LESSON – 9 FINANCIAL MANAGEMENT

Business finance
Money required for carrying out business activities is called business finance. Finance is needed
to establish a business, run it, modernize it, expand, diversify, buying assets, day to day
operations etc.
Financial management
Financial management is concerned with optimal procurement as well as the usage of finance.
It refers to the efficient acquisition of finance, efficient utilization of finance and efficient
distribution and disposal of surplus for smooth working of a business organisation. Financial
management aims at:
 Reducing the cost of funds procured.
 Keeping the risk under control.
 Effective deployment of funds.
 Ensuring availability of enough funds.
 Avoiding idle finance.
Importance / Role of financial management
Financial management has a direct bearing on the financial health of a business. Financial
statements reflect the firm’s financial health. Almost all items in the financial statements of a
business are affected directly or indirectly through some financial management decisions.
 Capital budgeting decisions affects the size and the composition of fixed assets of the
business.
 The quantum of current assets is also influenced by financial management decisions.
 Financial management involves decision about the proportion of long-term and short-
term funds which is a choice between liquidity and profitability.
 The proportion of debt and equity in long term finance is also a financial management
decision.
 Expansion of business is a capital budgeting decision which can affect all items in the
profit and loss account.
Thus the overall financial health of a business is determined by the quality of its financial
management.
Objectives of financial management
The primary aim of financial management is to maximize the wealth of the shareholders.
Wealth maximization:
Wealth maximization means to increase the capital invested in the business by the
shareholders. This can be attained by increasing the market price of the equity shares.
For e.g. A person buys 100 shares of X Ltd. At Rs. 100 per share. It means that his wealth in the
company is Rs. 10000. If the market price of the shares increases to Rs. 120 per share, his
wealth also has gone up to Rs. 12000. Thus his wealth has increased by Rs. 2000. But if the
market price falls to Rs. 80 per share, then his wealth in the company will be reduced to Rs.
8000.
Market price of shares increases if the benefits from a financial decision exceed the cost
involved. All financial decisions aim at ensuring that each decision is efficient and adds some
value. Such value additions tend to increase the market price of shares. Thus a finance manager
needs to take optimum investment decision, optimum financing decision and optimum
dividend decision to have a positive effect on the market price of the shares.
Financial decisions
These are decisions concerned with the three major issues relating to the financial operations
of a firm. They are:
 Investment decision
 Financing decision
 Dividend decision
It means selection of best financing alternative or best investment alternative.
Investment decision:
It is concerned with investment of firm’s funds in different assets so that they are able to earn
highest possible return. Investment decisions can be long term or short term.
Long term investment decision – A long term investment decision is also called a Capital
Budgeting decision. It involves investment in long term fixed assets.
 These decisions are crucial as it affects the earning capacity of the firm.
 Huge investments are involved.
 Decisions are irreversible except at a huge cost.
Short term investment decision – Short term investment decisions are also called working
capital decisions. It involves investment in short term assets like cash, stock, debtors etc.
 These decisions affect the day to day working of a business.
 These affect the liquidity and profitability of a business.
 Efficient cash management, inventory management and receivables management are
necessary for sound working capital management.
Factors affecting capital budgeting decision:
 1. Cash flows of the project – The cash flows in the form of cash receipts and cash
payments from each investment proposal should be carefully analysed before
considering capital budgeting decision.
E.g. If project 1 gives an annual cash inflow of Rs. 8 lakhs, for 5 years and project 2 yields
an inflow of Rs. 20 lakhs at the end of 5 years, then project 1 should be picked for better
annual returns.
2. The rate of return – The rate of return is calculated on the basis of expected return of
the project and risk attached with it. If two projects are of same risk class, the project
having higher rate of return will be accepted.
3. The investment criteria involved – The amount of investment, interest rate, cash flows
and rate of return are the different criteria for investment decision. Capital budgeting
techniques are applied to evaluate investment proposals before taking a final decision.
Financing decision
It deals with the quantum of finance to be raised from various long term sources. There are two
main sources of long term finance viz. shareholders’ funds and borrowed funds. Shareholders’
funds include equity capital and the retained earnings. Borrowed funds include debentures or
other forms of debt.
A firm needs to have a judicious mix of both debt and equity in making financing decisions after
considering the factors like financial cost, financial risk, floatation cost, company commitments
etc.
Factors affecting financing decisions:
1. Cost – Different financial sources have different cost like interest on debt, dividend of
shares etc. A company opts for a source which is the cheapest. Debt financing is cheaper
than equity.
2. Risk – Debt capital is more risky. Financial risk increases with the use of more debt.
Company should analyse its risk bearing capacity and choose accordingly.
3. Floatation costs – These are the expenses incurred on raising the funds. Higher the
floatation cost of a source, less attractive it appears to the management.
4. Cash flow position of the company – A stronger cash flow position make debt financing
more viable than funding through equity.
5. Fixed operating costs – If a business has high fixed operating costs (rent, salary,
premium), then it should use less debt financing. Similarly, if fixed operating cost is less,
more debt financing can be done.
6. Control considerations – Borrowed funds does not affect the management’s control
over the business. But the issue of equity shares may dilute the management control.
Therefore, the management will prefer borrowed funds to the equity funds.
 7. State of capital market – A depressed capital market makes issue of equity shares less
attractive source of finance in comparison to debt. Similarly, a rising capital market
makes equity more viable source of finance than debt.
Dividend decision
It refers to the determination of how much part of the earning should be distributed among
shareholders by the way of dividend and how much should be retained in the business as
retained earnings.
Factors affecting dividend decision:
1. Amount of earnings – The dividend is paid out of the present and reserved profits.
Therefore, greater amount of total profit will ensure greater dividend.
2. Stability of earnings – A company having stable earnings is in a position to declare more
dividends and vice-versa.
3. Stability of dividend – Generally companies follow a policy of stable dividend per share.
It is increased only when there is a confidence that their earning potential has gone up
permanently.
4. Growth opportunities – Companies having good growth opportunities retain more
money out of their earnings. Thus the dividend in growth companies is smaller than that
in the non-growth companies.
5. Cash flow position – The payment of dividend results in outflow of cash. The better the
cash flow position of company, the better will be the capacity of company to pay
dividends.
6. Shareholder’s preference – The management keeps in mind the shareholders’
preferences. If the shareholders’ prefer that a certain amount of dividend should be
paid as their regular income, the company will do that.
7. Taxation policy – If tax on dividend is higher, the companies would prefer to pay less
dividend whereas higher dividends may be declared if tax rates are relatively lower.
8. Stock market reaction – Share prices react positively and negatively on increase and
decrease in dividend respectively. This possible impact on share prices should be
considered while declaring dividend.
9. Access to capital market – Companies having easy access to capital market may depend
less on retained earnings and declare more dividends. While companies having less
access to capital market will retain more and pay less dividends.
10. Legal constraints – Certain provisions of the Companies Act place restrictions on payouts
of dividends. Such provisions have to be followed while declaring dividend.
11. Contractual constraints – While granting loans to a company, sometimes the lender may
impose certain restriction on the payment of dividends in future which should not be
violated by the company.
Financial planning
Financial planning is the preparation of a financial blueprint of an organization’s future
operations. It is the process of estimating the fund requirements of a business and specifying
the sources of funds.
Objectives of financial planning:
1. To ensure availability of funds whenever required – It involves estimation of the funds
required, the time at which these funds are to be made available and the sources of
these funds.
2. To see that the firm does not raise resources unnecessarily – It always ensures that the
balance of cash should neither be in excess nor short. Surplus money should be put to
best possible use so that they are not left idle.
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.
Importance of financial planning:
Financial planning aims to tackle the uncertainty and timing of the funds and helps in smooth
functioning of an organisation.
1. It helps in forecasting various business situations. On this basis alternative financial
plans are prepared. Thus it helps the firm to face the eventual situation in a better way.
2. It helps in avoiding business shocks and surprises by making proper provisions. Thus it
helps the company in preparing for the future.
3. It helps in coordinating various business functions by providing clear policies and
procedures.
4. It reduces waste, duplication of efforts and gaps in planning through detailed plans of
action prepared under financial planning.
5. It tries to link the present with the future.
6. It provides a link between investment and financing decisions on a continuous basis.
7. It makes the evaluation of the actual performance easier through the detailed
objectives.
Capital structure
Capital structure refers to the mix between owners and borrowed funds i.e. debt and equity
capital.
Debt and equity differs in their cost and riskiness for the firm. Increased use of debt lowers the
overall cost of capital of the firm. Debt is cheaper (lower return and deductible expense) but is
more risky (obligatory payments) for a business. Increased use of debt increases the financial
risk of a company.
Capital structure of a company, thus, affects both the profitability and the financial risk.
Financial risk
Financial risk is the chance that a firm would fail to meet its payment obligations.
Financial leverage
The proportion of debt in the overall capital is called financial leverage. It is computed as
(debt/equity) or (debt/ debt + equity). As the financial leverage increases, cost of funds declines
but the financial risk increases.
Impact of financial leverage on the profitability of a business (EBIT-EPS Analysis)
Refer the example 1 and 2 given in pages 251 and 252.
From example 1, the cost of debt is lower than the return on investment (EBIT/Total investment
x 100). This will lead to increase in Earnings per share (EPS) and a favorable financial leverage.
In such cases, companies often employ more of cheaper debt to enhance the EPS. This practice
is called Trading on Equity.
From example 2, the cost of debt is higher than the return on investment (ROI). This will reduce
the EPS and creates a situation of unfavorable financial leverage. Trading on equity is
unadvisable in such a situation.
A company must choose that risk-return combination which maximizes shareholders wealth.
The debt-equity mix that achieves it, is the optimum capital structure.
Trading on equity
It refers to the increase in profit earned by the equity shareholders due to the presence of fixed
financial charges like interest.
Factors affecting the choice of capital structure
1. Cash flow position – The future cash flow position of the company should be kept in
mind. Debt capital should be used only if the cash flow position is really good as
company has obligations for payment of interest and repayment of capital.
2. Interest Coverage Ratio (ICR) – This refers to the number of times earnings before
interest and taxes of a company covers the interest obligation.
ICR = EBIT/Interest
The capacity of the company to use debt capital will be in direct proportion to this ratio.
Higher the ratio, lower will be its financial risk. But this ratio is not an appropriate
measure of the capacity of company to pay interest. Cash flow position should also be
considered.
3. Debt Service Coverage Ratio (DSCR) – This ratio tells about the cash payments to be
made and the amount of cash available. This removes the weakness of ICR.
 DSCR = (Profit after tax+ Depreciation+ Interest+ Non-cash expenses)/ (Preference
dividend+ Interest+ Repayment obligations)
A higher DSCR indicates better capacity of the company for debt payment.
4. Return on investment (RoI) – The greater Return on investment of a company increases
its capacity to utilize more debt capital. Thus, the company can use trading on equity to
increase its EPS.
5. Cost of debt – If the rate of interest on the debt capital is less, more debt capital can be
utilized and vice versa.
6. Tax rate – Since interest is a deductible expense, cost of debt is affected by the tax rate.
A higher tax rate makes debt relatively cheaper or it decreases the cost of debt.
7. Cost of equity – Cost of equity capital is affected by the use of debt capital. When a
company increases debt, the financial risk faced by the equity shareholders increases.
Therefore, the use of the debt capital can be made only to a limited level.
8. Floatation costs – The cost of issuing debt capital is less than the share capital. This
attracts the company towards debt capital.
9. Risk consideration – There are two types of risks in a firm.
 Operating risk / business risk – inability to discharge permanent operating costs.
 Financial risks – inability to pay fixed financial payments.
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.
10. Flexibility – From the view point of flexibility, issuing debt capital is the best. For this,
the company must retain some borrowing powers to be used in case of emergency.
11. Control – Debt capital does not affect the management’s control over the business. But
the issue of more equity shares may dilute the management control.
12. Regulatory framework – Capital structure is also influenced by government regulations.
Raising funds from banks and other financial institutions require fulfillment of other
norms. Stringent regulations discourage a particular source and the lenient regulations
encourages the company.
13. Stock market conditions – If the stock markets are bullish, equity shares are more easily
sold. But during a bearish phase, company may find raising of equity capital more
difficult and it may opt for debt.
14. Capital structure of other companies – A company must take into consideration debt-
equity ratio prevalent in the related industry, as the pattern of their capital structure is
almost similar.
Fixed Capital
It is the money invested in fixed assets like land, machinery etc. which is to be used over a long
period of time.
Management of fixed capital
It involves allocation of firm’s capital to different projects or assets with long-term implications
for the business. These are called investment decisions or capital budgeting decisions.
Importance of fixed capital/investment decision/capital budgeting decision
1. Long term growth – The funds invested in long term assets are likely to yield returns in
the future. This will affect the future prospects of the business.
2. Large amount of funds involved – As large amounts of funds are involved, these
investments are planned after a detailed analysis.
3. Risk involved – These decisions affects the returns of the firm in the long term. Thus
they influence the overall business risk of the firm.
4. Irreversible decisions – These decisions should be taken after careful evaluation, as they
are not reversible without incurring heavy losses.
Factors affecting the requirement of fixed capital
1. Nature of business – A trading concern needs a lower investment in fixed assets as
compared to a manufacturing concern since it doesn’t require to purchase plant and
machinery.
2. Scale of operations – A larger organisation operating at a higher scale needs bigger plant
and more space and hence higher investment in fixed assets.
3. Choice of technique – A capital intensive organisation requires higher investment in
plant and machinery and thus requires higher fixed capital than a labour intensive
organisation.
4. Technology upgradation – Industries where assets become obsolete sooner require
higher fixed capital to purchase such assets.
5. Growth prospects – Higher growth prospects require higher investment in fixed assets
to meet anticipated demand quicker.
6. Diversification – Diversification will increase the fixed capital requirements as the
investment in fixed capital will increase.
7. Financing alternatives – Availability of leasing facilities may reduce the funds required to
be invested in fixed assets, thereby reducing the fixed capital requirements.
8. Level of collaboration – Availability of business collaboration reduces the level of
investment in fixed assets for each one of the participating organisations.
Working Capital
It is the money invested in current assets like stock, debtors etc. to facilitate smooth day to day
operations of the business. It is the excess of current assets over current liabilities.
Net working capital = Current Assets- Current liabilities.
Factors affecting the working capital requirements
1. Nature of business – Trading organisation requires less working capital than
manufacturing organisations as there is no processing. Service industries require less
working capital as they do not have to maintain inventory.
2. Scale of operations – Firms operating on a higher scale require more working capital as
their quantum of inventory and debtors is generally high.
3. Business cycle – Larger working capital is required during boom period as the sales and
production are more. But it will be lower during the period of depression.
4. Seasonal factors – Peak season requires higher working capital than lean season due to
higher level of activity.
5. Production cycle – Production cycle is the time span between the receipt of raw material
and their conversion into finished goods. Working capital requirement is higher in firms
with longer production cycle.
6. Credit allowed – A liberal credit policy results in higher amount of debtors, increasing
the requirement of working capital.
7. Credit availed – Credit availed on purchases from suppliers reduces the working capital
requirement.
8. Operating efficiency – Operational efficiencies may reduce the level of raw materials,
finished goods and debtors resulting in lower requirement of working capital.
9. Availability of raw material – If raw materials are available freely and continuously,
lower stock may be required. The time lag between the placement of order and the
actual receipt of the materials is also relevant. Larger the lead time, larger the quantity
of material to be stored and thus require larger worker capital.
10. Growth prospects – Higher growth prospects will require larger working capital so as to
meet higher production and sales targets.
11. Level of competition – Higher competition requires larger stocks to meet urgent orders
from customers and thus higher working capital.
12. Inflation – Rising prices increases the working capital requirements as larger amount of
money is required to maintain a constant volume of production and sales.

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