UNIT-IV

Concept of Financial Management

1. What is Financial Management?
Financial management is the process of planning, organizing, controlling, and monitoring financial
resources to achieve business goals. It ensures that a company has enough money to operate
efficiently while maximizing profits and reducing risks.
Example:
Imagine you run a small bakery. You need to decide:
 How much money to invest in ingredients and equipment?
 How to price your cakes to earn a profit?
 How to save money for future expansion?
These decisions are part of financial management!

2. Importance of Financial Management

Financial management is important because it helps businesses:
 Ensure sufficient funds – Businesses need money to buy raw materials, pay employees,
and expand.
 Use money wisely – Proper planning helps avoid unnecessary expenses.
Increase profits – Good financial decisions improve revenue.
Manage risks – Helps in handling financial crises or unexpected losses.
Ensure business growth – Helps companies expand and invest in new opportunities.

3. Objectives of Financial Management

1. Profit Maximization – Ensuring the company earns high profits.
2. Wealth Maximization – Increasing the value of the company for shareholders.
3. Proper Utilization of Funds – Avoiding waste and investing wisely.
4. Ensuring Liquidity – Having enough cash for daily operations.
5. Financial Stability – Reducing financial risks and maintaining stability.

4. Functions of Financial Management

A. Investment Decisions (Capital Budgeting)
 Deciding where to invest money to earn good returns.
 Example: A company deciding whether to open a new factory or invest in new
technology.
B. Financing Decisions
 Choosing the best way to raise funds (loans, issuing shares, etc.).
 Example: A business deciding whether to take a bank loan or sell company shares for
expansion.
C. Dividend Decisions
 Deciding how much profit to share with shareholders and how much to reinvest in the
business.
  Example: A company keeping 60% of its profits for business growth and giving 40% as
dividends to shareholders.
D. Working Capital Management
 Managing day-to-day expenses like salaries, rent, and raw materials.
 Example: A retail store ensuring it has enough money to pay suppliers and employees.

5. Sources of Business Finance

A. Internal Sources (Own Money)
1. Retained Earnings – Profits saved from previous years.
2. Owner’s Capital – Money invested by business owners.
3. Sale of Assets – Selling unused machinery, land, or buildings.
B. External Sources (Borrowed Money)
1. Bank Loans – Borrowing money from banks with interest.
2. Issuing Shares – Selling company shares to investors.
3. Bonds & Debentures – Borrowing money from the public for a fixed period.
6. Key Financial Statements
A. Balance Sheet
 Shows a company’s financial position (assets, liabilities, and equity).
 Example: If a company has assets worth $1 million and liabilities worth $500,000, its net
worth is $500,000.
B. Profit & Loss Statement (Income Statement)
 Shows the company’s income and expenses to calculate profit or loss.
 Example: If a business earns $50,000 and spends $30,000, its profit is $20,000.
C. Cash Flow Statement
 Shows how cash moves in and out of a business.
 Example: A company earning $10,000 but having $8,000 in expenses has $2,000 in cash
flow.

7. Financial Management Strategies for Success

 Budgeting – Planning income and expenses to avoid overspending.
 Cost Control – Reducing unnecessary expenses.
 Investment Planning – Choosing the right investments for future growth.
 Debt Management – Borrowing wisely to avoid financial trouble.
 Financial Forecasting – Predicting future income and expenses to make smart decisions.

Capital Structure and Various Sources of Finance

1. What is Capital Structure?
Capital structure refers to how a business finances its operations using different sources of funds,
such as equity (owner’s money) and debt (borrowed money).
Example:
Imagine you want to start a business. You need Rs. 100,000. You can:
  Invest your own money (Rs. 50,000) – This is equity.
 Take a bank loan of Rs. 50,000 – This is debt.
The mix of your own money (equity) and borrowed money (debt) forms your capital structure.

2. Importance of Capital Structure

Helps businesses raise funds efficiently.
Balances risk and profitability.
Ensures financial stability.
Helps in business expansion.
Affects the company's creditworthiness.

3. Components of Capital Structure

A. Equity Capital (Owner’s Funds)
 Money invested by business owners or shareholders.
 No repayment obligation, but owners/shareholders expect profits (dividends).
Types of Equity Capital:
1. Share Capital – Money raised by issuing company shares.
2. Retained Earnings – Profits saved instead of distributing as dividends.
3. Surplus Reserves – Extra funds saved for future investments.
Advantages: No repayment pressure, increases company control.
Disadvantages: Profit-sharing with shareholders, ownership dilution.

B. Debt Capital (Borrowed Funds)

 Money borrowed from external sources like banks and investors.
 Needs to be repaid with interest.
Types of Debt Capital:
1. Bank Loans – Money borrowed from banks at a fixed interest rate.
2. Bonds & Debentures – Company borrows money from the public and repays after a
fixed period.
3. Trade Credit – Buying goods from suppliers on credit.
4. Lease Financing – Renting equipment instead of buying it.
Advantages: Tax benefits, lower cost than equity.
Disadvantages: Fixed repayment obligations, increases financial risk.

C. Hybrid Capital (Mix of Debt & Equity)

 A combination of equity and debt financing.
 Example: A company issues convertible debentures, which can be changed into shares
later.
Advantages: Balances risk and return.
Disadvantages: Complex financial management.

4. Factors Affecting Capital Structure

1. Nature of Business – Manufacturing firms need more debt, while tech firms rely on
equity.
2. Business Size – Large firms get easy access to loans; small firms depend on equity.
3. Cost of Capital – Businesses choose the cheapest financing option.
 4. Risk & Financial Stability – More debt increases financial risk.
5. Control Considerations – Issuing more shares dilutes ownership.
6. Market Conditions – In good economic times, companies raise more equity.

5. Various Sources of Finance

A. Internal Sources of Finance (Own Funds)
1. Retained Earnings – Profits saved for future use.
o ✅ No interest or repayment.
o ❌ Limited amount available.
2. Sale of Assets – Selling unused machinery, land, or property.
o ✅ Quick source of cash.
o ❌ Reduces company assets.
3. Owner’s Capital (Personal Savings) – Business owners invest their own money.
o ✅ No borrowing costs.
o ❌ Risky for the owner.

B. External Sources of Finance (Borrowed Funds)

1. Equity Financing (Raising money from shareholders)
o Issuing Shares – Selling shares to investors.
o ✅ No repayment obligation.
o ❌ Dilutes ownership control.
2. Debt Financing (Borrowing money with repayment terms)
o Bank Loans – Borrowing from banks at fixed interest rates.
o ✅ Easily available for established businesses.
o ❌ Requires collateral (security).
o Debentures & Bonds – Companies borrow from investors and repay later.
o ✅ No ownership dilution.
o ❌ Fixed interest payments required.
o Trade Credit – Suppliers allow businesses to buy goods on credit.
o ✅ No immediate cash needed.
o ❌ Short-term solution.
o Leasing – Renting instead of buying machinery or equipment.
o ✅ Low initial investment.
o ❌ Long-term leasing can be expensive.

C. Government & Special Funding

1. Grants & Subsidies – Free financial aid from the government.
2. Venture Capital – Investors fund startups in exchange for ownership.
3. Angel Investors – Wealthy individuals invest in small businesses.
Advantages: No repayment needed.
Disadvantages: Hard to qualify for funding.
6. Choosing the Right Source of Finance
For Short-Term Needs – Trade credit, bank overdrafts.
For Long-Term Growth – Equity shares, bank loans.
For Startups – Angel investors, venture capital.
For Large Businesses – Bonds, debentures.

Working Capital, Short-Term & Long-Term Finances, and Capital Budgeting

1. What is Working Capital?
Working capital is the money a business needs for its daily operations, such as paying
employees, buying raw materials, and managing inventory.
Formula for Working Capital:
Working Capital=Current Assets−Current Liabilities
Current Assets – Cash, accounts receivable, and inventory.
 Current Liabilities – Short-term debts, accounts payable.
Example:
A business has:
 Current Assets: Rs.50,000 (cash, inventory, receivables).
 Current Liabilities: Rs. 30,000 (suppliers' payments, salaries).
Working Capital=50,000−30,000=20,000
A positive working capital means the business can pay its short-term debts easily, while a
negative working capital means financial trouble.

2. Types of Working Capital

A. Gross Working Capital
 Total current assets of a company.
 Example: Cash, accounts receivable, and stock.
B. Net Working Capital
 Difference between current assets and current liabilities.
 Example: If assets = Rs. 100,000 and liabilities = Rs. 70,000, then net working capital =
Rs.30,000.
C. Permanent Working Capital
 Minimum working capital required to keep the business running.
 Example: A shop must always have stock worth Rs.10,000 to operate.
D. Temporary Working Capital
 Extra working capital needed during peak seasons.
 Example: A toy store needs extra money to buy more stock before Christmas.

3. Short-Term and Long-Term Finances

A. Short-Term Finance
 Used for day-to-day business operations.
 Usually repaid within 1 year.
Sources of Short-Term Finance:
1. Trade Credit – Buying goods now and paying later.
o ✅ No interest cost.
o ❌ Late payments affect supplier relations.
 2. Bank Overdraft – Withdraw more money than available in a bank account.
o ✅ Quick access to cash.
o ❌ High interest.
3. Short-Term Loans – Loans for 3-12 months.
o ✅ Helps cover urgent needs.
o ❌ High repayment pressure.
4. Factoring – Selling invoices to a third party for immediate cash.
o ✅ Immediate cash flow.
o ❌ Less money received than invoice value.

B. Long-Term Finance
 Used for investments, expansion, and buying fixed assets.
 Repayment period more than 1 year.
Sources of Long-Term Finance:
1. Equity Shares – Selling company shares to investors.
o ✅ No repayment obligation.
o ❌ Dilutes ownership.
2. Debentures & Bonds – Borrowing from investors with a fixed repayment period.
o ✅ No ownership dilution.
o ❌ Fixed interest payments.
3. Bank Loans – Loans taken from banks for 5-20 years.
o ✅ Fixed repayment schedule.
o ❌ Requires collateral (security).
4. Venture Capital – Investors fund startups in exchange for ownership.
o ✅ Helps new businesses grow.
o ❌ Loss of some business control.

4. What is Capital Budgeting?

Capital budgeting is the process of planning and deciding long-term investments in projects like
new factories, machinery, or product launches. It helps businesses choose the best investment
option.
Example:
A company has $1 million to invest and is considering two projects:
 Project A: Build a new plant with expected profits of Rs. 2 million in 5 years.
 Project B: Buy new machinery that increases production speed, expected to earn $1.5
million in 5 years.
Capital budgeting helps the company decide which project will bring higher returns and lower
risks.
5. Steps in Capital Budgeting
1. Identify Investment Opportunities – Find projects that need funding.
2. Evaluate and Compare Projects – Use financial calculations to analyze returns.
3. Select the Best Option – Choose the most profitable and least risky project.
4. Allocate Funds – Arrange money for the selected investment.
5. Monitor Performance – Track the project’s success and make adjustments if needed.
6. Capital Budgeting Techniques
A. Payback Period Method
 Measures how quickly an investment pays back its cost.
 Formula:
Payback Period=Initial Investment/ Annual Cash Flow
Example: If a company invests Rs.200,000 and earns Rs. 50,000 per year,
Payback Period=200,000/50,000=4 years
❌ Ignores long-term profits

B. Net Present Value (NPV)

 Measures the value of future profits in today’s money.
 If NPV > 0, the project is profitable.
Example:
 Investment: Rs. 100,000
 Future earnings (discounted to present value): Rs. 120,000
 NPV = Rs. 120,000 – Rs. 100,000 = Rs. 20,000 (Accept project)
✅ Considers future profits
❌ Complex calculation

C. Internal Rate of Return (IRR)

 The rate at which an investment breaks even.
 If IRR > cost of capital, the project is good.
Example:
 Investment: Rs. 50,000
 IRR = 15%
 Cost of capital = 10%
✅ Since 15% > 10%, accept the project
✅ Helps compare projects
❌ Difficult to calculate manually

7. Importance of Capital Budgeting

✔ Helps businesses make smart investment decisions.
✔ Reduces the risk of financial losses.
✔ Ensures long-term profitability and growth.
✔ Helps in efficient fund allocation.