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Chapter 9 Financial Management Notes

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36 views5 pages

Chapter 9 Financial Management Notes

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4ashnagre
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Chapter 9: Financial Management - Summarized Notes

1. Meaning of Business Finance


Business finance refers to money required to carry out business activities like establishing,
running, modernizing, expanding, or diversifying a business. It is essential for acquiring
tangible (machinery, buildings) and intangible assets (trademarks, patents).

2. Financial Management
Concerned with the optimal procurement and utilization of finance.
Goals: Minimize costs, control risks, ensure fund availability, and avoid idle finances.
Objective: Maximize shareholders' wealth by increasing the market value of equity shares.

3. Objectives of Financial Management


1. Wealth Maximization: Increase market value of shares.
2. Efficient financial decision-making in three areas:
- Investment Decision: Allocation of funds in profitable projects (long-term and short-term
investments).
- Financing Decision: Decide sources of funds (debt vs. equity).
- Dividend Decision: Determine profit distribution between shareholders and business
reinvestment.

4. Financial Planning
Preparation of a financial blueprint for future operations.
Objectives:
1. Ensure fund availability when needed.
2. Avoid unnecessary fundraising.
Importance: Facilitates smooth functioning, avoids surprises, and links present plans to
future goals.

5. Capital Structure
Refers to the proportion of owners' funds (equity) and borrowed funds (debt).
Debt is cheaper but increases financial risk.
Optimal Capital Structure: Balance between risk and return to maximize shareholders'
wealth.

Factors Affecting Capital Structure:


1. Cash flow position.
2. Interest coverage ratio.
3. Cost of debt and equity.
4. Flexibility and control.
5. Stock market conditions.
6. Fixed and Working Capital
Fixed Capital:
- Investment in long-term assets like machinery, land, and buildings.
- Factors affecting fixed capital:
1. Nature of business.
2. Scale of operations.
3. Growth prospects.
4. Technology upgrades.

Working Capital:
- Investment in current assets like inventory, cash, and receivables.
- Ensures smooth business operations.
- Factors affecting working capital:
1. Nature of business.
2. Scale of operations.
3. Credit terms allowed and received.
4. Seasonal and cyclical factors.

7. Financial Decisions
1. Investment Decision: Allocation of funds to projects that yield high returns.
2. Financing Decision: Decide on sources of funds (equity, debt).
3. Dividend Decision: Balance between distributing profits as dividends and retaining them
for reinvestment.

8. Importance of Financial Management


Ensures financial stability and profitability.
Improves decision-making for investment, funding, and dividend distribution.

9. Investment Decision
Relates to how funds are allocated to various assets to earn maximum returns.
Two types:
1. Long-Term (Capital Budgeting): Investments in fixed assets like machinery or new
projects. Irreversible, involves high risk and funds.
2. Short-Term (Working Capital): Management of current assets like inventory and
receivables. Ensures smooth business operations.

Factors Affecting Capital Budgeting Decisions:


1. Expected cash flows.
2. Rate of return.
3. Investment criteria like cost, risks, and benefits.

10. Financing Decision


Determines the mix of debt and equity in capital structure.
Debt is cheaper but riskier due to fixed obligations like interest.
Equity is costlier but safer as it has no repayment obligations.

Factors Affecting Financing Decisions:


1. Cost of funds (debt vs. equity).
2. Financial risk associated with debt.
3. Cash flow position.
4. Market conditions and floatation costs.
5. Control considerations (equity dilutes ownership).

11. Dividend Decision


Determines how much profit to distribute as dividends and how much to retain for
reinvestment.

Factors Affecting Dividend Decisions:


1. Earnings: High earnings allow more dividends.
2. Stability of Earnings: Stable earnings encourage higher dividends.
3. Cash Flow Position: Adequate cash is needed for dividend payouts.
4. Growth Opportunities: Retaining profits is prioritized in growth-focused companies.
5. Shareholder Preferences: Some shareholders prefer regular dividends.
6. Tax Policy: Higher taxes on dividends may reduce payouts.

12. Management of Fixed Capital


Involves allocation of funds for acquiring, upgrading, or replacing long-term assets.

Factors Affecting Fixed Capital Requirements:


1. Nature of business (manufacturing vs. trading).
2. Scale of operations.
3. Technology advancements and obsolescence.
4. Growth and diversification plans.

13. Management of Working Capital


Focuses on managing current assets and liabilities to ensure liquidity and operational
efficiency.

Key Components of Working Capital:


1. Cash.
2. Inventories (raw materials, finished goods).
3. Debtors and creditors.

Factors Affecting Working Capital Requirements:


1. Nature of business.
2. Scale of operations.
3. Credit terms allowed and received.
4. Business cycle and seasonal variations.
5. Inflation and operating efficiency.

14. Capital Budgeting


Definition: A process to evaluate and select long-term investments that are profitable for
the firm.
Includes decisions like acquiring machinery, launching new products, or expanding
operations.

Importance:
1. Impacts long-term growth.
2. Involves large funds and high risk.
3. Irreversible in nature, so careful evaluation is required.

15. Trading on Equity


Definition: Increase in equity shareholders’ returns due to the presence of fixed financial
charges like interest on debt.

When to Use:
1. Return on investment (RoI) is higher than the cost of debt.

Risks: Excessive debt increases financial risk and may lead to insolvency if fixed obligations
are unmet.

16. EBIT-EPS Analysis


Earnings Before Interest and Taxes (EBIT): Measures operating profits before deducting
interest and taxes.
Earnings Per Share (EPS): Profit available for each equity share.

Used to assess the impact of capital structure (debt vs. equity) on shareholder returns.

17. Cost of Capital


Refers to the cost of funds (both debt and equity) used for financing a business.
Includes interest on debt (cheaper but risky) and the required return on equity (costlier but
safer).

18. Importance of Dividend Policy


Determines the share of profits distributed to shareholders and retained earnings.
Influences shareholder satisfaction and reinvestment capacity of the company.

19. Financial Leverage


Definition: Use of fixed-cost financing (debt) to enhance the return on equity.
High leverage increases risk but can improve EPS if RoI > Cost of Debt.
20. Risk Consideration in Capital Structure
Business Risk: Arises from fixed operational costs.
Financial Risk: Arises from fixed financial obligations like interest.
Companies must balance both risks to avoid insolvency.

21. Regulatory Framework for Financial Decisions


Companies must comply with SEBI guidelines, Companies Act provisions, and other laws
when raising funds or paying dividends.

22. Practical Application of Financial Management


Involves forecasting future financial needs, optimizing investments, balancing risks, and
ensuring profitability.

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