Financial Management Notes Business Studies Class 12

Summary Financial Management: Concept, role and objective Financial decisions: Meaning and factors affecting investment decision, financing decision and dividend decision Financial Planning: Concept and Importance Capital Structure – Concept and factors affecting capital structure Fixed and Working Capital - Concept and factors affecting their requirements

Financial Management is concerned with optimum procurement and utilisation of funds.

Objective of financial management - wealth maximization

The main objective of financial management is to maximize the wealth of shareholders. Maximization of shareholders' wealth refers to increase in the market price of shares of the company.

Financial planning is preparation of a financial blueprint of an organisation’s future operations.

Twin objectives of Financial Planning:

1. To ensure availability of funds whenever required.

2. To see that the firm does not raise resources unnecessarily.

Importance of Financial Planning:

Following are the points of importance of financial planning:

1. It helps in forecasting future happenings and helps the firms to face them in a better way.

2. It helps in avoiding business shocks and helps the company in preparing for the future.

3. If helps in coordinating various business functions, e.g., sales and production functions, by providing clear policies and procedures.

4. It helps in reducing the wastes and duplication of efforts. 

5. It tries to link the present with the future. 

6. It provides a link between investment and financing decisions.

7. By spelling out detailed objectives for various business segments, it makes the evaluation of actual performance easier.

Financial decisions

There are three types of decisions involved in financial management:

1. Investment decision

2. Financing decision

3. Dividend decision

Investment decision 

Investment decision is concerned with selection of assets in which the funds will be invested.

• Capital budgeting decisions - decisions relating to investment in fixed assets

• Working capital decisions - decisions relating to investment in current assets

Factors affecting investment decisions: 

1. Return - A company would choose a project where expected returns are higher. 

2. Cash flows of the project - A company would choose a project where cash inflows are higher than the cash outflows. 

3. Investment criteria - There are different techniques which are used to make calculations regarding the amount of investment, interest rates, cash flows and returns. 

Financing decision 

Financing decision is concerned with choice of long-term sources of finance. 

In this decision, the proportion of debt and equity is determined.

Factors affecting financing decisions:

1. Cost - Generally, the source which is least costly is selected.

2. Floatation cost - Generally, the source with lower floatation cost is selected.

3. Cash flow position - If cash position of a company is weak then it should not opt for debt. If cash flow position is strong then it can go for debt. 

4. Fixed operating costs - If fixed operating costs of a company are high then it should not go for debt as it will further add to the cost. If fixed operating costs of company are low then it can go for debt.

5. Control - If the company does not want to affect the control of shareholders then it should go for debt. 

6. Capital market consideration - If the stock market is rising people are investing in equity, but if the stock market is depressed then company should go for debt.

Dividend decision 

Dividend decision is related to distribution/appropriation of profits.

 It involves deciding whether to retain a part of their profits or to distribute the profits as dividends. 

Factors affecting dividend decision:

1. Earnings: If the earnings of a company are higher, the rate of dividend is also likely to be higher.

2. Stability of earnings: A company with stable earnings generally pay higher dividends to its shareholders.

3. Stability of dividends: A stable dividend policy has a favorable impact on the image of the company and its shares' prices.

4. Growth opportunities: If a company has higher opportunities for growth, it will retain more profit and distribute less dividends.

5. Cash flow position: A company must have sufficient cash to pay dividends. If cash position of a company is weak then it may have to skip payment of dividend.

6. Access to capital market: A company which has easy access to capital market can pay its profit as dividends. If a company does not have easy access to capital market then it will have to retain its profits.

7. Shareholders preferences: A company has to consider the expectations of its shareholders. Small shareholders prefer current income whereas big shareholders are interested in earning capital gains. 

8. Contractual constraints: When a company borrows funds, the lender may put restrictions on the company on payment of dividend. 

9. Legal constraints: The provisions of the companies act and other legal provisions have to be considered.

10. Tax policy: If dividend tax rate is high then the company will pay lower dividends and vice versa. 

11. Stock market considerations: If the share price of a company is falling at the stock exchange, it may distribute more dividends to the shareholders to check the fall in price.

Capital Structure:

Capital structure refers to the mix between owners and borrowed funds.

The proportion of debt in the capital structure is called financial leverage. As the financial leverage increases the cost of funds declined and therefore more earnings per share, but the financial risk increases.

Trading on equity refers to the increase in profit earned by the equity shareholders due to the presence of fixed financial charges like interest.

For example, A company raises Rs.50,000 through equity shares of Rs 10 each and earns a profit of Rs.5000. Here, the EPS is Rs 1 (5000/5000). On the other hand, if the company raises Rs.40,000 by way of 6% debentures and Rs.10,000 through equity shares of Rs 10 each, EPS is increased from Rs 1 to Rs 2.6 as follows:

Total Investment 40000 +10000 = 50,000

Total Profit = 5,000

Interest on debentures 40000 X 6/100 = 2,400

Profit available to equity shareholders (5000-2400) = 2,600

No. of shares = 10,000/10 = 1,000

EPS =2600/1000 = Rs 2.6

Factors affecting the choice of capital structure:

1. Cash Flow Position: If cash position of a company is weak then it should not opt for debt. If cash flow position is strong then it can go for debt.

2. Interest coverage ratio (ICR):

ICR = EBIT/Interest

If this ratio is higher, it indicates that the company is able to cover its interest obligations.

3. Debt service coverage ratio (DSCR):

DSCR = Profit after tax + Depreciation + Interest + Non-Cash exp./ Pref. Div + Interest + Repayment obligation

If this ratio is higher, it indicates that the company is able to cover its interest obligations.

4. Return on investment (ROI): If the ROI of the company is higher, it can choose to use trading on equity to increase its EPS. 

5. Cost of debt: If cost of debt is low, more debt can be used.

6. Tax rate: A higher tax rate, thus, makes debt relatively cheaper and increases its attraction as compared to equity. 

7. Cost of equity: If debt is used beyond that point, cost of equity may go up sharply and share price may decrease inspite of increased EPS.

8. Floatation costs: Floatation costs of sources should also be taken into consideration. 

9. Risk: Business risk depends upon fixed operating costs. Higher fixed operating costs result in higher business risk and vice-versa. If a firm’s business risk is lower, its capacity to use debt is higher and vice-versa.

10. Flexibility: To maintain flexibility, the firm must maintain some borrowing power to take care of unforeseen circumstances.

11. Control: If the company does not want to affect the control of shareholders then it should go for debt.

12. Stock market conditions: If the stock market is rising (in bullish phase) people are investing in equity, but if the stock market is depressed then company should go for debt.

13. Regulatory Framework: Every company operates within a regulatory framework provided by the law e.g.; public issue of shares and debentures have to be made under SEBI guidelines. These rules and regulations are also to be considered. 

14. Capital structure of other companies: Capital structure of other companies should also be considered. 

Fixed capital

Fixed capital refers to the capital which is invested in fixed assets such as land, building, plant machinery, furniture etc.

Factors affecting fixed capital requirements:

1. Nature of business: Manufacturing enterprises require more fixed capital as compared to trading enterprises.

2. Scale of operations: A large-scale enterprise requires more fixed capital as compared to small scale enterprise.

3. Choice of technique: Enterprises using capital intensive techniques require more fixed capital as compared to enterprises using labour intensive techniques.

4. Growth: If an organisation wants to grow, it requires more fixed capital.

5. Diversification: If an organisation chooses to diversify, its fixed capital requirement will go up.

6. Technology upgradation: If an organization wants to upgrade its technology, it would require a higher amount of fixed capital.

7. Level of collaboration: Less fixed capital is required if two or more businesses decide to share each other's facilities.

8. Financing alternatives: If the asset is available on lease, fixed capital requirement will be less.

Working capital 

Working capital refers to capital which is invested in current asset and for meeting current expenses like wages, salaries, rent etc.

Factors affecting working capital requirements

1. Nature of business: Manufacturing enterprises require more working capital as compared to trading enterprises.

2. Scale of operations: A large-scale enterprise requires more working capital as compared to small scale enterprise.

3. Growth: If a business wants to grow, its working capital requirement will go up.

4. Business cycle: During boom period the demand is higher so more working capital would be required. During depressed phase low working capital would be required.

5. Production cycle: If production cycle is long, more working capital would be required. 

6. Seasonal factors: during peak season, working capital requirement would be more.

7. Credit allowed: If the business is allowing credit to its customers, it's working capital requirement would be more.

8. Credit availed: If a company purchases raw material on credit, it will require less working capital.

9. Operating efficiency: If the management is efficient, the amount of working capital required would be low. 

10. Inflation: If there is inflation, working capital requirement would be more.

11. Competition: If competition is high working capital requirement would be more. 

12. Availability of raw material: If raw materials are easily available then low working capital is required. If raw materials are not easily available then more working capital would be required.