Financial Management - CBSE Class 12 Business Studies

Introduction
Financial Management refers to the strategic planning, organizing, directing, and controlling
of financial activities such as procurement and utilization of funds. It plays a crucial role in
ensuring that a business has adequate funds for its operations and growth. Effective
financial management helps a business maximize its profits while minimizing risks and
uncertainties.

Functions of Financial Management

Financial management is concerned with decision-making related to funds. The main
functions include:

1. **Investment Decision (Capital Budgeting):** It involves deciding where to allocate the

available resources for maximum profitability. This includes evaluating different
investment opportunities such as purchasing new machinery, expanding operations, or
investing in new projects.
**Example:** A manufacturing company deciding whether to buy automated machines to
increase production capacity.

2. **Financing Decision (Capital Structure):** This decision involves determining the best
source of financing for the company, whether through equity (shares), debt (loans), or a mix
of both. A proper balance between debt and equity is necessary to ensure financial stability.
**Example:** A company choosing between issuing new shares to raise money or taking a
bank loan.

3. **Dividend Decision:** This decision determines how much profit should be distributed
to shareholders as dividends and how much should be retained for future growth. A
company with high expansion plans may retain more profits, while a stable company may
offer higher dividends.
**Example:** A company earning ₹50 lakh profit may decide to distribute ₹20 lakh as
dividends and retain ₹30 lakh for expansion.

4. **Working Capital Management:** Managing short-term assets and liabilities to ensure

smooth business operations. It includes handling cash, inventory, and receivables
efficiently.
**Example:** A retailer ensuring they have enough stock before the festive season while
maintaining sufficient cash flow.

Financial Decisions
A company makes financial decisions in three major areas: investment, financing, and
dividends. These decisions determine the financial health and future prospects of the
business.
1. Investment Decision
Investment decisions involve selecting the best avenues to invest the company's funds to
maximize returns. This decision is divided into two categories:

• **Fixed Capital Decisions:** These involve long-term investments in assets such as land,
buildings, and machinery. Since these investments require huge funds and impact the
company for a long time, they need careful analysis.
**Example:** A car manufacturing company investing in a new assembly plant.

• **Working Capital Decisions:** These involve short-term investments in assets like raw
materials, finished goods, and cash. Working capital ensures that the company has sufficient
funds to meet daily expenses.
**Example:** A grocery store maintaining an adequate stock of goods to meet customer
demand.

2. Financing Decision
This decision involves determining how a company will raise the required capital for its
business activities. It includes choosing between different sources of finance like equity
(share capital), debt (loans), or a mix of both.

• **Equity Capital:** Raised by issuing shares to investors. It does not have to be repaid but
involves sharing profits with shareholders.
**Example:** A startup raising funds by selling shares to angel investors.

• **Debt Capital:** Raised by taking loans or issuing debentures. It must be repaid with
interest, increasing financial risk.
**Example:** A company taking a ₹10 crore loan from a bank to build a new factory.

3. Dividend Decision
This decision determines how much profit will be given to shareholders as dividends and
how much will be retained for future growth. A higher dividend may please shareholders
but could reduce funds for expansion.

Factors affecting dividend decisions include:

• **Profitability:** Higher profits allow higher dividends.

• **Growth Prospects:** Companies planning expansion may retain more earnings.
• **Legal Constraints:** Government regulations may restrict dividend payouts.

**Example:** A software company experiencing high growth may decide to reinvest most of
its profits into product development instead of distributing dividends.

Financial Planning
Financial planning ensures that the company has the right amount of funds at the right time
to achieve its goals. It involves estimating future financial needs and developing strategies
for fund allocation.
 **Example:** A retail business forecasting its budget for inventory purchases before the
holiday season.

Capital Structure
Capital structure refers to the mix of debt and equity used to finance a company’s
operations. A balanced capital structure helps maintain financial stability while minimizing
risks.

**Example:** A company may have 60% equity and 40% debt to maintain a low risk of
bankruptcy.

Factors Affecting Capital Structure

Several factors influence a company’s capital structure:

• **Cash Flow Position:** A company with strong cash flows can afford to take more debt.
• **Cost of Debt:** High-interest rates make debt financing expensive.
• **Market Conditions:** Economic downturns may limit a company's ability to raise funds
through equity.

Fixed Capital and Working Capital

1. Fixed Capital
Fixed capital refers to funds invested in long-term assets required for the business to
operate. These investments are essential for production and expansion.

Factors affecting fixed capital:

• **Nature of Business:** Manufacturing firms need more fixed capital than service firms.
• **Technology Used:** Advanced technology requires higher investment.

**Example:** A steel factory investing in new furnaces for production.

2. Working Capital
Working capital is the capital needed to manage daily operations such as paying wages,
buying raw materials, and handling receivables.

Factors affecting working capital:

• **Credit Terms:** Longer credit periods require more working capital.

• **Inventory Management:** A company holding more stock needs higher working
capital.

**Example:** A supermarket maintaining a large inventory of perishable goods.

Conclusion
Financial management is essential for the success of any business. Proper financial planning
and decision-making help a company achieve stability, profitability, and growth. By
managing investment, financing, and dividend decisions wisely, a company can maximize
shareholder value and ensure long-term success.