Concept and Decisions of Financial Management

Financial Management refers to management of flow of funds and

involves decisions relating to procurement of fund, investment of
funds and distribution of earnings to the owners.
Objectives of Financial Management
The primary objective of financial management is to maximise
shareholders’ wealth, which means to maximise the current market price
of equity shares of the company. The market price of equity shares
increases, if the benefit from a financial decision exceceds the cost
involved, so that some value addition takes place.
For example, 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.
Maximising shareholders’ wealth is only possible by:
(i) Ensuring availability of sufficient funds at reasonable cost.
(ii) Ensuring effective utilisation of funds.
(iii)Ensuring safety of funds procured by creating reserves, reinvesting
profits.
Role of Financial Management:
(i) Financial Management is concerned with optimal procurement as
well as the usage of finance.
(ii) Good financial management aims at procuring funds at a lower
cost and achieving effective deployment of such funds in most
productive activities.
(iii) It also aims at ensuring availability of enough funds whenever
required as well as avoiding idle finance.
(iv) 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
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Financial Decisions

1. Investment Decision: Investment decision involves deciding about

how the funds are invested in different assets so that they are able to
earn the highest possible return for their investors. Investment decision
can be long-term or short-term.
Long-term investment decision/Capital Budgeting Decision
It involves allocation of firm’s capital to different projects or assets with
long-term implications for the business.

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Examples of capital budgeting decisions: • Acquiring a new fixed
asset such as land, building, plant and machinery,
etc. • Opening a new branch • Expenditure on acquisition, expansion,
modernisation and their replacement • Launching
a new product line • Investing in advanced techniques of production •
Major expenditures on advertising campaign or research
and development programme

Reasons that make capital budgeting decision to be made carefully:

(a) These decisions have a bearing on the long term growth.
(b) These decisions result in a substantial portion of capital funds being
blocked in long-term project.
(c) These decisions influence the overall business risk complexion of the
firm.
(d) These decisions once taken, are not reversible without incurring
heavy losses.

Factors affecting Investment Decision/ Capital Budgeting Decision

1. Cash flows of the project: The amount of cash flows should be
carefully analyzed before considering the decision.
2. Rate of return of the project: The rate of return of the project
based on expected return and assessment of the risk involved from
each proposal should be analyzed.
3. Investment criteria: The decision to invest in a particular project
involves a number of calculations regarding the amount of investment,
interest rate, cash flows and rate of return.
There are different techniques, such as Pay Back Period, Net Present
Value(NPV), Internal Rate of Return(IRR), etc. to evaluate investment
proposals which are known as capital budgeting techniques. These
techniques are applied to each proposal before selecting a particular
project.

Fixed Capital DTC CNG

Fixed capital refer to investment in fixed assets (e.g., plant and
machinery, land and building, etc.).
Factors Affecting Fixed Capital Requirements
1. Nature of business: A trading concern needs a lower investment
in fixed assets as compared to a manufacturing concern since it doesn’t
require to purchase plant and machinery.

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2. Scale of operations: A larger organisation operating at a higher
scale needs bigger plant and more space and hence higher investment
in fixed assets.
3. Choice of technique: A capital intensive organisation requires
higher investment in plant and machinery and thus requires higher fixed
capital than a labour intensive organisation.
4. Technology upgradation: Industries where assets become
obsolete (e.g. computers) sooner require higher fixed capital to
purchase such assets.
5. Growth prospects: Higher growth prospects require higher
investment in fixed assets to meet anticipated demand quicker.
6. Financing alternatives: Availability of leasing facilities requires
lower investment in fixed assets and
hence requires less fixed capital. (Such a strategy is specially suitable in
high risk lines of business.)
7. Collaboration: Collaboration reduces the level of investment in
fixed assets for each firm. Therefore, fixed capital requirement is lower.
(For example, 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.)
8. Diversification: With diversification, the fixed capital requirements
will increase as the investment in fixed capital will increases.

Short-term investment decisions (also called working capital

decisions)
These decisions are concerned with the decisions about the levels of
cash, inventory and receivables.
These decisions affect the day-to-day working of a business. Efficient
cash management, inventory management and receivables
management are essential ingredients of sound working capital
management.

Working Capital PNB GIC

Working capital refers to investment in current assets such as cash, bills
receivables, prepaid expenses, inventories, etc. Net working capital is
the excess of current assets over current liabilities. This investment
facilitates smooth day-to-day operations of the business. Current assets
are expected to get converted
into cash or cash equivalents within a period of one year. Examples of
current assets (in order of their liquidity) are cash

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in hand/cash at bank, marketable securities, bills receivable, debtors,
finished goods inventory, work-in-progress, raw
materials and prepaid expenses. Current assets are more liquid but
less profitable than fixed assets. Thus,
working capital decisions affect the liquidity as well as profitability
of a business. Current liabilities are those
payment obligations which are due for payment within one year; such as
bills payable, creditors, outstanding expenses and advances received
from customers, etc. Some part of current assets is financed through
short-term sources, i.e. current liabilities. The rest is financed through
long-term sources and is called ‘Net Working Capital’.
Factors affecting working capital requirements:
1. Nature of business: A trading business needs less working
capital because there is no processing. A
manufacturing business requires more working capital since raw material
is converted into finished goods.
Service industries (e.g., transport, banking, insurance, warehousing,
advertising etc.) require less working capital since they do not
maintain inventory.
2. Business cycle: In case of boom, larger working capital is
required as the sales and production are more.
During depression, working capital requirement will be lower since
production and sales will be low.
3. Production cycle: It is the time span between the receipt of raw
materials and their conversion into
finished goods. Working capital requirement is higher in firms with longer
production cycle because funds are blocked in raw materials and semi-
finished goods.
4. Operating efficiency: Operating efficiency reduces the levels of
inventories and debtors. So working capital
requirements will decrease. Efficiency in managing raw materials is
reflected in higher inventory turnover ratio. Reducing the amount tied up
in debtors and receivables is reflected in higher trade receivables
turnover ratio.
5. Availability of raw materials: Easy and continuous availability of
raw materials enables the firms to keep
lesser stock and hence work with smaller working capital. (In addition,
the time lag between the placement of order and actual receipt of the
material (called lead time) is also relevant. Larger the lead time, larger
the quantity of material to be stored and larger shall be the amount of
working capital required.)

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6. Growth prospects: Higher growth prospects will require larger
amounts of working capital so that the
firm is able to meet higher production and sales targets
7. Level of competition: Higher competition requires larger stocks to
meet urgent orders from customers and
thus higher working capital. (Competition may also force the firm to
extend liberal credit terms.)
8. Inflation: With rising prices larger amounts are required to
maintain a constant volume of production and sales. Thus working
capital requirement of a business will be high.
9. Seasonal factors: Peak season requires higher working capital
than lean season due to higher level of activity.
10. Credit allowed affects the amount of debtors and consequently
the working capital requirement of a firm.
11. Credit availed: To the extent the firm avails credit on purchases,
the working capital requirement is reduced.
12. Scale of operations: A large-scale organisation requires larger
amount of working capital as compared to a small-scale organisation
because the quantum of inventory, debtors and cash required is
generally high.
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2. Financing Decision: It relates to the quantum of finance to be raised

from various long term sources—
Shareholders’ funds (or Equity) and Borrowed funds (or Debt). Financing
decision determines the overall cost of
capital and the financial risk of the enterprise
Factors affecting Financing Decision FORC3
1. Cost: The cheapest source of finance should be selected, i.e.,
debt. Cost of debt is lower than cost of equity because the lender’s risk
is lower than the equity shareholder’s risk. Since the lenders earn an
assured return and
repayment of capital on maturity, therefore, they should require a lower
rate of return. Moreover, interest paid
on debt is a deductible expense for computation of tax liability whereas
dividends are paid out of after-tax
profits. Therefore, increased use of debt is likely to lower the overall cost
of capital of the firm.
2. Risk: The less risky source of finance should be preferred, i.e.,
equity. Debt is cheaper, but is more risky for a business because the

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payment of interest and the return of principal is obligatory for the
business.
Any default in meeting these commitments may force the business to go
into liquidation. There is no such
compulsion in case of equity, which is therefore, considered riskless for
the business. Therefore, increased
use of debt increases the financial risk. Financial risk is the chance
that a firm would fail to meet its payment obligations,
i.e., interest and principal amount. Thus, overall financial risk depends
upon proportion of ‘Debt’ in the total capital.
3. Floatation costs: Cost of raising funds is called floatation cost,
e.g. costs of advertising, printing
prospectus, etc. Issue of equity involves floatation cost while debt (e.g.,
loan from banks) does not involve floatation costs.
4. Cash flow position: Debt financing is better than funding through
equity if cash flow position is strong.
5. Control: Debt normally does not cause a dilution of control while
issue of equity shares may reduce
management control over the business. (Therefore, companies afraid of
a takeover bid would prefer debt to equity.)
6. Level of fixed operating costs: If a business has high fixed
operating costs, i.e. high business risk (e.g.,
building rent, insurance premium, salaries, etc.), lower debt financing is
better.
7. State of the capital market: During the period when stock market is
rising (i.e., a bullish phase), equity shares are more easily sold even at a
higher price. However, during a bearish phase a company may opt for
debt.
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3. Dividend Decision: It relates to how much of the profit earned by the

company (after paying tax) is to
be distributed to the shareholders as dividend and how much of it should
be retained in the business. The decision regarding dividend should be
taken keeping in view the overall objective of maximising shareholder’s
wealth.
Factors affecting Dividend Decision SAS ECG
1. Amount of earnings: Dividends are paid out of current and past
earning. Therefore, earnings is a major determinant of the dividend
decision.

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2. Stability of earnings: A company having stable earnings is in a
position to declare higher dividends.
3. Stability of Dividends: Companies generally follow a policy of
stable dividend per share. The increase in
dividends is made only when the earning potential increases and not just
the earnings of the current year.
4. Cash Flow position: A good cash flow position is necessary for
declaration of dividend.
5. Growth opportunities: If a company has good growth
opportunities, it pays out less dividend and retain more profits to invest
in new projects.
6. Shareholders’ preference: Shareholder’s preference is kept in
mind by the management before declaring dividends.
7. Access to capital market: Large companies can raise funds
easily from the capital market to invest in new projects. So, they can
pay higher dividend.
8. Stock market reaction: Increase in dividend increases the
market price of shares in the stock market.
9. Taxation policy: A dividend distribution tax is levied on
companies. So, if tax rate on dividend is higher, it would be better for a
company to pay less dividend.
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Concept of Capital Structure
Capital structure refers to the mix between owners funds and borrowed
funds. OR, Capital structure means
the proportion of debt and equity used for financing the operations of a
business.
It can be calculated as debt-equity ratio, i.e., Debt/Equity or as the
proportion of debt in the total capital, i.e., Debt/Debt + Equity.
The proportion of debt in the total capital is also called financial
leverage.
As the financial leverage increases, the cost of funds declines because
of increased use of cheaper debt, but the financial risk increases. When
ROI is higher than cost of debt, financial leverage is favourable.
When ROI is less than cost of debt, financial leverage is
unfavourable.
Capital structure of a business affects both the profitability and the
financial risk.

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 Ideally, a company must choose that risk-return combination which
maximises shareholders’ wealth. The debt-equity mix that achieves it, is
the optimum capital structure.
Factors affecting the Choice of Capital Structure .
1. Risk consideration: (Already explained as factor affecting
financing decision)
2. Cost of debt: More debt can be used if debt can be raised at a
lower rate.
3. Tax rate: Since interest on debt is a tax deductible expense, a
higher tax rate makes debt relatively
cheaper and hence, more debt can be used. Example: Borrowing @
10% and the tax rate 30%, means that the
after-tax cost of debt is only 7%.
4. Return on Investment (RoI): When the RoI of the company is
higher than cost of debt, it can choose
to use trading on equity. Trading on Equity refers to the increase in
profit earned by the equity shareholders due to presence of fixed
financial charges like interest.

 The two conditions necessary for taking advantage of trading on

equity are:
 The rate of return on investment should be more than the rate of
interest.
 The amount of interest paid should be tax deductible.

Shareholders are likely to gain due to debt/loan component in the total

capital employed. How—With a higher debt EPS rises.
Why—It is because RoI is higher than cost of debt.
5. Cash flow position of the company:-
6. Floatation costs
7. Control considerations
8. Stock market conditions

9. Cost of equity: ‘Cost of equity’ means the desired rate of return

on equity capital for assuming risk. When a company
increases debt, the financial risk faced by the equity holders also
increases. So, cost of equity increases. Therefore, a company cannot
use debt beyond a point because share price may decrease in spite of
increased EPS.

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10. Flexibility: If a firm uses its debt potential to the full, it loses
flexibility to issue further debt. To maintain flexibility, it must maintain
some borrowing power to take care of unforeseen circumstances.
11. Interest Coverage Ratio (ICR): The higher the ratio, the lower
shall be the risk of company failing to meet its interest payment
obligations.
12. Debt Service Coverage Ratio (DSCR): A higher DSCR indicates
better ability to meet cash commitments.
It raises the company’s potential to increase debt component in its
capital structure.
13. Capital structure of other companies: Debt equity ratios of other
companies in the same industry is a useful
guideline for planning the capital structure. However, it should not follow
the industry norms blindly.

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Financial Planning
The process of estimating the funds requirements of a business
and specifying the sources of funds is called financial planning.
OR Financial planning is the preparation of a financial blueprint
of an organisation’s future operations.
It takes into consideration the growth, performance, investments and
requirement of funds for a given period.
Objectives: (i) To ensure availability of funds whenever required: It
involves estimation of the funds required, the time at which these funds
are to be made available and the sources of these funds. (ii) To see
that the firm does not raise resources unnecessarily as it will
increase the costs and the resources will remain idle.
Importance: (PCS LC W)
1. It helps the company to prepare for the future by forecasting what
may happen in the future under different business situations.
2. It helps in avoiding business shocks and surprises.
3. It helps in co-ordinating various business functions, e.g. sales and
production functions by providing clear policies and procedures.
4. It helps in reducing waste, duplication of efforts, gaps in planning
and confusion.
5. It provides a link between investment and financing decisions. 6.
It serves as a control technique as it makes evaluation of actual
performance easier.
7. It links the present with the future.

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Types of Financial Planning:
(i) Long-term financial planning relates to long term growth and
investment. It focuses on capital expenditure programmes. (ii)
Short-term financial planning covers short-term financial plan
called budget.
Financial Planning Process:
(i) Preparation of a sales forecast: Suppose a company is making
a financial plan for the next five years. Financial planning usually begins
with the preparation of a sales forecast.
(ii) Preparation of financial statements: Based on sales forecast,
the financial statements are prepared keeping in mind the requirement
of funds for investment in the fixed capital and working capital.
(iii)Estimation of expected profits: Then the expected profits during
the period are estimated so that an idea can be made of how much of
the fund requirements can be met internally i.e., through retained
earnings.
(iv) Estimation of sources of external funds: The sources from
which the external funds requirement can be met are identified.
(v) Preparation of cash budget: Cash budgets are made
incorporating the above factors.

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