Financial Management

Q1. What is business finance? Why do businesses need 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 modernize it, to expand, or diversify it.
 It is required for buying a variety of assets, which may be tangible like machinery,
factories, buildings, offices; or intangible such as trademarks, patents, technical
expertise, etc.
 Also, finance is central to running the day-to-day operations of the business, like
buying material, paying bills, salaries, collecting cash from customers, etc. needed at
every stage in the life of a business entity.
 Availability of adequate finance is crucial for every business’s survival.
Q2. What is financial management?

 Financial Management is concerned with optimal procurement as well as the usage

of finance. It aims at reducing the cost of funds procured, keeping the risk under
control and achieving effective deployment of such funds. It also aims at ensuring
availability of enough funds whenever required as well as avoiding idle finance.
Q3. What are some prominent aspects that are affected by financial management?
The role of financial management cannot be over-emphasised, since it has a direct bearing
on the financial health of a business. The financial statements, such as Balance Sheet and
Profit and Loss Account, reflect a firm’s financial position and its financial health. Almost all
items in the financial statements of a business are affected directly or indirectly through
some financial management decisions. For example:

 The size and the composition of fixed assets of the business

 The quantum of current assets and its break-up into cash, inventory and receivables:
With an increase in the investment in fixed assets, there is a commensurate increase
in the working capital requirement. The quantum of current assets is also influenced
by financial management decisions. In addition, decisions about credit and inventory
management affect the amount of debtors and inventory which in turn affect the
total current assets as well as their composition.
 The amount of long-term and short- term funds to be used: Financial management,
among others, involves decision about the proportion of long-term and short-term
funds. An organisation wanting to have more liquid assets would raise relatively more
amount on a long-term basis.
 Break-up of long-term financing into debt, equity etc.: Of the total long- term
finance, the proportions to be raised by way of debt and/or equity is also a financial
management decision. The amounts of debt, equity share capital, preference share
capital are affected by the financing decision, which is a part of financing
management.
  All items in the Profit and Loss Account, e.g., Interest, Expense, Depreciation, etc. :
Higher amount of debt means higher interest expense in future. Similarly, use of
higher equity may entail higher payment of dividends. Similarly, an expansion of
business which is a result of capital budgeting decision is likely to affect virtually all
items in the profit and loss account of the business.
Q4. What does good financial management aim at?

 Good financial management aims at mobilisation of financial resources at a lower

cost and deployment of these in most lucrative activities.
Q5. What is the primary objective of financial management?

 The primary aim of financial management is to maximise shareholders’ wealth, which

is referred to as the wealth-maximisation concept.
Q6. Enlist 3 financial decisions.

 Investment decision
 Financing decision
 Dividend decision
Q7. What are investment decisions?

 A firm’s resources are scarce in comparison to the uses to which they can be put. A
firm, therefore, has to choose where to invest these resources, so that they are able
to earn the highest possible return for their investors.
 The investment decision, therefore, relates to how the firm’s funds are invested in
different assets.
Q8. What are the different investment decisions?

 Investment decision can be long- term or short-term.

 A long-term investment decision is also called a Capital Budgeting decision. It
involves committing the finance on a long-term basis. For example, making
investment in a new machine to replace an existing one.
 These decisions are very crucial for any business since they affect its earning capacity
in the long run.
 The size of assets, profitability and competitiveness are all affected by capital
budgeting decisions.
 Moreover, these decisions normally involve huge amounts of investment and are
irreversible except at a huge cost. Therefore, once made, it is often almost impossible
for a business to wriggle out of such decisions.
 Therefore, they need to be taken with utmost care.
 A bad capital budgeting decision normally has the capacity to severely damage the
financial fortune of a business.
 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.
Q9. What are the factors that affect capital budgeting decisions?

 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 analyzed before
taking a capital budgeting decision.
 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.
 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.
Q10. What do you understand from financing decisions?

 Financing decisions are about the quantum of finance to be raised from various long-
term sources.
 It involves identification of various available sources. The main sources of funds for a
firm are shareholders’ funds and borrowed funds.
Q11. How are shareholders and borrowers funds different?

 The shareholders’ funds refer to the equity capital and the retained earnings.
 Borrowed funds refer to the finance raised through debentures or other forms of
debt.
Q12. Why should a firm have a judicious mix of debt and equity?

 A firm has to decide the proportion of funds to be raised from either sources of
finance, based on their basic characteristics.
 Interest on borrowed funds have to be paid regardless of whether or not a firm has
earned a profit. Likewise, the borrowed funds have to be repaid at a fixed time.
 The risk of default on payment is known as financial risk which has to be considered
by a firm likely to have insufficient shareholders to make these fixed payments.
 Shareholders’ funds, on the other hand, involve no commitment regarding the
payment of returns or the repayment of capital.
 A firm, therefore, needs to have a judicious mix of both debt and equity in making
financing decisions.
Q13. Why is debt cheap?
  Debt is considered to be the cheapest of all the sources because tax deductibility of
interest makes it cheaper.
Q14. What is floatation cost?

 The fund raising exercise also has a cost. This cost is called floatation cost. It also
must be considered while evaluating different sources of funds.
Q15. What does financing decision determine?

 This decision determines the overall cost of capital and the financial risk of the
enterprise.
Q16. What are the factors affecting financing decisions?

 Cost: The cost of raising funds through different sources are different. A prudent
financial manager would normally opt for a source which is the cheapest.
 Risk: The risk associated with each of the sources is different.
 Floatation Costs: Higher the floatation cost, less attractive the source.
 Cash Flow Position of the Company: A stronger cash flow position may make debt
financing more viable than funding through equity.
 Fixed Operating Costs: If a business has high fixed operating costs (e.g., building rent,
Insurance premium, Salaries, etc.), it must reduce fixed financing costs. Hence, lower
debt financing is better. Similarly, if fixed operating cost is less, more of debt
financing may be preferred.
 Control Considerations: Issues of more equity may lead to dilution of management’s
control over the business. Debt financing has no such implication. Companies afraid
of a takeover bid would prefer debt to equity.
 State of Capital Market: Health of the capital market may also affect the choice of
source of fund. During the period when stock market is rising, more people invest in
equity. However, depressed capital market may make issue of equity shares difficult
for any company.
Q17. What are dividend decisions?

 Dividend is that portion of profit which is distributed to shareholders.

 The decision involved here is how much of the profit earned by the company (after
paying tax) is to be distributed to the shareholders and how much of it should be
retained in the business.
 While dividend constitutes the current income reinvestment, the retained earnings
increase the firm’s future earning capacity.
 The extent of retained earnings also influences the financing decision of the firm.
 Since the firm does not require funds to the extent of re-invested retained earnings,
the decision regarding dividend should be taken keeping in view the overall objective
of maximizing shareholder’s wealth.
Q18. What are the factors that affect dividend decisions?
  Amount of Earnings: Dividends are paid out of current and past earning. Therefore,
earnings is a major determinant of the decision about dividend.
 Stability Earnings: Other things remaining the same, a company having stable
earnings is in a better position to declare higher dividends. A company having
unstable earnings is likely to pay smaller dividend.
 Stability of Dividends: Companies generally follow a policy of stabilizing dividend per
share. The increase in dividends is generally made when there is confidence that
their earning potential has gone up and not just the earnings of the current year. In
other words, the dividend per share is not altered if the change in earnings is small or
seen to be temporary in nature.
 Growth Opportunities: Companies having good growth opportunities retain more
money out of their earnings to finance the required investment. The dividend in
growth companies is, therefore, smaller than that in the non–growth companies.
 Cash Flow Position: The payment of dividend involves an outflow of cash. A company
may be earning profit but may be short on cash. Availability of enough cash in the
company is necessary for declaration of dividend.
 Shareholders’ Preference: While declaring dividends, managements must keep in
mind the preferences of the shareholders in this regard. If the shareholders in
general desire that at least a certain amount is paid as dividend, the companies are
likely to declare the same. There are always some shareholders who depend upon a
regular income from their investments.
 Taxation Policy: The choice between the payment of dividend and retaining the
earnings is, to some extent, affected by the difference in the tax treatment of
dividends and capital gains. If tax on dividend is higher, it is better to pay less by way
of dividends. As compared to this, higher dividends may be declared if tax rates are
relatively lower.
 Stock Market Reaction: Investors, in general, view an increase in dividend as good
news and stock prices react positively to it. Similarly, a decrease in dividend may have
a negative impact on the share prices in the stock market.
 Access to Capital Market: Large and reputed companies generally have easy access to
the capital market and, therefore, may depend less on retained earning to finance
their growth. These companies tend to pay higher dividends than the smaller
companies which have relatively low access to the market.
 Legal Constraints: Certain provisions of the Companies Act place restrictions on
payouts as dividend. Such provisions must be adhered to while declaring the
dividend.
 Contractual Constraints: While granting loans to a company, sometimes the lender
may impose certain restrictions on the payment of dividends in future. The
companies are required to ensure that the dividend does not violate the terms of the
loan agreement in this regard.
Q19. What is financial planning?
  Financial planning is essentially the preparation of a financial blueprint of an
organization’s future operations.
Q20. What is the objective of financial planning?

 The objective of financial planning is to ensure that enough funds are available at
right time.
 If adequate funds are not available the firm will not be able to honour its
commitments and carry out its plans.
 On the other hand, if excess funds are available, it will unnecessarily add to the cost
and may encourage wasteful expenditure.
Q21. How are financial management and financial planning different?

 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.
Q22. What are the twin objectives of financial planning?

 To ensure availability of funds whenever required: This includes a proper estimation

of the funds required for different purposes such as for the purchase of long-term
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.
 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.
Q23. What does financial planning include?

 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 programs. Short-term planning covers short-term financial plan called
budget.
Q24. What is the importance of financial planning?

 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.
 It helps in avoiding business shocks and surprises and helps the company in
preparing for the future.
  If helps in coordinating various business functions, e.g., sales and production
functions, by providing clear policies and procedures.
 Detailed plans of action prepared under financial planning reduce waste, duplication
of efforts, and gaps in planning.
 It tries to link the present with the future.
 It provides a link between investment and financing decisions on a continuous basis.
 By spelling out detailed objectives for various business segments, it makes the
evaluation of actual performance easier.
Q25. What is capital structure?

 Capital structure refers to the mix between owners and borrowed funds.
 It is calculated as the debt – equity ratio or as the proportion of debt out of the total
capital.
Q26. What are owners and borrowers funds?

 Owners’ funds consist of equity share capital, preference share capital and reserves
and surpluses or retained earnings.
 Borrowed funds can be in the form of loans, debentures, public deposits etc. These
may be borrowed from banks, other financial institutions, debenture holders and the
public.
Q27. How do debt and equity significantly differ?

 Debt and equity differ significantly in their cost and riskiness for the firm.
 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 overall cost of capital of the
firm provided that the cost of equity remains unaffected.
Q28. Debt is cheaper but riskier. Elaborate.

 Debt is cheaper but is 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 the 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.
Q29. What does capital structure affect?

 Capital structure of a company affects both the profitability and the financial risk.
Q30. When is the capital structure optimal?
  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.
Q31. What is financial leverage?

 The proportion of debt in the overall capital is also called financial leverage.
 It is computed as D/E or D/D+E.
 As the financial leverage increases, the cost of funds declines because of increased
use of cheaper debt but the financial risk increases.
 The impact of financial leverage on the profitability of a business can be seen
through EBIT-EPS Analysis.
Q32. Why does EPS rise with higher debt?

 It is because the cost of debt is lower than the return that company is earning on
funds employed.
Q33. What is trading on equity?

 With higher use of debt, the difference between RoI and cost of debt increases the
EPS. This is a situation of favourable financial leverage. In such cases, companies
often employ more of cheaper debt to enhance the EPS. Such practice is called
Trading on Equity.
 Trading on Equity refers to the increase in profit earned by the equity shareholders
due to the presence of fixed financial charges like interest.
Q34. What is unfavourable financial leverage?

 The cases in which the use of debt reduces the EPS are those of unfavourable
financial leverage. It is advised not to trade on equity.
Q35. What is optimum capital structure?

 A company must choose that risk-return combination which maximises shareholders’

wealth. The debt-equity mix that achieves it is the optimum capital structure.
Q36. What factors affect the choice of capital structure?

 Cash Flow Position: Size of projected cash flows must be considered before
borrowing. Cash flows must not only cover fixed cash payment obligations but there
must be sufficient buffer also. It must be kept in mind that a company has cash
payment obligations for normal business operations, for investment in fixed assets,
and for meeting the debt service commitments.
 Interest Coverage Ratio (ICR): The interest coverage ratio refers to the number of
times earnings before interest and taxes of a company covers the interest obligation.
The higher the ratio, lower shall be the risk of company failing to meet its interest
payment obligations. However, this ratio is not an adequate measure. A firm may
have a high EBIT but low cash balance.
 Debt Service Coverage Ratio (DSCR): Debt Service Coverage Ratio takes care of the
deficiencies referred to in the Interest Coverage Ratio (ICR). The cash profits
generated by the operations are compared with the total cash required for the
service of the debt and the preference share capital. A higher DSCR indicates better
ability to meet cash commitments and consequently, the company’s ability to
increase debt in its capital structure.
 Return on Investment (RoI): If the RoI of the company is higher, it can choose to use
trading on equity to increase its EPS, i.e., its ability to use debt is greater.
 Cost of debt: A firm’s ability to borrow at a lower rate increases its capacity to
employ higher debt. Thus, more debt can be used if debt can be raised at a lower
rate.
 Tax Rate: Since interest is a deductible expense, cost of debt is affected by the tax
rate. A higher tax rate, thus, makes debt relatively cheaper and increases its
attraction vis-à-vis equity.
 Cost of Equity: Stock owners expect a rate of return from the equity which is
commensurate with the risk they are assuming. When a company increases debt, the
financial risk faced by the equity holders increases. Consequently, their desired rate
of return may increase. It is for this reason that a company cannot use debt beyond a
point. If debt is used beyond that point, cost of equity may go up sharply and share
price may decrease in spite of increased EPS.
 Floatation Costs: Process of raising resources also involves some cost. Public issue of
shares and debentures requires considerable expenditure. Getting a loan from a
financial institution may not cost so much. These considerations may also affect the
choice between debt and equity and hence the capital structure.
 Risk Considerations: Financial risk refers to a position when a company is unable to
meet its fixed financial charges. Apart from the financial risk, every business has
some operating risk (business risk), which depends on fixed operating cost. Higher
fixed operating costs result in higher business risk and vice versa. The total risk
depends upon both the business risk and the financial risk. If a firm’s business risk is
lower, its capacity to use debt is higher and vice versa.
 Flexibility: If a firm uses its debt potential to the full, it loses flexibility to issue further
debt. To maintain flexibility, it must maintain some borrowing power to take care of
unforeseen circumstances.
 Control: Debt normally does not cause a dilution of control. A public issue of equity
may reduce the managements’ holding in the company and make it vulnerable to
takeover.
 Regulatory Framework: Every company operates within a regulatory framework
provided by the law. Public issues of shares and debentures have to be made under
SEBI guidelines. Raising funds from banks and other financial institutions require
fulfillment of other norms.
 Stock Market Conditions: If the stock markets are bullish, equity shares are more
easily sold even at a higher price. Use of equity is often preferred by companies in
 such a situation. However, during a bearish phase, a company, may find raising of
equity capital more difficult and it may opt for debt.
 Capital Structure of other Companies: A useful guideline in the capital structure
planning is the debt-equity ratios of other companies in the same industry. There are
usually some industry norms which may help. Care however must be taken that the
company does not follow the industry norms blindly.
Q37. Why is management of fixed capital or capital budgeting decisions important?

 Long-term growth: These decisions have a bearing on the long-term growth. The
funds invested in long-term assets are likely to yield returns in the future. These will
affect the future prospects of the business.
 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.
 Risk involved: Fixed capital involves investment of huge amounts. It affects the
returns of the firm as a whole in the long-term. Therefore, investment decisions
involving fixed capital influence the overall business risk complexion of the firm.
 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 consequences may be very heavy.
Q38. What are the factors affecting fixed capital requirements?

 Nature of Business: The type of business has a bearing upon the fixed capital
requirements. For example, a trading concern needs lower investment in fixed assets
compared with a manufacturing organisation; since it does not require to purchase
plant and machinery, etc.
 Scale of Operations: A larger organisation operating at a higher scale needs bigger
plant, more space etc. and therefore, requires higher investment in fixed assets when
compared with the small organisation.
 Choice of Technique: Some organisations are capital intensive whereas others are
labour intensive. A capital-intensive organisation requires higher investment in plant
and machinery as it relies less on manual labour. The requirement of fixed capital for
such organisations would be higher. Labour intensive organisations on the other
hand require less investment in fixed assets. Hence, their fixed capital requirement is
lower.
 Technology Upgradation: In certain industries, assets become obsolete sooner.
Consequently, their replacements become due faster. Higher investment in fixed
assets may, therefore, be required in such cases.
 Growth Prospects: Higher growth of an organisation generally requires higher
investment in fixed assets. Even when such growth is expected, a company may
choose to create higher capacity in order to meet the anticipated higher demand
 quicker. This entails larger investment in fixed assets and consequently larger fixed
capital.
 Diversification: A firm may choose to diversify its operations for various reasons, with
diversification, fixed capital requirements increase.
 Financing Alternatives: A developed financial market may provide leasing facilities as
an alternative to outright purchase. When an asset is taken on lease, the firm pays
lease rentals and uses it. By doing so, it avoids huge sums required to purchase it.
Availability of leasing facilities, thus, may reduce the funds required to be invested in
fixed assets, thereby reducing the fixed capital requirements.
 Level of Collaboration: At times, certain business organisations share each other’s
facilities. This is feasible if the scale of operations of each one of them is not
sufficient to make full use of the facility. Such collaboration reduces the level of
investment in fixed assets for each one of the participating organisations.
Q39. What are the factors that affect working capital requirements?

 Nature of Business: The basic nature of a business influences the amount of working
capital required. A trading organisation usually needs a smaller amount of working
capital compared to a manufacturing organisation. Similarly, service industries which
usually do not have to maintain inventory require less working capital.
 Scale of Operations: For organisations which operate on a higher scale of operation,
the quantum of inventory and debtors required is generally high. Such organisations,
therefore, require a large amount of working capital as compared to those at a lower
scale.
 Business Cycle: Different phases of business cycles affect the requirement of working
capital by a firm. In case of a boom, the sales as well as production are likely to be
larger and, therefore, larger amount of working capital is required. The requirement
for working capital will be lower during the period of depression as the sales as well
as production will be small.
 Seasonal Factors: Most business have some seasonality in their operations. In peak
season, because of higher level of activity, larger amount of working capital is
required. As against this, the level of activity as well as the requirement for working
capital will be lower during the lean season.
 Production Cycle: Production cycle is the time span between the receipt of raw
material and their conversion into finished goods. Some businesses have a longer
production cycle while some have a shorter one. Working capital requirement is
higher in firms with longer processing cycle and lower in firms with shorter
processing cycle.
 Credit Allowed: Different firms allow different credit terms to their customers. These
depend upon the level of competition that a firm faces as well as the
creditworthiness of their clientele. A liberal credit policy results in an increase in
working capital.
 Credit Availed: Just as a firm allows credit to its customers it also may get credit from
its suppliers. To the extent it avails the credit on purchases, the working capital
requirement is reduced.
 Operating Efficiency: Firms manage their operations with varied degrees of efficiency.
A better debtors turnover ratio may be achieved by reducing the amount tied up in
receivables. Better sales effort may reduce the average time for which finished goods
inventory is held. Such efficiencies may reduce the level of raw materials, finished
goods and debtors resulting in lower requirement of working capital.
 Availability of Raw Material: If the raw materials and other required materials are
available freely and continuously, lower stock levels may suffice. If, however, raw
materials do not have a record of un-interrupted availability, higher stock levels may
be required. Larger the lead time, larger the quantity of material to be stored and
larger shall be the amount of working capital required.
 Growth Prospects: If the growth potential of a concern is perceived to be higher, it
will require larger amount of working capital so that it is able to meet higher
production and sales target whenever required.
 Level of Competition: Higher level of competitiveness may necessitate larger stocks
of finished goods to meet urgent orders from customers. This increases the working
capital requirement.
 Inflation: With rising prices, larger amounts are required even to maintain a constant
volume of production and sales. The working capital requirement of a business thus,
become higher with higher rate of inflation.