CBSE Class 12 Business Studies - Financial Management
Financial Management: is concerned with optimum procurement as well as usage of finance.
Financial Management involves decisions relating to-
Procurement of Funds- Funds are procured from different available sources of finance which are:
(a) Issue of shares
(b) Issue of debentures
(c) Banak Loan
(d) Sale of asset
Investment of funds- Funds are invested in a way that business /organization earns a profit. FOR EXAMPLE- Purchase of new machinery
Distribution of earnings to the owners- it refers to how much amount of profits should be distributed to the owners/shareholders as per the profit-sharing ratio and how much amount of profit should be retained in the business for future investment.
Therefore, good Financial Management aims at the mobilization of funds at a lower cost and deployment of these funds in the most profitable activities.
OBJECTIVES OF FINANCIAL MANAGEMENT
The primary objective of financial management is to maximize the shareholder's wealth I.e increasing/maximizing them market value or price of equity shares of the company.
FOR EXAMPLE- the market value of equity shares of Maruti Suzuki India Limited is rs 8500 per share and the market value of equity shares of Tata motors is rs 263 per share. So, as the market value of Maruti Suzuki India Limited is more. Therefore, its shareholder's wealth is also more than Tata motors. By looking at the given data, we can see that 50% of cars are manufactured by mart Suzuki and only 6% are manufactured by Tata Motors.
Therefore, all the Financial decisions should be taken while considering the primary objective I.e maximizing the shareholder's wealth.
In order to maximize shareholders, wealth Financial Management aims at achieving the following specific objectives.
Ensuring availability of funds at a reasonable cost- Funds should be procured at a reasonable cost, keeping the risk into consideration.
FOR EXAMPLE- To raise funds, Maruti Suzuki has 2 options,
1.to take a bank loan @ 14% per annum
2. To issue 12% debentures
So, the cost of the bank loan is 14% and the cost of debentures is 12 %. So, Maruti decides to procure funds baby issuing debenture as it has less cost involved
Ensures Effective Utilisation of Funds- Business finance should be utilized in the most productive manner. so, that a business enterprise is able to cover its cost of capital as well as earn god profit. i.e better results.
FOR EXAMPLE- Maruti Suzuki has 2 options
Plan A: To launch a new SUV
Plan B: To launch a Small Car.
So, by conducting market survey Maruti ensures the demand for a small car is more and its price is less and can be manufactured by the existing Plant and Machinery. While on the other hand the future demand for SUV is more and its price is also more and is required to establish a new Plant and Machinery.
So, by considering all these factors the management of Maruti will decide to invest in Plan A or B.
If Maruti has sufficient funds to establish a new plant, then the managemnt should choose plan A and if it doesn’t have sufficient funds to establish a new plant then it should choose plan B.
Ensuring Safety of Funds- Financial management aim at ensuring the safety of funds procured by creating reserves, reinvesting profits, etc.
Avoiding idle finance- Financial management aims at utilizing business finance in the most profitable manner. I.e avoiding the idle finance because if excess funds are avqailable, it will unnecessarily add to the cost.
FOR EXAMPLE-Maruti Suzuki issued 1000 crores 12% debentures, which involves monthly interest payment of Rs1 crore, so, if the management of Maruti is unable to utilize these funds in a profitable manner, the company will bear a cost of Rs 1 crore per month.
Financial Decisions refers to the decisions concerning financial matters of the business firm.
Financial Matters refers to all those activities which are directly related to money or business finance.
Financial decisions are concerned with three broad categories -
Investment decision relates to how the firm's funds are invested in different assets so that the firm is able to earn the highest possible returns on investment.
An investment decision can be categorized as:
- Capital Budgeting Decisions or Long term investment decisions
- Working capital decisions or short term investment decisions
LONG TERM INVESTMENT DECISION
It refers to decisions relating to an investment in fixed assets.
Purchase of new fixed asset:
FOR EXAMPLE- Tata Motors decided to launch Tata nano in the market, for which they established a new plan in Singur, west Bengal.
Launching a new product:
FOR EXAMPLE- Earlier Apple was manufacturing iPhones and Mac but with time Apple started to manufacture Apple watch which is the worlds no 1 watch not only in smartwatch category but as a wearable watch too.
Investment in advanced techniques of production.
Major Expenditure on an advertising campaign or research and development programme etc.
Since investment in the long term, an asset is called find capital. Therefore, this called the management of fixed capital.
Why the management of fixed capital/investment/ capital budgeting is important?
1. Long term effect on profitability and growth- long term investment decision affect the profitability, growth and competitiveness of the firm in the long run.
FOR EXAMPLE- Every product has its own life cycle, after some time either there is some improvement made to the product or a new product is launched. Like earlier, landline phones were used after that cordless phones were introduced, and then mobile phones and then finally smartphones came into existence. So, just as a product has its product life cycle similarly a company also has its life cycle, like at the time of landline phones BELL was at worlds no1 position, but when mobile phones were introduced Nokia was worlds no1 mobile company and now smartphone category Apple is not just worlds no 1 mobile company but with 1 trillion Dollar of Capital is the worlds largest and wealthy company. Therefore all this was possible for apple just because of good investment decision which affected its profitability and growth.
2. A large number of funds involved- fixed capital decisions involve, the huge outflow of funds blocked in long term projects.
3. The risk involved- Presently, long term investment decision involve huge capital invested by business firms, which increases the return of the firm in the long run. Therefore influencing the overall business risk of the firm.
FACTORS AFFECTING INVESTMENT DECISION
- Rate of return- It is the most important criteria.
FOR EXAMPLE - Maruti Suzuki has 2 options to invest in:
Project A- To launch a small car whose demand is more and requires less investment, at which the company will get a return of 12%.
Project B- To launch a new SUV, whose demand in the future is more and requires more investment. And at which the company will get a return of 15%.
So, as we can see the company will earn more return if funds are invested in project B Therefore, The management should invest in project B.
2. The cash flow of the project- when a company invests huge amount of funds in some projects , it expects regular cash inflows form that project.
FOR EXAMPLE - There are 2 Projects.
Project A- Which involves regular cash inflow of Rs 5 lakhs per year for 4 years.
Project B- Which involves estimated cash inflow of Rs 18 lakh at the end of 4 years.
As project A involves regular and more cash inflow. Therefore, project A should be selected.
3. Investment criteria involved - the decision to invest in a particular project involves a number of calculations regarding :
(a) the amount of investment
(b) interest rate
(c) cash inflow
(d) rate of return
SHORT TERM INVESTMENT DECISION
It Involves decisions relating to investment in current asset like cash, inventories, debtors.
- these decisions affect the liquidity as well as the profitability of the business because shirt term assets are more liquid but lessprofitable.
- Efficient cash management inventory management and receivables management are the essential ingredients of sound working capital management.
Rate of return= profit/investment * 100
Project A- PROFIT= 4,00,00,000
ROR= 4,00,00,000/16,00,00,000*100= 25%
Project B= PROFIT= 2,00,00,000
So, project a should be selected.
Financing Decisions is concerned with about how much funds are to. Be raised from which long term source .i.e shareholders funds or borrowed funds.
Shareholders funds refer to share capital reserves and surplus and retained earnings.
Borrowed funds refers to finance required raised as debentures , long term loans , public deposits etc.
Financing decisions deals with -
- Determination of source of finace- finance manager has to decide the source of finance through which foods are to be procured. i.e shareholders funds or borrowed funds.
- Amount to be raised from each source of finance- finance manager decides the amount to be raised from shareholders fund and borrowed fund.
- Cost of each source of finance- a different source of finance has a different cost involved.
DEBT AND EQUITY DIFFER SIGNIFICANTLY IN TERMS OF COST AND RISK
1. Cost- the cost of debt is cheaper than the cost of equity-
(i)Tax Saving - it involves tax saving because interest is a tax-deductible expense.
(ii) Interest Payment- interest is a fixed payment which has to be paid monthly while dividend paid to shareholders is not a fixed payment.
So, more use of Debt in business finance, lesser the cost of capital.
2.Risk- Debentures are cheaper than equity but they are more riskIer because.
(i) it involves regular /timely interest payment irrespective of the business earns profits or incurs loss
(ii) use of borrowed funds to procure business finance involves repayment of the funds at the time maturity. Therefore, more use of debts in business finance results in high financial risk.
*FINANCIAL RISK- it refers to the chance that a company would fail to meet its payment obligations. I.e interest and principal amount.
While equity is less risky.
- there is no such committed payment of dividend. If the business earns profits then only the management decides either to pay a dividend or to reinvest the same. Or if the business incurs loss then no dividend is paid.
- There is no commitment to repayment of share capital. Only in the case of winding up of the company. Share capital is returned to the shareholders after deducting all the liabilities.
FACTORS AFFECTING FINANCING DECISION
1. COST- different source of finance involves different cost. So, a finance manager should raise funds from that source of finance whose cost is less. Debts are the cheapest source of finance. Because tax is a tax-deductible expense.
2. Risk- Each source of finance involves risk associated with it. Debt is cheaper but it is riskier for a business because it involves interest payment and redeems principal amount at the time of maturity.
3. Floatation cost- It refers to the cost involved in raising funds or issuing securities. So a finance manager should keep in mind the flotation cost involved while procuring funds. Higher the flotation cost less attractive the source is.
4. Cash flow position- if a company has a strong cash flow position then. Debt financing is better than raising funds through equity.
5. Control- raising funds through debts does not cause dilution of management control over the business while raising funds through equity may dilute the management control over the business. so, debt is preferred to equity.
Dividend is that part or profit which is distributed to the shareholders.
Dividend decision relates to how much of the company’s after-tax is to be distributed to the shareholders and how much of it should be retained in the business for meeting the investment requirements
FACTORS AFFECTING DIVIDEND DECISION
1. Earnings- Dividends are paid of current and past earnings. Therefore, earnings are a major determinant of dividend decision.
2. Stability of Earnings- if a business has stable earning then it can declare higher dividend but on the other hand, if the earnings of the business are unstable then less dividend is declared.
Preparation of the financial blueprint of an organisations future operations is called financial planning.
Financial planning means estimating the funds' requirement of a business and determining the sources of funds for current and fixed assets and future expansion prospects.
Financial planning also determines the funds to be raised either from an internal source or external source.
Financial planning includes both long terms as well as short term planning.
- long term financial planning- it relates to long term growth and investment. It is done for 3-5 years.
- Short term financial planning- it relates to detailed plans of action made. It is done for one year or less.
OBJECTIVES OF FINANCIAL PLANNING
Financial planning ensures that funds are available at the right time.
- To ensure availability of funds, whenever required - if adequate funds are not available, the firm will. Not be able to honor its commitments and carry out its plans.
- To see that the firms do not raise funds unnecessarily - if excess funds are available, it will unnecessarily add to the cost and may encourage wasteful expenditure.
IMPORTANCE OF FINANCIAL PLANNING
- Prepares for future challenges- financial planning prepares alternatives financial plans to meet different uncertain events .it makes the firm better prepared to face future and facilities smooth running of the business.
- Helps in avoiding business shocks and surprises- by forecasting the financial requirements, financial planning improves the chances of financial success.
FOR EXAMPLE - building rent, insurance premium, salary, etc.
- Helps in coordination - it helps in achieving coordination between various functions by providing clear policies and procedures.
- Helps in eliminating wasteful efforts - it involves preparation of detailed plans of action. It prevents duplication of efforts and reduces wasteful activities and gaps in planning.
- Helps to link present with future- it links the existing financial resources and future financial requirements by forecasting growth and expansion plans.
Capital structure refers to the mix between owners funds and borrowed funds.
FINANCIAL LEVERAGE- the proportion of debt in the total capital is called financial leverage.
- so, whenever a business uses more debt I.e the financial leverage increases. It will result in a decrease in the cost of capital and increase and profitability and financial risk.
- thus, the capital structure of affects. Both the profitability and financial risk of the business.
- So a business should always try to balance between cost of capital and financial risk.
- A business should always have an optimum capital structure where financial risk is not so high as well as the cost of capital is also low. Therefore, resulting in maximizing shareholders wealth which is the primary objective of any business enterprise.
FACTORS AFFECTING CAPITAL STRUCTURE
1. Risk- every business enterprise has 2 risK-
FINANCIAL RISK- that chance when the firm is unable to pay its payment obligations.i.e interest payment and principal amount.
BUSINESS RISK/OPERATING RISK- it refers to chance when the firm is unable to pay all those operating expenses which are required to run the day to day activities.
- higher the fixed operating cost higher the business risk
- More use of debts means high financial risk
TOTAL RISK= BUSINESS RISK+ FINANCIAL RISK
So, a business total risk depends on business risk and financial risk. Therefore, if the business risk is more so the management should use less proportion of debts so that financial risk is less and the total risk does not increase.
2. Cost of debt- it refers to the expected rate of return of lenders on debt capital for assuming the risk. It is the rate of interest payable on debentures or loans. More debts can be used in capital structure if the rate of interest on the debt is low. Debt is a cheaper source of finance because interest on the debt is a tax-deductible expense.
3. Cost of equity- it refers expected rate of return on equity capital for assuming the risk. It is the dividend paid on shares. When a company increases debt, the financial risk faced by the equity shareholders also increases. Resulting, an increased rate of return. Therefore a company cannot use debt beyond a point. hence, for maximizing shareholders wealth, debts can be used only up to a certain limit.
4. Floatation cost- Process of raising resources also involves some cost. Public issue of shares and debentures requires considerable expenditure. Getting a loan from a financial institution may not cost so much. These considerations may also affect the choice between debt and equity and hence the capital structure.
5. Cashflow position- The business has a good cash position, then it can pay its interest on time, then the management decides to use more debts in capital structure and vice-versa.
6. Control- Debt normally does not cause dilution of control. A public issue of equity may reduce the managements holding in the company and make it vulnerable to takeover. This factor also influences the choice between debt and equity especially in companies in which the current holding of management is on a lower side.
7. Tax rate- interest is a tax-deductible expense. Cost of debt is affected by the tax rate. For example borrowing @ 10%. Since the tax rate is 30%, the after-tax cost of debt is only 7%. A higher tax rate, thus, makes debt relatively cheaper and increases its attraction vis-à-vis equity.
Therefore ,tax = 30% of 90,000= Rs 27000
If there is no debt, tax= 30% of 1,00,000= Rs 30000
thus, tax savings due to debt= 30000-270000=3000
So, net interest payable = Rs 7000, which is 7% of 1,00,000
On, the other hand, dividend Is paid out of after-tax profits. So, it is not a tax -deductible expense.
8. Flexibility- If a firm uses its debt potential to the full, it loses the flexibility to issue further debt. To maintain flexibility, it must maintain some borrowing power to take care of future uncertain situations.
9. Interest coverage ratio- it refers to the number of times profit before interest and tax of a company cover the interest obligation.
Higher the interest coverage ratio lower the risk of failing to pay interest in i.e financial risk.
Interest coverage ratio = PBIT/INTEREST
Interest coverage ratio cannot be taken as a reliable source because it is calculated on accrue basis, therefore, it doesn’t show real cash position.
10. Debt service coverage ratio- Debt Service Coverage Ratio takes care of the deficiencies referred to in the Interest Coverage Ratio (ICR). It is calculated as follows:
A higher DSCR indicates better ability to meet cash commitments and consequently, the company’s potential to increase debt component in its capital structure.
11. Stock market condition- stock market refers to that place where companies shares are marketed. The stock market has 2 phase- (i) bullish (ii) bearish
-If the stock market is bullish, equity shares can be easily issued even at a higher price.
-If the stock market is in its bearish phase, a company may find it difficult to raise equity capital and may use debt as a source of finance.
Fixed capital refers to the proportion of capital invested in long term assets / fixed assets of a firm.
- a fixed capital requirement in different business is different.
- Fixed capital should be procured from long term sources of finances. Such as equity and preference shares, debentures, long term loans, etc.
FOR EXAMPLE - land and building, plant and machinery, furniture and fixtures.
FACTORS AFFECTING FIXED CAPITAL
1. Nature of business- Basically, a business can be divided into 2 types that are, Trading and Manufacturing. A trading concern needs lower investment in fixed assets compared with a manufacturing organization; since it does not require to purchase plant and machinery etc.
2. The scale of operations- A larger organization operating at a higher scale needs the bigger plant, more space, etc. and therefore, requires higher investment in fixed assets when compared with the small organization.
3. Choice of technique- a capital intensive technique requires more investment in plant ad machinery. So, its fixed capital requirement is more. While a labor-intensive technique requires less investment in fixed assets. So, their fixed capital requirement is less.
FOR EXAMPLE - computers become obsolete faster and are replaced much sooner than say airplanes.
4. Technology up-gradation - In some industries, assets become obsolete sooner. Resulting, in their replacements faster. Higher investment in fixed assets may, therefore, be required in such cases. Thus, such organizations which use assets which are prone to obsolescence require higher fixed capital to purchase such asset
FOR EXAMPLE - Indigo Airlines fly more than 180 aircraft. The cost of one airplane is 72 million dollars which are more than Rs 5300 crore rupees, so, the total cost of 180 airplanes will be more than 95 lakh crore. So, instead of spending this much big mount on purchasing an aircraft indigo airlines take these aircraft at the lease and pay monthly lease rental. Due to which it saves its fixed capital.
5. Financing alternatives- When an asset is taken on lease, the firm pays lease rentals and uses it. By doing so, it avoids huge sums required to purchase it. Availability of leasing facilities, thus, may reduce the funds required to be invested in fixed assets, thereby reducing the fixed capital requirements.
So, whenever a company has an option of taking asset on a lease than purchasing it, is known as financing alternatives, which results in less requirement of fixed capital.
6. Growth prospective- higher growth prospects require higher investment in fixed assets. So, the fixed capital requirement also increases.
7. Level of Collaboration- some, business organizations share each others facilities. Such collaboration reduces the level of fixed assets for each firm. So, the fixed capital requirement is less.
FOR EXAMPLE - State Bank of India has 22000 ATM’s and Axis bank has 11,000 ATM’S. Both of the banks have collaborated with each other. So the clients of SBI bank can withdraw money from Axis bank ATM and the client if the Axis bank can withdraw money from SBI ATM, so there is no such requirement of fixing ATM everywhere. Which results in less fixed capital requirement.
It refers to that proportion of capital invested in short term assets/ current assets.
- Current assets as compared to fixed assets are more liquid but less profitable.
- Some part of current assets can be financed through short term sources I.e current liabilities.
- CURRENT LIABILITIES are those payment obligations which are due for payment within one year. I.e bills payable, creditors, etc.
- And the rest is financed through long term sources and is called NETWORKING CAPITAL.
FOR EXAMPLE - cash in hand/ cash at bank, marketable securities, bills receivables, etc.
NETWORKING CAPITAL= Current Assets - Current Liabilities
FACTORS AFFECTING WORKING CAPITAL REQUIREMENTS
Production cycle- production cycle is the time span between the receipt of raw materials and their conversion into finished goods.
- when the production cycle is long, it would require more working capital to meet day-to-day operational expenses.
- when the production cycle is small, less working capital is required.
2. The business cycle- In case of a boom, the sales, as well as production, are likely to be higher, resulting in a higher amount of working capital is required. As against this, the requirement for working capital will be lower during the period of depression as the sales as well as production will be low.
3. Nature of business- A trading business requires less amount of working capital as there is no production involved. On, the contrary, manufacturing is more into production so it has a higher working capital requirement.
4. The scale of operations- A large scale of operation requires a larger amount of working capital as compared to a small scale organization because large organization generally require high quantum of debtors inventory.
5. Credit allowed - different firms have different credit terms. These depend upon the competition that a fir faces as wells the creditworthiness of their client. A liberal credit policy results in a higher amount of debtors, increasing the requirement of working capital.
6. Credit availed- Just as a firm allows credit to its customers it also may get credit from its suppliers. To the extent, it avails the credit on its purchases, the working capital requirement is reduced.
7. Availability of raw material- if raw material and other materials are easily available then there is no need for maintaining its stock, therefore less requirement of working capital. But the raw material is difficult to procure then the stock of raw material is to be maintained which results in high working capital requirement.
8. Level of Competition - Higher level of competitiveness may necessitate higher stocks of finished goods to meet urgent orders from customers. This increases the working capital requirement. Competition may also force the firm to extend liberal credit terms discussed earlier.
9. Seasonal Factors- Most businesses have some seasonality in their production. In the boom season, because of a higher level of production, a higher amount of working capital is required. On, the contrary, the level of activity as well as the requirement for working capital will be lower during the lean season.