Chapter-9

Financial Management

S I R
I S H
A N
M

Prepared by, BINOY GEORGE

Financial Management - Finance

Finance is essential for running a

S I R
business. Finance is needed to establish

I S H
business,acquire various assets,diversify

A N
business and to meeting day to day

M
expenses. So finance is called the life
blood of the business.
 Financial Management

Financial Management is concerned

S I R
management of flow of funds and involves

I S H
decisions relating to procurement of funds,

A N
investment of funds in long term and short term

M
assets and distribution of earnings to owners. It
is a science of money management.
 Financial Management-Importance
Financial management decisions are very relevant
because it affect almost all items in the financial

I R
statements of a business. The following points reveals its

S
importance:

I S H
N
1.It estimate size of the total financial requirements

M A
2.It decide the size and composition of fixed assets.

3.It decide the size and composition of current assets.

4.It decide the sources of funds

 Financial Management-Objectives

Objectives of financial management can

be classified into two:

S I R
H
1.Profit Maximisation

NI S
A
2.Wealth Maximisation

M
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 Financial Management-Objectives
Profit Maximisation:

I R
It means maximize the profit of the firm. It implies that

S
every decision relating to business is evaluated in the

I S H
light of profits. It is because:

A N
1.Profit is the test of economic efficiency

M
2.It is essential for growth and expansion.
3.It ensures maximum dividend to share holders,timely
payment to creditors,welfare of employees .etc
Reliance
State Bank of India reported Industries earned
a net profit of ₹3,955 crore a net profit stood
in the third quarter ended at Rs. 39,588
December 31, 2018 crores during the
FY 2018-19
 Financial Management-Objectives
Wealth maximization:

R
Wealth maximization means to earn maximum wealth for

S I
the shareholders. So, the finance manager tries to give a

S H
maximum dividend to the shareholders. He also tries to

NI
increase the market value of the shares.

M A
 Financial Management-Objectives
Shareholder's Wealth Maximisation-Story of Maruti
If you had invested Rs.1,25,000 and purchased 1000 shares

I R
of Maruti Suzuki Ltd in 2003,when it launched its initial public

S
offering(IPO) with a price of Rs.125 per share,you would be a

I S H
'crorepati' today(20-12-2017).Maruti share prices touched

A N
Rs.10,000 on 20-12-17 on BSE.

M
Value of Investment on 20-12-2017 =1000 X 10,000
=1,00,00,000(1 Crore)
Finance Function / Financial Decision
The finance functions relate to three major decisions which
every finance manager has to take.

S I R
1. Investment decision

S H
2. Financing decision

NI
A
3. Dividend decision

M Financial
Decision
Investment decision
Investment Decisions

R
This decision relates investment of firm's available funds

S I
among fixed and current assets. Investment in Fixed

S H
Assets is called Capital Budgeting and investment in

NI
Current Assets is called Working Capital Management

M A
Investment decision-Capital Budgeting

Capital Budgeting
The decision of investing funds in the long term assets like

S I R
plant and machinery, land and building etc is known as Capital

H
Budgeting. These decisions involve huge amount of

NI S
investment, affect the earning capacity and are irreversible

A
except at a high cost.

M
Investment decision-Types of Assets

S I R
I S H
A N
M
 Investment decision-Working Capital
Management
Working Capital Management

R
The decision of investing fund in current assets or short term

S I
assets is termed as Working Capital Management. It

S H
represents the funds available to the enterprise to finance

NI
regular operations, i.e. day to day business activities,

A
effectively.

M
Net working Capital
=Current Asset – Current Liability
 Factors Affecting Investment Decision
There are certain factors which will affect Investment
(capital budgeting) decisions:

I R
1. Cash flow of the project

H S
2. The rate of return

NI S
3. Risk involved

M A
4. Investment criteria involved
 Factors Affecting Investment Decision

1.Cash flow of the project

R
Investment in fixed assets generates cash inflows

S I
(receipts) over a period. Financial manager should

S H
evaluate and analyse present present and future cash

NI
flows before making a capital budgeting decision. In case

A
the cash flow position of a company is good enough then

M
it can easily use borrowed funds and pay interest on time.
 Factors Affecting Investment Decision
2.The rate of return
The most important criterion is the rate of return of

S I R
the project. A project is accepted only when it

S H
gives highest rate of return as compared to others.

NI
M A
 Factors Affecting Investment Decision

3. Risk Involved
The degree of risk involved in each project should

S I R
be assessed before making a long term

S H
investment.

NI
M A `
 Factors Affecting Investment Decision
4.Investment criteria involved
There are different capital budgeting decisions

S I R
techniques to evaluate investment proposals.

S H
These techniques are Net Present Value,

NI
Discounted Cash Flow, Payback Period Method

M A
etc.
Financing Decision
Financing decision relates to the quantum of
finance to be raised from various sources. Mainly

I R
there are two sources of funds-Owners Fund and

H S
Borrowed Funds.

NI S
M A
Factors Affecting Financing Decisions

1.Cost

R
2.Risk

S I
H
3.Flotation Cost

5.Fixed Operating N I S
A
4.Cash Flow Position of the Company

M
Costs
6.Control Considerations
Factors Affecting Financing Decisions

1.Cost

I R
The costs of raising funds through different sources are

S
different. The finance manager always prefers the source

I S H
with minimum cost.

A N
M
Factors Affecting Financing Decisions

2.Risk

R
The risk associated with each of the sources is different.

S I
More risk is associated with borrowed fund as compared

S H
to owners fund. Finance manager compares the risk with

NI
the cost involved and will take wise decision.

M A
Factors Affecting Financing Decisions

3.Flotation Cost

R
Higher the floatation cost makes the source less

S I
attractive. Floatation cost involves brokers

I S H
commission, underwriters commission, expenses

A N
on prospectus etc.

M
Factors Affecting Financing Decisions

4.Cash Flow Position of the Company

R
A stronger cash flow position may make debt

S I
financing more viable than funding through equity.

I S H
A N
M
Factors Affecting Financing Decisions

5.Fixed Operating Costs

R
If a business has high fixed operating costs (e.g., building

S I
rent, Insurance premium, Salaries, etc.), It must reduce

S H
fixed financing costs.

NI
M A
Factors Affecting Financing Decisions

6.Control Considerations

R
Issues of more equity shares may lead to dilution

S I
of management’s control over the business.

I S H
Companies afraid of a takeover bid would prefer

A N
debt to equity.

M
Dividend Decision
Dividend decision is related with the distribution of
dividend. The decision involved here is how much

S I R
of the profit earned by company (after paying tax)

H
is to be distributed to the shareholders as dividend

NI S
and how much of it should be retained in the

A
business.

M
[Maruti Suzuki Ltd announced a dividend of 80 per share for the FY 2018-
19.Face value of its share is Rs.5 i.e., 1600% dividend per year]
Factors Affecting Dividend Decision
1. Amount of Earnings
2. Stability Earnings

S I R
3. Growth Opportunities

I S H
N
4. Cash Flow Position

M A
5. Shareholders’ Preference
6. Taxation Policy
7. Stock Market Reaction
8. Access to Capital Market
9. Legal Constraints
10.Contractual Constraints
Factors Affecting Dividend Decision
1. Amount of Earnings

R
Dividend is paid out of current and past earning.

S I
Therefore, earnings are a major determinant of the

I S H
decision about dividend.

A N
M
During the FY 2018-19 Reliance Industries Ltd earned a
Net Profit of Rs.35163 crore,out of which they distribute
only Rs.4113 crore as dividend. Total Reserves and
Surplus is Rs.3,98,500 crores!
2. Stability Earnings

R
If a company has stable earnings, it will provide

S I
high dividend to its shareholders.

I S H
A N
M
3. Growth Opportunities

R
Companies having good growth opportunities retain

S I
more money out of their earnings so as to finance the

S H
required investment. The dividend in growth companies

NI
is, therefore, smaller, than that in the non– growth

M A
companies.

During the FY 2018-19 Reliance Industries Ltd earned a Net

Profit of Rs.35163 crore,out of which they distribute only
Rs.4113 crore as dividend. Total Reserves and Surplus is
Rs.3,98,500 crores!They can easily utilise these reserves to
start new ventures like Reliance Jio.
4. Cash Flow Position

R
Companies declare high rate of dividend only

S I
when they have surplus cash. In situation of

I S H
shortage of cash companies declare no or very

A N
low dividend

Jet Airways has not declared any dividend for the last
several years due to shortage of funds
5. Shareholders’ Preference

R
As shareholders have voting right,their interest

S I
regarding dividend plays an important role in dividend

S H
decision. There are always some shareholders who

NI
depend upon a regular income from their investments.

M A
6. Taxation Policy

R
If tax on dividend is higher, it is better to pay less

S I
dividend. So taxation policy of government also

I S H
influences dividend decision.

A N
M
7. Stock Market Reaction

R
A higher rate of dividend has a positive impact on

S I
stock price and vice versa. Therefore,

I S H
management should take into account the impact

A N
of dividend policy on the equity share price,while

M
taking a decision about it
D
I
V
I
D
E
D

IMPACT
8. Access to Capital Market

R
Large and reputed companies generally have easy access

S I
to the capital market and, therefore, may depend less on

S H
retained earning to finance their growth. These companies

NI
tend to pay higher dividends.

M A
9. Legal Constraints

R
Certain provisions of the Companies Act place

S I
restrictions on payouts as dividend. Such

I S H
provisions must be adhere to while declaring the

A N
dividend.

M
10.Contractual Constraints

R
While granting loans to a company, sometimes

S I
the lender may impose certain restrictions on the

I S H
payment of dividends in future. The companies

A N
are required to follow the terms of agreement.

M
 Financial Planning
Financial planning is the plan which estimate the
fund requirements of a business and determining the

S I R
sources for the same. Financial planning includes

H
both short-term as well as long-term planning.

NI S
Financial Planning ensures enough funds are

M A
available at right time,but having no surplus funds.
 Objectives of Financial Planning
1. Ensure availability of funds whenever required

S I R
2. To see that the firm does not raise resources

S H
unnecessarily

NI
M A
 Financial Planning - Importance
1. It helps the company to prepare for the future

R
2. Helps in coordination

S I
H
3. Base for Financial control

NI S
4. Reduce wastage

M A
5. Ensuring Liquidity
6. Helps in avoiding business shocks and surprises
1. It helps the company to prepare for the future
Financial planning forecast what may happen in future

S I R
under different business situations. For example, a

H
growth of 20% in sales is predicted. However, it may

I S
happen that the growth rate eventually turns out to be

A N
10% or 30%.

M
2. Helps in coordination

R
If helps in co-ordinating various business functions, e.g.,

S I
sales and production functions, by providing clear policies

S H
and procedures. It makes possible a closer cooperation

NI
between various departments of the firm.

M A
3. Base for Financial control

I R
Financial planning act as basis for checking the

S
financial activities by comparing the actual revenue

I S H
with estimated revenue and actual cost with estimated

A N
cost.

M
4. Reduce wastage

R
Detailed plans of action prepared under financial planning

S I
reduce waste, duplication of efforts, and gaps in planning.

I S H
A N
M
5. Ensuring Liquidity

R
Financial planning maintains the balance between inflow

S I
and outflow of funds makes it liquid funds available

S H
throughout the year.

NI
M A
6. Helps in avoiding business shocks and surprises

R
By anticipating the financial requirements financial

S I
planning helps to avoid shock or surprises which

S H
otherwise firms have to face in uncertain situations.

NI
M A
 Capital Structure
Capital Structure is the mixture of long-term
sources of funds in a firm’s capital. It represents

S I R
the proportion of debt capital and equity capital in

H
the total capital of a firm. On the basis of

NI S
ownership, the sources of business finance can be

A
broadly classified into two categories viz., ‘owners’

M
funds’ and ‘borrowed funds’.
Capital Structure

S I R
I S H
A N
M
 Capital Structure Models
The Capital Structure of a company may consists of any
of the following mix:

S I R
Model-1 Equity shares only

I S H
Model-2 Equity shares and preference shares

A N
M
Model-3 Equity shares and debentures
Model-4 Equity shares,preference shares and
debentures
Model-5 Equity shares,preference
shares,debenture and long term
loans
Capital Structure

S I R
I S H
A N
M
Risk in case of Equity shares and Fixed cost securities
An Analysis

Equity Shares Fixed Cost Securities

R
like Debentures

S I
H
Equity shares are safe Debt is more risky because

I S
securities from company’s payment of regular interest

A N
point of view as company on debt is a legal obligation

M
has no legal obligation to of the business. Any failure
pay dividend on to equity with reference to the
share holders if it is running payment of interest or
in loss but these are repayment of principal
expensive securities amount may lead to the
liquidation of the company.
Eg.Kingfisher Airlines Ltd
 Financial Leverage
The proportion of debt in the overall capital of a firm is called
Financial Leverage or Capital Gearing. When the proportion of

R
debt in the total capital is high then the firm is

S I
called highly levered firm but when the proportion of debts in

S H
the total capital is less, then the firm will be

NI
called low levered firm.

M A
Financial Leverage- Highly Geared
When the proportion of debt(fixed cost
securities) in the total capital is high then the

S I R
firm is called highly geared.

I S H
When the

A N
financial leverage

M
increases, (highly
geared) the cost
of fund will
decline due to
increased use of
low-cost debts.
DEBT But at the same
HIGH time financial risk
increases.
Financial Leverage- Low Geared
When the proportion of debts(fixed cost securities) in the
total capital is less, then the firm will be

I R
called low geared firm.

H S
I S
When the financial

A N
leverage

M
decreases, (low
geared) the cost of
fund will increase
due to increased
use of high cost
equity shares. But
DEBT at the same time
LOW financial risk will
increase.
 Trading on Equity
Trading on equity refers to the use of fixed cost securities
such as debentures and preference shares in the capital

I R
structure so as to increase the return of equity share

S
holders.

I S H
Trading on equity is a

A N
phenomenon where

M
shareholders return
increases due to the use of
fixed cost securities like
debentures,preference shares
etc.in capital structure.
 Trading on Equity-Example
There are two companies,Company-A and Company-B.Both
companies are working in the same industry and their total capital

I R
is also the same,i.e. Rs.8,00,000 But the structure of their capital

S
is different. Both of them earned an yearly net profit of

S H
Rs.80,000,shareholders of company A earned a rate of return of

NI
10% only but shareholders of B company earned a high rate

A
return i.e.15% on their investment. The reason for this magic is

M
that B company included fixed cost securities in its capital
structure.
Calculation:
Company-A

Rate of return of return of shareholders (A Ltd)=10%

[(80,000/8,00,000)100)]

(Cont.)
 Trading on Equity-Example
Company-B
Total capital(Equity-3,00,000 + Debenture-5,00,000) -8,00,000

S I R
Profit Earned During the Year -80,000

S H
Less Interest on Debentures (5,00,000 * 7%) -35,000

NI
Balance Profit Available to Equity Shareholders

M A
( 80,000– 35,000) -45,000
Rate of Return on equity Shareholders -15%
[(45,000 / 3,00,000)100)]

Conclusion:Shareholders of Company-B earned an addition 5% (15-10)

return as compared to equity shareholders of company-A just because of
inclusion fixed cost securities in its capital structure. This phenomenon is
called Trading on Equity.
Note: It is workout only where Return on Investment(here it is 10% i.e.
(80,000 /8,00,000)100 is higher than interest on debentures(here it is 7%).
1. Trading on equity/ financial leverage factor
2. Cash Flow Position

I R
3. Interest Coverage Ratio

H S
4. Control

I S
5. Return on Investment

A N
6. Floatation Cost

M
7. Flexibility
8. Cost of Debt
9. Stock Market Conditions
10.Tax Rate
11.Regulatory Framework Influencing
Factors
1.Trading on equity/ financial leverage factor
Trading on equity factor is the most important factor that

S I R
will influence the decision of capital structure. In a

H
favourable financial leverage situation, where ROI is

I S
higher than the cost of debts, companies often employ

A N
more debts in capital structure to enhance the EPS.

M
ROI = 10%
Interest = 7%
2.Cash Flow Position
A firm’s ability to pay expenses and loans determines

S I R
debt capacity. The Company may raise funds by issuing

H
debts if it has a fluent cash flow position, as they are to

I S
be paid back after some time.

A N
M
3. Interest Coverage Ratio
Interest Coverage Ratio reflects the number of times

I R
earnings before interest and taxes of a company cover

H S
the interest obligation. High-Interest coverage

I S
ratio indicates that company can have more of borrowed

A N
funds and vice versa.

M
4.Control
Debt generally does not cost dilution of control. To have

I R
control, the firm must issue debt. Further issue of equity

S
share may dilute the control of existing equity share

I S H
holders.

A N
M
5.Return on Investment
It will be beneficial for a firm to raise finance through

S I R
borrowed funds if the return on investment is higher than

H
the rate of interest on the debt. But if the return is

I S
uncertain and the company is not sure if it can cover the

A N
fixed cost of interest,better option is equity share.

M
6.Floatation Cost
Floatation cost is the cost involved in the issue of shares

S I R
or debentures. These cost include the cost of

H
advertisement, underwriting statutory fees, brokers

I S
commission etc. Cost of the Public issue is more than the

A N
floatation cost of taking a loan.

M
7.Flexibility
Issuing debenture and preference shares introduce

I R
flexibility. A good financial structure is flexible and sound

H S
enough to have scope for expansion or contraction of

I S
capitalization whenever the need arises.

A N
M

Debts can be repaid

When situation arise
8.Cost of Debt
A firm’s ability to borrow at a lower rate increases

I R
its capacity to employ higher debt. Thus, more

H S
debt can be used if debt can be raised at a lower

I S
rate.

A N
M

Reputed firms can raise

finance at lower rate
9.Stock Market Conditions
During the depression, people do not like to take a risk

I R
and do not take interest in the equity shares. During the

H S
boom, investors are ready to take a risk and invest in

I S
equity shares.

A N
M
10.Tax Rate
Interest on debt is allowed as a deduction; thus in case of

S I R
the high tax rate, debts are preferred over equity but in

H
case of low tax rate more preference is given to equity.

NI S
M A
11.Regulatory Framework
Provisions of the Companies Act, SEBI guidelines etc are

I R
to be followed while designing capital structure.

H S
NI S
M A
Fixed Capital
The capital invested in fixed assets like land and building,
plant and machinery, furniture and fixtures etc is known as

I R
fixed capital or block capital. Fixed assets are those assets

S
which are required for permanent use and are not meant for

I S H
resale. It must be financed through long-term sources like

N
equity shares,preference shares,debentures,retained earnings

M A
etc.
 Importance of fixed Capital Management/
Capital Budgeting
Capital budgeting decisions are very important because of
the following reasons:

S I R
1. Large amount of fund involved

I S H
2. Long Term Investment

A N
3. Irreversible in nature

M
4. Risk involved
1.Nature of business

I R
2.Scale of operations

H S
I S
3.Technique of production

A N
M
4.Growth prospects
5.Diversification
6.Technology up gradation
7.Financing alternatives
8.Level of collaboration
1.Nature of business

R
The nature of business determine how much fixed capital

S I
is required,a manufacturing concern needs more fixed

S H
capital as compared to a trading concern,as trading

NI
concern does not need plant, machinery etc.

M A
2.Scale of operations
A larger organization operating at a higher scale

S I R
needs bigger plant, more space etc.and therefore

S H
requires more fixed capital as compared to small

NI
organization.

M A
3.Technique of production

R
Companies using capital intensive techniques require

S I
more fixed capital whereas companies using labour

S H
intensive techniques require less capital. In capital

NI
intensive organization they require more fixed capital to

A
purchase machinery, construct building etc.

M
Labour oriented Vs Machine oriented
4.Growth prospects

R
Higher growth of an organization at present as well as

S I
anticipated future requires higher investment in fixed

S H
assets and they require larger fixed capital.

NI
M A
5.Diversification

R
When a firm diversifies its activities, requirements

S I
of fixed capital will increase. It requires more

S H
investment in fixed assets for the new project.

NI
M A

Product line -Jyothy Laboratories Ltd

6.Technology up gradation

R
In certain industries, assets become obsolete very soon,

S I
eg, computers. So their replacement also becomes due

S H
faster. So they require more fixed capital to replace old

NI
fixed assets like machinery, computers etc.

M A
7.Financing alternatives

R
An enterprise which procures fixed assets on

S I
lease requires lesser fixed capital than on outright

S H
purchase.

NI
M A

For Rent Outright Purchase

8.Level of collaboration

R
By collaborating with others, a firm uses another’s facility

S I
or jointly establishes a facility for common use. Such

S H
collaboration reduces the investment in fixed assets for

NI
each one of the participants.

M A

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 Working Capital
The capital invested in current assets like stock,
debtors, bills receivables, short term securities,

I R
cash and bank balance for meeting day to day

H S
expenses is known as working capital. These

I S
provide liquidity to the business.

A N
M
Net working Capital=Current Asset – Current Liability
1.Nature of business

I R
2.Scale of operations

H S
3.Operating Cycle

NI S
4.Business cycle

M A
5.Seasonal factors
6.Credit allowed
7.Credit availed
8.Availability of raw materials
9.Reorder period
10.Level of competition
11.Inflation
1.Nature of business

I R
The basic nature of a business influences the amount of

S
working capital required. The trading concern and

I S H
service industries usually needs a small amount of

AN
working capital as compared to a manufacturing

M
concern. This is because there is no production process
in trading concern.

Service Sector
2.Scale of operations

I R
There is direct link between the working capital and scale

S
of operations. In other words more working capital is

I S H
required in case of big organizations while less working

A N
capital is needed in case of small organizations.

M
3.Operating Cycle

I R
The amount of working capital directly depends upon the

S
length of operating cycle. Operating cycle in a

I S H
manufacturing concern refers to the time period involved

N
in production. If length of operating cycle is high working

M A
capital requirements also high and vice versa.
4.Business cycle

I R
In boom period, sales as well as production shoot up

S
which call for larger amount of working capital. But

I S H
during depression the demand declines and it affects

A N
both production and sales. therefore in depression less

M
working capital is required.
5.Seasonal factors

I R
Some business is seasonal in their operations. In peak

S
season, due to higher level of activity more amount of

I S H
working capital will be required. But during off season,

A N
they require only less amount of working capital.

M
6.Credit allowed

I R
Those enterprises which sell goods on cash basis need

S
little working capital but those who provide credit

I S H
facilities to the customers need more working capital.

A N
M
7.Credit availed

I R
A business may get credit facility from suppliers of goods.

S
More the credit facility, lesser would be the requirement of

I S H
working capital.

A N
M
8.Availability of raw materials

I R
If raw materials required for the business are available

S
freely and regularly, a firm needs to maintain only lesser

I S H
amount of working capital.

A N
M
9.Reorder period

I R
Time gap between placement of order and receipt of raw

S
materials is relevant. Longer the reorder period, larger

I S H
shall be the amount of working capital requirements

A N
M
10.Level of competition

S I R
High level of competition increases the need for more

H
working capital. In order to face competition, more stock

I S
is required for quick delivery. Credit sales also required

A N
at this situation.

M
 Factors Affecting the Requirements
of Working Capital
11.Inflation

I R
Inflation leads to rise in price. In such a situation more

S
capital is required than before in order to maintain the

I S H
previous scale of production and sales

A N
M