What are the factors influencing financial decisions

You are currently viewing What are the factors influencing financial decisions

The nature of financial decisions varies from one firm to the other. It may also be different from the same firm over a period of time. The reason is that the nature of financial decisions is influenced by different factors. These factors can be divided into two groups: (a) internal factors, and (b) External factors.

Internal Factors:

Internal factors are those internal matters of a firm that influences the financial decisions of that firm. On these factors, the firm has control. Internal factors are discussed below:

01. Nature of business:

Financial decisions are influenced by the nature of the business. If a firm is engaged in manufacturing operations or in the provision of public utility services, its investment in fixed assets is large and hence the capital structure has a large share of long-term capital.

The share of long-term capital in the capital structure is also large in firms producing capital goods. On the other hand, in trading concerns, a greater part of the investment is found in current assets. With a greater ratio of current assets, the ratio of current liabilities ratio.

02. Size of business:

The size of a business is an important factor influencing financial decisions. Concerns that are large in size need a large capital. Small firms may obtain their fixed assets on the lease, but large firms would need to construct their own building and assemble their own plant.

Small firms have lower goodwill in the capital market and so their financing decisions are different from that of large firms. It is because of the lack of sufficient goodwill in the capital market that small firms are largely dependent on large firms.

03. Legal form of organization:

The legal form of the organization influences financial decisions heavily. If the organizational structure is a Joint-Stock Company rather than a sole proprietorship or partnership. It may enjoy more facilities in case of borrowing and others. Thus the legal form of an organization plays an important role in making financial decisions.

04. Business cycle:

The business cycle also influences financial decisions. The financial manager takes different types of decisions in various situations of the business cycle like depression, boom, and expansion.

05. Pattern of ownership:

In a closely-held company where the ownership lies in a few hands, the management does not find it difficult to persuade owners to accept a conservative dividend policy in the interests of the firm. But in cases where there are many shareholders, their wishes matter considerably.

06. Level of risk and stability in earnings:

Risk is another important factor influencing financial decisions. The greater the risk, the higher the discount factor. Thus, risk influences the long-term investment decision or capital budgeting decision.

Again, if the risk is higher or income is no stable, the finance manager tries to impress on the shareholders for more retention of earnings rather than adopting a liberal dividend policy.

But with stable income or lower risk, the financial decision will be just the reverse. In such cases, the fixed cost capital, such as preference shares and debentures, may be preferred, and also the firm may adopt a liberal dividend policy.

07. Liquidity position:

Another factor influencing financial decisions is the liquidity position. Since the dividend is normally paid out of cash, firms with a sound liquidity position adopt a liberal dividend policy. But if in such a case, the working capital requirement is very large or the firm has to meet significant past obligations, it will have to follow a conservative dividend policy. Any title towards illiquidity will alter the nature of financing and dividend decisions.

08. Assets structure:

Assets structure is another important factor influencing financial decisions. The firm having more fixed assets can procure funds from a long-term source. On the other hand, the firm having more current assets procures funds from a short-term source.

09. Economic life of business:

The economic life of those firms is so long. They can obtain so much preference in borrowings. Because the fund invests in an old firm is less risky than in a new one.

10. Terms of credit:

Terms of credit are another important factor influencing financial decisions. It may be mentioned in the contract that the dividend could not be paid up to a certain period, In that case, the payment of the dividend will be influenced.

11. Attitude of the management:

Last but not least is the management’s attitude. A conservative finance manager will attach greater importance to liquidity rather than to profitability. On the other hand, an aggressive financial manager will stress the latter, and financial decisions will be taken accordingly.

For example, a conservative financial manager attempts to tread a beaten path, preferring to avoid fixed obligations for raising additional capital even if debt financing is advantageous. The preference is to maintain a large volume of current assets.

However, an aggressive finance manager is ready to bear the risk involved in debt financing or that involved in maintaining lower current assets. However, a prudent finance manager would prefer a compromise between risk and return or between profitability and liquidity.

External Factors:

External factors are those external matters which influence the financial decisions of the firm. On these factors, the firm has no control. External factors are discussed below:

01. The state of economy:

The state of the economy change from time to time and the financial decisions of a firm conform to these changes. When the economy is growing of proceeding towards recovery, the finance manager should be eager to avail of investment opportunities. But when the economy is facing a slump, the finance manager should proceed with care.

For example, in such a situation it would not be advisable to go for an expansion program. Similarly, when the economy is experiencing an uptrend, the finance manager can opt for trading on equity as larger profits are assured.

But in times of a downtrend, the stress should be on internal financing. Again, during an uptrend, higher dividends can be declared, but during a downtrend conservation of cash is necessary and therefore a strict dividend policy should be followed.

02. The structure of capital and money markets:

If the markets are well developed having a multitude of financial institutions and venturesome investors, the finance manager will find it easy to select the proportion-mix of capital structure and, accordingly, financing decisions will be broader. He can manage with a comparatively lower amount of cash as he can get funds whenever he desires.

The dividend policy too is broad in such, causes as the shareholders are not necessarily interested in regular and large dividends. But if the investors are not venturesome, they will wish for large dividends and the finance manager will have to adopt a liberal dividend policy, and will not be able to pot for trading on equity to any great extent.

Similarly, if the financial institutions provide concessional assistance for priority projects, the investment decisions will be influenced in favor of such projects. Moreover, If the financial institutions stress a particular debt-equity ratio, the financing decision will be so influenced.

03. Govt. regulations:

Apart from the state of the economy, governmental policy is no less significant in influencing corporate financial decisions. State intervention or state regulation is found in almost all countries, although its degree varies.

In Bangladesh where economic policies have become more liberal, entrepreneurs are comparatively free to take up any venture that pleases them. Thus corporate investment decisions are governed by the nature and extent of state regulations.

04. Tax policy:

Taxation rules farmed by the government also shape corporate decisions. Since taxation absorbs a good part of a firm’s income, the finance manager normally has to find out how to minimize the tax burden. Thus the shapes the firm’s depreciation policy, inventory valuation, and capital structure, distribute bonus shares that are exempted from tax, and takes a variety of financial decisions in accordance with the rules and regulations.

However, there is always scope to maneuver and this can be availed to by experienced finance managers, their experience or prudence absorbs, at least to some extent, the influences of the internal and external factors explained hitherto.

Leave a Reply

seventeen − 6 =