Financial

Management
CH- 9

By – Simran Ma’am
Topic
Financial Management –
Meaning, Role, Objectives
Financial Planning- Meaning,
Structure
Capital Structure- Meaning,
Factors affecting
Fixed Capital & Working
Capital-
Meaning, Factors affecting
Introduction
✓ We all know that finance is
essential for running a business.
✓ The success of a business
depends on:-
✓ How well finance is invested in
assets and operations and
✓ How timely and cheaply the
finance is arranged from
different sources.
Meaning of Business
Finance:-

• The money required for carrying

out business activities is known as
Business Finance.
• It is concerned with the acquisition
of funds and use of funds.
Need for Business
Finance:-
• To start a business.
• To run the day-to-day
activities like purchase of raw
materials, payment of salary,
etc.
• To expand the business
• To purchase assets like
machinery, land, building,
patents, etc.
Financial Management

• Financial Management is
concerned with optimal
procurement as well as the usage
of finance.
• It is concerned with two
aspects: procurement of funds as
well as usage of finance.
Procurement of funds Usage of finance

• For optimal procurement, • The finance procured

different available needs to be invested in a
sources of finance are manner that the ROI
identified and compared exceed the cost at which
in terms of their costs and procurement has taken
risks. place.
Importance of Financial
Management

• Financial management influences

the financial health of a business.
• The financial statements such as the
Balance Sheet and Profit and Loss
account show the firm’s financial
position and health.
Size as well as the
composition of fixed
assets

• Financial management
plays a significant role in
determining the size and
composition of fixed
assets of a business.
Amount of current
assets

• The quantum of current

assets has to determine
the amount of current
investment, as well as
stock, goods that are
ready to sell and the raw
materials used to produce
them and accounts
receivables.
 Amount of long-term
and short-term finance

• An organization raises more

for the long-term basis if it
wants to invest in liquid
assets.
• But long-term debts are
costly as compared to short-
term debts.
Breakup of long-term
finance into debt and
equity

• Of the total long term

finance, the proportions
to be raised by way of
debt and/or equity is also
a financial management
decision.
 All items in the profit
and loss account

• Financial management decisions also

affect the items in the profit and loss
account of the business.
• For example, the use of more debts
means higher interest expense and the
use of more equity means higher
dividend payments.
Objectives

Profit Maximization

Maintenance of Liquidity

Proper Utilization of Funds

Meetings of Financial
Commitments with Creditors
 Investment
Decision

Financial Decision

Dividend Decision
Financial Decision
Investment Decision

• Investment decision refers to the

decisions that involve the
investment of various resources of
the firm to gain the highest
possible return on investment for
their investors.
• An investment decision is
categorized as a long-term and
short-term investment decision.
Capital Budgeting Decision

• Long term decision is

known as Capital
Budgeting Decision.
• For example, investing in
a new machine to replace
an existing one or getting
a new fixed asset or
opening a new branch,
etc.
Working Capital Management

• A short-term investment
decision is known as
a Working Capital
Decision.
• Such decisions involve
decisions regarding the
levels of cash, inventory,
and receivables.
Cash Flows of the Project

• Whenever an investment
decision involving a huge
amount is taken, the firm looks
forward to generating some
cash flows over a period.
• Before taking any capital
budgeting decision, these cash
flows should be properly
measured and evaluated.
The Rate of Return
• In any project undertaken by the
firm, the most important part of it
is the rate of return received from
them.
• For example, if there are two
projects, X and Y (with the same
risk involved), with a rate of return
of 10 percent and 15 percent,
respectively, under any normal
circumstance, project Y should be
opted for. This is because project
Y has a higher rate of return and
therefore, more profit.
The Investment Criteria Involved

• The decision of investment in any of the projects is

concerned with the calculation and evaluation of
several elements, such as the amount of investment,
interest rate, cash flows, and rate of return.
• The selection of any particular project is based on
different evaluation techniques known as capital
budgeting techniques.
• Such techniques are applied to the projects before
choosing a certain one.
Financial Decision

• The financing decision is

about the amount of
finance to be raised from
various sources, as well as
it also provides the cost of
each source of finance.
The main sources of
finance are:
• Shareholders’ Funds
• Borrowed Funds
• This decision determines the overall cost of
capital and the financial risk of the enterprise.
• The borrowed funds contain risk because they
involve a commitment of fixed interest payment,
although there will be loss in the organisation.
• On the other hand, owners’ funds have less risk
because there is no such commitment regarding
payment of dividends.
Cost
• The cost of raising funds
from different sources is
different.
• A financing manager
generally prefers the
cheapest source of finance.
Risk
• The risk associated with
different sources of finance
is a different.
• The financial manager
considers the risk involved
with each source before
taking a financing decision.
• In the case of equity, the risk
is low, and in the case of
debt, the risk is high.
Floatation Cost

• Floatation cost refers to the cost, which is involved in the

raising funds from different sources.
• In the case of equity, floatation cost is low, and in the case of
debt, floatation cost is high.
• The firm prefers securities with the least floatation cost.
Cash Flow Position
• A company with a strong cash flow position can take the
advantage of debt because interest payment and re-payment of
principal amount can be preferred.
Level of Fixed Operating Costs
• Owner’s fund is preferred by
firms with a higher level of
operating costs, like rent,
salaries, insurance premiums,
etc., because interests
payment on debt will further
add to the cost burden.
• And in case of moderate or
low fixed operating costs,
firms can go for borrowed
funds.
Control Consideration
• The issue of more equity shares may lead to a dilution of
management control over the business.
• Debt financing has no such implication.
• If existing shareholders want to retain complete control of the
company, then the debt should be preferred.
• However, if they don’t mind the loss of control, then the
company may go for equity.
• So we can say that equity dilutes control, whereas debt doesn’t
affect control.
State of Capital Market
• The condition of the stock market
also helps in making the source
of finance.
• In the case when the stock
market is rising, it is easy to raise
funds for the issue of shares
because people are interested to
invest in equity shares.
• But in case of a depressed
market, company may face
difficulties for issue equity
shares.
Dividend Decision
• The dividend is that portion
of the profit that is
distributed to the
shareholders.
• The dividend decision should
be taken keeping in view the
overall objective of
maximizing shareholders’
wealth.
Amount of Earnings
More earnings will ensure greater dividends, whereas fewer
earnings will lead to low rate of dividends.
Stability of Earning
A company that is stable and has regular earnings can afford to
declare higher dividend as compared to those company which
doesn’t have such stability in earnings.
Stability of Dividend
✓Some companies follow the policy of paying a stable dividend
because it satisfies the shareholders and helps in increasing
companies reputation.
✓ If earning potential is high, it is declared as a high dividend,
whereas if the earning is not increasing, then it is declared as a
low dividend.
Growth of Opportunities
✓Companies with growth opportunities prefer to retain more
money out of their earnings to finance the new project.
✓ So, companies that have growth prospects will declare fewer
dividends as compared to companies that don’t have any
growth plan.
Cash Flow Position
In case the company has surplus cash, then the company can pay
more dividends, but during a shortage of cash, the company can
declare a low dividend.
Taxation Policy
✓ The rate of dividends also depends on the taxation policy of
the government.
✓ In the present taxation policy, dividend income is tax-free
income to the shareholders, so they prefer higher dividends.
✓The income earned as interest on debt is deductible .
 Stock Market Reaction
✓The rate of dividend and market value of a share are directly
related to each other.
✓A higher rate of dividends has a positive impact on the market
price of the shares.
✓Whereas, a low rate of dividends may hurt the share price in
the stock market.
✓So, management should consider the effect on the price of
equity shares while deciding the rate of dividend.
Access to Capital Market
✓Large and reputed companies generally have easy access to the
capital market and, therefore, may depend less on retained
earning to finance their growth.
✓These companies tend to pay higher dividends than the smaller
companies which have relatively low access to the market.
Legal Constraints
✓Certain provisions of the Companies Act place restrictions on
payouts as dividend.
Contractual Constraints
✓While granting loans to a company, sometimes the lender may
impose certain restrictions on the payment of dividends in
future.
Financial Planning
✓Financial planning is the process of
estimating the requirement of
finance of a business specifying the
sources and ensuring the
availability of enough funds at the
right time.

✓Financial planning is deciding in

advance how much funds are
required and from which source
funds are obtained on right time.
• Financial planning includes both short-term as well as long-
term planning.
• Long-term planning is normally done for 3 to 5 years.
• Whereas short-term financial plans are called budgets, and
they are for one year or less.
Objectives

1. To ensure availability of funds whenever

required:

• The main objective of financial planning is that sufficient funds

should be available in the company for different purposes such
as the purchase of long-term assets, to meet day-to-day
expenses, etc.
• It ensures the timely availability of finance.
2. To see that firm does not raise resources
unnecessarily:

• Excess funding is as bad as inadequate or shortage of funds.

• If there is surplus money, financial planning must invest it in the
best possible manner.
 Importance

Prepares for future

challenges:
• It helps in forecasting
what may happen in the
future under different
business situations.
Helps in avoiding
business shocks and
surprises:
• By preparing a blueprint to
face different types of
situations, financial planning
helps businesses in avoiding
business shocks and
surprises.
Coordinate various
functions:
• It helps in coordinating
various functions,
production, sales, etc by
providing clear policies and
procedures.
Proper utilization of
finance:
• Detailed plans of action
prepared under financial
planning reduce waste,
duplication of efforts, and
gaps in planning
Acts as a link:
• It tries to link the present with
the future by anticipating sales,
growth, etc.
• It also links the investment and
financing decisions
continuously
Evaluates actual
performance:
• By spelling out the detailed
objective for various business
segments.
• It makes the evaluation of
actual performance easier.
Capital structure
• Capital Structure refers to the
proportion of debt and equity
used for financial business
operations.

• According to J.J.
Hampton, ‘Capital structure is
the combination of debt and
equity securities that comprise a
firm’s financing of its assets’.
Financial Leverage/ Trading on Equity
• The proportion of debt in the overall capital is known as
Financial Leverage. It is computed as:-

Financial Leverage = Debt/ Equity

Let us take some examples to understand how leverage
enhances the returns on investment of a company under
the following three circumstances:

• ABC Ltd. is a firm in the automobile industry. The tax rate in

the industry is 40% p.a. and the firm’s earnings before
interest and tax(EBIT) is ₹8,00,000. You are required to
calculate the EPS in each of the following cases:
Case 1. When total funds are raised through Equity
Total Capital = ₹60 lakhs consisting of 6,00,000 shares @10
each
Debt = Nil

Particulars ₹

EBIT 8,00,000
Less: Interest Nil

Earning After Interest But Before Tax 8,00,000

Less: Tax @ 40% p.a. (3,20,000)

EAT(Earning After Tax) 4,80,000

Earning Per Share 0.80

Case 2. When some part is raised through debt and balance
from Equity
Total Capital = ₹40 lakhs consisting of 4,00,000 shares @10
each
Debt = ₹20,00,000
Particulars ₹
EBIT 8,00,000
Less: Interest on debt @ 5% 1,00,000
Earning After Interest But Before Tax 7,00,000
Less: Tax @ 40% p.a. 2,80,000
EAT(Earning After Tax) 4,20,000
Earning Per Share 1.05

Clearly, by incorporating debt, the EPS increased from 0.80 to 1.05 .

Case 3. When the major part is raised through debt and some
from Equity
Total Capital = ₹10 lakhs consisting of 1,00,000 shares @10
each
Debt = ₹70,00,000

Particulars ₹

EBIT 8,00,000
Less: Interest on debt @ 5% 3,50,000

Earning After Interest But Before Tax 4,50,000

Less: Tax @ 40% p.a. 1,80,000

EAT(Earning After Tax) 2,70,000

Earning Per Share 2.7

Cash Flow Position

• The company must have sufficient funds for funding business

operations, investing in fixed assets, and fulfilling debt
obligations, such as interest and capital repayments.
• If a company is confident in its ability to generate sufficient cash
flow, it should use more debt securities in its capital structure;
however, if there is a cash shortage, it should use more equity
securities since there is no obligation to pay its equity owners.
Interest Coverage Ratio

• The ICR specifies the number of times EBIT can repay the
interest obligation.

ICR=EBIT/Interest

• A high ICR shows that companies can have borrowed funds due
to the lower risk of making interest payments whereas a lower
ratio shows that the company should use less debt.
Return on Investment
• Return on Investment is a crucial factor in designing an
appropriate capital structure.

ROI=EBIT/Total Investment

• In case ROI> Rate of interest, then the company must prefer

borrowed funds in capital structure whereas
• in case ROI <Rate of interest on debt, then the company must
avoid debt and use equity financing.
Debt Service Coverage Ratio
• Under this, the amount of money needed to pay off debt and the
capital for preferred shares is compared to the profit generated
by operations.

• DSCR= Profit after tax + Depreciation + Interest + Non Cash

exp/ Pref. Div + Interest + Repayment obligation

A higher DSCR indicates a better capacity to meet cash

obligations, which implies that the company can choose more
debt. However, in the case of lower DSCR, the company prefers
more equity.
Cost of Debt

• The cost of debt has a direct impact on how much debt will be
used in the capital structure.
• The company will prefer higher debt over equity if it can
arrange borrowed funds at a reasonable rate of interest.
Tax Rate
• High tax rates reduce the cost of debt because interest paid to
debt security holders is deducted from income before
calculating tax, whereas businesses must pay tax on dividends
paid to shareholders.
• So, a high tax rate implies a preference for debt, whereas a low
tax rate implies a preference for equity in the capital structure.
Cost of Equity
• The cost of equity is another aspect that influences capital
structure.
• The usage of debt capital has an impact on the rate of return
that shareholders expect from equity.
• The financial risk that shareholders must deal with increases as
more debt is used.
• The required rate of return rises when the risk does as well. As
a result, debt should only be used sparingly.
• Any use beyond the amount, increases the cost of equity, and
even though the EPS is higher, the share price may fall.
Floatation Cost

• There are additional formalities and costs associated with

issuing shares and debentures.
• However, it is less expensive to raise funds through loans and
advances.
Risk Consideration
• There are two categories of risk:
• Financial risk is the state in which a business is unable to pay its
set financial obligations, such as interest, a dividend on
preferred stock, payments to creditors, etc.
• Business risk refers to the risk of the business’s inability to pay
its fixed operating expenses, such as rent, employees’ salaries,
insurance premiums, etc.
• Total risk refers to the sum of business and financial risk.
• Thus, if the company’s business risk is low, it may suffer
financial risk, implying that more borrowed capital can be
utilized. But when business risk is higher, debt should be used
to lower financial risk.
Flexibility
• The firm’s ability to borrow more money may be limited by an
excessive amount of debt.
• It must maintain some borrowing capacity to be flexible and
deal with uncertain events.
Control

• Debt should be employed if the current shareholders desire to

keep control.
• The company might opt for equity shares if they don’t mind
giving up control.
 Regulatory Framework
• When choosing its capital structure, every company is required
to follow the legal framework.
• The SEBI guidelines must be followed when issuing shares and
debentures.
• Loans from banks and other financial institutions are likewise
subject to several regulations.
• Companies may prefer to give securities as a source of
additional capital if SEBI regulations are straightforward, or they
may opt for more loans if monetary policies are more flexible.
Stock Market Conditions
• Market conditions can be divided into two categories: boom
conditions and recession or depression conditions.
• People are willing to take a risk and buy stock shares even at
greater prices during a boom period.
• Investors favour debt, which has a fixed rate of return, but, in a
recession or depression period.
Capital Structure of other Companies
• Some businesses design their capital structures in accordance
with industry norms.
• However, it must exercise proper care as blindly following
industry standards can result in financial risk.
• If a company cannot afford the high risk, it should not increase
debt just because other companies are doing so.
 Fixed Capital
• The assets which remain in the
business for a period of more than one
year are known as Fixed Assets.
• For example, plant, machinery,
building, land, furniture, equipment,
etc.
• Fixed Capital is the money invested by
a company in its fixed assets, which are
to be used over a long period of time.
• Hence, it can be said that fixed capital
is used for meeting the permanent or
long-term needs of the business.
Management of Fixed Capital
• Raising fixed capital required by the firm at minimum cost and
using it effectively sums up the management of fixed capital.
• The decision taken by a firm to invest in fixed assets is known
as Capital Budgeting Decision.

• It consists of decisions related to :-

❖The purchase of land, plant and machinery, building,
❖ Investing in advanced techniques of production, or
❖Launching a new product line.
Factors affecting requirement of Fixed
Capital

Nature of Business
❑The first factor which helps in determining the requirement of
fixed capital is the type of business in which the company is
involved.
❑ A manufacturing company requires more fixed capital, as
compared to a trading company.
❑It is because a trading company does not need plant,
machinery, equipment, etc.
Scale of Operation

• The companies operating at a large scale require more fixed

capital as compared to the companies operating at a small
scale.
• It is because the former requires more machinery and other
assets; however, the latter requires less machinery.
Technique of Production

• The companies that use capital-intensive techniques require

more fixed capital; however, the companies that use labour-
intensive techniques require less fixed capital.
• It is because the capital-intensive techniques use plant and
machinery, which requires more fixed capital.
•
Growth Prospects

• Companies having higher growth plans require more fixed

capital for expansion of business, which requires more plant and
machinery.
Technology Upgradation

• Industries, where technology upgradation is fast, requires more

fixed capital as whenever new technology is invented, the old
machines become obsolete and the firm has to purchase new
plant and machinery.
• However, the companies where technological upgradation is
slow, need less fixed capital as they can easily manage with old
machines.
Diversification

• The companies which are planning to diversify their activities by

including more range of products require more fixed capital.
• It is because, for diversification of the business, they have to
produce more products for which more plants and machinery
are required, ultimately increasing the need for more fixed
capital.
Level of Collaboration/Joint Ventures

• The companies that prefer collaborations or joint ventures need

less fixed capital as these companies can share plant and
machinery with the collaborators.
• However, if a company prefers to operate its business as an
independent unit, then it will require more fixed capital.
Availability of Leasing Facility
• If a company can easily arrange leasing facilities, then it will
require less fixed capital, as it can acquire the required assets in
easy instalments and won’t have to pay a huge amount at one
time.
• Whereas, if a company cannot find leasing facilities easily, then
it will require more fixed capital, as it has to purchase plant and
machinery by paying a huge amount at once.
Working Capital
• Excess of current assets of an
organisation over its current
liabilities is known as Working
Capital.
• It can also be defined as that
part of total capital, which is
required for holding current
assets.
The list of current assets in order of their
liquidity is as follows:

• Cash in hand/Cash at bank

• Debtors
• Marketable Securities
• Finished goods inventory
• Bills Receivable
• Work in progress
• Raw Materials
• Prepaid Expense
Factors affecting Working Capital

•Nature of Business
• A trading company or a retail shop requires less working capital
as the length of the operating cycle of these types of businesses
is small.
• The wholesalers require more working capital as they have to
maintain a large stock and generally sell goods on credit,
increasing the length of the operating cycle.
• A manufacturing company requires a huge amount of working
capital as it has to convert its raw material into finished goods,
sell the goods on credit, maintain the inventory of raw materials
and finished goods.
Scale of Operation
• The firms that are operating at a large scale need to maintain
more debtors, inventory, etc. Hence, these firms generally
require a large amount of working capital.
• However, the firms that are operating at a small scale require
less working capital.
Business Cycle Fluctuation
• A market flourishes during the boom period which results in
more demand, more stock, more debtors, more production, etc.,
ultimately leading to the requirement for more working capital.
• However, the depression period results in less demand, less
stock, fewer debtors, less production, etc., which means that
less working capital is required.
Seasonal Factors
• The companies which sell goods throughout the season require
constant working capital.
• However, the companies selling seasonal goods require a huge
amount of working capital during the season as at that time
there is more demand and the firm has to maintain more stock
and supply the goods at a fast speed, and during the off-
season, it requires less working capital as the demand is low.
Technology and Production Cycle

• A company using labour-intensive techniques requires more

working capital because it has to maintain enough cash flow for
making payments to labour.
• However, a company using capital-intensive techniques requires
less working capital because the investment made by the
company in machinery is a fixed capital requirement.
Credit Allowed
• The average period for collection of the sale proceeds is known
as the Credit Policy.
• A company following a liberal credit policy will require more
working capital, as it is giving more time to the creditors to pay
for the sale made by the company.
• However, if a company follows a strict or short-term credit
policy, then it will require less working capital.
Credit Avail

• If a company is getting long-term credit on raw materials from

its supplier, then it can manage well with less working capital.
• However, if a company is getting short period of credit from its
suppliers, then it will require more working capital.
Operating Efficiency
• If a company has a high degree of operating efficiency then it
will require less working capital.
• However, if a company has a low degree of operating efficiency,
then it will require more working capital.
Availability of Raw Materials
• If the raw material is easily available to the firm then the firm
can easily manage with less working capital as the firm does
not need to maintain any stock of raw materials, they can
manage with less stock.
• However, if there is a rough supply of raw materials, then the
firm will have to maintain a large inventory .Therefore, the firm
will require more working capital.
Level of Competition

• If there is competition in the market, then the company will have

to follow a liberal credit policy for supplying goods on time.
• For this, it will have to maintain higher inventories, resulting in
more working capital requirements.
• However, if there is less competition in the market, then it will
require less working capital as it can dictate its own terms
according to its requirements.
Inflation

• A inflation increases the price of raw materials and the cost of

labour, resulting in the increasing requirement for working
capital.
• However, if a company is able to increase the price of its goods
also, then it will face less problem with working capital.
Growth Prospects
• If a firm is planning on expanding its activities, then it will
require more working capital as it needs to increase the scale of
production for expansion, resulting in the requirement of more
inputs, raw materials, etc., ultimately increasing the need for
more working capital.
•
“The secret to wealth is simple:
Find a way to do more for
others than anyone else does.
Become more valuable. Do
more. Give more. Be more.
Serve more. And you will have
the opportunity to earn
more.”.

Tony
Thank
you
Presenter Name
Simran Ma’am