Functions of finance play an important role for an organization to promote its strengths & improve its weakness in order to become successful. There are number of functions of finance, which should be described well.
Functions of Finance
- Financial strengths & weaknesses are determined in order to formulate strategy
- Investment decisions
- Dividend decisions
- Financing decision
There are three main decisions that are associated with functions of finance / accounting which are financing decision, investment decision & dividend decision. In these decisional areas of Financial Management, there is a suitable method called financial ratio analysis that is mostly used by the organizations in ascertaining their strengths & weaknesses. It is obvious that all the functional areas of an organization are interrelated with one another therefore financial ratio analysis can be served as best method for highlighting the strengths & weaknesses of the organization in the functional areas of production, finance, marketing, information systems & research & development activities.
Capital budgeting is one of important investment Decision Making Technique in which capital & resources are allocated to certain projects, divisions, assets & products. When the formulation of strategies is made effectively then these strategies are implemented through capital budgeting decisions. The financing decisions are related to the determination of best capital structure for the organization along with evaluation of various methods of raising capital for the organization which may be in the shape of increasing debt, issuing stock or selling assets of the organization. Both the short term as well as long term needs of the working capital is considered in financing decisions. There are two financial ratios that clearly represent the effectiveness of the financing decisions of the organization. These value able financial ratios are debt-to-total asset ratio & debt-to-equity ratio.
The decisions related to dividend are concerned about certain issues like the stability of dividends paid over time, percentage of earnings paid to shareholders & the repurchasing or issuance of stock. The comparison between the amount paid as dividend and the amount of funds retained in the business is made in the dividend decisions.
There are three financial ratios that are helpful in ascertaining the dividend decisions of an organization which are dividends-per-share ratio, earning-per-share ratio & price-earnings ratio. Although there is no strict formula but the organization should balance the dividends paid to shareholder & the portion of dividends retained in the organization. In certain cases the organization decides to pay dividend to shareholders in spite of the fact that these dividends can become beneficial if they are reinvested in the organization. Moreover in some cases the organization raise outside funds in order to arrange dividend for their shareholders. The payment of dividends to stockholders is highlighted through the following points.
- In certain conditions it is customary to pay cash dividend which otherwise is considered as stigma & signals about the future of the organization.
- Investment bankers & other institutions considered those organizations that pay regular dividends to its stockholders.
- The shareholders are much interest in receiving dividends from the organization although the reinvestment of that dividend in the organization is beneficial.
- There is myth among people that dividend payment will enhance the stock prices
Fundamental Types of Financial Ratios
Income statement & balance sheet of an organization serve as source of preparing Financial Ratios. The financial ratios provide results that are pertained to one point in time picture of particular situation. Strengths & weaknesses of the organization are better highlighted by comparing financial ratios of organization from one period to another or with the industry averages. Both the time & industry average aspects of financial ratios are identified through trend analysis technique.
There are following five types of financial ratios.
- Liquidity Ratios
The measurement of clearing short term maturing obligations of organization is represented by the liquidity ratios. Following ratios are included in this category.
- Current ratio
- Quick or acid test ratio
- Leverage Ratios
The measurement of degree to which organization is financed is shown through leverage ratios. Following are some examples of these ratios.
- Debt to equity ratio
- Debt to total assets ratio
- Long term debt to equity ratio
- Times interest earned or coverage ratio
- Activity Ratios
The measurement of effectiveness of organization in the utilization of its resources is represented through activity ratios. Following are some of important activity ratios.
- Fixed assets turnover
- Inventory turnover
- Accounts receivables turnover
- Total assets turnover
- Average collection period
- Profitability Ratios
The measurement of overall effectiveness of the management in terms of returns produced on sales & investment is shown through profitability ratios. Following are some of examples of profitability ratios.
- Operating profit margin
- Gross profit margin
- Net profit margin
- Earnings per share
- Return on total assets (ROA)
- Price earnings ratio
- Return on shareholder’s equity (ROE)
- Growth Ratios
The ability of an organization to keep its economic position in the growth of industry economy is measured through growth ratios. Following are some of examples of growth ratios.
- Net income
- Dividends per share
- Earnings per share
Limitations of Financial Ratios
- Financial ratios have certain limitations which are as follow.
- Financial ratios are based on accounting data and different organizations use different techniques in dealing certain items like inventory valuation, depreciation, pension plan costs, research & development expenditures taxes, mergers etc.
- Comparative ratios are influenced by seasonal factors.
- The difference from the industry averages does not necessarily means that the organization is performing well or badly.
- The financial condition of organization is based on certain other factors too, besides only on the functions of finance/accounting like marketing, production, research and development, actions by suppliers, competitors etc.