Financial ManagementClass 12 Business Studies Part 2 Notes

Meaning of Business Finance

Think of a business as a car. For the car to move, it needs fuel. In the business world, that fuel is money. Business finance is the money required to carry out all business activities.

Every business, no matter its size or type, needs finance at every stage of its life:

• To start: Money is needed to establish the business, buy machinery, set up an office, and purchase initial materials.
• To run: Finance is essential for day-to-day operations like paying salaries, buying raw materials, and settling bills.
• To grow: To modernise, expand into new markets, or diversify its products, a business needs a significant amount of money.

This finance is used to buy both tangible assets (like factories and computers) and intangible assets (like patents and trademarks). Without adequate and timely finance, a business cannot survive or grow.

Financial Management

Just having fuel isn't enough; you need to use it efficiently. Financial Management is the art and science of managing a company's money. It deals with two main things:

1. Optimal Procurement: Finding the best sources to get funds. This means identifying different sources (like loans or selling shares), comparing their costs and risks, and choosing the cheapest and safest options.
2. Optimal Usage: Investing the procured funds wisely. The goal is to invest money in a way that the returns from the investment are greater than the cost of getting the funds in the first place.

In simple terms, financial management aims to:

• Reduce the cost of funds.
• Keep financial risks under control.
• Ensure money is available when needed.
• Avoid having idle cash that isn't earning anything.

The overall financial health of a business depends heavily on the quality of its financial management.

Importance of Financial Management

Financial management decisions have a direct impact on almost every item in a company's financial statements, like the Balance Sheet and Profit and Loss Account. Good financial management is crucial because it affects:

• The size and composition of fixed assets: A decision to invest ₹100 crores in a new factory (a capital budgeting decision) directly increases the company's fixed assets.
• The amount and type of current assets: Decisions about how much inventory to keep or how much credit to give customers determine the levels of cash, inventory, and receivables.
• The mix of long-term and short-term funds: The company must decide what proportion of its funds should be long-term (like shares and debentures) versus short-term (like creditors). This choice involves a trade-off between liquidity and profitability.
• The breakup of long-term financing: Financial managers decide the mix of debt (borrowed funds) and equity (owner's funds). This is also known as the capital structure.
• All items in the Profit and Loss Account: Using more debt means higher interest payments. Expanding the business affects sales, expenses, and profits.

Objectives of Financial Management

The primary objective of financial management is to maximise the wealth of the shareholders. This is known as the wealth-maximisation concept.

How is wealth measured? By the market price of the company's shares. A company's funds belong to its shareholders. When financial managers make good decisions that add value to the company, the market price of its shares increases.

• A good financial decision is one where the benefits are greater than the costs.
• Such decisions add value, which increases the share price.
• An increase in share price means the shareholders' wealth has grown.

Therefore, every financial decision—whether it's buying a new machine or choosing a source of finance—should be evaluated based on one key question: "Will this decision lead to an increase in the price of our equity shares?"

Financial Decisions

Financial management revolves around making three broad types of decisions for a firm:

1. Investment Decision: Where to invest the company's funds.
2. Financing Decision: Where to get the funds from.
3. Dividend Decision: What to do with the profits earned.

Investment Decision

A business has limited resources but many potential uses for them. The investment decision is about choosing how to invest the firm's funds into different assets to earn the highest possible return.

There are two types of investment decisions:

• Long-term Investment Decision (Capital Budgeting): This involves committing large amounts of money for a long period, typically for fixed assets like a new factory, machinery, or opening a new branch. Capital Budgeting decisions are extremely important because they:
  • Affect the company's long-term growth and profitability.
  • Involve huge amounts of money.
  • Are often irreversible, meaning a wrong decision can severely damage the company's financial future.
• Short-term Investment Decision (Working Capital Decision): This relates to managing day-to-day operational assets like cash, inventory, and receivables. These decisions affect the company's liquidity (ability to pay short-term bills) and profitability.

Factors affecting Capital Budgeting Decision

When deciding on a long-term investment project, a financial manager must carefully evaluate several factors:

• Cash flows of the project: Every investment is expected to generate cash over its lifetime. The manager must analyze the expected cash receipts and payments from the project.
• The rate of return: This is the most important criterion. The company calculates the expected return from a project and assesses the risk involved. If Project A offers a 10% return and Project B offers a 12% return with the same risk, Project B would be chosen.
• The investment criteria involved: There are various techniques (known as capital budgeting techniques) used to evaluate investment proposals. These techniques consider factors like the amount of investment, interest rates, cash flows, and rate of return to help select the best project.

Financing Decision

This decision is about how much money to raise and from which long-term sources. The main sources of funds for a firm are:

• Shareholders' Funds (Equity): This includes equity capital and retained earnings (profits reinvested in the business). There is no legal obligation to pay a return or repay this capital.
• Borrowed Funds (Debt): This includes funds raised through debentures or loans. The company is legally obligated to pay interest and repay the principal amount at a fixed time.

The risk of being unable to meet these fixed payment obligations is called financial risk.

The financing decision involves choosing a judicious mix of debt and equity. Key considerations include:

• Cost: Debt is generally cheaper than equity, especially because interest paid on debt is tax-deductible.
• Risk: Debt is riskier for the company because of the fixed payment obligation. Equity is risk-free for the company.
• Floatation Cost: The cost of raising funds (e.g., expenses for a public issue of shares) must also be considered.

This decision determines the company's overall cost of capital and its financial risk.

Factors Affecting Financing Decisions

Several factors influence the choice between debt and equity:

• Cost: A company will prefer the source with the lowest cost.
• Risk: The company must evaluate the financial risk associated with each source.
• Floatation Costs: Higher floatation costs make a source less attractive.
• Cash Flow Position: A company with a strong and stable cash flow can more easily afford debt financing.
• Fixed Operating Costs: If a business has high fixed operating costs (like rent and salaries), it should prefer lower debt to reduce its fixed financial costs.
• Control Considerations: Issuing more equity can dilute the control of existing owners. Debt financing does not affect control. Companies fearing a takeover might prefer debt.
• State of Capital Market: In a bullish (rising) stock market, it's easier to raise money through equity. In a bearish (falling) market, debt might be a better option.

Dividend Decision

The dividend decision relates to how much of the company's profit (after tax) should be distributed to shareholders as dividend, and how much should be kept in the business as retained earnings.

This is a crucial decision because it involves a trade-off:

• Paying Dividends: Provides current income for shareholders, which keeps them happy.
• Retaining Earnings: Increases the company's future earning capacity by providing funds for investment and growth.

The decision should be made with the overall objective of maximizing shareholder wealth.

Factors Affecting Dividend Decision

The choice of how much profit to distribute depends on many factors:

• Amount of Earnings: Dividends are paid from current and past earnings. Higher earnings allow for higher dividends.
• Stability of Earnings: A company with stable earnings can declare higher dividends than a company with fluctuating earnings.
• Stability of Dividends: Companies prefer to maintain a stable dividend per share. They usually increase dividends only when they are confident about their long-term earning potential.
• Growth Opportunities: Companies with good growth opportunities tend to retain more earnings to finance their expansion, thus paying smaller dividends.
• Cash Flow Position: Paying dividends requires cash. A company might be profitable but short on cash, which would limit its ability to pay dividends.
• Shareholders' Preference: Management considers what the shareholders want. If shareholders depend on regular income, the company is more likely to pay dividends.
• Taxation Policy: Tax laws on dividends and capital gains can influence the decision. If taxes on dividends are high, a company might prefer to pay less.
• Stock Market Reaction: An increase in dividends is often seen as good news, causing the stock price to rise. A decrease can have a negative impact.
• Access to Capital Market: Large, reputed companies can easily raise money from the market, so they may depend less on retained earnings and pay higher dividends.
• Legal Constraints: The Companies Act places certain restrictions on dividend payouts that must be followed.
• Contractual Constraints: Lenders may impose restrictions on dividend payments as a condition for a loan.

Financial Planning

Financial planning is the process of creating a financial blueprint for an organization's future operations. It's about estimating the funds a business will need and specifying the sources from which they will be obtained.

The twin objectives of financial planning are:

1. To ensure availability of funds whenever required: This involves estimating the amount and timing of funds needed for long-term assets and day-to-day expenses.
2. To see that the firm does not raise resources unnecessarily: Excess funds are as bad as inadequate funds because they add to costs without generating returns.

Financial planning typically begins with a sales forecast for the next three to five years. Based on this forecast, the company estimates its fund requirements, identifies internal sources (retained earnings), and then plans for raising the remaining funds from external sources.

Importance of Financial Planning

Financial planning is vital for the smooth functioning of any business. Its importance lies in the following:

• Helps in forecasting: It allows a firm to prepare for different future scenarios, making it better equipped to face uncertainties.
• Avoids business shocks and surprises: By anticipating fund requirements, it helps a company prepare for the future.
• Coordinates business functions: It provides clear policies that help in coordinating functions like sales and production.
• Reduces waste and duplication: Detailed plans of action help eliminate wasted efforts and gaps in planning.
• Links the present with the future: It establishes a bridge between where the company is and where it wants to go.
• Links investment and financing decisions: It ensures that decisions about investments are supported by a clear plan for financing them.
• Makes performance evaluation easier: By setting clear objectives, it provides a benchmark for evaluating actual performance.

Capital Structure

Capital structure refers to the mix of owners' funds (equity) and borrowed funds (debt) that a company uses to finance its assets. It can be measured by the debt-to-equity ratio.

Debt and equity have different costs and risks:

• Debt: The cost of debt is lower than equity because lenders face less risk and interest is a tax-deductible expense. However, debt is riskier for the company due to the fixed obligation to pay interest and repay the principal.
• Equity: The cost of equity is higher, but it is risk-free for the business as there is no compulsion to pay dividends.

Using more debt increases a company's financial leverage and its financial risk. An optimal capital structure is the mix of debt and equity that results in the highest possible value for the equity share, thereby maximizing shareholders' wealth.

Trading on Equity

Trading on Equity is the practice of using cheaper debt to increase the profit earned by equity shareholders. This works only when the company's Return on Investment (RoI) is higher than the interest rate on its debt.

• Total Funds: ₹30 Lakh
• Return on Investment (RoI): 13.33% (EBIT of ₹4 Lakh / ₹30 Lakh)
• Interest Rate on Debt: 10% Since the RoI (13.33%) is higher than the cost of debt (10%), using more debt will increase the Earning Per Share (EPS). With no debt, EPS is ₹0.93. With ₹20 Lakh of debt, the EPS rises to ₹1.40. This is a case of favourable financial leverage, and trading on equity is beneficial.

Unfavourable Situation (Company Y):

• Total Funds: ₹30 Lakh
• Return on Investment (RoI): 6.67% (EBIT of ₹2 Lakh / ₹30 Lakh)
• Interest Rate on Debt: 10% Here, the RoI (6.67%) is lower than the cost of debt (10%). Using more debt will decrease the EPS. With no debt, EPS is ₹0.47. With ₹20 Lakh of debt, the EPS drops to zero. This is unfavourable financial leverage, and trading on equity is not advisable.

Factors affecting the Choice of Capital Structure

Choosing the right mix of debt and equity is a complex decision influenced by many factors:

1. Cash Flow Position: A company must have sufficient cash flow to cover its fixed debt obligations (interest and principal repayment).
2. Interest Coverage Ratio (ICR): Calculated as EBIT / Interest. A higher ICR indicates a lower risk of default on interest payments, allowing for more debt.
3. Debt Service Coverage Ratio (DSCR): A more comprehensive ratio than ICR, it compares cash profits to total cash required to service debt. A higher DSCR indicates a better ability to meet all debt commitments.
4. Return on Investment (RoI): If RoI is higher than the cost of debt, the company can use more debt to its advantage (Trading on Equity).
5. Cost of debt: A firm's ability to borrow at a lower interest rate increases its capacity to use debt.
6. Tax Rate: A higher tax rate makes debt cheaper because interest is tax-deductible.
7. Cost of Equity: As a company takes on more debt, the risk for equity shareholders increases, and they may demand a higher rate of return. Beyond a certain point, this can offset the benefits of cheaper debt.
8. Floatation Costs: The cost of raising funds can influence the choice. Loans may have lower floatation costs than public issues of shares or debentures.
9. Risk Consideration: A company with high business risk (due to high fixed operating costs) should use less debt to avoid compounding its total risk.
10. Flexibility: A company should not use its debt capacity to the full, keeping some borrowing power for unforeseen circumstances.
11. Control: Issuing equity can dilute the management's control, whereas debt does not.
12. Regulatory Framework: Legal requirements from bodies like SEBI for issuing shares or from banks for granting loans can affect the choice.
13. Stock Market Conditions: In a bullish market, raising equity is easier. In a bearish market, debt may be preferred.
14. Capital Structure of other Companies: Companies often look at industry norms for debt-equity ratios as a guideline, but they should adjust based on their specific risk profile.

Fixed and Working Capital

Meaning

Every business needs funds to invest in two types of assets:

• Fixed assets: These are long-term assets that remain in the business for more than one year, such as land, buildings, and machinery. Decisions to invest in fixed assets are called capital budgeting decisions. They are crucial because they involve large sums and are often irreversible.
• Current assets: These are short-term assets that are expected to be converted into cash within one year, such as inventory, debtors, and cash.

Management of Fixed Capital

Fixed capital refers to the investment in long-term assets. Managing it involves allocating the firm's capital to projects with long-term implications. These capital budgeting decisions are vital for several reasons:

• Long-term growth: They determine the future profitability and growth of the business.
• Large amount of funds involved: They block a substantial portion of a company's capital for a long time.
• Risk involved: They influence the overall business risk of the firm.
• Irreversible decisions: Once made, these decisions cannot be reversed without incurring heavy losses.

Fixed assets should always be financed through long-term sources of capital like equity, debentures, or long-term loans.

Factors affecting the Requirement of Fixed Capital

The amount of fixed capital a business needs depends on:

1. Nature of Business: A manufacturing company needs more fixed capital (for plant and machinery) than a trading company.
2. Scale of Operations: A large-scale organization requires more fixed capital than a small-scale one.
3. Choice of Technique: A capital-intensive business (using more machines) needs more fixed capital than a labour-intensive business.
4. Technology Upgradation: Industries where technology becomes obsolete quickly (e.g., computers) require higher fixed capital for frequent replacements.
5. Growth Prospects: Companies with high growth potential will invest more in fixed assets to meet future demand.
6. Diversification: Expanding into new product lines or industries increases the need for fixed capital.
7. Financing Alternatives: If leasing facilities are available, a company can use assets without buying them, thus reducing its fixed capital requirement.
8. Level of Collaboration: If companies share facilities (like a bank sharing an ATM network), the fixed capital requirement for each company is reduced.

Working Capital

Besides fixed assets, a business needs to invest in current assets to ensure smooth day-to-day operations. This investment is known as working capital. Current assets (like cash and inventory) are more liquid but generally provide lower returns than fixed assets.

Net working capital is defined as the excess of current assets over current liabilities (NWC = CA - CL). It represents the portion of current assets financed through long-term sources. A business needs to strike a balance between liquidity and profitability when deciding on its level of working capital.

Factors Affecting the Working Capital Requirements

The amount of working capital needed varies based on several factors:

1. Nature of Business: A trading firm or service industry needs less working capital than a manufacturing firm.
2. Scale of Operations: Larger businesses need more working capital to maintain higher levels of inventory and debtors.
3. Business Cycle: During a boom period, sales and production are high, requiring more working capital. During a depression, the requirement is lower.
4. Seasonal Factors: Businesses with seasonal demand need more working capital during the peak season.
5. Production Cycle: The time taken to convert raw materials into finished goods. A longer production cycle means more funds are tied up, increasing working capital needs.
6. Credit Allowed: A liberal credit policy (giving customers more time to pay) results in higher debtors and a greater need for working capital.
7. Credit Availed: If a firm gets liberal credit from its suppliers, its working capital requirement is reduced.
8. Operating Efficiency: A firm that manages its operations efficiently (e.g., has a high inventory turnover) can manage with less working capital.
9. Availability of Raw Material: If raw materials are scarce or have long delivery times (lead time), a company must keep larger stocks, increasing working capital.
10. Growth Prospects: High-growth companies need more working capital to support higher levels of production and sales.
11. Level of Competition: High competition may force a firm to keep larger stocks of finished goods and offer liberal credit terms, both of which increase working capital.
12. Inflation: Rising prices mean that more money is required to maintain the same volume of production and sales, thus increasing working capital needs.