FINANCIAL MANAGEMENT

Money required for carrying out business activities is called business finance. Almost all
business activities require some finance. Finance is needed to establish a business, to run
it, to modernize it, expand it or diversify it.

FINANCE: Business finance includes those business activities which are concerned with
acquisition and conservation of capital funds in meeting the financial needs and overall
objectives of business enterprise.

FINANCIAL MANAGEMENT:
Financial management is concerned with optimal procurement as well as usage of
finance. For optimal procurement, different available sources of finance are identified
and compared in terms of their costs and associated risks.

Financial management refers to that part of the management which is concerned with
the efficient planning and controlling of financial affairs of the enterprise.

Objectives of Financial Management.

Primary aim of financial management is to maximize shareholders’ wealth, which is
referred to as the wealth maximization concept.

The other objectives are:

 To ensure availability of sufficient funds at reasonable costs.
 To ensure effective utilization of funds.
 To ensure safety of funds by creating reserves and reinvestment of profits.
 To control and coordinate the activities of various departments with financial
department.

ROLE OF FINANCIAL MANAGEMENT:

Financial management aims at reducing the cost of funds secured. It also aims at ensuring
availability of enough funds wherever required as well as avoiding ideal finance.
Financial management affects all financial activities of the company either directly or
indirectly. Financial Management plays the following role:

i) Determination of Fixed Assets: Financial management decision have a great

impact on the size and composition of fixed assets of a business concern. Eg.
Decision to invest a sum of Rs.100 crores in fixed asset would raise the size of
the fixed assets but this will block the funds of Rs.100 crores.
ii) Determination of Current Assets: Current assets are needed in the day to
day transaction of business. Under the financial management, the total
investment in current assets and separate current asset is determined. For
example, if the investment in current assets is Rs.100 crore, it will then be
determined how much should be invested in cash, stock, debtors, etc.
iii) Determination of Proportion of Long-term and short-term finance: All
the financial needs of business are fulfilled through long-term and short-term
 sources. Under financial management, a proportion of both the financial
sources is determined.
iv) Determination of Proportion of Various sources of Long term Finance:
Long-term financial sources include primarily Equity Share Capital, Retained
Earning, Debenture, Long-term loan, etc. Under financial management, the
proportion of various long-term financial sources is determined. All the
sources have their merits and demerits. After making an analysis of their
merits and demerits, a balanced decision is taken.
v) Cash Flow Position: The payment of divided results in outflow of cash. It is
possible that the company may have enough income but it is equally possible
that it may not have sufficient cash to pay dividend. In this way, the cash flow
position of the company is a factor that determined the dividend decision. The
better the cash flow position of the company, the better will be the capacity of
the company to pay dividend. (Dividend is a portion of profit which is
distributed to the shareholders.)
vi) Shareholder Preference: There are two types of shareholders from the point
of view of investment:
(a) Those who invest with the purpose of getting some regular income and
(b) Those who invest in the company to gain capital profit. If the majority of
the shareholders are of the former type, the company must declare divided
according to their expectation. On the contrary, if the majority of the
shareholders are of the latter type, the company enjoys freedom about
declaring dividend.

FINACIAL DECISION:
Financial management decision is concerned with 3 broad decisions:
i. Investment Decision
ii. Financing Decision
iii. Dividend Decision.

Investment Decision:
It refers to the selection of asset in which funds will be invested by the business. In
other words, these decisions are concerned with the effective utilization of funds in
one activity or other.
Financing Decision:
It refers to the determination as to how the total funds required by the business will
obtained from various long term sources.
Dividend Decision:
It refers to the determination of how much part of the earning should be distributed
among shareholders by the way of dividend and how much should be retained for
meeting future needs as retained earning.
I). INVESTMENT DECISION:
This decision relates to careful selection of assets in which funds will be invested by the
firm, i.e. how the firm’s funds are invested in different assets.

Investment decision can be:

 Long-term Investment Decision
 Short-term Investment Decision

Long-term Investment Decision: Long-term Investment Decision is called as

Capital Budgeting Decision. It involves committing finance on long-term basis. Eg.
Making investment in new machines to replace the existing one.

Long-term Investment Decision or Capital Budgeting Decisions are crucial for business
because:
o They are irreversible in nature.
o They involve heavy capital outlay.
o They affect the profitability of the company.
o They have bearing on long-term growth as the amount invested in fixed assets
are likely to yield returns in future.

FACTORS AFFECTING CAPITAL BUDGETING DECISION/LONG-TERM

INVESTMENT DECISION:

a).Cash Flows of the Project:

As we know investment decision (capital budgeting decision) is related with investment
in long-term assets. These assets involve both cash outflows and Cash inflows over a
series of years. The amount needed for investment is known as Cash Outflow, on the
other hand, returns from the same investment is known as cash inflows. Both of these
need to be analyzed carefully before finalizing the investment.

b). The Rate of Return:

The most important criteria is the rate of return of the project. These calculations are
based on expected returns and the assessment of risk involved. If two projects are of the
same risk class, the project having higher rate of return will be accepted.

c). Investment Criteria Involved:

The decision to invest in a particular project involves a number of calculations regarding :
 Funds Involved
 Rate of Interest
 Rate of Return
 Cash Flow.
These 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.
SHORT-TERM INVESTMENT DECISION:
This decision is related to working capital management. Keeping of adequate amount
of working capital at all times in the business is called management of working
capital. Adequate amount means that amount of working capital should neither be more
nor less than required. Both these situations are harmful. If the amount of working capital
is more than required, it will no doubt increase liquidity but decrease profitability. For
instance, if large amount of cash is kept as working capital, then this excessive cash will
remain idle and cause the profitability to fall. On the contrary, if the amount of cash and
other current assets are very little, then lot of difficulties will have to be faced in meeting
daily expenses and making payment to the creditors. Thus, the objective of management
of working capital is to determine optimum amount of both current assets and current
liabilities so that profitability of the business remain intact and there is no fall in liquidity.
In short, liquidity and profitability are the main factors which affect the short-term
investment decision.

II. FINANCING DECISION:

This decision is about the quantum of finance to be raised from various long-term sources
and identification of various available sources.

The main source of funds for a firm is Shareholder Funds and Borrowed Funds.

Shareholder funds refer to Equity Share Capital and Retained Earnings.

Borrowed Funds refer to Finance raised as Debentures and Other form of debts.

A firm has to decide from either source based on the characteristics.

Interest on Borrowed Fund has to be paid regardless of whether or not a firm makes a
profit. Likewise, borrowed funds have to be repaid at a fixed time.

The risk of default on payment is known as financial risk, which has to be considered by
the firm.

Shareholder Fund on the other hand involves no commitment regarding payment of

return or repayment of capital.

A firm therefore needs to have a judicious mix of both debt and equity while making
financing decision which may be Debt, Equity, Preference Share Capital and Retained
Earnings.
FACTORS AFFECTING FINANCING DECISION:
1. COST:
The cost of raising funds through different sources is different. A prudent
financial manager would normally opt for a source which is cheapest source.
For Example, the cost of raising debt fund is considered as the cheapest of all.
Moreover, interest paid on debt fund is deductible from the income of the firm. It
reduces the tax liability of the firm, which further makes it even more economical.
2. RISK:
The risk associated with different sources are different. The financial risk
depends upon the proportion of debt in total capital. Debt is more riskier because
of interest payment obligation attached.
More debt means high risk and vice versa.
More equity means low risk and vice versa.

3. FLOATATION COST: Higher the floatation cost , less attractive the source.
The fund raising exercise also costs something. This cost is called floatation cost.
More floatation cost(debt) means less debt and vice versa.
More floatation cost (equity) means less equity and vice versa.
4. CASH FLOW POSITION OF THE BUEINSS; A stronger cash flow position
may make debt financing more viable than funding through equity as it will not
find difficult to meet the fixed instalments and vice versa.
5. LEVEL OF FIXED OPERATING COST: If a business has high level of fixed
operating cost like Rent, Insurance premium and Salaries etc., lower debt
financing is better. If fixed operating cost is less, more of debt financing may be
preferred.
6. CONTROL CONSIDERATION: Issue of more equity may lead to dilution of
management control over the business. Debt financing has no such implication.
Companies afraid of takeover bid may consequently prefer debt to equity.
7. STATE OF CAPITAL MARKET: Health of the Capital market may also affect
the choice of source of funds. During the period when the Stock Market is rising,
more people are ready to invest in equity and it is easy for the business firm to
raise funds through equities.. However, depressed capital may make issue of
equity share difficult for a company.

III. DIVIDEND DECISION:

This decision involves how much amount of profit earned by the company is to be
distributed among he shareholder as divided and how much should be retained in the
business for meeting the investment requirements. While dividend constitutes current
income, retained earnings increases the firm’s future earning capacity. The decision
regarding dividend should be taken keeping in view the overall objectives of maximizing
shareholder’s wealth.

FACTORS AFFECTING DIVIDEND DECISION:

 Earnings:
  Dividends are paid out of current and past earning. Therefore,
earning is the major determinant of dividend decision.
 Stability of Earnings:
 Generally, a company with a stable earning is in a position to
declare higher dividends. As against this, a company having
instable earnings is likely to pay smaller dividend.
 Stability of Dividends:
 Most companies generally follow a policy of stabilizing dividend
per share. The increase in dividend is generally made when a
company is confident that its earning potential has increased and it
may also increase dividend per share. All other things being the
same, stable dividend have a positive impact on the market price of
share.
 Growth Opportunities:
 Companies having good growth opportunities retain more money
out of their earnings so as to finance the required investment. The
dividend in growing companies is therefore smaller than the non-
growing companies.
 Cash Flow Position:
 Dividends involve an outflow of cash. A company may be
profitable but out of cash (short of cash). Availability of enough
cash in the company is necessary for declaration of dividend.
 Shareholders’ Preference:
 If the shareholders in general desire that at least a certain amount is
paid as dividend, the companies are likely to declare the same.
There are always some shareholders who depend upon a regular
income from their investments.
 Taxation Policy:
 The choice between payment of dividends and retaining the
earnings is affected by difference in the tax treatment of dividend
and capital gains. If tax on dividend is higher it would be better to
pay less by way of dividends. As compared to this, higher
dividends may be declared if tax rates are relatively lower.
Shareholders are likely to prefer higher dividends as dividend
distribution tax is levied on companies.
 Stock Market Reaction:
 Investors view an increase in divided as a good news and stock
prices react positively to it, whereas a decrease in dividend may
have a negative impact on share prices in stock market.
 Access to Capital Market:
 Large and reputed companies have easy access to capital market
and therefore may depend less on retained earning to finance their
growth. These companies tend to pay higher dividends than
smaller companies which have low access to the market.
 Legal Constraints:
 
Certain Provisions of the Companies Act place restrictions on
payouts as dividend. Such provisions must be adhered to while
declaring the dividends.
 Contractual Constraints:
 While granting loans to a company, sometimes the lender may
impose certain restrictions on the payment of dividends in future.
The Companies should ensure that the dividends does not violate
the terms of loan agreement in this regard.

FINANCIAL PLANNING:
Financial Planning refers to the process and functions of determining capital
requirements of a business and deciding the various sources from which it can be
procured. It is essentially preparation of a financial blueprint of an organization’s future
operations.

It is a process of establishing the objectives, policies, procedures, programmes and

budgets etc. to deal with the financial activities of the organization.

The Objectives of financial planning are:

1. To ensure availability of fund whenever they are required.
2. To see that the firm does not raise resources unnecessarily.
3. It aims at enabling the company to tackle the uncertainty in respect of availability
and timing of the funds and helps in smooth functioning of an organization.

Explanation to the objectives:

a). This includes a proper estimation of funds required for different purposes like
purchase of long-term assets or to meet the day-to-day expense of the business and also
estimate the time at which these funds are to be made available. Financial planning also
tries to specify possible sources of these funds.
b). Excess funding is almost as bad as inadequate funding. Even if there is some surplus
money, good financial planning would put it to the possible use, so that these resources
are not left idle and do not unnecessarily add to the cost.

Financial planning includes both short-term and long-term planning. Long-term planning
relates to long-term growth and investment. It focuses on capital expenditure
programmes. Short-term planning covers short term financial plans called budget.
IMPORTANCE OF FINANCIAL PLANNING : Financial planning is essential for the
success of any business enterprise. It aims at enabling companies to tackle the uncertainty
in respect of the availability and timing of the funds and helps in smooth functioning of
an organization.

The Importance of Financial Planning is as follows:

I. It tries to forecast the future under the different business situation. It helps in
preparing alternative financial plans so that an action can be taken according to
the need of the situation.
II. It helps in avoiding business shocks and surprises, and help the company in
preparing for the future.
III. It helps in coordinating various business functions by providing clear policies
and procedures.
IV. It helps to reduce waste, duplication of efforts and gaps in planning.
V. It tries to link the present with the future. (By proper direction of efforts and
reduced uncertainties)
VI. It provides link between investment and financial decisions. In other words, it
ensures adequate provision of funds by balancing between inflows and outflows.
VII. It helps in evaluation of actual performance by spelling out objectives for every
business segment.

CAPITAL STRUCTURE:
Capital Structure means the proportion of debts and equity used for financing the
operations of a business i.e. the mix between Owner’s funds and Borrowed funds.
The right proportion of debt and equity is desired to maximize the use of funds. (Capital
structure is said to be optimal when the proportion of debt and equity is such that it
results in increase in shareholder’s value of share).

Capital Structure, therefore, is referred to the composition or makeup of long-term

sources such as equity share, preference shares, debentures and long-term loans.

According to C.W.Gerstenberg, “ Capital structure refers to the structure of the total

capital funds raised by a company.” It is also known as Capital Mix.
It can be represented by debt-equity ratio,

Debt
Equity.

Or
Debt
Debt +Equity

FACTORS AFFECTING THE CHOICE OF CAPITAL STRUCUTE:

 Cash Flow Position:
The capital structure of a company is depended upon its cash flow generating
capacity to meet not only fixed cash payment but leave sufficient funds: a. to meet
 normal business operation. b. for investment in fixed assets c. for meeting the
debt-service commitment i.e. payment of interest and repayment of principal
amount.
 Interest Coverage Ratio(ICR):
The interest coverage refers to the number of times earnings/ before interest and
taxes/ of a company cover the interest obligations. This may be calculated as
follows:
Earnings before interest and tax
I.C.R. = ---------------------------------------------------
Interest.

 The higher the ratio, lower is the risk of company failing to meet its interest
obligation (The limitation of this ratio is that it do not take into account the
availability of fund with the firm and repayment of loan).
 Debt-Service Coverage ratio(DSCR)
It takes care of the deficiency of interest coverage ratio. It is calculated as follows:

D.S.C.R = Net Profit after tax+Depreciation+Interest-Non cash expenses

Preference Dividend+Interest +Repayment obligation.
( A higher DSCR indicates better ability to meet payment of interest and the
Principal amount and enhance company’s capability to opt for debts financing)
 Return on investment (ROI):
If the ROI of the company is higher, it can choose to use trading on equity to
increase it’s EPS(Earning Per Share) i.e. it’s ability to use debt is greater.
(Trading on Equity: It refers to the increase in profit earned by the Equity
Shareholders due to presence of fixed financial charges like interest).
 Cost of Debt:
The company can employ more debt in its capital structure, if it is
available at low rate so that cost of servicing the debt does not become a
problem.
 Tax Rate:
Tax planning is likely to have a significant bearing on capital structure decisions.
A higher tax rate makes debt cheaper because interest on debt is deductible
expense after the profit to arrive at a earning after tax. For example, if the cost of
debt is 10% and the tax rate is 30%, then after tax, the cost of debt will be 10% -
30% x 10%
 Cost of Equity:
It is the return expected by equity shareholders commensurate to the risk assumed
by them. The risk for equity shareholders increases when firm makes excessive
use of debt funds. Thus, a firm should use a proper mix of debt and equity.
 Floatation Cost:
The Process of raising resources also involves some cost. Public issue of shares
and debentures requires considerable amount of expenditure.
 Risk Consideration: Use of debt increases the financial risk of a business. (It
refers to the position when the business or a company is unable to meet its fixed
financial charges mainly interest payment, preference dividend and repayment
 obligation). Apart from the financial risk, every business have some operation
risk(business risk). Business risk depends upon fixed operating cost. Higher fixed
operating cost results in higher business risk and vice-versa. The total risk
depends upon both the business risk and financial risk. The firm’s financial
(business) risk is lower, it’s capacity to use debt is higher and vice-versa.
 Flexibility: Capital structure should be flexible in nature. It should not only meet
the present capital needs but must have a provision for future as well.
 Retaining Control: If a company wants to protect itself from the dilution of
control or takeover, it will be prompted to issue less of equity shares and more of
preference shares and debentures.

 Regulatory Framework: Every company operates within a regulatory

framework provided by law. For example, the Security Exchange Board of
India(SEBI) has issued certain guidelines for the issue of shares and debenture.
The relative ease with which legal norms can be fulfilled also significantly
influence the choice of source of finance.
 Stock Market Condition( Capital Market Condition): Conditions prevailing in
the capital market(stock market) often affect /influence the capital structure of the
company. For example, during bullish phase, a firm may find it easy to off-load
equity shares whereas during bearish phase, a firm may find it difficult to off-
load equity shares and may be forced to opt for debt financing.
 Capital Structure of other Companies: Debt-equity ratio of other companies in
the industry can also act as guiding force before deciding an appropriate capital
structure.

FIXED CAPITAL:
Fixed capital refers to Investment in Long-term assets which are required in the
business for more than one year. Example- Plant and Machinery, Expenditure on –
acquisition, expansion and modernization and their replacement. These include
purchase of land, building, plant and machinery, launching a new product line or
investing in advanced techniques of production. (It must be financed through long-term
sources of capital such as Equity or Preference shares, Debentures, Long-term Loans
and Retained Earnings of business. Fixed Assets should never be financed through
short-term sources).

Nature of Capital Budgeting/Management of Fixed Asset:

 Heavy expenditure is involved in capital budgeting.

 It involves anticipation/estimation of benefits return from each proposal.
 There is high degree of return and uncertainty involved due to large amount of
money and estimation.

Importance of Capital Budgeting decisions/Management of Fixed Assets/

Management of Investment:

 Long-Tem Growth and effects:

 The funds invested in long-tem assets are likely to yield returns in the future.
These affect future possibilities and prospects of the business.
 Large amount of funds involved:
These decisions results in a substantial portion of capital funds being blocked in
long-term projects. Therefore, these investment programmes are planned after a
detailed analysis is undertaken. This may involve decisions like -where to
procure funds? and at what rate of interest?.
 Risk Involved:
Fixed capital involves investment of huge amounts. It affects the return of the
firm as a whole in the long-term. Therefore, investment decisions involving
fixed capital influence the overall risk complexion of the firm.
 Irreversible decisions:
These decisions once taken are not reversible without incurring heavy losses.
Abandoning a project after heavy investment is made quite costly in terms of
wastage of funds. Therefore, these decisions should be taken only after carefully
evaluating each detail or else the adverse financial consequences may be very
heavy.

FACTORS AFFECTING THE REQUIREMENT OF FIXED CAPITAL:

 Nature of Business:
The nature of business has a great impact on the requirement of fixed capital. For
example, Trading Concern needs lower investment in fixed assets compared with
manufacturing organization, since it does not require purchase of Plant and
Machinery.
 Scale of Operations:
A larger organization operating at a Large-scale needs bigger plant, more space
etc. Thus, requires higher investment in fixed assets.
 Choice of Technique:
The requirement of fixed capital also depends upon the technique or method
adopted by an organization i.e. capital intensive organization requires higher
investment in Fixed Asset as compared to one which adopts labour intensive
technique.
 Technology Up gradation:
The organization which uses assets like computers, etc. that may become obsolete
very soon , because of technology up gradation, requires higher fixed capital to
purchase such assets again and again.
 Growth Prospects:
Higher growth of an organization generally requires higher investment in fixed
assets. When such growth is expected, a business may choose to create higher
capacity, in order to meet the anticipated higher demand quickly.
 Diversification:
The firm may choose to diversify its operations for various reasons, therefore its
fixed capital requirements increase. Eg. For a textile company which is
diversifying and starting a cement manufacturing plant, obviously, its investment
requirement in fixed capital will increase.
 Financing alternatives:
 When an asset is taken on lease, the firm pays lease rentals and uses it. By doing
so, it avoids huge sums to purchase it. Availability of leasing facilities , thus, may
reduce the funds required to be invested in fixed assets, thereby reducing fixed
capital requirement.
 Level of Collaboration:
At times, certain business organizations share each other’s facilities. Eg. a bank
may use another’s ATM or Some of them may jointly establish a particular
facility. This is feasible, if the scale of operations of each one of them is not
sufficient to make full use of the facility. Such collaboration reduces the level of
investment in fixed assets for each one of the participating organizations.

WORKING CAPITAL: It refers to the short-term assets such as inventories and short
term liabilities such as creditors. Working capital is normally required for running the
day-to-day operations of the business. It is the relative liquid proportion of the total
capital.
There are two concepts of working capital:
a) Gross Working Capital.
b) Net Working Capital

Gross Working Capital:

Gross or total working capital refers to the investment in all current assets. It includes
cash, inventories (stock & work in progress) bills receivable and prepaid expenditure.
Net Working Capital: This may be defined as the excess of current assets over current
liabilities,. It indicates the liquidity position fo the firm.
NWC=CA-CL
New Working Capital = Current Asset – Current Liabilities.

FACTORS AFFECTING WORKING CAPITAL REQUIREMENTS.

The working capital requirements of a business are influenced by the following factors:
 Nature of Business:
The basic nature of a business influences the amount of working capital required.
A trading organization usually needs lower amount of working capital than a
manufacturing concern. This is because most transactions are in cash and the
length of operating cycle is small. The time gap between goods acquired and sold
is less and the turnover is high.
 Scale of Operations:
For organization which operates on higher scale, the quantum of inventory and
debtors are high. Such organizations require large amount of working capital as
compared to organization which operates on a lower scale.
 Business Cycle:
The working capital requirement of a concern depends upon the demand and sale
of goods. The demand and sale of goods usually increase when an economy is
going through a boom phase. As against this, the requirement for working capital
will be lower during the period of depression as the production and sales will be
low.
 Seasonal Factors:
 If the firm is operating in goods ad services having seasonal fluctuation in
demand, then the working capital requirements will also fluctuate. In peak season,
because of higher level of activity, higher amount of working capital is required.
As against this, the level of activity as well as requirement of working capital will
become lower during lean season.
 Production Cycle:
Production cycle is the time span between the receipt of raw material and their
conversion into finished goods. Business units having longer production cycle
will require more working capital as their funds get locked up in the production
process for a longer period of time.

 Credit Allowed:
Credit policy of a firm depends upon market tradition, level of competition and
credit worthiness of the clientele. A liberal credit policy results in higher amount
of debtors and hence increasing the requirements of working capital.
 Credit Availed:
The working capital needs will be low if raw materials and supplies are available
at credit to a firm.
 Operating Efficiency:
The optimum efficiency refers to optimum utilization of resources at minimum
costs. Efficiency of operation accelerates the pace of cash cycle and improves the
use of working capital. This can be reflected in:
a). Inventory Turnover: It indicates the velocity with which stock is converted
into sales. A firm having higher stock turnover will require lower amount of
working capital as compared to a firm having a low rate of turnover.
b). Debtor Turnover Ratio: A high debtor turnover ratio indicates faster
realization of cash from receivables. Hence, reduces the working capital
requirement.
c). Better Sales Efforts: It also reduces the average time for which finished goods
inventory is held by a firm and thereby reducing the working capital
requirements.
 Availability of Raw materials:
If raw material and other supplies can be obtained from the market quickly and
without any disruption, then the firms can even maintain lower stock levels.
However, non-availability or seasonal availability and higher lead time(it is time
between placing an order and receipt of material) may force a firm to maintain
higher level of stock and thereby pushing up its working capital requirements.
 Growth Prospects:
If the growth potential of a firm is perceived to be higher, it will require higher
amount of working capital so that it can meet higher production and sales target.
 Level of Competition:
The greater the level of competition more will be working capital requirements as
a firm would like to capture a significant share of market. To achieve it may offer
liberal terms of credit, and supply higher stock of finished goods to meet the
orders of the customers.
 Inflation:
Changes in the price level also affect the working capital requirements. In case of
rising prices, a firm requires more working capital to maintain the same level of
operations. However, the effect of inflation will be different for different
concerns.