Financial Policies and Strategies of an Organization

Financial policies and strategies of an organization are concerned with the raising and utilization of funds. The basic purpose is to ensure adequate and regular supply of capital to the organization, keeping the present and future requirements of business in mind. Capital   of course should not only be adequate but should also be judiciously employed. Wasteful use of capital is as bad  as inadequate capital. Hence, while estimating fixed and working capital requirements the types of securities to be issued, the sources to be exploited financial managers should bear in view the proper use of funds. While finalising financial plans, all contingencies should be taken into account.  The business in any case, should not suffer due to excess or shortage of funds. Also, the cost of raising capital should be minimum. There should always be a fine balance between fixed cost bearing securities (debentures and preference shares) and variable cost bearing securities (equity shares). After procuring the funds, they must be employed efficiently and effectively. Liquidity, safety and profitability should be the guiding factors in this regard. We present below each of these financial strategies and point out the important decisions that need careful attention.

Finance can be source of competitive advantage:

Finance can be a source of great strength in building distinctive competitive advantages to a company. Companies that manage their stocks, debtors and creditors will improve their cash flow and reduce both operating and borrowing expenses. They can borrow at competitive rates and reduce interest payments to a significant extent. Large finances help them to move ahead of competitors with confidence. Resources can be leveraged to increase the returns for shareholders. They can   increase their scale of operations and derive significant tax concessions through mergers and acquisitions.  Thus, companies that manage their funds well can build distinct competitive advantages over a period of time.

Procurement of funds:

Finance is required in order to maintain an adequate cash flow to keep the business operating and also for development. For the latter, the right amount is required at the right time and at the right cost. So the first question here is about deciding the capital structure of a company, which refers to the kind and proportion of different securities for raising long-term finance. It involves decisions regarding the form of capitalisation (the sum total of all long term securities issued by a company – equity as well as debt – and the surplus not meant for distribution). It deals with some ticklish questions such as what is the total capital required? What should be the mix of equity, i.e. owner’s capital and debt in the total capital? Generally speaking there should be a healthy mix of equity and debt in a company’s capital structure in order to maximize returns to its owners. At the same time, it should neither be over-capitalized nor undercapitalized.  A company is said to be over-capitalized when its earnings are not large enough to yield a fair return on the amount of stocks and bonds that have been issued or when the amount of securities outstanding exceeds the current value of the assets. A company may be under-capitalized when the rate of profit it is making is exceptionally high in relation to the return enjoyed by similarly situated companies in the same industry or when it has too little capital with which to conduct its business. If a business is under-capitalized it may remain still-born. On the other hand, if a business is over capitalized it runs the risk of being crushed under its own weight.

A company has many alternatives while raising funds such as equity shares, term loans from financial institutions, debentures, fixed deposits and bank finance for working capital requirements. All these funds carry a cost either explicit (interest on loans, debentures, deposits etc.,) or implicit as in the case of dividend on equity. The weighted average cost of all the funds   garnered should be kept as low as possible. If the cost of financing becomes very high, the company’s profitability and hence growth prospects, suffer. The time factor while mobilizing funds should also be kept in mind. A business should not be started for want of timely infusions of required cash. Capital markets, as a rule, go through a cyclical pattern — boom, recession and recovery. During a boom period, investors passionately embrace equity. During a recession, bond markets outperform equity markets. The right timing of capital issue, therefore, becomes crucial while raising funds from various sources.

Another important policy issue relates to dividends. The company should normally, strike a fine balance between paying reasonable amounts to investors who are looking for a steady income on their equity investment and those investors who would want the company to invest the surplus generated by the company in projects having great growth potential. Every company should have healthy dividend policy (whether to pay dividends or retain the surplus for expansion, modernization etc.) to satisfy the need for cash within the company as also to satisfy the expectations of the investors.  Experts, generally, arrange for a stable dividend policy wherein dividends are declared every year as a sort of reward for loyal shareholders. Stable dividends tends towards higher share prices because investors are more favourably disposed towards companies whose shares provide dividends they are sure of receiving than they are towards less reliable companies that are regarded as more risky. The reason is that some shareholders rely on dividend income and are willing to pay a higher price for less risky share.

by V S RAMA RAO on JUNE 18, 2012