functions

3.1 Liquidity Management

Objective: Maintain adequate cash and liquid assets.

Balance Required:

• Too much liquidity: Idle funds, low returns
• Too little liquidity: Cannot meet obligations, financial distress

Tools:

• Cash flow forecasting
• Working capital management
• Short-term investments

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3.2 Financial Control

Activities:

• Budgeting and variance analysis
• Ratio analysis
• Performance evaluation
• Cost control

Example Metrics:

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3.3 Financial Planning

Purpose: Estimate future financial needs.

Components:

• Sales forecasting
• Profit planning
• Cash budgeting
• Capital budgeting

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4. Interrelation of Functions

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All functions are interconnected and must be coordinated for optimal results.

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Exam Pattern Questions and Answers

Question 1: "Explain the major functions of financial management." (8 Marks)

Answer:

Introduction (1 mark): Financial management involves systematic decision-making in three major areas: financing decisions, investment decisions, and dividend decisions, along with supporting functions of liquidity management and financial control.

Financing Decision (2 marks): Also called capital structure decision, this determines how funds should be raised for business operations. Financial manager decides optimal mix of debt and equity considering cost of capital, financial risk, and control implications. For example, company needing ₹100 lakhs must choose between 100% equity financing or debt-equity combinations like 60:40 or 40:60, selecting option with lowest weighted average cost of capital.

Investment Decision (2 marks): Also called capital budgeting decision, this determines where raised funds should be invested. Includes long-term investments in fixed assets like machinery and buildings, and short-term investments in current assets like inventory and receivables. Financial manager evaluates projects using techniques like NPV, IRR, and payback period, selecting investments offering highest return relative to risk.

Dividend Decision (2 marks): This determines how much of net profit should be distributed as dividends versus retained for reinvestment. Growing companies typically retain more profits (70-80%) for expansion, while mature companies distribute higher dividends (60-70%). Decision balances shareholder expectations for immediate income against company's need for funds for future growth.

Supporting Functions (1 mark): These include liquidity management ensuring adequate cash availability, and financial control through budgeting, ratio analysis, and performance monitoring to ensure efficient utilization of resources.

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Question 2: "Distinguish between financing decision and investment decision." (4 Marks)

Answer:

Financing Decision (2 marks): Financing decision involves determining sources and mix of funds to be raised for business needs. It focuses on capital structure, deciding proportions of equity, preference shares, and debt considering cost, risk, and control. For example, choosing between issuing equity shares versus taking bank loan for ₹50 lakhs requirement.

Investment Decision (2 marks): Investment decision involves determining where to deploy the raised funds to generate returns. It focuses on selecting profitable projects and assets, both fixed assets for long-term and current assets for short-term operations. For example, evaluating whether to invest ₹50 lakhs in new machinery (15% return) or warehouse expansion (12% return).

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Summary

Key Points for Revision:

1. Three Major Functions:

   • Financing Decision (How to raise funds?)
   • Investment Decision (Where to invest?)
   • Dividend Decision (How much to distribute?)

2. Supporting Functions:

   • Liquidity Management
   • Financial Planning
   • Financial Control

3. All Functions Interconnected: Must be coordinated and balanced

4. Goal: Maximize shareholder wealth through optimal decisions

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Quiz Time! 🎯

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