MC0M-106 OE01-106 (A) Business Finance

Unit-I : Introduction
Business finance-meaning and concepts, characteristics, importance of business
finance, Scope of business finance, role of business finance, risk and business finance,
relationship between business finance and accounting

Unit-II : Sources of Business Finance

Short-term finance-its sources, ways of raising short-term sources, Long term finance,
equity capital, methods of raising equity finance, Preference share, Debentures, Convertible
loan notes, Warrants, Term loans, Asset-backed finance(securitization), Leasing
Unit-III : Finance Functions
Financial decision, Liquidity decision, Investment decision, Dividend decision-
factors affecting finance functions.

3.1 Finance Functions:

Definition of Finance Functions

The Finance Function is a part of financial management. Financial

Management is the activity concerned with the control and planning of financial
resources. In business, the finance function involves the acquiring and
utilization of funds necessary for efficient operations. Finance is the lifeblood of
business without it things wouldn’t run smoothly. It is the source to run any
organization, it provides the money, it acquires the money.

The Finance function has been classified into three:

 Long-Term Finance– This includes finance of investment 3 years or

more. Sources of long-term finance include owner capital, share capital,
long-term loans, debentures, internal funds and so on.
 Medium Term Finance– This is financing done between 1 to 3 years,
this can be sourced from bank loans and financial institutions.
 Short Term Finance – This is finance needed below one year. Funds
may be acquired from bank overdrafts, commercial paper, advances from
customers, trade credit etc.

Objectives of Finance Functions

 Investment Decisions– This is where the finance manager decides where

to put the company funds. Investment decisions relating to the
 management of working capital, capital budgeting decisions,
management of mergers, buying or leasing of assets. Investment
decisions should create revenue, profits and save costs.
 Financing Decisions– Here a company decides where to raise funds
from. They are two main sources to consider mainly equity and
borrowed. From the two a decision on the appropriate mix of short and
long-term financing should be made. The sources of financing best at a
given time should also be agreed upon.
 Dividend Decisions– These are decisions as to how much, how frequent
and in what form to return cash to owners. A balance between profits
retained and the amount paid out as dividends should be decided here.
 Liquidity Decisions– Liquidity means that a firm has enough money to
pay its bills when they are due and have sufficient cash reserves to meet
unforeseen emergencies. This decision involves the management of the
current assets so you don’t become insolvent or fail to make payments.

Why a Business Needs The Finance Functions

 Helps Establish a Business– Without money, you cannot get labor, land
and so on with the finance function you can determine what is required to
start your business and plan for it.
 Helps Run a Business– To remain in business you must cater to the day
to day operating costs such as paying salaries, buying stationery, raw
material, the finance function ensures you always have adequate funds to
cater to this.
 To Expand, Modernize, Diversify– A business needs to grow otherwise
it may become redundant in no time. With the finance function, you can
determine and acquire the funds required to do so.
 Purchase Assets-You need money to purchase assets. This can be
tangible assets like furniture, buildings or intangible like trademarks,
patents, etc. to get this you need finances.

Importance of Finance Functions

 Identify Need of Finance-To starts a business you need to know how

much is required to open it. So, the finance function helps you know how
much the initial capital is, how much of it you have and how much you
need to raise.
  Identify Sources of Finance-Once you know what needs to be raised
you look at areas you can raise these funds from. You can borrow or get
from various shareholders.
 Comparison of Various Sources of Finance– After identifying various
fund sources compare the cost and risk involved. Then choose the best
source of financing that suits your business needs.
 Investment-Once the funds are raised it is time to invest them.
Investment decisions should be done in a manner that a business gets
higher returns. Cost of funds procurement should be lower than the return
on investment, this will show a wise investment was made.

The Finance Function Involves

 Ensure enough funds at a reasonable cost.
 Ensure the safety of funds.
 Ensure efficient effective and profitable utilization of funds.
 Ensure that finance funds don’t remain idle.

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 of
finance, finance manager is associated, in modern business, in all activities as
no activity can exist without funds.
Financial Decisions or Finance Functions are closely inter-connected. 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
(C) Liquidity Decision or Short-term asset mix decision
(D) Dividend Decision or Profit allocation decision

(A) Investment Decision:

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 ration 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 organisation is exposed to. The more important aspect is
how the investors perceive the risk.
The investment decisions result in purchase of assets. Assets can be
classified, under two broad categories:
(i) Long-term investment decisions – Long-term assets
(ii) Short-term investment decisions – Short-term assets

Long-term Investment Decisions:

The long-term 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 car. The transaction, invariably, results in heavy loss
for a short period of owning. So, the finance manager has to evaluate
profitability of every investment proposal, carefully, before funds are
committed to them.

Short-term Investment Decisions:

The short-term investment decisions are, generally, referred 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.

(B) Finance Decision

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
interestbearing). 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.
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.
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. This is
the case in every walk of life!
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. In period of inflation, this would be advantageous while
it is a disadvantage or curse in times of recession.

(C) Liquidity Decision

Liquidity decision is concerned with the management of current assets.
Basically, this is Working Capital Management. 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 do not earn anything. Higher liquidity is at the cost of
profitability. Profitability would suffer with more idle funds. Investment in
current assets affects the profitability, liquidity and risk. 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
decisionworking capital management. Working capital management is day to
day problem to the finance manager. His skills of financial management are put
to test, daily.

(D) Dividend Decision

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
organisation for expansion. 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 firm. 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 dividend.
There is no ready-made answer, how much is to be distributed and what
portion is to be retained. Retention of profit is related to
• Reinvestment opportunities available to the firm.
• Alternative rate of return available to equity shareholders, if they invest
themselves.

3.2 Factors affecting finance functions

The factors affecting financing decisions. While taking financing

decisions, the finance manager keeps in the mind some important factors.

1. Cost: The cost of raising finance from various sources is different and
finance manager always prefer the source with minimum cost.

2. Risk: More risk is associated with borrowed fund as compared to owner’s

fund security. Finance manager compares the risk with the cost involved and
prefers securities with moderate risk factors.

3. Cash Flow Position: A stronger cash flow position may make debt financing
more viable than funding through the equity.

4. Floatation Cost: It refers to the cost involved in issue of securities such as

broker’s commission, etc. Firm prefers securities which involves less floatation
cost.

5. Fixed Operating Cost: If a company is having high fixed operating cost

(building rent, salaries) then they must prefer owner’s fund because due to high
fixed operational cost, the company may not be able to pay interests on debt
securities which can cause serious trouble for company.

6. Control Consideration: If existing shareholder’s wants to retain the

complete control of business then they prefer borrowed fund securities to raise
further fund. On the other hand, if they do not mind loosing the control then
they may go for owner’s fund securities.
7. State of Capital Market: Health of the capital market may also affect the
choice of the source of fund. During the period, when stock market is rising,
more people invest in equity. However depressed capital market may make
issue of equity shares difficult for any company.

This was all about the factors affecting financing decisions