Financial management

● Meaning of finance:
▪ It refers to the funds required to carry out business activities.
▪ It is essential to acquire fixed assets and to meet day to day expenses of the business.
● Meaning of financial management:
▪ it refers to managing all the financial activities of the business.
▪ It is concerned with optimum procurement and utilisation of funds so that it gives maximum return to
the shareholders.
● Objectives of financial management:
▪ The primary objective of financial management is to maximize the wealth of shareholders.
▪ Shareholders wealth maximizes when the market price of equity shares increases.
▪ Market price of equity shares increases when the benefits of financial decisions exceed its cost.

● Dividend decision:
▪ Dividend is the part of profit which is distributed among shareholders.
▪ Under dividend decision, it is decided that after paying tax on the profit, how much of remaining profit
should be distributed among the shareholders and how much of that should be kept in reserve.
▪ Factors affecting dividend decision:
❖ Amount of Earnings: Dividend is paid out of current and past earnings. High earnings leads to
high rate of dividend and vice - versa.

❖ Stability of earning: when earning of the company is stable or consistent, it pays higher rate of
dividend and vice versa.

❖ Stability of dividend: when a company has stable dividend policy then it pays fixed amount of
dividend per share. It may increase the rate of dividend with the increase in earning potential of
the company in future.

❖ Growth opportunities: Companies having growth opportunities are likely to pay low rate of
dividend and retain more profits to invest in profitable projects. On other hand non growth
companies can pay higher rate of dividend.

❖ Cash flow position: With strong cash flow position companies are in a situation to pay high rate
of dividend and vice versa.

❖ Shareholders preference: shareholders are the owner of the company. Therefore, Before taking
dividend decision, the preference of shareholders must be considered. If they have a desire for
certain amount of dividend then company must fulfil it.
 ❖ Taxation policy: Dividend is tax free in the hand of shareholders but the company has to pay
dividend tax to the government. If the rate of dividend tax is very high then companies pay low
rate of dividend and vice versa.

❖ Stock market reaction: Dividend decision affects the sentiments of stock market. High rate of
dividend has positive impact and low rate of dividend has negative impact over the stock market.
Therefore, before taking dividend decision, stock market reaction must be considered.

❖ Access to capital market: large and reputed companies have easy access to capital market and
can raise funds easily and are in a situation to pay high rate of dividend. On other hand small
companies find difficulties to raise funds from stock market and pay low rate of dividend and
make more reserves.

❖ Legal constraints: Before taking dividend decision legal provisions in this regard must be
considered. Some legal provisions put restrictions on the payment of dividend. Example:
minimum 15% of net divisible profit must be kept in reserve before paying dividend.

❖ Contractual constraints: While granting loans to a company, financial institutions may impose
certain restrictions on the payment of dividend in future. Before taking dividend decision,
company must consider this contractual constraints.

● Financing decision:
▪ It is concerned with how much long-term funds to be raised and identifying their various sources.
▪ Two main sources of long term funds are debt and equity.
▪ Financing decision determines overall cost of capital and financial risk of the business.
▪ Factors affecting financing decision:
❖ Cash flow position of the company: when cash flow position of the companies is very strong, it
should use more of debt because it can pay interest easily. If cash flow condition is not good
then it should use more of equity.

❖ Cost: Debt is cheaper source of finance because it reduces tax liabilities. If the cost of debt is
low, company should use more of it and vice versa.

❖ Risk: Debt is cheaper but it is very risky because it is compulsory to pay interest on debt and
redeem the principal amount. Using more debts increases financial risk of the business. But this
problem is not with equity. Therefore, risk factor must be considered before taking the financing
decision.

❖ Level of fixed operating cost: If a company has high operating cost ( rent of building, salaries of
permanent employees, cost of insurance etc. ) then it will have high operating risk. In this
situation company should use less amount of debts otherwise financial risk will also increase. If
operating cost is low, it can use more of debts.

❖ Floatation cost: Cost of raising funds is called floatation cost. Example: cost of printing
prospectus, cost of advertisement etc. Sources of funds with low floatation cost are more
attractive. Considering the floatation cost, getting loan from financial institution is more
preferable than issuing equity shares.
 ❖ Control considerations: Debt normally does not cause dilution of control as it does not have any
voting power. On other hand issuing more equity shares may cause dilution of control over the
management. Therefore, control factor must be considered before taking the financing decision.

❖ State of capital market: when stock market is rising ( bullish market ) company should use more
of equity as shares can be issued at premium price. When stock market is falling ( bearish market
) company should use more of debts.

● Investment decision:
▪ It is concerned with investment of funds into different assets so that the firm is able to earn profit. It is of
two types: short term and long-term investment decision.
▪ Short term investment decision is called working capital decision and long term investment decision is
called capital budgeting.

▪ Long term investment decision / capital budgeting:

❖ It refers to a decision which involves allocation of funds into different projects with long term
effects.
❖ It is also called management of fixed capital.
❖ Example: purchase of land and building; purchase of plant and machinery; purchase of
furniture; opening a new branch; launching new product line; investment in new technology;
expenditure on research and development etc.
▪ Factors affecting capital budgeting decision:
❖ Rate of return of the project: Before investing funds into different projects, their expected rate
of return must be compared. Funds should be invested into the project with higher rate of
return.

❖ Cash flow of the project: when a company invest funds in some projects, it expects cash inflow
over the time period. So, cash flow of the different projects must be compared before investing
funds into them. Funds should be invested into that project which involves comparatively regular
in flow of cash.

❖ Investment criteria involved: Before investing funds into any project, number of calculations
are done regarding cost of investment, rate of interest, cash flow of the project, rate of return
etc. There are some capital budgeting techniques like NPV, IRR, payback period etc. which are
used to evaluate different investment proposals. These techniques are applied before selecting a
particular investment proposal.

▪ Importance of capital budgeting:

❖ Long term growth: capital budgeting decision affects long term growth of the company. It helps
the firm to earn profit over long time period.

❖ Large amount of funds involved: it involves huge amount of funds being blocked over long time
period in long term projects.

❖ Risks involved: it involves high degree of risk because huge amount is involved and returns are
expected in long time period which is very uncertain.
 ❖ Irreversible decision: When capital budgeting decision is taken, it can not be reversed. it can be
reversed only at the cost of huge loss.

● Financial planning:
▪ Meaning of financial planning:
❖ It is essentially the preparation of financial blueprint of an organisation’s future operations.
❖ It is mainly concerned with estimating the requirement of funds and specifying its different
sources.
▪ Objectives of financial planning:
❖ To ensure availability of funds, whenever these are required.
❖ To see the firm does not raise resources unnecessarily because it involves cost and idle funds
may lead to wasteful expenditure.

▪ Importance of financial planning:

❖ It helps in forecasting what may happen in future under different business situations.
❖ It helps in avoiding business shocks and surprises and prepare the company for the future.
❖ It helps in coordinating various business activities.
❖ It reduces wasteful expenditure and duplication of efforts.
❖ It tries to link the present with the future.
❖ It provides link between investment and financing decision.
❖ To evaluate actual performance by setting performance standards.

● Capital structure:
▪ It refers to the mixture of debts and equity fund to finance the operations of business.
▪ Capital structure= Debts / Equity
▪ Capital structure is said to be optimum when it gives maximum return to the shareholders.

● Factors affecting capital structure:

▪ Risk consideration:
❖ Using more debts increases financial risk of the business because payment of interest is
compulsory even in case of losses.
❖ When business has high operating risk due to high fixed operating cost, it should not use more of
debts otherwise total risk ( operating risk + financial risk ) of the business will also increase and
vice versa.
▪ Cost of debts:
❖ Cost of debt means payment of interest on borrowed funds.
❖ When cost of debt is lower, more debts can be used in capital structure and vice versa.
▪ Tax rate:
❖ Payment of interest on borrowed fund is a tax deductible expense.
❖ When tax rate is very high, more debts can be used in capital structure because it will reduce the
tax liability and vice versa.
▪ Return on investment:
❖ When return on investment is greater than the rate of interest, more debts funds should be used
because it increases earning per share.
❖ When return on investment is lesser than rate of interest, more of equity funds should be used.
▪ Cash flow position:
❖ When cash flow position is good, more of debts can be used because business can pay interest
regularly.
❖ When cash flow position is not good, more of equity funds should be used because payment of
dividend is not compulsory.
▪ Cost of equity:
❖ Cost of equity means payment of dividend.
❖ When more debts are used, it increases financial risk for the shareholders.
❖ Due to this fact equity shareholders start demanding high rate of dividend and hence cost of
equity increases.
❖ Therefore, business should not use debts beyond a certain limit.
▪ Floatation cost:
❖ It is the cost of raising funds. Example: cost of advertisement, cost of printing prospectus etc.
❖ Public issue of shares involves high floatation cost whereas taking loan from financial institutions
involve low floatation cost.
❖ Considering the floatation cost, company should use more of loans from financial institutions
instead of issuing shares.
▪ Control:
❖ Borrowed funds do not have voting power and they normally do not cause dilution of control
over the business.
❖ Issue of equity shares may cause dilution of control over the business because equity
shareholders enjoy voting power.
❖ Considering the control factor business should use more of borrowed funds.
▪ Flexibility:
❖ When a capital structure is flexible, ratio between debt and equity can be changed whenever
required.
❖ When a company uses its full potential of debt capacity then the capital structure loses its
flexibility because it won't be able to use more of debts in case of a need.
❖ To maintain flexibility in capital structure, company should maintain borrowing capacity to meet
unforeseen situations.
▪ Interest coverage ratio:
❖ It refers to the number of times earning before interest and tax (EBIT ) of the company covers
interest obligation. ICR= EBIT/interest
❖ When ICR is higher more debts can be used because company can pay interest easily without
any risk and vice versa.
▪ Debt service coverage ratio:
❖ It refers to a number of times cash profit earned after interest and tax to cover fixed financial
cost like payment of interest, payment of preference dividend, payment of principal amount of
loan etc.
❖ DSCR = cash profit after interest and tax/ ( interest + dividend+ repayment of loan.)
❖ When DSCR is higher more debts can be used and vice versa.
▪ Stock market condition:
❖ When stock market is rising ( bullish market ), more of equity funds should be used because
company can issue shares at a premium price.
❖ When stock market is falling ( bearish market ), company should use more of debt funds because
it will be difficult to issue shares in this situation.
▪ Regulatory framework:
❖ Every company has to operate within the regulatory framework provided by the law.
❖ Shares and debentures must be issued according to SEBI's guidelines and companies act 2013.
 ❖ Similarly loan from financial institutions must be taken according to RBI guidelines.
● Working capital:
▪ It refers to the funds which remain invested in short term assets (current assets) up to 1 year.
▪ It helps in meeting day to day activities of the business.
▪ Gross working capital = sum of all current assets
▪ Net working capital = (current assets - current liabilities)
▪ It provides more liquidity and low return.
▪ So, it affects liquidity as well as profitability.
● Factors affecting the requirement of working capital:
▪ Nature of business:
❖ Manufacturing business requires more working capital than the trading business because it
involves processing of raw materials into finished goods, maintaining stocks of raw material and
finished goods etc.
❖ Trading business requires less working capital because it doesn’t involve processing of raw
material.
❖ Service industries like transportation warehousing banking advertising etc. involve less working
capital since they do not require to maintain stock.
▪ Scale of operation:
❖ Large scale business requires more working capital than the small scale business because it
involves maintaining more inventory, debtors, cash etc. and vice versa.
▪ Business cycle:
❖ In case of a boom period, more working capital is required because production and sales
activities will be on higher side.
❖ During the depression, less working capital is required because production and sales activities
will be very low.
▪ Seasonal factors:
❖ During the peak season, more working capital is required because it involves high level of sales
and production activities.
❖ On other hand during the lean season, less working capital is required.
❖ Example: cold drink dealers require more working capital during the summer than the winter
season.
▪ Production cycle ( operating cycle ):
❖ Production cycle is the time length between procurement of raw material and its conversion into
finished goods.
❖ Manufacturing business has usually longer production cycle and requires more working capital.
❖ Trading business has shorter production cycle and hence requires less working capital.
▪ Credit allowed:
❖ If a firm allows credit for a longer period of time ( liberal credit policy ) to its customers then it
requires more working capital.
❖ On other hand less working capital is required, if credit is allowed for a shorter period of time.
▪ Credit availed:
❖ If a firm gets credit from its suppliers for a longer period of time then it requires less amount of
working capital and vice versa.
▪ Availability of raw material:
❖ If raw material is available easily and continuously then firm will be require to maintain low level
of inventory and hence low working capital is required.
❖ If it is not available easily and continuously then the form will require to maintain more
inventory to carry out business activities smoothly and hence requires more working capital.
 ▪ Level of competition:
❖ Higher level of competition requires to maintain high level of inventory to meet the urgent
demand of potential customers.
❖ Higher level of competition also force the firm to allow credit to its customers and hence
requires more working capital and vice versa.
▪ Growth prospects:
❖ Growing firms require more working capital to meet higher production and sales target. On
other hand non growing firms require less working capital.
▪ Inflation:
❖ In case of inflation, more working capital is required because price level is going upward and vice
versa.
▪ Operating efficiency:
❖ Firms having high operating efficiency, require less amount of working capital because they are
able to maintain raw material, debtors, stock of finished goods etc. very efficiently.
❖ Firms having low operating efficiency, require more working capital.

● Fixed capital:
▪ Fixed capital refers to the funds which remain invested into long term assets ( fixed assets ).
▪ Example: funds invested in land and building, plant and machinery, furniture etc.
● Factors affecting the requirement of fixed capital:
▪ Nature of business:
❖ Manufacturing business requires more fixed capital than the trading business because it involves
purchase of plant and machinery, Land and building, equipment etc.
❖ On other hand, Trading business does not require plant and machinery, equipment etc. and
hence requires less fixed capital.
▪ Scale up operation:
❖ Large scale business requires more fixed capital than the small scale business because it requires
more fixed assets like land and building, plant and machinery etc.
▪ Choice of techniques:
❖ Capital intensive organisation requires more fixed capital as it requires more investment in plant
and machinery, equipment etc.
❖ Labour intensive organisation required less amount of fixed capital .
▪ Technology upgradation:
❖ Industries where technology gets obsoleted very soon, requires more fixed capital to upgrade
the technology. Example: Mobile industries, automobile industries, TV industries etc.
❖ Industries where technology does not get obsoleted very soon, require less amount of fixed
capital. Example: furniture industries, cement industries etc.
▪ Growth prospects:
❖ Companies having high growth prospects in future, require more fixed capital.
❖ Non growth companies require less amount of fixed capital.
▪ Diversifications:
❖ Diversification means setting of new line of business in addition to the existing business.
❖ A company which keeps on diversifying its business, requires more fixed capital than non
diversified business.
▪ Financial alternatives:
❖ When a firm procures fixed assets on rental basis, it will require less fixed capital.
❖ When rental or leasing facility is not used to procure fixed assets then firm will require more
fixed capital to purchase fixed assets like land and building, plant and machinery etc.
 ▪ Level of collaboration:
❖ Collaboration means sharing each other assets for mutual benefit.
❖ High degree of collaboration with the firms, requires less amount of fixed capital and vice versa.
❖ Example: Most of the banks use each other ATM and it reduces the need of more fixed capital.
● Trading on equity / financial leverage:
▪ Using fixed cost funds like debentures along with equity share capital to finance business operation with
the motive of increasing earning per share is known as trading on equity.
▪ ROI > rate of interest on debts, it is favourable financial leverage.
▪ ROI < rate of interest on debts, it is unfavourable financial leverage.
● Numerical example of favourable financial leverage:
ROI is 20% , total funds required rupees 5,00,000, tax rate 40%, face value of equity share rupees 100 each.

Particulars Case 1 Case 2

Equity shares cap 500000 Equity share cap 300000
No. of equity shares 5000 No. of equity shares 3000
10% debentures nil 10% debentures. 200000

PBIT 20% 100000 100000

(-) Interest Nil (20000)
PBT 100000 80000
(-) tax 40% 40000 32000
PAT 60000 48000

EPS= PAT/ no. of equity 60000/5000= 12 48000/3000= 16

shares

From the above table we can say that company should use debentures along with equity share because earning per
share is increasing due to favourable financial leverage.