Business Studies - Class 12th (CBSE) - Chapter 9 (Financial Management)

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Class: 12
Subject: Business Studies
Chapter Number: 9
Chapter Name: Financial Management

Financial Management

Business Finance - The fund required to carry out the activities of the Business.

Financial management refers to the efficient acquisition of finance, efficient utilization of finance and efficient distribution of surplus for the smooth working of the company.

Role of Financial Management

The overall financial health of a business and its future depend on its financial management.
Optimal procurement and the usage of finance.
It aims at ensuring the availability of enough funds whenever required and avoiding idle finance.
The financial statements, such as Balance Sheet and Statement of Profit and Loss Account, of a business are largely determined/affected by financial management decisions taken earlier.

Objectives of Financial Management

The objective of financial management is to maximize the current price of equity shares of the company or to maximize the wealth of owners of the company (shareholders).

Financial Decisions

Investment Decision (Capital Budgeting Decision)

This decision relates to the careful selection of assets in which funds will be invested by the firms.
The firm invests its funds in acquiring fixed assets as well as current assets.
When a decision regarding fixed assets is taken it is also called a Capital Budgeting Decision.

Factors Affecting Investment / Capital Budgeting Decision

· Cash flow of the Project - Cash flows are in the form of a series of cash receipts and payments over the life of an investment. The amount of these cash flows should be carefully analyzed

· Return on Investment - The rate of return an investment will be able to bring back for the company in the form of income. For example: If project A is bringing 10% return and project B is bringing 15% return then we should prefer project B.

· Risk Involved - The company must try to calculate the risk involved in every proposal and should prefer the investment proposal with a moderate degree of risk only.

· Investment Criteria - There are different techniques to evaluate investment proposals which are known as capital budgeting techniques. These techniques are applied to each proposal before selecting a particular project.

Financing Decision

This decision relates to the Quantum of finance to be raised from various long-term sources.

¯ A company can raise finance from various sources, but the main sources of finance are divided into two categories :

a) Owner’s Funds: It includes share capital and retained earnings.

b) Borrowed Funds: These include debentures, loans, bonds etc.

¯ Deciding how much to raise from which source

¯ The borrowed funds involve some degree of risk whereas in the owner's fund, there is no fixed commitment of repayment.

Factors Affecting Financing Decision 6CR

· Cash flow Position - With smooth and steady cash flow companies can easily afford borrowed funds securities but when companies have a shortage of cash flow, then they must go for owner's fund securities only.

· Cost- The cost of raising finance from various sources are different and finance manager always prefer the source with minimum cost.

· Flotation Cost- It refers to the cost involved in the issue of securities such as broker's commission, underwriter's fees, expenses on the prospectus, etc. The firm prefers securities which involve the least floatation cost.

· Fixed Operating Cost- If a company is having high fixed operating cost, then it must prefer an owner's fund because due to high fixed operational costs. For example: Building rent, Insurance premium, salaries etc. The company may not be able to pay interest on debt securities which can cause serious troubles for the company.

· Control Considerations- If existing shareholders want to retain complete control of the business, then they prefer borrowed fund securities to raise further funds. On the other hand, if they do not mind losing control then they may go for owner's fund securities.

· Capital Market- During the boom period, it is easy to sell equity shares as people are ready to take risks whereas, during the depression period, there is more demand for debt securities in the capital market.

· Risk- More risk is associated with the borrowed fund as compared to owner's fund securities.

Dividend Decision

Dividend is that portion of profit which is distributed to shareholders.

¯ The decision involved here is how much of the profit earned by company (after paying tax) is to be distributed to the shareholders and how much of it should be retained in the business.

¯ The extent of retained earnings also influences the financing decision of the firm.

Factors Affecting Dividend Decision

Cash Flow Position - Paying dividend means an outflow of cash. Companies declare a high rate of dividend only when they have surplus cash. In a situation of shortage of cash, companies declare no or very low dividend.
Earning- Dividends are paid out of the current and previous year's earnings. If there are more earnings then the company declares a high rate of dividend whereas, during a low earning period, the rate of dividend is also low.
Stability of Earnings- Companies having stable or smooth earnings prefer to give a high rate of dividend whereas companies with unstable earnings prefer to give a low rate of dividend. The increase in dividends is generally made when there is confidence that their earning potential has gone up and not just the earnings of the current year.
Growth Opportunities- If a company has a few investments plans then it should reinvest the earnings of the company. Hence, a company with no growth plans will distribute more in the form of dividends whereas growing companies will be kept aside more as retained earnings.
Preference of Shareholders- If a company is having many retired and middle-class shareholders then it will declare more dividend. Whereas if company is having many young and wealthy shareholders then it will prefer to keep aside more in the form of retained earnings and declare a low rate of dividend.
Taxation Policy- The rate of dividend also depends upon the taxation policy of the government. Under the present taxation system, dividend income is tax-free for shareholders, but a company must pay tax on dividends given to shareholders. If the tax rate is higher, then the company prefers to pay less in the form of dividend whereas if the tax rate is low then the company may declare higher dividend.
Access to Capital Market Consideration- If the capital market can easily be accessed or approached and there is enough demand for securities of the company then the company can give more dividends and raise capital by approaching the capital market. But if it is difficult for the company to approach the capital market then companies declare a low rate of dividend and use reserves for reinvestment.
Legal Restrictions / Constraints- Companies Act has given certain provisions regarding the payment of dividends. Apart from the company's act, there are certain internal provisions of the company like whether the company has enough cash flow to pay a dividend or not. The payment of dividend should not affect the liquidity of the company.
Contractual Constraints- When companies take long-term loans then financier may put some restrictions or constraints on the distribution of dividend and companies must abide by these constraints.
Stock Market Reactions- The declaration of dividend has impact on stock market as the increase in dividend is taken as good news in the stock market and prices of securities rise. Whereas a decrease in dividend may have negative impact on the share price in the stock market. Hence equity share price also affects dividend decision.
Stability of Dividend- Some companies follow a stable dividend policy as it has a better impact on shareholder and improves the reputation of the company in the share market. The stable dividend policy also satisfies the investor. When the company is confident then their earning potential has improved then they increase the dividend.

Financial Planning

The main objective of financial planning is that sufficient funds should be available in the company for different purposes such as for the purchase of long term assets, to meet day-to-day expenses, etc.
Excess funding is as bad as a shortage of funds. It may result in the wastage of resources.
If adequate funds are not available, the firm will not be able to honor its commitments and carry out its plans.
On the other hand if excess funds are available, it will unnecessarily add to the cost and may encourage wasteful expenditure.
It enables the management to foresee the fund requirements both the quantum as well as the timing.

Importance of Financial Planning

Financial planning helps in forecasting what may happen in future under different business situations. It helps the firm to face the eventual situations. For example: If a company is expecting 20% growth in sales there are chances that it may be 10% or maybe 30%. The planners prepare the blueprint of all three situations so that the company can be well known of all the possible situations and the planning for those situations.
It helps in avoiding business shocks and surprises and helps the company in preparing for the future.
If helps in coordinating various business functions e.g., sales and production functions, by providing clear policies and procedures.
It tries to link the present with the future.
It provides a link between investment and financing decisions on a continuous basis.
It makes the evaluation of actual performance easier.

Fixed Capital

Fixed Capital involves the allocation of firm's capital to long-term assets.
Managing fixed capital is related to investment decisions and it is also called Capital Budgeting.
This decision includes the purchase of land, building, plant and machinery, change of technology, expenditure of advertising campaign, research and development etc.

Factors Affecting the Requirement of Fixed Capital

1.Nature of Business - A manufacturing company needs more fixed capital as compared to a trading company and does not need a plant, machinery, etc.

2. Scale of Operation - Companies which are operating at large scale require more fixed capital. Whereas companies operating on a small scale need less amount of fixed capital as they need less amount of machinery and other assets.

3. Technique of Production - Companies using capital-intensive techniques require more fixed capital. Whereas companies using labor-intensive techniques require less fixed capital.

4.Technology Upgradation - Industries in which technology upgradation is fast need more amount of fixed capital as when new technology is invented old machines become obsolete and they need to buy new plants and machinery. Whereas companies, where technological Upgradation is slow, require less fixed capital as they can manage with old machines.

5. Growth Prospects - Companies which are expanding and have higher growth plans require more fixed capital as to expand their production capacity they need more plant and machinery so more fixed capital.

6. Diversification - Companies which have plans to diversify their activities by including more range of products require more fixed capital. As to produce more products they require more plants and machinery which means more fixed capital.

7. Availability of Finance and Leasing Facility - If companies can arrange financial and leasing facilities easily then they require less fixed capital as they can acquire assets in easy instalments instead of paying a huge amount at one time.

8. Level of Collaboration / Joint Ventures - If companies are performing collaborations, joint venture then companies will need less fixed capital as they can share plant and machinery. But if a company prefers to operate as an independent unit, then there is more requirement for fixed capital.

Working Capital

Capital required for smooth day-to-day operations of the business.
It refers to the investment in all the current assets such as cash, bills receivables, prepaid expenses, inventories, Debtors etc.
These current assets get converted into cash within an accounting year.

Factors Affecting the Requirement of Working Capital

1. The Scale of Operation- The firms operating at large scale need to maintain more inventory, debtors, etc. so they generally require large working capital.

2. Nature of Business- The manufacturing company requires a huge amount of working capital because they must convert raw materials into finished goods, sell on credit, and maintain the inventory of raw materials as well as finished goods. The trading organization usually needs a lower amount of working capital.

3. Business Cycle Fluctuations- During the boom period, the market is flourishing which means more demand, more production, more stock, and more debtors which means more amount of working capital is required. Whereas during the depression period low demand less inventories to be maintained, and less debtors, so less working capital will be required.

4.Seasonal Factors- The working capital requirement is constant for companies which are selling goods throughout the season. The companies which are selling seasonal goods require huge amounts during the season as more demand, more stock must be maintained and fast supply is needed. Whereas during the off-season demand is very low, so less working capital is required.

5.Credit Allowed- If a company is following a liberal credit policy result in a higher number of debtors, hence needs more working capital. Ø If a company is following a strict credit policy, then it can manage with less working capital also.

6.Credit Availed- It is how much and for how long a period a company is getting credit from its suppliers. If suppliers of raw materials are giving long-term credit, then the company can manage with less amount of working capital. Whereas if suppliers are giving only short-period credit then the company will require more working capital to make payments to creditors.

7.Operating Efficiency- A firm having a high degree of operating efficiency requires less amount of working capital.

8. Level of Competition- If the market is competitive then the company will have to adopt a liberal credit policy and supply goods on time. Higher inventories must be maintained so more working capital is required.

9. Inflation- If there is an increase or rise in price then the price of raw materials and cost of labor will rise, it will increase the working capital requirement.

10. Growth Prospects- Firms planning to expand their activities will require more amount of working capital. As for expansion, they need to increase the scale of production which means more raw materials, more inputs etc.

11. Technology and Production Cycle- If Production Cycle is long then more working capital is required because it will take a long time for converting raw material into finished goods.

Capital Structure

Capital structure means the proportion of debt and equity used for financing the operations of the business.
Capital Structure = 𝐃𝐞𝐛𝐭 / 𝐄𝐪𝐮𝐢𝐭y
An ideal capital structure is very difficult to define but it should be such that it increases the value of equity shares or maximizes the wealth of equity shareholders (EPS).

Debt and Equity differ in Cost and Risk:

Ø Debt involves less cost, but it is very risky because of the payment of regular interest which is the legal obligation of the business. If the company fails to pay its obligation the security holders can claim over the assets of the company.

Ø Equity securities are expensive securities, but these are safe securities from the company's point of view as a company has no legal obligation to pay a dividend to equity shareholders if it is running into losses.

Financial Leverage /Trading on Equity

Ø Financial leverage refers to the proportion of debt in the overall capital.

Ø Financial leverage = 𝐃𝐞𝐛𝐭 / 𝐄𝐪𝐮𝐢𝐭𝐲

Ø With debt funds company's funds and earnings increase (CONDITION 1)

More debt will increase the earning only when the return on investment (ROI) is more than the rate of interest on the debt. (CONDITION 2)

Ø 💥 Return on Investment > Rate of Interest = Favorable Situation.

Ø 💥 Return on Investment < Rate of Interest = Unfavorable Situation.

If we compare all the situations then we can see the situation 3 equity shareholders can get maximum return followed by the situation 2 and least earning in the situation 1.
Hence, it is proof that more debt brings more income for the owners in capital structure.
But this statement holds only till return on investment (ROI) of the company is more than the rate of interest charged on debt.

ROI = EBIT / Total Investment

= 7,00,000 / 50,00,000 X 100

= 14%

Hence, ROI > Rate of Interest. (14% > 10%)

Factors which Influence the Decision on Capital Structure

Factor	Details
1) Cash Flow Position	The decision related to the composition of the capital structure also depends upon the ability of a business to generate enough cash flow. Sometimes, a company makes sufficient profit, but it is unable to generate cash inflow for making payments. Hence, if the company fails to make fixed payments, it may face insolvency. The company must properly analyze the liquidity of its working capital before including debt in the capital structure.
2) Interest Coverage Ratio	It refers to the number of times a company's Earnings before Interest and Taxes (EBIT) cover the interest payment obligation. $\text{ICR} = \frac{\text{EBIT}}{\text{Interest}}$ A high ICR means companies can have more borrowed fund securities, whereas a lower ICR means fewer borrowed fund securities.
3) Return on Investment (ROI)	If the return on investment is more than the rate of interest, then the company should prefer debt in its capital structure. Whereas, if the return on investment is less than the rate of interest to be paid on debt, then the company should avoid debt and rely on equity capital.
4) Cost of Debt	If a firm can arrange borrowed funds at a low rate of interest, then it will prefer more debt compared to equity.
5) Tax Rate	High tax rates make debt cheaper, as interest paid to debt security holders is subtracted from income before calculating tax, whereas companies have to pay tax on dividends paid to shareholders. Thus, a high tax rate means a preference for debt, whereas at a low tax rate, equity is preferred in the capital structure.
6) Cost of Equity	Owners or equity shareholders expect a return on their investment, i.e., earnings per share. As long as debt increases the earnings per share (EPS), it can be included in the capital structure; however, when EPS starts decreasing with the inclusion of debt, the company must depend upon equity share capital only.
7) Flotation Costs	Flotation cost is the cost involved in the issue of shares or debentures. These costs include the cost of advertisement, underwriting statutory fees, etc. The issue of shares and debentures requires more formalities as well as higher flotation costs, whereas there is less cost involved in raising capital through loans or advances.
8) Risk Consideration	Financial risk refers to a position where a company is unable to meet its fixed financial charges, such as interest, preference dividends, payment to creditors, etc. If a firm's business risk is low, then it can raise more capital by issuing debt securities, whereas, at a time of high business risk, it should depend upon equity.
9) Flexibility	An excess of debt may restrict the firm's capacity to borrow further. To maintain flexibility, it must retain some borrowing power to take care of unforeseen circumstances.
10) Control	Equity shareholders are considered the owners of the company, and they have complete control over it, whereas debt does not cause a dilution of control.
11) Regulatory Framework	The issue of shares and debentures, as well as the taking of loans, must be done according to SEBI guidelines. Companies have to follow the regulations of monetary policies. If SEBI guidelines are easy, companies may prefer issuing securities for additional capital, whereas if monetary policies are more flexible, they may go for more loans.
12) Debt Service Coverage Ratio	It is one step ahead of ICR; i.e., ICR covers the obligation to pay back interest on debt, but DSCR takes care of the return of interest as well as principal repayment. $\text{DSCR} = \frac{\text{Profit after tax} + \text{Interest} + \text{Non-Cash Expense (Depreciation)}}{\text{Preference dividend} + \text{Interest} + \text{Repayment Obligation}}$ If DSCR is high, then the company can have more debt in the capital structure, as a high DSCR indicates the ability of the company to repay its debt. If DSCR is low, then the company must avoid debt and depend upon equity capital only.
13) Stock Market Condition	There are two main conditions of the market: boom conditions and recession or depression conditions. During the depression period (Bearish Phase) in the market, business is slow, and investors hesitate to take risks; so at this time, it is advisable to issue borrowed fund securities, as these are less risky and ensure regular payment of interest. If there is a boom period (Bullish Phase), business is flourishing, and investors take risks and prefer to invest in equity shares to earn more in the form of dividends.
14) Capital Structure of the Company	Some companies frame their capital structure according to industrial norms. However, proper care must be taken, as blindly following industrial norms may lead to financial risk. If a firm cannot afford high risk, it should not raise more debt simply because other firms are doing so.

The End

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A List of Notes:

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CBSE Class 12 Business Studies Chapter 9 Notes: Financial Management