of BST Chapter 9 - (Financial Management)
of BST Chapter 9 - (Financial Management)
of BST Chapter 9 - (Financial Management)
Business
Finance
The fund required
to carry out the
activities of the
Business is called
Business Finance.
Financial Management
Financial management refers to the efficient acquisition of
finance, efficient utilization of finance and efficient distribution
and disposal of surplus for the smooth working of the company.
In other words, it is concerned with the flow of
funds and involves decisions related to :
Procurement of Funds
Investment of Funds
Distribution of Earnings
Role of Financial Management
The overall financial health of a business and its future depends a
great deal on the quality of its financial management.
Financial Management is concerned with optimal procurement as
well as the usage of finance.
Good financial management aims at procuring funds at a lower
cost, keeping the risk under control and achieving effective
deployment of such funds in the most productive activities, so
that they can earn the highest possible return for their investors.
It also aims at ensuring the availability of enough funds
whenever required as well as avoiding idle finance.
The financial statements, such as Balance Sheet and Statement of
Profit and Loss Account, of a business are largely determined 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, that is, the shareholders.
Therefore, when a decision is taken about investment in a new machine, the aim of financial
management is to ensure that benefits from the investment exceed the cost so that some value
addition takes place. Similarly, when finance is procured, the aim is to reduce the cost so that the
value addition is even higher.
Working Retained
Capital
Equity Earnings
Investment Decision
(Capital Budgeting This decision relates to the careful selection of
Decision) assets in which funds will be invested by the firms.
The most important criteria to decide the investment proposal is the rate of
Return on return it will be able to bring back for the company in the form of income.
Investment For example : If project A is bringing 10% return and project B is bringing 15%
return then we should prefer project B.
With every investment proposal, there is some degree of risk is also involved.
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.
Along with the rate of investment return, risk, and cash flow, there are
Investment
various other criteria which help in selecting an investment proposal such as
Criteria the availability of labour, technologies, input, machinery, etc.
Importance or Scope of Capital Budgeting Decision
Long-term Growth
Capital budgeting decisions affect the long-term growth of the company.
As funds invested in long-term assets bring return in future and future prospects and growth of the company depends upon
these decisions only.
Risk
The fixed capital decisions involve huge funds which carry high risk also.
The return comes in the long run and the company has to bear the risk for a long period till the return start coming.
Irreversible Decision
Capital Budgeting Decisions cannot be reversed or changed overnight.
As these decisions involve huge funds and heavy costs and going back or reversing the decision
may result in heavy loss and wastage of funds.
Conclusion : Therefore, the Finance Manager must compare all the available alternatives very
carefully and then only decide where to invest the most valuable resource of the firm i.e. finance.
Financing Decision
(Quantum of finance to be raised from various long-term sources.)
The second most important decision that a finance
manager has to take is deciding the source of finance.
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 is a
concern of the financing decision.
The borrowed funds involve some degree of risk whereas in the
owner's fund, there is no fixed commitment of repayment and there is
no risk involved. But the finance manager prefers a mix of both types.
Factors Affecting Financing Decisions
The cost of raising finance from various sources are different and finance
Cost manager always prefer the source with minimum cost.
The cash flow position of the company also helps in selecting the securities.
A strong cash flow position may make debt financing more viable than funding through equity.
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.
If existing shareholders want to retain complete control of the business then they prefer borrowed fund
Control Considerations 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.
It refers to the cost involved in the issue of securities such as broker's commission, underwriter's fees,
Flotation Cost expenses on the prospectus, etc.
The firm prefers securities which involve the least floatation 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.
Fixed Operating Cost The company may not be able to pay interest on debt securities which can cause
serious troubles for the company.
More risk is associated with the borrowed fund as compared to owner's fund securities.
Risk The finance manager compares the risk with the cost involved and prefers securities
with a moderate risk factor.
The conditions of the capital market also help in deciding the type of securities to be raised.
State of 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.
Dividend Decision /
Residual Decision
This decision is concerned with the distribution of
surplus funds. The profit of the firm is distributed
among various parties such as creditors,
employees, debenture holders, shareholders, etc.
After the payment of fixed liabilities, a finance
manager has to decide what to do with the
residual profit of the company.
The surplus profit is either distributed to equity
shareholders or kept aside in the form of
retained earnings.
Therefore, under dividend decision, the finance
manager decides how much to be distributed in
the form of dividend and how much to keep
aside as retained earnings.
Factors Affecting Dividend Decisions
The Finance Manager analyses the following factors before dividing the net
earnings between dividends and retained earnings :
1) 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.
2) 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.
3) 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.
4) Growth Opportunities :
If a company has a number of investment 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.
5) Preference of Shareholders :
If a company is having a large number of retired and middle class shareholders
then it will declare more dividend.
Whereas if company is having a large number of 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.
6) 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 has to 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.
7) 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.
8) 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.
9) Contractual Constraints :
When companies take long-term loans then financier may put some restrictions or constraints
on the distribution of dividend and companies have to abide by these constraints.
Financial planning begins with the determination of the total capital requirement. For this, the finance
manager does the sales forecast.
If the prospects appear to be bright and then the firm needs to increase its production capacity which means
more requirement of long-term funds i.e., fixed capital as well as working capital.
Financial planning does not end by raising estimated finance. It includes long-term investment decisions. The
finance manager analyses various investment plans and selects the most appropriate one. The finance
manager also makes a short-term financial plan called budget.
Objectives of Financial Planning
To ensure the availability of funds To see that firm does not raise
whenever these are required resources unnecessarily
Excess funding is as bad as a
The main objective of financial shortage of funds. It may result
planning is that sufficient funds in the wastage of resources.
should be available in the If there is surplus money it must invest in
the best possible manner as keeping
company for different purposes financial resources idle is a great loss for
such as for the purchase of long- an organization.
term assets, to meet day-to-day Financial planning includes both short-
term as well as long-term planning.
expenses, etc. Long-term planning focuses on capital
It ensures the timely availability expenditure plan whereas short-term
of finance and also tries to financial plans are called budgets which
specify the sources of finance. include a detailed plan of action for one
year or less.
Importance of Financial Planning
It Makes the Firm Well-prepared to Face the Future
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 particular situations.
Helps in Coordination
It helps in coordinating various business functions such as production, sales function etc. by providing clear policies and procedures.
Step 2 : Preparation
Step 5 : Preparation
of financial
of a cash budget.
statements
Conclusion : A capital structure of the business affects the profitability and financial
risk. Generally, companies use the concept of financial leverage to set up the capital
structure.
Financial Leverage / Trading on Equity
Financial leverage refers to the proportion of debt in the overall capital.
𝐃𝐞𝐛𝐭
Financial leverage =
𝐄𝐪𝐮𝐢𝐭𝐲
With debt funds company's funds and earnings increase because debt is a
cheaper source of finance but it involves a high degree of risk.
More debt will increase by earning only when the return on
investment is more than the rate of interest on the debt.
Return on Investment > Rate of Interest = Favourable
Situation.
Return on Investment < Rate of Interest = Unfavourable
Situation.
If the Rate of Interest is more than the earnings then more debt means a loss for
the company.
Total Capital = Rs 50 Lakhs
Situation Equity Capital = Rs 50 Lakhs (5,00,000 shares @ Rs 10
1 each)
Debt = Nil
Tax Rate = 30% p.a.
Earning before Interest and Tax (EBIT) = Rs 7, 00,000
Total Capital = Rs 50 Lakhs
Situation Equity Capital = Rs 40 Lakhs (4,00,000 shares @ Rs 10 each)
2 Debt = Rs 10 Lakhs
Tax Rate = 30% p.a.
Interest on Debt = 10%
Earning before Interest and Tax (EBIT) = Rs 7,00,000
Companies which are operating at large scale require more fixed capital.
Scale of
Whereas companies operating on a small scale need less amount of fixed capital as
Operation they need less amount of machinery and other assets.
Companies which have plans to diversify their activities by including more range
Diversification of products require more fixed capital. As to produce more products they require
more plants and machinery which means more fixed capital.
Nature of Business
The type of business, the firm is involved in, is the next consideration while deciding the working capital.
In the case of retail shops, the requirement for working capital is less because the length of the operating
cycle is small.
The wholesalers as compared to retail shops require more capital as they have to maintain a large stock and
the length of the operating cycle is large.
The manufacturing company requires a huge amount of working capital because they have to convert raw
materials into finished goods, sell on credit, and maintain the inventory of raw materials as well as finished
goods.
Credit Allowed
If a company is following a liberal credit policy results in a higher number of debtors, Hence needs more
working capital.
If a company is following a strict credit policy then it can manage with less working capital also.
Credit Availed
Another factor related to credit policy 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.
Operating Efficiency
A firm having a high degree of operating efficiency requires less amount of working capital.
Whereas the firm has a low degree of efficiency which requires more working capital.
Availability of Raw Materials
If raw materials are easily available and there is a ready supply of raw materials and inputs then firms can manage the
amount of working capital also as they need not maintain any stock of raw materials.
Whereas if the supply of raw materials is not smooth then firms need to maintain a large
inventory to carry on the operating cycle smoothly. So, they require more working capital.
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 have to be maintained so more working capital is required.
A business with less competition will require less working capital as it can dictate terms according to its requirements.
Inflation
If there is an increase or rise in price then the price of raw materials and cost of labour will rise, it will increase by working
capital requirement.
But if the company can increase the price of its goods as well, then there will be fewer problems with working capital.
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. so more
working capital also.