Q1. “Financial management is an integral part of the jobs of all managers.

Hence, it cannot be entrusted to a staff department”. Discuss.

Ans. Financial management is a crucial aspect of any organization and

not just limited to a specific department or a group of professionals. It is an
essential part of the job of all managers as it helps them make sound
decisions regarding the allocation of resources, investment decisions, and
cost management.
Financial management plays a significant role in achieving
the organization's objectives and ensuring its sustainability. It cannot be
solely entrusted to a staff department as it requires continuous
communication and coordination with other departments to ensure effective
implementation. All managers must possess adequate financial literacy to
make informed decisions that align with the organization's financial
goals and objectives.

Four major areas of financial management:-

Planning

Financial planning plays a major role in allocating funds for growth, enabling
new product or service development, and ensuring positive cash flow even
during challenging times or throughout unforeseen events. Planning includes
analysing previous expenditure including capital expenses, travel and
entertainment (T&E) expenses, workforce expenses, operational expenses,
and indirect expenses.

Budgeting

The financial manager allocates budgets for the required spending of the
business such as rents, salaries, raw material, and travel and entertainment
expenses. Ideally, available funds should not be entirely used up in budgets
so that there’s some leeway in the case of an emergency or an opportunity.
Budgets may be static or flexible, the latter also providing some leeway,
which has been increasingly adopted in the past few years when the
pandemic has created uncertainty around financial stability. Larger
companies tend to have a master budget supported by other documentation that
details cash flow and operations, for instance.

Managing and accessing risk

Risk management has a knock-on effect on both investment planning and

budgeting with financial managers responsible for assessing and
implementing compensatory controls for risks such as:

Liquidity risk – this involves tracking current cash flow, estimating future
needs for cash, and preparing to free up working capital if needed.

Market risk – For public companies, the behaviour of financial markets affects
stock performance as well as potentially affecting any business investments.
This also involves market trends forced by circumstances such as the
pandemic e.g. bricks-and-mortar stores becoming online stores.

Credit risk – Credit is important because it impacts the ability of the company
to borrow at favourable rates. Maintaining good lines of credit by ensuring
customers pay invoices on time, for example, improves valuation.

Operational risk – This catch-all category can include risks such as cyber-
attacks and how to prevent them or react should one happen, office closures
due to extreme weather events or terrorist attacks, and crisis management
should a senior member of the team be involved in misconduct. Assessing
these risks includes drawing up specific insurance plans and creating
disaster recovery and business continuity plans.

Procedures

Policies and procedures help with the smooth running of financial

management systems and beyond, influencing all operations within the
business. From basics such as how the finance team securely distributes
financial data such as invoices, payments, and reports to who is responsible
for final sign off of those decisions, procedures build stability.
Q2. What is financial leverage? What cause it? How is the degree of financial
leverage measured?

Ans. Financial leverage results from using borrowed capital as a funding source
when investing to expand the firm's asset base and generate returns on risk
capital. Leverage is an investment strategy of using borrowed money—
specifically, the use of various financial instruments or borrowed capital—to
increase the potential return of an investment.

Financial Leverage
Leverage is the use of debt (borrowed capital) in order to undertake an
investment or project. The result is to multiply the potential returns from a
project. At the same time, leverage will also multiply the potential downside
risk in case the investment does not pan out. When one refers to a company,
property, or investment as "highly leveraged," it means that item has more
debt than equity.

The concept of leverage is used by both investors and companies. Investors

use leverage to significantly increase the returns that can be provided on an
investment. They lever their investments by using various instruments,
including options, futures, and margin accounts. Companies can use leverage
to finance their assets. In other words, instead of issuing stock to raise capital,
companies can use debt financing to invest in business operations in an
attempt to increase shareholder value.

Investors who are not comfortable using leverage directly have a variety of
ways to access leverage indirectly. They can invest in companies that use
leverage in the normal course of their business to finance or expand
operations—without increasing their outlay.

Calculating Leverage
There is an entire suite of leverage financial ratios used to calculate how much
debt a company is leveraging in an attempt to maximize profits. Several
common leverage ratios are listed below.

Debt-to-Assets Ratio
Debt-to-Assets Ratio = Total Debt / Total Assets
A company can analyze its leverage by seeing what percent of its assets have
been purchased using debt. A company can subtract the debt-to-assets ratio
by 1 to find the equity-to-assets ratio. If the debt-to-assets ratio is high, a
company has relied on leverage to finance its assets.

Debt-to-Equity Ratio
Debt-to-Equity Ratio = Total Debt / Total Equity

Instead of looking at what the company owns, a company can measure

leverage by looking strictly at how assets have been financed. The debt-to-
equity ratio is used to compare what the company has borrowed compared to
what it has raised by private investors or shareholders.

A debt-to-equity ratio greater than one means a company has more debt than
equity. However, this doesn't necessarily mean a company is highly levered.
Each company and industry will typically operate in a specific way that may
warrant a higher or lower ratio. For example, start-up technology companies
may struggle to secure financing and must often turn to private investors.
Therefore, a debt-to-equity ratio of .5 may still be considered high for this
industry compared.

Debt-to-EBITDA Ratio
Debt-to-EBITDA = Total Debt / Earnings Before Interest, Taxes, Depreciation,
and Amortization

A company can also compare its debt to how much income it makes in a given
period. The company will want to know that debt in relation to operating
income that is controllable; therefore, it is common to use EBITDA instead of
net income. A company that has a high debt-to-EBITDA is carrying a high
degree of weight compared to what the company makes. The higher the debt-
to-EBITDA, the more leverage a company is carrying.

Equity Multiplier
Equity Multiplier = Total Assets / Total Equity

Although debt is not directly considered in the equity multiplier, it is inherently

included as total assets and total equity each has direct relationships with total
debt. The equity multiplier attempts to understand the ownership weight of a
company by analyzing how assets have been financed. A company with a low
equity multiplier has financed a large portion of its assets with equity, meaning
they are not highly levered.

DuPont analysis uses the "equity multiplier" to measure financial leverage. One
can calculate the equity multiplier by dividing a firm's total assets by its total
equity. Once figured, one multiplies the financial leverage with the total asset
turnover and the profit margin to produce the return on equity.

For example, if a publicly traded company has total assets valued at $500
million and shareholder equity valued at $250 million, then the equity
multiplier is 2.0 ($500 million/$250 million). This shows the company has
financed half its total assets by equity. Hence, larger equity multipliers suggest
more financial leverage.

Degree of Financial Leverage (DFL)

Degree of Financial Leverage = % Change in Earnings Per Share / % Change in
EBIT

Fundamental analysis uses the degree of financial leverage. The degree of

financial leverage is calculated by dividing the percentage change of a
company's earnings per share (EPS) by the percentage change in its earnings
before interest and taxes (EBIT) over a period. The goal of DFL is to understand
how sensitive a company's earnings per share is based on changes to operating
income. A higher ratio will indicate a higher degree of leverage, and a company
with a high DFL will likely have more volatile earnings.
Q3. Explain gross working capital concept.

Ans. Gross working capital is the sum of a company's current assets (assets that
are convertible to cash within a year or less). Gross working capital less current
liabilities is equal to net working capital, or simply "working capital;" a more
useful measure for balance sheet analysis.

Gross working capital, in practice, is not useful. It is just one half of a picture of
a company's short-term financial health and the ability to use short-term
resources efficiently. The other half is current liabilities. Gross working capital,
or current assets, less current liabilities, equates to working capital. When
working capital is positive, it means that current assets are greater than
current liabilities. The preferred way to express positive working capital is the
ratio of current assets to current liabilities (e.g., > 1.0).

If this ratio is less than 1.0, then a company may have trouble paying back its
creditors in the short term. Negative working capital is when liabilities outstrip
assets and indicate that a company may be in distress. A company needs just
the right amount of working capital to function optimally.

With too much working capital, some current assets would be better put to
use elsewhere. With too little working capital, a company may not be able to
meet its day-to-day cash requirements. Managers aim for the correct balance
through working capital management.

Some methods in which a company can improve its working capital ratio
include a reduction in time to collect receivables from customers, extending
payable time frames with suppliers, a reduction on the reliance on short-term
debt, and appropriately managing inventory levels.

Gross working capital includes assets such as cash, accounts receivable,

inventory, short-term investments, and marketable securities. Unlike net
working capital, gross working capital omits liabilities and only focuses on what
the company owns. Gross working capital is the sum of current assets
including:

• Cash and cash equivalents

• Marketable securities
• Accounts receivables to be collected within the next year
• Interest receivable to be collected within the next year.
 • Inventory expected to be sold within the next year
• Other assets owned by the company expected to yield economic benefit
within the next year.

Q4. Explain the objects of capital structure planning and the factors affecting it?

Ans. The objects of capital structure planning and the factors affecting it by Interest

Coverage Ratio-ICR,Cash Flow Position,Cost of Debt,Tax Rate,

Flexibility.

Explanation:
1. Interest Coverage Ratio-ICR
This ratio attempts to determine the number of EBITs available to
pay interest. A company's ability to use its borrowings is directly
proportional to this ratio.
2. Cash Flow Position
Future cash flows should be considered when choosing a capital
structure. Borrowing requires a lot of cash to pay interest and
recover capital, so it should only be used if you have really good cash
flow.
3. Cost of Debt
A company's borrowing capacity depends on its cost of debt. A lower
interest rate on borrowing allows more use of the borrowed
money and vice versa.
4. Tax Rate:
Tax rates affect the value of debt. Higher tax rates reduce the value
of debt. The reason is that interest on borrowings is withheld from
profits, which is considered part of the cost and saves tax.
5.Flexibility
According to this principle, the capital structure must be sufficiently
flexible. Flexibility means that your business's capital can be easily
increased or decreased as needed. A reduction in the capital of a
business is possible only if it has borrowings or preferred stock.

Q5. Define optimal capital structure. What is its link with the cost of capital?
Ans. The optimal capital structure of a firm is the best mix of debt and
equity financing that maximizes a company’s market value while
minimizing its cost of capital. In theory, debt financing offers the
lowest cost of capital due to its tax deductibility. However, too much
debt increases the financial risk to shareholders and the return on
equity that they require. Thus, companies have to find the optimal
point at which the marginal benefit of debt equals the marginal cost.
he optimal capital structure is estimated by calculating the mix of debt
and equity that minimizes the weighted average cost of capital
(WACC) of a company while maximizing its market value. The lower
the cost of capital, the greater the present value of the firm’s future
cash flows, discounted by the WACC. Thus, the chief goal of any
corporate finance department should be to find the optimal capital
structure that will result in the lowest WACC and the maximum value
of the company (shareholder wealth).

According to economists Franco Modigliani and Merton Miller, in the

absence of taxes, bankruptcy costs, agency costs, and asymmetric
information, in an efficient market, the value of a firm is unaffected
by its capital structure.

The cost of debt is less expensive than equity because it is less risky.
The required return needed to compensate debt investors is less than
the required return needed to compensate equity investors, because
interest payments have priority over dividends, and debt holders
receive priority in the event of a liquidation. Debt is also cheaper than
equity because companies get tax relief on interest, while dividend
payments are paid out of after-tax income.

However, there is a limit to the amount of debt a company should

have because an excessive amount of debt increases interest
payments, the volatility of earnings, and the risk of bankruptcy. This
increase in the financial risk to shareholders means that they will
require a greater return to compensate them, which increases the
WACC—and lowers the market value of a business. The optimal
structure involves using enough equity to mitigate the risk of being
unable to pay back the debt—taking into account the variability of the
business’s cash flow.

Companies with consistent cash flows can tolerate a much larger debt
load and will have a much higher percentage of debt in their optimal
capital structure. Conversely, a company with volatile cash flows will
have little debt and a large amount of equity.

As it can be difficult to pinpoint the optimal capital structure,

managers usually attempt to operate within a range of values. They
also have to take into account the signals their financing decisions
send to the market.

A company with good prospects will try to raise capital using debt
rather than equity, to avoid dilution and sending any negative signals
to the market. Announcements made about a company taking debt are
typically seen as positive news, which is known as debt signaling. If a
company raises too much capital during a given time period, the costs
of debt, preferred stock, and common equity will begin to rise, and as
this occurs, the marginal cost of capital will also rise.

To gauge how risky a company is, potential equity investors look at

the debt/equity ratio. They also compare the amount of leverage other
businesses in the same industry are using—on the assumption that
these companies are operating with an optimal capital structure—to
see if the company is employing an unusual amount of debt within its
capital structure.

Another way to determine optimal debt-to-equity levels is to think

like a bank. What is the optimal level of debt a bank is willing to
lend? An analyst may also utilize other debt ratios to put the company
into a credit profile using a bond rating.

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