Business Studies

Class XII
Chapter – o9

financial
management
Financial management - overview
1. Meaning of Business Finance
2. Financial Management – Meaning, Importance, objective.
3. Financial Decisions
4. Capital Budgeting decision/Investment decision/Management of fixed capital– (a) Meaning
(b) Factors affecting Capital Budgeting decision
(c) Importance
(d) Factors affecting the requirement of fixed capital
5. Working Capital decision – Meaning, Importance, Factors affecting requirement of fixed capital
6. Dividend Decision – Meaning, Factors affecting dividend decision.
7. Financing Decision – (a) Meaning (b) Capital Structure (c) Trading on equity
(d) Factors affecting Choice of Capital Structure.
8. FINACIAL PLANNING – Meaning, Importance.
Financial management -
BUSINESS FINANCE
Money required for carrying out business activities is called business finance.
Almost all business activities require some finance. Finance is needed to
establish a business, to run it, to modernise it, to expand, or diversify it.
FINANCIAL MANAGEMENT
FINANCIAL MANAGEMENT IS CONCERNED WITH OPTIMAL
PROCUREMENT AS WELL AS THE USAGE OF FINANCE.
Financial Management aims at reducing the cost of funds procured, keeping
the risk undercontrol and achieving effective deployment of such funds. It also
aims at ensuring availability of enough funds whenever required as well as
avoiding idle finance
Financial management - IMPORTANCE
1. The size and the composition of fixed assets of the business:
2. The quantum of current assets and its break-up into cash, inventory and
receivables
3. The amount of long-term and shortterm funds to be used:
4. Break-up of long-term financing into debt, equity etc:
5. All items in the Profit and Loss Account, e.g., Interest, Expense,
Depreciation, etc
Financial management - OBJECTIVES
• The primary aim of financial management is to maximise shareholders’
wealth, which is referred to as the wealth-maximisation concept.
• We can say, the objective of financial management is to maximise the
current price of equity shares of the company or to maximise the wealth
of owners of the company, that is, the shareholders.
• It can happen through efficient decision-making. Decision-making is
efficient if, out of the various available alternatives, the best is selected.
• The market price of a company’s shares is linked to the three basic
financial decisions : investment, financing and dividend decision.
Financial decisions
1. INVESTMENT DECISION:
Investment decision, relates to how the firm’s funds are invested in
different assets. Investment decision can be long-term or short-term.
• 1(a) Capital Budgeting decision/Long term investment decision
• 1(b) Short-term investment decisions /called working capital decisions.
2. FINANCING DECISION:
This decision is about the quantum of finance to be raised from various
long-term sources.
3. DIVIDEND DECISION:
distribution of dividend
FINANCING DECISION -
The main sources of funds for a firm are shareholders’ funds and borrowed funds.
The shareholders’ funds = the equity capital + retained earnings.
Borrowed funds refer = debentures + other long term loan/debt.
A FIRM HAS TO DECIDE THE PROPORTION OF FUNDS TO BE RAISED FROM EITHER
SOURCES (SHAREHOLDER’S FUNDS AND BORROWED FUNDS) BASED ON THEIR BASIC
CHARACTERISTICS.

EQUITY DEBENTURES/DEBT/LOAN

RISK Low risk – dividend is paid only when company earns High financial risk
profit

COST High cost as higher rate of dividend is to be paid when Cheaper source of finance – Tax deductibility
company earns high profits. and rate of interest is fixed even in the years of
high profit

A firm, therefore, needs to have a judicious mix of both debt and equity in making financing decisions, which
may be debt, equity, preference share capital, and retained earnings.
 capital structure - FINANCING DECISION

• The overall financial risk depends upon the proportion of debt in the total capital. This decision determines the
overall cost of capital and the financial risk of the enterprise.
• CAPITAL STRUCTURE = OWNER’S FUNDS + BORROWED FUNDS
• CAPITAL STRUCTURE = EQUITY + DEBT
• The cost of debt is lower than the cost of equity for a firm because the lender’s risk is lower than the equity
shareholder’s risk, since the lender earns an assured return and repayment of capital and, therefore, they should
require a lower rate of return. Additionally, interest paid on debt is a deductible expense for computation of tax
liability whereas dividends are paid out of after-tax profit. Increased use of debt, therefore, is likely to lower the
over-all cost of capital of the firm provided that the cost of equity remains unaffected.
• Debt is cheaper but is more risky for a business because the payment of interest and the return of principal is
obligatory for the business. Any default in meeting these commitments may force the business to go into
liquidation
• There is no such compulsion in case of equity, which is therefore, considered riskless for the
business. Higher use of debt increases the fixed financial charges of a business. As a result,
increased use of debt increases the financial risk of a company.
FINANCING DECISION - TERMS
1. Financial risk: the risk of default on payment of interest on
debentures/loan or repayment of debentures/loan is known as financial
risk. The overall financial risk depends upon the proportion of debt in the
total capital.
2. Floatation cost: cost of raising funds.
3. Cost of debt = rate of interest or (rate of interest – tax rate)
4. Cost of equity = dividend
5. Eps = earning per share
6. Financial leverage: the proportion of debt in the overall capital is also
called financial leverage.
7. Favourable financial leverage = roi > cost of debt
8. Un favourable financial leverage = roi < cost of debt
capital structure - FINANCING DECISION

• Capital structure of a company, thus, affects both the profitability and the financial risk.
• A capital structure will be said to be optimal when the proportion of debt and equity
is such that it results in an increase in the value of the equity share.
• In other words, all decisions relating to capital structure should emphasise on increasing
the shareholders’ wealth.

• Trading On Equity Refers To The Increase In Profit Earned By The

Equity Shareholders Due To The Presence Of Fixed Financial Charges
Like Interest.
Favourable financial leverage/
trading on equity - EXAMPLE

• TOTAL FUNDS INVESTED – 30,00,000 (30 Lakhs)

• Interest Rate – Cost of Debt = @10% p.a.
• Tax Rate - @20%
• Earnings Before Interest and Tax = EBIT = 4,00,000
• Return on Investment = ROI = EBIT______X 100 = 400,000 X 100 = 13.33%
. total funds invested 30,00,000

• This Is A Condition Of Favourable Financial Leverage As

ROI (13.33%) > Cost of Debt (10%)
In case of favourable financial leverage more proportion of debt in capital
structure will increase Earnings per share i.e wealth or profits of
shareholders.
trading on equity-Favourable financial leverage - example

SITUATION I SITUTION II SITUATION III

If One SHARE @ Rs 10
NUMBER OF SHARES 300,000 2,00,000 100,000
EQUITY SHARE CAPITAL 30,00,000 20,00,000 10,00,000
DEBENTURE CAPITAL ZERO 10,00,000 20,00,000
Earnings before Interest and tax 400,000 400,000 400.000
Less – Interest on debentures@10% Zero_______ 100,000______ 200,000_______

Earnings after interest before tax 400,000 3,00,000 200,000

LESS – Tax @20% 80,000_____ 60,000_____ 40,000_____

Earnings after interest and tax (EAIT) 3,20,000 2,40,000 1,60,000

Earnings Per Share = EAIT / Number of shares 3,20,000 = 1.06 2,40,000 = 1.20 1,60,000 = 1.60
3,00,000 2,00,000 1,00,000
Unfavourable financial leverage
• In case of unfavourable financial leverage i.e
Return on Investment < Cost of Debt
Firm should have more proportion of equity and less proportion of
debenture in capital structure

In case of unfavourable financial leverage more proportion of debt

in capital structure will decrease Earnings per share i.e wealth or
profits of shareholders.
Factors affecting Choice of Capital
Structure
• 1. Cash Flow Position:. • 8. Floatation Cost
• 2. Interest Coverage Ratio (ICR): • 9. Risk Consideration
• 3. Debt Service Coverage Ratio • 10. Flexibility
(DSCR): • 11. Control
• 4. Return on Investment • 12. Regulatory Framework
• 5. Cost of Debt • 13. Stock Market Conditions
• 6. Tax Rate • 14. Capital Structure of Other
• 7. Cost of Equity Companies
 Capital budgeting decision/ long term
investment decision/ fixed capital
• Every company needs funds to finance its assets and activities. Investment is required to
be made in fixed assets and current assets.
• Fixed assets are those which remains in the business for more than one year, usually
for much longer, e.g., plant and machinery, furniture and fixture, land and building,
vehicles, etc. Decision to invest in fixed assets must be taken very carefully as the
investment is usually quite large. Such decisions once taken are irrevocable except at a
huge loss. Such decisions are called capital budgeting decisions .
• These long term assets last for more than one year. It must be financed through long-
term sources of capital such as equity or preference shares, debentures, long-term loans
and retained earnings of the business. Fixed Assets should never be financed through
short-term sources. Investment in these assets
• It involves committing the finance on a long-term basis. For example, making
investment in a new machine to replace an existing one or acquiring a new fixed asset or
opening a new branch, etc.
Capital budgeting decision/ long term
investment decision/ fixed capital
• Fixed capital refers to investment in long-term assets. Management of fixed
capital involves allocation of firm’s capital to different projects or assets with
long-term implications for the business.
• Investment in these assets would also include expenditure on acquisition,
expansion, modernisation and their replacement. These decisions include
purchase of land, building, plant and machinery, launching a new product line or
investing in advanced techniques of production.
• Major expenditures such as those on advertising campaign or research and
development programme having long term implications for the firm are also
examples of capital budgeting decisions.
Capital budgeting decision/ long term investment
decision/ fixed capital- IMPORTANCE
• The management of fixed capital or investment or capital budgeting decisions are important for
the following reasons:
• (i) Long-term growth: These decisions have bearing on the long-term growth. The funds
invested in longterm assets are likely to yield returns in the future. These will affect the future
prospects of the business.
• (ii) Large amount of funds involved: These decisions result in a substantial portion of capital
funds being blocked in long-term projects. Therefore, these investments are planned after a
detailed analysis is undertaken. This may involve decisions like where to procure funds from and
at what rate of interest.
• (iii) Risk involved: Fixed capital involves investment of huge amounts. It affects the returns of
the firm as a whole in the longterm. Therefore, investment decisions involving fixed capital
influence the overall business risk complexion of the firm.
• (iv) Irreversible decisions: These decisions once taken, are not reversible without incurring
heavy losses. Abandoning a project after heavy investment is made is quite costly in terms of
waste of funds. Therefore, these decisions should be taken only after carefully evaluating each
detail or else the adverse financial consequences may be very heavy.
Factors Affecting Capital budgeting decision
• A number of projects are often available to a business to invest in. But each project has to be evaluated
carefully and, depending upon the returns, a particular project is either selected or rejected. If there is
only one project, its viability in terms of the rate of return, viz., investment and its comparability with
the industry’s average is seen. There are certain factors which affect capital budgeting decisions.
• (a) Cash flows of the project: When a company takes an investment decision involving huge amount
it expects to generate some cash flows over a period. These cash flows are in the form of a series of
cash receipts and payments over the life of an investment. The amount of these cash flows should be
carefully analysed before considering a capital budgeting decision.
• (b) The rate of return: The most important criterion is the rate of return of the project. These
calculations are based on the expected returns from each proposal and the assessment of the risk
involved. Suppose, there are two projects, A and B (with the same risk involved), with a rate of return
of 10 per cent and 12 per cent, respectively, then under normal circumstance, project B should be
selected.
• (c) The investment criteria involved: The decision to invest in a particular project involves a number
of calculations regarding the amount of investment, interest rate, cash flows and rate of return. There
are different techniques to evaluate investment proposals which are known as capital budgeting
techniques. These techniques are applied to each proposal before selecting a particular project.
Factors Affecting Requirement of Fixed
Capital
1. Nature of Business
2. Scale of Operations
3. Choice of Technique
4. Technology Upgradation
5. Growth Prospects
6. Diversification
7. Financing Alternatives
8. Level Of Collaboration
Working Capital/ Short-term Investment Decision
Short-term investment decisions (also called working capital decisions) are
concerned with the decisions about the levels of cash, inventory and
receivables. These decisions affect the day-to-day working of a business.
These affect the liquidity as well as profitability of a business. Efficient
cash management, inventory management and receivables management are
essential ingredients of sound working capital management.
Examples of current assets, in order of their liquidity, are as under:
1. Cash in hand/Cash at Bank 2. Marketable securities 3. Bills receivable 4.
Debtors 5. Finished goods inventory 6. Work in progress 7. Raw materials 8.
Prepaid expenses
Working Capital/ Short-term Investment Decision
Current assets, as noted earlier, are expected to get converted into cash or cash
equivalents within a period of one year. These provide liquidity to the business. An
asset is more liquid if it can be converted into cash quicker and without reduction in
value.
Insufficient investment in current assets may make it more difficult for an organisation
to meet its payment obligations. However, these assets provide little or low return.
Hence, a balance needs to be struck between liquidity and profitability.
Current liabilities are those payment obligations which are due for payment within one
year; such as bills payable, creditors, outstanding expenses and advances received
from customers, etc.
Some part of current assets is usually financed through short-term sources, i.e., current
liabilities. The rest is financed through long-term sources and is called net working
capital.
Thus, NWC = CA – CL (i.e. Current Assets - Current Liabilities.)
Factors affecting the working capital
REQUIREMENTS

1. Nature of Business 7. Credit Availed

2. Scale of Operations 8. Operating Efficiency
3. Business Cycle 9. Availability of Raw Material
4. Seasonal Factors 10. Growth Prospects
5. Production Cycle 11. Level of Competition
6. Credit Allowed 12. Inflation
 DIVIDEND DECISION
• Dividend is that portion of profit which is distributed to shareholders. The decision
involved here is how much of the profit earned by company (after paying tax) is to be
distributed to the shareholders and how much of it should be retained in the business.
• While the dividend constitutes the current income re-investment as retained earning
increases the firm’s future earning capacity. The extent of retained earnings also
influences the financing decision of the firm.
• Factors Affecting Dividend Decision are:
s
Amount of Earnings Shareholders’ Growth Access to Capital
Preference: Opportunities: Market:
Stability earnings Taxation Policy Cash Flow Position Legal Constraints:

Stability of Dividends Stock Market Contractual

Reaction: Constraints
 FINANCIAL PLANNING
• Financial Planning Is Essentially The Preparation Of A Financial Blueprint Of An
Organisation’s Future Operations.
• financial planning is not equivalent to, or a substitute for, financial management.
Financial management aims at choosing the best investment and financing alternatives
by focusing on their costs and benefits. Its objective is to increase the shareholders’
wealth.
• Financial planning on the other hand aims at smooth operations by focusing on fund
requirements and their availability in the light of financial decisions.
• for example, if a capital budgeting decisions is taken, the operations are likely to be at
a higher scale. The amount of expenses and revenues are likely to increase. Financial
planning process tries to forecast all the items which are likely to undergo changes. It
enables the management to foresee the fund requirements both the quantum as well as
the timing. Likely shortage and surpluses are forecast so that necessary activities are
taken in advance to meet those situations.
 FINANCIAL PLANNING - objectives
• financial planning strives to achieve the following twin objectives.
• (a) To ensure availability of funds whenever required: This include a proper estimation of the funds
required for different purposes such as for the purchase of longterm assets or to meet day-to-day expenses
of business etc. Apart from this, there is a need to estimate the time at which these funds are to be made
available. Financial planning also tries to specify possible sources of these funds.
• (b) To see that the firm does not raise resources unnecessarily: Excess funding is almost as bad as
inadequate funding. Even if there is some surplus money, good financial planning would put it to the best
possible use so that the financial resources are not left idle and don’t unnecessarily add to the cost.
• Thus, a proper matching of funds requirements and their availability is sought to be achieved by financial
planning.
• This process of estimating the fund requirement of a business and specifying the sources of funds is
called financial planning. Financial planning takes into consideration the growth, performance,
investments and requirement of funds for a given period. Financial planning includes both short-term
as well as long-term planning. Long-term planning relates to long term growth and investment. It
focuses on capital expenditure programmes. Short-term planning covers short-term financial plan
called budget
 FINANCIAL PLANNING - importance
• (i) It helps in forecasting what may happen in future under different business situations. By doing so,
it helps the firms to face the eventual situation in a better way. In other words, it makes the firm better
prepared to face the future. For example, a growth of 20% in sales is predicted. However, it may happen
that the growth rate eventually turns out to be 10% or 30%. Many items of expenses shall be different in
these three situations. By preparing a blueprint of these three situations the management may decide what
must be done in each of these situations.
• (ii) It helps in avoiding business shocks and surprises and helps the company in preparing for the future.
• (iii) If helps in co-ordinating various business functions, e.g., sales and production functions, by
providing clear policies and procedures.
• (iv) Detailed plans of action prepared under financial planning reduce waste, duplication of efforts, and
gaps in planning.
• (v) It tries to link the present with the future.
• (vi) It provides a link between investment and financing decisions on a continuous basis.
• (vii) By spelling out detailed objectives for various business segments, it makes the evaluation of actual
performance easier.