Question

• Define the basic types of financial management decisions and the role of the financial manager

• Explain the goal of financial management

• Articulate the financial implications of the different forms of business organization

• Explain the conflicts of interest that can arise between managers and owners

Answer 1

FINANCIAL MANAGEMENT DECISIONS AND ROLES OF FINANCIAL MANAGER

There are three major types of financial management decisions

1. Investment decisions: This decision is concerned with how the firm’s fund must be invested in various assets. Broadly there are two investment avenues for a firm; long term investment avenues and short term investment avenues. Long term investment decisions are called capital budgeting decisions and short term investment decisions are called work capital decisions. A firm has to wisely consider investing either in short term or long term assets.

2. Financing decisions: This decision deals with raising funds from different sources. Like investment decisions, financing decision also involves raising funds from either short term assets or long term assets.

3. Dividend decisions: This decision on the proportion of distribution among shareholders (dividend) and retention with the firm (retained earnings) is dividend decision. Dividend decision has an impact on share value of the firm. High retained earnings will help firm in big investments; whereas high dividends increases stock value. The firm has to decisively deal with this trade off.

Roles of Financial Manager:

1. Planning: This is the most important role of a financial manager. The financial manager has to prepare a financial plan of costs, expenditures, cash flows etc.

2. Investing: The financial manager has to decide on the tricky issue of investing in either short term or long term assets.

3. Financing: The financial manager has to decide on raising the sources of funds from various sources like bonds, debentures, term loans, shares etc.

GOALS OF FINANCIAL MANAGEMENT

The goal of a financial management is wealth maximisation of shareholders and profit maximisation of a firm. The goal of a financial management can also be stated as maximising short term profits and minimising risks. In fulfilling the goals of financial management, a financial manager has to face conflict between manager’s interests (who wants profit maximisation) and shareholder’s interests (who wants wealth maximisation) and on the other hand maximising investments versus minimising risks. Attractive investment comes with huge risks. The financial manager has to strike a balance between minimising the risk and maximising the profits.

FINANCIAL IMPLICATIONS OF SOME MAJOR TYPES OF ORGANISATIONS

1. Sole proprietorship: It is a type of business owned and managed by a single person. Financial implications of sole proprietorship are discussed below:

a. The business can be started with only a limited capital

b. The owners of sole proprietorship do not have to pay taxes; rather they pay personal income tax based on their income.

c. The business owners have unlimited liability. The owners are personally responsible for all the debts of the company.

d. The business owner can withdraw the money for his/her personal use as required.

Partnership: A partnership is a type of business owned by two or more people. Financial implications of partnership business are discussed below:

a. All the owners are personally responsible for the financial implications of the company. The company has unlimited liability.

b. An interesting feature of this business type is mutual agency. Under this feature, a single owner can sign contract on behalf of all the owners.

c. Just like sole proprietorship, the business is not obligated to pay taxes; the earnings are divided among the partners and they pay their personal taxes.

d. The business has limited life; which means that the partners can leave the business any time and new partners can join in.

Private limited Corporations: Corporations are owned by shareholders. Financial implications are discussed below:

a. It has unlimited commercial life.

b. There is no provision of public funding.

C. Limited liability of shareholders

CONFLICT BETWEEN OWNERS AND MANAGERS

The conflict between the managers and owners (shareholders) is termed as principal-agent conflict. The principals (shareholders) are the real owners of the company and managers are the agents who manage the day to affairs of the company. The conflict arises when principal (owners) wants the agents (managers) to take decisions in their interests. But agents have their own interests of increased salary, benefits etc. The two parties different views and hence, conflict arises. There is a cost involved in the conflict termed as agency costs. These types of conflicts arise in firms where the management is divorced from the owners.