UNIT 1
STRATEGIC FINANCIAL MANAGEMENT
The term ‘’strategic financial management ‘’ aims at controlling and looking at all the finances of the company to achieve the desired targets and earn the desired profits for the company. The function of Strategic financial management starts from detecting the number of funds required for the business, then looking for the means or the ways through which these funds are raised at cheaper rates so that the financial requirement of the business are fulfilled. In other words, it can also be termed as applying principles of management to the financial resources of an organisation.
- Helps In Detecting The Requirements Of Capital In The Business
The first and foremost function of financial management is that it initially estimates the finance needed for the smooth running and functioning of the business. This is one of the primary duties of financial managers. The finance requirements of every business will vary due to the size of the operation, their profit target, and various other objectives and mission.
2. Helps In Deciding The Composition Of The Capital Structure
Once the capital requirements of the business are calculated, now the next function that needs to be completed by the financial manager is deciding what type of capital structure should be there. This basically involves the choices between the short-term and long-term sources of funds and also takes into consideration the cost involved in the raising of this finance.
3. Helps In Choosing Right Source Of Funds
As there is a different source of raising funds are available in the market. This step simply aims at choosing the most appropriate and accurate one. The common types of fundraising methods are raising funds through issuing shares & debentures, simply taking loans from the financial institution, or through the issuance of securities like bonds.
4. Allocating And Investing In Finance Raised
Now after the accurate amount of funds is raised then these funds are invested in various means that are revenue-generating for the business and are also in line with the objectives and goals of the business.
5. The Utilisation Of The Surplus Amount
It is concerned with a decision regarding the profit generated by the business and how it should be utilized and there are basically two options available for this profit utilization that are either excess profit should be used for distribution as a dividend or for the retained earnings depending on the future plans of the company.
6. Controlling All Cash Expenses
This simply means management of the cash so that neither of the expense goes out of the budget. It consists of various expenses where cash payments are to be made like salaries and wages payments, and expenses of water and electricity bills, and also the amount required for the purchase of the raw materials, etc.
7. Controlling All Finance
It is one of the important functions as it is the one which plays a very effective role in the accomplishment of the goals and objectives of the business. It makes sure that whether all the activities are going in accordance with the pre-decided plans and if not accurate control measures are taken.
Today most business enterprises engage in strategic planning, although the degrees of sophistication and ritual vary considerably. Conceptually, strategic planning is deceptively simple: Analyze the present and expected future situation, determine the direction of the firm, and develop means for achieving the mission. Actually, this is often a particularly complex process which demands a scientific approach for identifying and analyzing factors external to the organization and matching them with the firm’s capabilities.
Planning is completed in an environment of risk and uncertainty. Managements can't be sure what the external also because the internal environment is going to be even next week, much less several years from now: Therefore, management make assumptions or forecasts referred to as planning premises about the anticipated environment. A number of the forecasts become assumptions for other plans. For instance, the gross national product forecast becomes the idea for sales forecast, which successively becomes the idea for production planning then on.
Strategies and policies are closely related. Both give direction, both are the frame works for plans, both are the idea of operational plans, and both affect all areas of managing.
The term “strategy” (which springs from the Greek word strategies, meaning “general”) has been utilized in alternative ways. Authors differ in a minimum of one major aspect about strategies. Some writers specialize in both the top points (purpose, mission, goals, and objectives) and therefore the means of achieving them (policies and plans). Others emphasize the means to the ends within the strategic process instead of the ends intrinsically.
Policies are general statements or understandings which guide managers thinking in deciding. They make sure that decisions fall within certain boundaries. They typically don't require action but are intended to guide managers in their commitment to the choice they ultimately make.
The essence of policy is discretion. Strategy on the opposite hand, concerns the direction during which human and material resources are going to be applied so as to extend the prospect of achieving selected objectives.
Although Specific steps within the formulation of the strategy may vary, the method are often built, a minimum of conceptually, round the key elements which are as follows:
- Inputs
The various organizational inputs are the goal inputs of the claimants.
2. Enterprise Profile
The enterprise profile is typically the start line for determining where the corporate is and where it should go. Thus, top managers determine the basic purpose of the enterprises and clarify the firm’s geographic orientation, like whether it should operate in selected regions, altogether states within them, or maybe in several countries. Additionally, managers assess the competitive situation of their firm.
3. Orientation of Top Managers
The enterprise profile is formed by people, especially top managers, and their orientation is vital for formulating the strategy. They set the organizational climate, and that they determine the direction of the firm. Consequently, there values, their preferences, and their attitudes toward risks need to be carefully examined because they need an impression on the strategy.
4. Purpose and Objectives
The purpose and therefore the major objectives are the top points towards which the activities of the enterprise are directed. Since the previous chapter addressed these topics at length, additional discussion here makes no sense.
5. External Environment
The present and future external environment must be assessed in terms of threats and opportunities. The evaluation focuses on economic, social, political, legal, demographic, and geographic factors. Additionally, the environment is scanned for technological developments, for products and services on the market, and for other factors necessary in determining the competitive situation of the enterprises.
Internal Environment
Similarly the firms’ internal environment should be audited and evaluated in reference to its weaknesses and strengths in research and development, production, operations, procurement, marketing, and products and services. Other internal factors important for formulating a technique include that the assessment of human resources, financial resources, and other factors like the corporate image, the organization structure and climate, the design and system, and relations with customers.
6. Alternative Strategies
Alternative strategies are developed on the idea of an analysis of the external and internal environment. A corporation may pursue many various sorts of strategies. It's going to specialize or concentrate, because the South Korean Hyundai Company did by producing lower-priced cars (in contrast to General Motors, for instance, which features a complete line starting from inexpensive to luxurious cars).
Alternatively, a firm may diversity, extending the operation into new and profitable markets. “Sears” not only is in retailing but also provides many financial services.
Still another strategy is to travel international and expand the operation into other countries. The multinational firms provide many examples. An equivalent chapter also examines joint ventures, which can be an appropriate strategy for a few firms need to pool their resources, as illustrated by the venture of General Motors and Toyota to supply small cars in California.
Under certain circumstances, a corporation may need to adopt a liquidation strategy by terminating an unprofitable line or maybe dissolving the firm. But in some cases liquidation might not be necessary and a retrenchment strategy could also be appropriate. In such a situation the corporate may curtail its operation temporarily.
These are just a couple of samples of possible strategies. In practice, companies, especially large ones, pursue a mixture of strategies.
7. Evaluation and selection of Strategies
The various strategies need to be carefully evaluated before the selection is formed. Strategic choices must be considered in light of the risks involved during a particular decision. Some profitable opportunities might not be pursued because a failure during an adventure could end in bankruptcy of the firm. Another critical element in choosing a technique is timing. Even the simplest product may fail if it's introduced to the market at an inappropriate time. Moreover, the reaction of competitors must be taken into consideration. When IBM reduced its price of its PC’s as are action to the sales success of Apple’s Macintosh computer, firms producing IBM- compatible computers had little choice but to scale back their prices also. This illustrates the interconnection of the strategies of several firms within the same industry.
8. Medium and Short-Range Planning, Implementation, and Control
Although not a neighborhood of the strategic planning process and short- range planning also because the implementation of the plans must be considered during all phases of the method . Control must even be provided for monitoring performance against plans. The importance of feedback is shown by the loops within the model.
9. Consistency and Contingency
The last key aspect of the strategic planning process is testing for consistency the preparing for contingency plans.
For a commercial enterprise and, with some modification, for other forms of organizations as well), the main strategies and policies that give an overall direction to operations are likely to be within the following areas.
Growth
Growth strategies give answers to such questions as these: what proportion growth should occur? How fast? Where? How should it occur?
Finance
Every commercial enterprise and, for that matter, any non commercial enterprise must have a transparent strategy for financing its operations. There are various ways of doing this and typically many serious limitations.
Organisation
Organisational strategy has got to do with the sort of organizational pattern an enterprise will use. It answers practical questions. For instance, how centralized or decentralized should decision-making authority be? What sorts of departmental patterns are most suitable? How should staff positions be designed? Naturally, organization structures furnish the system of roles and role relationships that help people accomplish objectives.
Personnel
There are often many major strategies within the area of human resources and relationships. They affect such topics as union relations, compensation, selection, hiring, training, and appraisal, also like special areas like job enrichment.
Public Relations
Strategies during this area can hardly be independent; they need to support other major strategies and efforts. They need to even be designed within the light of the company’s sort of business, its closeness to the general public, and its susceptibility to regulation by government agencies. In any area, strategies are often developed as long as the proper questions are asked. While no set of strategies are often formulated which will fit all organizations and situations, certain key questions will help any company discover what its strategies should be. The proper questions will cause answers.
As examples, some key questions are presented below for 2 major strategic areas: products or services and marketing. With a touch thought, you'll devise key questions for other major strategic areas.
Products or Services
A business exists to furnish products or services. Actually, profits are merely a measure-although a crucial one-of how well a corporation serves its customers. New products or services, quite the other single factor, determine what an enterprise is or are going to be.
The key questions during this area can summarized as follows:
What is our business?
Who are our customers?
What do our customers want?
How much will our customers buy and at what price?
Do we wish to be a product leader?
Do we wish to develop our own new products?
What advantages can we have in serving customer needs?
How should we answer existing and potential competition?
How far can we enter serving customer needs?
What Profits can we expect?
What basic form should our strategy take?
Marketing
Marketing strategies are designed to guide managers in getting products or services to customers and in encouraging customers to shop for. Marketing strategies are closely associated with product strategies; they need to be interrelated and mutually supportive. As a matter of fact, Peter Drucker regards the 2 basic business functions as innovation (e.g., the creation of latest goods or services) and marketing. A business can scarcely survive without a minimum of one among these functions and preferably both.
The key questions that function guides for establishing a marketing strategy are these:
Where are our customers, and why do they buy?
How do our customers buy?
How is it best for us to sell?
Do we have something to supply that competitors do not?
Do we wish to require legal steps to discourage competition?
Do we need, and may we supply, supporting services?
What are the simplest pricing strategy and policy for our operation?
The term policy springs from the Greek word ‘politeia’ concerning policy, that's citizen and Latin word ‘politis’ meaning polished, that is to say , clear. According to New Webster Dictionary, policy means the art or manner of governing a nation, the road of conduct which rulers of a nation adopt on a specific question especially with reference to foreign countries, the principle on which any measure or course of action is based.
While these descriptions of policy relate to any field, policy within the organizational context is defined as “management’s expressed or implied intent to control action within the achievement of company’s aims”. This definition, however, is at high level of abstraction and requires simplification. It suggests that it governs actions of individuals within the organization but doesn't say how the action is governed. Therefore, an operational definition of policy could also be as follows:
A policy may be a statement or general understanding which provides guidelines in decision-making to members of a corporation with reference to any course of action.
On the idea of this definition, following features of policy are often identified:
- A policy provides guidelines to the members of the organization for deciding a course of action and, thus, restricts their freedom of action. Policy provides and explains what a member should do instead of what he's doing. Policies, when enforced, permit prediction of roles with certainly. Since a policy provides guidelines to thinking in decision-making, it follows that it must allow some discretion; otherwise it'll become a rule.
2. Policy limits a neighborhood within which a choice is to be made and assures that to decision are going to be according to and contributive to objectives. A policy tends to pre decide issues, avoid repeated analysis, and provides a unified structure to other sorts of plans, thus permitting managers to delegate authority and still retain control of action. For instance, if the organization has framed a policy that higher positions within the organization are going to be filled by internal promotion, the managers concerned can affect things during this light whenever a vacancy at higher level arises. Thus organization gets assurance that higher positions are filled by internal members without further control.
3. Policies are generally expressed in qualitative, conditional, or general way. The verbs most frequently utilized in stating policies are to take care of , to continue, to follow, to adhere, to supply , to assist, to assure, to employ, to make, to supply , or to be. Such prescriptions could also be either explicit or these could also be interpreted from the behavior of organization members, particularly at the highest level. When such a behavior is interpreted as policy guideline it's normally referred to as precedent that's what went on within the past on a specific issue if there's no clearly specified declaration.
4. Policy formulation may be a function of all managers within the organization because some sort of guidelines for future course of action is required at every level. However, higher the extent of a manager, more important is his role in politics. Similarly, policies may exist altogether in areas of the organization from major organizational policies to minor policies applicable to the littlest segment of the organization.
A policy is somewhat a permanent feature of an organization. It being a standing plan provides guidelines to managerial decisions. Therefore, policies should be developed on a sound basis. If this is often not done, managers need to make decisions again and again.
However, what features constitute a sound policy can't be prescribed universally because situations vary so greatly that a corporation may differ in respect of a policy formulation and implementation from others. However, the soundness of policy is often judged on the idea of following criteria:
- Does it reflect present or desired organizational practices and behaviour?
- Is it clear, definite, and explicit leaving no scope for misinterpretation?
- Does it exist within the area critical to the success of the organization?
- Is it according to other policies and does it reflect the timing needed to accomplish the objectives?
- Is it practical during a given existing or expected situation?
A sound policy will (i) specify more precisely how the choice will come – what's to be done, who is to try to it, how it's to be done, and when it's to be finished; (ii) establish a follow-up mechanism to form sure that the choice intended will happen and (iii) cause new strengths which may be used for decisions in future. Supported these questions and specifications, some major characteristics of a sound policy are often identified as follows:
Relationship to Organisational Objectives
A policy is formulated within the context of organizational objectives. Therefore, it tries to contribute towards the achievement of those objectives. Therefore, in formulation of a policy, those functions or activities which don't contribute to the achievement of objectives should be eliminated. For instance , if a policy of filling higher positions from within produces hindrance in attracting talents at higher level but the organization needs them, the policy are often changed because within the absence of suitable manpower, the organization might not be ready to achieve its objectives.
Planned formulation
A policy must be the results of careful and planned formulation process instead of the results of opportunistic decisions made on the spur of the movement. Since policies are relatively permanent features of the organization, adhocism should be avoided because it's likely to make more confusion. It's true it's impossible to unravel every problem within the organization on the idea of policies because new situations may arise, however, for matters of recurring nature, there should be well-established policies.
Clarity
As far as possible, policy should be clear and must not leave any scope for ambiguity. If there's a drag of misinterpretation, the organization should provide the tactic for overcoming the anomaly. Further, policy provides some discretion for managerial decisions but it should minimize the amount of cases were decisions are supported judgment in personam. If this happens frequently, there should be close scrutiny of the policy and suitable amendments should be made.
Consistency
The policy should provide consistency within the operation of organizational functions. Often the organization formulates various functional areas and every function is said to other functions of the organization. If the policy in one area is inconsistent with another area, there could also be conflict resulting into inefficiency. This happens very frequently in functions. Therefore, the formulation of policies should be taken in an integrated way in order that policies in each area contribute to other areas also.
Balanced
A sound policy maintains balance between stability and adaptability. On the one hand, a policy may be a long-term proposition and it must provide stability in order that members are cognizant about what they're required to try to in certain matters. On the opposite hand, the policy shouldn't be so inflexible that it can't be changed when the necessity arises. During a changed situation, the old policy becomes obsolete. Therefore, there should be a periodic review of policies and suitable changes should be incorporated from time to time. The changes could also be within the sort of addition, deflection, or substitution of the prevailing policy.
Must be in Writing
A policy could also be within the form a press release or it's going too interpreted by the behavior of the people at the highest level. However, clearly-specified policy works better than the one which has got to be interpreted by the organization members. When the policy is in writing, it becomes more specific and clear. It creates an environment during which individuals can take actions. A written policy is simpler to speak through the organizational manuals. However, written policy has certain disadvantages in the shape of being flexible, an excessive amount of emphasis on written words and their interpretation, and leakage of confidential policy. However, if the policy has been formulated carefully, many of the risks are going to be overcome. Of course, confidential policies can't be made a part of organizational manuals.
Communication
It's not just sufficient to formulate policies. Unless they're communicated property to the persons concerned, no meaningful purposes are going to be served. Therefore, a system should be developed to speak the policies to them who are to form decisions within the light of these policies. While written policies are often communicated easily, problems exist for communicating with written ones. In such cases, there should be more frequent interaction between policy framers and policy implementations.
Strategy
The term strategy is extremely well researched in management. The word strategy has entered within the field of management more recently. It’s been derived from Greek work ‘strategos’ which suggests general. Therefore, the word strategy means the art of general. Strategy isn't to be confused with tactics which may be a short term response to a drag or threat while strategy may be a long term process with well defined goals and objectives. Learned etc., have defined strategy as follows:
“Strategy is that the pattern of objectives, purposes or goals, stated in such how on define what business the corporate is in or is to be in and therefore the quite company it's or is to be”.
Chandler is more explicit on the topic, when he defines strategy as follows:
“Strategy is that the determination of basic long-term goals and objectives of an enterprise, and the adoption of course of action and the allocation of resources necessary for completing these goals".
If this view is taken, the scope of strategy becomes too broad to incorporate all managerial functions related with the achievement of organizational objectives with the co-operation of others. Further, whether strategy formulation should include objective determination is also not prescribed. For instance, one view suggests that strategy may be a way during which the firm, reacting to its environment, deploys its principal resources and marshals its main efforts in pursuit of its purpose. This is often wiped out context of organizational objectives. The controversy are often aside by identifying two sorts of strategies; master, root, or grand strategy and competitive strategy. In fact, the marshalling of resources may be a sort of competitive strategy while master strategy may include objective formulation also because the resultant actions. Therefore, strategy can be defined as follows:
"Strategy is that the determination of organizational objectives within the light of environmental variables and determination of course of action and commitment of organizational resources to achieve those objectives".
Based on these definitions of strategy, its following features are often identified.
- Strategy is that the action of relating the organization with its environment, particularly the external environment, management and treats a corporation as a part of a society consequently suffering from it.
2. Strategy is that the right combination of things both external and internal. In relating a corporation to its environment, management must also consider the interior factors too, particularly in terms of its strengths and weaknesses, that is, what it can do and what it cannot do.
3. Strategy may be a relative combination of actions. The mixture is to satisfy a specific condition, to unravel certain problems, or to achieve a desirable objective. It’s going to take any form; for various situations vary and, therefore, require somewhat different approach.
4. Strategy may involve even contradictory action. Since strategic action depends on environmental variables, a manager may take an action today and should revise or reverse his steps tomorrow counting on things.
5. Strategy is forward looking. It’s to try to orientation towards the longer term; Strategic action is required during a new situation. Nothing new requiring solutions can exist within the past, therefore, strategy has relevancy only to future. It's going to take advantages of the past analysis.
It is desirable to form distinction between strategy and tactics in order that top-level managers concentrate more on strategic functions instead of engage themselves in tactical functions. The main difference between strategy and tactics is that strategy determines what major plans are to be undertaken and allocates resources to them, while tactics is means by which previously determined plans are executed. Beyond this major difference, there are other differences which may be better understood by analyzing these words as utilized in military.
Therefore, from business point of view, the excellence between strategy and tactics are often identified as follows:
- Level of Conduct: Strategy is formulated at the top-level management, either at the headquarter level or major divisional office level. Tactics is used at comparatively lower-level management. In fact, tactics springs from the strategy itself and works within the parameters developed by it.
2. Periodicity: The formulation of strategy is both continuous and irregular. The method is continuous but the timing of decision is irregular because it depends on the looks of opportunities, new ideas, management initiative, and other non-routine factors. For instance, information collection which can form the idea of strategy formulation may be a regular process but when the choice on the knowledge is going to be taken isn't sure and, therefore, irregular. Tactics is decided by various organizations on endless periodic basis. For instance, budget preparation, a tactical exercise, may be a regular feature.
3. Time Horizon: Strategy features a long-term perspective; especially the successful strategies are followed for long periods. However, if the actual strategy doesn't succeed, it's changed. Thus counting on things, strategy may have flexible time horizon; however, emphasis is on future. On the opposite hand, time horizon of tactics is brief term and definite. Moreover, the duration is usually uniform. For instance, budgets are prepared at regular time intervals and for comparatively short period of your time. Deployment of resources, a part of strategy, is a decision committed for very long period, being investment in plant and machinery.
4. Information Needs: Formulation of strategy also as tactics requires the utilization of certain information. However, the sort of data required for 2 elements differs considerably. Within the case of strategic decisions, mangers require more information. Moreover, some assumptions are made about the character of environmental factors. In fact, strategic decisions are made under the condition of partial ignorance because managers don't have all the knowledge about the environment. Tactical decisions are taken basically on the knowledge generated within the organization, particularly from accounting and statistical sources.
5. Subject Values: The formulation of strategy is affected considerably by the private values of the persons involved within the process. For instance, what should be the target of the organization; a strategic decision is suffering from the private values of the person concerned. On the opposite hand, tactics in normally freed from such values because this sort of decision is taken within the context of strategic decisions.
6. Importance: Strategic decisions are more important for the organizational effectiveness as they decide the longer term course of the organization as an entire. They decide the character of the organization. On the opposite hand, tactical decisions are smaller because they're concerned with specific a part of the organization. This difference, though simple, is sort of important because once a technique fails; the organization requires considerable time to recoup its position.
Though these differences between strategy and tactics are there, often in practice, two are blurred. At one extreme, the differences between the 2 are quite clear, but at the opposite end, these differences might not hold well because tactics is generated by strategy and may be called as sub strategy.
Strategies and policies are important altogether sorts of organizations- business or non-business, public sector or private sector, small or large, in developed countries or underdeveloped countries. The systems approach of management suggests interaction of a corporation with its environment on continuous basis. This interaction can better be maintained through formulation of suitable strategies and policies. In fact, the function of formulation of strategies and policies has become so important that it's equated with total top management function because it's the highest management which is primarily liable for organizational adaptation to the requirements of environment.
Careful strategies and policies play a big role within the success of a corporation. If we glance at the Indian industrial scene over the last generation approximately , we discover that great names like Martin Burn, Jessops, Andrews have touched the lowest , while total unknowns few years ago like Reliance, Larsen and Tourbo, etc., have touched gigantic heights. Similarly, companies like Hindustan Lever, ITC Limited, TISCO, TELCO, have maintained their status. There are numerous such samples of good companies within the Indian scene also because the world over which are successful because they need adopted suitable strategies and policies. This happens because strategies and policies contribute in several ways in managing an organization; the more important of them are as follows:
- Framework for planning: Strategies and policies provide the framework for plans by channeling operating decisions and sometimes pre deciding them. If strategies and policies are deployment of organizational resources in those areas where they find better use. Strategies define the business area both in terms of consumers and geographical areas served. Better the definition of those areas, better are going to be the deployment of resources. For instance, if a corporation has set that it'll introduce new products within the market, it'll allocate more resources to research and development activities which are reflected in budget preparation.
2. Clarity in Direction of Activities: Strategies and policies specialise in direction of activities by specifying what activities are faithful be undertaken for achieving organizational objectives. They create the organizational objectives more clear and specific. For instance, a business may define its objective as social objective. But these definitions are too broad and even vague for putting them into operation. They’re better spelled by strategies which specialise in operational objectives and make them more practical. For instance, strategies will provide how profit objective are often sharply defined in terms of what proportion profit is to be earned and what resources are going to be required for that. When objectives are spelled call at these terms, they supply clear direction to persons within the organization liable for implementing various courses of action. Most of the people perform better if they know clearly what they're expected to try to and where their organizational goes.
Looking into the role of strategy and policy, Ross and Kami have suggested that “Without a technique the organization is sort of a ship without a rudder, going around in a circle. It’s sort of a tramp; it's no place to travel. They ascribe most business failures to lack of strategy, or the incorrect strategy, or lack of implementation of a fairly good strategy. They conclude from their study that without appropriate strategy effective implemented, failure may be a matter of time".
Formulation of strategies and policies may be a creative and analytical process. It’s a process because particular functions are performed during a sequence over the amount of your time. The method involves variety of activities and their analysis to reach a choice. Though there might not be unanimity over these activities particularly within the context of organizational variability, an entire process of strategy and policy formulation can be understood from below mentioned points.
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- Corporate Mission and Objective: Organisational mission and objectives are the start line of strategy and policy formulation. As discussed earlier, mission is that the fundamental unique purpose of a corporation that sets it aside from other organizations and objective is that the end-result which a corporation strives to realize. These together provide the direction of which other aspects of the method are going to be haunted.
2. Environmental Analysis: The second aspect of the method is that the environmental analysis. Since the essential objective of strategies and policies is to integrate the organization with its environment, it must know the type of study. The method of environmental analysis includes collection of relevant information from the environment, interpreting its impact on the longer term of organizational working, and determining what opportunities and threats-positive and negative aspects- are offered by the environment. The environmental information is often collected from various sources like various publications, verbal information from various people, spying, and forecasting. The method of environmental analysis works better if it's undertaken on continuous basis and is formed an intrinsic a part of the strategy formulation.
3. Corporate Analysis: While environmental analysis is that the analysis of external factors, corporate analysis takes under consideration the interior factors. These together are referred to as SWOT (strengths, weaknesses, opportunities and threats) analysis. It’s not only enough to locate what opportunities and threats are offered by the environment but equally important is that the analysis of how the organization can take the benefits of those opportunities and overcome threats. Corporate analysis discloses strengths and weaknesses of the organization and points out the areas during which business are often undertaken. Corporate analysis is performed by identifying the factors which are critical for the success of this or future business of the organization then evaluating these factors whether or not they are contributing in positive way or in negative way. A positive contribution is strength and a negative contribution may be a weakness.
4. Identification of Alternatives: Environmental analysis and company analysis taken together will specify the varied alternatives for strategy and policy. Usually this process will bring sizable amount of alternatives. For instance, if a corporation is robust in financial resources, these are often utilized in some ways, taking several projects. However, all the ways or projects can't be selected. Therefore, some criteria should be found out to gauge each alternative. Normally the standards are set within the light of organizational mission and objectives.
5. Choice the Strategy and Policy: The identification and evaluation of varied alternatives will narrow down the range of strategies and policies which may seriously be considered for choice. Choice is deciding the suitable alternative among the several which inserts with the organizational objectives. Normally at this stage personal values and expectations of decisions-maker can also play a crucial role in strategy and policy formulations. This happens because in a method, the organizational objectives reflect the private philosophy of people particularly at the highest management level.
6. Implementation: After the strategy and policy are chosen, they're put to implementation, that is, they're put into action. Choice of strategy and policy is usually analytical and conceptual while implementation is operational or putting them into action.
Various factors which are necessary for implementation are design of suitable organization structure, developing and motivating people to require up work, designing effective control and knowledge system, allocation of resources etc., when these are undertaken, these may produce results which may be compared within the light of objectives set and control process comes into operation. If the results and objectives differ, an extra analysis is required to seek out the explanations for the gap and taking suitable actions to beat the issues due to which the gap exists. This might require a change in strategy and policy if there's a drag due to the formulation inadequacy. This puts back the managers at the start line of the strategy and policy formulation.
The concept of corporate planning has in recent years gained wide currency in management literature. Its connotation is somewhat overlapping with the concept of strategic planning. It is, therefore necessary that the scope of corporate planning and strategic planning should be clearly understood.
Simply stated, corporate planning may be a comprehensive planning process which involves continued formulation of objectives and therefore the guidance of affairs towards their attainment. It’s a scientific of the objectives of a corporation or corporate body, determination of appropriate targets, and formulation of practical plans by which the objectives might be achieved. It's undertaken by top management for the corporate as an entire on endless basis for creating entrepreneurial (risk- taking) decisions systematically and with the simplest possible knowledge of their probable outcome and effects, organizing systematically the efforts and resources needed to hold out the choices , and measuring the results of those decisions against the expectations through organized systematic feedback.
The object of corporate planning is to spot new areas of investment and marketing. Initiating new projects, new courses of action and analyzing past experience are the subject-matter of corporate planning.
Thus, it implies
- The imposition of a planning discipline on this operations of the business, and
- A reappraisal of the business and of the company planning competencies to the foremost profitable uses. Innovation is that the core of such planning. At an equivalent time it ensures that managers are continually measuring their performance against the company’s long-term profit and market objectives, evaluating alternative methods of reaching the goals, and keeping in-tuned with changes within the market and in technology.
The comprehensive nature of the company planning process lies therein operational planning, project planning and strategic planning are its constituents. Let us to examine the character and scope of each of those constituents.
It is essential for each firm to manage its ongoing operations efficiently to stay the business a float within the market with which it's familiar. Operational planning is important soon make sure that changes within the market situation for the prevailing line don't adversely affect the earnings of the firm. Thus, operational planning involves study of the market conditions for the prevailing range of products to take care of and improve the position of the firm within the face of competition. It essentially a short-term exercise and deals with the prevailing product, market and facilities.
The degree of uncertainly in operational planning is of a coffee order; the time span of discretion is short; choice not alternatives is comparatively simple. But the firm can ill-afford to ignore long-term changes within the product markets. It’s to seem for brand spanking new markets for the prevailing product, develop new products, create a marketplace for an equivalent, and utilize the prevailing facilities and expertise to satisfy new requirements. Considerations like these characterize project planning, which may be a forward looking exercise concerned with new markets, new products and new facilities. Project planning, therefore involves a greater degree of uncertainty, and demands a better order of judgment on the part of planners thanks to the risks involved.
Strategic planning refers of a unified, comprehensive and integrated plan aimed toward relating the strategic advantages of the firm to the challenges of the environment. It’s concerned with appraising the environment in reference to the corporate, identifying the strategies to get sanction for one among the alternatives to be interpreted and communicated in an operationally useful manner. Thus, strategic planning provides the framework within which future activities of the corporate are expected to be administered. Compared with project planning, the time span of discretion in strategic planning is far longer, the degree of uncertainly and corresponding risks involved are much greater, and judgment to be exercised is more important.
In the maximum amount as strategic planning determines the longer term direction of a corporation, corporate planning is actually supported strategic planning, and at an equivalent time takes care of project planning and operational planning. Thus corporate planning is described as a proper systematic managerial process, organized by responsibility, time and knowledge , to make sure that operational planning, project planning and strategic planning are administered regularly to enable top management to direct and control the longer term of the enterprise. It follows that corporate planning cares determinedly of objectives and developing means to realize the objectives. It’s going to encompass both short periods also as long periods.
The time span depends on how far ahead a corporation wants to forecast and to plan, which, in turn, depends upon the character of business that the corporate wants to be in and commitment of resources required for it. As an example, within the modern heavy engineering industry, commitment of resources is usually required for a reasonably long period-10-15 or 20 years. Within the ready-made apparel industry, on the opposite hand, resource commitment is for a really short period, generally required for a reasonably long period –10, 15 or 20 years. Inside the ready-made apparel industry, on the opposite hand, resource commitment is for a really short period, generally one year, in order that operations could also be adapted to changing fashions and taste.
Therefore, corporate planning in an engineering enterprise will involve long-term considerations regarding market demand, technology and such other factors. It’ll have a brief time horizon within the case of apparel industry. Longtime horizon in view, generally five years or more. Corporate planning in capital-intensive industries is usually related to long-range planning. Besides, corporate planning cares with the prevailing products in existing markets also as new products and new markets. Long-range planning essentially takes care of only the prevailing products in existing markets.
A variety of reasons could also be adduced to justify business policy or strategic planning. One justification is that it's been found useful in practice. Research studies, supported the experience of companies and executive viewpoints, have indicated that strategic planning contributes positively to the performance of enterprises. Studies made by Igor Ansoff and his associates. Eastlack and Mc Donals David Herold have revealed that companies which had undertaken formal strategic planning not only outperformed the non-planners on most measures of success (return on equity, growth of sales, earnings per share, and value of the firm), but significantly outperformed their own past results also, besides, the businesses that used strategic planning were ready to predict the result of designing far better than others.
Malik and Karger in their analysis of the performance of 38 chemical/drug, electronics and machinery firms found that in nine out of 13 financial measures (sales volume, earnings per share, net , etc) firms having “formal, integrated, long-range planning” far outperformed those doing it informally. Investigations have also shown that strategic planning can isolate the key factors in an industry and thus help companies plan their strategies more effectively.
Executive viewpoints on the contribution of strategic getting to the success of firms were sought during a survey conducted by Ramanujam, Camillus and Venkatarman. The survey conducted 200 executives of US corporations. Their collective view clearly indicated that strategic management has been a big and important think about determining their individual and organizational success, as high as 887 p.c., of the respondents were of the view that reducing emphasis on strategic planning would be detrimental to their long-term performance. Again 70.6 p.c. Of the respondents stated that that they had improved the sophistication of strategic planning systems in their organisations.
Apart from the empirical evidence in support of strategic planning, it's justified on several other grounds. With fast changing environment of business and industry –product-market conditions, by which future opportunities and problems are often anticipated by company executives. It enables executives to supply necessary direction for the enterprise, take full advantage of latest opportunities and minimize the attendant risks.
Secondly, with clear goals and direction provided for the longer term, employees generally and mangers especially can better perceive the ways and means of achieving the company objectives consistently with the individual and group aspirations. This is often conducive to greater harmony and goal congruence. Moreover, formal strategic planning focuses on problems of the entire enterprise, not just functional problems within the marketing, finance or HRM areas. Persons exposed to strategy formulation thus develop a breadth of understanding and undergo change of attitudes within the process.
Strategic planning is probably going to be beneficial particularly in organisations when there's an extended delay between managerial decisions and therefore the results thereof. Thus, as an example, if research and development efforts take several years to finally design and manufacture a replacement product, events within the intervening period may nullify the result of the R&D effort supported the first decision. Strategic planning enables management to enhance the probabilities of creating decisions which can stand the test of your time, and revising the strategy on the idea of monitoring the progress of R & D and therefore the changes in product market conditions.
Thus, the benefits of a scientific approach to strategic planning and management could also be said to incorporate
(a) Providing necessary guidance to the whole organisation about what's expected to be achieved and the way
(b) Making managers more aware of new opportunities and potential threats
(c) Unifying organizational efforts resulting in greater harmony and goal congruence
(d) Creating a more proactive management posture
(e) Promoting a constantly evolving business model so on ensure bottom-line success for the enterprise and
(f) Providing the rationale for evaluating competing budget requests for steering resources into strategy-supportive and results- producing areas.
However, it might not be faithful contend that strategic planning alone invariably results in success. Achievements of corporate enterprises are caused by multiple factors: adequate resources, competent managers, specialist services, product-market conditions, then forth. Strategic planning may be a necessary, though not sufficient, condition for fulfillment. But is makes a difference. Executives who engage in formal strategic planning are likely to be simpler in achieving their objectives than those that don’t.
Formulation and implementation of strategies which constitute the 2 main aspects of strategic management could also be expected to yield several benefits.
1. Financial Benefits
On the idea of empirical studies and logical analysis it's going to be claimed that the impact of strategic management is primarily that of improved financial performance in terms of profit and growth of firms with a developed strategic management system having major impact on both planning and implementation of strategies.
2. Enhanced Capability of Problem Prevention
This is likely to result from encouraging and rewarding subordinate attention to planning considerations, and mangers being assisted in their monitoring and forecasting role by employees who are alerted to the requirements of strategic planning.
3. Improved Quality of Strategic Decisions through Group Interaction
The process of group interaction for decision-making facilitates generation of other strategies and better screening of options thanks to specialized perspectives of group members. The simplest alternatives are thus likely to be chosen and acted upon.
4. Greater Employee Motivation
Participation of employees or their representatives in strategy formulation results in a far better understanding of the priorities and operation of the reward system. Also there's better appreciation on their part of the productivity-reward linkage inherent within the strategic plan. Hence goal- directed behaviour is probably going to follow the incentives.
5. Reduction Resistance to vary
The advantage of acceptability of change with minimum resistance is additionally likely to follow the participative process of strategy making as there's greater awareness of the idea of selecting a specific option and therefore the limits to available alternatives. The uncertainty which is related to change in also eliminated within the process and resistance.
While the advantages of strategic management are well recognized, alongside the positive behavioral consequences of group-based strategic decisions, there are certain unintended negative effects as well:
- The method of strategic planning and management as a formalized system is of course a costly exercise in terms of the time that must be dedicated to it by mangers. But the negative effect of mangers spending time far away from their normal tasks could also be quite serious. For defaults on the part of managers in discharging their operational responsibilities could also be irreparable. This eventuality may in fact be guarded against. Mangers could also be trained to schedule their activities so on devote adequate time for strategic work without lowering the time they need to devote to normal operations.
b. Another sort of unintended negative effect may arise thanks to the non fulfillment of participating subordinates expectations resulting in frustration and disappointment. As an example, subordinates who are involved in strategy making at some stages may expect that their participation are going to be solicited in other areas too, which again might not happen. Such eventualities could also be unavoidable. So mangers got to be trained to anticipate disappointments, minimize the impact and respond constructively to the sense of frustration which will on occasions be experienced by subordinates.
c. A 3rd dysfunction or unintended effect of strategic management relates to the danger of participants shirking the responsibility of inputs within the decision-making process and therefore the conclusions subsequently drawn. This might happen if those related to the formulation of strategy aren't intimately involve the implementation of strategy. Hence, assurances with the outcomes and results of strategic decisions should be limited to the performance which will be achieved by the strategy-makers and their subordinates.
Is it worthwhile for managers of small business firms to interact within the strategic planning exercise? Little question the dimensions of a corporation can make a big difference in the nature and scope of designing. Small firms generally have a couple of products or services to supply, mainly because their resources and capabilities are limited. Usually they are doing not have formal procedures to watch the environment, make forecasts, or evaluate and control the prevailing strategy. Managerial personnel in such firms are mostly trained on the work. Thus, they have a tendency to believe experience as a guide, instead of on systematic, specified procedures. In many cases, the firms are owned and managed by relations, relatives and shut friends.
Obviously, due to their differentiating characteristics, the design process in small firms is sure to be less systematic and explicit also as less formal. The strategic planning model suited to large organizations may serve the aim of a suggestion, but it can't be adopted by small firms with an equivalent quite detailed and sophisticated analyses. However, it’s not going to be useful for managers of small firms to understand that strategic planning doesn't necessarily need to be an upscale, complex exercise or involve the utilization of quantitative data, nor does it got to be a proper exercise. It’s going to be undertaken on a modest scale that specializes in only the steps which are relevant to the firm’s needs. Gilmore has suggested in additional concrete terms that, in smaller companies, strategy should be formulated by the highest management team at the council table. According with him, “Judgment, experience, intuition and well-guided discussion are the key to success, not staff work and mathematical models".
Another point to be kept in view is that strategic planning may function a learning process. Managers of small firms may progressive come to understand more about the capabilities and limitations of the firm also as about the opportunities and threats within the environment. They will become increasingly more familiar also with the environment. They will become increasingly more familiar also with the method of strategic planning itself, which may become more formal and complicated over time as managers develop the required skills.
Thus, for strategic planning in small business, it's essential for managers to understand that
- To start out with strategic planning needn't be a posh , formal process, and
- It's its usefulness also as a learning process. Further, as a rice has observed, strategic planning is usually easier to accomplish in small companies, for once developed, strategies are often clearly communicated to, and understood by, all personnel which ensure effective implementation of the strategies.
Robinson, who conducted survey of 101 small retail, service and manufacturing firms in USA over a three-year period, reported a big improvement in sales, profitability and productivity of these firms which engaged in strategic planning in comparison to firms without systematic planning activities.
Non–Profit organisations, by definition, differ from profit- oriented business organisations. There are diverse sorts of not-for-profit organisations in India as in other countries, including research institutions, hospitals, educational, social, cultural, and political organisations, trade unions, and therefore the like. In spite of this diversity, however, certain common characteristics are noticeable in such organisations that distinguish them from business firms. Generally, their output consists of services of an intangible nature which aren't amenable to direct measurement.
The influence of their clients or customers is usually limited. Many of those organisations are funded by way of grants and donations from Government and public trusts. Discretionary powers of internal management team are thus subject to the general regulation of the funding bodies. The personnel of some organisations like research institutes, social and cultural organisations, often are committed more to their profession or to a cause or ideal. Their allegiance to the organization is thereby weakened. Rewards and punishments are subject to restraints thanks to the intangible nature of services, external funding and therefore the professional commitments of employees.
Because of these characteristics of not-for-profit organisations, partly due to their diversity inter se, and since strategic planning techniques have developed out of the experience of huge business enterprises, top management of not-for-profit organisations are said to be less likely to interact in strategic planning. Wortman in his study within the American context found that such organisations attended be managed far more during a short-term operational sense than during a strategic sense. According to Hofer and Schendel also, “There are few evidences that a number of these organisations haven't any strategies at all". Rather, they appear motivated more by short-term budget cycles and private goals than by any interest in re-examining their purpose or mission within the light of altered environmental circumstances.
The capital structure or the capitalization of an undertaking refers to the way during which is long-term obligations are distributed between different classes of householders and creditors. The capitalization of an enterprise depends on its expected average net. From the view point of investors, the yield on the securities which are issued should be like the yields of other securities which are subject to equivalent sorts of risk. The speed at which prospective earnings are capitalized will vary, for it's a subjective measure of risk and would, therefore, vary for firms in several fields of commercial activity. If the income is predicted to be regular, the speed would be less than that for a highly speculative venture. It might be higher for a replacement venture than for one which is well established. It might vary for an equivalent firm under different conditions of trade. It might be low then business conditions are brisk, and high once they are slack, for then a greater risk is involved in capitalization.
The need for capitalization arises altogether the phase’s trade cycle. Estimation of total funds of capital arises within the initial stages to start out the business unit. They need Land & Building etc. Funds also are needed to satisfy the capital through which raw materials, cash, components and stocks are provided.
At the time of growth stage, finance in needed for expansion, introducing technology, modernization programmes. Hence arrangement of capital in made through proper planning.
Thought the firm enjoys highest reputation, goodwill and credit worthiness at the saturation stage, it's to diversify its products to remain on within the market. Product diversification, improvement within the existing products requires huge sums of money; this will be arranged through reorganizing the capital structure.
Now, the prevailing period is identified “Era of mergers, acquisitions and Joint venture”. The economy has influenced mergers of massive giants within the country. Ex: Hindustan Levers with Brooke Bond India Ltd. And lots of others. The success of Mergers of the businesses in European Countries encouraged the Indian Corporate to possess same sort of business policies. This increases the potentiality of place of business to economies their scale of operation. Even at this stage, the concept of Capitalization in extensively used. This provides a suitable formula for exchange their businesses terms and restructure the capital for its effective and efficient usage.
Identifying the need of capitalization, it's referred as determination of the worth through which a corporation has got to be capitalized. This helps the management choose number of securities that are to be offered, the acceptable mix that has got to be designed between the debt and Equity. The ultimate decision on this matter is going to be made by considering two popular Capitalisation Theories: they're
Cost Theory
Under this theory, the entire value of the Capitalisation is calculated by taking the entire cost of acquiring fixed assets and therefore the current assets. During a real world situation, the quantity of capitalization for a replacement business is received, by adding up the value of fixed assets, the quantity of capital and therefore the cost of building the business (Plant & machinery, land and building, cost & raw materials, Preliminary expenses, floatation cost of shares & debentures etc.
Cost theory helps promoters to seek out the entire amount of capital needed for establishing the business. According to Husband and Dockeray, cost principle may appear to offer an assurance that capitalization would, at the simplest be representative of the worth of the enterprise.
However, the value theory has not been considered efficient base on the subsequent grounds:
i) It takes into consideration only the value of assets and not the first capacity of investments.
Ii) Earnings of the corporate fluctuate when the asset becomes obsolete or idle. This may not be detected, if capitalization is formed on the idea of cost.
Iii) it's not suitable for such companies where its earnings are varying.
Earnings Theory
Earnings theory stresses more on the earnings capacity of a business unit. The price of the corporate isn't measured by capitalization but by its earning capacity. According to this theory, the worth of the corporate (capitalization) is adequate to the worth of its earnings; Earnings are capitalized at a representative rate of return. Just in case of a replacement company, it'll need to estimate the typical annual future earnings and therefore the normal earnings rate prevalent within the same industry. The approach of Earnings theory is that the best method of capitalization for the prevailing companies. It’s going to not be suitable for brand spanking new companies, because the estimation of earnings is fairly a risky and difficult task.
For Example: If a replacement company estimates that its annual average earnings will amount to a sum of the Rs 1, 00,000, white the businesses within the same industry are earnings a return of 20% on their capital employed, the quantity of capitalization for the corporate would be.
Advantages
This method correlates the worth of a corporation directly with its earning capacity. Earnings theory acts a check on the prices of building new companies.
Disadvantages
The process of estimating earnings for a replacement company is extremely difficult. An error committed at the time of estimation the earnings are going to be directly influencing the quantity of capitalization.
Over-Capitalisation
Meaning: A business is claimed to be over-capitalised when:
* Capitalisation exceeds the important value of its assets:
* a good return isn't realized on capitalization; and
* Business has more net assets than it needs.
Example of overcapitalized situation
Balance Sheet
Liabilities | Amount (Rs) | Assets | Amount (Rs) |
Equity capital Debentures Current Liabilities | 10 15 10 | Fixed Assets Currents Assets | 22 13 |
| 35 |
| 35 |
In the above example, the component of equity capital is more in relation debt; equity ratio. The future funds aren't optimally deployed on fixed assets. A porting of future fends is allocated to current assets. The present liabilities aren't sufficient to satisfy the need of current assets. Hence, it's inferred that, the available funds aren't judiciously utilized.
Over- capitalization could also be considered to be within the nature of redundant capital. It's generally found in companies which have depleted assets like oil and mining concerns. This condition is usually referred to as “water stock”. A corporation is claimed to be over-capitalised when the mixture of the face value of its shares and debentures exceeds truth value of its fixed assets, in other words, over-capitalization takes place when the stock is watered or diluted. It's wrong to spot over- capitalization with more than capital, for there's every possibility that an over-capitalized concern could also be confronted with problems of illiquidity.
The correct indicator of over -capitalization is that the earnings of the corporate. Over- capitalization doesn't imply a surplus of funds any longer than under-capitalization indicates a shortage of funds. It’s quite possible that the corporate may have more funds and yet have low earnings. Often, funds could also be inadequate, and capitalization. The typical distributable income of a corporation could also be insufficient to pay the contract rate of return on fixed income securities elsewhere. Over-capitalization may happen when:
* Prospective income is over-estimated at the start;
* Unpredictable circumstances reduce down the income;
* The entire funds requires are over-estimated;
* Excess funds aren't efficiently employed;
* The low yield makes it difficult for a firm to boost new capital, particularly equity capital;
* The market price of the securities falls below the difficulty price;
* Arbitrary occasions are taken on the fees against income arising from depreciation, obsolescence, repairs and maintenance;
* The low yield may discourage competition and this limited competition becomes a social disadvantage.
Over-capitalization may go unnoticed during the amount business flourishers and should be encouraged by prosperity. However, it's going to be productive of ill-consequences when the distributable income diminishes under the pressure of declining demand and falling prices.
Causes
The causes of Over-capitalization are:
- Difference between value and Real worth of Assets: it's possible that a corporation may have purchased its assets at a worth which is above their real worth. This gap between the value and therefore the real worth of assets may account for over- capitalization.
- Promotional Expenses: there's an opportunity that promoters may have charged exorbitant promotional expenses for his or her services in creating the corporation. This excessive charge could also be a explanation for over-capitalization.
- Inflation: thanks to inflationary conditions an organization may need acquired assets at high prices. Inflationary conditions precipitate over-capitalization which affects new also as established corporations.
- Shortage of Capital: when faced with a shortage of funds, a corporation may borrow high rates of interests which is sure to end in excessive fixed charges.
- Depreciation Policy: Inadequate provision for depreciation, obsolescence or maintenance of assets may cause over- capitalization, and this is often sure to adversely affect the profit- earning capacity of an organization.
- Taxation Policy: High corporate tax may discourage corporation from implementing programmes of replenishment, renewals and renovations, as a results of which their profitability may suffer.
- Dividend Policy: Some corporations adopt a lenient dividend policy so as to realize popularity with their stockholders. However, such cash-down payments within the sort of dividends weakens their liquidity position. Their valuable resources are likely to be frittered away and, as a result, they'll find themselves during a state of over- capitalization.
- Market Sentiment: Company could also be tempted to boost security floatation within the market so as to make a favourable market sentiment on the stock market. While doing so, it's going to be saddled with the difficulty of unwarranted securities which are of no practical value thereto. As a result, it becomes over-capitalised and therefore the burden of its liabilities is unnecessarily inflated.
- Under-estimation of Capital Rate: If the particular rate at which a company’s earnings are capitalised, the capitalization rate is under- estimated, and this results into over-capitalization.
Advantages
- The management is assured of adequate capital for present operations.
- If conserved, a more than capital may preclude the need of financing sometime within the future when capital is required and may be obtained only with difficulty.
- Adequate amount of capital features a beneficial effect on an organization’s morale.
- Appropriate level of capitalization gives added flexibility to the corporation’s operation.
- Losses are often more easily observed without endangering the longer term of the firms .
- The reasonable rate of profits tends to discourages possible competitors.
Disadvantages
- When Stock is issued in more than the worth of the assets received, a company’s stock is claimed to be “watered”. Stock may arise by the issued of stock in any of the subsequent ways.
- For over-valued property or services;
- As a bonus;
- For cash at but the par or stated value of the stock;
- As a dividend when the excess of the corporation isn't offset by actual assets of a minimum of an equal amount. If known to be watered, stock features a market price which is less than it might enjoy if it weren't watered – until the “water” has been “squeezed out” (until sufficient assets are acquired from earnings to offset the surplus of stock.
- There's the likelihood of stockholders’ liability to creditors just in case a court should conclude that the stock was heavily watered, that the corporation didn't receive “reasonable” or “proper” value for the stock. This liability would attach only to such stock as was received as a results of an unreasonably excessive valuation of properties or services given in exchange for such stock.
- There could also be a possible difficulty of raising new capital funds. This might be obviated. However, by the utilization of “no-par” stock.
- In some States, the speed of the annual tax depends on the quantity of outstanding stock. Large capitalizations in such states may attract correspondingly large franchise taxes.
- There’s a bent to boost the costs of a company’s products and/ or to lower their quality. This might be partly or wholly forestalled, however, by competition and would apply more to utility services than to others, for utility rates are based, in part, upon a “reasonable” return on capital.
- Over-capitalization may include a failure, and therefore the failure of an organization may cause an unhealthy economic situation.
- The moral atmosphere of a business isn't improved by over- capitalization.
- The just about necessary “rigging” of the marketplace for the securities which first offered to the general public usually leads to market price losses to the investors after this support is removed. (This isn't to condemn the legitimate support of the market within the above-board floatation of a security issue).
- There could also be an inability to pay interest on bonds (when bonds constitute an outsized portion of the capitalization of an over-capitalised company).
- Injury to creditworthiness.
- Decline within the value of securities.
- Possible loss of orders due to inability to expand.
- Temptation for the management to juggle with depreciation, obsolescence, maintenance, and reserve accounts so as to seem to be making a profit and possible so as to pay a dividend.
- Possible injury to goodwill just in case a necessary reorganization.
- The holders of securities could also be dissatisfied.
- The business may subside to its competitors through its inability to get funds for expansion.
Effects of Overcapitalization
Over-capitalization has some effect on the corporation, its owners, consumers and therefore the society at large.
- On Corporation: The market value of the corporation’s stock falls and it's going to find it difficult to boost new capital. Very often, artificial devices like the reduction in depreciation, curtailment in maintenance, etc., are made use of to hide over-capitalization. But this only aggravates the evil of over-capitalization. The credit of the corporate is adversely affected. The corporate may appear to be during a robust, healthy condition, even if it's going to have lost its vigor and vitality and should collapse at any time due to the uneconomic economic condition from which it suffers.
- On Owners: Owners who have a true stake within the corporation are the most important losers. Due to a fall within the market price of its shares, shareholders aren't may be a position to eliminate their holdings profitably. Moreover, due to a fall in dividends, shareholders lose heavily. They develop the sensation that the corporation is funded on shifting sands.
- On Consumers: an organization cannot resist the temptation of accelerating the costs of its products to inflate its profits. At an equivalent time, there's every possibility that the standard of the merchandise would go down. The buyer may thus suffer doubly.
- On Society: over-capitalized concerns often come to gr5ief within the course of your time. They lose the backing of householders, customers and society at large. They suffer multi-pronged attacks from various sections of society. They’re not during a position to face competition. No wonder, therefore, that they gradually draw closer to a situation ordering liquidation. While the existence of such corporation can't be justified, their extinction would cause irreparable damage to society.
Remedies
Over-capitalization isn't easily rectified, chiefly because the factors which cause it within the first place don't entirely disappear.
In many cases, over-capitalization and excessive debts co-exist and an attack on one often involves the opposite. Indeed, a correction of the previous usually involves the latter. With this co-relationship in mind, it's going to be said that correction of over-capitalization may involve one or more of the subsequent procedures:
- Reduction in Funded Debt: this is often generally impossible unless the corporate goes through re-organization. Funds need to be raised for the redemption of bonds; and therefore the Sale of huge quantities of stock, presumably at low prices, would probably do more damage than good. Moreover, the creation of the maximum amount stock because the bonds retired wouldn't reduce the entire capitalisation. A real reduction in capitalization is often effected as long as the debts are retired from earnings.
- Reduction in rate of interest on Bonds: Here again, without a through re-organization, it would probably not be practicable to effect a discount within the rate of interest on bonds. A refunding operation, however, could be performed; but the saving in interest payments on the lower-rate refunding bonds would hardly offset the premium the corporate would be forced to permit the bond- holders so as to induce them to simply accept the refunding bonds; and, moreover, this procedure wouldn't really reduce capitalization. However, it might alleviate things.
- Redemption of preferred shares, if it carries a High Dividend Rate: Funds for redemption would probably need to come from the sale of common shares sufficient to extend somewhat the earnings from the common shares, even if this common share is increased substantially. If, however, the well-liked stock is cumulative, and if dividends on such stock are behind , this avenue of escape would seem to be a “dead-end street”
- Reduction in face value of Stock: this is often an honest method but is usually impossible due to the stockholders’ tenacious belief within the importance of face value. If the stockholders are convinced of the desirability of the move, it'd be somewhat effective, though not nearly the maximum amount because the reduction in high fixed.
- Reduction in Number of Shares of common Stock: This likewise is a good method but, again, is difficult of implementation because of the average stockholders’ unwillingness to turn in several shares in order to receive one, thought it does happen occasionally. Since this procedure does not Decrease the stockholder’s proportionate interest in the equity, it is sometimes used.
In some cases, several of these methods may be used, but unless a company goes through re-organization (a rather complicated a legally involved affair), the consent of the Security-holders should be obtained.
Under-Capitalisation
Under – Capitalization is the reverse of over-capitalization. It should not be confused with a condition implying a lack of funds. It merely refers to the amount of outstanding stock. It does not pose an economical problem in adjusting the capital structure. The condition is not as serious as that of over-capitalization and its remedies are much easily applied.
Under-capitalization comes about as a result of:
➢ Under-estimation of future earnings at the time of promotion; and / or
➢ An unforeseeable increase in earnings resulting From later developments;
➢ Under-capitalisation exists when A company earns sufficient income to meet its fixed interest and fixed dividend charges, and is able to pay A considerably better rate on its equity shares than the prevailing on similar shares in similar businesses.
Example of undercapitalized situation
Balance Sheet
Liabilities | Amount (Rs) | Assets | Amount (Rs) |
Equity capital Debentures Current Liabilities | 10 25 15 | Fixed Assets Currents Assets | 40 10 |
| 50 |
| 50 |
In the above example, the component of equity is substantially lesser than in reference to debt: equity ratio. The dimension of debt is more. Total future funds are enough to satisfy the cost requirement. The management has used short term funds for future purposes and assuming huge amount of risk, as a result, profitability of the firm would be more. Hence it's inferred that, the available funds are put to use more aggressive to earn substantial profit.
At this stage, the important worth of the assets exceeds their value, and therefore the rate of earnings is above corporation is ordinarily ready to afford. Bonneville and Dewey observe that when an organization is earning a very large return on its outstanding stock, it's said to be under capitalised. Husband and Dockeray express the view that, during a quantitative sense, on the foremost productive basis; qualitative under-capitalisation exists when in sufficient provision is formed for funds to work on the foremost productive basis; qualitative under-capitalisation exists when insufficient provision is formed for funds to work on the foremost productive basis; qualitative under-capitalisation, however, is found whenever values are deliberately carried on the books of accounts in an amount that's but the worth of the assets.
Causes
The causes of Under-Capitalisation are:
- Underestimation of earnings: it's possible that earnings could also be under-estimated, as a result of which the particular earnings could also be much above those expected.
- Efficiency: an organization may have optimally utilized its assets and enhanced its efficiency by exploiting every possibility of modernization and by taking the utmost advantage of market opportunities.
- Under-estimation of Funds: it's going to happen when the entire Funds required are under-estimated.
- Retained Earnings: due to its conservative dividend policy an organization may retain the earnings which could have accumulated into a mass of savings. This is often sure to improve its financial health.
- Windfall Gains: Companies which may afford to still operate during the amount of depreciation may find their earnings are unusually high once they enter the boom period. This shift from an adverse trade cycle to a prosperous one may under- capitalise the corporation.
- Indulgence in Rivalries: Under indulgence in rivalries flowing from unusually high earnings may tempt a corporation to embark upon speculative activities within the hope that it can easily survive its ill effects; for if speculative activities end up to be unfavourable, its earlier earnings are likely to be washed away.
- Taxation: due to excessive earnings, corporations are exposed to an important burden of taxation.
Effects
The effects of under-capitalisation are:
- Labour Unrest: Employees are often organized and become aware of the very fact that the corporation is making enormous profits. They feel that they need a legitimate right to share in these profits. In other words, they develop the sensation that they aren't adequately paid which the corporation is reluctant to pay what's their legitimate due. This generates a sense of hostility on the part of the employees, and results in labour unrest.
- Consumer Dissatisfaction: Consumers feel that the weird earnings of the corporation could are utilized by effecting a discount or by improving the standard of the merchandise.
- Government Interference: the govt generally keeps a watchful eye on under-capitalised concerns which earn abnormal profits. It may, at the instance of dissatisfied consumers, employees and investors, intervene within the affairs of such corporations and should even nationalize them.
- Need for brief term funds: an organization may need to resort frequently to short-term credit and should even seek additional long- term funds without much notice.
- Hamper of expansion programmes: Adaptability to charged circumstances could also be impaired and expansion programmes may hamper.
- Temptation to boost Fresh equity: Enormous earnings on equity Shares may end in a rise in market value and therefore the company are going to be tempted to boost new Capital.
- Competition: The prospect of enormous earnings may generate competition which can adversely affect the profitability of an organization.
- Share Prices: Higher prices of shares may restrict the market and shares could also be traded at prices below those justified by the usually high earnings.
Disadvantages
- The Stock would enjoy a high market price, but would limit its marketability and should cause wide (though not necessarily relatively wide) fluctuations in market prices. In many cases, this might not be considered a disadvantage.
- Due to its limited marketability, the stock might not enjoy as high a market value As its earnings justify.
- A high rate of earnings per share may encourage potential competitions to enter the market.
- In sight of the high rate of earnings, employees may become dissatisfied. Dissatisfaction would probably reduce their efficiency and produce other undesirable effects.
- In sight of the high rate of earnings, customers may feel they need been overcharged. Except possibly publicly utility undertakings, this is often not a completely justifiable point, for competitors might easily enter the sector and force reductions in price.
- If a corporation is a particularly large one and virtually controls the industry, its enormous earnings per share may encourage competitors or the govt to bring suit against it under the Anti-trust laws.
- Counting on the character of excess profit taxes, if any, the corporate may lose by under-capitalisation.
Remedies
Under-capitalisation is definitely remedied. It’s going to be done by one or more of the subsequent methods.
- Split – up: The Corporation may offer the stockholders several shares of latest stock for each share of the old. If there's a face value, it must be reduced to correspond with the rise within the number of shares, for by this method the capital stock account isn't affected. With this increase in shares and reduction in face value per share the speed of earnings won't be changed, but the earnings per share are going to be very substantially decreased. The effect is far more apparent than real, for the capitalization isn't increased, though the earnings per share are reduced.
- Increase in face value of Stock: If the excess is large or are often made larger (by revaluing assets upward, or otherwise), the corporation might offer the stockholders new stock for the old, the new stock to hold a better face value. This is able to not reduce the earnings per share, but it might reduce the speed of earnings per share. This method, however, is seldom used, partly because it might not improve the marketability factor. If it were desired to travel further, the corporation could offer the stockholders a stock split-up and a rise in face value. This is able to reduce both the earnings and therefore the rate of earnings per share Value enormously. This method, however, is extremely radical and is nearly never used.
- Stock Dividend: If the excess is large or are often made larger, the corporation might declare a dividend payable available. This is able to not affect face value per share, but would increase the capitalization and therefore the number of shares. Both the earnings per share and therefore the Rate of earnings per share would scale back. This is often probably the foremost used method and therefore the most easily effected.
Over Trading
According to Leslie R. Howard, the term overtrading means expansion of production and sakes without adequate support. If a corporation finds itself on a simple market, it's going to increase its production and sales to satisfy a ready demand. Reasonable and even comparatively large profits are made. So as to require full advantage of the favourable conditions, profits and ploughed back to the acquisition of latest plant and machinery, Storage facilities or otherwise, so depleting liquid resources. Creditors are made to await settlement as further raw materials are purchased or finished goods are procured for direct re-sale. Meanwhile production costs increase, particularly wages, and these make further demands on cash resources while settlement is awaited for debtors.
The delay between the acquisition of raw materials, the amount required for add progress, the last word sale of the finished product and therefore the final settlement by debtors, are often under-estimated and a corporation consequently can find itself during a difficult position with reference to liquid resources. Sometimes further capital could also be raised, but where such action is resorted to, during a period of overtrading, funds might not easily be forthcoming thanks to the unhealthy appearance of the record.
Furthermore, it's not very easy for little companies to boost additional capital, likewise where overtrading has taken place, altogether probability, the bank may have already got arranged for overdraft facilities and should be unwilling to oblige without adequate security. In any case it's not the custom of the bands to grant financial assistance to companies for any protracted length of your time.
They consider that more permanent means of financing should be resorted to. Overtrading isn't a firm is forced, though lack of adequate liquid resources, to increase the amount of credit taken from its suppliers beyond the terms agreed, which may be explicitly defined or implied for allowed payment patterns. Although a narrow definition, it does serve to spotlight the mixture of circumstances which will cause overtrading. The foremost common feature of a firm overtrading is just too narrow a capital base from which a rapid expansion of sales takes place. While the firm remains at normal growth rates, the owners can exercise tight control over the gathering of trade debts, any increase in liquidity being met by retained profits.
If, however changes in demand occur and the firm’s product becomes wanted, the owners will often attempt to meet the increased market without arranging additional capital resources, either of a short-or long-term nature. Within the words of Thomas Budd, Overtrading results from an effort to try to a greater amount of business than the capital investment warrants. Overtrading takes place when an organization business than the capital investment warrants.
Overtrading takes place when an organization expands beyond its legitimate scale of operations and doesn't have sufficient cash resources to satisfy the extent of activity. The corporation may plunge into the disaster of trading into expansion programmes in an untimely fashion. Like an excessive amount of air within the balloon it's likely to be overblown,. The dimensions is unduly increased, the margin of safety is excessively inflated, a way of strain is made and therefore the corporation is probably going to collapse suddenly like an overblown balloon whose capacity to blow further is exhausted.
Causes
1. Inflation: Inflation raises the hope for the corporation to flourish further. Within the anxiety to earn more profits, it's going to buy assets and properties at exorbitant prices and trade heavily. Heavy funds may get locked up into the business and therefore the corporation may get sandwiched for paucity of funds. Further, so as to stay the on- going operations, heavy renewals and replacements are undertaken. The corporation thus finds it very difficult to return out of the trap unscathed.
2. Excess Inventory: because the level of activity grows, large stocks of inventories need to be accumulated to facilitate a smooth flow of materials or to assist proper production planning and control. Stocks gradually get swollen and neither the corporation can use stocks profitably in it are neither production nor can it release them purchasable. The work-in-progress also gets accumulated and enormous funds are once more engaged in them.
3. Taxation: an organization may distribute fabulous dividends to appease the stockholders and to offer thanks to the profits earned by it. It should be remembered that prime earnings don't necessarily mean greater availability of money resources. With the distribution of dividends in cash, cash resources may get depleted. Including this is often the extra burden of heavy taxes that the corporation is required to pay on account of unusually high earnings. An organization thus suffers doubly and its cash resources come to an end sooner or later.
4. Depletion of Working Capital: The working capital may be depleted as a result of untimely repayment of long-term loans, excessive dividend payments, purchase of fixed assets or even as a result net trading losses. The depletion of working capital is the cause that leads to overtrading of activity. The corporation does not realize that its legs are not long enough to reach the ground.
Effects
1. Creditors increase sooner than debtors because the corporation may find it difficult to pay creditors on due dates and reduce the quantity of outstanding Creditors.
2. There could also be a rise in bank loans and other borrowings thanks to the excessive locking from funds in current assets.
3. Fixed assets could also be purchased out of short-term borrowings. The present ratio could also be two and therefore the turnover rations could also be very high. Similarly, there could also be a fall within the capital ratio.
4. There could also be a progressive fall in liquid resources and within the overall ability of the corporation to boost funds.
5. An organization may find it difficult to pay its wage and salary bills and tax payments may fall behind on account of its poor bargaining capacity within the market.
6. Thanks to excessive holding of stocks, the corporation may like better to sell its products at throw-away prices. This might result into trading losses.
7. The corporation will lose credit with the creditors and suppliers may encourage them to draw bills. Often it's going to not be ready to honour them which can result into loss of goodwill.
8. The corporation may leave of the thanks to collect the payment from the debtors. It’s going to offer them heavy discounts and sustain loss by prompt payment. Debtors may feel embarrassed by this overt attitude of the corporation to pressure up collection of payments from them.
9. An organization may defer the projects of assets or replacement of kit thanks to shortage of funds. This might affect efficiency of the corporation adversely.
Remedies
It is advisable for the corporation to maneuver into the reverse gear. The corporation should realize that it's stretched its legs too far and will be willing to trace its steps backward. It should reduce the extent of activity and curtail unnecessary ramifications. If there's no scope for the corporation to retrace its steps backward, it's going to had best to sell the priority goodbye because it is during a working condition, as “prevention is best than cure”.
The commercial banks could also be called on to assist by granting of an overdraft sometimes, further capital could also be raised, but where such action is resorted to during a period of overtrading, funds might not easily be forthcoming thanks to the unhealthy appearance of the record . Likewise, where overtrading has taken place, altogether probability, the banks may have earlier arranged for overdraft facilities may therefore, be unwilling to oblige without adequate security.
The banker detects signs of overtrading with the subsequent symptoms:
a) Longer credit and/or shorter credit than in customary therein particular trade.
b) Longer credit and/or shorter credit than is customary for the borrower.
c) “Hand-to-mouth” operation of checking account.
d) High inventory turnover ratio.
e) Low current ratio.
f) High short-term profits inciting business to grow fast.
g) Profits-and not real profits.
h) Frequent cash shortages.
i) Heavy bad debts.
j) Mounting pressures from creditors.
Under Trading
Under trading is that the reverse of overtrading. It means inappropriate utilization of resources. It takes place when Funds of the corporation remain idle and aren't being productively. Within the words to Thomas Budd, “When an enterprise is under trading, its stakes are rarely large. Under trading isn't as serious as overtrading”. Under trading means, trading is at a level which is way below the extent ratio and high current ratio. If a corporation under trades, its installed capacity remains under-utilized. The fixed overheads are going to be largely unrecovered then the cost of fixed expenses are going to be high inventory carrying charge. A general climate of lethargy inertia clouds the organization, which is most dangerous to its survival and future growth.
One of the most important functions of the financial manager is that of planning. Plans must fit the financial capabilities of the concern. Planning business finances and carrying out financial plans is a continuous process in the day-to-day administration of a business.
Financial planning is essentially concerned with the economical procurement and profitable use of funds – a use which is determined by realistic investment decisions. This approach requires a sensible appraisal of the economic, industrial and share market patterns which are likely to emerge as plans are developed and operationally assessed. The aim in financial planning should be to match the needs of the company with those of the investors with a sensible gearing of short-term and long- term fixed interest securities. The primary advantage accrued to financial planning is the elimination of waste resulting from complexity of operation. For example, technological advantages, higher taxes, increasing cost of social legislation, fluctuations tend to cause management to exert wasteful effort. A firm which performs no financial planning depends upon past experience for the establishment of its objectives, policies and procedures.
A clearly developed financial plan, when made known to executives at different levels of management, tends to relieve top management from detailed financial plan, the lower echelons of management may often develop their own policies and procedures, which would produce confusion and waste such as loss of time, goodwill and financial resources. The success or failure of production and distribution functions of firms hinges upon the manner in which the finance functions of firms hinges upon the manner in which the finance function is performed, and in many instances, a single financial decision as the policy-making level determines the success or planned before any action is taken. The objectives of a business enterprise should be well-known to the financial manager. On the basis of these objectives, he can formulate his financial plans.
But whatever the financial plans, their ultimate objective is to enable a firm to take such decision as would make it possible for it to accomplish its goals and objectives. Palmer and Taylor recommended that financial planning should be directed to aiding the management in achieving its objectives and in implementing its policy. At the same time, both the scope of the objectives and the nature of the policy may well be limited by financial considerations.
Financial planning is one of the most important aspects of the financial manager’s job. The success of an organization often depends upon the information contained in a plan for future performance. Not only should one plan the future with proper forecast and budgets, but one should continually evaluate the performance of the firm in comparison with past forecasts. Financial planning should achieve a total integration and co-ordination of all the plans of the other functions of the firm. It should estimate the resources that will be required to carry out the operations and determine how far these resources can be generated by the firm itself and how far they will have to be obtained externally. A system of control, on the other hand, involves obtaining, processing and recording information in such a way that it can be easily analyzed and thus highlights the areas in which improvement may be effected in the operations of the firm.
The financial plan of a corporation should be formulated in the light not only of present but of future developments as well. It should take into consideration the present capital needs for fixed assets, working capital, probable earnings, and requirements of investors; and it should anticipate possibilities of later expansion, combination with other corporations, higher or lower future interest rates, etc., All of these consideration resolve themselves into a determination of:
- The amount of capital to be raised;
- The form and proportionate amount of securities to be issued
- Policies bearing on the administration of capital
Total financial planning has been defined as advance programming of all the plans of financial management and the integration and co- ordination of these plans with the operating plans of the other functions of the enterprise.
A financial plan generally describes a firm’s operating or commercial activities, the investment it requires, and the sources of the funds to be used all in a time-phased schedule. S.K. Bose points out that one of the important ways in which some headway can be profitably made by a firm is the use of mathematical model of a company which has an input of various accounting and financial statistic, and an output of various financial measurements of business performance and Performa financial statements. Inputs may be sales forecasts, cash balances, debt structure and the cost of production and output may be projections of profit-and- loss statements, cash flow statements, balance sheets, sources and use of funds, and various ratio analyses.
The financial ability to impose more explicit goals on the global planning process and clear modes of analysis may help managers of the multi-national enterprise to obtain a more clear view of ‘the woods’ rather than ‘the trees’. Finally, placing international corporate finance decision- making within the context of the strategic analysis may help counteract some of the limitations of financial theory in the key area of integrated financial planning.
Step in Financial Planning
Establishing Objectives
Policy Formulation
Fore Casting
Formulation of Procedures
These steps are as discussed below:
Establishing Objectives
The financial objectives of any business enterprise is to employ capital in whatever proportion necessary to increase the productivity of the remaining factors of production over the long run. Although the extent to which capital is employed varies from firm to firma, the objective is identical in all firms. Business enterprises operate in a dynamic society, and in order to take advantages of changing economic conditions, financial planners should establish both short-term and long-run objectives. The long-run goal of any firm is to use capital in the correct proportion.
Policy Formulation
Financial policies are guides to all actions which deal with procuring, administering and disbursing the funds of business firms. These policies may be classified into several broad categories.
- Policies; governing the amount of capital required for firms to achieve their financial objectives.
- Policies which determine the control by the parties who furnish the capital
- Policies which act as a guide in the use of debt or equity capital
- Policies which guide management in the selection of sources of funds.
- Policies which govern credit and collection activities of the enterprise
Forecasting
A fundamental requisite of financial planning is the collection of ‘facts’ however, where financial plans concern the future, “facts” are not available. Therefore, financial management is required to forecast the future in order to predict variability of factors influencing the type of policies the enterprise formulates.
Formulation of Procedures
Financial policies are broad guides which, to be executed property, must be translated into detailed procedures. This helps the financial manger to put planned activities into practice.
To put it simply, we might say that the goal of any business is to maximise the returns to the owners of the business. So the goal of finance is to help the business in maximising returns. But if you talk to the companies, you also hear about many other goals that they are pursuing at the same time. These goals could include maximisation of sales, maximisation of market share, maximisation of growth rates of sales, maximisation of the market price of the share (whether real or specifically pushed up to benefit the owners), etc. Individually speaking, managers would be more concerned with the money that they are making from the organisation and the benefits that they are receiving rather than care about what the owners are making!
As there could be many goals for the organisation, we should try and summarise the organisational goals in financial terms so that we can call them the financial goals. They boil down to two:
1. Profit Maximisation or
2. Wealth Maximisation
Profit Maximisation
Let us first look at profit maximisation. Profit (also called net income or earnings) can be defined as the amount a business earns after subtracting all expenses necessary for its sales. To put it in an equation form:
Sales - Expenses = Profit
If you want to maximise profits, there are only two ways to do it. Either you reduce your expenses (also called costs) or you increase the sales (also called revenues). Both of these are not easy to achieve. Sales can be increased by selling more products or by increasing the price of the products. Selling more products is difficult because of the competition in the market and you cannot increase the price of the products without adding more features or value to it (assuming a competitive market). If you are a competitive company, reducing expenses beyond a certain level is possible only by reducing the investments in advertising, research and development, etc. which ultimately leads to reduction in sales in the long term and threatens the survival of the company. Profit maximisation goal assumes that many of the complexities of the real world do not exist and is, therefore, not acceptable.
Still, profit maximisation remains one of the key goals for the managers of the company because many managers' compensations are linked to the profits that the company is generating. Owners need to be aware of these goals and understand that it is the long- term viability of their companies that add value to them and not the short-term profitability. Therefore, the long-term survival of the company should not be sacrificed for the short- term benefits.
Wealth Maximisation
Shareholders' wealth can be defined as the total market value of all the equity shares of the company. So when we talk about maximising wealth we talk about maximising the value of each share. How the decisions taken by the organisation affects the value of the organisation is reflected in the figure below:
The shareholders' wealth maximisation goal gives us the best results because effects of all the decisions taken by the company and its managers are reflected in it. In order to employee use this goal, we do not have to consider every price change of our shares in the market as an interpretation of the worth of the decisions that the company has taken. What the company needs to focus on is the affect that its decision should have on the share price if everything else was held constant. This conflict of the decisions by the managers and the decisions required by the owners is known as the agency problem.
The traditional function of financial management has been limiting the role of finance manager to raising and administrating of funds needed by the company to meet their financial needs. It broadly covered:
1. Arrangement of funds through financial institutions
2. Arrangement of funds through financial instruments
3. Looking after the legal and accounting relationship between a corporation and its sources of funds
This has outlived its utility. With the advent of technology and need to tighten ships because of competition, financial management became as much a science as art. Efficient allocation of funds became the imperative. The modern approach is an analytical way of looking at the financial problems of a firm with the main concerns like:
1. What is the total volume of funds committed
2. What specific assets should be acquired or divested
3. How should the funds required be financed and from which markets the above questions relate to four broad decision areas, these are:
- Investment decision: Decisions relating to investment in both capital and current assets. The finance manager has to evaluate different capital investment proposals and select the best keeping in view the overall objective of the enterprise. Capital Budgeting is the typical name given to this decision.
2. Financing Decision: Provision of funds required at the proper time is one of the primary tasks of the finance manager. Identification of the sources, deciding which types of funds to raise (debt or equity), and raising them is one of the crucial tasks.
3. Dividend Decision: Determination of funds requirements and how much of it will be generated from internal accruals and how much to be sourced from outside is a crucial decision. Equity holders are the owners and require returns, and how much money to be paid to them is a crucial decision.
4. Working Capital Decision: The investment in current assets is a major activity that a finance manager is engaged in a day to day basis. How much inventory to keep, how much receivables can be managed, and what is the optimum cash levels, are three of the key questions that are dealt with regularly.
All these decisions interact, investment decision cannot be taken without taking the financing decision, working capital decision also needs financing, dividend decision is a payout mechanism and has to be taken care of from financing. These tasks are divided and are taken care of by various entities.
