CHAPTER

9
 Financial Management is concerned with:

Optimal procurement as well as the usage of

Finance.
Financial Management aims at:
 Reducing the cost of funds procured,
 Keeping the risk under control and
 Achieving effective deployment of such funds.
 It also aims at ensuring availability of enough funds whenever require.
 As well as avoiding idle finance.
Importance of Financial
Management
1. It determines the size and the composition of fixed assets of the business
2. We can determine the quantum of current assets and its break-up into cash,
inventory receivables etc.
3. The amount of long-term and short- term funds to be used/raised by the
firm.
4. Efficient allocation of long-term financing into debt, equity etc
5. Takes into account all items in the Profit and Loss Account, e.g., Interest,
Expense, Depreciation, etc.
 Financial Decisions

The finance function, is concerned with three broad decisions

which are as below, the types of financial decisions:
i) Investment Decision
ii) Financing Decision
iii) Dividend Decision
 The Investment
Decision
 The investment decision:
It relates to how the firm’s funds are invested in different assets.
Investment decision can be long-term(fixed assets/open a new
branch) or short-term(working capital).

A long-term investment decision is also called a Capital

Budgeting decision. It is very crucial for the business as it
involves huge amount of investment and also affects the earning
capacity of the business in the long run
Factors affecting Capital Budgeting Decision

 (a) Cash flows of the project: Project with maximum cash inflow
is to be selected.
 (b) The rate of return: Project with highest rate of return is to be
selected.
 (c) The investment criteria involved: The amount of investment,
interest rate, cash flows and rate of return involved in each project.
 Financing
Decision

It involves identification of various available sources. The main

sources of funds for a firm are: Shareholders’ funds and Borrowed
funds.
Financing decision is, concerned with the decisions about how much
finance to be raised and from which source.
This decision determines the overall cost of capital and the
financial risk of the enterprise.
 Factors Affecting Financing
Decisions
(a)Cost: A prudent financial manager would normally choose a source which is
the cheapest.
(b)Risk: The risk associated with each of the sources is different.
(c)Floatation Costs: Higher the floatation cost, less attractive the source.
(d)Cash Flow Position of the Company: A stronger cash flow position may
make debt financing more viable than funding through equity.
(e)Fixed Operating Costs: If a business has high fixed operating costs
(e.g., building rent, Insurance premium, Salaries, etc.). If fixed operating cost
is less, more of debt financing may be preferred.
(f)Control Considerations: Decisions regarding Debt and Equity have to be
made. Issues of more equity may lead to dilution of management’s control
 Dividend
Decision

Dividend is that portion of profit which is distributed to shareholders.

The third important decision that every financial manager has to take
relates to the distribution of dividend… how much of the profit earned by
the company(after paying tax) is to be distributed to the shareholders and
how much to be retained in the business. Thus it relates to the
appropriation of profit.
 Factors Affecting Dividend
Decision

 (a) Amount of Earnings: Dividends are paid out of

current and past earning, therefore amount has to be
decided for the distribution.
(b) Stability Earnings: A company having stable
earning is in a better position to declare higher
dividends.
 (c) Growth opportunity: The dividend is smaller in
companies having good growth opportunities.
(d) Cash Flow Position: Availability of enough cash is
necessary for declaring of dividend.
 (e) Shareholders’ Preference: While declaring
dividends, managements must keep in mind the
preferences of the shareholders to get regular dividend.
 (f) Taxation Policy: Shareholders are likely to decide
based the tax policy. They prefer higher
dividends if the tax rates are lesser and vice versa.
 (g) Legal constraints: Certain provisions of the
Companies Act must be adhered to while declaring
 Financial
Planning
 Financial planning is the preparation of a financial blueprint of an
organisation’s future operations.
 The objective of financial planning is to ensure that enough funds are
available at right time.
 The process of estimating the fund requirement of a business and
specifying the source of funds.
 Financial planning aims at smooth operations by focusing on fund
requirements and their availability in the light of financial decisions.
 Objectiv
es
 Financial planning strives to achieve the following twin objectives:

(a)To ensure availability of funds whenever required.

(b)To see that the firm does not raise resources unnecessarily.
 Importan
ce
i)It helps in forecasting on what may happen in future under
different business situations.

ii) It helps in avoiding business shocks and surprises and helps the
company in preparing for the future.

(iii)If helps in co-ordinating various business functions, e.g., sales

and production functions, by providing clear policies and
procedures.
 Cont…

(v)Detailed plans of action prepared under financial planning reduce

waste, duplication of efforts, and gaps in planning.

(vi) It tries to link the present with the future.

(vii)It provides a link between investment and financing decisions

on a continuous basis.
(viii)It makes the evaluation of actual performance easier.
 Capital
Structure
 Capital structure refers to the mix between owners and borrowed funds.
These shall be referred as debt-equity ratio.
Owners’ funds consist of:- Borrowed funds can be in t h e form of:
Equity share capital, Loans,
Preference share capital Debentur
Reserves and surpluses or es
retained earnings
Note: Public
deposits
1. Cost of debt(interest) is lower than the cost of equity(dividend).
etc.
2. Debt is more risky while equity is riskless for a business.
3. Optimal Capital Structure is that combination of debt and equity that
maximizes the market value of the equity shares.
Financial leverage :
The proportion of debt in the overall capital.
Financial leverage= Debt
Equity .

Trading on equity:
It refers to the increase in profit earned by the equity shareholders due to the
presence of fixed financial charges like interest.
It is the situation where companies employ more cheaper debt in their capital
structure to enhance the earning per share(EPS).
 Factors Affecting Capital
Structure
 i. Cash flow position:
The size of the projected cash flows must be considered before
borrowing and deciding the capital structure of the firm. If there is
sufficient cash flow, debt can be used.
 ii. Interest coverage ratio (ICR) :
Higher the Interest coverage ratio, lower shall be the risk of the
company failing to meet its interest payment obligations.
ICR = EBIT
Interest
 iii. Debt Service Coverage Ratio (DSCR):
Here, Cash profits generated are compared with the total cash
 Cont…

iv. Return On Investment(ROI) :

If return on investment of the company is higher, the company can
choose to use trading on equity to increase its EPS, i.e., its ability
to use debt is greater.
 v. Cost Of Debt :
More debt can be used if Debt can be raised at a lower rate of
interest.
 vi. Tax Rate : A higher tax rate makes debt relatively cheaper
and increases its attraction as compared to equity.
 vii. Cost Of Equity(Dividend to be paid): is another factor to
 Cont…

 ix. Risk Consideration:

If a firm‘s business risk is lower, its capacity to use debt is higher
and vice versa.
 x. Flexibility:
Flexibility in borrowing is another factor to be considered.
 xi. Control:
The issue of control over company is also another factor to be
considered.
 x. Capital structure of other companies:
A debt equity ratio of other companies in the same industry may
FIXED AND WORKING CAPITAL
 Fixed
Capital
Fixed capital refers to investment in long-term assets.
Investment in fixed assets is for longer duration and they must
be financed through long-term sources of capital. Decisions
relating to fixed capital involve huge capital funds.
 Factors Affecting Requirement of Fixed Capital
1.Nature of Business: Manufacturing concerns require huge investment
in fixed assets & thus huge fixed capital is required for them but trading
concerns need less fixed capital as they are not required to purchase
plant and machinery etc.
2.Scale of Operations: An organization operating on large scale
requires more fixed capital as compared to an organization
 Cont..

 4. Technology upgradation: Organizations using assets which become

obsolete faster require more fixed capital as compared to other
organizations.
 5. Growth Prospects: Companies having more growth plans require
more fixed capital. In order to expand production capacity more plant &
machinery are required.
 6. Diversification: In case a company goes for diversification then it will
require more fixed capital to invest in fixed assets like plant and
machinery.
 7. Distribution Channels: The firm which sells its product through
wholesalers and retailers requires less fixed capital.
 Working
Capital

Working Capital refers to the capital required for day to day

working of an organization. Apart from the investment in fixed
assets every business organization needs to invest in current
assets, which can be converted into cash or cash equivalents
within a period of one year.
 They provide liquidity to the business.
Working capital is of two types – Gross working capital and Net
working capital.

 Investment in all the current assets is called Gross Working Capital

 Factors which affect working
capital requirements of an
organization:
 l. Nature of Business: A trading organization needs a lower amount of
working capital as compared to a manufacturing organization, as
trading organization undertakes no processing work.
 2. Scale of Operations: An organization operating on large scale
will require more inventory and thus, its working capital requirement
will be more as compared to small organization.
 3. Business Cycle: In the time of boom more production will be
undertaken and so more
working capital will be required during that time as compared to
depression.
 4. Seasonal Factors: During peak season demand of a product
will be high and thus high working capital will be required as
 Cont…

 5. Credit Allowed: If credit is allowed by a concern to its customers

than it will require more working capital but if goods are sold on cash
basis than less working capital is required.
 6. Credit Availed: If a firm is able to purchase raw materials on credit
from its suppliers than less working capital will be required.
 7. Inflation: Working capital requirement is also determined by price
level changes. For example, during inflation prices of raw material,
wages also rise resulting in increase in working capital requirements.
 8. Operating Cycle/Turnover of Working Capital: Turnover means
speed with which the working capital is converted into cash by sale of
goods. If it is speedier, the amount of working capital required will be
The
End