In this unit, you will be introduced to finance functions in the various stages of activities of a business organization. You may recapitulate that in the business cycle figure drawn in Unit 1, you were shown the functional movement of funds/financial activities through investment to cash, production of goods and services, given their marketing thereof.
At the end of this unit, you should be able to:
- identify the functions of finance
- apply these functions of finance
- Establish effective execution of finance functions.
3.0 MAIN CONTENT
Finance functions have been acknowledged as major in most organisations. They are identified as raising funds, investing them in assets and distributing returns earned from assets to shareholder/owners. This exercise is known as financing decision, investment decision and dividend decision.
These finance phenomena which will be treated extensively later; were expressed in figure 1, Unit 1, Module 1 of this course. When a firm endeavours to balance the cash inflows and outflows while performing the above functions, it is called liquidity decision. Hence, the list of important finance functions includes:
- Long term asset-mix or investment function
- Capital-mix or financing function
- Profit allocation or dividend function
- Short-term asset-mix or liquidity function
A business organization performs finance functions simultaneously and continuously in the normal course of its activities. The occurrence may, however, not be in sequence. Finance functions require skill and professional planning, control and execution of an organization’s activities.
SELF ASSESSMENT EXERCISE 1
List the important finance functions in a firm
3.1 Investment Function
Investment decisions involve capital expenditures which are referred to as capital budgeting decision. This is the decision of allocating capital to long-term assets that will bring in beneficial yield (cash inflow) in the future.
There are two important aspects of investment decisions:
- The evaluation of the prospective profitability of new investment; and
- The measurement of a rate against the prospective return of new investments could be compared.
Risk in investment, as would be explained in the next unit, arises because of uncertainty in returns. Investment proposals should, therefore, be analysed and evaluated in terms of both expected return and risk.
SELF ASSESSMENT EXERCISE 2
What are the two important aspects of investment decisions?
3.2 Financing Function
This is another vital function in an enterprise. The financial manager has to identify the time, place and the technique for acquiring adequate funds to meet the enterprise’s investment needs. The central issue here is the determination of appropriate proportion of internal (equity) and
external (debt) finance required by the enterprise. The mix of the two is known as the capital structure of the business organization.
The Financial Manager strives to obtain and sustain the best financing mix, to optimize the capital structure, which forms the base of financing. The capital structure is said to be optimum when the market value of shares is maximized.
SELF ASSESSMENT EXERCISE 3
What is capital structure of an enterprise?
3.3 Dividend Function
This is the other major financial decision which affects the shareholders and the business as a whole – the decision to distribute all profits or retain same. The proportion of distribution of profit and the balance retained is subject to the firm’s policy, decision of the board of director or economic situation as applied. The proportion of profits distributed as dividend is called the dividend-payout ratio.
The retention ratio is the retained portion of profits. The dividend policy is determined by its impact on the shareholder’s value.
SELF ASSESSMENT EXERCISE 4
What is retention ratio in finance?
3.4 Liquidity Function
Liquidity and profitability affect investment in current assets in business organizations. Liquidity of an enterprise is affected by the level of management of current asset. Risk of illiquidity (lack of liquidity), in extreme situations, can lead to a business insolvency. Current assets if properly/efficiently managed would safeguard the business organization against risk of illiquidity. The firm needs to invest sufficient funds in current assets in order to become liquid.
It would lose profitability, if more of available current assets are not utilized to earn any revenue.
To sum it up, financial decisions is concerned with the acquisition or disposal of assets through commitment or recommitment of funds on a continuous basis.
This is why finance function affects the size, growth, profitability and risk of the firm, and ultimately, the value of the business/enterprise.
SELF ASSESSMENT EXERCISE 5
Liquidity of a business is affected by_____________.
3.5 Financial Procedures
Financial procedures involve a lot of measures to achieve effective execution of finance function. Some important routine finance functions are:
- Supervision of cash receipts and payments and cash balances safeguarding.
- Custody and safeguarding of securities, insurance policies and other valuable papers.
- Taking care of the mechanical details of new outside financing.
- Record keeping and reporting.
In recent years, the scope of finance function as stated in Unit 1 of this Module indicates that it has widened. This will be discussed more in the next unit.
The various finance functions have been identified and discussed showing they are applied at each stage of cash to investment as they affect production of goods and services and the marketing of these product.
In this unit, we have identified the finance function of a business enterprise are identified based on investment, financing, dividend and liquidity decisions. The effective procedure for the execution finance function was also established.
6.0 TUTOR-MARKED ASSIGNMENT
- State some financial procedures for effective execution of finance function.
- Explain in short note: investment decision and liquidity decision of a business concern.