Everyone faces financial choices in their daily lives. From individuals making budgeting decisions to companies deciding on investments, and even governments planning out policies, all these actions are part of financial decision-making. How quickly and effectively financial goals are achieved depends on one’s decision-making ability. However, making a financial decision in financial management specifically focuses on the strategic process that companies follow to optimise the use of resources. This includes many financial decisions, such as the allocation of resources, making investments, sourcing finances, and managing expenditures to achieve financial goals efficiently and effectively. Let’s understand the different types of financial decisions a company must make, and what factors influence them.
What is Financial Decision?
Financial Decision meaning refers to the process of making choices that influence the financial performance and stability of an individual or company, but a financial decision in financial management terms refers to the choices managers make about a company’s finances. This process includes making decisions on managing expenses, how to best allocate resources, where to invest, managing day-to-day capital, raising funds, and more. These decisions drive the financial health and growth of the company, make sure that the company achieves its financial goals, give it a competitive edge, and maximise shareholders’ wealth.
Different Types of Financial Decisions
There are three major types of financial decisions – investment decisions, financing decisions, and dividend decisions.
1. Investment Decisions
Also known as capital budgeting decisions, these are one of the most important types of financial management decisions. When making investment decisions, managers choose where and how to allocate resources to generate the best possible returns for the company’s investors. They carefully evaluate investments such as stocks, mutual funds, and real estate, and invest in those that are aligned with the company’s short-, and long-term financial goals and risk tolerance. Managers also forecast future cash flows and assess various financial risks before making investments. Resources are limited, that’s why an effective capital budgeting strategy can make sure that the company’s resources are invested efficiently in opportunities that can grow the company’s value and contribute to wealth maximisation.
2. Financing Decisions
Companies require a steady and reliable source of funds for operating. Financing decisions are very important in this regard as they involve finding out the best mix of debt and equity to fund the company’s operations. This means that other than profits earned, companies have two main options to source funds – The first is by issuing new shares, which is a part of equity financing. Secondly, companies can take out loans which is called debt financing.
Even if the company is not profitable yet, it has to pay interest on the borrowed funds by the set date. The risk of not being able to make these payments is known as default risk, and financing managers have to carefully manage it. On the other hand, shareholder funds do not have the same immediate pressure, as there is no obligation to pay returns or repay capital at a specific time. The manager’s goal is to find the right balance between equity and debt financing, as well as balancing the cost of capital with the associated risks to make sure that the company’s financial structure is sustainable in the long term.
3. Dividend Decisions
When a company earns a profit, it can either retain it for reinvestment purposes or distribute it amongst its shareholders as dividends. Financial managers create the company’s dividend policy which dictates how profits are allocated between retained earnings and dividend payouts. They consider various factors such as the company’s long-term growth plans, its liquidity needs, and the expectations of its shareholders. So here too a balance is needed between making sure there are sufficient funds available for the company’s future investments or operational needs, as well as keeping the shareholders happy.
Factors Affecting Financial Decisions
Let’s take a look at some factors affecting financial decisions:
Factors That Affect Investment Decisions
- Rate of Return – The expected rate of return on investment is an essential factor to evaluate before making financial decisions related to investments. Managers look to invest in opportunities that offer the highest returns based on the company’s risk profile.
- Cash Flows of the Venture – Managers project cash flows to estimate the future performance of the investment. If the cash flow estimate is positive and consistent, it means that the investment will generate enough income to cover daily operational costs and provide returns.
- Investment Criteria – With capital budgeting techniques, managers evaluate investment proposals by considering factors such as interest rates, internal rate of return, cash flows, net present value, and payback period. This helps them assess the viability and profitability of the investment proposals so they can decide on the most suitable ones.
Factors That Affect Financing Decisions
- Cash Flow Position – A positive cash position can make it easier for companies to get better terms for financing loans.
- Cost – Different sources of funds have different costs. Lower financing costs are preferred by managers as they reduce the overall expense to the company and ultimately increase the profitability. But managers don’t always select the source with the lowest cost. They weigh the costs against the benefits of different financing options before deciding.
- Floatation Cost – When a company issues new securities, the expenses incurred are called flotation costs. Underwriting fees, legal costs, brokerage, commissions, and administrative expenses are some examples of flotation costs. These costs are lower in equity compared to debt. Low flotation costs mean higher net proceeds from the financing, which is why equity is generally preferred by managers in this aspect.
- Risk – The risk associated with financing options also impacts the manager’s decisions. Debt financing has higher financial risk due to fixed interest payments and repayment obligations. If the company fails to repay the loan on time it can have considerable financial and reputational consequences. Equity financing on the other hand isn’t as risky, but it does dilute the ownership of the company.
- Control Consideration – Debt financing has no impact on the ownership of the company whatsoever, but equity financing leads to the dilution of existing shareholders’ control. If the aim is to raise funds while maintaining the shareholders’ current level of control, debt financing is preferred.
- Market Conditions – It’s easier for companies to raise funds when the interest rates are lower or there is a high demand from investors, but when the market is on a downtrend, financing options are limited and more costly.
Factors That Affect Dividend Decisions
- Earnings – A company’s earnings are the biggest factor in determining dividends. Companies with higher earnings can pay out higher dividends, while those with lower earnings pay either low dividends or suspended dividend payments entirely for a period.
- Shareholder Expectations – Based on a company’s past performance and dividend policies, investors have specific expectations regarding the frequency and size of dividend payments. Managers need to balance these expectations with the company’s financial health and long-term financial goals to maintain investor satisfaction as well as the company’s reputation.
- Tax Implications – Dividends can be subject to different tax rates compared to capital gains, so taxes also impact a company’s dividend decisions. If taxes are too high the amount of dividends paid out are lowered.
- Dividend Stability – Companies with a stable dividend policy are more attractive to shareholders, especially those who invest with the goal of generating an income. A stable dividend also raises the reputation of a company.
- Growth Opportunity – Companies that are looking to grow quickly in the short term generally choose to reinvest profits rather than pay out dividends to their shareholders. Investing in new projects or expanding their operations can mean higher long-term returns, which makes it more advantageous for growth-oriented companies to retain earnings for growth rather than distributing them as dividends.
- Cash Flow – In case a company’s profits aren’t very stable, there is a need for adequate and consistent cash flow to sustain dividend payments. Companies that have enough cash available to meet dividend commitments without compromising their operational needs or financial stability are more attractive to investors.
Conclusion
In financial management, there are three main types of financial decisions – investment decisions, financing decisions, and dividend decisions. Finance managers assess various factors before making choices in each of these areas. With investment decisions, managers determine the best opportunities for allocating the company’s resources to generate the highest possible returns while staying aligned with the company’s risk tolerance. Financing managers focus on finding a suitable balance between loans and issuing shares to fund the company’s daily operations and long-term growth. Managers make dividend decisions to decide how to distribute the company’s profits between reinvestment and shareholder payments.
