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Principles of Finance

Principles of Finance
What is Finance?
Business indicates the works that are related to distribution and marketing to gain profits. The
institution that performs such kind of works is called business institution and to collect the necessity
money to perform those works is known as finance. The field of finance is broad and dynamic. It
directly affects the lives of every person and every organization. It is the process of organizing the
flow of funds so that a business can carry out its objectives in the most efficient manner and meet
its obligations as they fall due. Without finance a firm cannot operate its business.
Many authors have presented numerous definitions
The definition of Business Finance gets alternation in time to time. But there are some definitions
which demand for a long time, given by many geniuses. Among them………
“Finance consists of providing and utilizing the money, capital rights, credit and any kind of funds
which are employed in the operation of an enterprise.”
George & Terry
“Finance is concerned with the process, institutions, markets and instruments in world in transfer of
money among and between individuals, business and governments.”
-Lawrence J. Gitman
From these definitions, it is obvious that efficient utilization of all revenue, adequate expenditures
and capital rights are implied in the meaning of finance. The immediate aim thereby assigned to
finance in any business is simply maintaining the adequate cash balances all times.
Analyzing above discussions we can find some features/ Functions of finance:
1. Managing funds
2. Raising the funds
3. Procurement of funds from various sources.
Finally, finance can be defined by the involvement with procurement of funds, managing funds and
all kinds of payment of an individual business organization and government institution.

What is Business Finance?
In our personal, social & corporate world everywhere, money and finance are very important
subjects. Every section of our life, we face some financial decisions. So, without those subjects it is
impossible to think our daily life. In very narrow concept, it only means bank balance. But in
business language, its meaning is wide. Virtually all individual and organizations earn or raise
money and spend money. Finance can be defined as the art and science of managing that money
where business finance is an art of playing with fund (money) to achieve the goal of a company.
The term business finance refers to the collection of money to produce new goods or services,
distribution and marketing activities. It is the act or process of accumulation and utilization of funds
in order to accomplish a firm’s ultimate goal of maximization of owners’ wealth.
Many authors have presented numerous definitions.
The definition of Business Finance gets alternation in time to time. But there are some definitions
which demand for a long time, given by many geniuses. Among them………
“Planning the fund to be utilized to business, collections, control and related administrative
activities are called business finance.”
-B. H.G. Guthman & H.E. Dougull

Prof M. Muzahidul Islma, Dept of Banking, Dhaka University

controlling and application of financial ideas of a business firm is called Business Finance. The size of the business organization has a major impact on taking financial decisions.E. IX. They are1. raise fund from the most suitable source and reach the goal by investing it in proper sector. INTERNAL FACTORS: The factors within a firm that can influence the financial decisions of a business organization are called internal factors. VIII. External factors 1. III. Walker “Business Finance is concerned with the sources of funds available to enterprises of all sizes and the proper use of money or credit obtained from such sources. VII. V. Some business organizations need more current assets whereas some need more fixed assets. total finance. Financial manger takes a great part in a business organization. then it is called Business Finance. He takes mainly three decisions.Principles of Finance “Financial Planning. storage and process. Size of Business Nature of Business The Form of Legal Organization Situation of Business Cycle Assets Structure Regularity and Adequacy of Income Economic Life of Business Terms of Credit Management Philosophy Discussion about different types of internal factors is as follows: Size of Business: A large organization gets more facilities than small organization in case of financing as large firms have more cash flow ability than small organizations.Professor Gloss & Baker According to above definitions we can say that business finance is the combination of the activities of measuring the amount of money. potential sources of money. Nature of Business: Some time financial decisions heavily depend on the nature of business. II. Dept of Banking.W. Factors that influence Financial Decision. justification of the terms and conditions. Prof M. There are two types of factors. Muzahidul Islma. The elements of internal factors are-I. So nature of business has created a huge impact on the financial decision of an organization. IV. which influence financial decisions. VI.” . Those financial decisions are influenced by many different types of factors. They are (1) Investment decision (2) Financing decision (3) Dividend decision. identify sources. Internal factors 2. Dhaka University . monitoring. That is to reach the ultimate goal of a firm if we make a financial plan. manufacturing company needs more fixed assets and non-manufacturing company needs more current assets. For example.” . Generally. business organizations have a control on those factors.

which must be considered by the financial manager in making financial decisions. Terms of Credit: The terms of debt agreement and rules and barriers influence the financing activities of a business. Management Philosophy: Management philosophies also influence the financial decision. But the organization with short economic life faces lots of problem to collect the same as established organization has less risk than new organization. They did not get any problem to collect the credit. it gets a lot of facilities than the organization having irregular and inadequate income. Tax system: Tight tax system discourages the investors to invest whereas flexible tax system encourages investors for the investment. economic life of business organization is an important factor for influencing financial decisions. The elements of external factors are-I. Regularity and adequacy of income: If a firm has regular and adequate income. are called external factors. In some financial market there are some restrictions in case of investment. III. Dept of Banking. board of directors and higher-level employee of an organization. Situation of Business Cycle: The business cycle can influence the financing decisions. Economic Life of Business: The business organizations having long term economic life get more preference for debt. EXTERNAL FACTORS: The factors outside the organization. Govt. regulations Tax system Economic condition of the country Condition of money market and capital market This elements are describe in below— Government Regulations: Government rules and regulations influence the organizational decisions. So. The nature of financing is determined by examining the term of debt agreement. it faces a lot of problems in getting loan from bank or other sources. If the managerial philosophy is to control the business then management will collect fund by issuing debt rather issuing shares. But if it is partnership it gets a lot of facilities in the same. Industrial rules are one of them. On the other hand. If the organization is sole proprietorship. Every organization must obey the rules and regulation of government. The businesses which have more fixed assets collect money from long term sources but the organizations which have little fixed assets with having huge current assets collect money from short term sources. The debt agreement can influence on the distributions of dividend.Principles of Finance The form of legal organization: There is a great influence of the form of legal organization on the financial decision. if management doesn’t have the interest about controlling the firm then it will issue shares to collect the fund considering the risk regarding debt capital. Dhaka University . 2. Prof M. Management means organization’s Owners. Assets Structure: Both the condition of assets structure of a business organization and the way of financing the business influence the financing decision very much. II. Muzahidul Islma. which increases the number of owners. So business cycle plays a major role on financing decisions. The Bad condition as well as good condition of the economy makes a hindrance in the growth of business. IV. which are not controlled by the business organization.

where and how to acquire funds to meet the firms investment needs. Three major decisions that financial managers must take. The functions are performed on a day-to-day basis as well as through infrequent use of the capital markets to acquire new funds. The central issue before him or her is to determine the proportion of equity and debt. or replaced. Countries having stable economic condition are very attractive to the investors to be invested whereas investors are not interested to invest in the country. It begins with a determination of the total amount of assets needed by the firm. It is the responsibility of financial management to allocate funds to current and fixed assets to obtain the best mix of financing alternatives and to develop an appropriate dividend policy within the contest of the firm’s objectives. So there should be an optimum mix for better performance. if he uses more equity then risk will be low but at the same time earning per share will also be low. On the other hand. Broadly. investment opportunities available within firm and the factors determining dividend policy in practice. Assets that can no longer be economically justified may need to be reduced.Principles of Finance Economic condition of the country: The stability and development of economic condition of a country have a major impact on financial decisions. Financing decision: Financing decision is the second important function to be performed by the financial manager. Condition of money market and capital market: The economic development of a country is highly depends on the development of money market and capital market of that country. Retaining a greater amount of current earnings in the firm means fewer takas will be available for Prof M. The structure in which expenses are less and share price is high is defined as optimum capital structure Dividend Decision: Dividend policy must be viewed as an integral part of the firm’s financing decision. Dept of Banking. In financing if he uses more debt then earning per share will rise but risk will be higher. The mix of debt and equity is known as the firm’s capital structure. Investment assets are divided as follows i) Working capital Management. which has unstable economic condition. Investment decision or capital budgeting involves the decision of allocation of capital or commitment of funds to long-term assets that would yield benefits in future. There are the three major decisions. In boom condition of money market and capital market. So investment should be applied after assessment of the future expected income and risk. which are very much important in case of business finance. An important element of dividend policy is the dividend payout ratio that is how much of the net profits should be paid out to the shareholders. So. ii) Capital budgeting. a) Investment decision. Dhaka University . he or she must decide when. investors make investments taking more risk. Investment decision: The most important decision that a business manager has to take is the decision of investment. eliminated. at that time it becomes easier to the management to take money from long term and short term sources. Muzahidul Islma. b) Financing Decision c) Dividend Decision. It will depend upon the preference of shareholders.

The value of the dividends paid to stockholders must therefore be balanced against the opportunity cost of retained earnings lost as a means of equity financing. In managing current assets. e) Financing Decision f) Dividend Decision. Functions of a Finance Manager It is the responsibility of financial management to allocate funds to current and fixed assets to obtain the best mix of financing alternatives and to develop an appropriate dividend policy within the contest of the firm’s objectives. d) Investment decision. it should always be working. A decision maker has to maintain the balance properly between the firm’s profitability and liquidity. It begins with a determination of the total amount of assets needed by the firm. eliminated. For this reason. i) Working capital management: If a firm’s current liabilities (obligations that must be paid within a year) are subtracted from its current assets then the result will be the value of working capital. He should have proper estimation about the investment of working capital so that the firm does not loss its profitability and ability to repay debt. Scope of business finance may broadly be classified into two groups1) Managerial Functions 2) Routine Functions.Which investment has comparatively suitable income and expenditure Investment asset is divided into two typesi) Working capital Management. Assets that can no longer be economically justified may need to be reduced. Investment decision or capital budgeting involves the decision of allocation of capital or commitment of funds to long-term assets that would yield benefits in future. is called Optimum Dividend Payout Ratio. Investment decision: The most important decision that a business manager has to take is the decision of investment. Prof M. It is an important and integral part of financial management as short-term survival is a pre-requisite of long term success. Working capital represents the amount of capital available for the day-to-day running of the firm. The Dividend Distribution Ratio. which are very much important in case of business finance. So investment should be applied after assessment of the future expected income and risk. Muzahidul Islma. or replaced. the financial manager needs to concentrate on three assets: cash. Dhaka University . which can make highest value of share. The primary concern with cash is that it should never be left idle.Principles of Finance current dividend payments. The functions are performed on a day-to-day basis as well as through infrequent use of the capital markets to acquire new funds. Sufficient working capital is obviously important to the effective management of a firm’s operations. Funds that are not immediately needed should be invested to earn interest. Dept of Banking. accounts receivable and inventory. 1) Managerial function: These are the three major decisions. a decision maker has to analyze the following functions.How much asset should be devoted to cash or inventory . ii) Capital budgeting.

. We can show the scope of business finance by the following diagram: Scope of finance Managerial Function Investment Decision Routine Function Financing Decision Working Dividend Decision Capital Capital Management Budgeting Figure: Scope of finance Financing decision: Financing decision is the second important function to be performed by the financial manager. The value of the dividends paid to stockholders must therefore be balanced against the opportunity cost of retained earnings lost as a means of equity financing. So there should be an optimum mix for better performance. The capital budgets are generally prepared separately from the operating budgets. if he uses more equity then risk will be low but at the same time earning per share will also be low. where and how to acquire funds to meet the firms investment needs. On the other hand.term implications for the firm. It will depend upon the preference of shareholders. The mix of debt and equity is known as the firm’s capital structure. Dept of Banking. The structure in which expenses are less and share price is high is defined as optimum capital structure Dividend Decision: Dividend policy must be viewed as an integral part of the firm’s financing decision. Those projects require large amount of funds and to have long. Capital budgets are difficult to be prepared because estimation of the cash flows over a long period has to be made which involve a great degree of uncertainty. The central issue before him or her is to determine the proportion of equity and debt. In financing if he uses more debt then earning per share will rise but risk will be higher. An important element of dividend policy is the dividend payout ratio that is how much of the net profits should be paid out to the shareholders. investment opportunities available within firm and the factors determining dividend policy in practice. Broadly. he or she must decide when. The Prof M. Muzahidul Islma. Retaining a greater amount of current earnings in the firm means fewer takas will be available for current dividend payments. Dhaka University .Principles of Finance ii) Capital budgeting: Capital budget involves the planning to acquire worthwhile projects together with the timing of the estimated cost and cash flows of each project.

return is high and if risk is low return is low”. Without having a clear idea about those principles. Routine functions of a Financial Manager A company needs to perform some regular activities to complete its managerial activities properly. 7. 4. a dollar today can be invested and will earn return over a period of time. Money has a time value. is called Optimum Dividend Payout Ratio. A dollar received today is worth more than a dollar received in the future. Principles of Risk and Return: The main theme of this principle is how risk affects the concerned organization when the financial manager takes the financial decision. These are called incidental or routine functions. This principle refers to the combination of financial risk and return. 2. achieving an expected goal becomes impossible. Principal of time value of money is very important for business finance. Principles of Cash Flow. collection of fund and b. A rational person is not indifferent between having a dollar today and a dollar in the future. “If risk is high. fund investments. In order to achieve an expected goal. maintenance of fund. Hedging Principles. The main objective of this principle is to adjust between risk and returns in the time of investment. Principles of Diversity. Principles of Risk and Return. such as a. 6. Principles of business finance. Firm won’t take additional risk unless it expects to be compensated with additional return. By considering this. Principles of Business Cycle. book-keeping and report preparing. Principals of Time Value of Money: The time value of money is one of the most important concepts in finance. In the time of investment. Dept of Banking. c. which can make highest value of share. it is very necessary for every company to know about the techniques and principles of business finance and the perfect application of those principles. d. 2.Principles of Finance Dividend Distribution Ratio. Principles of Cash Flow: Prof M. 3. 5. e. When organization finance in any project it must consider this principle. Muzahidul Islma. Regardless of inflation. collection of information regarding external financing. These principles come under consideration while taking decisions about fund collection. this principle should be under consideration. The major principles of business finance are given below: 1. Principles of Time value of Money. opening insurance policy. management will be able to take the right decisions because the maximum financial decision is taken in uncertainty. 3. Dhaka University . 1. Principles of Profitability and Liquidity. financial risk and financing any project. That is this principle says. Routine function refers to the daily work of an organization.

7. Prof M. So. marketable security etc. say. one should consider the adjustment between investment and business cycle. But if the firm wants to maximize profit. it will have to invest much and in this case the liquidity will have to be kept short which will lead it to a money crisis. Principles of Diversity: Finance Managers use this principle in Asset Management. instead of investing more in a specific asset of a business like stock. At the time of finance/investment decision. 4.Principles of Finance Cash flows are the blood of the firm. So Cash flows are very much important for the firm. this principle is very important. There is a trade off between liquidity and profitability. long-term assets should be financed by long term sources of financing. we can say that principle of finance is very important for financial management in decision-making. 5. The primary focus of the financial manager is both on managing day-to-day finances & planning and taking strategic decisions for the creation of shareholder’s value. a financial manager should have the ability to adjust between profitability and liquidity to avoid both excess liquidity and low profit. Hedging Principles: In case of fund collection and investment. short-term assets should be financed by short-term liability. one should invest money in other business assets like accounts receivables. it is possible to reduce the risk related to investment. which is discussed under Principles of cash flow. depreciation and recovery in economy. Both investment decision and business cycle can influence each other. i. This principle says cash inflows and cash outflows must be comparable in the business. Dhaka University . In the time of boom. The moral of this principle is that the maturity of the firm’s asset should match with the maturity of that firm’s liability. If an organization wants to maintain more liquidity. recession. For example. Principles of liquidity and profitability: Liquidity and profitability stands against one another. Through this. If one organization can make the proper use of these principles then this organization will be able to minimize the risk also. Dept of Banking. Principles of Business Cycle: According to this principle a level of business cycle should be maintained while taking every single financial decision.e. As a result the profit will get down. Muzahidul Islma. The basic of this principle is to invest in several projects instead of investing in a specific single project to reduce the risk and uncertainty in case of an investment decision. From the above. it will have little to invest. considering economic condition is the main subject while taking financial decision. Gaining more of one ordinarily means giving up some of the other. 6.