There are three most important activities of a business firm, viz. production, marketing and finance. A firm secures whatever capital it needs and employs it in activities which generate returns on invested capital. Finance is the most important activity as such in business.
The functions of raising funds, investing them in assets and distributing returns earned from assets to shareholders are respectively known as financing, investment and dividend decisions. While performing these functions, a firm attempts to balance cash inflows and outflows. This is liquidity decision. Finance function or decisions include:
• Investment or long term asset mix decision • Financing or capital-mix decision • Dividend or profit allocation decision • Liquidity or short-term asset-mix decision
A firm performs finance functions simultaneously and continuously in normal course of the business. They do not necessarily occur in a sequence. Finance functions call for skilful planning, control and execution of a firm’s activities.
The manager of the business has to decide when, where and how to acquire funds to meet the firm’s investment needs. The central issue before manager is to determine the proportion of equity and debt. The mix of debt and equity is known as the firm’s capital structure. The Financial manager must strive to obtain the best financing mix or the optimum capital structure. The firm’s capital structure is considered to be optimum when the market value of shares is maximized. The use of debt affects the return and risk of shareholders. It may increase the return on equity funds but it always increases risk. A proper balance will have to be struck between return and risk. In practice, the firm considers many other factors such as control, flexibility, loan covenants, legal aspects etc. in deciding the capital structure.
The firm’s investment and financing decisions are unavoidable and continuous. In order to make them rationally, the firm must have goal. It is generally agreed in theory that the financial goal of the firm should be the maximization of owner’s economic welfare. owner’s economic welfare could be maximized by maximizing the shareholders’ wealth as reflected in the market value of shares.